Money Markets and Capital Markets PDF

MONEY MARKETS AND CAPITAL MARKETS  It refers to the network of corporations, financial institutions, investors and governments which deal with the flow of short-term capital.  It exists to provide the loans that financial institutions and governments need to carry out their day-to-day operatio...

MONEY MARKETS AND CAPITAL MARKETS  It refers to the network of corporations, financial institutions, investors and governments which deal with the flow of short-term capital.  It exists to provide the loans that financial institutions and governments need to carry out their day-to-day operations.  For instance, banks may sometimes need to borrow in the short term to fulfill their obligations to their customers and they use the money market to do so.  Banks may find that they have greater demand for mortgages or loans than they do for savings accounts at certain times.  This creates a mismatch between the money they have available and the money they have loaned out, so the bank will need to borrow in order to be able to fulfill the demand for loans.  The money markets are the mechanisms that bring the borrowers and investors together without the comparatively costly intermediation of banks.  There is an identifiable money market for each currency because interest rates vary from one currency to another.  The money markets do not exist in a particular place or operate  These markets are not independent and both investors and according to a single set of rules nor do they offer a single set of posted borrowers will shift from one currency to another depending upon prices with one current interest rate for money. relative interest rates.  Rather, they are webs of borrowers and lenders, all linked by telephones  Most money market transactions occur in the investor’s home and computers. currency.  At the center of each web is the central bank whose policies determine the short-term interest rates for that currency. Who uses the money market?  The constant soundings among these diverse players for the best available rate at a particular money are the forces that keep the market competitive.  The money markets are related to the bond markets in which corporations and governments borrow and lend based on longer-term contracts. Similar to bond investors, money-market investors are extending credit without taking any ownership in the borrowing entity or any control over management.  A well-functioning money market facilitates the development of a market for longer-term securities.  Money markets attach a price to liquidity, the availability of money for immediate investment.  In the absence of active money markets to set short-term rates, issuers and investors may have less confidence that longer-term rates are reasonable and greater concern about being able to sell their securities should they so choose. Angel F. TYPES OF MONEY-MARKET INSTRUMENTS TREASURY BILLS Money Market Securities  They are often referred to as T-bills.  These are short-term instruments with an original maturity of less than  They are securities with a maturity of one year or less issued by national one year. governments.  These are used to “warehouse” funds until needed. The returns earned  They are issued by the government in its own currency are generally on these investments are low due to their low risk and high liquidity. considered the safest of all possible investments in that currency.  These are usually more widely traded than longer-term securities and so tend to be more liquid. GOVERNMENT AGENCY NOTES  National government agencies and government- sponsored corporations COMMERCIAL PAPER are heavy borrowers in the money markets in many countries.  It is a short-term debt obligation of a private-sector firm or a  These include entities such as development banks, housing finance government-sponsored corporation. corporations, education lending agencies and agricultural finance  Only companies with good credit ratings issue commercial paper agencies. because investors are reluctant to bring the debt of financially  These are issued by, provincial or local governments and by agencies of compromised companies. these governments such as schools authorities and transport  They tend to be issued by highly rated banks and are traded in a similar commissions. way to securities.  The ability of governments at this level to issue money-market securities  In most cases, the paper has lifetime or maturity, greater than 90 day varies greatly from country to country. but less than nine months.  In some cases, the approval of national authorities is required; in others,  It is usually unsecured although a particular commercial paper issue local agencies are allowed to borrow only from banks and cannot enter may be secured by a specific asset of the issuer or may be guaranteed the money markets. by a bank INTERBANK LOANS BANKER’S ACCEPTANCE  They are loans extended from one bank to another with which it has no  Before the 1980s, banker’s acceptances were the main way for firms to affiliation. raise short-term funds in the money markets.  Many of these loans are across international boundaries and are used  An acceptance is a promissory note issued by a non-financial firm to a by the borrowing institution to re-lend to its own customers. bank in return for a loan.  Bank lend far greater sums to other institutions in their own currency:  The bank resells the note in the money market at a discount and Overnight loans are short-term unsecured loans from one bank another. guarantees payment. They may be used to help the borrowing bank finance loans to  Acceptances usually have a maturity of less than six months. customers but often the borrowing banks adds the money to its reserves  It is different from commercial paper in significant ways: in order to meet regulatory requirements and to balance assets and  They are usually tied to the sale or storage of specific goods such as an liabilities. export order for which the proceeds will be received in two or three months. TIME DEPOSITS  They are not issued at all by financial-industry firms.  They are also known as Certificates of Deposit or CDs/  They do not bear interest; instead, an investor purchases the  They are interest bearing bank deposits that cannot be withdrawn acceptance at a discount from face value and then redeems it for face without penalty before a specified date. value at maturity. Investors rely on the strength of the guarantor bank, rather than of the issuing company for their security.  Although time deposits may last for as long as five years, those with  It occurs in either the primary market or the secondary market. terms of less than one year compete with other money-market  The primary market is where new issues of stocks and bonds are instruments. introduced.  Time deposits with terms as brief as 30 days are common.  A secondary market is where the sale of previously issued securities  Interest rates depend on length of maturity with longer terms getting takes place and it is important because most investors plan to sell long- better rate. term bonds before they reach maturity and eventually to sell their  The main risks are being locked into low interest rates if rates rise and holdings of stock as well. early withdrawal penalties. A. Organized Exchanges – has a building where securities (including stocks, bonds, options and features) trade. REPURCHASE AGREEMENTS (REPOS) B. Over-the-counter Exchanges  They serve to keep the markets highly liquid, which in turn ensures that there will be a constant supply of buyers for new money-market BOND instruments.  It is any long-term promissory note issued by the firm.  A repo is a combination of two transactions.  A bond certificate is the tangible evidence of debt issued by a  In the first, a securities dealer, such as a bank sells securities it owns to corporation or a governmental body and represents a loan made by an investor, agreeing to repurchase the securities at a specified higher investors to the issuer. price at a future date.  Bonds are the most prevalent example of the interest only loan with  In a second transaction, days or months later, the repo is unwound as investors receiving exactly the same two sets of cash flows: the dealer buys back the securities from the investor.  The periodic interest payments; and  The amount the investor lends is less than the market value of the  The principal (par value or face value) returned at maturity securities, a difference called the spread or haircut, to ensure that it still has sufficient collateral if the value of the securities should fall before the TRADING PROCESS FOR CORPORATE BONDS dealer repurchases them. The initial or primary sale of corporate bond issues occurs either through a public offering, using an investment bank serving as a security underwriter or CAPITAL MARKET through a private placement to a small group of investors (often financial  It is a financial market in which longer-term debt (original maturity of one institutions). year or greater) and equity instruments are traded. Most often , corporate bonds are offered publicly through investment banking  Capital market securities include bonds, stocks and mortgages. firms as underwriters.  These are often held by financial intermediaries such as insurance companies and pension funds which have little uncertainty about the amount of funds they will have available in the future. CAPITAL MARKET PARTICIPANTS National and Local Government It issues long-term notes and bonds to fund the national debt while local governments issue notes and bonds to finance capital projects. Corporations They issue both bonds and stock to finance capital investment expenditures and fund other investment opportunities. CAPITAL MARKET TRADING  The investment bank guarantees the firm a price for newly issued  Debt (other than income bonds) results in interest payments that, if not bonds by buying the whole issue at a fixed price (the bid price) from the met, can force the firm into bankruptcy. bond-issuing firm at a discount from par.  Debt (other than income bonds) produces fixed charges, increasing the  The investment bank then seeks to resell these securities to investors firm’s financial leverage. Although this may not be a disadvantage to all as the higher price (the offer price). firms, it certainly is for some firms with unstable earnings streams.  As a result, the investment bank takes a risk that it may not be able to  Debt must be repaid at maturity and thus at some point involves a major resell the securities to investors at a higher price. This may occur if a cash outflow. firm’s bond value suddenly falls due to an unexpected change in interest  The typically restrictive nature of indenture covenants may limit the rates or negative information being released about the issuing firm. firm’s future financial flexibility.  If this occurs, the investment bank takes a loss on its security underwriting. Bonds Features and Prices  However, the bond issuer is protected by being able to sell the whole 1. Par Value – the face value of the bond that is returned to the issue. bondholder at maturity 2. Coupon Interest Rate – the percentage of the par value of the bond Other arrangements can be as follows: that will be paid out annually in the form of interest (Stated interest Competitive Sale payment/par value  The investment bank can purchase the bonds through competitive 3. Maturity – the length of time until the bond issuer returns the par value bidding against other investment banks or by directly negotiating with to the bondholder and terminates the bond the issuer. 4. Indenture – the agreement between the firm issuing the bonds and the  Negotiated Sale bond trustee who represents the bondholders. It provides the specific  A single investment bank obtains the exclusive right to originate, terms of the loan agreement, including the description of the bonds, the underwrite and distribute the new bonds through a one-on-one rights of the bondholders, the rights of the issuing firm and the negotiation process. responsibilities of the trustees. Best Efforts Underwriting Basis 5. Current Yield – refers to the ratio of the annual interest payment to the  In their arrangement, the underwriter does not guarantee a firm price to bond’s market price the issuer. The investment banks incurs no risk of mispricing the security since it simply seeks to sell the securities at the best market Yield to Maturity price it can get for the issuing firm.  This refers to the bond’s internal rate of return.  It is the discount rate that equates the present value of the interest and Advantages of Bonds principal payments with the current market price of the bond.  Long-term Debt is generally less expensive than other forms of financing because (1) investors view debt as a relatively safe investment alternative and demand a lower rate of return, and (b) interest expenses are tax deductible.  Bondholders do not participate in extraordinary profits; the payments are limited to interest.  Bondholders do not have voting rights.  Flotation costs of bonds are generally lower than those of ordinary equity shares. Disadvantages of Bonds What is the bond’s approximate yield to maturity given the following info: Par value of Bond Php 1,000 Interest Rate 10% Term 10 years Current Price Php 900 Approximate Yield to Maturity = {100 +( 1,000−900)/10}/{(0.6 (900)+0.4 (1,000)} = 11.70% Credit Quality Risk It is the chance that the bond issuer will not be able to make timely payments. BOND RATINGS – involve a judgment about the future risk potential of the bond provided by rating agencies such as Moody’s, Standard and Poor’s and Fitch IBCA, Inc. Dominion Bond Rating Services. Bond Ratings are favorably affected by: 1. A low utilization of financial leverage 2. Profitable operations 3. A low variability of past earnings 4. Large firm size 5. Little use of subordinated debt  The poorer the bond rating, the higher the rate of return demanded in the capital markets.  The bond credit ratings agencies assign similar rating based on detailed analyses of issuers’ financial condition, general economic and credit market conditions and the economic value of any underlying collateral.  High quality corporate bonds are considered investment grade while higher credit risk bonds are speculative, also called junk bonds and high-yield bonds. CREDIT RATINGS  TYPES OF BONDS  They forbid the further use of the pledged assets security for other 1. Unsecured Long-term Bonds bonds. This protects the bondholders from dilution of their claims on  Debentures the assets by any future mortgage bonds. - These are unsecured long-term debt and backed only by the Open-end Mortgage Bonds reputation and financial stability of the corporation.  These bonds allow the issuance of additional mortgage bonds using - Because these bonds are unsecured, the earning ability of the the same secured assets as security. issuing corporation is of great concern to the bondholder.  However, a restriction may be placed upon the borrower, requiring  Subordinated Debentures that additional assets should be added to the secured property if - Claims of bondholders of subordinated debentures are honored new debt is issued. only after the claims of secured debt and unsubordinated debentures have Limited Open-end Mortgage Bonds been satisfied.  These bonds allow the issuance of additional bonds up to a limited  Income Bond amount at the same priority level using the already mortgaged - It requires interest payments only if earned and non-payment of assets as security. interest does not lead to bankruptcy. - Usually issued during the reorganization of a firm facing financial OTHER TYPES OF BONDS difficulties, these bonds have longer maturity and unpaid interest is generally allowed to accumulate for some period of time and must be paid prior to the Floating Rate or Variable Rate Bond payment of any dividends to stockholders.  It is one in which the interest payment changes with market 2. Secured Long-term Bonds conditions.  Mortgage Bond  A common feature of all the floating rate bonds is that an attempt is - It is a bond secured by a lien on real property. being made to counter uncertainty by allowing the interest rate to - Typically, the market value of the real property is greater than that float. In this way, a change in cash inflows to the firm may be offset of the mortgage bonds issued. by an adjustment in interest payments. - This provides the mortgage bondholders with a margin of safety in Junk or Low-rated Bonds the event that the market value of the secured property declines.  These are bonds rated BB or below. - Should the issuing firm fail to pay the bonds at maturity; the trustees  The major participants of this market are new firms that do not have can foreclose or sell the mortgaged property and use the proceeds to pay an established record of performance, although in recent years junk the bondholders. bonds have been increasingly issued to finance corporate buyouts Eurobonds Classifications of Mortgage Bonds  These are bonds payable or denominated in the borrower’s First Mortgage Bonds currency but sold outside the country of the borrower, usually by an  They have the senior claim on the secured assets if the same international syndicate of investment bankers. property has been pledged on more than one mortgage bond. Treasury Bonds  Second Mortgage Bonds  They carry the “full-faith-and-credit” backing of the government and  These bonds have the second claim on assets and are paid only investors consider them among the safest fixed income investments after the claims of the first mortgage bonds have been satisfied. in the world. Blanket or General Mortgage Bonds  The BSP sells Treasury securities through public auctions usually to All the assets of the firm are used as security for this type of bonds. finance the government’s budget deficit. Closed-end Mortgage Bonds ORDINARY (COMMON) EQUITY SHARES   It is a firm of long-term equity that represents ownership interest of Common Systems of Voting the firm. 1. Majority Voting is a voting system that entitles each  Ordinary equity shareholders are called residual owners because shareholder to cast one vote for each share owned. their claim to earnings and assets is what remains after satisfying 2. Cumulative Voting is a voting system that permits the the prior claims of various creditors and preferred shareholders. shareholder to cast multiple votes for a single director.  Ordinary (common) equity shareholders are the true owners of the Book value per share corporation and consequently bear the ultimate risks and rewards of  The accounting value of an ordinary equity share is equal to the ownership. ordinary share equity (ordinary share plus paid-in-capital plus  Business firms organized as a corporation may choose to issue retained earnings) divided by the number of share outstanding. publicly trade stock (publicly owned corporation) or keep ownership only among the original organizers (closely held corporation. Numerous rights of stockholders  As owners of the firm, ordinary shareholders are considered to be 1. Right to vote on specific issues as prescribed by the corporate charter residual domains. This means hat ordinary shareholders have the such as election of the BOD, selecting the firm’s independent auditors, right to claim any cash flows or value after all other claimants have amending the articles of incorporation and by-laws, increasing the received what they are owed. amount of authorized stock and so forth  Shareholders assume a limited liability because their risk of 2. Right to receive dividends if declared by the firm’s BOD potential loss is limited to their investment in the corporation’s equity 3. Right to share in the residual assets in the event of liquidation shares. 4. Right to transfer their ownership in the firm to another party 5. Right to examine the corporate banks Features of Ordinary Equity Shares 6. Right to share proportionately in the purchase of any new issuance of equity shares. This is known as the pre-emptive right. Par Value/No Par Value  Ordinary equity share may be sold with or without par value. PREFERRED SHARE  Par Value of Ordinary Equity Share is the stated value attached to a  Preferred Share is a class of equity shares which has preference single share at issuance. over ordinary (common) equity shares in the payment of dividends Authorized, Issued and Outstanding and in the distribution of corporation assets in the event of  Authorized Shares is the maximum number of shares that a liquidation. corporation may issue without amending its charter.  Preference means only that the holders of the preferred share must  Issued Shares is the number of authorized shares that have been receive a dividend (in the case of a going concern firm) before sold. holder of ordinary (common) equity shares are entitled to anything.  Outstanding Shares are those shares held by the public.  Preferred shares generally has no voting privileges but it is a form of  Treasury Shares are previously issued shares that are reacquired equity from a legal and tax sand point. and held by the firm.  The issuance of preferred shares is favored when the following No Maturity conditions prevail:  Ordinary equity share has no maturity and is a permanent form of  Control problems exist with the issuance of ordinary share long-term financing.  Profit margins are adequate to make of additional leverage  A tender offer is a formal offer to purchase shares of a corporation. attractive  Voting Rights  Additional debt poses substantial risk  Each share of ordinary equity generally entitles the holder to vote on  Interest rates are low lowering the cost of preferred share the selection of directors and in other matters.  The firm has a high debt ratio, suggesting infusion of equity  Proxy is a temporary transfer of the right to vote to another party. financing is needed.   The intrinsic value of a share of preferred share (Po) is the sum of the PREFERRED SHARE FEATURES present values of future dividends discounted at the investor’s required 1. Par Value is the face value that appears on the stock certificate. In rate of return. some cases, the liquidation value per share is provided for in the Po = Dp/Kp certificate. where: Dp = per share cash dividend 2. Dividends are stated as a percentage of the par value and are Kp = Investor’s required rate of return on preferred share commonly fixed and paid quarterly but are not guaranteed by the issuing firm. EXAMPLE: 3. Cumulative and Noncumulative Dividends. If preferred dividends are Federal Electric and Power Company has an issue of preferred share cumulative are not paid in a particular year, they will be carried forward outstanding that pays a yealy dividend of Php 10.80 Investors require a 12% as an arrearage. If the preferred dividends are noncumulative, dividends return on this preferred share. Determine the intrinsic value of the preferred not declared in any particular year are lost forever and the preferred share. shareholders cannot claim such anymore. Po = Dp/Kp 4. No definite maturity date. Preferred share is usually intended to be = 10.80/0.12 permanent part of a firm’s equity and has no definite maturity date. = Php 90 However, preferred share sometimes carries special retirement provisions. 5. Convertible Preferred Share. Owners of convertible preferred share have the option of exchanging their preferred share for ordinary (common) equity share based on specified terms and conditions. 6. Voting Rights. Preferred share does not ordinarily carry voting rights Special voting procedures may take effect if the issuing firm omits its preferred dividends for a specific time period. 7. Participating Features. Participating preferred share entitles its holders to share in profits above and beyond the declared dividend, along with ordinary (common) equity shareholders. 8. Protective Features. Preferred share issues often contain covenants to assure the regular payment of preferred share dividends and to improve the quality of preferred share. 9. Call Provision. It gives the issuing corporation the right to call in the preferred share for redemption. 10. Maturity. Today, most new preferred share has a sinking fund and thus, an effective maturity date. PREFERRED SHARE VALUATION  Preferred share is share that has a claim against income and assets before ordinary share but after debt.  Preferred share valuation is relatively simple if the firm pays fixed dividends at the end of each year.