Financial Markets And Types Of Securities

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term bond

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Type of bond with a single maturity date at the end of its term

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Serial bond

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Type of bond that matures in stated amounts at regular intervals.

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Variable rate bonds

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Type of bond that pays interest that is dependent on market conditions.

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Money Markets

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trade debt securities with maturities of less than 1 year. Low default risk.

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Types of Money Market Securities

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Government Treasury Bills

Government Treasury notes and bonds

Federal agency securities

Short-term tax-exempt securities

Commercial paper

Certificates of deposit

Repurchase agreements

Commercial paper

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Primary markets

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Markets in which corporations and governmental units raise new capital by making initial offerings of their securities

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Secondary markets

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Markets that provide for trading of previously issued securities among investors.

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Over-the-counter market (OTC)

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Market that is a dealer market. It consists of numerous brokers and dealers who are linked by telecommunications equipment that enables them to trade throughout the country.

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Financial Intermediaries

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specialized firms that help create and exchange the instruments of financial markets. Examples include commercial banks, life insurance companies, private pension funds, mutual funds, finance companies, and money market funds.

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Efficient Markets hypothesis

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states that current stock prices immediately and fully reflect all relevant information. Hence the market is continuously adjusting to new information and acting to correct pricing errors.

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fundamental analysis

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the evaluation of a security's future price movement based upon sales, internal developments, industry trends, the general economy, and expected changes in each factor.

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technical analysis

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the evaluation of a security's future price based on the number of shares traded in a series of recent transactions.

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3 forms of the efficient markets hypothesis

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1. strong form

2. Semi-strong form

3. Weak form

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Strong form

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all public and private information in instantaneously reflected in securities' prices. thus insider trading is assumed not to result in abnormal returns.

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Semi-strong form

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all publicly available data are reflected in security prices, but private or insider data are not immediately reflected. Accordingly, insider trading can result in abnormal returns.

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Weak form

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current securities

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AAA and AA

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Highest rating for Standard & Poor's ratings, signifying little chance of default and high quality

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A- and BBB-

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Standard and Poor's bonds that are of investment grade. they have strong interest and principal paying capabilities.

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BB

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Standard and Poor's rating of debt that is below speculative; junk bonds - high yield or low grade

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CCC and D

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Standard and Poor's rating of debt that is very poor. the likelihood of default is significant or already in default

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Investment Banking

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serve as intermediaries between businesses and the providers of capital

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The best efforts of the investment banker

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provides no guarantee that the securities will be sold or that enough cash will be raised.

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underwriting

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the investment banker agrees to purchase the entire issue and resell it - a firm commitments provides a guarantee

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Flotation costs

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the costs of issuing new securities - taxes, fees, management time, attorney's fees

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Advantages of going public

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1. the ability to raise additional funds

2. the establishment of the firms value in the market

3. An increase in the liquidity of the firms stock

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Disadvantages of going public

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1. costs of the reporting requirements of the SEC

2. access to the company's operating data by competing firms

3. access to the net worth information of major shareholders

4. limitations on self-dealing by corporate insiders

5. pressure from outside shareholders for earnings growth

6. Stock prices that do not accurately reflect the true net worth of the company

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Zero - coupon or deep discount bonds

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bonds that bear no stated rate of interest and thus involve no periodic cash payments; the interest component consists entirely of the bond's discount.

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commodity-backed bonds

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bonds that are payable at prices related to a commodity such as gold

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callable bonds

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bonds that may be repurchased by the issuer at a specified price before maturity.

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convertible bonds

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bonds that may be converted into equity securities of the issuer at the option of the holder under certain conditions

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Mortgage bonds

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bonds that are backed by specific assets, usually real estate

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debentures

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bonds that are backed by the borrower's general credit but not specific collateral - riskier to investors that secured bonds

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Equipment trust bonds

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bonds that are secured by a lien on a specific piece of equipment, such as an airplane or a railroad car.

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registration bonds

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bonds that are issued in the name of the holder. only the registered holder may receive interest and principal payments

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Bearer bonds

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bonds that are not individually registered. interest and principal are paid to whomever presents the bond

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Subordinated debentures and second mortgage bonds

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bonds that are junior securities with claims inferior to those of senior bonds

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Income bonds

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bonds that pay interest contingent on the issuers profitability

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Revenue bonds

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bonds that are issued by governmental units and are payable from specific revenue sources

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indenture

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Document stating the terms of the agreement of bonds

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Par value, maturity amount, or face amount

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the amount of money to be paid in the formal contractual obligation of a bond

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Stated rate or coupon rate

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a specified percentage to be paid the holder of a bond in addition to the par value

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Sinking fund

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may be required by the issue with the objective of making payments into the fund to segregate and accumulate sufficient assets to pay the bond principal at maturity.

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Advantages of Bonds

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1. interest paid is tax deductible

2. basic control of the firm is not shared with debtholders

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Disadvantages of Bonds

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1. unlike returns on equity investments

2. The legal requirement to pay debt services raises a firms risk level

3. the long-term nature of bond debt also affect risk profiles

4. Certain managerial prerogatives are usually given up in the contractual relationship outlined in the bonds indenture contract

5. the amount of debt financing available to the individual is limited

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Present value of bonds face amount

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face amount x present value factor

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Present value of cash interest

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Annual cash interest payments x present value factor

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Cash proceeds from bond issue

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PV of Face amount - PV of Cash interest. If cash proceeds exceed the face amount the bonds are issued at premium. If cash proceeds are less then face amount the bonds are issued at a discount.

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return on investment

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Amount received - Amount invested

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Rate of Return

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Return on investment / Amount invested

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Systematic risk (market risk)

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the risk faced by all firms. Changes in the economy as a whole, such as business cycle, affects all players in the market. undiversifiable risk

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Unsystematic risk (company risk)

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the risk inherent in a particular investment security. this type of risk is determined by the issuer's industry, products, customer loyalty, degree of leverage, management competence. diversifiable risk

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credit risk

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the risk that the issuer of debt security will default.

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foreign exchange risk

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the risk that a foreign currency transaction will be affected by fluctuations in exchange rates

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interest rate risk

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the risk that an investment security will fluctuate in value due to changes in interest rates. In general, the longer the time until maturity, the greater the degree of interest rate risk

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Political risk

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the probability of loss from actions of governments, such as from changes in tax laws or environmental regulations or from expropriation of asstes.

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liquidity risk

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the risk that a security cannot be sold on short notice for it market value

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Financial risk

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the risk of an adverse outcome based on a change in the financial markets, such as changes in interest rates or changes in investors desired rates of return.

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rank of lowest risk to highest risk

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1. U.S. treasury bonds

2. first mortgage bonds

3. second mortgage bonds

4. subordinated debentures

5. income bonds

6. preferred stock

7. convertible preferred stock

8. common stock

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expected rate of return

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sum (possible rate of return x probability)

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correlation coefficient

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has a range of 1.0 to -1.0. it measures the degree to which any two variables are related.

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perfect positive correlation

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means that the two variables always move together, equal to 1.0

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perfect negative correlation

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means that the two variables always move in the opposite direction, equal to -1.0. risk would in theory be eliminated.

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Covariance

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the correlation coefficient of two securities can be combined with their standard deviations to arrive at this, a measure of their mutual volatility.

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Covariance of a two stock portfolio

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correlation coefficient x standard deviation1 x standard deviation2

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Specific risk

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the risk associated with specific investee's operations: new products, patents, acquisitions, competitors' activities. also called diversifiable risk, unsystematic risk, residual risk, and unique risk. can be eliminated with diversification.

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Market risk

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is the risk of the stock market as a whole, also caled undiversifiable risk and systematic risk.

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Beta coefficient

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the sensitivity of an individual security on the volatility of a portfolio by the overall market

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measurement of a stocks beta coefficient

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1. average stock have a beta of 1 because its returns are perfectly positively correlated with those on the market portfolio

2. beta of less than 1 means that security is less volatile

3. beta over 1 indicates a volatile security

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Market risk premium

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Market return - Risk free return

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CAPM formula

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required rate of return = Risk free return + beta (market return - Risk free return)

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Advantages of common stock

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1. does not require fixed dividend

2. there is no fixed maturity date for repayment

3. sale increases the creditworthiness of the firm

4. more attractive to investors because it grows in value with success of the firm

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Disadvantages of common stock

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1. cash dividends are not tax deductible

2. control (voting rights) is usually diluted as more common stock is sold

3. new common stock sales dilute earnings per share available to existing shareholders

4. underwriting costs are typically higher

5. too much equity may raise the average costs of capital of the firm above its optimal level

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advantages of preferred stock

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1. builds creditworthiness

2. control is still held by common shareholders

3. superior earnings of the firm are usually still reserved for the common shareholders

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disadvantages of preferred stock

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1. cash dividends are not tax deductible

2. accumulated unpaid dividends may create major managerial and financial problems for the firm

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Constant Growth dividend discount model

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Dividend per share / Discount rate - dividend growth rate

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Preferred stock valuation

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Dividend per share / Cost of capital

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common stock with variable dividend growth

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1. calculate sum of PV of dividends in period of high growth

2. dividend per share / Discount rate - dividend growth rate

3.Sum the totals

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Earnings per share

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Net income available to common shareholders / Avg. shares outstanding

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Book value per share

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Shareholders equity / shares outstanding

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dividend yield

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Dividend per share / Market value per share

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price earnings ratio

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Market price / EPS

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market to book ratio

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market price per share / book value per share

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prices-sales ratio

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market price per share \ sales per share