Investments 3A

Chapter 5 – Introduction to the valuation of debt Securities

Week 4
• Valuation – Is the process of determining the fair value of a financial asset,
• the process is also referred to as valuing or pricing of financial assets
• Chapter content :
• 1. Explanation of the general principles of fixed income security valuation
• 2. Explanation will it be bathed on the valuation of option free bonds

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General Principles of Valuation
• The fundamental principle of financial asset valuation is that the value is equal to the present
value (PV) of its expected cash flows

• Steps
• 1. Estimate the expected cash flows
• 2. Determine the appropriate interest rate or interest rates that should be used to discount the
cash flows
• 3. Calculate the PV of expected cash flows found in step 1 using interest rate or interest rates
determined in Step 2

• (A) Estimating cash flows

• cash flow – it's simply the cash that is expected to be received in the future from an investment
• sometimes it can be difficult for investors to estimate cash flows when they purchase a fixed
income security if :
•

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(i) The issue of the investor there's the option to change the contractual due date for the payment
or principal
(ii) The coupon payment is reset periodically by a formula based on the same values of reference
rates, prices or exchange rates.
(iii) The investor has a choice to convert or exchange the security into common stock

• Callable bonds, puttable bonds, mortgage-backed securities and asset backed securities are
examples of (i)
• Floating rate securities are examples of (ii)
• Convertible bonds and exchangeable bonds are examples of (iii)

• For securities that fall into (i) future interest rates movements are key factors to determine if the
coupon option will be exercised.

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(B) Determining the appropriate rate or rates
• Once the cash flows for fixed income security are estimated the next step is to determine the
appropriate interest rate to be used to discount the cash flows
• The minimum interest rate and investor should require is the yield available in the market on the
default free cash flow
• For a government issued security, the yield required is on the run forward securities

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(C) Discounting expected cash flows
• Given expected [ estimated] cash flows and appropriate interest rate, or interest rates to be used
to discount the cash flows, the final step of the valuation process is to follow the cash flows
• QN : what is the value of a single cash flow to be received in the future  it is the amount that
must be invested today to generate that future value  present value (PV) / discounted value
• the PV of a cash flow depends on :
• (i) When the cash flow will be received ,that is, the timing.
• (ii) The interest rate used to calculate the PV

• the interest reduced is called discount rate

• first, we calculate the PV for each expected cash flow. then to determine the value of the security
we calculate the sum of the PV (ie, for all the security expected cash flows)

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• The value of your financial asset is the sum of the PV of all expected CF
• Therefore : Value = PV1 + PV2+ …+ PVN

• EXAMPLE
• Consider a simple bond that much was in four years, has a coupon rate of 10% and has a
maturity value of 100. Assuming the bond pays annually and the discount rate of 8% should be
used to calculate the PV of each cash flow.

Year Cashflow
1 10
2 10
3 10
4 110

• Calculate the PV of the bond

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Calculate the PV

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Present Value calculation :

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(i) Present Value Properties
• The PV decreases as we go further into the future

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For a given discount rate, the further into the future, a cash flow is received to lower the PV.

QN: suppose the discount rate 12% said it is per person what is the present value of the cash flow

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• That the discount rate the lower the security value and vice versa
• Exhibit one represents an inverse relationship between value and discount rate  the graph
depicted is referred to as a convex
• Convex means that the curve is bowed from the origin
• Convexity has its implications for the price for the price volatility of a bond when Interest rates
change.

• (ii) The relationship between coupon rate discount rate and price relative to par

• Relationships to consider :

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(iii) Changing bond value as it moves towards maturity
• As a bond moves closer to its maturity date, the value changes
• Assuming a discount rate does not change, a bond value :
• (i) decreases overtime if the bond is selling at a premium
• (ii) increases over time if a bond is selling at a discount
• (iii) is unchanged if the bond is selling at par

• At the maturity date, the bond value is equal to its par. overtime as the bond moves towards its
maturity date its price we'll move to its par value  “pull to par value”

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(D) Valuation using multiple discount rates
• suppose that the appropriate discount rates are as follows
•

• Calculate the PV

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(E) Valuing semi-annual Cashflows
• In previous example, description was that the bond pays annually, when valuing semi annual
bonds, the procedure is to divide the annual coupon payment by two and adjust the discount rate
by two,
• the time period (t) In the PV formula is treated in terms of a six month-period rather than years.

• EXAMPLE
• Consider a four-year 10% coupon bond with maturity of 100. calculate the present value

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Notice the difference between Semi-annual and Annual
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• The value of a non amortizing bond can be divided into two components :
• (i) PV of the coupon payment
• (ii) PV of the maturity value

• For its fixed income coupon bond, the bond payments represent an annuity
• A shortcut formula can be used to compute the value of your bond when using a single discount
rate : compute the present value of the annuity and add the present value of the maturity value.
• The present value of an annuity is equal to :
•

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• EXAMPLE

• Consider a four-year 10% coupon bond with an annual discount rate of 8% and a semi-annual
discount rate of 1/2 of the rate :

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• To determine the price, the PV of majority value must be added to the present value of the coupon
payment.
The present value of the majority value is:

Present value of maturity value = $100/(1.04)4×2 = $73.0690

Qn : What is the Price ?

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(F) VALUING A ZERO-COUPON BOND
• Is there a coupon bond only have one cash flow  the majority value
• the value of zero coupon wanted that matures N years from now is:

• Qn: Consider the value of a five-year 0 coupon bond with the maturity value of 100 discounted at
8% interest :
• Information
• i = (0.04) (0.08/2)
• N=5

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• Information
• i = (0.04) (0.08/2)
• N=5

$100/ (1.04)5×2 = $67.5564

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(G) VALUING A BOND BETWEEN COUPON PAYMENTS
• For coupon paying bond, a complication arises when you try to press a bond between coupon
payments.
• the amount that the buyer pays the seller in such a case in the PV of the cash flow
• but one of the cash flows, is the very next cash flow, encompasses 2 components :
• (i) interest earned by the seller
• (ii) interest and by the buyer
•

• The interest earned by the seller is the interest status accrued between the last coupon payment
date and the settlement date  accrued interest
• the buyer must compensate the seller of their accrued interest
• The buyer recovers their accrued interest when the next coupon payment is received
• the price is referred to as full price [dirty price]

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• It is the full price the buyer pays the seller
• From the full price, accrued interest must be deducted to determine the price of the bond,
sometimes it is referred to as the clean price.

• (i) Computing the full price

• To compute the full price, step 1 – determine the fractional periods between the settlement date
and the next coupon payment date.

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Jk

QN: What is the full price ?

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(ii) Computing the accrued interest and Clean Price
• Clean Price – it is the price without the accrued interest
• To determine the accrued interest, it is necessary to determine te number of days in the accrued
interest period.

• Calculation
• Days in the accrued interest period = days in coupon period – days beytween settlement and next CPD

• The percentage of the nect annual coupon payment that the seller has earned as accrued interest
is found as follows:

Recall example with full price computation, since there are 182 days in the coupon period and 78
days from the settlement date to the next coupon payment, the days in the accrued interest period is
182 – 78 = 104 days, therefore % of te coupon payment that is accrued is 104/ 182 = 0.5714

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• Notice it is the same percentage when you calculate (1-w)  1 – 0.4286

• Therefore the amount of accrued interest (AI) =

• AI = Semi-annual coupon payment X (1-w)
• AI = $5 X (1- 0.4286) = 2.8570

• Calculate the clean Price

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Clean Price = Full Price – AI

Therefore clean price = 106.8192 – 2.8570 = 103.9622

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(3) Day count conversions
• The practice for calculating the number of days between two dates depends on the day count
conventions used in the bond market.
• conversion different with type of security they count confessions are used to calculate the number
of days in the numeration and denominator of the ratio W

• #The AI assuming semi annual payments :

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III TRADITIONAL APPROACH TO VALUATION
• The traditional approach to valuation has been to discount if the cash flow of a fixed income
security by the same interest rate (discount rate )

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IV THE ARBITRAGE FREE VALUATION APPROACH
• Consider a 10-year 8% coupon bond

• by viewing any financial asset as a package of 0 coupon bonds, a consistent valuation framework
can be developed.
• in light of the concept, treasury spot rate is created
• this portrait for a treasure to security is the interest rate that should be used to discounted default
free cash flow with the same maturity
• value of a bond based on spot rates is called arbitrage free value =

• (a) Valuation using Spot rates

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(b) Reason for using Treasury Bonds

1. Stripping and the arbitrage free valuation

2. Reconstitution and arbitrage free valuation

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(c) Credit spreads and the valuation of non treasury securities
• The value of a non-treasury security is found by discounting the CF by the trwasury spot rates
plus a yield spread to reflect the additional risks

• The spot rate used to discount the CF of a non-Treasury security can be the treasury spot rate
plus constant credit spread.

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V VALUATION MODELS
• A valuation model provides fair value of your security
• in fixed income two common models are used:
• (i) The binomial model
• (ii) Monte Carlo simulation model

• Binomial – call appearance, put your opponents, floating rate notes, structured notes in which
formula is based on interest rates
• Monte Carlo simulation model – mortgage-backed securities and certain types of asset backed
securities

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Features of binominal and Monte Carlo simulation valuation models
1. each model begins with the yield on the run treasury securities and generate treasurer spot rates
2. each model makes an assumption about the expected volatility of the short term interest rates .
This is a critical assumption in both models since it can be significantly affect securities fair value
3. based on the volatility assumption, different“ branches” of the interest rate tree[ binomial model]
in the interest rates “path” open brackets Monte Carlo simulation model] are generated
4. the model is calibrated to the treasury market. That means for an “on the run” treasury issue is
value reduced in the model, the model will produce the observed market price
5. what was I developed to determine when an issuer or borrower who exercised embedded
options- call or put rule for callable or puttable bonds and a prepayment model for mortgage-
backed securities and certain types of asset backed securities

• the use of any valuation model is exposed to modeling risk

• Question : define modeling risk

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Any Questions ?

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