NATIONAL ECONOMICS UNIVERSITY

SCHOOL OF BANKING AND FINANCE

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CHAPTER 2
SECURITIES AND VALUATION

SECURITIES MARKET DEPARTMENT

1
 MAIN CONTENT

2.1. Overview

2.2. Types of securities

2.3. Bond valuation

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 2.1. Overview

Securities means instruments evidencing

their holders' legitimate rights and benefits
to the assets or capital shares of issuing
organizations. Securities take the form of
certificates, book entries or electronic
data, and are divided into the following
types:
a/ Stocks, bonds, fund certificates;
b/ Rights, warrants, call option, put
option, futures, securities classes or
indexes
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 2.1. Overview

• Characteristics
– Marketable
+ Possibility of convertibility
+ quickly to be sold
+ Assurance of value
– Risky
+ possibility of a decline in stock value
– Profitability
+ possibility of making a profit

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 2.1. Overview

• Systematic risk (market or nondiversifiable risk): affect

most firms
– Cannot be eliminated by diversification
– Consist of war, pandemic, inflation, recession, high interest rate
• Unsystematic risk ( company-specific, diversifiable risk):
affect a particular firm
- Can be eliminated by diversification
- Divide into 3 types:
+ Business risk: related to riskiness of the firm’s operations
+ Financial risk: related to firm’s decision to use of debt
+ Managerial risk: related to competence and experience of a manager

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 2.2. Types of securities

Based on
characteristics

Debt Equity Derivative

securities securities securities

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 2.2. Types of securities

Based on
marketability

Bearer security Registered security

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 2.2. Types of securities

Based on
income

Fixed Variable
income income Hybrid
securities securities

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 2.2. Types of securities
A bond is a security that obligates the issuer
to make specified interest and principal
payments to the holder on specified dates

A stock represent ownership shares in a

corporation

A derivative security is a financial contract

whose value is derived from an underlying
asset.
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 Features of Bond
• Bonds do not represent ownership in a
corporation.
• Bond owners receive priority over
stockholders when it comes to repayment if
the company that issues the bond goes out of
business.
• Bonds are classified as a fixed income
investment.
• This means that the bond will generate a
fixed amount of interest income.
• Bonds are typically considered to be safer
investments than stocks.

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 Types of Bond (based on issuer)
• Government Bonds
✓ Treasury Bills (Gilts)
▪ No coupons (zero coupon security)
▪ Face value paid at maturity
▪ Maturities up to one year
✓ Treasury Notes
▪ Coupons paid semiannually
▪ Face value paid at maturity
▪ Maturities from 2-10 years

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 Types of Bond (based on issuer)
• Government Bonds
✓ Treasury Bonds
▪ Coupons paid semiannually
▪ Face value paid at maturity
▪ Maturities over 10 years
▪ The 30-year bond is called the long bond.

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 Types of Bond (based on issuer)
• Corporate Bonds
✓ Secured Bonds (Asset-Backed)
▪ Secured by real property
▪ Ownership of the property reverts to the
bondholders upon default.
✓ Debentures
▪ General creditors
▪ Have priority over stockholders, but are
subordinate to secured debt.

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 Types of Bond (based on issuer)
• Corporate Bonds
✓ Secured Bonds (Asset-Backed)
▪ Secured by real property
▪ Ownership of the property reverts to the
bondholders upon default.
✓ Debentures
▪ General creditors
▪ Have priority over stockholders, but are
subordinate to secured debt.

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Types of Bond (based on types of payment)
• Pure Discount or Zero-Coupon Bonds
✓Pay no coupons prior to maturity.
✓Pay the bond’s face value at maturity.
• Coupon Bonds
✓Pay a stated coupon at periodic
intervals prior to maturity.
✓Pay the bond’s face value at maturity.

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 Types of Bond (based on issuer)
• Annuity bond: a fixed-rate bond that pays
out the same amount of cash every year
over its lifetime
• Perpetual Bonds (Consols)
✓No maturity date.
✓Pay a stated coupon at periodic
intervals.

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 Preferred stock
• A hybrid security that has characteristics of both
bonds and common stock
• Stated dividend must be paid before dividends
can be paid to common stockholders.
• Dividends are not a liability of the firm, and
preferred dividends can be deferred indefinitely.
• Most preferred dividends are cumulative – any
missed preferred dividends have to be paid
before common dividends can be paid.
• Preferred stock generally does not carry voting
rights

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 Types of preferred stock
• Cumulative
• Callable
• Convertible
• Participating

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 Common stock

• Equity securities/ equities

• Represent ownership shares in a corporation

• Shareholders are the legal owners of a

corporation

– Receive dividend

– Voting right

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 Derivatives
• A derivative security is a financial
contract whose value is derived from an
underlying asset.
Examples:
– A stock option’s value depends upon the
value of a stock on which the option is written.
– A gold futures contract’s value depends on
gold’s spot price (price for buying “now”)

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 Derivatives

• Rights

• Warrants

• Forwards

• Futures

• Options

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 2.3. Bond valuation
• Book value: value of an asset as shown
on a firm’s balance sheet
• Liquidation value: the dollar sum that
could be realized if an asset were sold
individually and not as part of a going
concern.
• Market value: the observed value for the
asset in the marketplace
• Intrinsic or economic value: also called
fair value—the present value of the
asset’s expected future cash flows.

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 2.3. Bond valuation
• Par value: face value of the bond,
returned to the bondholder at maturity
• Interest rate: The percentage of the par
value of the bond that will be paid out
annually in the form of interest.
• Coupon Payment: The coupon payments
represent the periodic interest payments
from the bond issuer to the bondholder.

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 2.3. Bond valuation
• Original Maturity
The time from when the bond was issued until its
maturity date.

• Remaining Maturity
The time currently remaining until the maturity
date.
• Maturity
The length of time until the bond issuer
returns the par value to the bondholder and
terminates or redeems the bond.

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 2.3. Bond valuation
• Yield to Maturity: To measure the
bondholder’s expected rate of return, we
would find the discount rate that equates
the present value of the future cash flows
with the current market price of the bond.
• YTM and expected rate of return are used
interchangeably when referring to bonds.

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 2.3. Bond valuation
• Current Yield
The ratio of the interest payment to the
bond’s current market price.
Current Yield = Annual interest payment/current
market price of the bond

Example: A $1,000 bond with 8% coupon rate and

market price of $700
Current yield = $80 / $700 = 11.4 %

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 2.3. Bond valuation
• Bond valuation
– Coupon bond
– Annuity bond
• Denote:
Par value : M
Interest rate : i (%/năm)
Required rate of return : k
Maturity : m
Remaining maturity : n

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 Bond valuation
• Step 1: Determine the stream of expected
returns (cash flows Ct)
• Step 2: Determine the required rate of
return k
• Step 3: Calculate the present value (PV)

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 Bond valuation formula

• Coupon bond
Coupon: I = i * M
I I I I+M

0 1 2 3 n

𝑃𝑉
𝐼 𝐼 𝐼 𝑀
= 1
+ 2
+ ⋯+ 𝑛
+
(1 + 𝑘) (1 + 𝑘) (1 + 𝑘) (1 + 𝑘)𝑛

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 Bond valuation formula

• Coupon bond
𝑛
𝐼𝑡 𝑀
𝑃𝑉 = ෍ 𝑡
+
(1 + 𝑘) (1 + 𝑘)𝑛
𝑡=1

𝐼[ 1+𝑘 𝑛 −1] 𝑀
=>𝑃𝑉 = +
𝑘(1+𝑘)𝑛 (1+𝑘)𝑛

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 Bond valuation formula
• Annuity bond

a a a a

0 1 2 3 n

𝑎 𝑎 𝑎
𝑃𝑉 = 1
+ 2
+ ⋯+
(1 + 𝑘) (1 + 𝑘) (1 + 𝑘)𝑛

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 Bond valuation formula
• Annuity bond
𝑎[ 1 + 𝑘 𝑛 − 1]
𝑃𝑉 =
𝑘(1 + 𝑘)𝑛

𝑖 × 𝑀 × (1 + 𝑖)𝑚
𝑎=
(1 + 𝑖)𝑚 −1

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 Relationships in bond valuation
• Relationship 1: Bond prices are
inversely related to interest rates (or
yields).
• Relationship 2 :
• k > i => PV < M
• k < i => PV > M
• k = i => PV = M

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 Relationships in bond valuation
• Relationship 3: bond market price gets
close to its face value when maturity
approaches

Required PV
rate of Change
return n=5 n=2

7% 1041.001 1018.08 -22.92

8% 1000 1000 0
9% 961.103 982.41 21.305

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 Relationships in bond valuation

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 Relationships in bond valuation
• Relationship 4: Longer term bonds are
more sensitive to changes in interest rates
than shorter term bonds
PV
Required rate
of return m=5 m=10

7% 1123.01 1273.24

10% 1000 1000

13% 894.48 806.13

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 Relationships in bond valuation

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 Relationships in bond valuation
• Relationship 5:
– Sensitivity to interest rate changes of bond price
depends not only on maturity but also type of
payments
For the same coupon rate, long-term bonds will have a larger price
change than bonds with shorter-terms (that means long bonds are
more sensitive to interest rate changes than short bonds).
For the same maturity, bonds with lower coupon rate will have a larger
price change than bonds with higher coupon rate (that means low
coupon rate bonds are more sensitive to interest rate changes than
high coupon rate bonds).

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 Relationships in bond valuation
• Duration: measures the interest rate sensitivity of the bond

𝒕 × 𝑪𝒕
σ𝒏𝒕=𝟏
(𝟏 + 𝒌)𝒕
𝑫=
𝑷𝟎
n: remaining maturity
Ct: cash flow of year t
k: investor’s required rate of return
P: bond market value

Modified D = D/(1+k) (years)

The percentage price changes of a bond due to D = - modified D *

percentage changes in interest rate

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 Relationships in bond valuation

• Convexity
t∗(1+t)×Ct
σn
t=1 (1+k)t+2
C= (years)
P0

The percentage price changes of a bond due to C = ½

convexity * (the percentage changes in interest rate)2

• The percentage changes in price of a bond

= The percentage price changes of a bond due to D +
The percentage price changes of a bond due to C

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 Calculating Yield to Maturity

• Trial and Error: Keep guessing until you find the rate
whereby the present value of the interest and principal
payments is equal to the current price of the bond.
(necessary procedure without a financial calculator or
computer). => Interpolation
• Easiest Approach: Use a computer or financial
calculator. Note, however, that it is extremely important to
understand the mechanics that go into the calculations

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 Calculating Yield to Maturity

PV
𝑷𝑽𝟏 −𝑷𝑽𝟎
𝒌𝟎 = 𝒌𝟏 + × (𝒌𝟐 − 𝒌𝟏 )
𝑷𝑽𝟏 −𝑷𝑽𝟐
PV1
Or
PV0

PV2

k1 k0 k2 k

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 Accrued interest and bond pricing
between coupon date

Accrued interest = annual coupon payment * days since last

coupon payment/days separating coupon payment
Of which:
- days since last coupon payment: number of days since the last
coupon payment date.
- days separating coupon payment: the number of days in the
coupon payment period (360)
- number of days in a month: 30
Accrued interest and bond pricing between coupon date
Accrued interest and bond pricing
between coupon date
 Accrued interest and bond pricing
between coupon date

Invoice price = flat price + accrued interest

Of which
- Invoice price (dirty price/ full price): Price paid to buy a bond
between coupon periods
- flat price (quoted price/ clean price): PV of cash flows at the
coupon period.
d interest and bond pricing between coupon date
 2.4. Equity valuation

Preferred stock

Common stock

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 Preferred stock valuation
𝒏
𝑫 𝑫
𝑷𝑺 = ෍ 𝒕
=
(𝟏 + 𝒌) 𝒌
𝒕=𝟏
Where:
• 𝑃𝑆 : Preferred stock value
• D : dividend
• k: required rate of return

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 Common stock valuation

Basic types of
model
Discounted Relative
cashflow valuation

DDM DCF P/E P/BV P/CF P/S

FCFE

FCFF

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 Dividend Discount Model

• No growth
𝒏
𝑫 𝑫
𝑷𝑽𝒄𝒔 = ෍ =
(𝟏 + 𝒌)𝒕 𝒌
𝒕=𝟏
–𝑃𝑆 : common stock price
–D : dividend
–k: required rate of return

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 Dividend Discount Model

• 1 year holding period:

𝐷1 𝑃1
𝑃𝑠 = +
(1 + 𝑘𝑐𝑠 ) (1 + 𝑘𝑐𝑠 )
• 2 year holding period
𝐷1 𝐷2 + 𝑃2
𝑃𝑠 = +
(1 + 𝑘𝑐𝑠 ) (1 + 𝑘𝑐𝑠 )2

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 Dividend Discount Model
• Constant growth model (g = perpetual
growth rate in dividends)
Dn = Do(1 + g)n
Pn = Po(1 + g)n
𝑔 = 𝑅𝑂𝐸 × 𝑏
b: retention rate
𝐷1
𝑃𝑠 =
(𝑘𝑐𝑠 − 𝑔)

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 Dividend Discount Model:
• 2 – stage discount model

g1

g2

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 Dividend Discount Model
𝐷0 ×(1+𝑔1 ) 𝐷0 ×(1+𝑔1 )2
• 𝑃𝑠 = + +…+
(1+ 𝑘𝑐𝑠 ) (1+ 𝑘𝑐𝑠 )2
𝐷0 ×(1+𝑔1 )𝑥 𝑃𝑥
𝑥 +
(1+ 𝑘𝑐𝑠 ) (1+ 𝑘𝑐𝑠 )𝑥
𝐷0 × 1+𝑔1 𝑥 (1+𝑔2 )
• 𝑃𝑥 =
(𝑘𝑐𝑠 −𝑔2 )

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 Other method

• FCF
• Relatives valuation method (: P/E.
P/CF,..)

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 Summary
• Securities and different types of securities
• Definition and characteristics of securities
• Bond, preferred stock, common stock,
derivatives
• Bond valuation
• Preferred stock valuation
• Common stock valuation
• Dividend Discount Model

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