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1、3.FINANCIAL MARKETS AND INSTRUMENTS,Financial markets & instruments,Businesses raise money to finance current operations as well as for future growth Money is raised In financial markets (capital markets and money markets) By issuing financial instruments (also called securities) which give the hold
2、ers claims on future cash flows of the business,2,Financial markets,Financial markets describes the distribution system by which cash-deficit entities engage in transactions with cash-surplus entities. Besides businesses, participants include government agencies, pension funds, endowments, individua
3、ls, commercial banks, insurance companies Regulated by Securities & Exchange Commission Capital markets deal with long term instruments like stocks and bonds while money markets deal with short-term instruments with maturity less than one year such as commercial paper.,3,Financial instruments,Instru
4、ments must appeal to investors and meet the needs of the company. They are designed keeping in mindInvestors claims on future cash flows Investors right to participate in company decisions Investors claims on company assets in the event of liquidation SEC regulations require adequate disclosure befo
5、re purchase.,4,Types of instruments,Debt instruments offer fixed claims. Equity offers residual claims. Hybrids such as convertible debt combine both. Derivatives such as forwards , futures and options provide a hedge against risk,5,BONDS,Fixed income security interest paid periodically Repayment of
6、 principal at maturity. Bonds are sold to the public in small increments, such as $1000, and can be traded on an exchange after issue. Yield (return with reference to market price) inversely related to market price,6,Bond characteristics,Par value Maturity date Coupon rate Current yield vs. yield to
7、 maturity (YTM) Sinking fund for periodic repayment of principal Variable rate vs. fixed rate bonds,7,Call Provisions提前赎回条款,Right to retire bonds prior to maturity.Investors require a premium for call provisions. Call price is typically a modest premium above par. Delayed call prevents retirement be
8、fore some date. Call options help companies take advantage of declines in interest rates and rearrange capital structure,8,Covenants契约,Contractual terms to protect bondholders by impacting management decisions. Examples: Lower limit on current ratio Upper limit on D/E ratio Required approval by bond
9、holders before major acquisition or sale of assets Bondholders have no direct say in a company unless it defaults on its interest, sinking fund, or covenant obligations.,9,Rights in Liquidation清偿权利,Rights of absolute priority Government in respect to taxes past due Senior creditors General creditors
10、 Subordinated creditors Preferred shareholders Common shareholders,10,Secured Creditors,Secured credit involves collateral. In liquidation, proceeds from the sale of collateral only go to the secured creditor up to the amount of the secured credit. Any residual goes into the pool shared by the other
11、 investors. If the sale of collateral is insufficient, the secured creditor becomes a general creditor for the balance.,11,Bonds Issuers perspective,Advantages : Lower cost of funds Interest is tax deductible No loss of controlDisadvantages : Interest payment mandatory Redemption cash outflows,12,Bo
12、nds investors perspective,Fixed income , no capital appreciation Convertible bonds seek to provide both Risk return tradeoff Lesser risk than equity , lower returns Annualized returns over 10 yrs for Barclays Bond Index 7.6% vs. S&P 500 10.4% Also refer Table 5-1 Real vs. nominal returns ir = (1+in)
13、 / (1 + p) - 1 where ir = Real return, in = Nominal return, p = Inflation rate,13,TABLE 5-1 Rate of Return on Selected U.S. Securities 1900 - 2007,14,Bond ratings,Expression of the opinion of the rating agency on the creditworthiness of the borrower Measures credit risk / default risk Credit rating
14、agencies- S&P, D&B,Moodys AAA High creditworthiness BBB Adequate CCC - Poor D Default Bond ratings and interest rates,15,Junk Bonds,Investment grade is “BBB” and above. Junk bonds are speculative or high yield bonds and are below investment grade. Junk bond market is an alternative to bank and insur
15、ance company loans for smaller, less prominent companies. Junk bonds have been used to finance mergers and acquisitions.,16,EQUITY or COMMON STOCK,Residual income securities Represent ownership securities - proportionate to shareholding Right to control - Voting rights Shareholders are represented t
16、hrough a board of directors, through which they exercise control. Right in liquidation residual claim over assets Riskier than debt instruments,17,Risk and return,What is the expected rate of return on equity?Rate of return =Dividend yield + capital appreciation= Div/Mkt price + % change in share pr
17、ice Risk return tradeoff : Higher the risk in an investment , higher the expected returns Equity investors expect a risk premium to compensate for the enhanced risk So return on equity = Risk free rate + Risk premium Risk free rate taken as Govt. Bond rate Risk premium (Table 5-1) = 11.6 - 5.3= 6.3%,
