Chapter 14:

Investing in Stocks and Bonds

1
 INTRODUCTION
The most commonly traded securities available to
investors are stocks and bonds. These securities,
either directly or indirectly owned, form the bulk of
most investors’ portfolios.

2
 TO-DO SOON!
1. Don’t be afraid of investing in the stock market so include stocks
and bond and/or stock mutual funds in your investment portfolio.
2. Use fundamental analysis to determine a company’s basic value
before investing in any stock, bond, or stock mutual fund.
3. Resist putting money into so-called hot investments.
4. Invest part of the conservative portion of your portfolio in TIPS
(Treasury Inflation-Protected Securities) to beat inflation. 3
5. When you have children, use zero-coupon bonds (in addition to
Roth IRAs) to help save for their education.
USING STOCKS AND BONDS AS INVESTMENTS
 Corporation are state incorporated entities that can
conduct business in their names
 They can own property, borrow and enter into contracts
 Dividends: Shareholders are entitled to a share of any
distributions from the company in proportion to the
shares they own
 Voting Rights: Shareholders elect Board of Directors
4
 Board of Directors elect /selects management
 USING STOCKS AND BONDS AS
INVESTMENTS

Limited Liability: In the event that the

corporation fails to pay its debt, creditors can
seize the assets of the company without recourse
to personal assets of creditors
Residual Claim: a right to share in the income
and assets of a corporation after higher-priority
claims are satisfied.
5
REASONS FOR SEPARATION OF OWNERSHIP FROM
MANAGEMENT

 Professional managers may be found who have superior

abilities than the owners
 To achieve efficient scale of a business the resources of many
household should be pooled
 Allows owners to diversify their risks across firms
 Separated structure results in savings in the costs of
information gathering. Owners need not know more about the
intensity, technology of the firm in details

6
 CORPORATION
Managers commitment is to make decisions in the
interest of shareholders
Management are faced with the task of making
decisions that increase the value of the firm to its
shareholders-maximize the wealth of current
stockholders 7

Stock markets provides efficient information to

management decision making
CORPORATIONS
Corporations can be:
1.Public Corporation:
 broadly dispersed ownership
issues stock purchased by the general public and traded on
stock exchanges such as the New York Stock Exchange

2.Privately- Held Corporation:

concentrated ownership
Stocks are held by a small number of people and is not traded
on a public stock exchange. 8
 USING STOCKS AS INVESTMENT
Common stocks are shares of ownership in a business corporation’s assets and
earnings.
Shareholder (or Stockholder) have a proportionate interest and look up to
the following
1. Dividends
 paying cash dividends or
through share repurchases in the stock market-reduces the shares outstanding
and those who wish to sell receives cash
Stock dividends (stock split)-increase the number of shares outstanding
Tax Implications of cash dividend payments

2.Capital Gains
9
 USING STOCKS AS INVESTMENTS
• Preferred stock :is a fixed-income ownership
security in a corporation where dividends must be
paid before dividends are paid to common
stockholders
• Preferred stock prices are subject to interest rate
risk 10
• Preferred stockholders rarely have voting rights
 STOCK INFORMATION
 Ticker Symbol
 Current Price
 Previous Close
 Open
 Bid : Highest price a buyer is wiling to pay for those number of
shares
 Ask: Lowest price a seller is willing to receive for those number
of shares

11
STOCK INFORMATION
 Beta OR Beta Coefficient: tells us how much the stock price
varies relative to the rest of the market. (or beta coefficient)
 A measure of an investment’s volatility compared with a broad
market index(such as S&P 500) for similar investments over
time
 A stock with a beta of +1.0 typically moves in lockstep with the
S&P.
 beta greater than 1.0 indicates higher-than-market volatility and
greater risk relative to the market
 A beta of less than 1.0 (0.0 to 0.9) indicates that the stock price
is less sensitive to the market. 12
 STOCK INFORMATION
 Volume refers to the number of shares that have been bought and sold
for the day.
 Market capitalization is the total size of a company in the stock market.
It is the number of shares outstanding multiplied by the share price of a
stock.
 Price/earning ratio is ratio of stock price to its annualized earnings per
share over the past four quarters. It demonstrates how expensive the
stock is versus the company’s recently reported earnings
 Dividend Yield is the annual dividend divided by stock price expressed
as a percentage

13
 USING BONDS AS INVESTMENTS
Bonds (IOU’s)are interest-bearing, negotiable
certificates of long-term debt.
Fixed income securities that promise a stream
of known future cash payments
Principal is the face value of the bond
Maturity Date is the date on which the face value of
the bond will be paid to the current bond owner 14
Bonds can be bought and sold many times before
maturity
 BONDS
 Coupon payments :issuer makes periodic payments to the
bondholder
 Coupon is the periodic interest paid
 Coupon rate Is the interest rate applied used to compute
the coupon payment
 Bondholders get their principal returned on a specific
day in the future, called the maturity date

15
 BONDS
 Par Bonds: coupon bonds where the market price
is equal to the face value
 Premium Bonds: when the market price is higher
than its face value
 Discount Bonds: when the price is lower than its
face value

 Bonds are exposed to interest rate risk

16
 CONCEPT CHECK
1. Distinguish between common stocks and bonds in
investments.
2. How do public corporations use stocks and bonds?

17
TYPES OF STOCKS
Income Stocks:
Company that pays a cash dividend higher than that offered by most companies.
 Stable and produce regular stream of incomes
 Stocks issued by telephone, electric, and gas utility companies; beta often less
than 1.0.
Growth Stocks:
 Corporations that dominate their markets, and that have consecutive years of
above-industry-average earnings 18
 Earnings will be above average companies in the industry
 pays some dividends.
• Amazon, Netflix etc.
• Lesser-known growth stocks
EVALUATING STOCKS
Value Stocks: company that grows with the economy and tends
to trade at a low price relative to its company fundamentals
Potential for higher returns
Speculative Stocks : A company that has a potential for
substantial earnings at some time in the future but those
earnings may never be realized
High degree of risk, with high uncertainty but potential higher
returns
Tech Stocks: A company in the technology sector that offer
technology-based products and services
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EVALUATING STOCKS
Blue-Chip Stocks: A company that has been
around for a long time, has a well-regarded
reputation, dominates its industry (often with annual
revenues of $1 billion or more)
Large-cap, Mid-cap, Small-cap, and Microcap
Stocks: The company’s size based on market its
capitalization. Large caps are those firms valued at
or more than $10 billion. Mid-caps are $2 billion20to
$10 billion. Small caps is $300 million to $2
billion.
 VALUATION STOCKS
Valuation of a stock is to estimate an assets
market value using information about the
prices of comparable assets
How much are assets worth?
Is the asset price too high or Low?
Why? Because the prices of all equivalent
assets must be the same- Law of one price
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EVALUATING STOCKS
 Law of one Price states that in a competitive market, if two
assets are identical, then they will tend to have the same
market price
 Enforced by arbitrage-the purchase and sale of equivalent
assets in order to earn a profit from a difference in their price
 Transaction costs and demand will push up or down prices, if
there are price discrepancies
 If the same stock sells at $100 per share On the London Stock
Exchange and at &$102 on Tokyo Stock exchange, what will
happen?
22
 EVALUATING STOCKS
Assets Fundamental value is the price well informed
investors pay in a free and competitive market
At any point in time, there may be a difference between
the market price and the fundamental value of the asset
If the market price is less than its fundamental value ,then
it is undervalued. A sign to Buy the asset
If the Market price is more than its fundamental value,
then a sell the asset

23
 EVALUATING STOCKS (USING BETA)
Beta : Measure of stock volatility
• By how much the stock price varies relative to the rest of the
market. (or beta coefficient)
• A measure of an investment’s volatility compared with a broad
market index(such as S&P 500) for similar investments
• A stock with a beta of +1.0 typically moves in lockstep with the
S&P.
• A beta greater than 1.0 indicates higher-than-market 24 volatility
and greater risk relative to the market
• A beta of less than 1.0 (0.0 to 0.9) indicates that the stock price
is less sensitive to the market.
EVALUATING STOCKS : FUNDAMENTAL ANALYSIS
Most investors use fundamental analysis to evaluate
the financial strength of the company.
 a stock’s basic value is largely determined by its
current and future earnings trends, assets and debts,
products, competition, and management’s expertise
to assess its growth potential
 Based on the intrinsic value of the firm

25
EVALUATING STOCKS
Corporate earnings are most important.
1.Earnings Per Shares A firm’s profit
divided by the number of outstanding
shares. If earnings were paid to
outstanding shares
 It indicates the income that a company 26
has available, on a per-share basis, to
pay dividends and reinvest as retained
earnings.
 EVALUATING STOCKS
2.Price/earning ratio (price multiple, earnings multiple):ratio of stock price to its
annualized earnings per share
 It demonstrates how expensive the stock is versus the company’s recently reported
earnings, to evaluate if the share price accurately reflects its earning per share
 The P/E ratios for corporations typically range from 5 to 25. The historical average P/E
ratio for stocks is 15, although it varies for different industries.
 Financially successful companies with a P/E ratio ranging from 7 to 10 tend to have
higher dividend yields, less risk, lower prices, and slower earnings growth.
 Rapidly growing companies would likely have a much higher P/E ratio—13 to 20.
 Speculative companies might have P/E ratios of 25 or 50 or even higher because

27
EVALUATING STOCKS USING OTHER
MEASURES.
• Evaluating stocks using
1.Cash Dividends
2.Dividends Per Share
3.Dividend Payout Ratio: the dividends per share
divided by EPS. It helps you judge the likelihood of
future dividends
4.Dividend Yield: The dividend yield is the cash28
dividend paid to an investor expressed as a percentage
of the current market price of a security
EVALUATING STOCKS USING OTHER MEASURES
5.Book Value: the value of the asset as it appears on
the balance sheet.
 the net worth of a company, which is determined by
subtracting the company’s total liabilities from its
assets.
6.Book Value Per Share: the book value of a company
divided by the number of shares of common stock
29
outstanding
7.Price-to-Book Ratio: the current stock price divided
by the per-share net value of the company’s plant,
equipment, and other assets (book value).
EVALUATING STOCKS: TECHNICAL ANALYSIS

 Some investors use Technical analysis to predict the success

of a stock based on indicators of the workings of the market
 Evaluate a security through the study of past market data,
primarily price and volume.
 Technical analysts do not attempt to measure a security’s
intrinsic value but instead use charts, graphs, mathematics,
and software programs to identify and predict future price
movement

30
 CALCULATING A STOCKS POTENTIAL RETURN
Step 1 – Use beta to estimate the risk of the investment.
 If you buy a stock with a beta of 1.5. If the average price
of all stocks rises by 20 percent over time,
 The price of the stock you chose might rise by
 30% = the beta(1.5) multiplied by 20
 If the average price of all stocks drops in value by 10
percent, 31
 the price of the stock you chose might drop by 15%
 CALCULATING POTENTIAL RATE OF RETURN
Step 2 – Estimate the market risk for the investment
 market risk = Expected rate of return – Risk free rate (T-Bills)

Step 3 – Calculate your required rate of return on the investment.

 multiply the beta value of an investment by the estimated
market risk and then add the risk-free T-bill rate
 Required rate of return = Till bill + ( Beta value * market Risk)

32
CALCULATING STOCKS POTENTIAL RETURN

 Step 4 – Calculate the stock’s potential return as an

annual compound yield by adding up projected income
and price appreciation
add anticipated income (from dividends, interest, rents, or
other sources) to the future value of the investment and then
subtract the investment’s original cost
 Step 5 – Compare your required rate of return with
potential rate of return to decide whether or not to buy
the stock

33
 RETURN FROM STOCKS
Returns on stocks come from 2 sources: Dividends and Capital Gains
 

Suppose you buy a stock at $100 per share

1.Rate of Return(r) without dividend payments
r = Ending price of a share – Beginning price of a share
Beginning Price of the share
2.Rate of return(r) if dividends are paid
r
Note:this includes the sum of the price component and the dividend
component
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 EVALUATING STOCKS
 Suppose you purchase a share at $100.It pays a
cash dividend of $5 at the end of the year, and the
price of the share after the dividend is paid is
$105.The one- year rate of return is 10%

 You invest in a stock $50.It pays a cash dividend

during the year of $1,and you expect its price to
be$60 at the year end. What is your expected rate
of return?

35
 CONCEPT CHECK
1. Distinguish between income stocks and growth stocks.
2. Define beta and explain what it mean.
3. What is fundamental analysis and why is it popular?
4. Choose three measures of corporate earnings that you
might use when selecting a stock in which to invest and
say why you like them. 36
5. What are the five steps in calculating the potential rate
of return on a stock investment.
 USE THE INTERNET TO EVALUATE STOCKS
Begin by setting criteria for your stock investments. A review
of your investment plan in terms of goals, time horizon etc. It
will help provide answers to:
 What classifications of stocks are best suited for your goals?
 What market capitalization size company meets your desires?
 What specific numeric measures do you require on beta,
sales, profitability, P/E ratio, dividends, payout ratio,37and
market price
 Do you want to invest in an industry leader?
USE THE INTERNET TO EVALUATE STOCKS
 Investor education is widely available online .Such as SEC, website of
Exchanges etc.
 Use online stock calculators. Several online investment websites
provide opportunities to do a lot of calculations concerning an
investment. Such as Yahoo Finance, Daily Finance. It helps to provide
answers to questions such as:
What is the return on my stock if I sell now? Should I wait a year to
sell my stock?
Should I sell my stock now and invest the money elsewhere?
What stock price achieves my target rate of return? Which is better:
income or growth stock?
38
USE INTERNET TO
EVALUATE STOCKS
Use Stock-Screening Tools.
 enables you to quickly search through large databases
of numerous companies to find those that best suit your
investment objectives.
The following websites ,Kiplinger, MSN Money, and
MarketWatch, are good

39
ACTIVITY (GET A SENSE OF A STOCK)

Download Stock prices for Yahoo finance

 Calculate using Excel: the daily, monthly
and historical annual returns
Returns:
(stock price / yesterday’s stock price) - 1
Calculate the variance (use the “varp”
function) and Standard deviation(stdev)
40
 USE THE INTERNET TO EVALUATE STOCKS
 A company’s website is a good source of information.
 Company information would be available from a company’s
annual report, filings at the SEC website-10-Q Quartelry
report and 10-K annual reports
 These reports: the financial results , a discussion from
management, a list of material events and other risk factors
that have occurred, a forecast of the company’s future, and
any significant changes or events in the quarter 41
 Electronic Disclosure for Investor’s NETwork (EDINET) in
Japan and
 other sources such as motley fool
USE INTERNET TO EVALUATE
STOCKS
 Read research newsletters.
 Pay attention to economic trends.
 Stage in the business cycle, Inflation rates
 Interest rates

42
 USE THE INTERNET TO EVALUATE STOCKS
 Pay attention to securities market indexes.
 A securities market index is an indicator of economic performance
 It measures the average value of a number of securities chosen as
a sample to reflect the behavior of a more general market.
 Popular indexes include the following.
• Dow Jones Industrial Average
• Standard & Poor’s 500 Index
• NASDAQ Composite Index 43
• Wilshire 5000 Index
• Russell 2000 Index
• Nikkei 225
 PAY ATTENTION TO
SECURITIES MARKET
http://bigcharts.marketwatch.com/advchart/f
rames/frames.asp?symb=AAPL&insttype=
&time=8&freq=1

Go to “Big Charts”

Use the advanced chart to compare a stock
to an index of your choice

44
 USE THE INTERNET TO EVALUATE STOCKS
 Look up stock prices on the various exchanges
Securities exchanges (stock markets).
 is a market where agents of buyers and sellers can find
each other easily by providing an orderly, open plan to
trade securities.
 Recently more trading are done electronically
 Over-The Counter(OTC) market
45
 stocks that trade via a dealer network are made over a
telephone and computer system rather than on the floor
of a centralized exchange
USE THE INTERNET TO EVALUATE STOCKS…
Use portfolio tracking to monitor your investments.
Set up your portfolio online.
You can set up a portfolio through an online brokerage
account or by using any of several websites.
 For example, AOL, Yahoo Finance etc.
The sites then track stock quotes to update the value of
your holdings.

46
 CONCEPT CHECK
1. How does one use a stock screening tool.
2. Name two places where you can go to find information
about a company.
3. Distinguish between the Dow Jones Industrial Average
and the S&P 500.
4. Where can you go to look up stock symbols and prices?
47
 HOW STOCKS ARE BOUGHT AND SOLD
• Securities transactions require the use of a licensed
broker
• You can buy or sell securities through an online or
human stockbroker who works for the brokerage firm
• It is easy to first open a brokerage account.
• Brokers receive a commission on each securities
48
transaction to cover the direct expenses of executing
the transaction and other overhead expenses
 HOW STOCKS ARE BOUGHT AND SOLD

• Regulations help protect against investment fraud.

• Securities and Exchange Commission (SEC)
• Self-regulatory agencies
• Brokerage firms
• Security Investors Protection Corporation (SPIC)
• Financial Services Oversight Council (FSOC)
49
• Check the background of your stockbroker or
investment advisor.
 HOW STOCKS ARE BOUGHT AND SOLD
• Types of stock orders: Basically a BUY OR SELL
• Market order: Buy or sell at current prevailing price
• Limit order: Buy at best possible price “but not above” a
specified limit or to sell at a certain price “but not below” a
specified price
• Stop order (or stop-loss order):Sell at the market price if it
goes below a specified price
• Time limits: 50
fill-or-kill order-Immediately buy or sell at current market
price or cancel,
day order
 HOW STOCKS ARE BOUGHT AND SOLD

Margin trading is buying stocks on credit (using

a margin account).
Some investors open a margin account with a
brokerage firm in addition to their cash account
Buying on margin can magnify returns
Buying on margin can also magnify losses 51
A margin call makes matters even worse
 HOW STOCKS ARE BOUGHT AND SOLD

Selling short is selling stock borrowed from your

broker.
• You sell short the borrowed stock at its current market
price
• Ideally, you buy the same stock later when the price has
dropped and repay the loaned stock from your broker
• If the stock, instead, has gone up in price you will 52
suffer a loss
 CONCEPT CHECK

1. Summarize the differences among types of stock orders:

market, limit, and stop order.
2. What is buying on margin and how can it go wrong for
an investor?
3. Explain what selling short is and how it can go wrong
53
for an investor.
PORTFOLIO SELECTION
 Portfolio selection is the study on how people should invest
their wealth. Includes decisions or whether to rent or buy a
house ,how much insurance etc.
 Market Portfolio selection focuses on what stocks ,bonds and
other securities people should invest their wealth.
 Type of portfolio varies from individual to individual, based
on factors such as wealth, income, family, job etc.
i. For some Individuals additions of an asset may be risk
reducing .
ii. For others, it may be risk addictions
QUESTION

 How would the investment portfolio that is best for a

young person with a secure job differ from the one that is
best for a retired person whose only source of income is an
investment portfolio?
TIME HORIZONS
 Portfolio selection involves deciding on your goals and time horizons
 Planning horizon-the total length of time for which one plans.
The time horizon could be short or long.
 Decision horizon: minimum length of time between decisions to revise
the an investor’s portfolio
Could be once a month, a year.
It depends on the individual circumstances
Dependent on the type of assets invested in

Do you have a decision horizon of fixed length? How long is it?
PORTFOLIO OPTIMIZATION
 The relation between risk and expected return
 What portfolio choice offers an individual with a highest
expected rate of return matching the individuals risk tolerance?
 Portfolio optimization may be undertaken by professional asset
managers
 Portfolio Optimization involves two stages:
I. Find the optimal combinations of risky assets
II. Mix the risky asset portfolio with a riskless asset
Whether an asset is risky or not is dependent on the individuals
characteristics such as job, age etc.
PORTFOLIO OPTIMIZATION

 A riskless asset is one that offers a perfectly predictable rate of return

in terms of unit of account and the length of the individual decision
horizon
In other words, a riskless asset is an asset that offers predictable rate of
return over the trading horizon
Example: if the U.S dollar is taken as the unit of account and the
trading horizon is a month
Then, the riskless asset is the interest rate on a U.S treasury bills
maturing in 30 days
What is the riskless asset when the unit of account is the Japanese yen
and the length of the decision horizon is a week?
 COMBINING THE RISKLESS ASSET AND A RISKY ASSET

 The expected return on an asset is determined by its mean and the risk
by its standard deviation(Volatility)
 We already looked at the expected return in terms of dividend paying
ONLY stocks and when dividends and capital gains are present

 The standard deviation is the dispersion of returns from the mean

the square of the variance
The higher the standard deviation ,the higher the volatility and the
risk
Can be computed in R and other software's
COMBINING THE RISKLESS ASSET AND RISKY
ASSET

P
r
o
b
a
b
i
l
t
y

D
e
n
s
i
t
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Rate of return
 COMBINING THE RISKLESS ASSET AND RISKY ASSET
 Having a given sum of money to invest, identify
the interest rate for the riskless asset
The expected rate of return on the risky asset and
the standard deviation
COMBINING THE RISKY ASSET WITH THE RISKLESS ASSET
 Assume that you have a $100,000 to invest between a risky asset and riskless
asset. The interest rate on the riskless asset is 0.06 and the expected rate of
return on the risky asset is 0.14, and the standard deviation is 0.20.How much
should you invest in the risky asset?
 The risk- return combinations:
If you invest all your money into the riskless asset, returns is 6% but no risk(SD
of zero)
If you invest all the money (100%)in the risky asset, the expected return is 14%
but with a risk of 20
If you invest 50% of the money in the riskless asset and 50 % in the risky asset.
The expected return will be 10% and 10

62
 COMBINING RISKLESS ASSET AND A RISKY ASSET
How do we determine the portfolio composition for an
expected rate of return of 9% or 0.09?
Given
E (r) = wE(rs) + (1-w)rf
Where rs is the risky asset
i. rf is the risk-free rate
ii. E (r) is the expected rate of return on your portfolio
iii. W the proportion to be invested in the risky asset ; and (1-
w) is the proportion to be invested in the risk-free asset
Then E (r) = rf +w[E( rs ) – rf]
 COMBINING A RISKLESS ASSET TO A RISKY ASSET
 Therefore, given an expected return of 0.09,and an interest rate of
6% on the riskless asset; expected return of the asset to be 14%
 Then
E (r ) = 0.06 + w(0.14 – 0.06)
= 0.06 + 0.08w
Then,
0.09 = 0.06 + 0.08w
W = 0.375
The portfolio will contain a mix of 37.5% risky asset and 62.5%
riskless asset
COMBINING A RISKLESS ASSET AND A RISKY ASSET

 What is the standard deviation of a portfolio that

contains a risky asset and risky asset?
SD of the portfolio = SD of the risky asset multiplied
by the weight of the risky asset
In our previous example
SD of the portfolio = 0.20 * 0.37.5 = 0.075

The portfolio Standard deviation is 7.5 %

COMBINING PORTFOLIOS OF A RISKLESS ASSET AND TWO
RISKY ASSETS
Process:
1. Determine the risk-return combinations of the risky asset
2. Add the riskless asset
EXERCISE
Find the portfolio corresponding to an
expected rate of return of 0.11. Given that the
interest rate is 6% and the expected rate of
return on the risky asset is 14%?

67
 COMBINING TWO RISKY
ASSETS
The expected rate of return
 on two given assets is the simple weighted average
of the expected returns of the assets ,where the
weights are the proportions invested in the assets
The formula for the expected rate of return of a
portfolio containing two risky assets, A and B, is
given as
E (r) = wE(rA) + (1-w)rB
 COMBINING PORTFOLIOS OF TWO RISKY ASSETS
The Risk or Standard deviation of a portfolio
 In combining two risky assets, correlation between the two risky assets is
important
 Correlation is the degree to which the rates of return on the assets tend to
“move together". This has implications for risk reduction and diversification
 Correlation coefficient can range from
+1 (perfect correlation)
-1 (Perfect negative correlation)
0 (no correlation)
 Correlation coefficient = covariance (σ1,2)
Product of SD of the two assets (σ1σ2)
DO IT IN CLASS
 Numerical Measures. A stock sells at $15 per share.

What is the EPS for the company if it has a P/E ratio of

20?
If the company’s dividend yield is 3 percent, what is its
dividend per share?

70
 INVESTING IN BONDS
• Pure discount bonds(Zero- coupon Bonds): Bonds that promise a
single payment of cash at some date in the future
 that are issued at a sharp discount from face value and pay no annual
interest but are redeemed at full face value upon maturity.
 Zeros pay no current income to investors, so investors do not have to be
concerned about where to reinvest interest payment
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• Face Value : the promised cash payment on a pure discount bond
• Secured bond or unsecured bond (debenture)-backed by assets versus
no assets
 INVESTING IN BONDS
 Coupon bonds obligate the issuer to make periodic payments
of interest
 Coupon payments: Periodic payments of interest
 Coupon rate ( stated interest rate applied to the face value to
compute the coupon payment
 Par Bonds: if the bonds price is equal to its face value
 Bond price has a price higher than its face value
 Discount Bonds: has a price below its face value

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 INVESTING IN BONDS
 Corporate Bonds
Interest-bearing certificates of long- term debt issued by a
corporation.
Because of tax regulations, corporations often finance major
projects by issuing long-term bonds instead of selling stocks
 Bonds with similar coupon rate and maturity may sell at different
prices. why?
1. Tax treatments
2. Default risk: Bond ratings and their associated default risk matter
3. Other features: Callable or convertible
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INVESTING IN BONDS
 Callable:
If the bond has a callable feature-An issuer has the right to
redeem it before the final maturity date
Stipulation in some indentures that allows issuer to
repurchase the bond at par value or by paying a premium

 Convertible: gives the holder of a bond the right to convert

the bond into a specified number of shares of common stock

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 INVESTING IN BONDS
Investment-Grade Bonds- High Quality bonds
Speculative Grade (or Junk) Bonds.
 pay a high interest rate.
 they are long-term, high-risk, high-interest-rate
corporate (or municipal)
 issued by companies (or municipalities) with weak or
no credit ratings. The interest rates paid investors on
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junk bonds are high
GOVERNMENT BONDS
 U.S. Treasury securities issued by the federal government are
the world’s safest investment because it has never
intentionally defaulted on its debt.
 U.S. Treasury securities , like all other government bonds,
are backed by the power of the government, and this all but
guarantees the timely payment of principal and interest.
 All bonds are risk free in their own currency but its riskiness
depends on the interest rate
 No! Due to exchange rate differences

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 GOVERNMENT BONDS
Treasury bills (t-bills), notes, and bonds.
• Discount yield, I-bonds
• TIPS (or Treasury Inflation-Protected Securities)
• Federal agency debt issues
Municipal Government Bonds (or Munis) are
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bonds issued by local government entities.
Tax-Free (or Tax-Exempt) Bonds
 INVESTING IN BONDS
Changes in Bond prices due to Changes in Interest
rates
 Interest rate risk results in a variable value.
 Long-term rates largely reflect the expectations
of future inflation by bond holders
 Short-term interest rates are manipulated by the78
Central Banks
 When inflation rises, the Central Bank often
raises interest rates to discourage borrowing.
INVESTING IN BONDS
When the economy slows, the Central Bank often
lowers the interest rates on short-term Treasury
issues .
The risk that interest rates will increase, and bond
prices will fall, thereby lowering the prices on older
bond issues.
There is an inverse relationship between Bond
prices and Interest rates
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FIGURE 14.3

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 BOND PRICE (VALUE OF THE
BOND)
 Value the Bond (The market price of a bond) equals the present
value of its future interest payments and the present value of its
face value when the bond matures.
= Present Value interest payments + Present Value of Lump Sum
= ( (Annual Interest payment/2)*PVIF i,n ) + ( Lump Sum *PVIFi,n )

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INVESTING IN BONDS

Bonds yield
For a discount bond that promises a single cash
payment,
Yield on 1 -year discount bond = Face value – Price
Price

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CALCULATING THE YIELD: CURRENT YIELD OR YIELD TO MATURITY

The current yield formula,

 

Current yield = Current annual Income / current market price

 The yield to maturity when bond maturity is greater than one

PVBond

Where, YTM : Annual Yield to Maturity; PMT = Coupon

Payment; FV=Face Value

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 CALCULATIONS
 A corporate bond maturing in 22 years with a coupon rate of
8.2 percent was purchased for $1,100 and is now selling for
$1,190.

 What is its current yield?

 What will the bond’s selling price be if comparable market
interest rates rise 1.8 percentage points in two years?

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 DO-IT –IN CLASS
 Bond Selling Price. What is the market price of a $1,000, 8 percent
bond if comparable market interest rates drop to 6 percent and the
bond matures in 15 years?
 Market Price. What is the market price of a $1,000, 8 percent bond
if comparable market interest rates rise to 10 percent and the bond
matures in 14 years

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 INVESTING IN BONDS
• Evaluating bond prices. Before buying any bond you will
want to perform these three calculations.
1. Determine the present value of a bond which is its
current market selling price.
2. The current yield equals the bond’s fixed annual interest
payment divided by its current market price. 86
3.When you plan to hold a bond till maturity you will also
want to determine its yield to maturity.
 INVESTING IN BONDS
• The four decisions of bond investors.
• Decide on credit quality
• Decide on maturity
• Determine the after-tax return
• Select the highest yield to maturity

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 WHAT DO YOU RECOMMEND?
What do you recommend to Arya Jutanugarn in the case at the beginning of
the chapter regarding:
1. Investing for retirement in 18 years?
2. Owning blue-chip common stocks and preferred stocks rather than
other common stocks given Arya's investment time horizon?
3. The wisdom of owning municipal bonds rather than corporate bonds?
4. The likely selling price of her corporate bonds, if sold today? 88
5. Investments that might be appropriate to fund her children’s
education?
 NEVER EVER!
1. Invest in stocks that do not match your investment
philosophy.
2. Fail to use fundamental analysis when making stock
investments.
3. Buy stocks on margin or sell stocks short.
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