MN10403: Lecture 5
The Capital Markets
Part 1
1
Lecture Structure
•
•
•
•
•
•
What are the Capital Markets?
Who uses them?
Characteristics of the instruments traded.
Pricing of these instruments.
Causes of price changes.
Reading and analysing FM data.
2
What are capital markets?
• In contrast to money markets, CMs
provide funds for long-term use.
• Bonds (debt)
• Equities (company shares).
• Bond (debt) maturity 5 years – 20 years.
• Equity: no maturity specified: just continue
as long as the company lasts.
3
Bondholders versus equity holders.
• Corporations are owned by their investors
(equity-holders and bond-holders).
• Bond-holders get first fixed claim on the
firm’s cashflows (annual interest
payments, plus redemption value at
maturity)
• Equity-holders get what’s left (residual
claimants): dividends (optional for firms)
plus capital gains => shares more ‘risky’.
4
The Importance of the Capital
Markets
• Table 6.1 in textbook shows:
• In 2004-2005, net amounts of shares (new
issues – repurchases): negative
• Dominance of fixed income securities
• More than half of corporate sector
investment uses internal funds.
• So is CM unimportant? No
• Secondary market promotes primary
market.
5
Importance of CM (continued)
• Firms use CM as a benchmark for yields on
internal funds.
• The expected return on an internally funded
project should exceed the opportunity cost (the
level of yields on CM investments of the same
risk).
• Existing shares affect the terms at which new
shares can be offered (eg high current share
price).
• Active secondary market => high liquidity of
securities => investor confidence => keeps down
cost of capital.
6
Importance of CM (continued)
• CM assets are part of investors’ portfolio
decision => part of investors’ wealth.
• Changes in CM affect changes in the
economy (therefore, watched closely by
CBs).
• More on the portfolio decision later!
7
Characteristics of Bonds
•
•
•
•
•
•
•
Issued with fixed period to maturity.
5 – 20 years.
Residual maturity.
Shorts (5 years Residual maturity)
Mediums (15 years RM)
Longs (> 15 years RM).
Bonds pay a fixed rate of interest (coupon)
8
Interest (coupon) of a bond:
• Normally receive 2 6-monthly instalments
= ½ coupon rate.
• Par value of bond = £100.
• Coupon/par value = coupon rate.
• Eg govt bond treasury 8% 2015.
• £4 every 6 months to the registered owner
until 2015.
• Guaranteed return!
9
Difference between par value and
market value
• Par value normally the price at which the
bond is first issued.
• However, market conditions may change
• Eg market interest rates , price of bond ?
• Market interest rates
, price of bond?
• Relationship between market interest rates
and bond prices?
• See page 152
10
Yield of a bond
• Running yield = return on a bond taking
account only of coupon payments
• Redemption yield = return on a bond
taking account of coupon cashflows and
capital gain or loss at redemption.
11
Price of a bond
• Buyers compare price of a bond with the
return on equivalent instruments
• If market rates rise, people switch out of
bonds, P : returns equalised in
equilibrium
12
Other types of bonds
• Callable: issuer can redeem them prior to
specified redemption date.
• Putable: holder can sell them back to the
issuer prior to redemption rate
• Convertibles: Corporate bonds, issued
with the option for holder to convert into
company shares (equities)
13
Equity markets
• Shareholders: ‘paid’ after bondholders
• Dividends (optional for the firm) plus
capital gains.
• Shareholders enjoy all of the upside of the
firm’s volatile cashflows.
• On the downside, bondholders can
liquidate company assets
• => bonds safer than equity: affects returns
required by investors.
14
Value of a firm
• Market value of bonds plus market value
of equity.
• In long-run, value of firm should rise
• Value of bonds fixed
• Value of equity should rise.
• Proportion of debt and equity finance in a
firm (debt-equity ration or gearing) affects
variability of returns to shareholders.
15
Required return on equity
• Risk-averse equity holders’ required return
increases with risk.
• A share’s Beta is a measure of this risk.
Equityholders’
reqd
return
Riskfree
Beta
0
1
16
Cost of equity
.
WACC
Cost of Debt:
Risk-free rate
D/E
Shares in highly geared companies regarded as riskier than those
in low geared companies: => higher return required.
Share’s one year return = (P1-P0 +D1)/P0 *100
17
Example (all-equity firm)
•
•
•
•
•
•
•
•
•
•
•
Shares in issue = 50 million
Market price £4
Market capitalisation = £200m
Earnings = £4m
Earnings per share = 8p
Distributed profit = £3m
Dividend per share = 6p
Payout ratio = 0.75
Dividend yield = 1.5 per cent
Earnings yield = 2 per cent
P/E ratio = 50
18
Price-earnings ratio
• High or low: Expensive or cheap?
• Could be high due to being overvalued
(conflicts with ideas of market efficiency)
• Could be high due to expected earnings
growth.
19
Equity market trading
• Secondary market dominates primary market:
• So, are EM.s just glorified gambling?
• Active SM transforms equities from very longterm investments into highly liquid assets.
• Accurate pricing of firms (efficient markets) =>
facilitates corporate control through takeovers.
• Share prices affect wealth.
• SM provides benchmark for new issues of
shares.
• But …..
20
Market efficiency versus
inefficiency
• efficient markets: all available info
currently incorporated into share prices:
• Immediate mkt reaction to news.
• Inefficient markets: slow reaction to news
=> market timing/ insider info/ FSA
intervention.
21
Efficient versus inefficient markets
• .
P
t
FSA test.
22
Next Lecture
• Equity markets (chapter 6: continued)
23