WEEK 5 Stock Valuation and Risk

Chapter Outline

 Stock valuation methods

 Determining the required rate of return to value stocks

 Factors that affect stock prices

 Measure the risk of stocks

 Concept of stock market efficiency

Stock Valuation Methods

 The price-earnings (PE) method assigns the mean PE ratio based on expected earnings of
all traded competitors to the firm’s expected earnings for the next year

◦ Assumes future earnings are an important determinant of a firm’s value

◦ Assumes that the growth in earnings in future years will be similar to that of the
industry

 Price-earnings (PE) method (cont’d)

◦ Reasons for different valuations

 Investors may use different forecasts for the firm’s 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 Method

A firm is expected to generate earnings of $2 per 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
firm’s shares according to the PE method?

Valuation per share=(Expected earnings of firm per share )×( Mean industry PE ratio)
=$2×14=$28

 Dividend discount model

◦ John Williams (1931) stated that the price of a stock should reflect the present
value of the stock’s future dividends:

∞ Dt
Price=∑
t=1 (1+k )t

 D can be revised in response to uncertainty about the firm’s cash flows

 k can be revised in response to changes in the required rate of return by

investors

◦ For a constant dividend, the cash flow is a perpetuity:

∞ Dt D
Price=∑ t
=
t=1 ( 1+ k ) k

◦ For a constantly growing dividend, the cash flow is a growing perpetuity:

∞ Dt D1
Price=∑ t
=
t =1 (1+ k ) k −g

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 firm’s stock. According to the dividend discount
model, what is a fair price for the firm’s stock?

∞ Dt D $ 2 .10
Price=∑ t
= = =$ 14
t=1 (1+k ) k 15 %
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 firm’s stock. According to the dividend discount model, what is a fair price
for the firm’s stock?

∞ Dt D1 $ 2 . 10
Price=∑ t
= = =$ 17 .50
t=1 (1+k ) k −g 15 %−3 %

◦ Relationship between dividend discount model and PE ratio

 The dividend discount model is influenced by the required rate of return

and the expected growth rate.

 The inverse relationship between required rate of return and value exists in
both models

 The positive relationship between a firm’s growth rate and its value exists
in both models

◦ 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

 Adjusting the dividend discount model

◦ The value of the stock is:

 The PV of the future dividends over the investment horizon

 The PV of the forecasted price at which the stock will be sold

◦ Must estimate the firm’s EPS in the year they plan to sell the stock
by applying an annual growth rate to the prevailing EPS
Using the Adjusted Dividend Discount Model

Parker Corp. currently has earnings of $10 per share. Investors expect that the EPS will growth
by 3 percent per year and expect to sell the stock in four years. What is the EPS in four years?

Forecasted earnings in n years=E( 1+G ) n

¿ $ 10×( 1 . 03)4 =$ 11 . 26

Other firms in Parker’s industry have a mean PE ratio of 7. What is the estimated stock price in
four years?

Stock price in 4 years=(Earnings in 4 years )×( PE ratio of industry)

=$ 11. 26×7=$ 78. 82

◦ Limitations of the adjusted dividend discount model

 Errors can be made in deriving the PV of dividends over the investment

horizon or the forecasted price at which the stock can be sold

 Errors can be made if an improper required rate of return is used

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 stock’s return and the market’s
return:

R j=R f +B j ( R m−Rf )
  The capital asset pricing model (cont’d)

◦ 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 firm’s beta

 Beta reflects the sensitivity of the stock’s return to the market’s 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 10%. What is the required rate of return of Fantasia Corp. according to the CAPM?

R j=R f +B j ( R m−Rf )
¿ 5 %+1 .7 (10 %−5 %)
¿ 13. 5 %
Determining the Required Rate of Return to Value Stocks (cont’d)

 The capital asset pricing model (cont’d)

◦ Limitations of the CAPM

 A study by Fama and French found that beta is unrelated to the return on
stock over the 1963–1990 period

 Chan and Lakonishok:

◦ Found that the relation between stock returns and beta varied with
the time period used

◦ Concluded that it is appropriate to question whether beta is the

driving force behind stock returns

◦ Found that firms with the highest betas performed much worse
than firms with low betas

◦ Found that high-beta firms outperformed low-beta firms during

market upswings

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

◦ Impact of the dollar’s exchange rate value

  The value of the dollar affects U.S. stocks because:

 Foreign investors purchase U.S. stocks when the dollar is weak

 Stock prices are affected by the impact of the dollar’s changing

value on cash flows

 Some U.S. firms are involved in exporting

 U.S.-based MNCs have some earnings in foreign currencies

 Exchange rates may affect expectations of other economic factors

 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

 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 industry’s products

◦ Market participants focus on announcements that signal information about a

firm’s sales growth, earnings, or characteristics that cause a revision in the
expected cash flows

◦ Dividend policy changes

 An increase in dividends may reflect the firm’s expectation that it can

more easily afford to pay dividends

◦ Earnings surprises

 When a firm’s announced earnings are higher than expected, investors

may raise their estimates of the firm’s future cash flows

◦ Acquisitions and divestitures

 Expected acquisitions typically result in an increased demand for the

target’s 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

 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 firm-specific conditions
Stock Risk

 Risk reflects the uncertainty about future returns such that the actual return may be less
than expected

 The holding period return is measured as:

( SP−INV )+ D
R=
INV

◦ The main source of uncertainty is the price at which the stock can be sold

◦ Dividends tend to be much more stable than stock price

 Measures of risk

◦ The volatility of a stock:

 May indicate the degree of uncertainty surrounding the stock’s future

returns

 Reflects total risk because it reflects movements in stock prices for any
reason

 Measures of risk (cont’d)

◦ The volatility of a stock portfolio depends on:

 The volatility of the individual stocks in the portfolio

 The correlations between returns of the stocks in the portfolio

 The proportion of total funds invested in each stock

 A portfolio containing some stocks with low or negative correlation will

exhibit less volatility

σ p = √ w2i σ 2i +w 2j σ 2j +2 w i w j σ i σ j CORRij
◦ 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 =B 0 +B1 Rmt +ut

◦ 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:

B p =∑ w i Bi

◦ The risk of a high-beta portfolio can be reduced by replacing some

of the high-beta stocks with low-beta stocks

◦ Value at risk:

 Is a risk measurement the estimates the largest expected loss to a particular

investment position for a specified confidence level

 Became very popular in the late 1990s after some mutual funds and
pension funds experienced abrupt large losses

 Is intended to warn investors about the potential maximum loss that could
occur

 Focuses on the pessimistic portion of the probability distribution of returns

Is commonly used to measure the risk of a portfolio
Stock Performance Measurement

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

R̄− R̄f
Sharpe index=
σ

◦ The higher the stocks’ mean return relative to the mean risk-free 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?

R̄ − R̄ f
Sharpe index=
σ
15 %−8 %
¿ =0 . 54
13 %

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

R̄− R̄f
Treynor index =
B

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

R̄− R̄ f
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

 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)

 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 and Performance

 Valuation of foreign stocks

◦ PE method

 The expected EPS of the foreign firm are multiplied by the appropriate PE
ratio based on the firm’s risk and local industry

 The PE ratio for a given industry may change continuously in some

foreign markets
  The PE ratio for a particular industry may need to be adjusted for the
firm’s country

◦ Dividend discount model

 An adjustment for expected exchange rate movements is required

 The value of foreign stocks from a U.S. perspective is subject to more

uncertainty than the value of the stock from a local investor’s perspective

 Measuring performance from investing in foreign stocks

◦ The performance measurement should control for general market movements and
exchange rate movements in the region where the portfolio managers has been
assigned to invest funds

 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

◦ 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
WEEK 6 MARKET MICROSTRUCTURE AND STRATEGIES

Chapter Outline

 Common types of stock transactions

 How stock transactions are executed

 Regulation of stock transactions

 How barriers to international stock trading have been reduced

Stock Market Transactions

 Placing an order

o Brokerage firms:

 Serve as financial intermediaries between buyers an sellers of stock

 Receive orders from customers and pass the orders on to the exchange
through a telecommunications network

o Full-service brokers offer advice to customers on stocks to buy or sell

 Charge about 4 percent of the transaction amount

o Discount brokers only execute the transactions

 Charge about 1 percent of the transaction amount

o The larger the transaction amount the lower the percentage charged by many
brokers

o Investors communicate their order to brokers by specifying:

 The name of the stock

 Whether to buy or sell that stock

 The number of shares to be bought or sold

 Whether the order is a market order or a limit order

 o A market order to buy or sell a stock means to execute the transaction at
the best possible price

o A limit order differs from a market order in that a limit is placed on the
price at which a stock should be purchased or sold

o Stop-loss orders:

 Are orders where the investor specifies a selling price that is below
the current market price of the stock

 Are typically placed by investors to either protect gains or limit

losses

o Stop-buy orders are orders where the investor specifies a purchase price
that is above the current market price

o Placing an order online

 Many brokers accept orders online, provide real-time quotes, and

provide access to information

 Individual investors maintain more than 5 million online brokerage

accounts

 About one of every seven stock transactions is initiated online

 Traditional brokers have started to offer some online services

 Some of the more popular online brokers include Ameritrade,

Charles Schwab, Datek, E*Trade, and National Discount Brokers

 Average execution speed is about 8 seconds

 Margin trading

o A margin trade involves cash along with funds borrowed from the broker

o The Federal Reserve imposes margin requirements which limit the

amount of credit brokers can extend to their customers
  Currently, at least 50 percent of an investor’s invested funds must
be paid in cash

 Margin requirements are intended to ensure that investors can

cover their position if the value of their investment declines over
time

o Investors:

 Must establish a margin account with their broker

 Are required to satisfy a maintenance margin

 Initially satisfy the maintenance margin with the initial margin

o Impact on returns

 The return on stocks purchased on margin is:

SP−INV −LOAN + D
R=
INV

Computing the Return on A Margin Purchase

Billy purchases a stock on margin, borrowing 50% of the funds necessary to complete the
purchase. The stock is currently priced at $50 per share, and the stock pays an annual dividend of
$.50 per share. The brokerage firm charges an annualized interest rate of 8%. After one year, the
stock is sold at a price of $55 per share. What is the return on the margin transaction?

SP−INV −LOAN +D
R=
INV
$ 55−$ 25−$ 27+$ .50
=
$ 25
=14 %
Reconsider the previous example, but assume that the stock declined from $50 to $47 per share
over the one year period. What would the return on the margin transaction have been in this
case?

SP−INV −LOAN +D
R=
INV
$ 47−$ 25−$ 27+$ . 50
=
$ 25
=−18 %

 Margin trading (cont’d)

o Impact on returns (cont’d)

 Purchasing stock on margin increases the potential return but magnifies the
potential losses

Computing the Return on A Cash Purchase

Compute the return that would have been realized in the previous two examples if Billy had paid
the entire price of the stock, without borrowing on margin.

Stock Rises to $55:

$ 55−$ 50+$ .50

R= =11%
$ 50

Stock Falls to $47:

$ 47−$ 50+$ .50

R= =−5 %
$ 50

 Margin calls

o If the investor’s equity no longer represents the minimum percentage of the

stock’s value required by the broker, the investor may receive a margin call

o With a margin call, the investor is required to provide more collateral

(cash or stocks) or sell the stock
 o The volume of margin lending on the NYSE reached a peak of $278
billion in March 2000 and declined to $165 billion by August 2001

 Short selling

o In a short sale, investors place an order to sell a stock that they do not own

o Short sellers:

 Anticipate a price decline

 Essentially borrow the stock from another investor and will ultimately have
to provide that stock back to the investor

 Make a profit equal to the difference between the original sell price and the
price paid for the stock after subtracting any dividend payments made

o Measuring the short position of a stock

 The ratio of the number of shares sold short divided by the total number of
shares outstanding is a measure of the degree of short positions

 The short interest ratio is the shares sold short divided by the average daily
trading volume

 The higher the short interest ratio, the higher the level of short sales

 The short interest ratio is also measured for the market to determine the
level of short sales for the market overall

o Using a stop-buy order to offset short selling

 Investors who have established a short position commonly request a stop-

buy order to limit their losses

 e.g., an investor sells shares short for $50 per share and places a stop-buy
order with a purchase price of $60
  If the stock price rises to $60 or over, the investor will pay approximately
$60 per share

How Trades Are Executed

o Floor brokers:

 Are situated on the floor of stock exchanges

 Receive requests from brokerage firms to fulfill orders and execute them

o Specialists and market-makers

 Specialists:

 Can serve a broker function

 Gain from the bid-ask spread

 Take position in specific stocks to which they are assigned

 Have access to the limit order book

 Typically handle between 5 and 8 stocks each

 Are mostly employed by one of seven specialist firms

 Are required to signal floor brokers if they have unfilled orders

 Make a market in stock they are assigned by standing ready to buy or sell
assigned stocks if no other investors are willing to participate

 Participate in about 10 percent of the value of all shares traded

 Can set the spread to reflect their preferences

 Front running involves the specialist setting a price below the price offered by other
investors

 May prevent other investors from having their orders executed if the price
reverses as a result
  The “trade-through rule” on the NYSE requires that an order for stocks must be
executed on the exchange that offers the best price

 In 2004:

 The SEC investigated several specialist firms for various illegal activities

 The SEC allows investors to circumvent the trade-through rule

 Transactions in the Nasdaq market are facilitated by market makers, who:

 Stand ready to buy stocks in response to customer orders made through a

telecommunications network

 Benefit from the spread between the bid and ask prices

 Can take positions in stocks

 Often take positions to capitalize on the discrepancy between the prevailing stock
price and their own valuation

 Effect of the spread on transactions costs

 The spread:

 Is the difference between the ask and bid prices and is commonly measured as a
percentage of the ask price

 Is separate from the commission charged by the broker

 Has declined substantially over time due to increased efficiency of executing

orders and increased competition from ECNs

Computing the Spread

Your broker quotes a bid price of $28.50 and an ask price of $29.05 for Palmetto stock. What is
the bid-ask spread?
 $29.05−$ 28 .50
Spread=
$29.05
=1 .89 %

o The spread is influenced by the following factors:

 Order costs (+) represent the cost of processing orders, including clearing costs and
recording transactions

 Inventory costs (+) represent the cost of maintaining an inventory of a particular stock

 If interest rates are high, the opportunity cost of holding inventory is high

 Competition (–) reduces the spread

 Volume (–) increases liquidity and reduces the risk of a sudden decline in the stock’s
price

 Risk (+) increases volatility and the risk for the specialist or market-maker

Proses Pelaksanaan di Bursa

Proses Pelaksanaan Perdagangan secara Remote
How Trades Are Executed (cont’d)

o Electronic communication networks (ECNs):

 Are automated systems for disclosing and sometimes executing stock trades

 Were created in the mid-1990s to publicly display buy and sell orders of stock

 Were adapted to facilitate the execution of orders and normally serve institutional
rather than individual investors

 Are appealing to traders because they do not require traders to execute the transaction

 Now account for about 30 percent of the total trading volume on the Nasdaq

 Execute a small proportion of all transactions on the NYSE

 Some ECNs focus on market orders while others focus on limit orders

 When a new limit order matches an existing order, the transaction is immediately
executed
  Archipelago serves as an ECN for many online buyers and sellers

 Established the first truly electronic stock exchange which allows trading of
NYSE, AMEX, and Nasdaq stocks

 Island facilitates the trading of about 100 million shares per day on the Nasdaq

 Instinet facilitates daily stock transactions requested by U.S. financial institutions after
the U.S. exchanges are closed

o Interaction between direct access brokers and ECNs

 A direct access broker is a trading platform on a computer website that allows

investors to trade stocks without the use of a broker

 The website serves as the broker and interacts with ECNs that can execute the trade

 Examples include Schwab’s CyberTrader, Touch Trade, FidelityTrading, and

NobleTrading

 To use a direct access broker, investors must meet certain requirements

o Program trading

 The NYSE defines program trading as the simultaneous buying and selling of a
portfolio of at least 15 different stocks that are in the S&P 500 index and have an
aggregate value of more than $1 million

 The most common program traders are large securities firms

 Program trading is commonly used to reduce the susceptibility of a stock portfolio to

stock market movements

 Program trading can be combined with the trading of stock index futures to create
portfolio insurance

 More than 20 million shares per day are traded as a result of program trading

 Impact of program trading on stock volatility

 Program trading can cause share prices to reach a new equilibrium more rapidly
  Furbush found that greater declines in stock prices were not systematically
associated with more intense program trading during the 1987 crash

 Roll found that markets that do not use program trading declined more than
markets using program trading around the 1987 crash

 Collars applied to program trading

 Collars (“curbs”) on the NYSE restrict program trading when the DJIA changes
by 2 percent from the closing index on the previous trading day

 Program selling is allowed only when the last movement in the stock’s
price was an uptick

 Program buying is allowed only when the last movement in the stock’s
price was a downtick

 Collars are intended to prevent program trading from adding momentum to the
prevailing direction of movement

Regulation of Stock Trading

 Stock trading is regulated by the individual exchanges and by the SEC

o The Securities Act of 1933 and the Securities Exchange Act of 1934 were enacted to
prevent unfair or unethical trading practices on the security exchanges

o The NYSE:

 States that every transaction made at the exchange is under surveillance

 Uses a computerized system to detect unusual trading

 Employs personnel who investigate any abnormal price or trading volume

o In 2002, the NYSE required its listed firms to have their board of directors composed of
a majority of independent members

 Intended to reduce potential conflict of interests

  The NYSE was criticized in 2003 for not abiding by some of the governance
guidelines it was requiring of other firms

o Circuit breakers:

 Are restrictions on trading when stock prices or a stock index reaches a specified
threshold level

 Currently have three levels on the NYSE for a daily change in the DJIA from its
previous closing price:

 Level 1 (10%) resulting in a 30- or 60-minute trading halt

 Level 2 (20%) resulting in a 1- to 2-hour trading halt

 Level 3 (30%) resulting in the market closing for the day

o Trading halts:

 Can be imposed for individual stocks if the stock exchange believes market
participants need more time to receive and absorb material information

 Are intended to reduce stock price volatility

o Securities and Exchange Commission (SEC)

 The Securities Act of 1933 and the Securities Exchange Act of 1934:

 Gave the SEC authority to monitor the exchanges

 Required listed companies to file a registration statement and financial

reports

 According to SEC regulations:

 Firms must publicly disclose all information about themselves that could
affect their stock price

 Employees of firms may only trade their own firm’s stock when they do not
have inside information
  Participants in security markets who facilitate trades must work in a fair and
orderly manner

 Structure of the SEC

 Composed of five commissioners appointed by the U.S. president and

confirmed by the Senate

 Commissioners have five-year staggered terms

 One commissioner chairs the SEC

 Commissioners assess whether existing regulations are successfully

preventing abuses ad revise regulations as needed

 Key divisions of the SEC

 The Division of Corporate Finance reviews the registration statement filed

when a firm goes public, corporate filings, and proxy statements

 The Division of Market Regulation requires the orderly disclosure of

securities trades by various organizations

 The Division of Enforcement assesses possible violations of the SEC’s

regulations and can take action against individuals or firms

 SEC oversight of corporate disclosure

 In October 2000, the SEC issued Regulation FD

 Requires firms to disclose relevant information broadly to investors at

the same time

 Some analysts suggest that Regulation FD has caused firms to disclose

less information

 SEC oversight of analyst recommendations

 The SEC has become concerned about analyst recommendations that appear
excessively optimistic
How Barriers to International Stock Trading Have Decreased

 Reduction in transaction costs

o Some countries have consolidated their exchange, increasing efficiency and

reducing transaction costs

 Eurolist

 The Swiss stock exchange

 Reduction in information costs

o Information via the Internet

o Attempts to make accounting standards uniform across countries

 Reduction in exchange rate risk

o The euro should lead to more stock offerings in Europe by U.S. and European-
based firms
WEEK 7 MONEY MARKETS

Chapter Outline

• Money market securities

• Institutional use of money markets

• Valuation of money market securities

• Risk of money market securities

• Interaction among money market yields

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 (cont’d)

• 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

  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

 Pricing Treasury bills

• The price is dependent on the investor’s required rate of return:

Pm=Par /(1+k )n

• Treasury bills do not pay interest

• To price a T-bill with a maturity less than one year, the annualized return
can be reduced by the fraction of the year in which funds would be
invested

Computing the Price of a Treasury Bill

A one-year Treasury bill has a par value of $10,000. Investors require a return of 8 percent on the
T-bill. What is the price investors would be willing to pay for this T-bill?

Pm=Par /(1+k ) n
¿ $ 10 , 000 /(1. 08 )
¿ $ 9 ,259
• Treasury bill auction
• Investors submit bids on T-bill applications for the maturity of their choice
• Applications can be obtained from a Federal Reserve district or branch
bank
• Financial institutions can submit their bids using the Treasury Automated
Auction Processing System (TAAPS-Link)
• Institutions must set up an account with the Treasury
 • Payments to the Treasury are withdrawn electronically from the
account
• Payments received from the Treasury are deposited into the
account
• Weekly auctions include 13-week and 26-week T-bills
• 4-week T-bills are offered when the Treasury anticipates a short-term cash
deficiency
• Cash management bills are also occasionally offered
• Investors can submit competitive or noncompetitive bids
• The bids of noncompetitive bidders are accepted
• The highest competitive bids are accepted
• Any bids below the cutoff are not accepted
• Since 1998, the lowest competitive bid is the price applied to all
competitive and noncompetitive bids
• 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
• Treasury bills (cont’d)
• Estimating the yield (cont’d)
• The annualized yield is:
SP−PP 365
Y T= ×
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
Y T= ×
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 %
• 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 firm’s 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
 Has no active secondary market
 Is typically not purchased directly by individual investors
 Ratings
• The risk of default depends on the issuer’s financial condition and cash
flow
 • Commercial paper rating serves as an indicator of the potential risk of
default
• Corporations can more easily place commercial paper that is assigned a
top-tier rating
• Junk commercial paper is rated low or not rated at all
 Volume of commercial paper:
• Has increased substantially over time
• Is commonly reduced during recessionary periods
 Placement
• Some firms place commercial paper directly with investors
• Most firms rely on commercial paper dealers to sell
• Some firms (such as finance companies) create in-house departments to
place commercial paper
 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 T-bill
• 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
Y cp = ×
289,000 120
¿ 11. 42 %
 The commercial paper yield curve:
• Illustrates the yield offered on commercial paper at various maturities
 • Is typically established for a maturity range from 0 to 90 days
• Is similar to the short-term range of the Treasury yield curve
• Is affected by short-term interest rate expectations
• Is similar to the yield curve on other money market instruments

o Negotiable certificates of deposit (NCDs):

 Are issued by large commercial banks and other depository institutions as a short-
term source of funds
 Have a minimum denomination of $100,000
 Are often purchased by nonfinancial corporations
 Are sometimes purchased by money market funds
 Have a typical maturity between two weeks and one year
 Have a secondary market
 Placement
• Directly
• Through a correspondent institution
• Through securities dealers
 Premium
• NCDs offer a premium above the T-bill yield to compensate for less
liquidity and safety
 Yield
• NCDs provide a return in the form of interest and the difference between
the price at which the NCD was redeemed or sold and the purchase price
• If investors purchase a NCD and hold it until maturity, their annualized
yield is the interest rate
• 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
 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?
SP−PP 360
Repo rate= ×
PP n
10 , 000 , 000−9 ,913 , 314 360
= ×
9,913,314 90
=3 . 50 %

 Federal funds
o The federal funds market allows depository institutions to lend or borrow short-
term funds from each other at the federal funds rate
 The rate is influenced by the supply and demand for funds in the federal
funds market
 The Fed adjusts the amount of funds in depository institutions to influence
the rate
  All firms monitor the fed funds rate because the Fed manipulates it to
affect economic conditions
 The fed funds rate is typically slightly higher than the T-bill rate

o Two depository institutions communicate directly through a communications

network or through a federal funds broker
o The lending institution instructs its Fed district bank to debit its reserve account
and to credit the borrowing institution’s reserve account by the amount of the loan
o Commercial banks are the most active participants in the federal funds market

o Most loan transactions are or $5 million or more and usually have one- to seven-
day maturities
• Banker’s acceptances:
o Indicate that a bank accepts responsibility for a future payments

o Are commonly used for international trade transactions

• An unknown importer’s bank may serve as the guarantor

• Exporters frequently sell an acceptance before the payment date
o Have a return equal to the difference between the discounted price paid and the
amount to be received in the future
o Have an active secondary market facilitated by dealers

o Steps involved in banker’s 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 exporter’s bank
• The exporter sends the goods to the importer and the shipping documents
to its bank
• The shipping documents are passed along to the importer’s 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
o 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
• 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
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
o The discount rate is the required rate of return by investors

• Explaining money market price movements

o The price of a noninterest-paying money market security is:

Pm=Par /(1+k )n
o A change in the price can be modeled as:

ΔP m=f ( Δk ) and Δk=f ( ΔR f , Δ RP )

• Indicators of future money market security prices
o Economic growth is monitored since it signals changes in short-term interest rates
and the required return from investing in money market securities
 Employment
 GDP
 Retail sales
 Industrial production
 Consumer confidence
 Indicators of inflation
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
o Investors commonly invest in securities that offer a slightly higher yield than T-
bills and are very unlikely to default
o Although investors can assess economic and firm-specific conditions to determine
credit risk, information about the issuer’s financial condition is limited
• Measuring risk
o 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
Interaction Among Money Market Yields
• Money market instruments are substitutes for each other
• Market forces will correct disparities in yield and the yields among securities tend
to be similar
• In periods of heightened uncertainty, investors tend to shift from risky money market
securities to Treasuries
• Flight to quality
• Creates a greater differential between yields
Globalization of Money Markets
• Interest rate differentials occur because geographic markets are somewhat segmented
• Interest rates have become more highly correlated:
o Conversion to the euro
o The flow of funds between countries has increased because of:

 Tax differences
 Speculation on exchange rate movements
 A reduction in government barriers
o Eurodollar deposits, Euronotes, and Euro-commercial paper are widely traded in
international money markets
• Eurodollar deposits and Euronotes
 o Eurodollar certificates of deposit are U.S. dollar deposits in non-U.S. banks

• Have increased because of increasing international trade and historical

U.S. interest rate ceilings
o In the Eurodollar market, banks channel deposited funds to other firms that need
to borrow them in the form of Eurodollar loans
• Typical transactions are $1 million or more
• Eurodollar CDs are not subject to reserve requirements
• Interest rates are attractive for both depositors and borrowers
• Rates offered on Eurodollar deposits are slightly higher than NCD rates
o Investors in fixed-rate Eurodollar CDs are adversely affected by rising market
rates
o Issuers of fixed-rate Eurodollar CDs are adversely affected by declining rates

• Eurodollar-floating-rate CDs (FRCDs) periodically adjust to LIBOR

o The Eurocurrency market is made up of Eurobanks that accept large deposits
and provide large loans in foreign currencies
o Loans in the Eurocredit market have longer maturities than loans in the
Eurocurrency market
o Short-term Euronotes are issued in bearer form with maturities of one, three, and
six months
• Euro-commercial paper (Euro-CP):
o Is issued without the backing of a banking syndicate
o Has maturities tailored to satisfy investors

o Has a secondary market run by CP dealers

o Has a rate 50 to 100 basis points above LIBOR

o Is sold by dealers at a transaction cost between 5 and 10 basis points of the face
value
• Performance of foreign money market securities
o Measured by the effective yield (adjusted for the exchange rate

Y e=(1+Y f )×(1+%ΔS )−1

o Depends on:
 • The yield earned on the money market security in the foreign currency
• The exchange rate effect

Computing the Effective Yield

A U.S. investor buys euros for $1.15 and invests in a one-year European security with a yield of
8 percent. After one year, the investor converts the proceeds from the investment back to dollars
at the spot rate of $1.16 per euro. What is the effective yield earned by the investor?

Y e=(1+Y f )×(1+%ΔS )−1

¿1. 08×1.0087−1
¿8. 94 %