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Chapter 08: Properties and

Pricing of Financial Assets


Properties of financial assets:
1. Moneyness: some financial assets are used
as medium of exchange or in settlements of
transactions.

2. Divisibility and Denomination: Divisibility


relates to the minimum size in which a financial
asset can be liquidated and exchanged for
money. The smaller the size, the more the
financial asset is divisible. Denomination is the
value of each divided smaller unit.
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Chapter 08: Properties and


Pricing of Financial Assets
3. Reversibility: It refers to the costs of
investing in a financial asset and then
getting out of it and back into cash
again.
4. Cash flow: It refers to the cash
benefits to be received in future as
dividend/interest
and
capital
gain/loss from the financial asset.
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Chapter 08: Properties and


Pricing of Financial Assets
5. Term to maturity: It is the length of period
until the date at which the instrument is
scheduled to make its final payment or the
owner is entitled to demand liquidation.

6. Convertibility: Some of the financial asset


contains the feature of conversion from one
nature to another nature. For example, bonds
and preferred stocks may be converted into
common stock if terms included.
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Chapter 08: Properties and


Pricing of Financial Assets
7. Currency: Generally a financial asset is
issued in a certain currency in which all
relevant cash flows will be incurred.
8. Liquidity: It relates to the conversion of
financial asset into cash or cash equivalent
easily and quickly when required.
9. Tax status: Tax is applicable on some
financial assets at different rates in different
periods.

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Chapter 08: Properties and


Pricing of Financial Assets
10. Return predictability: Return is the rate of
additional benefit that can be earned from a
financial asset and this return should be
predicted earlier.
11. Complexity: Some financial assets are
combinations of two or more simpler financial
assets. Bonds attaching coupon and callable
bonds are complex in nature.

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Principles
pricing
financial
The
fundamentalof
principle
of finance
is that the
true or correct price of a financial asset is the
assets
discounted present value of all future cash flows
to be generated by that asset at desired
discount rate. The following formula is applied
for calculating price of a financial asset:
CF1
CF2
CFn


Po =
1
2
n
(1 k )

(1 k )

Here, Po = price of the financial asset


CFt = cash flows in period t (t=1, 2, n)
n = Maturity of the financial asset
k = appropriate discount rate

(1 k )

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Example
01: Expected dividends from Mega Corporation are
Tk15, Tk.16.5, Tk.20, Tk27.5 and Tk30 in the next
five years. If the required rate of return of the
stockholder of the corporation is 11.5%.
Forecasted reselling price is Tk.120. What is the
current price of corporations stock?
02: Mega capital Inc. just paid a dividend Tk10.50
per share and the dividends are expected to grow
at a constant rate of 5% for next 4 years.
Expected selling price is Tk.150. If investors
require a 12% return, then what is the current
price?
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The appropriate discount rate


The appropriate discount rate is the expected
rate of return of the investor or supplier or
lender based on real risk free rate, inflation
premium and risk premium. Expression of this
appropriate discount rate is:
k = RR + IP + DP + MP + LP + EP

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The appropriate discount rate


RR = rate of return can be earned in inflation and risk free
condition.
IP = compensation for the expected decline in the
purchasing power of money
DP = reward for taking on the risk of default in case of loan
i. e. risk of loss of principal
MP = the compensation for lending for long time period
LP = reward for investing in an asset that may not be
readily converted to cash at a fair market value
EP = reward for investing in an asset that is denominated in
foreign currency.
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Example 01:
There is an investment in Tk.10000,
10%, 12 years bond. Real risk-free rate
in the economy is 7%. The investors
expectation about different risk and
inflation premium are: IP= 2%, DP =
1.5%, MP = 2.5%, LP = 1% & EP = 0%.
What will be the price of this financial
asset?
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Solution
P

1 k ) n 1
= CF
n
k
(
1

k
)

= 1000

1 0.14)

Pn

1 k n

1
0.14 (1 0.14)12
12

10000
12
1 0.14

= 7735.80

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For charging transfer tax and brokerage commission of Tk.15 and


Tk.20 respectively at the time of both buying and selling the price
of the asset will be:

1 0.14)

1
P = Tk.[-15-20 +1000
12
0
.
14
(
1

0
.
14
)

12

10000 15 20

1 0.14 12

= Tk.7694.54

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Example # 02: There is an investment


in Tk.1000, 5%, 4 years bond. Real riskfree rate in the economy is 2.5%. The
investors expectation about different
risk and inflation premium are: IP= 3%,
DP = 2%, MP = 0.5%, LP = 1% & EP =
0%. What will be the price of this
financial asset?
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Based on above information the price of the asset is


Tk.870.41. Now the relationship between discount rate
and price of the asset is shown in the following table:
Discount rate, k (%)
Price
4
1036.30
5
1000.00
6
965.35
7
932.26
8
900.64
9
870.41
10
841.51
11
813.85
12
787.39
13
762.04
14
737.77
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Price Volatility of Financial Assets: Price


volatility of financial asset means the change in
present value of discounted future cash flows of
the asset. It also termed as sensitivity of price
with respect to some independent variables
change. Price volatility mainly depends on
maturity period of the asset, coupon rate, level
of yields and interest rate changes i.e. duration.
The level of price volatility for these variables is
reported in different tables below:
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1. Price of a bond paying Tk.50 annually and


Tk.1000 at maturity for various discount rates
and maturities:
Maturity Period

4 years

Discoun
t rate, k
(%)
4
5
6
7
8
9
10
11
12
13

10 Years

15 Years

20 Years

Price
Price
Price
Price
1036.30 1081.11 1111.18 1135.90
1000.00 1000.00 1000.00 1000.00
965.35 926.40 902.88 885.30
932.26 859.53 817.84 788.12
900.64 798.70 743.22 705.46
870.41 743.29 677.57 634.86
841.51 692.77 619.70 574.32
813.85 646.65 568.55 522.20
787.39 604.48 523.24 477.14
762.04 565.90 483.01 438.02

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2. Price of a bond paying Tk.50


annually and Tk.1000 at maturity for
different coupon rates:
5% Coupon Bond
Maturity 15 Years
Principal Tk.1000
Required Yield 9%
Price at 9%= Tk.677.57
Price at 10%= Tk.619.70
Price fall 57.87 i.e. 8.5%

10% Coupon Bond


Maturity 15 Years
Principal Tk.1000
Required Yield 9%
Price at 9%= Tk.1081.61
Price at 10%= Tk.1000
Price fall 80.61 i.e. 7.5%
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3. Price of a zero-coupon and bond


paying Tk.50 annually and Tk.1000 at
maturity for 15 years:
5% Coupon Bond
Maturity 15 Years
Principal Tk.1000
Required Yield 9%
Price at 9%= Tk.677.57
Price at 10%= Tk.619.70
Price fall 57.87 i.e. 8.5%

Zero Coupon Bond


Maturity 15 Years
Principal Tk.1000
Required Yield 9%
Price at 9%= Tk.274.54
Price at 10%= Tk.239.39
Price fall 35.15 i.e. 12.8%
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4. Price of a bond paying Tk.50


annually and Tk.1000 at maturity for 15
years for different yields:
5% Coupon Bond
Maturity 15 Years
Principal Tk.1000
Required Yield 5%
Price at 5%= Tk.1000
Price at 6%= Tk.902.88
Price fall 97.20 i.e. 9.72%

5% Coupon Bond
Maturity 15 Years
Principal Tk.1000
Required Yield 13%
Price at 13%= Tk.483.01
Price at 14%= Tk.447.20
Price fall 35.81 i.e. 7.41%
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Measuring Price Sensitivity to


Interest Rate Changes: Duration
The technique of approximation an assets price
sensitivity to interest rate changes is to examine how
the price changes if the yield changes by a small
number of basis points. This can be expressed
through the following notations:
y = change in yield
Po = initial price of the asset
P- = assets price if the yield is decreased by y
P+ = assets price if the yield is increased by y
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Example of Duration calculation


The price of a 5% coupon bond with a principal of
Tk.1000, 15 years maturity at 9% yield or discount
rate is Tk.677.57. If the yield is increased by 50 basis
points from 9% to 9.5%, the price would be
Tk.647.73. If the yield is decreased by 50 basis points
from 9% to 8.5%, the price would be Tk.709.35. Then
we have these values:
y = 0.005
Po = Tk.677.57
P- = Tk.709.35
P+ = Tk.647.73
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Example of Duration calculation


P P
2 Po ( y)

D=

709.35 647.73
D (Duration) =
2 * 677.57 * 0.005

9.09 (% or X)
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Pricing of Islamic Financial


Instruments (Benchmark to Use)
In order to be guided to set their rate for
pricing financial assets, IFIs use Base
Financing Rate (BFR). It is the minimum
interest rate calculated by Islamic financial
institutions based on a formula which takes
into account the institutions cost of funds and
other administrative costs. Usually it is similar
amongst the major Islamic Banks. Some
adjustments to the BFR are made by banks at
the almost same time, though not regularly.
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