Already have an account? Get multiple benefits of using own account!
Login in your account..!
Remember me
Don't have an account? Create your account in less than a minutes,
Forgot password? how can I recover my password now!
Enter right registered email to receive password!
The main drawback of the tradition approach of valuation is that it discounts every cash flow using the same discount rate. For example, let us take 5-year (7.00 per cent) Treasury security (maturing in 2010). The cash flow per Rs.100 of par value would be a payment of Rs.3.50 every six months and Rs.103.50 tenth 6-month period from now. However, the best way to see the 5-year 7% security is as a package of zero-coupon bonds whose maturity value and date is the amount and date of cash flow respectively. Thus, 5-year, 7% security should be viewed as 10 zero-coupon bond. The main reason is that it does not allow a market participant to realize an arbitrage profit by taking apart or "stripping" a security and selling off the stripped securities at a higher aggregate value it would cost to purchase the security in the market. This approach is known as an arbitrage-free valuation approach.
The difference between the traditional and arbitrage-free valuation approach is explained in the table 5.
Table 1: Comparison of Traditional Approach and Arbitrage-Free Valuation Approach in 7% Treasury Security
Period (6 month each)
Discount (Base Interest) Rate
Cash Flows per Rs. 100 of par value
Traditional Approach
Arbitrage-Free Valuation Approach
1
5-year Treasury rate
1-period Treasury spot rate
3.5
2
2-period Treasury spot rate
3
3-period Treasury spot rate
4
4-period Treasury spot rate
5
5-period Treasury spot rate
6
6-period Treasury spot rate
7
7-period Treasury spot rate
8
8-period Treasury spot rate
9
9-period Treasury spot rate
10
10-period Treasury spot rate
103.5
Under traditional approach interest rate on the bond is the yield of 5-year treasury security. In arbitrage-free approach the interest rate for a cash flow is the theoretical rate that the treasury security has to pay if it issued as a zero-coupon bond with maturity date equal to the maturity date of the cash flow. So, it is necessary to decide the theoretical rate that the treasury security has to pay on a zero coupon for each maturity. Zero-coupon treasury rate is also known as 'Treasury Spot Rate'. In the next chapter, we will understand how to calculate the treasury spot rate. When the value of a bond is calculated based on spot rate, the resulting value is known as arbitrage-free value.
Define the concept of a real option. Discuss some real options a firm can be confronted with when investing in real projects. A positive APV project is accepted under the supposi
Harley Davidson purchases components from three suppliers. Components purchased from Supplier A are priced at $ 5 each and used at the rate of 240,000 units per year. Components pu
Assume Intel''s stock has an expected return of 26% and a volatility of 50%, while Coca-Cola''s has an expected return of 6% and volatility of 25%. If these two stocks were perfect
Question: The Statement of Principles for Financial Reporting sets out the principles that should underlie the preparation and presentation of general-purpose financial stateme
Harmonisation of Accounting Standards Recognising the required for international harmonisation of accounting standards, in year 1973, the International Accounting Standards Co
Scope of Financial Management The approach to scope and functions of financial management is divided, forpurposes of exposition, into two broad categories: (a) Traditional A
Q. Explain Present Value of a Series of Cash Flows? Present Value of a Series of Cash Flows: - In a business circumstances it is very natural that returns received by a firm ar
A developer has purchased a commercial office site in Melbourne and wishes to develop a building which will be sold to an institutional owner before completion of the building.
Exit strategy Venture capitalists and other financiers will negotiate an exit strategy at the point of advancing the money. The exit strategy will involve them realising their
Market Capitalization : Often referred to as market cap, it refers to the value of a company, that is, the market worth of its outstanding shares. A common misconception is that
Get guaranteed satisfaction & time on delivery in every assignment order you paid with us! We ensure premium quality solution document along with free turntin report!
whatsapp: +91-977-207-8620
Phone: +91-977-207-8620
Email: [email protected]
All rights reserved! Copyrights ©2019-2020 ExpertsMind IT Educational Pvt Ltd