Chapter Four: Financial Markets in the

Financial Systems
 What is Financial markets?
• A financial market can be defined as a market in which
entities can trade financial claims under some
established rules of conduct.
• It is a market in which financial assets (securities)
such as stocks and bonds can be purchased or sold.
• Funds are transferred in financial markets when one
party purchases financial assets previously held by
another party.
• They facilitate the flow of funds and thereby allow
financing and investing by households, firms, and
government agencies.
•
 Types of financial markets
I. Classification by origin:
• Primary Market
• Secondary Market
II. Classification by maturity of claim:
• Money market
• Capital Market
III. Classification by type of financial claim:
• Equity (Stock) market
• Debt market
V Classification by organizational structure.
• auction market
• Over The Counter (OTC) market
 Cont,d
• Other markets
• Commodity markets
• Foreign exchange markets
• Insurance Markets
• Derivative markets
 Primary Market
• The primary market is a financial market that
deals with the issuance of new securities.
• primary market refers to the market where
securities are created.
• Companies, governments or public sector
institutions can obtain funding through the
sale of a new stock or bond issue.
• The process of selling new issues to investors is
called underwriting. In the case of a new stock
issue, this sale is an initial public offering (IPO).
 Features of primary markets
• It is a market for new long term capital.
• The securities are issued by the company directly
to investors.
• The company receives the money and issues new
security certificates to the investors.
• Used to form capital in the economy.
• Borrowers in the new issue market may be
raising capital for converting private capital into
public capital; this is known as "going public."
• The financial assets sold can only be redeemed
by the original holder.
Methods of issuing securities in the
primary market are

– Initial public offering;

– Rights issue (for existing companies);
– Preferential issue
 Initial Public Offering (IPO)
• An initial public offering (IPO) refers to the process of
offering shares of a private corporation to the public in
a new stock issuance.
• It also referred to simply as a "public offering" or
"flotation," is when a company issues common stock
or shares to the public for the first time.
• The company that needs to issues securities has to
seek approval from various regulators and banks
before asking the public for money.

• It also has to issue a prospectus, which explains what

the company does why it is raising money and what
opportunities and risks are to investors from buying
shares in the firm.
 Cont,d
 Prospectus is a document that contains information
relating to the various aspects of the issuing company.
o The general details of prospectus include:
The company’s name and address of its registered office,
The name and address of the company’s promoters, managing
director, director, company secretary, legal adviser, auditors of
the company etc.
The date of opening and closing subscription list
Contents of Articles
The name and address of underwriters,
Material details regarding the project, i.e., location, plant and
machinery, technology, performance guarantee,
infrastructure, nature of products, marketing set-up, past
performance, future prospects etc.
 Cont,d
• They are often issued by smaller, younger
companies seeking capital to expand, but can also
be done by large privately- owned companies
looking to become publicly traded.
 In an IPO the issuer may obtain the assistance of an
underwriting firm, which helps it determine what
type of security to issue (common or preferred),
best offering price and time to bring it to market.
 Reasons for listing
1. Increase your company’s equity
• There comes a point in a company’s development
when the initial or existing shareholders won't
provide the necessary capital to fund the
company’s expansion.
• At this stage, an Initial Public Offering (IPO, the act
of going public) may be the solution. By going
public, the company can diversify the sources of
financing, reinforce its equity and obtain a
substantial cash position, securing its future
investments and growth.
2. Increase liquidity for financial, family or
minority shareholders
• Going public provides the opportunity for the
company’s financial, family or minority
shareholders to sell shares at the time of the
IPO or gradually once the company is listed.
 3. Pay for acquisitions with shares
• Shares in a listed company are a negotiable trading
currency.
• By listing on the stock exchange, a company can
make acquisition and finance them wholly or in part
with shares.
• This avoids excessive debt or the need to use cash
assets.
 4. Structure the company’s business and
strategy
• Going public is the opportunity for senior
management to review the company’s growth,
strategic issues, vision and goals, such as its place in
the competitive environment, success factors, and
its strategy for the coming years.
 5. Open your company’s share capital
• With the IPO, you can welcome new shareholders
into your capital.
• This stage should be considered an opportunity,
since new shareholders often bring with them new
insight about the company’s strategy and sector.
They can also open their network to help accelerate
the business.
 6. Enhance the reputation of your
business
• Your credibility as a business should be
positively impacted by the publicity that
comes with being listed. You can expect media
coverage and visibility across financial
markets all over the world.
 7. Benefit from market exposure

• Another benefit of listing is your visibility in

the marketplace.
• Being part of an index increases your
stock's visibility to investors and can boost
trading volumes.
 8. Attract new staff and boost
employees’ retention
• Going public is a unifying project which will
involve your employees and be a source of
motivation, itself resulting in retention and
finally, pride. Hiring new staff is also made
easier thanks to the boost in the company’s
reputation.
 Rights issue
• Under a secondary market offering or seasoned
equity offering of shares to raise money, a company
can opt for a rights issue to raise capital.

• The rights issue is a special form of shelf offering or

shelf registration.

• With the issued rights, existing shareholders have

the privilege to buy a specified number of new
shares from the firm at a specified price within a
specified time.
 Cont,d

• A rights issue is offered to all existing shareholders

individually and may be rejected, accepted in full or
accepted in part.
• Rights are often transferable, allowing the holder to
sell them on the open market.
 Cont,d
• To issue rights the financial manager has to
consider:
– Subscription price per new share
– Number of new shares to be sold
– The value of rights
– The effect of rights on the value of the current share
– The effect of rights to existing and new shareholders
• Rights issues may be underwritten. The role of the
underwriter is to guarantee that the funds sought
by the company will be raised.
 Cont,d
• The agreement between the underwriter and the
company is set out in a formal underwriting
agreement.
• Typical terms of an underwriting require the underwriter to
subscribe for any shares offered but not taken up by
shareholders.
• The underwriting agreement will normally enable the
underwriter to terminate its obligations in defined
circumstances.
 Cont,d
• A sub- underwriter in turn sub-underwrites some
or all of the obligations of the main underwriter
– Underwriters and sub-underwriters may be financial
institutions, stock-brokers, major shareholders of the
company or other related or unrelated parties.
 Preferential Issue
• Preferential Issue is the fastest way for a company to
raise capital.
• A preferential issue is an issue of shares or convertible
securities by listed or unlisted companies to a select
group of investors, but it is neither a rights issue nor a
public issue.

• A person holding preferential shares has the right to

be paid from company assets before common
stockholders if the company goes into bankruptcy.
They usually do not have voting rights, and are
rewarded only by dividends
 Cont,d
• Preferential issue of shares refers to the procedure
of bulk allotment of fresh shares to a specific
group of individuals, venture capitalists,
companies, or any other person by any particular
company for fund raising.
• This process is termed as the preferential
allotment of shares.
 Secondary Market
• The secondary market, also known as the
aftermarket, is the financial market where
previously issued securities and financial
instruments such as stocks, bonds, options, and
futures are bought and sold.
• It is also refer to a market where securities are
traded after being initially offered to the public in
the primary market and/ or listed in the stock
exchange.
 Function of Secondary markets

• Provide regular information about the value of

securities
• Helps to observe prices of bonds and their
interest rates.
• Offers to investor liquidity for their assets.
• Secondary market bring together many
interested parties.
• It keeps the cost of transactions low
Money markets
 Money Market Securities
• Money market securities are debt securities with
a maturity of one year or less.
• They are issued in the primary market through a
telecommunications network by the Treasury,
corporations, and financial intermediaries that
wish to obtain short-term financing.
money market securities are issued by:
– The Treasury (government)
– Corporations.
– Financial institutions
 Cont,d
• This securities are purchased by
– households,
– corporations (including financial institutions), and
– government agencies

 money market securities have a short-term maturity and

can typically be sold in the secondary market, they provide
liquidity to investors.
 Cont,d
One specific money market is the interbank market, which is
the market in which banks lend to each other. This market
allows banks with excess liquidity to lend these funds to banks
with a shortage of funds, often overnight and usually on an
unsecured basis.

 An efficient interbank market improves the functioning of the

financial system by enabling the central bank to add or drain liquidity
from the system more effectively and banks to redistribute their
individual excesses and shortages of liquidity among themselves
without causing undue interest rate volatility.
 The common types of money market
securities
I. Treasury bills
II. Commercial paper
III. Negotiable certificates of deposit
IV. Repurchase agreements
V. Banker’s acceptances
 Treasury Bills
• When the government needs to borrow funds, it
frequently issues short- term securities known as
Treasury bills (or T-bills).
• The government issues T-bills with 4-week, 13-
week, and 26-week maturities on a weekly basis.
However, the maturity of T-bills differs from
country to country.
• T- bills used to be issued in paper form but are now
maintained electronically.
 Cont,d
• Since T-bills do not pay interest, they are sold
at a discount from par value, and the gain to
an investor holding a T- bill until maturity is
the difference between par value and the
price paid.
 Cont,d
• T-bills are attractive to investors because:
– T-bills are backed by the federal government and
therefore are virtually free of credit (default) risk.
– T-bills is Highly liquidity, which is due to their
short maturity and strong secondary market.
• Existing T-bills can be sold in the secondary
market through government securities
dealers, who profit by purchasing the bills at a
slightly lower price than the price at which
they sell them.
 Cont,d
• Pricing Treasury Bills: As mentioned, T-bills do
not pay interest, but are priced at a discount
from their par value.

• The price that an investor will pay for a T-bill

with a particular maturity is dependent on the
investor’s required rate of return on that T-
bill. That price is determined as the present
value of the future cash flows to be received.
 Cont,d

• Since the T-bill does not generate interest

payments, the value of a T-bill is the present
value of the par value. Thus, investors are
willing to pay a price for a one-year T-bill that
ensures that the amount they receive a year
later will generate their desired return.
 Cont,d

• Example; If investors require a 7 percent

annualized return on a one-year T-bill with a
$10,000 par value, the price that they are
willing to pay is
 Cont,d
• If the investors require a higher return, they will
discount the $10,000 at that higher rate of
return, which will result in a lower price that they
are willing to pay today.

• To price a T-bill with a maturity shorter than one

year, the annualized return can be reduced by
the fraction of the year in which funds will be
invested.
 Cont,d
Quiz
• If investors require of a 12 percent annualized
return on a six-month T- bill with a T-bill par
value of $90,000. calculate T- bill price
 Cont,d
• Estimating the Yield: As explained earlier, T-bills do
not offer coupon payments, but are sold at a
discount from par value.
• Their yield is influenced by the difference between
the selling price and the purchase price. If an
investor purchases a newly issued T-bill and holds it
until maturity, the return is based on the difference
between the par value and the purchase price.
 Cont,d
• If the T-bill is sold prior to maturity, the return
is based on the difference between the price
for which the bill was sold in the secondary
market and the purchase price.
• The annualized yield from investing in a T-bill
(YT) can be determined as:
• YT= 𝑆𝑃−𝑃𝑃 X 365
𝑃𝑃 𝑛
 Cont,d
• Example; An investor purchases a T-bill with a
six-month (182-day) maturity and $10,000 par
value for $9,600. If this T-biIl is held to
maturity, its yield is
 Cont,d
• If the T-bill is sold prior to maturity, the selling price
and therefore the yield are dependent on market
conditions at the time of the sale.
• Suppose the investor plans to sell the T-bill after
120 days and forecasts a selling price of $9,820 at
that time. The expected annualized yield based on
this forecast is:
 Commercial Paper
• Commercial paper is a short-term debt
instrument issued only by well-known,
creditworthy firms and is typically unsecured.

• It is normally issued to provide liquidity or

finance a firm’s investment in inventory and
accounts receivable.
• The issuance of commercial paper is an
alternative to short-term bank loans.
 Cont,d
• Financial institutions such as finance
companies and bank holding companies are
major issuers of commercial paper. They
usually have short term maturities.
 Cont,d
• Because of the high minimum denomination,
individual investors rarely purchase
commercial paper directly although they may
invest in it indirectly by investing in money
market funds that have pooled the funds of
many individuals.
 Cont,d

• Money market funds are major investors in

commercial paper. An active secondary
market for commercial paper does not exist.
• However, it is sometimes possible to sell the
paper back to the dealer who initially helped
to place it.
 Negotiable Certificates of Deposit (NCDs)

• Negotiable certificates of deposit (NCDs) are written

promises by a bank to pay a depositor. They are
certificates that are issued by large commercial
banks and other depository institutions as a short-
term source of funds.
• Nonfinancial corporations often purchase NCDs.
Although NCD denominations are typically too large
for individual investors, they are sometimes
purchased by money market funds that have
pooled individual investors’ funds.
 Cont,d
• A secondary market for NCDs exists, providing
investors with some liquidity. However,
institutions prefer not to have their newly
issued NCDs compete with their previously
issued NCDs that are being resold in the
secondary market.
• An oversupply of NCDs for sale can force them
to sell their newly issued NCDs at a lower
price.
 Cont,d
• Placement: Some issuers place their NCDs
directly; others use a correspondent
institution that specializes in placing NCDs.
• Another alternative is to sell NCDs to
securities dealers, who in turn resell them. A
portion of unusually large issues is commonly
sold to NCD dealers. Normally, however, NCDs
can be sold to investors directly at a higher
price.
 Cont,d
• Premium: NCDs must offer a premium above
the T-bill yield to compensate for less liquidity
and safety.

• The premiums are generally higher during

recessionary periods. The premiums also
reflect the market’s perception about the
safety of the financial system.
 Cont,d
• Yield: NCDs provide a return in the form of interest
along with the difference between the price at
which the NCD is redeemed (or sold in the
secondary market) and the purchase price.
 Given that an institution issues a NCD at par value,
the annualized yield that it will pay is the
annualized interest rate on the NCD.
 If investors purchase this NCD and hold it until
maturity, their annualized yield is the interest rate.
 Cont,d
• However, the annualized yield can differ from the
annualized interest rate for investors who either
purchase or sell the NCD in the secondary market
instead of holding it from inception until maturity.
•
 Example

• An investor purchased an NCD a year ago in

the secondary market for $970,000. He
redeems it today upon maturity and receives
$1,000,000. He also receives interest of
$40,000. His annualized yield (YNCD) on this
investment is
 Repurchase Agreements
• With a repurchase agreement (or repo), one
party sells securities to another with an
agreement to repurchase the securities at a
specified date and price. In essence, the repo
transaction represents a loan backed by the
securities.
 Cont,d

• If the borrower defaults on the loan, the

lender has claim to the securities. Most repo
transactions use government securities,
although some involve other securities such as
commercial paper or NCDs.
 Cont,d
• A reverse repo refers to the purchase of
securities by one party from another with an
agreement to sell them. Thus, a repo and a
reverse repo can refer to the same transaction
but from different perspectives.
• These two terms are sometimes used
interchangeably, so a transaction described as
a repo may actually be a reverse repo.
 Cont,d
• Financial institutions such as banks, savings and
loan associations, and money market funds often
participate in repurchase agreements. Many
nonfinancial institutions are active participants as
well. The most common maturities are from one
day to 15 days and for one, three, and six months. A
secondary market for repos does not exist.
 Cont,d
• Some firms in need of funds will set the
maturity on a repo to be the minimum time
period for which they need temporary
financing. If they still need funds when the
repo is about to mature, they will borrow
additional funds through new repos and use
these funds to fulfill their obligation on
maturing repos.
 Cont,d

• Placement Repo transactions are negotiated

through a telecommunications network.
Dealers and repo brokers act as financial
intermediaries to create repos for firms with
deficient and excess funds, receiving a
commission for their services.
 Cont,d
• Estimating the Yield: The repo rate is
determined by the difference between the
initial selling price of the securities and the
agreed-on repurchase price, annualized with a
360-day a year.
•
 Cont,d
• Example; An investor initially purchased
securities at a price (PP) of $9,852,211, with
an agreement to sell them back at a price (SP)
of $10,000,000 at the end of a 60-day period.
The yield (or repo rate) on this repurchase
agreement is
 Assignment1

• What is Term vs. Open Repurchase Agreements?

Write short explanation about term Repo and open
Repo
 Banker’s Acceptances
• A banker’s acceptance indicates that a bank accepts
responsibility for a future payment. Banker’s
acceptances are commonly used for international
trade transactions. An exporter that is sending
goods to an importer whose credit rating is not
known will often prefer that a bank act as a
guarantor.
 Cont,d
• The bank therefore facilitates the transaction by
stamping ACCEPTED on a draft, which obligates
payment at a specified point in time. In turn, the
importer will pay the bank what is owed to the
exporter along with a fee to the bank for
guaranteeing the payment.
 Cont,d
• Exporters can hold a banker’s acceptance until
the date at which payment is to be made, but
they frequently sell the acceptance before
then at a discount to obtain cash immediately.
The investor who purchases the acceptance
then receives the payment guaranteed by the
bank in the future.
 Cont,d

• The investor’s return on a banker’s

acceptance, like that on commercial paper, is
derived from the difference between the
discounted price paid for the acceptance and
the amount to be received in the future.
 Con,d
• Maturities on Banker’s acceptances often
range from 30 to 270 days. Because there is a
possibility that a bank will default on
payment, investors are exposed to a slight
degree of credit risk. Thus, they deserve a
return above the T-bill yield as compensation.
 Cont,d
• Because acceptances are often discounted
and sold by the exporting firm prior to
maturity, an active secondary market exists.
Dealers match up companies that wish to sell
acceptances with other companies that wish
to purchase them. A dealer’s bid price is less
than his/her ask price, which creates the
spread, or the dealer’s reward for doing
business.
 Cont,d
• Steps Involved in Banker’s Acceptances: The
sequence of steps involved in a banker’s
acceptance is illustrated under this. To
understand these steps, consider the example
of a U.S. importer of Japanese goods.
 Cont,d
• First, the importer places a purchase order for
the goods (Step I). If the Japanese exporter is
unfamiliar with the U.S. importer, it may demand
payment before delivery of goods, which the
• U.S. importer may be unwilling to make. A
compromise may be reached through the
creation of a banker’s acceptance. The importer
asks its bank to issue a letter of credit (L/C) on its
behalf (Step 2). The L/C represents a
commitment by that bank to back the payment
owed to the Japanese exporter.
 Cont,d
• Then the L/C is presented to the exporter’s bank
(Step 3), which informs the exporter that the L/C
has been received (Step 4). The exporter then sends
the goods to the importer (Step 5) and sends the
shipping documents to its bank (Step 6), which
passes them along to the importer’s bank (Step 7).
• At this point, the banker’s acceptance is created,
which obligates the importer’s bank to make
payment to the holder of the banker’s acceptance
at a specified future date.
 Part Two

Capital Market
 Capital Market and Capital Market Securities
• Capital markets facilitate the sale of long-term
securities by deficit units to surplus units. The
securities traded in this market are referred to as
capital market securities. Capital market securities
are commonly issued to finance the purchase of
capital assets, such as buildings, equipment, or
machinery.
• Three common types of capital market securities are:
– bonds
– mortgages and
– stocks
 Cont,d
• Bonds can be sold in the secondary market if
investors do not want to hold them until
maturity.
• Since the prices of debt securities change over
time, they may be worth less when sold in the
secondary market than when they were
purchased.
 Bond/Debt Markets
• Bonds are long-term debt securities that are
issued by government agencies or
corporations.
• The issuer of a bond is obligated to pay
interest (or coupon) payments periodically
(such as annually or semiannually) and the par
value (principal) at maturity.
• An issuer must be able to show that its future
cash flows will be sufficient to enable it to
make its coupon and principal payments to
bondholders.
 Cont,d
• Most bonds have maturities of between 10
and 30 years.
• Bonds that have a maturity of more than 1
year but less than 10 years are commonly
known as treasury notes.
• There are also some bonds with a maturity of
more than 30 years, even up to 100 years,
that are issued by large and creditworthy
corporations.
 Cont,d
• Bonds are issued in the primary market.
• Government issues bonds and uses the
proceeds to support deficit spending on
government programs.
• Federal agencies issue bonds and use the
proceeds to buy mortgages that are originated
by financial institutions.
 Cont,d
• Thus, they indirectly finance purchases of
homes.
• Corporations issue bonds and use the
proceeds to expand their operations.
• Overall, by allowing households, corporations,
and the government to increase their
expenditures, bond markets finance economic
growth.
 Cont,d
• The bond can be issued by
– Government
– Commercial banks,
– savings institutions, and
– Finance companies and non financial companies
• Common investors in the bond market
• Commercial banks,
• savings institutions,
• bond mutual funds,
• insurance companies, and
• pension funds
 Thus Financial institutions dominate the bond market in that they
purchase a very large proportion of bonds issued.
 Classification of bonds
• 1. classification according to the type of
issuer. Those are:
Treasury bonds are issued by the government
Treasury,
Federal agency bonds are issued by federal
agencies,
Municipal bonds are issued by state and local
governments, and
Corporate bonds are issued by corporations.
 Cont,d
2. Classification by the ownership structure
such as
 bearer bonds or
 registered bonds.
 Bearer bonds
 Require the owner to clip coupons attached to the bonds and
send them to the issuer to receive coupon payments.
 A bearer bond is a fixed-income security that is owned by the
holder, or bearer, rather than by a registered owner.
 The coupons for interest payments are physically attached to
the security.
 The bondholder is required to submit the coupons to a bank
for payment and then redeem the physical certificate when
the bond reaches the maturity date.
 Cont,d
• Registered bonds require the issuer to maintain
records of who owns the bond and
automatically send coupon payments to the
owners.
• A registered bond is a debt instrument whose
bondholder's information is kept on record with
the issuing party.
• By archiving the owner's name, address, and
other details, issuers ensure they're making the
bond's coupon payments to the correct person.
 Types of bonds

• Bonds can be classified into Treasury and

Federal Agency Bonds, Municipal Bonds, and
Corporate Bonds.
 Government bond
 Government bonds are long-term negotiable
debt securities issued by governments, in order
to raise debt capital. The majority of bonds are
straight bonds which:
– Pay fixed interest amounts known as coupons on
regular dates; and
– Have a fixed maturity or redemption date, at which
point the bond’s par or face value is repaid to the
bond investors.
 Cont,d
• Different governments in different countries,
especially in developed economies, issue
bonds to finance their deficit at federal level.
The followings, for example, are the types of
bond that are issued by the government in the
United States.
 U. S Treasury and Federal Agency Bonds
• The U.S. Treasury commonly issues Treasury
notes or Treasury bonds to finance federal
government expenditures. The minimum
denomination for Treasury notes or bonds is
$1,000.
• The key difference between a note and a bond
is that note maturities are less than 10 years,
whereas bond maturities are 10 years or
more. An active over-the-counter secondary
market allows investors to sell Treasury notes
or bonds prior to maturity.
 Cont,d
• The yield from holding a Treasury bond, as
with other bonds, depends on the coupon
rate and on the difference between the
purchase price and the selling price. Investors
in Treasury notes and bonds receive
semiannual interest payments from the
Treasury.
• Although the interest is taxed by the federal
government as ordinary income, it is exempt
from state and local taxes, if any exist.
 U. S Federal Agency Bonds

• Federal agency bonds are issued by federal

agencies. The Government National Mortgage
Association (Ginnie Mae) issues bonds and uses
the proceeds to purchase mortgages that are
insured by the Federal Housing Administration
(FHA) and by the Veterans Administration (VA).
• The bonds are backed both by the mortgages that
are purchased with the proceeds and by the
federal government.
 Trading Methods
• In some markets such as the UK, France and
Germany government bonds are listed on the
local stock exchange.
• However, in these and most countries
including the US government bonds are
traded mainly on over-the-counter (OTC)
markets through dealers who work for the
large banks and security houses.
• Dealers support the liquidity of the market by
making bid (buy) and offer or ask (sell) prices
 Cont,d
• Their prices are displayed on screen-based
information services such as Bloomberg and
deals are contracted over the telephone or by
electronic communication.
 Bond Quotations
• Bond quotations indicate the bid price; ask
price, maturity and other important
information. The bid price is what a bond
dealer is willing to pay and the ask price is
what a bond dealer is willing to sell the bond
for are quoted per hundreds of dollars of par
value.
 Municipal Bonds
• It is a bond issued by state and local
governments
Types of Municipal Bonds
1.General obligation bonds: Payments on
general obligation bonds are supported by the
municipal government’s ability to tax
2.Revenue bonds: payments on revenue bonds
must be generated by revenues of the project
(toll way, toll bridge, state college dormitory,
etc.) for which the bonds were issued.
 Credit Risk of Municipal Bonds

• Both types of municipal bonds are subject to

some degree of credit (default) risk. If a
municipality is unable to increase taxes, it
could default on general obligation bonds.
• If it issues revenue bonds and does not
generate sufficient revenue, it could default
on these bonds.
Corporate Bonds
 Cont,d
• Corporate bonds are long-term debt securities
issued by corporations. Their maturity is
typically between 10 and 30 years, although
Boeing, Chevron, and other corporations have
issued 50-year bonds, and Disney, AT&T, and
the Coca- Cola Company issued 100-year
bonds.
 Cont,d

• The interest paid by the corporation to

investors is tax-deductible to the corporation,
which reduces the cost of financing with
bonds
• Since equity financing does not involve
interest payments, it does not offer the same
tax advantage.
 Cont,d
• This is a major reason why many corporations
rely heavily on bonds to finance their
operations.

• Nevertheless, there is a limit to the amount of

funds a corporation can obtain by issuing
bonds, because it must be capable of making
the coupon payments.
 Corporate Bond Offerings
• Corporate bonds can be placed with investors through a
public offering or a private placement.
• Public Offering: Corporations commonly issue bonds through
a public offering.
• A corporation that plans to issue bonds hires an investment
bank to underwrite the bonds.
• The underwriter:
– assesses market conditions
– attempt to determine the price at which the corporation’s
bonds can be sold and
– determine the appropriate size (dollar amount) of the
offering.
 Cont,d
• The goal is to price the bonds high enough to
satisfy the issuer, but also low enough so that
the entire bond offering can be placed.
• If the offering is too large or the price is too
high, there may not be enough investors who
are willing to purchase the bonds. In this case,
the underwriter will have to lower the price in
order to sell all the bonds.
 Cont,d
• The issuer registers with the Securities and
Exchange Commission (SEC) and submits a
prospectus that explains
– the planned size of the offering,
– its updated financial condition (supported by financial
statements), and
– its planned use of the funds.

• Meanwhile, the underwriter distributes the

prospectus to other investment banks that it
invites to join a syndicate to help place the
bonds in the market.
 Private Placement
• Some corporate bonds are privately placed
rather than sold in a public offering. A private
placement does not have to be registered
with the SEC.
• Small firms that borrow relatively small
amounts of funds may consider private
placements rather than public offerings, since
they may be able to find an institutional
investor that will purchase the entire offering.
 Cont,d
• Although the issuer does not need to register
with the SEC, it still needs to disclose financial
data to convince any prospective purchasers
that the bonds will be repaid in a timely
manner.
• The issuer may hire a securities firm to place
the bonds because such firms are normally
better able to identify institutional investors
that may be interested in purchasing privately
placed debt.
 Cont,d
• The SEC creates liquidity for privately placed
securities by allowing large institutional
investors to trade privately placed bonds (and
some other securities) with each other even
though the securities are not required to be
registered with the SEC.
 Bond Ratings
• When an investor or institution buys bonds,
they are lending the issuer money.
• Bond ratings were developed to help these
creditors to understand the relative risk
involved with the purchase of a bond.
• They enable the investor to evaluate, and
balance, the risk of default with the interest
rate, or yield, paid on the security.
 Cont,d
• Bonds can be classified into two based on
their relative risk.
• Investment-grade – Bonds considered having
a relatively low rate of risk.
• Junk bonds – A term used to refer to the
below-investment-grade status of high-yield
bonds.
 Credit Rating Agencies

• Currently, there are three credit agencies that

set standards for bond quality ratings:
Moody's, Standard and Poor's, and Fitch
Ratings in the U.S. Each agency has a slightly
different bond rating system.
 Cont,d
• This means an investor has access to several
independent sources of information when
evaluating the risk of default.
• For Moody's, this alert system is termed
Under Review. For S&P it's called
CreditWatch, and Fitch simply calls it Rating
Watch.
• These terms are used to alert investors to a
possible, or pending, change in a company's
bond rating.
 Assignment

• Explain each of investment grade and junk

bond
 Bond Investment Strategies
• Some investors such as bond portfolio
managers of financial institutions commonly
follow a specific strategy for investing in
bonds. Some of the more common strategies
are described here.
 1. Matching Strategy

• Some investors create a bond portfolio that

will generate periodic income that can match
their expected periodic expenses.
 For example, an individual investor may
invest in a bond portfolio that will provide
sufficient income to cover periodic expenses
after retirement.
 Cont,d
• The matching strategy involves estimating
future cash outflows and then developing a
bond portfolio that can generate sufficient
coupon or principal payments to cover those
cash outflows.
 2. Laddered Strategy
• With a laddered strategy, funds are evenly
allocated to bonds in each of several different
maturity classes.
• For example, an institutional investor might
create a bond portfolio with one-fourth of the
funds invested in bonds with five years until
maturity, one-fourth invested in 10- year
bonds, one-fourth in 15-year bonds, and one-
fourth in 20-year bonds.
 Cont,d
• The laddered strategy has many variations, but in
general, this strategy achieves diversified
maturities and therefore different sensitivities to
interest rate risk.
• Nevertheless, because most bonds are adversely
affected by rising interest rates, diversification of
maturities in the bond portfolio does not
eliminate interest rate risk.
 3. Barbell Strategy
• With the barbell strategy, funds are allocated
to bonds with a short term to maturity and
bonds with a long term to maturity.
• The bonds with the short term to maturity
provide liquidity if the investor needs to sell
bonds in order to obtain cash.
• The bonds with the long term to maturity
tend to have a higher yield to maturity than
the bonds with shorter terms to maturity.
 Cont,d
• Thus, this strategy allocates some funds to
achieving a relatively high return and other
funds to covering liquidity needs.
 Interest Rate Strategy
• With the interest rate strategy, funds are
allocated in a manner that capitalizes on
interest rate forecasts. This strategy is very
active because it requires frequent
adjustments in the bond portfolio to reflect
the prevailing interest rate forecast.
 Cont,d
• Consider a bond portfolio with funds initially
allocated equally across various bond maturities.
• If recent economic events result in an expectation
of higher interest rates, the bond portfolio will be
revised to concentrate on bonds with short terms
to maturity. Because these bonds are the least
sensitive to interest rate movements, they will limit
the potential adverse effects on the bond
portfolio’s value.
 Cont,d
• For example, if a new 10-year government bond is
issued with a 6% yield, suddenly an existing 10-year
government bond yielding 8% looks quite attractive.
• Given the new issue’s lower yield, investors will
buy the higher yielding bond, pushing up its price,
lowering its yield.
• As a result, demand for the bond will taper out as
its price rises.
 Equity Markets
• The equity market is where equity securities
are traded.
• Equity markets facilitate the flow of funds
from individual or institutional investors to
corporations.
• Thus, they enable corporations to finance
their investments in new or expanded
business ventures. They also facilitate the flow
of funds between investors.
 Cont,d
• Stocks: Stocks (or equity securities) represent
partial ownership in the corporations that
issued them.
• They are classified as capital market securities
because they have no maturity and therefore
serve as a long-term source of funds.
• Some corporations provide income to their
stockholders by distributing a portion of their
earnings in the form of dividends.
 Cont,d
• Other corporations retain and reinvest all of
their earnings, which increase their growth
potential.

• As corporations grow and increase in value,

the value of their stock increases; investors
can then earn a capital gain from selling the
stock for a higher price than they paid for it.
 Cont,d
• Thus, investors can earn a return from stocks
in the form of periodic dividends (if there are
any) and in the form of a capital gain when
they sell the stock.
• However, equity securities are subject to risk
because their future prices are uncertain.
• Their prices commonly decline when the firms
perform poorly, resulting in negative returns
to investors.
 Cont,d

• A measure of stock liquidity calculated by

dividing the total number of shares traded
over a period by the average number of
shares outstanding for the period. The higher
the share turnover, the more liquid the share
of the company is.
 Trading in Stock Market and Market Participants
• Participants in the stock market range from
small individual stock investors to large hedge
fund traders, who can be based anywhere.
• These participants include individuals who buy
and sell securities (retail investors) or
institutional investors such as banks,
insurance companies, pension funds, investor
group, and other non-bank financial
institutions.
 Cont,d
• Their orders usually end up with a
professional at a stock exchange, who
executes the order.
• Some exchanges are physical locations where
transactions are carried out on a trading floor,
by a method known as open outcry.
• This type of auction is used in stock exchanges
and commodity exchanges where traders may
enter "verbal" bids and offers simultaneously.
 Cont,d
• The other type of stock exchange is a virtual
kind, also called Over the Counter (OTC)
market, composed of a network of computers
where trades are made electronically via
traders.
 Cont,d
• Actual trades are based on an auction market
model where a potential buyer bids a specific
price for a stock and a potential seller asks a
specific price for the stock.
• When the bid and ask prices match, a sale
takes place on a first come first served basis if
there are multiple bidders or askers at a given
price.
 Cont,d
• Exchange markets are called central auction
specialist systems and OTC markets are called
multiple market maker system.
 Types of stock market
• There are four major types of markets on
which stocks are traded. Thos are:
• First Market- trading on exchange of stocks
listed on an exchange ( in floors of the
exchange such as NYSE
• Second Market- trading in the OTC market of
stocks not listed on an exchange
• Third market- trading in the OTC market of
stocks listed on an exchange
 Cont,d
• Fourth Market- Private Transactions between
institutional investors who deal directly with
each other without utilizing the services of a
broker-dealer intermediary.
 Stock Market Securities

1. Common Stock is the fundamental ownership

claim in a public corporation.
• the followings are characteristics of common stock
which differentiate it from other types of financial
securities.
– Discretionary dividend payments
– Variable dividends
– Residual claim in dividends and assets
– Limited liabilities
– Voting and controlling power (Right)
 Preferred Stock
• It is a hybrid security that has characteristics
of both a bond and a common stock.
• Preferred stock is similar to common stock in
that it represents an ownership interest in the
issuing firm, but like a bond it pays a fixed
periodic dividend payment.
• Preferred stock is senior to common stock but
junior to bonds.
 Cont,d

• Some of its characteristics include:

– Preferred stock holders receive their claim
(dividend or assets before common stock holders
but after bond holders)
– Preferred stock holders generally do not have
voting rights in the firm.
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