468-3 - Chapter 3 - INTEREST RATES AND SECURITY VALUATION...

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Chapter 3 - INTEREST RATES AND SECURITY VALUATION 1. INTEREST RATE MEASURES Coupon Interest Rate: The interest rate that determines a bond's annual or semi-annual coupon CF or payment. Required Rate of Return (rrr): The interest rate an investor should receive given its risk (default, liquidity, etc.). The rrr is used to discount future CFs to determine the Fair Present Value (FPV) of a security. Generally the current market price (P) should equal the FPV, (P = FPV). If P < FPV, the security is undervalued, if P > FPV it's overvalued. Expected Rate of Return (Err): Yield on a security bought at the current market price and held for a desired period. Compare Err vs. rrr: If Err > rrr, P < FPV and security is ________________ . Buy or not? If Err < rrr, P > FPV and security is ________________. Buy or not? Example: 4 year bond with $100 PMTS, expected value of $960 in YR 4. Market Price is $925, what is the Err? N I* PV PMT FV 4 ______ (925) 100 960 If the rrr is 11.25%, what is the Price? N I PV* PMT FV 4 11.25 _______ 100 960 Therefore, rrr (11.25%) < Err (11.607%) and the P ($925) < FPV ($935). Buy or not? Points: 1) Err and rrr are both ex ante (before the fact) interest rates. 2) When market are efficient, securities are priced fairly and efficiently to reflect all available information, and P = FPV and rrr = Err. Securities would only be undervalued or overvalued infrequently and temporarily. Why? Realized Rate of Return (rr) is the actual, ex post (after the fact) return on an investment, looking back with complete information about the original Price, the actual CFs, actual reinvestment rate, actual selling Price, etc. Example : You buy a bond for $890 with $100 annual CFs and sell it in two years for $925: BUS 468 / MGT 568: FINANCIAL MARKETS – CH 3 Professor Mark J. Perry 1
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rr N I* PV PMT FV 2 ______ (890) 100 925 2. BOND VALUATION (Example 3-4, p. 67) Coupon Bonds. Bond with a 10% coupon rate, semiannual payments, face value of $1000 and maturity of 12 years. rrr = 8% N I PV* PMT FV 24 4 ________ 50 1000 rrr = 10% N I PV* PMT FV 24 5 ______ 50 1000 rrr = 12% N I PV* PMT FV 24 6 _________ 50 1000 Notice: 1. When rrr = Coupon Rate, bond sells at par, P = $1000. 2. When rrr < Coupon Rate, bond sells at a premium, P > $1000. 3. When rrr > Coupon Rate, bond sells at a discount, P < $1000.
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468-3 - Chapter 3 - INTEREST RATES AND SECURITY VALUATION...

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