PORTFOLIO

MANAGEMENT
SECURITY
ANALYSIS

Dr. Sawkat Hossain

1
Acknowledgement Ross et al, 2011, Essentials of Corporate Finance, 7th Ed, McGraw-Hill Companies, Inc..
 SECURITY ANALYSIS-1
Critically evaluate bond analysis with applications.

1. BOND ANALYSIS
Dr. Sawkat Hossain

08/12/2024 2
FIRM VALUE: AN OVERVIEW

VF = VE + VD
Where
VF = value of firm
VE = value of equity
VD = value of debt
Equity represents fund raised through issuing of shares or owners
capital
Debt represents fund raised through debenture and issuing of
bonds

08/12/2024 3
THE BASIC VALUATION MODEL

◼ The value (or price) of any asset is the present value of all
future cash flows it is expected to provide over the relevant time
period.
CF1 CF2 CF3 CFn
P= + + + ... +
(1 + r ) (1 + r ) (1 + r )
2 3
(1 + r ) n

 CFn n

P =  n 
1= n  (1 + r ) 

◼ P = present value (or price) of the asset

◼ CFn = cash flow expected at end of time n
◼ r = required rate of return (used as discount rate)
◼ n = relevant time period (in years or months)

08/12/2024 4
ILLUASTRATION-1
◼ Basil plc has made an investment in oil well in Nja and is expected to
generate income of £4,000 and £10,000 respectively over the next two
years. Basil cost of capital in this class of risk investment is 12%.
◼ Determine the price or present value of Basil investment income.

P= 4,000 + 10,000
(1 + 0.12)¹ (1 + 0.12)²

P= 4,000 + 10,000
(1.12)¹ (1.12)²

P = £11,543.35

08/12/2024 5
 EXERCISE-A1
Year Cash Inflow

1 $3.00

2 $4.50

3 $9.50

The above is cashflow structure of Wilson Hardware Co.. Calculate the current
value or price of Wilson if the security can be sold for $45.5 in three years’ time
and the required rate of return is 10.5%.

Current value or price =

08/12/2024 6
1.1 BOND VALUATION ANALYSIS
◼ A bond is a loan issued by corporations and governments
to raise finance.
◼ It promises to pay interest and repay loan capital.
◼ Once issued, bonds are traded in the secondary markets.
◼ Bonds are priced at nominal or par value
£100(UK);$1,000(US); TK….. (BD).
◼ The actual value will vary according to cash flows it pays
(i.e., interest and redeemed amount) and the prevailing
interest rate.
◼ Bonds are priced at ……….
◼ The fair price/or value of a bond is the present value of
future interest payments and principal repayment.
◼ P = PV (interest payments) + PV ( ? Value )

08/12/2024 7
ACTIVITY-X:

◼ Basil plc has made an investment in oil well in India and

is expected to generate income of £4,000 , £10,000 and
15,000 respectively over the next three years. Basil cost
of capital in this class of risk investment is 12% and risk
free rate of returns is 5%.
Determine the present value of Basil investment income:

PV (PRICE) =

08/12/2024 8
1.2 Interest Rates and Bond Pricing
◼ Bond prices can be related to interest rate.
◼ In pricing bonds you need both the coupon rate and interest rate
◼ Suppose AX plc issues two-year bond at £100 with a 10 per cent per
annum coupon rate. The interest rate is 10 per cent. Determine the
appropriate price of the bond.

P= £

P=£

Note: Non discount bond –coupon rate is equal to required return (i.e
interest rate).

08/12/2024 9
Interest Rates and Bond Pricing

◼ Assume that interest rate unexpectedly rises

to 12%.
◼ P =£

◼ P=£

◼ Note: discount bond because it’s less

attractive and priced below par value.

08/12/2024 10
Interest Rates and Bond Pricing

◼ Assume now that the interest rate fell to 8%.

Determine the new price of the bond.
◼ P =£
◼ We find that bond prices fall with a rise in
interest rates and increase with a fall in
interest rates. What can ,therefore, be
concluded?

08/12/2024 11
08/12/2024 12
 1.2 TYPES OF BONDS:
Based on relationships between
coupon rate and market interest rate Or
face value and bond price:
◼ Non-discount bonds
◼ Discount bonds

◼ Premium bonds.

08/12/2024 13
 Bond Market Reporting

Exercise-X:
◼ On the stock exchange bond market
reporting is represented as, for example:
AT&T-10%/25. What does this mean?

◼ The coupon rate means 10% of the par value

(or face value) of £100.Therefore the annual
coupon for AT&T is £-------.
08/12/2024 14
 1.3 BOND YIELD & YTM
◼ Current yield is annual coupon divided by price.
◼ For premium bonds, the current yield is less
than the YTM.

◼ The yield to maturity (YTM) of a bond is the internal

rate of return (IRR) if the bond is held until the
maturity date.
◼ YTC assumes that the bond is redeemable at a call
date before the maturity.
◼ Premium bonds, coupon rate greater than YTM
which is greater than current yield.
15
 EXERCISE—Y-1

The Smart Choice Plc, USA has 10

percent coupon bonds on the market
with ten years left to maturity. The
bonds make annual payments. If the
bond currently sells for $1,145.70, what
is its YTM?

08/12/2024 16
 EXERCISE—Y-2
◼ Suppose a bond with a 10% coupon
rate and Semiannual coupons, has 20
years to maturity and is selling for
$1,200. Calculate the Current Yield
and YTM.
◼ Which type of bond is this? Provide
your comment as a potential investor.

08/12/2024 17
 EXERCISE—Y-2.5
◼ Han and Co. has 14% debenture with a
face value of $100 that matures at par in
15 years. The security is callable in 5
years at $114.It currently sells for $105.
Calculate:
◼ Current yield-
◼ Yield to call-
◼ Yield to maturity-

08/12/2024 18
 EXERCISE—Y-3

◼ Han and Co. wants to issue new 10-

year semi-annual coupon bonds at
7.50 percent coupon rate. The
current selling price is $950.
Compute the yield to maturity of this
bond if par value is $1,000.

08/12/2024 19
 EXERCISE—Y-4 (Yield to Call)
◼ Example #1: Let us assume a $1,000 par value zero-
coupon bond that matures in three years and is callable in
two years at a call price that is 98% of the par value.
Determine the yield to call the bond if its current market
price is $887.
◼ Example #2: Let us assume John purchased a $1,000
par value bond with a 5% annual coupon. Although the
bond matures in five years, it can be called by the issuer
at the end of three years at a call price of 105% of the par
value. First, determine the yield to call the bond if its
current market price is $985.

08/12/2024 20
 1.4 METHODS OF BOND
VALUATION AND PRICING
Year 1 2 3 4 5

Pure Disc Bonds F

Coupon bonds C C C C ?

Consols C C C C ?

Which one is highly preferred?

08/12/2024 21
 i. Valuing Pure Discount Bonds
◼ It promises a single payment.

◼ If the payment is in a year’s time,

the bond is called one-year discount
bond.

◼ The date when the issuer of the

bond makes the final payment is ◼ Price of Zero-bond
called maturity date or simply
maturity.
=
◼ Pure discount bonds are sometimes
called zero –coupon bonds to
emphasize the fact ….

◼ The price and yield to maturity are

calculated as follows.

◼ Here, annual rate of return is called

Spot Interest Rate.

08/12/2024 22
 ACTIVITY-P-1:
◼ Consider a bond with a face value of £1.25m
that matures in 25 years with an interest rate
of 11.5%. For the bond holder, the initial
investment (cost) of the bond is £175,000.
◼ Determine the current price paid for the bond:

P=
◼ Is it worth-while for the investor?

08/12/2024 23
 ACTIVITY-P-2:
◼ Consider a deep discount bond with
a face value of £1000 that matures
in 5 years. Determine the spot
interest rate if the issue price of
bond is £519.37. Is it worth-while for
the bond investor if market discount
rate is 15.25%?
◼ Ans.

08/12/2024 24
 ii. VALUING COUPON BONDS

 CPN1
n
CPN 2 CPN n + FVn 
P =  + + ... + n 
1= n  (1 + YTM1 ) (1 + YTM 2 ) (1 + YTM n ) 
2

◼ P = price or present value of bond

◼ CPN = annual interest/or coupon payments
◼ n = number of years to maturity
◼ FV = future value or par value@ redemption (R)
◼ YTM= yield to maturity or rate of return on bond

08/12/2024 25
 ACTIVITY-a:
◼ On the 1st May 2015, you decide to purchase
a £1,000 face value of a 6.5% coupon rate
Tesco plc., UK corporate bond maturing on 1st
May 2020. When the bond matures in 2020,
Tesco plc will repay the original loan of £1,000.
Given the current treasury bill rate & market
interest rate are 3.5% & 5.5%respectively.
◼ Calculate the present value of your bond.
◼ Which type of bond it is? Provide comment.

08/12/2024 26
 ACTIVITY-b:
◼ Define bond at par. Let us assume,
Lycan Inc., USA has 7 percent coupon
bonds on the market that have 8 years
left to maturity. The bonds make
annual payments. If the YTM on these
bonds is 9 percent, what is the current
value of the bond?
◼ Which type of bond it is?

08/12/2024 27
 iii. VALUING CONSOLS
◼ No final maturity.
◼ It is called irredeemable bonds
◼ Pays coupon for perpetual.
◼ In the 18th century BoE issued ‘English consols’
and the bank guaranteed payment to holders
forever
◼ Through wars and depressions
◼ You can still buy such bonds today in London
from the bank.
◼ This instrument is valued or priced by the
perpetuity formula. Hence Price = ?

08/12/2024 28
 Illustration-k1
◼ Suppose, the current treasury bill rate &
market interest rate are 3.5% & 10.25%
respectively; initial bond investment is £500
which is non-refundable, and a console bond
with a yearly coupon payment of £59.5 on UK
bonds is valued at-

P=
◼ Distinguish Current yield and Yield to maturity
of bond.
◼ What are the key features of corporate bond?
08/12/2024 29
 Illustration-k2

◼ Lycan Inc., has 10.75 percent irredeemable

bond having market interest rate is 9.25
percent and nominal value of taka 1000,
what is the current value of the bond?
◼ Is this bond financially profitable for the
investor?

08/12/2024 30
Bond Class: Maturity & Debt Variability
1. Callable Bonds
◼ These securities have provisions allowing the issuer to redeem the
issue prior to the scheduled maturity date.
2. Puttable Bonds
◼ The holder of a puttable bond has the right to seek redemption
(sell) from the issuer at any time before the maturity date. The holder
may exercise put option in part or in full.
3. Convertible Bonds
◼ The holder of a convertible bond has the option to convert the bond
into equity (in the same value as of the bond) of the issuing firm
(borrowing firm) on pre-specified terms. This results in an automatic
redemption of the bond before the maturity date.

31
 Bond Class: Maturity & Debt Variability
4. Serial Bond
◼ Serial bond is the type of bond in which loan amounts/borrowing
are to be repaid in small instalments every year.
5. Fixed-Rate Bond
◼ Fixed-rate bonds of those whose coupon rate doesn't always
change over the course of the investment.
6. Floating Rate Bond
◼ The holder of a puttable bond has the right to seek redemption
(sell) from the issuer at any time before the maturity date. The holder
may exercise put option in part or in full.
7.Extendable Bond
◼ The extendable bonds are those bonds which can be extended by
their maturity period by the investors.
08/12/2024 32
 PHASE-2
2.1 BOND CREDIT RATING
◼ Bonds are rated by specialist credit-rating companies, e.g.
Moody’s and Standard & Poor’s (S&P) in the US; Fitch IBCA in
Europe (French owned co.).
◼ Moody’s assigns credit ratings of Aaa, Aa, A, Baa, Ba, B, Caa,
Ca, C,.
◼ S&P and Fitch assign credit ratings of
AAA,AA,A,BBB,BB,B,CCC,CC,C.
◼ AAA/Aaa, AA/Aa, A,BBB/Baa = ……… Bonds
◼ BB/Ba, B, CCC/Caa, CC/Ca,C = …….. Bonds

Ques A: Between investment & junk bond, which one

offers relatively higher coupon rate to investors?
Ques B: What are key risk factors of bond?

08/12/2024 33
 2.2 Risks associated with bond:
The risks associated with bond may be classified
among three main categories:

◼ a. Default risk : Credit risk increases.

◼ b. Call risk: Buy-back before maturity.

◼ c. Market risk: Systematic risk factor.

08/12/2024 34
 2.3 STRATEGIC FINDINGS ON
BOND VALUATION
A. Effect of Coupon Size on Bond Pricing:
With the reference of the relationship
between price and interest rate on
fixed-income, bond offering lower
coupon size is more sensible to bond
pricing than bond offering higher
coupon rate.

08/12/2024 35
 STRATEGIC FINDINGS

B. Effect of YTM on Bond pricing:

With the reference of the relationship
between price and interest rate on
fixed-income, bond offering lower YTM
size is more price sensible to bond
pricing than bond offering higher YTM
size .

08/12/2024 36
 C. Maturity Period
C. Effect of Maturity on Bond pricing:

• Positive Association between Maturity and price

sensitivity.

• Maturity represents how much time requires

until final payment.

• Does not capture all other information about the

timing and magnitude of interim payments.
08/12/2024 37
 D. Duration and Bond Pricing
◼ Duration is an estimation of price sensitivity to the rate of market
return movements. It is underlying risk adjusted maturity of a bond.
◼ Duration (Macaulay’s Duration) is a weighted average of a bond’s
time periods relative to the security’s price.
◼ Macaulay’s Duration is:

◼ The percentage change in the bond’s price for a small change in

yield, may be termed as the modified duration. Thus the Modified
duration is equal to Macaulay’s duration divided by (1+r).
◼ Specifically, the greater a bond’s maturity, the greater its------------.

08/12/2024 38
 EXERCISE-D-1

◼ Assume a bond with RM1,000 face

value, 10% coupon, 3 years to
maturity but the YTM is 20%, the
Duration of this bond may be
calculated as:

◼ DURATION=
◼ COMMENT =
08/12/2024 39
 EXERCISE-D-2.0
◼ What is the underlying relationships
between maturity and duration of a bond?
What is their relationships with market
index rate dynamics?
◼ Assume a coupon bond with $1,000 face
value, 10% coupon, 3 years to maturity but
the YTM is 20%, having semi-annual
payment frequency considered, Duration
of this bond may be calculated as:
08/12/2024 40
 EXERCISE-D-3
◼ Assume a pure discount bond with
RM1,000 face value, 0% coupon, 3 years
to maturity but the YTM is 20%, the
Duration of this bond may be calculated
as:
◼ DURATION=
◼ REMARK= Duration of a zero-coupon bond is equal to its -----.

08/12/2024 41
1.4 (a): ‘Bangla bond’ listed on LSE
on 11th Nov. 2019
◼ The International Finance Corporation (IFC), a sister
concern of the World Bank, is set to offer the first-ever
Bangladeshi Taka-denominated bond (Bangla Bond) on
the London Stock Exchange (LSE).
◼ The debt certificate—the Bangla Bond—is being backed
by the International Finance Corporation (IFC), the
private sector arm of the World Bank Group.
◼ A successful implementation of the bond issuance will
signal the confidence offshore investors have in the
stability of the Bangladesh economy and the taka, (IFC
April 2015).
08/12/2024 42
 1.5 (b): Concept of Green Bond
◼ A green bond is a bond specifically issued for climate
and sustainable environmental projects;
◼ Green bonds finance projects aimed at energy
efficiency, pollution prevention, sustainable agriculture,
fishery and forestry, protection of aquatic and terrestrial
ecosystems, clean transportation, sustainable water
management, green financial system, and the
cultivation of environmentally friendly technologies.
◼ Green bonds come with tax incentives such as tax
exemption.
◼ The World Bank itself is a major issuer of green bonds.
08/12/2024 43
 Comparison between Bond & Debenture
Both Bonds and Debenture are popular debt based financial instruments. A
debenture is a form of unsecured debt and most common variety of short-
term to medium term bond preferably issued by governments and private
organizations that lacks collateral.

Issue Bond Debenture

•Issuing time preference
•Maturity period
•Risk factor
• Interest rate
• Security/ collateral
• Principal Repayment
•Convertibility
•Asset liquidation
 EXAM TYPE QUESTION-1
◼ Let us consider the context of corporate
coupon bonds, where Beximco issued a set
of bonds 5 years ago and has only 18
months until maturity. The bond has a face
value of taka100. The coupon on the issue is
10% pa paid in semi-annual instalments.
What is the bond price right now if the yield
to maturity is 11% pa compounded half-
yearly?

08/12/2024 45
 EXAM TYPE QUESTION-2
◼ A) An investor owns a $ 1000 face value bond
with 5 years to maturity. The bond pays annual
interest payment of $80. The bond is currently
priced at $960. Given market interest rate is
10%, should the investor hold or sell the bond?
◼ B) A bond pays interest annually and sells
for $835. It has six years to maturity and a
par value of $ 1000. What is its coupon rate
& current yield if its promised YTM is 12 %?

08/12/2024 46
 EXAM TYPE QUESTION-3
A) Find the duration of a 6% coupon bond with a
face value of $1000 making annual interest
payment. The bond has a 5 years maturity and
redeemable at 5% premium at maturity. The
market interest rate is currently 8%. Estimate
bond Duration with comment.
B)
➢ i) Distinguish among callable, puttable & convertible
bond.
➢ ii) What are the key three types of underlying risks of
bond?
➢ iii) Distinguish between Bond & Debenture if any.
08/12/2024 47
 EXAM TYPE QUESTION-4
◼ Let us consider the context of corporate
coupon bonds, where Telford issued a set of
bonds 10 years ago and has only 2 years
until maturity. The bond has a face value of
taka100. The coupon on the issue is 12% pa
paid in semi-annual instalments. What is the
bond price right now if the yield to maturity is
14% pa compounded half-yearly?

08/12/2024 48