Lecture 4: Financial Securities Flashcards
What is equity?
o Equity (share): a share representing an ownership stake in a company, the holder is entitled at periodic dividends and can sell the shares to other parties at the market price. o Traded in secondary markets at market price. - A secondary market deals in financial securities that have already been issued, which means that the issuer of the asset does not receive any proceeds from the sale of the security. The secondary market is nonetheless important to the original issuer. The price of an issuer’s shares on the secondary market will indicate the value of the company, and this in turn will help to indicate how the market would respond to any rights issue by the company. The secondary market is also vital for investors as it provides the liquidity that enables them to sell their shares. Without a healthy secondary market for shares there would be only a limited market for new issues.
Underwriting and distribution
- Underwriting: the process by which investment banks guarantee that companies and governments will obtain the funds that they are seeking when issuing debt and equity securities.
What is debt?
o Debt: an amount of money borrowed by one party from another; government debt is borrowed via the issue of Treasury bonds and bills while corporate debt is borrowed from financial institutions via the issue of corporate bonds or commercial paper
o Holders of debt instruments typically face relatively low risks compared to holders of equity. For example, when a bank lends to a firm it typically faces default risk, that is the risk that the firm will not repay part or all of its obligations. To reduce this possibility, there is usually a covenant in the loan agreement that entitles the bank to full repayment if the firm fails to meet the interest rate and capital repayments specified in the loan contract.
Debt vs equity
o Both are sources of finance
o A firm can be financed by debt (bank loans, corporate bonds, etc)
o A firm can be financed by equity (issuing shares, i.e. public limited companies- PLC)
o A firm can be financed by both equity and debt
o Leverage ratio = debt/ equity
- A leverage ratio is any one of several financial measurements that look at how much capital comes in the form of debt or evaluates the ability of a firm to meet its financial obligations. The leverage ratio category is important because firms rely on a mixture of equity and debt to finance their operations and knowing the amount of debt held by a firm is useful in evaluating whether it can pay off its debts as they come due.
Types of debt
Money Market: o Treasury bill (no coupon, sold at a discount) o London interbank offered rate (LIBOR) o Banker’s acceptance o Commercial paper (unsecured) o Repurchase agreements (repo) o Certificates of deposit (CD): negotiable/ non-negotiable Capital market: o Government bonds o Corporate bonds
What is a bond
o Bond is a type of financial claim (financial instrument)
o A bond is a certificate showing that a borrower owes a specified sum
o To repay the borrowing, the borrower has agreed to make interest and principal payments on a designated date
Bond issuers
o Corporations, private firms, governments
o Government bond market accounts for the largest share of the whole bond market
o Government use bond to manage the long-term and short-term cash flow and money supply.
Some terms of bonds
Coupon: The stated interest payment made on a bond
Face/ par value: The principal amount of a bond that is repaid at the end of the term
Coupon rate: The annual coupon divided by the face value of a bond
Maturity: The specified date on which the principal amount of a bond is paid
Bond value and interest rate
o If the cash flows from a bond keep constant, while the interest rate changes in the market, the value of the bond will fluctuate
o If the interest rate rises, the present value (PV) of the bond’s cash flows declines, then the bond’s values declines, and vice versa.
o To determine the value of a bond at a particular point in time, we need to know the number of periods remaining until maturity, the face value, the coupon and the interest rate (discount rate) for bonds with similar features. The interest rate required in the market on a bond is called the bond’s yield to maturity (YTM) or the bond’s yield.
o A simple example of a bond
Company A just issued 100,000 bonds for £100 each, where the bonds have a coupon rate of 5 percent and a maturity of two years. Coupon on the bonds is to be paid yearly.
o Example illustration
£10,000,000 (100,000 × £100) has been borrowed by the company (Company A just issued 100,000 bonds for £100 each)
The firm must pay coupon (interest) of £500,000 (5%× £ 10,000,000) at the end of year 1.
The firm must pay both £500,000 of coupon (interest) and £10,000,000 of principal at the end of year 2.
Bonds Price
Bond price quotes:
o If you buy a bond between coupon payment dates, the price you pay is usually more than the price quoted.
Standard convention in the UK bond market is to quote prices net of so called ‘accrued interest’, meaning that the accrued interest is deducted to arrive at the quoted price.
o Clean price (Quoted price): The price of a bond net of accrued interest. That is the price is typically quoted.
o Dirty price: The price of a bond including accrued interest, also known as the full or invoice price. That is the price the buyer actually pays.
Types of bonds
o Pure discount bonds (zero coupon bonds): It is sold at discount, i.e., sold at ₤90 and promises a single payment, i.e., ₤100, at a fixed future date.
o Level coupon bonds (plain vanilla): It offers cash payments not just at maturity, but also at regular times in between, i.e., annual coupon, semi-annual coupon.
o Consols: It is the bond that never stops paying a coupon, has no final maturity date, and therefore never matures, similar to a perpetuity
Pure discount bonds
PV=F/(1+R)^T
where PV is the present value (fair market price) of the bond, F is the face value of the bond, R is the discount rate (normally, market interest rate), and T is the time to maturity.
PV=F/(1+R)^T
If the face value of the bond (F) is £100, the discount rate (R) is 0.1%, and the time to maturity (T) is 2 years, what is the present value (PV, the fair market price) of the bond?
PV=”£100” /(1+0.1%)^2 = “£100” /(1+0.001)^2 = “£100” /(1.001)^2 =”£100” /(1.001 × 1.001)=”£100” /1.002001 = £99.8003
