Unit 3: Financial Markets and type of Securities Flashcards
1
Q
Money vs Capital Markets
A
Money Markets: trade DEBT securities with maturities of less than 1 year.
- Dealer driven markets, as dealers are the principal in most transactions (not agents like brokers).
- “While a broker facilitates security trades on behalf of investors, a dealer facilitates trades on behalf of itself.”*
- Usually short term and marketable.
- Examples
- T-bills . Treasury bonds are not included since they are usually long-term investments. Treasury notes also have a maturity of more than 1 year.
- Examples
- Usually short term and marketable.
BONDS (10+) > Notes (1-10) > Bills (<1)
- Federal agency securities
- Short-term tax-exempt securities
- Commercial paper
- Certificates of deposit
- Repurchase agreements
- Eurodollar CDs
- Banker’s acceptance
- They exist in NY, LON and TKYO.
VS
Capital Markets: trade long term debt and equity securities. Ex: NYSE. Tnotes and tbonds
2
Q
Primary Vs Secondary Market
A
- Primary market: initial offering of securities.
- Secondary market: trading of previously issued securities (NASDAQ, NYSE, LSE, THE NORMAL ONES WHERE SOMEONE TRADES SECURITIES THEY ALREADY OWN). Examples:
- Auction markets (NYSE) conduct trading at particular physical sites, and prices are communicated directly to the public.
- Matching of buy and sell orders is facilitated by a specialist.
- Specialists maintain an inventory of stocks and sets bid and asked prices.
- The profit margin of the specialist is the spread (asked over the bid price delta).
- Stock exchanges also include derivatives including commodity and financial futures.
3
Q
OTC Market
A
-
OTC market is a dealer market (trades securities that are not in the SE)
- Consists of numerous dealers and brokers who are linked by telecommunication equipment that enables them to trade through the country.
- Transaction examples:
- Bond of US companies
- Bonds of federal, state and local government
- Open-end investment company shares of mutual funds
- New security issues
- Most secondary stock dx, whether or not listed on an exchange.
- Governing authority for the OTC Market is the National Association of Securities Dealers (NASD) and its computerized trading system is the NASDAQ (add automated quotation)
- Majority of stocks are traded in OTC but volumes are bigger in exchanges because they list the largest companies.
- Brokers and dealers may also maintain inventory.
- Trading in the bonds of corporations is primarily done in the OTC market by large institutional investors, such as pension funds, mutual funds, and life insurance companies. VERY LARGE AMOUNTS TRADED AMONG FEW INVESTORS, AND THEREFORE DEALERS CAN FEASIBLY ARRANGE TRANSACTONS.
- Transaction examples:
- Consists of numerous dealers and brokers who are linked by telecommunication equipment that enables them to trade through the country.
4
Q
Financial Intermediary
A
-
Financial intermediaries
- A financial intermediary obtains funds from savers, issues its own securities, and uses the money to purchase an enterprise’s securities. Examples:
- Commercial banks
- Life insurance companies
- Private pension funds
- Nonbank thrift institutions: savings banks and credit unions.
- State and local pension funds
- Mutual funds
- Finance companies
- Casualty insurance companies
- Money market funds
- Mutual savings banks
- Credit unions
- Investment bankers
- A financial intermediary obtains funds from savers, issues its own securities, and uses the money to purchase an enterprise’s securities. Examples:
5
Q
Insider Trading and Efficient Market Hypothesis (EMH)
Strong (Public and Private- No way)
Semistrong (Public - Insider Trading +)
Weak (Past Data - Fundamental Analysis +)
A
- Efficient market hypothesis implies on no abnormal returns with either fundamental or technical analysis.
- EMH implies that expected return of each security matches the return required by the marginal investor given the risk of the security and matches fair value perceived by investors.
-
EMH versions
- Strong form: all public and private information is instantly reflected in securities price.
- Semistrong form: all publicly available data are reflected. Inside trading can result in abnormal returns.
- Weak form: current securities reflect all recent past price movement data, so technical analysis does not hold (fundamental yes since is based on expected future behavior). But fundamental analysis is still work.
TECHNICAL ANALYSIS NEVER HOLD.
6
Q
Rates and Rating Agencies
A
- Ratings are based on the probability of default and the protection for investors in case of default.
- Ratings are significant because higher ratings (lower risk of default) reduce interest costs to issuing firms.
- S&P Ratings:
- AAA and AA are the highest.
- A- and BBB are investment grade.
- BB and below is speculative, also known as junk bonds.
- CCC to D are very poor debt ratings with high likelihood of default.
7
Q
Investment Banking (ers)
(Best effort Sales vs Underwritten Deal)
and
Flotation costs - costs of issuing new securities
and
Seasonable (secondary offerings)
vs
Unseasonable Issue (IPO)
A
- They don’t help only to sell new securities but also assist in business combinations as brokers in secondary markets, and trade for their own accounts.
- Only a few large issuers seek competitive bids.
- Predominance of negotiated deals is linked to the fact of issuing a price with a fee is very hard with asymmetrical information.
- Issues securities with best effort sales and underwriting deals.
- Best effort sales provide no guarantees
- Underwritten deal or firm commitment where investment banker agrees to purchase the entire issue and resell it, thus the issuer bears the entire risk.
-
Steps:
- 1. Pre-underwriting conference to discuss amounts to be raised, type o security and nature of the agreement.
- 2. Filling registration statement with SEC.Seasoned issue is a secondary issue.
- For a seasoned issue, the offering price may be pegged to the price of existing securities, such as the market price of stock or the yield on bonds.
- A single investment banker does not ordinarily underwrite an entire issue of securities unless amount is relatively small: prefers to share the risk if a syndicate of other firms.
-
Flotation costs or the costs of issuing new securities are relatively lower for large issues than for small uses. They include:
- Underwriting spread. Delta between paid by purchaser and the net amount received by the issuer.
- Filing fees, taxes, accountants fees, and attorney fees.
- Indirect mgmt costs.
- Price decline due to bad signaling coming from a seasoned security issue.
”New shares issued by blue-chip companies are considered seasoned issues.”
- Seasoned security is a financial instrument that has been publicly traded long enough to eliminate any short-term effects caused by its IPO. Euromarket long enough = 40 days.
-
Unseasoned securities (IPO) tends to be significant underpriced compared with the price in the after market.
- Usually Flotation costs are higher for common stock, than preferred stock than for stocks than for bonds.
8
Q
IPOs
(Read Carefully)
A
-
IPOs
- Later issues of stock:
- Subsequent offering (NOT DILUTIVE TO EARNINGS): issue additional shares that are usually coming from treasury.
- Secondary offering (DILUTIVE): the company issues new stock for public sale.
- Advantages of higher share price:
- Later issues of stock:
“companies benefit in various ways from a higher stock price.
- Companies can and do issue “secondary offerings” - the company (and thus shareholders, indirectly) sells new stock for cash. Existing shares are diluted, but the company may be more valuable since it has more cash.
- Companies can use their stock to make acquisitions or other deals. Higher stock price means fewer shares are paid for the same cash value.
- Companies dilute shareholders by issuing stock compensation to employees, which shows up (these days) as an expense on the financial statements, lowering EPS to reflect the harm to shareholders. If the stock price is higher, fewer shares are needed to make employees happy.
- A company with a high stock price is not as vulnerable to a takeover. In a takeover, shareholders might receive less than the company is worth. Though generally at least some parties will feel the takeover is a good deal that gives shareholders more than the company is worth - after all shareholders are getting more than the stock price.”
- Disadvantages of going public
- Stock prices that do not accurately reflect the net true worth of the company
- Increased shareholder servicing costs
- More reporting requirements
- A public issue of securities may be sold through a cash offer or a rights offer.
- Cash offer is the normal one.
- A rights offer gives existing shareholders an option to purchase new shares before they are offered to the public. If the corporate charter provides for a preemptive right, A RIGHTS OFFER IS MANDATORY.
- Under a standby underwriting agreement, an underwrite may agree to buy undersubscribed shares.
- A green shoe option is a stabilization mechanism for offerings. It consists in issuing more shares than agreed.
- When there is strong demand and the stock price rises, the underwriter assures the offer price covering the short sell at the same price initially agreed. So no money is lost by exercising the greenshoe option.
- When there is a broke issue, they buy back at a lower price covering their short position (no exercise of greenshoe) and making a profit.
- Debt is normally sold at cash offer, but equity might be sold by either mean (cash or rights offer).
- IPO necessarily requires a cash offer, since security is new.
- Proceeds from a secondary offer goes to the holder, and not to the original issuer
- IPO requires in quality report material which involves a set of audited financial statements accompanied by opinion of independent external auditor.
- An unmodified opinion proves the highest level of assurance as it states that financial statements present fairly in all material aspects financial positions, results, cash flows in line with accepted accounted accounting principles.
9
Q
Systematic vs Unsistematic Risk
A
- Systematic risk or market risk, and is also undiversifiable risk since this cannot be eliminated with portfolio diversification
- Unsystematic risk or company risk, inherent to a particular investment security, and can be diversified with portfolio diversification.
10
Q
Other Types of Risk
(Check for Financial Risk)
A
- Credit risk: risk of default
- FX risk
- Interest rate risk
- Industry risk
- Political risk (expropriation). Political risk can be reduced by making foreign company dependent on domestic parent technology, market or supplies.
- Liquidity risk. Risk that a security cannot be sold at short notice unless excessively discounted.
- Financial risk. Change coming from change on interest rates or desired return by investors. Only debt backed company has financial risk.
- “Financial risk refers to your business’ ability to manage your debt and fulfil your financial obligations”*
- Purchase power risk.
11
Q
Financial Instruments - Concept and Types
A
Concept: fin managers may select from a wide range of financial instruments in which to invest and with which to raise money
Types of financial instruments:
- Long-term financial instruments, from the lowest to the highest rate of return.
- US treasury bonds
- First mortgage bonds
- Second mortgage bonds (ON TOP OF SUBORDINATED BECAUSE THERE IS COLLATERAL)
- Subordinate debentures
- Income bonds
- Preferred stocks
- Convertible preferred stock
- Common stock
- COMMERCIAL PAPER IS UNSECURED.
- BE CAREFUL WITH TERMS MARKETABLE SECURITY(SHORT TERM) VS LONG TERM (CAPITAL MARKET)
12
Q
Bonds Overview
(General Aspects - Indenture - / Advantages / Disadvantages)
A
-
Aspects of bonds
- Face or maturity amount is received on the bonds maturity date.
- Annual cash interest equals face amount times the coupon rate.
- All of the terms of the agreement are stated in a document called indenture.
- Defines what can issuer can do with the money.
- E.g. buy property only if insured and cannot be pledged as a security to another loan.
- May require that the issuer establish or maintain a bond sinking fund.
- Usually, the higher the return of the bond, the higher the yield demanded to compensate for risk.
-
Advantages of bonds to the issuer
- Interest paid on debt is tax deductible
- Basic control of the firm is not shared with debtholders (as opposed to equity financing)
-
Disadvantages to the issuer
- Payment of interest and principal is an obligation.
- The legal requirement to pay debt service raises a firm’s risk level. (higher capitalization on retained earnings is demanded by shareholders).
- Long term nature of debt can create a big liability if interest rates fall, and the firm is unable to refinance.
- Management loses financial flexibility in order to respect ratios/covenants.
- Amount of debt available is limited and company should respect a certain debt equity ratio.
13
Q
Bonds: Debt Covenants and Call Provisions
(Restrictive Covenants > Impact on Rates??)
(Call Provision > Impact on Rates??)
A
-
Debt covenants
- Examples of debt covenants
- Limitation on issuing additional long/short term debt.
- Limitations on dividends payment
- Maintaining certain financial rations
- Maintaining specific collateral
- More restrictive the debt covenants, the lower the risk that the borrower will not be able to repay its debt, therefore the lower the interest rate (since risk premium is lower).
- If the debtor breaches the debt covenant, the debt becomes due immediately.
- Examples of debt covenants
- Call Provisions allow for early exercise, and therefore decrease the attractiveness to investors, therefore imply on higher rate of return.
14
Q
Types of Bonds: Maturity
(Term vs Serial)
A
- Term bond has a single maturity date at the end of its term
- Serial bond matures in stated amounts at regular intervals. Investors have the flexibility to choose when therefore rates are usually lower.
15
Q
Types of Bonds: Valuation
(Variable Rate & Zero-coupon - Commodity Backed)
A
- Variable rate bonds pay interest that is dependent on market conditions
- Zero-coupon or deep discount bonds bear no started rate of interest and thus not involve periodic cash payments. The interest component is entirely the bond discount.
- Commodity-backed bonds are payable at prices related to commodities.
