Chapters 10&11 - Debt Securities

 Bond characteristics
 Interest rate risk
 Bond rating
 Bond pricing
 Term structure theories
 Bond price behavior to interest rate changes
 Duration and immunization
 Bond investment strategies

 Bond characteristics
Bond: long-term debt security that the issuer makes specified payments of interest
(coupon payments) over a specific time period and repays a fixed amount of
principal (par or face value) at maturity

Face value or par value: usually $1,000

Coupon rate and interest payment

Zero-coupon bond: coupon rate is zero, no coupon payment, sells at a discount.

For example: a 10 year zero-coupon bond sells at $550 and yields 6.16% per year

Maturity date

Call provision: the issuer can repurchase bonds during the call period

Call premium and call price

Convertible bonds: can be converted into common stocks

Puttable bonds: bondholders can sell bonds back to the issuer before maturity

Floating-rate bonds: coupon rates vary with some market rates

Indexed bonds: payments are tied to a general price index

Junk bonds: high yields with high default risk

Government bonds, corporate bonds, international bonds

Preferred stocks: hybrid security, often considered as an equity but usually

included in fixed-income securities

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 Interest rate risk
Interest rate price risk vs. interest rate reinvestment risk (reinvestment risk)

Interest rate price risk: risk that a bond value (price) falls when market interest
rates rise

Reinvestment risk: risk that the interests received from a bond will be reinvested
at a lower rate if market interest rates fall

 Bond rating
Letter grades that designate quality (safety) of bonds (Figure 10.8 - Digital Image)
AAA
AA Investment grade bonds with low default risk
A
BBB
BB
B Speculative grade (junk) bonds with high default risk
.

Why bond rating? Firm's credit; Borrowing capacity

Determinants:
Coverage ratios - ratios of earnings to fixed costs
Leverage ratio - debt to equity ratio
Liquidity ratios - current ratio and quick ratio
Profitability ratios - ROA and ROE
Cash-flow-to debt ratio - ratio of total cash to outstanding debt

 Bond pricing
Accrued interest and quoted price

Invoice price = quoted (flat) price + accrued interest

0 182 days

40 days 142 days remaining until next coupon

Suppose annual coupon is $80 and the quoted price is $990,

Invoice price = 990 + (40/182)*40 = $998.79

Bond price = present value of coupons + present value of par value

The required rate of return serves as the discount rate

Premium bonds vs. discount bonds

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A premium bond sells for more than its face value ($1,000)
A discount bond sells for less than its face value ($1,000)

Annual interest payment valuation model

P = present value of coupons + present value of par value

= C (PVIFAr,n) + PV (PVIFr,n),

P: intrinsic value of the bond

C: annual coupon payment
r: the required rate of return, the market interest rate for the bond
n: the number of years until the bond matures
PV: par value (face value, $1,000 usually)

Semiannual interest payment valuation model: adjust the annual coupon to

semiannual (C to C/2), the annual required rate of return to semiannual (r to r/2),
and the number of years to maturity to semiannual periods (n to 2n)

Overpriced securities vs. underpriced securities

If the intrinsic value > the market price, the bond in the market is underpriced
If the intrinsic value < the market price, the bond in the market is overpriced
If the intrinsic value = the market price, the bond in the market is fairly priced

Example: A 30-year 8% coupon bond pays semiannual coupon payments. The

market interest rate (required rate of return) on the bond is 10%. What should be
the bond price (fair value)? If the market price of the bond is $850.00, should you
buy the bond?

Answer: n = 60, i/y = 5%, FV = 1,000, PMT = 40, solve for PV = -810.71
No, you should not buy the bond since the intrinsic value ($810.71) < the market
price ($850.00)

If the market interest rate for the bond is 8%, what should be the bond price?
Answer: PV = -1,000

If the market interest rate for the bond is 7%, what should be the bond price?
Answer: PV = -1,124.72

Bond price and market interest rates have an inverse relationship: keeping other
things constant, the higher the market interest rate, the lower the bond price
(Figure 10.3 - Digital Image)

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 Yield to maturity (YTM): rate of return from a bond if it is held to maturity

Example (continued): what is YTM of the bond?

Answer: PV = -850, FV = 1,000, PMT = 40, n = 60, solve for i/y = 4.76%,
YTM = 4.76*2 = 9.52%

Yield to call (YTC): rate of return from a bond until it is called

Example (continued): suppose the bond can be called after 5 years at a call price
of $1,050, what is YTC?
Answer: PV = -850, FV = 1,050, PMT = 40, n = 10, solve for i/y = 6.45%,
YTC = 6.45*2 = 12.91%

Current yield (CY): annual coupon payment divided by the current bond price
Example (continued): what is the current yield of the bond?
CY = 80/850 = 9.41%

If market interest rates rise what would happen to the current yield of a bond?

Answer: the current yield would increase since the bond price would decrease

Realized compound return: compound rate of return on a bond with all coupons
reinvested until maturity

Example: 10.5 (Figure 10.5 - Digital Image)

Consider a two-year bond selling at par and paying 10% coupon once a year. The
YTM is 10%. If the coupon payment is reinvested at an interest rate of 8% per
year, the realized compound return will be less than 10% (actually it will be
9.91%)

 Term structure theories

Term structure of interest rates: relationship between time to maturity and yields
for a particular fixed-income security

Yield curve: a graphical presentation of the term structure

Expectation theory: the yield curve is determined solely by expectations of future

short-term interest rates

Forward rates: implied short-term interest rates in the future

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 Example: suppose that two-year maturity bonds offer yields to maturity of 6% and
three-year bonds have yields of 7%. What is the forward rate for the third year?

Using the formula: and solving for fn = 9.02%

Approximation: fn = 7%*3 – 2*6% = 9.00%

Liquidity preference theory: investors demand a risk premium on long-term bonds

Liquidity premium: the extra expected return to compensate for higher risk of
holding longer term bonds

Market segmentation theory: investors have their preferences to specific maturity

sectors and unwilling to shift from one sector to another

 Bond price behavior to interest rate changes

(1) The value of a bond is inversely related to its yield.: As yields increase,
bond prices fall; as yields fall, bond prices rise.

(2) An increase in a bond’s yield to maturity results in a smaller price change

than a decrease in yield of equal magnitude.

(3) As the maturity date approaches, the value of a bond approaches to its par
value.

(4) Prices of long-term bonds tend to be more sensitive to interest rate

changes than prices of short-term bonds.

(5) The sensitivity of bond prices to changes in yields increases at a deceasing

rate as maturity increases.

(6) Interest rate risk is inversely related to the bond’s coupon rate. Prices of
low-coupon bonds are more sensitive to changes in interest rates than
prices of high-coupon bonds.

(7) The sensitivity of a bond’s price to a change in its yield is inversely

related to the yield to maturity at which the bond is currently selling.

(Figure 11.1 - Digital Image)

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 Duration and immunization
Duration: a measure of the effective maturity of a bond, defined as the weighted
average of the times until each payment is made, with weights proportional to the
present value of the payment.

Measuring duration: Macaulay duration = D = , where

Note: T is the number of years until the bond matures, y is the yield to maturity,
and P0 is the market price of the bond

Example: A 3-year bond with coupon rate of 8%, payable annually, sells for
$950.25 (face value is $1,000). What is yield to maturity? What is D?

Answer: y = 10%, D = 2.78 years (Spreadsheet 11.1 - Digital Image)

Relationship between duration and bond price volatility

=-D = - D* y

where D* = , is the modified duration

Example (continued): What is D*?

Answer: D* = D/(1+y) = 2.53 years

If the yield drops by 1%, what will happen to the bond price?

Answer: the price will increase by 2.53%

If the yield rises by 1%, what will happen to the bond price?

Answer: the price will decrease by 2.53%

Rules for duration

(1) for a zero-coupon bond, the duration is equal to the time to maturity
(2) the lower the coupon rate, the higher the D
(3) the longer the time to maturity, the higher the D
(4) the lower the yield, the higher the D
(5) for a perpetuity, the D = (1+y)/y

Bond immunization: a strategy to shield net worth from interest rate movements;
to get interest rate price risk and interest rate reinvestment risk to cancel each
other over a certain time period to meet a given promised stream of cash outflows

46
 See the example (Table 11.4 - digital Image)

Note: immunization works only for small changes in interest rates

Cash flow matching: matching cash flows from a fixed-income portfolio with
those of an obligation

Dedication strategy: refers to multi-period cash flow matching

Application of bond immunization: banking management, pension fund

management

 Bond investment strategies

Passive strategy: lock in specified rates given the risk, or buy and hold

Active management strategy: more aggressive and risky; try to timing the market

Bond swaps: an investment strategy where an investor liquidates one bond

holding and simultaneously buys a different issue (more in FIN 436)

Interest rate swaps: a contract between two parties to exchange a series of cash
flows based on fixed-income securities (more in FIN 436)

Tax swaps: replace a bond that has a capital loss for a similar security in order to
offset a gain in another part of an investment portfolio

 ASSIGNMENTS

Chapter 10
1. Concept Checks
2. Key Terms
3. Intermediate: 10-15, CFA 1 and 5

Chapter 11
1. Concept Checks
2. Key Terms
3. Intermediate: 10-11, CFA 1-2, and 10

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 Chapter 12 - Macroeconomic and Industry Analysis

 Global economy
 Domestic macro economy
 Industry analysis
 Company analysis

 Global Economy
Top-down analysis starts with the global economy: overview of the economic
conditions around the world

Exchange rate and exchange rate risk

Political risk (country risk)

 Domestic macro economy

To develop an economic outlook for domestic economy

Gross domestic product (GDP): total value of goods and services produced
High grow rate of GDP indicates rapid expansion – check for inflation
Negative grow rate of GDP indicates contraction – check for recession

Demand and/or supply shocks

Unemployment rate

Inflation: general level of prices for goods and services

Interest rates
Nominal interest rates vs. real interest rates (Figure 12.3 - Digital Image)

Determinants of interest rates

Supply side: from savers, mainly households
Demand side: from borrowers, mainly business
Government side: borrower or saver, through Fed
The expected inflation rate

Budget deficit: spending exceeds revenue

Sentiment: optimism or pessimism of the economy

Federal government policy: fiscal and monetary policies

Fiscal polity - the government uses spending and taxing to stabilize the economy

48
 Monetary policy – the Fed uses money supply and interest rate to stabilize the
economy (price level)

Consumer spending

Exchange rates

Business cycle: repetitive cycles of recession and recovery

(Figure 12.4 - Digital Image)

Peak vs. trough

Cyclical industries: with above average sensitivity to the state of the economy

Defensive industries: with below average sensitivity of the state of the economy

Economic indicators (Table 12.2 - Digital Image)

Leading indicators: rise or fall in advance of the rest of the economy
Coincident indicators: rise or fall with the economy
Lagging indicators: rise or fall following the economy

 Industrial analysis
To develop an industrial outlook

NAICS code to classify industries (Table 12.3 - Digital Image)

Sensitivity to the business cycle

Sector rotation

Industry life cycle

Industry structure and performance

Threat of entry; Competitors; Substitutes; Bargaining power

Technology development

Future demand

Labor problem

Regulations

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 Company analysis
Fundamental analysis: intrinsic value, financial statements, ratio analysis,
earnings and growth forecast, P/E ratio, and required rate of return (risk)

Valuation models (covered in Chapter 13)

 ASSIGNMENT

1. Concept Checks
2. Key Terms
3. Intermediate: 12, 14, and CFA 6

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 Chapter 13 - Equity Valuations

 Characteristics of common stock

 Valuation by comparables
 Dividend discount model (DDM)
 Alternative models
 Free cash flow valuation approach

 Characteristics of common stocks

Ownership with residual claims

Advantages and disadvantages of common stock ownership

Higher returns
Easy to buy and sell (liquidity)
Higher risk
Less current income

Cash dividend, stock dividend, and stock split

Treasury stocks - repurchased stocks held by a firm

Capital gains yield and dividend yield

 Valuation by comparables
Stocks with similar characteristics should sell for similar prices

Book value: the net worth of common equity according to a firm’s balance sheet

Liquidation value: net amount that can be realized by selling the assets of a firm
and paying off the debt

Replacement cost: cost to replace a firm’s assets

Tobin’s q: the ratio of market value of the firm to replacement cost

P/E ratio approach

Price-to-sales ratio approach
Market-to-book value approach
Price-to-cash flow approach

Example (Table 13.1 - Digital Image)

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 Dividend discount model (DDM)
Market price vs. intrinsic value

Market price: the actual price that is determined by the demand and supply in the
market

Intrinsic value: the present value of a firm’s expected future net cash flows
discounted by the required rate of return

In market equilibrium, the required rate of return is the market capitalization rate

Net income, retained earnings, and cash dividends

General formula:

Forecasting sales and growth rate: g = ROE * b (b is the retention ratio)

Estimating EPS and DPS

(1) Zero growth DDM (g = 0), which means that dividend is a constant (D)

or

where k is the required rate of return and E(r) is the expected rate of return

Example: if D = $2.00 (constant) and k = 10%, then V0 = $20.00

Preferred stocks can be treated as common stocks with zero growth (g = 0)

(2) Constant growth DDM (g = a constant)

D1 = D0*(1+g)
D2 = D1*(1+g) = D0*(1+g)2, and in general,
Dt = Dt-1*(1+g) = D0*(1+g)t

or

Example: assume D0 = 3.81, g = 5%, k = 12%, then V0 = 57.15

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Stock price and PVGO (present value of growth opportunity)

Dividend payout ratio (1-b) vs. plowback ratio (b, earnings retention ratio)

Price = no-growth value per share + PVGO

, where is the no-growth value per share

Example: assume E1 = $5.00, k = 12.5%, ROE = 15%

If D1 = $5.00, then g = 0% (g = ROE * b, b = 0)

P0 = 5/0.125 = $40.00

If b = 60%, then g = 15%*0.6 = 9%, D1 = 5*(1-0.6) = $2.00

P0 = $57.14 (from constant DDM)

PVGO = 57.14 – 40.00 = $17.14

(3) Life cycle and multistage growth models: the growth rates are different at
different stages, but eventually it will be a constant

Two-stage growth DDM

Example: Honda Motor Co.
Expected dividend in next four years:
$0.90 in 2009 $0.98 in 2010 $1.06 in 2011 $1.15 in 2012
Dividend growth rate will be steady beyond 2012

Assume ROE = 11%, b = 70%, then long-term growth rate g = 7.7%

Honda’s beta is 1.05, if the risk-free rate is 3.5% and the market premium is 8%,
then k = 11.9% (from CAPM)

Using constant DDM, P2012 = 1.15*(1 + 0.077) / (0.119 - 0.077) = $29.49

$29.49
$0.90 $0.98 $1.06 $1.15
2008 2009 2010 2011 2012

Discount all the cash flows to the present at 11.9%, V2008 = $21.88

Multistage growth DDM: extension of two stage DDM

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 Alternative models
P/E ratio approach
If g = ROE*b, the constant growth DDM is

, with k>ROE*b.

Since P/E ratio indicates firm’s growth opportunity, P/E over g (call PEG ratio)
should be close to 1.

If PEG ratio is less than 1, it is a good bargain. For the S&P index over the past
20 years, the PEG ratio is between 1 and 1.5.

Price-to-book ratio approach

Price-to-cash flow ratio approach

Price-to-sales ratio approach

 Free cash flow valuation approach

Free cash flow: cash flow available to the firm or to the shareholders net of capital
expenditures

Free cash flow to the firm (FCFF)

FCFF = EBIT*(1-tc) + depreciation – capital expenditures – increase in NWC

Use FCFF to estimate firm’s value by discounting all future FCFF (including a
terminal value, PT) to the present

Free cash flow to equity holders

FCFE = FCFF – interest expense*(1-tc) + increases in net debt

Use FCFE to estimate equity value by discounting all future FCFE (including a
terminal value, PT) to the present

Examples

 ASSIGNMENTS

1. Concept Checks
2. Key Terms
3. Intermediate: 12, 13, 14, and CFA 1-4

54
 Chapter 18 - Portfolio Performance and Evaluation

 Risk-adjusted returns
 M2 measure
 T2 measure
 Active and passive portfolio management
 Market timing

 Risk-adjusted returns
Comparison groups: portfolios are classified into similar risk groups

Basic performance-evaluation statistics

Starting from the single index model

Where is the portfolio P’s excess return over the risk-free rate, is the
excess return on the market portfolio over the risk-free rate, is the portfolio
beta (sensitivity), is the nonsystematic component, which includes the
portfolio’s alpha and the residual term (the residual term has a mean
of zero)

The expected return and the standard deviation of the returns on portfolio P

and

Estimation procedure

(1) Obtain the time series of RPt and RMt (enough observations)

(2) Calculate the average of RPt and RMt ( and )

(3) Calculate the standard deviation of returns for P and M ( and )

(4) Run a linear regression to estimate

(5) Compute portfolio P’s alpha:

(6) Calculate the standard deviation of the residual:

55
 Risk-adjusted portfolio performance measurement (Table 18.1 - Digital Image)

(1) The Sharpe measure: measures the risk premium of a portfolio per unit of total
risk, reward-to-volatility ratio

Sharpe measure =

(2) The Jensen measure (alpha): uses the portfolio’s beta and CAPM to calculate
its excess return, which may be positive, zero, or negative. It is the difference
between actual return and required return

(3) The Treynor measure: measures the risk premium of a portfolio per unit of
systematic risk

Treynor measure =

 M2 measure
M2 measure: is to adjust portfolio P such that its risk (volatility) matches the risk
(volatility) of a benchmark index, then calculate the difference in returns
between the adjusted portfolio and the market

Example: Given the flowing information of a portfolio and the market, calculate
M2, assuming the risk-free rate is 6%.

Portfolio (P) Market (M)

Average return 35% 28%
Beta 1.2 1.0
Standard deviation 42% 30%

S for P = (0.35 - 0.06) / 0.42 = 0.69

S for M = (0.28 - 0.06) / 0.30 = 0.73

M2 = (0.69 - 0.73)*0.30 = -0.0129 = -1.29%

(Figure 18.2 - Digital Image)

56
 E(r) CML

rP = 35% P
M
rM = 28%
rP* =26.71% M2 CAL
P*

rf = 6%

=30% =42%

Alternative way: adjust P to P* (to match the risk of the market)

Determining the weights to match the risk of the market portfolio

30/42 = 0.7143 in portfolio
1-0.7143 = 0.2857 in risk-free asset
Adjusted portfolio risk = 30%
Adjusted portfolio return = 0.7143*35% + 0.2857*6% = 26.71% < 28%

M2 = 26.7% – 28% = -1.29%

The portfolio underperforms the market

 T2 measure
T2 measure: is similar to M2 measure but by adjusting the market risk - beta

Example (continued)

Weights: 1/1.2 = 0.8333 in P and 1 – 0.8333 = 0.1667 in risk-free asset

The adjusted portfolio has a beta of 1: 1.2*0.8333 + 0*0.1667 = 1

Adjusted portfolio return = 0.8333*35% + 0.1667*6% = 30.17% > 28%

T2 = 30.17% – 28% = 2.17%

57
 E(r)

P
rP = 35%
P*
rP* = 30.17%
rM = 28% T2 SML
M

rf = 6%

=1 =1.2

The portfolio outperforms the market

Why M2 and T2 are different?

Because P is not fully diversified and the standard deviation is too high

 Active and passive portfolio management

Active: attempt to improve portfolio performance either by identifying mispriced
securities or by timing the market; it is an aggressive portfolio management
technique

Passive: attempt of holding diversified portfolios; it is a buy and hold strategy

 Market timing
A strategy that moves funds between the risky portfolio and cash, based on
forecasts of relative performance

(Table 18.7 - Digital Image)

When can we time the market?

(Figure 18.9 - Digital Image)

Can we time the market?

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 Example: Intermediate 6 (Figure - Digital Image)

We first distinguish between timing ability and selection ability. The intercept of
the scatter diagram is a measure of stock selection ability. If the manager tends to
have a positive excess return even when the market’s performance is merely
“neutral” (i.e., the market has zero excess return) then we conclude that the
manager has, on average, made good stock picks. In other words, stock selection
must be the source of the positive excess returns.

Timing ability is indicated by the curvature of the plotted line. Lines that become
steeper as you move to the right of the graph show good timing ability. The
steeper slope shows that the manager maintained higher portfolio sensitivity to
market swings (i.e., a higher beta) in periods when the market performed well.
This ability to choose more market-sensitive securities in anticipation of market
upturns is the essence of good timing. In contrast, a declining slope as you move
to the right indicates that the portfolio was more sensitive to the market when the
market performed poorly, and less sensitive to the market when the market
performed well. This indicates poor timing.
We can therefore classify performance ability for the four managers as follows:
Selection Ability Timing Ability
A Bad Good
B Good Good
C Good Bad
D Bad Bad

 ASSIGNMENTS

1. Concept Checks
2. Key Terms
3. Intermediate: 5, 6, and CFA 1-4

59
 Chapter 19 - International Investing

 Global equity markets

 Risk factors in international investing
 International diversification
 Exchange rate risk and political risk

 Global equity markets

Developed markets vs. emerging markets

(Tables 19.1 and 19.2 - Digital Image)

Market capitalization and GDP: positive relationship, the slope is 0.66 and R2 is
0.28, suggesting that an increase of 1% in the ratio of market capitalization to
GDP is associated with an increase in per capita GDP by 0.66%

Home-country bias: investors prefer to invest in home-country stocks

 Risk factors in international investing

Exchange rare risk

Direct quote vs. indirect quote

Direct quote: $ for one unit of foreign currency, for example, $2 for one pound

Indirect quote: foreign currency for $1, for example, 0.5 pound for $1

Interest rate parity:

Example: 19.1 - 19.3

Given: you have $20,000 to invest, rUk = 10%, E0 = $2 per pound, the exchange
rate after one year is E1 = $1.80 per pound, what is your rate of return in $?

$20,000 = 10,000 pounds, invested at 10% for one year, to get 11,000 pounds

Exchange 11,000 pounds at $1.80 per pound, to get $19800, a loss of $200

So your rate of return for the year in $ is -1% = (19,800 - 20,000) / 20,000

If E1 = $2.00 per pound, what is your return? How about E1 = $2.20 per pound?
If F0 = $1.93 (futures rate for one year delivery) per pound, what should be the
risk-free rate in the U.S.?

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 Answer: rUS = 6.15%, using the interest rate parity

If F0 = $1.90 per pound and rUS = 6.15%, how can you arbitrage?

Step 1: borrow 100 pounds at 10% for one year and convert it to $200 and invest
it in U.S. at 6.15% for one year (will receive 200*(1 + 0.0615) = $212.3)

Step 2: enter a contract (one year delivery) to sell $212.3 at F0

Step 3: in one year, you collect $212.3 and covert it to111.74 pounds

Step 4: repay the loan plus interest of 110 pounds and count for risk-free profit of
1.74 pounds

Country-specific risk (political risk)

 International diversification
Adding international equities in domestic portfolios can further diversify domestic
portfolios’ risk (Figure 19.10 - Digital Image)

Portfolio Risk

With US stocks only

US and international stocks

# of stocks in portfolio

Adding international stocks expands the opportunity set which enhances portfolio
performance (Figure 19.10 - Digital Image)

E(rP)

US and international stocks

With US stocks only

(Way? Because investors with more options (choices) will not be worse off)

World CML (Figure 19.2 - Digital Image)

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 World CAMP

Choice of an international diversified portfolio (Figure 19.14 - Digital Image)

 ASSIGNMENTS

4. Concept Checks
5. Key Terms
6. Intermediate: 5-7 and CFA 1-2

62