Capital and Financial Market Bond and Stock Market

1
Capital and Financial MarketBond and Stock Market

• Hall and Lieberman, 3rd edition, Thomson
  South-Western, Chapter 13

2
Overview

• Bond market
• Concepts Principal / yield / maturity date
• How much is a bond worth?
• Why do bond prices differ?
• How will bond value responding to inflation?
• Stock market
• Issue and Valuation of stock
• Price Earnings (PE) ratio
• Explain the stock price
• Gamble and investment
• Fair bet / unfair bet
• Risk and investment
• Portfolio for diversification

3
Financial Assets and Financial Market

• Financial asset
• A promise to pay future income in some form, such
  as future profits or future interest
• traded in financial markets
• Financial assets generate future payments
• Valued in total present value
• Two types of financial market
• Bond market
• Stock market

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Part I The Bond Market

• One of the methods to finance the production is
  selling bonds
• Bond is a promise to pay a specific sum of money
  at some future date
• This amount of money is principal (face value)
• Most common amount 10,000
• The date at which a bonds principal will be paid
  to bonds owner is Maturity Date

5
The Bond Market

• Pure discount bond
• Promises no payments except for principal it pays
  at maturity
• Coupon payments
• Series of periodic payments that a bond promises
  before maturity
• Yield
• Rate of return a bond earns for its owner

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How Much is a Pure Discount Bond Worth?

• Value of a bond with a face value of 10,000
  which matures in exactly one year and has an
  interest rate of 10 is
• Bond will sell for 9,091

7
How Much Is A Coupon Payment Bond Worth?

• Bond with a principal of 10,000, a five-year
  maturity and an annual coupon payment of 600 has
  a present value of
• Total present value is what bond is worth
• Price at which it will trade
• As long as buyers and sellers use the same
  discount rate of 10 in their calculations

8
How To Calculate Yield?

• Suppose bond matures in one period
• PBOND PV FV/(1r)
• Yield is implied by
• (1r) FV/PV
• If bond matures T periods from now
• PBOND PV FV/(1r)T
• Annual yield is implied by
• (1r) ( FV/PV ) 1/T
• The higher the price of any given bond the lower
  the yield on that bond

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Bonds Yield Example

• Suppose FV 10,000
• PBOND 9500
• Maturity in one period
• Then, yield is
• (1r) FV/PV (10,000/9,500) 1.053
• Implying that annual interest rate r 0.053

10
Primary and Secondary Bond Markets

• Bond is traded in two different types of markets
• Primary market
• Market in which newly issued bonds are sold for
  first time
• Secondary market
• Market in which previously issued bonds are sold

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Primary and Secondary Bond Markets

• Bond issuers are not directly participants in
  secondary market trading
• but they are affected by what happens in
  secondary market
• Price of newly issued bonds in the primary market
  will rise if a similar bonds price rises in
  secondary market rises
• If a bonds yield falls in the secondary market,
  yield of similar newly issued bonds in the
  primary market will fall as well

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Why Do Bond Prices (and Bond Yields) Differ?

• Each bond traded everyday has its own unique
  yield
• Why doesnt each bond sell at a price that makes
  its yield identical to the yield on any other
  bond?
• A bondlike any assetis worth the total present
  value of its future payments

13
Why Do Bond Prices (and Bond Yields) Differ?

• To put a value on riskier bonds, markets
  participants use a higher discount rate than on
  safe bonds
• Leads to lower total present values and lower
  prices for riskier bonds
• With lower prices, riskier bonds have higher
  yields
• Higher risk, higher yield, lower price

14
Why Do Bond Prices (and Bond Yields) Differ?

• Riskiness is only one reason that bond prices and
  bond yields differ
• Other reasons include
• Differences in maturity dates
• Differences in frequency of coupon payments
• Because one bond is more widely traded (and
  therefore easier to sell on short notice) than
  another

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Rating on Bonds

• According to the likelihood of default, bonds are
  rated in the following(Moodys Investors
  Services estimate)
• U.S. Treasury bond - the least risky
• Aaa Corporate bond
• Aa Corporate bond
• A Corporate bond
• Baa Corporate bond
• Ba Corporate bond
• B Corporate bond - higher risk

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Figure 1(a) How does bond market respond to
rising inflation expectations?
PV
Supply of FV 10,000 bonds
Initial equilibrium sets price implied r 0.053
9,500
D low inflation
Bonds issued
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Figure 1(b) How does bond market respond to
rising inflation expectations?
PV
Supply of FV 10,000 bonds
With higher inflation, 10,000 one year from now
will be worth less, so demand shifts left
9,500
D low inflation
Bonds issued
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Figure 1(c) How does bond market respond to
rising inflation expectations?
PV
Supply of FV 10,000 bonds
New lower equilibrium price implied r 0.081
9,500
D low inflation
9,250
D high inflation
Bonds issued
(1 r) (FV/PV) (10000/9250) 1.081
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Part II The Stock Market

• A share of stock promises its owner future
  payments
• By issuing a share of stock, a corporation brings
  in new ownership of the firm itself
• When a corporation issues a bond, it is borrowing
  funds and promising to pay them back

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The Stock Market issuing new shares of stock

• When a firm wishes to raise money in the stock
  market, it gets in touch with an investment bank
• Prospectus
• Worked out by the firm and investment bank
• Inform potential investors of risks involved
  about
• Nature of the firms business
• Number of shares to be sold, etc
• must be reviewed by Securities and Exchange
  Commission
• Principal regulatory agency that oversees
  financial markets
• If approved, shares will be sold to the public

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The Stock Market issuing new shares of stock

• If it is the first-ever offering of shares by
  this firm, sale will be called an initial public
  offering (IPO)
• In practice, its usually large institutional
  investors, such as mutual funds, who first
  purchase new shares
• A mutual fund is a Corporation that specializes
  in owning shares of stock in other corporations

22
Primary and Secondary Stock Markets

• Only time a corporation receives any income from
  a trade in its stock is when the corporation
  itself sells the stock in the primary stock
  market
• Thereafter, stock is traded in secondary market,
  in which previously issued shares are sold and
  resold
• Price changes in secondary market affect price a
  firm can get from selling shares in primary market

23
Direct and Indirect Ownership of Stock

• Many people own shares of stock directly
• Can also own stock indirectly by purchasing
  shares of a mutual fund
• Or through retirement accounts that are managed
  by their employers
• Stock ownership in United States is growing
  rapidly

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Valuing a Share of Stock

• Value of a share in a firm is equal to
• Total present value of firms after tax profits
  divided by number of shares outstanding
• Note that we are valuing a share of stock by
  future profits, not by dividends

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Valuing a Share of Stock

• Important conclusions about factors that can
  affect a stocks value
• An increase in current profits increases value of
  a share of stock
• An increase in anticipated growth rate of profits
  increases value of a share of stock
• A rise in interest ratesor even an anticipated
  rise in interest ratesdecreases value of a share
  of stock
• An increase in perceived riskiness of future
  profits decreases value of a share of stock

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Fundamental Value of Stocks

• Stock price should be the present value of the
  stream of future earnings per share (E)
• PV Pstock E/r
• Price Earnings (PE) ratio Pstock/E (1/r)
• Very high PE ratios imply having to pay a lot per
  of expected earnings

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Reading the Stock Pages

• Wall Street Journal and other newspapers report
  on changes in different stock market averages or
  indexes
• The most popular average is Dow Jones Industrial
  Average
• Tracks prices of 30 of largest companies in
  United States, including Boeing, Microsoft, and
  Wal-Mart
• Another popular average is the much broader
  Standard Poors 500
• Tracks stock prices of 500 large corporations

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Explaining Stock Prices

• Stock prices are determined by supply and demand
• Supply
• On any given day, the number of FedExCp shares in
  existence is just the number that FedExCp has
  issued previously, up until that day
• Therefore, no matter what happens to the price
  today, the number of shares remains unchanged
• But, it does not mean that this is the number of
  shares that people want to hold
• Demand
• Value of a share of stock to any owner is equal
  to total present value of its future after-tax
  profits
• At any given moment, there is an array of
  estimates of a stocks total present value

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Figure 2(a) The Market for FedEx
S
78
A
64
50
D
298 million
30
Explaining Stock Prices

• Only at equilibrium price of 64 are people
  satisfied holding the number of shares they are
  actually holding
• Where supply and demand curves intersect
• Stocks achieve their equilibrium price almost
  instantly
• Can have confidence that price of a share at any
  time is the equilibrium price
• Cannot be caused by shifts in the supply curve
• Must be caused by shifts in demand

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Figure 2(b) An Increase in Demand for Shares of
FedEx
S
80
64
D2
D1
863 million
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Explaining Stock Prices

• What causes these sudden shifts in demand for a
  share of stock?
• Anything that causes large groups of individuals
  to change their estimates of total present value
  of future profits will shift demand curve
• When stock prices move dramatically, it is
  usually because new information has become
  available

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Part III Gambling vs. Investing

• Expected return
• Pi probability that outcome i happens
• Ri Return when outcome i happens
• C investment costs
• N outcomes
• Probabilities add up to 1
• Expected Return S Pi Ri - C

N
i1
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Gambling vs. investing

• Fair bet Expected return is zero
• Coin flip Pay C 1 to play
• Heads Receive R1 2, P1 .5
• Tails Receive R2 0, P2 .5
• Expected Return P1R1 P2 R2 - C
• .52 .50 - 1 0

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Gambling

• Unfair bet
• Gambler Expected return lt0
• Casino Expected return gt0
• Example slot machines pay 92 per bet
• Expected return for customer -8
• Expected return for Casino 8
• Lottery
• Expected return for customer -50/
• Expected return for Lottery 50/

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Gambling

• Cards, Horses
• Gambler Expected return depends on skill
• Casino Expected return gt0 on average or else
  they rent the space (poker)
• Casinos will not offer games that have negative
  expected return to the Casino

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What proportion of ISU college students gamble?

• Overall 56
• Males 61
• Females 49
• Gamblers spent
• 64 lt 20/month
• 18 20-60/month
• 18 gt 60/month
• Average 33 per month

T. Hira and K. Monson. A social learning
perspective of gambling among college students
38
Why do ISU students gamble?

• Entertainment 65
• To win money 30
• Women more likely to say for entertainment
• Men more likely to say to win

T. Hira and K. Monson. A social learning
perspective of gambling among college students
39
Risk From Uncertainty

• Future payment is not guaranteed sometimes
• There is uncertainty in your investment
• The higher the risk, the higher the payoff
• Goal maximize the expected future return by
  choosing one or some among a bunch of financial
  assets, given the same risk
• Or reduce the risk to the least given the same
  expected return

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The Higher the Risk, the Higher the Payoff

• Investment on A is less risky than investment on
  B, but has a lower expected return from
  investment
• tradeoff

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Diversification - Portfolio

• Holding several assets can lower risk without
  sacrificing return
• The mixed portfolio yields higher utilitysame
  expected return, lower variance

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Diversification

• How can you low the risk?
• Mutual fund
• Financial intermediary holds a portfolio of
  stock.
• Individual investors buy shares of the portfolio
• Holding assets over a long period can lower risk
  - Higher average return wins out
• Warren Buffet Asked when is the best time to
  sell stockNever