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1、3.FINANCIAL MARKETSAND INSTRUMENTS Financial markets&instrumentsBusinesses 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 holders clai
2、ms on future cash flows of the business2Financial marketsFinancial 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,individuals,commercial ba
3、nks,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.3Financial instrumentsInstruments must appeal to in
4、vestors and meet the needs of the company.They are designed keeping in mind Investors claims on future cash flowsInvestors right to participate in company decisionsInvestors claims on company assets in the event of liquidationSEC regulations require adequate disclosure before purchase.4Types of inst
5、rumentsDebt 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 risk5 BONDSFixed income security interest paid periodically Repayment of principal at maturity.Bonds are sol
6、d 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 price6Bond characteristicsPar valueMaturity dateCoupon rateCurrent yield vs.yield to maturity(YTM)Sinking fund for periodic repayment
7、of principalVariable rate vs.fixed rate bonds7Call 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 before some date.Call options help companies take advantage o
8、f declines in interest rates and rearrange capital structure8Covenants契约Contractual terms to protect bondholders by impacting management decisions.Examples:Lower limit on current ratioUpper limit on D/E ratioRequired approval by bondholders before major acquisition or sale of assetsBondholders have
9、no direct say in a company unless it defaults on its interest,sinking fund,or covenant obligations.9Rights in Liquidation清偿权利Rights of absolute priorityGovernment in respect to taxes past dueSenior creditorsGeneral creditorsSubordinated creditorsPreferred shareholdersCommon shareholders10Secured Cre
10、ditorsSecured 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 investors.If the sale of collateral is insufficient,the secured creditor becomes a g
11、eneral creditor for the balance.11Bonds Issuers perspectiveAdvantages:Lower cost of fundsInterest is tax deductibleNo loss of controlDisadvantages:Interest payment mandatoryRedemption cash outflows12Bonds investors perspectiveFixed income,no capital appreciationConvertible bonds seek to provide both
12、Risk return tradeoff Lesser risk than equity,lower returnsAnnualized returns over 10 yrs for Barclays Bond Index 7.6%vs.S&P 500 10.4%Also refer Table 5-1 Real vs.nominal returnsir=(1+in)/(1+p)-1 whereir=Real return,in =Nominal return,p=Inflation rate 13 TABLE 5-1 Rate of Return on Selected U.S.Secur
13、ities TABLE 5-1 Rate of Return on Selected U.S.Securities 1900-20071900-200714Bond ratingsExpression of the opinion of the rating agency on the creditworthiness of the borrower Measures credit risk/default riskCredit rating agencies-S&P,D&B,MoodysAAA High creditworthinessBBB AdequateCCC -PoorD Defau
14、lt Bond ratings and interest rates15Junk BondsInvestment 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 insurance company loans for smaller,less prominent companies.Junk bonds have been used to finan
15、ce mergers and acquisitions.16EQUITY or COMMON STOCKResidual income securitiesRepresent ownership securities-proportionate to shareholdingRight to control-Voting rightsShareholders are represented through a board of directors,through which they exercise control.Right in liquidation residual claim ov
16、er assetsRiskier than debt instruments17Risk and return What is the expected rate of return on equity?Rate of return=Dividend yield+capital appreciation =Div/Mkt price +%change in share priceRisk return tradeoff:Higher the risk in an investment,higher the expected returns Equity investors expect a r
17、isk premium to compensate for the enhanced risk So return on equity=Risk free rate+Risk premiumRisk free rate taken as Govt.Bond rateRisk premium(Table 5-1)=11.6 -5.3=6.3%18Common stock(contd)Advantages to investor *Higher returns than debt*Liquidity*Wealth sharingDisadvantages to investor *Higher r
18、isk *Dividend payment not mandatory19Common stock(contd)Advantages to issuer*Dividend payment not mandatory*No redemption cash outflows*Higher equity means better borrowing ability Disadvantages *Costlier source of funds than debt *Dilution in control *Dividends not tax deductible(unlike interest)20
19、A note on retained earningsReadily available source of funds internally(internal equity)No issue costsNo dilution in controlReflects the robustness of companys health and reduces dependance on outside fundingThe only point to be remembered is that retained earnings also has a cost in terms of opport
20、unity cost to investors21Higher priority over common stockholders in payment of dividends and in repayment of capitalAnnual fixed dividend at coupon rate x par valueDividend is discretionaryCumulative dividends featureDividend not tax deductible for issuerNo voting rights except in matters which con
21、cern themPREFERRED STOCK22Preferred stock(contd)To the investor:Lesser risk,but lesser returns and less liquid than common stock To the issuer:Lesser cost,dividend payment not mandatory(but not tax deductible),no loss of control 23 MARKET CHANNELSMarket Channels for raising fundsPrivate equityVentur
22、e capitalInitial public offers(IPOs)and seasoned equity issues(SEOs)Shelf registrationPrivate placementInternational markets24Private Equity FinancingSource of funds for startups,new or small businesses viewed as too risky for bank lending and too small to attract the attention of investors in publi
23、c markets.Funding done by strategic investors,venture capital firms who provide seed money with potential acquisition on their minds.25Private Equity PartnershipsStructured as limited partnerships with a specified duration such as 10 years.General partner is the private equity firm,which raises a po
24、ol of money from limited partners,such as institutional investors and insurance companies.Limited partners have limited liability.Typical fee structure is 2 and 20,the sum of a management fee and carried interest based on capital appreciation.Induce managers to create value over long run26 Venture c
25、apitalA venture capital company is a financing institution which joins an entrepreneur as a co-promoter in a project and shares the risks and rewards of the enterprise.Projects are generally high risk with potential high rewards.Sought by new/untried businesses having little/no access to public capi
26、tal/bank loans.27Venture capital-featuresLong term equity finance high stakes.Returns through capital gains at the time of exit by selling out equity holdings at high premiums.Selective-generally seek above average returns.Generally financing of new/untried technology,new/no track record promotersNo
27、t only financing but also active role in mgmt.Medium to long term investment horizon.Incentives to promoters on performance.28Exit routeGoing publicSale of shares to promoter.Sale of company to another company management buyin or buyout.Selling to a new investor.Liquidation29FIGURE 5-3 Venture Capit
28、al Investment in U.S.CompaniesFIGURE 5-3 Venture Capital Investment in U.S.Companies30Initial Public Offerings (IPOs)When companies raise capital for the first time by issuing new shares Seasoned equity offerings(SEOs)refer to issue of new shares by a company that is already publicly traded(already
29、made an IPO)Company assesses proposals from investment banks and chooses one managing underwriter31IPO RisksManaging underwriter advises the company on security designregisters the issue with the SEC(30-90 days)orchestrates a“road show”assembles an underwriting syndicate who engage in book buildingS
30、yndicate acts as wholesaler.Offer price set hours before stock goes public.Company bears price risk during the registration process;syndicate bears risk associated with unsold shares,which they cannot sell above the offer price.32Shelf registrationShelf registration is a general purpose registration
31、 giving broad terms of the securities to be issued,good up to two years,that allows the firm to get quick approval A single underwriter often buys the entire issue.Cuts the time lag from several months to a few days Competitive bids lower the issue costs.33Private PlacementCorporations can avoid reg
32、istering with SEC by placing the securities privately with institutional investors.The private placement market is about half the size of the public market,excluding bank loans.Attractive option if public investors not especially receptive for reasons of complexity.Advantages to company are quicker
33、and easier to negotiate,can be custom tailored to specific needs Disadvantage is that as unregistered securities they cannot be traded on financial markets less liquidRule 144A now allows for trading of privately placed securities among institutional investors.34Issue CostsFor privately negotiated t
34、ransactions,issue cost amounts to the investment banking fee.For public issues,there are also legal,accounting,and printing fees.Cost comparisons2.2%for straight debt.3.8%for convertible bonds.7.1%for secondary offerings.11%for IPOs.35ComparisonIPO Pvt.PlmntCapital raisedHighLesserDistributionWidely
35、 distributedLimitedDilution of ControlHighLowerFloatation cost&timeHighLower36Efficient MarketsIssues in raising new capitalTimingPricingMarket efficiency is with reference to how quickly prices in competitive markets respond to new informationEfficient market is one where prices adjust rapidly to n
36、ew information and current prices fully reflect available information 37Efficiency in DegreesA market is weak-form efficient when prices fully reflect all information about past pricesSemi-strong form efficient when prices fully reflect all publicly available informationstrong form efficient when pr
37、ices fully reflect all information,public or private.38Empirical evidence-implicationMarkets are not strong form efficient.With limited exceptions,markets are semi-strong form efficient and hencePublicly available information has no predictive power in respect to market prices.Typical investors shou
38、ld not expect to earn abnormal returns trading on publicly available information.It is pointless to time the purchase or sale of the firms securities.39Conclusions to DrawApart from market sentiment,managers can use private information about their own companies in making timing decisions.Pricing dec
39、isions in practice are based on Market value Fair valuePrice discovery thro book building 40Managing RiskRisk is defined as the variability of returns from the expected valuesIn financial markets volatility results in riskCompanies use derivatives to manage risk and incentivize managers.Derivatives
40、include forwards,futures,optionsSo called as their value is derived from that of the underlying assets which could be shares/currency/commodities 41Forward contractsYou can buy in spot market today for immediate delivery spot contract.You can contract today at a predetermined price for future delive
41、ry forward contract.By locking in a price today,you can avoid price riskAn exporter with 1 million receivable in 90 days,can sell (an importer with a payable can buy)at a predetermined rate in the forward marketFutures contracts are similar to forwards except that they are exchange traded(while forw
42、ards are bilateral)42 Option contractsForward contracts are obligations to deliver/accept delivery at a pre-specified price.Options are rights,but not obligations to either take delivery or to deliver,at a pre-specified(exercise or strike)price.Call options confer the right to buy the underlying sha
43、res at the strike pricePut options confer the right to sell the underlying shares at the strike priceThe option buyer pays a premium to the option seller(writer)for this right43Option contractsFor a call optionIn the money:When the spot exceeds the strike At the money:When the spot=strikeOut of the
44、money:When spot is less than strikeFor a put optionIn the money:When the spot is less than strike At the money:When the spot=StrikeOut of the money:When the spot exceeds strike44Valuing OptionsIn theory,the value of an option depends upon(Black Scholes model):The current price of the underlying assetThe options time to maturityThe options strike priceThe interest rateThe expected volatility on the underlying assetBut not the expected future value of the underlying asset45