Bond and Stock Valuation Concepts

Question 1

Bond Relationships

Answer 1

• The coupon sets the payment
• lower-coupon bonds are more affected by interest rate changes than are short-term bonds
• lower-coupon bonds are more affected by interest rate changes than higher-coupon bonds. The smaller the interest rate (coupon rate), the greater the bond’s relative price fluctuation
• market interest rates (YTM) are inversely related to duration

Question 2

Bond Duration

Answer 2

• measure of bond price volatility and captures both price and reinvestment risks
• it is the weighted average time it takes to receive ALL payments (interest and principal) from the bond on a present value basis.
• for a given change in interest rates, a bond’s price will change (inversely) approximately equal to the interest rate change multiplied by the bonds duration.
• at the point when the bond’s duration equals the time frame of a predetermined cash flow, the bond is said to be immunized (protected) against any adverse effects from changes in interest rates (interest rate risk, reinvestment risk)
• for every 1% movement of interest rates, the bond price will fluctuate by the amount of duration in the opposite direction.

Question 3

Duration/Convexity Relationships

Answer 3

• there is an inverse relationship between the coupon rate of a bond and its duration. Therefore, the lower the coupon rate, the greater the bond’s duration (and the more its interest rate sensitivity)
• There is an inverse relationship between the YTM of a bond and its duration. Therefore, the smaller the YTM, the greater the bonds duration.
• There is a direct relationship between the maturity date of a bond and its duration. Therefore, the longer the maturity date, the greater the bond’s duration.

Question 4

Convexity

Answer 4

• a measure of the relationship between a bond’s YTM and its market price.
• helps explain the change in bond prices that cannot be accounted for simply by the bond’s duration.
• it specifies a more precise measure of the change in bond prices given a respective change in market interest rates.

Question 5

The Three dividend growth models

Answer 5

• the zero growth model
• the constant growth model
• the multistage or non-constant growth model

Question 6

Assumptions for the Constant Growth Dividend Model

Answer 6

• the stock must currently pay (or be expected to pay) a steady dividend
• the required rate of return for the investor must be greater than the growth rate of the dividends.

Question 7

Constant Growth Dividend Model

Answer 7

-the the investors rate of return increases, the intrinsic value of the stock will fall; conversely, if the investors required rate of return decreases, the intrinsic value of the stock will rise.

Question 8

Price/Sales

Answer 8

• a measure of how much an investor is willing to pay for a specific revenue stream, in this case the company’s annual sales.
• only used for unprofitable companies and is not generally viewed as an effective complement to price/earnings ratio of price/free cash flow