Introduction to Financial Markets

1
Introduction to Financial Markets
2
Financial Statements

• Balance Sheet Income Statement

3
Financial Statements

• Balance Sheet
• Accounting picture of all a firms sources of
  external funds (liabilities stockholders
  equity) and uses of funds (assets purchased) at a
  single point in time.
• Total Assets Total Liabilities Stockholders
  equity
• Income Statement
• Accounting picture of all a firms income and
  expenses that reveals the profits or losses for
  the firms operations over a period of time.
• Sales - expenses profit (ve) or loss (-ve)

4
IBC Balance SheetDecember 31, 1997

• Assets
• (Uses of Funds)
• Cash 10,900
• Marketable Securities 5,877
• Accounts Receivable 32,975
• Inventories 58,950
• Other Current Assets 7,150
• Total Current Assets 115,852
• Investments 27,900
• Property, Plant Equipment 509,200
• Total Assets 652,952

• Liabilities
• (Sources of Funds)
• Current Liabilities
• Accounts Payable 40,500
• Accrued Expenses 17,700
• Notes Payable 19,900
• Income Taxes Payable 1,050
• Total Current Liabilities 79,150
• Long Term Debt 271,050
• Shareholder Equity Retained Earnings
  302,752
• Total Liabilities 652,952 Equity

5
IBC Income StatementFor Year Ending Dec. 31, 1997

• Total Revenues 1,025,475
• Cost of Goods Sold 690,300
• Administrative Expenses 295,075
• Total Operating Expenses 985,375
• Earnings before Interest and Taxes
  (EBIT) 40,100
• Interest Expense 17,375
• Other Expenses 400
• Total Expenses 1,003,150
• Equals Earnings Before Tax 22,325
• Less Corporate Income taxes 9,800
• Equals Net Income After taxes 12,525
• Less Cash Dividends 6,250
• Equals Add to Retained earnings 6,275

• Per Share Data
• Number of Shares O/S 17,100
• Market Price per Share 9.10
• Earnings per Share (EPS) .732
• Cash Dividends per Share .365
• Price-Earnings Ratio (P/E) 12.43

6
Fixed Income Securities

• The Bond Markets

7
Characteristics of a Bond

• A Bond is simply a standardized loan agreement.
  It generally has the following characteristics
• Face Value Principal Amount repaid at Maturity.
• Coupon Interest Payment Periodic Interest
  Payment to holder over life of the Bond.
• Maturity Date Date at which loan is repaid.
• Indenture Provisions Legal restrictions on
  borrower.
• Main sources of risk for a Bond are
• Default Risk Borrower not able to pay principal
  and/or interest.
• Interest Rate Risk Changes in interest rates
  affect Bond value and reinvestment returns of
  coupons.

8
Valuing a 5-Year Bond
Time 0
1
2
3
4
5
6
7

• Discounted Cash Flow Approach
• Current Bond Price Present value of all future
  Cash Flows (Interest Principal) at required
  return, i.

9
Calculating Yields for a Bond

• Coupon Rate
• Annual Coupon Interest Payment
• Face value of the Bond
• Current Yield
• Annual Coupon Interest Payment
• Current Market Price of the Bond
• Yield-to-Maturity (YTM)
• Interest rate that makes Present Value of Bonds
  Cash Flows equal to its Current Market Price if
  bond held to maturity no default.
• One-Period Rate of Return
• (Capital Gain/Loss) Coupon Interest
  Purchase Price of the Bond

10
Money Market Securities

• Money Markets
• Short-term, zero coupon debt purchased at
  discount to Face Value.
• Types of Money Market Securities
• U.S. Treasury Bills lowest risk, issued by U.S.
  govt
• Federal Funds Deposits at Federal Reserve
• Certificates of Deposit (CDs) Issued by Banks.
• Eurodollar Deposits US deposits outside of U.S.
• Commercial Paper unsecured loan to large firms.
• Repurchase Agreements collaterized loans

11
Corporate Bonds

• Corporate Bonds
• More than one year to maturity.
• Contain indenture provision (limits on issuer
  behavior)
• Most bonds pay coupon interest based on Face
  Value.
• Quality Rated according to default risk of corp.
  issuer.
• Bond ratings by Moodys, Standard Poor
• Depend on issuers financial condition
  indenture provisions.
• Highest rating Moodys Aaa, SP AAA - Blue Chip
  stocks
• Adequate rating Moodys Baa, SP BBB - economic
  risk
• Poor quality Moodys Caa, SP CCC - danger of
  default
• Junk Bonds Moodys Ba, SP BB or lower rated

12
U.S. Treasury Agency Bonds

• Types of U.S. Treasury Bonds (very liquid)
• Treasury Bills (T-Bills) Short-term, sold at
  discount.
• Treasury Notes Mature 1-10 yrs, pay coupon
  interest.
• Treasury Bonds (T-Bonds) Mature 10 to 30 years,
  pay coupon interest, callable prior to maturity
  by govt.
• Special Issues sold only to govt agencies with
  cash.
• Types of U.S. Agency Bonds
• Agency Securities FHA, FNMA, GNMA, SLMA, etc
  have implicit or explicit govt guarantee
• Zero Coupon Bonds pay no interest, sell at
  discount.

13
Equity Instruments

• The Stock Markets

14
Common Preferred Stock

• Common Stock
• Residual claim (ownership) on firm earnings
  assets.
• Voting power Preemptive right to new stock
  issues.
• Receive Cash Dividends at management discretion.
• Preferred Stock
• Preferential treatment to common stock
• First claim to dividends up to set level.
• First owner claim to assets (after bondholders)
  in bankruptcy.
• Little or no voting power but Preemptive right to
  new issues of stock.
• Receive stipulated Cash Dividend amount each year.

15
Valuing Common Stock I

• Annual Holding Period Return
• rt (Pt1- Pt) Dt/Pt Capital Gain/Loss
  Dividend
• Pt Share Price at time t, Dt Dividends in
  Period t
• Book Value of Common Stock
• Firm Assets - Firm Liabilities
• Total Shares Outstanding
• Easy to calculate but means very little because
  Assets and Liabilities are carried at historic
  costs rather than current market values on
  Balance Sheet.

16
Valuing Common Stock II
Uncertain Dividends, Dti
Time 0
1
2
3
4
5
6
7

• Discounted Cash Flow Approach
• Current Stock Price Present value of all future
  Expected Cash Flows (Dividends) at required
  return, r.

17
Financial Markets

• Primary Secondary Markets

18
Primary Markets

• When a firm sells new securities to raise funds,
  offering is called a primary issue.
• Generally employ an agent to find buyers for the
  securities investment banker or underwriter.
• Advisory Determine financing strategy
• Administrative Satisfy regulations red tape.
• Underwriting Guarantees certain minimum price or
  cash.
• Distribution services Finds investors to
  purchase issue.
• Market stabilization Stabilizes new issue price
  for some period by making market .

19
Secondary Markets I

• Organized Security Exchanges
• provide continuous market where investors can buy
  or sell securities immediately at fair market
  prices.
• provide liquidity and marketability to securities
  investors.
• Largest Organized Exchanges
• New York Stock Exchange (NYSE)
• American Stock Exchange (AMEX)
• Regional Exchanges
• NYSE
• Voluntary association with memberships.
• Trading floor with member market-makers quoting
  prices.
• Listing Requirements for Corporations.

20
Secondary Markets II

• Over the Counter (OTC) Markets
• provide continuous market where investors can buy
  or sell securities immediately at fair market
  prices.
• No organized central exchange.
• Broker-Dealers linked by phone or computer.
• Securities traded cover govt bonds through
  speculative stocks.
• OTC Markets
• Broker-Dealers make markets (buy/sell) in certain
  security.
• Natl Assoc. of Security Dealers (NASD)
• NASDAQ Automated Quote System with current
  bid/ask prices.
• Competition among market-makers is setting quoted
  prices.

21
Security Market Indexes

• Market Indexes Pure numbers indexed to a base
  year.
• Normally a weighted average ratio calculated from
  an average of a large number of securities of
  interest.
• Weights chosen as either Value-weights or
  Equal-weights on prices of securities included in
  index.
• Denominator is the weighted average value in a
  chosen base year.
• Many different indices used depending on interest
• Dow Jones Industrial Average (DJIA)
• Standard Poors 500 composite stocks average
• NYSE index
• Dow Jones 40 bond index
• Dow Jones indices of spot commodity prices.

22
Efficient Markets Hypothesis

• Information Expectations

23
Market Efficiency

• A Security Market said to be efficient if it
  fully and correctly reflects all available
  information in determining security prices.
• Formally, a market is said to be efficient with
  respect to some set of information.
• Changes in prices or returns are not forecastable
  using this information. (Random Walk, Pt Pt-1
  et)
• Thus in an efficient market, no excess profits
  are made by individuals using only this
  information to trade.

24
Forms of Market Efficiency

• Weak Form Market Efficiency
• The information set allowed includes only the
  history of past prices or returns.
• Semi-Strong Form Market Efficiency
• Information set includes all information known to
  market players, all publicly available
  information.
• Strong Form Market Efficiency
• Information set includes all information known to
  any market player, all publicly privately
  available information.
• Tend to find markets are Weak Semi-Strong form
  efficient but not Strong Form efficient.

25
Deviations from Efficiency

• Most studies support Weak or Semi-Strong
  efficiency but there are some anomalies to
  efficient securities markets.
• Weekend Effect Monday returns slightly lower.
• January Effect Small firm returns higher in
  January.
• Low P/E Stocks Low P/E stocks outperform market.
• Small-Firm Effect Small firm stocks beat the
  market.
• Unexpected Quarterly Earnings Firms whose
  earnings beat estimates have positive excess
  returns.
• Neglected Firm Effect Stocks with little analyst
  coverage have abnormal returns.

26
Technical Analysis

• Technical analysts reject efficient markets.
• They believe important information about future
  price moves can be found from past price moves.
• Market value determined by Demand and Supply.
• Supply Demand governed by many factors.
• Security prices tend to move in trends that
  persist.
• Changes in the trend are caused by changes in
  demand and supply.
• Shifts in demand or supply can be detected from
  market transactions.
• Some price patterns tend to repeat themselves.