Chapter 8– Bond Valuation and Structure of Interest RatesCopyright 2008 John Wiley & Sons 1 MT480...

Chapter 8– Bond Valuation and Structure of Interest Rates Copyright 2008 John Wiley & Sons1

MT480 Unit 4MT480 Unit 4

Chapters 8 and 9


Capital Market Efficiency Capital Market Efficiency

Supply and demand for securities are better reflected in organized markets.

Any price balancing overall supply and demand for a security is market equilibrium price.

A security’s true value is price reflecting investors’ estimates of value of expected future cash flows.

In efficient capital market, security prices fully reflect knowledge and expectations of all investors at particular point in time.



If markets are efficient, investors and financial managers can believe securities are priced at or near true value.

The more efficient a security market, the more likely securities are priced at or near true value.

Overall efficiency of a capital market depends on its operational and informational efficiency.

Operational efficiency focuses on bringing buyers and sellers together at lowest possible cost.



Competition among investors is important driver of informational efficiency.

In an informationally efficient market, market prices adjust quickly to new information about a security as it becomes available.

Markets exhibit informational efficiency if market prices reflect all relevant information about securities at particular point in time.


Corporate Bonds Corporate Bonds

Largest investors in corporate bonds are life insurance companies and pension funds. Trades in this market tend to be in very large

blocks of securities.

Market for Corporate Bonds

Less than 1% of all corporate bonds are traded on exchanges. Most secondary market corporate bond

transactions take place through dealers in the over-the-counter (OTC) market.


Corporate Bonds Corporate Bonds

Corporate bonds are long-term IOUs that represent claims against a firm’s assets.

Types of Corporate Bonds

Debt instruments where the interest income paid to investors is fixed for the life of the contract are called fixed-income securities.

Three types of corporate bonds are – vanilla bonds, zero coupon bonds, and convertible bonds.


Vanilla BondsVanilla Bonds

Face value, or par value, for most corporate bonds is $1,000.

Bond’s coupon rate is calculated as annual coupon payment (C) divided by bond’s face value (F).



Zero Coupon Bonds Zero Coupon Bonds

Corporations sometimes issue bonds with no coupon payments, only offering one payment at maturity.

Zero coupon bonds sell well below their face value (at deep discount) because they offer no coupons.

U.S. Treasury is most frequent and regular issuer of zero coupon securities.



Convertible Bonds Convertible Bonds

Convertible bonds are bonds that can be converted into shares of common stock at pre-determined ratio at discretion of bondholder.

Convertibility feature allows bondholders to share firm’s good fortunes if the firm’s stock rises above certain level.



Bond Valuation Bond Valuation

The value, or price, of any asset is present value of its future cash flows.

To calculate bond’s price, follow same process as to value any financial asset.

Estimate expected future cash flows – these are the coupons that the bond will pay.


Bond Valuation Bond Valuation

If a bond’s coupon rate is equal to market rate, bond will sell at price equal to its face value; these are called par bonds.

Par, Premium, and Discount Bonds

If a bond’s coupon rate is less than market rate, then bond will sell at price less than its face value; these are called discount bonds.

If a bond’s coupon rate is greater than market rate, then bond will sell at price more than its face value; these are called premium bonds.


Bond Yields Bond Yields

A bond’s yield to maturity: Discount rate that makes present value of

coupon and principal payments equal to price of bond.

Yield to Maturity

It is the yield that investor earns if bond is held to maturity, and all coupon and principal payments are made as promised.

A bond’s yield to maturity changes daily as interest rates increase or decrease.


The Market for StocksThe Market for Stocks

Equity securities are a corporation’s certificates of ownership.

Basic Facts

Households dominate holdings of equity securities, owning >36% of outstanding corporate equities.

Pension funds are largest institutional investors in equities (21%), followed by mutual funds (20%), and foreign investors (10%).



Outstanding shares of a stock are bought and sold among investors.

Secondary Markets

From investor’s perspective, secondary markets provide marketability at a fair price for shares of securities they own.

Active secondary market enables firms to sell their new debt or equity issues at lower funding costs than can firms without secondary markets that sell similar securities.



In US, most secondary market transactions are done on one of the stock exchanges.

The Efficiency of Secondary Markets

In terms of total volume of activity and total capitalization of firms listed, NYSE is the world’s largest and NASDAQ is the second largest.

In terms of number of companies listed and shares traded daily, NASDAQ is larger than NYSE.



Brokers bring buyers and sellers together to earn a fee, called a commission.

The Efficiency of Secondary Markets - Brokered

Brokers’ extensive contacts provide a pool of price information that individual investors could not economically duplicate themselves.

By charging a commission less than cost of direct search, they give investors incentives to utilize information by hiring them as brokers.



NASDAQ is best-known example of dealer market.

The Efficiency of Secondary Markets - Dealer

Electronic communications network (ECN) systems provide additional price information to investors.

Increase marketability and competition, which should improve NASDAQ efficiency.



In an auction market, buyers and sellers confront each other directly and bargain over price.

The Efficiency of Secondary Markets - Auction

NYSE is best-known example of auction market.

In NYSE, auction for a security takes place at a specific location on the floor of the exchange, called a post.


Types of Equity SecuritiesTypes of Equity Securities

Two types of equity securities 1) Common stock 2) Preferred stock

Common Stock and Preferred Stock

Common stock represents basic ownership claim in a corporation.

One of the owners’ rights is to vote on all important matters that affect life of company, such as vote to elect board of directors, capital budget, or proposed merger or acquisition.



Owners of common stock are not guaranteed any dividend payments; have lowest priority claim on firm’s assets in event of bankruptcy.


Legally, common stockholders enjoy limited liability.



Preferred stock owners are given priority over common stock owners with respect to dividends payments and claims against firm’s assets in event of bankruptcy or liquidation.


Preferred stocks are generally viewed as perpetuities because they have no maturity.

Even though preferred stock is equity, owners have no voting privileges.


Problem A8.4Problem A8.4

Chapter 8– Bond Valuation and Structure of Interest RatesCopyright 2008 John Wiley & Sons 1 MT480...

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Transcript of Chapter 8– Bond Valuation and Structure of Interest RatesCopyright 2008 John Wiley & Sons 1 MT480...