PROPERTIES AND PRICING OF FINANCIAL ASSETS

What is a ‘financial asset’?

A financial asset is an intangible asset that derives value because of a contractual claim. While a
real asset, such as land, has physical value, a financial asset is a document that has no
fundamental value in itself until it is converted to cash. Common types of financial assets
include bonds, stocks, and bank deposits.

Principal Economic Functions of Financial Assets

Financial markets have two principal economic functions.
 The first is to transfer funds from those who have surplus funds to invest to those who
need funds to invest in tangible assets.

 The second function is transferring funds in such a way as to redistribute the

unavoidable risk associated with the cash flow generated by tangible assets among
those seeking and those providing the funds.

Financial markets provided three additional economic functions. First the interactions of buyers
and sellers in the financial market determine the price of the traded asset; or equivalently, the
required return on a financial asset is determined. The inducement for firms to acquire funds
depends on the required return that investors demand, and it is this feature of the financial
markets that signals how the funds in the economy should be allocated among financial assets.
This is called the price discovery process.

Second, financial markets provide a mechanism for an investor to sell a financial asset. Because
of this feature, it is said that a financial market offers liquidity, an attractive feature when
circumstances either force or motivate an investor to sell. In the absence of liquidity, the owner
will be forced to hold a debt instrument until it matures and an equity instrument until the
company is either voluntarily or involuntarily liquidated. While all financial markets provide
some form of liquidity, the degree of liquidity is one of the factors that characterize different
markets.

The third economic function of a financial market is that it reduces the search and information
costs of transacting. Search costs represent explicit costs, such as the money spent to advertise
the desire to sell or purchase a financial asset, and implicit costs, such as the value of time
spent in locating a counterpart. The presence of some form of organized financial market
reduces search costs.
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The Nature and Functions of Money

Various functions of money can be classified into three broad groups:

a) Primary functions, which include the medium of exchange and the measure of value;
b) Secondary functions which include standard of deferred payments, store of value and
transfer of value; and
c) Contingent functions which include distribution of national income, maximization of
satisfaction, basis of credit system, etc.

Inflation and the Determination of the Value of Money

In a broad sense of the term, inflation means a considerable and persistent increase in the
general price level over a long period of time (continuous increase in the general price level). It
measures the annual rate of change of the general price level in the economy. The overall level
of prices throughout the economy should be considered rather than prices in one particular
market or industry.

One of the major effects of inflation is the erosion of the real value (purchasing power) of
money and of the real value of financial assets that are denominated in money terms. Cash and
certain other financial assets such as bank deposits that pay no interest are subject to the full
eroding effect of inflation on the real value.

Therefore, inflation undermines the ability of money to act as store of value. When the inflation
rate is extremely high, the destruction of the store of value function of money becomes so
great that people refuse to hold money or to accept it as payment for goods and services so
that it also loses its function as a medium of exchange.

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 BONDS
A debt investment in which an investor lends money to an entity (corporate or governmental)
that borrows the funds for a defined period of time at a fixed interest rate. Bonds are used by
companies, municipalities, and local and foreign governments to finance a variety of projects
and activities.

Bonds are commonly referred to as fixed-income securities and are one of the three main asset
classes, along with stocks and cash equivalents.

Corporate Bonds: A company can issue bonds just as it can issue stock. Corporate bonds are
characterized by higher yields because there is a higher risk of a company defaulting than a
government. The upside is that they can also be the most rewarding fixed-income investments
because of the risk the investor must take on. The company's credit quality is very important:
the higher the quality, the lower the interest rate the investor receives.

Zero-Coupon Bonds: This is a type of bond that makes no coupon payments but instead is
issued at a considerable discount to par value. For example, let's say a zero-coupon bond with a
Rs. 1,000 par value and 10 years to maturity is trading at Rs. 600; you'd be paying Rs. 600 today
for a bond that will be worth Rs. 1,000 in 10 years.

International bonds: these types of bonds are issued within a market that is foreign to the
issuer's home market, but some international bonds are issued in the currency of the foreign
market and others are denominated in another currency.

Eurobonds: Although the euro is the currency used by participating European Union countries,
Eurobonds refer neither to the European currency nor to a European bond market. A Eurobond
instead refers to any bond that is denominated in a currency other than that of the country in
which it is issued. Bonds in the Eurobond market are categorized according to the currency in
which they are denominated. As an example, a Eurobond denominated in Japanese yen but
issued in the U.S. would be classified as a Euroyen bond.

Foreign bonds: These bonds are denominated in the currency of the country in which a foreign
entity issues the bond. An example of such a bond is the samurai bond, which is a yen-
denominated bond issued in Japan by an American company.

Global bonds: These bonds are structured so that they can be offered in both foreign and
Eurobond markets. Essentially, global bonds are similar to Eurobonds but can be offered within
the country whose currency is used to denominate the bond. As an example, a global bond
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denominated in yen could be sold to Japan or any other country throughout the Eurobond
market.

Bond Type Specifics

Before getting to the all-important subject of bond pricing, we must first understand the many
different characteristics bonds can have.

1) Bond Issuers
As the major determiner of a bond's credit quality, the issuer is one of the most
important characteristics of a bond. In general, securities issued by the government
have the lowest risk of default while corporate bonds are considered to be riskier
ventures.

2) Priority
In addition to the credit quality of the issuer, the priority of the bond is a determiner of
the probability that the issuer will pay you back your money. The priority indicates your
place in line if the company defaults on payments. If you hold an unsubordinated
(senior) security and the company defaults, you will be first in line to receive payment
from the liquidation of its assets. On the other hand, if you own a subordinated (junior)
debt security, you will get paid out only after the senior debt holders have received their
share.

3) Coupon Rate
Bond issuers may choose from a variety of types of coupons, or interest payments.
 Straight, plain vanilla or fixed-rate bonds pay an absolute coupon rate over a
specified period of time.
 Floating rate debt instruments or floaters pay a coupon rate that varies
according to the movement of the underlying benchmark.
 Inverse floaters pay a variable coupon rate that changes in direction opposite to
that of short-term interest rates. An inverse floater subtracts the benchmark
from a set coupon rate. For example, an inverse floater that uses LIBOR as the
underlying benchmark might pay a coupon rate of a certain percentage (say 6%),
minus LIBOR.
 Zero coupon or accrual bonds do not pay a coupon. Instead, these types of
bonds are issued at a deep discount and pay the full face value at maturity.

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4) Redemption Features
Both investors and issuers are exposed to interest rate risk because they are locked into
either receiving or paying a set coupon rate over a specified period of time. For this
reason, some bonds offer additional benefits to investors or more flexibility for issuers:
 Callable, or a redeemable bond features gives a bond issuer the right, but not
the obligation, to redeem his issue of bonds before the bond's maturity. The
issuer, however, must pay the bond holders a premium.
 Convertible bonds give bondholders the right but not the obligation to convert
their bonds into a predetermined number of shares at predetermined dates
prior to the bond's maturity. This only applies to corporate bonds.
 Puttable bonds give bondholders the right but not the obligation to sell their
bonds back to the issuer at a predetermined price and date. These bonds
generally protect investors from interest rate risk.

Bond Pricing

Bonds can be priced at a premium, discount, or at par. If the bond's price is higher than its par
value, it will sell at a premium because its interest rate is higher than current prevailing rates. If
the bond's price is lower than its par value, the bond will sell at a discount because its interest
rate is lower than current prevailing interest rates.

When you calculate the price of a bond, you are calculating the maximum price you would want
to pay for the bond, given the bond's coupon rate in comparison to the average rate most
investors are currently receiving in the bond market. Required yield or required rate of return is
the interest rate that a security needs to offer in order to encourage investors to purchase
it. Usually the required yield on a bond is equal to or greater than the current prevailing interest
rates.

Fundamentally, however, the price of a bond is the sum of the present values of all expected
coupon payments plus the present value of the par value at maturity. For bond pricing, this
interest rate is the required yield.

Here is the formula for calculating a bond's price, which uses the basic present value (PV)
formula:

FV

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You may have guessed that the bond pricing formula shown above may be tedious to calculate,
as it requires adding the present value of each future coupon payment. Because these
payments are paid at an ordinary annuity, we can use the shorter PV-of-ordinary-annuity
formula that is mathematically equivalent to the summation of all the PVs of future cash flows.
This PV-of-ordinary-annuity formula replaces the need to add all the present values of the
future coupon.

The farther into the future a payment is to be received, the less it is worth today is the
fundamental concept for which the PV-of-ordinary-annuity formula accounts. It calculates the
sum of the present values of all future cash flows, but unlike the bond-pricing formula we saw
earlier, it doesn't require that we add the value of each coupon payment.

By incorporating the annuity model into the bond pricing formula, which requires us to also
include the present value of the par value received at maturity, we arrive at the following
formula:

FV

Accounting for Different Payment Frequencies

In the example above coupons were paid semi-annually, so we divided the interest rate and
coupon payments in half to represent the two payments per year. A simple modification of the
above formula will allow you to adjust interest rates and coupon payments to calculate a bond
price for any payment frequency:

FV

Notice that the only modification to the original formula is the addition of “F", which represents
the frequency of coupon payments, or the number of times a year the coupon is paid.
Therefore, for bonds paying annual coupons, F would have a value of one. Should a bond pay
quarterly payments, F would equal four, and if the bond paid semi-annual coupons, F would be
two.
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Example: Calculate the price of a bond with a par value of $1,000 to be paid in ten years, a
coupon rate of 10%, and a required yield of 12%. Assume coupons are paid semi-annually.

Pricing Zero-Coupon Bonds

As the name implies, there is no coupon payment until maturity for these types of bonds.
Because of this, the present value of annuity formula is unnecessary. You simply calculate the
present value of the par value at maturity.

Example : Calculate the price of a zero-coupon bond that is maturing in five years, has a par
value of $1,000 and a required yield of 6%.

You should note that zero-coupon bonds are always priced at a discount: if zero-coupon bonds
were sold at par, investors would have no way of making money from them and therefore no
incentive to buy them.

Pricing Bonds between Payment Periods

So far, our calculations would assume that we would receive the next coupon payment in
exactly six months. Of course, because you won't always be buying a bond on its coupon
payment date, it's important to know how to calculate price if, a semi-annual bond is paying its
next coupon in three months, one month, or 21 days.
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Determining Day Count

To price a bond between payment periods, we must use the appropriate day-count convention.
Day count is a way of measuring the appropriate interest rate for a specific period of time. For
example, if you purchased a semi-annual Treasury bond on March 1, 2012, and its next coupon
payment is in four months (July 1, 2012), the next coupon payment would be in 122 days:

Time Period = Days Counted

March 1-31 = 31 days
April 1-30 = 30 days
May 1-31 = 31 days
June 1-30 = 30 days
Total Days = 122 days

In other words, 60 days of the payment period (182 - 122) have already passed. If the
bondholder sold the bond today, he or she must be compensated for the interest accrued on
the bond over these 60 days.

Determining Interest Accrued

Accrued interest is the fraction of the coupon payment that the bond seller earns for holding
the bond for a period of time between bond payments. The bond price's inclusion of any
interest accrued since the last payment period determines whether the bond's price is "dirty"
or "clean." Dirty bond prices include any accrued interest that has accumulated since the last
coupon payment while clean bond prices do not. In newspapers, the bond prices quoted are
often clean prices.

However, because many of the bonds traded in the secondary market are often traded in
between coupon payment dates, the bond seller must be compensated for the portion of the
coupon payment he or she earns for holding the bond since the last payment. The amount of
the coupon payment that the buyer should receive is the coupon payment minus accrued
interest. The following example will make this concept clearer.

Example: On March 1, 2003, Francesca is selling a corporate bond with a face value of $1,000
and a 7% coupon paid semi-annually. The next coupon payment after March 1, 2003, is
expected on June 30, 2003. What is the interest accrued on the bond?

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Bond price quotes are typically the clean prices, but buyers of bonds pay the dirty, or full price.
As a result, both buyers and sellers should understand the amount for which a bond should be
sold or purchased. In addition, the tools discussed in this section will help to learn the
relationship between coupon rate, required yield and price as well as the reasons for
which bond prices change in the market.
Yield and Bond Price

The general definition of yield is the return an investor will receive by holding a bond to
maturity. So if an investor wants to know what his bond investment will earn, he should know
how to calculate yield. Required yield, on the other hand, is the yield or return a bond must
offer in order for it to be worthwhile for the investor. The required yield of a bond is usually the
yield offered by other plain vanilla bonds that are currently offered in the market and have
similar credit quality and maturity.

A simple yield calculation that is often used to calculate the yield on both bonds and the
dividend yield for stocks is the current yield. The current yield calculates the percentage return
that the annual coupon payment provides the investor.

Now we must also account for other factors such as the coupon payment for a zero-coupon
bond, which has only one coupon payment. For such a bond, the yield calculation would be as
follows:

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Calculating Yield to Maturity

The yield to maturity is an interest rate that must be calculated through trial and error. Such a
method of valuation is complicated and can be time consuming, so investors will typically use a
financial calculator or program that is quickly able to run through the process of trial and error.

To demonstrate this method, we first need to review the relationship between a bond's price
and its yield. In general, as a bond's price increases, yield decreases.

The charted relationship between bond price and required yield appears as a negative curve:

This is due to the fact that a bond's price will be higher when it pays a coupon that is higher
than prevailing interest rates. As market interest rates increase, bond prices decrease.
The second concept we need to review is the basic price-yield properties of bonds:

Premium bond: Coupon rate is greater than market interest rates.

Discount bond: Coupon rate is less than market interest rates.
Thirdly, remember to think of YTM as the yield a bondholder receives if he or she reinvested all
coupons received at a constant interest rate, which is the interest rate that we are solving for. If
we were to add the present values of all future cash flows, we would end up with the market
value or purchase price of the bond.

The calculation can be presented as:

Example: You hold a bond whose par value is $100 but has a current yield of 5.21% because the
bond is priced at $95.92. The bond matures in 30 months and pays a semi-annual coupon of
5%.
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Because our bond price is $95.92, our list shows that the interest rate we are solving for is
between 6%, which gives a price of $95, and 7%, which gives a price of $98. Now that we have
found a range between which the interest rate lies, we can make another table showing the
prices that result from a series of interest rates that go up in increments of 0.1% instead of
1.0%. Below we see the bond prices that result from various interest rates that are between
6.0% and 7.0%:

We see then that the present value of our bond (the price) is equal to $95.92 when we have an
interest rate of 6.8%. If at this point we did not find that 6.8% gives us the exact price that we
are paying for the bond, we would have to make another table that shows the interest rates in
0.01% increments. You can see why investors prefer to use special programs to narrow down
the interest rates - the calculations required to find YTM can be quite numerous!

Calculating Yield for Callable and Puttable Bonds

Bonds with callable or puttable redemption features have additional yield calculations.
A callable bond's valuations must account for the issuer's ability to call the bond on the call date
and the puttable bond's valuation must include the buyer's ability to sell the bond at the pre-
specified put date. The yield for callable bonds is referred to as yield-to-call, and the yield for
puttable bonds is referred to as yield-to-put.

Yield to call (YTC) is the interest rate that investors would receive if they held the bond until the
call date. The period until the first call is referred to as the call protection period. Yield to call is
the rate that would make the bond's present value equal to the full price of the bond.
Essentially, its calculation requires two simple modifications to the yield-to-maturity formula:

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Yield to put (YTP) is the interest rate that investors would receive if they held the bond until its
put date. To calculate yield to put, the same modified equation for yield to call is used except
the bond put price replaces the bond call value and the time until put date replaces the time
until call date.

For both callable and puttable bonds, investors will compute both yield and all yield-to-
call/yield-to-put figures for a particular bond, and then use these figures to estimate the
expected yield.

Factors which affect the yield spread between two Bonds

Bond yields depend on a variety of factors, including the type of issuer, the characteristics of
the bond issue, and the state of economy.

Factors affecting the spread

1. Type of issuer
2. Issuer’s perceived creditworthiness
3. Term or maturity of the instrument
4. Provisions that grant either issuer or investors an option
5. Taxability of the interest received
6. Expected liquidity of the security

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 STOCKS

Stocks are financial assets that do not have an agreed upon ending date. Investing in stock
means the investor has part ownership of a company and shares in the company’s profits and
losses. He or she can keep the stock for any length of time or decide to sell it to another
investor.

Holding Period Return

Holding period return is the increase in price of an asset plus any cash flow received from that
asset, divided by the initial price of the asset. The measurement or holding period can be a day,
a month, a year, and so on. In most cases, we assume the cash flow is received at the end of the
holding period, and the equation for calculating holding period return is:

Realized and Expected Holding Period Return

A realized return is a historical return based on past observed prices and cash flows. An
expected return is based on forecasts of future prices and cash flows. Such expected returns
can be derived from elaborate models or subjective opinions.

Required Return
An asset’s required return is the minimum return an investor requires given the asset’s risk. A
more risky asset will have a higher required return. Required return is also called the
opportunity cost for investing in the asset. If expected return is greater (less) than required
return, the asset is undervalued (overvalued).

In stock valuation models, there are three predominant definitions of future cash flows:
dividends, free cash flow, and residual income.

Dividends - Dividend discount models (DDMs) define cash flow as the dividends to be received
by the shareholders. The primary advantage of using dividends as the definition of cash flow is
that it is theoretically justified. The shareholder’s investment today is worth the present value
of the future cash flows he expects to receive, and ultimately he will be repaid for his
investment in the form of dividends. Even if the investor sells the stock at any time prior to the

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liquidation of the company, before all the dividends are paid, he will receive from the buyer of
the shares the present value of the expected futuredividends.

Free cash flow - Free cash flow to the firm (FCFF) is defined as the cash flow generated by the
firm’s operations that is in excess of the capital investment required to sustain the firm's
current productive capacity. Free cash flow to equity (FCFE) is the cash available to stockholders
after funding capital requirements and expenses associated with debt financing.

Residual income -Residual income is the amount of earnings during the period that exceeds the
investors’ required return. The theoretical basis for this approach is that the required return is
the opportunity cost to the suppliers of capital, and the residual income is the amount that the
firm is able to generate in excess of this return. The residual income approach can be applied to
firms with negative free cash flow and to dividend- and non-dividend-paying firms.

Dividend Discount Model (DDM)

One-Period DDM

We can rearrange the holding period formula to solve for the value today of the stockgiven the
expected dividend, the expected price in one year, and the required return:

Example: Calculating value for a one-period DDM

Buy-Best shares are expected to pay a dividend at the end of the year of €1.25. The analyst
estimates the required return to be 8% and the expected price at the end of the year to be
€28.00. The current price is €26.00. Calculate the value of the shares today, and determine
whether Buy-Best is overvalued, undervalued, or properly valued.

Two-Period DDM

The value of a share of stock using the two-period DDM is the present value of thedividends in
years 1 and 2, plus the present value of the expected price in Year 2:

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Example: Calculating value for a two-period DDM
Machines Unlimited shares are expected to pay dividends of 1.55 Canadian dollars(C$) and
C$1.72 at the end of each of the next two years, respectively. The investor expects the price of
the shares at the end of this 2-year holding period to be C$42.00.The investor’s required rate of
return is 14%. Calculate the current value of Machines Unlimited shares.

Multi-Period DDM

The DDM can easily be adapted to any number of holding periods by adjusting thediscount
factor to match the time to receipt of each expected return. With this, thepresent value
becomes the sum of the properly discounted values of all expected cashflows (dividends and
terminal value):

Example: Calculating value for a three-period DDM

Reliable Motors shares are expected to pay dividends of $1.50, $1.60, and $1.75 at the end of
each of the next three years, respectively. The investor expects the price of the shares at the
end of this 3-year holding period to be $54.00. The investor's required rate of return is 15%.
Calculate the current value of Reliable’s shares.

The Gordon growth model (GGM) assumes that dividends increase at a constant rate
indefinitely. The simplifying factor of the constant growth assumption is that the rate of growth
can be expressed per period in the same way that the required return is expressed, allowing the
expression to be condensed into a simple formula:

Example: Calculating value with the Gordon growth model

Down-Under Financial recently paid a dividend of 1.80 Australian dollars (A$). An analyst has
examined the financial statements and historical dividend policy of Down-Under and expects
that the firm’s dividend rate will grow at a constant rate of 3.5% indefinitely. The analyst also
determines Down-Under’s required return is 10%. Calculate the current value of Down-Under’s
shares.

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Example: Calculating the implied growth rate using the Gordon growth model
Assume that the current price and most recent annual dividend for Aurora Mining (AM) are
$24.25 and $1.10, respectively. If the required return on Aurora is 8.5%,what is the implied
growth rate?

References
1. Goacher D, 1999, The Monetary and Financial System – 4th Edition, CIB Publishing,
United Kingdom.
2. CFA Level 2 Book 3; Equity Investments
3. CFA Level 2 Book 4; Fixed Income: Valuation Concepts
4. http://www.investopedia.com
5. http://www.cbsl.gov.lk/

Unless you try to do something beyond what you have

already mastered, you will never grow.
George Bernard Shaw

Sanjeewa Guruge
M.Sc. Investments (UK), B.Sc. Accountancy (Special) - 1st Class, FCA, FCMA

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