INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT
Dr. Umra Rashid
Assistant Professor - SS
School of Business
Chapter 10
Bond Return
and
Valuation
Chapter Objectives
To understand the basics of bond
To know the concept of bond return and valuation
To learn about the types of bond risk
To understand the bond value theorems
To understand the concept of duration and
immunisation
Concept of Bond
It is a contract between a borrower and a lender in
which the borrower is required to pay a certain
amount of interest income to the lender.
In general, bonds carry a fixed payment of interest
till the maturity date.
The rate of interest is also known as coupon rate.
Bond Risk
Bonds are considered to be quite safe but they also
carry a certain amount of risk.
Types of bond risk:
Interest rate risk: The value of bonds changes due to
variability of the market interest rates.
Default risk: The borrower fails to pay the agreed value of
debt instrument on time.
Marketability risk: There is difficulty in liquidating the
bonds in the market.
Callability risk: There is an uncertainty created in the
returns of the investor by the issuer’s right to call the bond
any time.
Bond Return
There are several ways of describing a rate of return on
bond. Some of them are:
Holding period return
The current yield
Yield to maturity
Holding Period Return
It is a return in which an investor buys a bond and
liquidates it in the market after holding it for a
definite period of time.
The formula for calculating holding period of return
is as follows:
Price gain + Coupon payment
Purchase price
It can be calculated on a daily, monthly or annual
basis.
The Current Yield
It is a measure through which the investors can easily
figure out the rate of cash flow on the investments
made by them every year.
It is calculated as:
Annual Coupon Payment
Purchase Price
Yield to Maturity
It is the single discount factor that makes the present
value of future cashflows from a bond equivalent to
the current price of the bond.
The following assumptions are used to calculate yield
to maturity:
There should not be any default.
The interest payments are reinvested at yield to maturity.
The investor has to hold the bond till its maturity.
It is calculated as:
Coupon1 Coupon 2 (Coupon n + Face value)
Present value = 1
+ 2
+....+
(1+y) (1+y) (1+y) n
Bond Value Theorems
These are evolved on the basis of three factors:
(i) coupon rate (ii) years to maturity (iii) expected rate of return.
The five bond value theorems are as follows:
Theorem 1: If the bond’s market price increases then its yield declines
and vice versa.
Theorem 2: If the bond’s yield remains constant over its life, then the
discount or premium depends on the maturity period.
Theorem 3: If the yield remains constant over its life, the discount and
premium on bonds will decline at an increasing rate as its life gets
shorter.
Theorem 4: A raise in the bond’s price for a decline in the bond’s
yield is greater than the fall in the bond’s price for a raise in the yield.
Theorem 5: The percentage change in the bond’s price owing to
change in its yield will be small if the coupon rate is high.
Duration
It measures the time structure and interest rate risk of
the bond.
The formula for calculating the duration is as follows:
T
Pv (C t )
D=
t =1 P0
×t
where D = Duration
C = Cashflow
R = Current yield to maturity
T = Number of years
Pv(ct) = Present value of the cashflow
P0 = Sum of the present value of cashflow
Immunisation
It is a technique that makes a bondholder relatively
certain about the promised cash stream.
An immunisation can be achieved by reinvesting the
coupons in the bonds that offer higher interest rate .
Chapter Summary
By now, you should have:
Understood the basics of bond
Understood the concept of bond return and valuation
Learnt about the types of bond risks
Understood the various bond value theorems
Learnt the concept of immunisation
Chapter Objectives
To understand the concept of stock return and
valuation
To understand the constant growth model
To explain the two stage growth model
To understand the concept of price-earnings ratio
To explain the concept of preferred stock valuation
Concept of Stock Return
It is a return which includes current income and
capital gain that is caused by increase in the price.
The current income and capital gain are expressed as
a percentage of the money invested in the beginning.
An investor before investing in securities must
properly analyze the returns associated with the
securities.
Anticipated Return
It is the expected rate of return an investor will get in
future on his investments.
The anticipated rate of return can be calculated with
the help of probability.
Probability refers to the likelihood occurrence of an
event.
It can be calculated as:
N
E(R) = (Probability P ) (Return R )
t=1
t t
Multiple Year Holding Period
If the holding period is more than a year, it is called multiple
year holding period.
The formula for calculating the multiple year holding period is
as follows:
N [(e0 )d / e] (1 + g) n (P / E) [ (e 0 )(1 + g) N + 1 ]
P0 = n +
n=1 (1 + r) (1 + r) N
where g = annual expected growth in earnings, dividends and price
e = most recent earnings per share
d / e = dividend pay out
r = required rate of return
P / E = price-earnings ratio
N = holding period in years
Constant Growth Model
The basic assumption of this model is that the
dividends are expected to grow at the same rate.
It is calculated as:
D1
P0 =
r g
where P0 = Present value of the stock
r = Required rate of return
g = Growth rate
D1 = Next year’s dividend
Two Stage Growth Model
It is an extended form of constant growth model, where the
growth stages are divided into:
A period of remarkable growth
A period of constant growth
It is calculated as:
N
D0 (1 + g s ) t D N+1 1
P0 = + ×
t=1 (1 + rs ) t (rs - g n ) (1 + rs ) N
where D0 = Dividend of the previous period
gs and gn = Above normal and normal growth rate
rs = Required rate of return
N = Period of above normal growth
Valuation through
Price-Earnings Ratio
P/E ratio indicates price per rupee of share earnings.
The advantages of price earning ratio are as:
It helps in comparing the stock prices that have
different earnings per share.
It helps in estimating the stocks of those companies
that do not pay the dividends.
The formula for calculating P/E ratio is as:
d/e
P/E =
r – ROE (1 – d/e)
Preferred Stock Valuation
Preferred stocks are those stocks that provide a steady
rate of return.
Preferred stocks can be calculated with the help of the
following formula:
D
P0 =
r
where D = dividend paid
r = required rate of return
Chapter Summary
By now, you should have:
Understood the concept of stock return and valuation
Understood the constant growth model
Learnt the two stage growth model
Understood the concept of price-earnings ratio
Understood the concept of preferred stock valuation
