Chapter 4

Financial Markets
 Outline
• Types and Functions of Financial Markets
A. The Money Markets
B. The Bond Market
C. The Stock Market
D. Derivatives
E. The Foreign Exchange Market
 Money Market Securities
• Money market securities:
- The term ―money market is a misnomer.
Money (currency) is not actually traded in the money
markets.
- 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
The Purpose of Money Markets

• Investors in Money Market: Provides a place for

warehousing surplus funds for short periods of time.
• Borrowers from money market provide low-cost source of
temporary funds.
• Corporations and governments use these markets
because the timing of cash inflows and outflows are not
well synchronized.
• Money markets provide a way to solve these cash-timing
problems.
Money Market Instruments

• Money Market Instruments includes:

• Treasury Bills
• Federal Funds
• Repurchase Agreements
• Negotiable Certificates of Deposit
• Commercial Paper
• Eurodollars
 Treasury Bills
- Are issued by the U.S. Treasury/NBE
- Are sold weekly through an auction
- Have a par value of $1,000/ Br. 100
- 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
 Computing the Price of a Treasury Bill

A one-year Treasury bill has a par value of Br. 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?
 Cont’d

•Risk
• Treasury bills have virtually zero default risk
because even if the government ran out of money,
it could simply print more to redeem them when
they mature.
• The risk of unexpected changes in inflation is also
low because of the short term to maturity.
• The market for Treasury bills is extremely deep and
liquid.
• A deep market is one with many different buyers
 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
- 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
 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?
 Negotiable Certificates of Deposit (NCDs):

o A bank-issued security that documents a deposit

and specifies the interest rate and the maturity
date.
• 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

• A firm sells Treasury securities, but agrees to buy them

back at a certain date (usually 3–14 days later) for a
certain price.
• This set-up makes a repo agreements essentially a short-
term collateralized loan.
• This is one market the Fed may use to conduct its
monetary policy, whereby the Fed purchases/sells
Treasury securities in the repo market.
• These work similar to the market for fed funds, but
nonbanks can participate.
 Repurchase Agreements

- 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?
 Federal Funds/Interbank Loan
- Short-term funds transferred (loaned or borrowed)
between financial institutions, usually for a period of
one day.
- Used by banks to meet short-term needs to meet
reserve requirements.
- Two depository institutions communicate directly
through a communications network or through a federal
funds broker
- 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
- Commercial banks are the most active participants in the
federal funds market
- usually have one- to seven-day maturities
 Banker's Acceptances
- 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
 Sequence of Steps in the Creation of A
Banker's Acceptance

1
/
Purchase Order /
'
.-
Importer Exporter
5 Shipment of Goods
.
\. /
,,
'-

4 L/C Notific ation

2 L/C Application

6 Shipping Dbcuments & Ti me Draft

3 L/C
..
Ethiopian Bank Shipping Documents Japanese Bank
(Importer's Bank) 7)& Time Draft Accepted (Exporter's Bank)
Eurodollars

• Eurodollars represent Dollar denominated deposits held in

foreign banks.
• The market is essential since many foreign contracts call for
payment in U.S. dollars due to the stability of the dollar, relative
to other currencies.
• The Eurodollar market has continued to grow rapidly because
depositors receive a higher rate of return on a dollar deposit in
the Eurodollar market than in the domestic market.
 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 (cont'd)

• 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
Chapter 4

Bonds
 Learning Objectives
1. Explain the relationship between bond pricing
and present value.
2. Define the relationship among a bond’s price
and its coupon rate, current yield, yield to
maturity, and holding period return.
3. Explain how bond prices are determined and
why they change.
4. Identify the three major types of bond risk:
default, inflation, and interest rate changes.
 Bond Market
• A bond is, very simply, a loan.
• A company or government that needs to raise money to finance an
investment could borrow money from its bank or,
• alternatively, it could issue a bond to raise the funds it needs by
borrowing from the investing public.
• With a bond, an investor lends in return for the promise to have the
loan repaid on a fixed date and (usually) a series of interest
payments.
• Bonds are commonly referred to as loan stock, debt or (in the case
of those which pay fixed income) fixed-interest securities.
• The feature that distinguishes a bond from most loans is that a bond
is tradable.
• Investors can buy and sell bonds without the need to refer to the
original borrower.
 Bond Market

• Although bonds do not often generate as much media

attention as shares, they are the larger market of the two
in terms of global investment value.
• Bonds are roughly equally split between government and
corporate bonds.
• Government bonds are issued by national governments
and by supranational agencies such as the European
Investment Bank and the World Bank and the African
Development Bank.
• Corporate bonds are issued by companies, such as large
banks and other large corporate listed companies, as well
as by state-owned enterprises, such as electricity utilities
or road-building companies.
 Bond Prices
• A standard bond specifies the fixed amounts
to be paid and the exact dates of the
payments.

How much should you be willing to pay for a

bond?

• That depends on the bond characteristics.

• We will examine four basic types.
 Bond Prices
1. Zero-coupon or discount bond
– Promise a single payment on a future date
– Example: Treasury bill

2. Fixed-payment loan
– Sequence of fixed payments
– Example: Mortgage or car loan

3. Coupon bond
– Periodic interest payments + principal repayment at maturity
– Example: U.S. Treasury Bonds and most corporate bonds

4. Consol
– Periodic interest payments forever, principal never repaid
– Example: U.K. government has some outstanding
 Zero-Coupon Bonds
• U.S. Treasury bills (T-bills) are the most
straightforward type of bond.
– Each T-bill represents a promise by the U.S.
government to pay $100 on a fixed future date.
– No coupon payments - zero-coupon bonds
– Also called pure discount bonds (or discount bonds)
since the price is less than face value - they sell at a
discount.
• Price of $100 face value zero-coupon bond
$100

(1  i) n
 Zero-Coupon Bonds
Assume i = 5%
Price of a One-Year Treasury Bill
100
  $95.24
(1  0.05)

Price of a Six-Month Treasury Bill

100
 1/ 2
 $97.59
(1  0.05)
 Fixed-Payment Loans
Conventional home mortgages and car loans are
fixed-payment loans.
– They promise a fixed number of equal payments at
regular intervals.
– Amortized loans - the borrower pays off part of the
principal along with the interest for the life of the loan.
• Value of a Fixed Payment Loan =
FixedPayment FixedPayment FixedPayment
 2   n
 (1 i) (1 i) (1 i)

• The sum of the present value of the payments.


 Coupon Bonds
• The issuer of a coupon bond promises to make
a series of periodic interest payments (coupon
payments), plus a principal payment at
maturity.
Price of Coupon Bond =
 CouponPayment CouponPayment CouponPayment 
PCB   1
 2
 ......  n 
 (1  i ) (1  i ) (1  i ) 

FaceValue

(1  i ) n
 Consols
• Consols or perpetuities, are like coupon bonds
whose payments last forever.
• The borrower pays only interest, never repaying
the principal.
• The U.S. government sold consols once in 1900,
but the Treasury has bought them all back.
• The price of a consol is the present value of all
future interest payments.
Yearly Coupon Payment
PConsol 
i
 Yield to Maturity
• The most useful measure of the return on
holding a bond is called the yield to maturity:
– The yield bondholders receive if they hold the
bond to its maturity when the final principal
payment is made. $5 $100

Price of 1yr 5% Coupon Bond =
(1  i ) (1  i )

• The value of i that solves the equation is the

yield to maturity.
 Yield to Maturity
• If Bond Price = $100,
Yield to maturity = the coupon rate

• If Bond Price > $100,

Yield to maturity < the coupon rate

• If Bond Price < $100,

Yield to maturity > the coupon rate

Bond Price   Yield to maturity 

 Yield to Maturity
• This relationship should make sense.
• If you pay $95 for a $100 face value bond, you
will receive both the interest payments and
the increase in value from $95 to $100.
• This rise in value is referred to as a capital gain
and is part of the return on your investment.
• When the price of a bond is higher than face
value, the bondholder incurs a capital loss.
 Current Yield
• Current yield is the measure of the proceeds
the bondholder receives for making a loan.
Yearly Coupon Payment
Current Yield 
Price Paid

• The current yield measures that part of the


return from buying the bond that arises solely
from the coupon payments.
• If the price is below par, the current yield will
be below the yield to maturity.
 Current Yield
Example:
1 year, 5% coupon bond selling for $99

Current Yield = 5  0.0505 , or 5.05%

99

Yield to maturity for this bond is 6.06

percent found as the solution to:
$5 $100
  $99
(1  i ) (1  i )
 Current Yield
• We can see the relationship between the
current yield and the coupon rate.
• Table 6.1 summarizes these relationships.
 Holding Period Returns
• The holding period return is the return to
holding a bond and selling it before maturity.
• The holding period return can differ from the
yield to maturity.
 Holding Period Returns
• The one-year holding period return is the sum of
the yearly coupon payment divided by the price
paid for the bond and the change in the price
divided by the price paid.
Yearly Coupon Payment Change in Price of the Bond
 
Price Paid Price of the Bond

= Current Yield + Capital Gain (as a %)

 Holding Period Returns
• Whenever the price of a bond changes, there
is a capital gain or loss.
• The greater the price change, the more
important that part of the holding period
return becomes.
• The longer the term of the bond, the greater
those price movements and associated risk
can be.
 The Bond Market and the
Determination of Interest Rates
• How are bond prices determined and why do
they change?
• We must look at bond supply, bond demand, and
equilibrium prices.
– First we will restrict discussion to the quantity of
bonds outstanding - stock of bonds.
– Secondly, we will talk about bond prices rather than
interest rates.
– Finally, we will consider the market for a one-year
zero-coupon bond with a face value of $100.
 The Bond Market and the
Determination of Interest Rates
• Assume an investor is planning to purchase a
one-year bond and hold until maturity.
– They have a one-year investment horizon.
– The holding period return equals the bond’s yield
to maturity - both determined directly from price.
• The present value formula shows the
relationship between price and yield as:

$100 $100  P
P or i 
1 i P
 Bond Supply, Bond Demand and
Equilibrium in the Bond Market
• Supply and demand determine bond prices
(and bond yields).
• The bond supply curve is the relationship
between the price and the quantity of bonds
people are willing to sell, all else equal.
• The higher the price of a bond, the larger the
quantity supplied.
– The bond supply curve slopes upward.
 Bond Supply, Bond Demand and
Equilibrium in the Bond Market
• The bond demand curve is the relationship
between the price and the quantity of bonds
that investors demand, all else equal.
• The price of bonds is inversely related to the
yield, the demand curve implies that the higher
the demand for bonds, the higher the yield.
• The bond demand curve slopes downward.
Bond Supply, Bond Demand and
Equilibrium in the Bond Market

Equilibrium is the
point at which
supply equals
demand.
 Bond Supply, Bond Demand and
Equilibrium in the Bond Market
• What if bond prices are above equilibrium?
– Quantity supplied > quantity demanded.
– With excess supply, supplier cannot sell bonds
they want at current price.
– Suppliers begin to cut the price.
– Excess supply puts downward pressure on the
price until supply equals demand.
 Bond Supply, Bond Demand and
Equilibrium in the Bond Market
• What if the price is below equilibrium?
– Those who wish to buy bonds cannot get what
they want at that price.
– They start bidding up the price.
– Excess demand puts upward pressure on the
price until supply equals demand.
 Bond Supply, Bond Demand and
Equilibrium in the Bond Market
• To understand bond prices, we really need to
understand what determines supply and
demand.
• Remember the distinction between moving
along a curve (change in quantity supplied or
demanded) versus a shift in the curve (change
in supply or demand).
• A shift in either supply or demand changes the
price of bonds, so it changes yields as well.
 Factors That Shift Bond Supply
1. Changes in Government Borrowing
– Any increase in the government’s borrowing needs
increases the quantity of bonds outstanding,
shifting the bond supply curve to the right.
2. Change in General Business Conditions
– As business conditions improve, the bond supply
curve shifts to the right.
3. Changes in Expected Inflation
– When expected inflation rises, the cost of
borrowing falls, shifting the bond supply curve to
the right.
Factors That Shift Bond Supply
When borrowers’
desire for funds
increases, the
supply curve shifts
to the right.

This lowers bond

prices, thereby
raising interest
rates.
Factors That Shift Bond Demand
1. Wealth
– Increases in wealth shift the demand for bonds to the
right.
2. Expected Inflation
– Declining inflation means promised payments have
higher value - bond demand shifts right.
3. Expected Returns and Expected Interest Rates
– If the expected return on bonds rises relative to the
return on alternative investments, bond demand will
shift right.
– When interest rates are expected to fall, prices are
expected to rise shifting bond demand to the right.
Factors That Shift Bond Demand
4. Risk Relative to Alternatives
– If bonds become less risky relative to alternative
investments, demand for bonds shifts to the
right.
5. Liquidity Relative to Alternatives
– Investors like liquidity: the more liquid the bond,
the higher the demand.
Factors That Shift Bond Demand

When bonds
become more
attractive for
investors, the
demand curve
shifts to the right.

This raises bond

prices, lowering
interest rates.
Factors That Shift Bond Demand
Factors That Shift Bond Demand
 Understanding Changes in
Equilibrium Bond Prices and Interest
Rates
• Increasing expected inflation
– Reduces the real cost of borrowing shifting bond
supply to the right.
– But, lowers real return on lending, shifting bond
demand to the left.
 Why Bonds Are Risky
Bonds are a promise to pay a certain amount in
the future. How can that be risky?
1. Default risk - the chance the bond’s issuer
may not make payment.
2. Inflation risk - investor cannot be aware of
the real value of the payments made.
3. Interest rate risk - a rise in interest rates
before bond is sold could mean a capital
loss.
 Understanding Changes in
Equilibrium Bond Prices and Interest
Rates
S0 1) Shift S right

S1 2) Shift D left
E0
These two effects
Price per Bond

reinforce each other.

• Lower bond prices
• Raise interest rates
E1 However, graphically
unknown effect on
D0
quantity of bonds.
D1

Quantity of Bonds
 Understanding Changes in
Equilibrium Bond Prices and Interest
Rates
• A business cycle downturn:
– Reduces business investment opportunities shifting
bond supply to the left.
– Reduces wealth, shifting bond demand to the left
also.
• Although both shifts could give an ambiguous
answer in terms of bond price, theory is not
ambiguous.
– In recessions, interest rates tend to fall meaning
that bond prices should rise.
 Understanding Changes in
Equilibrium Bond Prices and Interest
Rates
S1
1) Shift S left

2) Shift D left
S0
E1
We know price
Price per Bond

increases so
E0 supply shifts
more than
demand.

D0
D1

Quantity of Bonds
 Why Bonds are Risky
• Default risk is the change that the issuer may
not make the promised payment
• Inflation risk an investor can’t be sure of what
the real value of the payments will be, even if
they are made
• Interest rate risk arises from a bondholder’s
investment horizon, which may be shorter
than the maturity of the bond
 Default Risk
• Although there is little to no default risk with
U.S. Treasury bonds, there is with other
government and corporate bonds.
• In determining what happens to bond prices
when we consider default risk, we can look at
an example of a corporate bond.
• Assume the one-year risk-free interest rate is 5
percent.
• A company has issued a 5 percent coupon
bond with a face value of $100.
 Default Risk
• If this bond was risk-free, the price of the bond
would be the present value of the $105
payment.
Price of risk free bond = ($100 + $5)/$1.05 = $100
• Suppose, however, there is a 10% probability
that the company will go bankrupt before paying
back the loan.
– Assume the outcome is either $105 or $0.
– Expected value equals $94.50
Price of bond = $94.50/1.05 = $90
 Default Risk
• If the price of the bond is $90, what yield to
maturity does this price imply?
Promised yield on bond = $105/$90 - 1 = 0.1667
• Since the default risk premium is the promised
yield to maturity minus the risk-free rate:
= 16.67 percent - 5 percent = 11.67 percent.
• Any risk premium will drive the price below $90
and push the yield to maturity above 16.67
percent.
• The higher the default risk, the higher the yield.
 Inflation Risk
• With few exceptions, bonds promise to make
fixed-dollar payments.
• Remember that we care about the purchasing
power of our money, not the number of
dollars.
– This means bondholders care about the real
interest rate.
• How does inflation risk affect the interest rate?
 Inflation Risk
• Think of the interest rate having three
components:
1. The real interest rate
2. Expected inflation, and
3. Compensation for inflation risk.
• Example:
– Real interest rate is 3 percent.
– Inflation could be either 1 percent or 3 percent.
– Expected inflation is 2 percent, with a standard
deviation of 1.0 percent.
 Inflation Risk
• Nominal interest rate should equal
– 3 percent real interest rate +
– 2 percent expected inflation +
– Compensation for inflation risk
• The greater the inflation risk, the larger the
compensation for it.
 Interest-Rate Risk
• Interest-rate risk arises from the fact that investors
don’t know the holding period return of a long-term
bond.
– The longer the term of the bond, the larger the price
change for a given change in the interest rate.
• For investors with holding periods shorter than the
maturity of the bond, the potential for a change in
interest rates creates risk.
– The more likely the interest rates are to change during the
bondholder’s investment horizon, the larger the risk of
holding a bond.
Chapter 4

The Stock Market

 Introduction
• By giving individuals a way to transfer risk,
stocks supply a type of insurance enhancing
our ability to take risk.
• Companies use stocks as a way to obtain
financing.
• Stocks are a central link between the financial
works and the real economy.
• Stocks tell us the real value of a company.
• Stocks allocate scarce resources.
 The Essential Characteristics of
Common Stock
• Stocks, also known as common stock or equity,
are shares in a firm’s ownership.
– Stocks first appeared in the 16th century as a way to
finance voyages of explorers.
– The idea was to spread the risk through joint-stock
companies, organizations that issued stock and used
the proceeds to finance several expeditions at once.
– In exchange for investing, stockholders received a
share of the company’s profits.
 The Essential Characteristics of
Common Stock
• Shares were issued in small denominations,
allowing investors to buy as little or as much
as they wanted.
• Shares were transferable - an owner could
sell them to someone else.
• Although one used to receive a stock
certificate, most stockholders no longer do.
– Information is all computerized which is safer and
makes it easier to transfer.
 The Essential Characteristics of
Common Stock
• The ownership of common stock conveys rights:
– A stockholder is entitled to participate in the profits
of the enterprise.
– Stockholders are entitled to vote at the firm’s annual
meeting.
 The Essential Characteristics of
Common Stock
• Although a stockholder is entitled to participate in
the profits of the firm, they are merely a residual
claimant.
– Stockholders are paid last, only after all other creditors
have been paid.
• However, stockholders have limited liability in the
firm.
– Even if a company fails completely, the maximum
amount a shareholder can lose is their initial
investment.
 The Essential Characteristics of
Common Stock
• The thriving market of stocks is possible
because:
– An individual share is only a small faction of the
company’s value.
– A large number of shares are outstanding.
– Prices of individual stocks are low.
– Stockholders are residual claimants.
– Stockholders have limited liability.
– Shareholders can replace managers who are doing
a bad job.
Measuring the Level of the Stock
Market
• We need to understand the dynamics of the
stock market.
• We also need to be able to measure the level
of fluctuation in all stock values.
– This concept is the value of the stock market.
– We will refer to its measures as stock-market
indexes.
Measuring the Level of the Stock
Market
• Stock indexes:
– Tell us how much the value of an average stock has
changed, and how much total wealth has gone up or
down.
– Provide benchmarks for performance of money
managers.
 The Dow Jones Industrial
Average
• The DJIA
– Is the first and best known stock market index.
– Is based on the stock prices of 30 of the largest
companies in the U.S.
– Measures the value of purchasing a single share of
each of the stocks in the index.
• The percentage change in the DJIA over time is
the percentage change in the sum of the 30
prices.
The Dow Jones Industrial Average
• The DJIA is a price-weighted average, which
gives greater weight to shares with higher
prices.
• The behavior of higher priced stocks dominates
the movement of a price-weighted index.
 The Standard and Poor’s 500 Index

• The S&P 500 is constructed from the prices of

many more stocks than the DJIA.
• It is based on the value of 500 largest firms in
the U.S. economy.
– It tracks the total value of owing the entirety of
those firms.
• It uses a value-weighted index where larger
firms carry more weight.
The Standard and Poor’s 500 Index
• If a firm is priced at $100 and has 10 million
shares outstanding, its total market value or
market capitalization, is worth $1 billion.
• A price weighted index gives more importance
to stocks that have high prices.
• A value weighted index gives more importance
to companies with a high market value.
• Price per se is irrelevant.
 Other U.S. Stock Market Indexes
• The Nasdaq Composite Index and the Wilshire 5000
are the next largest indexes in the U.S.
– Nasdaq is a value-weighted index of over 5000 companies
traded on the over-the-counter (OTC) market.
– Nasdaq is mainly composed of smaller, newer firms and
has recently been dominated by technology and Internet
companies.
– The Wilshire 5000 is the most broadly based index in use;
it covers all publicly traded stocks in the U.S. with readily
available prices.
– Wilshire is value-weighted and is the best measure of
overall market wealth.
 World Stock Indexes
• About one-third of all the countries in the world
have a stock market and each has an index.
• Most are value-weighted indexes.
• Table 8.2 gives behavior of these in early 2013.
– The percentage change in these indexes is the most
important as their stated number does not mean much
without comparison.
• Investors view global stock markets as a means to
diversify risk away from domestic markets.
• However, there is now increased correlation of
global markets.
 Valuing Stocks
• People differ on how stocks should be valued.
• Some believe they can predict changes by
looking at patterns or past movements -
chartists.
• Some estimate the value of stocks based on
their perceptions of investor psychology and
behavior - behavioralists.
• Others estimate stock based on both its current
assets and on estimates of future profitability -
the fundamentals.
 Fundamental Value and the
Dividend-Discount Model
• A stock represents a promise to make monetary
payments on future dates, under certain
circumstances.
• The payments are usually in the form of
dividends:
– Distributions made to the owners of a company
when the company makes a profit.
• If a company is sold, the stockholders receive a
final distribution that represents their share of
the purchase price.
 Valuing Stocks:
Dividend-Discount Model
• The current price is the present value of next
years price plus the dividend:
Dnext year Pnext year
Ptoday  
(1 i) (1 i)
• Expanding over an investment horizon of n
years:

Dnext year Din two years Dn years from now Pn years from now
Ptoday   2  ..... n  n
(1 i) (1 i) (1 i) (1 i)


 Valuing Stocks:
Dividend-Discount Model
• The price today is the present value of the
sum of the dividends plus the present value
of the price at the time the stock is sold n
years from now.
• What if a company does not pay dividends?
– We estimate when the company will start paying
dividends and use the present-value framework.
– We must know something more about annual
dividend payments.
 Valuing Stocks:
Dividend-Discount Model
• Assume that dividends grow at a constant rate
of g per year so:
.
Dnext year  Dtoday(1 g)

• As long as growth remains constant, we can do

this for
 n year from now:
n
Dn years from now  Dtoday(1 g)
 Valuing Stocks:
Dividend-Discount Model
• We can rewrite the price equation as:
Dtoday(1 g) Dtoday(1 g) 2 Dtoday(1 g) n Pn years from now
Ptoday    ... 
(1 i) (1 i) 2 (1 i) n (1 i) n

• But we don’t know the price in n years, so we

.

assume firm pays dividends forever turning the

stock into something like a consol.
• We can then covert the above into:
Dtoday(1 g)
Ptoday 
ig
 Example 1
• Moonshine Industries has produced a barrel per
week for the past 20 years but cannot grow
because of certain legal hazards. It earns $25 per
share per year and pays it all out to stockholders.
The stockholders have alternative, equivalent-risk
ventures yielding 20 percent per year on average.
How much is one share of Moonshine worth?
Assume the company can keep going indefinitely.
 Example 2
• You believe that the Non-stick Gum Factory will
pay a dividend of $2 on its common stock next
year. Thereafter, you expect dividends to grow at
a rate of 6 percent a year in perpetuity. If you
require a return of 12 percent on your
investment, how much should you be prepared to
pay for the stock?
 Example 3
• Tattletale News Corp. has been growing at a rate
of 20 percent per year, and you expect this growth
rate in earnings and dividends to continue for
another 3 years.
a. If the last dividend paid was $2, what will the
next dividend be?
b. If the discount rate is 15 percent and the steady
growth rate after 3 years is 4 percent, what
should the stock price be today?
 Example 4
• A company will pay a $1 per share dividend in 1 year.
The dividend in 2 years will be $2 per share, and it is
expected that dividends will grow at 5 percent per
year thereafter. The expected rate of return on the
stock is 12 percent.
a. What is the current price of the stock?
b. What is the expected price of the stock in a year?
c. Show that the expected return, 12 percent, equals
dividend yield plus capital appreciation.
 Example 5
• Phoenix Industries has pulled off a miraculous
recovery. Four years ago it was near bankruptcy. Today,
it announced a $1 per share dividend to be paid a year
from now, the first dividend since the crisis. Analysts
expect dividends to increase by $1 a year for another 2
years. After the third year (in which dividends are $3
per share) dividend growth is expected to settle down
to a more moderate long-term growth rate of 6
percent. If the firm’s investors expect to earn a return
of 14 percent on this stock, what must be its price?
 Valuing Stocks:
Dividend-Discount Model
• This relationship is the dividend-discount model.
– The fundamental price of a stock is the current dividend
divided by the interest rate, minus the dividend growth
rate
• The model tells us that stock prices should be high
when
– dividends are high (Dtoday),
– dividend growth is rapid (g is large), or
– the interest rate (i) is low.
• Although this model is simple, we have ignored risk
in deriving it.
 Why Stocks are Risky
• When you buy stocks, it is as if you put up
your wealth to buy the firm and borrow the
rest.
– Stockholders get part of the profits, but only after
everyone else is paid, including bondholders.
• The borrowing creates leverage, and leverage
creates risk.
• The more debt, the more leverage and the
greater the owners’ risk.
Return to Debt & Equity Holders
for Different Financing
Assumptions
 Why Stocks are Risky
• Stocks are risky because shareholders are
residual claimants.
– They never know for sure how much their return will
be.
• In contrast, bond holders receive fixed nominal
payments and are paid before stockholders in
the event of bankruptcy.
 Risk and the Value of Stocks
• Stockholders require compensation for risk.
– The higher the risk, the higher the compensation.
• An investor will buy a stock with the idea of
obtaining a certain return, which includes
compensation for the stock’s risk.
• We know the return to holding stock for one
year Dnext year Pnext year  Ptoday
 
Ptoday Ptoday
 Risk and the Value of Stocks
• We can think of the required return as the sum
of the risk-free return and the risk premium
(equity risk premium).
• We can write this as:
Required Stock Return (i)
= Risk-free Return (rf) + Risk Premium (rp)
• Rewrite dividend-discount model:
Dtoday (1  g )
Ptoday 
rf  rp  g
Risk and the Value of Stocks
 Deja Vu All Over Again
Capital Market -- The market for relatively long-
term (greater than one year original maturity)
financial instruments.
Primary Market -- A market where new securities
are bought and sold for the first time (a “new
issues” market).
Secondary Market -- A market for existing (used)
securities rather than new issues.
 Public Issue
Public Issue -- Sale of bonds or stock to
the general public.
• Securities are sold to hundreds, and often
thousands, of investors under a formal contract
overseen by federal and state regulatory authorities.
• When a company issues securities to the general
public, it is usually uses the services of an
investment banker.
 Investment Banker
Investment Banker -- A financial institution that
underwrites (purchases at a fixed price on a fixed
date) new securities for resale.
• Investment banker receives an underwriting spread when
acting as a middleman in bringing together providers and
consumers of investment capital.
• Underwriting spread -- the difference between the price the
investment bankers pay for the security and the price at
which the security is resold to the public.
 Investment Banker
 Investment bankers have expertise, contacts, and the sales organization
to efficiently market securities to investors.

• Thus, the services can be provided at a lower cost to the firm

than the firm can perform the same services internally.
• Three primary means companies use to offer securities to
the general public:
– Traditional (firm commitment) underwriting
– Best efforts offering
– Shelf registration
 Traditional Underwriting
Underwriting -- Bearing the risk of not being able
to sell a security at the established price by
virtue of purchasing the security for resale to the
public; also known as firm commitment
underwriting.
• If the security issue does not sell well, either
because of an adverse turn in the market or
because it is overpriced, the underwriter, not the
company, takes the loss.
 Traditional Underwriting
Underwriting Syndicate -- A temporary
combination of investment banking firms formed
to sell a new security issue.
A. Competitive-bid
– The issuing company specifies the date that sealed bids
will be received.
– Competing syndicates submit bids.
– The syndicate with the highest bid wins the security
issue.
 Traditional Underwriting
B. Negotiated Offering
• The issuing company selects an investment banking firm and
works directly with the firm to determine the essential
features of the issue.
• Together they discuss and negotiate a price for the security
and the timing of the issue.
• Depending on the size of the issue, the investment banker
may invite other firms to join in sharing the risk and selling
the issue.
• Generally used in corporate stock and most corporate bond
issues.
 Traditional Underwriting
Best Efforts Offering -- A security offering in which the investment bankers
agree to use only their best efforts to sell the issuer’s securities. The
investment bankers do not commit to purchase any unsold securities.

Shelf Registration -- A procedure whereby a company is permitted to

register securities it plans to sell over the next two years; also called SEC
Rule 415. These securities can then be sold piecemeal whenever the
company chooses.
 Shelf Registration: Flotation
Costs and Other Advantages
 A firm with securities sitting “on the shelf” can require that investment
banking firms competitively bid for its underwriting business.

• This competition reduces underwriting spreads.

• The total fixed costs (legal and administrative) of successive
public debt issues are lower with a single shelf registration
than with a series of traditional registrations.
• The amount of “free” advice available from underwriters is
less than before shelf registration was an alternative to firms.
 Privileged Subscription
Privileged Subscription -- The sale of new securities in which existing
shareholders are given a preference in purchasing these securities up to
the proportion of common shares that they already own; also known as a
rights offering.

Preemptive Right -- The privilege of shareholders to maintain their

proportional company ownership by purchasing a proportionate share of
any new issue of common stock, or securities convertible into common
stock.
 Terms of Offering
Right -- A short-term option to buy a certain number
(or fraction) of securities from the issuing corporation;
also called a subscription right.
Terms specify:
– the number of rights required to subscribe for an
additional share of stock
– the subscription price per share
– the expiration date of the offering
 Private Placement
Private (or Direct) Placement -- The sale of an
entire issue of unregistered securities (usually
bonds) directly to one purchaser or a group of
purchasers (usually financial intermediaries).
• Eliminates the underwriting function of the investment
banker.
• The dominant private placement lender in this group is
the life-insurance category (pension funds and bank
trust departments are very active as well).
 Private
Placement Features
• Allows the firm to raise funds more quickly.
• Eliminates risks with respect to timing.
• Eliminates SEC regulation of the security.
• Terms can be tailored to meet the needs of the
borrower.
• Flexibility in borrowing smaller amounts more
frequently rather than a single large amount.
 Initial Financing -- Initial
Public Offerings
Initial Public Offering (IPO) -- A company’s first
offering of common stock to the general public.
• Often prompted by venture capitalists who wish to
realize a cash return on their investment.
• Founders of the firm may wish to go through an IPO
to establish a value for their company.
• There exists greater price uncertainty with an IPO
than with other new public stock issues.
 The Secondary Market
• Purchases and sales of existing stocks and bonds occur in the
secondary market.
• Transactions in the secondary market do not provide additional
funds to the firm.
• The secondary market increases the liquidity of securities
outstanding and lowers the required returns of investors.
• Composed of organized exchanges like the New York Stock
Exchange and American Stock Exchange plus the over-the-
counter (OTC) market.