Time Influence on Valuation

Question 1

The capitalization of income method of valuation

Answer 1

“The intrinsic value of any asset is based on the discounted value of the cash flows that the investor expects to receive in the future from owning the asset.”

Question 2

Capitalization of Income (Stock)

Answer 2

When you purchase a share of common stock, you receive dividend payments whenever they are declared, and then at some point in the future you generally sell the stock. Where does that price you are going to get when you sell your common stock come from? Well, it’s based on the future dividend payments the buyer expects while the stock is held plus some capital gains. Therefore, the value of a share of stock should be the present value of its future dividends. The difference between using the Capitalization of Income for stocks versus bonds is that the cash flows for a stock are unknown and there is no maturity date where the principal (par value) is returned to the investor. Companies can pay out dividends forever, because common stock has no termination date.

Question 3

Convexity

Answer 3

The relationship between bond prices and yields is referred to as Convexity. A graph of this relationship between YTM and bond prices would convex downwards. Although this is true for standard types of bonds, the degree of curvature is not the same for all bonds. Instead, it depends on, among other things, the size of the coupon payments, the life of the bond, and its current market price.

Question 4

Duration

Answer 4

Duration is a measure of the average maturity of the stream of payments generated by a financial asset. Mathematically, duration is the weighted average of the lengths of time until the remaining payments of the asset are made.

Question 5

Bond Pricing Theorems

Answer 5

Theorem One - If a bond’s market price increases, then its yield to maturity must decrease. Conversely, if a bond’s market price decreases, then its yield to maturity must increase.

Theorem Two - If a bond’s yield does not change over its life, then the size of its discount or premium will decrease as its life gets shorter.

Theorem Three - If a bond’s yield does not change over its life, then the size of its discount or premium will decrease at an increasing rate as its life gets shorter.

Theorem Four - A decrease in a bond’s yield will raise the bond’s price by an amount that is greater in size than the corresponding fall in the bond’s price that would occur if there were an equal-sized increase in the bond’s yield. (That is, the price-yield relationship is convex.)

Theorem Five - The percentage change in a bond’s price as a result of a change in its yield, will be smaller if the coupon rate of the bond is high.