Financial Markets and Instruments Flashcards
Equity Finance
The process of raising capital through the sale of shares in an enterprise. Selling of ownership interest to raise funds for business purposes
Primary & Secondary Market
Primary: where new shares and bonds are issued
Secondary: where previously owned shares are traded
Ways of Issuing Shares in the Primary Market
Private placing - shares issued only to financial institutions or bank’s private clients
Offers for sale - biz sells shares to a bank who then take on the risk of selling them to investors
Public issue - invitation to purchase is issued to the public using prospectuses
Rights issue - existing shareholders given the option to buy more shares
Market Capitalisation
The value of a business, as determined by the total market price for all of a businesses shares
Capital Markets Instruments
Ordinary shares - equity shares that carry rights to a div and voting rights
Preference shares - get a set dividend before ordinary shares but no voting rights
Company bond/debenture holders - a type of loan in which the shareholder does not own any part of the company
Money Markets
Firms can also raise firms through the money market which is where short term borrowing and lending occur. Designed for large transactions between financial institutions and companies or governments
Calculating Returns on Financial Instruments
Shareholders receive returns as dividends. When expressed as a % it’s known as the dividend yield
Dividend Yield
Dividend paid per share
———————————— x 100
Market price of the share
Bond Returns
3 formulas are needed:
- The bill rate
- The running rate or interest yield
- The gross redemption yield
Bill Rate
Equivalent to the coupon rate:
Yield = bond value x coupon rate
Doesn’t take into account the market price
Running Yield
Takes into account a bond’s market value
Interest (coupon rate)
——————————– x 100%
Market rate
Fails to take into account the gain in MV
Gross Redemption Yield
Takes a bond’s MV and gains in MV into account, therefore it’s the best estimate.
The investor can compare the result of the calculation to their required yield, the interest rate, and the level of risk being undertaken to make their decision to invest
Risk
Affects the rate of return and the market price for bonds. An investor will have a certain rate of return in mind based on the perceived risk taken on. This is therefore the required value of their net dividend yield
Net Dividend Yield
Annual dividend
———————— x 100%
Market value
Formula can be rearranged to get the MV
Market Value Formula
Net dividend yield
The Effects of Risk
The higher the perceived risk, the lower the market price will fall so as to maintain the yield
The lower the perceived risk, the higher the market price will be
Loans and their relationship with Interest Rates
Loans with high fixed interest rates: guaranteed returns, used when market price is falling
Loans with arrangement fees: size of arrangement fees could mean any savings due to low interest rates are offset
Mitigating Risk
Risk is significant in determining the market price of a company so businesses use credit rating agencies: organisations which provide some indication of how likely it is a company will default on their debt
Credit Rating
Rating is calculated by taking into account:
- Ratio of debt to assets
- Size and strength of a co’s cashflow
- Stability of a co’s asset value
- How long the debt is due to be outstanding
Credit Spread
An amount charged over and above the rate of a government bond; the no risk rate. This amount acts as compensation for the lender for taking on the risk
No-Risk Rate
The rate charged on bonds is considered to be the no-risk rate as governments always pay back their debts
Yield on a Corporate Bond
Yield on gov bond + spread
Interest Rates: Base Rate
The rate around which all rates are set and used by central banks to determine the rates at which they lend money to companies
Nominal Return Rate
Rates often advertised by banks which do not factor in inflation
Real interest Rate
Rates which do factor in inflation
Hedging
When companies take action to reduce risk
Interest Rate Hedging
Forward rate agreement - a contract between 2 parties that determines the rate of interest on a future obligation
Interest rate guarantees - option on a FRA that allows a co to have the option of taking out a FRA in future for an up-front fee
Interest Rate Futures - similar to FRA as it fixes future a rate, unlike FRA it is an exchange traded agreement
Interest rate options - grants buyer the right, not obligation, to deal in IR futures, is exchange traded and a premium is payable
