FINA 3080

Investment Analysis and

Portfolio Management
Prof. Chao Ying
Lecture 5A
Bond Pricing Relationships

FINA 3080 Prof. Chao Ying 1

 Bond Pricing Relationships
1. Inverse relationship between price and yield.
2. An increase in a bond’s YTM results in a smaller price decline
than the gain associated with a decrease in yield.

T = maturity
Coupon Par Value
Bond Price = ∑t =1 (1 + r ) t
+
(1 + r )T

FINA 3080 Prof. Chao Ying 2

∆P
T = maturity
Coupon Par Value
Bond Price = ∑t =1 (1 + r ) t
+
(1 + r )T
P

ΔY

Compare A and B (only differ in maturity):

3. Long-term bonds tend to be more price sensitive than
short-term bonds: larger impact for more-distant cash flow

FINA 3080 Prof. Chao Ying 3

 T = maturity
Coupon Par Value
∆P Bond Price = ∑ (1 + r ) t
+
(1 + r )T
t =1

ΔY

Compare A and B (maturity 6 times but price change <6)

4. As maturity increases, price sensitivity increases at a
decreasing rate.
FINA 3080 Prof. Chao Ying 4
 T = maturity
Coupon Par Value
∆P Bond Price = ∑ (1 + r ) t
+
(1 + r )T
t =1

ΔY

Compare B and C (only differ in coupon rate)

5. Price sensitivity is inversely related to a bond’s coupon
rate: lower-coupon bond has greater sensitivity ✓
FINA 3080 Prof. Chao Ying 5
 T = maturity
Coupon Par Value
∆P Bond Price = ∑t =1 (1 + r ) t
+
(1 + r )T
P

ΔY

Compare C and D (only differ in YTM)

6. Price sensitivity is inversely related to the yield to
maturity at which the bond is selling.
FINA 3080 Prof. Chao Ying 6
 Price sensitivity: Summary
• Larger price sensitivity T = maturity
Coupon Par Value
– Larger maturity Bond Price = ∑
t =1 (1 + r ) t
+
(1 + r )T
– Lower coupon bond
– Lower initial YTM

Can be used for

All of these affect the bond’s went
duration! >
linear
approximation
Effective Maturity (duration) is a major determinant of interest
rate risk.

FINA 3080 Prof. Chao Ying 7

 Rules for Duration

Rule 1. The duration of a zero-coupon bond equals its

time to maturity.
FINA 3080 Prof. Chao Ying 8
 Rules for Duration

Rule 2. Holding maturity constant, a bond’s

duration is lower when the coupon rate is higher.
FINA 3080 Prof. Chao Ying 9
 Rules for Duration

%:::::
in Financial

Rule 3. Holding the coupon rate constant, a bond’s

duration generally increases with maturity
(except for deep-discounted bond, i.e., r>> coupon rate).
FINA 3080 Prof. Chao Ying 10
 Rules for Duration

Rule 4. Holding other factors constant, the duration of a

coupon bond is higher when the bond’s YTM is lower. ✓
FINA 3080 Prof. Chao Ying 11
 Rules for Duration
Rule 1. The duration of a zero-coupon bond equals its
time to maturity.
Rule 2. Holding maturity constant, a bond’s duration is
lower when the coupon rate is higher.
Rule 3. Holding the coupon rate constant, a bond’s
duration generally increases with maturity
(except for deep-discounted bond, i.e., r>> coupon rate).
Rule 4. Holding other factors constant, the duration of a
coupon bond is higher when the bond’s YTM is lower.
Rule 5. The duration of a perpetuity is:
(1+YTM)/YTM
FINA 3080 Prof. Chao Ying 12
 FINA 3080
Investment Analysis and
Portfolio Management
Prof. Chao Ying
Lecture 5B
Introduction to Valuing Equity

FINA 3080 Prof. Chao Ying 13

 Lecture 5B Overview
• Concepts behind equity valuation
– Claim on assets’ residual cash flows (CFs)
– Estimating the CFs and discount rate is difficult
• Different models & measures for valuing equity
– Book values and liquidation values
– Observed market value
– Intrinsic values
• Estimating equity (stock) value
– Using the dividend discount model (DDM)

FINA 3080 Prof. Chao Ying 14

 Valuing Equity
• Asset value is E(PV of CF on assets)
– It is the value of equity plus the value of debt

• Valuing equity is harder than valuing bonds

– The cash flow amounts and timing are unknown
• These include dividends, share repurchases
and/or resales
– The discount rates are difficult to determine

FINA 3080 Prof. Chao Ying 15

 Four Measures of Equity Value
• Book value: net wealth in balance sheet
– Ignores expected NPV of current/future projects
– Only current value without considering future growth (
Not
) accurate

• Liquidation value: the remaining value to shareholder

when
only
after selling its assets and repaying its debt ( liquidation happens]
accurate

but firm DIVE

liquidation
after

• Market value: market price* total share outstanding

. - -

– Market-clearing price is determined by demand and supply

• Intrinsic value: E(PV of CFs) at required return
– Efficient market hypothesis (EMH): Price = Value

FINA 3080 Prof. Chao Ying 16

 Limitations of Book Value
• Book value is an application of arbitrary
accounting rules
– different regions have different accounting rules.
- -
-

• Can book value represent a floor for stock price?

– Book value does not consider future growth
– No. Honda’s market price below book value in 2019.

FINA 3080 Prof. Chao Ying 17

 Limitations of Book Value: Better approaches

• Liquidation value:
/
– the remaining value to shareholder after selling its
Range
of Mkt assets and repaying its debt

rake
• Replacement cost:
– The money that builds the same company
– Higher than liquidation value: P(new car)>P(old car)

FINA 3080 Prof. Chao Ying 18

 The boundaries of Market Value
Replacement Cost

Market
Value
Liquidation Value
• LV>MV: buy all the stocks and liquid company; many
arbitragers buy stocks so that price increases
• RC<MV: build another same firm and make it IPO, sell
shares at market value; More selling lower price.
• Harder to arbitrage from overpricing in reality
FINA 3080 Prof. Chao Ying 19
 Intrinsic Value vs. Market Price
• Intrinsic Value
– Self assigned Value from a specific valuation model
– Different models generate different intrinsic results

• Market Price: determined by demand and supply

– Consensus value of all potential traders

• Trading Signal
– IV > MP: undervalue and Buy ( * ᵗ¥¥k÷tE¥t¥* )
– IV < MP: overpriced and Sell or Short Sell
– IV = MP: Hold or Fairly Priced

FINA 3080 Prof. Chao Ying 20

 Dividend Discount Model (DDM)
• Idea: investors value the cash flows from equity
• What about firms that don’t pay dividends?
– Perhaps they will disburse cash eventually
– If they’ll never pay CFs, they’re worthless
∞
Dt V0 = Value of Stock
Vo = ∑ Dt = Dividend
t =1 (1 + k )
t
k = required return
T= infinite (no default)
21
FINA 3080 Prof. Chao Ying
 Dividend Discount Model (DDM)
• Dividend Discount Models (Intrinsic values)
∞
Dt
– Constant growth model Vo = ∑
t =1 (1 + k ) t

– No growth model: preferred stocks (fixed)

– Multi-stage growth model

FINA 3080 Prof. Chao Ying 22

 Constant Growth Model
• If we assume
– Dividends today are equal to D0
– Dividends grow at a constant rate g per year forever
– Investors discount dividends at the risky discount rate k
• Then value V0 can be calculated
∞
Dt D0 (1 + g ) D0 (1 + g ) 2 D0 (1 + g ) 3
Vo = ∑ V0 = + + + ...
t =1 (1 + k )
t
(1 + k ) (1 + k ) 2
(1 + k ) 3

D0 (1 + g )
V0 =
k−g
23
FINA 3080 Prof. Chao Ying
 DDM Example
• Suppose the following
– A stock pays dividends equal to $1.00 today
– Investors expect dividends to grow at 5% forever
– Investors require returns of 10% forever
𝐷𝐷0 ∗ 1+𝑔𝑔 1∗ 1+5%
• Then 𝑉𝑉0 = = = 21
𝑘𝑘−𝑔𝑔 10%−5%
• If the expected growth rate fell to 2%...
1∗ 1+2%
– the value fall to 𝑉𝑉0 = = 12.75
10%−2%
• If required returns fall, then the value goes up
FINA 3080 Prof. Chao Ying 24
 Can Growth (g) Exceed the Discount Rate (k)?

𝐷𝐷0 ∗ 1 + 𝑔𝑔
• formula 𝑉𝑉0 = fails for this case, but…
𝑘𝑘 − 𝑔𝑔

• … this case isn’t possible

– It would imply the firm will forever grow faster than
all other firms in the economy
– Eventually, the firm would become the economy
• Natural economic forces slow growth
– Competition
– Diminishing returns to scale

FINA 3080 Prof. Chao Ying 25

No Growth Model (g=0): Example
Preferred stock pays a fixed dividend
D0 (1 + g ) D0 Perpetuity
Vo = =
k−g k
D0 = $5.00
k = .15
V0 = $5.00 / .15 = $33.33
26
FINA 3080 Prof. Chao Ying
 Multi-Stage Growth Models
• More realistic to assume growth varies over time
• Realism complicates the formulas
• Example of a two-stage growth DDM
– Growth is 12% for 3 years and 5% thereafter
– Current dividend is $2 and the discount rate is 10%
D1 D2 D3 + V3 𝐷𝐷0 ∗ 1+𝑔𝑔1 3 (1+𝑔𝑔2 )
V0 = + + 𝐷𝐷3 ∗ 1+𝑔𝑔2
𝑉𝑉3 = 𝑘𝑘−𝑔𝑔 =
(1 + k ) (1 + k ) 2
(1 + k ) 3 2
3
2∗ 1+0.12 (1+0.05)
𝑘𝑘−𝑔𝑔2

= =59.01
2.81 + 59.01
0.1−0.05
2.24 2.51
V0 = + 2
+
(1.10) (1.10) (1.10) 3
V0 = 2.04 + 2.07 + 2.11 + 44.33 = $50.55
27
FINA 3080 Prof. Chao Ying
 FINA 3080
Investment Analysis and
Portfolio Management
Prof. Chao Ying
Lecture 5C
Midterm Review
(open the Midterm review sheet)
FINA 3080 Prof. Chao Ying 28
 Stock Index (Value/Price/Equal weighted)

• Market price stock A/B/C: 10, 20, and 25.

• Total shares: 100, 200, and 300
• You have 1000 dollars in total. 4 stocks in exam
• Value weighted:
– 10*100+20*200+25*300=12500
10∗100 20∗200 25∗300
– 𝑤𝑤𝐴𝐴 = = 8%; 𝑤𝑤𝐵𝐵 = = 32%; 𝑤𝑤𝐶𝐶 = = 60%
12500 12500 12500
– 𝑀𝑀𝐴𝐴 = 1000 ∗ 8% = 80; 𝑀𝑀𝐵𝐵 = 1000 ∗ 32% = 320; 𝑀𝑀𝐶𝐶 = 1000 ∗
60% = 600;
80 320 600
– 𝑆𝑆𝐴𝐴 = = 8; 𝑆𝑆𝐵𝐵 = = 16; 𝑆𝑆𝐶𝐶 = = 24
10 20 25

FINA 3080 Prof. Chao Ying 29

 Stock Index (Value/Price/Equal weighted)

• Market price stock A/B/C: 10, 20, and 25.

• Total shares: 100, 200, and 300
• You have 1000 dollars in total.
• Price weighted (buy the same share for each):

– 1000/(10+20+25) =18.18 shares of each stock

– 𝑀𝑀𝐴𝐴 = 18.18 ∗ 10 = 181.8; 𝑀𝑀𝐵𝐵 = 18.18 ∗ 20 = 363.6; 𝑀𝑀𝐶𝐶 = 18.18 ∗

25 = 454.5

FINA 3080 Prof. Chao Ying 30

 Stock Index (Value/Price/Equal weighted)

• Market price stock A/B/C: 10, 20, and 25.

• Total shares: 100, 200, and 300
• You have 1000 dollars in total.
• Equal weighted (invest same amount money):

– 1000/3 =333.33 dollars on each stock

333.33 333.33 333.33

– 𝑆𝑆𝐴𝐴 = = 33.33; 𝑆𝑆𝐵𝐵 = = 16.67; 𝑆𝑆𝐶𝐶 = = 13.33
10 20 25

FINA 3080 Prof. Chao Ying 31

 Building Bonds from Zeros
• Suppose an investor wants to buy 100 T-notes
– A 6% coupon rate; A 2-year maturity; Par = $1,000

0 6 12 18 24

30*100 30*100 30*100 (30+1000)*100

• Replication: the investor could, instead, buy Par = 1000

– 3 of each of the following Zeros
• Zero-coupon bonds: 6-month, 12-month and 18-month
– And 103 shares of 2-year Zeros

FINA 3080 Prof. Chao Ying 32

 HPR: Reinvestment and Resale

Year 0 Year 20 Year 30

10
(1+6%)20 −1 75 1000
75 ∗ =2,758.92 966.45 = � +
6% (1 + 8%)𝑡𝑡 (1 + 8%)10
𝑡𝑡=1
show eqt .

,
then Fin .
calculator

FINA 3080 Prof. Chao Ying

 Example of Forward Rates
• 3-year YTM y3=7%; 2-year YTM y2=6%
• Two equivalent 3-year strategies
• Buy a 3-year zero
• or buy a 2 year zero and roll over into 1 year
zero at year 2 at forward short rate f3
• (1+y3)3=(1+y2)2 * (1+f3) f3=9.02%
•(1+yn)n=(1+ym)m * (1+f)n-m ; where 𝑛𝑛 > 𝑚𝑚

FINA 3080 Prof. Chao Ying 34

 Convexity (Hard)
Convexity implies that duration predictions:

I. Underestimate the percentage increase in bond price when the

yield falls.
II. Underestimate the percentage decrease in bond price when
the yield rises.
III. Overestimate the percentage increase in bond price when the
yield falls.
IV. Overestimate the percentage decrease in bond price when
the yield rises.
A) I and III only
B) II and IV only
C) I and IV only
°
D) II and III only

FINA 3080 Prof. Chao Ying

 Convexity (Hard)
Convexity implies that duration predictions:

I. Underestimate the percentage increase in bond price

when the yield falls.
II. Underestimate the percentage decrease in bond price when
the yield rises.
III. Overestimate the percentage increase in bond price when the
yield falls.
IV. Overestimate the percentage decrease in bond price
when the yield rises.
A) I and III only
B) II and IV only
C) I and IV only
D) II and III only

FINA 3080 Prof. Chao Ying

 Passive Bond Management
Banks and other financial institutions can best
manage interest rate risk by ________.

A) maximizing the duration of assets and minimizing

the duration of liabilities
B) minimizing the duration of assets and maximizing
the duration of liabilities
C) matching the durations of their assets and
liabilities
D) matching the maturities of their assets and
liabilities

FINA 3080 Prof. Chao Ying

 Passive Bond Management
Banks and other financial institutions can best
manage interest rate risk by ________.

A) maximizing the duration of assets and minimizing

the duration of liabilities
B) minimizing the duration of assets and maximizing
the duration of liabilities
C) matching the durations of their assets and
liabilities
D) matching the maturities of their assets and
liabilities

FINA 3080 Prof. Chao Ying

 The Midterm
1. Plot the timeline
2. Specify the cash flow
3. Write down the related equations
4. Write down how you calculate each
number

5. Otherwise, no partial credits

FINA 3080 Prof. Chao Ying 39

 The Midterm
• Time and location: Lee Shau Kee Building (LSK) LT5
from 7 pm to 8:30 on October 17

• If you have any conflicts, please tell me today (Oct 10th)

before 11:59 pm with related documents. I will not
accept late notice.

• The TA will assign the seats and please bring the

calculator and your school ID

FINA 3080 Prof. Chao Ying 40