Chapter 10.

Properties & Pricing of Financial

Assets
properties
pricing
price sensitivity

I. Properties that affect value
moneyness
is asset a medium of exchange?
or easily converted to one?
checking account--YES
Tbills--easily converted
real estate--NO
divisibility/denomination
minimum amount to buy/sell asset
money, bank deposits -- $.01
bonds--$1000 to $10,000
commercial paper--$25,000
reversibility
cost of buying asset, then selling it
deposits--near zero
stocks--commissions
costs low for thick markets
-- Tbill market
costs higher for thin markets
-- small company stocks
cash flows
size and timing of promised cash
flows
dividends, interest, face value,
options, resale price
maturity
time until last cash flow
may be uncertain
convertibility
asset converts to different assets
convertible bonds
currency
is cash flow in domestic or foreign
currency?
exchange rates impact value of
cash flows
liquidity
how easy is it to sell?
how cheap is it to sell?
Tbills are liquid
real estate is not
related to
-- moneyness
-- reversibility
risk/return predictibility
risk = variability in return
investors are risk averse
default risk
--not receiving cash flows
interest rate risk
--changes in rates affect value of
debt securities
currency risk
-- exchange rates affect value of
cash flows
regulatory risk
-- tax treatment changes
risk rises with time horizon
complexity
rules governing cash flow size,
timing
complex assets are more difficult
to value
tax treatment
depends on issuer for bonds
-- municipal, Treasury, corporate
depends on holding period
-- for capital gains
II. Pricing of Financial Assets
basic rule:
price of asset
= present value of
future cash flows
problems
default risk
weight cash flows by likelihood of
getting them
maturity may be uncertain
cash flow unknown
timing of cash flows unknown
proper discount rate
discount rate
may include
real interest rate
inflation premium
default premium
maturity premium
liquidity premium
exchange rate risk premium
Pricing Zero Coupon bonds
discount bonds
pay face value, F, at maturity, N
par value
purchase price, P
P < F
purchased at a discount
only one cash flow
example 1
Tbill, 90 days to maturity
N = 90/365
F = $10,000, r = 5%(annual)
r = yield to maturity
bond equivalent basis
what is P?
price =
(

|
.
|

\
|
+
365
days
r 1
F
( ) | |
365
90
05 . 1
000 , 10
+
=
= $9878.20
example 2
Tbill, 180 days to maturity
F = $10,000, P = $9700
what is r?

(

|
.
|

\
|
+
=
365
days
r 1
F
P
F
365
days
r 1 P =
(

|
.
|

\
|
+
|
|
.
|

\
|
(

=
days
365
1
P
F
r
|
|
.
|

\
|
(

=
days
365
1
P
F
r
|
.
|

\
|
(

=
180
365
1
9700
000 , 10
r
= 6.27%
Pricing Coupon Bonds
Pay face value at maturity
pay interest based on coupon rate
every 6 months
Price may be <, =, > face value
depends on coupon rate vs.
market interest rates
example
N = 3, coupon rate = 6%
F = $10,000, P = $9850
semiannual pmts.
interest payments
.06(10,000) = $600 per year
$300 every 6 mos.
what is r?
discount rate where
PV cash flows = $9850
what are cash flows?
6 mos $300
1 yr. $300
1.5 yrs. $300
.
.
.
3 yrs $10,300
r solves
( )
( )
( ) ( )
6 3
2
2
r
1
300 , 10
...
2
r
1
300
2
r
1
300
2
r
1
300
9850
+
+ +
+
+
+
+
+
=
how to solve?
trial-and-error
financial calculator
spreadsheet
bond table
yield/N 3 5 10
5.50% -$10,136.56 -$10,216.00 -$10,380.68
6% -$10,000.00 -$10,000.00 -$10,000.00
6.50% -$9,865.69 -$9,789.44 -$9,636.52
7% -$9,733.57 -$9,584.17 -$9,289.38
6% coupon bond, F=$10,000
bond table
approx r = 6.5%
r = 6.56%
note
P and r are inversely related
P falls as r rises
P rises as r falls
true for ALL debt securities
size of change in P depends on N
as r rises, P falls
how much?
-- for greater N, P falls a lot
-- for smaller N, P falls a litte
relationship between r and coupon
if r > coupon
then P < F (discount)
if r < coupon
then P > F (premium)
if r = coupon
then P = F (par)
III. Price Sensitivity
price volatility, interest rate risk
if r changes by 1 percentage pt.,
how much does P change?
a lot (bond is sensitive)
a little (bond is not sensitive)
several factors affect price
sensitivity
Maturity
why?
stuck with the yield a longer time
either very good or very bad
longer
maturity
greater
price
sensitivity
Coupon rate
why?
higher coupon rate, receive more
cash flows sooner
lower
coupon
rate
greater
price
sensitivity
Level of yield
increase of 5% to 6% NOT same as
increase of 10% to 11%
5% to 6% means larger decrease
in bond prices
lower
initial
yield
greater
price
sensitivity
why?
from 5 to 6 is an increase of 20%
from 10 to 11 is an increase of 10%
Bond Duration
measure price sensitivity
taking N, coupon, r into account
approx. % change in P when r
changes by 1 percentage pt.

example
7 year bond, 7% yield, 6% coupon
10 year bond, 7.5% yield, 8% coupon
which bond has greater interest rate
risk?
generate price changes as yield rises
above and below initial level:
7 year bond 10 year bond
yield
6.5%
7%
7.5%
yield
7%
7.5%
8%
price
$972
$945
$919
price
$1071
$1035
$1000
Duration
=
high price - low price
initial price (high r - low r)
D
7
=
972 - 919
945 (.075 - .065)
= 5.6
= 6.9
D
10
=
1071 - 1000
1035 (.08 - .07)
7 year bond price fall by approx. 5.6%,
when yield rises from 7% to 8%
10 year bond price fall by approx.
6.9%,
when yield rises from 7.5% to 8.5%
so 10-year bond is more price
sensitive
in general,
higher
duration
greater
price
sensitivity
why hold a bond with high
duration?
plan to hold bond until maturity
do not care about price
fluctuations
believe interest rates are going to fall
big increase in bond price

why hold a bond with low
duration?
plan to sell bond prior to maturity
believe interest rates are going to
rise
highly risk averse