Financialinstruments金融工具.ppt

3.FINANCIAL MARKETS AND INSTRUMENTS,Financial markets & instruments,Businesses raise money to finance current operations as well as for future growth Money is raised In financial markets (capital markets and money markets) By issuing financial instruments (also called securities) which give the holders claims on future cash flows of the business,2,Financial markets,Financial markets describes the distribution system by which cash-deficit entities engage in transactions with cash-surplus entities. Besides businesses, participants include government agencies, pension funds, endowments, individuals, commercial banks, insurance companies Regulated by Securities & Exchange Commission Capital markets deal with long term instruments like stocks and bonds while money markets deal with short-term instruments with maturity less than one year such as commercial paper.,3,Financial instruments,Instruments must appeal to investors and meet the needs of the company. They are designed keeping in mind Investors claims on future cash flows Investors right to participate in company decisions Investors claims on company assets in the event of liquidation SEC regulations require adequate disclosure before purchase.,4,Types of instruments,Debt instruments offer fixed claims. Equity offers residual claims. Hybrids such as convertible debt combine both. Derivatives such as forwards , futures and options provide a hedge against risk,5,BONDS,Fixed income security interest paid periodically Repayment of principal at maturity. Bonds are sold to the public in small increments, such as $1000, and can be traded on an exchange after issue. Yield (return with reference to market price) inversely related to market price,6,Bond characteristics,Par value Maturity date Coupon rate Current yield vs. yield to maturity (YTM) Sinking fund for periodic repayment of principal Variable rate vs. fixed rate bonds,7,Call Provisions提前赎回条款,Right to retire bonds prior to maturity. Investors require a premium for call provisions. Call price is typically a modest premium above par. Delayed call prevents retirement before some date. Call options help companies take advantage of declines in interest rates and rearrange capital structure,8,Covenants契约,Contractual terms to protect bondholders by impacting management decisions. Examples: Lower limit on current ratio Upper limit on D/E ratio Required approval by bondholders before major acquisition or sale of assets Bondholders have no direct say in a company unless it defaults on its interest, sinking fund, or covenant obligations.,9,Rights in Liquidation清偿权利,Rights of absolute priority Government in respect to taxes past due Senior creditors General creditors Subordinated creditors Preferred shareholders Common shareholders,10,Secured Creditors,Secured credit involves collateral. In liquidation, proceeds from the sale of collateral only go to the secured creditor up to the amount of the secured credit. Any residual goes into the pool shared by the other investors. If the sale of collateral is insufficient, the secured creditor becomes a general creditor for the balance.,11,Bonds Issuers perspective,Advantages : Lower cost of funds Interest is tax deductible No loss of control Disadvantages : Interest payment mandatory Redemption cash outflows,12,Bonds investors perspective,Fixed income , no capital appreciation Convertible bonds seek to provide both Risk return tradeoff Lesser risk than equity , lower returns Annualized returns over 10 yrs for Barclays Bond Index 7.6% vs. S&P 500 10.4% Also refer Table 5-1 Real vs. nominal returns ir = (1+in) / (1 + p) - 1 where ir = Real return, in = Nominal return, p = Inflation rate,13,TABLE 5-1 Rate of Return on Selected U.S. Securities 1900 - 2007,14,Bond ratings,Expression of the opinion of the rating agency on the creditworthiness of the borrower Measures credit risk / default risk Credit rating agencies- S&P, D&B,Moodys AAA High creditworthiness BBB Adequate CCC - Poor D Default Bond ratings and interest rates,15,Junk Bonds,Investment grade is “BBB” and above. Junk bonds are speculative or high yield bonds and are below investment grade. Junk bond market is an alternative to bank and insurance company loans for smaller, less prominent companies. Junk bonds have been used to finance mergers and acquisitions.,16,EQUITY or COMMON STOCK,Residual income securities Represent ownership securities - proportionate to shareholding Right to control - Voting rights Shareholders are represented through a board of directors, through which they exercise control. Right in liquidation residual claim over assets Riskier than debt instruments,17,Risk and return,What is the expected rate of return on equity? Rate of return =Dividend yield + capital appreciation = Div/Mkt price + % change in share price Risk return tradeoff : Higher the risk in an investment , higher the expected returns Equity investors expect a risk premium to compensate for the enhanced risk So return on equity = Risk free rate + Risk premium Risk free rate taken as Govt. Bond rate Risk premium (Table 5-1) = 11.6 - 5.3= 6.3%,18,Common stock (contd),Advantages to investor * Higher returns than debt * Liquidity * Wealth sharing Disadvantages to investor * Higher risk * Dividend payment not mandatory,19,Common stock (contd),Advantages to issuer * Dividend payment not mandatory * No redemption cash outflows * Higher equity means better borrowing ability Disadvantages * Costlier source of funds than debt * Dilution in control * Dividends not tax deductible (unlike interest),20,A note on retained earnings,Readily available source of funds internally (internal equity) No issue costs No dilution in control Reflects the robustness of companys health and reduces dependance on outside funding The only point to be remembered is that retained earnings also has a cost in terms of opportunity cost to investors,21,Higher priority over common stockholders in payment of dividends and in repayment of capital Annual fixed dividend at coupon rate x par value Dividend is discretionary Cumulative dividends feature Dividend not tax deductible for issuer No voting rights except in matters which concern them,PREFERRED STOCK,22,Preferred stock (contd),To the investor : Lesser risk , but lesser returns and less liquid than common stock To the issuer : Lesser cost, dividend payment not mandatory (but not tax deductible), no loss of control,23,MARKET CHANNELS,Market Channels for raising funds Private equity Venture capital Initial public offers (IPOs) and seasoned equity issues (SEOs) Shelf registration Private placement International markets,24,Private Equity Financing,Source of funds for startups, new or small businesses viewed as too risky for bank lending and too small to attract the attention of investors in public markets. Funding done by strategic investors, venture capital firms who provide seed money with potential acquisition on their minds.,25,Private Equity Partnerships,Structured as limited partnerships with a specified duration such as 10 years. General partner is the private equity firm, which raises a pool of money from limited partners, such as institutional investors and insurance companies. Limited partners have limited liability. Typical fee structure is 2 and 20, the sum of a management fee and carried interest based on capital appreciation. Induce managers to create value over long run,26,Venture capital,A venture capital company is a financing institution which joins an entrepreneur as a co-promoter in a project and shares the risks and rewards of the enterprise. Projects are generally high risk with potential high rewards. Sought by new/untried businesses having little/no access to public capital /bank loans.,27,Venture capital - features,Long term equity finance high stakes. Returns through capital gains at the time of exit by selling out equity holdings at high premiums . Selective - generally seek above average returns. Generally financing of new / untried technology , new / no track record promoters Not only financing but also active role in mgmt . Medium to long term investment horizon. Incentives to promoters on performance.,28,Exit route,Going public Sale of shares to promoter. Sale of company to another company management buyin or buyout. Selling to a new investor. Liquidation,29,FIGURE 5-3 Venture Capital Investment in U.S. Companies,30,Initial Public Offerings (IPOs),When companies raise capital for the first time by issuing new shares Seasoned equity offerings (SEOs) refer to issue of new shares by a company that is already publicly traded (already made an IPO) Company assesses proposals from investment banks and chooses one managing underwriter,31,IPO Risks,Managing underwriter advises the company on security design registers the issue with the SEC (30-90 days) orchestrates a “road show” assembles an underwriting syndicate who engage in book building Syndicate acts as wholesaler. Offer price set hours before stock goes public. Company bears price risk during the registration process ; syndicate bears risk associated with unsold shares, which they cannot sell above the offer price.,32,Shelf registration,Shelf registration is a general purpose registration giving broad terms of the securities to be issued , good up to two years, that allows the firm to get quick approval A single underwriter often buys the entire issue. Cuts the time lag from several months to a few days Competitive bids lower the issue costs.,33,Private Placement,Corporations can avoid registering with SEC by placing the securities privately with institutional investors. The private placement market is about half the size of the public market, excluding bank loans. Attractive option if public investors not especially receptive for reasons of complexity. Advantages to company are quicker and easier to negotiate, can be custom tailored to specific needs Disadvantage is that as unregistered securities they cannot be traded on financial markets less liquid Rule 144A now allows for trading of privately placed securities among institutional investors.,34,Issue Costs,For privately negotiated transactions, issue cost amounts to the investment banking fee. For public issues, there are also legal, accounting, and printing fees. Cost comparisons 2.2% for straight debt. 3.8% for convertible bonds. 7.1% for secondary offerings . 11% for IPOs.,35,Comparison,36,Efficient Markets,Issues in raising new capital Timing Pricing Market efficiency is with reference to how quickly prices in competitive markets respond to new information Efficient market is one where prices adjust rapidly to new information and current prices fully reflect available information,37,Efficiency in Degrees,A market is weak-form efficient when prices fully reflect all information about past prices Semi-strong form efficient when prices fully reflect all publicly available information strong form efficient when prices fully reflect all information, public or private.,38,Empirical evidence - implication,Markets are not strong form efficient. With limited exceptions, markets are semi-strong form efficient and hence Publicly available information has no predictive power in respect to market prices. Typical investors should not expect to earn abnormal returns trading on publicly available information. It is pointless to time the purchase or sale of the firms securities.,39,Conclusions to Draw,Apart from market sentiment , managers can use private information about their own companies in making timing decisions. Pricing decisions in practice are based on Market value Fair value Price discovery thro book building,40,Managing Risk,Risk is defined as the variability of returns from the expected values In financial markets volatility results in risk Companies use derivatives to manage risk and incentivize managers. Derivatives include forwards , futures, options So called as their value is derived from that of the underlying assets which could be shares/currency/ commodities,41,Forward contracts,You can buy in spot market today for immediate delivery spot contract. You can contract today at a predetermined price for future delivery forward contract. By locking in a price today, you can avoid price