Valuation of Bond Valuation of Long-Term Securities Valuation ...

Pricing/Valuation of Bond Valuation of Long-Term Securities Valuation of Financial Assets Assets= CA Accounting equation: liabilities + capital LT FA Tradable

Also called real assets ( physically existing assets and functioning ) (Having book value & trade in market) Bond Debenture TFC ST Non-tradable (Only have book value)

Bank loan Syndicate loan Also called consotium Bond Bond is a paper having face value written on the bond and its the debt instrument issued by firm or corporate or government. Debenture Debenture is also the debt instrument issued by firm having fixed rate of return. TFC (Term Finance Certificate) TFC is also the debt instrument issued by the firm

for raising the short or medium funds. Syndicate Loan Or Consotium Joint venture of banks providing a loans to company or corporate. More than one bank join for providing a loan to company when one bank is unable to provide loan to the company they join with each other. Bond Coupon (Interest earned on bond you can say it coupon) Stock Dividend Project NPV (Value creation is value greater than zero) Company FCF (Future cash flow)

Price/Value Price is the present value of future cash flow discounted at an appropriate rate of return or discount rate. On loan cost (interest) we pay denoted by i On tradable cost (interest) we pay denoted by kd & ke Kd= Cost of debt Ke=Cost of equity Financial Asset Always financial assets are the claims of real asset. Important Steps While Discussing the

Bond/Stock Step-1:- Pricing/Valuation of Bond/Stock At what price I will buy bond At what price company will sell the bond Step-2:- Yield to Maturity (YTM) Definition:- Average rate of return if the bond is purchased on market price and held till maturity. YTM is changeable/variable over the life of bond Coupon is constant over the life of bond Important Steps While Discussing the Bond/Stock Step-3:- Duration Duration is average life of bond Systematic risk of bond/bond market will be just

like Beta which is the risk of stock/stock market Higher the life of bond higher will be the risk Step-4:- Convexity Sensitivity of bond price due to change in interest rate Indenture (Steps/Terms of Contract) Coupon Rate Interest calculated on the face value of bond Face Value Its the price written on the bond Maturity Maturity is the life of bond

Payments Schedule Frequency of payments (which can be made Annually, Semi-Annually, Quarterly, Monthly) Indenture (Steps/Terms of Contract) Callable or Not Either the bond is buy back (callable) or not by company before maturity Convertible or Not Either the bond is convert able or not into stock at the time of maturity. E.g.; If bond price=1000, Market price per share=100, Shares=10

Indenture (Steps/Terms of Contract) Redemption Value (If Callable) Price of bond before maturity if its callable Security or Collateral Either the bond is secured or unsecured If secured then we can say it Mortgage bond If unsecured then we can say it Naked bond Types of Bond Government Bond Corporate Bond Domestic Bond Global Bond

Types of Bond Government Bond Issued by state at zero coupon rate If life of bond is < 1 year we can say it T-Bill If life of bond is > 1 year we can say it T-Note T-Bills are always issued in discount bases Always face value of bond is less than its today price Face value is same as future value Types of Bond Corporate bond Issued by the company and maturity will be more than one year. Two types of corporate bond a) Domestic Bond

Offered to only local investors b) Global Bond Offered to local and foreign investor Features of corporate bond a) Foreign bond b) Euro bond a) Zero coupon bond b) Coupon payment bond

a) Dual currency bond b) Currency option bond c) Cocktail bond Sukkuk bond a) Mortgage bong (secured) b) Naked bond (Unsecured) Features of Corporate Bond 1 a) Foreign Bond

If US company issued the bond in Pakistan in Rs Currency is same as per country b) Euro Bond If US company issued the bond in Pakistan in \$ Different currency as per the country currency Features of Corporate Bond 2 a) Dual Currency Bond

Coupon in one currency Face value in another currency b) Currency Option Bond Coupon is the choice Face value is the desire of company c) Cocktail Bond Choice on face value Coupon is the desire of company

Features of Corporate Bond 3 a) Zero Coupon Bond No interest b) Coupon Payment Bond Fixed Rate Floating Rate

KIBOR + Fixed Rate KIBOR (Karachi Inter Bank Offering Rate) Definition:- The rate issued by state bank of Pakistan to commercial banks for lending/borrowing with in the bank Features of Corporate Bond 4 a) Mortgage Bond Secured bond b) Naked Bond

Unsecured bond 5 a) SUKKUK Bond Islamic bond Shari compliance bond Example 10% of 1000 face value bond trading in the market having 5 years life and rate of return (yield rate OR discount rate OR interest rate) What is the fair price/value of bond

What will be the duration What will be the convexity is yield rate increases by 1% and decrease by 2% Note:- The rate which is given before the face value will always represent the coupon rate. Solution Coupon Rate = 10% Face Value = 1000

Coupon Amount = 100 Maturity = 5 years Kd = 12% 0 1 2 3 4 5 100 100 100 100 100 1000 Solution P = C1_ + C2__+ C3__+ C4_ + C5__+ FV__ (1 + kd)1 (1 + kd)2 (1 + kd)3 (1 + kd)4 (1 + kd)5 (1 + kd)5

P = 100_+ 100_+ 100_+ 100_+ 100_+ 1000_ (1.12)1 (1.12)2 (1.12)3 (1.12)4 (1.12)5 (1.12)5 P = 927.4 Year Cash Flows PVIF P.V. CFs * PVIF * t 1 100

0.891 89.1 89.1 2 100 0.797 79.7 159.4

3 100 0.717 71.1 213.3 4 100 0.634

63.4 254 5 1100 0.566 623.7 3118.5 927.4

3834.3 Total Solution Duration = S (CF*PVIF(i,t)*t) =3834.3 =4.13 S(CF * PVIF(i,t)) 927.4 Always duration is less than the life of maturity PVIF(i,t) = 1 _ (1+i) t FVIF(i,t) = (1+i) t Solution Convexity = -D * i__

1+kd D = 4.12 Kd = 12% a) If increase by 1% i = 1% increase Convexity = -4.12 * 0.01_ 1.12 = 3.7% =0.037 YTM (Yield to Maturity) Kd/Rate of return Average rate when bond is purchased at market price and held till maturity Higher the rate, lower will be price or present

value Formula of YTM and pricing is same, if one thing is missing other can be found YTM (Yield to Maturity) Formula 1 1 (1 YTM ) t Faced Po+ C Value YTM

t (1+YTM) Po = C + C + C + C + C + FV__ (1+YTM)1 (1+YTM)2 (1+YTM)3 (1+YTM)4 (1+YTM)5 (1+YTM)5

If maturity is 5 years YTM (Yield to Maturity) YTM can be found by hit & trail method OR Trail & error method Price/present value of future cash flows of a bond will be equal to its face value When bond is discounted at coupon rate during its life at any time if, Coupon rate=Rate of return Then face value and present value will always equal Selling The Bond

Discount Mkt < P.V. YTM > Coupon Rate Par Mkt = P.V. YTM = Coupon Rate Premium Mkt > P.V. YTM < Coupon Rate Yield Curve (Term Structure) Its a graphical explanation of term structure of interest rate Its also the relationship between interest rate

and maturity period Longer the life, larger or higher will be the interest rate

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