Chapter 3: Interest Rates and Security Valuation

Learning Goals

• LG3-1: Understand the differences in required, expected, and realized rates of return.
• LG3-2: Calculate bond values.
• LG3-3: Calculate equity values.
• LG3-4: Appreciate how security prices are affected by interest rate changes.
• LG3-5: Understand how maturity and coupon rate on a security affect price sensitivity to interest rate changes.
• LG3-6: Know what duration is.
• LG3-7: Understand how maturity, yield to maturity, and coupon rate affect duration.
• LG3-8: Understand the economic meaning of duration.

Interest Rates as a Determinant of Financial Security Values

Interest Rates and Security Valuation

• Coupon Rate: Interest rate on a bond used to calculate the annual cash flow promised.
• Required Rate of Return (R): Interest rate suitable for a security given its risk.
• Expected Rate of Return (E, R): Interest rate expected by buying the security at market price and selling at the end.
• Realized Rate of Return: Actual interest rate earned on an investment.

Bond Valuation

• Coupon Bond: Bonds that pay a stated coupon rate of interest. Coupon payments are annuities.
• Zero-Coupon Bonds: Bonds that do not pay coupon interest.
• Bond Valuation Formula: Used to calculate the fair present value and yield to maturity.

Equity Valuation

• Zero Growth in Dividends: Constant dividends.
• Constant Growth in Dividends: Dividends grow at a constant rate.
• Supernormal Growth in Dividends: Initial high growth that stabilizes later.

Impact of Interest Rate Changes

• Security Prices: Inverse relationship with interest rates.
• Maturity and Coupon Rates: Affect price sensitivity to interest rate changes.
• Duration: Measure of price sensitivity and average time to maturity.

Duration

Features of Duration

• Economic Meaning: Sensitivity of an asset's value to interest rate changes.
• Factors Affecting Duration: Maturity, Yield, & Coupon Rate
• Calculation: Weighted average time to maturity using present value of cash flows as weights.

Appendix

• Appendix 3A: Duration and Immunization.
• Appendix 3B: More on CONVXID.

Important Concepts

• Market Efficiency: Price adjustments to unexpected news.
• Duration and Price Sensitivity: Relationship between duration and bond price elasticity.
• Convexity: Nonlinear relationship in bond pricing.

Key Examples

• Bond and Equity Valuations: Calculation methodologies for required, expected, and realized returns.
• Impact Analysis: How duration and convexity affect bond price changes with interest rate variations.

Summary

• Application of time value of money principles to bond and equity valuation.
• Examination of how interest rates, coupon rates, and maturity affect bond pricing.
• Introduction of duration as a measure for price sensitivity to interest rate changes.