Equity Valuation II

Learning Module 1
Free Cash Flow Valuation

LOS: Compare the free cash flow to the firm (FCFF) and free cash flow to equity (FCFE)
approaches to valuation.

LOS: Explain the ownership perspective implicit in the FCFE approach.

LOS: Explain the appropriate adjustments to net income, earnings before interest and taxes
(EBIT), earnings before interest, taxes, depreciation, and amortization (EBITDA), and cash flow
from operations (CFO) to calculate FCFF and FCFE.

LOS: Calculate FCFF and FCFE.

LOS: Describe approaches for forecasting FCFF and FCFE.

LOS: Explain how dividends, share repurchases, share issues, and changes in leverage may
affect future FCFF and FCFE.

LOS: Compare the FCFE model and dividend discount models (DDMs).

LOS: Evaluate the use of net income and EBITDA as proxies for cash flow in valuation.

LOS: Explain the use of sensitivity analysis in FCFF and FCFE valuations.

LOS: Explain the single-stage (stable-growth), two-stage, and three-stage FCFF and FCFE
models and justify the selection of the appropriate model given a company's characteristics.

LOS: Estimate a company's value using the appropriate free cash flow model(s).

LOS: Describe approaches for calculating the terminal value in a multistage valuation model,
and evaluate whether a stock is overvalued, fairly valued, or undervalued based on a free cash
flow valuation model.

LOS: Evaluate whether a stock is overvalued, fairly valued, or undervalued based on a free cash
flow valuation mode.

Introduction

LOS: Compare the free cash flow to the firm (FCFF) and free cash flow to equity (FCFE)
approaches to valuation.

LOS: Explain the ownership perspective implicit in the FCFE approach.

For equity valuation, analysts generally prefer free cash flow models over dividend discount models
(DDMs). One key rationale for this preference is the ownership perspective implicit within FCFE models.
FCFE presupposes that an investor with a controlling stake can control how the firm spends its free cash

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flows, and therefore can dictate its dividend payout policy. In contrast, DDMs reflect the perspective of a
minority shareholder who cannot control dividend policies and only receives dividends based on policies set
by controlling shareholders.

Exhibit 1

Rationales for using FCFE instead of dividends for company valuation

● Company does not pay dividends

● Actual dividends do not reflect company's capacity to pay dividends
● Free cash flows better align to long-term profitability
● Free cash flows reflect an acquirer's control perspective

When valuing companies targeted for takeovers, free cash flow valuation should be used since the acquirer
will have control over the target's cash flows. The purchase price usually includes a premium to obtain the
benefits of control.

FCFF and FCFE Valuation Approaches

Defining Free Cash Flow

The free cash flow is the cash flow available for distribution to capital providers after accounting for
operating expense and capital investments. There are two main forms of free cash flow.

● Free cash flow to the firm (FCFF) is the cash flow available to all the firm's capital suppliers (ie,
bondholders, common shareholders, and preferred shareholders) after accounting for operating
expenses, capital expenditures, and investments in net working capital. A firm can use its FCFF to pay
interest, retire debt, pay dividends, or repurchase stock.
● Free cash flow to equity (FCFE) is the cash flow available to common shareholders after deducting
interest payments to debtholders, principal repayments, new borrowings, and preferred dividends from
FCFF. A firm can use its FCFE to pay common dividends or repurchase stock.

The level of debt in a firm's capital structure is the primary driver that accounts for the difference between
FCFF and FCFE.

Present Value of Free Cash Flow

Investors discount free cash flow to value firms. Free cash flow is superior to other cash flow measures
(eg, CFO) and proxies (eg, EBITDA, net income) for valuing companies since no other metric collectively
captures the impact of taxes, noncash items, interest, and capital investments.

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 Free Cash Flow Valuation

Exhibit 2 FCFF and FCFE approaches to calculating equity value

Equity value = Firm value − Noncommon equity capital

FCFF approach ∞
FCFFt Market value of debt +
Equity value = −⎛ ⎞
(1 + WACC)t Market value of preferred stock
t=1 ⎝ ⎠

∞
FCFFt
FCFE approach Equity value =
(1 + r)t
t=1

Theoretically, both the FCFF and FCFE approaches should yield the same intrinsic equity value for a
company. With FCFF, analysts can discount FCFFs by the firm's weighted average cost of capital (WACC)
to find the firm's value then subtract the market value of debt to determine equity value. Alternatively,
analysts can directly discount FCFE by the cost of equity (r) to determine equity value. The intrinsic value
for each share of common stock can be calculated using the number of shares outstanding.

At times, using FCFE to calculate equity value is easier when a firm's capital structure is stable. However,
when capital structure is volatile or when FCFE is negative, using FCFF may be more appropriate.

Single-Stage (Constant-Growth) FCFF and FCFE Models

Free cash flow valuation models are present value equations structurally similar to their DDM counterparts.
The single-stage free cash flow model assumes that cash flows will grow at a constant growth rate (g)
into perpetuity.

Exhibit 3 Value calculations from free cash flow with constant growth

FCFF0 (1 + g) FCFF1
Firm Value = =
WACC − g WACC − g

FCFF0 (1 + g) FCFF1
Equity Value = =
r−g r−g

Note that the FCFF calculation uses WACC, as the FCFF is discounted by the WACC adjusted for growth,
considering all the firm's types of capital. In contrast, the FCFE calculation uses r adjusted for growth, the
required return of equity holders, since it is the free cash flow available only to the equity holders.

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Example 1 Calculating value based on constant-growth FCFF valuation model

An analyst wants to estimate the value of Star Manufacturers stock and gathers the following information
about the company:

● FCFF at the end of 20X9 = $660 million

● Before-tax cost of debt = 4.5%
● Required rate of return on equity = 11%
● Target debt-to-equity ratio = 0.4
● Number of common shares outstanding = 300 million
● Expected long-term growth rate in FCFF = 5%
● Tax rate = 40%
● Market value of debt = $1.2 billion

1. Calculate Star Manufacturers WACC.

2. What is the intrinsic value of the company's stock at the end of 20X9?

Solution

0.4
1. WACC = ⎛ × 0.045 × (1 − 0.4)⎞ + (1.4 × 0.11) ≈ 8.63%
⎝ 1.4 ⎠

2. The value of the firm is calculated by applying the constant-growth FCFF model:

FCFF 660 × 1.05

Value = = ≈ $19,091 million ≈ $19.091 billion
WACC − g 0.0863 − 0.05

The value of equity equals the value of the firm minus the market value of the firm's debt:

MVEquity = 19,091 − MVDebt = 19.091 − 1.2 = $17.891 billion

The intrinsic value of a share of stock equals the value of the equity divided by the number of
common shares outstanding:

17,891
Value per share = ≈ $59.64
300

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 Free Cash Flow Valuation

Example 2 Calculating value based on constant-growth FCFE valuation model

An analyst wants to estimate the value of Veta Inc.'s stock. He gathers the following information
regarding the company:

● FCFE at the end of 20X9 = $3.25 per share

● The company's WACC = 12.25%
● Risk-free rate of return = 4%
● Equity market risk premium = 6.5%
● Beta of the company's stock = 1.2
● Expected long-term growth rate in FCFE = 5.5%

Calculate the value of Veta's stock at the end of 20X9.

Solution

First, use the capital asset pricing model to calculate the required rate of return on equity:

Required rate of return on equity = 0.04 + (1.2 × 0.065) = 11.8%

Then compute the value of the firm's equity based on the constant-growth FCFE model:

FCFE 3.25 × 1.055

Value of equity = = = $54.42
r−g 0.118 − 0.055

Forecasting Free Cash Flow and Computing FCFF from Net Income

LOS: Explain the appropriate adjustments to net income, earnings before interest and taxes
(EBIT), earnings before interest, taxes, depreciation, and amortization (EBITDA), and cash flow
from operations (CFO) to calculate FCFF and FCFE.

LOS: Calculate FCFF and FCFE.

LOS: Describe approaches for forecasting FCFF and FCFE.

To calculate FCFF from net income:

FCFF = NI + NCC + Int(1 – t) – FCInv – WCInv

Where:
NI = Net income
NCC = Noncash charges
Int = Interest
t = Tax rate
FCInv = Investments in fixed capital
WCInv = Investments in working capital

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Recall that FCFF is cash flow available to all capital providers (eg, creditors, shareholders) after accounting
for operating expenses, capital expenditures, and investments in net working capital. Net income, which
is prepared on an accrual basis, is net of operating expenses including interest expense, depreciation,
and taxes. As such, net income differs from FCFF in several ways. Primarily, net income includes noncash
charges (NCC) (eg, depreciation and amortization, stock-based compensation) and ignores investments in
fixed and working capital.

To derive FCFF from net income, analysts should:

● add back NCC;

● add back interest expense net of taxes to reflect funds available for paying interest to creditors;
● subtract FCInv, which typically include capital expenditures (CapEx) net of proceeds from sale of
equipment; and
● subtract changes to net working capital. Net working capital is the difference between operating current
assets and operating current liabilities.
○ Operating current assets (eg, accounts receivable, inventory) are current assets excluding cash and
cash equivalents.
○ Operating current liabilities (eg, accounts payable) are current liabilities excluding any interest-
bearing debt (eg, short-term debt, current portion of long-term debt).

Computing FCFF from the Cash Flow Statement

LOS: Explain the appropriate adjustments to net income, earnings before interest and taxes
(EBIT), earnings before interest, taxes, depreciation, and amortization (EBITDA), and cash flow
from operations (CFO) to calculate FCFF and FCFE.

LOS: Calculate FCFF and FCFE.

LOS: Describe approaches for forecasting FCFF and FCFE.

To compute FCFF from the cash flow statement:

FCFF = CFO + Int(1 − t) − FCInv

Where:
CFO = Cash flow from operations
Int = Interest
t = Tax rate
FCInv = Investments in fixed capital

Unlike net income (which is accrual-based), cash flow from operations (CFO) reflects actual cash flows, so
fewer adjustments are required to derive FCFF. CFO is generally net income plus NCC less investments
in working capital (WCInv) (ie, NI + NCC − WCInv). Analysts should add back after-tax interest to include
funds available for interest payments to creditors and subtract investments in fixed capital (FCInv) to
account for net capital expenditures.

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 Free Cash Flow Valuation

Additional Considerations in Computing FCFF

LOS: Calculate FCFF and FCFE.

LOS: Describe approaches for forecasting FCFF and FCFE.

Classification of Certain Items on the Statement of Cash Flow

Exhibit 4 Differences between US GAAP and IFRS for cash flow statement items

US GAAP IFRS

Interest received Operating Operating or investing

Interest paid Operating Operating or financing

Dividend received Operating Operating or investing

Dividend paid Financing Operating or financing

Typically operating, but specific

Taxes paid Operating portions can be classified as
financing or investing

For companies that report under IFRS, analysts should understand how certain items are categorized
on the cash flow statement when using CFO to calculate FCFF. One such item is interest paid; IFRS
allows interest paid to be classified under financing or operating activities. If interest paid is captured
as a CFF outflow (instead of a CFO outflow), then after-tax interest paid should not be added to CFO
when calculating FCFF. Conversely, if interest paid is captured in CFO, then after-tax interest should
be added back.

Adjustments to Derive Operating Cash Flow from Net Income

The operating cash flow section of the statement of cash flows typically includes various adjustments
to reconcile net income to CFO. These adjustments are noncash (eg, depreciation, amortization) or
nonoperating (eg, gain from sale of assets) in nature.

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Exhibit 5 Noncash or nonoperating adjustments to net income

Reported net income

+ Depreciation
+ Amortization and impairment of intangibles
+ Restructuring charges
− Restructuring income from reversal
+ Amortization of bond discounts
− Amortization of bond premiums
+ Losses on nonoperating activites
− Gains on nonoperating activities
+ Deferred taxes (requires careful examination)

Adjustments to Derive Operating Cash Flow from Net Income That May Merit
Additional Attention from an Analyst
Deferred taxes result from differences between income tax expense reported on financial statements and
taxes payable on the tax return. The discrepancies are due to timing differences in recognizing income
and expenses for accounting purposes and tax purposes. Over time, these temporary differences should
reverse and have no material impact on cash flows.

However, if a company can defer its tax liabilities indefinitely into the future (ie, not reverse), then these
deferred tax liabilities should be added back to net income. Similarly, if a company does not expect to ever
realize its tax benefits, then these deferred tax assets should be subtracted from net income.

Computing FCFE from FCFF

LOS: Explain the ownership perspective implicit in the FCFE approach.

LOS: Calculate FCFF and FCFE.

LOS: Describe approaches for forecasting FCFF and FCFE.

To compute FCFE from FCFF:

FCFE = FCFF − Int(1 − t) + Net borrowing

FCFE is the cash flow available to common shareholders after accounting for transactions with creditors.
Therefore, FCFF is adjusted for cash flows to (from) creditors by subtracting after-tax interest and adding
net borrowing (ie, new borrowing less debt repayments). FCFE can be used for repurchasing shares or for
paying dividends to shareholders.

FCFE = NI + NCC − FCInv − WCInv + Net borrowing

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 Free Cash Flow Valuation

FCFE can also be derived from net income. Note that the first four terms (NI + NCC − FCInv − WCInv) are
equal to FCFF less after-tax interest [FCFF − Int(1 − t)], as shown in the previous equation. Therefore, add
net borrowing to the first four terms to derive FCFE:

FCFE = CFO − FCInv + Net borrowing

FCFE can also be derived from CFO. Note that:

CFO − FCInv = FCFF − Int(1 − t) = NI + NCC − FCInv − WCInv

Therefore, add net borrowing to the first two terms of the above equation to derive FCFE.

Finding FCFF and FCFE from EBIT or EBITDA

LOS: Explain the appropriate adjustments to net income, earnings before interest and taxes
(EBIT), earnings before interest, taxes, depreciation, and amortization (EBITDA), and cash flow
from operations (CFO) to calculate FCFF and FCFE.

LOS: Calculate FCFF and FCFE.

To calculate FCFF from earnings before interest and taxes (EBIT):

FCFF = EBIT(1 − t) + Dep − FCInv − WCInv

EBIT is also net of depreciation. To derive FCFF, first remove taxes (but not interest) to calculate cash flows
available to creditors. Next, add back depreciation (Dep), which is a noncash charge. Finally, subtract the
investments in fixed and working capital:

FCFF = EBITDA(1− t) + Dep(t) − FCInv − WCInv

EBITDA is earnings before interest, taxes, depreciation, and amortization. First remove taxes (but
not interest) then add back the depreciation tax savings. Finally, subtract investments in fixed and
working capital.

FCFE can also be calculated from EBIT and EBITDA. Since FCFE = FCFF − Int(1 − t) + Net borrowings:

FCFE = EBIT(1 − t) + Dep − FCInv − WCInv − Int(1 − t) + Net borrowings

FCFE = EBITDA(1 − t) + Dep(t) − FCInv − WCInv − Int(1 − t) + Net borrowings

The next example incorporates all these formulas.

Example 3 Calculating FCFF

The tables shown provide the balance sheet and income statement for Saturn Inc. for 20X8 and the
forecasted balance sheet and income statement for 20X9. Saturn Inc. prepares its financial statements
in accordance with US GAAP.

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Income Statement ($ millions) 20X9 20X8

Sales 625 450

Cost of goods sold (280) (225)
Gross profit 345 225
SG&A (25) (20)
Depreciation (60) (50)
EBIT 260 155
Interest expense (20) (15)
Pretax earnings 240 140
Taxes (30%) (72) (42)
Net income 168 98

Balance Sheet ($ millions) 20X9 20X8

Cash 24 25
Accounts receivable 8 10
Inventory 53 45
Total current assets 85 80
Gross PPE 1,443 1,125
Less: Accumulated depreciation (260) (200)
Net property, plant & equipment 1,183 925
Total noncurrent assets 1,183 925
Total assets 1,268 1,005
Accounts payable 38 35
Short-term debt 62 45
Total current liabilities 100 80
Long-term debt 365 290
Total liabilities 465 370
Common stock 300 300
Retained earnings 503 335
Total equity 803 635
Total equity & liabilities 1,268 1,005

Saturn did not dispose of any of its long-term assets in 20X9. Based only on the information provided,
calculate 20X9 FCFF from:

● Net Income
● CFO
● EBIT
● EBITDA

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 Free Cash Flow Valuation

Solutions

Before diving into each equation, first calculate two variables that will appear repeatedly: FCInv and WCInv.

WCInv Calculation 20X9 20X8

Accounts receivable 8 10
+ Inventory 53 45
− Accounts payable 38 35
Net working capital 23 20

WCInv = 23 − 20 = 3

Saturn Inc.'s net working capital increased by $3 million year on year, this represents a cash outflow.

FCInv Calculation 20X9

Net PPE (20X9) 1,183

− Net PPE (20X8) 925
+ Depreciation 60
FCInv 318

Beginning Net PPE + FCInv − Dep = Ending Net PPE

Therefore:

FCInv = Beginning Net PPE − Ending Net PPE + Dep

FCInv equals CapEx less proceeds from the sale of equipment. In this scenario, Saturn Inc. did not
dispose of any of its equipment, so FCInv equals CapEx.

1. Calculating FCFF from net income

Net Income to FCFF 20X9

Net income 168

+ Depreciation 60
+ Int(1 − t) 14 20 × (1 − 0.3)
− FCInv 318
− WCInv 3
FCFF (79)

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Learning Module 1

2. Calculating FCFF from CFO

CFO is not given in the question, so first calculate CFO.

Net Income to CFO

Net income 168

+ Depreciation 60
− WCInv 3
CFO 225

Next, calculate FCFF from CFO.

CFO to FCFF

CFO 225
+ Int(1 − t) 14
− FCInv 318
FCFF (79)

3. Calculating FCFF from EBIT

EBIT to FCFF

EBIT(1 − t) 182 260 × (1 − 0.3)

+ Depreciation 60
− FCInv 318
− WCInv 3
FCFF (79)

4. Calculating FCFF from EBITDA

EBITDA to FCFF

EBITDA(1 − t) 224 (260 + 60) × (1 − 0.3)

+ Depreciation × t 18 60 × 0.3
− FCInv 318
− WCInv 3
FCFF (79)

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 Free Cash Flow Valuation

Example 4 Calculating FCFE

Income Statement ($ millions) 20X9 20X8

Sales 625 450

Cost of goods sold 280 225
Gross profit 345 225
SG&A 25 20
Depreciation 60 50
EBIT 260 155
Interest expense 20 15
Pretax earnings 240 140
Taxes (30%) 72 42
Net income 168 98

Balance Sheet ($ millions) 20X9 20X8

Cash 24 25
Accounts receivable 8 10
Inventory 53 45
Total current assets 85 80
Gross property, plant & equipment 1,443 1,125
Less: Accumulated depreciation 260 200
Net property, plant & equipment 1,183 925
Total noncurrent assets 1,183 925
Total assets 1,268 1,005

Accounts payable 38 35
Short-term debt 62 45
Total current liabilities 100 80
Long-term debt 365 290
Total liabilities 465 370
Common stock 300 300
Retained earnings 503 335
Total equity 803 635
Total equity & liabilities 1,268 1,005

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Learning Module 1

Continuing from the example above, calculate 20X9 FCFE from:

● FCFF
● Net Income
● CFO

Solution

First calculate net borrowing, which equals new borrowings less debt repayments, which can simply be
calculated from the change in total debt outstanding.

Net Borrowing 20X9 20X8

Short-term debt 62 45
Long-term debt 365 290
Total debt 427 335
Net borrowing = 427 − 355 = 92

1. Calculating FCFE from FCFF

FCFF to FCFE

FCFF (79)
− Int(1 − t) 14
+ Net borrowing 92
FCFE (1)

2. Calculating FCFE from Net Income

Net Income to FCFE

Net Income 168

+ Depreciation 60
− FCInv 318
− WCInv 3
+ Net borrowing 92
FCFE (1)

3. Calculating FCFE from CFO

CFO to FCFE

CFO 225
− FCInv 318
+ Net borrowing 92
FCFE (1)

Although memorizing every formula may not be practical, try to memorize a few formulas as a baseline, and
understand how to modify the baseline formulas to derive the variants.

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 Free Cash Flow Valuation

Exhibit 6 Free cash flow formulas

FCFF FCFE

FCFF = NI + NCC + Int(1 − t) − FCInv − WCInv FCFE = FCEE − Int(1 − t) + Net borrowing

FCFF = EBIT(1 − t) + NCC − FCInv − WCInv FCFE = NI + NCC − FCInv − WCInv + Net borrowing

FCFF = EBITDA(1 − t) + NCC(t) − FCInv − WCInv FCFE = CFO − FCInv + Net borrowing

FCFF = CFO + Int(1 − t) − FCInv

NI = Net income Int = Interest expense

NCC = Noncash charges (eg, depreciation FCInv = Investments in fixed capital
t = Tax rate WCINV = Investements in working capital

FCFF and FCFE on a Uses-of-Free-Cash-Flow Basis

LOS: Calculate FCFF and FCFE.

LOS: Explain how dividends, share repurchases, share issues, and changes in leverage may
affect future FCFF and FCFE.

Up until now, free cash flow has been calculated based on its sources (eg, net income, CFO, EBIT).
Alternatively, free cash flow can also be calculated based on its uses, mainly as a reconciliation tool. In
general, FCFF can be used to:

● increase cash balances,

● distribute cash to debt providers (ie, interest and principal payments in excess of new borrowings),
● distribute cash to shareholders (ie, dividend payments and share repurchases in excess of new
share issuance).

Therefore, FCFF based on uses can be calculated as:

Increases in cash balances

Plus: Net payments to debt providers

+ Interest expense (1 − tax rate)
+ Repayment of principal
− New borrowings

Plus: Net payments to shareholders

+ Cash dividends
+ Share repurchases
− New equity issues
= FCFF based on uses

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Learning Module 1

FCFE reflects cash flows available after accounting for transactions with debt providers. Therefore, FCFE
can be calculated as:

Increases in cash balances

Plus: Net payments to shareholders

+ Cash dividends
+ Share repurchases
− New equity issues
= FCFE based on uses

Example 5 FCFF calculated on uses of cash

Saturn Inc.'s FCFF of −$79 million can also be calculated based on the uses-of-free-cash-flow approach:

Uses of FCFF

Decrease in cash & cash equivalents (= 24 − 25) (1)

+ After-tax interest payments to providers of debt capital 14
− Net borrowing (92)
+ Dividends 0
+ Share repurchases 0
FCFF (79)

Forecasting FCFF and FCFE

LOS: Describe approaches for forecasting FCFF and FCFE.

Analysts can forecast free cash flows through a simple approach or complex approach. The simple
approach involves using average historical free cash flow growth rates to forecast future free cash flows
(for example, a firm's FCFF may be forecasted to grow at 3% indefinitely). Although this approach is
straightforward, the complex approach is more realistic and more popular. Note that this section discusses
one out of many complex approaches used by analysts.

The complex approach involves forecasting individual free cash flow components (eg, EBIT, WCInv, FCInv)
based on their relationship to revenue growth. The rationale is that operating expenses, working capital
investments, and capital expenditures all correlate to sales growth.

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 Free Cash Flow Valuation

When forecasting free cash flow components, analysts forecast:

● sales growth rates;

● profits margins as a percent of sales (eg, gross margin %, EBIT %);
● WCInv as a percent of sales growth (increase in working capital / increase in sales);
● incremental fixed capital expenditures as a percent of sales growth [(FCInv − Dep) / increase in sales];
● debt ratio (for FCFE).

Once the components are forecast, analysts can calculate FCFF and FCFE:

FCFF = EBIT(1 − t) – (FCInv − Dep) − WCInv

With FCFF, when forecasting capital expenditures, analysts separate maintenance from growth.
Maintenance supports existing sales capacity and is captured by depreciation. Growth supports sales
growth and is captured by (FCInv − Dep); this expression is also referred to as incremental fixed capital
expenditures or net new FCInv. This approach eliminates the need to separately forecast depreciation since
the forecast of net new FCInv already captures depreciation.

With FCFE, analysts often assume that the firm aims to maintain a constant target debt ratio (DR)
(ie, DR = Debt / [Debt + Equity]) when financing investments in fixed and working capital. Thus, the
equity-financed portion of FCInv is (1 − DR) × (FCInv − Dep) and in working capital is (1 − DR) × (WCInv).

Using the debt ratio in forecasting allows analysts to forecast FCFE without having to separately forecast
debt issuance and repayments for net borrowing. This then creates another variation of the FCFE formula:

FCFE = NI − (1 − DR) × (FCInv − Dep) − (1 − DR) × (WCInv)

Start with net income, then subtract the equity FCInv and WCInv:

Net borrowing = (DR) × (FCInv − Dep) + (DR) × (WCInv)

FCFE = NI − (FCInv − Dep) − (WCInv) + Net borrowing

FCFE = NI − (FCInv − Dep) − (WCInv) + (DR) × (FCInv − Dep) + (DR) × (WCInv)

FCFE = NI − (1 − DR) × (FCInv − Dep) − (1 − DR) × (WCInv)

Example 6 Forecasting FCFF and FCFE using a complex approach

An analyst collects the following historical data for Phesco Inc. to forecast free cash flows for 20X2.

Phesco Selected Data (€ millions)

20X0 20X1

Sales 5,000.00 5,250.00

EBIT 750.00 787.50
Net income 450.00 472.50
FCInv − Dep 71.43 75.00
WCInv 23.81 25.00

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In addition, Phesco Inc. is subject to a tax rate of 25% and maintains a target debt ratio of 40%. The
analyst will make forecasts based on 20X1's year-on-year (YoY) growth and margins.

1. Based on 20X1's YoY growth and margins, define the inputs the analyst should use for:
a. sales growth %
b. EBIT margin
c. net profit margin
d. growth of capital expenditure to sales
e. working capital investments to sales

2. Forecast 20X2 FCFF using the complex approach.

3. Forecast 20X2 FCFE using the complex approach.

Solution

1. Inputs are calculated as follows:

20X0 20X1 Calculation to derive inputs

Sales 5,000.00 5,250.00 Sales growth % 5,250 / 5,000 − 1 = 5%

EBIT 750.00 787.50 EBIT margin 787.5 / 5,250 = 15%
Net income 450.00 472.50 Net profit margin 472.5 / 5,250 = 9%
FCInv − Dep 71.43 75.00 Growth CapEx % 75 / (5,250 − 5,000) = 30%
WCInv 23.81 25.00 WCInv % 25 / (5,250 − 5,000) = 10%

2. 20X2 FCFF is calculated as follows:

FCFF 20X1 20X2(F) Formula

Sales 5,250.00 5,512.50 Salest − 1 × (1 + sales growth%) = 5,250 × (1 + 0.05)

EBIT 787.50 826.88 Sales × EBIT Margin = 5,512.5 × 0.15
EBIT (1 − t) 590.63 620.16 EBIT (1 − t) = 826.88 × (1 − 0.25)
Increase in sales × Growth CapEx % =
− FCInv − Dep 75.00 78.75
(5,512.5 − 5,250) × 0.3
− WCInv 25.00 26.25 Increase in sales × WCInv % = (5,512.5 − 5,250) × 0.1

FCFF 490.63 515.16

3. 20X2 FCFE is calculated as follows:

FCFE 20X1 20X2(F) Formula

Net income 472.50 496.13 Sales × Net profit margin = 5,512.5 × 0.09
− (1 − DR) × (FCInv − Dep) 45.00 47.25 (1 − DR) × (FCInv - Dep) = (1 − 0.4) × (78.75)
− (1 − DR) × (WCInv) 15.00 15.75 (1 − DR) × (WCInv) = (1 − 0.4) × (26.25)
FCFE 412.50 433.13

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Other Issues in Free Cash Flow Analysis

LOS: Compare the FCFE model and dividend discount models (DDMs).

LOS: Explain how dividends, share repurchases, share issues, and changes in leverage may
affect future FCFF and FCFE.

LOS: Evaluate the use of net income and EBITDA as proxies for cash flow in valuation.

Free Cash Flow versus Dividends and Other Earnings Components

FCFE versus DDM

Analysts prefer FCFE models over DDMs for several reasons:

● Some corporations pay irregular, negligible, or no dividends.

● Dividends paid may not reflect the firm's true long-term profitability. For example, a firm with negative
profits but positive retained earnings can still pay dividends in the near term.
● DDMs reflect a minority perspective since shareholders only realize value when dividends are paid,
whereas FCFE models reflect a controlling perspective since majority shareholders can dictate the
dividend policy from the available FCFE. When analyzing a firm targeted for takeover, analysts should
use the FCFE approach since the acquirer will have control.

Dividends, Share Repurchases, and Changes in Leverage

Dividends, share repurchases, and share issuance have no effect on free cash flow. Free cash flows
represent cash flows available to shareholders before returning any capital to creditors or shareholders.
Dividends and repurchases represent uses of cash and are transactions between the company and its
investors, but they do not reduce the cash flows that are available for use.

Changes in leverage have some impact on FCFE but not on FCFF. For example, additional leverage
will initially increase FCFE through more net borrowing but subsequently decrease FCFE through
interest payments.

Net Income and EBITDA Proxies

Due to the complexity of calculating free cash flows, investors often adopt several alternative cash flow
proxies such as net income, EBIT, EBITDA, and CFO; however, there are drawbacks with these proxies.
For example, net income includes NCC (ie, depreciation) and ignores WCInv and FCInv. EBITDA does not
capture taxes and ignores FCInv and WCInv. CFO ignores capital expenditures.

Free Cash Flows and Complicated Capital Structures

The discussion thus far has assumed a capital structure consisting of debt and common equity, but more
complex capital structures do exist. If the firm's capital structure includes preferred stock, the income
statement may report net income available to common shareholders (which is net income after preferred
dividends), and preferred dividends would have to be added back to derive FCFF.

FCFF = NI available to common shareholders + NCC + Int(1 − t) + Preferred dividends − FCInv − WCInv

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Learning Module 1

Free Cash Flow Model Variations

LOS: Explain the use of sensitivity analysis in FCFF and FCFE valuations.

An International Application of the Single-Stage Model

A variation of the constant growth free cash flow model is frequently used to value international stocks using
real discount rates and real growth rates, especially if they are easier to estimate than nominal discount
and growth rates (eg, when inflation rates are high and volatile). In this variation, real (inflation-adjusted)
discount rates and cash flows are used.

To estimate the real required rate of return (rreal) for an international stock, analysts start with the real
required rate of return on stocks for a particular country and then adjust it for the company's industry, size,
and leverage.

Exhibit 7

Country return x%
± Industry adjustment x%
± Size adjustment x%
± Leverage adjustment x%
Real required rate of return x%

Next, analysts estimate the real growth rates (greal) for these international stocks' FCFEs. Once those two
variables are determined, analysts can plug them into the single-stage model to calculate intrinsic value:

FCFE0(1 + greal)
V0 =
rreal − greal

Sensitivity Analysis of FCFF and FCFE Valuations

Sensitivity analysis can show analysts how a firm's FCFE and FCFF valuations can range based
on different inputs. This example displays how changes to sales growth, gross margin, and capital
expenditures impact a company's valuation:

Exhibit 8

Valuation with Valuation with

Base-Case Low High Low Estimate High Estimate
Variable Estimate Estimate Estimate (RUB billions) (RUB billions)

Sales growth rate 15% 12% 18% 460 530

Gross margin % 30% 29% 31% 490 500
CAPEX % of sales 5% 4% 6% 535 540

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 Free Cash Flow Valuation

Two-Stage Free Cash Flow Models

LOS: Explain the single-stage (stable-growth), two-stage, and three-stage FCFF and FCFE
models and justify the selection of the appropriate model given a company's characteristics.

LOS: Estimate a company's value using the appropriate free cash flow model(s).

LOS: Describe approaches for calculating the terminal value in a multistage valuation model,
and evaluate whether a stock is overvalued, fairly valued, or undervalued based on a free cash
flow valuation model.

Exhibit 9 Two-stage Free Cash Flow models

Two stage: Two stage:

1st stage constant g 1st stage declining g

High
growth
High
Stable growth Stable

Time Time

There are two popular versions of two-stage free cash flow models, distinguished by the growth rates in the
first stage:

● The growth rate is constant in Stage 1 and abruptly drops to the long-term sustainable growth
rate in Stage 2.
● The growth rate gradually declines during Stage 1 toward the long-term sustainable growth
rate of Stage 2.

In both versions, the growth rate in the second stage is a long-run sustainable growth rate. For a declining
industry, the second-stage growth rate could be slightly lower than the GDP growth rate. For an industry
with brighter prospects, the second-stage growth rate could be slightly greater than the GDP growth rate.

Below are the generally expressions for the two-stage FCFF and FCFE models:

n
FCFFt FCFFn + 1 1
Firm value = � +
(1 + WACC) t (WACC − g) (1 + WACC) n −
t=1
n
FCFE t FCFE n + 1 1
Equity value = � +� �� �
(1 + r ) t r −g (1 + r ) n
t=1

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Learning Module 1

The discounted cash flow(s) of the first stage are added to the discounted cash flows (ie, the terminal
value) of the second stage. The terminal value is the present value of the second stage's cash flows at the
beginning of the second stage.

Example 7 Calculating value using two-stage FCFF model

The following information relates to Alpha Inc.:

● Net profit margin = 22%

● Sales in Year 0 = $15m
● Fixed capital investment in Year 0 = $4m
● Depreciation in Year 0 = $5m
● Working capital investment as a percentage of sales = 8.5%
● Tax rate = 40%
● Interest expense on par value of debt of $20m in Year 0 = 11.5%
● WACC during the high growth phase = 19%
● WACC during the mature phase = 16%

Net income, fixed capital investment, depreciation, interest expense, and sales are expected to grow at
a rate of 12% for the next 5 years and then stabilize at a long-term constant growth rate of 6%.

Compute the value of the firm.

Solution

FCFF in each of the first 6 years is calculated in the table below:

Year 0 1 2 3 4 5 6

Sales ($ millions) 15.00 16.80 18.82 21.07 23.60 26.44 28.02

Net income 3.30 3.70 4.14 4.64 5.19 5.82 6.16

Add: Depreciation 5.00 5.60 6.27 7.02 7.87 8.81 9.34
Add: After-tax interest expense 1.38 1.55 1.73 1.94 2.17 2.43 2.58
Less: Fixed capital investment 4.00 4.48 5.02 5.62 6.29 7.05 7.47
Less: Working capital investment 1.28 1.43 1.60 1.79 2.01 2.25 2.38
FCFF 4.41 4.93 5.53 6.19 6.93 7.76 8.23

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 Free Cash Flow Valuation

Calculations for Year 0 and Year 1:

Year 0 Year 1
$ $

Sales 15m 15m × (1 + 0.12) = 16.8m

Net income 22% of 15m = 3.3 3.3m × (1 + 0.12) = 3.696m
Depreciation 5m 5m × (1 + 0.12) = 5.6m
After-tax interest expense 11.5% of 20m × (1 − 0.4) = 1.38m 1.38m × (1 + 0.12) = 1.5456m
Fixed capital investment 4m 4m × (1 + 0.12) = 4.48m
Working capital investment 8.5% of 15m = 1.275m 8.5% of 16.8m = 1.428m

Next, calculate the terminal value as of the end of Year 5 (end of Stage 1) using Year 6 FCFF (8.23m),
the mature stage WACC (16%), and the Stage 2 constant growth rate (6%) in the calculation.

8.23
Terminal value at the end of Year 5 = = $82.3m
(0.16 − 0.06)

Compute the value of the firm as the sum of the present values of FCFF in Stage 1 and the present
value of the terminal value. Note that the high growth phase WACC (19%) is used in this calculation.

4.93 5.53 6.19 6.93 7.76 + 82.3

Value of firm = + + + + = $52.92m
(1.19)1 (1.19)2 (1.19)3 (1.19)4 (1.19)5

Example 8 Two-stage FCFE model with declining growth in Stage 1

The following information relates to Violet Inc.:

Year 0 1 2 3 4 5 6

Revenues ($ millions) 15
Sales growth rate (%) 35% 30% 25% 30% 15% 10%
Net profit margin (%) 8.5% 8% 7.5% 7% 6.5% 6%
(FCInv − Dep) as a % of increase in sales 25% 25% 25% 25% 25% 25%
WCInv as a % of increase in sales 8% 8% 8% 8% 8% 8%

● Long-term constant growth rate = 6%

● Investors' required return on equity = 13%
● Debt ratio = 35%

If the company has 2 million shares outstanding, what is the per-share value of Violet Inc.'s stock today?

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Learning Module 1

Solution

FCFE for each of the first 6 years is calculated as:

Year 0 1 2 3 4 5 6

Sales ($ millions) 15.000 20.250 26.325 32.906 39.488 45.411 49.952

Net income 1.721 2.106 2.468 2.764 2.952 2.997

Less: FCInv − Dev 1.313 1.519 1.645 1.545 1.481 1.135
Less: WCInv 0.420 0.486 0.527 0.527 0.474 0.363
Add: Net Borrowings 0.606 0.702 0.760 0.760 0.684 0.524
FCFF ($ millions) 0.595 0.803 1.056 1.352 1.681 2.023

Media ID: LXXXXX

Illustration of calculations for Year 1:

1. FCInv − Dep = 25% × (20.25 − 15) = $1.3125m

2. WCInv = 8% × (20.25 − 15) = $0.42m
3. Net borrowings = 35% × (1.3125 + 0.42) = $0.6063m

FCFE in Year 1 can be calculated two ways:

Method 1

FCFE = NI − (FCInv − Dep) − WCInv + Net borrowings

= 1.721 − 1.313 − 0.42 + 0.606 = 0.595m

Method 2

FCFE = NI − [(1- DR) × (FCInv − Dep)] − [(1 − DR) × WCInv]

= 1.721m − [(1 − 0.35) × 1.313m] − [(1 − 0.35) × 0.420m] = $0.595m

Calculate the terminal value as of the end of Stage 1 based on Year 6 FCFE (2.023m), required return
on equity (13%), and the long-term constant growth rate (6%):

2023
Terminal value in Year 5 = = $28.901m
(0.13 − 0.06)

Next, calculate the value of equity as the sum of the present values of Stage 1 FCFE and the present
value of the terminal value:

0.595 0.803 1.056 1.352 1.681 + 28.901

Value of equity = + + + + = $19.31m
(1.13)1 (1.13)2 (1.13)3 (1.13)4 (1.13)5

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 Free Cash Flow Valuation

Three-Stage Free Cash Flow Models

LOS: Explain the single-stage (stable-growth), two-stage, and three-stage FCFF and FCFE
models and justify the selection of the appropriate model given a company's characteristics.

LOS: Estimate a company's value using the appropriate free cash flow model(s).

LOS: Describe approaches for calculating the terminal value in a multistage valuation model,
and evaluate whether a stock is overvalued, fairly valued, or undervalued based on a free cash
flow valuation model.

Exhibit 10 Three-stage Free Cash Flow models

Three stage: Three stage:

2nd stage constant g 2nd stage declining g

High High
growth growth
Transition
Transition
Stable Stable

Time Time

Three-stage models are straightforward extensions of two-stage models. There are two primary versions of
three-stage models:

● Each stage has a constant but different growth rate.

● Stages 1 and 3 have constant but different growth rates, and Stage 2 has a declining growth rate.

As is the case with two-stage models, the growth rate could refer to FCFF, FCFE, sales, profits, or any other
component of free cash flow.

After calculating the intrinsic value per share from the differently staged free cash models, analysts can
determine whether the stock is undervalued or overvalued. If the intrinsic value is greater than the market
price, then the stock is undervalued. Conversely, if the intrinsic value is less than the market price, then the
stock is overvalued.

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Learning Module 1

Example 9 Calculating value based on the three-stage FCFE model

Jeremy Traders' most recent FCFE/per share amounted to $1.25. An analyst has the following
expectations regarding the company's growth in FCFE:

● FCFE will grow at a rate of 35% for the next 3 years, during which investors' required rate of return
will be 25%.
● During the following 3 years, FCFE growth will decline by 10% per year toward its stable long-term
growth rate. During this time, investors' required rate of return will be 20%.
● From Year 7 onward, FCFE will grow at a stable long-term growth rate of 5%, during which investors'
required rate of return will be 10%.

The company's stock is currently trading at $35.00 per share. Determine whether the stock is
undervalued or overvalued based on the intrinsic value of the company's common stock.

Solution

FCFE per share for the next 7 years and relevant present values are:

Stable
High growth period Transitional period g growth
g = 35% declines by 10% each year g = 5%

Year 0 1 2 3 4 5 6 7

FCFE ($) 1.250 1.688 2.278 3.075 3.844 4.421 4.642 4.874
Terminal value in Year 6 97.483
Discount factors 0.800 0.640 0.512 0.427 0.356 0.296
Present values 1.350 1.458 1.575 1.640 1.572 30.259
Sum of Present Values 37.854

The terminal value as of the end of Stage 2 (Year 6) is computed based on FCFE in Year 7 (4.874), the
Stage 3 required return on equity (10%), and the Stage 3 constant growth rate (5%):

4.874
Terminal Value = = $97.48
(0.10 − 0.05)

The value of the company's stock is estimated as the sum of the present values of forecasted FCFEs
for each year during the first two stages and the present value of the terminal value. In calculating the
present values, be careful about the discount rates applied to each year's cash flow.

1.688 2.278 3.075

Value of stock = + +
(1.25)1 (1.25)2 (1.25)3
3.844 4.421 4.642 + 97.483
+ + + = $37.854
(1.25)3 (1.2)1 (1.25)3 (1.2)2 (1.25)3 (1.2)3

Since the intrinsic value of $37.85 is greater than the market price of $35.00, the stock is undervalued.

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 Free Cash Flow Valuation

Integrating ESG Factors in Free Cash Flow Models

Environmental, social, and governance (ESG) factors, both quantitative and qualitative, can materially impact
valuation. Quantitative ESG factors (eg, carbon-emission fines, employee lawsuits) are easier to integrate
into valuation models. In contrast, qualitative ESG factors are more difficult to integrate. The typical but
highly subjective approach is for analysts to adjust the cost of equity by adding an estimated risk premium. If
considerable ESG risks exist, analysts should consider downward adjustments to their valuation results.

Nonoperating Assets and Firm Value

LOS: Estimate a company's value using the appropriate free cash flow model(s).

Exhibit 11 Components of firm value

Equity value
Market value of debt Value of operating assets
Market value of preferred stock
Excess cash
Excess marketable securities Value of nonoperating assets
+ Vacant land

Firm value

So far, the discussion has focused on calculating firm value based on a firm's operating assets (ie, assets
that generate cash flows). For firms that contain large amounts of nonoperating assets (ie, excess cash,
excess marketable securities, speculative land), analysts should add the value of nonoperating assets to
operating assets to estimate the firm's value. In an acquisition, an acquirer would still be required to pay for
the nonoperating assets.

Value of firm = Value of operating assets + Value of nonoperating assets

Example 10 Value of nonoperating assets

Consider the following information regarding PS Manufacturing (PSM):

● Value obtained from FCFF model = $510 million

● Market value of cash and short-term investments = $75 million
● Book value of land held as an investment = $35 million
● Market value of land held as an investment = $50 million
● Bonds and notes outstanding = $275 million
● Number of shares outstanding = 150 million

Based on this information, determine the value of PSM stock.

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Learning Module 1

Solution

First, compute the total value of nonoperating assets (cash, short-term investments, and investment in
land) held by the company:

Value of nonoperating assets = 75 + 50 = 125 million

Then determine the total value of the company as the sum of value of operating assets (obtained from
the FCFF model) and non operating assets:

Total value of firm = 510 + 125 = 635 million

The value of equity is the value of the firm net of the value of debt:

Equity value = 635 − 275 = 360 million

Therefore, the stock price is $360 million / 150 million shares = $2.40 per share.

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Learning Module 2
Market-Based Valuation:
Price and Enterprise Value Multiples

LOS: Contrast the method of comparables and the method based on forecasted fundamentals
as approaches to using price multiples in valuation and explain economic rationales for
each approach.

LOS: Calculate and interpret a justified price multiple.

LOS: Describe rationales for and possible drawbacks to using alternative price multiples and
dividend yield in valuation.

LOS: Calculate and interpret alternative price multiples and dividend yield.

LOS: Calculate and interpret underlying earnings, explain methods of normalized earnings per
share (EPS), and calculate normalized EPS.

LOS: Explain and justify the use of earnings yield (E/P).

LOS: Describe fundamental factors that influence alternative price multiples and dividend yield.

LOS: Calculate and interpret a predicted P/E, given a cross-sectional regression on

fundamentals, and explain limitations to the cross-sectional regression methodology.

LOS: Calculate and interpret the justified price-to-earnings (P/E), price-to-book (P/B), and price-
to-sales (P/S) for a stock, based on forecasted fundamentals.

LOS: Calculate and interpret the P/E-to-growth (PEG) ratio and explain its use in
relative valuation.

LOS: Calculate and explain the use of price multiples in determining terminal value in a
multistage discounted cash flow (DCF) model.

LOS: Evaluate whether a stock is overvalued, fairly valued, or undervalued based on

comparisons of multiples.

LOS: Evaluate a stock by the method of comparables and explain the importance of
fundamentals in using the method of comparables.

LOS: Explain alternative definitions of cash flow used in price and enterprise value (EV)
multiples and describe limitations of each definition.

LOS: Calculate and interpret EV multiples and evaluate the use of EV/EBITDA.

LOS: Explain sources of differences in cross-border valuation comparisons.

LOS: Describe momentum indicators and their use in valuation.

LOS: Explain the use of the arithmetic mean, the harmonic mean, the weighted harmonic mean,
and the median to describe the central tendency of a group of multiples.

Vol 4-31
Learning Module 2

Introduction

LOS: Contrast the method of comparables and the method based on forecasted fundamentals
as approaches to using price multiples in valuation and explain economic rationales for
each approach.

Valuation multiples are used to estimate a stock’s value from a performance indicator, often based on some
measure of earnings:

y Price multiples are ratios of a company’s equity market price to a measure of value, based on
performance (eg, company earnings), or asset values.
y EV multiples are ratios of the total market value of a company’s capital (from all sources) to a measure
of company value, based on performance (eg, EBITDA), or asset values.
y Momentum indicators are time-series indicators that relate either the stock price or a fundamental
factor to its value in the past.

Multiples are commonly used to estimate whether a stock price is overvalued, fairly valued, or undervalued
by the market.

Price and EV Value Multiples in Valuation

The Method of Comparables

The method of comparables refers to valuation based on multiples of comparable (similar) companies that
serve as the benchmark in the valuation. The method of comparables is based on the “law of one price” (ie,
similar assets should be priced similarly [or trade at similar multiples]).

For example, the value of a company’s stock may be estimated by multiplying its EPS by the P/E multiple
of a comparable company or a benchmark P/E multiple. This value can then be compared with the stock’s
current market price to assess whether the stock is overvalued, undervalued, or fairly valued relative to the
benchmark. Equivalently, the stock’s actual P/E ratio can be compared with the benchmark P/E multiple to
assess relative value.

Note that this valuation is relative to comparable companies or to a benchmark. To be effective, the
choice of comparable companies and/or benchmark must be appropriate, and their multiple must be
efficiently priced.

The Method Based on Forecast Fundamentals

The method of forecasted fundamentals refers to valuation based on multiples that are derived from
forecasts of the company’s own fundamentals, rather than comparisons with other companies. Company
fundamentals refer to characteristics of the business related to profitability, growth, or financial strength.

A justified price multiple for a stock refers to the estimate of the fair value of a price multiple that can be
justified, either on the basis of the method of comparables or on the basis of the method of forecasted
fundamentals. The justified price multiple is the value that the multiple would take if the stock were currently
trading at its fair value. If the justified price multiple is larger (smaller) than the actual current multiple of the
stock, the stock is undervalued (overvalued).

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 Market-Based Valuation: Price and Enterprise Value Multiples

Example 1 Calculating P/E based on the method of comparables

Star Manufacturers’ stock is currently trading at $42. The company reported EPS of $3 last year. Given
that the average trailing P/E of peer companies is 12, comment on whether Star’s stock is undervalued,
overvalued, or fairly valued.

Solution

Trailing P/E = 42/3 = 14

Since Star’s actual trailing P/E (14) is a higher-than-average trailing P/E of peer companies (12), it is
relatively overvalued.

Alternately, estimate the value of Star’s stock by applying the benchmark P/E to its EPS and compare it
with its market price.

Estimated value = 3 × 12 = $36

Star’s actual market price ($42) is higher than its intrinsic value ($36), so Star is relatively overvalued.

Example 2 Calculating P/E based on forecasted fundamentals

The stock of Jeremy Traders is currently trading at $27 per share. The following information is also
available:

y Next year’s expected EPS = $3

y Dividend payout ratio = 40%
y Required rate of return on equity = 12%
y Long-term growth rate = 6%
1. Calculate the stock’s leading P/E multiple based on its market price.
2. Calculate the stock’s leading P/E multiple based on its fundamental value using the Gordon
growth model, and comment on whether its shares are undervalued, overvalued, or fairly valued.

Solution

Leading P/E ratio = 27/3 = 9

Next year’s expected dividend = 3 × 0.4 = 1.2

D1 1.2
Intrinsic Value = = = 20
r−g 0.12-0.06

20
Leading PE ratio = = 6.67
3

Since the stock’s actual P/E ratio (9) is higher than the P/E ratio based on its fundamentals (6.67), it is
overvalued.

Vol 4-33
Learning Module 2

Price/Earnings: The Basics

LOS: Calculate and interpret a justified price multiple.

LOS: Describe rationales for and possible drawbacks to using alternative price multiples and
dividend yield in valuation.

LOS: Calculate and interpret alternative price multiples and dividend yield.

LOS: Calculate and interpret underlying earnings, explain methods of normalizing earnings per
share (EPS), and calculate normalized EPS.

LOS: Explain and justify the use of earnings yield (E/P).

Price/Earnings
The price-to-earnings (P/E) ratio has several advantages and disadvantages. The advantages include:

y Earnings are key drivers of stock value.

y The ratio is simple to calculate and interpret and is widely accepted by investors.
y According to empirical research, differences in P/E ratios are significantly related to long-term average
stock returns.

Some disadvantages include:

y Companies that have negative earnings have negative EPS and P/E ratios. Negative P/E ratios are not
informative and thus not useful in relative valuation.
y It may be difficult to separate the recurring components of earnings that drive intrinsic value from the
transient components.
y Management may use different accounting assumptions to prepare financial statements, which distorts
reported EPS and reduces the comparability of P/E ratios across companies.

Alternative Definitions of P/E

There are alternative definitions of the P/E ratio based on the time horizon for the measurement of earnings:

y Trailing P/E is based on earnings over the last four quarters (or trailing 12 months [TTM]) and is
generally used when earnings are expected to be volatile going forward and cannot be forecasted
accurately.
y Normalized P/E is based on the average year earnings over a longer time. If a company has negative
earnings in the most recent 12-month period, it may be more meaningful to use normalized earnings
in the ratio.
y Leading or forward P/E is based on next year’s expected earnings. The “next year” can be defined
as (1) the next four quarters, (2) the next 12 months, or (3) the next fiscal year. The leading P/E ratio
should be used if a company’s business has changed fundamentally (eg, due to an acquisition or
divesture) such that use of the trailing P/E (which is based on past EPS) would not be appropriate.

Calculating the Trailing P/E

Analysts should consider the potential dilution of EPS by dilutive securities, such as convertible bonds,
convertible preferred shares, and stock options, that the company has issued. Because companies must

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 Market-Based Valuation: Price and Enterprise Value Multiples

report both basic and diluted EPS, this information is readily available. Note that P/E calculated with diluted
EPS will be greater than P/E calculated with basic EPS.

ANALYST ADJUSTMENTS FOR NONRECURRING ITEMS

The analyst’s focus should be on estimating recurring earnings, which should eliminate nonrecurring items.
Some examples of nonrecurring items include gains and losses from the sale of assets, asset write-downs,
goodwill impairment, provisions for future losses, and changes in accounting estimates.

ANALYST ADJUSTMENTS FOR BUSINESS-CYCLE INFLUENCES

In addition to company-specific effects, transitory effects on earnings can come from business-cycle or
industry-cycle influences. Business-cycle effects can be expected to recur in subsequent cycles, but the
most recent four quarters might not reflect the long-term earning power. Trailing EPS for cyclical stocks
will be lower at the bottom of a cycle and higher at the top of the cycle, causing the P/E to be higher at the
bottom of the cycle and lower at the top of the cycle. This countercyclical property of P/E ratios is known as
the Molodovsky effect.

One way to adjust for this is by estimating a normal or normalized (mid-cycle) EPS. The two most common
ways to calculate mid-cycle EPS are:

y Historical average EPS

y Average return on equity

ANALYST ADJUSTMENTS FOR COMPARABILITY

Analysts should be aware of accounting assumptions, such as inventory valuation or depreciation methods,
that affect the comparability of peer companies’ earnings.

DEALING WITH EXTREMELY LOW, ZERO, OR NEGATIVE EARNINGS

Zero and negative earnings can pose problems if the analyst is ranking P/E ratios. Generally, a lower P/E
ratio is preferable because it indicates that the investor is paying a lower price for earnings. However, if the
company has negative earnings, the P/E ratio will also be negative despite having a higher relative price
than other companies with positive earnings. For this reason, the P/E ratio is not meaningful if the company
has negative earnings.

One approach to accommodating negative earnings is to use normalized earnings; another is to use
forward EPS and forward P/E if historical EPS is negative.

Yet another solution is to use the inverse of the P/E ratio, (E/P), the earnings yield. This ratio shows
earnings (per share) as a percentage of price (per share), and, in that sense, is a measure of return on
investment, which can be ranked for comparison.

Forward P/E
Because valuation is forward-looking, the forward P/E ratio is a logical alternative to the trailing P/E ratio.
The forward P/E ratio can be based on earnings estimated for the next four quarters, the next 12 months
(NTM), or the next fiscal year. If the next calendar year encompasses two different fiscal years, earnings
can be based on a weighted average of the fiscal years’ projected earnings. For companies with volatile
earnings, forward P/E estimates may be less reliable.

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Learning Module 2

Calculating the Trailing and Forward P/E

Example 3 Calculating trailing and forward price-to-earnings ratios

On December 31, 20X8, the stock of Alpha Associates was trading at $32.80. The following information
is provided:

y EPS for 20X8 = $2.50

y Expected EPS in the first quarter of 20X9 = $0.47
y Expected EPS in the second quarter of 20X9 = $0.75
y Expected EPS in the third quarter of 20X9 = $0.83
y Expected EPS in the fourth quarter of 20X9 = $0.80

Calculate Alpha’s:

1. Trailing P/E ratio.

2. Forward P/E ratio.

Solutions

1.

Current stock price 32.80

Trailing P/E ratio = = = 13.12
EPS2009 2.50

2.

Current stock price 32.80

Forward P/E ratio = = = 11.51
Expected EPS (0.47 + 0.75 + 0.83 + 0.80)

To make the P/E ratios comparable, analysts should apply the same definition (trailing or forward P/E
ratio) to all companies and time periods covered in the analysis.

Price/Earnings: Valuation Based on Forecasted Fundamentals

LOS: Describe fundamental factors that influence alternative price multiples and dividend yield.

LOS: Calculate and interpret a predicted P/E, given a cross-sectional regression on

fundamentals, and explain limitations to the cross-sectional regression methodology.

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 Market-Based Valuation: Price and Enterprise Value Multiples

Justified P/E
The simplest of all the discounted cash flow (DCF) models is the constant growth model using dividends:
D1
P0 =
(r – g)

This model can easily be adjusted to calculate a justified forward P/E ratio:

P0 D1/E1 1–b
= =
E1 (r – g) (r – g)

This formula can easily be adjusted for a trailing P/E ratio.

P0 D0(1 + g)/E0 (1 + b)(1 + g)

= =
E0 (r + g) (r – g)

Where:
P0 = Current price
E0 = Trailing earnings
E1 = Forward earnings
D1 = Expected dividend
D0 = Recent dividend
r = Required rate of return
g = Dividend growth rate
b = Earnings retention rate

The justified (fundamental) P/E ratio can be compared to the observed P/E ratio to determine whether the
stock is undervalued, fairly valued, or overvalued.

The logic from other valuation models carries over to the justified P/E ratio: a higher growth rate or a lower
required return translates to a greater intrinsic value for the stock and a greater justified P/E ratio.

Predicted P/E Based on Cross-Sectional Regression

The predicted P/E ratio is conceptually similar to the justified P/E ratio, except that, instead of using the
Gordon growth model to derive an estimated P/E ratio, the analyst derives a regression formula using any
set of explanatory values. As with all regressions, the analyst should try to avoid multicollinearity among the
independent variables.

Although the cross-sectional regression can summarize a large amount of data into a single equation, it is
not used frequently since:

y The valuation relationship captured by this method applies only to the specific stock in a specific
time-period.
y Regression coefficients and their explanatory power diminish over time.
y Multicollinearity between independent variables complicates the interpretation of individual regression
coefficients.

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Learning Module 2

Price/Earnings: Using the P/E in Valuation

LOS: Calculate and interpret the justified price-to-earnings ratio (P/E), price-to-book ratio (P/B),
and price-to-sales (P/S) for a stock, based on forecasted fundamentals.

LOS: Calculate and interpret the P/E-to-growth (PEG) ratio and explain its use in
relative valuation.

LOS: Calculate and explain the use of price multiples in determining terminal value in a
multistage discounted cash flow (DCF) model.

LOS: Evaluate whether a stock is overvalued, fairly valued, or undervalued based on

comparisons of multiples.

Using any multiple in the method of comparables involves the following steps:

y Select and calculate the price multiple that will be used.

y Select the comparison asset or assets and calculate the value of the multiple for the comparison
asset(s). If using a group of assets use the mean or median of the multiple for those assets. In either
case, that will become the benchmark value of the multiple.
y Use the benchmark value of the multiple (adjusted if necessary) to estimate a value for the
company’s stock.
y Assess whether differences between the estimated value and the current price can be explained by
fundamental differences and modify conclusions accordingly.

Peer-Company Multiples
Multiplying the benchmark P/E ratio by the company’s EPS provides an estimate of the stock’s value that
can be compared with the stock’s market price. If the subject stock has higher-than-average (or higher-than-
median) expected earnings growth than a P/E ratio higher than the benchmark, P/E ratio is justified. If the
risk is higher than the average (or median) than a P/E ratio lower than the benchmark, P/E ratio is justified.

The P/E-to-growth (PEG) ratio attempts to incorporate earnings growth on the P/E ratio. The PEG ratio is
calculated as the ratio of the P/E ratio to the expected earnings growth rate. In effect, it is a calculation of
units of P/E ratio per units of growth; some consider a PEG ratio of less than 1 to be an attractive level. This
ratio must be used with caution because the PEG ratio:

y incorrectly assumes a linear relationship between the P/E ratio and the expected growth rate
y does not factor in differences in duration of growth
y does not take into account differences in risk

Industry and Sector Multiples

The mechanics of using industry multiples are identical to those used for peer group comparisons; however,
some databases report only the mean multiple when an analyst might prefer to use the median industry
multiple as the benchmark.

Comparisons with broader segments of the economy can also provide insights, but the more likely
the important differences in fundamentals, the more dissimilar the subject company in relation to
the benchmark.

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 Market-Based Valuation: Price and Enterprise Value Multiples

Overall Market Multiple

The logic of the comparables approach dictates that similar assets should be priced at similar multiples, and
although this is more likely to hold for peer groups, industries, and sectors than for a broader market, some
analysts use an equity market index multiple as the comparison asset. The mechanics of using the method
of comparables do not change when comparing to an equity index, but the user should take into account
the differences between the benchmark and the subject company.

Factors to consider when using an index P/E as a benchmark include the index weighting, the efficient
pricing of the index, and the time horizon the market multiple reflects.

Most equity indexes are market-cap weighted, and databases often report the weighted average market
P/E ratio with the individual company P/E ratios weighted by the market cap. This gives larger market cap
companies more weight in the market P/E ratio calculation. However, there is some evidence that P/Es
differ systematically by market cap (eg, the use of the “size” factor used in the Fama-French factor model),
which would need to be factored into the comparison to the benchmark.

As with any comparison, it is important to note whether the index constituents are efficiently priced, or
whether their P/Es are influenced by interest rates, by the stage of the business cycle, or by some other
macro event that causes the entire market to be over- or undervalued, for example.

The time frame is relevant to identifying whether the index constituents are under- or overvalued relative to
their own historical averages.

There have also been attempts to estimate whether the market itself is under- or overvalued, using
extensions of the method of comparables. The Fed model (created by three analysts at the US Federal
Reserve) explores the relationship between the P/E and the rate of the 10-year US Treasury yield, based
on the inverse relationship between equity value and interest rates. The Yardeni model explores the
relationship between earnings yields and corporate bond yields and expected earnings growth.

Exhibit 1 Fed and Yardeni models

Model Justified P/E Components

P 1
Fed = Y10 = 10-year US T-Bond yield
E Y10

CBY = A-rated corporate bonds yield

P 1 LTEG = Market index 5-year earnings
Yardeni =
E (CBY – b × LTEG) growth rate

b = Weight the market give to LTEG

Own Historical P/E

A common alternative to comparing a subject company to other company’s stocks is to use past values of
its own P/E multiple. This approach assumes that the multiple will regress toward its historical average. In
addition to a relative comparison, this approach can also be used to calculate a justified price.

The assumption that a stock’s P/E should regress to its historical P/E assumes that company-specific
factors (business mix, leverage, etc.) and external factors (inflation, interest rates, etc.) will remain
constant over time.

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Learning Module 2

P/Es in Cross-Country Comparisons

When comparing P/E ratios of companies in different countries, analysts should be aware of the effects
of accounting standards on EPS and should also take into account that the benchmarks used will also be
affected by different macroeconomic contexts (eg, different rates of inflation).

Using P/Es to Obtain Terminal Value in Multistage Dividend Discount Models

When multistage models in a DDM or spreadsheet modeling are used to value a stock, the process requires
a terminal value, which reflects long-term growth. Analysts often use a terminal price multiple based on
fundamentals or on comparables.

Price/Book Value

LOS: Calculate and interpret a justified price multiple.

LOS: Describe rationales or and possible drawbacks to using alternative price multiples and
dividend yield in valuation.

LOS: Calculate and interpret alternative price multiples and dividend yield.

LOS: Describe fundamental factors that influence alternative price multiples and dividend yield.

LOS: Calculate and interpret the justified price-to-earnings ratio (P/E), price-to-book ratio (P/B),
and price-to-sales (P/S) for a stock, based on forecasted fundamentals.

LOS: Evaluate a stock by a method of comparables and explain the importance of fundamentals
in using a method of comparables.

LOS: Evaluate whether a stock is overvalued, fairly valued, or undervalued based on

comparisons of multiples.

The price-to-book (P/B) value multiple has a long history of use in valuation. This approach has several
advantages and disadvantages. The advantages include:

y Book value usually remains positive even when the company reports negative earnings.
y Book value is typically more stable over time compared to reported earnings.
y For financial sector companies that have significant holdings of liquid assets, such as banks or
insurers, P/B is more meaningful because book values reflect recent market values.
y P/B is useful in valuing companies that are expected to go out of business.
y Studies suggest that differences in P/B ratios over time are related to differences in long-term average
returns on stocks.

The disadvantages include:

y Book values ignore some intangible “assets” such as the quality of a company’s human capital and
brand image, as they are not reflected on the balance sheet.
y P/B can lead to misleading valuations if significantly different levels of assets are used (due
to differing business models) by the companies being studied. For example, a company that
outsources production will have fewer fixed assets and a higher P/B ratio than a similar firm that does
not outsource.

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 Market-Based Valuation: Price and Enterprise Value Multiples

y Accounting differences can impair the comparability of P/B ratios across companies. For example,
rules for capitalization of R&D costs vary across sets of accounting standards.
y In most cases, book values of assets are based on historical cost adjusted for accumulated
depreciation. Over time, inflation and changes in technology may result in significant differences
between accounting book values and actual market values of a company’s assets and can reduce the
comparability of P/B ratios across companies.
y Share repurchases or issuances can distort historical P/B comparisons.

The P/B ratio is calculated as:

Market price per share

P/B ratio =
Book value per share

Market value of common shareholders’ equity

P/B ratio =
Book value of common shareholders’ equity

Determining Book Value

The calculation of the book value of equity can be understood using the following formulas:

Book value of equity = Common shareholders' equity

Common shareholders’ equity = Shareholders’ equity – Equity claims that are senior to common stock

Book value of equity = Total assets – Total liabilities – Preferred stock

Analysts usually make the following adjustments to book value to (1) make book value more reflective of the
shareholders’ investment and (2) increase its comparability across companies:

y Certain intangible assets are removed from total assets on the balance sheet, and shareholders’ equity
is adjusted (downward) accordingly.
○ It makes sense to remove items such as goodwill from book value because goodwill is not a
separately identifiable asset and merely represents an “overpayment” for an acquisition.
○ However, removal of individual intangibles such as patents may not be justified because they can be
separated from the entity and sold.

y Certain adjustments are required to eliminate the effects of differences in accounting standards across
companies. For example, in an inflationary environment, the book value (and assets) of a LIFO firm
must be revised upward to make comparisons with a FIFO firm.
y Certain off-balance sheet assets and liabilities (eg, debt guarantees) must be accounted for in the
calculation of book value.
y Certain balance sheet (historical) values may need to be adjusted to reflect (current) fair value.

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Learning Module 2

Example 4 Calculating P/B ratio

The following table contains the equity portion of ADF Company’s balance sheet:

(in $)
Common stock (issued 20,000 common shares) 200,000
Preferred stock (issued 1,000 preferred shares) 25,000
Additional paid-in capital 1,000
Retained earnings 43,875
Total shareholders’ equity 269,875

The current market price of ADF stock is $14.35. Calculate its P/B ratio.

Solution

Common shareholders’ equity = Total shareholders’ equity – Total value of preferred stock

$244,875 = $269,875 – 25,000

$244,875
Book value per share = = 12.24
20,000

$14.35
P/B ratio = = 1.17
$12.24

Valuation Based on Forecasted Fundamentals

Using the Gordon growth model and defining the sustainable growth rate as g = ROE × b, the formula for
justified P/B ratio using the most recent book value is:

P0 (ROE – g)
=
B0 (r – g)

The practical insight is that a justified P/B ratio cannot be known without knowing the company’s profitability
(ie, ROE). Furthermore, when comparing two companies with similar P/B ratios, the company that has a
higher ROE is relatively more undervalued.

Valuation Based on Comparables

Evaluation of relative P/Bs should consider differences in ROE, risk, and expected earnings growth.

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 Market-Based Valuation: Price and Enterprise Value Multiples

Price/Sales

LOS: Calculate and interpret a justified price multiple.

LOS: Describe rationales or and possible drawbacks to using alternative price multiples and
dividend yield in valuation.

LOS: Calculate and interpret alternative price multiples and dividend yield.

LOS: Describe fundamental factors that influence alternative price multiples and dividend yield.

LOS: Calculate and interpret the justified price-to-earnings ratio (P/E), price-to-book ratio (P/B),
and price-to-sales (P/S) for a stock, based on forecasted fundamentals.

LOS: Evaluate a stock by a method of comparables and explain the importance of fundamentals
in using a method of comparables.

LOS: Evaluate whether a stock is overvalued, fairly valued, or undervalued based on

comparisons of multiples.

Some private companies, including investment management firms and some partnerships, have long been
valued using a multiple of net revenues. As with other valuation multiples this ratio has advantages and
disadvantages. Advantages include:

y Sales are less prone to manipulation by management than earnings and book values.
y Sales are positive even when earnings are negative.
y The P/S ratio is usually more stable than the P/E ratio because earnings reflect operational and
financial leverage.
y P/S ratios are especially appropriate for valuing mature, cyclical, and loss-making companies.
y Studies have shown that differences in P/S ratios are related to differences in long-term average
returns on stocks.

Disadvantages of the P/S ratio include:

y Using sales reveals no information about the operating profitability of a company. Ultimately, a
company derives its value from its ability to generate profits.
y Using the P/S ratio does not reflect differences in cost structure and operating efficiency
between companies.
y There is a “logical mismatch” when price (which reflects the effects of debt finance, profitability, and
risk) is compared with sales (which is a prefinancing measure of income).
y Management can manipulate revenue figures (eg, recognizing sales made on bill-and-hold basis in the
current period or inflating sales through barter transactions).
y The relatively stable nature of sales may not reflect a sudden change in a key indicator (eg, rise in
interest expense causes a sharp decline in earnings when sales are stable).

The P/S ratio is calculated as:

Market price per share

P/S ratio =
Sales per share

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Learning Module 2

Analysts should also be familiar with the relationship between the P/E ratio and the P/S ratio:

P
E
× Net profit margin = ( EP × ES ) = SP
Therefore, for two companies with the same positive P/E ratios, the company with the higher P/S ratio will
have a higher net profit margin.

Example 5 Calculating P/S ratio

The stock of Gamma Corp. is currently trading at $25. The company just reported sales amounting
to $12.5 million and has 2 million shares outstanding. Given that the benchmark P/S multiple is 5.5,
comment on whether the stock is undervalued, overvalued, or fairly valued on a relative basis.

Solution

First calculate sales per share:

12.5m
Sales per share = = $6.25
2m

And then compute the P/S ratio:

P 25
= = 4.17
S 6

Because the benchmark P/S multiple (5.5) is higher than the Gamma’s P/S multiple (4.17), the stock
appears to be relatively undervalued.

Determining Sales
Generally, an analyst uses annual sales from the company’s most recent fiscal year in the calculation.
However, given that valuation is fundamentally forward looking, some analysts calculate the P/S ratio based
on next year’s forecasted sales. The analyst should evaluate the company’s revenue recognition policies.

Valuation Based on Forecasted Fundamentals

As with other multiples, the P/S multiple can be based on the Gordon growth model:

E
� 1 �(1 − b)
P0 S1 Net margin × Payout ratio
= =
S1 (r − g) (r − g)

Valuation Based on Comparables

Using a P/S in the method of comparables to value stocks follows the same steps as for using the P/E ratio
with the method of comparables. Analysts may use the P/S based on reported sales or based on forecasted
sales. If using the method of comparables, analysts should also consider profit margins, risk, and expected
earnings growth. Accounting differences should also be taken into account.

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 Market-Based Valuation: Price and Enterprise Value Multiples

Price/Cash Flows

LOS: Calculate and interpret a justified price multiple.

LOS: Describe rationales or and possible drawbacks to using alternative price multiples and
dividend yield in valuation.

LOS: Calculate and interpret alternative price multiples and dividend yield.

LOS: Describe fundamental factors that influence alternative price multiples and dividend yield.

LOS: Calculate and interpret the justified price-to-earnings ratio (P/E), price-to-book ratio (P/B),
and price-to-sales (P/S) for a stock, based on forecasted fundamentals.

LOS: Evaluate a stock by a method of comparables and explain the importance of fundamentals
in using a method of comparables.

LOS: Evaluate whether a stock is overvalued, fairly valued, or undervalued based on

comparisons of multiples.

The price-to-cash flow (P/CF) indicator is a widely reported valuation indicator. Analysts should be careful to
understand (and communicate) the exact definition of “cash flow.”

Advantages of the P/CF ratio include:

y Cash flows are less prone to management manipulation than earnings.

y The P/CF ratio is more stable than the P/E ratio.
y Using the P/CF ratio sidesteps the problem related to differences in the quality of earnings reported
by companies.
y Research has shown that differences in the P/CF ratio over time are related to differences in long-term
average returns on stocks.

Possible drawbacks include:

y When “EPS plus noncash charges” is used as the definition for cash flow, noncash revenue and
changes in working capital items are ignored.
y FCFE is more appropriate for valuing a company than operating cash flow. However, FCFE has the
following drawbacks:
○ For many businesses, it is more volatile than operating cash flow.
○ It is more frequently negative than operating cash flow.

y Management may be able to inflate reported CFO by:

○ securitizing accounts receivable.
○ outsourcing payments of accounts payable (to delay outflows of cash).

The P/CF ratio is calculated as:

Market price per share

P/CF ratio =
Free cash flow per share

Analysts usually calculate the trailing P/CF ratio, which uses cash flow from the four most recent quarters.

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Learning Module 2

Determining Cash Flow

Analysts and data venders often use approximations of cash flow from operating activities in calculating
cash flow or price-to-cash-flow. One approximation is merely to take EPS and add back depreciation,
amortization, and depletion. Other cash flow concepts that are more technically accurate include EBITDA,
cash flow from operating activities, and FCFE. Analysts may find that ranking companies by P/CFO differ
from ranking P/FCFE because period-by-period FCFE is often more volatile than CFO.

Example 6 Calculating P/CF ratio

An analyst gathered the following information regarding Mercury Inc:

y Market price per share = $26

y Total earnings = $4.8 million
y Depreciation and amortization = $0.85 million
y Total number of shares outstanding = 2 million

Using EPS plus noncash charges as a proxy for free cash flow, calculate the company’s P/CF ratio.

Solution:

4,800,000
EPS = = 2.40
2,000,000

850,000
Depreciation and amortization per share = = 0.425
2,000,000

CF per share = EPS + noncash charges per share = 2.40 + 0.425 = $2.825

P 26
= = 9.20
CF 2.825

Valuation Based on Forecasted Fundamentals

As with the justified price multiples already covered in this learning module, the price-to-trailing FCFE
multiple is based on the constant growth model (the Gordon growth model).

FCFE0(1 + g)
V0 =
(r – g)

Then:

P0 (1 + g)
=
FCFE0 (r – g)

The formula for the price-to-forward FCFE is:

P0 1
=
FCFE1 (r – g)

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 Market-Based Valuation: Price and Enterprise Value Multiples

Valuation Based on Comparables

The method of comparables for valuing stocks based on price to cash flow follows the steps previously
given and illustrated for the P/E, P/B, and P/S ratios.

Price/Dividends and Dividend Yield

LOS: Calculate and interpret a justified price multiple.

LOS: Describe rationales or and possible drawbacks to using alternative price multiples and
dividend yield in valuation.

LOS: Calculate and interpret alternative price multiples and dividend yield.

LOS: Describe fundamental factors that influence alternative price multiples and dividend yield.

LOS: Calculate and interpret the justified price-to-earnings (P/E) ratio, price-to-book (P/B) ratio,
and price-to-sales (P/S) ratio for a stock, based on forecasted fundamentals.

LOS: Evaluate a stock by a method of comparables and explain the importance of fundamentals
in using a method of comparables.

LOS: Evaluate whether a stock is overvalued, fairly valued, or undervalued based on

comparisons of multiples.

Dividend yield data are frequently reported to provide investors with an estimate of the dividend yield
component in total return. The advantage of using the dividend yield to valuation are:

y Dividend yield is a component of total return.

y Dividends are a less risky component of total return than capital appreciation.

Potential drawbacks include:

y Dividend yield is only one component of total return.

y Investors may trade off lower dividend yields for higher future earnings growth (displacement
of earnings).
y The argument that dividends are relatively safe assumes that market prices reflect differences in
relative risk between the two components of total return.

Calculation of Dividend Yield

The dividend yield is calculated as the dividend per share as a percentage of the price of the stock; as such,
it is a measure of one kind of return on investment.

The trailing dividend yield is calculated by dividing the dividend rate by the current market price of the stock.

y For companies paying quarterly dividends, the dividend rate is four times the most recent
quarterly dividend.
y For companies that pay semiannual dividends in which the interim dividend typically differs from the
final dividend, the dividend rate is the most recent annual per-share dividend.

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Learning Module 2

The leading dividend yield calculates next year’s forecasted dividends per share (dividends expected over
the next four quarters, the next 12 months, or the next fiscal year) as a percentage of the current market
price of the stock.

Example 7 Calculating trailing and leading dividend yield

On June 30, 20X2, the stock of Pyramid Inc. was trading at $42.50 per share. The following information
regarding the company’s quarterly dividends is also available:

Dividends paid per share on:

y September 30, 20X1 = $0.45

y December 31, 20X1= $0.48
y March 31, 20X2 = $0.50
y June 30, 20X2 = $0.50
y Next year’s dividend is expected to be $2.40 per share.

Calculate the company’s trailing dividend yield.

Calculate the company’s leading dividend yield.

Solution

Because the company makes quarterly dividend payments, the dividend rate is calculated based on the
most recent dividend declared.

Dividend rate at June 30,20X2 = 0.50 × 4 = $2.00

Dividend rate 2.00

Trailing dividend yield = = = 4.71%
Current price per share 42.50

Net year's dividend 2.40

Leading dividend yield = = = 5.65%
Current price per share 42.50

Example 8 Calculating trailing dividend yield

On June 30, 20X3, the stock of Alton Associates was trading at $22.80 per share. The following
information regarding the company’s historical semi-annual dividends is also available:

Dividends paid per share on:

y December 31, 20X1 = $0.75

y June 30, 20X2 = $0.36
y December 31, 20X2 = $0.80
y June 30, 20X3 = $0.40

Calculate the company’s trailing dividend yield.

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 Market-Based Valuation: Price and Enterprise Value Multiples

Solution

Because the interim semi-annual dividends significantly differ in magnitude from the final dividend, the
dividend rate is calculated as total dividend for the most recent year.

Dividend rate at June 30,20X3 = 0.40 + 0.80 = 1.20

Last year's dividend 1.20

Trailing dividend yield = = = 5.26%
Current price per share 22.80

Valuation Based on Forecasted Fundamentals

The formula for the justified trailing dividend yield can be derived from the Gordon growth model:

D0(1 + g)
V0 =
(r – g)

P0 (1 + g)
=
D0 (r – g)

The formula for justified trailing dividend yield is the following:

D0 (r – g)
=
P0 (1 + g)

Valuation Based on Comparables

Using dividend yield with comparables is similar to using the process that has been illustrated for other
multiples, in which an analyst compares a company with peers to determine whether it is under- or
overvalued. Analysts should also examine differences in expected growth to see if they explain differences
in dividend yield.

To evaluate dividend safety (the probability that the dividend will be reduced or eliminated), the analyst can
look at balance sheet metrics, as well as interest coverage ratio and EBITDA coverage.

EV/EBITDA

LOS: Explain alternative definitions of cash flow used in price and enterprise value (EV)
multiples and describe limitations of each definition.

LOS: Calculate and interpret EV multiples and evaluate the use of EV/EBITDA.

LOS: Evaluate whether a stock is overvalued, fairly valued, or undervalued based on

comparisons of multiples.

EBITDA is calculated by adding depreciation and amortization to EBIT, which in turn is calculated by
adding interest and taxes to net income. Given that EBITDA represents a flow to both equity holders and
bondholders, it should be used as a measure of total company value.

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Learning Module 2

EV/EBITDA
The EV to EBITDA (EV/EBITDA) multiple is the most commonly used EV multiple.

Exhibit 2 EV/EBITDA multiple

Market value of common equity

Net income
+ Market value of preferred stock
EV + Income taxes
+ Minority interest
+ Interest
+ Market value of debt EBITDA
+ Depreciation and amortization
− Cash and short-term investments

EV = Enterprise value

Advantages of the EV/EBITDA multiple include:

y It is more useful than P/E for comparing companies with different levels of financial leverage because
interest expense is included in EBITDA.
y Unlike net income, EBITDA controls for differences in depreciation and amortization between
companies and is therefore more appropriate for valuing capital-intensive businesses.
y EBITDA is often positive even when EPS is negative.

Disadvantages include:

y EBITDA ignores the effects of differences in revenue recognition policies on cash flow from operations.
y EBITDA may overstate cash flow from operations if working capital is growing.
y Free cash flow to the firm (FCFF) may be a better measure (than EBITDA) because it reflects
the amount required for capital expenditures and is therefore more strongly linked to valuation
theory. EBITDA reflects differences in capital programs only if depreciation expenses match capital
expenditures.

Determining EV
The following formula can be used to calculate EV:

EV = Market value of common equity + Market value of preferred stock + Market value of debt
+ Minority interest – Value of cash and short term investments

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 Market-Based Valuation: Price and Enterprise Value Multiples

Example 9 Calculating EV/EBITDA

An analyst gathered the following information regarding Global Investments:

y Number of common shares outstanding = 300,000
y Market price per share = $20
y Market value of preferred stock = $1.5 million
y Market value of debt = $3.5 million
y Cash and short-term investments = $0.8 million
y Revenues = $8 million
y Depreciation and amortization expense = $0.60 million
y Interest expense = $0.10 million
y Taxes = $0.35 million
y Net income = $2.4 million

Calculate the company’s EV/EBITDA ratio.

Solution

EV = Market value of common equity + Market value of preferred stock

+ Market value of debt – Value of cash and short term investments

EV = (300,000 × 20) + 1,500,000 + 3,500,000 – 800,000 = $10,200,000

EBITDA = Net income + Interest + Taxes + Depreciation and amortization

EBITDA = 2,400,000 + 100,000 + 350,000 + 600,000 = $3,450,000

10,200,000
EV/EBITDA = = 2.96x
3,450,000

Valuation Based on Forecast Fundamentals

The same intuition used in valuing price based multiples also applies when using EV/EBITDA in valuation.
The EV/EBITDA ratio should be positively correlated with the expected long-term growth rate and negatively
related to risk (in this case, the weighted average cost of capital [WACC]).

Valuation Based on Comparables

All else equal, a lower EV/EBITDA ratio relative to peers is preferable. However, this is not the only indicator
that should be taken into consideration.

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Learning Module 2

Other EV Multiples

LOS: Explain alternative definitions of cash flow used in price and enterprise value (EV)
multiples and describe limitations of each definition.

LOS: Calculate and interpret EV multiples and evaluate the use of EV/EBITDA.

LOS: Evaluate whether a stock is overvalued, fairly valued, or undervalued based on

comparisons of multiples.

Although EV/EBITDA is the most commonly used EV multiple, other multiples can be used with or instead
of EV/EBITDA. Some examples include:

y EV/FCFF.
y EV/EBITDAR (“R” stands for rent expense).
y EV/EBITA.
y EV/EBIT.

EV/Sales
The major alternative to the P/S ratio is the EV/Sales (EV/S) ratio. The EV/S ratio has several advantages
over the P/S ratio and corrects several conceptual weaknesses. Given that equity holders do not have a
right to all the net revenues but that a portion will be dedicated to paying interest and principal to providers
of debt capital, the EV/S ratio is particularly useful when valuing companies with diverse capital structures.

Example 10 Comparable EV multiples

Susan wants to evaluate the stock of Dagha Corp. relative to three of its peers. She gathers the following
information:

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 Market-Based Valuation: Price and Enterprise Value Multiples

Measure Alpha Beta Gamma

Price 30.00 14.00 18.00
Shares outstanding 240 2,100 600
= Equity market cap 7,200 29,400 10,800
+ Debt (most recent quarter) 740 3,200 1,250
+ Preferred stock 0 0 0
= Total invested capital (TIC) 7,940 32,600 12,050
− Cash 900 5,500 1,600
= EV 7,040 27,100 10,450
EBITDA (TTM) 1,450 2,850 2,600
TIC/EBITDA 5.48 11.44 4.63
EV/EBITDA 4.86 9.51 4.02
Debt/Equity 22.40% 28.90% 40.70%
ROIC (TTM) 7.50% 4.20% 8.80%
Quarterly revenue growth (YoY) 42.50% 18.60% 9.40%

y In the given scenario, ranking based on both TIC/EBITDA and EV/EBITDA is the same. State the
circumstances in which rankings based on these two measures might differ.
y Based solely on the information given, comment on the relative valuation of Alpha Inc.

Solution

y Total invested capital and EV differ in that EV does not take into account cash, cash equivalents,
and marketable securities. Therefore, a material change in any of these accounts relative to EBITDA
could cause a ranking based on TIC/EBITDA and EV/EBITDA to vary.
y From the table, Alpha is trading at a lower TIC/EBITDA and EV/EBITDA (5.48 and 4.86) compared to
Beta (11.44 and 9.51) and therefore seems relatively undervalued. Furthermore, Alpha has a higher
ROIC (7.5% versus 4.2%) and a higher revenue growth rate (42.5% versus 18.6%) than Beta, which
provide more reasons to believe that Alpha is relatively undervalued compared to Beta.

Compared to Gamma, Alpha is trading at higher TIC/EBITDA and EV/EBITDA multiples despite the
fact that it has a lower ROIC (7.5% versus 8.8%). However, Alpha’s higher multiples may be justified
based on its lower leverage (22.4% versus 40.7%) and higher revenue growth rate (42.5% versus 9.4%)
compared to Gamma.

International Considerations When Using Multiples

LOS: Explain sources of differences in cross-border valuation comparisons.

Comparing companies across borders (when applying relative valuation techniques) is difficult due to
differences in accounting methods, cultural differences, and differences in risk and growth opportunities
resulting from different economic and political environments. Furthermore, benchmarking is difficult because

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Learning Module 2

P/Es for companies in the same industry vary across countries and P/Es of national markets can vary
substantially at a given point in time.

Areas where differences in accounting treatment exist include inventory, goodwill, R&D expenses, and
foreign exchange adjustments. Cash flow ratios, such as P/CFO and P/FCFE, are least affected by
accounting differences, whereas P/B, P/E, and EBITDA multiples are affected to a greater extent because
they are based on accounting earnings.

Momentum Valuation Indicators

LOS: Describe momentum valuation indicators and their use in valuation.

Momentum indicators relate either the price or a fundamental (eg, earnings) of a company to the time series
of its historical or expected value.

Exhibit 2 Momentum valuation indicators

Indicator Description Formula (at time t)

Unexpected earnings (UE) Difference between reported

UEt = EPSt – E(EPSt)
(earnings surprise) EPS and expected EPS

Standardized unexpected Ratio of UE to standard EPSt – E(EPSt)

SUEt =
earnings (SUE) deviation of historical UE σ[EPSt – E(EPSt)]

Example:
Ratio of stock performance to
Stock
y Own past perfromance
Relative strength (RSTR) Stock indext
y Performance of group RSTRt =
stocks Stock0
Stock index0

Momentum indicators include unexpected earnings (UE) or earnings surprise, which is the difference
between reported earnings and expected earnings. It is generally believed that positive earnings surprises
are associated with persistent positive risk-adjusted returns (alpha). ww

UEt = EPSt – E(EPS)t

In applying this concept to valuation, analysts usually calculate the scaled earnings surprise, which is UEs
relative to (ie, scaled by) the standard deviation of analysts’ forecasts. The underlying principle here is that
the lower the divergence in analysts’ forecasts, the more meaningful the forecast error relative to the mean.

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 Market-Based Valuation: Price and Enterprise Value Multiples

Standardized unexpected earnings (SUEs) is calculated as:

EPSt w– E(EPS)t
SUEt =
σ[EPSt – E(EPS)t]

Where:
EPSt = Actual EPS for time t
E(EPS)t = Expected EPS for time t
σ[EPSt – E(EPS)t ] = Standard deviation of [EPSt – E(EPS)t ] over some historical time period.

Relative-strength indicators compare a stock’s performance during a particular period either with its own
past performance or with the performance of a group of stocks. Relative strength indicators include:

y price momentum, the stock’s compounded rate of return over the recent past.
y moving-average oscillators and resistance and support levels that are defined based on the
relationship between a stock’s return over a recent period and its return over a longer period.
y the ratio of the stock’s performance to the performance of an equity index.

The rationale for the use of relative strength indicators is that patterns of persistence or reversal in
returns may exist.

Valuation Indicators: Issues in Practice

LOS: Explain the use of the arithmetic mean, the harmonic mean, the weighted harmonic mean,
and the median to describe the central tendency of a group of multiples.

Averaging Multiples: The Harmonic Mean

Analysts usually use the harmonic mean and the weighted harmonic mean to calculate the average of a
group of price multiples.

Consider a portfolio consisting of 100 shares each of Stock A and Stock B:

Stock A is trading at $48 with an EPS of $4, resulting in a P/E of 12.

Stock B is trading at $27 with an EPS of $3, resulting in a P/E of 9.

Calculate the P/E ratio of the portfolio directly by dividing the combined market value of the stocks by the
combined earnings:

(4,800 + 2,700)
Portfolio's P/E = = 10.71
(400 + 300)

Now assess which method of computing the portfolio’s average P/E best reflects the value of 10.71: the
portfolio’s arithmetic mean, weighted mean, harmonic mean, and weighted harmonic mean:

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Learning Module 2

12 + 9
Arithmetic mean P/E = = 10.50
2

48 27
Weighted mean P/E = � × 12� + � × 9� = 10.92
75 75

2
Simple harmonic mean = = 10.29
1 1
�� �+� ��
12 9

1
Weighted harmonic mean = = 10.71
48 1 27 1
�� �� �� + � � �� ��
75 12 75 9

The weighted harmonic mean is the most precise measure for computing the average of a group of price
multiples. Also note that:

y The simple harmonic mean (10.29) is less than the arithmetic mean (10.50). This makes sense
because simple harmonic mean inherently gives a lower weight to higher P/E ratios and a greater
weight to lower P/E ratios.
y Using the median (as opposed to the mean) mitigates the effect of outliers.
y The harmonic mean may also be used to reduce the impact of outliers. However, although the
harmonic mean mitigates the impact of large outliers, it may actually aggravate the impact of
small outliers.
y For an equal-weighted index, simple harmonic mean and weighted harmonic mean are equal.

Using Multiple Valuation Indicators

Analysts typically use multiple valuation indicators because different indicators provide them with different
kinds of information. Valuation indicators are used by analysts to define their universe of investments
through a process called screening. Stock screens usually define criteria for including stocks in an
investor’s portfolio and are an efficient way to narrow down a search for investments. Limitations of stock
screens include the lack of control over the calculation of important inputs in vendor-provided data and the
absence of qualitative factors.

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Learning Module 3
Residual Income Valuation

LOS: Calculate and interpret residual income, economic value added, and market value added.

LOS: Describe the uses of residual income models.

LOS: Calculate the intrinsic value of a common stock using the residual income model and
compare value recognition in residual income and other present value models.

LOS: Explain fundamental determinants of residual income.

LOS: Explain the relation between residual income valuation and the justified price-to-book ratio
based on forecasted fundamentals.

LOS: Calculate and interpret the intrinsic value of a common stock using single-stage (constant
growth) and multistage residual income models.

LOS: Calculate the implied growth rate in residual income, given the market price-to-book ratio
and an estimate of the required rate of return on equity.

LOS: Explain continuing residual income and justify an estimate of continuing residual income at
the forecast horizon, given company and industry prospects.

LOS: Compare residual income models to dividend discount and free cash flow models.

LOS: Explain strengths and weaknesses of residual income models and justify the selection of a
residual income model to value a company’s common stock.

LOS: Describe accounting issues in applying residual income models.

Introduction

LOS: Calculate and interpret residual income, economic value added, and market value added.

LOS: Describe the uses of residual income models.

An advantage of residual income (RI) valuation is that it addresses a weakness of financial statement
earnings-based valuations. Income statement earnings are reduced by the interest paid on debt capital but
include no adjustment for the cost of equity capital. RI accounts for the cost of both debt and equity capital.

Residual Income
Accounting net income reflects earnings available to common shareholders but not adjusted for the cost
of equity capital. As a result, income statement net income alone is inadequate for determining whether a
company is earning enough to cover the opportunity cost of its shareholders’ capital (required ROE). On the

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Learning Module 3

other hand, the RI deducts for the cost of equity, which makes it easier to determine whether the company
is earning an abnormal return (ie, a return in excess of opportunity costs) for equity investors.

RI = Net income − Equity charge

Equity charge = Cost of equity capital × Equity capital

Example 1 Calculating RI

Gamma Associates’ balance sheet shows total assets with a book value (BV) of £5 million. Gamma’s
financing is 60% equity and 40% debt. The company’s cost of equity capital is 10% and its cost of debt
capital 6%. Given a tax rate of 35% and EBIT of £500,000, calculate Gamma’s net income and RI.

Solution

First, calculate Gamma’s interest expense:

Since company is 40% debt financed

Debt = BV of assets × 40%

= 5,000,000 × 0.40
= £2,000,000
Interest expense = Debt × Cost of debt capital
= 2,000,000 × 0.60
= £1,200,000

Next, calculate Gamma’s net income (in £)

EBIT 500,000
Minus interest expense 120,000
Pretax income 380,000
Minus income tax expense (380,000 × 0.35) 133,000
Net income £247,000

Gamma’s positive net income indicates that it generated revenue in excess of operating expenses,
interest expense, and tax expense. However, to determine whether £247,000 of net income represents a
fair rate of return on shareholders’ equity, calculate Gamma’s RI.

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 Residual Income Valuation

The amount of equity:

Equity = BV of assets × 60% Equity = BV of assets − Debt

= 5,000,000 × 0.60 or = 5,000,000 − 2,000,000
= £3,000,000 = £3,000,000

Equity charge = Equity capital × Cost of equity capital

= 3,000,000 × 0.10

= £300,000

Finally, calculate Gamma’s RI (itn £):

Net income 247,000

Minus equity charge 300,000
RI −53,000

Negative RI means that the return to Gamma’s shareholders was less than the opportunity cost of
equity capital. Therefore, even though Gamma earned an accounting profit (ie, net income of £247,000),
Gamma’s shareholders suffered an economic loss (ie, RI of −£53,000).

A second approach to calculating RI starts with a company’s net operating profit after taxes (NOPAT), which
is reduced by a capital charge for the providers of both debt and equity financing. Under this approach, a
capital charge (the company’s total cost of capital in money terms) is deducted from the company’s NOPAT.

Example 2 Calculating RI using the capital charge method

Gamma Associates’ balance sheet shows total assets with a BV of £5 million. Gamma’s financing is 60%
equity and 40% debt. The company’s cost of equity capital is 10% and its cost of debt capital 6%. Given
a tax rate of 35% and NOPAT of £325,000 [= 500,000 × (1 – 0.35)], calculate Gamma’s RI using the
capital charge method.

Solution

NOPAT 325,000
Minus debt charge [2,000,000 × 0.06 × (1 − 0.35)] 78,000
Minus equity charge (3,000,000 × 0.10) 300,000
RI −53,000

As shown, both methods calculate the same RI. Example 3 shows the reconciliation of the two methods.

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Learning Module 3

Example 3 Reconciling the net income less equity charge method and the capital charge
method for calculating RI

(amount in £)

Net income − equity charge method Reconciliation Capital charge method

Net income 247,000 + after-tax interest NOPAT 325,000
Minus equity charge 300,000 expense of 78,000 Minus capital charge 378,000
RI −53,000 RI −53,000

RI can also be calculated by using a company’s return on invested capital (ROIC) and its effective capital
charge (ie, after-tax cost of debt and equity as a percentage of total capital). This percentage is equivalent
to the after-tax WACC. The invested capital is the amount invested in the business (ie, cost of acquiring the
total assets), so ROIC = NOPAT / Total assets.

ROIC = 325,000 / 5,000,000

= 6.5%
Effective capital charge = (78,000 + 300,000) / 5,000,000
= 7.56%
Residual income = (ROIC − Effective capital charge) × Beginning capital
= (0.065 − 0.0756) × 5,000,000
= −£53,000

That Gamma is incurring an economic loss despite reporting an accounting profit is readily apparent from
the fact that its ROIC is less than its effective capital charge.

The Use of RI in Equity Valuation

RI directly expresses the impact of company operations on shareholder value. Positive (negative) RI
measures the amount of value creation (destruction).

Building on the examples provided, assume the following:

y Gamma is 100% equity financed, and its 1,000,000 shares outstanding are currently trading at book
value (BV), or £5 per share (= BV of assets / shares outstanding)
y Earnings are £325.000 and are expected to remain at the current level indefinitely
y Earnings per share (EPS) is £0.325
y Each year, 100% of net income is distributed as dividends

As in the earlier examples, Gamma is earning less than its cost of capital, so its share price should decline.
In this case, ROIC of 6.5% (£325,000 / £5,000,000) is less than its 10% cost of equity capital. Therefore,
Gamma is destroying £175,000 (= 0.035 × 5,000,000 or 325,000 − [5,000,000 × 0.10]) of value per year,
or £0.175 per share. Valued as a perpetuity using the cost of equity capital as the discount rate, the PV of
this economic loss per share is £1.75. The intrinsic value of Gamma shares based on an RI valuation is
Gamma’s BV per share minus the PV of the value destruction or 5.00 − 1.75 = £3.25.

An alternative approach for valuing a no-growth company such as Gamma is to view its earnings yield (ie,
Earnings / Price) as an estimate of its expected rate of return. Note that if Gamma common stocks were

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 Residual Income Valuation

trading at the intrinsic value calculated above (£3.25), the stock’s earnings yield (£0.325 / £3.25) is exactly
equal to its cost of equity capital (10%).

A company’s RI provides insight as to whether a stock is likely to trade at a premium or discount to BV.
The relationship between the market price per share and the BV per share, or P/B ratio compared to RI, is
that if RI is:

y negative, shares should trade below BV (ie, P/B < 1)

y positive, shares should trade above BV (ie, P/B > 1)

Commercial Implementations
Economic value added (EVA) is one of several variations of RI-based valuation methods commercialized
by financial analysis consultants. EVA attempts to estimate company or share values based on projected
economic profits. It takes an approach similar to that illustrated in Example 2:

EVA = NOPAT − (C% × TC)

Where:
NOPAT = Net operating profit after taxes = EBIT (1 − Tax rate)
C% = Cost of capital (WACC)
TC = Total capital

In this model, both NOPAT and TC are calculated based on US GAAP but adjusted for the following items:

y R&D expenses are capitalized and amortized instead of being expensed, so R&D expenses net of
amortization are added back to NOPAT.
y For strategic investments not expected to generate an immediate return, no capital charge is assessed
until a later date.
y Deferred taxes are ignored. Only taxes paid are treated as an expense.
y Any LIFO inventory reserve is added to capital and any increase in the LIFO reserve over the year is
added to NOPAT.
y Operating leases are treated as capital leases, and nonrecurring items are adjusted.

In practice, analysts do consider the impact of accounting methods on financial statement values and make
revisions similar to those discussed in the determination of EVA, as discussed in a later section of this
learning module.

Another approach to assessing corporate performance from an economic profit perspective is market
value added (MVA). MVA posits that value is created when a company generates positive economic profits,
resulting in the company’s securities trading at market values greater than the BVs of debt and equity (total
capital). MVA is calculated as:

MVA = Market value of company − Accounting BV of total capital

Where:
Market value of company = Market value of equity + Market value of debt

MVA is more commonly used for internally evaluating corporate performance and determining executive
compensation rather than common stock valuation by equity securities analysts.

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Learning Module 3

The Residual Income Model

LOS: Calculate the intrinsic value of a common stock using the residual income model and
compare value recognition in residual income and other present value models.

LOS: Explain fundamental determinants of residual income.

LOS: Explain the relation between residual income valuation and the justified price-to-book ratio
based on forecasted fundamentals.

The RI model values a common stock by summing the value of two contributing factors, the:

y current BV of shareholders’ equity; and

y PV of expected future RI

Therefore, the intrinsic value of a stock can be calculated as:

∞
RIt
V0 = B0 + �
t=1
(1 + r ) t

∞
Et − rBt − 1
= B0 + �
(1 + r ) t
t=1

Where:
V0 = Intrinsic value of the stock today
B0 = Current BV per share of equity
Bt = Expected BV per share of equity at any time t
r = Required rate of ROE
Et = Expected EPS for time t
RIt = Expected RI per share

The RI per share in a given period (RI t) is that period’s EPS (Et) net of the equity charge per share (rBt−1),
where the equity charge is a function of the required rate of return and the period’s beginning BV per share.
Expected positive (negative) RI results in an intrinsic value above (below) current BV (B0).

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 Residual Income Valuation

Example 4 Forecasting RI per share

Veronica Lange, CFA, wants to forecast the RI for Omega Printers for the next two years, 20X3 and
20X4. She gathers the following information on the company:

y Market price of Omega shares as of December 31, 20X2, is $50

y BV of Omega shares as of December 31, 20X2, is $20
y Consensus EPS forecasts:

20X3 = $2.35

20X4 = $2.50

The company is 100% equity financed and is expected to maintain a constant dividend payout ratio of
60%. Given a 10% cost of equity capital, calculate Omega’s RI for 20X3 and 20X4.

Solution

($ amounts)

Omega Printers Residual Income Forecast 20X3 20X4

Beginning BV per share (Bt−1) 20.00 20.94
+ forecasted EPS (Et) 2.35 2.50
− forecasted dividend per share (D t) 1.41 1.50
= Expected ending BV per share (Bt−1 + Et − Dt) 20.94 21.94
Equity charge per share (r × Bt−1) 2.00 2.09
RI per share [Et − (r × Bt−1)] 0.35 0.41

Once an analyst has a forecast for RI, the RI model can be used to estimate a common stock’s
intrinsic value.

Example 5 Estimating a stock’s value with the RI model

An analyst gathers the following information on Alpha Ltd.

y Alpha’s current BV per share is €8.00

y Alpha’s expected EPS and dividends per share for the next three years are:

Year 1: earnings €2.25; dividend €1.25

Year 2: earnings €3.00; dividend €2.00
Year 3: earnings €4.50; dividend €14.50
y Alpha is expected to cease operations at the end of Year 3 and distribute its entire BV as a
liquidating dividend

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Learning Module 3

Given a required rate of ROE of 10%:

1. Calculate Alpha’s BV per share and RI for the next 3 years.
2. Estimate the intrinsic value of Alpha’s stock using the RI model.
3. Estimate the intrinsic value of Alpha’s stock using the dividend discount model (DDM).

Solutions

1. Alpha’s RI and (BV) per share are calculated as:

(€ amounts)

Alpha’s book value and residual income Year 1 Year 2 Year 3

Beginning BV per share (Bt−1) 8.00 9.00 10.00
+ expected EPS (Et) 2.25 3.00 4.50
− expected dividend per share (D t) 1.25 2.00 14.50
= Expected ending BV per share (Bt−1 + Et − Dt) 9.00 10.00 0.00
Equity charge per share (r × Bt−1) 0.80 0.90 1.00
RI per share [Et − (r × Bt−1)] 1.45 2.10 3.50

2. A stock’s intrinsic value using the RI model is the sum of the PV of a company’s RI, which is
calculated as:
n
Et − rBt − 1
V0 = B0 + �
t=1
(1 + r ) t

For Alpha Ltd.:

1.45 2.10 3.5

V0 = 8.00 + + +
1.11 1.12 1.13

= €13.68
3. A stock’s intrinsic value using the DDM is the sum of the PV of a company’s dividends, which is
calculated as:
n
Dt
V0 = �
t=1
(1 + r ) t

For Alpha Ltd.:

1.25 2.00 14.50

V0 = + +
1.11 1.12 1.13

= €13.68

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 Residual Income Valuation

Note several important insights regarding dividend discount model (DDM) compared to RI model valuations
of common stocks:

y If the same assumptions (eg, EPS forecasts, dividend payout ratios) are consistently applied to both,
DDMs and RI models should estimate the same intrinsic value for common stocks.
y RI models recognize value earlier compared to DDMs:
○ A significant portion of a stock’s value in RI models is typically associated with the initial BV.
○ In DDMs the greatest portion of value is usually in the distant future. In the typical application of
the multistage DDM, a terminal value reflects dividends to perpetuity, and that terminal value often
accounts for 70%-90% of a stock’s intrinsic value.

The General RI Model

The RI model can be derived from the DDM. Consider the general expression of the DDM:

D1 D2 D3
V0 = + + + ...
(1 + r)1 (1 + r)2 (1 + r)3

The connection between earnings, dividends, and BV according to the clean surplus relation is:

B0 = Bt−1 + Et − Dt

The circumstance in which retained earnings (ie, earnings minus dividends) in a given period explain all
changes in that period’s BV (aside from any ownership transactions) is known as clean surplus accounting.

Rearranging the clean surplus relation as:

Dt = Et − (Bt − Bt−1)

states that any period’s dividend can be viewed as that period’s net income minus the earnings retained by
the company, or alternatively as:

Dt = Et + Bt−1 − Bt

Substituting Et + Bt−1 − Bt for Dt in the general expression of the DDM obtains:

E1 + B0 − B1 E2 + B1 − B2 E3 + B2 − B3
V0 = + + + ...
(1 + r)1 (1 + r)2 (1 + r)3

which can be restated as:

E1 − rB0 E2 − rB1 E3 − rB2

V0 = B0 + + + + ...
(1 + r)1 (1 + r)2 (1 + r)3

Expressing this equation with summation notation obtains the RI model introduced earlier in this
learning module:
∞
RIt
V0 = B0 + �
t=1
(1 + r ) t

∞
Et − rBt − 1
= B0 + �
t=1
(1 + r ) t

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Learning Module 3

The intrinsic value of a stock is the sum of the current BV per share and the PV of the RI per share.

Because RI is the difference between earnings over a period and the required rate of return on the period’s
beginning BV, RI, or excess earnings, can be expressed as:

RIt = Et − (r × Bt−1)

The RI model can be re-expressed in the form of excess earnings method for valuing a stock. Because
ROE for any period can be express as:

ROEt = Et / Bt−1

which can be restated as:

Et = ROEt × Bt−1

and substituting this into the RI formula results in:

RIt = (ROEt × Bt−1) − (r × Bt−1)

= (ROEt − r) Bt−1

using this expression of RI as the numerator in the summation portion of the RI model restates the model
into the variant known as the excess earnings method.
∞
(ROE − r)Bt − 1
V0 = B0 + �
t=1
(1 + r ) t

Example 6 uses the information on Alpha Ltd. from Example 5 to illustrate the calculation of intrinsic value
using the excess earnings method.

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 Residual Income Valuation

Example 6 Estimating a stock’s value using the excess earnings method

(€ amounts)

Year 1 2 3
Earnings per share (EPS t) 2.25 3.00 4.50
Beginning BV per share (Bt−1) 8.00 9.00 10.00
ROE (EPSt / Bt−1) 28.13% 33.33% 45.00%
Less: Required rate of ROE 10.00% 10.00% 10.00%
Abnormal rate of return (ROE – r) 18.13% 23.33% 35.00%

A stock’s intrinsic value using the excess earnings method = the original BV + the sum of the PV of a
company’s abnormal returns, which is calculated as:
n
(ROE − r)Bt − 1
V0 = B0 + �
t=1
(1 + r ) t

For Alpha Ltd.:

(0.2813 − 0.1) X 8.00 (0.3333 − 0.1) X 9.00 (0.45 − 0.1) X 10.00

V0 = 8.00 + + +
1.11 1.12 1.13

1.45 2.10 3.5

= 8.00 + + +
1.11 1.12 1.13

= €13.68

Note that once the abnormal returns are rendered as money amounts, the excess earnings are exactly
the same as the RI from the previous examples, rendering the same estimated intrinsic value for
Alpha Ltd.

The RI model (and deriving the same intrinsic value estimate from the RI model and the excess earnings
method) relies on the clean surplus relation (ie, B0 = Bt−1 + Et − Dt ) holding true. However, under IFRS and
US GAAP, various types of income and expense (eg, foreign currency translation adjustments, cash flow
hedge gains and losses) bypass a company’s income statement, directly impacting its balance sheet. Such
items (ie, dirty surplus items) are recorded as other comprehensive income (OCI), so that:

Comprehensive income = Net income + OCI

If an analyst expects material OCI items in the future (ie, company financial statements differing from clean
surplus accounting), adjustments to net income may be appropriate.

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Fundamental Determinants of RI
The general RI model does not rely on any specific assumptions regarding income or dividend growth.
However, assuming constant growth in earnings and dividends leads to a variant of the RI model that
highlights the fundamental drivers of RI. The following variant of the model is based on the:

y justified forward P/B ratio based on forecasted fundamentals

y constant growth DDM (ie, Gordon growth model)
y sustainable growth rate equation, g = b × ROE

For a stock trading at intrinsic value, the Gordon growth model states that:

D1
P0 =
r−g

Substituting the expression for the forward dividend derived earlier in this learning module for D1 results in:

E1 + B0 − B1
P0 =
r−g

Dividing both sides of equation by B0 to render the P/B ratio formula results in:

E1 B0 – B1
+
P0 B0 B0
=
B0 r−g

which can be restated as:

P0 ROE − g
=
B0 r−g

This equation is mathematically equivalent to:

P0 ROE − r
=1+
B0 r−g

Because a stock’s justified price equals its intrinsic value (P0 = V0), making that substitution into this formula
and multiplying both sides of the equation by B0 result in:

ROE − r
V0 = B0 + B0
r−g

Therefore, given constant growth RI model, the intrinsic value of a stock equals the sum of:

y its current BV (B0)

y the PV of its expected stream of RI [(ROE – r) × B0] / (r − g)

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This term represents the additional value created by a company’s ability to generate returns in excess of its
cost of equity (ie, economic profits). Furthermore, a company that earns a return exactly equal to its cost of
equity capital (ROE = r) has an intrinsic value equal to its BV.

The RI model implies that a stock’s justified P/B ratio is directly related to the company’s expected abnormal
earnings (ie, RI). This conception of value is closely linked to Tobin’s q, which describes a link between the
value of a company’s outstanding securities with the cost of replacing its assets.

Market value of debt and equity

Tobin's q =
Replacement cost of total assets

Although the two measures are similar, Tobin’s q differs from the P/B ratio in several significant ways.
Tobin’s q uses:

y the market value of equity and debt (rather than just equity) in the numerator.
y the BV of total assets (rather than just equity) in the denominator.
y the replacement cost for asset values rather than their BVs.

All else equal, the greater the productivity of a firm’s assets, the higher the Tobin’s q.

Single-Stage and Multistage RI Valuation

LOS: Calculate and interpret the intrinsic value of a common stock using single-stage (constant
growth) and multistage residual income models.

LOS: Calculate the implied growth rate in residual income, given the market price-to-book ratio
and an estimate of the required rate of return on equity.

LOS: Explain continuing residual income and justify an estimate of continuing residual income at
the forecast horizon, given company and industry prospects.

LOS: Compare residual income models to dividend discount and free cash flow models.

LOS: Explain strengths and weaknesses of residual income models and justify the selection of a
residual income model to value a company’s common stock.

The constant-growth, or single-stage, RI model assumes a constant ROE and dividend payout ratio, which
lead to a constant rate of earnings growth over time. The constant-growth RI model can be expressed as

Exhibit 1 Single-stage residual valuation model:

Stock's intrinsic value (V0)

ROE − r
V0 = B0 + B0
r−g
B0 = Book value per share ROE = Constant ROE
r = Required rate of return g = Constant growth rate

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Example 7 illustrates using this version of the RI model to estimate a stock’s intrinsic value:

Example 7 Estimating intrinsic value with the single-stage RI model

An analyst gathers the following information to estimate the intrinsic value of Beta Inc.’s common stock:

y Current market price per share = £44

y Current BV per share = £20
y Constant ROE = 18%
y Constant growth rate = 6%
y Cost of equity capital = 12%

Calculate the intrinsic value of Beta Inc.’s common stock and determine whether the shares are fairly
valued, undervalued or overvalued.

Solution

Using the single-stage RI model, the intrinsic value of Beta Inc.’s shares is calculated as:

V0 = 20 + ( 0.18 − 0.12
0.12 − 0.06 ) 20

w = £40

Because the shares are currently trading above their intrinsic value (£44 versus £40), Beta Inc. shares
are currently overvalued.

Given a stock’s current market price, a company’s BV, a constant ROE, and a required rate of return, the
single-stage RI model can be used to determine the market-implied earnings growth rate for a company:

P0 ROE − r
=1+
B0 r–g

Using this formula, an equation for calculating a market-implied constant growth rate can be derived as:

ROE – r
g=r–
P0
–1
B0

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Example 8 uses the information for Beta Inc. from Example 7 to illustrate the use of this formula to calculate
a market-implied constant growth rate:

Example 8 Calculate the market-implied growth rate using the single-stage RI model

Using the same information provided for Beta Inc. in Example 7, calculate the market-implied constant
growth rate of RI for Beta Inc.

Solution

0.18 − 0.12
g = 0.12 − = 0.07 = 7.0%
44
–1
20

The market-implied growth rate calculated in Example 8 is generally consistent with the conclusions
reached in Example 7. Example 7 determined that the stock was overvalued, assuming a constant growth
rate of 6%. Therefore, it should not be surprising that using a market price greater than the intrinsic value
obtains a market-implied growth rate that is higher than the growth rate used to calculate intrinsic value.

There is a problem with applying the single-stage RI model for a company generating abnormal earnings.
A valuation determined by a constant growth rate to infinity implies that the company can perpetually
earn economic profits. This is inconsistent with historical observation. Companies or industries earning
economic profits (losses) cause new competitors to enter and/or drive some existing competitors from
the industry. This causes ROE to trend toward an industry’s required rate of return. As with variants of the
DDM, multistage RI models can be used to capture the impact of a decrease in above-normal levels of
ROE over time.

Multistage Residual Income Valuation

Multistage RI models take an approach similar to that used in multistage dividend discount and FCFE
valuation models. The analyst forecasts RI over a horizon and estimates a terminal value for any RI beyond
the forecast horizon (ie, continuing RI). The estimated intrinsic value of the stock is the sum of the initial BV,
the PVs for the RI over the forecast horizon, and the PV of the terminal value.

Exhibit 2 Multistage residual income model:

Stock's intrinsic value (V0)
T (ROEt − r ) Bt − 1
V0 = B0 + � + PV (Terminal value)
t=1
(1 + r )t

B0 = Book value per share, ROE = Constant ROE, r = Required rate of return

Because reversion to the mean is typically observed for RI, above-normal levels of ROE are likely to decline
toward the cost of equity, and this is typically reflected in multistage RI models. Projected RI declines in
tandem with decreases in ROE. At an ROE equal to the cost of equity, the RI equals zero.

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Analysts typically use one of the following assumptions regarding continuing RI for calculating a terminal
value. Continuing RI:

y is zero beyond the last year of the forecast horizon due to an abrupt drop in ROE to the required ROE
at that time.
y continues indefinitely at a positive level.
y gradually declines to zero as ROE reverts to the required ROE over time.
y reflects the reversion of ROE to some mean level (other than zero).

FCFE models and DDMs also discount the pertinent future value metrics by the required rate of turn on
equity. However, for the:

y RI model, a significant proportion of the intrinsic value comes from its current BV, whereas the
proportion from the terminal value is typically relatively small (and may even be zero).
y DDM and FCFE models, a majority (often a vast majority) of the intrinsic value comes from the
estimated terminal value. This terminal value is highly sensitive to the assumptions regarding the
required rate of return and the sustainable growth rate.

Examples 9, 10, 11, and 12 illustrate the multistage RI model. However, each uses different assumptions
regarding continuing RI. The examples illustrate the impact on the estimated terminal values of the various
assumptions.

Example 9 Calculating intrinsic value of a stock using the multistage RI model (1):
No continuing residual income (ie, terminal value = 0)

Eriko Fujimura, CFA, an analyst at Polarian Securities gathers the following information to estimate the
intrinsic value of Shebby Inc.’s common stock.

y Current BV per share = $11

y Current market price per share = $20
y Initial ROE = 15%
y Years 1–5 EPS is calculated as ROE times the beginning of the year BV per share
y Required rate of ROE = 12%
y Constant dividend payout ratio = 30%

Calculate the intrinsic value for Shebby Inc.’s common stock using the multistage RI model assuming
that after Year 5 ROE will fall to 10%.

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 Residual Income Valuation

Solution

First, project per share amounts for earnings, dividends, BV, and RI through Year 5.

(Per share $ amounts)

Year 1 2 3 4 5
Beginning BV (Bt−1) 11.00 12.16 13.43 14.84 16.40
+ EPS (Et) 1.65 1.82 2.01 2.23 2.46
− dividend (D t) 0.50 0.55 0.60 0.67 0.74
= Ending BV (Bt−1 + Et − Dt) 12.16 13.43 14.84 16.40 18.12
Equity charge (r × Bt−1) 1.10 1.22 1.34 1.48 1.64
RI [Et − (r × Bt−1)] 0.55 0.61 0.67 0.74 0.82
*Apparent number inconsistencies due to rounding.

From Year 6 onward, RI is $0, which is most apparent using the alternate method for determining RI
introduced earlier in the learning module, calculated for Year 6 as:

Residual income = (ROEt − r) Bt−1

= (0.1 − 0.1) × 18.12

= $0

For subsequent years, EPS is increasing but at a rate such that ROE = r, so there is no RI beyond the
forecast horizon, which results in a terminal value of zero. Therefore, the value of the common stock is
the initial BV plus the PV of the RI from Years 1 through 5, calculated as:
5
RIt
V0 = B0 + �
t=1
(1 + r ) t

0.55 0.61 0.67 0.74 0.82

= 11.00 + + + + +
1.11 1.12 1.13 1.14 1.15

= $13.52

Because the estimated intrinsic value is significantly below the current market price, given the
assumption in this scenario, Shebby Inc.’s shares appear to be significantly overvalued.

The next three examples use different assumptions regarding the RI beyond the 5-year forecast horizon.
These examples illustrate different methods for calculating terminal values and highlight the impact of
terminal values on estimated intrinsic value.

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Example 10 Calculating intrinsic value of a stock using the multistage RI model (2):
Stable continuing residual income

A portfolio manager at Polarian, who is considering an investment in Shebby Inc., reviews Fujimura’s
initial analysis of the stock. The manager is more optimistic regarding Shebby’s long-term earnings
prospects and asks Fujimura to use different assumptions for the company’s RI.

Use all the information for Shebby Inc. from Example 9 with one exception. For Year 6 and beyond,
assume that Shebby is able to continue earning the same level of RI as it earned in Year 5.

Solution

First, determine the terminal value (VT) at the end of Year 5, which is calculated as:

RI6
VT =
r–g

0.82
=
0.1 − 0

= $8.20

Then determine Shebby’s intrinsic value, which is calculated as:

5
RIt VT
V0 = B0 + � +
t=1
(1 + r ) t (1 + r ) 5

0.55 0.61 0.67 0.74 0.82 8.20

= 11.00 + + + + + +
1.11 1.12 1.13 1.14 1.15 1.15

= $18.61

Based on the assumption of continuing RI stable at the Year 5 level, Shebby still appears overvalued,
although by considerably less than in Example 9. The higher estimated intrinsic value in Example 10
implies that the market price reflects input values differing from those used in this valuation. Assuming
the cost of equity is accurate, the market is either expecting a higher ROE over the forecast horizon and/
or a higher level of continuing RI.

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 Residual Income Valuation

Another variant of the multistage RI model assumes a gradual decline of ROE to the required rate of ROE.
In this approach, beyond an initial forecast horizon using a higher ROE, ROE declines at a stable rate until
it reaches the cost of equity. This approach results in an explicit ROE to be determined each period over
which ROE is declining. The RI model that embodies this assumption captures the decline in ROE using a
persistence factor and is calculated as:

Exhibit 3 Multistage residual income model:

Stock's intrinsic value using terminal value with persistence factor (V0)
T (ROEt − r ) Bt − 1
V0 = B0 + � + PV (Terminal value)
t=1
(1 + r ) t

ET − r BT − 1 RIT
PV (Terminal value) = =
(1 + r − ω)(1 + r) T − 1 (1 + r − ω)(1 + r) T − 1

B0 = Book value per share ROE = Constant ROE

r = Required rate of return ω = Persistence factor
RIT = Residual income at Time T ET = Expected earnings for period T

The persistence factor used in the calculation of the terminal value (ie, the final element in the formula) is
set between zero and one. The higher the persistence factor, the slower the rate of decline in ROE and
the greater the amount of the terminal value. A persistence factor of zero implies no RI beyond the initial
forecast horizon (as in Example 9). A persistence factor of one implies stable continuing RI beyond the
initial forecast horizon (as in Example 10).

Persistence factors attempt to capture the speed at which ROE is mean-reverting toward the cost of
equity over time and the resulting decrease in RI. For example, a persistence factor of 44% means RI is
decreasing at a rate of 56% per year. Studies of RI persistence find:

y greater persistence is associated with

○ companies that have a strong market leadership position
○ industries that have historically exhibited greater persistence
○ lower dividend payout ratios

y less persistence is associated with companies that previously reported very high
○ accounting rates of return (ie, high ROEs)
○ returns related to nonrecurring items
○ accounting accruals (eg, high revenue and/or low expense accruals)

Example 11 illustrates the use of persistence factors in capturing the decline in RI for determining a terminal
value when estimating a common stock’s intrinsic value.

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Example 11 Calculating intrinsic value of a stock using the multistage RI model (3):
Steady decrease in RI

The portfolio manager reviews Fujimura’s evaluation of Shebby based on stable continuing RI. However,
given the tendency of above-average ROEs to revert toward the cost of equity, the manager asks
Fujimura to run the analysis again, this time assuming a gradual decline in RI.

Use all the information for Shebby Inc. from Example 9 with one adjustment. Use a persistence factor of
60% to reflect the gradual decline of RI beyond Year 5.

Solution

First, determine the terminal value (VT) at the end of Year 5, which is calculated as:

ET − rBT–1
VT =
(1 + r – ω) (1 + r) T−1

2.46 – (0.1 X 16.40)

=
(1 + 0.1 – 0.6) 1.14

= $1.12

Then calculate Shebby’s intrinsic value, which is calculated as:

5
RIt
V0 = B0 + � + VT
t=1
(1 + r ) t

0.55 0.61 0.67 0.74 0.82

= 11.00 + + + + + + 1.12
1.11 1.12 1.13 1.14 1.15

= $14.64

Based on the assumption of decreasing RI beyond Year 5 level, Shebby still appears overvalued,
considerably more so than in Example 10, which assumed a stable continuing RI.

Another variant of the RI model obtains a value for RI beyond the forecast horizon by estimating a terminal
residual value of the firm. A firm’s terminal residual value is derived by subtracting a terminal book value
(BT) from the terminal price (PT). A variety of methods can be used to estimate a terminal price. Common
approaches include using a DDM, a P/E multiple, or a P/B multiple. In this variant of the RI model, the
estimated intrinsic value would be calculated as:
n
Et − rBt − 1 PT − BT
V0 = B0 + � +
t=1
(1 + r ) t (1 + r ) T

Or as:
∞
(ROE − r)Bt − 1 PT − BT
V0 = B0 + � +
t=1
(1 + r ) t (1 + r ) T

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 Residual Income Valuation

Example 12 illustrates this approach with a terminal price based on a P/B multiple:

Example 12 Calculating intrinsic value of a stock using the multistage RI model (4): Two-
stage model with terminal price based on a P/B multiple

The portfolio manager asks Fujimura to run the analysis one more time, using a P/B multiple to estimate
the value of RI beyond 5 years.

All the information for Shebby Inc. from Example 9 applies; assume a P/B multiple of 1.3 to estimate a
terminal price for the company.

Solution

First, determine the terminal price at the end of Year 5, which is calculated as:

Terminal price = PT / BT × BT

= 1.3 × 18.12

= $23.56

Then calculate Shebby’s intrinsic value, which is calculated as:

5
RIt P5 − B5
V0 = B0 + � +
t=1
(1 + r )t (1 + r ) 5

0.55 0.61 0.67 0.74 0.82 23.56 − 18.12

= 11.00 + + + + + +
1.11 1.12 1.13 1.14 1.15 1.15

= $16.90

Relationship to Other Approaches

LOS: Compare residual income models to dividend discount and free cash flow models.

LOS: Explain strengths and weaknesses of residual income models and justify the selection of a
residual income model to value a company’s common stock.

DDMs and FCF models calculate the intrinsic value of a stock by discounting a stream of expected
future cash flows at the required rate of return. On the other hand, the RI model begins with the BV of
shareholders’ equity (taken from the company’s balance sheet) and adds the PV of expected future RI.

The earlier recognition of a much greater proportion of the estimated intrinsic value is a potential advantage
of the RI model. This is especially true in comparison to DDMs and FCF models in which a large proportion
of the value is tied to cash flows far in the future (or the terminal value in multistage models). Thus, DDMs
and FCF model valuations are much more sensitive to changes in discount rates or growth rates, which
are estimated further in the future. RI model valuations are much less sensitive to terminal value estimates,
which, in some cases, may be zero.

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In theory, RI models and DDMs should estimate the same intrinsic value if using the same assumptions
consistently applied to both models. However, in practice, the inputs for the different models are forecasted
with varying degrees of accuracy, resulting in different values. Significant inconsistencies in the results
offered by different models should prompt analysts to question the validity of their assumptions and
examine the relative appropriateness of the models for the company being valued.

Strengths and Weaknesses of the RI Model

Strengths of RI models include:

y Terminal values do not constitute a significant proportion of total intrinsic value

y Widely available accounting data are used
y They are applicable to companies that are not currently paying dividends or that have negative FCFs
y They are applicable to companies with unpredictable cash flows
y Value is associated with the ability to earn economic profits

Weaknesses of RI models include:

y They are vulnerable for management manipulation of accounting data

y Substantial adjustment of accounting data may be needed
y Clean surplus accounting relation may not hold
y Use of accounting income assumes that interest expense appropriately reflects the cost of debt capital

Broad Guidelines for Using an RI Model

RI models are most appropriate if:

y Companies do not have a history of paying dividends, or they pay unpredictable dividends
y Companies have negative FCFs that are expected to persist for the foreseeable future
y There is significant uncertainty regarding terminal value estimates from other valuation models

RI models are least appropriate if:

y There are significant violations of the clean surplus relation

y It is difficult to predict the main determinants of RI (ie, BV, ROE)

Similar to DDMs and FCF models, RI models can be used to determine justified P/E or P/B multiples for
assessing a stock’s relative value. For instance, an RI model value can be divided by reported or estimated
earnings to calculate a justified P/E.

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 Residual Income Valuation

Accounting and International Considerations

LOS: Describe accounting issues in applying residual income models.

Obtaining good estimates of value from the RI model requires using accounting data consistent with the
clean surplus relation. This means that analysts often need to adjust:

y reported net income to determine a company’s comprehensive income to reflect all changes in equity
other than contributions from, and distributions to, shareholders.
y the BV of common equity to capture any differences between reported net income and comprehensive
income, as well as the effect of any off-balance sheet items.

The main drivers of value in the RI model are current BV and future expected RI. One advantageous feature
of the model is the counterbalancing nature of these two factors when a company’s financial statements are
presented to reflect the clean surplus relation.

All else equal, more conservative (aggressive) accounting choices result in lower (higher) future earnings
and higher (lower) reported BVs. If clean surplus accounting is followed, any difference in current BV
resulting from an accounting choice is exactly equal and opposite to the change in the PV of future
earnings. The offsetting nature of these changes means that different accounting choices do not affect the
intrinsic value estimated by the RI model.

However, in practice, such perfect offsets are often not observed because clean surplus accounting does
not always hold. Accounting standards permit various items to bypass the income statement and get
recorded directly to the balance sheet in shareholders’ equity. Also, nonoperating and nonrecurring income
statement items, as well as off-balance sheet liabilities, result in reported income and BVs that diverge from
those that would be reported under clean surplus accounting, requiring analyst adjustments.

Analysts must consider the following questions regarding the use of information obtained from company
financial statements:

y Are there violations of clean surplus accounting?

y Do any balance sheet items need fair value adjustments?
y How should intangible assets be valued?
y How should nonrecurring items be treated?
y Has the company engaged in aggressive accounting practices?
y Are there any impacts that result from differences in accounting standards (ie, international
considerations)?

Violations of the Clean Surplus Relationship

The clean surplus relation is violated if gains/losses bypass the income statement and are reported directly
to owners’ equity. For example, both IFRS and US GAAP require certain securities holdings to be reported
at market values. Any change in market values requires a change in the value shown on the balance
sheet. However, these unrealized gains or losses are not reported on the income statement but instead are
reported in OCI in the equity section of the balance sheet.

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Learning Module 3

When violations of clean surplus accounting exist, analysts must use comprehensive income to determine
the changes between beginning and ending BV to create inputs for RI model valuation consistent with
clean surplus accounting. Items that commonly bypass the income statement and directly affect the BV of
equity include:

y unrealized gains/losses on certain financial instruments

y currency translation adjustments
y certain pension adjustments
y a portion of gains/losses on specified hedges
y changes in revaluation surplus of fixed or intangible assets (IFRS only)
y changes in fair value of certain liabilities’ attributable to changes in their credit risk (IFRS only)

Because these items are not included in net income, they are not reflected in the historical ROE data.
Therefore, if the clean surplus relation does not hold and violations are not expected to offset in future
years, analysts should try to incorporate explicit assumptions about future amounts of OCI into their
analyses. This would bring RI forecasts closer to what they would be if the clean surplus relation held.

Accounting Considerations: Other

LOS: Describe accounting issues in applying residual income models.

Obtaining appropriate RI model inputs requires a BV of equity and thus an analysis of off-balance sheet
assets and liabilities. Also, reported asset and liability values need to be adjusted to reflect their fair value to
the furthest extent possible. Items that typically deserve scrutiny include (but are not limited to):

y inventory
y deferred tax items
y operating leases
y reserves and allowances (eg, allowance for uncollectible receivables)
y intangible assets

Intangible Assets
For the purposes of valuation based on the RI model, the calculation of BV of equity should be adjusted to
include the value of intangible assets developed by the company that are separately identifiable and that
can be sold. Many intangible assets have a BV only if purchased or acquired through an acquisition.

When developed internally, valuable intangible assets (eg, trademarks, brand names, patents) have no BV.
Most of the costs of developing these assets (eg, marketing/advertising, research and development) are
recognized as expenses as incurred. However, the value of highly prized trademarks and brands will be
reflected in stock prices, which can result in divergences with the current BV of the company’s equity.

Accurate valuation using an RI model requires an initial BV that reflects the current fair value of assets.
Therefore, analysts should recognize separately identifiable and sellable intangible assets that companies
develop internally. The BV of total assets and shareholders’ equity should be increased by the estimated fair
value of such intangibles.

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 Residual Income Valuation

R&D expenditures incurred in developing intangible assets (eg, patent on a new pharmaceutical) also
need to be considered. Unproductive R&D expenses lower RI by the amount of the expenditures.
Productive R&D expenditures increase RI in the future. Immediate expensing of those expenditures (rather
than capitalizing and amortizing them) effectively understates current income and BV and overstates
future earnings.

Capitalizing and amortizing productive R&D expenses should have no effect on estimated intrinsic value
because it results in a higher current BV that is exactly equal to the decline in the PV of future earnings.
However, the different treatments of R&D expenditures affect ROE calculations. Analysts must weigh the
impact of R&D expenses on their forecasts of RI, as well as their effect on long-term ROE.

Nonrecurring Items
Forecasts of RI should be based on recurring revenues and expenses, excluding the nonrecurring items
reported on the income statement. However, it is not necessary to adjust BV for these items because any
related gains and losses are already reflected in the balance sheet values of those assets. When reviewing
financial statements and related disclosures before forecasting recurring earnings, analysts need to be
aware the potential impact on their forecasts on items such as:

y unusual items
y extraordinary items
y restructuring charges
y discontinued operations
y accounting changes

Analysts should not base their decisions to include or exclude items from recurring earnings due to financial
statement description such as "income from continuing operations" or "nonoperating loss." Furthermore,
if nearly every operating period includes restructuring or other unusual charges, an analyst may view
these as an ordinary expense and not adjust the income statement to exclude such items from past
recurring earnings.

Other Aggressive Accounting Practices

Companies may sometimes engage in aggressive accounting practices that overstate asset values (BV)
and/or earnings. Analysts must be sensitive to any attempt by management to shift revenue and expenses
between periods. For example, deferring expense recognition or accelerating revenue recognition results in
an overstatement of income and assets. Analysts should carefully evaluate a company’s accounting policies
and also consider management’s integrity when estimating the inputs for the RI model.

International Considerations
Empirical studies have found that, when applied in the global valuation setting, RI models work best in
situations in which:

y Reliable earnings forecasts are available

y Clean surplus violations are limited
y Accounting rules do not allow delayed recognition of material events

The RI model works best when reported financial statements and disclosures allow the analyst to
understand the "economic reality" of the company.

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Learning Module 4
Private Company Valuation

LOS: Contrast important public and private company features for valuation purposes.

LOS: Describe uses of private business valuation and explain key areas of focus for
financial analysts.

LOS: Explain cash flow estimation issues related to private companies and adjustments required
to estimate normalized earnings.

LOS: Explain factors that require adjustment when estimating the discount rate for
private companies.

LOS: Compare models used to estimate the required rate of return to private company equity
(for example, the CAPM, the expanded CAPM, and the build-up approach).

LOS: Explain and evaluate the effects on private company valuations of discounts and
premiums based on control and marketability.

LOS: Explain the income, market, and asset-based approaches to private company valuation
and factors relevant to the selection of each approach.

LOS: Calculate the value of a private company using income-based methods.

LOS: Calculate the value of a private company using market-based methods and describe the
advantages and disadvantages of each method.

Public vs. Private Company Valuation

LOS: Contrast important public and private company features for valuation purposes.

Private companies play an important role in the global economy due to their vast numbers, ranging from
neighborhood convenience stores to global real estate holding companies. In fact, some of the world’s
largest companies like Aldi, Cargill, and Vitol are privately held.

Unlike publicly traded companies, private companies are not listed on public exchanges, and therefore are
not subject to the same reporting requirements; as a result, share price and financial reports are not readily
accessible to the public. Other company-specific and stock-specific factors distinguish private firms from
public firms. However, enough similarities exist that analysts can still use traditional valuation methods on
private firms.

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Exhibit 1 Public versus private company features

Company-specific
Early/Late life cycle phase
Mature companies Smaller size
Concentrated ownership
Liquid shares Limited disclosures
Owner/Manager overlap
Greater
Public Private
transparency
Standardized
disclosures
Stock-specific
Owner/Manager Liquidity
separation Concentrated control
Sale restrictions
© CFA Institute

The company-specific factors for private companies include life cycle stage, size, and an overlap of
shareholders and management.

Private companies tend to include more early-stage companies that are not as mature, resourceful, or
profitable as their public counterparts. However, private companies also include large, stable, mature firms
and failed firms near liquidation.

Private companies tend to be smaller in terms of profits, assets, and employee count compared to public
companies. Due to their smaller scale of operations, private firms are generally subject to more risk and
have limited access to capital to support growth, both demanding a return premium.

Private company management often holds a controlling ownership stake in the company, which helps
reduce conflicts of interest that may arise between owners and managers (ie, principal-agent conflicts).
This owner/manager overlap allows management to focus on long-term strategic initiatives without worrying
about conflicting interests from noncontrolling shareholders. This arrangement is also the rationale for
private equity firms that take underperforming public companies private.

The stock-specific factors for private companies include illiquidity of shares and concentration of control.
Private company shares are less liquid due to fewer existing and potential shareholders, and their private
share prices often reflect an illiquidity discount. Ownership is concentrated in a few controlling investors,
which often necessitates a control premium.

In general, stock-specific factors negatively impact private company valuation. However, company-specific
factors can negatively (eg, limiting access to capital) or positively (eg, focusing on long-term strategy)
impact valuation. Due to the unique characteristics and the range of private companies, assumptions used
in private company valuation are more customized than they are for public companies.

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 Private Company Valuation

Private Company Valuation Uses and Areas of Focus

LOS: Describe uses of private business valuation and explain key areas of focus for
financial analysts.

Uses of Private Company Valuation

Exhibit 2 Uses of private company valuation

Public equity
Debt raise or (IPO) Acquisition/
refinancing divestiture
Venture
Bankruptcy
capital

Private equity Share-based

(Purchase/Sale) compensation
Transaction

Financial Compliance Litigation

Corporate
reporting disputes

Shareholder
Tax
disputes
© CFA Institute

Private companies are valued for transactional, compliance, and litigation purposes. Transactional events
that affect ownership or financing include:

y Venture capital financing (early stage): Venture capital firms raise capital to invest in startups through
various rounds of financing attached to milestones. Valuations serve as a negotiating tool between
entrepreneurs and potential investors.
y Private equity financing (growth or buyout stage): Growth equity funds typically obtain minority stakes
in growth-stage companies to rapidly scale the business. In contrast, buyout firms typically acquire
majority control in mature companies to optimize operations and improve profits.
y Debt financing: Issuers and creditors perform valuation to determine debt capacity.
y Initial public offering (IPO): Investment banks, potential investors, and issuers perform valuation to
determine the offering share price.
y Acquisitions and divestitures: Valuations are needed for acquiring target companies or for divesting
existing segments.

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y Bankruptcy: Valuations for firms nearing bankruptcy are critical to determine whether they should be
restructured or liquidated. If a company chooses to undergo restructuring, valuation insights are critical
for determining the new capital structure.
y Share-based compensation: If a company compensates management with stock option grants,
restricted stock grants, or through employee stock ownership plans, valuations are necessary for
accounting and tax purposes.

Compliance-related valuations that support financial reporting and tax reporting for legal and regulatory
purposes consist of:

y Financial reporting: Valuations are primarily performed for impairment testing purposes.
y Tax reporting: Valuations are required for corporate and individual tax reporting. Corporate tax matters
are tied to corporate restructurings, transfer pricing, and property tax matters. Individual tax matters
are related to estate and gift taxation purposes.

Litigation-related valuations concern damages, lost profits, shareholder disputes, and civil actions (eg,
divorce) that require assets to be valued.

Private Company Valuation Areas of Focus

Analysts should pay attention to several key areas where analyst’s discretion and/or judgment is critical
when using discounted free cash flow models for private company valuation.

y Cash flow and earnings adjustments: Analysts often need to adjust various income statement and
balance sheet items to normalize forecasts.
y Discount rate and rate of return adjustments: Private debt and equity market prices are usually
unavailable to the public, so analysts need to make assumptions when calculating the cost of capital.
y Valuation discount or premium: Premiums and discounts must be factored for the degree of control and
illiquidity for the interest (ie, controlling interest or minority interest) being valued.

Earnings Normalization and Cash Flow Estimation

LOS: Explain cash flow estimation issues related to private companies and adjustments required
to estimate normalized earnings.

Given the nature of a private company, analysts should normalize earnings to adjust for related-party
transactions that may not be “arms’ length” and to correct for other items that are nonrecurring or
noneconomic in nature. Related-party transactions take place between actors that are not independent,
as they share economic interests and/or transactions that do not take place at fair market values. Such
transactions typically include personal expenses, use of assets, and above-market compensation.

When adjusting financials, analysts need to distinguish between nonrecurring items, such as a one-off
purchase of a personal property under the business name, or ongoing items, such as a nonactive family
member on the company’s payroll.

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Another common area of adjustment is for real estate.

y Company-owned non-core real estate: Non-core real estate (eg, a company-owned gym for its
employees) is nonessential to a company’s core operations. Analysts often separate these assets
alongside its associated revenues and expenses.
y Company-owned core real estate: Analysts often add a market rent charge to produce a more accurate
estimate of earnings of the business operations. Doing so allows analysts to separate the value of real
estate from the value of the firm.

Exhibit 3 Earnings normalization

Adjust earnings for unusual items that are not part of continuing
Nonrecurring items
operations

Cyclicality Smooth the effects of seasonal factors

Discretionary expenses Differentiate between corporate and personal discretionary expenses

Excessive compensation Adjust compensation to market rates

Separate assets (such as real estate properties) that are not part of
Nonoperating assets
the core business

When making adjustments, analysts must realize that private company financials are typically only reviewed
or compiled, but not audited. Reviews and compilations provide less assurances compared to audits
regarding the fairness and reliability of the company’s financial statements.

Example 1 Calculating normalized earnings

Sara Sophia is valuing Alpha Inc., a private manufacturing company. She gathers the following
information regarding the company:

y Alec Stewart is the principal shareholder and CEO of Alpha Inc. His compensation for the year was
$2 million, which was included in SG&A. Sophia believes that a market-based compensation of $1
million is suitable for this CEO role.
y The company incurred expenses amounting to $500,000 on a farmhouse, which Sophia does
not consider necessary for the core operations of the company. $350,000 worth of expenses was
included in SG&A, and $150,000 was included in depreciation expense.
y Alpha Inc. has debt amounting to $1.5 million outstanding at an interest rate of 7%. Sophia believes
that the company’s current leverage levels are less than optimal, so she decides to use an earnings
figure that excludes interest expense altogether in her analysis. In the event that the company is
acquired, the acquirer would likely change the company’s capital structure by increasing leverage,
which would result in a change in interest expense and, therefore, in profit after taxes.

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Based on the company’s financial statements, Sophia computed operating income after taxes:

Alpha Manufacturers Operating Income after Taxes

Reported

Revenues $100,000,000
Less: Cost of goods sold 60,000,000
Gross profit 40,000,000
Less: Selling, general, and administrative expenses 15,000,000
EBITDA 25,000,000
Less: Depreciation and amortization 1,500,000
Earnings before interest and taxes 23,500,000
Less: Pro forma taxes (at 35%) 8,225,000
Operating income after taxes $15,275,000

1. Based on this information, identify the adjustments that Sophia should make to Alpha Inc.’s reported
income to estimate normalized earnings assuming that the firm will be acquired.
2. Based on the answer to Part 1, construct a pro forma statement of normalized operating income
after taxes for the company.

Solution

1. Sophia must make the following adjustments to reported income to estimate normalized earnings:

y Since the appropriate market-based compensation expense for the CEO is $1 million, SG&A
expenses must be reduced by $1 million (= 2 − 1).
y Since the farmhouse is not required for the company’s core operations, related expenses should
be removed from operating income. Therefore, SG&A expenses must be reduced by $350,000
and depreciation expense by $150,000.

2. The pro forma statement of normalized operating income after taxes is:

Alpha Manufacturers Operating Income after Taxes

As of December 31, 20X9 Adjusted

Revenues $100,000,000
Less: Cost of goods sold 60,000,000
Gross profit 40,000,000
Less: Selling, general, and administrative expenses 13,650,000
EBITDA 26,350,000
Less: Depreciation and amortization 1,350,000
Earnings before interest and taxes 25,000,000
Less: Pro forma taxes (at 35%) 8,750,000
Operating income after taxes $16,250,000

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Cash Flow Estimation Issues for Private Companies

In addition to adjusting earnings, analysts typically need to adjust free cash flow to the firm (FCFF) and free
cash flow to equity (FCFE) forecasts (used to value private companies) with special consideration given to
the interest being valued, future operations, and possible managerial bias,

The valuation from the perspective of a controlling shareholder position differs greatly from that of a
minority shareholder position since controlling shares reflect a control premium. The control premium allows
controlling shareholders to make decisions on matters, such as dividend payout policies, that affect cash
flow and thus valuation forecasts.

Many events occur in the life cycle of a private company that may significantly change financial
performance. Early-stage companies may face uncertainty in achieving milestones to obtain sequential
rounds of financing. Mature companies may get acquired, go public, or face bankruptcy. The vast array of
potential outcomes can make forecasting cash flows difficult.

For a private company, a heavier level of information asymmetry exists between insiders and the public.
Management forecasts often include bias. For example, for goodwill impairment testing, management
may provide overly optimistic projections to avoid impairment or for operating expense reduction,
management may understate company value to reduce stock-based compensation expense reported on
the income statement.

Private Company Discount Rates and Required Rates of Return

LOS: Explain factors that require adjustment when estimating the discount rate for
private companies.

LOS: Compare models used to estimate the required rate of return to private company equity
(for example, the CAPM, the expanded CAPM, and the build-up approach).

Factors Affecting Private Company Discount Rates

With respect to discount rates, analysts can use weighted average cost of capital (WACC) to discount FCFF
and the cost of equity (re) to discount FCFE. Analysts should consider various factors when estimating
discount rates.

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Exhibit 4 Discount rate estimation: issues and considerations

Size premium Add size premium for small companies

CAPM may be inappropriate since some small private companies have little
Validity of CAPM
prospect of going public

Expanded CAPM Includes a size premium and a company-specific premium, which is subjective

Implicitly estimates beta to be 1 but includes an industry risk premium, which

Build-up approach
can be challenging to measure

Debt availability
Less access to debt and greater reliance on equity may result in higher WACC
and cost of debt

Discount rate used Acquirers will use target's cost of capital, which is typically higher than
in acquisition acquirer's capital cost, to discount target company's cash flow

Discount rate
Private company information is often less transparent; may result in less
adjustment for
accurate forecasts and warrant higher discount rates
projection risk

Required Rate of Return Models

Given the questionable validity of the capital asset pricing model (CAPM), an analyst may calculate an
alternative cost of equity using the expanded CAPM approach or build-up approach.

Exhibit 5 Expanded CAPM

E(Rc) = Rf + (β × RPe) + RPs + RPc

E(Rc) = Company required rate of return

Rf = Risk-free rate

RPe = Equity risk premium

RPs = Risk premium based on size

RPc = Risk premium for specific company

The expanded CAPM adds idiosyncratic risk premia to the original model, whereas the build-up approach
adds various risk premia to the risk-free rate.

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 Private Company Valuation

Exhibit 6 Build-up approach for required cost of equity

Risk-free rate
+ Equity risk premium
+ Small size risk premium
+ Company-specific risk adjustment
+ Industry risk adjustment (premium or discount)
= Required cost of equity

Example 2 Estimating the discount rate

Continuing from Example 1, Sophia now wants to determine the appropriate discount rate to compute
the present value of Alpha Inc.’s expected future cash flows. She gathers the following information
regarding Alpha Inc.:

y Estimated beta (based on publicly traded comparables) = 0.9

y Small stock premium = 4%
y Company-specific risk premium = 1.5%
y Industry risk premium (for the build-up method) = 1%
y After-tax cost of debt = 6%
y Current debt-to-equity ratio = 0.33
y Optimal debt-to-equity ratio = 0.60

Given that the risk-free rate equals 4.5% and the expected return on the equity market is 10%, calculate:

1. The required return on equity based on the CAPM.

2. The required return on equity based on the expanded CAPM.
3. The required return on equity based on the build-up method.
4. The company’s WACC based on its current debt-to-equity ratio and a cost of equity of 15%.
5. The company’s WACC based on the optimal debt-to-equity ratio and a cost of equity of 15%.

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Solutions

y Required return on equity = Risk-free rate + (Beta × Market risk premium)

= 0.045 + [0.9 × (0.1 − 0.045)] = 9.45%
y Required return on equity = Risk-free rate + (Beta × Market risk premium)
+ Small stock premium + Company-specific risk premium
= 0.045 + [0.9 × (0.1 − 0.045)] + 0.04 + 0.015 = 14.95%
y Required return on equity = Risk-free rate + Equity risk premium +Small stock premium
+ Company-specific risk premium + Industry risk premium
= 0.045 + (0.1 − 0.045) + 0.04 + 0.015 + 0.01 = 16.5%

1 0.33
y (
WACC = 0.15 ×
1.33
) + ( 0.06 × 1.33 ) = 12.77%
1 0.6
y (
WACC = 0.15 ×
1.6 ) (
+ 0.06 ×
1.6
) = 11.63%
Notice that the WACC assuming the optimal capital structure is lower than Alpha Inc.’s current WACC
(11.63% versus 12.77%) because the weight of (relatively cheaper) debt is greater in the optimal capital
structure than in Alpha Inc.’s current capital structure (37.5% versus 24.81%). For valuation in a potential
sale of Alpha Inc., the optimal capital structure should be used to determine the WACC because an
acquirer would be able to establish the optimal capital structure (by taking on more debt) and would be
willing to do this (as it lowers the cost of capital).

Also note that the weight of debt of public comparable companies may be higher than what is optimal for
Alpha Inc., which is a private company. Public companies have greater access to public debt markets
and also entail lower risk due to their relatively large sizes. Both these factors result in public companies
having a lower cost of debt than private companies.

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Valuation Discounts and Premiums

LOS: Explain and evaluate the effects on private company valuations of discounts and
premiums based on control and marketability.

Exhibit 7 Valuation of shareholding percentage

Value of
comparable
interest

Discount for lack of

marketability

Minority interest Minority interest Firm acquired by Firm acquired by

in private firm in listed firm financial buyer strategic buyer

Synergies Control premium

Public company valuation often presupposes the exchange of noncontrolling shares in a liquid market.
In contrast, private company valuation assumes adjustments for the degree of control and the level of
liquidity. Thus, private company shares often include a discount for the lack of control (for noncontrolling
shareholders) and a discount for lack of marketability.

A private company’s value is subject to the position of the investor. The greatest perceived value comes
from a strategic buyer (ie, a large competitor) who intends to acquire a controlling stake and unlock
potential synergies through operational efficiencies.

The next greatest perceived value comes from a financial buyer (eg, private equity firm) who is willing to
pay a premium for control but is not necessarily able to extract any synergies

The next level of perceived value would come from a potential minority shareholder with readily marketable
(ie, liquid) shares. This private company’s share value is theoretically closer to publicly traded stock prices
since public shares primarily reflect noncontrolling interests.

The least perceived value would be to a potential minority shareholder with nonmarketable (ie, illiquid)
shares. This category of investors have neither control nor liquidity.

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Other than the type of investor, other factors impact private company valuation:

y The purpose of the valuation (whether the valuation is for a competitive bid)
y The size of the holding and distribution of shares
y The relationships between different stakeholders.
y The laws protecting minority shareholder rights
y The prospects and timing of a potential liquidity event (eg, IPO)

Lack of Control Discounts

In general, shares of minority interest positions (ie, noncontrolling shares) incorporate a discount from the
controlling shares to reflect the lack of control. Minority shareholders have little to no say in selecting key
personnel and thus are unable to influence matters that affect their returns, such as dividends, investments,
and exit strategies. Furthermore, controlling shareholders can benefit from excessive compensation at the
expense of minority shareholders.

Due to the lack of data required to estimate a discount for lack of control (DLOC), the DLOC is computed
based on the control premium:

1
DLOC = 1 −
1 + Control premium

For example, if the control premium equals 20%, the DLOC would equal:

1
DLOC = 1 − = 0.1667, or 16.67%
1 + 0.2

Typically, the default free cash flows and discount rates reflect controlling positions, so analysts need
to properly adjust for the DLOC. Conversely, if the cash flows and discount rates do reflect those of a
noncontrolling interest, then such adjustments are not needed to reflect the DLOC.

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 Private Company Valuation

Lack of Marketability Discounts

A discount for lack of marketability (DLOM) reflects low levels or the absence of liquidity. The DLOC is
often linked to the DLOM. A lack of marketability discount is typically applied since a minority interest in
the company cannot influence the timing or the exit strategy of liquidity events. The DLOM is affected by
the prospects for liquidity events, restrictions on share transfers, a limited number of potential buyers, and
ownership concentration.

Exhibit 8 Sources for estimating discount for lack of marketability (DLOM)

Restricted stock Compare public company's restricted stock price to its

transactions freely trade stock price

IPOs Compare pre-IPO share price to post-IPO share price

Put options Compare at-the-money put option price to stock price

Except for trading restrictions, restricted stocks share the same characteristics as freely traded shares
of public corporations. Restricted shares become freely tradeable after these temporary restrictions are
lifted, usually when a prescribed amount of time has passed after an IPO. Restricted shares are often
awarded to key executives. Analysts can compare the price of restricted shares to freely traded shares to
estimate DLOM.

The price of pre-IPO shares is compared to the price of post-IPO shares to determine the size of the DLOM.
However, analysts should bear in mind that post-IPO prices tend to be higher not only because of greater
marketability but also because of lower risk and greater predictability of the future cash flows of the now-
public company.

Combining put options with restricted shares essentially creates future marketability. The put premium
is effectively the DLOM discount. The discount in percentage terms equals the put premium divided by
the stock’s price. The advantage of this approach is that the put option captures the volatility estimate.
However, this approach can be misleading since the entire cost of the put primarily reflects the cost of
downside protection.

The total discount that combines DLOC and DLOM is calculated as:

Total discount = 1 − (1 − DLOC) × (1 − DLOM)

When estimating valuation discounts or premiums, analysts should first adjust for the degree of control,
then adjust for the degree of marketability.

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Example 3 Applying valuation discounts

Olivia Martin is the CEO of Luxury Travels and holds 80% of the company’s shares, whereas the
remaining 20% is held by Roy Anderson. Martin is interested in selling 100% of the company to a third
party, which leads to the possibility of the following two scenarios:

Scenario 1: Martin will likely sell the company very soon.

y Under this scenario, since the company is likely to be sold by the controlling shareholder, the lack of
marketability discount applicable on Anderson’s minority equity interest will be modest. Assume that
the DLOM equals 5%.
y A DLOC will not be applicable under this scenario as both shareholders will receive the same price
per share.
y Further, the company should be valued based on normalized earnings (as opposed to reported
earnings), and the discount rate applied to future earnings should be based on an optimal capital
structure (as opposed to the actual current capital structure).
y The value of the company’s equity in this scenario is estimated as $75 million.

Scenario 2: Martin has no plans to sell the company.

y Under this scenario, since the company is not likely to be sold, a higher DLOM will be applicable on
Anderson’s noncontrolling equity interest in the company. Assume that the DLOM equals 30%.
y Furthermore, the company will be valued on the basis of reported earnings (as opposed to
normalized earnings) that are not adjusted for any above-market compensation and perquisites
that Martin may be charging the company. Use of reported earnings captures the adverse impact
associated with lack of control, so there is no need to apply DLOC separately.
y The discount rate applied to future earnings should be based on the actual capital structure (as
opposed to the optimal capital structure).
y The value of the company’s equity in this scenario is estimated as $60 million.

Calculate the value of Anderson’s equity interest for both scenarios.

Solutions

Scenario 1

Value of Anderson's 20% equity interest = Pro rata value of 20% equity interest − DLOC − DLOM
= ($75m × 20%) − 0% − ($75m × 20% × 5%)
= $14.25m

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 Private Company Valuation

Scenario 2

Value of Anderson's 20% equity interest = Pro rata value of 20% equity interest − DLOC − DLOM
= ($60m × 20%) − 0% − ($60m × 20% × 30%)
= $8.4m

Note that the value of the company is greater in Scenario 1 since:

y Normalized earnings are greater than reported earnings (eg, due to above-market compensation for
the owner).
y The WACC based on the optimal capital structure is lower than the WACC based on the current
capital structure.

Private Company Valuation Approaches

LOS: Explain the income, market, and asset-based approaches to private company valuation
and factors relevant to the selection of each approach.

The three primary private company valuation approaches are the income approach using discounted
expected cash flows and/or earnings, the market approach using relative price multiples, and the
asset-based approach using net asset values.

Exhibit 9 Private company valuation methods

Asset-based Income approach Market approach

approach Projected economic Observed
Net asset values benefits multiples

Free cash flow Capitalized cash flow Excess earnings*

PV of projected cash PV assuming Sum of PV of intangible
flows and terminal stable growth of cash assets, working capital,
value of enterprise flows into perpetuity and fixed assets

*Also referred to as residual income

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Income-Based Approaches

Free Cash Flow Valuation Approach

The free cash flow approach involves discounting a finite stream of free cash flows (eg, FCFF or FCFE) at
the appropriate discount rate (eg, WACC or re) and adding a discounted terminal value. The terminal value
can be viewed as the exit value or a value that reflects constant and predictable future growth (g).

The terminal value can be calculated using the capitalized cash flow method, excess earnings method, or
market-based multiple method.

Exhibit 10 Terminal valuation approaches

1) Earnings normalization/Cash
flow issues Capitalized cash flow
Cash flow/g
n
FCFFt + l Terminal value Excess earnings
IVt = � +
(1 + WACC) l (1 + WACC) n Residual income/(r − g)
t=1

2) Discount rate/Rate of return Market-based multiple

adjustments

3) Valuation discount
or premium

© CFA Institute

Capitalized Cash Flow Method

The capitalized cash flow model (CCM) is essentially the constant growth free cash flow model. It requires
just one future cash flow estimate (ie, FCFFt+1) and assumes a constant growth in cash flows over an
infinite period:

FCFFt + 1
Firm valuet =
WACC − g

The CCM is only appropriate for valuing a relatively small private company when future projections are
uncertain and comparable company market data are not available but stable growth is expected.

An expanded version of the CCM shows that FCFFt+1 in the numerator can be calculated as after-tax
earnings before interest and taxes (EBIT) net of reinvestments:

FCFFt + 1 = EBIT(1 − t)(1 − RIR)

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 Private Company Valuation

The reinvestment rate (RIR) captures investments in working capital and fixed capital and can be
calculated as:

g
RIR =
WACC

Once firm value is calculated, analysts can derive equity value by subtracting the market value of
private debt:

(EBITt + 1 × (1 − t) × (1 − RIR))
Firm valuet =
WACC − g

Alternatively, analysts can directly calculate equity value (IVt = intrinsic value of equity) with FCFE. In either
case, the denominator (WACC − g or re − g) is referred to as the capitalization rate:

FCFEt + 1
IVt =
re − g

The Excess Earnings Method

According to the excess earnings method (EEM), a business’s value is the sum of its tangible and intangible
assets. Tangible asset value is the sum of the fair values of the working capital (eg, inventory) and fixed
assets (eg, PPE).

Intangible asset value is the present value of the stream of excess earnings with steady growth in
perpetuity. Excess earnings is the residual earnings net of the required return on working capital and
fixed assets.

Exhibit 11 Excess earnings method (EEM)

Excess earning0 = Normalized earnings0 − rworking capital (Working capital) − rfixed assets (Fixed assets)

Excess earning0 (1 + g)
Intangible assets value =
rintangibles − g

Firm value = Working capital + Fixed asset value + Intangible asset value

The EEM is generally used to value very small businesses or businesses with significant intangibles when
other valuation methods are not feasible.

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Example 4 Estimating firm value based on the excess earnings method

RFS is a small private business that harvests and sells seafood. RFS has $22,000 in working capital
requirements and fixed assets with a fair value of $230,000. RFS’s required returns on working capital,
fixed assets, and intangible assets are estimated as 3%, 9%, and 11%, respectively. Normalized
earnings for the year just ended amounted to $82,000, and residual income is expected to grow at 2%
per year. Determine the value of RFS using the excess earnings method.

Solution

First, determine residual income for the year just ended by subtracting returns required from working
capital and fixed assets from normalized earnings:

Excess earnings = 82,000 − (0.03 × 22,000) − (0.09 × 230,000) = $60,640

Then compute the value of intangible assets:

60,640 × 1.02
Intangible assets = = $687,253
0.11 − 0.02

Finally, we compute the value of the firm as the sum of the values of working capital, fixed assets, and
intangible assets:

Firm value = 22,000 + 230,000 + 687,253 = $939,253

Market-Based Approaches
The market approach values a private company based on company price multiples, or from sales of
comparable private companies. Common multiples include EV-to-EBITDA, MVIC-to-EBITDA, and PE.

Exhibit 12 Private company valuation methods

Asset-based Market approach Income approach

approach Observed Projected economic
Net asset values multiples benefits

Guideline public Guideline Prior

company transactions transactions
Recent trading of Recent acquisitions Past trades or
minority interests in of comparable private transactions of the
comparable public firms or public firms same firm

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The market approach has the following variations:

y The guideline public company method (GPCM) derives a private company’s value from observed
trading multiples of comparable public companies.
y The guideline transaction method (GTM) derives a private company’s value from historical acquisition
multiples paid for public or private companies.
y The prior transaction method (PTM) derives a private company’s value from past transactions in the
private company itself (eg, exchange of shares between shareholders).

Market approaches rely on data from actual market transactions, so it is preferred to the income and asset-
based approaches for private company valuation by some practitioners (including U.S. tax courts).

Guideline Public Company Method

To value a private company, analysts often reference public companies with similar risk and growth profiles
within the same industry. This method is known as the guideline public company method (GPCM). In
general, the process involves:

y Obtaining a reference multiple (eg, MVIC-to-EBITDA) from a public competitor or public peer group.
y Adjust the multiple for factors such as size, capital structure, and age.
y Adjust the multiple for a control premium.
y Apply the multiple to the private company’s financial metric (eg, EBITDA).

When comparing public companies to private companies, analysts should also account for any difference
in leverage by adjusting the value of beta. To do so, first unlever the reference beta and then relever it to
reflect the private company’s specific capital structure.

Exhibit 13

Unlevered beta (βꢀ )

Levered beta

βL Debt
βU =
1 + (1 − t ) D
E
Tax rate Equity

Levered beta (βꢁ)

Debt
D
βL = βU 1 + (1 − t ) E
Equity
Unlevered beta Tax rate

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Example 5 Unlevering and relevering beta of a reference public company

An analyst wants to estimate a private company’s beta from that of a public competitor. To do this, the
analyst gathers the following information:

Debt Equity Levered

Company (£ millions) (£ millions) Beta Tax Rate

Private company 25.0 75.0 – 30%

Public competitor 15.0 85.0 1.3 34%

What is the private company’s beta after unlevering and relevering the public competitor’s beta?

Solution

Steps Calculations

βL, public
βU, public =
Dpublic
�1 + �(1 − tpublic) ��
Unlever public company's beta to Epublic
remove financial leverage impact 1.3
βU, public = = 1.164
15.0
1 + �(1 − 0.34) × �
85.0

Dprivate
βL, private = βU, public � 1 + �(1 − tprivate) × ��
Relever the unlevered beta above to Eprivate
include the financial leverage impact
specific to private company 25.0
βL, public = 1.164 � 1 + �(1 − 0.30) × �� = 1.44
75.0

When analyzing a private conglomerate that operates across multiple industries, analysts may need to
create a composite profile from multiple groups of comparable companies. Composite profiles are often
weighted by sales or net income.

The primary advantages to using GPCM include the large sample size of public firms available along with
supplemental financial disclosure. Disadvantages include the possibility that the appraiser will be unable to
find comparable firms and the difficulty in determining growth and risk-related adjustments to multiples.

Vol 4-102
 Private Company Valuation

As discussed earlier, when valuing a controlling interest, an analyst needs to adjust public company
references to reflect control premiums. Historically, control premiums are estimated based on prices paid to
acquire public companies. When estimating a control premium, an analyst should consider:

y Type of transaction: Control premiums for strategic purchase transactions tend to be higher than for
financial purchase transactions due to potential strategic synergies.
y Industry factors: Industries experiencing significant acquisition activities are deemed “in-play.” As such,
stock prices of in-play public companies may already reflect some level of control premium. Applying
a standard control premium to these prices may overestimate the value of a controlling interest in a
private company.
y Form of consideration: Control premiums are more difficult to assess from reference transactions when
acquisitions were paid for in stock (instead of cash) since acquirers tend to prefer stock transactions
when their own shares are overvalued.

Guideline Transaction Method and Prior Transaction Methods

The guideline transaction method (GTM) reference multiples come from recent acquisitions of similar public
or private companies. Since acquisition prices already reflect some sort of control premium, the valuation
multiple does not necessarily need such adjustments. When applying multiples from historical transactions,
analysts should consider:

y Synergies: The prices paid in strategic transactions likely include a premium for expected synergies.
However, if the transaction is financial, there may not be premiums for synergies. As such, the
premium must be adjusted on a case-by-case basis.
y Contingent consideration: Contingent consideration (eg, earnout) refers to potential future payments
to the seller contingent upon achieving certain performance milestones (eg, a target level of EBITDA).
Such reference transactions must be carefully assessed to reflect the potential obligations faced
by the seller.
y Non-cash consideration: When an acquisition is paid for in the form of stock of the acquirer, the
transaction price may be inflated if the acquirer’s stock is overvalued in the market.
y Availability of transactions: Finding guideline transactions is not always easy or straightforward in
certain industries.
y Changes between the transaction date and the valuation date: Historical transaction prices may no
longer be relevant due to changes in the industry or economic environment. Such changes may impact
risk and growth profiles.

In addition to all the factors listed, analysts should factor in company size, country, tax status, and leverage.

Vol 4-103
Learning Module 4

Example 6 Valuing a company’s equity using GTM

Using the data from Example 5, suppose that the analyst is able to find several comparable companies
that have recently been sold. Acquisition prices in those transactions indicate an average MVIC-EBITDA
ratio of 6.2. Given that the risk and growth prospects of this company are similar to those of the acquired
companies, calculate the value this company’s equity using the GTM.

Solution

The MVIC-EBITDA multiple provided in the question does not need to be adjusted for control (as the
multiple already reflects the control premium embedded in acquisition prices) or for risk and growth
prospects. Therefore, the market value of equity can be calculated as follows:

Market value = 6.2 × 18.5m = $114.7 million

Market value of equity = Total market value − Market value of debt

= 114.7m − 12m = $102.7 million

Private Company Valuation: Income-Based Approach

LOS: Calculate the value of a private company using income-based methods.

The income based approach involves discounting expected cash flows or earnings. Example 7 illustrates
valuing a private company based on the income-based methods.

Example 7 Estimating firm value based on free cash flow

The following information relates to Alpha Inc.:

y Net profit margin = 22%

y Sales in Year 0 = 15m
y Fixed capital investment in Year 0 = 4m
y Depreciation in Year 0 = 5m
y Working capital investment as a percentage of sales = 8.5%
y Tax rate = 40%
y Interest expense on par value of debt of $20m in Year 0 = 11.5%
y WACC during the high-growth phase = 19%
y WACC during the mature phase = 16%

Vol 4-104
 Private Company Valuation

Net income, fixed capital investment, depreciation, interest expense, and sales are expected to grow at
a rate of 12% for the next 5 years and then stabilize at a long-term constant growth rate of 6%. Compute
the value of the firm.

Solution

FCFF in each of the first 6 years is calculated as (differences due to rounding):

Year 0 1 2 3 4 5 6

Sales ($ millions) 15.00 16.80 18.82 21.07 23.60 26.44 28.02

Net income 3.30 3.70 4.14 4.64 5.19 5.82 6.16

Add: Depreciation 5.00 5.60 6.27 7.02 7.87 8.81 9.34
Add: After-tax interest expense 1.38 1.55 1.73 1.94 2.17 2.43 2.58
Less: Fixed capital investment 4.00 4.48 5.02 5.62 6.29 7.05 7.47
Less: Working capital investment 1.28 1.43 1.60 1.79 2.01 2.25 2.38
FCFF 4.41 4.93 5.53 6.19 6.93 7.76 8.23

Illustration of calculations for Year 0 and Year 1:

Year 0 Year 1
S $

Sales 15m 15m × (1 + 0.12) = 16.8m

Net income 22% of 15m = 3.3 3.3m × (1 + 0.12) = 3.696m
Depreciation 5m 5m × (1 + 0.12) = 5.6m
After-tax interest expense 11.5% of 20m x (1 – 0.4) = 1.38m 1.38m × (1 + 0.12) = 1.5456m
Fixed capital investment 4m 4m × (1 + 0.12) = 4.48m
Working capital investment 8.5% of 15m = 1.275m 8.5% of 16.8m = 1.428m

Next, calculate the terminal value as of the end of Year 5 (end of Stage 1), using Year 6 FCFF (8.23m),
the mature stage WACC (16%), and the Stage 2 constant growth rate (6%) in the calculation.

Terminal value at end of Year 5 = 8.23 × (0.16 − 0.06) = $82.3 million

Now compute the value of the firm as the sum of the present values of FCFF in Stage 1 and the present
value of the terminal value. Note that the high-growth phase WACC (19%) is used in this calculation.

4.93 5.53 6.19 6.93 7.76 + 82.3

Value of firm = = $52.92 million
1.191 1.192 1.19 3 1.19 4 1. 195

Vol 4-105
Learning Module 4

Private Company Valuation: Market-Based Approach

LOS: Calculate the value of a private company using market-based methods and describe the
advantages and disadvantages of each method.

Market-based approaches use relevant market multiple for comparable firms, as Example 8 illustrates.

Example 8 Valuing a company’s equity using the GPCM

Alex Donovan is interested in valuing the equity of Star Enterprise, a private company, using the GPCM.
He gathers the following information regarding comparable public companies in the same industry:

y Average MVIC-EBITDA multiple = 6.5

y A downward adjustment of 20% to the average comparable public company MVIC-EBITDA ratio is
required to reflect the relative risk and growth characteristics of Star Enterprise.
y Based on past acquisitions of public companies in the industry, a 15% premium for control is
considered appropriate.

Alex obtains the following information regarding Star Enterprise:

y Normalized EBITDA = $18.5 million

y Market value of debt = $12 million
y Normalized D/E ratio = 0.5

Estimate the value of Star Enterprise’s equity using the GPCM.

Solution:

The average MVIC-EBITDA of other public companies in the industry needs to be adjusted downward
by 20% to reflect the relative risk and growth characteristics of Star Enterprise. Therefore, use an
MVIC-EBITDA ratio of 5.2 [= 6.5 × (1 − 0.2)] in the valuation.

This MVIC-EBITDA then needs to be adjusted to reflect a control premium of 15%. Be careful: A control
premium is only applied to a company’s equity, not to its debt. Therefore, do not simply apply the 15%
control premium to Star Enterprise’s MVIC-EBITDA multiple as the MVIC reflects the value of both equity
and debt.

Given the normalized capital structure of one third debt and two thirds equity (D/E ratio = 0.5), apply
a 10% (= 2/3 × 15%) premium for control on the MVIC-EBITDA multiple. Therefore, use an MVIC to
EBITDA ratio of 5.72 (= 5.2 × 1.10).

Market value of Star Enterprise’s invested capital = 5.72 × 18.5 million = $105.82 million

Market value of Star Enterprise’s equity = Total market value − market value of debt
= $105.82 million − 12 million = $93.82 million

Vol 4-106
Fixed Income
Learning Module 1
The Term Structure and Interest
Rate Dynamics

LOS: Describe relationships among spot rates, forward rates, yield to maturity, expected and
realized returns on bonds, and the shape of the yield curve.

LOS: Describe how zero-coupon rates (spot rates) may be obtained from the par curve by
bootstrapping.

LOS: Describe the assumptions concerning the evolution of spot rates in relation to forward
rates implicit in active bond portfolio management.

LOS: Describe the strategy of rolling down the yield curve.

LOS: Explain the swap rate curve and why and how market participants use it in valuation.

LOS: Calculate and interpret the swap spread for a given maturity.

LOS: Describe short-term interest rate spreads used to gauge economy-wide credit risk and
liquidity risk.

LOS: Explain traditional theories of the term structure of interest rates and describe the
implications of each theory for forward rates and the shape of the yield curve.

LOS: Explain how a bond’s exposure to each of the factors driving the yield curve can be
measured and how these exposures can be used to manage yield curve risks.

LOS: Explain the maturity structure of yield volatilities and their effect on price volatility.

LOS: Explain how key economic factors are used to establish a view on benchmark rates,
spreads, and yield curve changes.

Spot Rates, Forward Rates, and the Forward Rate Model

LOS: Describe relationships among spot rates, forward rates, yield to maturity, expected and
realized returns on bonds, and the shape of the yield curve.

LOS: Describe how zero-coupon rates (spot rates) may be obtained from the par curve by
bootstrapping.

Interest rates are both an economic indicator and a control mechanism for the economy. The term structure
of interest rates, that is, rates over different maturities, is crucial to valuing financial products, while
understanding interest rate dynamics is vital for risk management and fixed-income market participants.

Vol 4-109
Learning Module 1

Spot Rates and Forward Rates

The discount factor, denoted as DFN, represents the price of a risk-free payment of $1 after N periods,
where N is the maturity. The spot rate, indicated by ZN, also known as the zero-coupon yield or zero rate, is
the yield to maturity of this bond payment for N periods.

1
DFN =
(1 + ZN)N
DFN = The discount factor
ZN = Spot rate for N periods

The discount function is the discount factor for a range of maturities in years. The spot yield curve or
spot curve is the spot rate for a range of maturities in years. The spot curve reflects the interest rate term
structure and shows the annualized return on an option-free and default-risk-free zero-coupon bond with a
single payment of principal at maturity.

As the prices of these bonds fluctuate, the shape and level of the spot yield curve also change. The spot
rate curve is a benchmark for the time value of money, the most basic term structure, as it represents the
yield on bonds that make no payments, eliminating reinvestment risk. If the bond is held until maturity, the
stated yield equals the realized yield.

A forward rate is an interest rate established today for a loan that will be initiated in the future. The forward
curve represents the term structure of these forward rates for loans initiated on specific dates. Both forward
rates and forward curves are mathematically derived from the current spot curve.

The notation ƒ A, B − A represents the forward rate for a loan scheduled to start A periods from the present,
with maturity at B. As an example, the forward rate for three years, set for initiation in two years, is denoted
as ƒ 2, 1. This indicates that in the second year, the buyer will pay the agreed forward price ƒ 2, 1 to the seller,
who will subsequently pay the buyer in the third year, as initially defined. Since this involves a commitment
to the future, no initial money exchange takes place.

Forward contracts are valued using the forward pricing model, which is based on the principle of no-
arbitrage. The forward pricing model is:

DFB = DFA × FA,B − A

Where:
DFA = The discount factor A for period A.
DFB = The discount factor B for a longer period B.
FA, B − A = The no-arbitrage forward contract price, which starts in the future at time A and
ends at time B.

To understand the reasoning behind the forward pricing model, consider two alternative investments:

y Investment 1: Buy a two-year zero-coupon bond at a cost of DF2 = 0.91.

y Investment 2: Enter a one-year forward contract to buy a one-year zero-coupon bond for DF1 = 0.93.

Since the payoffs in two years remain consistent and the initial investment costs must be equal, the no-
arbitrage forward price for F1, 1 is determined as 0.91 / 0.93, equivalent to 0.9785.

The Forward Rate Model

The forward rate model demonstrates that forward rates rise above spot rates when the spot curve has an
upward slope and fall below spot rates when the spot curve slopes downward. The connection between
spot and forward rates is important for predicting future rates and evaluating fixed-income instruments.

Vol 4-110
 The Term Structure and Interest Rate Dynamics

As the forward rate ƒ A, B − A represents the discount rate for a risk-free, unit-principal payment B periods
from today, the forward contract price, DFA,B − A, can be calculated as:

1
DFA,B − A =
(1 + FA,B − A)B − A

By substituting the equation above and the discount factor formula into the formula for the forward pricing
model, the forward pricing model can be expressed in terms of rates, as shown below. This is known as the
forward rate model:

(1 + ZB)B = (1 + ZA)A × (1 + ƒ A,B − A) B − A

ZA = The spot rate for period A
ZB = The spot rate for a longer period B

This demonstrates the extrapolation of forward rates from known spot rates at any given point in time.

The forward rate represents the reinvestment rate that would render an investor indifferent between
purchasing a B-period zero-coupon bond or investing in an A-period zero-coupon bond and then reinvesting
the proceeds for an additional period of B − A. In this context, the forward rate can be thought of as a
breakeven interest rate.

The forward rate can also be interpreted as the rate for the B − A period that can be secured today
by selecting a B-period zero-coupon bond over an A-period bond and extending the maturity by the
B − A period. In this context, the forward rate can be thought of as a rate that can be locked in by
extending maturity.

The relationship between spot rates and one-period forward rates can be shown using the forward rate
model and repeated substitution:

(1 + ZT)T = (1 + Z1) × (1 + ƒ 1,1) × (1 + ƒ 2,1) ∙∙∙ × (1 + ƒ T − 1,1)

1
ZT = {(1 + Z1 ) × (1 + ƒ1,1 ) × (1 + ƒ2,1 ) ∙∙∙ × (1 + ƒ T − 1,1)}T − 1

This equation is crucial for active fixed-income portfolio managers. Although there is debate as to whether
forward rates are an accurate predictor of future spot rates, implied forward rates are generally the
best proxy available for predicting future spot rates. If a proactive trader can find short-term bonds with
returns higher than current forward rates, they could outperform a buy-and-hold strategy if the yield curve
remains stable.

The forward rate ƒA, B − A can be rewritten as follows after rearranging the forward rate model equation:

A
1 + ZB B − A
ƒA,B − A = �� � × (1 + ZB)� − 1
1 + ZA

Suppose A = 1, B = 4, Z1 = 2.5%, and Z4 = 3.5%, then ƒ1, 3 is:

1
1 + 0.035 3
ƒ1,3 =�� � × (1 + 0.035)� − 1 = 3.84%
1 + 0.025

Vol 4-111
Learning Module 1

With an upward-sloping yield curve (ie, ZB > ZA), the forward rate model indicates a forward rate from A to
B that is greater than the long-term spot rate (ie, ƒ A, B − A > ZB). In an upward-sloping curve, forward rates
increase with time, causing the forward curve to be positioned above the spot curve.

Exhibit 1 1-period forward rates and forward curve

Maturity Spot Forward Forward

(years) rates rate calc rates
1 4% 4.00%
Upward-sloping curve:
(1 + 0.05) 2 Forward rates above spot rates
2 5% = − 1 6.01%
(1 + 0.04)1 25%
(1 + 0.06) 3
3 6% = − 1 8.03%
(1 + 0.05) 2
20%
(1 + 0.07) 4
4 7% = − 1 10.06%
(1 + 0.06) 3
15%
(1 + 0.08) 5
5 8% = − 1 12.09%
(1 + 0.07) 4
(1 + 0.09) 6 10%
6 9% = − 1 14.14%
(1 + 0.08) 5
(1 + 0.10) 7 5%
7 10% = − 1 16.20%
(1 + 0.09) 6
(1 + 0.11) 8
8 11% = − 1 18.26% 0%
(1 + 0.10) 7 1 2 3 4 5 6 7 8 9 10
(1 + 0.12) 9 Years
9 12% = − 1 20.33%
(1 + 0.11) 8 Spot rates Forward rates
(1 + 0.13)10
10 13% = − 1 22.41%
(1 + 0.12) 9

Conversely, in a downward-sloping curve (ie, ZB < ZA), the forward rate is less than the long-term spot rate
(ie, ƒ A, B − A < ZB). In a downward-sloping curve, forward rates decrease with time, resulting in the forward
curve lying below the spot curve. The forward rate model also highlights that in a flat spot curve, all one-
period forward rates match the spot rate.

The government par curve reflects yields to maturity on coupon-paying government bonds priced at par
across different maturities. Typically, recently issued (ie, on-the-run) bonds are used due to their liquidity
and proximity to par value.

The par curve is crucial for valuation as it forms the basis for creating a zero-coupon yield curve. This
involves treating a coupon-paying bond as a set of zero-coupon bonds. Zero-coupon rates are derived from
par yields using a process called bootstrapping, where rates are solved sequentially from the shortest to
the longest maturities.

The idea of bootstrapping can be effectively demonstrated through a numerical example. Suppose the one-
year par rate = 4.5%, the two-year par rate = 5.27%, and the three-year par rate = 6.11%. Assuming annual
coupons, the one-year zero-coupon rate corresponds to the one-year par rate, as both involve a single cash
flow (ie, z 1 = 4.5%). However, bonds with durations of two years or more have a coupon payment before
maturity, so the calculation of the zero-coupon rates begins with the two-year maturity.

Vol 4-112
 The Term Structure and Interest Rate Dynamics

Calculating the two-year zero-coupon rate uses the one-year zero-coupon rate (z 1 = 4.5%) and solves for
z 2, as shown below:

0.0527 1 + 0.0527
1= +
(1 + 0.045)1 (1 + z2)2

Therefore, the bootstrapped two-year spot rate is 5.29%.

The three-year zero-coupon rate can be determined through bootstrapping by solving for z 3 using the
values of the one-year and two-year spot rates. The one-year rate was given as 4.5%, while the two-year
rate was derived through bootstrapping as 5.29%.

0.0611 0.0611 1 + 0.0611

1= + +
(1 + 0.045)1 (1 + 0.0529)2 (1 + z3)3

z3 = 6.18%

YTM in Relation to Spot and Forward Rates

LOS: Describe the assumptions concerning the evolution of spot rates in relation to forward
rates implicit in active bond portfolio management.

Since most bonds have coupons and various features like call provisions, the YTM for bonds with maturity
T differs from the spot rate at T, but it is mathematically linked to the spot curve. The principle of no
arbitrage implies that a bond’s value comes from summing the present values of payments discounted by
corresponding spot rates, thereby making the YTM a weighted average of the discount factors determined
by those spot rates.

Bond investors might not achieve the YTM due to restrictive conditions. The YTM forecasts bond returns
when coupons are reinvested at YTM, but this scenario rarely holds due to volatile interest rates, sloped
yield curves, default risks, or embedded options. The realized return of the bond, based on actual
reinvestment and the yield curve, often differs from the YTM. Only with perfect foresight do expected and
realized bond returns align.

Yield Curve Movement and the Forward Curve

When future spot rates align with the predictions of today’s forward curve, forward rates remain unchanged,
and consequently, the forward contract price remains constant. Changes in the forward rate (and the
corresponding forward price) reflect a diversion from the trajectory anticipated by today’s forward curve.

If a trader anticipates that the forthcoming spot rate will be less than the prevalent forward rate projection,
the trader will purchase the forward contract, expecting an increase in its value. Alternatively, if the trader
envisions future interest rates to be less than the market’s predictions, they will invest in a bond.

Conversely, if a trader foresees the future spot rate to be greater than the prevailing forward rate projection,
the trader will sell the forward contract, anticipating a decrease in its value. In simpler terms, if the trader
expects future interest rates to be higher than what the market predicts, the trader will divest a bond.

Vol 4-113
Learning Module 1

Active Bond Portfolio Management

LOS: Describe the strategy of rolling down the yield curve.

The annual returns on bonds with different maturities will match the one-year rate (the risk-free rate for
one year) over a one-year duration, if the future spot rates (at the end of the first year) follow the pattern
indicated by the existing forward curve. The forward rate model provides insight:

(1 + ZB)B = (1 + ZA)A × (1 + ƒ A,B − A) B − A

By rearranging terms in the equal above and setting the time horizon to one period, A = 1, we obtain:

(1 + ZB)B
Z1 = −1
(1 + ƒA,B − 1)B − 1

If the existing spot yield curve following one period (A = 1) aligns with the present forward curve, then this
equation demonstrates that the bond’s total return equals the one-period risk-free rate.

Example 1 Evolution of spot rates as implied by the current forward curve

Consider the following information:

y z 1 = 8%
y z 2 = 9%
y z 3 = 10%
y f1,1 = 10.01%
y f1,2 = 11.01%

Calculate the returns for the following bonds over a one-year period if the spot curve one year from today
aligns with the current forward curve.

1. One-year zero-coupon bond.

Solution
At t = 0, the one-year zero-coupon bond will be valued at 100 ⁄ (1 + 0.08) = $92.59. In one year (at
maturity), this bond will be worth $100, so the total return over the year can be calculated as:

100 100 100

�100 / �− 1 = �100 / �− 1= − 1 = 8%
1 + z1 1 + 0.08 92.59

Vol 4-114
 The Term Structure and Interest Rate Dynamics

2. Two-year zero-coupon bond.

Solution
At t = 0, the two-year zero-coupon bond will be valued at 100 ⁄ (1 + 0.09)2 = 84.168. At t = 1, the
one-year spot rate equals the one-year forward rate one year from today, f1,1. Therefore, this bond
will be worth 100 ⁄ (1 + 0.1001) = 90.90. The total return over the year can be calculated as:

100 100 100 100 90.90

� � / �100 ÷ � −1=� �/� �− 1= − 1 ≈ 8%
(1 + ƒ1,1) (1 + z2)2 (1 + 0.1001) (1 + 0.09)2 84.168

3. Three-year zero-coupon bond.

Solution
At t = 0, the three-year zero-coupon bond will be valued at 100 ⁄ (1 + 0.10)3 = $75.1315. At t = 1, the
two-year spot rate equals the two-year forward rate one year from today, f1,2. Therefore, this bond
will be worth 100 ⁄ (1 + 0.1101)2 = $81.148. The total return over the year can be calculated as:

100
� �
(1 + ƒ1,2)2 100 100 81.148
−1=� �/� �−1= − 1 ≈ 8%
(1 + 0.1101) 2 (1 + 0.10) 3 75.1315
100
� 100 / �
(1 + z3)3

This example shows that the bond’s one-year performance matches the one-year rate (representing
the risk-free rate) when spot rates follow the current forward curve. But if the spot curve diverges after a
year, bond returns will not all remain at 8% for the one-year holding period.

Example 2 Result when spot rates are less than implied by the current forward curve

Using the same information as in Example 1, calculate the one-year returns on the three bonds if the
spot rate curve at Year 1 is flat with a yield of 9% for all maturities.

1. One-year zero-coupon bond.

Solution
At t = 0, the one-year zero-coupon bond will be valued at 100 ÷ (1 + 0.08) = $92.5926. In one year
(at maturity), this bond will be worth $100, so the total return over the year can be calculated as:

100 100 100

�100 / �− 1 = �100 / � −1= − 1 = 8%
1 + z1 1 + 0.08 92.5926

Vol 4-115
Learning Module 1

2. Two-year zero-coupon bond.

Solution
At t = 0, the two-year zero-coupon bond will be valued at 100 ⁄ (1.09)2 = $84.168. At t = 1, if the
one-year spot rate equals 8%, this bond will be worth 100 ⁄ (1.08) = $95.5926. The total return over
the year can be calculated as:

100 100 100 100 95.5926

� � / �100 ÷ �− 1= � �/� � −1= − 1 ≈ 10.01%
(1 + ƒ1,1) (1 + z2)2 (1 + 0.08) (1 + 0.09)2 84.168

3. Three-year zero-coupon bond.

Solution
At t = 0, the three-year zero-coupon bond will be valued at 100 ⁄ (1.10)3 = $75.1315. At t = 1, if the
two-year spot rate equals 9%, this bond will be worth 100 ⁄ (1.09)2 = $84.168. The total return over
the year can be calculated as:

100 100 100 100 84.168

� � / �100 ÷ �− 1= � �/� � −1= − 1 ≈ 12.03%
(1 + ƒ1,2 )2 (1 + z3 )3 (1 + 0.09)2 (1 + 0.10)3 75.1315

If an investor’s predicted spot curve is above (below) the forward curve and this prediction holds true,
the return will be less (more) than the one-period risk-free interest rate. This results from the market
overestimating (underestimating) the forward contract’s value.

In Example 2, the spot curve ends up lower than the existing forward curve. As a result, the returns
on the two-year and three-year bonds exceed the current risk-free rate (8%) due to the market having
underpriced the forward contract.

Riding the Yield Curve (Rolling Down the Yield Curve)

When the yield curve slopes upward, the forward curve is always higher than the current spot curve. If
a trader thinks the yield curve will not change, buying bonds with a longer maturity than the matching
investment horizon would lead to a higher total return than the strategy of matching maturities. This idea
forms the core of a popular yield curve strategy called rolling down the yield curve, also known as riding
the yield curve.

Vol 4-116
 The Term Structure and Interest Rate Dynamics

Exhibit 2 Riding the yield curve: One-year breakeven rates

Yield Rates above the forward

rate curve result in losses Forward rate curve
"Breakeven" from riding the curve
investment rate in If spot rates in one
one year for riding year stay below
the curve today's forward
rates, riding the
curve generates
Spot rate curve greater returns

Static curve:
Greater returns
from riding the curve

Maturity (Years)

Investors can keep a bond for a while as its price goes up, then sell it before it matures to generate a higher
return. This strategy works well if interest rates stay steady and the yield curve keeps going up—it can keep
generating additional total return to a bond portfolio.

The Swap Rate Curve

LOS: Explain the swap rate curve and why and how market participants use it in valuation.

Interest rate swaps are important in the fixed-income market. They involve swapping fixed for variable
interest payments, and participants use them to control risks or to speculate. The exact payments,
either fixed or variable, are calculated by multiplying the interest rate by an amount for each period until
the swap ends.

The Swap Rate Curve

In an interest rate swap, the fixed interest rate is called the swap rate. It is similar to the YTM on a
government bond, which can be bootstrapped from zero rates. The key difference is that the swap rate
uses short-term borrowing rates instead of risk-free rates. In the past, the floating rates in swaps were
linked to short-term survey-based rates such as the three- or six-month US dollar LIBOR. Now, these rates
are transitioning to a transaction-based market reference rate (MRR) based on secured overnight funding
transactions. The yield curve of swap rates is called the swap rate curve or just the swap curve.

The swap curve is a kind of par curve (ie, the government par yield curve) since it’s based on par swaps,
where the fixed rate is determined to make sure no money is exchanged when the contract starts. In these
par swaps, the present values of the fixed-rate and benchmark floating-rate parts are the same.

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The swap market is liquid because it’s flexible and effective for managing risk. In some places, the swap
curve is crucial for interest rates when long-term government bonds are scarce. In Europe, swaps are a
common benchmark, while in Asia, both swaps and government bonds are used to assess value in credit
and loan markets.

Example 3 Application of swaps

ABC Bank wants to raise funds by issuing certificates of deposit (CDs).

y It can raise $10 million through a 2.5% CD that has a three-year term.
y It can raise another $10 million through a 3.5% CD that has a five-year term.

The bank issues $20 million worth of CDs and takes the pay-floating side of two plain-vanilla interest
rate swaps.

y On Swap 1, the bank receives 2.5% fixed and pays a three-month LIBOR minus 10 bp with a
three-year term and a notional amount of $10m.
y On Swap 2, the bank receives 3.5% fixed and pays a three-month LIBOR minus 20 bp with a five-
year term and a notional amount of $10m.

By entering into these swap contracts, the bank has effectively converted its fixed-rate liabilities to
floating-rate liabilities. The fixed-rate payments received from the swaps will be passed on to the CD
investors, leaving the bank with only floating-rate obligations. The margins on the floating rates thereby
become the standard by which value is measured in assessing the bank’s cost of funding. In this case,
the bank’s cost of funding is three-month LIBOR minus 15 bp for the next three years.

Why Do Market Participants Use Swap Rates When Valuing Bonds?

The main reference curves for valuing fixed-income assets are government spot curves and swap rate
curves. The choice depends on factors like market liquidity. In the US, institutions select a benchmark
based on their interest rate exposure. Wholesale banks, using swaps to hedge, often prefer the swap curve.
Retail banks with less swap market involvement lean toward the government spot curve.

How Do Market Participants Use the Swap Curve in Valuation?

For valuing an interest rate swap, it is essential to calculate the fixed rate for the swap that establishes a
neutral value for both parties at the outset. When a floating-rate bond is issued, it is priced at par because
the coupon rate for the upcoming settlement period aligns with the market interest rate. The objective in
valuing an interest rate swap is to determine the coupon rate on the fixed-rate bond (which signifies the
swap’s fixed rate) that would render its value equivalent to that of the floating-rate bond (ie, par).

The swap rate can be calculated as follows:

T
sT 1
+ =1
(1 + zt)t (1 + zT)T
t=1

Where:
ST = The T-period swap rate

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 The Term Structure and Interest Rate Dynamics

The left-hand side of the equation represents the value of the fixed-rate bond. The term represents
coupon payments, and represents the principal repayment at the end of Year T.

The right-hand side of the equation represents the value of the floating-rate bond (which is at par at swap
initiation). It is valued at $1 (par value) at both swap initiation and every coupon reset date since the floating
rate matches the market rate. For the swap to have a zero value at initiation, the fixed-rate and floating-rate
bonds must have equal values.

Example 4 Determining the swap rate curve

Consider the following spot rates:

y z 1 = 5.5%
y z 2 = 6.5%
y z 3 = 7.5%

Based on this information, determine the swap fixed rate for the following:

1. One-year plain-vanilla interest rate swap.

Solution
Using the formula, for T = 1:

s1 1 s1 + 1
+ = =1
(1 + z 1) 1 (1 + z 1) 1 (1 + 0.055)1
s1 = 5.5%

2. Two-year plain-vanilla interest rate swap.

Solution
Using the formula, for T = 2:

s2 s2 1 s2 s2 + 1
+ + = + =1
(1 + z 1) 1 (1 + z 2) 2 (1 + z 2) 2 (1 + 0.055)1 (1 + 0.065)2
s2 = 6.47%

3. Three-year plain-vanilla interest rate swap.

Solution

s3 s3 s3 1
+ + =
(1 + z 1) 1 (1 + z 2) 2 (1 + z 3) 3 (1 + z 3) 3
s3 s3 s3 1
= + + + =1
(1 + 0.055)1 (1 + 0.065)2 (1 + 0.075)3 (1 + 0.075)3
s3 = 7.40%

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Learning Module 1

The Swap Spread and Spreads as a Price Quotation Convention

LOS: Calculate and interpret the swap spread for a given maturity.

LOS: Describe short-term interest rate spreads used to gauge economy-wide credit risk and
liquidity risk.

The swap spread is defined as the difference between the swap fixed rate and the rate of an on-the-run
government security with the same maturity (ie, tenor) as the swap. The spread reflects the added yield for
credit risk versus the benchmark government bond, derived from risky short-term market rates. This spread
tends to widen in downturns and narrow in upswings, displaying countercyclical behavior.

The term swap spread can also refer to a bond’s spread over the interest rate swap curve, indicating credit
and/or liquidity risk. The swap spread reflects the excess yield of swap rates over government bond yields.
The I-spread (also known as the ISPRD or interpolated spread) refers to terms for bond yields adjusted for
corresponding swap rates. The basic I-spread calculates the difference between the bond’s yield-to-maturity
and the swap rate interpolated from the curve.

It is common for fixed-income securities to be quoted as a swap rate with an additional spread. In this
context, the yield corresponds to the yield of a government bond with the same maturity, increased by the
swap spread. For example, if a three-year plain-vanilla interest rate swap features a swap fixed rate of 4%,
and the three-year Treasury has a yield of 3.65%, the swap spread is calculated as 4% − 3.65% = 0.35% or
35 basis points.

The popularity of the swap curve can be attributed to several factors:

y It reflects the default risk of private issuers that are rated A1/A+, which closely aligns with the ratings
of many commercial banks.
y The unregulated nature of the swap market makes swap rates more comparable across countries.
y The swap market offers a broader range of maturities for constructing a yield curve, compared with
government bond markets.

By using the swap curve as a benchmark for assessing the time value of money, investors can determine
the swap spread needed to ensure the swap is fairly priced with the given spread. Conversely, when
presented with a swap spread, investors can establish a fair price for the bond.

The swap spread quantifies credit risk and liquidity risk. A larger swap spread indicates greater
compensation sought by investors for taking on credit and/or liquidity risk. It is important to note, however,
that if a bond carries no default risk, the swap spread might point to liquidity risk or indicate a mispricing of
the bond. Additionally, this spread widens during recessions and contracts during economic expansions.

A more precise gauge of credit and liquidity risk than the swap spread is the zero-spread, also known as the
Z-spread. The Z-spread is a constant spread added to the implied spot curve such that the present value
of a bond’s cash flows, when discounted using relevant spot rates plus the Z-spread, matches its current
market price.

Spreads as a Price Quotation Convention

The Treasury rate for a given maturity may differ from the swap rate for the same term. Consequently,
when quoting bond prices in terms of spreads over one of these benchmarks (ie, Treasury curves and swap
curves), the actual spread would vary based on the chosen benchmark.

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 The Term Structure and Interest Rate Dynamics

The swap spread indicates the difference between the swap rate and the yield of a government bond with
the same maturity. However, a challenge arises with this definition. A five-year swap initiated today would
mature in precisely five years, but there might not be a government bond with a maturity of exactly five
years. As a convention, the swap spread is calculated as the difference between the five-year swap rate
and the yield of the five-year on-the-run government bond. It is important to note that the swap rate does
encompass some counterparty credit risk, while US Treasuries are generally considered free from default
risk, leading to the typical scenario where the swap rate exceeds the corresponding Treasury note rate.

The Treasury-Eurodollar (TED) spread is calculated by comparing the MRR to the yield of a T-bill with the
same maturity. The TED spread provides insight into the perceived level of credit risk across the economy.
An increase (decrease) in the spread indicates lenders’ belief in an increasing (decreasing) risk of default
on interbank loans. Additionally, the TED spread can be seen as a measure of counterparty credit risk in
swap contracts. In comparison with the 10-year swap spread, the TED spread more accurately reflects
risks in the banking system, while the 10-year swap spread predominantly mirrors variations in demand and
supply conditions.

The MRR-OIS spread is determined by contrasting the MRR with the overnight indexed swap (OIS) rate.
An OIS is an interest rate swap in which the periodic floating rate equals the geometric average of an
overnight rate (or overnight index rate) across every day of the payment period. Typically, the index rate is
based on the rate for overnight unsecured lending between banks (eg, the federal funds rate for US dollars).
The MRR-OIS spread serves as an indicator of the risk and liquidity within money-market securities.

The Traditional Theories of the Term Structure of Interest Rates

LOS: Explain traditional theories of the term structure of interest rates and describe the
implications of each theory for forward rates and the shape of the yield curve.

Expectations Theory
Traditional term structure theories focus on interpreting the shape of the term structure based on investor
expectations. The unbiased expectations theory, also known as pure expectation theory, suggests
that forward rates predict future spot rates without bias, implying that bonds of varying maturities are
interchangeable. This theory assumes risk neutrality, with no uncertainty or risk premiums.

The local expectations theory, more rigorous than the unbiased expectations theory, maintains that
short-term expected returns for all bonds are at the risk-free rate due to a no-arbitrage condition. Unlike the
unbiased expectations theory, it can be applied to both risk-free and risky bonds.

However, despite the economic appeal of the local expectations theory, it is observed that returns on
long-dated bonds tend to surpass those on short-dated bonds. Demand for short-term securities, driven by
liquidity needs and risk hedging, typically exceeds that for long-term securities, resulting in lower yields and
returns for short-dated securities compared with long-dated ones.

Liquidity Preference Theory

Liquidity preference theory, an alternative to expectations theories, addresses investor risk aversion.
It proposes liquidity premiums to counter higher interest rate risk in long-term lending, contributing to an
upward-sloping yield curve. Forward rates, including a liquidity premium, challenge unbiased expectations.

Investors demand compensation, known as the liquidity premium, for holding long-term bonds despite
shorter horizons. This differs from yield premiums due to illiquidity, applying to all long-term bonds.

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However, liquidity preference theory doesn’t explain all term structure shapes. A downward-sloping curve
could exist alongside liquidity premiums, influenced by deflation or spot rate changes.

Segmented Market Theory

Segmented markets theory considers lender and borrower preferences as factors that influence the shape
of the yield curve. According to this theory, yields do not mirror expected spot rates or liquidity premiums;
they depend solely on the supply and demand for specific maturities. Each maturity segment functions as
an independent market, determining yields distinctly from other segments.

This theory applies to scenarios with asset/liability management constraints, whether regulatory or self-
imposed. Investors may focus on maturities aligning with their liabilities, thereby mitigating risks of asset/
liability mismatch.

Preferred Habitat Theory

The preferred habitat theory suggests that many borrowers and lenders favor specific maturities.
However, it doesn’t claim that yields across maturities are independent. This theory argues that agents
and institutions accept more risk for higher expected returns. Balancing segmented markets and unbiased
expectations theories, the preferred habitat theory better explains actual scenarios. It accounts for both
market expectations and institutional factors that shape the term structure of interest rates.

Yield Curve Factor Models

LOS: Explain how a bond’s exposure to each of the factors driving the yield curve can be
measured and how these exposures can be used to manage yield curve risks.

A Bond’s Exposure to Yield Curve Movement

Shaping risk is the measure of how a bond’s price reacts to changes in the shape of the yield curve. The
yield curve is in constant flux, and its movements seldom follow a uniform pattern. When actively managing
bonds, an investor might make trades guided by anticipated shifts in the yield curve’s configuration
or employ swaps to mitigate yield curve risk within a portfolio. Furthermore, shaping risk significantly
influences the valuation of various options, a critical consideration due to the prevalence of embedded
options in many fixed-income instruments.

Factors Affecting the Shape of the Yield Curve

A yield curve factor model is a representation of yield curve fluctuations that aligns with historical data,
offering a plausible interpretation. Research efforts have yielded models that provide reasonably accurate
descriptions of these fluctuations. The three-factor model by Litterman and Scheinkman (1991) pinpointed
three distinct dynamics—level, steepness, and curvature—that historically account for shifts in the
yield curve.

y Level captures upward or downward shifts in the yield curve.

y Steepness refers to shifts where short-term or long-term rates change more dramatically.
y Curvature encompasses shifts across three segments of the yield curve: short-term and long-term
segments rising while the middle-term segment declines, or vice versa.

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 The Term Structure and Interest Rate Dynamics

Exhibit 3 Yield curve shaping risk

Level Slope Curvature

Yield Yield Yield

Maturity Maturity Maturity

Original curve Curve shift

In practice, the level movement factor predominantly drives changes in swap and bond market yields. It
signifies parallel yield curve shifts. The steepness factor reflects curve shape, with more significant changes
in short-term yields. Gradual changes make steepness less impactful than the level factor. The third factor,
curvature, influences intermediate-, short-, and long-term yields, explaining the yield curve’s twist with the
least impact.

The Maturity Structure of Yield Curve Volatilities

LOS: Explain the maturity structure of yield volatilities and their effect on price volatility.

Yield Volatility
Measuring interest rate volatilities is significant for fixed-income managers for two reasons:

y Any fixed-income instruments and derivatives may come with embedded options. The value of these
options, and consequently the overall instrument’s value, is highly dependent on the level of interest
rate volatility.
y Effective management of interest rate risk is an integral part of comprehensive management
practices. This involves managing the impact of interest rate volatility on the instrument’s price
fluctuations.

The structure depicting interest rate volatilities across various maturities is a representation of the yield
volatility of a zero-coupon bond. Referred to as the volatility term structure or vol, this curve serves as an
indicator for the risk associated with the yield curve.

Interest rate volatility varies across the yield curve. Using the lognormal model assumption, an interest
rate’s uncertainty is measured by the annualized standard deviation of proportional bond yield changes
within a timeframe. The volatility term structure typically shows higher volatility for short-term rates than for
long-term rates, considering the influence of duration on long-term bond prices.

Research indicates short-term rate volatility is tied to monetary policy uncertainty, while long-term rate
volatility relates more to real economy and inflation uncertainties. The interaction between short and long-
term volatilities hinges on the changing correlations among monetary policy, the real economy, and inflation.

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Learning Module 1

Managing Yield Curve Risks Using Key Rate Duration

Addressing yield curve risk involves using sensitivity measures to predict the impact of yield curve shifts on
portfolio value. This approach to risk management includes adjusting exposures through trades in security
or derivative markets.

Effective duration and key rate duration are two measures used to assess yield curve sensitivity:

y Effective duration gauges how a bond’s price reacts to a slight uniform shift in a reference yield curve.
y Key rate duration measures a bond’s response to a slight shift in a benchmark yield curve at a
specific maturity.

These measures help manage both shaping risk (sensitivity to changes in the yield curve’s shape) and the
risk linked to parallel yield curve shifts, captured by effective duration.

Exhibit 4 Key rate duration analysis: shaping risk example

Yield (%)
No change
5.00%
+25 bps
T0

T1
4.00% −70 bps

Key rate duration analysis allows for customizable

3.00%
nonparallel yield curve assumptions

2.00%

1 5 10 20 30
Maturity

Original yield curve (T0) Shifted yield curve (T1)

Developing Interest Rate Views Using Macroeconomic Variables

LOS: Explain how key economic factors are used to establish a view on benchmark rates,
spreads, and yield curve changes.

The bond risk premium is the expected additional return of a default-free long-term bond compared with
a short-term bond or the risk-free rate. It is estimated using government bonds and reflects uncertainty
in default-free rates, while other risks like credit and liquidity may increase overall risk. Unlike historical
returns, it is a forward-looking expectation.

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 The Term Structure and Interest Rate Dynamics

Factors like inflation, GDP, and monetary policy influence bond pricing and returns. Research shows that
these factors explain most yield variance. Monetary policy drives short- and intermediate-term yields, while
inflation impacts long-term yields. Around two-thirds of short- and intermediate-term yield variation is due to
monetary policy, with the rest attributable to economic growth and inflation. Long-term yields are explained
largely by inflation, and the rest by monetary policy.

Monetary policy shapes the bond risk premium. Central banks, like the European Central Bank, set certain
rates and try to manage the money supply to attain stable prices and growth. During expansions, rates may
be raised to curb inflation, flattening the yield curve. In recessions, the rate may be cut to stimulate activity,
steepening the curve. These actions lead to procyclical changes in short-term rates.

Factors influencing bond prices, yields, and the risk premium include fiscal policy, debt maturity structure,
and investor demand.

y Budget deficits impact bond supply and yield, with rising deficits increasing yields.
y Longer debt maturities lead to higher bond yields due to increased supply.
y Domestic investors like pension funds affect bond prices, reducing the risk premium, while nondomestic
investors impact bonds through currency management or reserves, affecting prices and the risk premium.

Market uncertainty drives a flight to quality, pushing investors to government bonds and flattening the yield
curve. Fixed-income trades based on interest rate forecasts vary but often use bond futures to minimize
portfolio changes. Interest rate views must be assessed compared with current short-term rates and the
forward curve, reflecting returns from rolling down the curve with implied forward rates.

Anticipating lower rates, investors extend portfolio duration to benefit from rising bond prices. For higher
rates, they shorten duration to mitigate falling bond prices. To exploit a steeper curve with rising long-term
rates, traders short long-term bonds and buy short-term bonds. For a flattening curve, they buy long-term
bonds and short short-term bonds.

Positions can be designed as duration-neutral to counter term structure level changes. Long-only investors
may switch between single-maturity (bullet) and mixed-duration (barbell) portfolios. For instance, they might
shift from a bullet to a barbell setup to capitalize on an expected curve flattening.

Exhibit 5 Fixed-income strategies for yield curve changes

Bullet portfolio Barbell portfolio Ladder portfolio

Yield Yield Yield
50% 20%
100% 20% 20%
20%
50% 20%

Maturity Maturity Maturity

Portfolio allocation

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Learning Module 1

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Learning Module 2
The Arbitrage-Free Valuation Framework

LOS: Explain what is meant by arbitrage-free valuation of a fixed-income instrument.

LOS: Calculate the arbitrage-free value of an option-free, fixed-rate coupon bond.

LOS: Describe a binomial interest rate tree framework.

LOS: Describe the process of calibrating a binomial interest rate tree to match a specific
term structure.

LOS: Describe the backward induction valuation methodology and calculate the value of a fixed-
income instrument given its cash flow at each node.

LOS: Compare pricing using the zero-coupon yield curve with pricing using an arbitrage-free
binomial lattice.

LOS: Describe pathwise valuation in a binomial interest rate framework and calculate the value
of a fixed-income instrument given its cash flows along each path.

LOS: Describe a Monte Carlo forward-rate simulation and its application.

LOS: Describe term structure models and how they are used.

Introduction

LOS: Explain what is meant by arbitrage-free valuation of a fixed-income instrument.

The Meaning of Arbitrage-Free Valuation

Arbitrage-free valuation is a method for determining the value of securities by ensuring there are no
opportunities for riskless profits. In efficient markets, prices adjust to eliminate arbitrage opportunities,
based on the principle that identical assets should have the same price. This principle is fundamental to the
validity of arbitrage-free valuation.

Arbitrage-free bond valuation involves treating a bond as a portfolio of cash flows determined by the spot
curve (ie, the term structure of discount rates). This method ensures that each component of the bond, no
matter how complex, has an arbitrage-free value. Bonds with embedded options can be valued by breaking
them down into two parts: the arbitrage-free value of the bond with and without options.

The Law of One Price

The law of one price asserts that identical goods or perfect substitutes should have the same price in a
market without transaction costs. If there is a price difference and trading is costless, individuals would buy

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Learning Module 2

at the lower price and sell at the higher one, making a riskless profit. This process would continue until both
prices equalize or converge.

Arbitrage Opportunity
An arbitrage opportunity refers to a transaction with no initial cash investment that leads to a guaranteed
riskless profit. There are two types of arbitrage opportunities; each violates one of the following principles:

● Value additivity dictates that the total value of a bond is equal to the sum of its individual parts.
● Dominance asserts that a financial asset guaranteeing a risk-free future payoff must have a positive
price in the present.

The existence of any arbitrage opportunities is temporary, given markets with any degree of efficiency.
When investors recognize these mispricings, they will buy or sell the securities in question without
limits. This continuous trading will force prices to adjust until no arbitrage opportunities remain, ensuring
market stability.

Implications of Arbitrage-Free Valuation for Fixed-Income Securities

The arbitrage-free valuation method prevents market participants from exploiting arbitrage through
processes like stripping and reconstitution.

● Stripping is when dealers separate a bond’s individual cash flows and trade them as zero-
coupon securities.
● Reconstitution is when dealers recombine the appropriate individual zero-coupon securities to re-
create the underlying coupon bond.

Arbitrage-free valuation prevents profit from value discrepancies. Viewing securities as combinations of
zero-coupon bonds ensures consistent pricing, even for different coupons and cash flows.

Arbitrage-Free Valuation of an Option-Free Bond

LOS: Calculate the arbitrage-free value of an option-free, fixed-rate coupon bond.

The arbitrage-free valuation of option-free bonds involves calculating their value as the sum of present
values of expected future cash flows, using benchmark spot rates as discount rates. These benchmark
rates are based on highly liquid and secure securities, such as sovereign debt in many countries. In cases
where the sovereign debt market lacks liquidity, the swap curve can serve as an alternative benchmark.

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 The Arbitrage-Free Valuation Framework

Example 1 Arbitrage-free value of an option-free bond

Assume that one-year benchmark bonds yield 3%, two-year bonds yield 4%, and three-year bonds yield
5%. Currently, a three-year, 6% annual coupon bond that has similar risk and liquidity to the benchmark
bonds sells for 102.78 (par value 100) at a yield of 4.98%. Does this bond’s price accurately reflect the
term structure of interest rates?

Solutions

First, find the correct spot rate (zero-coupon rate) for each year’s cash flow, using the equation shown.
As discussed in the previous chapter, we use bootstrapping to determine the spot rates.

Par rate Par rate Par rate + 1

1= + +…+
(1 + z1)1 (1 + z2)2 (1 + zN)N

Considering annual coupons, the one-year zero-coupon rate corresponds to the one-year par rate as
both involve a single cash flow (ie, z 1 = 3%).

The calculation of the two-year zero-coupon rate (z 2) involves utilizing z 1 = 3% and solving for z 2.

0.04 0.04 + 1 0.04 0.04 + 1

1= + = +
(1 + z1)1 (1 + z2 )2 (1 + 0.03)1 (1 + z2)2

Therefore, the bootstrapped two-year spot rate (z 2) is 4.02% (rounded).

To solve for z3:

0.05 0.05 0.05 + 1 0.05 0.05 0.05 + 1

1= + + = + +
(1 + z1)1 (1 + z2)2 (1 + z3)3 (1 + 0.03)1 (1 + 0.0402)2 (1 + z3)3

Therefore, the bootstrapped three-year spot rate (z 3) is 5.07%.

The arbitrage-free price of the bond is:

6 6 100 + 6
P0 = + + = 5.8252 + 5.5261 + 91.3839 = 102.7352
1.03 (1.042)2 (1.0507)3

Since the bond is currently priced at 102.78, it is overpriced by 0.0448 per 100 of par value.

Option-free bonds can be accurately valued by discounting their cash flows using spot rates, ensuring an
arbitrage-free valuation. However, when dealing with bonds that include embedded options, a different
valuation approach is required because their expected future cash flows are interest-rate dependent.

Interest rate trees, also known as lattice models, are employed to value bonds with and without embedded
options, based on assumed volatility. Consistent with the current benchmark yield curve and interest rate
volatility, they provide a model that can reflect the random process of interest rates.

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Learning Module 2

The Binomial Interest Rate Tree

A binomial interest rate tree visually represents two potential interest rate values following each node,
determined by an interest rate model and assumptions about interest rate volatility. A lognormal interest rate
model is used because it adheres to two critical characteristics:

● Interest rates are always non-negative.

● Volatility tends to be higher at higher interest rate levels.

Exhibit 1

Lognormal binomial tree interest rate formula

Time 0 Time 1 Time 2

i2, HH

i1, H i2, HH = i2, HL × e 2σ

i0 i2, HL i2, HH = i2, LL × e 4σ
i1, L i2, HL = i2, LL × e 2σ
i2, LL

i0 = 1-period spot rate at Time 0 iJ,K = 1-period forward rate at Time J and interest rate K
e = Euler's number Hs/Ls = Number of higher (H ) or lower rate (L) changes on paths to node

σ = Standard deviation (ie, volatility)

The i variables in Exhibit 1 represent nodes, denoting potential one-period interest rate values over time.
The interest rate displayed at Time 0 acts as the discount rate for converting Time 1 payments into present
values at Time 0. The initial node, called the root, represents the current one-period rate at Time 0, while
subsequent nodes are identified by both a time element and a rate change component.

At each node in the interest rate tree, there are two potential interest rates for one period forward at Time
1. These rates can either be higher or lower than the one-year forward rate at Time 1, which will occur one
period from the present. We use the notation iL to refer to the lower rate compared with the implied forward
rate, and iH represents the higher forward rate (sometimes, rL and rH are used interchangeably). The
lognormal random walk model describes the following relationship between i1,L and i1,H:

i1,H = i1,L (e2σ)

σ = The standard deviation, assumed volatility of the one-year rate

e = Euler’s number, 2.7183 in natural logarithms

In each period, the random outcomes are approximately centered around the forward rates determined from
the benchmark curve.

At Time 1:

● i1,L = The lower one-year forward rate one year from now at Time 1
● i1,H = The higher one-year forward rate one year from now at Time 1

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 The Arbitrage-Free Valuation Framework

At Time 2, there are three potential values for the one-year interest rate:

● i2,LL = One-year forward rate at Time 2, assuming the lower rate at Time 1 and the lower
rate at Time 2
● i2,HH = One-year forward rate at Time 2, assuming the higher rate at Time 1 and the higher
rate at Time 2
● i2,HL = One-year forward rate at Time 2, assuming the higher rate at Time 1 and the lower rate at
Time 2 or, equivalently, the lower rate at Time 1 and the higher rate at Time 2

The middle rate closely approximates the implied one-year forward rate two years from now as determined
by the spot curve, while the other two rates deviate by two standard deviations, with one being higher and
the other being lower than this value.

The relationship between i2,LL and the other two one-year rates can be expressed as follows:

i2,HH = i2,LL (e4σ), and i2,HL = i2,LL (e2σ)

Exhibit 2

Two-year binomial interest tree (20% volatility)

Time 0 Time 1 Time 2

i2, HH

i1, H i2, HH = i2, HL × e 2σ

i0 i2, HL i2, HH = i2, LL × e 4σ
i1, L i2, HL = i2, LL × e 2σ
i2, LL
Time 0 Time 1 Time 2

i2, HH = 10.40%

i1, H = 6.059% = 0.06968 × e 2(0.20)

i0 = 3.00% i2, HL = 6.968% or

i1, L = 4.061% = 0.04671 × e 4(0.20)

i2, LL = 4.671%

In the example shown in Exhibit 2, if i1,L is 4.061% and σ is 20% per year; then i1,H can be calculated as:

i1,H = i1,L (e2σ) = 4.061% × e2(20%) = 6.059%

If i2,LL is 4.671% per year, and assuming once again that σ is 20% per year, then i2,HL and i2,HH can be
calculated as follows:

i2,HL = i2,LL (e2σ) = 4.671% × e2(20%) = 6.968%

i2,HH = i2,HL (e2σ) = 6.968% × e2(20%) = 10.40%, or i2,HH = i2,LL (e4σ) = 4.671% × e4(20%) = 10.40%

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Learning Module 2

Creating a Binomial Interest Rate Tree

LOS: Describe a binomial interest rate tree framework.

Determining the Value of a Bond at a Node

The backward induction valuation method is used to determine the bond’s value at a given node. Starting
at maturity, the bond’s value at each node is calculated “backward” in time, from right to left, filling in values
along the way.

Exhibit 3

Backward induction on a binomial tree

Time 0 Time 1 Time 2 Time 3

100
+ C3

PV2, HH
+ C2
i2, HH
PV1, H
100
+ C1
+ C3
i1, H
PV2, HL
P0
+ C2
i0
i2, HL
PV1, L
100
+ C1
+ C3
i1, L
PV2, LL
Third (ie, final) round of + C2
backward induction i2, LL
100
Second round of
+ C3
backward induction
First round of
backward induction

P0 = Arbitrage-free price at Time 0 PVJ, K = Present value at period J and interest rate K
i0 = 1-period spot rate at Time 0 iJ, K = Interest rate at period J and interest rate K
CJ = Coupon payment at Time J

The value of a bond at a specific node is influenced by both the upcoming coupon payment, Cj + 1, and the
anticipated future bond value. This expected value is calculated as an average of the values associated with

Vol 4-132
 The Arbitrage-Free Valuation Framework

a higher forward rate, KH, and a lower forward rate, KL. It is a simple average because in the lognormal
model the probabilities of the rate increasing or decreasing are equal.

Therefore, the value of the bond at any given node is calculated using the following formula:

CJ + 1 + (0.5 × PVJ + 1, KH + 0.5 × PVJ + 1, KL)

PVJ, K =
(1 + iJ, K)

CJ = Coupon payment due at time J PVJ + 1, KH = Present value at time J + 1 and interest rate at higher level

PVJ, K = Present value at time J and interest rate K PVJ + 1, KL = Present value at time J + 1 and interest rate at lower level

iJ, K = Interest at time J and interest rate K

Calibrating the Binomial Interest Rate Tree to the Term Structure

LOS: Describe the process of calibrating a binomial interest rate tree to match a specific
term structure.

The calibration of a binomial interest rate tree involves adjusting the tree’s parameters, such as the number
of periods, volatility, and interest rates at each node, iteratively until it produces bond prices or other
derivative instrument values that are consistent with real market prices. This calibration process seeks
to make the tree’s implied interest rates match a specific term structure as well as produce arbitrage-
free pricing.

The process begins by choosing a trial rate for one of the Time 1 forward rates, such as i1,L or r1,L, which
should be lower than the implied forward rate. The binomial tree extends around the forward rate curve,
with the average being slightly higher than the implied forward rate due to the assumption of lognormality.

Assume that the two-year bond has a coupon rate of 1.20% and is trading at $100, as shown in Exhibit 4.
It is already known that the current one-year rate is 1%. Determining the two possible rates at t = 1 is an
iterative process. Given the interest rate model, the interest rate volatility assumption, the coupon rate, the
par value of the two-year bond, and the current one-year rate, the rates in the tree must be arbitrage-free.
Therefore, the application of backward induction should result in a bond value equal to its current market
price of $100.

Exhibit 4 Benchmark par curve

Maturity (years) Par rate Bond Price

1 1.00% 100

2 1.20% 100

3 1.25% 100

4 1.40% 100

5 1.80% 100

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Learning Module 2

To calculate values for r1,L and r1,H, use trial-and-error or an analytical tool such as Solver in Excel. If Solver
provides a value of 1.1943% for r1,L, verify whether this value is arbitrage-free. Starting with a value of
1.1943% for r1,L and using the interest rate model (rH = rL × e2σ) with an interest rate volatility assumption
of σ = 15%, calculate the value of r1,H as follows:

1.1943% × e2 × 0.15 = 1.6121%

Exhibit 5 Deriving one-year forward rates one year from today

Time 0 Time 1 Time 2

Par = $100
NH C = $1.20

r1,H = 1.6121%
V1,H = ??
N0
C = $1.20
Par = $100
r0 = 1.00%
C = $1.20
V0 = ?? NL
r1,L = 1.1943%
V1,L = ??
C = $1.20 Par = $100
C = $1.20

Using these rates, the values of the bond at NH and NL are calculated as:

V1,H = � (1 100 + 1.20

+ 0.016121) 1
+
100 + 1.20
(1 + 0.016121) 1 � ×
1
2
= $99.5944

V1,L = � (1 100 + 1.20

+ 0.011943)1
+
100 + 1.20
(1 + 0.011943)1
� ×
1
2
= $100.0056

Based on these expected values of the bond at t = 1 plus the coupon payment and the one-year rate today,
V0 is calculated as:

V0 = � 99.5944 + 1.20 100.0056 + 1.20

(1 + 0.01) 1
+
(1 + 0.01) 1 � ×
1
2
= $100

The expected value of the bond determined by discounting its expected future cash flows at the interest
rates in the binomial tree equals its observed market price, so the possible one-year forward rates at t = 1
are arbitrage-free.

Now determine the one-year forward rates at t = 2, as shown in Exhibit 3. Use the same process, but with
the three-year benchmark bond that carries a coupon rate of 1.25% (see Exhibit 1), the same interest rate
model, the same interest rate volatility assumption, a current one-year rate of 1%, and possible one-year
forward rates at t = 1 of 1.6121% (r1,H) and 1.1943% (r1,L).

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 The Arbitrage-Free Valuation Framework

Exhibit 6 Deriving one-year forward rates two years from today

Time 0 Time 1 Time 2 Time 3

NHHH
V3,HHH = $100
NHH
C = $1.25
r2,HH = ?

NH V2,HH = ?
NHHL
r1,H = 1.6121% C = $1.25
V3,HHL = $100
V1,H = ? NHL
N0 C = $1.25
C = $1.25 r2,HL = ?
r0 = 1%
V2,HL = ?
V0 = $100 NL NHLL
r1,L = 1.1943% C = $1.25
V3,HLL = $100
V1,L = ? NLL
C = $1.25
C = $1.25 r2,LL = ?
V2,LL = ?
NLLL
C = $1.25
V3,LLL = $100
C = $1.25

Assume that Solver generates a value of 0.9803 for r2,LL; verify whether this value is correct (ie, arbitrage-
free). Based on the value for r2,LL, calculate r2,HL and r 2,HH as:

r2,HL = 0.9803 × e2 × 0.15 = 1.3233%

r2,HH = 0.9803 × e4 × 0.15 = 1.7862%

Based on these three possible one-year forward rates at t = 2, apply the backward induction methodology
to determine the possible values of the bond at t = 2.

100 + 1.25 100 + 1.25 1

V2,HH = � (1 + 0.01786)1 + (1 + 0.01786)1� × 2 = $99.4734

100 + 1.25 100 + 1.25 1

V2,HL = � (1 + 0.01323)1 + (1 + 0.01323)1� × 2 = $99.9279

100 + 1.25 100 + 1.25 1

V2,LL = � (1 + 0.0098)1 +
(1 + 0.0098)1
�× 2 = $100.2674

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Learning Module 2

Based on these values, the bond’s coupon rate, and the two possible one-year forward rates at t = 1 (r1,H
and r1,L), calculate the two possible values of the bond at t = 1.

99.4734 + 1.25 99.928 + 1.25 1

V1,H = �(1 + 0.016121)1 + (1 + 0.016121)1
�× 2 = $99.3492

99.928 + 1.25 100.2674 + 1.25 1

V2,L = �(1 + 0.011943)1 + (1 + 0.011943)1
×
2
�
= $100.1519

Finally, based on these possible bond values at t = 1, the bond’s coupon rate, and the one-year rate at t = 0,
calculate the current value of the bond.

V0 = � 99.3492 + 1.25 100.1519 + 1.25

(1 + 0.01) 1
+
(1 + 0.01) 1 � ×
1
2
= $100

Now the one-year rates in the interest rate tree have been verified as arbitrage-free (as the resulting value
of the three-year 1.25% coupon bond equals its price, $100). Exhibit 7 presents the same information as
Exhibit 6, but with all the values calculated above filled in:

Exhibit 7 Deriving one-year forward rates two years from today

Time 0 Time 1 Time 2 Time 3

NHHH
V3,HHH = $100
NHH
C = $1.25
r2,HH = 1.786%

NH V2,HH = $99.473
NHHL
r1,H = 1.612% C = $1.25
V3,HHL = $100
V1,H = 99.3492 NHL
N0 C = $1.25
C = $1.25 r2,HL = 1.323%
r0 = 1%
V2,HL = 99.928
V0 = $100 NL NHLL
r1,L = 1.194% C = $1.25
V3,HLL = $100
V1,L = 100.152 NLL
C = $1.25
C = $1.25 r2,LL = 0.980
V2,LL = 100.267
NLLL
C = $1.25
V3,LLL = $100
C = $1.25

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 The Arbitrage-Free Valuation Framework

Exhibit 8 presents the binomial interest rate tree that includes possible one-year forward rates at t = 3 based
on the information in Exhibit 7. Note that only the calculations of possible one-year forward rates at t = 1
and t = 2 have been solved. Determining the rates at t = 3 requires solving for the possible one-year forward
rates that would result in a $100 (market price) value for the four-year 1.4% coupon bond (see Exhibit 4)
while adhering to the interest rate model and volatility assumption and using the calculated possible one-
year forward rates at t = 1 and t = 2.

Exhibit 8 Three-year binomial interest rate tree

Time 0 Time 1 Time 2 Time 3

NHHH
r3,HHH = 2.834%

NHH
r2,HH = 1.786%

NH NHHL
r1,H = 1.612% r3,HHL = 2.099%
N0 NHL
r0 = 1% r2,HL = 1.323%

NL NHLL

r1,L = 1.194% r3,HLL = 1.555%

NLL
r2,LL = 0.980
NLLL
r3,LLL = 1.152%

Valuing an Option-Free Bond with a Binomial Tree

LOS: Describe the backward induction valuation methodology and calculate the value of a fixed-
income instrument given its cash flow at each node.

LOS: Compare pricing using the zero-coupon yield curve with pricing using an arbitrage-free
binomial lattice.

The process for the bond valuation in this section involves two steps:

1. Calculate the arbitrage-free value of an option-free, fixed-rate coupon bond.

2. Compare the value obtained using the zero-coupon yield curve with the value obtained using an
arbitrage-free binomial lattice.

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Learning Module 2

Both methods are arbitrage-free, so their results should be identical.

Exhibit 9 demonstrates how to value a three-year zero-coupon bond based on the interest rate tree in
Exhibit 7. The bond makes no coupon payments and is worth par in three years (at maturity).

Exhibit 9 Pricing a three-year zero-coupon bond

Time 0 Time 1 Time 2 Time 3

NHHH
V3,HHH = $100
NHH
r2,HH = 1.786%

NH V2,HH = $98.2453
NHHL
r1,H = 1.612%
V3,HHL = $100
N0 V1,H = 96.9076 NHL
r0 = 1% r2,HL = 1.323%
V0 = $96.338 V2,HL = 98.6943
NL
NHLL
r1,L = 1.194%
V3,HLL = $100
V1,L = 97.6954 NLL
r2,LL = 0.980%
V2,LL = 99.0295
NLLL
V3,LLL = $100

To illustrate how the values in Exhibit 9 have been derived, the calculation of V2,HL is provided:

100 100 1
V2,HL = � (1 + 0.01323)1 +
(1 + 0.01323)
�1
×
2
= 98.6943

Valuing an Option-Free Bond with Pathwise Valuation

LOS: Describe pathwise valuation in a binomial interest rate framework and calculate the value
of a fixed-income instrument given its cash flows along each path.

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 The Arbitrage-Free Valuation Framework

Pathwise valuation is an alternative approach to backward induction. It involves calculating the present
value of a bond for each potential interest rate path and then finding the average of those values. The
resulting price of an option-free bond matches the price determined through backward induction. Pathwise
valuation involves the following steps:

● Specify a list of possible paths through a tree.

● Determine the present value of the bond for each potential path.
● Calculate the average present value across all possible paths.

The number of interest rate paths in the binomial model can be calculated using Pascal’s Triangle, which is
shown in Exhibit 10:

Exhibit 10 Pascal’s Triangle

1
1 1
1 2 1
1 3 3 1
1 4 6 4 1
1 5 10 10 5 1

● Start with the number 1 at the top of the triangle.

● The numbers in the boxes below are the sum of the two numbers above them, except that the edges
on each side are all 1.

Exhibit 11 shows the possible outcomes for interest rates:

Exhibit 11 Possible outcomes at t = 1, t = 2, and t = 3

Interest Rate Movement

Number of Years U = Up, D = Down Pascal's Triangle

U
1 1, 1
D

UU

2 UD DU 1, 2, 1

DD

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Learning Module 2

Interest Rate Movement

Number of Years U = Up, D = Down Pascal's Triangle

UUU

UUD UDU DUU

3 1, 3, 3, 1
UDD DUD DDU

DDD

The total number of possible paths can easily be worked out using Pascal’s Triangle. For example, at t = 3
there are eight possible interest rate paths.

The example demonstrated in Exhibit 12 illustrates pathwise valuation by valuing the three-year zero-
coupon bond (valued at $96.338 in the previous section using the interest rate tree).

From Exhibit 13, there are four possible paths at t = 2 to arrive at Year 3: UU, UD, DU, and DD. In Exhibit
12, these four paths are specified along with the one-year interest rates along each of these paths (which
are the same as in Exhibit 10). The last column in the table shows the present value for each path. The
average of these present values represents the current price of the bond.

Exhibit 12 Valuing a three-year zero-coupon bond using pathwise valuation

Path s1 f1 f 1,2 Present value ($)

1 1.00% 1.612% 1.786% 95.729

2 1.00% 1.612% 1.323% 96.167

3 1.00% 1.194% 1.323% 96.564

4 1.00% 1.194% 0.980% 96.892

96.338

The present value along each path can be calculated as shown for Path 2:

100
PV2 = = $96.167
(1.01)(1.01612)(1.01323)

Notice that the value of the bond obtained here, $96.338, is identical to the value obtained in Exhibit 9. Both
the methods result in the same value for the three-year zero-coupon bond.

Vol 4-140
 The Arbitrage-Free Valuation Framework

The Monte Carlo Method

LOS: Describe a Monte Carlo forward-rate simulation and its application.

The Monte Carlo method is used to simulate a large number of potential interest rate paths to understand
how they impact the value of a fixed-income security. It is especially valuable when a security’s cash flows
are path-dependent, such that they depend not only on the current interest rate level but also on the path
that interest rates have taken to reach the current level.

For example, in mortgage-backed securities, cash flows in a given period include prepayments. While
interest rates may currently be low, if they were even lower in the recent past, the current prepayment
speed will not be as high as it would be if interest rates had fallen from higher levels to the current low level.

Interest rate paths in a Monte Carlo simulation are generated based on:

● A probability distribution
● An assumption about volatility
● The current benchmark term structure of interest rates

The benchmark term structure is represented by the current spot rate curve such that the average present
value across all the interest rate paths equals the benchmark bond’s actual market value. By using this
approach, the model is rendered arbitrage-free.

For example, to value a 30-year mortgage-backed security (that makes monthly coupon payments) using
the Monte Carlo method:

● Simulate numerous paths of one-month interest rates under:

○ An interest rate volatility assumption
○ Probability distribution

● Generate spot rates from the simulated future one-month interest rates
● Determine the periodic cash flows along each interest rate path
● Calculate the present value of cash flows for each path
● Calculate the average present value across all interest rate paths

The value of the benchmark bond generated from the procedure described may or may not equal the
bond’s actual market value. Therefore, check that the value generated equals the observed market price.
If it does not, then a constant (known as the drift term) must be added to all interest rates on all paths such
that the average present value equals the observed market price. Such a model is said to be drift-adjusted.

The model can also incorporate mean reversion in interest rates. This has the effect of moving the interest
rate toward the forward rates implied by the yield curve.

Finally, note that increasing the number of paths in the model will not necessarily bring the resulting value
closer to the true fundamental value of the security. After all, results are only as good as the valuation model
and inputs used.

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Learning Module 2

Example 2 Application of the Monte Carlo method to bond pricing

Consider a three-year, annual-pay, 5% coupon bond that is currently trading at $102.81. This market
price has been verified as the arbitrage-free price for this bond, given the current term structure of
interest rates. An analyst uses the Monte Carlo method to generate the eight interest rate paths given.

Path Time 0 (%) Time 1 (%) Time 2 (%)

1 2 2.500 4.548

2 2 3.600 6.116

3 2 4.600 7.766

4 2 5.500 3.466

5 2 3.100 8.233

6 2 4.500 6.116

7 2 3.800 5.866

8 2 4.000 8.233

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 The Arbitrage-Free Valuation Framework

Determine whether the Monte Carlo simulation has been calibrated correctly.

Given the bond’s cash flows, their present value along each interest rate path, as well as the average
present value, is:

Path PV0

1 105.7459

2 103.2708

3 100.9106

4 103.8543

5 101.9075

6 102.4236

7 103.3020

8 101.0680

Average 102.8103

To illustrate the calculation of the present value along the interest rate paths, the present values of cash
flows along Path 5 are shown. Note that the annual coupon is $5, and the par value of the bond is $100.

5 5 105
PV0 = + + = $101.9075
(1 + 0.02) (1 + 0.02)(1 + 0.031) (1 + 0.02)(1 + 0.031)(1 + 0.08233)

Because the average of the present values along each interest rate path used in the simulation equals
the benchmark bond’s observed market price, the model has been calibrated correctly. There are
enough representative paths to now value path-dependent securities.

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Learning Module 2

Term Structure Models

LOS: Describe term structure models and how they are used.

Model Choice
Term structure models go beyond the random walk of the interest rate tree of the arbitrage-free approach to
try to capture the many dynamics of interest rate movements. Since no one model adequately captures all
interest rate dynamics, there are many models and model features to be aware of. Models may be single-
factor or multi-factor models.

Equilibrium Term Structure Models

Equilibrium term structure models aim to describe how the term structure behaves using fundamental
economic variables that influence interest rates. These models can be structured as either single-factor or
multi-factor models.

Both the Cox-Ingersoll-Ross (CIR) and Vasicek models are single-factor models. They use the short-term
interest rate as the sole factor to explain yield curve changes. This approach is reasonable because studies
have shown that parallel shifts can explain a significant portion of yield curve movements.

Multi-factor models have the potential to more accurately model the yield curve’s curvature by including
additional factors, such as changes in the slope of the yield curve. However, these models come with
added complexity.

Equilibrium term structure models rely on assumptions about the behavior of the included factors. For
instance, they must decide whether the short-term interest rate should be modeled as mean-reverting or
should exhibit jumps. Generally, equilibrium term structure models require estimating fewer parameters
than arbitrage-free term structure models. However, this simplicity comes at the expense of less precision in
replicating the observed yield curve.

The Cox-Ingersoll-Ross Model

The Cox-Ingersoll-Ross (CIR) model uses one factor (ie, the short-term rate) to determine the entire term
structure of interest rates. It assumes that interest rates are mean reverting. The model contains a variable
that defines how fast it reverts to the mean. It assumes that volatility is directly related to the short-term
rate (ie, interest rate volatility increases with the level of interest rates). It also precludes the possibility of
negative interest rates.

The Vasicek Model

The Vasicek model also assumes that interest rates are mean reverting but assumes that interest rate
volatility is constant. It is theoretically possible for interest rates to be negative.

Note that the yield curve estimated with the Vasicek or CIR model may not match the observed yield curve.
However, if model parameters are believed to be correct, these models can be used to identify mispricing.

Arbitrage-Free Models
Arbitrage-free models start with market prices of a reference set of financial instruments. Under the
assumption that these instruments are correctly priced, a random process with a drift term and volatility
factor is used to generate the yield curve.

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 The Arbitrage-Free Valuation Framework

The advantage of arbitrage-free models is the ability to calibrate the model to market data. Equilibrium
models, such as the CIR and Vasicek models, have only a finite number of free parameters, so it is
not possible to specify these parameter values in a manner that matches model prices with observed
market prices.

Arbitrage-free models exhibit greater accuracy in modeling the market yield curve. They are also known
as partial equilibrium models because they do not attempt to explain the yield curve; instead, they take the
yield curve as given.

The Ho-Lee Model

The Ho-Lee model utilizes the relative valuation concepts of the Black-Scholes-Merton option-pricing
model, which relies on risk-neutral probabilities. The model’s advantage lies in its simplicity, allowing it to
illustrate most of the key features of arbitrage-free interest rate models. It assumes a constant drift (no
mean reversion) and constant volatility. Theoretically, negative interest rates are possible in this model.

The Kalotay-Williams-Fabozzi (KWF) Model

The KWF model is similar to the Ho-Lee model in that it assumes a constant drift and constant volatility.
However, it models the natural logarithm of the short-term rate, so negative rates are not possible.

The Gauss+ Model

The Gauss+ model is a multi-factor interest rate model widely used for valuation and hedging. It
incorporates short-, medium-, and long-term rates.

● The long-term factor is mean reverting and reflects trends in macroeconomic variables.
● The medium-term rate also reverts to the long-run rate.
● The short-term rate does not exhibit a random component, which is consistent with the central bank
controlling the short end of the rate curve.

Vol 4-145
Learning Module 2

Vol 4-146
Learning Module 3
Valuation and Analysis of Bonds with
Embedded Options

LOS: Describe fixed-income securities with embedded options.

LOS: Explain the relationships between the values of a callable or putable bond, the underlying
option-free (straight) bond, and the embedded option.

LOS: Describe how the arbitrage-free framework can be used to value a bond with
embedded options.

LOS: Explain how interest rate volatility affects the value of a callable or putable bond.

LOS: Explain how changes in the level and shape of the yield curve affect the value of a callable
or putable bond.

LOS: Calculate the value of a callable or putable bond from an interest rate tree.

LOS: Explain the calculation and use of option-adjusted spreads.

LOS: Explain how interest rate volatility affects option-adjusted spreads.

LOS: Calculate and interpret effective duration of a callable or putable bond.

LOS: Compare effective durations of callable, putable, and straight bonds.

LOS: Describe the use of one-sided durations and key rate durations to evaluate the interest
rate sensitivity of bonds with embedded options.

LOS: Compare effective convexities of callable, putable, and straight bonds.

LOS: Calculate the value of a capped or floored floating-rate bond.

LOS: Describe defining features of a convertible bond.

LOS: Calculate and interpret the components of a convertible bond's value.

LOS: Describe how a convertible bond is valued in an arbitrage-free framework.

LOS: Compare the risk-return characteristics of a convertible bond with the risk-return
characteristics of a straight bond and of the underlying common stock.

Vol 4-147
Learning Module 3

Introduction

LOS: Describe fixed-income securities with embedded options.

Overview of Embedded Options

Embedded bond options are provisions within a bond's indenture or offering circular that grant specific
rights related to interest rate movements. These options can be exercised by either the issuer or the
bondholder, or they may activate automatically based on interest rate changes. A call option lets the issuer
benefit from lower interest rates by paying off the bond early and refinancing at a lower cost, while a put
option allows the bondholder to profit from higher interest rates by returning the bonds to the issuer and
reinvesting at a better yield. These options are tied to the bond and cannot be traded separately.

The underlying bond associated with these options has various characteristics, including the issuer,
issue date, maturity date, principal amount, coupon rate, and payment structure. The coupon rate on this
underlying bond can be either fixed or floating, with floating rates determined periodically, based on a
formula involving a reference rate and a credit spread.

Call Options
A callable bond gives the issuer the discretion to exercise the embedded call option, which allows for the
bond's redemption before its maturity date. Typically, issuers call a bond if they can refinance at a lower
interest rate, such as when:

y interest rates have dropped or

y the issuer's creditworthiness has improved.

In the past, many long-term US corporate bonds were callable with decreasing call prices. Today, most
investment-grade corporate bonds are essentially nonrefundable, offering a "make-whole call" provision
that ensures bondholders are typically fully compensated for surrendering their bonds, which lessens the
bond investors' risk.

Callable bonds typically come with a call protection period, ranging from as short as one month to several
years, during which the issuer is restricted from calling back the bond. Callable bonds offer various call
features, including European-, American-, and Bermudan-style options:

y European-style callable bonds allow the issuer to exercise the call option only once, on a
specific call date.
y American-style callable bonds are continuously callable starting from the first call date.
y Bermudan-style call options can be exercised on predetermined dates after the call protection period,
as specified in the bond's indenture or offering circular.

Put Options and Extension Options

A putable bond is a bond with an embedded put option that is controlled by the bondholder. It allows
bondholders to sell the bonds back to the issuer before maturity, typically at par value, often when interest
rates have risen and higher-yielding bonds become available.

Putable bonds, like callable bonds, often have protection periods. They can have European- or, rarely,
Bermudan-style put options, but there are no American-style putable bonds. Another similar option is an
extension option, found in extendible bonds. With this option, bondholders can choose to keep the bond
for a specified number of years after maturity, possibly with a different coupon. The bond's terms are
adjusted accordingly, but the bond remains outstanding.

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 Valuation and Analysis of Bonds with Embedded Options

Complex Embedded Options

There are various types of bonds with embedded options beyond callable and putable bonds. Some bonds
can have both call and put options, providing flexibility for both the issuer and bondholders. Convertible
bonds allow bondholders to convert them into common stock and are often callable by the issuer, allowing
them to take advantage of lower interest rates or force conversion.

Complexity increases when options are contingent on specific events, such as the estate put or survivor's
option for retail investors. With this option, the bond can be put at par by the heir(s) in the event of the
bondholder's death. The value of bonds with this option depends on the bondholder's life expectancy.

Bonds can feature multiple issuer options while lacking investor options. For example, a sinking fund bond
(sinker) requires the issuer to reserve funds to pay off the bond over time, minimizing credit risk. Sinkers
may be callable and may have additional features exclusive to them, such as acceleration provisions and
delivery options.

Callable and Putable Bonds

LOS: Explain the relationships between the values of a callable or putable bond, the underlying
option-free (straight) bond, and the embedded option.

LOS: Describe how the arbitrage-free framework can be used to value a bond with
embedded options.

Relationships between the Values of a Callable or Putable Bond, Straight

Bond, and Embedded Option
The value of a bond with embedded options can be broken down into two parts:

y The value of the bond without options

y The value of the embedded options

In the case of a callable bond, where the issuer decides when to exercise the call option, the investor holds
the bond but is short the call option. Consequently, from the investor's viewpoint, the value of the call option
reduces the overall value of the callable bond compared with the value of a straight bond.

Value of callable bond = Value of straight bond − Value of issuer call option

Value of issuer call option = Value of straight bond − Value of callable bond

In the case of a putable bond, the investor holds the authority to decide whether to exercise the put option,
so the put's value enhances the investor's position: the investor is long both the bond and the put option.

Value of putable bond = Value of straight bond + Value of investor put option

Value of investor put option = Value of putable bond − Value of straight bond

Vol 4-149
Learning Module 3

Valuation of Default-Free and Option-Free Bonds: A Refresher

Example 1 Valuation of default-free and option-free bonds

Calculate the value of a three-year 4.0% annual coupon bond with the information provided, assuming
annual coupons and annual compounding.

Maturity Par rate

1 2.00%
2 2.50%
3 3.00%

Solutions

Assuming annual coupons and annual compounding, the one-year spot rate is equal to the one-year
par rate.

The hypothetical one-year par bond, based on the provided par rate, has a single cash flow of 102.00
(Principal + Coupon) in Year 1. The one-year spot rate is the discount rate that equates this future cash
flow with the present par value, which is 2.00%.

A two-year 2.50% par bond has two cash flows: 2.5 in Year 1 and 102.5 in Year 2. The sum of the two
discounted cash flows must equal 100.

The two-year spot rate (z 2) can be calculated as:

2.50 102.50
+ = 100
(1.02) (1 + z 2) 2
z 2 = 2.5063%

The three-year spot rate (z 3) can be determined as:

3.00 3.00 103.00

+ + = 100
(1.02) (1.025063)2 (1 + z 2) 3
z 3 = 3.0204%

The one-year forward rate one year from now (F1,1) can be calculated as follows:

(1.025063)2 = (1.02) × (1 + F1,1)

F1,1 = 3.0151%

Similarly, the one-year forward rate two years from now (F2,1) can be calculated as:

(1.030)3 = (1.025063)2 × (1 + F2,1)

F2,1 = 4.0551%

Vol 4-150
 Valuation and Analysis of Bonds with Embedded Options

Equivalent forms of a yield curve

Maturity Par rate Spot rate One-year forward rate

1 2.00% 2.00% 0 years from now 2.00%

2 2.50% 2.5063% 1 year from now 3.0151%
3 3.00% 3.0204% 2 years from now 4.0551%

The three-year 4.0% annual coupon bond can now be valued using the spot rates:

4.0 4.0 104.0

+ + = 3.9216 + 3.8068 + 95.1193 = 102.8477
(1.02) (1.025063)2 (1.0302)3

An equivalent way to value this bond is to discount its cash flows using the derived one-year forward
rates for the appropriate number of periods:

4.0 4.0 104.0

+ + = 102.8477
(1.02) (1.02)(1.030151) (1.02)(1.030151)(1.040551)

Valuation of Default-Free Callable and Putable Bonds in the Absence of

Interest Rate Volatility
When valuing bonds with embedded options, it is more effective to use one-period forward rates instead of
spot rates since information about the bond's value at various future points is needed to assess whether the
embedded option would be exercised at those times.

Vol 4-151
Learning Module 3

Valuation of a Callable Bond at Zero Volatility

Example 2 Valuation of a callable bond at zero volatility

Using the information generated in the table, calculate the valuation of a Bermudan-style three-year
4.0% annual coupon bond that is callable at par one year and two years from now. The issuer will
exercise the call option when the value of the bond's future cash flows is higher than the call price
(exercise price).

Solutions

To value a callable bond, we begin by discounting its cash flow at maturity (104.0) to Year 2 using the
one-year forward rate two years from now (4.0551%). The present value at Year 2 is 99.473, which is
less than the call price of 100. Therefore, a rational borrower will not call the bond at that point in time.

Next, we add the cash flow in Year 2 (4.0) to the present value at Year 2 (99.473) and discount the total
to Year 1 using the one-year forward rate one year from now (3.0151%). The present value at Year 1 is
100.3121. At this time, a rational borrower will call the bond at 100 as it is the cheaper option.

Finally, we add the cash flow in Year 1 (4.0) to the present value at Year 1 (100.00) and discount the total
to today at 2.00%. The result (101.9608) represents the value of the callable bond.

(Note: All values are expressed as a percentage of par.)

Valuation of a default-free three-year 4.0% annual coupon

bond callable at par one year and two years from now at zero volatility

Today Year 1 Year 2 Year 3

Cash flow 4.0 4.0 104.0
Discount rate 2.0% 3.0151% 4.0551%
100 + 4 99.947 + 4 104
Value of the = 101.9608 = 100.3121 = 99.473
callable bond 1.02 1.030151 1.040551
Called at 100 Not called

To calculate the value of the call option on the callable bond, the following equation is applied:

Value of issuer call option = Value of straight bond − Value of callable bond

The value of the straight bond is determined as the value of a default-free and option-free three-year
4.0% annual coupon bond, which was previously calculated in Example 1 as 102.8477. Therefore, the
value of the issuer's call option is found by subtracting the value of the callable bond from the straight
bond value:

Value of issuer call option = 102.8477 − 101.9608 = 0.6669

This exercise demonstrates that the presence of a call option reduces the value of a callable bond
compared with an otherwise identical bond without the call option.

Vol 4-152
 Valuation and Analysis of Bonds with Embedded Options

Valuation of a Putable Bond at Zero Volatility

Example 3 Valuation of a putable bond at zero volatility

Calculate the valuation of a Bermudan-style three-year 4.0% annual coupon bond that is putable at par
one year and two years from now, using the information in Example 1.

Solutions

To value a putable bond, we can follow a similar process to the one shown in Example 2. The investor
will exercise the put option when the value of the bond's future cash flows is lower than the put price
(exercise price).

The table shows how to calculate the value of the three-year 4.0% annual coupon bond putable at par
one year and two years from today.

Valuation of a default-free three-year 4.0% annual coupon

bond putable at par one year and two years from now at zero volatility

Today Year 1 Year 2 Year 3

Cash flow 4.0 4.0 104.0
Discount rate 2.0% 3.0151% 4.0551%
4 + 100.9561 4 + 100 104
Value of the = 102.8981 = 100.9561 = 99.473
putable bond 1.02 1.030151 1.040551
Not put Put at 100

To calculate the value of the put option in the putable bond, the following equation is applied:

Value of issuer put option = Value of putable bond − Value of straight bond

The value of the straight bond is determined as the value of a default-free and option-free three-year
4.0% annual coupon bond, which was previously calculated in Example 1 as 102.8477. Therefore, the
value of the investor's put option is as follows:

Value of investor put option = 102.8981 − 102.8477 = 0.0504

Through this exercise, we can affirm that the presence of a put option enhances the value of the putable
bond when compared with an otherwise identical bond without such an option.

Vol 4-153
Learning Module 3

Effect of Interest Rate Volatility

LOS: Explain how interest rate volatility affects the value of a callable or putable bond.

LOS: Explain how changes in the level and shape of the yield curve affect the value of a callable
or putable bond.

Greater interest rate volatility increases the value of embedded options in bonds, offering more exercise
opportunities. Visualized through an interest rate tree below, this volatility helps assess potential rate
movements, emphasizing its importance for bond issuers and investors.

Exhibit 1 Volatility and binomial interest rate trees

Time 0 Time 1

i1, H
i0 i1, H = i1, L × e 2σ
i1, L

i0 = 1-period spot rate at Time 0 i1, H = 1-period higher forward rate at Time 1
σ = Annual volatility of interest rates i1, L = 1-period lower forward rate at Time 1

Level and Shape of the Yield Curve

Changes in the yield curve's level and shape have an impact on the valuation of callable and putable bonds.

Effect on the Value of a Callable Bond

All else equal, as interest rates drop, the value of a straight bond rises, but the value of a callable bond
does not increase as quickly due to the rising value of the call option. Changes in the yield curve shape also
affect the call option's value, with flattening or inverting curves increasing the likelihood of calls. Callable
bonds issued at a premium are more likely to be called under similar conditions.

Effect on the Value of a Putable Bond

All else equal, as interest rates increase, the value of a straight bond decreases. However, this decline is
partially balanced by the rising value of the put option, making the put option a hedge against rising interest
rates for investors.

The value of the put option tends to decrease as the yield curve transitions from upward sloping to flat or
downward sloping. When the yield curve is upward sloping, higher one-period forward rates in the interest
rate tree offer more opportunities for investors to exercise the put option. Conversely, as the yield curve
flattens or inverts, the number of these opportunities decreases.

Vol 4-154
 Valuation and Analysis of Bonds with Embedded Options

Valuation of Default-Free Callable and Putable Bonds with Interest

Rate Volatility

LOS: Calculate the value of a callable or putable bond from an interest rate tree.

Valuation of a Callable Bond with Interest Rate Volatility

To value a bond with an embedded option in the context of interest rate volatility:

y Create an interest rate tree using the provided yield curve and assumptions about interest
rate volatility.
y Evaluate whether the embedded option will be exercised at each node of the tree.
y Employ the backward induction valuation approach, which begins at maturity and moves backward
from right to left, to determine the bond's present value.

Example 4 Calculate the value of a callable bond from an interest rate tree

Calculate the value of a default-free three-year 4.0% annual coupon bond callable at par. The bond's
parameters include one-year, two-year, and three-year par yields of 2.0%, 2.5%, and 3.0%, respectively,
along with an annual interest rate volatility of 12%.

Solutions

The one-year par rate, one-year spot rate, and one-year forward rate zero years from now are all the
same at 2.0%. However, for one-year forward rates one year from now, iterative methods are used,
aiming to meet two specific constraints.

Ru = Rd e2σ t

Where:
Rd = The rate if the interest rate moves down
Ru = The rate if the interest rate moves up
σ = The interest rate volatility
t = The time in years between "time slices" (here t = 1)

At Time 1:

If Rd is 2.48%, Ru can be calculated as follows:

Ru = 0.0246 × e2 × 0.12 1 = 3.1273%

At Time 2:

If Rdd is 2.824%, Rud and Ruu can be calculated as follows, respectively:

Rud = 0.02824 × e2 × 0.12 1 = 3.59%

Ruu = 0.0359 × e2 × 0.12 1 = 4.5638% or Ruu = 0.02824 × e4 × 0.12 1 = 4.5638%

Vol 4-155
Learning Module 3

By utilizing the one-year forward rates, it is possible to assess the valuation of a three-year 4.0% annual
coupon bond, which has callable features and can be called at par one year or two years from now.

Year 0 Year 1 Year 2 Year 3

99.4608 104.00
4.5638%

100.5848
100 4.00
3.1273%
100.3958
101.9608
4.00 100.00 104.00
2.000%
3.590%
101.4832
100 4.00
2.480%
101.1437
100.00 104.00
2.824%

The process begins by determining the bond values in Year 2. This is achieved by discounting the cash
flow for Year 3 using the three available interest rates:

104
= 99.4608
1.045638
104
= 100.3958; Called at 100
1.0359
104
= 101.1437; Called at 100
1.02824

The value in each state for Year 1 is calculated by discounting the values in the two future states
stemming from the current state, along with the coupon payment at the relevant rate in the current state:

4 + (0.5 × 99.4608 + 0.5 × 100)

= 100.5848; Called at 100
1.031273
4 + (0.5 × 100 + 0.5 × 100)
= 101.4832; Called at 100
1.0248

At Year 0, the value of the callable bond can be calculated as follows:

4 + (0.5 × 100 + 0.5 × 100)

= 101.9608
1.02

With the value of the straight bond at 102.8477 (found in Example 1), the value of the call option is:

102.8477 − 101.9608 = 0.8869

Compared with the call option value at 0% volatility (0.6669) found in Example 2, the value of the call
option at 12% volatility is higher. This aligns with the earlier discussion that option value increases with
interest rate volatility.

Vol 4-156
 Valuation and Analysis of Bonds with Embedded Options

Valuation of a Putable Bond with Interest Rate Volatility

Valuing a putable bond is similar to valuing a callable bond, with the key difference being that in each
state, the bond's value is compared with the put price. The investor exercises the put option only when the
present value of the bond's future cash flows is less than the put price.

Example 5 Calculate the value of a putable bond from an interest rate tree

Calculate the value of a default-free three-year 4.0% annual coupon bond putable at par. The bond's
parameters include one-year, two-year, and three-year par yields of 2.0%, 2.5%, and 3.0%, respectively,
along with an annual interest rate volatility of 12%.

Solutions

Valuing a putable bond is akin to the method for valuing a callable bond shown in Example 4, but the key
distinction lies in comparing the bond's value with the put price in each state. The investor exercises the
put option only when the present value of the bond's future cash flows is less than the put price.

Year 0 Year 1 Year 2 Year 3

99.4608
100.00 104.00
4.5638%

101.0381
4.00
3.1273%

103.5649 100.3958
4.00 3.590% 104.00
2.000%

102.2343
4.00
2.480%

101.1437
2.824% 104.00

The process begins by determining the bond value in Year 2. This is achieved by discounting the cash
flow for Year 3 using the three available interest rates:

104
= 99.4608; Put at 100
1.045638
104
= 100.3958
1.0359
104
= 101.1437
1.02824

Vol 4-157
Learning Module 3

The value in each state for Year 1 is calculated by discounting the values in the two future states
stemming from the current state, along with the coupon payment at the relevant rate in the current state:

4 + (0.5 × 100 + 0.5 × 100.3958)

= 101.0381
1.031273

4 + (0.5 × 100.3958 + 0.5 × 101.1437)

= 102.2343
1.0248

At Year 0, the value of the putable bond can be calculated as follows:

4 + (0.5 × 101.0381 + 0.5 × 102.2343)

= 103.5649
1.02

With the value of the straight bond at 102.8477 (found in Example 1), the value of the put option is:

103.5649 − 102.8477 = 0.7172

Compared with the put option value at 0% volatility (0.0504) in Example 3, the value of the put option in
this example is higher at 12% volatility.

Valuation of Risky Callable and Putable Bonds

LOS: Explain the calculation and use of option-adjusted spreads.

LOS: Explain how interest rate volatility affects option-adjusted spreads.

There are two main methods for valuing bonds that are susceptible to default risk:

y Industry-standard approach: This method adjusts the discount rates upward, factoring in default
risk. Higher discount rates lead to lower present values, resulting in a lower value for a risky bond
compared with an equivalent default-free bond.
y Explicit default probability approach: Default probabilities are assigned to each future time period,
making the risk of default explicit. This approach provides a more detailed assessment of the bond's
value by considering the likelihood of default over time.

Option-Adjusted Spread
When valuing risky bonds with embedded options using an interest rate tree, the concept of an option-
adjusted spread (OAS) comes into play. The OAS represents a constant spread that, when added to
all the one-period forward rates on the interest rate tree, aligns the arbitrage-free value of the bond with
its market price. The value of a risky bond is significantly reduced compared with an otherwise identical
default-free bond because of an additional spread applied to account for the risk.

It is important to note that for an option-free bond, the zero-volatility spread or Z-spread is essentially its
OAS when there's no volatility. The Z-spread quantifies the additional yield that an investor demands over
the risk-free rate to compensate for the bond's credit risk and any embedded options.

Vol 4-158
 Valuation and Analysis of Bonds with Embedded Options

Exhibit 2 Binmial trees and option-adjusted spreads (OAS)

Attempting to replicate
price of risky bond with
embedded option

Correct OAS found

by trial and error

Based on risk-free
spot rate curve

The OAS is the constant spread above one-period forward rates in a

risk-free binomial interest rate tree that equates the observed market
price of a risky bond with an embedded option to the PV of the cash
flows to maturity and/or early retirement when the option is in the money.

When the bond's price is known, a trial-and-error method is used to determine the OAS. For instance,
if the market price of a three-year 4.0% annual coupon bond with callable features is 101.00, the OAS
is determined by adjusting all the rates at each node by adding a constant spread. This process is done
iteratively to match the bond's market price. In this example, the OAS is a measure that considers the
impact of call option exercise on a bond's value. It removes the option-related risk component from the
spread calculation, making it an indicator of a bond's relative value compared with a benchmark. A lower
OAS than that of a similar bond suggests overpricing (richness), while a higher OAS indicates underpricing
(cheapness). If the OAS is similar to the OAS of a comparable bond, the bond is considered fairly priced.

Effect of Interest Rate Volatility on Option-Adjusted Spread

Interest rate volatility has contrasting effects on callable and putable bonds. For callable bonds, rising
interest rate volatility reduces the OAS, making the bond seem less attractive to investors. Conversely, for
putable bonds, increasing interest rate volatility tends to increase the OAS, making the bond appear more
attractive to investors due to the greater value of the put option when interest rates are uncertain.

Vol 4-159
Learning Module 3

Bonds with Embedded Options: Effective Duration

LOS: Calculate and interpret effective duration of a callable or putable bond.

LOS: Compare effective durations of callable, putable, and straight bonds.

Duration
Duration measures the sensitivity of a bond's full price, including accrued interest, to either:

y a change in the bond's yield-to-maturity (in the case of yield duration measures) or
y changes in benchmark interest rates (in the case of curve duration measures).

Yield duration measures can only be applied to option-free bonds since they assume that the bond's
expected cash flows remain unchanged when yields change. However, for bonds with embedded options,
cash flows can vary if the embedded options, typically contingent on interest rates, are exercised.
Therefore, the appropriate duration measure for bonds with embedded options is a curve duration measure
known as effective (or option-adjusted) duration. It is worth noting that effective duration also applies to
straight bonds.

Effective Duration
Effective duration measures the sensitivity of a bond's price to a 100 bps parallel shift in the benchmark
yield curve, assuming no change in the bond's credit spread.

(PV−) − (PV+)
Effective duration =
2 × (ΔCurve) × (PV0)

Where:
ΔCurve = The magnitude of the parallel shift in the benchmark yield curve (as a decimal)
PV− = Full price of the bond when the benchmark yield curve is shifted down by ΔCurve
PV+ = Full price of the bond when the benchmark yield curve is shifted up by ΔCurve
PV0 = Current full price of the bond (ie, with no shift)

For a bond with an embedded option, effective duration can also be calculated as follows:

y Given the price of the bond, calculate its OAS to the benchmark yield curve at an appropriate interest
rate volatility. For example, the OAS for a risky, Bermudan-style, four-year, 7% annual-pay callable
bond is 30 bps based on a market price of $103.083.
y Shift the benchmark yield curve up by a small number of basis points (ΔCurve). Based on these
benchmark rates, generate a new arbitrage-free interest rate tree. To each of the one-year rates in
the tree, add the same OAS that was calculated earlier (30 bps) and revalue the bond. The resulting
value is PV+. It is important to remember that the effective duration and effective convexity calculations
assume that the OAS remains unchanged when interest rates change.
y Shift the benchmark yield curve down by the same number of basis points (ΔCurve) as in Step 2.
Based on these benchmark rates, generate a new arbitrage-free interest rate tree. To each of the one-
year rates in the tree, add the same OAS that was calculated earlier (30 bps) and revalue the bond.
The resulting value is PV−.

Vol 4-160
 Valuation and Analysis of Bonds with Embedded Options

y Note that this example uses ΔCurve = 25 bps to derive the interest rate tree but has not simply added
25 bps to the forward rates. The process outlined above requires adding 25 bps to the benchmark yield
curve, recalculating all the forward rates for the interest rate tree (given the interest rate model used
and the volatility assumption), and then adding the OAS before generating the value of the bond.
y Calculate the bond's effective duration.

Exhibit 3 shows the value of the risky, Bermudan style, four-year, 7% annual-pay, callable bond (that
offered an OAS of 30 bps) if the yield curve has moved up by 25 bps.

Exhibit 3 Value of V+ to be used in duration and convexity calculations

The value of the bond at each node (V1) is the lower of the call ꢀꢁꢁꢁꢁ
price (CP) and the value obtained through backward induction
(VBI). The lower value is included in the tree, while the higher P = $100
value, along with an indication of, whether it represents CP or ꢀꢁꢁꢁ CP = $100 C = $7
VBI, is listed in gray beside the relevant node. r3,HHH = 9.84%
V3,HHH = $97.410
ꢀꢁꢁ CP = $100
ꢀꢁꢁꢁꢂ
r2,HH = 7.61% C = $7
P = $100
V2,HH = $97.75 ꢀꢁꢁꢂ CP = $100
ꢀꢁ CP = $100 C = $7
r1,H = 6.01% C = $7 r3,HHL = 8.11%
V1,H = $99.875 V3,HHL = $98.969
ꢀꢁꢂ VBI = $100.185
ꢀ0 ꢀꢁꢁꢂꢂ
C = $7 r2,HL = 6.29% C = $7
r+ = 4.05% P = $100
V2,HL = $100 ꢀꢁꢂꢂVBI = $100.283
V+ = 102.775 ꢀꢂ VBI = $101.9322 C = $7
r1,L = 4.97% C = $7 r3,HLL = 6.70%
V1,L = $100 V3,HLL = $100
ꢀꢂꢂ VBI = $101.71
ꢀꢁꢂꢂꢂ
C = $7 r2,LL = 5.20% C = $7
P = $100
V2,LL = $100 ꢀꢂꢂꢂVBI = $101.385 C = $7
C = $7 r3,LLL = 5.54%
V3,LLL = $100
ꢀꢂꢂꢂꢂ
1 97.410 + 7 98.969 + 7 C = $7
V2,HH =
2
� (1.0761)1
+
(1.0761)1
� = $97.75 P = $100
C = $7

t=0 t=1 t=2 t=3 t=4

Exhibit 3 gives us a value of $102.775 for V+, assuming a yield volatility of 10%, an OAS of 30 bps, and a
ΔCurve of 25 bps. Given a V− of $103.332 (the calculation is not illustrated here), the effective duration for
this bond is:
103.332 − 102.7752
Effective duration = = 1.0807
2 × 0.0025 × 103.083

An effective duration of 1.0807 indicates that a 100 bps increase in interest rates would result in a decrease
of 1.0807% in the value of the callable bond.

Vol 4-161
Learning Module 3

The effective duration of a callable bond cannot exceed that of the straight bond.

y When interest rates are high relative to the bond's coupon, the embedded call option is out of the
money, so the bond is unlikely to be called. In this case, the price-yield profile of the callable bond is
very similar to that of a straight bond, implying that the effect of an interest rate change on the price of
a callable bond is very similar to the effect on the price of an otherwise identical option-free bond. At
high interest rates, callable and straight bonds have very similar effective durations.
y As interest rates fall, the embedded call option moves closer to being in the money, increasing the
likelihood that the bond will be called. The price of the callable bond is effectively capped at the call
price, resulting in price compression at low interest rates. The limitation on potential price gains due to
the presence of the call option reduces the effective duration of the callable bond relative to that of the
straight bond.

The effective duration of a putable bond also cannot exceed that of the straight bond.

y When interest rates are low relative to the bond's coupon, the embedded put option is out of the
money, so the bond is unlikely to be put. In this case, the price-yield profile of the putable bond is very
similar to that of a straight bond, resulting in the putable bond and straight bond having very similar
effective durations.
y When interest rates rise, the embedded put option moves toward the money and effectively places
a floor on the value of a putable bond. The price of the putable bond does not fall as much as that
of a straight bond as interest rates rise, meaning that its effective duration is lower than that of the
straight bond.

It may help you to remember the relationships described here by looking at the slope of the price-yield profiles
of callable and putable bonds relative to straight bonds (presented in Exhibit 4 and Exhibit 5). The steeper
(flatter) the slope, the higher (lower) the duration (price sensitivity of the bond to changes in interest rates).

Exhibit 4 Callable bonds versus straight bonds

Price

Call option value

Call
price

Option free bond value

At low interest rates,
the embedded call Callable bond value At high interest rates,
option prevents the the price-yield profile
callable bond's price of a callable bond is
from rising beyond similar to that of a
the call price. straight bond.

Ys Yield

Vol 4-162
 Valuation and Analysis of Bonds with Embedded Options

Exhibit 5 Putable bonds versus straight bonds

Price

The value of the

embedded put option
At low yields, the rises at higher yields.
price-yield profile of Therefore, it cush-
a putable bond is ions the fall in price
similar to that of an of the putable bond.
option-free bond.
Putable bond

Value of put
Option-free bond in dollar terms

Y Yield

When the embedded option (call or put) is deep in the money, the effective duration of the bond with an
embedded option resembles that of the straight bond maturing on the upcoming exercise date, reflecting
the fact that the bond is highly likely to be called or put on that date.

Also note that:

y The effective duration of an option-free bond changes very little in response to interest
rate movements.
y A putable bond's effective duration falls when interest rates rise, as the put moves into the money and
the bond's price-yield profile flattens out.
y A callable bond's effective duration falls when interest rates fall, as the call moves into the money and
the bond's price-yield profile flattens out.

Practically speaking, effective duration is often applied in the context of portfolio management.
Understanding the effective durations of various types of instruments helps manage portfolio duration.
Exhibit 6 presents some properties of the effective durations of cash and common types of bonds.

Exhibit 6 Properties of effective durations of cash and common types of bonds

Type of bond Effective duration

Cash 0

Zero-coupon bond ≈ Maturity

Fixed-rate bond < Maturity

Callable bond ≤ Duration of straight bond

Putable bond ≤ Duration of straight bond

Floater (LIBOR flat) ≈ Time (in years) to next reset

Vol 4-163
Learning Module 3

A bond's effective duration does not exceed its maturity. However, there are a few exceptions (eg, tax-
exempt bonds when analyzed on an after-tax basis).

y If a portfolio manager wants to shorten the effective duration of a portfolio of fixed-rate bonds, she
could do so by adding floating-rate bonds to the portfolio.
y A company can reduce the effective duration of its liabilities by issuing callable bonds instead of
straight bonds.

One-Sided and Key Rate Duration

LOS: Describe the use of one-sided durations and key rate durations to evaluate the interest
rate sensitivity of bonds with embedded options.

The calculation of effective duration works well for option-free bonds but can be misleading when it comes
to bonds with embedded options. The reason for this is that effective duration is calculated by averaging the
changes in a bond's price resulting from shifting the benchmark curve up and down by a specified number
of basis points. The problem with this process is that:

y For callable bonds, when the embedded call option is in the money, the upside potential from a decline
in interest rates is limited to the call price, while the downside from an increase in interest rates is
much larger.
○ In short, callable bonds are much more sensitive to interest rate increases than to interest
rate declines.

y For putable bonds, when the embedded put option is in the money, the downside potential from an
increase in interest rates is limited to the put price, while the upside from a decrease in interest rates is
much larger.
○ In short, putable bonds are much more sensitive to interest rate declines than to interest
rate increases.

Therefore, the average price response to up-and-down movements in interest rates (ie, effective duration) is
not as useful in capturing the interest rate sensitivity of either callable or putable bonds:

y The price response to interest rate increases (ie, one-sided up-duration) is more effective for
callable bonds.
y The price response to interest rate decreases (ie, one-sided down-duration) is more effective for
putable bonds.

This is especially true when the embedded option is near the money.

Key Rate Durations

Key rate durations (or partial durations) measure the sensitivity of a bond's price to changes in specific
maturities on the benchmark yield curve. Key rate durations are used to identify the shaping risk for bonds
(ie, the bond's sensitivity to changes in the shape of the yield curve: steepening and flattening). The
calculation of key rate duration is like the calculation of effective duration, but instead of shifting the entire
benchmark yield curve, only key points are shifted, one at a time.

Exhibit 7 presents the key rate durations for 10-year bonds with various coupon rates, assuming a flat 4%
yield curve.

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Exhibit 7 Key rate durations of 10-year option-free bonds valued at a 4% flat yield curve

Coupon (%) Price (% of par) Key rate durations

Total 2-year 3-year 5-year 10-year

0 67.30 9.81 −0.07 −0.34 −0.93 11.15

2 83.65 8.83 −0.03 −0.13 −0.37 9.37

4 100.00 8.18 0.00 0.00 0.00 8.18

6 116.35 7.71 0.02 0.10 0.27 7.32

8 132.70 7.35 0.04 0.17 0.47 6.68

10 149.05 7.07 0.05 0.22 0.62 6.18

Notice the following from Exhibit 7:

y For option-free bonds that are not trading at par (the unshaded rows), a change in any of the key rate
durations has an impact on the price of the bond.
○ For example, for the 2% bond, a 1% change in the two-year results in a 0.03% change in its value.

y For option-free bonds that are not trading at par (the unshaded rows), a change in the key/par rate
corresponding to the bond's maturity (10 years) has the greatest impact on price. This is because
duration is a kind of weighted average time to receipt of the bond's cash flows, and the largest cash
flow for fixed-rate bonds occurs at maturity, when both the final coupon and principal are paid.
○ For example, for the 2% bond, a 1% change in the 10-year rate results in a 9.37% change
in its value.

y For option-free bonds trading at par (the row shaded in green), the par rate corresponding to the
bond's maturity is the only one that affects its price. Given that the yield curve is flat at 4%, the 4%
coupon bond trades at par. This bond's price is not affected by a change in any key rates other than
the 10-year par rate.
○ For example, if there is a change in the two-year or six-year par rate, the value of the 4% coupon
bond that is trading at par will not change.

y Notice (from the top two rows in Exhibit 7) that key rate durations can sometimes be negative at
maturity points that are shorter than the maturity of the bond if the bond has a very low coupon
rate or is a zero-coupon bond. Recall that bond prices and interest rates are negatively related, so,
mathematically speaking, duration is a negative number. However, convention dictates that the inverse
relationship between bond prices and interest rates be captured by a positive duration measure.
Therefore, a negative duration value implies that the bond price is positively related to the relevant par
rate. We explain this relationship using the zero-coupon bond in Exhibit 7 (top row).
○ If there is an increase in the five-year par rate, there will be no impact on the price of a 10-year 4%
coupon-bearing bond trading at par. Note that a bond that trades at par is only sensitive to changes
in the par rate corresponding to its maturity.
○ However, the increase in the five-year par rate would result in an increase in the five-year
zero-coupon rate (ie, the five-year spot rate). Therefore, the discount factor for the coupon paid at
Year 5 on the 10-year coupon-bearing bond will be lower, and the present value of that payment will
also be lower.

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○ To make up for this reduction in the present value of the fifth coupon (to ensure that the overall value
of the 10-year coupon-bearing bond remains at par), all other cash flows on the bond, including the
cash flow occurring at Year 10, must be discounted at slightly lower rates.
○ This results in a slightly lower 10-year zero-coupon rate (which would be used to discount the Year
10 cash flow on the coupon-bearing bond).
○ This slight decline in the 10-year zero-coupon rate makes the value of a
10-year zero-coupon bond rise.
○ Thus, an increase in the five-year par rate leads to a slightly lower 10-year zero-coupon rate, which
in turn results in an increase in the 10-year zero-coupon bond. Therefore, the five-year key rate
duration for the 10-year zero-coupon bond is negative (−0.93).

For option-free bonds, duration is (among other factors) a function of time to maturity. For bonds with
embedded options, duration depends on time to maturity and on time to exercise, as illustrated in Exhibit 8.

Exhibit 8 Key rate durations of 30-year bonds callable in 10 years

valued at a 4% flat yield curve (15% interest rate volatility)

Coupon (%) Price (% of par) Key rate durations

Total 2-year 3-year 5-year 10-year 30-year

2 64.99 19.73 −0.02 −0.08 −0.21 −1.97 22.01

4 94.03 13.18 0.00 0.02 0.05 3.57 9.54

6 114.67 9.11 0.02 0.10 0.29 6.00 2.70

8 132.27 7.74 0.04 0.17 0.48 6.40 0.66

10 148.95 7.14 0.05 0.22 0.62 6.06 0.19

Notice the following from Exhibit 8:

y When the bond's coupon rate is significantly less than market interest rates, it is highly unlikely to be
called. In such a case it is more likely to behave like a straight bond, and the par rate that will have the
largest impact on its price will be the par rate that has the greatest impact on the straight bond's price.
○ For example, the bond with a 2% coupon rate is unlikely to be called, as its coupon rate is much
lower than the market yield of 4%. Therefore, the 30-year (maturity-matched) par rate has the
greatest impact on its price (ie, has the highest key rate duration; 22.01).

y As the bond's coupon increases, the likelihood of the bond being called also increases. As a result, the
bond's effective duration decreases and, gradually, the rate that has the largest impact on the bond's
price moves from the 30-year rate to the 10-year rate.
○ For example, the bond with a 10% coupon rate is almost certain to be called, so it behaves more
like a 10-year straight bond. The 10-year key rate duration is much larger than the 30-year key rate
duration (6.06 versus 0.19).

Exhibit 9 presents the key rate durations for 30-year bonds that are putable in 10 years (European-style)
with various coupon rates, assuming a flat 4% yield curve and volatility of 15%.

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 Valuation and Analysis of Bonds with Embedded Options

Exhibit 9 Key rate durations of 30-year bonds putable in 10 years

valued at a 4% flat yield curve (15% interest rate volatility)

Coupon (%) Price (% of par) Key rate durations

Total 2-year 3-year 5-year 10-year 30-year

2 83.89 9.24 −0.03 −0.14 −0.38 8.98 0.81

4 105.97 12.44 0.00 −0.01 −0.05 4.53 7.97

6 136.44 14.75 0.01 0.03 0.08 2.27 12.37

8 169.96 14.90 0.01 0.06 0.16 2.12 12.56

10 204.38 14.65 0.02 0.07 0.21 2.39 11.96

Notice the following from Exhibit 9:

y When the bond's coupon rate is significantly higher than market interest rates, it is highly unlikely to be
put. In such a case it is more likely to behave like a straight bond, and the par rate that will have the
largest impact on its price will be the par rate that has the greatest impact on the straight bond's price.
○ For example, the bond with a 10% coupon rate is unlikely to be put, as its coupon rate is much
higher than the market yield of 4%. Therefore, the 30-year (maturity-matched) par rate has the
greatest impact on its price (ie, has the highest key rate duration: 11.96).

y As the bond's coupon decreases, the likelihood of the bond being put increases. As a result, the bond's
effective duration decreases and, gradually, the rate that has the largest impact on the bond's price
moves from the 30-year rate to the 10-year rate.
○ For example, the bond with a 2% coupon rate is highly likely to be put, so it behaves more like
a 10-year straight bond. The 10-year key rate duration is much larger than the 30-year key rate
duration (8.98 versus 0.81).

Effective Convexity

LOS: Compare effective convexities of callable, putable, and straight bonds.

Recall that duration is only an approximate measure of the sensitivity of a bond's price to changes in
interest rates. This is because a bond's price-yield profile is not linear. Bond price sensitivity estimates
based on duration can be improved upon using the convexity adjustment. A bond's effective convexity can
be calculated as:

(PV−) + (PV+) − [2 × (PV0)]

Effective convexity =
(ΔCurve)2 × (PV0)

For example, calculate effective convexity for the same risky, Bermudan-style, four-year, 7% annual-pay
callable bond that we calculated effective duration for earlier in the module (PV+ = $102.775;
PV− = $103.332; PV0 = $103.083; OAS = 30 bps; σ = 10%; ΔCurve = 25 bps).

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Learning Module 3

(103.332) + (102.775) − [2 × (103.083)]

Effective convexity = = −91.577
(0.0025)2 × (103.083)

Note that:

y Option-free bonds exhibit positive effective convexity. Their prices rise slightly more when interest rates
fall than they fall when interest rates rise by the same magnitude.
y For callable bonds:
○ When interest rates are high and the embedded call option is far out of the money, they behave like
straight bonds.
○ When interest rates fall and the embedded call option is at or near the money, their effective
convexity turns negative. This is because their price is effectively capped at the call price.

y For putable bonds:

○ When interest rates are low and the embedded put option is far out of the money, they behave like
straight bonds.
○ When interest rates increase and the embedded put option is at or near the money, their effective
convexity remains positive. At this point, the upside from a decrease in interest rates is far greater
than the downside from an increase in interest rates, as the put price effectively creates a floor on
the putable bond's value.

y Therefore, putable bonds have more upside potential than otherwise identical callable bonds when
interest rates fall, while callable bonds have more downside potential than otherwise identical putable
bonds when interest rates rise.

Capped and Floored Floating-Rate Bonds

LOS: Calculate the value of a capped or floored floating-rate bond.

Valuation of a Capped Floater

Capped floaters are floating-rate securities with the coupon rate capped at a pre-specified level. Valuing a
capped floater using a binomial interest rate tree differs from valuing an option-free bond in two key ways:

y Since it is a floating-rate security, the coupon payment for the capped floater one year from today is
based on the current interest rate. This means that the coupon for the period is determined at the
beginning but paid at the end of the period.
y Due to the capped coupon rate, each node's coupon must be adjusted to account for the cap's
characteristics.

Because an investor in a capped floater is essentially long an uncapped bond but effectively short the
embedded cap (which favors the issuer), the value of a capped floater can be calculated as:

y Value of capped floater = Value of uncapped floater − Value of embedded cap

y Value of embedded cap = Value of uncapped floater − Value of capped floater

Exhibit 10 illustrates the valuation of a capped floater with a 7.5% cap. For simplicity, assume:

y High issuer credit quality, eliminating the need for a credit spread
y The MRR swap curve aligns with the par yield curve

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 Valuation and Analysis of Bonds with Embedded Options

Exhibit 10 Valuing a floater with a cap of 7.5%

t=0 t=1 t=2 t=3 t=4

ꢀꢁꢁꢁꢁ

ꢀꢁꢁꢁ P = $100

r3,HHH = 9.1987%
V3,HHH = $98.444
ꢀꢁꢁ
r2,HH = 7.0053% C = $7.50 ꢀꢁꢁꢁꢂ
V2,HH = $99.26 ꢀꢁꢁꢂ P = $100
ꢀꢁ
r1,H = 5.4289% C = $7.005 r3,HHL = 7.5312%
V1,H = $99.642 V3,HHL = $99.971
ꢀ0 ꢀꢁꢂ
r0 = 3.50% C = $5.429 r2,HL = 5.7354% C = $7.50 ꢀꢁꢁꢂꢂ
V0 = $99.824 V2,HL = $99.986 ꢀꢁꢂꢂ P = $100
ꢀꢂ
C = $3.50 r1,L = 4.4448% C = $5.735 r3,HLL = 6.166%
V1,L = $99.993 V3,HLL = $100
ꢀꢂꢂ
C = $4.444 r2,LL = 4.6958% C = $6.166 ꢀꢁꢂꢂꢂ
V2,LL = $100 P = $100
ꢀꢂꢂꢂ
C = $4.696 r3,LLL = 5.0483%
V3,LLL = $100
C = $5.048 ꢀꢂꢂꢂꢂ
P = $100

At each node, the listed coupon payment is the lower of (1) the cap rate-based coupon or (2) the coupon
based on the current one-year rate. Note that the coupon will be paid in the next period. For example, the
coupon payment of $7.50 at node NHHH is based on the cap rate of 7.50%, which is less than the current
one-year rate of r3,HHH = 9.1987%. However, this coupon will be paid at t = 4, even though it is listed at a
node corresponding to t = 3 in the tree.

To illustrate the bond's values at various nodes, focus on Node NH. The effective coupon rate for this node
is 5.4289%, and the coupon will be paid at nodes corresponding to t = 2 (NHH and NHL). The bond's value
at Node NH is calculated as:

1 (99.26 + 5.4289) (99.986 + 5.4289)

VH = × + = 99.6424
2 (1 + 0.054289) (1 + 0.054289)

If the coupon on this bond was uncapped, the bond's value at each node would be $100 since the coupon
rate would match the discount rate: a floating-rate security trades at par at each coupon reset date as its
coupon rate aligns with market interest rates.

With the cap in place, the issuer exercises the caplet at nodes where the coupon rate exceeds the cap rate.
In this example, the caplet is exercised at nodes boxed in green in Exhibit 10. At nodes where the caplet is

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Learning Module 3

exercised, the bond's value falls below par because the coupon rate is lower than market interest rates. The
value of the cap in this example can be calculated as:

Value of embedded cap = Value of uncapped floater − Value of capped floater

= $100 − $99.824 = $0.176

Also, note that a higher cap rate will result in the instrument trading closer to its par value because the
embedded interest rate call options have a lower likelihood of exercise and are therefore less valuable
to the issuer.

Valuation of a Floored Floater

A floor provision in a floater prevents the effective coupon rate from falling below a specified minimum rate,
offering investors protection against declining interest rates. Since investors in floored floaters are long on the
underlying floating bond and the embedded option, the value of a floored floater can be calculated as follows:

Value of floored floater = Value of nonfloored floater + Value of embedded floor

Value of embedded floor = Value of floored floater − Value of nonfloored floater

Valuing a floored floater through a binomial interest rate tree is like valuing a capped floater. At each node,
the effective coupon rate for the upcoming period is the higher of (1) the current one-year rate or (2) the
floor rate, resulting in a higher value for the floored floater compared with a nonfloored floater.

Convertible Bonds

LOS: Describe defining features of a convertible bond.

LOS: Calculate and interpret the components of a convertible bond's value.

Defining Features of a Convertible Bond

A convertible bond is a hybrid security that grants the holder the option to convert it into a predetermined
number of the issuer's common shares, essentially functioning as a call option on the stock, during a
predetermined conversion period at a specified conversion price. Convertible bonds offer benefits to both
the issuer and the investor:

y Investors accept lower coupon rates on convertible bonds compared with otherwise identical
nonconvertible bonds because they can participate in the issuer's equity upside through conversion.
y Issuers benefit from lower coupon rates and then no longer need to repay the debt if the bonds are
converted into equity.

However, it is important to note that:

y Current shareholders' interests may be diluted if these securities are converted.

y If the bond is not converted (if the share price remains below the conversion price), the issuer may
need to refinance the debt at a higher cost.
y If bondholders do not convert, they will realize less interest income than if the bonds had not been
convertible.

Exhibits 11 and 12 provide information to describe the features of a convertible bond and to illustrate how
to analyze it.

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 Valuation and Analysis of Bonds with Embedded Options

Exhibit 11 Excerpt from ABC Company's callable convertible bond offering circular

Issue date March 3, 20X4

Due date March 3, 20X9

Status Senior unsecured, unsubordinated

3.50% of nominal value (par) per annum, payable

Interest annually in arrears, with the first interest payment date
on March 3, 20X5, unless prior redeemed or converted

100% of par denominated into bons of $100,000 each

Issue price
and integral multiples of $1,000 each thereafter

Conversion period April 3, 20X4, to February 5, 20X9

Initial conversion price $5.00 per share

Each bond of par value of $100,000 is convertible to

Conversion ratio
20,000 ordinary shares

Threshold dividend $0.25 per share

Change of control
$3.50 per share
conversion price

From the third anniversary of issuance: 110%; from the

Issuer call price
fourth anniversary of issuance: 105%

Exhibit 12 Market information

Convertible bond price on September 9, 20X4 $125,628

Share price on issue date $ 4.50
Per-share price of ABC common stock on September 9, 20X4 $ 5.85
Dividend per share: $ 0.13
Share price volatility per annum as of September 9, 20X4 20%

Note that the straight value of the bond on September 9, 20X4 is estimated at $106,657.87

y The share price for which an investor can convert a convertible bond into ordinary shares is known
as the conversion price. In this case, the conversion price was set at $5 per share, which is the initial
conversion price in Exhibit 12.
y The conversion ratio determines the number of common shares that the convertible bondholder
receives upon converting the bonds into shares. In this example, if a bondholder invests the minimum
stipulated amount of $100,000 and converts her bonds into shares, she will receive 20,000 shares
(calculated as $100,000 divided by $5).

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y Conversion can usually be exercised during a specific period or at set intervals during the bond's
life span. In this example, the conversion period begins shortly after issuance and ends shortly
before maturity.
y The conversion ratio is adjusted for stock splits and stock dividends. For instance, if ABC were
to undergo a 3:1 stock split, the conversion price would be adjusted to $1.67 per share, and the
conversion ratio would become 60,000 shares per $100,000 of nominal value.

Until convertible bondholders convert their bonds into shares, they receive only coupon payments, while
common shareholders receive dividend payments. The terms of a convertible bond issue can vary widely,
from providing no compensation to convertible bondholders for dividend payments made during the bond's
life to offering full protection by adjusting the conversion price downward for dividend payments. Typically,
a threshold dividend is defined ($0.25/share in this case). Annual dividends below this level have no
impact on the conversion price. However, if annual dividends exceed this threshold, the conversion price is
adjusted downward to compensate convertible bondholders.

Change-of-control events, such as mergers, are defined in the prospectus. If a change-of-control event
occurs, convertible bondholders have two choices:

y A put option, exercisable during a specified period after the change-of-control event, that provides full
redemption of the bond's nominal value.
y An adjusted conversion price, set lower than the initial conversion price. This option allows convertible
bondholders to convert their bonds into shares earlier and on more favorable terms.

Almost all convertible bonds are callable, and some may also be putable.

y The issuer may call the bond under various circumstances:

○ Interest rates have fallen.
○ Its credit rating has improved.
○ It anticipates its share price will significantly increase in the near future.

y There may be a lockout period when the security cannot be called. After the lockout period expires,
the bonds can be called at a premium, which decreases over time. In this example, the bond cannot
be called until its third anniversary (at a 10% premium), with the premium decreasing to 5% by its
fourth anniversary.
y If a convertible bond is callable, the issuer has an incentive to call the bond to avoid interest payments
if the underlying share price rises beyond the conversion price. This scenario is referred to as a forced
conversion; bondholders are compelled to convert their bonds into shares (as the value of the shares
obtained from conversion exceeds the amount received from bond redemption). Forced conversion
enables the issuer to leverage favorable capital market conditions, strengthen its capital structure,
and eliminate the risk of an equity market downturn preventing conversion, which would require bond
redemption at maturity.
y The put option may be classified as either a hard put (redeemable only for cash) or a soft put
(redeemable for cash, common stock, subordinated notes, or a combination of these).

Analysis of a Convertible Bond

Conversion Value
The conversion (or parity) value of a convertible bond indicates the value of the bond if converted at the
market price of the shares:

Conversion value = Market price of common stock × Conversion ratio

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For ABC's convertible bond:

y Conversion value at issuance = $4.50 × 20,000 = $90,000

y Conversion value on September 9, 20X4 = $5.85 × 20,000 = $117,000

Minimum Value of a Convertible Bond

The minimum value of a convertible bond is the greater of its:

y conversion value (the value if the security is immediately converted into shares) or
y straight value (its value without the conversion option).

The straight value is calculated using the arbitrage-free valuation framework, discounting the bond's future
cash flows at appropriate rates.

The minimum value of the convertible bond can be described as a floor. It is essential to note that it is a
dynamic floor because the straight value is not fixed; it fluctuates with changes in interest rates and the
issuer's credit quality.

For ABC's convertible bond, the minimum value can be calculated as:

Minimum value at issuance = Max($90,000, $100,000) = $100,000

Note that the straight value at issuance is $100,000 since the issue price is set at 100% of par.

Minimum value on September 9, 20X4 = Max($117,000, $106,657.87) = $117,000

If the value of the convertible bond falls below its minimum value, which is the greater of the conversion
value and the straight value, an arbitrage opportunity would arise:

y Suppose the minimum value of the convertible bond equals its straight value. If the convertible bond is
selling for less than its straight value, it implies that the convertible bond offers a higher yield than an
otherwise identical nonconvertible bond. Consequently, investors will buy the convertible bond until its
price equals its straight value.
y Now, suppose the minimum value of the convertible bond equals its conversion value. If the convertible
bond is selling for less than its conversion value, an arbitrageur can buy the convertible bond, convert
it into shares based on the conversion ratio, and sell the shares for the conversion value. Over time, as
more arbitrageurs engage in this trade, the convertible bond's price will rise to its conversion value.

Market Conversion Price, Market Conversion Premium Per Share, and Market Conversion
Premium Ratio
The price that an investor effectively pays for common stock when purchasing and converting a convertible
bond is known as the market conversion price or conversion parity price. This price essentially represents
the breakeven point for the investor, as any increase in the stock price beyond this level will increase the
value of the convertible bond by at least the same percentage.

Market conversion price = Market price of convertible security / Conversion ratio

For ABC's convertible bond, the market conversion price on September 9, 20X4, can be calculated as:

Market conversion price = $125,628 / 20,000 = $6.28

The market conversion premium per share is the extra amount an investor pays for acquiring the company's
shares by purchasing a convertible bond instead of buying directly in the open market.

Market conversion premium per share = Market conversion price − Current market price

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For ABC's convertible bond, the market conversion premium per share on September 9, 20X4, can be
calculated as:

Market conversion premium per share = $6.28 − $5.85 = $0.43

The market conversion premium ratio is determined by dividing the market conversion premium per share
by the current market price of the company's common stock.

Market conversion premium ratio = (Market conversion premium per share / Market price of common stock)

For ABC's convertible bond, the market conversion premium ratio on September 9, 20X4, can be
calculated as:

Market conversion premium ratio = $0.43 / $5.85 = 7.35%

An investor pays a premium when purchasing common stock through a convertible bond, rather than
acquiring shares directly from the open market, due to the fact that the straight value of the bond acts as a
moving floor for the convertible security's price. In this context, the market conversion premium per share
can be seen as the price of the conversion call option.

However, there is a distinction between (1) buying a stand-alone call option on the issuer's stock and (2)
purchasing the call option on the issuer's stock embedded in a convertible bond. The buyer of the stand-
alone call option knows the exact dollar amount of the downside risk (the call premium), whereas the buyer
of the convertible bond only knows that their maximum loss is the difference between the price paid for the
convertible bond and its straight value. The straight value at any future date remains unknown.

Downside Risk of a Convertible Bond

The premium over straight value is sometimes used as a measure of downside risk in a convertible bond.
This interpretation, however, is theoretically flawed because the straight value, which acts as a floor for the
convertible's price, changes as interest rates and credit spreads fluctuate. Downside risk is expressed as a
percentage of the straight value and is calculated as:

Premium over straight value = (Market price of convertible bond / Straight value) − 1

For ABC's convertible bond, the premium over straight value is calculated as:

Premium over straight value = ($125,628 / $106,657.87) − 1 = 17.79%

It's important to note that, all other factors being equal, the higher the premium over straight value, the less
attractive the convertible bond becomes.

Upside Potential of a Convertible Bond

The upside potential of a convertible security depends on the prospects of the underlying stock, which are
assessed using common stock analysis techniques discussed in the equity analysis section.

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Comparison of Risk-Return Characteristics

LOS: Describe how a convertible bond is valued in an arbitrage-free framework.

LOS: Compare the risk-return characteristics of a convertible bond with the risk-return
characteristics of a straight bond and of the underlying common stock.

An investor should consider the following when investing in a convertible bond:

y The issuer's ability to service the bonds and repay the principal amount.
y The bond's terms of issuance, including collateral, credit enhancements, covenants, and
contingent provisions.
y Interest rate forecasts.
y Factors affecting the issuer's common stock, such as dividend payments, potential acquisitions,
disposals, or rights issues.
y Any external factors that could negatively impact the bond's value.

In the valuation of convertible bonds, the arbitrage-free framework is the most commonly used model.

For an investor in a noncallable or nonputable convertible bond, the investment effectively consists of a
straight bond and a call option on the company's stock, with the number of shares obtainable equaling the
conversion ratio.

Convertible security value = Straight value + Value of the call option on the stock

Note:

y The Black-Scholes-Merton (BSM) option pricing model is used to calculate the value of the call option
on the stock.
y Higher stock price volatility, a key input into the BSM model, results in a higher value for the call option
and, consequently, a higher value for the convertible bond.

For an investor in a callable but nonputable convertible bond, the investment entails a straight bond, a call
option on the company's stock, and writing (being short on) a call option on the bond.

Convertible callable bond value = Straight value + Value of the call option on the stock
− Value of the call option on the bond

Note:

y Valuing the embedded call option in callable convertible bonds requires analysis of future interest rates
and economic factors affecting the issuer's decision to call the security. The arbitrage-free framework
is used for this purpose. The BSM model, which incorporates stock price volatility but not interest rate
volatility, cannot be used to price the call option on the bond. It is suitable only for pricing the call option
on the stock.
y Increased interest rate volatility raises the value of the call option on the bond and reduces the value of
a callable convertible bond.

For an investor in a callable and putable convertible bond, the investment comprises a straight bond, a call
option on the company's stock, writing a call option on the bond, and owning a put option on the bond.

Convertible callable putable bond value = Straight value + Value of the call option on the stock
− Value of the call option on the bond + Value of the put option on the bond

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Learning Module 3

Comparison of the Risk-Return Characteristics of a Convertible Bond, the

Straight Bond, and the Underlying Common Stock
y If the company's stock price is relatively low, causing the straight value of the convertible bond to
significantly exceed the conversion value, the bond will trade like a fixed-income security. Factors such
as interest rates and credit spreads will heavily influence its price.
○ In this situation, when the call option on the stock is out of the money, the bond may be called a
fixed-income equivalent or a busted convertible. As the conversion period nears its end, the bond
increasingly behaves like a fixed-income security because the likelihood of the call option expiring
out of the money rises.

y If the company's stock price is relatively high, making the conversion value significantly greater than
the straight value, the bond will trade as an equity instrument. Its value will be strongly influenced by
stock price movements and less affected by changes in interest rates.
○ In this case, it may be referred to as a common stock equivalent. Note that when the embedded
call option on the stock is in the money, it is more likely to be exercised when the conversion value
exceeds the redemption value of the bond.

y In between these scenarios, the convertible will trade as a hybrid security with characteristics of both
fixed-income and equity instruments. It is essential to consider the risk-return characteristics of convertible
bonds when the underlying share price is above or below the conversion price and moves toward it.
○ When the share price is below the conversion price and increases toward it, the convertible bond's
return rises significantly, but at a lower rate than the underlying share price. Once the share price
exceeds the conversion price, the change in the convertible bond's price increases at the same rate
as the underlying share price.
○ When the share price is above the conversion price and decreases toward it, the relative change in
the convertible bond's price is less than the change in the share price due to the bond's value floor.

Exhibit 13 illustrates the price behavior of a convertible bond and the underlying stock.

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 Valuation and Analysis of Bonds with Embedded Options

Exhibit 13 Price behavior of convertible bond and underlying common stock

Price
(US dollars) A B C D

Convertible
bond price

Share price

Conversion
price

Hybrid
As share price
Hybrid decreases
As share price toward
increases toward conversion price,
conversion price, convertible bond
Bond Equivalent convertible bond price decreases
("Busted price increases but at a lower
Convertible") but at a lower rate rate than share Stock Equivalent
Convertible bond than share price. price because it Convertible bond price
price behavior Returns converge has a floor in the behavior similar to
similar to straight when conversion value of the underlying share
bond price behavior. price is exceeded. straight bond. price behavior.
Time
© CFA Institute

When the underlying share price exceeds the conversion price, the investor may choose not to exercise the
conversion option for various reasons:

y The call option on the stock embedded in the convertible bond may be European-style and not
currently exercisable.
y The investor might delay exercise until the option becomes even more in the money.
y The investor may decide to sell the bond instead of converting it into equity.

In most cases, except for busted convertibles, the primary driver of a convertible bond's value is the
underlying share price. Nevertheless, significant movements in interest rates or the issuer's credit spread
can still impact the convertible bond's value. For a convertible bond with a fixed coupon, under all else
equal conditions:

y If interest rates rise significantly, its value decreases.

y If the issuer's credit rating improves, its value increases.

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Learning Module 3

Vol 4-178
Learning Module 4
Credit Analysis Models

LOS: Explain expected exposure, the loss given default, the probability of default, and the credit
valuation adjustment.

LOS: Explain credit scores and credit ratings.

LOS: Calculate the expected return on a bond given transition in its credit rating.

LOS: Explain structural and reduced-form models of corporate credit risk, including
assumptions, strengths, and weaknesses.

LOS: Calculate the value of a bond and its credit spread, given assumptions about the credit
risk parameters.

LOS: Interpret changes in a credit spread.

LOS: Explain the determinants of the term structure of credit spreads and interpret a term
structure of credit spreads.

LOS: Compare the credit analysis required for securitized debt to the credit analysis of
corporate debt.

Modeling Credit Risk and the Credit Valuation Adjustment

LOS: Explain expected exposure, the loss given default, the probability of default, and the credit
valuation adjustment.

The credit spread, also known as the G-spread, measures credit risk by comparing the YTMs of corporate
and government bonds with the same maturity. It compensates investors for default risk and potential
losses in case of default. Default risk focuses on the probability of default, while credit risk considers both
the probability and expected loss. Assumptions include equal taxation and liquidity. Ignoring tax and liquidity
variations allows a focus on default risk and expected loss as key determinants of the credit spread.

Modeling credit risk involves three key factors:

y Expected exposure to default loss: This represents the projected amount an investor could lose
if a default event occurs, excluding any potential recovery. Default events can include nonpayment
leading to bankruptcy or other events specified in the bond prospectus.
y Recovery rate: This is the percentage of the loss that can be recovered from a defaulted bond. It
varies based on industry, seniority in the capital structure, leverage, and collateralization. With the
assumed recovery rate, the assumed loss given default (the amount lost if default occurs) can be
calculated as:

Loss given default = Expected exposure to default loss × (1 − Recovery rate)

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Learning Module 4

y Probability of default: This is the likelihood that a bond issuer will fail to meet its contractual
obligations as scheduled. Note that it is important to differentiate between risk-neutral and actual (or
historical) default probabilities. Risk-neutral refers to a methodology used in option pricing, where
the expected value of payoffs is discounted using the risk-free interest rate. When determining the
expected value of an option, it is essential to employ risk-neutral probabilities associated with the
payoffs. This distinction is important for accurate credit risk assessment and modeling.

The disparity between actual and risk-neutral default probabilities arises from the absence of the default risk
premium in actual probabilities and the complexity of observed spreads, which include factors beyond just
credit risk.

Credit value adjustment (CVA) represents the credit risk’s value in present value terms and can be
expressed as follows:
M
CVA = (Expected lossN × Discount factorN)
N=1

Exhibit 1 Fair value of a risky bond given risk-free discount factors

Steps Calculations

Value given no default (VND)

Periodic coupon plus present value of cash

Expected exposure (EE) for each time period
flows over time remaining to maturity

Loss given default (LGD) for each period EEN × (1 − Recovery rate)

PODN = CPODN × (1 − CPOD1) × (1 − CPOD2)

Probability of default (POD) for each period
× ∙∙∙ × (1 − CPOD N − 1)

Expected loss (EL) for each period LGDN × PODN

Credit value adjustment (CVA)

Bond's fair value VND − CVA

CF = Cash flow DF = Discount factor M = Periods until maturity

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 Credit Analysis Models

Credit Scores and Credit Ratings

LOS: Explain credit scores and credit ratings.

LOS: Calculate the expected return on a bond given transition in its credit rating.

Credit scores and ratings play a crucial role in lending decisions, impacting both eligibility and contract
terms. Credit scores are predominantly employed in the retail lending sector for individuals and small
businesses, whereas credit ratings are utilized in the wholesale market for corporate and government bonds
and asset-backed securities.

Credit scoring methods can vary by region, with some nations considering only negative information like
payment defaults when determining scores. In such cases, individuals start with a good credit score that
may be downgraded by their lapses. Conversely, other countries incorporate a broader range of data in
their scoring systems, reflecting a more comprehensive assessment of creditworthiness.

Credit reporting agencies typically operate on a national scale due to legal disparities and privacy concerns
between countries, ensuring consistent and accurate credit assessments.

The FICO score, used by 90% of US lenders, is calculated based on five factors: payment history (35%),
debt burden (30%), length of credit history (15%), types of credit used (10%), and recent credit inquiries
(10%). The FICO score ranges from a low of 300 to a perfect score of 850. It relies on data from Experian,
Equifax, and TransUnion.

The global credit rating industry is dominated by three major agencies: Moody’s Investors Service, Standard
& Poor’s, and Fitch Ratings. These agencies offer quality ratings for both issuers and specific financial
instruments. Like credit scores, these ratings are ordinal and assess the likelihood of default.

Credit rating agencies employ the technique of notching to evaluate the expected loss given default:
adjusting the rating of debt issues to reflect their position in the issuer’s capital structure and any
subordination. Normally, the issuer rating is assigned to senior unsecured debt, while the rating for
subordinated debt is lowered by one or two levels. The incorporation of loss given default, in addition
to the probability of default, is the reason these assessments are termed credit ratings rather than just
default ratings.

Credit rating agencies not only assign a letter-grade rating to issuers but also offer an outlook (positive,
stable, or negative) to indicate the issuer’s potential future creditworthiness. They may also place the issuer
under watch to signify ongoing monitoring or evaluation.

Credit rating agencies use historical data to create transition matrices, which show the chances of a specific
rating moving to another within a year. As shown in Exhibit 2, for example, an AA-rated issuer has an 88%
chance of staying at that level, a 1.5% chance of reaching AAA, and various probabilities of moving to
different lower ratings, with a 0.02% chance of default (D rating).

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Learning Module 4

Exhibit 2 Representative one-year corporate transition matrix (entries are %)

From/to AAA AA A BBB BB B CCC,CC,C D

AAA 90.00 9.00 0.60 0.15 0.10 0.10 0.05 0.00

AA 1.50 88.00 9.50 0.75 0.15 0.05 0.03 0.02
A 0.05 2.50 87.50 8.40 0.75 0.60 0.12 0.08
BBB 0.02 0.30 4.80 85.50 6.95 1.75 0.45 0.23
BB 0.01 0.06 0.30 7.75 79.50 8.75 2.38 1.25
B 0.00 0.05 0.15 1.40 9.15 76.60 8.45 4.20
CCC,CC,C 0.00 0.01 0.12 0.87 1.65 18.50 49.25 29.60
Credit Spread 0.60% 0.90% 1.10% 1.50% 3.40% 6.50% 9.50%

Source: CFA Institute

Credit transition matrices show the probabilities of debt issue credit rating outcomes over time (eg, one year). Current
ratings are indicated in the far left-hand column and period-end ratings on the top row below the header bar. The bolded
numbers in the diagonal indicate the probability of no change in rating. Starting from the diagonal, the table shows the
probability of an issue receiving higher (to the left) or lower (to the right) ratings.
Using the AAA bond shown in the above transition matrix, there is a 90% probability that the rating will be unchanged in one
year. There is a 9% probability that it will be downgraded to a AA, a 0.6% probability that it will be downgraded to A, etc.

Exhibit 2 also provides credit spreads for a 10-year corporate bond and a credit transition matrix. These
tools enable a fixed-income analyst to estimate the one-year rate of return, considering potential credit
rating changes but no defaults. If we assume a BBB-rated 10-year corporate bond with a modified duration
of 6.2 at year-end under stable yields and spreads, the analyst can calculate the expected percentage
price change for each potential transition by multiplying the modified duration by the change in the
spread as follows:

y From BBB to AAA: −6.2 × (0.60% − 1.50%) = 5.58%

y From BBB to AA: −6.2 × (0.90% − 1.50%) = 3.72%
y From BBB to A: −6.2 × (1.10% − 1.50%) = 2.48%
y From BBB to BB: −6.2 × (3.40% − 1.50%) = −11.75%
y From BBB to B: −6.2 × (6.50% − 1.50%) = −31.00%
y From BBB to CCC, CC, or C: −6.2 × (9.50% − 1.50%) = −49.60%

To calculate the expected percentage change in the bond’s value over the year, we use the probabilities
of credit rating migration. For a BBB-rated corporate bond, this calculation involves multiplying each
expected percentage price change associated with possible credit transitions by its corresponding
transition probabilities in the row linked to the BBB rating. The sum of these products gives us the expected
percentage change in the bond’s value.

(0.02% × 5.58%) + (0.30% × 3.72%) + (4.8% × 2.48%) + (85.5% × 0%) + (6.95% × −11.78%)
+ (1.75% × −31.00%) + (0.45% × −49.60%) = −1.4531%

The expected return on the bond over the next year, assuming no default, is YTM −1.4531%. However, for
non-investment-grade bonds, the small probability of transitioning to default should be considered.

Credit spread migration tends to reduce the expected return for two main reasons:

y The probabilities of credit rating changes are skewed toward downgrades rather than upgrades.
y The increase in the credit spread is typically much greater for downgrades compared with the
decrease in the spread for upgrades.

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 Credit Analysis Models

Structural and Reduced-Form Credit Models

LOS: Explain structural and reduced-form models of corporate credit risk, including
assumptions, strengths, and weaknesses.

Credit analysis models are categorized into two main types:

y Structural credit models, which trace their roots back to the 1970s and the work of Fischer Black,
Myron Scholes, and Robert Merton, analyze a company’s credit risk by examining its balance sheet
structure, including assets, liabilities, and equity. These models are often called company-value
models because they primarily aim to assess the company’s asset value. They operate on the
principle that a company defaults on its debt when its asset value falls below its liabilities, and they
view the probability of default as having characteristics like an option.
y Reduced-form models, developed in the 1990s, address the limitations of structural models,
assuming that the assets are actively traded, which is not typically the case. They treat default as an
external, random event, focusing on when it occurs, known as the default time. This is modeled using
a Poisson stochastic process, with the key parameter being the default intensity, which represents the
probability of default in the next period. These models are also called intensity-based and stochastic
default rate models.

Both structural and reduced-form credit risk models have their advantages and drawbacks.

y Structural models offer insights into credit risk but can be complex to implement. They require
determining the company’s value, volatility, and default threshold based on its liabilities. While these
models are conceptually straightforward, practical implementation can be challenging due to data
limitations. If a company is hiding debt, that makes it hard to know when it might go bankrupt, and this
is especially problematic for investors who need to stay informed about the risk of default.
y Reduced-form credit risk models have the advantage of using observable data for inputs, including
historical information and various financial and economic indicators. They can capture the business
cycle’s impact on credit risk. However, these models do not explain the economic reasons behind
defaults and assume that defaults occur suddenly, whereas in reality, defaults are often preceded by
downgrades over time.

Structural credit models enable the interpretation of debt and equity values in terms of options. In these
models, if A(T) represents the random asset value at time T, and considering zero-coupon bonds with a
maturity at T and a face value of K (representing the default barrier), the values of debt and equity at time T,
denoted as D(T) and E(T), depend on the relationship between A(T) and K, as shown in the equations below:

y D(T) + E(T) = A(T)

○ This equation represents the balance sheet identity, stating that the market values of debt and
equity at time T must equal the asset value.
y E(T) = max [A(T) − K, 0]
○ This reveals that equity can be viewed as a call option on the company’s assets, with the strike
price being the debt’s face value. It behaves like a long position in a call option because equity
gains value when the asset value rises, and, like options, it cannot have negative value.
y D(T) = A(T) − max[A(T) − K, 0]
○ This suggests that the company’s debtholders effectively own the company’s assets and have written
the call option held by the shareholders (equity holders). The premium received by debtholders for
writing this option can be seen as the value they gain from having priority of claim if the asset value
falls below the debt’s face value (K), which results in equity becoming worthless and the debtholders
taking control of the remaining assets.

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Learning Module 4

Structural models, based on option pricing, have practical value in assessing credit risk. Credit rating
agencies and firms use them to estimate default probabilities. Structural models require internal company
information and are useful for risk management, while reduced-form models use publicly available data and
are better suited for valuing risky debt securities and credit derivatives.

Valuing Risky Bonds in an Arbitrage-Free Framework

LOS: Calculate the value of a bond and its credit spread, given assumptions about the credit
risk parameters.

To calculate the value of a bond and its credit spread, use binomial interest rate trees assuming no
arbitrage. Exhibits 3–6 display the annual payment benchmark for government bonds, spot rates, discount
factors, and forward rates. As these tables demonstrate sequentially, coupon rates are equal to yields to
maturity and discount factors, while spot rates are derived by bootstrapping bond cash flows.

Exhibit 3 Value of a floating-rate note with coupon of benchmark rate plus 0.50%
(assumes no default and 10% interest rate volatility)

Maturity Coupon rate Price Discount factor Spot rate Forward rate

1 1.00% 100
2 1.50% 100
3 1.75% 100
4 2.00% 100
5 2.25% 100

To determine the discount factors (DF) for each year:

y 100 = (100 + 1) × DF1

○ DF1 = 0.9901

y 100 = (1.5 × 0.9901) + (101.5 × DF2)

○ DF2 = 0.9706

y 100 = (1.75 × 0.9901) + (1.75 × 0.9706) + (101.75 × DF3)

○ DF3 = 0.9491

y 100 = (2.0 × 0.9901) + (2.0 × 0.9706) + (2.0 × 0.9491) + (102 × DF4)

○ DF4 = 0.9233

y 100 = (2.25 × 0.9901) + (2.25 × 0.9706) + (2.25 × 0.9491) + (2.25 × 0.9233) + (102.25 × DF5)
○ DF5 = 0.8936

Exhibits 4–6 show the discount factors, spot rates, and forward rates for the benchmark
government par curve:

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 Credit Analysis Models

Exhibit 4 Discount factors

Maturity Coupon rate Price Discount factor Spot rate Forward rate

1 1.00% 100 0.9901

2 1.50% 100 0.9706
3 1.75% 100 0.9491
4 2.00% 100 0.9233
5 2.25% 100 0.8936

Spot rates (ie, implied zero-coupon rates) are calculated from the discount factors:
y Spot rate Year 1 = (1 / DF1) − 1 = 1.0000%
y Spot rate Year 2 = (1 / DF2)(1/2) − 1 = 1.5038%
y Spot rate Year 3 = (1 / DF3)(1/3) − 1 = 1.7574%
y Spot rate Year 4 = (1 / DF4)(1/4) − 1 = 2.0140%
y Spot rate Year 5 = (1 / DF5)(1/5) − 1 = 2.2743%

Exhibit 5 Spot rates

Maturity Coupon rate Price Discount factor Spot rate Forward rate

1 1.00% 100 0.99010 1.000%

2 1.50% 100 0.97059 1.504%
3 1.75% 100 0.94908 1.757%
4 2.00% 100 0.92334 2.014%
5 2.25% 100 0.89365 2.274%

Forward rates (FR) are calculated as a ratio of discount factors:

y FR Year 2 = (DF1 / DF2) − 1 = 2.0101%
y FR Year 3 = (DF2 / DF3) − 1 = 2.2665%
y FR Year 4 = (DF3 / DF4) − 1 = 2.7878%
y FR Year 5 = (DF4 / DF5) − 1 = 3.3223%

Exhibit 6 Forward rates

Maturity Coupon rate Price Discount factor Spot rate Forward rate

1 1.00% 100 0.990099 1.0000%

2 1.50% 100 0.970590 1.5038% 2.0101%
3 1.75% 100 0.949079 1.7574% 2.2665%
4 2.00% 100 0.923338 2.0140% 2.7878%
5 2.25% 100 0.893648 2.2743% 3.3223%

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Learning Module 4

Using the methodology outlined in the arbitrage-free valuation framework (Learning Module 3), we can
construct a binomial interest rate tree based on the one-year forward rates generated above, assuming a
future interest rate volatility of 10%. The binomial tree reflecting these assumptions is displayed in Exhibit 7.

The exhibit is organized in such a way that each corresponding interest rate (either up or down) is displayed
above the probability of reaching that interest rate. For instance, the one-year interest rate of 1.00%, as
generated above, has an equal probability of increasing to 2.2108% or decreasing to 1.8101%. This pattern
continues for the subsequent years, extending out to Year 4.

Exhibit 7 One-year binomial interest rate tree (10% volatility)

Date 0 Date 1 Date 2 Date 3 Date 4

4.8718%
6.25%

3.7125%
12.50%

2.7425% 3.9887%
25.00% 25.00%

2.2108% 3.0396%
50.00% 37.50%

1.0000% 2.2454% 3.2656%

100% 50.00% 37.50%

1.8101% 2.4886%
50.00% 37.50%

1.8384% 2.6737%
25.00% 25.00%

2.0375%
12.50%

2.1890%
6.25%

The arbitrage-free nature of this binomial interest rate tree is demonstrated by calculating the value at Date
0 of a 2.25% annual payment bond, priced at par value (Exhibits 3–6). The results are presented in Exhibit
8, where the coupon and principal payments are displayed to the right of each forward rate.

To demonstrate the arbitrage-free property of the binomial tree in Exhibit 7, work backward starting from
the right side of Exhibit 8. This involves discounting principal and interest payments to determine the
bond’s value.

For instance, calculate the bond values at Date 4 by discounting the principal and interest payments due at
Date 5 (102.25) using the corresponding interest rates at Date 4.

Vol 4-186
 Credit Analysis Models

y 102.25 / 1.048718 = 97.5

y 102.25 / 1.039887 = 98.3280
y 102.25 / 1.032656 = 99.0165
y 102.25 / 1.026737 = 99.5874
y 102.25 / 1.02189 = 100.0597

Next, discount the values of the bonds at Date 4 (each value is equally weighted) that correspond to Date
3 nodes using their respective interest rates. This process is repeated back to Date 0, resulting in a bond
value of 100.

y [(97.5 × 0.50) + (98.3280 × 0.50) + 2.25] / 1.037125 = 96.5785

y [(98.3280 × 0.50) + (99.0165 × 0.50) + 2.25] / 1.030396 = 97.9451
y [(99.0165 × 0.50) + (99.5874 × 0.50) + 2.25] / 1.024886 = 99.0861
y [(99.5784 × 0.50) + (100.0597 × 0.50) + 2.25] / 1.020375 = 100.0353

Exhibit 8 Valuation of a 2.25% annual pay government bond

Date 0 Date 1 Date 2 Date 3 Date 4 Date 5

97.5000
4.8718% 102.25
6.25%
96.5785
2.25
3.7125%
12.50%
96.8556 98.3280
2.25
2.7425% 3.9887% 102.25
25.00% 25.00%
97.7921 97.9451
2.25 2.25
2.2108% 3.0396%
50.00% 37.50%
98.5527 99.0165
100.00 2.25 2.25
2.2454% 3.2656% 102.25
1.0000%
50.00% 37.50%
99.7080 99.0861
2.25 2.25
1.8101% 2.4886%
50.00% 37.50%
99.9728 99.5874
2.25
1.8384% 2.6737% 102.25
25.00% 25.00%
100.0353
2.25
2.0375%
12.50%
100.0597
2.1890% 102.25
6.25%

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Learning Module 4

Now we will work with corporate bonds that involve expected default rates. Consider a five-year, 3% annual
payment corporate bond with a hazard rate of 1.5%, a recovery rate of 30%, and the same interest rate
assumptions utilized in Exhibit 8 to calculate the bond’s value given no default (VND). The binomial tree
representing this bond is presented in Exhibit 9.

To assess the fair value of this bond:

y Determine the corporate bond’s VND.

y Calculate the credit valuation adjustment (CVA).
y Subtract the CVA from the fair value of the bond.

Exhibit 9 3% annual pay corporate bond (assumes no default)

Date 0 Date 1 Date 2 Date 3 Date 4 Date 5

98.2152
4.8718% 103.00
6.25%
97.9942
3.00
3.7125%
12.50%
98.9705 99.0493
3.00
2.7425% 3.9887% 103.00
25.00% 25.00%
100.6066 99.3754
3.00 3.00
2.2108% 3.0396%
50.00% 37.50%
100.6911 99.7428
103.5451 3.00 3.00
2.2454% 3.2656% 103.00
1.0000%
50.00% 37.50%
102.5546 100.5285
3.00 3.00
1.8101% 2.4886%
50.00% 37.50%
102.1307 100.3178
3.00
1.8384% 2.6737% 103.00
25.00% 25.00%
101.4879
3.00
2.0375%
12.50%
100.7936
2.1890% 103.00
6.25%

As shown in Exhibit 9, the VND is 103.5451. Alternatively, this value could be calculated by discounting
cash flows using the discount factors presented in Exhibits 3–6.

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 Credit Analysis Models

Exhibit 10 Discount factors to value corporate bond

Cash flow Discount factor

3.0 × 0.9901 = 2.9703

3.0 × 0.9706 = 2.9118
3.0 × 0.9491 = 2.8472
3.0 × 0.9233 = 2.7700
103.0 × 0.8936 = 92.0457
103.5451

Exhibit 11 demonstrates that the CVA for this bond is 4.9835, based on expected exposures derived from
the binomial tree. For instance, the expected exposure for Date 1 is calculated as follows:

Date 1 exposure = (0.50 × 100.6066) + (0.50 × 102.5466) + 3.0 = 104.5806

This process can be repeated for Dates 2–4 to determine expected exposures, with the expected exposure
at Date 5 being 103 (equal to par value plus interest). To obtain the remaining information required
for calculating cumulative CVA, assume the discount factors from Exhibits 3–6 and follow the process
discussed earlier to derive loss given default (LGD), probability of default (POD), and CVA per year (as
shown in Exhibit 11).

Exhibit 11 CVA for 3% annual payment corporate bond

Date Expected exposure LGD POD Discount factor CVA per year

0
1 104.5806 73.2064 1.5000% 0.990099 1.0872
2 103.6208 72.5346 1.4775% 0.970590 1.0402
3 102.8992 72.0295 1.4553% 0.949079 0.9949
4 102.6834 71.8784 1.4335% 0.923338 0.9514
5 103.0000 72.1000 1.4120% 0.893648 0.9098
7.2783% CVA = 4.9835

Based on this CVA, the fair value of the bond is 103.5451 − 4.9835 = 98.5616. With this value in hand,
determine the bond’s YTM using a net present value/IRR equation:

Exhibit 12 Corporate bond IRR

3 3 3 3 3
98.5616 = = = = =
(1 + YTM)1 (1 + YTM)2 (1 + YTM)3 (1 + YTM)4 (1 + YTM)5

In this instance, the YTM is 3.3169%. Therefore, given that the five-year government bond yield is 2.25%,
the credit spread for this bond is 3.3169% − 2.25% = 1.0669%.

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Changing the assumed level of interest volatility will not affect the fair value of a bond unless it involves
credit risk or the bond contains embedded put or call options. To illustrate this point, Exhibit 13 and Exhibit
14 display a no-arbitrage binomial interest rate tree and CVA calculations for the same 3% annual-pay
corporate bond (without embedded options) used in the previous calculations but with 20% interest
rate volatility.

Due to the differing interest volatility assumptions between Exhibits 9 and 13, the range of forward rates is
broader. For instance, Date 3 interest rates in Exhibit 9 range from 2.0375% to 3.7125%, whereas in Exhibit
13, they range from 1.4499% to 4.8137%. Nevertheless, as demonstrated in Exhibit 13, altering interest
rate volatility assumptions has no impact on the VND.

Exhibit 13 Value of 3% corporate bond assuming no default and 20% interest volatility

Date 0 Date 1 Date 2 Date 3 Date 4 Date 5

96.3467
6.9055% 103.00
6.25%
95.7841
3.00
4.8138%
12.50%
97.2140 98.4431
3.00
3.2577% 4.6289% 103.00
25.00% 25.00%
99.6526 98.9779
3.00 3.00
2.4086% 3.2268%
50.00% 37.50%
100.8916 99.9002
103.5451 3.00 3.00
2.1837% 3.1029% 103.00
1.0000%
50.00% 37.50%
103.5084 101.2116
3.00 3.00
1.6145% 2.1630%
50.00% 37.50%
103.4676 100.9013
3.00
1.4638% 2.0799% 103.00
25.00% 25.00%
102.7527
3.00
1.4499%
12.50%
101.5837
1.3942% 103.00
6.25%

As mentioned earlier, changing interest rate volatility assumptions will impact a bond’s price only when
the bond has embedded options or when credit risk is involved. Exhibit 14 illustrates the effects of higher
interest rate volatility on bonds with credit risk. Here, a slightly lower CVA results from changes in expected
exposures to default loss due to differing interest rate assumptions. Consequently, due to this slightly
reduced CVA, the bond’s value increases marginally from 98.5616 to 98.5619 (103.5451 − 4.9832).

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Exhibit 14 CVA of 3% corporate bond (no default, 20% volatility)

Date Expected exposure LGD POD Discount factor CVA

0
1 104.5805 73.2064 1.5000% 0.990099 1.0872
2 103.6162 72.5313 1.4775% 0.970590 1.0401
3 102.8882 72.0217 1.4553% 0.949079 0.9948
4 102.6694 71.8686 1.4335% 0.923338 0.9513
5 103.0000 72.1000 1.4120% 0.893648 0.9098
7.2783% CVA= 4.9832

The arbitrage-free valuation framework can also be applied to a risky floating-rate note. To illustrate,
consider a five-year floater that pays 0.50% (quoted margin) over the benchmark with an assumed interest
rate volatility of 10%. Exhibit 15 demonstrates that the VND for the floater is 102.3634.

When dealing with a floater, it is important to note that interest payments are made in arrears. This means
that rates are set at the beginning of a period and paid at the end of the period. This is why interest
payments are listed to the right, depending on the realized rate in the binomial tree. For instance, the
interest payment at Date 1 is 1.50% (1.00% + 0.50%), and the interest payment at Date 5 is 103.7656 if the
one-year rate at Date 4 is 3.2656%.

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Exhibit 15 Value of floater with coupon of benchmark rate plus 0.50% (no default, 10% volatility)

Date 0 Date 1 Date 2 Date 3 Date 4 Date 5

100.4768
4.8718% 105.3718
6.25%
100.9438
4.2125
3.7125%
12.50%
101.4100 100.4808
3.2425
2.7425% 3.9887% 104.4887
25.00% 25.00%
101.8763 100.9535
2.7108 3.5396
2.2108% 3.0396%
50.00% 37.50%
101.4256 100.4842
102.3634 1.50 2.7454
2.2454% 3.2656% 103.7656
1.0000%
50.00% 37.50%
101.8977 100.9617
2.3101 2.9886
1.8101% 2.4886%
50.00% 37.50%
101.4386 100.4870
2.3384
1.8384% 2.6737% 103.1737
25.00% 25.00%
100.9684
2.5375
2.0375%
12.50%
100.4893
2.1890% 102.6890
6.25%

The corresponding calculations to determine the floating rate note’s CVA are displayed in Exhibit 16. In this
example of CVA derivation, different hazard rates are applied over various years to account for potential
increases in the issuer’s credit risk. For Dates 1–3, the hazard rate is 0.50%, and for Dates 4–5, the hazard
rate is 1.00%. Additionally, the recovery rate is assumed to be 20% for the first period and 10% for the
second period.

Exhibit 16 CVA of a floater with coupon of benchmark rate plus 0.50%

Date Expected exposure LGD POD Discount factor CVA per year

0
1 103.3870 82.7096 0.5000% 0.990099 0.4095
2 103.9354 83.1483 0.4975% 0.970590 0.4015
3 103.7251 82.9801 0.4950% 0.949079 0.3898
4 103.7757 93.3981 0.9851% 0.923338 0.8495
5 103.8315 93.4483 0.9752% 0.893648 0.8144
3.4528% CVA = 2.8647

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 Credit Analysis Models

When calculating the CVA for a floating-rate note, it’s important to consider that the expected exposure
takes into account that bond values on a specific date are influenced by the probabilities of reaching certain
rates, and that interest payments are based on probabilities from previous dates.

For example, the expected exposure for Date 4 is 103.7757.

y Discounted bond values at Date 4:

= (0.0625 × 100.4768) + (0.25 × 100.4808) + (0.375 × 100.4842) + (0.25 × 100.4870)

+ (0.0625 × 100.4893) = 100.4839

y Discounted interest values at Date 4:

= (0.125 × 4.2125) + (0.375 × 3.5396) + (0.375 × 2.9886) + (0.125 × 2.5375) = 3.2918

y Expected exposure = 100.4839 + 3.2918 = 103.7757

We also need to consider the differing hazard rates (POD) over the five-year period.

y POD Date 2 = 0.50% × (100% − 0.50%) = 0.4975%

y POD Date 3 = 0.50% × (100% − 0.50%)2 = 0.4950%

This means the probability of survival into the fourth year = (100% − 0.50%)3 = 98.5075%. Therefore:

y POD Date 4 = 98.5075% × 1.0% = 0.9851%

y POD Date 5 = 1.0% × (100% − 1.0%) × (100% − 0.50%)3 = 0.9752%

With a CVA of 2.8647 for the floating-rate note, the fair value is 99.4987 (= 102.3634 − 2.8647). The
discount margin (DM) for a floating-rate bond serves as a yield measure. Given that the bond is priced
below par value, the DM must be higher than the quoted floating rate margin of 0.50%.

To determine the DM for this floating-rate note, use trial and error. To do this, add a trial DM to the
benchmark rates used to calculate values for each node in the binomial tree. Then, adjust the trial DM
margin until the Date 0 value of the note matches the previously calculated price of 99.4987. This process is
detailed in Exhibit 17 and results in a DM of 0.6079%.

We can apply this DM to demonstrate that it results in the same value for the floating-rate note by using the
VND and CVA models and adding the DM to the interest rates shown in the binomial tree at Date 1.

[(0.50 × 99.6008) + (0.50 × 99.5963) + 1.50] / (1 + 1.00% + 0.6079%) = 99.4987

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Exhibit 17 DM for floater with coupon of benchmark rate plus 0.50% (10% assumed volatility)

Date 0 Date 1 Date 2 Date 3 Date 4 Date 5

99.8977
4.8718% 105.3718
6.25%
99.7980
4.2125
3.7125%
12.50%
99.6991 99.8968
3.2425
2.7425% 3.9887% 104.4887
25.00% 25.00%
99.6008 99.7960
2.7108 3.5396
2.2108% 3.0396%
50.00% 37.50%
99.6958 99.8961
99.4987 1.50 2.7454
2.2454% 3.2656% 103.7656
1.0000%
50.00% 37.50%
99.5963 99.7942
2.3101 2.9886
1.8101% 2.4886%
50.00% 37.50%
99.6931 99.8955
2.3384
1.8384% 2.6737% 103.1737
25.00% 25.00%
99.7928
2.5375
2.0375%
12.50%
99.8950
2.1890% 102.6890
6.25%

Interpreting Changes in Credit Spreads

LOS: Interpret changes in a credit spread.

Fixed-income analysts must track and explain the daily changes in corporate and benchmark bond yields
and the credit spread. Benchmark bond yields reflect macroeconomic factors, such as inflation and real
returns, and compensate risk-averse investors for uncertainties.

The credit spread over benchmark yields relates to microeconomic factors specific to the issuer and the bond.
It includes expected default loss, liquidity, and tax differences. These factors can be challenging to separate,
as bonds that are difficult to assess in terms of default probability and recovery rate tend to be less liquid.

The credit risk model and the arbitrage-free framework can be used to explore the relationships between
the default probability, the recovery rate, and the credit spread. This is necessarily a simplified modeling;
researchers and analysts can develop more complex models including the CVA and additional adjustments
for funding, liquidity, and taxation that affect the spreads between corporate and government bonds.

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Investors are concerned about credit spread widening, particularly if they do not plan to hold the bond until
maturity. Even for high-quality investment-grade corporate bonds, credit rating migration from year to year is
a concern. Additionally, observed credit spreads encompass more than just credit risk as they also involve
liquidity and tax differences. This explains the gap between risk-neutral and actual default probabilities.

The Term Structure of Credit Spreads

LOS: Explain the determinants of the term structure of credit spreads and interpret a term
structure of credit spreads.

Like a government bond yield curve, a credit-spread curve can be created for a single issuer of debt or
a set of issuers across industries/sectors and credit ratings. This is referred to as the term structure of
credit spreads and serves as a valuable tool for issuers, underwriters, and investors when assessing the
risk/return tradeoff associated with bond offerings. For instance, issuers can utilize credit spreads when
collaborating with underwriters to determine terms and pricing for new debt or evaluate outstanding debt for
tender offers. Additionally, portfolio managers can rely on credit-spread curves for making bids on new debt,
as well as assessing and trading existing debt.

There are several factors that determine the term structure of credit spreads:

y Credit quality:
○ Investment-grade bonds with high ratings and low spreads typically have a flat short-term credit
spread curve. Over the long term, this curve tends to slope upward due to increasing probabilities
of default over time. Factors like economic uncertainty, industry competition, and company
fundamentals contribute to this trend.
○ High-yield bonds with low ratings are more sensitive to economic and credit conditions. Poorly
rated bonds usually exhibit steep upward-sloping credit curves due to a higher likelihood of default
over time. However, high-yield bonds may have low near-term credit spreads but expect them
to rise in the long term as the economy cycles from expansion to recession, or may experience
an inverted credit curve, indicating expectations of an economic rebound. Improved company
fundamentals can also lead to inverted credit curves when investors anticipate better operations
and profitability.

y Macroeconomic conditions: The pace of economic growth significantly impacts perceived credit risk.
Economic strengthening often leads to higher risk-free bond yields and narrower credit spreads, while
a period of economic weakening has the opposite effect.
y Market supply and demand: Corporate bond markets, unlike government debt markets, lack high
liquidity. New bond issues influence credit spread movements significantly, as most existing bonds do
not trade regularly.
y Microeconomic conditions: Industry-specific factors such as peer financial ratios, cash flows,
leverage, and profitability can influence credit spread structures. Company-specific fundamental
analysis incorporating equity market valuations, equity volatility, and balance sheet information also
plays a role. Higher volatility in these microeconomic factors tends to steepen the credit curve, while
declining volatility has the opposite effect.

When analyzing term structures of credit spreads, choosing an appropriate risk-free benchmark is crucial.
Ideally, a frequently traded government bond matching the corporate bond’s maturity is preferred. However,
finding exact matches between corporate and highly liquid government bonds can be challenging. In such
cases, analysts can interpolate yields based on two government bonds with the closest durations. Swap
curves are another option, offering greater liquidity for less liquid maturities.

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It is important to consider that term structure analysis should focus on bonds with similar credit
characteristics, typically including senior unsecured debt. Bonds with embedded options, lien provisions, or
unique structural issues should be excluded from the analysis.

Moreover, it is worth noting that default expectations can significantly impact the shape of the term structure
of credit spreads. A change in the POD while keeping the recovery rate at 30% can lead to variations in
credit spreads, emphasizing their sensitivity to default projections (as shown in Exhibit 18).

Exhibit 18 Increasing the probability of default for a four-year, zero-coupon corporate bond

Loss given Probability Probability Expected Discount PV of

Year Exposure Recovery default of default of survival loss factor expected loss

1 86.3838 25.9151 60.4686 7.5000% 92.5000% 4.5351 0.95238 4.31919

2 90.7029 27.2109 63.4921 6.9375% 85.5625% 4.4048 0.90703 3.99525
3 95.2381 28.5714 66.6667 6.4172% 79.1453% 4.2781 0.86384 3.69561
4 100.0000 30.0000 70.0000 5.9359% 73.2094% 4.1551 0.82270 3.41843
26.7906% CVA= 15.4285

If the price of a similar risk-free bond was 82.2702 and the new CVA is 15.4285, this implies that the fair
value of the corporate bond is now 66.8417 (= 82.2702 − 15.4285). The YTM can be calculated as follows:

100
= 66.8417
(1 + YTM)4
YTM = 10.5956%

It is also crucial to consider what can occur when investors demand higher compensation due to increasing
default risk over extended time frames. Exhibits 19–21 illustrate that the credit spread rises from 2.2203%
to 2.8080% and further to 3.3961% when assuming rising default probabilities.

y Years 1–4: 3%
y Years 5–7: 5%
y Years 8–10: 7%

Exhibit 19 Increasing the probability of default for longer times to maturity

Loss given Probability Probability Expected Discount PV of

Year Exposure Recovery default of default of survival loss factor expected loss

1 86.3838 25.9151 60.4686 3.0000% 97.0000% 1.8141 0.9524 1.7277

2 90.7029 27.2109 63.4921 2.9100% 94.0900% 1.8476 0.9070 1.6758
3 95.2381 28.5714 66.6667 2.8227% 91.2673% 1.8818 0.8638 1.6256
4 100.0000 30.0000 70.0000 2.7380% 88.5293% 1.9166 0.8227 1.5768
11.4707% CVA= 6.6059

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 Credit Analysis Models

If the price of a similar risk-free bond was 82.2705 (= 100 × 0.822705) and the new CVA is 6.6059, this implies
that the fair value of the corporate bond is now 75.6644 (= 82.2705 − 6.6059). The YTM can be calculated as:

100
= 75.6644
(1 + YTM)4
YTM = 7.2203%

Using a 5% default probability, the credit spread is 2.2203% (= 7.2203% − 5%).

Exhibit 20 Increasing the probability of default for longer times to maturity

Loss given Probability Probability Expected Discount PV of

Year Exposure Recovery default of default of survival loss factor expected loss

1 74.6215 22.3865 52.2351 3.0000% 97.0000% 1.5671 0.95238 1.49243

2 78.3526 23.5058 54.8468 2.9100% 94.0900% 1.5960 0.90703 1.44766
3 82.2702 24.6811 57.5892 2.8227% 91.2673% 1.6256 8.86384 1.40423
4 86.3838 25.9151 60.4686 2.7380% 88.5293% 1.6556 0.82270 1.36210
5 90.7029 27.2109 63.4921 4.4265% 84.1028% 2.8105 0.78353 2.20206
6 95.2381 28.5714 66.6667 4.2051% 79.8977% 2.8034 0.74622 2.09196
7 100.0000 30.0000 70.0000 3.9949% 75.9028% 2.7964 0.71068 1.98736
24.0972% CVA= 11.9878

If a similar risk-free bond is priced at 71.0681 (= 100 × 0.710681), and the new CVA is 11.9878, this
indicates that the fair value of the corporate bond now stands at 59.0803 (= 71.0681 − 11.9878). The YTM
can be determined as follows:
100
= 59.0803
(1 + YTM)4
YTM = 7.8080%

Then, using a 5% default probability, the new credit spread is 2.8080% (= 7.8080% − 5%).

Exhibit 21 Increasing the probability of default for longer times to maturity

Loss given Probability Probability Expected Discount PV of

Year Exposure Recovery default of default of survival loss factor expected loss

1 64.4609 19.3383 45.1226 3.0000% 97.0000% 1.3537 0.95238 1.28922

2 67.6839 20.3052 47.3788 2.9100% 94.0900% 1.3787 0.90703 1.25054
3 71.0681 21.3204 49.7477 2.8227% 91.2673% 1.4042 8.86384 1.21303
4 74.6215 22.3865 52.2351 2.7380% 88.5293% 1.4302 0.82270 1.17663
5 78.3526 23.5058 54.8468 4.4265% 84.1028% 2.4278 0.78353 1.90223
6 82.2702 24.6811 57.5892 4.2051% 79.8977% 2.4217 0.74622 1.80711
7 86.3838 25.9151 60.4686 3.9949% 75.9028% 2.4157 0.71068 1.71676
8 90.7029 27.2109 63.4921 5.3132% 70.5896% 3.3735 0.67684 2.28329
9 95.2381 28.5714 66.6667 4.9413% 65.6483% 3.2942 0.64461 2.12346
10 100.0000 30.0000 70.0000 4.5954% 61.0529% 3.2168 0.61391 1.97482
38.9471% CVA= 16.7371

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If a similar 10-year risk-free bond is priced at 61.3913 (= 100 × 0.613913), and the new CVA is 16.7371, this
indicates that the fair value of the corporate bond now stands at 44.6542 (= 61.3913 − 16.7371). The YTM
can be determined as follows:
100
= 44.6542
(1 + YTM)10
YTM = 8.3961%

Then, using a 5% default probability, the new credit spread is 3.3961% (= 8.3961% − 5%).

Understanding credit spread curves is very important for investors aiming to capitalize on constantly
changing credit conditions. Many fixed-income managers generate most of their alpha by identifying
instances where the market has incorrectly priced credit spreads. For instance, if the market has factored in
a recession by widening credit spreads, but a manager believes this is unwarranted, the manager can buy
when spreads are wide and sell when they narrow. The opposite strategy can be employed when markets
anticipate excessive economic strength.

Furthermore, managers can profit by understanding credit spreads in relation to a company’s improving or
deteriorating fundamentals. For example, managers can acquire bonds with wide spreads from companies
facing unfavorable conditions and benefit from the subsequent narrowing of spreads as conditions improve.

Credit Analysis for Securitized Debt

LOS: Compare the credit analysis required for securitized debt to the credit analysis of
corporate debt.

Securitized debt involves the use of a specific set of assets or receivables, such as home mortgages,
business loans, auto loans, and credit card receivables, as collateral for debt. This is distinct from general
debt obligations, which are based on a company’s balance sheet. Securitizing assets allows lenders to
bundle and sell debt in public markets. This, in turn, helps reduce balance sheet risk, free up capital for
originating more loans, generate fees, and ease the need to maintain regulatory capital. Additionally,
companies often find that securitizing assets independently offers lower financing costs compared with
general debt obligations.

However, from an investor’s perspective, securitized debt is more intricate than general debt obligations,
requiring a fundamentally different approach to credit analysis, as discussed below. This is why investors
generally demand a higher rate of return for securitized debt compared with general debt obligations, even
when they carry similar credit ratings.

When individual debt obligations within the asset pool of a securitized instrument are similar in nature and
have common underwriting criteria for borrowers, they allow credit analysts to draw generalized conclusions
about the nature of loans. A prime example of such homogeneity is securitized auto loans, where borrowers
typically need to meet minimum credit score requirements. In contrast, when underlying debt obligations
lack common characteristics, often stemming from differing underwriting criteria, this heterogeneity
necessitates scrutiny on a loan-by-loan basis. Examples of such securitized debt can include business
project financing or real estate loans.

Granularity describes the number of individual debt obligations within the asset pool of a securitized
instrument. A highly granular asset pool may encompass hundreds of underlying creditors, enabling
credit analysts to base their analysis on summary statistics rather than scrutinizing each loan individually.
Conversely, a nongranular pool of fewer assets requires credit analysts to assess loans on an
individual basis.

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 Credit Analysis Models

The combination of homogeneity or heterogeneity and granularity or non-granularity guides the approach to
credit analysis. In general, when securitized instruments consist of homogeneous and highly granular loans,
analysts rely on summary statistics for credit analysis. Conversely, when loan pools are heterogeneous and
nongranular, credit analysis necessitates a loan-by-loan examination.

The origination and servicing of assets over the life of a loan pool represent another critical issue in credit
analysis. Investors face operational and counterparty risk, relying on the originator/servicer to establish and
enforce eligibility criteria, maintain documentation, facilitate repayments, and manage delinquencies. For
instance, a servicer may be tasked with repossessing an automobile if a borrower defaults on payments or
enforcing financial penalties and collections for credit card borrowers. Servicers might even be responsible
for eviction and tenant replacement in commercial properties to maintain cash flow. This underscores the
need for investors to evaluate the creditworthiness of servicers and their track record in loan servicing,
particularly across credit cycles.

The structure of a securitized instrument is another crucial consideration for investors. This encompasses
an analysis of the originator and the obligor, typically a special-purpose entity (SPE) acquiring assets and
issuing securitized instruments, along with any structural enhancements such as overcollateralization
and tiering the priority of claims or tranching. Additionally, investors must ascertain whether the originator
can insulate itself from the risk of bankruptcy in the securitized instrument through a true sale of
assets to the SPE.

Credit enhancements represent another significant structural aspect in credit risk evaluation. These
enhancements may include payout or performance triggers activated by adverse credit conditions. For
instance, borrower defaults within the loan pool can trigger security amortization. Excess spread is another
credit enhancement, denoting the additional return built into the security to safeguard investors against
anticipated or historical losses linked to the asset pool. Securitized debt may also incorporate senior and
subordinated tranches, where senior debt tranches offer a return cushion, as subordinated tranches are
designed to absorb initial losses.

Covered bonds are senior debt obligations backed by a segregated pool of assets, typically consisting of
commercial or residential mortgages. They differ from asset-backed securities (ABS) in the following ways:

y In the case of covered bonds, the pool of assets remains on the originator’s balance sheet, whereas
with ABS, they are transferred from the originator to a bankruptcy-remote special legal entity.
y Covered bonds typically consist of one bond class per cover pool, whereas ABS often employ credit
tranching to create bond classes with varying exposures to default risk.
y Any prepaid or nonperforming loans in the cover pool must be replaced by the sponsor to ensure
sufficient cash flows until the maturity of the covered bond. In contrast, the pool of loans backing an
ABS is typically static.

In the event of default, redemption regimes built into a covered bond’s structure serve to align the covered
bond’s cash flows as closely as possible with the original maturity schedule.

y For hard-bullet covered bonds, if payments do not occur according to the original schedule, a bond
default is triggered, and bond payments are accelerated.
y On the other hand, soft-bullet covered bonds delay the bond default and payment acceleration
of bond cash flows until a new final maturity date, which is usually up to a year after the original
maturity date.
y Conditional pass-through covered bonds convert to pass-through securities after the original maturity
date if all bond payments have not yet been made.

Due to their dual recourse nature, strict eligibility criteria, dynamic cover pool, and redemption regimes
in the event of sponsor default, covered bonds typically carry lower credit risk and offer lower yields than
otherwise similar asset-backed securities.

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Credit Default Swaps

LOS: Describe credit default swaps (CDS), single-name and index CDS, and the parameters
that define a given CDS product.

LOS: Describe credit events and settlement protocols with respect to CDS.

LOS: Explain the principles underlying and factors that influence the market’s pricing of CDS.

LOS: Describe the use of CDS to manage credit exposures and to express views regarding
changes in the shape and/or level of the credit curve.

LOS: Describe the use of CDS to take advantage of valuation disparities among separate
markets, such as bonds, loans, equities, and equity-linked instruments.

Basic Definitions and Concepts

LOS: Describe credit default swaps (CDS), single-name and index CDS, and the parameters
that define a given CDS product.

Credit derivatives are financial instruments tied to a borrower’s credit quality. There are four main types:
total return swaps, credit spread options, credit-linked notes, and credit default swaps (CDS). In a CDS, one
party pays the other and receives compensation if a third party defaults.

CDS are derivatives linked to a borrower’s credit quality. They compensate for expected recovery in a
credit event but also change in value as market perceptions of credit quality change. The value of a CDS
fluctuates with shifting opinions about default likelihood, even if an actual default never happens, causing
mark-to-market losses. Common credit events include bankruptcy, failure to pay, and restructuring.
Sovereign and municipal government bonds may experience unique credit events like moratoriums or
debt repudiation.

Investors use CDS for purposes beyond hedging credit risk. These include:

● leveraging portfolios,
● gaining exposure to specific maturities unavailable in the cash market,
● accessing credit risk while minimizing interest rate risk, and
● enhancing portfolio liquidity due to the limited liquidity of corporate bonds in the market.

The CDS market has improved transparency and provides a better understanding of the actual cost of
credit risk. It benefits from increased liquidity and the expertise of CDS investors, leading to more accurate
pricing and the ability to trade during liquidity crises when bond cash markets become illiquid. A basic
understanding of this essential fixed-income tool is important for all investment professionals.

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Learning Module 5

CDS are derivative contracts between credit protection buyers and credit protection sellers. The buyer
pays periodic cash amounts to the seller, and in exchange, the seller commits to providing compensation
in case of credit losses resulting from a credit event in an underlying asset or reference entity. If a default
occurs, the buyer’s periodic payments to the seller cease.

Exhibit 1 CDS Cash Flows

Periodic CDS coupon

Upfront premium
Credit Credit
CDS coupon < CDS spread
protection protection
or
buyer seller
CDS coupon > CDS spread
(1 − Recovery rate) in event of default

CDS are similar to put options, offering protection against a poorly performing underlying asset. In a credit
event, the buyer of credit protection receives a payment from the seller equal to the par or notional value of
the security less the expected recovery value.

However, a CDS does not eliminate credit risk entirely, as its definition of default may not align precisely
with traditional default events, leading to differences in contract value compared with the underlying asset.
Additionally, the credit protection buyer faces counterparty risk with the credit protection seller, although
most sellers are high-quality borrowers. CDS are primarily written on corporate debt but can also cover
government debt and portfolios of loans or securities.

Types of CDS
There are three main types of CDS:

● Single-name CDS focus on a specific borrower, called the reference entity, and a designated
reference obligation, usually a senior unsecured debt instrument. The payoff depends on the
cheapest-to-deliver obligation, which is the least expensive debt instrument with the same seniority
as the reference obligation.
● Index CDS involve portfolios of single-name CDS, allowing participants to take positions on the
credit risk of a combination of companies, like trading equity indexes or exchange-traded funds.
Commonly traded index CDS include North American (CDX) and European, Asian, and Australian
(iTraxx) indexes. Correlation of defaults among companies significantly impacts the behavior of
these portfolios.
● Tranche CDS cover combinations of borrowers up to pre-specified loss levels, resembling the
structure of asset-backed securities with different tranches covering specific loss levels.

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Important Features of CDS Markets

LOS: Describe credit events and settlement protocols with respect to CDS.

The CDS market is global and well-organized. The International Swaps and Derivatives Association (ISDA)
acts as the unofficial industry governing body, publishing industry-supported conventions. Parties in CDS
contracts generally agree to conform to ISDA specifications through an ISDA Master Agreement. Different
standardized contracts exist for various regions.

Each CDS contract specifies a notional amount (ie, the size of the contract) and has a maturity date,
typically ranging from 1 to 10 years. The buyer pays a periodic premium, called the CDS spread, to
the seller, which compensates for credit risk. Standard coupon rates of 1% or 5% are now used; any
discrepancies are accounted for with an upfront premium.

Changes in the reference entity’s credit quality can impact the CDS’s value, reflected in market prices. In
single-name CDS, the buyer is short credit exposure, while the seller is long credit exposure. However, in
CDS index positions, the roles are reversed.

Credit and Succession Events

A credit event in CDS contracts defines default and triggers payment from the seller to the buyer. Common
credit events include bankruptcy, failure to pay, and restructuring:

● Bankruptcy is a formal declaration with legal procedures, often leading to a temporary company fence
and potential liquidation.
● Failure to pay occurs when scheduled payments are missed without bankruptcy.
● Restructuring involves changes in debt terms and must be involuntary or coercive to qualify as a
credit event.

The Determinations Committee (DC) of the ISDA decides if a credit event has occurred. The DC also
handles succession events caused by changes in corporate structures, like mergers or spinoffs, where
debt responsibility becomes uncertain. Resolution involves complex legal interpretations, and the CDS
contract may be modified accordingly.

Settlement Protocols
When a credit event is declared in a CDS contract, the parties have the option but not the obligation to
settle. Settlement typically occurs 30 days after the DC’s declaration. There are two methods of settlement:
physical and cash settlement.

● Physical settlement involves delivering the actual debt instrument in exchange for a payment by the
credit protection seller, equal to the notional amount of the contract. This method is less common.
● Cash settlement: The credit protection seller pays cash to the credit protection buyer; however,
determining the payment amount is not straightforward. Default on a debt does not necessarily result
in a total loss since a portion of the loss may be recovered. The recovery rate (RR) represents the
percentage of the loss that can be recovered, while the loss given default (LGD) estimates the
expected credit loss. The payout amount is calculated as LGD multiplied by the notional:
○ LGD = 1 − RR (%)
○ Payout amount = LGD × Notional

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Actual recovery can take a long time, and it may differ from the CDS payout date. To determine an
appropriate LGD, an auction is conducted, in which major banks and dealers submit bids and offers for
the defaulted debt that is cheapest to deliver. This process establishes the market’s expectation for the
recovery rate and LGD. CDS parties typically accept the outcome of the auction, even though the actual
recovery rate may ultimately differ, which is important to consider if the CDS protection buyer also holds the
underlying debt.

CDS Index Products

Index CDS products, such as those developed by Markit, are significant in the derivatives market. These
indexes are classified by region and credit quality, with common regions being North America (CDX)
and Europe/Asia/Australia (iTraxx). There are investment-grade and high-yield indexes within each
region. Investment-grade indexes are quoted in spreads, while high-yield indexes are quoted in prices.
Standardized coupons and equal weighting of entities are used for all CDS indexes.

Markit updates index components every six months, creating new on-the-run series while retaining older
off-the-run series. Defaults in an index lead to the removal of the defaulted entity, settled as a single-name
CDS. Index CDS are mainly used for taking credit risk positions on sectors and protecting bond portfolios.
They offer increased trading volume compared with single-name CDS due to their standardized portfolios
and are considered more liquid, with higher daily trading volumes.

Market Characteristics
CDS are traded in the over-the-counter market. They emerged around the mid-1990s to transfer credit risk
from lenders to other parties, separating credit risk from interest rate risk. This innovation allowed banks to
expand corporate lending, knowing that credit risk could be transferred. Credit derivatives, particularly CDS,
facilitate economic growth, especially in corporate bond markets.

CDS transactions occur through various communication channels and are reported to organizations like the
Depository Trust and Clearinghouse Corporation. Regulations have led to central clearing of many CDS
contracts, with clearinghouses handling payments, margin requirements, and mark-to-market valuations.
The central clearing of CDS has increased significantly since 2010.

The CDS market has shrunk since the 2008 financial crisis. In December 2019, the gross notional amount
of CDS was approximately $7.6 trillion with a market value of $199 billion. Major CDS indexes, such as
iTraxx Europe and CDX IG, account for more than 90% of market activity.

Basics of Valuation and Pricing

LOS: Explain the principles underlying and factors that influence the market’s pricing of CDS.

Derivatives, including CDS, are priced by determining the cost of a position that fully hedges the underlying
exposure and earns the risk-free rate. In the case of CDS, this pricing results in the CDS spread or upfront
payment for a specific coupon rate in the contract. Despite being called swaps, CDS resemble options due
to their contingent payment (in a credit event, determined by the ISDA Determinations Committee).

Unlike conventional derivatives tied to actively traded assets like equities, interest rates, or currencies, CDS
settlement amounts in credit events are less clear. Credit does not trade in the traditional sense but exists
within the bond and loan market. Each CDS reference entity’s unique debt structure adds complexity to
establishing the connection between a CDS contract and a specific outstanding bond or loan.

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Basic Pricing Concepts

The credit valuation adjustment (CVA) represents the present value of credit risk associated with a loan,
bond, or derivative obligation. In essence, it serves as an approximation for the CDS hedge position, aiming
to ensure that an investor retains a risk-free rate of return when considering credit risk.

CVA is determined by several components, including expected exposure (EE), RR, LGD, probability of
default (POD), and a discount factor for the present value of expected loss:

● EE is based on the notional value of the underlying CDS contract.

● RR is the percentage of loss recovered from a defaulted bond.
● LGD depends on the severity of the loss multiplied by the exposure amount.
● POD is a crucial element in CDS pricing and can be estimated using a simplified formula for a one-
period CDS swap. It is also a conditional probability over time.

CDS spread ≈ (1 − RR) × POD

● Probability of survival is 1 − POD.

● Hazard rate is the conditional probability of default for a specific entity or borrower within a given
period. It measures the likelihood that a default event will occur at a particular point in time, given that
the entity has survived without default up to that point.

CVA combines these components to arrive at the present value of expected loss due to credit risk.

Exhibit 2 CDS pricing and conditional probabilities

Hazard rates

Year 1 Year 2 Year 3

Pricing a CDS involves understanding two key components: the protection leg and the premium leg.

● The protection leg represents a potential payment from the credit protection seller to the credit
protection buyer in a credit event.
● The premium leg consists of a sequence of payments that the credit protection buyer commits to
providing to the credit protection seller throughout the duration of the contract.

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The upfront payment in a CDS can be determined as the difference in the present values of these two legs.

Upfront payment = PV (Protection leg) − PV (Premium leg)

If the result is greater than zero, the protection buyer pays the protection seller, and if it is less than zero,
the protection seller pays the protection buyer.

The Credit Curve and CDS Pricing Conventions

The CDS market is closely linked to a borrower’s credit curve. Factors affecting the curve include hazard
rates, with a constant hazard rate flattening the curve. Upward-sloping curves suggest a higher likelihood
of default in later years, while downward-sloping curves indicate a greater probability of default in earlier
years, often indicating near-term financial stress. Even with constant hazard rates, the credit curve is not
entirely flat due to discounting. For instance, a company issuing 5- and 10-year zero-coupon bonds might
have equal probabilities of default but different present values of expected payoffs, leading to different
discount rates. The efficiency of the CDS market plays a significant role in determining the credit curve.

CDS Pricing Conventions

When evaluating corporate bonds or CDS, a focus on their prices alone may not provide sufficient
information; spreads are a more informative measure. For instance, two bonds with identical prices at the
offering date, even similar prices throughout their lifetimes, may represent very different bonds. Comparing
spreads to a market reference rate or risk-free rate can help investors gauge the implied credit risk based
on factors like prices, maturities, and coupons.

CDS contracts may not match the standardized 1% or 5% coupons found in actual reference entity debt.
This leads to differences in the present value of promised payments from the protection buyer to the
protection seller, compared with the coupons on the reference entity’s debt. This difference is known as the
upfront premium.

Present value of credit spread = Upfront premium + Present value of fixed coupon

A common industry approximation for the upfront premium is approximately equal to the difference between
the credit spread and fixed coupon, multiplied by the duration. This upfront premium is then converted into a
price by subtracting it from 100, expressed as a percentage premium.

Upfront premium ≈ (Credit spread − Fixed coupon) × Duration

Upfront premium % = 100 − Price of CDS in currency per 100 par

In this equation, effective duration is used since the cash flows tied to the coupon leg of the CDS are
uncertain and are contingent on the reference entity not defaulting.

Valuation Changes in CDS During Their Lives

The value of a CDS fluctuates throughout its life, determined by market dynamics. Market participants
continuously assess the credit quality of the reference entity to determine its current value and implied
credit spread. Several factors change over time, including the CDS’s duration, probability of default,
expected LGD, and the shape of the credit curve. The valuation procedure remains the same as when the
CDS is initially issued, incorporating new information. The new market value of the CDS reflects gains and
losses for the parties involved.

A rough estimate of the buyer’s profit or loss due to a change in spread can be calculated as:

Profit or loss for the buyer of protection ≈ Change in spread in basis points × Duration × Notional

Alternatively, the percentage change in the CDS price can be calculated as:

% Change in CDS price = Change in spread (in bps) × Duration

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Example 1 Profit and loss from change in credit spread

An investor purchased $5 million of 5-year CDS protection. The CDS contract has a duration of 4 years.
The company’s credit spread was originally 400 bps and widens to 600 bps.

Does the investor benefit or lose from the change in credit spread?

Estimate the CDS price change and the profit to the investor.

Solutions

The investor has purchased protection, so she benefits from an increase in the company’s credit spread
(as she is paying a lower premium than required by the company’s current credit risk). In other words,
she can now sell the protection for a higher premium.

The percentage price change is calculated as:

% Change in CDS price = Change in spread in basis points × Duration

= 200 bps × 4 = 8%

The profit to the investor is calculated as:

Profit for the buyer of protection ≈ Change in spread in basis points × Duration × Notional
= 200 bps × 4 × $5,000,000 = $400,000

This calculation is analogous to measuring the percentage change in a bond’s price based on changes in its
yield and modified duration. For the CDS, the change in yield corresponds to the change in spread (in basis
points), and the duration relates to the bond that is the subject of the CDS.

Monetizing Gains and Losses

Changes in the price of a CDS offer opportunities to monetize gains or losses.

● The protection seller effectively holds a long position on the reference entity.
● The protection buyer effectively holds a short position on the reference entity.

As the credit quality of the company deteriorates (improves), the market value of the CDS increases
(decreases). Thus, as the credit quality of the company changes, the market value of the CDS changes,
resulting in gains or losses for the counterparties.

To monetize these gains or losses, counterparties can enter new offsetting contracts. These offsetting
positions effectively close out the CDS exposure by selling CDS positions to other parties. The implied
upfront premium on a new CDS matching the terms of the original CDS with an adjusted maturity
reflects the market value of the original CDS. The premium on the new CDS is typically smaller than the
original one.

For example, if the original protection buyer wants to unwind its position, it can enter into a new CDS as
a protection seller, receiving a reduced upfront premium compared with the original payment. Similarly,
the protection seller can offset its position by entering a new CDS as a protection buyer, paying a smaller
upfront premium than what it initially received. This process allows the original protection buyer to realize a
loss, while the seller captures a gain. The unwind transaction does not necessarily have to involve the same
original party, although doing so may have advantages. Central clearing of CDS transactions can facilitate
this process.

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In summary, three methods can be used to realize a profit or loss on a CDS:

● Exercise the CDS in response to a default.

● Unwind the position by entering a new offsetting CDS in the market.
● Hold the position until expiration if there is no default.

In the last approach, the CDS seller captures premiums without making any payments, and the buyer’s
position is not necessarily a loss, especially if the buyer is a creditor of the reference entity.

Applications of CDS

LOS: Describe the use of CDS to manage credit exposures and to express views regarding
changes in the shape and/or level of the credit curve.

CDS serve various purposes and applications in the financial market. There are two primary uses of CDS:

● Exploiting expected movements: CDS can be used to capitalize on anticipated changes in underlying
credit risk. They require less capital and are more accessible for creating short economic exposures
compared with the underlying assets. The derivatives market, including CDS, tends to react quickly
to new information and offers greater liquidity, making it efficient for leveraging expectations of
underlying movements.
● Exploiting valuation differences: CDS can be used to benefit from pricing disparities between the CDS
market and the underlying bonds or assets. If a CDS is mispriced concerning the underlying credit
risk, an investor can take a position in the CDS while simultaneously offsetting it with a position in the
underlying asset. If the valuation analysis is accurate and others in the market share the same view,
the prices of the CDS and the underlying asset will eventually align. This strategy can yield a return
essentially free of risk because the risk associated with the underlying asset is hedged by holding
opposing positions in the CDS and the underlying asset. Successful execution of this strategy relies
on market efficiency and the quality of valuation models. Differences in pricing can also exist among
different derivatives linked to the same underlying credit risk.

These two broad categories of uses, managing credit exposures and exploiting valuation disparities,
encompass the major applications of CDS in the financial industry.

Managing Credit Exposures

Purchasers of CDS protection are typically lenders seeking to reduce their credit exposure to a borrower,
while sellers of protection are often dealers aiming to profit from market activities. Speculators also play a
role, making bets on credit risk by either buying or selling protection based on their expectations of credit
spread movements.

Naked credit default swaps involve taking a position without underlying exposure to the reference entity.
Buying protection on a naked CDS anticipates a credit quality deterioration, leading to increased credit
spreads. Conversely, selling protection on a naked CDS anticipates improved credit quality and lower
credit spreads.

Long/short trades involve simultaneously taking a long position in one CDS and a short position in another,
typically based on different reference entities. This trade strategy bets on the relative improvement or
deterioration of credit quality between the two entities.

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A curve trade, a type of long/short trade, focuses on the credit curve’s shape. When the curve is
upward-sloping (indicating higher long-term rates), a curve-steepening trade involves buying long-term
protection and selling short-term protection. This is seen as bullish for the short term, suggesting a more
favorable short-term outlook for the reference entity. Conversely, a curve-flattening trade involves the
opposite positions.

It is important to note that these interpretations may be reversed when the credit curve is downward sloping,
although such scenarios are less common and often arise from short-term financial market stress.

Example 2 Curve trade

An investor who holds short-term bonds issued by a company has grown increasingly concerned
about a short-term default. However, she remains less worried about a long-term default. Currently, the
company’s 1-year duration CDS trades at 250 bps, while the 5-year duration CDS trades at 600 bps.

What type of curve trade could the investor initiate to hedge against default risk?

Also, explain why an investor might prefer a curve trade, rather than taking a short position in a single
CDS, to hedge against the company’s default risk.

Solutions

The investor anticipates a flattening of the credit curve. She can hedge the default risk by buying
protection in the 1-year CDS and simultaneously selling protection on the 5-year CDS.

Engaging in a curve trade, involving both buying and selling CDS positions on the same reference
entity, helps mitigate some risk by shielding the investor from an adverse parallel shift in the credit
curve. Additionally, the cost of one position may be offset, or even more than offset, by the premium
earned on the other.

Note that changes in the credit curve do not always mean a change in slope (steepening or flattening). It is
possible to have a parallel shift of spreads across all maturities. In such a case, for a given change in credit
spreads across all maturities, longer-term CDS values will be more affected than shorter-term CDS values,
owing to their greater durations.

Valuation Differences and Basis Trading

LOS: Describe the use of CDS to take advantage of valuation disparities among separate
markets, such as bonds, loans, equities, and equity-linked instruments.

A basis trade capitalizes on any difference between the credit spread implied by a bond’s price or yield
and the credit spread on a CDS linked to the same reference obligation with the same maturity period. In
theory, the credit risk component of a bond’s yield should align with the credit spread on a CDS since both
represent compensation for the investor/protection seller for assuming the associated credit risk.

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Exhibit 3 Bond vs. credit default swaps (CDS) risks

Yield

Corporate
curve

CDS spread = Credit risk

Bond YTM =
Credit risk +
Interest rate risk
Reference rate/swap curve

0 Maturity
3 months 5 years

However, practical variations can arise due to differences in opinions and/or valuation models used by
market participants, liquidity disparities in the two markets, and supply-demand dynamics in the repo market.

Example 3 Bond versus CDS

A company’s bond currently yields 5% and matures in 10 years. A 10-year CDS contract on the same
bond has a credit spread of 2.75%. The investor can borrow in the market at a 2% interest rate.

Calculate the bond’s credit spread and identify a basis trade that would exploit the current situation.

Solutions

The bond’s credit spread equals its yield (5%) minus the investor’s cost of funding (2%), which equals 3%.

The investor should buy protection in the CDS market at 2.75% and go long on the bond (which prices
in a 3% credit risk premium). Overall, the investor will have no exposure to credit risk and will earn the
0.25% differential if the markets converge.

Note that the yield on a bond has many components (eg, risk-free rate, funding spread, liquidity risk), making
it difficult to isolate the credit risk component of a bond’s yield. Therefore, the success of a basis trade
critically depends on the accuracy of models used to calculate the credit risk component of a bond’s yield.

Basis trades operate on the assumption that mispricing of credit risk between the bond and CDS markets
is likely to be temporary, with credit spreads expected to converge once recognized by market participants.
For example, suppose the bond market implies a 4% credit risk premium for a particular bond, while the
CDS market offers a 3% credit risk premium. This scenario, where the credit spread (CDS premium) is less
than the bond credit risk premium, indicates that the CDS market prices in too little credit risk, and/or the
bond market prices in too much credit risk. A trader would:

● Buy protection from credit risk through the CDS market at what may be an unjustifiably low rate.
● Buy the underpriced bond at what may be an unjustifiably low price while assuming the credit risk.
(If the credit spread is too high, the bond’s price would be too low.)

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Overall, the trader has no exposure to credit risk because of the short position on the CDS (protection
buyer). If convergence occurs, the trader will capture the 1% differential between the two markets.

Note that the investor does bear interest rate risk on the bond, but this risk can be hedged with a duration
strategy or interest rate derivatives. The idea is to eliminate all risks and capitalize on the disparity between
the pricing of credit risk in the CDS and bond markets.

To calculate the profit potential of a basis trade, it is essential to decompose the bond yield into three
components: the risk-free rate, the funding spread, and the credit spread. The sum of the risk-free rate and
the funding spread equals the market reference rate (MRR). Therefore, the credit spread can be defined as
the excess of the bond yield over the MRR.

The basis of the trade is determined by whether the credit spread is higher in the CDS market (positive
basis) or the bond market (negative basis).

Basis = CDS market spread − Bond market spread

Example 4 Using CDS to trade on a leveraged buyout

An investor believes that a company will soon undergo a leveraged buyout (LBO) transaction (where the
company will raise large amounts of debt to repurchase equity from the market).

Why might the CDS spread change?

What positions would the investor take on the company’s equity and on its credit in anticipation of
the LBO?

Solutions

Issuing significant amounts of debt will increase the company’s probability of default, translating into a
widening of the CDS spread.

The investor might consider buying the stock and buying CDS protection. Both these positions will profit
if the LBO occurs:

● The stock price will rise from the repurchase.

● The CDS spread will rise to reflect the higher probability of default.

CDS may also be used in:

● Trades that aim to exploit mispricing of credit risk between the CDS market and the credit risk reflected
in the yields of the company’s unsecured debt instruments or capital leases. It is important to note that
such trades are highly complex due to differences in the payout priority of claims in case of default.
● Arbitrage trades between the cost of an index CDS and the combined cost of index components. This
trade typically involves significant transaction costs.

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