Chapter 5 Property and Pricing of Financial Assets

CHAPTER 5
DETERMINANTS OF ASSET PRICE

AND
INTEREST RATE
Properties and Pricing of

Financial Assets
1 FIREW CHEKOL (Ph.D)

Properties of Financial Assets
The properties of financial assets are
Moneyness Convertibility
Divisibility and Denomination Currency
Reversibility Liquidity
Term to Maturity Complexity
Cash Flow & Return Tax Status
Predictability

Moneyness:
 The ability to transfer a financial asset into money at little

cost, delay or risk. Some examples are cash and checking
accounts.
Divisibility :
 It is related to the minimum size in which a financial asset

can be liquidated and exchanged for money.
Reversibility (round-trip cost):
 refers to the cost of investing in a financial asset and then

getting out of it and back into cash again.

Liquidity: how easy is it to sell? how cheap is it to sell?
 how much the seller stands to lose if he wishes to sell
immediately rather than allowing some time to pass.
Convertibility:
 refers to the notion that some financial assets can be
converted into other assets, e.g., a convertible bond
Currency:
 this refers to the foreign exchange value or foreign
exchange currency denomination of the financial asset.
Term to maturity:
 this is the length of the interval until the date at which the
instrument is scheduled to make its final payment, or the time
until the owner is entitled to demand liquidation.

 Cash flow and return predictability:
this is the cash yield of a financial asset per unit of time and
consists of all the cash distributions that the financial asset will
pay to its owners.
 Complexity:
this involves combinations of two or more simple assets. For

instance, a callable bond can be valued as a straight bond plus the
value of the put option to the issuer.
 Tax status:
 refers to the taxability of interest income generated from a

financial asset.
 Incomes from bonds are normally taxed, but municipals are free
from federal income taxes.

PRINCIPLES OF PRICING OF FINANCIAL
ASSETS
The fundamental principle of finance is that the true or correct

price of an asset equals the present value of all cash flows
that the owner of the asset expects to receive during its life.
CF1 CF2 CFn

PV    ... 
(1  r )1
1  r  2
1  r  n
where PV = present value of the asset
CF = cash flow
r = discount rate
N = maturity of the financial asset

Appropriate Discount Rate
The appropriate discount rate, r, is the return that the
market or the consensus of investors requires on the asset.
The discount rate can be expressed as:
r = RR + IP + DP + MP + LP + EP
where RR = real rate of interest
IP = inflation premium
DP = default risk premium
MP = maturity premium
LP = liquidity premium
EP = exchange-rate risk premium

 Example:
 Suppose a bond has a maturity of four years and annual coupon interest rate
of 10%. The principal value of the bond is Br 1,000. Furthermore; assume
that the market thinks the real rate is 2.5%, the inflation premium is 3%, the
bond’s default risk justifies a premium of 2%, the maturity premium is 0.5%
and the liquidity premium is 1%. For an Ethiopian investor, since the cash
flows are denominated in Birr, the foreign exchange rate premium is zero.
Here, we want to determine the price of the financial asset (Bond). So let us
determine the annual cash flows from the bond during its four year life
N=4
CF1= coupon rate X principal = 0.1x1000= Br. 100
CF2 = 100
CF3 = 100
CF4 = coupon payment + principal
= 100+ 1000 = Br. 1,100

After determining the annual cash flows, the next task is
to determine the discount rate, r
RR= 2.5%, IP = 3%, DP=2%,MP=0.5%,Lp=1% and
EP=0%
r = RR+IP+DP+MP+LP+EP
r = 2.5%+3%+2%+0.5%+1%+0
r = 9%
Based on the market rate, r = 9%, we can calculate the
valueP0of CF 1 CF 2 CF 3 CF N
 bond1       
1  r  1  r  2 1  r  3 1  r  N
100 100 100 1,100
     Br. 1032.40
1.09 1
1.09 2
1.09 3
1.09 4

Price and Asset Properties
The price of a financial asset is inversely related to
its discount rate.
As the discount rate rises, the price falls.
As the discount rate falls, the price rises.
Reversibility in the form of commissions and
transfer fees reduce the price of the asset.

Effect of Asset Properties on the
Discount Rate
Asset Properties Discount Rate

Default Risk Positive
Liquidity Risk Positive
Convertibility Negative
Currency Risk Positive

Tax Treatment
After-tax discount rate equals
Pretax discount rate x (1 - marginal tax rate)
If the marginal tax rate is expected to increase, the after-

tax discount rate will decrease
If the marginal tax rate is expected to decrease, the after-
tax discount rate will increase

Example:
 Suppose a bond has a maturity of four years and pays annual interest
of $50 at the end of each year plus a principal of $1,000 at the
conclusion of the fourth year.
 A bond: 4 year maturity, annual interest of $50, principal $1,000
 Thus,
n=4, CF1=50, CF2=50, CF3=50, CF4=1,050
RR=2.5%, IP=3.0%, DP=2.0%, MP=0.5%, LP=1%, EP=0
r=2.5%+3.0%+2.0%+0.5%+1%+0%=9.0%
50 50 50 1,050
P 1
 2
 3

(1.09) (1.09) (1.09) (1.09) 4
 $870.41
 Reversibility
 Broker’s commission: $35 to buy or sell
50 50 50 1,050  35
P  35    
(1.09)1 (1.09) 2 (1.09)3 (1.09) 4
 $810.62
 Transfer tax: $20 by government on each transaction

50 50 50 1,050  35  20
P  35  20    
(1.09)1 (1.09) 2 (1.09)3 (1.09) 4
 $776.45
 If Default risk (DP): changed from 2% to 1%; or
2% to 3% and
 Liquidity (LP): changed from 1% to 3%
what will be the price of the bond?

 PRICE VOLATILITY OF FINANCIAL ASSETS
A fundamental principle is that a financial asset’s price
changes in the opposite direction of the change in the
required rate of return, or the required yield.
It is convenient to measure a change in yield in terms of
what market participants refer to as a basis point rather
than in terms of a percentage change.
A 100 basis points is equal to one percentage point and
the yield change from 9% to 10% is represents a 100
basis point change in yield.
A yield change from 7% to 7.5% is a 50 basis point
change, and a yield change from 6% to 8.35% is a 235
basis point change in yield.

Effect of Maturity
An asset’s maturity is a factor affects its price

sensitivity to change in yield.
In fact a bond’s price sensitivity to change in the
discount rate is positively related to the bond’s
maturity.
A change in price is a function of maturity. The
longer the period to maturity, the greater is the
change in price for a given change in discount rate.

The Effect of Maturity
 Price of a bond paying $50 annually and $1,000 at Maturity for Various
Discount Rates and Maturities
Discount rate Number of years to maturity
(%) 4 10 15 20
4% $1,036.30 $1,081.11 $1,111.18 $1,135.90

5 1,000.00 1,000.00 1,000.00 1,000.00
6 965.35 926.40 902.88 885.30
7 932.26 859.53 817.84 788.12
8 900.64 798.70 743.22 705.46
9 870.41 743.29 677.57 634.86
10 841.51 692.77 619.70 574.32
11 813.85 646.65 568.66 522.20
12 787.39 604.48 523.24 477.14
13 762.04 565.90 483.01 438.02
14 737.77 530.55 447.20 403.92
Price Decline if the Discount Rate Increases 100 basis
points for various discount rates and maturities
Price change
Discount Rate Changes Number of years to maturity
from 4 10 15 20
4% to 5% -$36.30 -$81.11 -$111.18 -$135.91

5 to 6 -34.65 -73.60 -97.20 -114.70
6 to 7 -33.09 -66.87 -85.04 -97.18
7 to 8 -31.62 -60.83 -74.62 -82.66
8 to 9 -30.23 -55.41 -65.65 -70.60
9 to 10 -28.90 -50.52 -57.85 -60.54
10 to 11 -27.66 -46.12 -51.15 -52.12
11 to 12 -26.40 -42.17 -45.13 -45.06
12 to 13 -25.35 -38.58 -40.23 -39.12
13 to 14 -24.27 -35.35 -35.81 -34.12
Price Decline if the Discount Rate Increases 100 basis
points for various discount rates and maturities
Percentage Price Change
Discount Rate Changes Number of years to maturity
from 4 10 15 20
4% to 5% -3.50% -7.50% -10.01% -11.96%

5 to 6 -3.47 -7.36 -9.71 -11.47
6 to 7 -3.43 -7.22 -9.42 -10.98
7 to 8 -3.39 -7.08 -9.12 -10.49
8 to 9 -3.36 -6.94 -8.83 -10.01
9 to 10 -3.32 -6.80 -8.54 -9.54
10 to 11 -3.29 -6.66 -8.25 -9.08
11 to 12 -3.25 -6.52 -7.97 -8.63
12 to 13 -3.22 -6.38 -7.69 -8.20
13 to 14 -3.18 -6.25 -7.41 -7.79
Thus, the effect of maturity
 Thus, the effect of maturity is positive for discount rate
 Take Two bonds
1. A 4-year bond, discount rate increases from 9% to 10%,then

the price falls from $870.41 to $841.51, and there is a decline
of $28.90, which is a 3.32% (28.90/870.41=0.0332)
2. A 20-year bond, discount rate increases from 9% to 10%, and

then the price falls from $634.86 to $574.32, and there is a
decline of $60.54, which is a 9.54% (60.54/634.86=0.0954)
Thus, the longer the maturity period, the higher will be the
price sensitivity (change in price)

Effect of Coupon Rate
The lower the coupon, the greater is the percentage of

price sensitivity due to the reinvestment factor.
While an increase in interest rates causes a drop in

price, it allows interest incomes to be reinvested at
higher returns, therefore moderating a price drop.
The greatest price sensitivity is associated with zero-

coupon bonds, which afford no reinvestment of
earnings at higher rates.

The effect of coupon rate
Negative
Take Two bonds
A 5% coupon rate, 15-year, discount rate increases
from 9% to 10%, a result of price falls from
$677.57 to $619.70 and a decline of $57.87, 8.5%
A 10% coupon rate, 15-year, discount rate
increases from 9% to 10%, a result of price falls
from $1,080.61 to $1,000 and a decline of $80.61,
7.5%

Measuring Price Sensitivity to Interest Rate Change:
Duration
 Level of Interest Rates
 The lower the prevailing yield level, the greater the price sensitivity
to a change in the required yield
 In managing the price sensitivity of portfolio management
participants seek to measure of the sensitivity of assets to interest
rate changes that encompasses all three factors (interest rate,
maturity and coupon payment)
Pr ice if yeild is decreased  price if yeild is increased

 X 100
Intial price * (higheer yeild  lower yeild )

 Duration can be interpreted as the approximate percentage change
in price for a 100 basis point change in interest rates around the
prevailing yield
∆y=change in yield (in decimal)
P0=initial price of the asset
P-=asset’s price if the yield is decreased by ∆y
P+=asset’s price if the yield is increased by ∆y
P-  P0
P0
For small decrease in the percentage price change is
 The percentage price change per basis point change is dividing the
percentage price change by the number of basis point.
 That is the percentage price change per basis point decrease is
P-  P0
0 y)100
P（

 The percentage price change per basis point increase:
P0  P
0 y )100
P（
 The percentage price change for an increase and decrease in interest
rates is not the same. Therefore, the average percentage price change
per basis point change in yield is calculated as: :
1  P  P0 P0  P 

2  P0 (y )100 P0 (y )100 

P  P

2 P0 (y )100
The approximate percentage price change for a 100 basis point change in yield:
P  P
2 P0 (y )
Example:
 The price of a 5% coupon bond with a principal of $1,000

and a maturity of 15 year is $677.57. If the yield is
increased by 50 basis points from 9% to 9.5%, the price
would be $647.73. If the yield is decreased by 50 basis
points from 9% to 8.5%, the price would be $709.35.
Then,
∆y=0.005
P0=$677.57
P-=$709.35
P+=$647.73 $709.35  $647.73
 9.09
2($677.57)(0.005)

Relationship between Duration and
Price Sensitivity
An estimate of the percentage change in the
price of a financial asset is:
Duration x (y) x 100
P  P
Duration 
2 P0 ( y )

Example: Determining Duration
Duration= 3.4%
Change in price = Duration * P0*∆y
Change in price = 3.4%*870.41*0.005
= 1.7%
Price at 9.5% = 870.41*(1-0.017) =855.61
Price at 8.5% = 870.41*(1+0.017)=885.20
THE LEVEL AND STRUCTURE OF INTEREST RATE
An interest rate is the price paid by a borrower to a

lender for the use of resources that will be used during
some time period then returned.
The acts of saving and lending, and borrowing and
investing, are significantly influenced by and tied
together by the interest rate.

Functions of the Interest Rate in the
Economy
The interest rate helps guarantee that current savings
will flow into investment to promote economic growth.
It rations the available supply of credit, generally
providing loanable funds to those investment projects
with the highest return.
It brings the supply of money into balance with the
public’s demand for money.
The interest rate serves as an important tool for
government policy through its influence on the volume
of savings and investment.

Theories of Interest Rates
Fisher’s Classical Approach
 Liquidity Preference Theory
 Loanable Funds Theory

Fisher’s Classical Theory
approach
 The classical theory argues that the rate of interest is determined
by two forces:
 the supply of savings, derived mainly from households, and
 the demand for investment capital, coming mainly from the
business sector.
Household Savings
 Current household savings equal the difference between current
income and current consumption expenditures.
 Individuals prefer current over future consumption, and the
payment of interest is a reward for waiting.
 Higher interest rates encourage the substitution of current saving
for current consumption.

The Classical Theory of Interest
Rates
The Substitution Effect
Relating Savings and Interest Rates
Interest
Rate
r2 
r1 
Current
S1 S2 Saving
Rates
Business and Government Savings
Most businesses hold savings balances in the form of
retained earnings, the amount of which is determined
principally by business profits, and to a lesser extent,
by interest rates.
Income flows in the economy and the pacing of
government spending programs are the dominant
factors affecting government savings (budget surplus).

Rates
The Demand for Investment Funds
Gross business investment equals the sum of
replacement investment and net investment.
The investment decision-making process typically
involves the calculation of a project’s expected
internal rate of return, and the comparison of that
expected return with the anticipated returns of
alternative projects, as well as with market interest
rates.

Rates
The Cost of Capital and the Investment Decision
Expected
Internal A – acceptable
Rates of 15%
Return on B – acceptable
Alternative Cost of
Investment 12% C – indifferent Capital
Projects Funds
10% D = 10%
E
unprofitable 8%
unprofitable 7%
Dollar Cost of Investment Projects

Rates
The Investment Demand Schedule
In the Classical Theory of Interest Rates
Interest
Rate
r2 
r1 
Investment
I2 I1 Spending
Rates
The Equilibrium Rate of Interest
In the Classical Theory of Interest Rates
Interest
Rate Investment Savings
rE 
Savings &
QE Investment
Rates
Limitations
Factors other than savings and investment that affect
interest rates are ignored. For example, many financial
institutions can “create” money today by making loans
to the public.
Today, economists recognize that income is more
important than interest rates in determining the volume
of savings.
In addition to the business sector, both consumers and
governments are also important borrowers today.

The Liquidity of fund Theory of Interest Rates
The liquidity preference (or cash balances) theory of

interest rates is a short-term theory that was
developed for explaining near-term changes in
interest rates, and hence, is more relevant for
policymakers.
According to the theory, the rate of interest is the
payment to money (cash balances) holders for the
use of their scarce resource (liquidity), by those who
demand liquidity (i.e. money or cash balances).

The Liquidity Preference Theory of Interest Rates
 The demand for liquidity stems from:

 the transactions motive - the purchase of goods and
services
 the precautionary motive - to cope with future
emergencies and extraordinary expenses
 the speculative motive - a rise in interest rates results
in lower bond prices
  and  depend on the level of national income,
business sales, and prices (but not interest rates). So,
demand due to  and  is fixed in the short term.

The Liquidity Preference theory of Interest Rates
The Total Demand for Money or Cash Balances

in the Economy
Interest
Rate  : transactions
Total Demand demand
= ++  : precautionary
demand
r   : speculative
demand
+ 
Quantity of
Money / Cash
K Q Balances
The Liquidity Preference theory of Interest Rates
In modern economies, the money supply is controlled,

or at least closely regulated, by the government.
The supply of money (cash balances) is often assumed
to be inelastic with respect to interest rates, since
government decisions concerning the size of the
money supply should presumably be guided by public
welfare.

The Equilibrium Interest Rate
In the Liquidity Preference Theory
Interest
Rate Money
Supply
rE  Total
Demand
Quantity of
Money / Cash
QE Balances
The Liquidity Preference Theory of Interest Rates
Limitations
The liquidity preference theory is a short-term
approach. In the longer term, the assumption that
income remains stable does not hold.
Only the supply and demand for money is considered.
A more comprehensive view that considers the supply
and demand for credit by all actors in the financial
system - businesses, households, and governments - is
needed.

The Loanable Funds Theory of Interest
 The popular loanable funds theory argues that the risk-

free interest rate is determined by the interplay of two
forces:
 the demand for credit (loanable funds) by domestic
businesses, consumers, and governments, as well as
foreign borrowers
 the supply of loanable funds from domestic savings,

dishoarding of money balances, money creation by the
banking system, as well as foreign lending

The Demand for Loanable Funds

Consumer (household) demand is relatively inelastic
with respect to the rate of interest.
Domestic business demand increases as the rate of
interest falls.
Government demand does not depend significantly upon
the level of interest rates.
Foreign demand is sensitive to the spread between
domestic and foreign interest rates.

The Loanable Funds Theory of
Interest
Total Demand for Loanable Funds (Credit)
Interest
Rate
Total Demand = Dconsumer +
Dbusiness +
Dgovernment +
Dforeign
Amount of
Loanable Funds

The Supply of Loanable Funds
Domestic Savings. The net effect of income, substitution,
and wealth effects is a relatively interest-inelastic supply
of savings curve.
Dishoarding of Money Balances. When individuals and
businesses dispose of their excess cash holdings, the
supply of loanable funds available to others is increased
Creation of Credit by the Domestic Banking System.
Commercial banks and nonbank thrift institutions offering
payments accounts can create credit by lending and
investing their excess reserves.
Foreign lending is sensitive to the spread between
domestic and foreign interest rates.
Total Supply of Loanable Funds (Credit)
Interest
Rate Total Supply
= domestic savings +
newly created money +
foreign lending –
hoarding demand
Amount of
Loanable Funds

The Equilibrium Interest Rate
Interest
Rate Supply
rE 
Demand
Amount of
QE Loanable Funds
 At equilibrium:
 Planned savings = planned investment across the

whole economic system
 Money supply = money demand
 Supply of loanable funds = demand for loanable funds
 Net foreign demand for loanable funds = net exports
 Interest rates will be stable only when the economy,
money market, loanable funds market, and foreign
currency markets are simultaneously in equilibrium.

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CHAPTER 5

DETERMINANTS OF ASSET PRICE

Properties and Pricing of

1 FIREW CHEKOL (Ph.D)

2 FIREW CHEKOL (Ph.D)

 The ability to transfer a financial asset into money at little

 It is related to the minimum size in which a financial asset

Reversibility (round-trip cost):

 refers to the cost of investing in a financial asset and then

3 FIREW CHEKOL (Ph.D)

4 FIREW CHEKOL (Ph.D)

this involves combinations of two or more simple assets. For

 refers to the taxability of interest income generated from a

5 FIREW CHEKOL (Ph.D)

The fundamental principle of finance is that the true or correct

CF1 CF2 CFn

6 FIREW CHEKOL (Ph.D)

7 FIREW CHEKOL (Ph.D)

8 FIREW CHEKOL (Ph.D)

9 FIREW CHEKOL (Ph.D)

10 FIREW CHEKOL (Ph.D)

Asset Properties Discount Rate

11 FIREW CHEKOL (Ph.D)

Pretax discount rate x (1 - marginal tax rate)

If the marginal tax rate is expected to increase, the after-

12 FIREW CHEKOL (Ph.D)

 Transfer tax: $20 by government on each transaction

14 FIREW CHEKOL (Ph.D)

15 FIREW CHEKOL (Ph.D)

An asset’s maturity is a factor affects its price

16 FIREW CHEKOL (Ph.D)

4% $1,036.30 $1,081.11 $1,111.18 $1,135.90

4% to 5% -$36.30 -$81.11 -$111.18 -$135.91

4% to 5% -3.50% -7.50% -10.01% -11.96%

1. A 4-year bond, discount rate increases from 9% to 10%,then

2. A 20-year bond, discount rate increases from 9% to 10%, and

20 FIREW CHEKOL (Ph.D)

The lower the coupon, the greater is the percentage of

While an increase in interest rates causes a drop in

The greatest price sensitivity is associated with zero-

21 FIREW CHEKOL (Ph.D)

22 FIREW CHEKOL (Ph.D)

Pr ice if yeild is decreased  price if yeild is increased

23 FIREW CHEKOL (Ph.D)

24 FIREW CHEKOL (Ph.D)

 The price of a 5% coupon bond with a principal of $1,000

26 FIREW CHEKOL (Ph.D)

27 FIREW CHEKOL (Ph.D)

An interest rate is the price paid by a borrower to a

29 FIREW CHEKOL (Ph.D)

30 FIREW CHEKOL (Ph.D)

 Liquidity Preference Theory

 Loanable Funds Theory

31 FIREW CHEKOL (Ph.D)

32 FIREW CHEKOL (Ph.D)

34 FIREW CHEKOL (Ph.D)

35 FIREW CHEKOL (Ph.D)

Dollar Cost of Investment Projects

39 FIREW CHEKOL (Ph.D)

The liquidity preference (or cash balances) theory of

40 FIREW CHEKOL (Ph.D)

 The demand for liquidity stems from:

41 FIREW CHEKOL (Ph.D)