CAPITAL MARKETS

By Ramon G. del Rosario

Overview of Financial Markets

A financial market is a market in which financial assets (securities) can be purchased or sold Financial markets facilitate financing and investing by households, firms, and government agencies Participants that provide funds are called surplus units
e.g., households

Participants that enter markets to obtain funds are deficit units

e.g., the government

A major participant in financial markets is the Fed, because it controls the money supply

Types of Financial Markets

Financial markets can be distinguished by the maturity structure and trading structure of its securities Money versus capital markets
The flow of short-term funds is facilitated by money markets The flow of long-term funds is facilitated by capital markets

Primary versus secondary markets

Primary markets facilitate the issuance of new securities
e.g., the sale of new corporate stock or new Treasury securities

Secondary markets facilitate the trading of existing securities

e.g., the sale of existing stock Securities traded in secondary markets should be liquid

Types of Financial Markets (contd)

Organized versus over-the-counter markets
A visible marketplace for secondary market transactions is an organized exchange Some transactions occur in the over-the-counter (OTC) market (a telecommunications network)

Knowledge of financial markets is power

Decide which markets to use to achieve our investment goals or financing needs Decide which markets to use as part of your job Avoid common mistakes in investing and borrowing

THE PHILIPPINE FINANCIAL SYSTEM

BANGKO SENTRAL NG PILIPINAS Banking System Banking Institution Universal Banks Non-Bank Financial Institution
(w/ Quasi Banking Function)

Non-Bank Financial Institution Lending Investors Pawnshops Government NBFIs Venture Capital Corporations

Investment Houses Financing Companies Securities Dealers Investment Companies

Commercial Banks
Thrift Banks Rural Banks Cooperative Banks Islamic Banks Microfinance Banks

Insurance Companies
Fund Managers

Source: Bangko Sentral ng Pilipinas

The Financial Market

Money Market Capital Market

Debt Market

Bond Market Bank Loan Market Stock market Over-The-Counter Market

Equities Market

Foreign Exchange Market Derivatives Market

Direct Market

Direct Credit Markets 1. Money Market 2. Capital Market

Surplus Unit (Savers) 1. Households 2. Governments 3. Business firms Financial Intermediaries 1. Banks 2. Insurance companies

Deficit-Spending Units (Borrowers) 1. Business firms 2. Governments 3. Households

Intermediation Market

Structure of the Financial Market

(Larry S. Esguerra IV) ATENEO-BAP Institute of Banking

Basic Elements of Financial Markets

Buyers and Sellers Financial commodities Spread Competition Payment System Communication / Dealing System Lines / Limits

Financial Market Participants

CENTRAL BANKS COMMERCIAL BANKS BROKERS INTERNATIONAL & LARGE LOCAL CORP GOVERNMENT BODIES MARGIN ACCOUNTS/INDIVIDUALS NON-BANK FINANCIAL INSTITUTIONS

Securities Traded in Financial Markets

Money market securities
Money market securities are debt securities with a maturity of one year or less Characteristics:
Liquid Low expected return Low degree of risk

Securities Traded in Financial Markets (contd)

Capital market securities
Capital market securities are those with a maturity of more than one year
Bonds and mortgages Stocks

Capital market securities have a higher expected return and more risk than money market securities

Securities Traded in Financial Markets (contd)

Bonds and mortgages
Bonds are long-term debt obligations issued by corporations and government agencies Mortgages are long-term debt obligations created to finance the purchase of real estate Bonds and mortgages specify the amount and timing of interest and principal payments

Securities Traded in Financial Markets (contd)

Stocks
Stocks (equity) are certificates representing partial ownership in corporations Investors may earn a return by receiving dividends and capital gains Stocks have a higher expected return and higher risk than long-term debt securities

Securities Traded in Financial Markets (contd)

Derivative securities
Derivative securities are financial contracts whose values are derived from the values of underlying assets Speculating with derivatives allow investors to benefit from increases or decreases in the underlying asset Risk management with derivatives generates gains if the value of the underlying security declines

Valuation of Securities in Financial Markets

Securities are valued as the present value of their expected cash flows, discounted at a rate that reflects their uncertainty Market pricing of securities
Different investors may value the same security differently based on their interpretation of information

Impact of valuations on pricing

Every security has an equilibrium market price at which demand and supply for the security are equal
Favorable information results in upward valuation revisions; unfavorable information results in downward revisions

Securities reach a new equilibrium price as new information becomes available

Market Efficiency
Markets are efficient when security prices fully reflect all available information In an efficient market, different investors may still prefer different securities because of differences in:
Risk preference Desired liquidity Tax status

Market Efficiency (contd)

Impact of asymmetric information
Asymmetric information is information a firms managers have that is not available to investors The valuation process is influenced by the financial statements that are used to derive cash flow estimates Securities may be mispriced because of
Flexibility in accounting guidelines Overestimation of earnings

The asymmetric information problem can be reduced if managers frequently disclose financial data and information to the public or through increased regulation

Financial Market Regulation

The Securities Regulation Code
R.A. 8799

Securities and Exchange Commission Philippine Stock Exchange Bangko Sentral ng Pilipinas Insurance Commission Bureau of Treasury Philippine Dealing and Exchange Corporation

Global Financial Markets

Financial markets vary among countries in terms of
The volume of funds that are transferred from surplus to deficit units The types of funding that are available

How financial markets influence economic development

Many foreign countries have converted to market-oriented economies
Allows businesses and consumers to obtain financing

Many Eastern European countries allowed for privatization, the sale of government-owned firms to individuals
Financial markets in these countries ensure that businesses can obtain funding from surplus units

Global Financial Markets (contd)

Global integration
Many financial markets are globally integrated
Participants move funds out of one countrys market and into another Foreign investors serve as key surplus units in the U.S. by purchasing securities U.S. investors serve as key surplus units for foreign countries by purchasing foreign securities

Market movements and interest rates have become more correlated between markets

Global Financial Markets (contd)

Global integration (contd)
Barriers to global integration
Lack of information about foreign companies Different accounting regulation Excessive cost of executing international transactions

Financial market integration within Europe

Elimination of regulations Merging of some European stock exchanges Adoption of the euro

Global Financial Markets (contd)

Role of the foreign exchange market
The foreign exchange market facilitates the exchange of currencies Financial intermediaries serve as brokers and/or dealers in foreign exchange markets Foreign exchange market
The exchange rate is the market-determined price of a currency
Price changes in response to supply and demand

Role of Banks in the Financial Markets

Major player in the financial market Intermediary between fund providers and fund users Accept funds and pay interest on deposits Lend funds and charge interest on loans Observe prudent lending practices to protect depositors money Invest unlent funds to generate income

Role of Non-depository Financial Institutions

Role of nondepository financial institutions
Nondepository institutions generate funds from sources other than deposits Finance companies
Obtain funds by issuing securities Lend funds to individuals and small businesses

Role of Other Financial Institutions

Mutual funds
Sell shares to surplus units Use funds to purchase a portfolio of securities
Some focus on capital market securities (e.g., stocks or bonds) Money market mutual funds concentrate on money market securities

Role of Other Financial Institutions (cont.)

Securities firms
Broker function
Execute securities transactions between two parties Charge a fee in the form of a bid-ask spread

Investment banking function

Underwrite newly issued securities

Dealer function
Securities firms make a market in specific securities by adjusting their inventory

Role of Other Financial Institutions (contd)

Insurance companies
Provide insurance policies to individuals and firms for death, illness, and damage to property Charge premiums Invest in stocks or bonds issued by corporations

Role of Other Financial Institutions (contd)

Pension funds
Offered by most corporations and government agencies Manage funds until they are withdrawn from the retirement account Invest in stocks or bonds issued by corporations or in bonds issued by the government

Comparison of Roles among Financial Institutions

Deposits

Depository Institutions Finance Companies

Individual Surplus Units Securities

Purchase Shares

Purchase

Mutual Funds Insurance Companies

Deficit Units

Policyholders

Premiums

Employers Employees

Employee Contributions

Pension Funds

Global Expansion by Financial Institutions

Various financial institutions have expanded through international mergers, resulting in:
More services to clients An international customer base

The introduction of the euro has increased international mergers

Economic Environment
Current Situation of Philippine Economy Economic Outlook

Major Economic Indicators

Macroeconomic Variables Source Usual Applications

GDP/GNP Growth Rate

Inflation P/$ exchange rate 91-day T-Bill rate 10-year Philippine Bond yields

National Statistical Coordination Board

National Statistics Office Philippine Dealing System Bloomberg Bloomberg

Basis for growth in consumer market demand

Escalation Factors for Costs, prices Base for foreign borrowing costs Base for domestic borrowing costs Base for long-term riskfree rate and corresponding cost of capital Barometer of Business Activity

PSEi

Philippine Stock Exchange

Economic Forces That Affect Interest Rates

Economic growth
Shifts the demand schedule outward (to the right) There is no obvious impact on the supply schedule
Supply could increase if income increases as a result of the expansion

The combined effect is an increase in the equilibrium interest rate

Loanable Funds Theory (contd)

SA

i2 i DA2 DA Impact of Economic Expansion

Economic Forces That Affect Interest Rates (contd)

Inflation
Shifts the supply schedule inward (to the left)
Households increase consumption now if inflation is expected to increase

Shifts the demand schedule outward (to the right)

Households and businesses borrow more to purchase products before prices rise

Loanable Funds Theory (contd)

SA2 S A i2

i DA2 DA Impact of Expected Increase in Inflation

Economic Forces That Affect Interest Rates (contd)

Fisher effect
Nominal interest payments compensate savers for:
Reduced purchasing power A premium for forgoing present consumption

The relationship between interest rates and expected inflation is often referred to as the Fisher effect

Economic Forces That Affect Interest Rates (contd)

Money supply
If the BSP increases the money supply, the supply of loanable funds increases
If inflationary expectations are affected, the demand for loanable funds may also increase

If the BSP reduces the money supply, the supply of loanable funds decreases

Economic Forces That Affect Interest Rates (contd)

Budget deficit
A high deficit means a high demand for loanable funds by the government
Shifts the demand schedule outward (to the right) Interest rates increase

The government may be willing to pay whatever is necessary to borrow funds, but the private sector may not
Crowding-out effect

The supply schedule may shift outward if the government creates more jobs by spending more funds than it collects from the public

Economic Forces That Affect Interest Rates (contd)

Foreign flows of funds
The interest rate for a currency is determined by the demand for and supply of that currency
Impacted by the economic forces that affect the equilibrium interest rate in a given country, such as:
Economic growth Inflation

Shifts in the flows of funds between countries cause adjustments in the supply of funds available in each country

Forecasting Interest Rates

It is difficult to predict the precise change in the interest rate due to a particular event
Being able to assess the direction of supply or demand schedule shifts can help in understanding why rates changed

Regulatory Framework
Philippine Capital Market

Bangko Sentral ng Pilipinas

Highest regulatory body in the Philippine financial system Created under The New Central Bank Act of 1993 (RA 7653) Primary Mandate: to promote price stability balance and sustainable growth of the economy

Bangko Sentral ng Pilipinas

Exercise supervision over the following:

1. 2.

3.

4. 5. 6.

Banks Non-bank with quasi-banking functions and/or with trust or IMA license Non-bank subsidiaries / affiliates of banks and quasi banks Non-stock savings and loans association Trust companies Pawnshops

Functions of the BSP

1.

2.
3. 4.

5.

6. 7.

Conducting monetary policy Issuing currency Lending to other banks and the government Managing foreign currency reserves Supervision and regulation of financial institution Determination of exchange rate policy Other activities

Securities and Exchange Commission

Advantages of Public Offering An alternative to debt capital Provides required volume of funding Allows for repayment of debts Improves companys balance sheet Establishes a market for companys stock Improves employee relations Attracts able executives Enhances companys image Helps influence legislation

Disadvantages of Public Offering

Change in management style Disclosure of company information Payment of dividends Maintenance of growth Loss of control Cost of public offering

SEC Underwriting Requirements

Registration of the Issue
Registration Statement Prospectus Articles of Incorporation Corporate Bylaws Draft of Underwriting Agreement

Concept of Full Disclosure

Material Contracts Pending Lawsuits Historical Financial Statements Operations Management

Explanation of Valuation Methodology SEC Legal/Financial Analysis Opposition Period

Critical Component of SEC Registration Statement

Issue Size and net proceeds Type of offering Equity structure Underwriter/s Work Program Subsidiaries and affiliates Historical financial statements Ownership structure Officers and directors Material contracts Pending lawsuits

Underwriting Process Investment Decision

Financial Advisory Review Present Organization Formulate Business Plan Formulate Financial Plan Organizational Restructuring Evaluate IPO Viability Company Valuation Design Terms of Offering Prepare Registration Statement Prepare Prospectus SEC Registration Underwriting Formation of Underwriting Syndicate Draft Underwriting Documents PSE Approval Offering Period Listing Post Listing Activities

Listing Time Table

Filing of listing application Processing of registration statement Release of pre-effective clearance Presentation to listing Presentation to Board of Directors Release of offering circular] Book building process Price setting Reservation of additional shares by member brokers Release of registration and licensing order and permit to offer securities for sale Offer period Confirmation of trading symbol Submission of complete list of subscribers Delivery of stock certificates to be lodged in PCD Listing Day

Underwriter/issuer
PSE SEC SEC PSE PSE PSE Underwriter Underwriter PSE PSE Underwriter Underwriter/Issuer Transfer Agent Transfer Agent PSE

Money Markets
Securities, use, features and valuation

Money Market Securities

Money market securities:
Have maturities within one year Are issued by corporations and governments to obtain short-term funds Are commonly purchased by corporations and government agencies that have funds available for a short-term period Provide liquidity to investors

Money Market Securities (contd)

Treasury bills:
Are issued by the U.S. Treasury Are sold weekly through an auction Have a par value of $1,000 Are attractive to investors because they are backed by the federal government and are free of default risk Are liquid Can be sold in the secondary market through government security dealers

Money Market Securities (contd)

Treasury bills (contd)
Investors in Treasury bills
Depository institutions because T-bills can be easily liquidated Other financial institutions in case cash outflows exceed cash inflows Individuals with substantial savings for liquidity purposes Corporations to have easy access to funding for unanticipated expenses

Money Market Securities (contd)

Treasury bills (contd)
Estimating the yield
T-bills are sold at a discount from par value
The yield is influenced by the difference between the selling price and the purchase price If a newly-issued T-bill is purchased and held until maturity, the yield is based on the difference between par value and the purchase price

Money Market Securities (contd)

Treasury bills (contd)
Estimating the yield (contd)
The annualized yield is:

SP PP 365 YT PP n Estimating the T-bill discount

The discount represents the percent discount of the purchase price from par value for newly-issued T-bills:

Par PP 360 T - bill discount Par n

Computing the Yield of a Treasury Bill

An investor purchases a 91-day T-bill for $9,782. If the T-bill is held to maturity, what is the yield the investor would earn?
SP PP 365 YT PP n 10,000 9,782 365 9,782 91 8.94%

Estimating the T-Bill Discount

Using the information from the previous example, what is the T-bill discount?

Par PP 360 T - bill discount Par n 10,000 9,782 360 10,000 91 8.62%

Money Market Securities (contd)

Commercial paper:
Is a short-term debt instrument issued by well-known, creditworthy firms Is typically unsecured Is issued to provide liquidity to finance a firms investment in inventory and accounts receivable Is an alternative to short-term bank loans Has a minimum denomination of $100,000 Has a typical maturity between 20 and 270 days Is issued by financial institutions such as finance companies and bank holding companies Has no active secondary market Is typically not purchased directly by individual investors

Money Market Securities (contd)

Commercial paper (contd)
Backing commercial paper
Issuers typically maintain a backup line of credit
Allows the company the right to borrow a specified maximum amount of funds over a specified period of time Involves a fee in the form of a direct percentage or in the form of required compensating balances

Estimating the yield

The yield on commercial paper is slightly higher than on a Tbill The nominal return is the difference between the price paid and the par value

Estimating the Commercial Paper Yield An investor purchases 120-day commercial paper
with a par value of $300,000 for a price of $289,000. What is the annualized commercial paper yield?

300,000 - 289,000 360 Ycp 289,000 120 11.42%

Money Market Securities (contd)

Repurchase agreements
One party sells securities to another with an agreement to repurchase them at a specified date and price
Essentially a loan backed by securities

A reverse repo refers to the purchase of securities by one party from another with an agreement to sell them Bank, S&Ls, and money market funds often participate in repos Transactions amounts are usually for $10 million or more Common maturities are from 1 day to 15 days and for one, three, and six months There is no secondary market for repos

Money Market Securities (contd)

Repurchase agreements (contd)
Placement
Repo transactions are negotiated through a telecommunications network with dealers and repo brokers When a borrowing firm can find a counterparty to a repo transaction, it avoids the transaction fee
Some companies use in-house departments

Estimating the yield

The repo yield is determined by the difference between the initial selling price and the repurchase price, annualized with a 360-day year

Estimating the Repo Yield

An investor initially purchased securities at a price of $9,913,314, with an agreement to sell them back at a price of $10,000,000 at the end of a 90-day period. What is the repo rate?
Repo rate SP PP 360 PP n 10,000,000 9,913,314 360 9,913,314 90 3.50%

Money Market Securities (contd)

Bankers acceptances:
Indicate that a bank accepts responsibility for a future payments Are commonly used for international trade transactions
An unknown importers bank may serve as the guarantor Exporters frequently sell an acceptance before the payment date

Have a return equal to the difference between the discounted price paid and the amount to be received in the future Have an active secondary market facilitated by dealers

Money Market Securities (contd)

Bankers acceptances (contd)
Steps involved in bankers acceptances
First, the U.S. importer places a purchase order for goods The importer asks its bank to issue a letter of credit (L/C) on its behalf
Represents a commitment by that bank to back the payment owed to the foreign exporter

The L/C is presented to the exporters bank The exporter sends the goods to the importer and the shipping documents to its bank The shipping documents are passed along to the importers bank

Sequence of Steps in the Creation of A Bankers Acceptance

1
Purchase Order Shipment of Goods 4 2 L/C Application 6 3 L/C Shipping Documents & Time Draft

Importer
5

Exporter

L/C Notification

American Bank (Importers Bank)

Shipping Documents 7 & Time Draft Accepted

Japanese Bank (Exporters Bank)

Institutional Use of Money Markets

Financial institutions purchase money market securities to earn a return and maintain adequate liquidity Institutions issue money market securities when experiencing a temporary shortage of cash Money market securities enhance liquidity:
Newly-issued securities generate cash Institutions that previously purchased securities will generate cash upon liquidation Most institutions hold either securities that have very active secondary markets or securities with short-term maturities

Institutional Use of Money Markets (contd)

Financial institutions with uncertain cash in- and outflows maintain additional money market securities Institutions that purchase securities act as a creditor to the initial issuer Some institutions issue their own money market instruments to obtain cash Many money market transaction involve two financial institutions

Valuation of Money Market Securities

For money market securities making no interest payments, the value reflects the present value of a future lump-sum payment
The discount rate is the required rate of return by investors

Risk of Money Market Securities

Because of the short maturity, money market securities are generally not subject to interest rate risk, but they are subject to default risk
Investors commonly invest in securities that offer a slightly higher yield than T-bills and are very unlikely to default Although investors can assess economic and firm-specific conditions to determine credit risk, information about the issuers financial condition is limited

Measuring risk
Money market participants can use sensitivity analysis to determine how the value of money market securities may change in response to a change in interest rates

Debt Market
Bonds, Government Securities, LTCP, Valuation and Yield Calculation

Background on Bonds
Bonds represents long-term debt securities that are issued by government agencies or corporations Interest payments occur annually or semiannually Par value is repaid at maturity Most bonds have maturities between 10 and 30 years Bearer bonds require the owner to clip coupons attached to the bonds Registered bonds require the issuer to maintain records of who owns the bond and automatically send coupon payments to the owners

Background on Bonds (contd)

Bond yields
The issuers cost of financing is measured by the yield to maturity
The annualized yield that is paid by the issuer over the life of the bond Equates the future coupon and principal payments to the initial proceeds received Does not include transaction costs associated with issuing the bond Earned by an investor who invests in a bond when it is issued and holds it until maturity

The holding period return is used by investors who do not hold a bond to maturity

Corporate Bonds
Corporations issue corporate bonds to borrow for long-term periods Corporate bonds have a minimum denomination of $1,000 Larger bonds offerings are achieved through public offerings registered with the SEC Secondary market activity varies Financial and nonfinancial institutions as well as individuals are common purchasers Most corporate bonds have maturities between 10 and 30 years Interest paid by corporations is tax-deductible, which reduces the corporate cost of financing with bonds

Corporate Bonds (contd)

Corporate bond yields and risk
Investor assessment of risk
Investors may only consider purchasing corporate bonds after assessing the issuing firms financial condition and ability to cover its debt payments Investors may rely heavily on financial statements created by the issuing firm, which may be misleading

Bond ratings
Bonds with higher ratings have lower yields Corporations seek investment-grade ratings, since commercial banks will only invest in bonds with that status Rating agencies will not necessarily detect any misleading information contained in financial statements

Corporate Bonds (contd)

Characteristics of corporate bonds
The bond indenture specifies the rights and obligations of the issuer and the bondholder A trustee represents the bondholders in all matters concerning the bond issue Sinking-fund provision
A requirement to retire a certain amount of the bond issue each year

Protective covenants:
Are restrictions placed on the issuing firm designed to protect the bondholders from being exposed to increasing risk during the investment period Often limit the amount of dividends and corporate officers salaries the firm can pay

Corporate Bonds (contd)

Characteristics of corporate bonds (contd)
Call provisions:
Require the firm to pay a price above par value when it calls its bonds
The difference between the call price and par value is the call premium

Are used to:

Issue bonds with a lower interest rate Retire bonds as required by a sinking-fund provision

Are a disadvantage to bondholders

Corporate Bonds (contd)

Bond collateral
Typically, collateral is a mortgage on real property
A first mortgage bond has first claim on the specified assets A chattel mortgage bond is secured by personal property

Unsecured bonds are debentures Subordinated debentures have claims against the firms assets that are junior to the claims of mortgage bonds and regular debentures

Corporate Bonds (contd)

Low- and zero-coupon bonds:
Are issued at a deep discount from par value Require annual tax payments although the interest will not be received until maturity Have the advantage to the issuer of requiring low or no cash outflow

Variable-rate bonds:
Allow investors to benefit from rising market interest rates over time Allow issuers of bonds to benefit from declining rates over time

Convertibility
Convertible bonds allow investors to exchange the bond for a stated number of shares of common stock Investors are willing to accept a lower rate of interest on convertible bonds

Corporate Bonds (contd)

Junk bonds
Junk bonds have a high degree of credit risk About two-thirds of junk bonds are used to finance takeovers Size of the junk bond market
Currently about 3,700 junk bond offerings exist with a market value of $80 billion

Participation in the junk bond market

70 large issuers of junk bonds each have more than $1 billion in debt outstanding Primary investors in junk bonds are mutual funds, life insurance companies, and pension funds The junk bond secondary market consists of 20 bond traders

Corporate Bonds (contd)

How corporate bonds facilitate restructuring (contd)
Using bonds to revise the capital structure
Debt is perceived to be a cheaper source of capital than equity as long as the corporation can meet its debt payments Sometimes, corporations issue bonds and use the proceeds for a debt-for-equity swap Corporations with an excessive amount of debt can conduct an equity-for-debt swap

Institutional Use of Bond Markets

All financial institutions participate in bond markets
On any given day, commercial banks, bond mutual funds, insurance companies, and pension funds are dominant participants

A financial institutions investment decisions will often simultaneously affect bond market and other financial market activity

Globalization of Bond Markets

Bond markets have become increasingly integrated as a result of frequent cross-border investments in bonds Low-quality bonds issued globally by governments and large corporations are global junk bonds The global development of the bond market is primarily attributed to bond offerings by country governments (sovereign bonds)

Globalization of Bond Markets (contd)

Eurobond market
Bonds denominated in various currencies are placed in the Eurobond market Dollar-denominated bearer bonds are available in the Eurobond market Underwriting syndicates help place Eurobond issues

Bond Valuation Process

Bonds:
Are debt obligations with long-term maturities issued by government or corporations to obtain long-term funds Are commonly purchased by financial institutions that wish to invest for long-term periods

The appropriate bond price reflects the present value of the cash flows generated by the bond (i.e., interest payments and repayment of principal):

C C C Par PV of bond .... 1 2 (1 k ) (1 k ) (1 k )n

Computing the Current Price of A Bondof $1,000 and a A 2-year bond has a par value
coupon rate of 5 percent. The prevailing annualized yield on other bonds with similar characteristics is 7 percent. What is the appropriate market price of the bond?
C C C Par PV of bond .... 1 2 (1 k ) (1 k ) (1 k )n 50 1050 , 1.07 1.072 963.84

Bond Valuation Process (contd)

Bond valuation with a present value table
Present value interest factors in Exhibit 8A.3 can be multiplied by coupon payments and the par value to determine the present value of the bond

Impact of the discount rate on bond valuation

The appropriate discount rate for valuing any asset is the yield that could be earned on alternative investments with similar risk and maturity Investors use higher discount rates to discount the future cash flows of riskier securities The value of a high-risk security will be lower than the value of a low-risk security

Computing the Current Price of A Bondpar value ofPVIFsand a Using $1,000 A 2-year bond has a
coupon rate of 5 percent. The prevailing annualized yield on other bonds is 7 percent. What is the appropriate market price of the bond using PVIFs?
PV of bond $50(PVIFk 7%,n 1 ) $1,050(PVIFk 7%,n 2 ) $50(.9346) $1,050(.8734) $46.73 $917.07 $963.80

Bond Valuation Process (contd)

Impact of the timing of payments on bond valuation
Funds received sooner can be reinvested to earn additional returns A dollar to be received soon has a higher present value than one to be received later

Valuation of bonds with semiannual payments

First, divide the annual coupon by two Second, divide the annual discount rate by two Third, double the number of years

C/2 C/2 C / 2 Par PV of bond .... 1 2 (1 k / 2) (1 k / 2) (1 k / 2)2n

Computing the Current Price of A Bond With Semiannual Coupons

A 2-year bond has a par value of $1,000 and a semiannual coupon rate of 5 percent. The prevailing annualized yield on other bonds with similar characteristics is 7 percent. What is the appropriate market price of the bond?
PV of bond C/2 C/2 C / 2 Par .... (1 k / 2)1 (1 k / 2)2 (1 k / 2)2n 25 25 25 1025 , 1.0351 1.035 2 1.0353 1.035 4 963.27

Bond Valuation Process (contd)

Use the annuity tables for valuation
A bond can be valued by separating its payments into two components:
PV of bond = PV of coupon payments + PV of principal

The bonds coupon payments represent an annuity (an even stream of payments over a given period of time)
The present value can be computed using PVIFAs

Computing the Current Price of A Bond Using value of $1,000 andPVIFAs PVIFs and an annual A 30-year bond has a par
coupon rate of 10 percent. The prevailing annualized yield on other bonds with similar characteristics is 9 percent. What is the appropriate market price of the bond?
PV of coupon payments C(PVIFAk 9%,n 30 ) $100(10.274) $1027.40 , PV of principal $1000(PVIFk 9%,n 30 ) , $1000(.0754) $75.40 , PV of bond $1,027.40 $75.40 $1,102.80

Relationship between Coupon Rate, Required Return, and Price

If the coupon rate of a bond is below the investors required rate of return, the present value of the bond should be below par value (discount bond) If the coupon rate equals the required rate of return, the price of the bond should be equal to par value If the coupon rate of a bond is above the required rate of return, the price of the bond should be above par value

Relationship between Coupon Rate, Required Return, and Price

$1,800.00 $1,600.00 $1,400.00 $1,200.00 $1,000.00 $800.00 $600.00 $400.00 $200.00 $0.00 0.05 0.08 0.1 Required Return 0.12 0.15

Present Value

5-Year Bond 10-Year Bond 20-Year Bond

 Implications for financial institutions

Relationship between Coupon Rate, Required Return, and Price

The impact of interest rate movements depends on how the institutions asset and liability portfolios are structured
Institutions with interest rate-sensitive liabilities that invest heavily in bonds are exposed to interest rate risk Many institutions adjust the size of their bond portfolio according to interest rate expectations When rates are expected to rise, bonds can be sold and the proceeds used to purchase short-term securities When rates are expected to fall, the bond portfolio can be expanded in order to capitalize on the expectations

Sensitivity of Bond Prices to Interest Rate Movements

Duration
Duration measures the life of a bond on a present value basis The longer the bonds duration, the greater its sensitivity to interest rates

Ct ( t ) (1 k )t DUR t n1 Ct (1 k )t t 1

Computing the Duration of A Bond

A bond has two years remaining to maturity, a $1,000 par value, a 9 percent coupon rate, and a 10 percent yield to maturity. What is the duration of this bond?
Ct ( t ) (1 k )t DUR t n1 Ct (1 k )t t 1

$90 $1,090(2) (1.10)1 (1.10)2 $90 $1,090 (1.10)1 (1.10)2 1.92 years

Sensitivity of Bond Prices to Interest Rate Movements (contd)

Duration (contd)
Duration of a portfolio
Bond portfolio managers commonly immunize their portfolio from the effects of interest rate movements A bond portfolios duration is the weighted average of bond durations, weighted according to relative market value:

DUR p

w DUR
j j 1

Sensitivity of Bond Prices to Interest Rate Movements (contd)

Duration (contd)
Modified duration
Duration can be used to estimate the percentage change in a bonds price in response to a 1 percentage point change in bond yields:

DUR DUR* The estimate of modified (1 k ) should be applied such that duration

the bond price moves in the opposite direction from the change in bond yields The percentage change in a bonds price in response to a change in yield is:

%P -DUR * y

Computing the Modified Duration of A Bond

A bond has two years remaining to maturity, a $1,000 par value, a 9 percent coupon rate, and a 10 percent yield to maturity. What is the modified duration of this bond? Interpret the modified duration for this bond.
DUR* DUR (1 k ) 1.92 1.75 1.10

A 1 percent increase in bond yields leads to a 1.75 percent decline in the price of the bond.

Computing the Price Change of A Bond in Response to A Change in Yield

In the previous example, assume that bond yields rise by 0.30%. What is an estimate of the percentage drop in the bonds price?

%P -DUR * y 1.75 0.003 .53%

Sensitivity of Bond Prices to Interest Rate Movements (contd)

Duration (contd)
Estimation errors from using modified duration
If investors rely only on modified duration to estimate percentage price changes in bonds, they will tend to overestimate price declines and underestimate price increases To accurately estimate the percentage change in price, bond convexity must also be considered

Sensitivity of Bond Prices to Interest Rate Movements (contd)

Duration (contd)
Bond convexity
Modified duration estimates assume a linear relationship between bond prices and yields The actual relationship between bond prices and yields is convex

How the estimation errors from modified duration can vary

For high-coupon, short-maturity bonds, price change estimates based on modified duration will be very close to actual price changes For low-coupon, long-maturity bonds, price change estimates based on modified duration can give large estimation errors

Bond Investment Strategies Used by Investors

Matching strategy
The bond portfolio generates periodic income that can match expected periodic expenses Involves estimating future cash outflows and developing a bond portfolio that can generate sufficient payments to cover those outflows

Laddered strategy
Funds are evenly allocated to bonds in each of several different maturity classes Achieves diversified maturities and different sensitivities to interest rate risk

Bond Investment Strategies Used by Investors (contd)

Barbell strategy
Funds are allocated to bonds with a short term to maturity and bonds with a long term to maturity
Allocates some funds to achieving relatively high returns and other funds to cover liquidity needs

Interest rate strategy

Funds are allocated to capitalize on interest rate forecasts Requires frequent adjustment in the bond portfolio to reflect current forecasts

Return and Risk of International Bonds

The value of an international bond is influenced by:
Changes in the risk-free rate of the currency denominating the bond Changes in the perceived credit risk of the bond Exchange rate risk

Return and Risk of International Bonds (contd)

Influence of foreign interest rate movements
An increase in the risk-free rate of the foreign currency results in a lower value for bonds denominated in that currency

Influence of credit risk

An increase in risk causes a higher required rate of return on the bond and lowers the present value of the bond

Influence of exchange rate fluctuations

The most attractive foreign bonds offer a high coupon rate and are denominated in a currency that strengthens over the investment horizon

Return and Risk of International Bonds (contd)

International bond diversification
Reduction of interest rate risk
International diversification of bonds reduces the sensitivity of the overall bond portfolio to any single countrys interest rate movements

Reduction of credit risk

Because economic cycles differ across countries, there is less chance of a systematic increase in the credit risk of internationally diversified bonds

Reduction of exchange rate risk

Financial institutions attempt to reduce their exchange rate risk by diversifying among foreign securities denominated in various foreign currencies

Background on Stocks
A stock is a certificate representing partial ownership in a corporation Stock is issued by firms to obtain long-term funds Owners of stock:
Can benefit from the growth in the value of the firm Are susceptible to large losses

Individuals and financial institutions are common purchasers of stock The primary market enables corporations to issue new stock The secondary market creates liquidity for investors who invest in stock Some corporations distribute earnings to investors in the form of dividends

Background on Stocks (contd)

Ownership and voting rights
The owners are permitted to vote on key matters concerning the firm:
Election of the board of directors Authorization to issue new shares Approval of amendments to the corporate charter Adoption of bylaws

Voting is often accomplished by proxy Management typically receives the majority of the votes and can elect its own candidates as directors

Background on Stocks (contd)

Preferred stock
Preferred stock represents an equity interest in a firm that usually does not allow for significant voting rights A cumulative provision on most preferred stock prevents dividends from being paid on common stock until all preferred dividends have been paid Preferred stock is less risky because dividends on preferred stock can be omitted Preferred stock is a less desirable source of funds than bonds because:
Dividends are not tax deductible Investors must be enticed to purchase the preferred stock since dividends do not legally have to be paid

Background on Stocks (contd)

Issuer participation in stock markets
The ownership feature attracts many investors who want to have an equity interest but do not necessarily want to manage their own firm A firm issuing stock for the first time engages in an IPO If a firm issues additional stock after the IPO, it engages in a secondary offering

Stock Valuation Methods

The price-earnings (PE) method assigns the mean PE ratio based on expected earnings of all traded competitors to the firms expected earnings for the next year
Assumes future earnings are an important determinant of a firms value Assumes that the growth in earnings in future years will be similar to that of the industry

Stock Valuation Methods (contd)

Price-earnings (PE) method (contd)
Reasons for different valuations
Investors may use different forecasts for the firms earnings or the mean industry earnings Investors disagree on the proper measure of earnings

Limitations of the PE method

May result in inaccurate valuation for a firm if errors are made in forecasting future earnings or in choosing the industry composite Some question whether an investor should trust a PE ratio

Valuing A Stock Using the PE Methodearnings of $2 per A firm is expected to generate

share next year. The mean ratio of share price to expected earnings of competitors in the same industry is 14. What is the valuation of the firms shares according to the PE method?
Valuation per share (Expected earnings of firm per share) (Mean industry PE ratio) $2 14 $28

Stock Valuation Methods (contd)

Dividend discount model
John Williams (1931) stated that the price of a stock should reflect the present value of the stocks future dividends:

firms cash flows k can be revised in response to changes in the required rate of return by investors

Dt Price (1 k )tuncertainty about the D can be revised in response to t 1

Stock Valuation Methods (contd)

Dividend discount model (contd)
For a constant dividend, the cash flow is a perpetuity:

Dt D Price t k (1 k )dividend, the cash flow t 1 For a constantly growing is a growing perpetuity:

Price

Dt D1 (1 k )t k g t 1

Valuing A Stock Using the Dividend Discount Model

Example 1: A firm is expected to pay a dividend of $2.10 per share every year in the foreseeable future. Investors require a return of 15% on the firms stock. According to the dividend discount model, what is a fair price for the firms stock?
Price

Dt D $2.10 $14 t k 15% t 1 (1 k )

Valuing A Stock Using the Dividend Discount Model

Example 2: A firm is expected to pay a dividend of $2.10 per share in one year. In every subsequent year, the dividend is expected to grow by 3 percent annually. Investors require a return of 15% on the firms stock. According to the dividend discount model, what is a fair price for the firms stock?
Dt D1 $2.10 Price $17.50 t k g 15% 3% t 1 (1 k )

Stock Valuation Methods (contd)

Dividend discount model (contd)
Relationship between dividend discount model and PE ratio
The PE multiple is influenced by the required rate of return and the expected growth rate of competitors The inverse relationship between required rate of return and value exists in both models The positive relationship between a firms growth rate and its value exists in both models

Stock Valuation Methods (contd)

Dividend discount model (contd)
Limitations of the dividend discount model
Errors can be made in determining the:
Dividend to be paid Growth rate Required rate of return

Errors are more pronounced for firms that retain most of their earnings

Determining the Required Rate of Return to Value Stocks

The capital asset pricing model:
Assumes that the only important risk is systematic risk Is not concerned with unsystematic risk Suggests that the return on an asset is influenced by the prevailing risk-free rate, the market return, and the covariance between a stocks return and the markets return:

R j Rf B j ( R m Rf )

Determining the Required Rate of Return to Value Stocks (contd)

The capital asset pricing model (contd)
Estimating the risk-free rate and the market risk premium
The yield on newly issued T-bonds is commonly used as a proxy for the risk-free rate The terms within the parentheses measure the market risk premium Historical data over 30 or more years can be used to determine the average market risk premium over time

Estimating the firms beta

Beta reflects the sensitivity of the stocks return to the markets overall return Beta is typically measured with monthly or quarterly data over the last four years or so

Using the CAPM

Fantasia Corp. has a beta of 1.7. The prevailing risk-free rate is 5% and the market risk premium is 5%. What is the required rate of return of Fantasia Corp. according to the CAPM?
R j Rf B j ( R m R f ) 5% 1.7(10% 5%) 13.5%

Factors That Affect Stock Prices

Economic factors
Impact of economic growth
An increase in economic growth increases expected cash flows and value Indicators such as employment, GDP, retail sales, and personal income are monitored by market participants

Impact of interest rates

Given a choice of risk-free Treasury securities or stocks, stocks should only be purchased if they offer a sufficiently high expected return

Factors That Affect Stock Prices (contd)

Market-related factors
Investor sentiment
In some periods, stock market performance is not highly correlated with existing economic conditions Stocks can exhibit excessive volatility because their prices are partially driven by fads and fashions A study by Roll found that only one-third of the variation in stocks returns can be explained by systematic economic forces

January effect
Many portfolio managers invest in riskier small stocks at the beginning of the year and shift to larger companies near the end of the year Places upward pressure on small stocks in January

Factors That Affect Stock Prices (contd)

Firm-specific factors
Some firms are more exposed to conditions within their own industry than to general economic conditions, so participants monitor:
Industry sales forecasts Entry into the industry by new competitors Price movements of the industrys products

Market participants focus on announcements that signal information about a firms sales growth, earnings, or characteristics that cause a revision in the expected cash flows

Factors That Affect Stock Prices (contd)

Firm-specific factors (contd)
Dividend policy changes
An increase in dividends may reflect the firms expectation that it can more easily afford to pay dividends

Earnings surprises
When a firms announced earnings are higher than expected, investors may raise their estimates of the firms future cash flows

Acquisitions and divestitures

Expected acquisitions typically result in an increased demand for the targets stock and raise the stock price The effect on the acquiring firm is less clear

Expectations
Investors attempt to anticipate new policies so they can make their move before other investors

Factors That Affect Stock Prices (contd)

Integration of factors affecting stock prices
Whenever economic indicators signal the expectation of higher interest rates, there is upward pressure on the required rate of return Firms expected future cash flows are influenced by economic conditions, industry conditions, and firmspecific conditions

Stock Risk (contd)

Measures of risk (contd)
The beta of a stock:
Measures the sensitivity of its returns to market returns Is used by many investors who have a diversified portfolio of stocks Can be estimated by obtaining returns of the firm and the stock market and applying regression analysis to derive the slope coefficient:

R jt B0 B1Rmt ut

Stock Risk (contd)

Measures of risk (contd)
The beta of a stock portfolio:
Is useful for investors holding more than one stock Can be measured as a weighted average of the betas of stocks in the portfolio, with the weights reflecting the proportion of funds invested in each stock:

The risk of a high-beta portfolio can be reduced by replacing p i i some of the high-beta stocks with low-beta stocks

w B

Stock Performance Measurement

The Sharpe index is appropriate when total variability is thought to be the appropriate measure of risk:

R Rf Sharpe index The higher the stocks mean return relative to the mean riskfree rate and the lower the standard deviation, the higher the Sharpe index Measures the excess return above the risk-free rate per period

Using the Sharpe Index

Patrick stock has an average return of 15% and an average standard deviation of 13%. The average risk-free rate is 8%. What is the Sharpe index for Patrick stock?
R Rf Sharpe index 15% 8% 0.54 13%

Stock Performance Measurement (contd)

The Treynor index is appropriate when beta is thought to be the most appropriate type of risk:

The higher the Treynor index, the higher the return relative to the risk-free rate, per unit of risk

R Rf Treynor index B

Using the Treynor Index

Patrick stock has an average return of 15% and a beta of 1.8. The average risk-free rate is 8%. What is the Sharpe index for Patrick stock?
R Rf Treynor index B 15% 8% 0.04 1.8

Stock Market Efficiency

Forms of efficiency
Weak-form efficiency suggests that security prices reflect all trade-related information Semistrong-form efficiency suggests that security prices fully reflect all public information
Includes announcements by firms, economic news or events, and political news or events If semistrong-form efficiency holds, weak-form efficiency holds as well

Strong-form efficiency suggests that security prices fully reflect all information, including private or insider information

Stock Market Efficiency (contd)

Tests of the efficient market hypothesis
Test of weak-form efficiency
Tested by searching for a nonrandom pattern in security prices Studies have generally found that historical price changes are independent over time There is some evidence that stocks:
Have performed better in January (January effect) Have performed better on Fridays than on Mondays (weekend effect) Have performed well on the trading days just before holidays (holiday effect)

Stock Market Efficiency (contd)

Tests of the efficient market hypothesis
Test of semistrong-form efficiency
Tested by assessing how security returns adjust to particular announcements Generally, security prices immediately reflect the information from announcements There is evidence of unusual profits from investing in IPOs

Test of strong-form efficiency

Difficult to test There is evidence that share prices of target firms rise substantially when the acquisition is announced Insiders are discouraged from using inside information because it is illegal

Foreign Stock Valuation, Performance, and Efficiency (contd)

Performance from global diversification
Stock investors can benefit by diversifying internationally
Economies do not move in tandem Stock markets across countries may respond to some of the same expectations In general, correlations between stock indexes have been higher in recent years than they were several years ago

Foreign Stock Valuation, Performance, and Efficiency (contd)

Performance from global diversification (contd)
Integration of markets during the 1987 crash
There was a high correlation among country stock markets during the crash This suggests that the underlying cause of the crash systematically affected all markets

Integration of markets during mini-crashes

On August 27, 1998 (Bloody Thursday) most stock markets around the world experienced losses Illustrates that even a well-diversified international portfolio is not insulated from some events

Diversification among emerging stock markets

These markets have lower correlations with developed countries, but also higher risk

Foreign Stock Valuation, Performance, and Efficiency (contd)

International market efficiency
Some foreign markets are inefficient because of the small number of analysts and portfolio managers Market inefficiencies are more common in small foreign stock markets Insider trading is more prevalent in many foreign markets Political and exchange rate risk may be high in some foreign markets