Lecture No. 05_Determinants of Asset Prices and Interest Rates

7/27/2019 Lecture No. 05_Determinants of Asset Prices and Interest Rates

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Fall 2 13all 2 13ADVANCED FINANCIAL INSTRUMENTS AND MARKETS

LectureNo.0DeterminantsofAssetPricesand

Hammad HassanMirzaAssistantProfessor(Finance)

UniversityofSargodha


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InterestRatesandTheoriesofInterest

2Propertyof

Department

of

Business

Administraiton,

University

of

Sargodha


3/38

Principles

of

Pricing

Financial

Assets

The

market

price

of

an

asset

equals:

N

N

rrrrP

)1(...

)1()1()1( 33

2

2

1

1

+++

++

++

+=

where: P = the price of the financial assetCF = cash flow at end of ear t t=1 2 NN = maturity of the financial assetr = appropriate discount rate

3Propertyof

Department

of

Business

Administraiton,

University

of

Sargodha


4/38

r=

RR

+

IP

+

DP

+

MP

+

LP

+

EP

where: RR =therealrateofinterest

DP =thedefaultriskpremiumMP=thematurit remiumLP =theliquiditypremiumEP

=

the

exchange

rate

risk

premium

4Propertyof

Department

of

Business

Administraiton,

University

of

Sargodha


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discountrate.

Asthe

discount

rate

rises,

the

price

falls.

Asthediscountratefalls,thepricerises.

Reversibilityintheformofcommissionsandtransfer

.

5Propertyof

Department

of

Business

Administraiton,

University

of

Sargodha


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EffectofAssetPropertiesonthescoun

a e

Asset Properties Discount Rate

Liquidity Risk Positive

Convertibility Negative

Currency Risk Positive

6PropertyofDepartmentofBusinessAdministraiton,UniversityofSargodha


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Pretaxdiscount

rate

x

1

mar inaltax

rate

Ifthemarginaltaxrateisexpectedtoincrease,the

aftertax

discount

rate

will

decrease

Ifthemarginaltaxrateisexpectedtodecrease,the

7Propertyof

Department

of

Business

Administraiton,

University

of

Sargodha


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assetisinverselyrelatedtoitsprice.

Thesensitivityof

the

assets

price

to

a

change

in

the

.

Changesintherequiredyieldaremeasuredintermsofbasispoints.

8Propertyof

Department

of

Business

Administraiton,

University

of

Sargodha


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Price

Sensitivity

of

Financial

Assets

changeinyieldisaffectedbytheassets:

Maturity Coupon

Yieldlevel

9Propertyof

Department

of

Business

Administraiton,

University

of

Sargodha


10/38

Price

Sensitivity

of

Financial

Assets

Thelonger

the

maturity

of

an

asset,

the

greater

the

price

sensitivitytoachangeintherequiredyield.

CouponRate

Thelower

the

coupon

rate,

the

greater

the

price


LevelofInterestRates

Thelower

the

prevailing

yield

level,

the

greater

the

price


10Propertyof

Department

of

Business

Administraiton,

University

of

Sargodha


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Measuring

Price

Sensitivity

to

InterestRateChanges

Forasmalldecreaseinrequiredyield,thepercentagechangeinpriceis:

0PP

0P

Where: P- = asset price if required yield decreasesP0 = initial asset price

11Property

of

Department

of

Business

Administraiton,

University

of

Sargodha


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Measuring

Price

Sensitivity

to

InterestRateChanges

Theaveragepercentagechangeinpriceperbasispointchangeinrequiredyieldis:

PP +

0 y

ere: - = asse pr ce y e ecreasesP+ = asset price if yield increases

0 y = change in required yield

12Property

of

Department

of

Business

Administraiton,

University

of

Sargodha


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same yield, the bond with the longermaturity

will have the reater duration.

For bonds with the same maturity and thesame ield, the bond with the lower cou onratewill have the greater duration.

The lower the initial yield, the greater theduration for a given bond.

13Property

of

Department

of

Business

Administraiton,

University

of

Sargodha


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RelationshipbetweenDurationand

r ce

ens v y

afinancialassetis:

Durationx(y)x100

14Property

of

Department

of

Business

Administraiton,

University

of

Sargodha


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Modified

Duration

and

Effective

Duration

Assumesfuturecashflowsfromanassetdonotchange

withchanges

in

interest

rates.

EffectiveDuration

Assumesfuturecashflowsfromanassetchangewith

15Property

of

Department

of

Business

Administraiton,

University

of

Sargodha


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lenderfortheuseofresourcesthatwillbeused

duringsome

time

period

then

returned.

Realrate

Riskfreerate

16Property

of

Department

of

Business

Administraiton,

University

of

Sargodha


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s er s ass ca pproac

Loan

able

Funds

Theory KeynesLiquidityPreferenceTheory

17Property

of

Department

of

Business

Administraiton,

University

of

Sargodha


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Marginalrateoftimepreference

Income Rewardforsaving

DemandforBorrowedResources

arg na

pro uc v y

o

cap a

Rateofinterest

18Property

of

Department

of

Business

Administraiton,

University

of

Sargodha


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RealRateofInterest(r)

Premiumfor

Ex ected

Inflation

FishersLaw

(1+

i)

=

(1

+

r)(1

+

p)

or

= +

19Property

of

Department

of

Business

Administraiton,

University

of

Sargodha


20/38

,Governments,andHouseholds

Changesin

the

money

supply

Governmentdeficits

Changesinpreferencesbyhouseholds

EquilibriumRateofInterest

20Property

of

Department

of

Business

Administraiton,

University

of

Sargodha


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Transactionsdemand

Precautionarydemand

Speculativedemand

SupplyofMoney

Equ r umRate

o

Interest

21PropertyofDepartmentofBusinessAdministraiton,UniversityofSargodha


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ChangesintheDemandforMoneyandInterestRates

Ifincreasing,causestheinterestratetorise.

IncomeEffect

Ifincreasing,causestheinterestratetorise.

PriceExpectationsEffect

Ifincreasing,

causes

the

interest

rate

to

rise.

NetEffect: e n eres ra emayr se, a ,orrema n

unchanged

depending

on

the

net

effect

of

changes

indesiredliquidity,income,andpriceexpectations.22

PropertyofDepartmentofBusinessAdministraiton,UniversityofSargodha


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PrincipalorParValue

Cou onInterest

YieldtoMaturity(YTM)

IfYTM=couponrate,marketprice=parvalue

IfYTM

>

coupon

rate,

market

price

Lecture No. 05_Determinants of Asset Prices and Interest Rates

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