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
• This securities are purchased by
Cont,d
– 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 to day
 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.
• 1. If this T-biIl is held to maturity, what is the
amount of T-bill yield
• What is T-bill discount
 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. how much
investor annualized yield (YNCD) on this
investment?
 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

1. What is Term vs. Open Repurchase Agreements? Write short

explanation about term Repo and open Repo
2. What it mean bank holding company? Write the difference between
bank holding company and financial holding company
 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. Thus,
they indirectly finance purchases of homes.
 Cont,d
• 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

• Write and briefly 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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