## Multiperiod Dividend Discount Models

When you buy shares, you are essentially buying into the dividend stream. Unless you sell the shares, the only income is the dividend and therefore the value could be viewed as the present value of the future dividends. The simple perpetuity formula is the Gordon's growth model as a shortcut to present valuing a stream of cash flows. The simple formula is Dj Dividend for next period i.e. Do * (1 + g) E(Ri) Desired return g Implied growth Cost ofequity Dividend yield (1+Dividend yield) In Figure...

## Cost of capital

The model generates the forecast cash flows over five years that belong to all providers of capital. Therefore the discount rate or cost of capital needs to reflect systematic risk and cost of each form of capital. This is the weighted average cost of capital. Equity is calculated using the standard Capital Asset Pricing Model as an extension of Portfolio Theory. The formula is E Ri Expected return on share i Rf Risk free rate E R Expected return on the market Beta of share i The risk-free rate...

## Forward Rate Agreement

Forward agreements are designed to 'lock in' future interest rates and are 'over the counter' OTC or private transactions rather than contracts available exclusively at exchanges such as the London International Financial Futures Exchange LIFFE . This is defined as a contract between two parties that sets out the interest rate that will apply to a future loan or deposit. There is no loan between the parties but merely an agreement to compensate the other in the event of movements in the...

## Call Put Parity

There is a mathematical relationship between call and put options known as call put parity. If you have a portfolio where you purchase a share with an exercise price of 60, purchase a put and immediately sell a call option. If the share price on expiry rises to 100, the net position would be Share Call option Put option Net position If the price were below exercise price then the call would be worthless and the put option would be in the money. The net position would be eight. The call put...

## Hedging Example

In Figure 10.4, the current spot price is 4,500 and futures are priced at 4,400 implying a fall in the market. Given that the market is expected to fall, you buy futures which make money with price increases. On expiry in December, the spot price has gone the other way and risen to 4,600. aj_ On the future you make 200 4,600 4,400 , however, there is a loss on the underlying commodity of 100 4,600 4,500 . The overall payoff is plus 100 and with ten contacts the total margin is 1,000. If you...

## Amortization

This chapter introduces methods of amortizing loans or leases and compares the result with depreciation methods for writing off equipment. Amortization is the reduction of the value of an asset by prorating its initial cost over a number of periods. You can calculate the payment required under an annuity and then you need to split each payment into capital and interest. Due to the compounding nature of the time value of money, more capital is outstanding in the earlier periods and therefore...

## Implied coupon date price

The implied coupon date price is the level at which the security must be sold in order to break even on the investment Figure 6.6 . It is one method of marking the instrument to market the current holding in a specific security. Purchase Settlement Date Last Coupon Next Coupon Price 25 May 2005 20 May 2005 20 Nov 2005 'JB.50 360jdays Cost of Carrying FRMto Wext Coupon Date l-nrr FMfi I . .eil ued Interest Pl JijS V ' lay. - ' 7i -J I R jDay - i ii i m h I 1 basis- bans- t- Ei - Price price days...

## Auditing

Whilst it is important to set the models out correctly, model auditing is often ignored or performed inadequately. Simply looking at the model will not find the errors and it is important to work from a position of assuming that there are errors in a model and applying consistent methods. There are a few initial tests that can be run to try and understand the reliability of the output. You can use these tests to understand the spreadsheets in this book. Instances that need to be checked...

## Effective margin

This is the total marginal return over the index to maturity and comprises a combination of margin negative or positive over the index plus capital growth or depreciation see Figure 6.1 . The formula is Simple effective margin margin redemption value price life Simple effective margin margin redemption value price life 25 basis points over six month LIBOR The second formula takes into account the price of the floating rate note with this formula Modified simple effective margin price The simple...