Title: General framework for valuation of risky securities intrinsic value and market value
1- General framework for valuation of risky
securities -- intrinsic value and market value
2Three perspectives on discounted cash flow (CAPM)
valuation of assets with uncertain future cash
flows
- valuation -- any attempts to determine the
underlying worth or intrinsic value of any
capital asset - worth -- is related to the benefit from
consumption enabled by the assets future payoffs
or future cash flows - relationship between future cash flows and worth
-- is described by some model or function that
transforms cash flow payoffs into units of value,
e.g. the CAPM - three perspectives on these concepts
3I. Underlying worth or intrinsic value
- underlying worth or intrinsic value -- the value
that would be created in an open and competitive
market with full information about the
probability distribution of future payoffs --
Pei0 - full information -- the information set created
with full disclosure of what is known at the
point of the valuation (t0) -- - information set -- -- would include all
things useful to the prediction of - amount and timing of future cash flows
- beta -- uncertainty of flows
- risk free rate
- market price of risk
4underlying worth --neither right nor left hand
side observable
5II. Market price
- market price -- the value for which the security
sells in the open market, the market price
created through the interplay of actual supply
and demand -- Pmi0 - public information -- the market uses only the
information set publicly revealed, but focuses in
on the same items that give rise to underlying
worth cash flow expectations, their timing,
beta, risk free rate, market price of risk -- - rationale for describing Pmi0 -- the market
realizes that since underlying value is the value
that ultimately will be revealed (on average in
the long run) the focus of rational market
participants must be on those same factors.
Thus, it must be
6market price (left hand side observable, but not
right hand side)
7III. Personal value
- personal value -- the value estimate of the
investor -- Pki0 - public information and proprietary analysis --
the investor focuses on public information (re
FCF, E(ri), etc), which ultimately would affect
market price, and supplements the public info
with proprietary analysis(insight, intuition,
modeling, etc) - rationale -- since market price is determined by
all investors who are trying to determine
underlying value, the investor must also.
8personal value (both sides observable)
- corollary k can generate abnormal normal (risk
adjusted) returns only by being better at
predicting underlying value, Pei0, than is m
9defining under- and over-valuation
- Fact from the definitions,
- if Pei0 gt Pmi0 -- market has under-valued
asset - if Pei0 Pmi0 -- market is in equilibrium
- if Pei0 lt Pmi0 -- market has over-valued
asset - Therefore, it follows that, since k is estimating
e, - if Pki0 gt Pmi0 -- investor believes market has
under-valued the asset - if Pki0 Pmi0 -- investor believes market has
correctly valued the asset - (its in equilibrium)
- if Pki0 lt Pmi0 -- investor believes market has
over-valued the asset - If investor beliefs are more accurate than market
consensus, then investor can generate abnormal
return.
10Valuing Fixed Income Securities(bonds, notes
mortgages, and other senior claims)
11Characteristics of Bond Markets
- small on exchanges large in O-T-C trading
- corporates and treasuries quoted without accrued
interest but settlement (confirmation slip)
includes accrued interest - quoted in 1/32s of a dollar, and in 100 par
value -- 103 and 17/32s for a bond at 1035.31. - US Treasury market volume is extremely large,
agency debt quite large, corporate and municipal
markets have much lower turnover than equities - market value of corporates is about 2 trillion,
market value of treasuries is -- well, you know
what that is from the size of the national debt
12Valuation methods and techniques
Two fixed income security valuation techniques
are widely used in the financial markets
- I. Absolute Value
- II. Relative Value
13 - I. Absolute Value - FCF/DCF (CAPM) valuation --
in all respects equivalent to the valuation of
equities -- based on estimating FCFs and an
appropriate discount rate, E(ri) - FCFs are a function of issuers ability to pay
now and in future -- dependent on - issuers expected cash flows,
- issuers assets, and access to financial markets
- issuers willingness and ability to comply with
indenture contract - E(ri) is determined in the same way as for
equities -- bonds and stock trade in one,
integrated market -- beta is relevant and
determined by comovement of the securitys return
with the market return -- a function of - interest rate risk (duration risk, maturity risk)
- cash flow risk (default risk)
14value of a straight debt security is
- E(Interest) or E(Prin) -- are not the promised
sums unless the security is default free --
greater the default expectations the lower the E(
) -- thus E( ) reflects the possibility of
default (the center of the probability
distribution of cash flows) - E(ri) -- reflects the risk due to the possibility
of default (the deviation of possible cash flows
from their expected values and the comovement of
those deviations with similar market deviations)
and the possible variation in bond price due to
changes in interest rates (SML)
15 - default risk -- is related to the firms
creditworthiness (ability to pay) -- by custom,
for convenience, and for those investors
restricted to a grade of security each issue is
rated by one or more of four rating agencies - Standard Poors (AAA, AA, A, BBB, BB, B , CCC,
CC, C, D, NR) (P-1,P-2) (Credit Watch) - Moodys (Aaa, Aa, A, Baa, Ba, B, Caa, Ca, C)
- Duff Phelps
- e.g. consider the following latent risks
- bad (good) news on employment and take home pay
reduces (increases) Dillards revenues and
squeezes (pushes up) margins -- cash flow
expectations are reduced (increased) and firm
finds it more difficult to meet its obligations
to debtholders -- debt beta is high - Dillards expands into New York and Boston where
its store layouts are not (are very) suitable to
the high rise malls common in those locations,
cost rise (fall) making those units unprofitable
(profitable)
16 - duration risk -- measures the exposure to
interest rate risk through the average length of
time before receipt of expected cash flows - duration defined -- for security i
17 - duration for a newly issued 8 coupon security
with no default risk and 10 years to maturity
(with all principal repayments at maturity) is - beta -- on any fixed income security, therefore,
is a function of default and duration - beta f (default risk, duration)
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19 - II. Relative value -- yield to maturity, ry,
defined from current market price and promised
payments to solve for an IRR - free cash flows are those promised by the
contract and not those rationally expected from
the issuer - yield to maturity will overstate expected (CAPM)
returns for any security with a possibility of
default -- the greater the default the greater
the overstatement - thus, at most, y-t-m can be used for relative
comparisons only
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21sample yields to maturity
22value of a complex (debt and equity components to
it) security is