Winning at Active Management

Appendix B Financial Asset Valuation

In this appendix we review principles of valuation for financial assets, to illustrate how securities prices change with variations in interest rates. We first consider the case of hypothetical simple bonds, to establish two basic principles: (1) for a given financial asset, prices tend to rise as interest rates fall, and fall as interest rates rise, and (2) for a given change in interest rates, bonds with longer maturities show greater variations in price than those with short maturities.

Then we apply the methods of bond valuation to equity securities, through a technique known as the dividend discount model. We also consider duration measures for equities.

Bonds—A Basic Case

Bonds provide simple illustrations of the principles of valuation of financial assets. They typically have a finite life, and involve many fixed terms—their beginning, ending, payments in between, and many other factors—so their prices can be precisely calculated. The one dynamic in most cases is the market rate of interest at a given time, but with the knowledge or assumption of that data point, prices can be readily estimated. We rely on two simple examples of a bond—with annual coupon payments based on fixed interest rates, and respective maturities of five and 10 years.

1. Prices of Bonds at Issuance

Two hypothetical bonds are issued for $1,000 each at the start of Year 1. One matures in five years, and pays interest at a rate of 6% (the market rate for a ...