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Finance > Topic 8 > Flashcards

Topic 8 Flashcards

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1
Q

What are the 2 ways we can raise capital?

A

Through the debt market and through equity finance.

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2
Q

2 positives about debt securities

A
  1. flexible.

2. cost of finance.

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3
Q

How are debt securities flexible?

A

Very large amounts if capital can be raised quickly and easily for short maturities (days) or long-dated terms (years).

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4
Q

What is the cost of debt securities?

A

For an issuer, debt is the cheaper form of finance compared to raising equity share capital.

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5
Q

Why is debt the cheaper form of capital?

A

Because debt is less risky; debt holders have to be paid, equity holders don’t, thus equity holders have the greatest risk of not being paid and thus should demand a greater return.

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6
Q

Equity holders should earn more than?

A

Creditors

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7
Q

Any risky asset has to earn more than the _________

A

Benchmark rate.

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8
Q

What does financing through debt essentially mean?

A

Corporates and governments are in effect borrowing money.

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9
Q

How is debt financing carried out? (3)

A
  • By issuing (creating) debt securities and then selling them.
  • The issuer receives capital upon sale, from the buyer, and agrees to pay the buyer or subsequent holder a return over the life of the security.
  • at the end of the life of the security the issuer returns the capital to the holder of the security.
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10
Q

Debt securities are liabilities for ?

Assets for?

A

Liabilities for the issuer (borrower - must give money back).
Assets to the lenders (investors).

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11
Q

How is financing through debt securities different from traditional banking?

A

It is a form of direct finance, borrowers and lenders usually deal directly with one another.

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12
Q

What is the most common form of debt (borrowing money from a bank) - indirect or direct finance?

A

Indirect.

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13
Q

Debt securities: life cycle 1 (4)

A
  1. Deficit Unit (company a) needs capital so it creates/issues a debt security (loan contract).
  2. This is sold to s surplus unit (company b) who has capital.
  3. Deficit unit pays a price (return) to surplus unit.
  4. Deficit unit returns capital to surplus unit at loan maturity.
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14
Q

In debt securities deficit units are (3):

A
  • originators, issuers, sellers of the security.
  • borrower of money.
  • debt security is a liability.
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15
Q

In debt securities, surplus units are (3):

A
  • buyers, holders of security.
  • lend money to deficit unit as investment.
  • debt security is asset.
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16
Q

Debt securities life cycle 2: What is this alternative?

A

The trading of secondary securities; alternatively after its creation and initial sale, the security could be sold to another holder and on sold multiple times until maturity.

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17
Q

Life cycle 2 (4):

A
  • company B (owns debt security).
  • sells to company c.
  • company a (deficit) now provides return to company C.
  • upon loan maturity, whomever is the final owner (company c) receives the capital back from company a.
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18
Q

What does the price company b initially pays for the debt security depend on? (3)

A

The intrinsic value, the maturity and the yield (how much money you need to make) of the security.

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19
Q

Is the debt securities market the largest capital market in the world?

A

Yes!

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20
Q

What 2 markets can debt securities be split into?

A
  • short-term market (Money Market - MM).

- long-term market (Bond Market/Fixed-Interest Market).

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21
Q

Both markets are what type of markets?

A

Wholsesale markets; where the buyers and sellers are financial institutions, non-financial institutions and governments that trade in millions and billions of debt securities.

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22
Q

Distinctions between the markets:

What their securities are called and their maturity?

A

MM securities are called discount securities and have a short maturity < 1 year.
Bond market securities are called bonds and have maturity > 1 year.

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23
Q

How is money earned on each security by the buyer of the security?

A

Bonds make periodic (usually semi-annual) interest payments called Coupons (fixed coupons only) to the current holder prior to maturity.
Discount (MM) securities pay a price back to the buyer that is greater than the price that was lent initially.

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24
Q

Do discount securities pay a coupon?

A

No.

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25
Face value
The money you get back when the loan matures.
26
How are bonds traded vs discount securities?
Bonds: traded over-the-counter (OTC) privately and on public exchanges (stock exchange). Discount securities: traded OTC (privately) only.
27
Is borrowing money in the MM or bond market cheaper than the equivalent borrowing from a bank? Why/Why not?
Yes it is cheaper; financial institutions (banks) charge an intermediation cost, if you do it yourself there is no fee.
28
What is the prime role of the money market?
The provision of short-term liquidity for the economy.
29
The money market helps corporates and governments by?
When corporates and government need capital they can obtain it quickly, easily and at relatively low cost through short-term borrowing.
30
Short term liquidity provided by the MM is essential to? (2)
1. Trade: the exchange of goods and services - buyers can obtain the capital to pay sellers from short term discount securities. 2. Working capital management: current assets such as inventory can be financed through current liabilities such as discount securities.
31
The 4 characteristics of discount securities that allow for the effective transfer of capital from surplus to deficit units:
1. Low default risk and transaction costs. 2. Large denominations with standardised attributes (e.g. Standard FV, risk etc.) 3. Short-term, standardised maturities (often 30, 90 or 180 days). 4. High marketability + a deep pool of buyers and sellers.
32
5 examples of discount securities and their issuers:
1. Treasury notes (federal gov.) 2. Commercial paper (state gov and large corporation). 3. Negotiable certificates of deposit and bank accepted bills (banks). 4. Promissory notes (institutions at least as credit worthy as banks). 5. Repurchase Agreements (federal and state gov.).
33
Do MM securities carry any income payment?
No, not other than the repayment of the face value at maturity.
34
Th nominal value of the security is?
The value that is issued by borrowers (is less than the face value if a discount security) at the beginning of the loan.
35
The bond market
Where medium to long-dated debt securities, over a year in maturity, are issued and traded.
36
What are bonds?
Medium to long-term debt securities that play regular interest on the face value.
37
Bonds; does the buyer of the bond receive the face value on bond maturity?
Yes, like all other debt securities.
38
What do bonds allows corporates and governments to do?
Maturity match; by funding long-term assets with long-term liabilities.
39
What does maturity matching aid?
It helps to synchronise cash inflow (earnings) to cash outflow (capital cost) and reduces liquidity risk.
40
MM securities are primarily used to manage ______ and to provide _____. Bonds are primarily used to _____ .
MM securities are primarily used to manage working capital and provide short-term liquidity. Bonds are primarily used to fund non-current assets or capital investment.
41
Is it possible to use MM securities to finance non-current assets?
It is, however such a strategy faces heightened liquidity risk.
42
Why do corporates want to use MM securities to finance non-current assets?
Because the short-term MM is cheaper than the long-term MM because of lower maturity risk in the short term and thus lower interest rates.
43
What is the risk of using MM securities to finance non-current projects?
In the event of a credit crisis, companies will have to repay the short-term debt securities instead of rolling them over, however as the money is locked away in NC assets and cannot be liquidated the company will face insolvency.
44
What is a coupon?
What bond investors are paid periodically, that is a % of the face value (coupon rate) over the life of the bond.
45
Bond value =
Present value of coupons and present value of face value.
46
Premium bond
A bond that is sold for higher than its face value.
47
YTM (yield to maturity)
The bond buyers' required rate of return of the bond - can be higher, lower or the same as the return paid by the bond (coupon rate).
48
Is YTM the same as y used in pricing discount securities?
Yes
49
What is YTM affected by? (3)
1. Risk-free rate of return. 2. Inflation premium. 3. Risk premium; comprised of compensation for different risks.
50
Who sets the coupon rate?
The bond issuer.
51
Who sets YTM?
The bond buyer.
52
Why are the coupon rate and YTM often different?
As they are set by different stakeholders who use their own judgments of the bond risks.
53
Does the coupon rate change?
No, it is fixed from bond issue.
54
Can YTM change?
Yes.
55
What can influence YTM changing over time life of the bond? (3)
The official cash rate, the credit rating of the bond issuer and the bond buyer's risk aversiveness.
56
When YTM = coupon rate
The bond buyer requires a yield equal or what the interest earned provides (coupon rate) - so bond price will be same as FV.
57
YTM > coupon rate
Th bond buyer requires a yield greater than what the interest earned provides - a lower price will be paid than FV, in order to earn the greater yield - discount bond.
58
YTM < coupon rate
The bond buyer requires a yield smaller than what the interest earned provides - a higher price will be paid than the FV, in order to earn a smaller yield - a premium bond.
59
Why would a bond buyer be willing to earn a lower yield than what the interest earned provides on the FV?
If the debt market is an auction market: coupon rate is > YTM so a higher price > FV is paid - this is very attractive as it means the effective cost of the bond (i.e. The coupon rate) is lower at the lower YTM of the bond buyer.
60
So why would bon buyers be willing to earn a lower yield than the coupon?
Because buying bonds is competitive - you have to pay more than other investors which means you will be willing to accept a lower yield on the fixed coupon. However a price too high shouldn't be paid - that lowers yield beneath an acceptable limit.
61
If a debt security is highly desirable and sought after it will ___ If it is undesirable or overly risky it will ____
Trade at a significant premium to FV. | Trade at a significant discount to FV.
62
When YTM ^ bond price? | Explain.
Decreases. | Coupon and face value are fixed so for future cash flows to earn a higher return, a lower price must be paid.
63
When YTM decreases, bond price? | Explain
Increases. | For future cash flows to earn lower return, a higher price must be paid.

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