Chapter 2 - Securities N Se. Valuation

NATIONAL ECONOMICS
UNIVERSITY SCHOOL OF BANKING

AND FINANCE
----------***----------
CHAPTER 2
SECURITIES AND
VALUATION
SECURITIES MARKET DEPARTMENT
1
MAIN CONTENT
2.1. Overview
2.2. Types of securities
2.3. Bond valuation
Securities Market Department 2

2.1. Overview
Securities means instruments evidencing

their holders' legitimate rights and benefits to
the assets or capital shares of issuing
organizations. Securities take the form of
certificates, book entries or electronic data,
and are divided into the following types:
a/ Stocks, bonds, fund certificates; b/
Rights, warrants, call option, put
option, futures, securities classes or
indexes

2.1. Overview
• Characteristics
– Marketable
+ Possibility of convertibility
+ quickly to be sold
+ Assurance of value
– Risky
+ possibility of a decline in stock value
– Profitability
+ possibility of making a profit

2.1. Overview
• Systematic risk (market or nondiversifiable risk): affect
most firms
– Cannot be eliminated by diversification
– Consist of war, pandemic, inflation, recession, high interest rate
• Unsystematic risk ( company-specific, diversifiable risk):
affect a particular firm
- Can be eliminated by diversification
- Divide into 3 types:
+ Business risk: related to riskiness of the firm’s operations
+ Financial risk: related to firm’s decision to use of debt
+ Managerial risk: related to competence and experience of a manager

Based on
characteristic
s
Debt Equity Derivativ
securities securities e
securities

Based on
marketabilit
y
Bearer security Registered security

Based on
income
Fixed Variable
income income Hybrid
securities securities

A bond is a security that obligates the issuer to
make specified interest and principal payments
to the holder on specified dates
A stock represent ownership shares in a

corporation
A derivative security is a financial contract

whose value is derived from an underlying
asset.
1. Debt Securities
Debt securities—like corporate bonds, government bonds, and certificates of deposit—are essentially loans. They act like IOUs from a government
or corporation to the debt security holder. Owners of debt securities lend a certain amount of money (the principal) to another party. That party is
then obligated to pay pre-determined interest payments to the owner at regular intervals per the terms specified in their agreement until the
instrument matures, at which time the debtor must pay back the security owner in the amount of the principal.
The purpose of a debt security (like a bond) is twofold. On one hand, it allows a corporation, government, or other entity (the borrower) the
temporary use of the security owner’s capital. On the other hand, it allows the security owner to receive regular interest payments for a period of
time in exchange for the temporary use of their money before having it returned to them in full at a certain agreed-upon date.
2. Equity Securities
Equity securities indicate partial ownership of an entity—often a business. The most common example of an equity security is a share of a
company’s stock. Shares of mutual funds are also considered equity securities, as are shares of certain ETFs (those that do not include debt
securities like bonds).
While individuals purchase debt securities in order to receive periodic payments in exchange for the temporary use of their money, individuals
usually purchase equity securities as investments for the purpose of realizing capital gains over time. An equity security is an asset, so if its value
increases, the party that holds it can sell it for a profit.
While most equity securities usually do not entitle their holders to periodic payments, some do, and these payments are called dividends.
Companies that pay dividends use a small percentage of their profits to pay shareholders a certain amount of money per share—usually once per
quarter or once per year. Because holders of equity securities are partial owners of an entity, they are also often entitled to certain voting rights
when it comes to some of that entity’s business decisions.
Generally, equity securities offer higher potential returns than debt securities because a company or entity’s value is technically limitless, whereas a
bond’s value, interest payments, and maturity are fixed and pre-determined. Equity securities also come with greater risk, however. While a
company or entity’s potential value is limitless, that value could also change in a negative direction, resulting in capital losses for shareholders. If a
business goes bankrupt, its shareholders are only entitled to their portion of whatever value remains after the business has paid all of its creditors
and fulfilled all of its obligations per the terms of the bankruptcy.
4. Derivative Securities
A derivative is a security whose value is based on a specific asset or group of assets (like a stock or commodity). A derivative usually takes the form
of a contract between two parties relating to the purchase or sale of a specific asset or pool of assets. Derivatives are often used by individuals and
institutions to mitigate risk, but they can also be used speculatively by investors to make money.
One common derivative is a futures contract, which is an agreement to buy or sell an asset at a pre-determined future date for a specific price. If
someone were to purchase a futures contract that entitled them to purchase a bale of hay for $35 dollars in three months, but by the time three
months had passed, bales of hay were worth $45, the buyer would realize a $10 gain. Forward contracts behave similarly, but they are more
customizable and typically carry more risk for both buyer and seller.
Options contracts are also common. These behave like futures, but instead of the buyer being obligated to purchase or sell a specific security at a
specific price at a specific point in time, they simply have the option to do so.
Another common derivative is a swap, which is an agreement between two parties to exchange one cash flow for another. One cash flow is usually
fixed (like a fixed interest rate), and the other is usually variable (like a variable interest rate). Sometimes, companies swap loan interest rates in
different currencies to take advantage of exchange rates.
Debt Equity Hybrid Derivative
Corporate Common stock Convertible Futures
bonds bonds
Government Preferred stock Convertible Forwards

bonds preference
shares
Certificates of Mutual fund Equity warrants Options

Deposit shares
Some ETF Some ETF Some ETF Swaps

shares shares shares
5 differences between equity and debt securities
1. Equity securities indicate ownership in the company whereas debt
securities indicate a loan to the company.
2. Equity securities do not have a maturity date whereas debt

securities typically have a maturity date.
3. Equity securities have variable returns in the form of dividends and
capital gains whereas debt securities have a predefined return in the
form of interest payments.
4. Both securities are issued at face value and trade at market value
which maybe higher or lower than the face value.
5. Equity shareholders are entitled to voting rights whereas debt
securities do not hold such rights.
6. Bonds: fixed amount of interest income; Equity: volatile
7. Bonds: safer than stocks
8. Bond owners receive priority over stockholders when it comes to
repayment if the company that issues the bond goes out of business.
Còn equity thì khi DN phá sản là hết sạch
Features of Bond
• Bonds do not represent ownership in a
corporation.
• Bond owners receive priority over stockholders
when it comes to repayment if the company that
issues the bond goes out of business.
• Bonds are classified as a fixed income
investment.
• This means that the bond will generate a fixed
amount of interest income.
• Bonds are typically considered to be safer
investments than stocks.

Types of Bond (based on issuer)
• Government Bonds
 Treasury Bills (Gilts)
 No coupons (zero coupon security)

 Face value paid at maturity
 Maturities up to one year
 Treasury Notes
 Coupons paid semiannually
 Maturities from 2-10 years

• Government Bonds
 Treasury Bonds
 Coupons paid semiannually

 Maturities over 10 years
 The 30-year bond is called the long bond.

• Corporate Bonds
 Secured Bonds (Asset-Backed)
 Secured by real property

 Ownership of the property reverts to the
bondholders upon default.
 Debentures
 General creditors
 Have priority over stockholders, but
are subordinate to secured debt.

• Corporate Bonds
 Secured Bonds (Asset-Backed)
 Secured by real property

 Ownership of the property reverts to the
bondholders upon default.
 Debentures
 General creditors
 Have priority over stockholders, but
are subordinate to secured debt.

Types of Bond (based on types of payment)
• Pure Discount or Zero-Coupon Bonds
 Pay no coupons prior to maturity.
 Pay the bond’s face value at maturity.
• Coupon Bonds
Pay a stated coupon at
periodic intervals prior to maturity.
 Pay the bond’s face value at maturity.

• Annuity bond: a fixed-rate bond that pays
out the same amount of cash every year over
its lifetime
• Perpetual Bonds (Consols)
 No maturity date.
Pay a stated coupon at
periodic intervals.

Preferred stock
• A hybrid security that has characteristics of both
bonds and common stock
• Stated dividend must be paid before
dividends can be paid to common stockholders.
• Dividends are not a liability of the firm,
and preferred dividends can be deferred
indefinitely.
• Most preferred dividends are cumulative – any
missed preferred dividends have to be paid
before common dividends can be paid.
• Preferred stock generally does not carry voting
rights
Types of preferred stock
• Cumulative
• Callable
• Convertible
• Participating

Common stock
• Equity securities/ equities
• Represent ownership shares in a corporation
• Shareholders are the legal owners of

a corporation
– Receive dividend
– Voting right

Derivatives
• A derivative security is a financial
contract whose value is derived from an
underlying asset.
Examples:
– A stock option’s value depends upon the value of
a stock on which the option is written.
– A gold futures contract’s value depends on
gold’s spot price (price for buying “now”)

Derivatives
• Rights
• Warrants
• Forwards
• Futures
• Options

2.3. Bond valuation
• Book value: value of an asset as shown on a
firm’s balance sheet
• Liquidation value: the dollar sum that
could be realized if an asset were sold
individually and not as part of a going
concern.
• Market value: the observed value for the
asset in the marketplace
• Intrinsic or economic value: also called
fair value—the present value of the asset’s
expected future cash flows.

2.3. Bond valuation
• Par value: face value of the bond,
returned to the bondholder at maturity
• Interest rate: The percentage of the par
value of the bond that will be paid out
annually in the form of interest.
• Coupon Payment: The coupon payments
represent the periodic interest payments from
the bond issuer to the bondholder.

2.3. Bond valuation
• Original Maturity
The time from when the bond was issued until its
maturity date.
• Remaining Maturity
The time currently remaining until the maturity
date.
• Maturit
y The length of time until the bond issuer
returns the par value to the bondholder and
terminates or redeems the bond.

2.3. Bond valuation
• Yield to Maturity: To measure the
bondholder’s expected rate of return, we
would find the discount rate that equates the
present value of the future cash flows with the
current market price of the bond.
• YTM and expected rate of return are used
interchangeably when referring to bonds.

2.3. Bond valuation
• Current Yield
The ratio of the interest payment to the
bond’s current market price.
Current Yield = Annual interest payment/current
market price of the bond
Example: A $1,000 bond with 8% coupon rate and

market price of $700
Current yield = $80 / $700 = 11.4 %

2.3. Bond valuation
• Bond valuation
– Coupon bond
– Annuity bond
• Denote:
Par value : M
Interest rate : i (%/năm)
Required rate of return : k
Maturity : m
Remaining maturity : n

Bond valuation
• Step 1: Determine the stream of expected
returns (cash flows Ct)
• Step 2: Determine the required rate of
return k
• Step 3: Calculate the present value (PV)

Bond valuation formula
• Coupon bond
Coupon: I = i * M
I I I+M
0 I1 2 3 n
𝑃𝑉
= 𝐼 + 𝐼 +⋯+ 𝐼 + 𝑀
(1 + 𝑘)1 (1 + 𝑘)2 (1 + 𝑘)𝑛 (1
+ 𝑘)𝑛
• Coupon bond
𝑛
𝐼𝑡 𝑀
𝑃𝑉 = +
(1 + 𝑘)𝑡 (1 + 𝑘) 𝑛
෍
=>𝑃𝑉 =
𝑡=1 𝑛 −1]
𝐼[ 1+𝑘 + 𝑀 𝑛
𝑘(1+𝑘) 𝑛 (1+𝑘)

• Annuity bond
a a a a
0 1 2 3 n
𝑎 𝑎
𝑎
𝑃𝑉 = + +⋯+
(1 + 𝑘)1 (1 + 𝑘)2 (1
+ 𝑘) 𝑛
• Annuity bond
𝑎[
𝑃𝑉 =
𝑘(1 + 𝑘)𝑛
1+𝑘
𝑖 × 𝑀 × (1 + 𝑖) 𝑚
𝑎= 𝑛
(1 + 𝑖)𝑚 −1
− 1]

Relationships in bond valuation
• Relationship 1: Bond prices are
inversely related to interest rates (or
yields).
• Relationship 2 :
• k > i => PV < M
• k < i => PV > M
• k = i => PV = M

• Relationship 3: bond market price gets close to its face
value when maturity approaches As a bond approaches maturity, its price
moves closer to its face value -- the contractual amount that will be repaid at maturity. If a
bond is trading above face value, its price will come down; if it is trading below face value, its
price will go up.
Required PV
rate of Change
return n=5 n=2
7% 1041.001 1018.08 -22.92

8% 1000 1000 0
9% 961.103 982.41 21.305


• Relationship 4: Longer term bonds are
more sensitive to changes in interest rates
than shorter term bonds
PV
Required rate
of return m=5 m=10
7% 1123.01 1273.24
10% 1000 1000
13% 894.48 806.13

When interest rates rise, bond prices fall (and vice-versa), with long-maturity bonds most
sensitive to rate changes.
This is because longer-term bonds have a greater duration than short-term bonds that are
closer to maturity and have fewer coupon payments remaining.
Long-term bonds are also exposed to a greater probability that interest rates will change
over its remaining duration.
There is a greater probability that interest rates will rise (and thus negatively affect a
bond's market price) within a longer time period than within a shorter period. As a result,
investors who buy long-term bonds but then attempt to sell them before maturity may be
faced with a deeply discounted market price when they want to sell their bonds. With
short-term bonds, this risk is not as significant because interest rates are less likely to
substantially change in the short term. Short-term bonds are also easier to hold until
maturity, thereby alleviating an investor's concern about the effect of interest rate-driven
changes in the price of bonds.
Long-term bonds have a greater duration than short-term bonds. Duration measures the
sensitivity of a bond's price to changes in interest rates. For instance, a bond with a
duration of 2.0 will lose $2 for every 1% increase in rates. Because of this, a given interest
rate change will have a greater effect on long-term bonds than on short-term bonds. This
concept of duration can be difficult to conceptualize but just think of it as the length of
time that your bond will be affected by an interest rate change. For example, suppose
interest rates rise today by 0.25%. A bond with only one coupon payment left until
maturity will be underpaying the investor by 0.25% for only one coupon payment. On the
other hand, a bond with 20 coupon payments left will be underpaying the investor for a
much longer period. This difference in remaining payments will cause a greater drop in a
long-term bond's price than it will in a short-term bond's price when interest rates rise.
• Relationship 5:
– Sensitivity to interest rate changes of bond price
depends not only on maturity but also type of
payments
For the same coupon rate, long-term bonds will have a larger price
change than bonds with shorter-terms (that means long bonds are more
sensitive to interest rate changes than short bonds).
For the same maturity, bonds with lower coupon rate will have a larger price
change than bonds with higher coupon rate (that means low coupon rate
bonds are more sensitive to interest rate changes than high coupon rate
bonds).

• Duration: measures the interest rate sensitivity of the bond
𝒕 × 𝑪𝒕
σ 𝒏𝒕=𝟏 (𝟏 + 𝒌)𝒕
𝑫=
𝑷𝟎
n: remaining maturity
Ct: cash flow of year t
k: investor’s required
rate of return
P: bond market value
Modified D = D/(1+k)
(years)
The percentage price changes of a bond due to D = - modified D *

percentage changes
Securities Market in interest rate
Department 43
• Convexity
t∗(1+t)×C t
σ nt=1
C= (1+k)t+2 (years)
P0
The percentage price changes of a bond due to C = ½

convexity * (the percentage changes in interest rate)2
• The percentage changes in price of a bond

= The percentage price changes of a bond due to D +
The percentage price changes of a bond due to C

Calculating Yield to Maturity
• Trial and Error: Keep guessing until you find the rate
whereby the present value of the interest and principal
payments is equal to the current price of the bond. (necessary
procedure without a financial calculator or computer). =>
Interpolation
• Easiest Approach: Use a computer or financial calculator.
Note, however, that it is extremely important to understand the
mechanics that go into the calculations

Calculating Yield to Maturity
PV
𝒌𝟎 = 𝒌𝟏 + 𝑷𝑽𝟏−𝑷𝑽𝟎
× (𝒌 𝟐 − 𝒌𝟏 )
𝑷𝑽𝟏−𝑷𝑽𝟐
PV1
Or
PV0
PV2
k1 k0 k
k2
Accrued interest and bond pricing
between coupon date
Accrued interest = annual coupon payment * days since last

coupon payment/days separating coupon payment
Of which:
-days since last coupon payment: number of days since the last
coupon payment date.
- days separating coupon payment: the number of days in the
coupon payment period (360)
- number of days in a month: 30
between coupon date
between coupon date
Invoice price = flat price + accrued interest

Of which
-Invoice price (dirty price/ full price): Price paid to buy a bond
between coupon periods
-flat price (quoted price/ clean price): PV of cash flows at the
coupon period.
2.4. Equity valuation
Preferred stock
Common stock

Preferred stock valuation
𝒏
𝑫 𝑫
𝑷𝑺 = ෍
=
(𝟏 + 𝒌)𝒕
𝒌
𝒕=𝟏
Where:
• 𝑃𝑆 : Preferred stock value
• D : dividend
• k: required rate of return
Common stock valuation
Basic types of
model
Discounted Relative
cashflow valuation
DDM DCF P/E P/BV P/CF P/S
FCFE
FCFF
Securities Market Department

Dividend Discount Model
• No growth 𝒏
𝑫 𝑫
𝑷𝑽𝒄𝒔 = ෍ =
𝒕=𝟏 (𝟏 + 𝒌)𝒕 𝒌
–𝑃𝑆 : common stock price
–D : dividend
–k: required rate of return

• 1 year holding period:

𝐷1 𝑃1
𝑃𝑠 = +
(1 + 𝑘 𝑐 𝑠 ) (1 +
• 2 year holding
𝑘 𝑐 𝑠 ) period
𝐷1 𝐷2 + 𝑃2
𝑃𝑠 = +
(1 + 𝑘 𝑐 𝑠 ) (1 + 𝑘 𝑐 𝑠 )2

• Constant growth model (g = perpetual
growth rate in dividends)
Dn = Do(1 + g)n
Pn = Po(1 + g)n
�
�
𝐷1
𝑃=
𝑠 =
(𝑘𝑐𝑠 − 𝑔)
�
�
�
Dividend Discount Model:
• 2 – stage discount model
g1
g2

2
𝐷0 ×(1+𝑔1) 0 ×(1+𝑔 1 )
• 𝑃𝑠 = + +…+
𝐷 (1+ 𝑘 𝑐 𝑠 ) (1+ 𝑘 𝑐 𝑠 ) 2
𝐷 0×(1+𝑔 1)𝑥
(1+ 𝑘 𝑐 𝑠 ) 𝑥 + (1+ 𝑘 𝑐 𝑠 ) 𝑥
𝑃𝑥 �
𝐷0× 1+𝑔1 � (1+𝑔2
• 𝑃�=
) (𝑘 𝑐 𝑠 −𝑔 2 )
�

Other method
• FCF
• Relatives valuation method (: P/E.
P/CF,..)

Summary
• Securities and different types of securities
• Definition and characteristics of securities
• Bond, preferred stock, common stock,
derivatives
• Bond valuation
• Preferred stock valuation
• Common stock valuation
• Dividend Discount Model

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NATIONAL ECONOMICS

UNIVERSITY SCHOOL OF BANKING

2.2. Types of securities

2.3. Bond valuation

Securities Market Department 2

Securities means instruments evidencing

Securities Market Department 3

Securities Market Department 4

Securities Market Department 5

Securities Market Department 6

Bearer security Registered security

Securities Market Department 7

Securities Market Department 8

A stock represent ownership shares in a

A derivative security is a financial contract

Government Preferred stock Convertible Forwards

Certificates of Mutual fund Equity warrants Options

Some ETF Some ETF Some ETF Swaps

2. Equity securities do not have a maturity date whereas debt

Securities Market Department 13

 No coupons (zero coupon security)

Securities Market Department 14

 Coupons paid semiannually

Securities Market Department 15

 Secured by real property

Securities Market Department 16

 Secured by real property

Securities Market Department 17

Securities Market Department 18

Securities Market Department 19

Securities Market Department 21

• Equity securities/ equities

• Represent ownership shares in a corporation

• Shareholders are the legal owners of

Securities Market Department 22

Securities Market Department 23

Securities Market Department 24

Securities Market Department 25

Securities Market Department 26

Securities Market Department 27

Securities Market Department 28

Example: A $1,000 bond with 8% coupon rate and

Securities Market Department 29

Securities Market Department 30

Securities Market Department 31

Securities Market Department 33

Securities Market Department 35

Securities Market Department 36

7% 1041.001 1018.08 -22.92

Securities Market Department 37

Securities Market Department 38

Securities Market Department 40

Securities Market Department 42

The percentage price changes of a bond due to D = - modified D *

The percentage price changes of a bond due to C = ½

• The percentage changes in price of a bond

Securities Market Department 44

Securities Market Department 45