PricingValuation of Bond Valuation of LongTerm 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) v. Bond v. Debenture v. TFC ST Non-tradable (Only have book value) v. Bank loan v. Syndicate loan Also called consotium

• Bond – Bond is a paper having face value written on the bond and it’s 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 • Company FCF (Value creation is value greater than zero) (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 – It’s 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 1 100 2 100 3 100 4 100 5 1000

Solution – P = C 1_ + C 2__+ C 3__+ C 4_ + C 5__+ FV__ (1 + kd)1 (1 + kd)2 (1 + kd)3 (1 + kd)4 (1 + kd)5 – P = 100_+ 100_+ 1000_ (1. 12)1 (1. 12)2 (1. 12)3 (1. 12)4 (1. 12)5 – P = 927. 4 Year Cash Flows PVIF P. V. CFs * PVIF * t 1 100 0. 891 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 S(CF * PVIF(i, t)) 927. 4 =4. 13 • 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 + Faced Value (1+YTM) t – Po = C + C + C + FV__ (1+YTM)1 (1+YTM)2 (1+YTM)3 (1+YTM)4 (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