Role of capital markets in consumption timing,
Some individuals in an economy are earning more than they currently wish to spend. Others, for
example, retirees, spend more than they currently earn. How can you shift your purchasing power from
high-earnings periods to low-earnings periods of life? One way is to “store” your wealth in financial
assets. In high-earnings periods, you can invest your savings in financial assets such as stocks and bonds.
In low-earnings periods, you can sell these assets to provide funds for your consumption needs. By so
doing, you can “shift” your consumption over the course of your lifetime, thereby allocating your
consumption to periods that provide the greatest satisfaction.
DEBENTURES,
Debentures, which constitute most of the corporate bonds issued, are bonds that have no pledged
collateral. However, the holders of debentures do have a claim over all of the property of the issuer as a
general creditor.
Most debentures are issued by creditworthy corporations that can sell their bonds for a low yield
without pledging collateral. However, some debentures are issued by companies that have already
issued mortgage bonds or have already pledged much of their property for loans. These debentures are
subordinated to the secured credit.
Contingent convertibles,
only allow the investor to convert into stock if the price of the stock is a certain percentage above the
conversion price. For example, a contingent convertible with a $10 stock price at issue, 30% conversion
premium and a contingent conversion trigger of 120%, can be converted (at $13) only if the stock trades
above $15.60 ($13 x 120%) over a specified period, often 20 out of 30 days before the end of the
quarter. The co-co feature was often favored by issuers because the shares of underlying common stock
were only required to be included in diluted EPS calculation if the issuer’s stock traded above the
contingent conversion price. In contrast, non-co-co convertible bonds result in an immediate increase in
diluted shares outstanding, thereby reducing the EPS. The impact to diluted shares outstanding is
calculated using the “as-if-converted” method, which requires the most conservative EPS value be used.
Recent changes to GAAP have eliminated the favorable treatment of co-co’s, and as a result their
popularity with issuers has waned.
Characteristics of Common Stock,
The two most important characteristics of common stock as an investment are its residual claim and its
limited liability features.
Residual claim means stockholders are best last in line of all those who have a claim on the assets and
income of the corporation. In a liquidation of the firm’s assets, the shareholders have claim to what is
left after paying all other claimants, such as the tax authorities, employees, suppliers, bondholders, and
other creditors. In a going concern, shareholders have claim to the part of operating income left after
interest and income taxes have been paid. Management either can pay this residual as cash dividends o
shareholders or reinvest it in the business to increase the value of the shares.
Limited liability means that the most shareholders can lose in event of the failure of the corporation is
their original investment. Shareholders are not like owners of unincorporated businesses, whose
creditors can lay claim to the personal assets of the owner- such as houses, cars, and furniture. In the
event of the firm’s bankruptcy, corporate stockholders at worst have worthless stock. They are not
personally liable for the firm’s obligations: Their liability is limited.
BONDS FINANCIAL FEATURES,
Denomination or par value – is the face or stated value of a bond, the value used to calculate
interest coupon and the repayment amount. As an exception the bonds could be redeemed at a
different value (in this case the redemption price is different from its par value) and a redemption
premium could be created.
Bond selling price - bonds can be priced at a premium, discount or at par. If the bond's price is
higher than its par value, it will sell at a premium because its interest rate is higher than current
prevailing rates. If the bond's price is lower than its par value, the bond will sell at a discount because its
interest rate is lower than current prevailing interest rates.
Bond's maturity date - refers to a future date on which the issuer pays the principal to the
investor. Bond maturities usually range from one day up to 30 years or even more. But this maturity
date must be seen as the last future date (except if the borrower is in default) on which the investor will
receive the principal amount from to the issuer. Depending on redemption features, the real
reimbursement date can be very different (much shorter). These redemption features usually give the
right to the investors and/or the issuer to advance the maturity date of the bond
The coupon or coupon rate of a bond is the amount of interest paid per year expressed as a
percentage of the face value of the bond. It is the interest rate that a bond issuer will pay to a
bondholder
Swap contracts,
A swap is a derivative in which counterparties exchange cash flows of one party's financial instrument
for those of the other party's financial instrument. The benefits in question depend on the type of
financial instruments involved. The swap agreement defines the dates when the cash flows are to be
paid and the way they are calculated. Usually at the time when the contract is initiated at least one of
these series of cash flows is determined by a random or uncertain variable such as an interest rate,
foreign exchange rate, equity price or commodity price.
The cash flows are calculated over a notional principal amount, which is usually not exchanged between
counterparties. Consequently, swaps can be in cash or collateral.
Swaps can be used to hedge certain risks such as interest rate risk, or to speculate on changes in the
expected direction of underlying prices.
Types of swaps : Interest rate swap, Currency swaps, Credit default swaps
Short selling,
This practice of selling securities that are not owned at the time of sale is referred to as selling short. The
security is purchased subsequently by the investor and returned to the party that lent it. When the
security is returned, the investor is said to have “covered the short position.” A profit will be realized if
the purchase price is less than the price that the investor sold the security.
The ability of investors to sell short is an important mechanism is financial markets. In the
absence of an effective short-selling mechanism, security prices will tend to be biased toward the view
of more optimistic investors, causing a market to depart from the standards of a perfect price-setting
situation.
Functions of an investment company,
1.
Record keeping and administration. Investment companies issue periodic status reports,
keeping track of capital gains distributions, dividends, investments, and redemptions, and they may
reinvest dividend and interest income for shareholders.
2.
Diversification and divisibility. By pooling their money, investments companies enable investors
to hold fractional shares of many different securities. They can act as large investors even if any
individual shareholder cannot.
3.
Professional management. Most, but not all, investment companies have full-time staffs of
security analysts and portfolio managers who attempt to achieve superior investment results for their
investors.
4.
Lower transaction costs. Because they trade large blocks of securities, investment companies
can achieve substantial savings on brokerage fees and commissions.
Commingled funds,
Comingled funds are partnerships of investors that pool their funds. The management firm that
organizes the partnership, for example, a bank or insurance company, manages the funds for a fee.
Typical partners in a commingled fund might be trust or retirement accounts that have portfolios much
larger then those of most individual investors but are still too small to warrant managing on a separate
basis.
Commingled funds are similar in a form to open-end mutual funds. Instead of shares, though, the funds
offer units, which are bought and sold at net asset value. A bank or insurance company may offer an
array of different commingled funds, for example, a money market fund, a bond fund, and a common
stock fund.