1. ©2009, The McGraw-Hill Companies, All Rights Reserved 1 5. WEEK FINANCIAL INSTRUMENTS AND VALUATION

2. ©2009, The McGraw-Hill Companies, All Rights Reserved 2 TYPESOF SECURITIES Negotiable instruments that represent ownership: Equity instruments such as C.S. Negotiable instruments that denote indebtness: Debt (fixed income) securities such as bills, notes and bonds.

3. ©2009, The McGraw-Hill Companies, All Rights Reserved 3 PREFERRED STOCKS They are issued in international markets representing ownership and carrying some privileges: The right to be paid dividends before the common stockholders The right to receive a specific amount in the form of dividends each year.

4. ©2009, The McGraw-Hill Companies, All Rights Reserved 4 PREFERRED STOCKS cont. Different from C.S. In a way that their cash dividends are certain (guaranteed) and they do not increase as earnings rise. The are callable unilaterally: they have a redemption feature.

5. ©2009, The McGraw-Hill Companies, All Rights Reserved 5 COMMON STOCKS Holders of the common stock are the actual owners of the issuing corporation. If you have stocks, you have the right of the companies earnings depending on your proportional share after the interest paid on bonds and dividends paid on preferred stockholders.

6. ©2009, The McGraw-Hill Companies, All Rights Reserved 6 RIGHTS OF COMMON STOCKHOLDERS Receiving dividend Voting right Pre-emptive right: subscribing to capital increases Receiving proportionate share from dissolution if any Receiving information about the corporation

7. ©2009, The McGraw-Hill Companies, All Rights Reserved 7 DUITIES AND RESPONSIBILITIES OF STOCKHOLDERS They must honor their capital subscription payment promises when appealed by the board of directors. If delayed, they become liable for interest and punitive payments. Their liabilities are confined to their subscriptions only.

8. ©2009, The McGraw-Hill Companies, All Rights Reserved 8 PRICES OF COMMON STOCKS Nominal (par) value: face value of the stock Issuance value: it is the value of the common stock which is calculated by utilizing the discounted cash flows technique by some experts. It can not be lower than its nominal value according to the C.M. Law. Market value: it is the price at which the stock is traded.

9. ©2009, The McGraw-Hill Companies, All Rights Reserved TYPES OF THE STOCKS Hamiline ve nama yazılı (bearer shares – name shares) Adi ve imtiyazlı (common and preferred shares) Bedelli –bedelsiz (scrip issues) Primli-primsiz (shares with premium or not) Kurucu-intifa (preferred stocks)

10. ©2009, The McGraw-Hill Companies, All Rights Reserved DERIVATIVES OF THE EQUITY INSTRUMENTS 1. Profit and Loss Sharing Certificates (Kar ve Zarar Ortaklığı Belgeleri) 2. Participation Dividend Certificates (Katılma İntifa Senedi) 3. Non-voting Shares (Oydan Yoksun Hisse Senedi)

11. ©2009, The McGraw-Hill Companies, All Rights Reserved 1. PROFIT AND LOSS SHARING CERTIFICATES Companies issue them in order to meet their financial needs. They can be put to sale in or out of Turkey. They have a maturity of 3 months- 7 years. The longest maturity for them is 15 years. If they are issued by “Participation Banks” the max. Maturity is 2 years.

12. ©2009, The McGraw-Hill Companies, All Rights Reserved 1. PROFIT AND LOSS SHARING CERTIFICATES cont. Issued with longer than 2 year maturity, have got to be issued on exchange. Can not be issued with coupon, no profit guarantee. If there is loss they have to contribute to the loss.

13. ©2009, The McGraw-Hill Companies, All Rights Reserved 1. PROFIT AND LOSS SHARING CERTIFICATES cont. They provide the participation of profit and loss but they are not recognize as common stocks since they have a maturity and no voting rights. Also they can not be recognized as income bonds since it requires to participate loss if any.

14. ©2009, The McGraw-Hill Companies, All Rights Reserved 1. PROFIT AND LOSS SHARING CERTIFICATES cont. Investors can get principal and dividend at the end of the maturity. They can be sold either directly by the issuer or through securities dealers. They must be registered by the CMB.

15. ©2009, The McGraw-Hill Companies, All Rights Reserved 2. PARTICIPATION DIVIDEND CERTIFICATES Issued for cash, not represent a specific capital. Provide Dividend payment, Dispolution payment if any, Pre-emptive right. Not provide Voting rights (ownership rights), Involment into management.

16. ©2009, The McGraw-Hill Companies, All Rights Reserved 2. PARTICIPATION DIVIDEND CERTIFICATES Can be put to sales in or out of Turkey. Overseas sales require approval of the ministry of finance. Issue limit is max. Net worth of the issuer. Min issue can be one-sixth of net-worth. They can be issued infinitely in accordance to the decision of the board of company.

17. ©2009, The McGraw-Hill Companies, All Rights Reserved 3. NON-VOTING SHARES They are like the ordinary shares, however they do not provide voting rights. Holders of them benefit from dividend payments and dissolution payments if any. If not authorized by the articles of association, non-voting shares cannot be issued.

18. ©2009, The McGraw-Hill Companies, All Rights Reserved 3. NON-VOTING SHARES cont. They have to be in the name, not to the bearer. In the event of; No dividend distributed for 3 successive years No dividend is distributed for the year while any permission is given by regulations. Non-voting shares automatically transform to voting shares

19. ©2009, The McGraw-Hill Companies, All Rights Reserved 3. NON-VOTING SHARES cont. They have subscription rights in capital increases. Rights to bonus shares (scrip issues). Rights to get information. Rights to participate the general meeting of shareholders with no voting power.

20. ©2009, The McGraw-Hill Companies, All Rights Reserved 3. NON-VOTING SHARES cont. Non-voting shareholders may convene special meeting of shareholders cannot prejudice the rights of non-voting shareholders. The validity of the ordinary shareholders’ decisions is subject to approval by non-voting shareholders. First issue of non-voting shares has to be offered to public.

21. ©2009, The McGraw-Hill Companies, All Rights Reserved 21 BONDS It is a certificate indicating that a corporation has borrowed a fixed sum of money and promises to repay it at a future date. They are long-term securities. Bondholders do not have any voice in the management.

22. ©2009, The McGraw-Hill Companies, All Rights Reserved 22 BONDS cont. Corporation agrees to pay at a specified intervals interest at a stated rate. The principle is paid off at the maturity date. Bonds generally can be traded anywhere in the world. Mostly there are OTC markets for them. Some corporation bonds in USA are listed on an exchange.

23. ©2009, The McGraw-Hill Companies, All Rights Reserved 23 BONDS cont. Trading for bonds is usually done by bond dealers. There are bond trading desks of major investment dealers in USA. The dealers provide liquidity for bond investors. They also buy and sell bonds among themselves.

24. ©2009, The McGraw-Hill Companies, All Rights Reserved 24 BONDS cont. Bonds can be issued with or without coupons. No-coupon bonds are issued and sold below par paid off at maturity in full sums: Treasury bills in Turkey. Treasury notes and bonds are generally in bearer form.

25. ©2009, The McGraw-Hill Companies, All Rights Reserved 25 BONDS cont. Bonds can be issued in Turkey With fixed interest With variable interest All bonds must be listed on an exchange.

26. ©2009, The McGraw-Hill Companies, All Rights Reserved TYPES OF BONDS Government-corporate Bonds Premium- Par Lottery Bonds Fixed Rate-Variable (Floating Rate) Indexed Bonds (Foreign Exchange or Gold) Guaranteed or Nonguaranteed

27. ©2009, The McGraw-Hill Companies, All Rights Reserved DERIVATIVES OF THE BONDS 1. Income Bonds (Kara İştirakli Tahvil) 2. Convertible Bonds (H.S İle Değiştirilebilinir Tahvil)

28. ©2009, The McGraw-Hill Companies, All Rights Reserved 1. INCOME BONDS They can be redeemed at maturity only, the principle payment can not be split over years. There are three types of period income (returns): Interest+dividend Either interest or dividend Dividend only

29. ©2009, The McGraw-Hill Companies, All Rights Reserved 1. INCOME BONDS cont. Interest is paid on due dates. Dividend payment is declarated latest two months from the general meeting of the shareholders when profit for the year is approved.

30. ©2009, The McGraw-Hill Companies, All Rights Reserved 2. CONVERTIBLE BONDS It is a bond with a call option to buy the C.S. of an issuer. The holder of it can exchange the security, at his option for the C.S. of the issuer in accordance of the terms of the bond indepture.

31. ©2009, The McGraw-Hill Companies, All Rights Reserved 2. CONVERTIBLE BONDS cont. These securities carry a maturity of 2-7 years. Conversion of bonds can be made after 2 years. Conversion is made through the intermediary of bank branches. Convertible bonds are issued with coupons which are payable on an annual basis only.

32. ©2009, The McGraw-Hill Companies, All Rights Reserved 32 Various Interest Rate Measures Coupon rate periodic cash flow a bond issuer contractually promises to pay a bond holder Required rate of return (rrr) rates used by individual market participants to calculate fair present values (PV) Expected rate of return (Err) rates participants would earn by buying securities at current market prices (P) Realized rate of return (rr) rates actually earned on investments Coupon rate periodic cash flow a bond issuer contractually promises to pay a bond holder Required rate of return (rrr) rates used by individual market participants to calculate fair present values (PV) Expected rate of return (Err) rates participants would earn by buying securities at current market prices (P) Realized rate of return (rr) rates actually earned on investments

33. ©2009, The McGraw-Hill Companies, All Rights Reserved 33 Required Rate of Return The fair present value (PV) of a security is determined using the required rate of return (rrr) as the discount rate CF 1 = cash flow in period t (t = 1, …, n) ~ = indicates the projected cash flow is uncertain n = number of periods in the investment horizon The fair present value (PV) of a security is determined using the required rate of return (rrr) as the discount rate CF 1 = cash flow in period t (t = 1, …, n) ~ = indicates the projected cash flow is uncertain n = number of periods in the investment horizon

34. ©2009, The McGraw-Hill Companies, All Rights Reserved 34 Expected Rate of Return The current market price (P) of a security is determined using the expected rate of return (Err) as the discount rate CF 1 = cash flow in period t (t = 1, …, n) ~ = indicates the projected cash flow is uncertain n = number of periods in the investment horizon The current market price (P) of a security is determined using the expected rate of return (Err) as the discount rate CF 1 = cash flow in period t (t = 1, …, n) ~ = indicates the projected cash flow is uncertain n = number of periods in the investment horizon

35. ©2009, The McGraw-Hill Companies, All Rights Reserved 35 Realized Rate of Return The realized rate of return (rr) is the discount rate that just equates the actual purchase price ( ) to the present value of the realized cash flows (RCF t ) t (t = 1, …, n)

36. ©2009, The McGraw-Hill Companies, All Rights Reserved 36 EXAMPLE 3-1 A bond you purchased two years ago for $890 is now selling for $925. The bond paid $100 per year in coupon interest on the last day of each year. You intend to hold the bond for more 4 years and project that you will be able to sell it at the end of year 4 for $960. Given the risk associated with the bond, its required rate of return over the next four years is 11.25%. Find its fair value, Expected rate of return. And realized rate of return.

37. ©2009, The McGraw-Hill Companies, All Rights Reserved 37 Bond Valuation The present value of a bond (V b ) can be written as: M = the par value of the bond INT = the annual interest (or coupon) payment T = the number of years until the bond matures i = the annual interest rate (often called yield to maturity (ytm)) The present value of a bond (V b ) can be written as: M = the par value of the bond INT = the annual interest (or coupon) payment T = the number of years until the bond matures i = the annual interest rate (often called yield to maturity (ytm))

38. ©2009, The McGraw-Hill Companies, All Rights Reserved 38 EXAMPLE 3-4 You are considering the purchase of a $1000 face value bond that pays 10% coupon interest per year with the coupon paid semiannually. The bond matures in 12 years. If the required rate of return on the bond is 8%. Find the market value of the bond.

39. ©2009, The McGraw-Hill Companies, All Rights Reserved 39 Bond Valuation A premium bond has a coupon rate (INT) greater then the required rate of return (rrr) and the fair present value of the bond (V b ) is greater than the face value (M) Discount bond: if INT < rrr, then V b < M Par bond: if INT = rrr, then V b = M A premium bond has a coupon rate (INT) greater then the required rate of return (rrr) and the fair present value of the bond (V b ) is greater than the face value (M) Discount bond: if INT < rrr, then V b < M Par bond: if INT = rrr, then V b = M

40. ©2009, The McGraw-Hill Companies, All Rights Reserved 40 Yield to Maturity The return or yield the bondholder will earn on the bond if he buys it at its current market price, receives all coupon and principal payments and hold the bond until maturity.

41. ©2009, The McGraw-Hill Companies, All Rights Reserved 41 EXAMPLE 3-5 You are considering to purchase of a $1000 face value bond that pays 11% coupon interest per year, paid semiannually. The bond matures in 15 years. If the current market price of the bond is $931.176, what is the yield to maturity?

42. ©2009, The McGraw-Hill Companies, All Rights Reserved 42 Equity Valuation PV of the future dividends. Example: Suppose you owned a stock for the last two years for $25 and just sold it for $35. The stock paid an annual dividend of $1 on the last day of each of the past two years. Calculate the realized rate of return.

43. ©2009, The McGraw-Hill Companies, All Rights Reserved 43 Equity Valuation The present value of a stock (P t ) assuming zero growth in dividends can be written as: D = dividend paid at end of every year P t = the stock’s price at the end of year t i s = the interest rate used to discount future cash flows The present value of a stock (P t ) assuming zero growth in dividends can be written as: D = dividend paid at end of every year P t = the stock’s price at the end of year t i s = the interest rate used to discount future cash flows

44. ©2009, The McGraw-Hill Companies, All Rights Reserved 44 EXAMPLE 3-8 A stock you are evaluating is expected to pay a constant dividend of $5 per year. The expected rate of return (Err) on the stock is 12%. Calculate the price of the stock.

45. ©2009, The McGraw-Hill Companies, All Rights Reserved 45 Equity Valuation The present value of a stock (P t ) assuming constant growth in dividends can be written as: D 0 = current value of dividends D t = value of dividends at time t = 1, 2, …, ∞ g = the constant dividend growth rate The present value of a stock (P t ) assuming constant growth in dividends can be written as: D 0 = current value of dividends D t = value of dividends at time t = 1, 2, …, ∞ g = the constant dividend growth rate

46. ©2009, The McGraw-Hill Companies, All Rights Reserved 46 EXAMPLE 3- 9 A stock you are evaluating paid a dividend at the end of last year of $3.5. Dividend have grown at a constant rate of 2 per year over the last 20 years, and this constant growth rate is expected to continue into the future. The required rate of return (rrr) on the stock is 10%. Calculate the price.

47. ©2009, The McGraw-Hill Companies, All Rights Reserved 47 EXAMPLE 3-11 A stock you are evaluating is expected to experience supernormal growth in dividends of 10%, over the next 5 years. Following to this period dividends are expected to grow at a constant rate of 4%. The stock paid a dividend of $4 last year, and the rrr on the stock is 15%. Find the fair PV of the stock.

48. ©2009, The McGraw-Hill Companies, All Rights Reserved 48 Equity Valuation The return on a stock with zero dividend growth, if purchased at price P 0, can be written as: The return on a stock with constant dividend growth, if purchased at price P 0, can be written as: The return on a stock with zero dividend growth, if purchased at price P 0, can be written as: The return on a stock with constant dividend growth, if purchased at price P 0, can be written as:

49. ©2009, The McGraw-Hill Companies, All Rights Reserved 49 Relation between Interest Rates and Bond Values Interest Rate Bond Value Interest Rate Bond Value 12% 10% 8% 874.501,0001,152.47

50. ©2009, The McGraw-Hill Companies, All Rights Reserved 50 Impact of Maturity on Interest Rate Sensitivity Absolute Value of Percent Change in a Bond’s Price for a Given Change in Interest Rates Absolute Value of Percent Change in a Bond’s Price for a Given Change in Interest Rates Time to Maturity

51. ©2009, The McGraw-Hill Companies, All Rights Reserved 51 Impact of Coupon Rates on Interest Rate Sensitivity Bond Value Bond Value Interest Rate Low-Coupon Bond High-Coupon Bond

52. ©2009, The McGraw-Hill Companies, All Rights Reserved 52 Duration Duration is the weighted-average time to maturity (measured in years) on a financial security Duration measures the sensitivity (or elasticity) of a fixed-income security’s price to small interest rate changes Duration is the weighted-average time to maturity (measured in years) on a financial security Duration measures the sensitivity (or elasticity) of a fixed-income security’s price to small interest rate changes

53. ©2009, The McGraw-Hill Companies, All Rights Reserved 53 Duration Duration (D) for a fixed-income security that pays interest annually can be written as: t = 1 to T, the period in which a cash flow is received T = the number of years to maturity CF t = cash flow received at end of period t R = yield to maturity or required rate of return PV t = present value of cash flow received at end of period t Duration (D) for a fixed-income security that pays interest annually can be written as: t = 1 to T, the period in which a cash flow is received T = the number of years to maturity CF t = cash flow received at end of period t R = yield to maturity or required rate of return PV t = present value of cash flow received at end of period t

54. ©2009, The McGraw-Hill Companies, All Rights Reserved 54 Duration Duration (D) (measured in years) for a fixed-income security in general can be written as: m = the number of times per year interest is paid Duration (D) (measured in years) for a fixed-income security in general can be written as: m = the number of times per year interest is paid

55. ©2009, The McGraw-Hill Companies, All Rights Reserved 55 EXAMPLE Consider a bond with one year remaining to maturity, a $1000 face value, an 8% coupon rate and an interest rate of 10%. Coupons are paid semiannually. Find duration for this bond.

56. ©2009, The McGraw-Hill Companies, All Rights Reserved 56 EXAMPLE 3-12 Suppose you have a bond that offers a coupon rate of 10% paid semiannually. The face value of the bond is $1000, it matures in 4 years, its current yield to maturity is 8%, and its current market price is $1067.34. Calculate the duration.

57. ©2009, The McGraw-Hill Companies, All Rights Reserved 57 Duration Duration and coupon interest the higher the coupon payment, the lower the bond’s duration Duration and yield to maturity the higher the yield to maturity, the lower the bond’s duration Duration and maturity duration increases with maturity at a decreasing rate Duration and coupon interest the higher the coupon payment, the lower the bond’s duration Duration and yield to maturity the higher the yield to maturity, the lower the bond’s duration Duration and maturity duration increases with maturity at a decreasing rate

58. ©2009, The McGraw-Hill Companies, All Rights Reserved 58 Duration and Modified Duration Given an interest rate change, the estimated percentage change in a (annual coupon paying) bond’s price is found by rearranging the duration formula: MD = modified duration = D/(1 + R) Given an interest rate change, the estimated percentage change in a (annual coupon paying) bond’s price is found by rearranging the duration formula: MD = modified duration = D/(1 + R)

59. ©2009, The McGraw-Hill Companies, All Rights Reserved 59 EXAMPLE 3-12 cont Suppose that yield to maturity increases by 10 basis points (1/10 of 1%) from 8% to 8.1%. Find the percentage change on bond price. What will be the price if the coupon rate is 6%

60. ©2009, The McGraw-Hill Companies, All Rights Reserved 60 DURATION cont. The higher the coupon rate, the shorter the duration and the smaller the percentage decrease in bond price. Duration model predicts symmetric effects for rate increases and decreases. Capital loss effect of large rate increases tends to be smaller than capital gain effect of large rate decreases.

61. ©2009, The McGraw-Hill Companies, All Rights Reserved 61 Figure 3-7

62. ©2009, The McGraw-Hill Companies, All Rights Reserved 62 Convexity Convexity (CX) measures the change in slope of the price-yield curve around interest rate level R Convexity incorporates the curvature of the price- yield curve into the estimated percentage price change of a bond given an interest rate change: Convexity (CX) measures the change in slope of the price-yield curve around interest rate level R Convexity incorporates the curvature of the price- yield curve into the estimated percentage price change of a bond given an interest rate change: