Chapter 04: The Pricing of

Financial Assets
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I. Background
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II. Present Value
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III. Maturity and Price Sensitivity
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IV. Holding Period v. Maturities
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V. Return v. Yield
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VI. Duration
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VII. Nominal v. Real Yields
 I. Background
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The pricing of real estate is similar to a share of common stock, which gets value
from the cash payments that will be paid to its own at different points over time.
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The current value is based on the payments of cash to the investor at different
points in the future.
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The valuation process is complicated by the fact that the cash flows paid to the
owner of an asset contribute to the current value of that asset to different
degrees, depending on when they are paid.
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Assets are valued based on an underlying principle: The current price of an
asset is the present value of all future cash flows to which the owner is entitled.
 I. Background
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The value between the money today and the value in the future
is called time value of money. A currency today is worth more in
the future. This is because complex interaction between the
reluctance of people to save today – that is, preference to
consume now, sometimes called time preference impatience –
and the ability to business to put these saved funds to good use
in generating future value.
II. Present Value
 A. Value of a Single Future Payment
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For single user payment the following formula can be used:

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For example, if a payment of $ 1,000 will be made in 2 years
and the current interest rate is 5% we will have the following:
 Example No. 2
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In another example, the present value of $ 100,627 in 30 years at an 8%
interest rate:

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A particularly popular form of single-payment instrument is the zero-
coupon security. In cases where there is a sale of this type of instrument
by the treasury to its initial buyer, it contains semi-annual payments for
the life of the security and a payment of principal at maturity. Dealers
acquire these securities and remove each payment of interest or principal.
 A. Value of a Single Future Payment
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Some investors favor zero-coupon securities over because they
foresee a need for cash in the future to be concentrated at a
single time. Some institutions also hold these securities in
preparation for pension funds, anticipating cash payments to
retirees.
 Example No. 3
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You won the lottery for the prize of $ 600,000 today, or $ 1 million in 10
years. If the discount rate is 7% will you take the $600,000 or decide
to get it after 10 years with $ 1 million.

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In this case we will take the $ 600,000 currently because after 10
years the value of $ 1,000,000 is only $ 508,349.35. It is worth more
than the present value of the cash price presented.
 A. Value of a Single Future Payment
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At lower interest rates its better to get the $ 1 million in 10
years. Try computing this with an interest rate of lets say 2% ($
820,348.30
 B. Value of a Coupon Security
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Most treasury securities and corporate bonds provide their
owners with coupon payments (twice) each year until maturity
and then payment of principal at maturity
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The cash flows for the first few years are only equivalent
payments while the last year includes the principal amount of
the bond.
 Example 01
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The value of the corporate bond with a principal of $ 100,000,
coupon payments of $ 6,000 per year, an interest rate of 8%,
and a maturity of 5 years, How much is the present value?
 B. Value of a Coupon Security
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While the amount of each interest payment is the frame ($ 6000), its
contribution to the value of this bond diminishes as the payment is
made farther into the future.
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The present value of this bond ($ 92,105.97) is less than its principal
or par value of $ 100,000. This is not always the case. It depends on
the current interest rate used to discount the cash flows is higher or
lower than the bond’s coupon rate. The coupon rate of 6% can be
computed by 6,000/100,000 or monthly payments divided by the
principal. In this case 8% is larger than the coupon rate which results
in the present value being below the par value.
 C. Other Applications
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You can use this equation also in real properties, especially if you want to determine
the price you are willing to pay to buy an apartment building or for an apartment
building.
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For example, you have seen a beautiful building in downtown Manhattan that can be
used for an apartment. You have determined that this will provide cash flows of $
100,000 per year after expenses, beginning in 5 years, and you will be able to sell the
building for $ 1 million in 10 years. Determine the present value.
 D. The Special Case of Consol
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Since the eighteenth century, the British have issued a bond
that has no specified maturity – it has perpetual coupon. The
equation below can be used to determine the value of bonds, if
one regards the coupons to be paid for an unlimited period
(mathematically speaking to infinity). The equation is:
 D. The Special Case of Consol
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This can be very useful expression for deriving quick
approximations for values of assets pay steady cash flows for
very long periods of time.
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Example: A commercial building that is fully leased out under a
very long-term lease is expecting to provide its owner $ 500,000
year and the current interest rate is 8% provide a rough
estimate of the value of building:
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$ 500,000/0.08 = $ 6,250,000 or $ 6.25 million
 III. Maturity and Price Sensitivity
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The price of financial instrument with a longer maturity will be
more sensitive to a given-sized change in interest rates than the
price of a short-term instrument.
 Example
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For example, we have two instruments having different maturities. 1 year and 10 year
instrument. The current interest rate is 5 percent for each instrument. The 1-year
instrument will pay $ 105 in a year, while the 10-year plus $ 100 at maturity. Both
instruments have a current price of $ 100. Find the price of the 1 year instrument:
 Example
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Should the interest rate increase to 10%, the decline in the
price of the 10-year note would be considerably larger than that
of the 1-year instrument.
 III. Maturity and Price Sensitivity
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The impact of the same increase in the interest rate on the price
of a consol, with an indefinite maturity, would be even greater
than that of a 10 year note.

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At an interest rate of 10 percent, the price declines to:
 III. Maturity and Price Sensitivity
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The impact of a change in interest rates will be larger for a zero-
coupon security than for a coupon security for the same
maturity. A single payment of $ 162.89 in 10 years would, at the
interest rate have the following present value:
 IV. Holding Period v. Maturities
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An investor’s holding period – the length of time before the investor expects to need the
cash from the investment – need not be the same as the maturity of the investment.
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When the holding period and the maturity are not the same, the investor is exposed to a
risk.
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If the holding period exceeds the maturity, then the investor is exposed to reinvestment
or rollover risk. In this case reinvestment is required.
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Alternatively, the investor could have acquired an instrument with a maturity that
exceeds the holding period, thereby becoming exposed to price (interest rate) risk.
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When the maturity of the investment exceeds the investors holding period, the investor
is exposed to price risk, and when the maturity is shorter than the holding period, the
investor is exposed to reinvestment risk.
 V. Return v. Yield
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The return of an investment will be its yield to maturity if the
instrument is held to maturity.
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If the investment is held for less than its maturity, the investor is
likely to experience a capital gain or loss because interest rates
are likely to be higher or lower than at the time of investment.
 Example
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An investor have a 5-year instrument having 4% yield to maturity. When the interest
rates rise, he sold the instrument in just 3 years at a loss of 6%. The lost has been
pro-rated at 2% for the 3 years. The return of investment would be 2% per year. This
can be expressed formally in the formula:

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This means the return equals the annual yield on the asset plus the capital gain
divided by the number of years the asset is held.
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The concept of return can be applied to investments other than interest-earning
investments. Common stocks have a tendency to appreciate over time, and thus
capital gains can be an important component of their investment return.
 VI. Duration
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The concept of duration is related to maturity. This is a weighted average
of the maturities of the cash flows that an investor is scheduled to receive.
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It can be expressed algebraically below:

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In this expression, D represents the instrument’s during in years, w
represents the weight attached to the first cash flow provided by the
instrument, t represents the time into the future when the first cash flow is
paid the investor (in years of fractions thereof).
 VI. Duration
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In practice, the weights, are the share price (present value) of
the instrument accounted for the corresponding cash flow:
 VI. Duration
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Extending to the terms, the equation now becomes:
 Example
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A has an instrument which is a 5 year note that pays a coupon
annually, beginning in a year. The coupon rate is 5% the current
interest rate is 4% and the par value is $ 100 find the present
value of the payments and the duration.
 Getting the Duration
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The result has given the notion that the bond is selling above
par value at $ 104.44. This is because the current interest rate
is 4% which is below the coupon rate of 5%. Using the provided
solution above we can now plug the formula to get the duration.
The result is units in years.
 VI. Duration
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Note that the maturity of this note is 5 years while its duration is less. This is because four of
the six cash flows are received prior to maturity and the weight attached to the last cash flow
associated with 5 years is less than 100%.
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In the provided example, the weight attached to maturity of the cash flow – 5 years – is 0.826.
This means that the weight of shorter maturities is at 0.174.
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This resulted to the weighted maturity of the cash flow of the instrument is less than the
maturity. The longer the maturity of the instrument, all else the same, the greater will be its
duration.
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In case of a zero-coupon instrument, there is only one cash flow and that is at maturity. As a
consequence, the duration of a zero coupon security will be the same at its maturity. As a
consequence, the duration of a zero-coupon security will always be the same as its maturity,
then the weights attached to all cash flows up to and including t will be zero. All of weight will be
attached to it. Thus, D will be the same as the maturity.
 Example
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In the previous calculation of the 5 year instrument, should the
interest rate increase to 7 percent from 4 percent, the present
value of cash flows would decline to:

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This resulted in a fall below par at $ 91.79. Because of the
change we can compute the duration as per below:
 VI. Duration
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A third feature is that the longer the duration of an instrument, the more
sensitive its price to a change on interest rates. This can be seen by
comparing the 5-year zero coupon security – having a duration of 5
years. When the interest rates rose, the price of the instrument fell.
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A final feature worth noting is, the duration of a portfolio of instruments is
equal to a weighted average of all the individual instruments making up
the portfolio where the weights represent the shares of each instrument
in the portfolio. In this examples if we have two investments this will lead
to 7.5 years. Computed as 0.5 x 5 years x 10 years.
 VIII. Nominal v. Real Yields
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Interest rates such as rates on mortgages of a car or loan interest on retail CD – are
nominal interest rates.
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Nominal interest rates does not have adjustments based on inflation.
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The actual return to the investor, in terms of the purchasing power of the interest
payment would only cover the deterioration in the purchasing power of the principal. For
example, if one invested the funds a 5% interest rate and inflation turned out to be 5%
the investors payments would only cover the deterioration in the purchasing power of the
principal.
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The so-called real return or real interest rate would be zero. If instead, inflation were to
be 3 percent over the year, the real interest rate would be 2 percent. This can be
expressed in the formula I = r + P where I is the nominal interest rate, r is the real
interest rate and P is the rate of inflation.
 VIII. Nominal v. Real Yields
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Subtracting the actual rate of inflation from the nominal interest rate results in the ex-post
real rate of interest.
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In practice, markets are forward looking and investors will be seeking compensation for
the loss of purchasing power based on their expectations of what inflation will be over
the life of the financial instrument. Thus we can still use where P is the expected
inflation.
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This states that the nominal interest rate plus the expected rate of inflation. This is the
expected or ex ante real rate of interest.
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It is thought that saving and spending decisions are based more on real interest rates
than nominal rates. For example, a business contemplating undertaking a capital rise
with inflation and will view its actual financing cost to be the nominal interest rate less its
expectations of inflation.