Determinants of Interest Rates Wiley

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Determinants of Interest Rates Wiley Powered By Docstoc
  Sixth Canadian Edition
     Lusztig, Cleary, Schwab

Bond and Common Share
     Learning Objectives

1. Name the five variables of a debt contract.
2. Describe how to estimate bond prices and
   bond yields.
3. Discuss the three leading theories on the
   term structure of interest rates, and explain
   how they differ.
4. Explain the dividend discount model (DDM)
   and how financial officers use it to value

   Topics explored and discussed include:
•   valuation of bonds and common share
•   Rates at which debt instruments are
    discounted and determined through the
    financial markets
•   valuation of bonds and common share
    without explicit consideration of risk
•   Risk premiums associated with interest rates
         Valuation of Bonds

   Bond – a debt instrument that entitles the
    owner to specified periodic interest payments
    and eventually to the repayment of principle
    at the stated date of maturity
   Coupon rate – the rate specified on the
    original contract in relation to the face value
    of the debt
   Effective yield or yield to maturity – the yield
    investors realize by holding to maturity a debt
    contract that they bought at a particular
    market price
        Valuation of Bonds

   Debt contracts are characterized by
    • The face value
    • Stated interest rate
    • Time pattern of repayment under the debt
    • Current market price of the debt contract
    • Effective yield of the debt contract, based
      on its current price
  Calculating Market Price

                  1       
           1             
      B  I
               1  r n   
                r           1  r n
                          

B = current market price of the bond
F = face value of the bond
I = interest or coupon payments
r = yield to maturity
      Semi-annual coupons

   In calculating the bond price for semi-annual
    coupons the following changes must be
•   Divide the annual coupon by two to
    determine the amount of semi-annual coupon
•   Divide the market yield by two to obtain the
    six-month market yield
•   Multiply the number of years to maturity by
    two to obtain the number of semi-annual
    periods to maturity
           Perpetual Bonds

   Zero-coupon bond (or strip bond) do not pay
    any interest during its life
   Zeros are created when financial
    intermediaries buy traditional bonds and strip
    the cash flow from them and sell the coupon
    and cash flow separately
   Purchaser pays less for zeros and receives
    face value at maturity
                Bond Yields
    Yield to Maturity - the yield investors realize
     by holding to maturity a debt contract that
     they bought at a particular market price.
     The yield captures both the coupon income
     and the capital gain or loss realized by
     purchasing the bond at a price different
     from its face value

    Two methods in calculating YTM include:
    1.   Linear interpolation
    2.   Approximation formula
            Current Yield

   Current yield – the ratio of annual
    coupon interest to the current market

            Annual interest
       CY 
Determinants of Interest
   The effective yield of a debt contract is
    established by the general economic
    factors that effect the overall level of
    interest rates and by such features of
    the debt contract as its maturity,
    currency denomination, and risk of
Determinants of Interest

   Interest - the price paid for borrowing
    • Changes in interest is measured in basis
    • One basis point = 1/100th of one percent
    Determinants of Interest
   Loanable fund theory –the relationship
    between the supply and demand for
    funds where the supply of capital  with
     interest rates and the demand for
    funds  as the costs . At equilibrium
    interest rates are such that demand
    equals supply.
    Determinants of Interest
 Real risk-free rate interest – the basic
  interest rate that must be offered to
  individuals to persuade them to save
  rather than consume and is not affected
  by price changes or risk factors
 Nominal interest rates – represent the
  real rate (RR) plus the expected
Determinants of Interest

           RF = RR + EI
RF = short-term treasury bill rate
RR = the real risk-free rate of interest
EI = the expected rate of inflation over
the term of the instrument
Term Structure of Interest
 Term Structure of Interest Rates – the
  relationship between time to maturity
  and yields for a particular category of
  bonds at a particular time
 Yield curve – the graphical depiction of
  the relationship between yields and
  time to maturity
    Term Structure of Interest
    The three most common term
     structure of interest rate theories
    1. Expectations theory
    2. Liquidity preference theory
    3. Market segmentation theory
Common Share Valuation

   Two basic approaches are used in
    fundamental security analysis:
    1. Present Value using the DDM
    2. Relative valuation methods which values
       shares relative to some company
       characteristics based on a multiple that is
       deemed appropriate
    Common Share Valuation

   Dividend discount model (DDM) – uses the
    expected future cash flows as the basis for
    valuing common shares
                       D
                      1  r 
                     t 1          cs
Po = estimated price of a common share today
D = the dividends expected to be received for
   each future period
rcs = the required rate of return
    No-Growth-Rate Version of
           the DDM
   The fixed dollar dividend reduces to a
    perpetual annuity

            P    0
                      D0
                       r   cs
D0 = the constant-dollar dividend
rcs = the required rate of return
    The Constant-Growth-Rate
       Version of the DDM
   Dividends are expected to grow at a
    constant rate over time

              P            D    1
                        r   cs

D1 = the dividend expected to be
 received at the end of year 1
Estimating the Growth Rate
    in Future Dividends
    Three estimates are required in order to
     implement the constant-growth-rate of the
    1. The expected dividend at the end of the
    2. The required rate of return by
    3. The expected growth rate in dividends
    Estimating Growth Rates

   Internal growth rate of earnings or

       g = ROE X (1- Payout ratio)

•   Used where g can be estimated using data
    for a particular year using long-term averages
    or “normalized” figures for ROE and payout
         Estimating Growth
•   Under the assumptions g=0, D1=EPS1 the
    constant-growth-rate version of the DDM is
    represented by:

                    EPS 1
               Po 
         Estimating Growth
•   Firms that do have growth opportunities
    can have their growth represented in
    the PVGO

         Po        PVGO
Other Versions of The DDM

   Multiple-growth-rate version

   Two-stage-growth-rate version
1. Market prices of debt such as bonds are
   calculated by discounting future cash flows
   specified under the loan contract (periodic
   interest payments and eventual repayment
   of principle) at the prevailing interest rate.
2. Interest is the price paid for borrowed
   money, and in free financial markets, it is
   determined by the laws of supply and
   demand. Interest rates tend to parallel
   inflation, and in an environment of general
   price-level changes, we have to distinguish
   between nominal and real interest rates.
3. The liquidity preference theory postulates
  that investors prefer short maturities, and
  borrowers desire long maturities. Therefore,
  the term structure should be upward sloping
  and exhibit a built-in liquidity premium.
  According to the expectations hypothesis, the
  yield curve reflects expectations about the
  future levels of interest rates. When investors
  expect short-term rates to fall, we must
  observe an inverted or downward-sloping
  yield curve.

4. According to the dividend discount model
  (DDM), the value of a stock today is the
  discounted value of all future dividends. To
  account for an infinite stream of dividends,
  stocks to be valued are classified by their
  expected growth rate in dividends.

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