Unit 3: Financial Markets and type of Securities Flashcards Preview

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Flashcards in Unit 3: Financial Markets and type of Securities Deck (32)
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1
Q

Money vs Capital Markets

A

Money Markets: trade DEBT securities with maturities of less than 1 year.

  • Dealer driven markets, as dealers are the principal in most transactions (not agents like brokers).
  • “While a broker facilitates security trades on behalf of investors, a dealer facilitates trades on behalf of itself.”*
    • Usually short term and marketable.
      • Examples
        • T-bills . Treasury bonds are not included since they are usually long-term investments. Treasury notes also have a maturity of more than 1 year.

BONDS (10+) > Notes (1-10) > Bills (<1)

  • Federal agency securities
  • Short-term tax-exempt securities
  • Commercial paper
  • Certificates of deposit
  • Repurchase agreements
  • Eurodollar CDs
  • Banker’s acceptance
  • They exist in NY, LON and TKYO.

VS

Capital Markets: trade long term debt and equity securities. Ex: NYSE. Tnotes and tbonds

2
Q

Primary Vs Secondary Market

A
  • Primary market: initial offering of securities.
  • Secondary market: trading of previously issued securities (NASDAQ, NYSE, LSE, THE NORMAL ONES WHERE SOMEONE TRADES SECURITIES THEY ALREADY OWN). Examples:
    • Auction markets (NYSE) conduct trading at particular physical sites, and prices are communicated directly to the public.
    • Matching of buy and sell orders is facilitated by a specialist.
      • Specialists maintain an inventory of stocks and sets bid and asked prices.
      • The profit margin of the specialist is the spread (asked over the bid price delta).
    • Stock exchanges also include derivatives including commodity and financial futures.
3
Q

OTC Market

A
  • OTC market is a dealer market (trades securities that are not in the SE)
    • Consists of numerous dealers and brokers who are linked by telecommunication equipment that enables them to trade through the country.
      • Transaction examples:
        • Bond of US companies
        • Bonds of federal, state and local government
        • Open-end investment company shares of mutual funds
        • New security issues
        • Most secondary stock dx, whether or not listed on an exchange.
      • Governing authority for the OTC Market is the National Association of Securities Dealers (NASD) and its computerized trading system is the NASDAQ (add automated quotation)
      • Majority of stocks are traded in OTC but volumes are bigger in exchanges because they list the largest companies.
      • Brokers and dealers may also maintain inventory.
      • Trading in the bonds of corporations is primarily done in the OTC market by large institutional investors, such as pension funds, mutual funds, and life insurance companies. VERY LARGE AMOUNTS TRADED AMONG FEW INVESTORS, AND THEREFORE DEALERS CAN FEASIBLY ARRANGE TRANSACTONS.
4
Q

Financial Intermediary

A
  • Financial intermediaries
    • A financial intermediary obtains funds from savers, issues its own securities, and uses the money to purchase an enterprise’s securities. Examples:
      • Commercial banks
      • Life insurance companies
      • Private pension funds
      • Nonbank thrift institutions: savings banks and credit unions.
      • State and local pension funds
      • Mutual funds
      • Finance companies
      • Casualty insurance companies
      • Money market funds
      • Mutual savings banks
      • Credit unions
      • Investment bankers
5
Q

Insider Trading and Efficient Market Hypothesis (EMH)

Strong (Public and Private- No way)

Semistrong (Public - Insider Trading +)

Weak (Past Data - Fundamental Analysis +)

A
  • Efficient market hypothesis implies on no abnormal returns with either fundamental or technical analysis.
  • EMH implies that expected return of each security matches the return required by the marginal investor given the risk of the security and matches fair value perceived by investors.
  • EMH versions
    • Strong form: all public and private information is instantly reflected in securities price.
    • Semistrong form: all publicly available data are reflected. Inside trading can result in abnormal returns.
    • Weak form: current securities reflect all recent past price movement data, so technical analysis does not hold (fundamental yes since is based on expected future behavior). But fundamental analysis is still work.

TECHNICAL ANALYSIS NEVER HOLD.

6
Q

Rates and Rating Agencies

A
  • Ratings are based on the probability of default and the protection for investors in case of default.
  • Ratings are significant because higher ratings (lower risk of default) reduce interest costs to issuing firms.
  • S&P Ratings:
    • AAA and AA are the highest.
    • A- and BBB are investment grade.
    • BB and below is speculative, also known as junk bonds.
    • CCC to D are very poor debt ratings with high likelihood of default.
7
Q

Investment Banking (ers)

(Best effort Sales vs Underwritten Deal)

and

Flotation costs - costs of issuing new securities

and

Seasonable (secondary offerings)

vs

Unseasonable Issue (IPO)

A
  • They don’t help only to sell new securities but also assist in business combinations as brokers in secondary markets, and trade for their own accounts.
    • Only a few large issuers seek competitive bids.
    • Predominance of negotiated deals is linked to the fact of issuing a price with a fee is very hard with asymmetrical information.
    • Issues securities with best effort sales and underwriting deals.
      • Best effort sales provide no guarantees
      • Underwritten deal or firm commitment where investment banker agrees to purchase the entire issue and resell it, thus the issuer bears the entire risk.
    • Steps:
      • 1. Pre-underwriting conference to discuss amounts to be raised, type o security and nature of the agreement.
      • 2. Filling registration statement with SEC.Seasoned issue is a secondary issue.
    • For a seasoned issue, the offering price may be pegged to the price of existing securities, such as the market price of stock or the yield on bonds.
    • A single investment banker does not ordinarily underwrite an entire issue of securities unless amount is relatively small: prefers to share the risk if a syndicate of other firms.
    • Flotation costs or the costs of issuing new securities are relatively lower for large issues than for small uses. They include:
      • Underwriting spread. Delta between paid by purchaser and the net amount received by the issuer.
      • Filing fees, taxes, accountants fees, and attorney fees.
      • Indirect mgmt costs.
      • Price decline due to bad signaling coming from a seasoned security issue.

​”New shares issued by blue-chip companies are considered seasoned issues.”

  • Seasoned security is a financial instrument that has been publicly traded long enough to eliminate any short-term effects caused by its IPO. Euromarket long enough = 40 days.
  • Unseasoned securities (IPO) tends to be significant underpriced compared with the price in the after market.
    • Usually Flotation costs are higher for common stock, than preferred stock than for stocks than for bonds.
8
Q

IPOs

(Read Carefully)

A
  • IPOs
    • Later issues of stock:
      • Subsequent offering (NOT DILUTIVE TO EARNINGS): issue additional shares that are usually coming from treasury.
      • Secondary offering (DILUTIVE): the company issues new stock for public sale.
    • Advantages of higher share price:

“companies benefit in various ways from a higher stock price.

  • Companies can and do issue “secondary offerings” - the company (and thus shareholders, indirectly) sells new stock for cash. Existing shares are diluted, but the company may be more valuable since it has more cash.
  • Companies can use their stock to make acquisitions or other deals. Higher stock price means fewer shares are paid for the same cash value.
  • Companies dilute shareholders by issuing stock compensation to employees, which shows up (these days) as an expense on the financial statements, lowering EPS to reflect the harm to shareholders. If the stock price is higher, fewer shares are needed to make employees happy.
  • A company with a high stock price is not as vulnerable to a takeover. In a takeover, shareholders might receive less than the company is worth. Though generally at least some parties will feel the takeover is a good deal that gives shareholders more than the company is worth - after all shareholders are getting more than the stock price.”
  • Disadvantages of going public
    • Stock prices that do not accurately reflect the net true worth of the company
    • Increased shareholder servicing costs
    • More reporting requirements
  • A public issue of securities may be sold through a cash offer or a rights offer.
    • Cash offer is the normal one.
    • A rights offer gives existing shareholders an option to purchase new shares before they are offered to the public. If the corporate charter provides for a preemptive right, A RIGHTS OFFER IS MANDATORY.
    • Under a standby underwriting agreement, an underwrite may agree to buy undersubscribed shares.
  • A green shoe option is a stabilization mechanism for offerings. It consists in issuing more shares than agreed.
    • When there is strong demand and the stock price rises, the underwriter assures the offer price covering the short sell at the same price initially agreed. So no money is lost by exercising the greenshoe option.
    • When there is a broke issue, they buy back at a lower price covering their short position (no exercise of greenshoe) and making a profit.
  • Debt is normally sold at cash offer, but equity might be sold by either mean (cash or rights offer).
  • IPO necessarily requires a cash offer, since security is new.
  • Proceeds from a secondary offer goes to the holder, and not to the original issuer
  • IPO requires in quality report material which involves a set of audited financial statements accompanied by opinion of independent external auditor.
    • An unmodified opinion proves the highest level of assurance as it states that financial statements present fairly in all material aspects financial positions, results, cash flows in line with accepted accounted accounting principles.
9
Q

Systematic vs Unsistematic Risk

A
  • Systematic risk or market risk, and is also undiversifiable risk since this cannot be eliminated with portfolio diversification
  • Unsystematic risk or company risk, inherent to a particular investment security, and can be diversified with portfolio diversification.
10
Q

Other Types of Risk

(Check for Financial Risk)

A
  • Credit risk: risk of default
  • FX risk
  • Interest rate risk
  • Industry risk
  • Political risk (expropriation). Political risk can be reduced by making foreign company dependent on domestic parent technology, market or supplies.
  • Liquidity risk. Risk that a security cannot be sold at short notice unless excessively discounted.
  • Financial risk. Change coming from change on interest rates or desired return by investors. Only debt backed company has financial risk.
  • “Financial risk refers to your business’ ability to manage your debt and fulfil your financial obligations​”*
  • Purchase power risk.
11
Q

Financial Instruments - Concept and Types

A

Concept: fin managers may select from a wide range of financial instruments in which to invest and with which to raise money

Types of financial instruments:

  • Long-term financial instruments, from the lowest to the highest rate of return.
    • US treasury bonds
    • First mortgage bonds
    • Second mortgage bonds (ON TOP OF SUBORDINATED BECAUSE THERE IS COLLATERAL)
    • Subordinate debentures
    • Income bonds
    • Preferred stocks
    • Convertible preferred stock
    • Common stock
  • COMMERCIAL PAPER IS UNSECURED.
  • BE CAREFUL WITH TERMS MARKETABLE SECURITY(SHORT TERM) VS LONG TERM (CAPITAL MARKET)
12
Q

Bonds Overview

(General Aspects - Indenture - / Advantages / Disadvantages)

A
  • Aspects of bonds
    • Face or maturity amount is received on the bonds maturity date.
    • Annual cash interest equals face amount times the coupon rate.
    • All of the terms of the agreement are stated in a document called indenture.
      • Defines what can issuer can do with the money.
      • E.g. buy property only if insured and cannot be pledged as a security to another loan.
      • May require that the issuer establish or maintain a bond sinking fund.
    • Usually, the higher the return of the bond, the higher the yield demanded to compensate for risk.
    • Advantages of bonds to the issuer
      • Interest paid on debt is tax deductible
      • Basic control of the firm is not shared with debtholders (as opposed to equity financing)
    • Disadvantages to the issuer
      • Payment of interest and principal is an obligation.
      • The legal requirement to pay debt service raises a firm’s risk level. (higher capitalization on retained earnings is demanded by shareholders).
      • Long term nature of debt can create a big liability if interest rates fall, and the firm is unable to refinance.
      • Management loses financial flexibility in order to respect ratios/covenants.
      • Amount of debt available is limited and company should respect a certain debt equity ratio.
13
Q

Bonds: Debt Covenants and Call Provisions

(Restrictive Covenants > Impact on Rates??)
(Call Provision > Impact on Rates??)

A
  • Debt covenants
    • Examples of debt covenants
      • Limitation on issuing additional long/short term debt.
      • Limitations on dividends payment
      • Maintaining certain financial rations
      • Maintaining specific collateral
    • More restrictive the debt covenants, the lower the risk that the borrower will not be able to repay its debt, therefore the lower the interest rate (since risk premium is lower).
    • If the debtor breaches the debt covenant, the debt becomes due immediately.
  • Call Provisions allow for early exercise, and therefore decrease the attractiveness to investors, therefore imply on higher rate of return.
14
Q

Types of Bonds: Maturity

(Term vs Serial)

A
  • Term bond has a single maturity date at the end of its term
  • Serial bond matures in stated amounts at regular intervals. Investors have the flexibility to choose when therefore rates are usually lower.
15
Q

Types of Bonds: Valuation

(Variable Rate & Zero-coupon - Commodity Backed)

A
  • Variable rate bonds pay interest that is dependent on market conditions
  • Zero-coupon or deep discount bonds bear no started rate of interest and thus not involve periodic cash payments. The interest component is entirely the bond discount.
  • Commodity-backed bonds are payable at prices related to commodities.
16
Q

Types of Bonds: Redemption Provisions

(Callable & Convertible)

A
  • Redemption provisions
    • Callable bond may be repurchased by the issuer at a specified price before maturity.
      • As discussed usually pay higher rates.
    • Convertible bonds may be converted to equity securities of the issuer.
      • Pays lower rates because gives the optionality to the holder to convert to stocks.
      • However, if a lot of bonds are converted then the shareholder base gets dilluted.
17
Q

Types of Bonds: Securitization

(Mortgage Bonds & Debentures & Equipment Trust Bonds)

A
  • Mortgage bonds are backed by specific assets (usually real state)
  • Debentures are backed by the issuer’s full faith and credit but not by specific collateral. Thus debentures are riskier.
  • Equipment trust bonds secured by a lien on specific piece of equipment like airplane or railroad car. Similar to mortgage.
18
Q

Types of Bonds: Ownership

(Registered vs Bearer Bonds)

A
  • Registered bonds are issued in the name of the holder. Only the registered holder may receive interest and principal payments.
  • Bearer bonds are not individually registered. Is paid to whoever presents the bond.
19
Q

Types of Bonds: Repayment Provisions

A
  • Income bonds pay interest only if the issuer has earnings deemed sufficient by the company.
  • Revenue bonds are issued by government, and are payable from specific revenue sources.
20
Q

Bond Ratings (BB down)

and

Ranking (from higher to lower rate of return)

A
  • Investment grade are considered safe investments with moderate risk.
    • Highest rating is triple-A.
    • Lowest is triple-B.
  • Non-investment grade also called speculative-grade bonds (double B downwards), high yield bonds or junk bonds carry risk.
  • Ranking of bonds:
    • 1. T-bonds
    • 2. Secured bonds
    • 3. Second mortgage bonds
    • 4. Investment grade bonds
    • 5. Subordinated bonds (deep discount bounds)
    • 6. Income bonds
    • 7. Junk bonds
  • HOWEVER, IN TERMS OF PRIORITY INCOME BONDS ARE LESS JUNIOR THAN SUBORDINATED DEBT, BECAUSE IS NONSUBORDINATE
21
Q

Interest Rate Risk

A
  • Investment security will fluctuate in value due to changes in interest rates.
    • The duration a bond is the best measure of the interest rate risk. This is why upward sloping is more common (exposed to volatility for a longer period).
  • Interest rate is also affected by inflation expectation.
    • The lower the inflation, the lower the interest rate.
22
Q

Bond Valuation

(Effective vs Market Rate)

A
  • Using the effective interest rate method ensures that bond’s yield to maturity is equal to the rate prevailing in the market at the time of sale, and that face value will be reflected upon maturity.
  • Effective rate VS Market rate
    • If ER = MR, present value of the bond will equal exactly their face amount, and the bolds are sold at par.
    • If ER < MR, investors need an incentive to buy the bond therefore they will be discounted bods.
    • If ER > MR, investors need an incentive to buy the bond therefore they will be premium bonds.
23
Q

Convertible and SemiAnnual Bonds

A
  • Convertible bonds
    • Conversion ratio = Par Value of Convertible Bond / Conversion Price
  • Interest on bond paid more often than annually
    • The interest rate on an annual basis (for market and effective rate) / number of times interest is paid per year
    • Relevant calculation period = year x 2 (for semiannually)
24
Q

Bond Interest Calculation

(and in HP12c)

A

Effective Rate (if semiannual divide by 2)* Face Amount of Bonds

but values are brought to present value using the Market Rate (which should also be divided by 2 if semiannually)

25
Q

Advantages

and

Disadvantages to the Issuer

A
  • Advantages to the issuer
    • Does not require a fixed dividend; dividends are paid from profit when available.
    • There is no fixed maturity date for repayment of capital
    • Sale of common stock increases creditworthiness of the firm by providing more equity
    • Common stock is more attractive to investors because it grows in tandem with firm’s success.
    • Common shareholders ordinarily have preemptive rights = preemptive rights give common shareholders the right to purchase any additional stick issuances in proportion to their current ownership percentages.
  • Disadvantages to the issuer
    • Cash dividends on common stock are not tax deductible
    • Control is diluted as more common stock is sold
    • New common stock sales dilute earnings per share available to existing shareholders
    • Underwriting costs are typically higher for common stock issues
    • Too much equity may raise the average cost of capital of the firm above the optimal level.
    • Inflation may increase the yields of new bond issues and decrease demand for common stock
26
Q

Preferred Stock: General Aspects (remember 3 key ones underlined)

A
  • Hybrid of debt and equity since it has a fixed charge, but payment of dividends is not a legal obligation. Bond > preferred stock > common stock
  • Typical provisions of preferred stock issues
    • Priority in assets and earnings (priority in dividends over common stock)
    • Accumulation of dividends
    • Participation on excess interests (usually only common shareholders have this) if preferred stock is participative.
    • Par value is the liquidation value, and a percentage of par equals the preferred dividend.
    • Redeemability. Some stocks might be redeemed at a given time or at a time not controlled by the issuer. This feature makes it more nearly akin to debt.
    • Do not ordinarily have voting rights.
    • Retirement.
      • May be converted into common stock at the option of the shareholder.
      • Issuer may have the right to repurchase the stock through a call provision.
      • May also have a sinking fund.
27
Q

Preferred Stock: Pros and Cons

(Cash Dividends Implication on Tax)

A
  • Advantages to the issuer
    • It is a form of equity and helps on creditworthiness of the firm.
    • Control is still held by common shareholder.
    • Superior earnings of the firm are still reserved for the common shareholders.
  • Disadvantages
    • Cash dividends are not tax-deductible and are paid with after-tax income
    • Accumulated unpaid dividends may create major managerial and financial problems to the firm.
28
Q
  • Corporation has 6000 shares of 5% cumulative at 100Eur par value preferred stock. In two years, how much will be paid?
  • Dividend yield vs dividend per share
A

> Par Value vs Dividend Yield (5%) vs number of shares vs 2

> Dividend per share: dividend yield * par value

29
Q

Dividend Policy: Influencing Factors

A
  • Legal restrictions: ordinarily cannot be paid out of paid-in capital (only from excess/retained earnings).
  • Stability of earnings: more fluctuation of earnings >> less dividends.

DIVIDENDS ARE MORE STABLE THAN EARNINGS TO KEEP CONFIDENCE.

  • Rate of growth: faster growth lower dividend ratio to fuel growth via retained earnings.
  • Cash position: cash must be available for payment.
  • Restriction in debt agreements: restrictive covenants in bond indentures often limit the dividends that a firm can declare.
  • Tax position of shareholders: sometimes you pay less dividends because you want to avoid the impact of high tax brackets.
  • Residual theory of dividends:
    • Dividend payout ratio depends on the availability of investment opportunities and the debt/equity ratio. Firm may prefer to pay dividends when investment opportunities are poor and when the use of internal equity financing would move the firm away from its ideal capital structure.
30
Q

Dividend Timing

(1. Date of Declaration
2. Ex-dividend date
3. Date of Record
4. Date of Dx

A
  • The date of declaration: on this day the dividend becomes a liability to the corporation (goes to dividend payable).
  • The ex-dividend date is a date established by stock exchanges, such as 2 BDs before the date of record. It is not established by the corporate board of directors.
    • Period between ex-dividend date and date of record is a buffer so exchange members are prepared to process transactions.
    • Investor who buys stock before ex-dividend date will receive the dividend which was previously declared. If bought after will not receive the dividend declared (but rather the person who sold).
    • Usually a stock price drop happens on the ex-dividend date by the amount of dividend, because new investors will not receive it.
  • The date of record is the date where the shareholders are selected to receive the declared dividend (2-6 weeks after the declaration date).
  • The date of distribution is the date where dividend is actually paid out (2-4 weeks after date of record). Checks are mailed.
31
Q

Stock Dividends (Non-Dillutive)

vs

Stock Split (No entries)

A
  • Stock dividends and splits
    • Involves the issue of additional shares to existing shareholders.
    • Stock dividend: is an issuance of stock and entails the transfer of a sum from the retained earnings to a paid-in capital account. EPS reduces but number of shares increase so everybody is as well off.
      • Give something to shareholders but not cash (that could be needed for the daily business/WC).
    • Stock split: does not involve any accounting entries
32
Q

Treasury Stock Repurchase impact on Leverage

A

Purchase of treasury usually involves a decrease on assets (usually cash) and a corresponding decrease in equity (treasury is a contra-equity account). Thus D/E (leverage) increases.