Security Analysis

M. Jibran Sheikh

jibransheikh@comsats.edu.pk

Office hours: Tuesday 16:00 to 18:00or by
appointment via e-mail.
Outlook
Introduction to Securities

Bonds

Efficient Markets - Theory, Evidence & Alternatives

Valuation of Ordinary Shares

Wrap-up

INTRODUCTION TO SECURITIES
Securities can be broadly defined as financial assets that offer a
claim on the issuers real assets and the cash that they produce.
Or more simply, they are a document that can be assigned a
value and sold, and in many cases traded in organised markets
such as a Stock Exchange.
A more complex definition of a security is often needed for legal
and practical reasons, involving for instance the resolution of
disputes or assessment of tax implications. One such definition
is offered for the US in the Securities Exchange Act of 1934:
Securities Exchange Act of 1934
The term 'security' means any note, stock, treasury stock, bond,
debenture, certificate of interest or participation in any profit-sharing
agreement or in any oil, gas, or other mineral royalty or lease, any
collateral-trust certificate, reorganisation certificate or subscription,
transferable share, investment contract, voting-trust certificate,
certificate of deposit, for a security, any put, call, straddle, option, or
privilege on any security, certificate of deposit, or group or index of
securities (including any interest therein or based on the value
thereof), or any put, call, straddle, option, or privilege entered into on
a national securities exchange relating to foreign currency, or in
general, any instrument commonly known as a 'security'; or any
certificate of interest or participation in, temporary or interim
certificate for, receipt for, or warrant or right to subscribe to or
purchase, any of the foregoing; but shall not include currency or any
note, draft, bill of exchange, or banker's acceptance which has a
maturity at the time of issuance of not exceeding nine months,
exclusive of days of grace, or any renewal thereof the maturity of
which is likewise limited.
Financial Securities
Debt / Fixed Income Securities
loans
leases
commercial papers
bonds

Derivatives
options
futures / forwards
Equity / Variable Income
Securities
ordinary shares
preferred shares
warrants


Fixed income securities:
They have a defined, limited, monetary claim. The receipts from
investing in these securities will never exceed the promised claim,
although it can be less in case of default.
Variable income securities:
They offer a residual claim on the earnings of an issuer. Holders of
these securities are entitled to the remaining funds after all other
security holders have been paid their entitlements.
Primary securities:
They oblige the issuer to some form of payment from their income.
The issuer is typically a government or a company.
Derivative securities:
Derivative securities are issued by individual traders. These securities
derive their value from another financial asset, hence their name. For
each trader purchasing such a security there has to be another one
selling it, so the net-total of all outstanding positions is zero


Bonds

A bond is a financial instrument that promises to make certain
fixed payments, usually in the form a periodic interest payments
and a redemption payment at the end of the bonds life.
However, bonds come in a variety of forms. Some simply make
the periodic interest payments, and do not provide a
commitment to repay the bond's principal (such bonds are
generally referred to as irredeemable). Others, known as pure
discount bonds or zeros, offer no interest payments but a
commitment to redeem the bond at its par or face value at a
specified time in the future. Some are convertible into other
securities on specified terms, and others are callable, giving the
issuer the right to redeem the bonds before the in maturity date
on certain terms.
BONDS
bond covenants

embedded options

cash flow pattern

maturity

price

rating
bond covenants
asset covenant

dividend covenant

financing covenant

bonding covenant
embedded bond options
convertibility

callability

putability

exchangeability
bond cash flow patterns
straight

deferred

zero

annuity

consol

variable coupon bonds
Cas
h
flow
Cas
h
flo
w
Year
T
Year
T
Cas
h
flow
Year T Year T
Cas
h
flow
Deferred Bond
Zero Coupon Bond
Annuity Bond
C
as
h
flo
w
Consol
T T+1 T+2 T+3
Principal
Interest
Straight Bond






BOND PRICING
bond price = present value of the expected cash flows from the bond

cash flows from a straight bond:

periodic coupon interest payments
the face/par value at maturity
formulae - straight bond
n n
c
n n
r
B
r r r
C V
B r C
r
B
r
C
r
C
r
C
V
) 1 ( ) 1 (
1 1
) 1 ( ) 1 (
...
) 1 ( 1
0
2
+
+
(

+
=
=
+
+
+
+ +
+
+
+
=
o
formulae - straight bond
Where







The discount rate is given by the market determined rate of
return that can be expected on bonds of the same maturity,
coupon rate and risk. The valuation equation assumes that the
bond is being valued immediately following the receipt of an
interest payment.


Example 1-A
A bond with nominal value of 100 issued 3 years ago has 5
years to run to maturity. It carries a coupon of 7%, but bonds
issued today with 5 years to maturity are offering an interest rate
of only 5%.

What is the current value of the bond?


66 . 108
) 05 . 0 1 (
1
100
) 05 . 0 1 (
1
) 100 07 . 0 (
) 1 (
1
) 1 (
1
) (
0
5
5
1
0
1
0
=
+
+
+
- =
+
+
+
- =

=
=
V
V
r
B
r
B r V
t
t
n
n
t
t
c
The bond is selling above its par value as a result of the interest
rate having fallen since the bond was first issued, and there is an
inverse relationship between the present value of a series of
positive cash flows and the discount rate. A six year bond issued
today that offers a coupon rate of 5 per cent and thereby an
annual interest payment of 5 will sell at its par value of 1 00:
clearly, another bond with six years to run to maturity that
offers an annual interest payment of 7 will be valued more
highly in the market. The market value of the 8 per cent bond is
given for a range of different interest rates in the following table,
and the relationship between the value of a bond and a range of
possible interest rates is illustrated in the Figure (in nest slide).
The table and diagram also consider the relationship between
the value of a bond and the interest rates for other bonds with
coupon rates of interest of eight per cent but maturities of one
year, ten years, and twenty years. The diagram reveals that the
sensitivity of value of a bond to the interest rate increases with
the length of a bond's remaining life.
Figure
BOND PRICES AND INTEREST RATES (8 PER CENT COUPON BOND 10 YEAR BONDS)
Example 1-B
A bond issued last year has 10 years to run to maturity, it
offers a coupon of 5 % paid semi-annually.

What is the current bond value?
100
) 05 . 0
2
1
1 (
1
100
) 05 . 0
2
1
1 (
) 100 05 . 0 (
2
1
)
2
1
1 (
1
)
2
1
1 (
) (
2
1
0
10 2
10 2
1
0
2
2
1
0
=
+
+
+
-
=

+
+
+
=
-
-
=
-
-
=

V
V
ents couponpaym annual semi
r
B
r
C
V
t
t
n
n
t
t
formulae - zero coupon bond


n
O
r
B
V
) 1 ( +
=
Example 2
A zero-coupon bond issued 5 years ago has 8 years to
maturity. It is trading today at 82.07 .

What interest rate does this imply?

Hint:

n
r
B
V
) 1 (
0
+
=
Solution
0250 . 0 1
07 . 82
100
0250 . 0 1
07 . 82
100
) 1 (
100
07 . 82
8
1
8
8
=
|
.
|

\
|
= = =
+
=
r or r
r
dirty & clean prices
dirty price = bond price with
accrued interest

clean price = bond price without
accrued interest
Yield
Internal rate of return

current yield = annual coupon interest / price
yield to maturity:


n n
O
y
B
y y y
C V
) 1 ( ) 1 (
1 1
+
+
(

+
=
Example 3

What is the yield to maturity on a 6% coupon bond with

4 years to maturity which is currently selling for 97.05?
3205 . 87
) 1 . 0 1 (
1
100
) 1 . 0 1 ( 1 . 0
1
1 . 0
1
6 % 10
100
) 06 . 0 1 (
1
100
) 06 . 0 1 ( 06 . 0
1
06 . 0
1
6 % 6
:
) 1 (
1
100
) 1 (
1 1
6 05 . 97
) 1 (
1
100
) 1 (
1 1
6 05 . 97 0
4 4
0
4 4
0
4 4
4 4
=
+
+
(

+
= =
=
+
+
(

+
= =
+
+
(

+
=
+
+
(

+
+ = =
V y f
V y if
y for vakues different try now
y y y y
y y y y
NPV
spot & forward rates
1
) 1 (
) 1 (
) 1 ( ) 1 ( ) 1 (
1
1 ,
,
,
,
1
1 , ,

(
(

+
+
=
+ + = +

n
n s
n
n s
n f
n f
n
n s
n
n s
r
r
r
r r r
Example 4-A
The interest rate for the next year is 4% and the spot
rate of interest on a 2 year zero coupon bond is 5%.

What is the implied forward rate for year 2?
060096 . 0 1
) 04 . 0 1 (
) 05 . 0 1 (
) 1 ( ) 04 . 0 1 ( ) 05 . 0 1 (
) 1 ( ) 1 ( ) 1 (
) 1 ( ) 1 ( ) 1 (
2
2 ,
2 ,
2
2 ,
1
1 ,
2
2 ,
,
1
1 , ,
=
+
+
=
+ - + = +
+ - + = +
+ - + = +

f
f
f s s
n f
n
n s
n
n s
r
r
r r r
r r r
Example 4-B
An 8 year zero coupon bond has a yield to maturity of
9.58% and a 9 year zero coupon bond offers a yield of
9.68%.

Determine the forward rate for year 9.
) 1 ( ) 1 ( ) 1 (
) 1 ( ) 1 ( ) 1 (
9 ,
8
8 ,
9
9 ,
,
1
1 , ,
f s s
n f
n
n s
n
n s
r r r
r r r
+ - + = +
+ - + = +

Useful sources
Investors Chronicle:
http://www.investorschronicle.co.uk

Yahoo:
http://uk.finance.yahoo.com
http://finance.yahoo.com (US)
Assignment
Determine the yield to maturity of this 10 year, 7%
coupon bond.
The bond is currently selling for $950 and coupon
payments are made semi-annually.