BUSINESS FINANCE/

FINANCIAL MARKETS & INSTITUTIONS

[B Sc (Hons) in Management]

SEMINAR 2

S2
SOURCES OF FINANCING :
DEBT VS EQUITY
Characteristic Debt Equity

 Cash flow Coupon Dividends

+ Face Value

 Variability Fixed Variable

 Redemption Yes No
Face Value

 Maturity Fixed Term Infinite

(@ n years) (growing perpetuity)

 Relative riskiness Low High

 Formula [PV(Ann) + PV(S)] [D1/(r-g)]

BONDS

1. Valuation of Bonds
• Price = PV (Cashflow)
= PV (Coupons) + PV (Face Value)
2. Yields
• Yield to Maturity/Redemption Yield

• Rate of Return
(coupon + price change)/investment
3. Price vs Face Value
• Coupon rate = YTM, sell @ par
• Coupon rate > YTM, sell @ premium
• Coupon rate < YTM, sell @ discount
BONDS

1. Accrued Interest
• When an investor purchases a bond between
coupon payments, the investor must compensate
the seller of the bond for the coupon interest earned
from the time of the last coupon payment to the
settlement date of the bond.

PRICE Clean Dirty

Other Names Market price Invoice price

Quoted price Full price
Accrued interest Excluded Included
BONDS

1. Spot vs Forward
• Spot rate (aka zero-coupon rate) : current interest rate
for a stipulated period
• Forward rate : interest rate payable that commences n
months from the spot date for a stipulated period
Eg.
 1-year spot = 7%
 2-year spot = 8%
 Find the Forward from year 1 to year 2, F1,2
TERM STRUCTURES

1. Yield Curve
• Yields vs Maturity

• Variations :
• Par yield

• Spot

• Annuity
TERM STRUCTURES

1. Theories of Term Structure

• Unbiased Expectations Theory
Expectations about the future state of the economic
world
• Liquidity Premium Theory
Unbiased Expectations Theory + liquidity premium
• Segmentation Theory
Each segment of the yield curve is determined
independently by the supply & demand
conditions of that segment
2. Risk Structure
• Interest Rate/Price Risk
• Default Risk
RISK STRUCTURES
- Bond Price Sensitivity to Interest Rates
Bond price

$1 800
Coupon = $100
20 years to maturity
$1 600 $1 000 face value

$1 400 Key Insight: Bond prices and

YTMs are inversely related.
$1 200

$1 000

$ 800

$ 600 Yield to maturity, YTM

4% 6% 8% 10% 12% 14% 16%
EXAMPLE
Let us assume that you are considering the respective merits of three bonds,
whose details are :

BOND
A B C
Coupon Rate 10% 8% 6%
Maturity Value US$1000 US$1000 US$1000
Time to Maturity 3 years 4 years 5 years
Expected YTM 12% ? 10%
Price ? US$906.5 ?

a) Calculate :
• Current market price of Bond A
• YTM of Bond B
b) Calculate the current market price of Bond C. Draw the yield curve as far
as the data permits and comment on this curve
c) Let us assume that we have the above 5 year to maturity US government
bond and a similar bond issued by the Singaporean government. What
does the difference between their yields tell you? Explain what would
happen if these 2 bonds offer different real yields?