Chapter 3 - Financial Markets.pdf

PRINCIPLES OF FINANCE Structure of the Course Chapter 1: Introduction to Finance Chapter 2: Time Value of Money Chapter 3: Financial Markets Chapter 4: Risk and Return Chapter 5: Corporate Finance Materials Chapter 2, Mishkin, F. S. (2019). The economics of money, banking and financial markets, Global Edition, (12th ed.), Pearson. Chapter 2, 7 & 8, Keown, A., Martin, J. and Petty, J. (2019). Foundations of Finance, Global Edition, (10th ed.), Pearson. Chapter 3: Financial Markets 1. Overview of Financial Markets 2. Structure of Financial Markets Bond, notes, bills 3. Financial Instruments: Fixed-Income Securities Stocks, shares 4. Financial Instruments: Equity Securities 5. Financial Instruments: Derivatives ? Difference bet fixed-income securities and Equity 1. Overview of Financial Markets v The Financial System: 1. Overview of Financial Markets v The Financial System: Direct Finance: Borrowers borrow funds directly from Lenders in financial markets by selling the lenders securities. 1. Overview of Financial Markets v The Financial System: Case: FLC. Outside investors don't know the internal situation of FLC, they only know about the increased share price Direct Finance: NKG: not as popular, but share price still increase and still considered a good investment - Transaction cost: The time and money spent in carrying out financial transactions - Asymmetric information: Should I invest in gov bond or in specific stocks The situation where one party have less info compared to the other party This problem leads to 2 consequences: ? B - Adverse Selection: before the transaction is made. A + The riskier borrowers will be more easily to approach the funds form SSU --> Crowd out the good borrowers --> Lenders will not receive their investment back --> lose trust in the market --> No longer lend money --> Disrupt the transfer of funds - Moral Hazard (after): ? C Adverse Moral Hazard Selection 1. Overview of Financial Markets v The Financial System: Indirect Finance: Borrowers borrow funds indirectly from Lenders through a Financial intermediary that stands between the lenders and the borrowers. 1. Overview of Financial Markets v The Financial System: Indirect Finance: Disadvantages - Low rate of return Lender - Not easy to approach funds Borrower 1. Overview of Financial Markets v The Financial Market: Definition: A financial market is a market in which financial assets (securities) can be purchased or sold. Function: Allow funds to move from people who lack productive investment opportunities to people who have such opportunities. Þ Produce an efficient allocation of capital. Þ Generate higher production and efficiency for the overall economy. 2. Structure of Financial Markets v Based on the characteristics of instruments Debt Market: The market where debt instruments are bought and sold. Equity Market: The market where equity instruments are bought and sold. Derivative Market: The market where derivative contracts are bought and sold. 2. Structure of Financial Markets v Based on the characteristics of instruments In debt and equity markets, actual claims are bought and sold for immediate cash payments. In derivative markets, investors make agreements that are settled later. 2. Structure of Financial Markets v Based on term (maturity) of instruments: Money Market: ddd A financial market in which only short-term debt instruments (original maturity terms of less than one year) are traded. Capital Market: A financial market in which longer-term debt instruments (original maturity terms of one year or greater) and equity instruments are traded. 2. Structure of Financial Markets v Based on term (maturity) of instruments: Money Market: A financial market in which only short-term debt instruments (original maturity terms of less than one year) are traded. Capital Market: A financial market in which longer-term debt instruments (original maturity terms of one year or greater) and equity instruments are traded. 2. Structure of Financial Markets v Based on term (maturity) of instruments: Money Market: - A wholesale market with large trading volume. because the trading volume is too large for normal indiv. - Participants are normally creditworthy institutions: Commercial banks, Governments, Corporations, Government-sponsored enterprises, Money market mutual funds, etc. (professional players) - Highly liquid, low risk, low rate of return. short-term - Purpose of trading: liquidity - An OTC market. 2. Structure of Financial Markets v Based on term (maturity) of instruments: Capital Market: - A retail market with varying trading volume. - Individuals can participate in the capital market. - Higher risk and higher rate of return than money market. - Purpose of trading: rate of return - Can be either OTC or exchange market. 2. Structure of Financial Markets v Based on the flow of funds: Primary Market: the only time the issuing firm ever gets any money for the securities A financial market in which securities are bought and sold for the first time. Secondary Market: A financial market in which people can buy and sell existing securities. Securities Securities Borrowers Investor 1 Investor 2 $$$ $$$ 2. Structure of Financial Markets v Based on term (maturity) of instruments: Primary Market: - In this market, the firm selling securities actually receives the money raised. + IPO: Initial Public Offering The first time a company issues stock to the public + SEO: Seasoned Equity Offering the sale of additional shares by a company whose shares are already publicly traded - The primary markets for securities are not well known to the public because the selling of securities to initial buyers often takes place behind closed doors. + Investment bank as an underwriter. 2. Structure of Financial Markets v Based on the flow of funds: Secondary Market: - In this market, the issuing firm does not receive any new financing: securities are simply transferred from one investor to another investor. - Brokers and Dealers help facilitate stock trading. - Function: + Provide liquidity to financial instruments. + Determine the price of the security sold in the primary market. Currently trading in Secondary market: 120k --> Primary market issuing: ~120k 2. Structure of Financial Markets v Based on the way of trading securities: Exchanges: A financial market in which buyers and sellers of securities meet in one central location to conduct trades. Eg: NYSE (New York Stock Exchange), HNX (Hanoi Stock Exchange),… Over-the-counter Markets: A financial market in which market participants trade over the telephone, facsimile or electronic network instead of a physical trading floor. Eg: NASDAQ (National Association of Securities Dealers Automated Quotations System), … 3. Financial Instruments: Fixed-Income v Money Market Instruments: Definition: Money market securities are debt securities with a maturity of one year or less Characteristics: + Liquid + Low expected return + Low degree of risk 3. Financial Instruments: Fixed-Income v Money Market Instruments: Types: - Treasury Bills (T-Bills) Government - Negotiable Certificate of Deposits (NCDs) Commercial Bank - Commercial Papers Corporate - Banker’s Acceptance based on commercial papers - Repurchase Agreement based on T-bill; raise immediate short-term cash Different issuer means different risks and returns 3. Financial Instruments: Fixed-Income v Money Market Instruments: Treasury Bills (T-Bills): - Issued by the Federal Government, to finance national debt and new deficits. - Sold through an auction. - Generally viewed as having zero-default risk => Risk-free asset - After initial sale, they have an active secondary market. - T-bills are sold at a discount from par value: do not pay interest 3. Financial Instruments: Fixed-Income v Money Market Instruments: Treasury Bills (T-Bills): - Pricing T-bills: The price is dependent on the investor’s required rate of return: Par Value P! = 1+i + To price a T-bill with a maturity less than one year, the annualized return can be reduced by the fraction of the year in which funds would be invested. 3. Financial Instruments: Fixed-Income v Money Market Instruments: Treasury Bills (T-Bills): Exercise 1: A one-year Treasury bill has a par value of $10,000. Investors require a return of 7 percent on the T-bill. What is the price investors would be willing to pay for this T-bill? 9345.79 Exercise 2: A 6-month Treasury bill has a par value of $10,000. Investors require a return of 8 percent on the T-bill. What is the price investors would be willing to pay for this T-bill? 9615.38 3. Financial Instruments: Fixed-Income v Money Market Instruments: Treasury Bills (T-Bills): - Estimating T-bill discount: The T-bill discount represents the percentage discount of the purchase price from par value for newly issued T-bills: 𝑃𝑎𝑟 𝑉𝑎𝑙𝑢𝑒 − 𝑃𝑢𝑟𝑐ℎ𝑎𝑠𝑒 𝑃𝑟𝑖𝑐𝑒 360 𝑇 − 𝑏𝑖𝑙𝑙 𝑑𝑖𝑠𝑐𝑜𝑢𝑛𝑡 = 𝑥 𝑃𝑎𝑟 𝑉𝑎𝑙𝑢𝑒 𝑛 Exercise 3: A newly issued 6-month (182-day) T-bill with a par value of $10,000 is purchased for $9,800. Calculate the T-bill discount. 3. Financial Instruments: Fixed-Income v Money Market Instruments: Treasury Bills (T-Bills): - Estimating the Yield to the holder: The Yield reflects the rate of return for the creditor by holding the financial instrument. - The annualized yield: 𝑆𝑒𝑙𝑙𝑖𝑛𝑔 𝑃𝑟𝑖𝑐𝑒 − 𝑃𝑢𝑟𝑐ℎ𝑎𝑠𝑒 𝑃𝑟𝑖𝑐𝑒 365 𝑌𝑖𝑒𝑙𝑑 !"#$%% = 𝑥 𝑃𝑢𝑟𝑐ℎ𝑎𝑠𝑖𝑛𝑔 𝑃𝑟𝑖𝑐𝑒 𝑛 + n = number of days of investment (holding period) 3. Financial Instruments: Fixed-Income v Money Market Instruments: Treasury Bills (T-Bills): - Estimating the Yield to the holder: If a newly-issued T-bill is purchased and held until maturity, the yield is based on the difference between par value and the purchase price. 𝑃𝑎𝑟 𝑉𝑎𝑙𝑢𝑒 − 𝑃𝑢𝑟𝑐ℎ𝑎𝑠𝑒 𝑃𝑟𝑖𝑐𝑒 365 𝑌𝑖𝑒𝑙𝑑 !"#$%% = 𝑥 𝑃𝑢𝑟𝑐ℎ𝑎𝑠𝑖𝑛𝑔 𝑃𝑟𝑖𝑐𝑒 𝑛 3. Financial Instruments: Fixed-Income v Money Market Instruments: Treasury Bills (T-Bills): Exercise 4: An investor buys a 3-month (91-day), $100,000 par value 6.11% Treasury bill for $98,500. What is the annualized yield for this investor? What is the quoted discount for the T-bill? Exercise 5: Suppose the investor plans to sell the bill in one month (30 days) Selling price 9.26 at a price of $99,250. What is the expected annual yield for this investor? What is the expected annual yield for the buyer of the bill if he decides to keep T-bill until maturity? 3. Financial Instruments: Fixed-Income v Money Market Instruments: Negotiable Certificate of Deposits (NCDs): - NCDs are interest-bearing securities issued by banks to raise money for loans. - Denominations: $100,000 and above (Large Time Deposits) - They have maturities of one year or less. - NCDs offer a premium above the T-bill yield to compensate for less liquidity and safety. Premiums are generally higher during recessionary periods. - NCDs have a secondary market 3. Financial Instruments: Fixed-Income v Money Market Instruments: Commercial Papers (CPs): - Are unsecured debt issued by corporations with good credit ratings to finance short-term debt (e.g. inventories) - Most buyers are large institutions. - Are typically established for a maturity range from 0 to 90 days. - Inactive secondary market. 3. Financial Instruments: Fixed-Income v Money Market Instruments: Commercial Papers (CPs): 3. Financial Instruments: Fixed-Income v Money Market Instruments: Commercial Papers (CPs): 3. Financial Instruments: Fixed-Income v Money Market Instruments: Banker’s Acceptance (BAs): higher liquidity than CP - A bankers' acceptance (BA) is a short-term credit investment created by a non-financial firm and guaranteed by a bank to make payment. - Are commonly used for international trade transactions. - Exporters frequently sell an acceptance before the payment date. - Have an active secondary market facilitated by dealers. - Acceptances are traded at discounts from face value in the secondary market. 3. Financial Instruments: Fixed-Income v Money Market Instruments: Repurchase Agreement (Repo): Normally exchange T-bill or T-bond (secured, less risk) - One party sells securities to another with an agreement to repurchase them at a specified date and price. - Transactions amounts are usually for $10 million or more - Common maturities are from 1 day to 15 days and for one, three, and six months. - There is no secondary market for repos. Why? - The bank needs immediate cash 3. Financial Instruments: Fixed-Income v Capital Market Instruments: Bonds Definition: A bond is a contractual agreement between the issuer and the bondholders. => The Borrower (Issuer) promises to pay its holders: - A pre-determined and fixed amount of interest per year - The face value of the bond at maturity. 3. Financial Instruments: Fixed-Income v Capital Market Instruments: Bonds Features: - Face (Par) Value = $5000 - Coupon rate 8% --> each year you receive $400 - Maturity 10 years 3. Financial Instruments: Fixed-Income v Capital Market Instruments: Bonds Characteristics: - From Lender’s perspective: should you issue bonds or shares/ stocks? Advantages + Claims on Assets and Income of the issuer: o Have an expiration time. o Receive periodic interest payments and the principal amount at maturity. o If payments on bonds are not made on time: the creditors can legally classify the firm as insolvent and force it into bankruptcy. firms must sell their assets to pay back o Claims of debt must be honoured before those of equity. --> safer Pay: Employees - Supplies - Government - Creditors ( Bank + Bondholders) - Shareholders + Do not have ownership interest in the organization. Disadvantage - Low and fixed interest rate 3. Financial Instruments: Fixed-Income v Capital Market Instruments: Bonds Characteristics: - From Borrower’s perspective: Disadvantage: + Debt is a liability: o The issuer must promise to make regularly scheduled interest payments and to repay the original amount borrowed on time. o If payments on bonds are not made: liquidation or reorganization - two of the possible consequences of bankruptcy. Advantages: + Payment of interest is considered a cost of doing business and fully tax deductible. + Lower cost of capital. buyer will require lower rate of return 3. Financial Instruments: Fixed-Income v Capital Market Instruments: Bonds Types of Bonds: - Based on the issuers: national city/ state + Government Bonds: Treasury Bonds and Municipal Bonds + Corporate Bonds by corp. - Based on the interest rate: + Fixed-rate Bonds + Floating-rate Bonds the rates change overtime due to D/S - LIBOR +- r% + Zero-coupon Bonds No interest payment during the time you hold the bond --> you buy the bond at a discount from the face value of the bond Buy 3500, maturity 20 years and are paid the face amount when the bond matures amount receive then = 10000 Whether you choose which type of bond, base on the PV/ selling price and the Rate of return you need. 3. Financial Instruments: Fixed-Income v Capital Market Instruments: Bonds Bond Ratings: - An assessment of the creditworthiness of the issuer. + Creditworthiness: how likely the issuer is to default and which protection creditors have in the event of a default. + Concerned only with the possibility of default (default risk). - Credit-rating organizations: + Standard & Poor’s (S&P) + Moody’s Investor Services (Moody’s) + Fitch IBCA (Fitch) 3. Financial Instruments: Fixed-Income v Capital Market Instruments: Bonds Bond Ratings: - An assessment of the creditworthiness of the issuer. + Creditworthiness: how likely the issuer is to default and which protection creditors have in the event of a default. + Concerned only with the possibility of default (default risk). - Credit-rating organizations: + Standard & Poor’s (S&P) + Moody’s Investor Services (Moody’s) + Fitch IBCA (Fitch) 3. Financial Instruments: Fixed-Income v Capital Market Instruments: Bonds Bond Ratings: - The lower the rating, the higher the chance of default. Safe - good to go - The lower the bond rating, the higher the interest rate demanded by investors. - A bond’s credit rating can change as the issuer’s ﬁnancial strength improves DO NOT INVEST or deteriorates. 3. Financial Instruments: Fixed-Income v Capital Market Instruments: Bonds Bond Ratings: Moody's Rating Default Spread (%) Aaa 0.0000 - Access the link: Aa1 0.3377 Aa2 0.4222 https://pages.stern.nyu.edu/~adamodar/New_ Aa3 0.5143 A1 0.5987 Home_Page/datafile/ctryprem.html A2 0.7216 A3 1.0209 Baa1 1.3587 Baa2 1.6197 Baa3 1.8730 Ba1 2.1263 Ba2 2.5562 Ba3 3.0628 B1 3.8304 B2 4.6824 B3 5.5345 Caa1 6.3789 Caa2 7.6608 Caa3 8.5052 Ca 10.2093 3. Financial Instruments: Fixed-Income v Capital Market Instruments: Bonds Valuation of Bond: - Valuation of a bond is the process of determining its intrinsic (economic) value. + Intrinsic value: the present value of the asset’s expected future cash flows. - Principle of Asset valuation: “Asset’s expected future cash flows will be discounted back to the present, using the investor’s required rate of return, to determine the fair value that the asset should be purchased or sold” 3. Financial Instruments: Fixed-Income v Capital Market Instruments: Bonds Valuation of Bond: ,"(-"# -&./)#0 ,"(-"# -&./)#0 ,"(-"# -&./)#0 ;&1 !"#$ -)12"$ 1 -)12"$ 2 -)12"$ # %&'() = ! + " + ⋯+ #+ # %&'() 1)6(21)$ 1)6(21)$ 1)6(21)$ 1)6(21)$ 41 + 8 41 + 8 41 + 8 41 + 8 1&0) "7 1)0(1# 1&0) "7 1)0(1# 1&0) "7 1)0(1# 1&0) "7 1)0(1# - In which: + Coupon Payment = (Coupon Rate * Par Value)/Number of payments per year + n = number of payments = Number of payments per year * Maturity + Required rate of return = Risk-free rate of interest + Risk premium for compensation 3. Financial Instruments: Fixed-Income v Capital Market Instruments: Bonds Valuation of Bond: Exercise 7: 832.322 Calculate C/ interest La Fiesta Restaurants issued bonds that have a 4 percent coupon interest rate, $1000 par value. Interest is paid annually. The bonds mature in 12 years. If your required rate of return is 6 percent, what is the value of a bond to you? Calculate PV Why lower RoR = Higher PV? Look again at the formula. Exercise 8: 1032.54 Consider a bond issued by Toyota with a maturity date of 2022 and a stated annual coupon rate of 3.4 percent. In 2017, with 5 years left to maturity, investors owning the bonds were requiring a 2.7 percent rate of return. Calculate the value of the bonds, knowing that Toyota pays interest to its bondholders on a semiannual basis with a face value of $1000. 4. Financial Instruments: Equity v Capital Market Instruments: Common Stocks Definition: Common stock is a certificate that indicates ownership in a corporation. Þ The Common Stockholder can receive: + Dividend payments from the issuing firm. + Capital gain from difference between purchasing and selling price. 4. Financial Instruments: Equity v Capital Market Instruments: Common Stocks Features: - Par Value 300 000 - Book Value Value of Equity in Financial statement (Accounting value - does not reflect future value) - Market Value - Intrinsic Value (Fair value of stock) - use this to determine whether to invest or not - Dividends 4. Financial Instruments: Equity v Capital Market Instruments: Common Stocks Characteristics: - From Stockholders’ perspective: + Claims on Income and Assets of the issuer: o Do not have maturity date o Common stockholders are residual owners: they receive what is left after all other claims on the firm’s income and assets have been satisfied. + Limited Liability + Voting right: o Elect the board of directors o Approve any change in the corporate charter 4. Financial Instruments: Equity v Capital Market Instruments: Common Stocks Characteristics: - From Firm’s perspective: + Payment of dividend is not a liability of the firm: o Payment of dividends is at the discretion of the BoD. o A corporation cannot default on an undeclared dividend: non-payment of dividends does not result in bankruptcy. + The payment of dividends is not a business expense and not deductible for corporate tax purposes. + Higher cost of capital: o Common stockholders require higher returns for their higher risk position. 4. Financial Instruments: Equity v Capital Market Instruments: Common Stocks Valuation of Common Stock: - Difficulties: (1) With common stock, no promised cash ﬂows are known in advance. (2) The life of the investment is essentially forever because common stock has no maturity. (3) There is no way to easily observe the rate of return that the market requires. 4. Financial Instruments: Equity v Capital Market Instruments: Common Stocks Valuation of Common Stock: - Starting point: Cash Flow in 01 period Imagine that you are considering buying a share of stock today and plan to sell the stock in one year. You somehow know that the stock will be worth How to estimate this value?? PV $70 at that time. You predict that the stock will also pay a $10 per share dividend at the end of the year. If you require a 25 percent return on your investment, what is the most you would pay for the stock? Present Value: After 1 year, you would receive - Div = $10 - - P1= $70 - A buyer would have to agree to buy 𝐷' + 𝑃' your stock at that $70 price. - Buyer would estimate what he would receive & 𝑃 = = (70+10)/ (1+25%) = 64 if he buys at $70 at year 2. (D2 + P2). 1+ 𝑟 --> This is the price you agree to sell TODAY - Buyer C would discount this (D2 + P2) to year 1 4. Financial Instruments: Equity v Capital Market Instruments: Common Stocks Valuation of Common Stock: - We have: 𝐷# + 𝑃# 𝑃" = 1+ 𝑟 - Hence: 𝐷 +𝑃 𝐷" + 1# + 𝑟# 𝐷" 𝐷# P# 𝑃! = = + # + 1+ 𝑟 1 + 𝑟 (1 + 𝑟) (1 + 𝑟)# 4. Financial Instruments: Equity v Capital Market Instruments: Common Stocks Valuation of Common Stock: - Repeat the procedure: 𝐷$ + 𝑃$ 𝑃# = 1+ 𝑟 - Hence: 𝐷$ + 𝑃$ 𝐷" 𝐷# 1+ 𝑟 𝑃! = + + 1 + 𝑟 (1 + 𝑟)# (1 + 𝑟)# 𝐷" 𝐷# 𝐷$ 𝑃$ = + # + $ + 1 + 𝑟 (1 + 𝑟) (1 + 𝑟) (1 + 𝑟)$ 4. Financial Instruments: Equity v Capital Market Instruments: Common Stocks Valuation of Common Stock: - Stock’s Present value: 𝐷" 𝐷# 𝐷$ 𝐷% 𝑃& 𝑃! = + + + + ⋯+ 1 + 𝑟 (1 + 𝑟)# (1 + 𝑟)$ (1 + 𝑟)% (1 + 𝑟)& When n → ∞: 𝐷" 𝐷# 𝐷$ 𝐷% 𝑃! = + # + $ + % +⋯ 1 + 𝑟 (1 + 𝑟) (1 + 𝑟) (1 + 𝑟) 4. Financial Instruments: Equity v Capital Market Instruments: Common Stocks Valuation of Common Stock: - Case 1: Zero-growth Dividend. Shareholders receive equal amount of Div. For a zero-growth share of common stock, this implies that: 𝐷" = 𝐷# = 𝐷$ = ⋯ = 𝐷 Per-share value: 𝐷 𝑃! = 𝑟 4. Financial Instruments: Equity v Capital Market Instruments: Common Stocks Valuation of Common Stock: - Case 2: Constant-growth Dividend. The dividend of the firm always grows at a steady rate, g. Let 𝐷! be the dividend just paid, then the next dividends will be: 𝐷' = 𝐷& ∗ 1 + g 10 - 11 -12 -13... infinity 𝐷( = 𝐷' ∗ 1 + g = 𝐷& ∗ 1 + 𝑔 ( 𝐷) = 𝐷( ∗ 1 + g = 𝐷& ∗ 1 + 𝑔 ) … 𝐷* = 𝐷*"' ∗ 1 + g = 𝐷& ∗ 1 + 𝑔 * 4. Financial Instruments: Equity v Capital Market Instruments: Common Stocks Valuation of Common Stock: - Case 2: Constant-growth Dividend. Per-share Value: 𝐷& ∗ 1 + g 𝐷" year 1: 11 𝑃& = = 𝑟−g r − g in which: 𝐷! = Dividend payment in period 1 r = required rate of return by stockholders g = constant growth rate of dividend payments 4. Financial Instruments: Equity v Capital Market Instruments: Common Stocks Valuation of Common Stock: Exercise 9: The Paradise Prototyping Company has a policy of paying a $10 per share dividend every year. If this policy is to be continued indeﬁnitely, what is the value of a share of stock if the required return is 20 percent? Exercise 10: The next dividend for the Gordon Growth Company will be $4 per share. Investors require a 16 percent return on companies such as Gordon. Gordon’s dividend increases by 6 percent every year. Based on the dividend growth model, what is the value of Gordon’s stock today? What is the value in four $40 years? D5/ g 4. Financial Instruments: Equity v Capital Market Instruments: Common Stocks Valuation of Common Stock: - Case 3: Nonconstant-growth Dividend. Growth rates are “supernormal” over some ﬁnite length of time. Exercise 11: A company currently not paying dividends and will pay a dividend for Discount back 5 years the ﬁrst time after 5 years. The dividend will be $.50 per share. You expect that this dividend will then grow at a rate of 10 percent per year indeﬁnitely. The required return on companies such as this one is 20 use this to percent. What is the price of the stock today? calculate PV Period = 4 4. Financial Instruments: Equity v Capital Market Instruments: Common Stocks Valuation of Common Stock: - Case 3: Nonconstant-growth Dividend. Exercise 12: Chain Reaction, Inc., has been growing at a phenomenal rate of 30 percent per year because of its rapid expansion and explosive sales. You believe this growth rate will last for three more years and will then drop to 10 percent per year. If the growth rate then remains at 10 percent indeﬁnitely, what is the total value of the stock? Total dividends just paid were $5 million, and the required return is 20 percent. 4. Financial Instruments: Equity v Capital Market Instruments: Common Stocks Valuation of Common Stock: - Case 3: Nonconstant-growth Dividend: Two-stage Growth The dividend will grow at a rate of 𝑔" for t years and then grow at a rate of 𝑔# thereafter forever. Per-share Value: 𝐷" 1 + g" ' 1 𝐷+,' 𝑃! = ∗ 1− ' + ∗ 𝑟 − g" 1+𝑟 1+𝑟 + 𝑟 − g( 4. Financial Instruments: Equity v Capital Market Instruments: Common Stocks Valuation of Common Stock: - Case 3: Nonconstant-growth Dividend: Two-stage Growth Exercise 13: The Highﬁeld Company’s dividend is expected to grow at 20 percent for the next ﬁve years. After that, the growth is expected to be 4 percent forever. If the required return is 10 percent, what’s the value of the stock? The dividend just paid was $2. 4. Financial Instruments: Equity v Capital Market Instruments: Preferred Stocks Definition: Preferred stock is an equity security that gives its holders certain privileges over common stockholders. ÞThe Preferred stockholders can receive: + A fixed periodic payment of dividend as stated. 4. Financial Instruments: Equity v Capital Market Instruments: Preferred Stocks Characteristics: - From Preferred Stockholders’ perspective: + Claims on Income and Assets of the issuer: o Do not have maturity date. o Holders of the preferred shares must receive a dividend before holders of common shares are entitled to anything. o In the case of bankruptcy, the preferred stock claim is honored after that of bonds and before that of common stock. + No voting right. 4. Financial Instruments: Equity v Capital Market Instruments: Preferred Stocks Characteristics: - From Firm’s perspective: + Payment of dividend is not a liability of the firm: o Non-payment of preferred dividends does not result in bankruptcy. + The payment of dividends is not a business expense and not deductible for corporate tax purposes. 4. Financial Instruments: Equity v Capital Market Instruments: Preferred Stocks - Preferred stock is also referred to as a hybrid security as it has features of both common stock and bonds. - Preferred stock is similar to common stocks in that: + It has no fixed maturity date + The non-payment of dividends does not result in bankruptcy of the firm + The dividends are not deductible for tax purposes. - Preferred stock is similar to corporate bonds in that: + The dividends are typically a fixed amount + There are no voting rights. 5. Financial Instruments: Derivatives v Derivative contracts Definition: Derivatives are financial contracts whose values are derived from the values of underlying assets. Characteristics: - The derivative is a contract - The contract always refers to an underlying asset - The value of the contract depends on the value of the underlying asset. 5. Financial Instruments: Derivatives v Derivative contracts Definition: Derivatives are financial contracts whose values are derived from the values of underlying assets. Characteristics: - The derivative is a contract - The contract always refers to an underlying asset - The value of the contract depends on the value of the underlying asset. 5. Financial Instruments: Derivatives v Derivative contracts Types of Derivatives: - Forward Contract - Futures Contract - Option Contract - Swap Contract 5. Financial Instruments: Derivatives v Derivative contracts: Forward Definition: Forward contracts are contracts that allow the purchase or sale of a specified underlying asset on a specified future date at a fixed price that is agreed today. Counter party risk: - For Seller: no payment, buyer no longer present at delivery time Characteristics: --> Missing out on other potential customers - For Buyer: no delivery, damaged goods - Traded on OTC market. (not physical) - Is customizable and can be tailored to a specific commodity, amount, and delivery date. A buys coffee beans from B Current price So = 1000/ton. Predictions: Price will increase - A predicted it would be S1 = 1350/ ton in 1 year, but market price at that time is 1400/ton --> Contract: A will buy from B at price S1 in 1 year 5. Financial Instruments: Derivatives v Derivative contracts: Forward Forward Payoffs: market price fixed price in the contract Fo 5. Financial Instruments: Derivatives v Derivative contracts: Futures Definition: in terms of price, quantity, quality, etc Futures contracts are standardized contracts that allow the purchase or sale of a specified underlying asset at a specified price and date. Characteristics: unlike forward on OTC - Traded on a futures exchange, which is highly regulated at the national level. - Clearing house: --> Help reduce counter party + Daily settlement of gains and losses (mark-to-market process). risk using the deposited money + Buyers and sellers need to make deposit (10% of futures price) before entering the transaction. If a party want to leave the contract, they will have to pay an auction fee at the beginning of the contract 5. Financial Instruments: Derivatives v Derivative contracts: Options Definition: Option premium An options contract offers the buyer the right, but not obligation, to buy or sell the underlying asset at a fixed price either on a specific expiration date or at any time prior to the expiration date. Characteristics: - Is standardized and traded on an exchange. - Option premium must be paid at the beginning of the contract 5. Financial Instruments: Derivatives v Derivative contracts: Options Call Option: - Definition: A call option gives the holder the right, but not the obligation, to buy the underlying security at the strike price on or before expiration. - Investors would buy a call option if they expect the price of the underlying asset will increase in the future. 5. Financial Instruments: Derivatives v Derivative contracts: Options Call Option Payoffs: Seller of the contract - The most profit seller gonna get is $100 from the option price - When the underlying (spot) price is lower than the contract price --> Buyer no longer pay. --> $100 - When the spot price is higher --> Buyer benefits ---> Seller loses + $100 5. Financial Instruments: Derivatives v Derivative contracts: Options Put Option: - Definition: A put option gives the holder the right, but not the obligation, to sell the underlying security at the strike price on or before expiration. - Investors would buy a put option if they expect the price of the underlying asset will decrease in the future. 5. Financial Instruments: Derivatives v Derivative contracts: Options Put Option Payoffs:

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