Financial Markets and Institutions PDF

Learning Goals Chapter One Differentiate between primary and secondary markets....

Learning Goals Chapter One Differentiate between primary and secondary markets. Differentiate between money and capital markets. Introduction Understand the concept of foreign exchange markets. Understand the concept of derivative security markets. The different types of financial institutions. Know the services financial institutions perform. Know the risks financial institutions face. Appreciate why financial institutions are regulated. Copyright 2022 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC. © McGraw Hill 1-2 Financial Markets Why Study Financial Markets? In our society, markets and institutions play an important Financial markets are structures through which role in deciding where capital is allocated. funds flow. Understanding how money flows through the economy Financial markets can be: is important for managers and individual investors primary and secondary markets when making investment and financing decisions. money and capital markets. Managers and individuals must also understand the operation and structure of domestic and international financial markets. © McGraw Hill 1-3 © McGraw Hill 1-4 Primary versus Secondary Primary and Secondary Market Markets 1 Transfer of Funds TimeLine Primary markets: Markets where corporations raise funds through new issues of financial instruments like stocks and bonds. Include equity issues for firms going public through initial public offerings (IPOs). Secondary markets: Markets where financial instruments are traded after they are issued. Secondary markets offer liquidity, pricing information, and low transaction costs. © McGraw Hill 1-5 © McGraw Hill 1-6  Money versus Capital Markets How were primary markets Money markets are where short-term debt securities and instruments with maturities of one year or less are traded. affected by the financial less risk, less price fluctuations crisis? The financial crisis significantly impacted firms' primary Capital markets trade debt (bonds) and equity (stocks) market sales. New issues fell to $1,068.0 billion in 2008 instruments with more than one-year maturities. from $2,389.1 billion in 2007. As of 2018, primary market larger price fluctuations than money market instruments. sales had still not recovered. Access the text alternative for slide images. © McGraw Hill 1-7 © McGraw Hill 1-8 Foreign Exchange Markets Derivative Security Markets 1 The foreign exchange market is the global market for A derivative security is a financial security (for example, exchanging currencies of different countries. future, option, swap, or mortgage-backed security) whose payoff is linked to another previously issued security, such as security traded in capital or foreign exchange markets. Foreign exchange risk is the sensitivity of cash flows on Derivatives are traded in derivative security markets. foreign investments to changes in the foreign currency's value in terms of dollars. Generally involves an agreement between two parties to exchange a standard quantity of an asset or cash flow at a U.S. dollars received on a foreign investment depends on the specified price and at a specified future date. exchange rate between the U.S. dollar and the foreign currency when the non-dollar cash flow is converted into U.S. Derivative markets are the most recent type of financial security dollars. markets and can also be the riskiest. © McGraw Hill 1-9 © McGraw Hill 1-10 Derivative Security Markets 2 Financial Market Regulation Derivative activity: Financial instruments are regulated by agencies like the Tremendous growth between 1992 to 2013. Capital Market Authority (CMA). Large drop from 2013 to 2019, due largely to the 2014 CMA's main claim is that information on securities issues implementation of the Volcker Rule. should be fully and fairly disclosed to actual and potential TABLE 1–4 Derivative Contracts Held by Commercial Banks, by Contract Product (in billions of investors. dollars). CMA monitors trading on the major exchanges to ensure 1992 2000 2008 2013 2016 2019 Futures and forwards $ 4,780 $ 9,877 $ 22,512 $ 45,599 $ 35,685 $ 46,165 stockholders and managers do not trade on inside Swaps 2,417 21,949 131,706 138,361 107,393 106,837 information about their firms Options 1,568 8,292 30,267 33,760 30,909 44,134 Credit derivatives ---- 426 15,897 13,901 6,986 4,145 Total $ 8,765 $ 40,544 $ 200,382 $ 231,621 $ 180,973 $ 201,281 Note: Em dashes represent values that are too small to register. Sources: Office of the Comptroller of the Currency website, various dates, www.occ.treas.gov © McGraw Hill 1-11 © McGraw Hill 1-12 Overview of Financial Institutions Types of Financial Institutions 2 Financial institutions play a significant role in transferring funds from surplus funds to those with shortages of funds. Securities firms and investment banks Financial institutions Types of Financial Institutions assist firms in issuing securities and performing activities like Commercial banks— depository institutions whose major assets are loans and brokerage and trading. major liabilities are deposits. They offer a wide range of loans, including consumer, commercial, and real estate loans; their liabilities include deposits and non-deposit Finance companies are financial intermediaries that make loans sources of funds such as (subordinate notes and debentures) to individuals and businesses. Unlike depository institutions, Thrifts—Depository institutions include savings associations, banks, and credit finance companies do not accept deposits but rely on short—and unions. Thrifts offer services like commercial banks but mainly focus on specific areas like real estate or consumer loans. long-term debt for funding. Insurance companies are financial institutions that protect individuals and Investment funds are financial institutions that pool the financial corporations (policyholders) from adverse events. Life insurance protects against resources of individuals and companies and invest those death, illness, and retirement, while Property-casualty insurance protects against personal injury and liability due to accidents, theft, fire, etc. resources in diversified portfolios of assets. © McGraw Hill 1-13 © McGraw Hill 1-14 Types of Financial Institutions 3 Flow of Funds Pension funds—Financial institutions offer savings plans for Flow of Funds in a Flow of Funds in a accumulating funds during working years, to be withdrawn in World without FIs World with FIs retirement. Pension fund investments are tax-exempt. FinTechs—Institutions that utilize technology to provide financial services in a way that competes with traditional financial methods. Access the text alternative for slide images. © McGraw Hill 1-15 © McGraw Hill 1-16 Risks Incurred by Financial Risks Incurred by Financial Institutions Institutions Off-balance sheet risk FIs hold contingent assets and liabilities Default risk: all FIs hold some assets that are potentially subject to off the balance sheet, which presents an additional risk known default or credit risk (such as loans, stocks, and bonds). as off-balance-sheet risk. Foreign exchange risk and country: As FIs expand their services Liquidity risk: All financial institutions face liability withdrawal internationally, they face foreign exchange and country risks. or liquidity risk based on the type of claims they have sold to Interest rate risk: FIs face interest rate risk due to mismatched liability holders. maturities of their assets and liabilities. Technology and operational risk: All financial institutions face Market risk or asset price risk: FIs that actively trade assets and technology and operational risks due to using resources and liabilities are more exposed to market or asset price risk. support systems in providing services. Insolvency risk: An FI faces the risk of insufficient capital reserves to offset sudden losses, creating insolvency risk. © McGraw Hill 1-17 © McGraw Hill 1-18 Benefits and Functions of FIs: Services Benefits and Functions of FIs: Services that Benefit Suppliers of Funds Benefiting the Overall Economy  Monitoring costs: In an FI, pooling funds leads to lower average monitoring costs due to economies of scale.  Money supply transmission: Deposits are a significant  Liquidity and price risk: Financial institutions offer financial component of the money supply, which in turn directly claims to household savers with better liquidity and lower price impacts the rate of economic growth risk.  Credit allocation: FIs are a major source of financing  Transaction cost services: Similar to economies of scale in for particular sectors of the economy information production costs, an FI's size can lead to  Intergenerational wealth transfers: FIs, such as life economies of scale in transaction costs. insurance companies and pension funds, enable savers  Maturity intermediation: FIs can better manage the risk of to transfer wealth from generation to generation. mismatching the maturities of their assets and liabilities.  Payment services: FIs provide payment services that directly benefit the economy such as transfer services. © McGraw Hill 1-19 © McGraw Hill 1-20 Regulation of Financial Institutions Failures of FIs can cause widespread panic and withdrawal runs in institutions. Fintech The 2008 increase in the deposit cap (to $250,000 per person Financial technology, or fintech, refers to using technology to per bank) was intended to instill confidence in the banking deliver financial solutions that compete with traditional methods. system. Includes services such as cryptocurrencies (for example, bitcoin) and FIs regulated to prevent market failures and their blockchain. associated costs to the economy and society at large. Fintech risk involves the risk that fintech firms could disrupt the business of financial services firms, resulting in lost customers and revenue. Supports models of peer-to-peer mass collaboration. © McGraw Hill 1-21 © McGraw Hill 1-22 Appendix 1A - The Financial Crisis: Appendix 1A - The Financial Crisis: The Failure of FIs The Failure of FIs (Continued) Home prices dropped in late 2006 and early 2007  The Crisis Hits  Defaults by subprime mortgage borrowers began to affect the mortgage lending industry, as well as the rest  September 8, 2008: of the economy  Approximately $9b in losses in the last half of 2007 related to subprime mortgage-backed securities  FIs that held these mortgages and mortgage-backed securities started announcing huge losses as borrowers  September 15, 2008: defaulted  Lehman Brothers filed for bankruptcy  Losses reached over $400b worldwide through 2007 © McGraw Hill 1-23 © McGraw Hill 1-24  The Dow Jones Industrial Average, Overnight LIBOR, 2001 to 2010 October 2007 to January 2010 Access the text alternative for slide images. Access the text alternative for slide images. © McGraw Hill 1-25 © McGraw Hill 1-26 Chapter Two Determinants of End of Main Content Interest Rates Copyright 2022 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC. Copyright 2022 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC. 1-27 Interest Rate Fundamentals Learning Goals  Know who are the main suppliers and demanders of Nominal interest rates: These nominal interest loanable funds rates (or just interest rates) directly impact the value  Understand how equilibrium interest rates are determined (price) of most securities traded in the money and  Analyze the factors that lead to shifts in the supply and capital markets. demand curves for loanable funds.  Changes in interest rates impact the decisions  Understand the determinants of interest rates for and performance of individuals, businesses, and individual securities and why individual investments have different interest rates governments.  FIs try to identify factors that determine interest rates and their  Understand how interest rates are used to determine movements over time. present and future values © McGraw Hill 2-2 © McGraw Hill 2-3  Loanable Funds Theory Supply of Loanable Funds “Supply of loanable funds” describes funds provided to the  One commonly used model to explain interest rates financial markets by net suppliers of funds: and interest rate movements is the loanable funds  Generally, the quantity of loanable funds supplied theory. increases as interest rates rise (the reward for supplying The loanable funds theory suggests that equilibrium funds is higher)  The household and business sectors supply loanable funds, and interest rates in financial markets are the result of the governments and foreign investors also contribute to the U.S. supply and demand for loanable funds. financial markets.  It categorizes participants in the financial market— consumers, businesses, governments, and foreign entities— as either suppliers or demanders of funds. © McGraw Hill 2-4 © McGraw Hill 2-5 Supply of and Demand for Demand for Loanable Funds Loanable Funds “Demand for loanable funds” describes fund users’ total net demand for funds. In general, the quantity of loanable funds demanded is higher as interest rates fall. Household demand reflects purchases of homes and goods, businesses need funds for investments and working capital, governments borrow heavily, and foreign participants borrow in U.S. financial markets. Access the text alternative for slide images. © McGraw Hill 2-6 © McGraw Hill 2-7 Factors That Affect the Supply of and Factors That Cause the Supply Demand for Loanable Funds for a Curve for Loanable Funds to Shift Financial Security 1 Factors that cause the supply curve of loanable funds to shift, at Panel A: The supply of any given interest rate: funds Factor Impact on Supply of Funds Impact on Equilibrium Interest Rate* 1. As the wealth of fund suppliers increases (decreases), the supply of Interest rate Movement along the supply curve Direct loanable funds increases (decreases). Total wealth Shift supply curve Inverse 2. As the risk of financial security increases (decreases), the supply of Risk of financial security Shift supply curve Direct loanable funds decreases (increases). Near-term spending needs Shift supply curve Direct Monetary expansion Shift supply curve Inverse 3. Near-term spending needs When financial market participants have few Economic conditions Shift supply curve Inverse near-term spending needs, the absolute dollar value of funds available to invest increases. 4. When monetary policy allows the economy to expand (restrict expansion), *A “direct” impact on equilibrium interest rates means that as the “factor” increases (decreases) the equilibrium interest the supply of loanable funds increases (decreases). rate increases (decreases). An “inverse” impact means that as the factor increases (decreases) the equilibrium interest rate decreases (increases). 5. As economic conditions improve in a domestic (foreign) country, the supply of funds increases (decreases). © McGraw Hill 2-8 © McGraw Hill 2-9  Factors That Cause the Supply and Factors That Affect the Supply of and Demand Curves for Loanable Funds to Demand for Loanable Funds for a Shift 2 Financial Security 2 1. As the utility derived from an asset purchased with Panel B: The demand for funds borrowed funds increases (decreases), the demand for Factor Impact on Supply of Funds Impact on Equilibrium Interest Rate loanable funds increases (decreases). Positive relationship Interest rate Movement along the demand Direct 2. As the restrictiveness of nonprice conditions on borrowed curve Utility derived from asset Shift demand curve Direct funds increases (decreases), the demand for loanable funds purchased with borrowed decreases (increases). the inverse relationship funds fees, collateral, or Shift demand curve Inverse  Nonprice conditions may include fees, collateral, or requirements or requirements restrictions on the use of funds (i.e., restrictive covenants) Economic conditions Shift demand curve Direct 3. When domestic economic conditions result in a period of growth (stagnation), the demand for funds increases (decreases) Positive relationship © McGraw Hill 2-10 © McGraw Hill 2-11 Determinants of Interest Rates Determinants of Interest Rates for for Individual Securities: Inflation Individual Securities: Default Risk  Inflation is the continual increase in the price level of a basket of goods and services  Default risk is the risk that a security issuer  The higher the level of inflation, the higher the level of may not make promised interest and interest rates principal payments.  Inflation is measured using indexes  The higher the default risk, the higher the  Consumer price index (CPI) interest rate demanded by the buyer as a  Producer price index (PPI) premium for this risk. © McGraw Hill 2-12 © McGraw Hill 2-13 Determinants of Interest Rates for Determinants of Interest Rates for Individual Securities: Special Individual Securities: Liquidity Risk Provisions or Covenants 1. Liquidity risk is the risk that a security cannot be sold at a predictable price with low transaction costs at short notice. (land,  A convertible security can be converted into another security car) of the same issuer, such as bonds or preferred stocks into common stock. 2. A highly liquid asset can be converted into its full market value at short notice ( stock, three month T-Bills)  giving them a lower interest rate than non-convertible securities. 3. The interest rate on security reflects its relative liquidity, with highly  Special provisions benefiting the security holder are linked to liquid assets carrying the lowest interest rates lower interest rates, while those benefiting the security issuer 4. If the security is less liquid, investors add a liquidity risk premium are linked to higher interest rates. (LRP) to the interest rate on the security 5. A diffInvestors demand a liquidity premium to compensate for the security’s lack of liquidity (e.g., bonds) 6. liquidity risk premium may also be added if investors dislike long- term securities because their prices are more sensitive to interest rate changes than short-term securities. © McGraw Hill 2-14 © McGraw Hill 2-15  Determinants of Interest Rates for Common Shapes for Yield Curves Individual Securities: Term to Maturity on Treasury Securities  The relationship between interest rate and term to maturity of a security is called term structure of interest rates or the yield curve  It compares market yields on securities, assuming (i.e., default risk, liquidity risk) are the same except for maturity.  Change in required interest rates as the maturity of a security changes is called the maturity premium (MP)  The maturity premium is the difference between the required yield on long- and short-term securities. Everything else is constant except maturity  The maturity premium can be positive, negative, or zero. Access the text alternative for slide images. © McGraw Hill 2-16 © McGraw Hill 2-17 Time Value of Money Present Value  Interest rates affect the value of financial securities  The present value of an investment is the in-trinsic value  The time value of money is that a dollar received or price of the investment. today is worth more than a dollar received at some  The present values of the security investment decrease future date. as interest rates increase  Time value of money is used to convert the value of future cash flows into their current or present values © McGraw Hill 2-18 © McGraw Hill 2-19 Future Value Calculation of Present Value  Future value converts cash flow received at the  You have been offered a security investment beginning of an investment period into a terminal value such as a bond that will pay you $10,000 at at the end of an investment period. the end of six years in exchange for a fixed  The future value of an investment increases as interest payment today. If the appropriate annual rates increase interest rate on the investment is 8 percent compounded annually, what is the present value of this investment? © McGraw Hill 2-20 © McGraw Hill 2-21  Calculation of Future Value Problem Set  You plan to invest $10,000 today in exchange  Calculate the present value of $5,000 received five for a fixed payment at the end of six years. If years from today if your investments pay:  10 percent compounded annually the appropriate annual interest rate on the  10 percent compounded semiannually investment is 8 percent compounded  10 percent compounded quarterly. annually, what is the future value of this investment? © McGraw Hill 2-22 © McGraw Hill 2-23 Chapter 4 Suppose you can save $2,000 annually for the next ten years in an account earning 7 percent annually. How much will you have at the end of Money Markets the tenth year if you make the first deposit today? Copyright © 2022 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill. © McGraw Hill 2-24 Learning Goals Money Markets  Money market Money markets trade debt securities or  Define money markets. instruments with less than one year of maturity.  Identify the major types of money market securities.  Examine the process used to issue Treasury securities. Money market instruments have the following characteristics:  List the main participants in money markets.  They are generally sold in large denominations ($1m to  Examine the extent to which foreign investors participate in $10m units).  They have low default risk. U.S. money markets.  They must have an original maturity of one year or less. © 2022 McGraw-Hill Education. 5-2 © 2022 McGraw-Hill Education. 5-3  Bond Markets Learning Goals Equity and debt instruments with maturities of more than one year trade Describe the major bond markets. in capital markets. Identify the characteristics of the various bond market securities. Bonds are long-term debt obligations issued by corporations and government units. List the major bond market participants. Proceeds from a bond issue are used to raise funds to support the long-term Describe the types of securities traded in international operations of the issuer. bond markets. If the bond issuer does not meet the terms of the repayment, the bond holder (investor) has a claim on the assets of the bond issuer. Bond markets are markets in which bonds are issued and traded. Treasury notes (T-notes) and bonds (T-bonds). Municipal bonds. Corporate bonds. © McGraw Hill 6-2 © McGraw Hill 6-3 Treasury Notes and Bonds 1 Treasury Notes and Bonds 2 Treasury notes and bonds (T-notes and T-bonds) are T-bills have an original maturity of one year or less issued by the U.S. Treasury to finance the national debt and T-notes have original maturities from over 1 to 10 years, other government expenditures. T-bonds have original maturities from over 10 years. once issued, T-notes and T-bonds trade in very active secondary markets. T-notes and bonds are backed by the U.S. government but are not completely risk-free due to their longer maturity and wider T-notes have original maturities from 1 to 10 years and pay price fluctuations. interest semi-annually. T-notes and T-bonds are issued in minimum denominations of $100 or T-bonds have original maturities over 10 years. multiples of $100. © McGraw Hill 6-4 © McGraw Hill 6-5 Treasury Inflation Protected Treasury Notes and Bonds Securities (TIPS) 3 Treasury issued two types of notes and bonds: fixed principal Unlike fixed-principal bonds, the principal value of a TIPS and (Treasury Inflation-Protected Securities TIPS) bond can increase (or decrease) every six months by the Both types pay interest twice per year(semi-annually). amount of U.S. inflation (or deflation) as measured by the percentage change in the CPI. inflation-indexed bonds(TIPS) adjust their principal value and interest payments based on inflation metrics such as the Consumer It is used by investors who wish to earn a rate of return on their Price Index (CPI) investments that keeps up with inflation over time. In other words, the semi-annual coupon payments and the final principal payment are based on the inflation-adjusted principal value of the security. © McGraw Hill 6-6 © McGraw Hill 6-7  Accrued Interest 1 STRIPS Accrued interest: When you buy a T-note or T-bond between A STRIPS is a Treasury security in which periodic coupon coupon payments, you need to pay the seller the interest accrued interest payments can be separated from each other and from between the last coupon payment and the settlement day. the final principal payment. The U.S. Treasury doesn't sell STRIPS to investors directly. Instead, financial institutions and government securities brokers and dealers create STRIPS by At settlement, the buyer must pay the seller the purchase price of the purchasing the original T-notes or T-bonds. T-note or T-bond plus accrued interest. The sum of these two is often called the full price or the dirty price of the security. Investors who require a large sum of money in the future The price without the accrued interest added on is called the clean would rather hold the principal portion of the STRIPS. price. Investors wanting nearer-term cash flows would prefer the interest portions of the STRIPS. © McGraw Hill 6-8 © McGraw Hill 6-9 Primary and Secondary Market Municipal Bonds Trading in T-Notes and T-Bonds U.S. Treasury sells T-notes and T-bonds through Municipal bonds are bonds issued by state or local governments. competitive and non-competitive Treasury auctions. The auction is a single-price auction—all bidders pay the Attractive to household investors because interest is exempt same price, which is the price associated with the highest from federal and most state/local income taxes. competitive yield bid. Exempt from federal taxation, investors require lower yields At each auction, non-competitive bids are filled first. than other bonds. Next, competitive bids are ranked from the lowest to highest Two types of municipal bonds exist: yield (a bidder willing to accept the lowest yield is willing to 1. General obligation (G O) bonds pay the highest price). 2. Revenue bonds Most secondary trading occurs directly through broker and dealer trades. © McGraw Hill 6-10 © McGraw Hill 6-11 The Trading Process for Two types of municipal bonds Municipal Bonds. The initial (primary market) sale for municipal bonds (and corporate 1. General obligation (GO) bonds: are backed by the full faith bonds, discussed below) occurs either through a public offering, using and credit of the issuer“are backed by the full revenue stream an investment bank serving as a security underwriter, or through a of the municipality (often called the General Fund). They private placement to a small group of investors (often financial typically require voter approval” institutions). A best efforts offering is the issue of securities in which the 2. Revenue bonds are sold to finance specific revenue- investment bank does not guarantee a price to the issuer and generating projects and are backed by the cash flows from that acts more as a placing or distribution agent on a fee basis project. (are backed by a specific project's revenues) related to its success in placing the issue. Private placement is a security issue placed with one or a few Revenue bonds are thus riskier than GOs. large institutional buyers. © McGraw Hill 6-12 © McGraw Hill 6-13  Secondary Market Trading Corporate Bonds Trading municipal bonds in the secondary market is not common. Corporate bonds are long-term obligations issued by This is because there is not enough information available about the corporations. bond issuers. Minimum denomination on publicly traded corporate bonds is $1,000. Coupon-paying corporate bonds generally pay interest semiannually. It can be expensive to get and assess information about municipal bond issuers, especially smaller government units. However, bond rating agencies help reduce some of these costs. A bond indenture is a legal contract that specifies the rights and obligations of the bond issuer and the bondholders. Contains several covenants associated with a bond issue. Bond covenants describe rules and restrictions placed on the bond issuer and bondholders. © McGraw Hill 6-14 © McGraw Hill 6-15 Corporate Bonds Characteristics 1 Corporate Bonds Characteristics 2 Bearer versus Registered Bonds. Mortgage bonds are issued to finance specific projects, Bearer bonds have coupons attached to the bonds, and the which are pledged as collateral for the bond issue. holder presents the coupons to the issuer for payments of interest when they come due. Debentures and Subordinated Debentures. Registered bonds are those in which the owner is recorded Debentures are bonds backed solely by the general credit by the issuer and the coupon payments are mailed to the worthiness of the issuing firm, unsecured by specific assets or registered owner. collateral. Term versus Serial Bonds. Subordinated debentures are bonds that are unsecured and are junior in their rights to mortgage bonds and regular Term bonds are those in which the entire issue matures on a debentures. single date. Serial bonds mature on a series of dates, with a portion of the Convertible bonds may be exchanged for another security of issue paid off on each. the issuing firm at the discretion of the bond holder. © McGraw Hill 6-16 © McGraw Hill 6-17 Corporate Bonds Characteristics The Trading Process for 3 Corporate Bonds Bonds issued with stock warrants give the bond holder the Primary sales of corporate bond issues occur through either a public option to detach the warrants to purchase common stock at a sale (issue) or private placement in a manner identical to that discussed for municipal bonds. prespecified price up to a prespecified date. Two secondary markets trade corporate bonds: Callable bonds. 1. Exchange market (for example NYSE Bonds). o Many corporate bond issues include a call provision, which allows 2. Over-the-counter (OTC) market. the issuer to require the bond holder to sell the bond back to the issuer at a given (call) price— usually set above the par value of the The major exchange for corporate bonds is the New York Stock bond. Exchange Bonds Trading Platform. o The difference between the call price and the face value on the bond Only a small amount of bond trading volume occurs on organized is the call premium. exchanges. Sinking fund provision is a requirement that the issuer retire a certain amount of the bond issue each year. © McGraw Hill 6-18 © McGraw Hill 6-19  Bond Ratings and Interest Bond Credit Ratings Rate Spreads 1 Explanation Moody’s S&P Fitch Three major bond rating agencies are the following: Best quality; smallest degree of risk Aaa AAA AAA Moody’s. High quality; slightly more long-term risk than top rating Aa1 AA+ AA+ Standard & Poor’s (S&P). Aa2 AA AA Aa3 AA− AA− Fitch Ratings. Upper medium grade; possible impairment in the future A1 A+ A+ A2 A A A3 A− A− Each of these companies rank bonds based on the perceived Medium grade; lacks outstanding investment characteristics Baa1 BBB+ BBB+ probability of issuer default and assign a rating based on a letter Baa2 BBB BBB Baa3 BBB− BBB− grade. Speculative issues; protection may be very moderate Ba1 BB+ BB+ The highest credit quality (lowest default risk) that rating agencies Ba2 BB BB Ba3 BB− BB− assign is a triple-A (Aaa for Moody’s and AAA for S&P and Fitch). Very speculative; may have small assurance of interest and B1 B+ B+ Bonds rated below Baa by Moody’s and BBB by S&P and Fitch are principal payments B2 B B considered to be speculative grade bonds and are often termed junk B3 B− B− bonds, or high-yield bonds. Issues in poor standing; may be in default Caa CCC CCC © McGraw Hill 6-20 © McGraw Hill 6-21 Bond Credit Ratings 2 Bond Market Indexes Explanation Moody’s S&P Fitch Indexes are managed by major investment banks and Speculative in a high degree; with marked shortcomings Ca CC CC Lowest quality; poor prospects of attaining real investment C C C reflect both the monthly capital gain and loss on bonds in standing the index plus any interest (coupon) income earned. Payment default D D Sources: Websites for Moody’s, Standard & Poor’s, and Fitch Ratings, www.moodys.com; www.standardandpoors.com; www.fitchratings.com Changes in values of broad bond market indexes can be used by bond traders to evaluate changes in the investment attractiveness of bonds of different types and maturities. © McGraw Hill 6-22 © McGraw Hill 6-23 International Aspects of Bond Bond Market Participants Markets 1 The major issuers of debt market securities are federal, International bonds can be classified into three main groups: state and local governments, as well as corporations. 1. Eurobonds are long-term bonds issued and sold outside the The major purchasers of capital market securities are country of the currency in which they are denominated (e.g., households, businesses, government units, and foreign dollar-denominated bonds issued in Europe or Asia) investors. 2. Foreign bonds are long-term bonds issued by firms and governments outside of the issuer’s home country and are usually denominated in the currency of the country in which they are issued rather than in their own domestic currency 3. Sovereign bonds are government-issued, foreign currency- denominated debt, issued in a strong currency such as the dollar or euro rather than in the issuing country’s home currency. © McGraw Hill 6-24 © McGraw Hill 6-25  Bond Market in KSA  Sukuk and bonds can be traded like any other securities through brokers during trading hours. They can also be traded over the counter (OTC), which means this occurs outside the formal exchange environment and without oversight by the End of Main Content regulator. https://www.saudiexchange.sa/wps/portal/saudiexchange/trading/ market-services/sukuk-and-bonds Copyright 2022 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC. © McGraw Hill 6-26 6-27 Learning Goals Chapter 5  Identify the major characteristics of common stock. Stock Markets Identify the major characteristics of preferred stock   Know who the major stock market participants are.  Examine the process by which common stock is issued in primary stock markets.  Describe the major secondary stock markets.  Recognize the major stock market indexes.  Explain the three forms of market efficiency  Describe the major characteristics of international stock markets. Copyright © 2022 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill. © 2022 McGraw-Hill Education. 8-2 The Stock Markets: Chapter Stock Market Securities: Overview Common Stock  Corporate stock serves as a source of financing for firms  Common stock is the fundamental ownership claim in a  Secondary stock markets are the most closely watched public or private corporation, and many characteristics and reported of all financial security markets differentiate it from other types of securities:  Stock market movements are sometimes seen as predictors of economic activity and performance.  Dividends  corporate stocks may be the most widely held of all  Residual claim financial securities.  Limited liability  Two types of corporate stock exist:  Voting rights 1. Common stock 2. Preferred stock  All public corporations issue common stock, but few issue preferred stock © 2022 McGraw-Hill Education. 8-3 © 2022 McGraw-Hill Education. 8-4