Question

After comparing the fixed income valuation formula to the profit maximization formula, what does the use of the fixed income valuation equation begin to suggest about the valuation of all other assets? And because fixed income securities are driven by interest rates, what does the nominal—or quoted—interest rate formula suggest about the level of market interest rates today?

Answer 1

Solution:

Valuation is an important part to analysis the business. The same should be done by using the fixed income of the business. The income of the business is depending upon the risks of the business. Generally, there are two types of risk. One is systematic and the other one is unsystematic risk. The unsystematic are internal risk of the business which can be controlled and eliminated by proper and effective internal management. The systematic risks are uncontrollable. These types of risks are depending upon the market factors. The systematic risks are measured through beta. The beta represents that if the market returns changes by 1% then the stock return will change by what percent. The market interest rate is computed by considering this beta factor. The Capital Assets Pricing Model (CAPM) plays an important role in the same.

The formula of CAPM model is:

Required Rate of Return (R_e) = R_f + (R_m – R_f)* ?

Where;

R_f = Risk Free Return

R_m – R_f = Market Risk Premium

?= Beta

The required rate of return from the market is used to compute the fixed income valuation. The formula to compute the business valuation is

Valuation = Fixed Income/Required Rate of Return (R_e)

References:

Glau, K., Grbac, Z., Scherer, M., & Zagst, R. (Eds.). (2016). Innovations in Derivatives Markets: Fixed Income Modeling, Valuation Adjustments, Risk Management, and Regulation(Vol. 165). Springer.

Hanson, S. G., Shleifer, A., Stein, J. C., & Vishny, R. W. (2015). Banks as patient fixed-income investors. Journal of Financial Economics, 117(3), 449-469.