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Economics 173A. Comprehensive (excluding MPT) Slide Deck. To help to finance Companies Annual Working Capital increases = $ 150 Billion Annual Capital Expenditures “CAPEX” = $ 900 Billion = $ 1,050 Billion Source of funds: Annual Earnings = ($ 800 Billion)

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economics 173a
Economics 173A

Comprehensive (excluding MPT) Slide Deck

capital markets
To help to finance Companies

Annual Working Capital increases = $ 150 Billion

Annual Capital Expenditures “CAPEX” = $ 900 Billion

= $ 1,050 Billion

Source of funds:

Annual Earnings = ($ 800 Billion)

GAP $ 250 Billion

2. Annual Debt issued ($ 300 Billion)

( $ 50 Billion)

Equity -this represents repurchases of Equity

Capital Markets
assets investing
The Assets

Fixed Income


Real Estate







The Process

Asset Allocation




120/20 ?

Security Selection

Security Analysis

Assets & Investing

Risk Return Trade-off

prices and coupon rates
Prices and Coupon Rates

Risk and expected Return



financial instruments
Money Market

Certificates of Deposit

U.S. Treasury Bills

Money Market Funds

Bond Market

U.S Treasury Notes, Bills, and Bonds

U.K. Gilts and Consols

Municipal Bonds

Corporate Bonds

Equity Market

Common Stock

Preferred Stock

Derivative Market






Financial Instruments
intermediation and innovation

Commercial Banks

Investment Banks





Private Equity

Foreign Exchange





Bundling (Un)



Custom-tailored Risk/Return

Synthetics – derivative hedges – mimic something

Intermediation and Innovation
fixed securities rates

CDs – bank time-deposits

Paper – unsecured, trade-able company debt

Acceptances – bank promises

Eurodollars - $ denominated foreign bonds

Repos, Reverse Repos – of treasury debt

Treasuries – bills, notes, bonds



Fed Funds


TED Spread : the 3-month Treasury less LIBOR

Fixed Securities & Rates

TED Spread

Originally calculated as the difference between interest rates on 3-month T-bills and 3-month Eurodollar contracts w/ identical expiration.

Acronym is derived from the “T” for “Treasuries" and the ticker symbol for Eurodollars, which is “ED”.Today, the TED spread is calculated as the difference between interest rates on 3-month T-bills and 3-month LIBOR (London Interbank Offered Rate).


TED Spread

Denominated in basis points (bps).

Historically 10 to 50 bps – average 30 bps

A rising TED spread indicates shrinking liquidity –an indicator of perceived credit risk:

T-bills are considered risk-free

LIBOR reflects the credit risk of lending banks.

Widening TED spread is a sign that lenders believe default risk on interbank (counterparty) loans is increasing.]


Historically 20 to 30 bps

2007 Average 150 – 200 bps

September 2008 > 300 bps; and on October 8th 465 bps

  • Characteristics
  • Pricing
  • Yields
  • Sensitivity to Time, i.e. maturity
  • Sensitivity to interest rates

Economics 175

bond characteristics
Bond Characteristics
  • Debt Security – related to borrowing
  • Also called a Fixed Income security
  • Covenants or Indenture define the contract (this can be complex)
  • 2 types of Payments: interest & principal
  • Interest payments are the Coupon
  • Principal payment is the Face
bond basics
Bond Basics
  • Fixed Income Securities: A security such as a bond that pays a specified cash flow over a specific period.

Fixed Income Securities vs. Common Stock

Fixed Claim

Residual Claim

High Priority on cash flows

Lowest Priority on cash flows

Tax Deductible

Not Tax Deductible

Fixed Maturity

Infinite life

No Management Control

Management Control


Hybrids (Combinations

Common Stock

of debt and equity)

bond basics1
The bond indenture usually lists:

Amount of Issue, Date of Issue, Maturity

Denomination (Par value) Face

Annual Coupon, Dates of Coupon Payments


Sinking Funds

Call Provisions


Features that may change over time:



Market price

Bond Basics
  • The indenture is a written agreement between the corporate debt issuer and the lender.
types of bonds fixed income instruments
Types of Bonds (Fixed Income Instruments)
  • Convertibles (into Equity)
  • Callable Bond (buy-back by Issuer) – shorten the term
  • Putable Bond (sell-back by Owner) – extend the term
  • Floating-rate & Inverse Floaters
  • Asset-backed (like CMOs)
  • Zeros – no Coupons
  • Strips – no Face
  • Senior versus Subordinated

Economics 175

treasury bonds bills notes
Treasury Bonds, Bills, & Notes
  • Notes – up to 10 year term
  • Bonds – to 30 years
  • Face (denomination) of $1,000; quotes in $100’s
  • Coupon (rate) paid semi-annually
  • Prices quoted in points (of face) + 1/32
  • No default / credit risk
bond pricing
Bond Pricing

As with all Financial Assets

The price is a Present Value of the expected cash flows discounted at the appropriate (relative to risk) discount (interest) rate.

coupon payments
Coupon Payments
  • Relative to other types of securities, bonds produce cash flows that an analyst can predict with a high degree of precision.
    • Fixed rate
    • Variable rate
    • Zero coupons
    • Consols – consolidated annuities - perpetuities introduced in 1751.

Annual percentage yield (APY)

The effective, or true, annual rate of return. The APY is the rate actually earned or paid in one year, taking into account the affect of compounding. The

APY is calculated by taking 1+r

… the periodic rate and raising it to the number of periods in a year.

For example, a 1% per month rate has an APY of 12.68% (1.01^12).

bond pricing1
Bond Pricing
  • DCF Technique

PB = Price of the bond

Ct = interest or coupon payments

T = number of periods to maturity

r = semi-annual discount rate or the semi-annual yield to maturity

bond pricing2
















Bond Pricing
  • Example (annual coupon paid SA). Solving for Price: 10-yr, 8% Coupon Bond, Face = $1,000 in a 6% risk-adjusted market.

Ct = 40 (SA), F = 1000, T = 20 periods, r = 3% (SA)

PB = $1,148.77

bond pricing3
Bond Pricing
  • Zero Coupon Bonds
  • Consols – Zero Face Bonds
bond yields
Bond Yields
  • Yield to Maturity: The discount rate that makes the present value of a bond’s payments equal to its price.
    • Internal rate of return from holding bond till maturity.
    • Example3 year bond with interest payment of $100, principal of $1,000 and current price of $900
    • Assume coupon proceeds are reinvested at the YTM.
bond pricing4
















Bond Pricing
  • Example (annual coupon paid SA) in a 6 percent world.Solving for Price: 10-yr, 8% Coupon Bond, Face = $1,000

Ct = 40 (SA), P = 1000, T = 20 periods, r = 3% (SA)

PB = $1,148.77

approximate yield to maturity
Approximate Yield to Maturity

Bond Yields

  • Approximating YTM

Using the earlier example

Avg. Income = 80 + (1000-1149)/10 = 65.10

Avg. Price = (1000 + 1149)/2 = 1074.50

Approx. YTM = 65.10/1074.50 = 0.0606

Actual YTM = 6.00%

bond yields1
Bond Yields
  • Prices and Yields (required rates of return) have an inverse relationship
    • When yields get very high the value of the bond will be very low
    • When yields approach zero, the value of the bond approaches the sum of the cash flows
prices and coupon rates1
Prices and Coupon Rates

Bond Yields



yield curve
Yield Curve
  • A plot of interest rates against time to maturity.




Daily Treasury Yield Curve Rates


Daily Treasury Yield Curve Rates

bond yields2
Bond Yields
  • Current or Annual Yield: Annual coupon divided by bond price.
    • Different from YTM!
  • Accrued Interest
    • Interest is earned for each day that a bond is held, although interest payments are generally made twice a year only.
    • A bond buyer must pay the accrued interest to the seller of the bond.
      • dirty price = bond price + accrued interest
      • clean price = bond price
    • By convention, accrued interest is calculated using a 360-day year.
bond pricing accrued interest
Bond Pricing: Accrued Interest
  • Example
    • Consider a bond that is paying a six percent annual coupon rate in semiannual payments with a yield to maturity of 10 percent and two years and ten months until its maturity.
      • What is the quoted price or clean price?
      • What is the dirty price?
bond pricing accrued interest1
Bond Pricing: Accrued Interest
  • What is the quoted price or clean price?

Step One: Calculate the present value of a bond that has 2.5 years until it matures and pays semiannual interest coupons.

Step Two: The $30 coupon is added to $913.39. The sum is $943.19.

Step Three: The value $943.19 is discounted back 4 months to the purchase date.

bond pricing accrued interest2
Bond Pricing: Accrued Interest
  • What is the dirty price?

Calculate the accrued interest for two months. There are 180 days between semiannual coupon payments and 30 days in a month. Therefore 60/180 is the fraction of the coupon payment earned by the seller. In other words the accrued interest is $10 and the dirty price is $923.16.

bond risks
Bond Risks
  • Price Risks
    • Default risk
    • Interest rate risk
  • Convenience Risks
    • Call risk
    • Reinvestment rate risk
    • Marketability risk
default risk
Default Risk
  • The income stream from bonds is not riskless unless the investor can be sure the issuer will not default on the obligation.
  • Rating companies
    • Moody’s Investor Service
    • Standard & Poor’s
    • Duff and Phelps
    • Fitch
default risk1
Default Risk
  • Rating Categories
    • Investment Grade Bonds
    • Speculative Grade Bonds

S&P Moody’s

Very High Quality AAA, AA Aaa, Aa

High Quality A, BBB A, Baa

Speculative BB, B Ba, B

Very Poor CCC, CC, C, D Caa, Ca, C, D


Forward Rates

term yearsrat year

One-year rate one year from now

One-year rate two years from now

bond duration
Linear measure of the sensitivity of a bond's price to fluctuations in interest rates.

Measured in units of time; always less-than-equal to the bond’s maturity because the value of more distant cash flows is more sensitive to the interest rate.

“Duration" generally means Macaulay duration.

Bond Duration
macaulay duration
For small interest rate changes, duration is the approximate percentage change in the value of the bond for a 1% increase in market interest rates.

The time-weighted average present value term to payment of the cash flows on a bond.

Macaulay Duration
macaulay duration2
A 10-year bond with a duration of 7 would fall approximately 7% in value if interests rates increased by 1%.

The higher the coupon rate of a bond, the shorter the duration.

Duration is always less than or equal to the overall life (to maturity) of the bond.

A zero coupon bond will have duration equal to the maturity.

Macaulay Duration
dollar duration
Duration x Bond Price: the change in price in dollars, not in percentage, and has units of Dollar-Years (Dollars times Years).

The dollar variation in a bond's price for small variations in the yield.

For small interest rate changes, duration is the approximate percentage change in the value of the bond for a 1% increase in market interest rates.

Dollar Duration
modified duration1
Modified Duration

What will happen to the price of a 30 year 8% bond priced to yield 9% (i.e. $897.27) with D* of 11.37 - if interest rates increase to 9.1%?

duration characteristics
Duration Characteristics
  • Rule 1: the duration of a zero coupon bond is equal to its time-to-maturity.
  • Rule 2: holding time-to-maturity and YTM constant, duration is higher when the coupon rate is lower.
  • Rule 3: holding coupon constant, duration increases with time-to-maturity. Duration always increases with maturity for bonds selling at par or at a premium.
  • Rule 4: cateris parabus, the duration of coupon bonds are higher when its YTM is lower.
  • Rule 5: duration of a perpetuity is [(1+r)/r].
bond convexity
Bond Convexity
  • Bond prices do not change linearly, rather the relationship between bond prices and interest rates is convex.
  • Convexity is a measure of the curvature of the price change w.r.t. interest rate changes, or the second derivative of the price function w.r.t. relevant interest rates.
  • Convexity is also a measure of the spread of future cash flows.
  • Duration gives the discounted mean term; convexity is used to calculate the discounted standard deviation of return.
prices and coupon rates2
Prices and Coupon Rates

Duration versus Convexity



common stocks
Common Stocks
  • Residual Owners:
  • Stockholders of a firm are entitled to dividend income derived from the firm’s earnings.
    • Stocks may provide a steady stream of current income through dividends.
    • Stocks may increase in value over time through capital gains.
market performance
Market Performance
  • Routine Decline: a drop of 5% or more in one of the major market indexes, like the Dow Jones Industrial Average (DJIA)
  • Correction: a drop of 10% or more in one of the major market indexes
  • Bear Market: a drop of 20% or more in one of the major market indexes
Stock Returns:

Both price changes, called capital gains, and dividend income:

    • Over past 50 years, stock returns have ranged from +48.28% in 1954 to -21.45% in 1974
    • Stock returns over past 50 years have averaged around 11%
    • From 1998 through mid-’03, DJIA averaged 1.7%
Provide opportunity for higher returns than other investments
  • Over past 50 years, stocks averaged 11% and high-grade corporate bonds averaged 6%
  • Good inflation hedge since returns typically exceed the rate of inflation
  • Easy to buy and sell stocks
  • Price and market information is easy to find in financial media
  • Unit cost per share of stock is low enough to encourage ownership
Stocks are subject to many different kinds of risk:
    • Business risk
    • Financial risk
    • Market risk
    • Event risk
  • Hard to predict which stocks will go up in value due to wide swings in profits and general stock market performance
  • Low current income compared to other investment alternatives
Stock Split: when a company increases the number of shares outstanding by exchanging a specified number of new shares of stock for each outstanding share
    • Usually done to lower the stock price to make it more attractive to investors
    • Stockholders end up with more shares of stock that sells for a lower price
    • Investor with 200 shares in a 2-for-1 stock split would have 400 shares after the stock split
    • If the stock price was $100 before the split, the price would be near $50 after the split
Treasury Stock: shares of stock that were originally sold by the company and have been repurchased by the company. Share repurchases are often called “buybacks.”
    • Reduces the number of shares outstanding to public
    • Companies buyback when they believe stock is undervalued and a good buy
    • Companies may try to raise undervalued stock price or prop up overvalued stock price
    • May be used for employee stock option plans
Classified Common Stock: common stock issued in different classes, each of which offers different privileges and benefits to its holders
    • Different shares may have different voting rights
    • Often used to allow a relatively small group to control the voting of a publicly-trade company
    • Ford family owns “B” shares and other investors own “A” shares; Ford family controls 40% of Ford Motor Company
    • May have different dividend payout schedules
Par Value: the stated, or face, value of a stock
    • Mainly an accounting term and not very useful to investors
  • Book Value: the amount of stockholders’ equity
    • The difference between the company’s assets minus the company’s liabilities and preferred stock
  • Market Value: the current price of the stock in the stock market
Market Capitalization: the overall current value of the company in the stock market
    • Total number of shares outstanding multiplied by the market value per share
  • Investment Value: the amount that investors believe the stock should be trading for, or what they think it’s worth
    • Probably the most important measure for a stockholder
Earnings Per Share: the amount of annual earnings available to common stockholders, stated on a per-share basis
  • Dividend income is one of the two basic sources of return to investors.
  • Dividend income is more predictable than capital gains, so preferred by investors seeking lower risk.
  • Dividends are taxed at maximum 15% tax rate, same as capital gains.
  • Dividends tend to increase over time as companies’ earnings grow; increases average 3-5% per year.
  • Dividends represent the return of part of the profit of the company to the owners, the stockholders.
Dividend Payout Ratio: the portion of earnings per share (EPS) that a firm pays out as dividends
    • Companies are not required to pay dividends
    • Some companies have high EPS, but reinvest all money back into company
dividends and dividend yield
Dividends and Dividend Yield
  • Dividend Yield: a measure to relate dividends to share price on a percentage basis
    • Indicates the rate of current income earned on the investment dollar
    • Convenient method to compare income return to other investment alternatives
Stock Dividend: payment of a dividend in the form of additional shares of stock
  • Dividend Reinvestment Plans (DRIPs): plans where cash dividends are automatically reinvested into additional shares of the firm’s common stock
    • Over 1,000 companies offer DRIPs
    • Usually have no brokerage fees
    • Uses dollar-cost averaging
Blue Chip Stocks: financially strong, high-quality stocks with long and stable records of earnings and dividends
    • Companies are leaders in their industries
    • Relatively lower risk due to financial stability of company
    • Popular with investing public looking for steady growth potential, perhaps dividend income
    • Provide shelter during unsettled markets
    • Examples: Wal-Mart, Proctor & Gamble, Microsoft, United Parcel Service, Pfizer and 3M Company
Income Stocks: stocks with long and sustained records of paying higher-than average dividends
    • Dividends tend to increase over time (unlike interest payments on bonds)
    • Examples: Verizon, Conagra Foods, Pitney Bowes.

Growth Stocks: stocks that experience high rates of growth in operations and earnings

    • Investors expect higher price appreciation due to increasing earnings; pay little or no dividends
    • Examples: Lowe’s, Harley-Davidson, Starbucks, Kohls

Speculative Stocks: stocks that offer potential for substantial price appreciation, usually due to some special situation such as a new product.

    • Examples: Chipotle, P.F. Chang’s, Quicksilver.
Tech Stocks: stocks representing the technology sector of the market
    • Small companies that have never shown a profit and blue chip stocks of large companies that are growth-oriented
    • Difficult to put value on due to erratic or no earnings
    • Examples: Microsoft, Cisco Systems, Dell.
Cyclical Stocks: stocks whose earnings and overall market performance are closely linked to the general state of the economy
    • Best for investors willing to move in and out of market as economy changes
    • Examples: Caterpillar, Maytag Corp.

Defensive Stocks: stocks that tend to hold their value, and even do well, when the economy starts to falter

    • Stock price remains stable or increases when general economy is slowing
    • Products are staples that people use in good times and bad times, such as electricity, beverages, foods and drugs; Gold stocks.
    • Best for aggressive investors looking for “parking place” during slow economy
    • Examples: Proctor & Gamble, WD-40
market capitalization
Market Capitalization
  • Small-Cap Stocks: under $1 billion
  • Mid-Cap Stocks: $1 billion to $4 or $5 billion
  • Large-Cap Stocks: more than $4 or $5 billion
Small-Cap Stocks: small companies with market capitalizations less than $1 billion
    • Provide opportunity for above-average returns (or losses)
    • Usually do not have a financial track record
    • Earnings tend to grow in spurts and can have dramatic impact on stock price
    • Usually not widely-traded; liquidity is issue
    • Examples: Rubio’s, Hot Topic, Sonic Corp.
Mid-Cap Stocks: medium-sized companies with market capitalizations between $1 billion and $4 or $5 billion
    • Provide opportunity for greater capital appreciation than Large-Cap stocks, but less price volatility than Small-Cap stocks
    • Usually have long-term track records for profits and stock valuation
    • “Baby Blues” offer same characteristics of Blue Chip stocks except size
    • Examples: Wendy’s, Barnes & Noble, Petsmart, Cheesecake Factory
Large-Cap Stocks: large companies with market capitalizations over $4 or $5 billion
    • Number of companies is smaller, but account for 80% to 90% of the total market value of all U.S. equities
    • Bigger is not necessarily better
    • Tend to lag behind small-cap and mid-cap stocks, but typically have less volatility
    • Examples: AT&T, General Motors, Microsoft
the valuation process
The Economy, The Market, The Business

Forecast Earnings and Cash Flows

Growth rates

Dividend payout rate

Select Valuation Model

Select the Discount Rate

Exogenous or endogenous

Conclusion & Recommendation

Under or over Valued

Buy, Sell, Hold

The Valuation Process
economy sector market company
Economy, Sector, Market, Company
  • Inherent sector and industry profitability
  • Industry structure
  • Company’s relative competitive position
  • Market share
  • Cost leadership
  • Pricing power
  • Product differentiation versus product focus
  • Top-down forecast
  • Economy-Sector-Industry-Company
  • Financial forecast
  • Financial Statement Analysis: revenues & expenses
  • From profits to cash flows, esp. Free Cash Flows
  • Costs, prices, and the Product life cycle
concepts of value
Concepts of Value
  • Book Value
  • Market value
  • Liquidation Value
  • Fair Market Value, Intrinsic Value
  • Value given a thorough appreciation of the Company, its prospects, and the market
  • Look for mispricing
  • Alpha = E(HPR) less Market RRR
the valuation model
The Valuation Model
  • Approach
  • Cost
  • Income
  • Market
  • Method
  • De Novo or M&A
  • Revenues, Earnings, Cash flows
  • Comparables
  • Dividend Discount Model
  • D.C.F.
  • C.A.P.M.
  • Guideline Company Approach
discount rates
Discount Rates
  • Build-up Method
  • Risk-free Rate +
  • Equity risk premium +
  • Company risk premium
  • P/E implied
  • C.A.P.M.
  • Risk-free Rate +
  • Non-systematic risk premium