B8306

Capital Markets & Investments

Security, NPV & IRR, Yield History

Professor Xuelin Li

9/10/2023 Capital Markets – Fall 2023 – Xuelin Li 1

Today’s Class:

1. Security types
2. PV, NPV, and IRR
3. The History and Term Structure of Bond Yields

9/10/2023 Capital Markets – Fall 2023 – Xuelin Li 2

Security Types
❑ A financial asset is a claim to a series of cash flows
❑ Value (asset) = Value of “cash flows” (or “payoffs”)
▪ We will (mostly) assume that investors buy financial assets only so they can receive the future
cash flows (or sell the asset)

Financial Asset: Cash Flow Characteristics:

Zero Coupon Bond One certain payoff in the future
Coupon Bond Series of certain payoffs
Stock Series of uncertain payoffs
Derivative Security Contingent uncertain payoffs

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Compounding
❑ If you invest $1 for n years at rate r you get:
𝐹𝑉 = $1 × 1 + 𝑟 𝑛
❑ In finance, interest rate is always written in an annual base
❑ But it can be paid out multiple times in that given year (N = 1 in the following example)
Annual: 1 + 0.05 𝑁 = 1.05
(5% per year)
0.05 2×𝑁 2
Semi-annual: 1+ = 1.025 = 1.050625
2
(2.5% every 6 months)
0.05 365×𝑁
Daily: 1+ = 1.051267
365
(1.37 bps per day)
0.05 𝑇×𝑁
Continuous: lim 1 + = exp 0.05 × N = 1.051271
𝑇→∞ 𝑇
NOTE: This is also sometimes written as 𝑒 0.05×𝑁
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Present Value
❑ PV is the reverse way of thinking
❑ Discount factor 𝛿𝑖 : to get $1 in n years later, how much do you have to pay today?
𝛿𝑖 = 1/ 1 + 𝑟𝑖 𝑖
❑ In general, for any amount of future cash flows
𝑃𝑉 = 𝐶𝐹/ 1 + 𝑟𝑖 𝑖
❑ The following table shows the present value of $10
▪ Paid at different times: Time = 1, 2, 5, 10, 30
▪ Using different interest rates: Rate = 2%, 3%, 5%, 10%
Cashflow 10.0

Rate 2% 3% 5% 10%
Time 1 9.80 9.71 9.52 9.09
2 9.61 9.43 9.07 8.26
5 9.06 8.63 7.84 6.21
10 8.20 7.44 6.14 3.86
30 5.52 4.12 2.31 0.57

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Valuation Approaches:
❑ Present Value (PV)/Net Present Value (NPV):
▪ Discount the cash flows (CFt), using appropriate discount rates (rt)
𝑇 𝑇
𝐶𝐹𝑖 𝐶𝐹𝑖
𝑃𝑉 = ෍ 𝑖
, 𝑁𝑃𝑉 = 𝐶𝐹0 + ෍ 𝑖
1 + 𝑟𝑖 1 + 𝑟𝑖
𝑖=1 𝑖=1
▪ This notation is just shorthand for:
𝑇

෍ 𝑋𝑖 = 𝑋1 + 𝑋2 + 𝑋3 + ⋯ + 𝑋𝑇
𝑖=1
❑ “No Arbitrage” pricing:
▪ Replicate the cash flows using the cash flows of other securities, whose prices are known
❑ As we will see, these two approaches are equivalent.

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Value a Bond
Bond pays: $C/2 $C/2 $C/2 $C/2 $C/2 $100 +
C/2

Time: 0 1/2 1 1.5 2 2.5 T

Investor buys bond paying $X (initial cash flow = -$X)

❑ Here C is the bond’s annualized coupon, paid semi-annually

▪ NOTE: C is fixed for the life of the bond
❑ Bonds with no coupons are called zero-coupon bonds
❑ T is the maturity date of the bond
❑ The $100 paid at T is called the principal or face value
❑ What should $X be?
Capital Markets – Fall 2023 – Xuelin Li
PV and NPV Calculations (Review)
❑ A 10-year bond has a face-value of $100 and pays an annual 10% coupon. If the
appropriate (annual) discount rate is 5%, what should the market price of this
bond be?
Discount Rate = 5.00%

𝑟𝑖 = 5% Discoun
1 Time Cashflow t Factor CF * Disc
δ𝑖 = 1 10 0.952 9.52
(1 + 𝑟𝑖 )𝑖 2 10 0.907 9.07
3 10 0.864 8.64
4 10 0.823 8.23
5 10 0.784 7.84
6 10 0.746 7.46
7 10 0.711 7.11
8 10 0.677 6.77
9 10 0.645 6.45
10 110 0.614 67.53
PV = 138.61

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PV and NPV Calculations (Review)
❑ Suppose you (and you alone) have the opportunity to purchase this
bond at $100, to and resell at the market price. What is the NPV of this
investment for you?
Discount Rate = 5.00%
𝑟𝑖 = 5%
1 Discount
δ𝑖 = Time Cashflow Factor CF * Disc
(1 + 𝑟𝑖 )𝑖 0 -100 1.000 -100.00
1 10 0.952 9.52
2 10 0.907 9.07
3 10 0.864 8.64
4 10 0.823 8.23
5 10 0.784 7.84
6 10 0.746 7.46
7 10 0.711 7.11
8 10 0.677 6.77
9 10 0.645 6.45
10 110 0.614 67.53

NPV = 38.61

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Internal Rate of Return
❑ IRR – value of discount rate y such that
the NPV is zero
0 = 𝑁𝑃𝑉 𝑦
𝑇
𝐶𝐹𝑖
= −𝑃
ด +෍ 𝑖
𝐶𝐹
1+𝑦
0 𝑖=1
❑ When NPV is zero, we’ll have
𝑇
𝐶𝐹𝑖
𝑃
ณ =෍ 𝑖
𝐵𝑜𝑛𝑑 1+𝑦
𝑖=1
𝑃𝑟𝑖𝑐𝑒
❑ y is known as the bond yield
• What happens to NPV as we increase y?
• Assume all 𝐶𝐹’s after −𝑃 are positive
• What’s special about 𝑦 = 10%?
• See spreadsheet for details

Capital Markets – Fall 2023 – Xuelin Li

Sovereign Bond Yields

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US 10 Year Treasury Note Yields

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US 10 Year Treasury Note Yields

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Switzerland 10 Year Bond Yields

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Term Structure

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Term Structure
5.57 5.58
5.37

4.97
4.7 4.64
4.44 4.5 5.57 5.58
5.37 4.46 4.42 4.45
4.3 4.29 4.34 4.32
4.97
4.13 4.7 4.09 4.64 4.12
4.44 4.5
4.3 4.29 4.46 4.42 4.34 4.01 4.45
4.32 3.96
4.13 4.09 4.01 3.96 4.12

Yield
Yield

1.42
1.2
0.72 0.83
0.36 0.51
0.13 0.3
0 0.04
3 Mo 6 Mo 1 Yr 2 Yr 3 Yr 5 Yr 7 Yr 10 Yr 20 Yr 30 Yr

3/26/2020 10/27/2022 8/21/2023 1.42

1.2
0.83
0.72
0.51
0.3 0.36
0.04 0.13
0

3 Mo 6 Mo 1 Yr 2 Yr 3 Yr 5 Yr 7 Yr 10 Yr 20 Yr 30 Yr
3/26/2020 10/27/2022 8/21/2023

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