Introduction to Financial Markets

1
Introduction to Financial Markets
2
Fixed Income Securities

• The Bond Markets

3
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.

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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.

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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

6
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

7
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

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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.

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Equity Instruments

• The Stock Markets

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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.

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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.

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Valuing a Companys Shares

• Value based on a satisfactory trend must be
  wholly arbitrary and hence speculative, and hence
  inevitably subject to exaggeration and later
  collapse
• Graham and Dodd, Security Analysis

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Valuing Common Stock
Uncertain Dividends, Dt
Time 0
1
2
3
4
5
6
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Dividend Discount Model (DDM) Current Stock
Price Present value of all future Expected
Dividends at required return, rE.
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Constant Earnings Dividends
1
2
3
4
5
6
7

• Assume firm has constant earnings per share (E)
  of 100 forever.
• It payouts half of these earnings each year
  (payout ration, k.5) as dividends (D) of 50 per
  share.
• What is one share of this company worth?

• Share price equals present value of 50 each year
  forever at required return.
• Assume required return on equity is 20, i.e. rE
  .20
• Can show PS D/rE kE/rE 50/.20 250 or
  PS/E k/rE 2.5

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Constant Earnings Growth
1
2
3
4
5
6
7

• Firm has current earnings per share (E) of 100.
• Earnings expected to grow at 10 a year forever
  (g .10).
• It payouts half of these earnings each year
  (payout ration, k.5) as dividends (D).
• What is one share of this company worth?

• Share price equals present value of constantly
  growing dividends.
• Required return on equity is 20, i.e. rE .20
• Can show PS D1/(rE g) kE1/(rE g)
  55/(.20 - .10) 550

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Valuing Firm using Cash Flows

• Majority of firms do not issue dividends.
• How to value these firms?
• Look at cash flows generated by firm in excess of
  what is needed to operate
• Called Free Cash Flows, FCF
• Total value of firm (Debt Equity) equals
  present value of these future FCFs.
• Analyst forecasts these FCFs, arrives at
  estimate of firms total value.
• Subtract off value of firms debt. What remains
  is value for shareholders.
• Divide by of shares outstanding to arrive at
  share price.

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Financial Statements

• How do Accounting Statements help us in thinking
  about a Shares value?

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What Does The Investment Analyst Scrutinize?

• The Balance Sheet
• Assets vs. Liabilities Shareholder Equity
• The Income Statement
• Revenues vs Costs
• The Cash Flow Statement
• Sources and Uses of cash

"Financial statements are like fine perfume to
be sniffed but not swallowed. Abraham
Brilloff
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Sources of Information

• Company issues
• Annual quarterly reports Press releases
  investor relations materials
• SEC Filings for the Company
• 10K, 10Q, Form 4
• Online Filings with Edgar
• www.edgar-online.com or www.sec.gov

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Balance SheetOwn Owe Statement

• Assets
• Current Assets
• Cash
• Accounts Receivable
• Inventories
• Marketable Securities
• Non-current Assets
• Land Property
• Equipment- Accumulated Depreciation

• Liabilities
• Current Liabilities
• Accounts Payable
• Accrued Expenses, e.g. taxes
• Short-term Borrowings
• Dividends
• Non-current Liabilities
• Long-term Borrowings
• Shareholders Equity
• Capital Stock
• Retained Earnings

Assets Liabilities Shareholders Equity
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Income StatementAbility to Make Sales Control
Expenses

• Revenues/Sales Other Income - Costs
• Operating Income (EBIT)
• - Provisions for income tax
• Net Earnings (Income) of common
  shares
• Earnings per Share (EPS) - Dividends
• Retained Earnings

• Costs includeCOGSRDS G ADepreciationAmort
  izationInterest Expense

and earn Profits over Time.
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Cash Flow StatementThe Ins and Outs of Money ...

• Net Income
• / Changes in Assets and Liabilities
• Depreciation and Amortization Expenses
• Operating Cash Flow
• Investing Activities
• Financing Activities
• Increase / (Decrease) in Cash
• Over a
  Set Period
• of Time.

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Whats Important To A Company?

• To show
• Consistent earnings growth
• Positive public image
• Efficient management/process/service
• Perception of market savvy
• Ahead of its competition

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What Are the Clues?

• The Easy ones
• Asset Turnover Sales / Assets
• ProfitabilityIncome / Sales
• Financial Leverage Assets / Equity
• Return on Equity Income / Equity

• The Hard(er) Ones
• Investments for the Future, e.g. RD, MA
  strategy
• Trends in sales, costs, unit growth, margins
• Accounting Practices (a black hole into which
  much can be hidden)

The Secret Much of this is in the Notes to the
Financial Statements
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How Is It All Tied Together?

• A dose of skepticism never hurts.
• Hidden costs (deception) and fraud are different
  and have brought more than one company down.
• Extrapolation of the past is good but not enough.
• Not all investors are the same Different
  strokes for different folks.
• Read the Notes to Financial Statements
• Accept that - in general - Markets are Efficient.

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Financial Markets

• Primary Secondary Markets

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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 .

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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.

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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.

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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.

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Efficient Markets Hypothesis

• Information Expectations

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Market Efficiency

• Generally assume that financial markets are
  efficient.
• Financial market is efficient if it fully and
  correctly reflects all available information in
  determining security prices.
• Formally, a market is efficient with respect to
  some set of information.
• In an efficient market, no systematic excess
  profits are made by investors trading on this
  information.
• An investor may beat the market this year, but
  very few investors will beat the market in
  several consecutive years.

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Forms of Market Efficiency

• Weak Form Market Efficiency
• Information includes only history of past prices
  or returns.
• Technical Analysis
• Semi-Strong Form Market Efficiency
• Information includes all information known to
  market, i.e. all publicly available
  information.
• Fundamental Analysis
• Strong Form Market Efficiency
• Information set includes all information known to
  any market player, all publicly privately
  available information.
• Insider Trading
• Tend to find markets are Weak Semi-Strong
  efficient but not Strong efficient.

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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.

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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.