Fernandez College of Arts and Technology

Baliuag Bulacan

FINMAR – FINANCIAL MARKET

MODULE 3: Interest Rates and Security Valuation

I. LEARNING OBJECTIVES:
1. Understand the differences in the required rate of return, the expected rate of return,
and the realized rate of return.
2. Calculate bond values.
3. Calculate equity values.
4. Appreciate how security prices are affected by interest rate changes.
5. Understand how the maturity and coupon rate on a security affect its price sensitivity
to interest rate changes.
6. Know what duration is.
7. Understand how maturity, yield to maturity, and coupon rate affect the duration of a
security.
8. Understand the economic meaning of duration.

II. TOPIC OUTLINE:

• Introduction
• Various Interest Rate Measures
• Bond Valuation
• Equity Valuation

III. LESSON PROPER

INTRODUCTION

With this understanding of how and why interest rates change, in this module we apply time value
of money principles to the valuation of specific financial securities, paying particular attention to the
change in a security’s value when interest rates change. We examine how characteristics specific to
a financial security (e.g., coupon rate and remaining time to maturity) also influence a financial
security’s price. Duration, which measures the weighted-average time to maturity of an asset or
liability, using the present values of the cash flows as weights, also has economic meaning as the
sensitivity of an asset or liability’s value or price to a small interest rate change. The valuation and
duration models reviewed in this module are used by traders to determine whether to transact in the
various financial markets.

◼ VARIOUS INTEREST RATE MEASURES

The term interest rates can actually have many different meanings depending on
the time frame used for analysis and the type of security being analyzed.

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➢ Coupon Rate
One variation on the meaning of the term interest rate specific to debt instruments is the coupon
rate paid on a bond. As discussed in detail in the next section, the coupon rate on a bond instrument
is the annual (or periodic) cash flow that the bond issuer contractually promises to pay the bond
holder. This coupon rate is only one component of the overall return (required, expected, or realized
rate of return) the bond holder earns on a bond, however. As discussed below, required, expected,
or realized rates of return incorporate not only the coupon payments but all cash flows on a bond
investment, including full and partial repayments of principal by the issuer.

➢ Required Rate of Return

Market participants use time value of money equations to calculate the fair present value of a
financial security over an investment horizon. As we discussed in Chapter 2 and will see later in this
chapter, this process involves the discounting of all projected cash flows 2 (CF s) on the security at
an appropriate interest rate. (For easy reference to the notation used in this chapter, we list and
define all variables used in this chapter at the end of the chapter.) The interest rate used to find the
fair present value of a financial security is called the required rate of return ( r ). This interest rate is a
function of the various risks associated with a security (discussed in Chapter 2) and is thus the interest
rate the investor should receive on the security given its risk (default risk, liquidity risk, etc.). The
required rate of return is thus an ex ante (before the fact) measure of the interest rate on a security.
The present value ( PV ) is determined by the following formula:

Once a PV is calculated, market participants then compare this present value with the current
market price ( P ) at which the security is trading in a financial market. If the current market price of
the security ( P ) is less than its fair value ( PV ), the security is currently undervalued. The market
participant would want to buy more of this security at its current price. If the current market price of
the security is greater than its present value, the security is overvalued. The market participant would
not want to buy this security at its current price. If the present value of the security equals its current
market price, the security is said to be fairly priced given its risk characteristics. In this case, PV equals
P.

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➢ Expected Rate of Return
The expected rate of return , E ( r ), on a financial security is the interest rate a market participant
expects to earn by buying the security at its current market price ( P ), receiving all projected cash
flow payments ( CF s) on the security, and selling the security at the end of the participant’s
investment horizon. Thus, the expected rate of return is also an ex ante measure of the interest rate
on a security. However, the expected rate of return on an investment is based on the current market
price rather than fair present value. As discussed above, these may or may not be equal. Again, time
value of money equations are used to calculate the expected rate of return on a security. In this case,
the current market price of the security is set equal to the present value of all projected cash flows
received on the security over the investment

Once an expected rate of return, E ( r ), on a financial security is calculated, the market participant
compares this expected rate of return to its required rate of return ( r ). If the expected rate of return
is greater than the required rate of return, the projected cash flows on the security are greater than
is required to compensate for the risk incurred from investing in the security. Thus, the market
participant would want to buy more of this security. If the expected rate of return is less than the
required rate of return, the projected cash flows from the security are less than those required to
compensate for the risk involved. Thus, the market participant would not want to invest in the
security. We summarize these relationships in Table 3–2 .

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➢ Realized Rate of Return
Required and expected rates of return are interest rate concepts pertaining to the returns expected
or required just prior to the investment being made. Once made, however, the market participant is
concerned with how well the financial security actually performs. The realized rate of return ( r ) on a
financial security is the interest rate actually earned on an investment in a financial security. The
realized rate of return is thus a historical interest rate of return—it is an ex post (after the fact)
measure of the interest rate on the security. To calculate a realized rate of return ( r ), all cash flows
actually paid or received are incorporated in time value of money equations to solve for the realized
rate of return. By setting the price actually paid for the security ( P ) equal to the present value of the
realized cash flows ( RCF1 , RCF2 , . . . , RCFn ), the realized rate of return is the discount rate that
just equates the purchase price to the present value of the realized cash flows.

If the realized rate of return ( r ) is greater than the required rate of return ( r ), the market participant
actually earned more than was needed to be compensated for the ex ante or expected risk of
investing in the security. If the realized rate of return is less than the required rate of return, the
market participant actually earned less than the interest rate required to compensate for the risk
involved.

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◼ BOND VALUATION
➢ Bond valuation is a technique for determining the theoretical fair value of a particular bond.
Bond valuation includes calculating the present value of a bond's future interest payments, also
known as its cash flow, and the bond's value upon maturity, also known as its face value or par
value.

➢ Understanding Bond Valuation

A bond is a debt instrument that provides a steady income stream to the investor in the form of
coupon payments. At the maturity date, the full face value of the bond is repaid to the bondholder.
The characteristics of a regular bond include:

Coupon rate: Some bonds have an interest rate, also known as the coupon rate, which is paid to
bondholders semi-annually. The coupon rate is the fixed return that an investor earns periodically
until it matures.

Maturity date: All bonds have maturity dates, some short-term, others long-term. When a bond
matures, the bond issuer repays the investor the full face value of the bond. For corporate bonds, the
face value of a bond is usually $1,000 and for government bonds, the face value is $10,000. The face
value is not necessarily the invested principal or purchase price of the bond.

Current price: Depending on the level of interest rate in the environment, the investor may purchase
a bond at par, below par, or above par. For example, if interest rates increase, the value of a bond will
decrease since the coupon rate will be lower than the interest rate in the economy. When this occurs,
the bond will trade at a discount, that is, below par. However, the bondholder will be paid the full
face value of the bond at maturity even though he purchased it for less than the par value.

➢ Coupon Bond Valuation

Calculating the value of a coupon bond factors in the annual or semi-annual coupon payment and
the par value of the bond.

The present value of expected cash flows is added to the present value of the face value of the
bond as seen in the following formula:

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➢ Yield to Maturity (YTM) – otherwise referred to as redemption or book yield – is the speculative
rate of return or interest rate of a fixed-rate security, such as a bond. The YTM is based on the
belief or understanding that an investor purchases the security at the current market price and
holds it until the security has matured (reached its full value), and that all interest and coupon
payments are made in a timely fashion.

How YTM is Calculated

YTM is typically expressed as an annual percentage rate (APR). It is determined through the use
of the following formula:

Where:

C – Interest/coupon payment
FV – Face value of the security
PV – Present value/price of the security
t – How many years it takes the security to reach maturity

The formula’s purpose is to determine the yield of a bond (or other fixed-asset security) according to
its most recent market price. The YTM calculation is structured to show – based on compounding –
the effective yield a security should have once it reaches maturity. It is different from simple yield,
which determines the yield a security should have upon maturity, but is based on dividends and not
compounded interest.

Example
Assume that there is a bond on the market priced at $850 and that the bond comes with a face value
of $1,000 (a fairly common face value for bonds). On this bond, yearly coupons are $150. The coupon
rate for the bond is 15% and the bond will reach maturity in 7 years.

The formula for determining approximate YTM would look like below:

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The approximated YTM on the bond is 18.53%.

Importance of Yield to Maturity

The primary importance of yield to maturity is the fact that it enables investors to draw comparisons
between different securities and the returns they can expect from each. It is critical for determining
which securities to add to their portfolios. It’s also useful in that it also allows the investors to gain
some understanding of how changes in market conditions might affect their portfolio because when
securities drop in price, yields rise, and vice versa.

➢ Zero-Coupon Bond Valuation

A zero-coupon bond makes no annual or semi-annual coupon payments for the duration of the bond.
Instead, it is sold at a deep discount to par when issued. The difference between the purchase price
and par value is the investor’s interest earned on the bond. To calculate the value of a zero-coupon
bond, we only need to find the present value of the face value.

Following our example above, if the bond paid no coupons to investors, its value will simply be:

$1000 / (1.03) 4 = $888.49

Under both calculations, a coupon-paying bond is more valuable than a zero-coupon bond.

◼ EQUITY VALUATION
The valuation process for an equity instrument (such as preferred or common stock) involves finding
the present value of an infinite series of cash flows on the equity discounted at an appropriate
interest rate. Cash flows from holding equity come from dividends paid out by the firm over the life
of the stock, which in expectation can be viewed as infinite since a firm (and thus the dividends it
pays) has no defined maturity or life. Even if an equity holder decides not to hold the stock forever,
he or she can sell it to someone else who in a fair and efficient market is willing to pay the present
value of the remaining (expected) dividends to the seller at the time of sale. Dividends on equity are
that portion of a firm’s earnings paid out to the stockholders. Those earnings retained are normally
reinvested to produce future income and future dividends for the firm and its stockholders. Thus,
conceptually, the fair price paid for investing in stocks is the present value of its current and future
dividends. Growth in dividends occurs primarily because of growth in the firm’s earnings, which is, in
turn, a function of the profitability of the firm’s investments and the percentage of these profits paid
out as dividends rather than being reinvested in the firm. Thus, earnings growth, dividend growth,
and stock value (price) will generally be highly correlated.

1. Zero Growth Dividend Discount Model – This model assumes that all the dividends that are paid
by the stock remain one and the same forever until infinite.

Example:
If a preferred share of stock pays dividends of $1.80 per year, and the required rate of return for
the stock is 8%, then what is its intrinsic value?

Solution:

Here we use the dividend discount model formula for zero growth dividend,

Dividend Discount Model Formula = Intrinsic Value = Annual Dividends / Required Rate of Return

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Intrinsic Value = $1.80/0.08 = $22.50.

2. Constant Growth Dividend Discount Model – This dividend discount model assumes that
dividends grow at a fixed percentage annually. They are not variable and are constant
throughout.

Example:
If a stock pays a $4 dividend this year, and the dividend has been growing 6% annually, then
what will be the intrinsic value of the stock, assuming a required rate of return of 12%?

Solution:

DDM Formula - Constant Growth Rate

D1 = $4 x 1.06 = $4.24

Ke = 12%

Growth rate or g = 6%

Intrinsic stock price = $4.24 / (0.12 – 0.06) = $4/0.06 = $70.66

3. Variable Growth Dividend Discount Model or Non-Constant Growth – This model may divide
the growth into two or three phases. The first one will be a fast initial phase, then a slower
transition phase, a then ultimately ends with a lower rate for the infinite period.

REFERENCES:

BOOKS/REFERENCES:
Anthony Saunders and Marcia Millon Cornett, Financial Markets and Institutions, sixth edition

https://www.investopedia.com/terms/b/bond-valuation.asp
https://www.wallstreetmojo.com/dividend-discount-model/
https://corporatefinanceinstitute.com/resources/knowledge/finance/yield-to-maturity-ytm/

Prepared by:

Myrna C. Calma, CPA, Ph.D.

Associate Professor