BONDS AND STOCKS

Program : PGDM - 01

Faculty : Dr Srikanth Parthasarathy

Course : MS1202

Trimester : 2

Session/s : 11-20

Week : 4-5
 Loan is an IOU between two specific entities

 Bond is also a loan but

 Bond is an IOU between an entity and the

population in general. This can now be traded

in an exchange.

 What is the advantage?

Industry Overview

Fixed-Income Market Participants

 Issuers:􀂃Governments􀂃Corporations􀂃Commercial
Banks􀂃States􀂃Municipalities􀂃SPVs
 Intermediaries:􀂃Primary Dealers􀂃Other
Dealers􀂃Investment Banks􀂃Credit-rating Agencies
 Investors:􀂃Governments􀂃Pension
Funds􀂃Insurance Companies􀂃Commercial
Banks􀂃Mutual Funds􀂃Foreign
Institutions􀂃Individuals
Bond Perspectives
DEBT ASSET

 Needs Rupees  Has Rupees

 Borrower
 Issuer or seller
 Debtholder
 Cost of borrowing
◦ Interest Paid (Expense) –
generates tax benefit (Svgs)
◦ Cost of Debt
 = Rd or Kd;
 After-tax cost = Rd (1-t)
 Lender
 Buyer or Investor
 Bondholder
 Creditor
 Requires return to
invest rupees in bonds
based on risk
◦ Interest Received (earned)
(Revenue) - pay tax on it
◦ Capital Appreciation

5
Key Features of a Bond
 Par value: Face amount; paid at maturity.
Assume $1,000.
 Coupon interest rate: Stated interest rate.

Multiply by par value to get rupees of

‘interest??’. Generally fixed.

(More…)
6
 Maturity: Years until bond must be repaid.
Declines.
 Issue date: Date when bond was issued.
 Default risk: Risk that issuer will not make

interest or principal payments.

7
Characteristics of Bonds
 Bonds: debt securities that pay a rate of interest based
upon the face amount or par value of the bond.

 Price changes as market interest

changes

 Interest payments are commonly

semiannual

 Bond investors receive full face

amount when bonds mature

 Zero coupon bonds – no periodic

payment (no interest reinvestment
rate)
 Originally sold at a discount
Zero coupon bond
 Pure Discount Bond
 No coupons, single payment of principal at maturity
 Bond trades at a “discount” to face value
 Also known as zero-coupon bonds
 Valuation is straightforward application of PV

 P0 = F /(1+r)t

 Note: (P0, r, F) is “over-determined”; given two, the third is

determined

 Now What If r Varies Over Time?

 Different interest rates from one year to the next
 Denote by rt the spot rate of interest in year t
Example
 Suppose a zero coupon bond pays Rs. 1000
(face value) exactly five years from now. What
is the price or value today if the interest rate
on similar bonds is 9%.
YTM
 Yield to maturity – It is the return you can
expect if you hold the bond to maturity.
 What is the YTM of a 10 year zero coupon

bond with a face value of Rs. 1000 and a

current price of Rs. 422.41

 The price is given, face value is given, the

question is what is the rate of return built
into this?
 What makes a YTM of a zero coupon
government bond risk free?(let us ignore
inflation risk)

 VALUE in finance is not what you say,

 But
 what people perceive what’s going to happen??
Now try semi annual compounding
 Coupon Bond
 The most common type of Bond is a coupon bond
 They pay periodic coupons and a larger face value

at maturity
 All payments are explicitly stated in the IOU

contract.
Bonds
WARNING
The coupon rate IS NOT the discount rate
used in the Present Value calculations.

The coupon rate merely tells us what cash

flow the bond will produce.

Since the coupon rate is listed as a %, this

misconception is quite common.
Simple problems
 A Rs.1000 par value bond, bearing a coupon
rate of 12 percent will mature after 6 years.
What is the value of the bond, if the discount
rate is 16 percent?
 Example – very important
 Suppose a government bond has a 10% coupon, a
face value of Rs 1000 and 10 years to maturity.
What is the price of the bond if similar bonds yield
a annual return of 10%. What if the similar bond
yield 8% or 12%?
Find out the absolute and percentage difference
in both the cases.
Yield Curve

 The relation between maturity and the YTM of

government bonds

 Typical relation? Why?

 Some idea of risk
Theories of
Interest Rate Structure
 Expectations theory
 Liquidity preference theory
 Inflation premium theory

20
Expectations Theory
 According to the expectations theory of
interest rates, investment opportunities with
different time horizons should yield the same
return:

(1  R2 ) 2  (1  R1 )(1  1 f 2 )

where 1 f 2  the forward rate from time 1 to time 2

21
Expectations Theory (cont’d)
Example

An investor can purchase a two-year CD at a rate of 5

percent. Alternatively, the investor can purchase two
consecutive one-year CDs. The current rate on a one-
year CD is 4.75 percent.

According to the expectations theory, what is the

expected one-year CD rate one year from now?

22
Expectations Theory (cont’d)
Example (cont’d)

Solution:

(1  R2 )  (1  R1 )(1  1 f 2 )
2

(1.05) 2  (1.045)(1  1 f 2 )
(1.05) 2
(1  1 f 2 ) 
(1.045)
1 f 2  5.50%

23
Liquidity Preference Theory
 Proponents of the liquidity preference theory
believe that, in general:
◦ Investors prefer to invest short term rather than
long term
◦ Borrowers must entice lenders to lengthen their
investment horizon by paying a premium for long-
term money (the liquidity premium)
 Under this theory, forward rates are higher
than the expected interest rate in a year

24
Inflation Premium Theory
 The inflation premium theory states that risk
comes from the uncertainty associated with
future inflation rates
 Investors who commit funds for long periods

are bearing more purchasing power risk than

short-term investors
◦ More inflation risk means longer-term investment
will carry a higher yield

25
Bond Risk
 Price risks
 Malkiel’s interest rate theories
 Duration as a measure of interest rate risk

26
Risks
 Interest rate risk
Price risk
Reinvestment risk
 Default risk

27
Interest Rate Risk
 Interest rate risk is the chance of loss
because of changing interest rates
 The uncertainty concerning bond
values/prices due to interest rate fluctuations
are called interest rate risk

 Examples 1. zerocoupon
 2. coupon bonds

28
Interest rate risk
 Bond prices are sensitive to the
market interest rate

 If interest rates rise, the market

value of bonds fall in order to
compete with newly issued bonds
with higher coupon rates.

 Sensitivity to the interest rate

chance become more severe for
longer term bonds

 Percentage rise in price is not

symmetric with percentage decline.
Reinvestment Rate Risk
 Reinvestment rate risk refers to the
uncertainty surrounding the rate at which
coupon proceeds can be invested

 The higher the coupon rate on a bond, the

higher its reinvestment rate risk

30
Corporate Bonds
 They almost always pay coupons

 Like Government bomds, they are exposed to

interest rate risk
 But they also subject to default risk
Default Risk
 Default risk measures the likelihood that a
firm will be unable to pay the principal and
interest on a bond

 CRISIL. ICRA and CARE are the leading

advisory services in monitoring default risk

32
Default Risk (cont’d)
 Investment grade bonds are bonds rated BBB
or above

 Junk bonds are rated below BBB

 The lower the grade of a bond, the higher its

yield to maturity

33
Pricing of corporate bonds
Suppose you have two bonds with same
maturities and same coupon rates, but one is
a government bond and other is a corporate
bond,
which will sell for less?
why?
Theorem 1
 Bond prices move inversely with yields:
◦ If interest rates rise, the price of an existing bond
declines

◦ If interest rates decline, the price of an existing

bond increases

35
Theorem 2
 Bonds with longer maturities will fluctuate
more if interest rates change

 Long-term bonds have more interest rate risk

36
Theorem 3
 Higher coupon bonds have less interest rate
risk

 Money in hand is a sure thing while the

present value of an anticipated future receipt
is risky

37
TYPES
Type of Bonds
Issuer Maturity Coupon Option Redemption

Govt Short term Zero put single

Banks/PSU/ Fixed
Local bodies Medium coupon call multiple
Floating
Corporations Long coupon
perpetual
Duration as A Measure of Interest
Rate Risk
 The concept of duration
 Calculating duration

39
The Concept of Duration
 For a noncallable security:
◦ Duration is the weighted average number of years
necessary to recover the initial cost of the bond

◦ Where the weights reflect the time value of money

40
The Concept of
Duration (cont’d)
 Duration is a direct measure of interest rate
risk:
◦ The higher the duration, the higher the interest rate
risk

41
Inflation and Interest Rates
 Real rate of interest – change in
purchasing power
 Nominal rate of interest – quoted rate of

interest, change in purchasing power, and

inflation
 The ex ante nominal rate of interest

includes our desired real rate of return

plus an adjustment for expected inflation

42
The Fisher Effect
 The Fisher Effect defines the relationship
between real rates, nominal rates, and
inflation
 (1 + R) = (1 + r)(1 + h), where

◦ R = nominal rate
◦ r = real rate
◦ h = expected inflation rate
 Approximation
◦R=r+h

43
The Bond Indenture
 Contract between the company and the
bondholders and includes
◦ The basic terms of the bonds
◦ The total amount of bonds issued
◦ A description of property used as security, if
applicable
◦ Sinking fund provisions
◦ Call provisions
◦ Details of protective covenants

44
Priority of claims in liquidation

1. Secured creditors from sales of

secured assets.
2. Wages, subject to limits
3. Taxes
4. Unfunded pension liabilities
5. Unsecured creditors
6. Preferred stock
7. Common stock
Stocks and Their Valuation

 Features of common stock

 Determining common stock values

 Efficient markets

 Preferred stock
What is common stock / share /
equity
 Equity, an ownership position, in a
corporation.
 If you buy a share of stock, you can receive

cash in two ways

◦ The company pays dividends
◦ You sell your shares, either to another investor in
the market or back to the company
 As with bonds, the price of the stock is the
present value of these expected cash flows

 However, the difference is that the payout is

uncertain both in magnitude and timing
Key characterstics

 Residual claimant to corporate assets

What is great about it?
 Limited liability
 Voting rights
 Access to public markets
Facts about Common Stock

 Represents ownership.
 Ownership implies control.
 Stockholders elect directors.
 Directors elect management.
 Management’s goal: Maximize stock
price.
When is a stock sale an initial public
offering (IPO)?

 A firm “goes public” through an IPO

when the stock is first offered to the
public.
 Prior to an IPO, shares are typically
owned by the firm’s managers, key
employees, and, in many situations,
venture capital providers.
Cash Flows for Stockholders
 If you buy a share of stock, you can receive
cash in two ways
◦ The company pays dividends
◦ You sell your shares, either to another investor in
the market or back to the company
 As with bonds, the price of the stock is the
present value of these expected cash flows
Developing The Model
 You could continue to push back the year in
which you will sell the stock
 You would find that the price of the stock is

really just the present value of all expected

future dividends
 So, how can we estimate all future dividend

payments?
Estimating Dividends: Special Cases
 Constant dividend
◦ The firm will pay a constant dividend forever
◦ This is like preferred stock
◦ The price is computed using the perpetuity formula
 Constant dividend growth
◦ The firm will increase the dividend by a constant
percent every period
 Supernormal growth
◦ Dividend growth is not consistent initially, but
settles down to constant growth eventually
Zero Growth
 If dividends are expected at regular intervals
forever, then this is a perpetuity and the present
value of expected future dividends can be found
using the perpetuity formula
◦ P0 = D / R
 Suppose stock is expected to pay a Rs 5 dividend
every year and the required return is 10% with
quarterly compounding. What is the price?
◦ P0 = .50 / (.1 ) = Rs 50
Dividend Growth Model
 Dividends are expected to grow at a
constant percent per period.
◦ P0 = D1 /(1+R) + D2 /(1+R)2 + D3 /(1+R)3 + …
◦ P0 = D0(1+g)/(1+R) + D0(1+g)2/(1+R)2 +
D0(1+g)3/(1+R)3 + …
 With a little algebra and some series work,
this reduces to:

D 0 (1  g) D1
P0  
R -g R -g
 Stock Value = PV of Dividends

  D1 D2 D3 D
P   . . .
0
1  k  1  k  1  k 
s
1
s
2
s
3
1  k 
s


What is a constant growth stock?

One whose dividends are expected to

grow forever at a constant rate, g.
For a constant growth stock,

D1  D0 1  g
1

D2  D0 1  g
2

Dt  Dt 1  g
t

If g is constant, then:
P  D0 1  g  D1
0
ks  g ks  g
 $
D t  D 0 1  g
t

0.25 Dt
PVD t 
1  k t

If g > k, P0  !
P0   PVD t

0 Years (t)
What happens if g > ks?

D1
P 0  requires k s  g.
ks  g
 If ks< g, get negative stock price, which is
nonsense.
 We can’t use model unless (1) g < k and
s
(2) g is expected to be constant forever.
Because g must be a long-term growth
rate, it cannot be > ks.
D0 was Rs2.00 and g is a constant 6%.
Find the expected dividends for the next
3 years, and their PVs. ks = 13%.

0 g=6% 1 2 3 4

D0=2.00 2.12 2.2472 2.3820

1.8761 13%
1.7599
1.6508
What’s the stock’s market value?
D0 = 2.00, ks = 13%, g = 6%.

Constant growth model:

 
P
D0 1  g 
D1
0
ks  g ks  g
2.12 2.12
= = Rs30.29.
0.13 - 0.06 0.07
What is the stock’s market value one year
from now, P1? ^

 D1 will have been paid, so expected

dividends are D2, D3, D4 and so on. Thus,

D2
P̂1 
ks  g
$2.2472
  Rs32.10.
0.07
Find the expected dividend yield and
capital gains yield during the first year.

D1 2.12
Dividend yield = = = 7.0%.
P0 30.29

^
P1 - P 0 32.10 - 30.29
CG Yield = =
P0 30.29
= 6.0%.
Find the total return during the
first year.

 Total return = Dividend yield +

Capital gains yield.
 Total return = 7% + 6% = 13%.
 Total return = 13% = k .
s
 For constant growth stock:
Capital gains yield = 6% = g.
Rearrange model to rate of return form:

D1 D1
P 0  
to k s   g.
ks  g P0

^
Then, ks = Rs 2.12/Rs 30.29 + 0.06
= 0.07 + 0.06 = 13%.
What would P0 be if g = 0?

The dividend stream would be a

perpetuity.
0 k =13% 1 2 3
s

2.00 2.00 2.00

^ PMT Rs2.00
P0 = = = Rs15.38.
k 0.13
If we have supernormal growth of
30% for 3 years, then a long-run
^
constant g = 6%, what is P0? k is
still 13%.

 Can no longer use constant growth

model.
 However, growth becomes constant after
3 years.
Nonconstant growth followed by constant
growth:
0 1 2 3 4
ks=13%
g = 30% g = 30% g = 30% g = 6%
D0 = 2.00 2.60 3.38 4.394 4.6576

2.3009

2.6470

3.0453
$4.6576
46.1135 P̂3   $66.5371
0.13  0.06
^
54.1067 = P0
What is the expected dividend yield and
capital gains yield at t = 0? At t = 4?

At t = 0:
D1 $2.60
Dividend yield = = = 4.8%.
P0 $54.11

CG Yield = 13.0% - 4.8% = 8.2%.

(More…)
 During nonconstant growth, dividend yield
and capital gains yield are not constant.
 If current growth is greater than g, current
capital gains yield is greater than g.
 After t = 3, g = constant = 6%, so the t t =
4 capital gains gains yield = 6%.
 Because k = 13%, the t = 4 dividend yield
s
= 13% - 6% = 7%.
 Suppose g = 0 for t = 1 to 3, and
^
then g is a constant 6%. What is P 0?

0 1 2 3 4
ks=13%
...
g = 0% g = 0% g = 0% g = 6%
2.00 2.00 2.00 2.12

1.7699
1.5663
1.3861
$ 2.12
20.9895
P3 = = 30.2857
25.7118 0.07
What is dividend yield and capital gains
yield at t = 0 and at t = 3?

D1 2.00
t = 0: P = $25.72= 7.8%.
0

CGY = 13.0% - 7.8% = 5.2%.

t = 3: Now have constant growth

with g = capital gains yield = 6% and
dividend yield = 7%.
If g = -6%, would anyone buy the
stock? If so, at what price?

Firm still has earnings and still pays

^
dividends, so P0 > 0:
D0  1 g D1
P̂0  
ks  g ks  g
$2.00(0.94) $1.88
= = = $9.89.
0.13 - (-0.06) 0.19
A Differential Growth Example
A common stock just paid a dividend of Rs 2.
The dividend is expected to grow at 8% for 3
years, then it will grow at 4% in perpetuity.
What is the stock worth? The discount rate is
12%.
With the Formula
æDivN +1 ö
ç
ç - ÷ ÷
C é (1 g1 )
+ T
ù è r g2 ø
P= ê1 - T ú + N
r g1 ë (1 r ) û (1 r )
- + +
æ$2(1.08)3 (1.04) ö
ç
ç ÷
÷
$ 2 ´(1.08) é (1.08)3
ù è -
.12 .04 ø
P= 1-
ê 3ú
+ 3
-
.12 .08 ë (1.12) û (1.12)
($32.75)
P =$54 ´[1 -.8966]+ 3
(1.12)
P =$5.58 +$23.31 P =$28.89
A Differential Growth Example (continued)

3 3
$2(1.08) $2(1.08)
2
$2(1.08) $2(1.08) (1.04)
…
0 1 2 3 4 The constant
growth phase
beginning in year 4
$2.62
$2.16 $2.33 $2.52 + can be valued as a
.08 growing perpetuity
at time 3.
0 1 2 3 $ 2 . 62
P3   $ 32 . 75
. 08
$2.16 $2.33 $2.52 +$32.75
P0 = + 2
+ 3
=$28.89
1.12 (1.12) (1.12)
5.5 Estimates of Parameters in
the Dividend-Discount Model
 The value of a firm depends upon its growth
rate, g, and its discount rate, r.
◦ Where does g come from?
◦ Where does r come from?
Where does g come from?
g = Retention ratio × Return on retained
earnings
Where does r come from?
 The discount rate can be broken into two parts.
◦ The dividend yield
◦ The growth rate (in dividends)
 In practice, there is a great deal of estimation
error involved in estimating r.
5.6 Growth Opportunities
 Growth opportunities are opportunities to
invest in positive NPV projects.
 The value of a firm can be conceptualized

as the sum of the value of a firm that pays

out 100-percent of its earnings as
dividends and the net present value of the
growth opportunities.

EPS
P= + NPVGO
r
5.7 The Dividend Growth Model
and the NPVGO Model (Advanced)
 We have two ways to value a stock:
◦ The dividend discount model.
◦ The price of a share of stock can be calculated as the
sum of its price as a cash cow plus the per-share value
of its growth opportunities.
Preferred Stock

 Hybrid security.
 Similar to bonds in that preferred
stockholders receive a fixed dividend which
must be paid before dividends can be paid
on common stock.
 However, unlike bonds, preferred stock
dividends can be omitted without fear of
pushing the firm into bankruptcy.
What’s the expected return on
preferred stock with Vps = $50 and
annual dividend = $5?

$5
Vps  $50  
kps

 $5
k ps   0 .10  10 .0%.
$50