5. WEEK
FINANCIAL INSTRUMENTS AND
VALUATION
1
©2009, The McGraw-Hill Companies, All Rights Reserved
TYPESOF SECURITIES
 Negotiable instruments that represent
ownership: Equity instruments such as C.S.
 Negotiable instruments that denote
indebtness: Debt (fixed income) securities
such as bills, notes and bonds.
2
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PREFERRED STOCKS
 They are issued in international markets
representing ownership and carrying some
privileges:


The right to be paid dividends before the
common stockholders
The right to receive a specific amount in the
form of dividends each year.
3
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PREFERRED STOCKS cont.
 Different from C.S. In a way that their cash
dividends are certain (guaranteed) and they
do not increase as earnings rise.
 The are callable unilaterally: they have a
redemption feature.
4
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COMMON STOCKS
 Holders of the common stock are the
actual owners of the issuing corporation.
 If you have stocks, you have the right of
the companies earnings depending on
your proportional share after the interest
paid on bonds and dividends paid on
preferred stockholders.
5
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RIGHTS OF COMMON STOCKHOLDERS
 Receiving dividend
 Voting right
 Pre-emptive right: subscribing to capital
increases
 Receiving proportionate share from
dissolution if any
 Receiving information about the corporation
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DUITIES AND RESPONSIBILITIES OF
STOCKHOLDERS
 They must honor their capital subscription
payment promises when appealed by the
board of directors. If delayed, they become
liable for interest and punitive payments.
 Their liabilities are confined to their
subscriptions only.
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PRICES OF COMMON STOCKS
 Nominal (par) value: face value of the stock
 Issuance value: it is the value of the common stock
which is calculated by utilizing the discounted cash
flows technique by some experts. It can not be lower
than its nominal value according to the C.M. Law.
 Market value: it is the price at which the stock is
traded.
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TYPES OF THE STOCKS
 Hamiline ve nama yazılı (bearer shares –
name shares)
 Adi ve imtiyazlı (common and preferred
shares)
 Bedelli –bedelsiz (scrip issues)
 Primli-primsiz (shares with premium or not)
 Kurucu-intifa (preferred stocks)
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DERIVATIVES OF THE EQUITY
INSTRUMENTS
 1. Profit and Loss Sharing Certificates (Kar ve
Zarar Ortaklığı Belgeleri)
 2. Participation Dividend Certificates (Katılma
İntifa Senedi)
 3. Non-voting Shares (Oydan Yoksun Hisse
Senedi)
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1. PROFIT AND LOSS SHARING
CERTIFICATES
 Companies issue them in order to meet their
financial needs.
 They can be put to sale in or out of Turkey.
 They have a maturity of 3 months- 7 years.
The longest maturity for them is 15 years. If
they are issued by “Participation Banks” the
max. Maturity is 2 years.
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1. PROFIT AND LOSS SHARING
CERTIFICATES cont.
 Issued with longer than 2 year maturity, have
got to be issued on exchange.
 Can not be issued with coupon, no profit
guarantee. If there is loss they have to
contribute to the loss.
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1. PROFIT AND LOSS SHARING
CERTIFICATES cont.
 They provide the participation of profit and
loss but they are not recognize as common
stocks since they have a maturity and no
voting rights.
 Also they can not be recognized as income
bonds since it requires to participate loss if
any.
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1. PROFIT AND LOSS SHARING
CERTIFICATES cont.
 Investors can get principal and dividend at
the end of the maturity.
 They can be sold either directly by the issuer
or through securities dealers.
 They must be registered by the CMB.
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2. PARTICIPATION DIVIDEND
CERTIFICATES
 Issued for cash, not represent a specific
capital.
 Provide



Dividend payment,
Dispolution payment if any,
Pre-emptive right.
 Not provide


Voting rights (ownership rights),
Involment into management .
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2. PARTICIPATION DIVIDEND
CERTIFICATES
 Can be put to sales in or out of Turkey.
Overseas sales require approval of the
ministry of finance.
 Issue limit is max. Net worth of the issuer. Min
issue can be one-sixth of net-worth.
 They can be issued infinitely in accordance to
the decision of the board of company.
©2009, The McGraw-Hill Companies, All Rights Reserved
3. NON-VOTING SHARES
 They are like the ordinary shares, however
they do not provide voting rights. Holders of
them benefit from dividend payments and
dissolution payments if any.
 If not authorized by the articles of association,
non-voting shares cannot be issued.
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3. NON-VOTING SHARES cont.
 They have to be in the name, not to the
bearer.
 In the event of;


No dividend distributed for 3 successive years
No dividend is distributed for the year while
any permission is given by regulations.
Non-voting shares automatically transform
to voting shares
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3. NON-VOTING SHARES cont.
 They have subscription rights in capital
increases.
 Rights to bonus shares (scrip issues).
 Rights to get information.
 Rights to participate the general meeting of
shareholders with no voting power.
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3. NON-VOTING SHARES cont.
 Non-voting shareholders may convene
special meeting of shareholders cannot
prejudice the rights of non-voting
shareholders.
 The validity of the ordinary shareholders’
decisions is subject to approval by non-voting
shareholders.
 First issue of non-voting shares has to be
offered to public.
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BONDS
 It is a certificate indicating that a corporation
has borrowed a fixed sum of money and
promises to repay it at a future date.
 They are long-term securities.
 Bondholders do not have any voice in the
management.
21
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BONDS cont.
 Corporation agrees to pay at a specified
intervals interest at a stated rate. The
principle is paid off at the maturity date.
 Bonds generally can be traded anywhere in
the world. Mostly there are OTC markets for
them. Some corporation bonds in USA are
listed on an exchange.
22
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BONDS cont.
 Trading for bonds is usually done by bond
dealers. There are bond trading desks of
major investment dealers in USA.
 The dealers provide liquidity for bond
investors. They also buy and sell bonds
among themselves.
23
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BONDS cont.
 Bonds can be issued with or without coupons.
 No-coupon bonds are issued and sold below
par paid off at maturity in full sums: Treasury
bills in Turkey.
 Treasury notes and bonds are generally in
bearer form.
24
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BONDS cont.
 Bonds can be issued in Turkey


With fixed interest
With variable interest
 All bonds must be listed on an exchange.
25
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TYPES OF BONDS
 Government-corporate Bonds
 Premium- Par
 Lottery Bonds
 Fixed Rate-Variable (Floating Rate)
 Indexed Bonds (Foreign Exchange or Gold)
 Guaranteed or Nonguaranteed
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DERIVATIVES OF THE BONDS
 1. Income Bonds (Kara İştirakli Tahvil)
 2. Convertible Bonds (H.S İle Değiştirilebilinir
Tahvil)
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1. INCOME BONDS
 They can be redeemed at maturity only, the
principle payment can not be split over years.
 There are three types of period income
(returns):



Interest+dividend
Either interest or dividend
Dividend only
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1. INCOME BONDS cont.
 Interest is paid on due dates.
 Dividend payment is declarated latest two
months from the general meeting of the
shareholders when profit for the year is
approved.
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2. CONVERTIBLE BONDS
 It is a bond with a call option to buy the C.S.
of an issuer.
 The holder of it can exchange the security, at
his option for the C.S. of the issuer in
accordance of the terms of the bond
indepture.
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2. CONVERTIBLE BONDS cont.
 These securities carry a maturity of 2-7 years.
 Conversion of bonds can be made after 2
years.
 Conversion is made through the intermediary
of bank branches.
 Convertible bonds are issued with coupons
which are payable on an annual basis only.
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Various Interest Rate Measures
 Coupon rate
 periodic cash flow a bond issuer contractually
promises to pay a bond holder
 Required rate of return (rrr)
 rates used by individual market participants to
calculate fair present values (PV)
 Expected rate of return (Err)
 rates participants would earn by buying securities at
current market prices (P)
 Realized rate of return (rr)
 rates actually earned on investments
32
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Required Rate of Return
 The fair present value (PV) of a security is
determined using the required rate of return (rrr)
as the discount rate
~
~
~
~
CF3
CFn
CF1
CF2
PV 


 ... 
1
2
3
(1  rrr ) (1  rrr ) (1  rrr )
(1  rrr ) n
CF1 = cash flow in period t (t = 1, …, n)
~ = indicates the projected cash flow is uncertain
n = number of periods in the investment horizon
33
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Expected Rate of Return
 The current market price (P) of a security is
determined using the expected rate of return (Err)
as the discount rate
~
~
~
~
CF3
CFn
CF1
CF2
P


 ... 
1
2
3
(1  Err ) (1  Err ) (1  Err )
(1  Err ) n
CF1 = cash flow in period t (t = 1, …, n)
~ = indicates the projected cash flow is uncertain
n = number of periods in the investment horizon
34
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Realized Rate of Return
 The realized rate of return (rr) is the discount rate
that just equates the actual purchase price ( ) to
the present value of the realized cash flows (RCFt) t (t
=P
1, …, n)
RCF3
RCFn
RCF1
RCF2
P


 ... 
1
2
3
(1  rr ) (1  rr ) (1  rr )
(1  rr ) n
35
©2009, The McGraw-Hill Companies, All Rights Reserved
EXAMPLE 3-1
 A bond you purchased two years ago for $890 is now
selling for $925. The bond paid $100 per year in
coupon interest on the last day of each year. You
intend to hold the bond for more 4 years and project
that you will be able to sell it at the end of year 4 for
$960. Given the risk associated with the bond, its
required rate of return over the next four years is
11.25%. Find its fair value, Expected rate of return.
And realized rate of return.
36
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Bond Valuation
 The present value of a bond (Vb) can be written as:
t

INT 
1
M


Vb 


2 t 1  (1  id / 2)  (1  id / 2) 2T
2T
INT

( PVIFAid / 2, 2T )  M ( PVIFid / 2, 2T )
2
M = the par value of the bond
INT = the annual interest (or coupon) payment
T = the number of years until the bond matures
i = the annual interest rate (often called yield to maturity (ytm))
37
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EXAMPLE 3-4
 You are considering the purchase of a $1000
face value bond that pays 10% coupon
interest per year with the coupon paid
semiannually. The bond matures in 12 years.
If the required rate of return on the bond is
8%. Find the market value of the bond.
38
©2009, The McGraw-Hill Companies, All Rights Reserved
Bond Valuation
 A premium bond has a coupon rate (INT)
greater then the required rate of return (rrr)
and the fair present value of the bond (Vb) is
greater than the face value (M)
 Discount bond: if INT < rrr, then Vb < M
 Par bond: if INT = rrr, then Vb = M
39
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Yield to Maturity
 The return or yield the bondholder will earn
on the bond if he buys it at its current market
price, receives all coupon and principal
payments and hold the bond until maturity.
40
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EXAMPLE 3-5
 You are considering to purchase of a $1000
face value bond that pays 11% coupon
interest per year, paid semiannually. The
bond matures in 15 years. If the current
market price of the bond is $931.176, what is
the yield to maturity?
41
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Equity Valuation
 PV of the future dividends.
 Example 3.6: Suppose you owned a stock for
the last two years for $25 and just sold it for
$35. The stock paid an annual dividend of $1
on the last day of each of the past two years.
Calculate the realized rate of return.
42
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 Example 3.7: You are considering the
purchase of a stock that you expect to own
for the next three years. The current market
price of the stock is $32 and you expect to
sell it for $45 in three years’ time. You also
expect the stock to pay an annual dividend of
$1.5 on the last day of each of the next three
years. Calculate the expected rate of return
on the stock.
©2009, The McGraw-Hill Companies, All Rights Reserved
Equity Valuation
 The present value of a stock (Pt) assuming zero
growth in dividends can be written as:
Pt  D / is
D = dividend paid at end of every year
Pt = the stock’s price at the end of year t
is = the interest rate used to discount future cash flows
44
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EXAMPLE 3-8
 A stock you are evaluating is expected to pay
a constant dividend of $5 per year. The
expected rate of return (Err) on the stock is
12%. Calculate the price of the stock.
45
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Equity Valuation
 The present value of a stock (Pt) assuming
constant growth in dividends can be written as:
D0 (1  g )t Dt 1
Pt 

is  g
is  g
D0 = current value of dividends
Dt = value of dividends at time t = 1, 2, …, ∞
g = the constant dividend growth rate
46
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EXAMPLE 3- 9
 A stock you are evaluating paid a dividend at
the end of last year of $3.5. Dividend have
grown at a constant rate of 2% per year over
the last 20 years, and this constant growth
rate is expected to continue into the future.
The required rate of return (rrr) on the stock is
10%. Calculate the price.
47
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Example 3.10
 A stock you are evaluating paid a dividend at
the end of last year of $4.80. Dividends have
grown at a constant rate of 1.75 percent per
year over the last 15 years, and this constant
growth rate is expected to continue into the
future. The stock is currently selling at a price
of $52 per share. Calculate the expected rate
of return on this stock.
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EXAMPLE 3-11
 A stock you are evaluating is expected to
experience supernormal growth in dividends
of 10%, over the next 5 years. Following to
this period dividends are expected to grow at
a constant rate of 4%. The stock paid a
dividend of $4 last year, and the rrr on the
stock is 15%. Find the fair PV of the stock.
49
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Equity Valuation
 The return on a stock with zero dividend growth, if
purchased at price P0, can be written as:
is  D / P0
 The return on a stock with constant dividend growth,
if purchased at price P0, can be written as:
D0 (1  g )
D1
is 
g g
P0
P0
50
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Relation between Interest
Rates and Bond Values
Interest
Rate
12%
10%
8%
Bond Value
874.50
1,000
1,152.47
51
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Impact of Maturity on
Interest Rate Sensitivity
Absolute Value of
Percent Change in a
Bond’s Price for a
Given Change in
Interest Rates
Time to Maturity
52
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Impact of Coupon Rates on
Interest Rate Sensitivity
Bond
Value
High-Coupon Bond
Low-Coupon Bond
Interest Rate
53
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Duration
 Duration is the weighted-average time to
maturity (measured in years) on a financial
security
 Duration measures the sensitivity (or
elasticity) of a fixed-income security’s price to
small interest rate changes
54
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Duration
 Duration (D) for a fixed-income security that pays interest
annually can be written as:
T
CF t t
PVt  t


t
(1  R)
D  tT1
 t 1T
CF t
PVt


t
t 1 (1  R )
t 1
T
t = 1 to T, the period in which a cash flow is received
T = the number of years to maturity
CFt = cash flow received at end of period t
R = yield to maturity or required rate of return
PVt = present value of cash flow received at end of period t
55
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Duration
 Duration (D) (measured in years) for a fixed-income
security in general can be written as:
CF t t

mt
(
1

R
/
m
)
D  t 1T/ m
CF t

mt
(
1

R
/
m
)
t 1/ m
T
m = the number of times per year interest is paid
56
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EXAMPLE
 Consider a bond with one year remaining to
maturity, a $1000 face value, an 8% coupon
rate and an interest rate of 10%. Coupons are
paid semiannually. Find duration for this
bond.
57
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EXAMPLE 3-12
 Suppose you have a bond that offers a
coupon rate of 10% paid semiannually. The
face value of the bond is $1000, it matures in
4 years, its current yield to maturity is 8%,
and its current market price is $1067.34.
Calculate the duration.
58
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Duration
 Duration and coupon interest
 the higher the coupon payment, the lower the bond’s
duration
 Duration and yield to maturity
 the higher the yield to maturity, the lower the bond’s
duration
 Duration and maturity
 duration increases with maturity at a decreasing rate
59
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Duration and Modified Duration
 Given an interest rate change, the estimated
percentage change in a (annual coupon paying)
bond’s price is found by rearranging the duration
formula:
P
 R 
 D
  MD  R

P
1  R 
MD = modified duration = D/(1 + R)
60
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EXAMPLE 3-14 (Exp 12 cont.)
 Suppose that yield to maturity increases by
10 basis points (1/10 of 1%) from 8% to 8.1%.
Find the percentage change on bond price
(Price of the bond = $1067.34.
 Find percentage change on bond price with a
lower coupon rate (when coupon rate is 6%,
duration is 3.6 years. Price of the bond is
$932.68)
61
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DURATION cont.
 The higher the coupon rate, the shorter the
duration and the smaller the percentage
decrease in bond price.
 Duration model predicts symmetric effects for
rate increases and decreases.
 Capital loss effect of large rate increases
tends to be smaller than capital gain effect of
large rate decreases.
62
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Figure 3-7: Price-Yield Curve
63
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Convexity
 Convexity (CX) measures the change in slope of the
price-yield curve around interest rate level R.
 Convexity incorporates the curvature of the priceyield curve into the estimated percentage price
change of a bond given an interest rate change:
P
1
 R  1
2
2
 D

CX
(

R
)


MD


R

CX
(

R
)
P
2
1  R  2
64
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Example 15
 Consider a four year, $1,000 face value bond
with a 10% coupon paid semiannually and an
8% yield. Duration=3.42 years. Current
market price= $1,067.34. If int. Rate rises
from 8 to 10 percent what will be the price of
the bond.
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