Financial Markets PDF

Financial Markets 1 Financial Market/system A financial market /system is a market/system in which financial assets (securities) such as stocks and bonds can be purchased or sold. Financial markets/systems facilitate the flow of funds and thereby allow financing and i...

Financial Markets 1 Financial Market/system A financial market /system is a market/system in which financial assets (securities) such as stocks and bonds can be purchased or sold. Financial markets/systems facilitate the flow of funds and thereby allow financing and investing by households, firms, and government agencies. Financial markets/systems transfer funds from those who have excess funds to those who need funds. Financial Market Participants Households Intermediaries and Business units Central/Federal, state, and local governments Regulators (RBI, SEBI, IRDA) Supranationals (IMF, WB, ADB) 3 Role of Financial Markets Determine price or required rate of return of asset. Provide liquidity. Reduce transactions costs, which consists of search costs and information costs. 5 Classification of Financial Markets Debt vs. equity markets Money market vs. capital market Primary vs. secondary market Cash or spot vs. derivatives market Auction vs. over-the-counter vs. intermediated market 6  Primary and Secondary Markets Primary Market: Eg. IPO, FPO; They are source of capital for firms. Secondary Market: Eg., Exchange Intermediated, Over the Counter, Auctioned trade of Securities; They provide liquidity to investors Debt, Equity and other claims Debt: Fixed payments, preference in claim, no-ownership – Un securitized debt Secured term loan (capital) Unsecured term loan (capital) Short term loan, line of credit, overdraft (revenue) – Securitized secured long term debt instruments Issued by companies (Corporate bonds), other bonds not issues by the government / treasury (Capital) Issued by treasury ( Government securities): T. Bills (revenue) T. Notes (capital), T. Bonds (capital) – Securitized Long term (capital) unsecured debt: Debentures: Issued by companies (Corporate debentures) – Un securitized short term unsecured debt: Commercial papers issued by banks, FI’s and Companies with high credit worthiness Additional possible features of a debt: convertible term loan, bonds and debentures, puttable and callable loans, bonds and debentures Equity Capital Claims (Equity shares) Non-fixed residual claim (except in preferred stock), ownership (except in non-participative or differential voting shares) Eg: Common stock, partnership share Hybrid: Preference shares Derivatives, Contingent claims, swaps and synthetics 8 Role of Financial Assets To transfer funds from surplus to deficiency Cash Funds Surplus of funds Deficiency of funds Financial Claims/Assets To transfer funds to redistribute the unavoidable risk associated with the C.F. generated by the tangible assets among those seeking and those providing the funds Investment type Investors Equity B 60% C 20% FI 20% Debt A FI Bank Working Capital FI 9 Bank Types of Financial Intermediaries Deposit accepting Commercial Banks/Post offices Payment Banks Investment and Merchant banks FI’s MF’s Insurance firms Pension funds NBFC Micro Finance Firms Hedge Funds …. 10 Services of Financial Intermediaries Transforming Financial Assets Exchanging Financial Assets on Behalf of Customers Exchanging Financial Assets on Own Account Assisting in the Creation of Financial Assets Providing Investment Advice Managing Portfolios 11 Debt markets  Term structure of interest rate Possible plots of treasury instruments over various maturities Credit spread Interest rates Demand and supply of credit given the credit ratings and the terms to maturities 0.050 G.Sec. 0.070 AAA 0.0775 AA C 0.0900 R A E 0.1025 Y D BAA I I 0.1150 E T BBA L 0.1275 D Q BBB U 0.1425 A CAA L. I CAB T.. Y... Junk bonds. T=o 0. 1. 2. 3. 4. 6…………………………………………………………n Term to maturity  Opportunity cost of debt Cost of debt is generally lower than the cost of equity as debt has lower risk to equity Debt brings a payment obligation which brings financial distress increasing the default risk for the firm Opportunity cost of debt is the interest rate for the given term to maturity with the given credit quality of the debt at the given time in the given market Interest is a tax deductible expense for the firms creating an interest tax shield making the cost of debt lower than the interest rates Effects of new issues, types of instruments & issues  Effects of new issue Debt – Bonds (LT & secured), Debentures (ST to Mid Term & unsecured), Term loan, Short term loan and credit – Financing risk – Cost of capital – Protective covenants Equity – Control dilution (Equity shares vs. shares with differential rights – Diversification of holdings – Share price Hybrid – Preference Shares; Convertible bonds; Call-able and put-able bonds; Royalty on sales, production, etc. – Usually is a deal sweetener brings the cost of finance low but with some stress – Convertibles if attractive are likely to dilute holdings  Agency problem Separation of ownership and management (information asymmetry) Agency problem arises when agents (managers) have a conflict of interest against principals (owners) It results in sub-optimal behaviour of managers who may have an incentive (moral hazard) to engage in activities which may decrease or destroy firm value (adverse selection) or limit action on opportunities for enhancement of firm value (risk aversion) Agency problem results in loss in firm value either due to suboptimal behaviour manager or due to cost of monitoring born to control suboptimal behaviour. Corporate governance Executive compensation and performance measurement (ESOPS)  Primary and non-primary instruments Primary – Debt Bonds (LT & secured), Debentures (ST to Mid Term & unsecured), Term loan, Short term loan and credit Financing risk Cost of capital Protective covenants – Equity Control dilution (Equity shares vs. shares with differential rights Diversification of holdings Share price – Hybrid Preference Shares; Convertible bonds; Call-able and put-able bonds; Royalty on sales, production, etc. Usually is a deal sweetener brings the cost of finance low but with some stress Convertibles if attractive are likely to dilute holdings Non-primary – Mutual funds, ADR, GDR, derivatives  Issues Primary Issues Secondary Transactions ESPOS/ Sweat Capital Exchange (Retail/Block) OTC Auction / Warrants New Business financing, private placement markets and non- public issues  Typical Stages in startup financing FFF: Friend family and fools, Grants, Donations, Schemes, …. Seed Capital. Just starting out and have no product or organized company yet; to create a sample product, fund market research, or cover administrative set-up costs, etc. (more serviced by Angel Investors) Startup Capital. Have a sample product with at least one principal working full-time; to cover recruitment of other key management, additional market research, and finalizing of the product or service (more serviced by Angel Investors and some early stage VC’s) Early Stage Capital. company off the ground, a management team is in place, and sales are increasing; to increase sales to the break-even point, improve your productivity, or increase your company's efficiency (more serviced by VC’s) Expansion and Growth Capitals. company is well established; to help take your business to the next level of growth, to enter new markets or increase your marketing efforts. (more serviced by VC’s) Late Stage Capital. company has achieved impressive sales and revenue and have a second level of management in place; to increase capacity, ramp up marketing, or increase working capital (more serviced by VC, Private Placement, or public offer https://www.startups.com/library/expert-advice/series-funding-a-b-c-d-e  Typical stages and forms of venture Financing Pre Seed Stage (Personal Funding), Seed Funding (Angel/Crowd funding/Incubators/ Government aids and funds), Early Stage Funds Startup Capital, Stage 1: Growth Capital financing VC Series A round funding, Stage 2: Working Capital financing VC Series B round funding, Stage 3: Expansion or Mezzanine Financing VC Series C round funding, Stage 4: Special requirement financing for M&A, Buyouts, Strategic Deals VC Series D Round Funding, PE may also become interested if ticket size is large enough Early exit by VC through PE’s, acquirers, Promoters or other private placements, IPO: Exit, Fresh capital (Shares with Differential rights) FPO: Late Exit, Additional Capital PIPE (S): Private Investment in a Publicly Enterprise (Growth), Mostly done by Hedge Funds, HNIs, VC’s, FI’s and PE’s using Hybrid financing options Bridge Financing: to meet smaller requirements in between VC’s full rounds Series A, B, C, D…. rounds may happen at earlier stages as well depending on the requirements and VC’s readiness All VC’s may not be funding at all stages, some focus on only a particular stage of funding VC’s provide technical help and guidance as well in addition to capital VC’s mostly finance using Equity, but sometimes may finance via debt or some hybrid Recently debt funding has come up as a growing alternative to equity VC funding In India A grant can also come as a source of funding at usually stage 3 or later depending upon availability  Private placements Private placement by unlisted companies – Sale of securities to limited investors with no public offering Preferential issue (Private placement by listed companies) – A preferential issue is an issue of shares or of convertible securities by listed companies to a select group of persons under Section 81 of the Companies Act, 1956 which is neither a rights issue nor a public issue. – A listed company going for preferential allotment has to comply with the requirements contained in Chapter XIII of SEBI (DIP) Guidelines. Qualified Institutions Placement (QIP) – QIP is a private placement of equity shares or securities convertible into equity shares by a listed company to Qualified Institutional Buyers (QIB) only in terms of provisions of Chapter XIIIA of SEBI (DIP) guidelines.  Rights, ESOPS Rights: Issued by companies to the preexisting shareholders, to provide with the opportunity to preserve their fraction of ownership before exploring outside financing. ESOPS: Option to defined set of employees to buy shares of their company on a future date with prefixed price up to a given quantity. Employee Stock Ownership Plans (ESOPs) are a powerful tool that companies use to align employee interests with the organisation’s to minimize agency conflict.  Rights issue process Cum-Rights TerraForm Power Inc: Effects of Rights issue and trading 2  Value of a right Ivanhoe Mines needs C$1.2 billion of new equity. Market price C$25. Ivanhoe Mines decides to raise additional funds by offering the right to buy 1 new shares for 5 held at C$13 per share. With 100% subscription, what is the right value? Assume that the Ex- rights price of shares adjusts exactly by value of rights, then what is the Ex-rights value of shares? _________________________________________________________ Solution: Discount = 25-13 = 12 Total Shares = 5 + 1 = 6 Value of right = 12/6 = 2 Ex-Rights value of shares = 25-2 = 23  Ex: Rights valuation Tata Motors needs Rs 500 crore worth of new equity. Tata Motors offered right to buy 1 new shares for 7 held at 300 per share. Post announcement market price of its shares are 380. With 100% subscription, what is the value of each right? Assume that the Ex- right price of shares adjusts exactly by value of rights, then what is the Ex-rights value of shares? ________________________________________________________ Solution: Discount = 380-300 = 80 Total shares = 7 + 1 = 8 Value of right = 80/8 = 10 Ex-right price of share = 380 – 10 = 370 Public Issues markets and processes  Primary vs. Secondary Markets Primary Market: where security (debt or equity) is issued to the investors for the first time. Issues in this market are called Primary Issues (Eg. IPO, FPO). They are source of capital for firms. Secondary Market: Where securities are bought and sold by investors after primary issue. Issues in this market are called Secondary Transaction. (Eg., Exchange Intermediated, Over the Counter, Auctioned trade of Securities)  Red herring prospectus and Offer Document Offer details and risk factors (Debt: Indenture: Terms of issue (Currency, Face Value, Int., Duration, Etc.), Seniority, Repayment terms (Sinking fund), Call feature, Convertible, Protective covenants) RHP/Offer Document – http://www.sebi.gov.in/  After market Major Steps in an IPO/FPO Transacti activities Issue on open and closure Price Marketin stabiliz g close Allotme Pre- nt of ation Marketin Wide Receivi Filing the ng shares Researc listing/off g distribu h Finalizati tion of applicat Transfe on on er Adverti ions r of analysis Preparati request sing for prospe Pricing shares and Feasibilit on and enhanc ctus, Managi and Getting to coverag y analysis due ement offer ng Company allotment the Red DMAT e and diligence of docum books Plans an basis Herring Refund IPO or choice of Valuati brand ent and Fixed prospe the of FPO Stock on ctus equity Exchange Price applicat money Board Prospe approv ctus Issue ion Listing Approv Regulat Mecha ed for drafting docum of es ory nism v. listing ent via security Shareh complia Appoin Book the book for olders nce tment Buildin offer runner trading Approv Stock of g Offer Lead, networ e exchan Mecha registra k ge co nism tion Initial book- Adverti Agreem complia vs. nce runners sing ent Auction Market , Process with underw Invest Liquidit Applica y riters, ment registra tion Bank analysis money and r to and Fast Track Issue: Enables well‐established and compliant listed issue companies satisfying listed criteria to access Indian Primary Market Core Calls Advisor Under quickly. Issuer can proceed with FPOs/Right Issues by filing prospectus writing Allotme s nt basis with the RoC or Letter of Offer with Stock Exchanges and SEBI without basis, Lock up filing Draft Offer Document for SEBI comments and to Stock Exchange terms Reverse Book Building: Process of collection of bids to determine the buy back price in a voluntary delisting of equity shares from stock exchanges attempted by the promoter or the acquirer of the company  Major Participants to a Public Issue Initial Public Offer (IPO) Follow-on Public offer (FPO) – IPO: First offering of stock to public (leads to listing of the shares on a stock exchange) – FPO: A public offer of stock from a company already listed on a stock exchange Underwriter – Firm that buys and resells an issue of securities Book runner – Usually the lead (in case of syndicated issue) underwriter/lead-manager/arranger/coordinator in a public issue responsible for running the issue and handling the books Underwriting Spread and Commission – Underwriting spread is the difference between public-offer price and price paid by underwriter – commission is the fee charged by the underwriter to perform underwriting services Red Herring Prospectus – Provides information on issue of securities Pricing – Setting issue price (issue of underpricing) IPO Grading (rating) – Mandatory (SEBI) as is helpful for investors in determining offer quality; by CRISIL or Credit Rating Information Services, Fitch Ratings, ICRA or CARE or Credit Analysis And Research Registrar to the issue – Appointed by the issuer is responsible for allotment and credit of shares to investors DMAT accounts before listing. Also responsible for returning money back to investors in case of no allotment or partial allotment.  Public issue pricing mechanisms Fixed Price Issues – issuer at the outset decides the issue price and mentions it in the offer document Book-building – Process by which a lead book-runner tries to determine the appetite of investors (both retail and institutional) for a particular IPO issue and fixes the price of that issue – Price band: Range between which investors can bid while applying for an IPO (floor price and a cap price) Auction – Differential pricing (as per the bid) & Equal pricing (market clearing price) Reverse Book-building – Process of collection of bids for detraining the buy back price in a voluntary delisting of equity shares from stock exchanges attempted by the promoter or the acquirer of the company  Fast Track Issues (FTI) Enables well‐established and compliant listed companies satisfying certain criteria to access Indian Primary Market quickly. Issuer can proceed with FPOs/Right Issues by filing prospectus with the RoC or Letter of Offer with Stock Exchanges and SEBI without filing Draft Offer Document for SEBI comments and to Stock Exchange. Motives for IPO  Average Initial IPO Returns Russia Argentina Austria Canada Denmark Chile Norway Netherlands France Turkey Spain Portugal Nigeria Belgium Israel Hong Kong Mexico UK Italy USA Finland S. Africa New Zealand Philippines Iran Australia Poland Cyprus Ireland Germany Indonesia Sweden Singapore Switzerland Sri Lanka Brazil Bulgaria Thailand Taiwan Japan Greece Korea Malaysia India China 0 20 40 60 80 100 120 140 Return, percent Cost of raising capital Market regulators and operations  Role of secondary market Where the primary issues are traded – Expands primary market – Price discovery – Liquidity – Efficient distribution of capital – Efficient distribution of risk Clearing and settlement process at NSE  Infotainment https://www.youtube.com/watch?v=50yJHK_ g_Ts Concept of Value  Premise A $ today is not equal in value to a $ tomorrow or a $ yesterday (incomparable). Time and $ value both are bidimensional. Value of money changes through time (T) by a factor which represents the OPPORTUNITY COST (r) which is defined as the rate of return available for investing in investment opportunities in the same risk class (investment opportunity set) If we estimate a composite value of Cash Flows (C) at a common point in time for all Cs which actually occurred at different points in time, those C’s values can be compared. The Single period – Single CF Case ❑ If you were to invest $10,000 at 5-percent interest for one year, your investment would grow to $500 would be interest ($10,000 ×.05) $10,000 is the principal repayment ($10,000 × 1) $10,500 is the total due. It can be calculated as: $10,500 = $10,000×(1.05) ❑ The total amount due at the end of the investment is call the Future Value (FV).  Future Value In the one-period case, the formula for FV can be written as: FV = C0×(1 + r) Where C0 is cash flow today (time zero), and r is the appropriate interest rate.  Present Value If you were to be promised $10,000 due in one year when interest rates are 5-percent, your investment would be in today’s dollars worth $ 10 ,000 $ 9 ,523.81 = 1.05 The amount that a borrower would need to set aside today to be able to meet the promised payment of $10,000 in one year is called the Present Value (PV). Note that $10,000 = $9,523.81×(1.05).  Present Value In the one-period case, the formula for PV can be written as: C1 PV = 1+ r Where C1 is cash flow at date 1, and r is the appropriate interest rate.  Net Present Value The Net Present Value (NPV) of an investment is the present value of the expected cash flows, less the cost of the investment. Suppose an investment that promises to pay $10,000 in one year is offered for sale for $9,500. Your interest rate is 5%. Should you buy?  Net Present Value $10,000 NPV = −$9,500 + 1.05 NPV = −$9,500 + $9,523.81 NPV = $23.81 The present value of the cash inflow is greater than the cost. In other words, the Net Present Value is positive, so the investment should be purchased. In the one-period case, the formula for NPV can be written as: NPV = –Cost + PV  The Multi period - single CF Case The general formula for the future value of an investment over many periods can be written as: FV = C0×(1 + r)T Where C0 is cash flow at date 0, r is the appropriate interest rate, and T is the number of periods over which the cash is invested.  Present Value and Discounting How much would an investor have to set aside today in order to have $20,000 five years from now if the current rate is 15%? PV $20,000 0 1 2 3 4 5 $ 20 ,000 $ 9 ,943.53 = (1.15 ) 5  Future Value Suppose a stock currently pays a dividend of $1.10, which is expected to grow at 40% per year for the next five years. What will the dividend be in the filth year? FV = C0×(1 + r)T $5.92 = $1.10×(1.40)5  Future Value and Compounding $ 1. 1 0  (1. 4 0 ) 5 $ 1. 1 0  (1. 4 0 ) 4 $ 1. 1 0  (1. 4 0 ) 3 $ 1. 1 0  (1. 4 0 ) 2 $ 1. 1 0  (1. 4 0 ) $ 5.9 2 $ 4.2 3 $ 1. 10 $ 2.1 6 $ 3.0 2 $ 1. 54 0 1 2 3 4 5 Multiple period – Multiple Cash Flows case Consider an investment that pays $200 one year from now, with cash flows increasing by $200 per year through year 4. If the interest rate is 12%, what is the present value of this stream of cash flows? If the issuer offers this investment for $1,500, should you purchase it?  Multiple Cash Flows 0 1 2 3 4 200 400 600 800 178.57 318.88 427.07 508.41 1,432.93 Present Value (1432.93)0 / =0 / 35000 Y benefits from the difference Price