InvestmentPlanningWeek8 - FSU Certificate in Financial...

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FSU Certificate in Financial Planning Investment Planning © Florida State University Page 1 Lecture Title: Week 8: Compounding, Yields, Duration, Bond Portfolios, Preferreds, Features and Valuation of Convertibles Week 8: Valuation of Fixed-Income Securities & Convertibles Introd uctio n In 1973, a fellow named Philip Morrison wrote in Technology Review magazine: "The human mind can be described as a slow-clockrate modified-digital machine with multiple distinguishable parallel processors, all working in salt water." Who knows exactly what that means, but if you're beginning to feel this way, especially the salt-water part, take heart; we are moving to the study of bonds this week. Yes, good old simple, reliable, understandable bonds. I'm hoping that after you've worked your way through the minefield of stock analysis and valuations, this will feel like slipping on a comfortable pair of bedroom slippers. Objectives At the end of this lecture, you will be able to: 1. Determine the factors that affect a bond's price. 2. Explain the reasoning for an inverse relationship between interest rates and bond prices. 3. Articulate the differences between current yield, yield to maturity, and yield to call. 4. Illustrate the relationship between a bond's duration and its price volatility. 5. Describe the features of convertible bonds and convertible preferred stock. Lecture Presentation Chapter 14 Perpetual bonds are quite rare, but Mayo uses them to illustrate a basic component of the valuation of bonds. On page 454 he takes us all the way around the block to get next
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FSU Certificate in Financial Planning Investment Planning © Florida State University Page 2 door, but ultimately we learn the current value of an infinite stream of interest is the payment divided by the interest rate. It's very easy to understand the inverse relationship between interest rates and bond prices once you know that bonds are priced so their yields are the same. When market interest rates rise, bond prices decline; when they fall, bond prices rise. Most bonds have a stated maturity, at which time the face value of the bond (which is sometimes generally referred to as principal) is returned to the investor. The current price of a bond must also consider this return of principal.
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FSU Certificate in Financial Planning Investment Planning © Florida State University Page 3 Therefore the price of any bond (within a risk class) is primarily related to the following: 1. Interest the bond pays 2. Interest rates on comparable bonds available to the investor 3. Maturity date of the bond Let me reiterate something I've indicated since the beginning of this course. The text was written to give students the ability to learn how to solve time value of money problems through the use of formulas, rate tables, and the financial calculator. It's fine for you to learn all of these methods and if time is an abundantly available resource for you, feel free to do so. Those of you with limited time desiring to learn the most efficient and expedient method should use the financial calculator whenever possible. The basic
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