Chapter 3 - Interest Rates and Security Valuation

Various Interest Rate Measures:

Coupon Rate: Periodic cash flow a bond issuer contractually promises to pay a bond holder.
- Coupon rate never changes
Required Rate of Return: rates used by individual market participants to calculate fair present value
- Present value - (solve for required rate)
Expected Rate of Return: rates participants would earn by buying securities at current market prices
Realized Rate of Return: rate actually earned on investments

Premium Bond: If Coupon rate > r, then V > par

Discount Bond: if coupon < r, then V (price) < par

Par Bond: if coupon. = r, then V = par

Equity Valuation

(No Growth Model)

Present value of a Stock (Pt) = D/Rs

D = Constant dividend at end of year

Pt = stocks price at end of year

Rs= interest rate used to discount future cash flows

(Constant Growth Model)

Present value of a Stock (Pt) = (Dt+1) / Rs - g

D = Constant dividend at end of year

Pt = stocks price at end of year

g = dividend growth rate

Rs= interest rate used to discount future cash flows

Longer maturity = more sensitive to interest rate changes

Shorter Maturity = less sensitive to interest rate changes

Lower Coupon Rate = More sensitive to interest rate changes

Larger Coupon Rate = less sensitive to interest rate changes

Higher YTM, less sensitivity

Lower Yield to Maturity, More Sensitive

Duration: The weighted average time to maturity

Convexity: Degree of curvature of the price-interest rate curve.