FINA2330 tutorial 6
Bond and stock markets
Foreign exchange market
Long term bonds vs short term bonds
Compare long term bond and short term bond yields
 Recall liquidity premium, long term bond get higher
yields most of the time
 Long term bond yields fluctuate less than short term
bond yields, suggesting expected short term rates
having tendency to revert towards long-term average.
Bond features
Some bond contracts contain options, such as
call provision for issuers and conversion into
equity for holders
When interest rates are falling, redeeming the
callable bond make sense, then issuer can issue
another bond at lower yields.
When stock price is expected to rise, convertible
bond holders convert them into equity to obtain
higher returns
Dividend discount vs PE pricing for equity
Assume constant dividend growth rate, Gordon
𝐷1
𝐷0 (1+𝑔)
growth model: 𝑆0 =
=
(𝑟−𝑔)
(𝑟−𝑔)
PE model estimate stock price using price to
earning ratio among comparable firms
Dividend discount vs PE pricing for equity
Gordon growth model takes risk directly into
account, higher risks means higher required
return (r)
Gordon growth model suitable for firms with
regular dividend payment
PE model suitable for firms not paying dividends
with many available comparable firms
Parameters often hard to estimate, leading to
significant errors in valuation
ETF on stock exchanges
 Contain an index portfolio and available for stock
investors, they hold ETFs in the same manner as stocks
 Number of shares of ETF is not constant, when demand
increases, ETF can issue more shares and increase
holdings on index portfolio.
 Very liquid and popular among investors, low
management fees compared to traditional mutual
funds
 Commission is charged at brokers for ETF trading, which
may be a disadvantage in costs
Foreign exchange rates
Foreign exchange rates in Hong Kong are usually quoted
as 1 (or 100) unit of foreign currency against x units of
domestic currency (direct quote).
Example: 1 USD = 7.85 HKD as of Nov 1
1 GBP (Pound Sterling) = 9.04 HKD
100 HKD = 92.7 CNY (indirect quote)
Foreign exchange rate fluctuates over time.
Purchasing power parity (PPP)
Theoretically, if basket of goods on average
worth the same across the world, exchange
rates across the globe should match the
purchasing power of each country.
Big Mac index, using price of Big Mac across the
world, often used to illustrate PPP and FX rates
should follow PPP in the long run
Non tradable goods are not taken into account,
limiting usefulness
Interest rates and exchange rates
As the Fed rises interest rates significantly
recently, USD appreciates against all major
currencies. Reasons are given as following:
US interest rates rise more significantly than other
countries, causing traders sell foreign currencies
and purchase USD denominated bonds for
profit (carry trade)
Interest rates and exchange rates
Demand for USD denominated assets rises, then
USD appreciates against foreign currencies.
Investors can benefit from the trade because
they can borrow foreign bonds at lower interest
rate and purchase USD bonds at higher interest
rate.
Once USD appreciates, this profit opportunity
will be eliminated.
Factors affecting exchange rates
 Import barrier (tariff): appreciation
 Higher productivity growth: appreciation
 Rising expected domestic price level: depreciation
 Rising expected import demand: depreciation
 Rising expected foreign export demand: appreciation
 Exchange rate in the short run: mainly through asset
demand
 Long run: mainly through price level and export/ import
demand
International assets at central banks
 Central banks across the world hold some assets
denominated in major foreign currencies in international
reserves.
 For example, Chinese and Japanese central banks hold
billions of US treasury securities in international reserves
 Both international reserves and domestic assets kept at
the Fed are used to issue USD notes, their total levels
determine the monetary base (then the money supply).
Practice Questions 6 Q5
According to the Gordon growth model, what is an investor's
valuation of a stock whose current dividend is $1.00 per year if
dividends are expected to grow at a constant rate of 10
percent over a long period of time and the investor's required
return is 15 percent?
A) $20
B) $11
C) $22
D) $7.33
E) $4.40