Valuation of Securities

Interest Rates and Bond Valuation

Stock Valuation
INTEREST RATE FUNDAMENTALS

The interest rate or required return represents the A variety of factors can
cost of money. influence the equilibrium
interest rate.

inflation
Usually the term interest rate is risk
applied to debt instruments such as
liquidity preference
bank loans or

bonds, and the term required

return is applied to equity liquidity preference
investments, such as A general tendency for
common stock, investors to prefer short-term
(that is, more liquid) securities.
real rate of interest nominal rate of interest
The rate that creates equilibrium The actual rate of interest
between the supply of savings charged by the supplier of
and the demand for investment funds and paid by the
funds in a perfect world, without demander.
inflation, where suppliers and
demanders of funds have no
liquidity preferences and there is
no risk.
TERM STRUCTURE OF INTEREST RATES

The term structure of interest rates is the

relationship between the maturity and
rate of return for bonds with similar levels of risk.

A graph of this relationship is

called the yield curve.

inverted yield curve

A downward-sloping yield
curve indicates that short-
term
interest rates are generally
higher than long-term
interest
normal
rates. yield curve
flat yield curve
An upward-sloping yield curve
A yield curve that indicates
indicates that long-term interest
that interest rates do not vary
rates are generally higher than
much at different maturities.
short-term interest rates.
 Theories of Term Structure

expectations theory liquidity preference theorymarket segmentation

The theory that the yield curve Theory suggesting that longterm theory
reflects investor expectations rates are generally higher Theory suggesting that the
about future interest rates; an than short-term rates (hence,
market for loans is segmented
expectation of rising interest the yield curve is upward
on the basis of maturity and
sloping)
rates results in an upwardsloping because investors
that the supply of and demand
yield curve, and an perceive short-term investments
for loans within each segment
expectation of declining rates to be more liquid and less risky
determine its prevailing interest
results in a downward-sloping than long-term investments.
rate; the slope of the yield
yield curve. Borrowers must offer higher
curve is determined by the
rates on long-term bonds to
general relationship between
entice investors away from
the prevailing rates in each
their preferred short-term
market segment.
securities.
Corporate Bonds
corporate bond
A long-term debt instrument
indicating that a corporation
has borrowed a certain
amount of money and
promises to repay it in the
future under clearly defined
terms.
standard debt provisions
Provisions in a bond indenture
specifying certain recordkeeping
and general business
practices that the bond issuer
must follow; normally, they do
not place a burden on a
financially sound business.
coupon interest rate bond indenture
The percentage of a bond’s A legal document that
par value that will be paid specifies both the rights of th
annually, typically in two equal bondholders and the duties o
semiannual payments, as the issuing corporation.
interest.
restrictive covenants
Provisions in a bond indenture
that place operating and
financial constraints on the
borrower.
GENERAL FEATURES OF A BOND ISSUE
conversion feature
A feature of convertible bonds
that allows bondholders to
change each bond into a
stated number of shares of
common stock.
call feature
A feature included in nearly
all corporate bond issues that
gives the issuer the opportunity
to repurchase bonds at a
stated call price prior to
maturity.
BOND YIELDS

The yield, or rate of return, on a bond is frequently

used to assess a bond’s performance over a given
period of time, typically 1 year.

Because there are a number of ways to measure a

bond’s yield, it is important to understand popular
yield
measures.

The three most widely cited bond yields are

(1)current yield,
(2) Yield to maturity (YTM), and
(3) yield to call (YTC).
Valuation Fundamentals

BASIC VALUATION MODEL the value of any asset is the present value of all
future cash flows it is expected to provide over the
relevant time period.
BASIC BOND VALUATION