Master of Business Administration
Money and Capital Markets
Module MBAZ510
Author:
Kennell Madzirerusa
Master of Science Finance and Investment (NUST)
Bachelor of Commerce (Honours) in Banking (NUST)
Institute of Bankers (Diploma)
Content Reviewer:
Roy Robson Jubenkanda
MSc Strategic Management (Derby, UK)
MSc in International Economics, Banking and Finance (Cardiff,
UK)
BSc (Hons.) Economics (UZ)
Diploma in Business Adminstration (Solusi University)
Certificate in Distance Education (UNISA)
Certificate in Higher Education Management (Witts. University,
SA)
Editor:
Kudzanayi Ruvharo
MSc in Statistics (UZ)
BSc Special Honours in Statistics (UZ)
BSc Mathematics and Statistics (Gweru Teachers’ College)
Published by:
The Zimbabwe Open University
P.O. Box MP1119
Mount Pleasant
Harare, ZIMBABWE
The Zimbabwe Open University is a distance teaching and open
learning institution.
Year:
2012
Cover design:
T. Ndhlovu
Layout :
S. Mushore
Printed by:
ZOU Press
ISBN:
978-1-77938-639-7
Typeset in Times New Roman, 12 point on auto leading
© Zimbabwe Open University. All rights reserved. No part of this
publication may be reproduced, stored in a retrieval system, or
transmitted, in any form or by any means, electronic, mechanical,
photocopying, recording or otherwise, without the prior permission of
the Zimbabwe Open University.
To the student
The demand for skills and knowledge
and the requirement to adjust and
change with changing technology, places
on us a need to learn continually
throughout life. As all people need an
education of one form or another, it has
been found that conventional education
institutions cannot cope with the
demand for education of this magnitude.
It has, however, been discovered that
distance education and open learning,
now also exploiting e-learning
technology, itself an offshoot of ecommerce, has become the most
effective way of transmitting these
appropriate skills and knowledge
required for national and international
development.
Since attainment of independence in
1980, the Zimbabwe Government has
spearheaded the development of
distance education and open learning at
tertiary level, resulting in the
establishment of the Zimbabwe Open
University (ZOU) on 1 March, 1999.
ZOU is the first, leading, and currently
the only university in Zimbabwe entirely
dedicated to teaching by distance
education and open learning. We are
determined to maintain our leading
position by both satisfying our clients
and maintaining high academic
standards. To achieve the leading
position, we have adopted the course
team approach to producing the varied
learning materials that will holistically
shape you, the learner to be an all-round
performer in the field of your own
choice. Our course teams comprise
academics,
technologists
and
administrators of varied backgrounds,
training, skills, experiences and personal
interests. The combination of all these
qualities inevitably facilitates the
production of learning materials that
teach successfully any student, anywhere
and far removed from the tutor in space
and time. We emphasize that our
learning materials should enable you to
solve both work-related problems and
other life challenges.
To avoid stereotyping and professional
narrowness, our teams of learning
materials producers come from different
universities in and outside Zimbabwe,
and from Commerce and Industry. This
openness enables ZOU to produce
materials that have a long shelf life and
are sufficiently comprehensive to cater
for the needs of all of you, our learners
in different walks of life. You, the
learner, have a large number of optional
courses to choose from so that the
knowledge and skills developed suit the
career path that you choose. Thus, we
strive to tailor-make the learning
materials so that they can suit your
personal and professional needs. In
developing the ZOU learning materials,
we are guided by the desire to provide
you, the learner, with all the knowledge
and skill that will make you a better
performer all round, be this at certificate,
diploma, undergraduate or postgraduate
level. We aim for products that will settle
comfortably in the global village and
competing successfully with anyone. Our
target is, therefore, to satisfy your quest
for knowledge and skills through
distance education and open learning
Any course or programme launched by ZOU is
conceived from the cross-pollination of ideas
from consumers of the product, chief among
whom are you, the students and your employers.
We consult you and listen to your critical analysis
of the concepts and how they are presented. We
also consult other academics from universities
the world over and other international bodies
whose reputation in distance education and open
learning is of a very high calibre. We carry out
pilot studies of the course outlines, the content
and the programme component. We are only
too glad to subject our learning materials to
academic and professional criticism with the
hope of improving them all the time. We are
determined to continue improving by changing
the learning materials to suit the idiosyncratic
needs of our learners, their employers, research,
economic circumstances, technological
development, changing times and geographic
location, in order to maintain our leading
position. We aim at giving you an education
that will work for you at any time anywhere and
in varying circumstances and that your
performance should be second to none.
As a progressive university that is forward
looking and determined to be a successful part
of the twenty-first century, ZOU has started to
introduce e-learning materials that will enable
you, our students, to access any source of
information, anywhere in the world through
internet and to communicate, converse, discuss
and collaborate synchronously and
asynchronously, with peers and tutors whom
you may never meet in life. It is our intention
to bring the computer, email, internet chatrooms, whiteboards and other modern methods
of delivering learning to all the doorsteps of
our learners, wherever they may be. For all these
developments and for the latest information on
what is taking place at ZOU, visit the ZOU
website at www.zou.ac.zw
Having worked as best we can to prepare your
learning path, hopefully like John the Baptist
prepared for the coming of Jesus Christ, it is my
hope as your Vice Chancellor that all of you,
will experience unimpeded success in your
educational endeavours. We, on our part, shall
continually strive to improve the learning
materials through evaluation, transformation of
delivery methodologies, adjustments and
sometimes complete overhauls of both the
materials and organizational structures and
culture that are central to providing you with
the high quality education that you deserve. Note
that your needs, the learner ‘s needs, occupy a
central position within ZOU’s core activities.
Best wishes and success in your studies.
_____________________
Prof. Primrose Kurasha
Vice Chancellor
The Six Hour Tutorial Session At
The Zimbabwe Open University
A
s you embark on your studies with the Zimbabwe
Open University (ZOU) by open and distance
learning, we need to advise you so that you can make
the best use of the learning materials, your time and
the tutors who are based at your regional office.
The most important point that you need to note is
that in distance education and open learning, there
are no lectures like those found in conventional
universities. Instead, you have learning packages that
may comprise written modules, tapes, CDs, DVDs
and other referral materials for extra reading. All these
including radio, television, telephone, fax and email
can be used to deliver learning to you. As such, at
the ZOU, we do not expect the tutor to lecture you
when you meet him/her. We believe that that task is
accomplished by the learning package that you receive
at registration. What then is the purpose of the six
hour tutorial for each course on offer?
At the ZOU, as at any other distance and open
learning university, you the student are at the centre
of learning. After you receive the learning package,
you study the tutorial letter and other guiding
documents before using the learning materials. During
the study, it is obvious that you will come across
concepts/ideas that may not be that easy to understand
or that are not so clearly explained. You may also
come across issues that you do not agree with, that
actually conflict with the practice that you are familiar
with. In your discussion groups, your friends can bring
ideas that are totally different from yours and
arguments may begin. You may also find that an idea
is not clearly explained and you remain with more
questions than answers. You need someone to help
you in such matters.
This is where the six hour tutorial comes in. For it
to work, you need to know that:
·
There is insufficient time for the tutor to
lecture you
·
Any ideas that you discuss in the tutorial,
originate from your experience as you
work on the materials. All the issues
raised above are a good source of topics
(as they pertain to your learning) for
discussion during the tutorial
·
The answers come from you while the
tutor’s task is to confirm, spur further
discussion, clarify, explain, give
additional information, guide the
discussion and help you put together full
answers for each question that you bring
·
You must prepare for the tutorial by
bringing all the questions and answers
that you have found out on the topics to
the discussion
·
For the tutor to help you effectively, give
him/her the topics beforehand so that in
cases where information has to be
gathered, there is sufficient time to do
so. If the questions can get to the tutor
at least two weeks before the tutorial,
that will create enough time for thorough
preparation.
In the tutorial, you are expected and required to
take part all the time through contributing in every
way possible. You can give your views, even if
they are wrong, (many students may hold the same
wrong views and the discussion will help correct
The Six Hour Tutorial Session At The Zimbabwe Open University
the errors), they still help you learn the correct thing
as much as the correct ideas. You also need to be
open-minded, frank, inquisitive and should leave no
stone unturned as you analyze ideas and seek
clarification on any issues. It has been found that
those who take part in tutorials actively, do better in
assignments and examinations because their ideas are
streamlined. Taking part properly means that you
prepare for the tutorial beforehand by putting together
relevant questions and their possible answers and
those areas that cause you confusion.
Only in cases where the information being discussed
is not found in the learning package can the tutor
provide extra learning materials, but this should not
be the dominant feature of the six hour tutorial. As
stated, it should be rare because the information
needed for the course is found in the learning package
together with the sources to which you are referred.
Fully-fledged lectures can, therefore, be misleading
as the tutor may dwell on matters irrelevant to the
ZOU course.
Distance education, by its nature, keeps the tutor
and student separate. By introducing the six hour
tutorial, ZOU hopes to help you come in touch with
the physical being, who marks your assignments,
assesses them, guides you on preparing for writing
examinations and assignments and who runs your
general academic affairs. This helps you to settle
down in your course having been advised on how
to go about your learning. Personal human contact
is, therefore, upheld by the ZOU.
The six hour tutorials should be so structured that the
tasks for each session are very clear. Work for each
session, as much as possible, follows the structure given
below.
Session I (Two Hours)
Session I should be held at the beginning of the semester. The main aim
of this session is to guide you, the student, on how you are going to
approach the course. During the session, you will be given the overview
of the course, how to tackle the assignments, how to organize the logistics
of the course and formation of study groups that you will belong to. It is
also during this session that you will be advised on how to use your
learning materials effectively.
The Six Hour Tutorial Session At The Zimbabwe Open University
Session II (Two Hours)
This session comes in the middle of the semester to respond to the
challenges, queries, experiences, uncertainties, and ideas that you are
facing as you go through the course. In this session, difficult areas in the
module are explained through the combined effort of the students and
the tutor. It should also give direction and feedback where you have not
done well in the first assignment as well as reinforce those areas where
performance in the first assignment is good.
Session III (Two Hours)
The final session, Session III, comes towards the end of the semester.
In this session, you polish up any areas that you still need clarification on.
Your tutor gives you feedback on the assignments so that you can use
the experience for preparation for the end of semester examination.
Note that in all the three sessions, you identify the areas
that your tutor should give help. You also take a very
important part in finding answers to the problems posed.
You are the most important part of the solutions to your
learning challenges.
Conclusion
In conclusion, we should be very clear that six
hours is too little for lectures and it is not
necessary, in view of the provision of fully selfcontained learning materials in the package, to
turn the little time into lectures. We, therefore,
urge you not only to attend the six hour tutorials
for this course, but also to prepare yourself to
contribute in the best way possible so that you
can maximally benefit from it. We also urge you
to avoid forcing the tutor to lecture you.
BEST WISHES IN YOUR STUDIES.
ZOU
Contents
Course Overview __________________________________________________________ 1
Unit One: Functions and Roles of the Financial System in the Global
Economy
1.0 _______ Introduction ___________________________________________________ 3
1.1 _______ Objectives _____________________________________________________ 4
1.2 _______ The Financial System ___________________________________________ 4
_________ 1.2.1 Functions of the financial system ____________________________ 4
1.3 _______ Flows within the Global Economic System _________________________ 4
_________ Activity 1.1 _____________________________________________________ 5
1.4 _______ The Role of Markets in the Global Economic System ______________ 6
1.5 _______ Types of Market _______________________________________________ 6
1.6 _______ Financial Assets ________________________________________________ 7
_________ 1.6.1 Characteristics of financial assets ___________________________ 7
_________ 1.6.2 Different kinds of financial assets ___________________________ 8
_________ 1.6.3 How financial assets are created ____________________________ 8
1.7 _______ Financial Assets and the Financial System _________________________ 8
_________ Activity 1.2 _____________________________________________________ 9
1.8 _______ The Evolution of Financial Transactions __________________________ 9
1.9 _______ Disintermediation of Funds ____________________________________ 12
_________ Activity 1.3 ____________________________________________________ 13
1.10 ______ Financial Markets and the Financial System ______________________ 14
_________ Activity 1.4 ____________________________________________________ 14
1.11 ______ The Global Financial System ___________________________________ 14
1.12 ______ Functions of the Global Financial System ________________________ 15
_________ Activity 1.5 ____________________________________________________ 15
1.13 ______ Factors Tying all Financial Markets Together _____________________ 16
1.14 ______ The Dynamic Financial System __________________________________ 16
1.15 ______ Bank-dominated versus Security-dominated Financial Systems _____ 17
_________ Activity 1.6 ____________________________________________________ 17
1.16 ______ Summary _____________________________________________________ 17
_________ R ef erences ___________________________________________________
18
Unit Two: The Roles of Financial Markets and Financial Institutions
2.0 _______ Introduction __________________________________________________ 19
2.1 _______ Objectives ____________________________________________________ 20
2.2 _______ What is a Financial Market? ____________________________________ 20
2.3 _______ The Role of Financial Markets and Institutions ___________________ 20
2.4 _______ Types of Financial Markets ____________________________________ 21
_________ 2.4.1 Money versus capital markets ______________________________ 21
_________ 2.4.2 Primary versus secondary markets __________________________ 21
_________ Activity 2.1 ____________________________________________________ 22
2.5 _______ How Financial Markets Facilitate Corporate Finance ______________ 22
2.6 _______ How Financial Markets Facilitate Investment _____________________ 23
_________ Activity 2.2 ____________________________________________________ 23
2.7 _______ Securities Traded in Financial Markets __________________________ 23
_________ 2.7.1 Money market securities __________________________________ 24
_________ 2.7.2 Capital market securities __________________________________ 24
_________ 2.7.3 Derivative securities ______________________________________ 24
2.8 _______ Valuation of Securities in Financial Markets _____________________ 24
2.9 _______ Market Efficiency _____________________________________________ 25
_________ Activity 2.3 ____________________________________________________ 25
2.10 ______ Global Financial Markets _______________________________________ 25
2.11 ______ International Corporate Governance Relating to Financial Markets _ 26
2.12 ______ Global Integration _____________________________________________ 26
2.13 ______ Role of the Foreign Exchange Market ____________________________ 26
_________ Activity 2.4 ____________________________________________________ 27
2.14 ______ Role of Financial Institutions ___________________________________ 27
2.15 ______ Role of Depository Institutions _________________________________ 28
2.16 ______ Role of Non-depository Financial Institutions ____________________ 28
_________ 2.16.1 Finance companies ______________________________________ 28
_________ 2.16.2 Mutual funds ___________________________________________ 28
_________ 2.16.3 Securities firms _________________________________________ 29
_________ 2.16.4 Insurance companies ____________________________________ 29
_________ 2.16.5 Pension funds __________________________________________ 29
2.17 ______ Comparison of Roles among Financial Institutions ________________ 30
_________ Activity 2.5 ____________________________________________________ 32
2.18 ______ Summary ____________________________________________________ 32
_________ R ef erences ___________________________________________________ 33
Unit Three: Money Markets
3.0 _______ Introduction __________________________________________________ 35
3.1 _______ Objectives ____________________________________________________ 36
3.2 _______ Money Markets _______________________________________________ 36
_________ 3.2.1 Why do we need money markets? __________________________ 36
_________ Activity 3.1 ____________________________________________________ 37
_________ 3.2.2 Functions of money markets _______________________________ 37
3.3 _______ Money Market Securities _______________________________________ 38
_________ Activity 3.2 ____________________________________________________ 39
3.4 _______ Securities Quoted on a Yield Basis ______________________________ 39
_________ 3.4.1 Money market deposits ___________________________________ 39
_________ 3.4.2 Certificates of deposit ____________________________________ 40
3.5 _______ Securities Quoted on a Discount Basis __________________________ 40
_________ Activity 3.3 ____________________________________________________ 40
_________ 3.5.1 Treasury bills (T-bills) ____________________________________ 41
_________ Activity 3.4 ____________________________________________________ 46
_________ 3.5.2 Commercial paper ________________________________________ 46
_________ Activity 3.5 ____________________________________________________ 49
_________ 3.5.3 Negotiable certificates of deposit (NCDs) ___________________ 49
_________ 3.5.4 Repurchase agreements (repo) _____________________________ 50
_________ 3.5.5 Bankers’ Acceptances (BA) ________________________________ 51
_________ Activity 3.6 ____________________________________________________ 53
3.6 _______ Summary _____________________________________________________ 53
_________ R ef erences ___________________________________________________ 54
Unit Four: Bond Markets
4.0 _______ Introduction __________________________________________________ 55
4.1 _______ Objectives ____________________________________________________ 56
4.2 _______ Purpose of Capital Markets ____________________________________ 56
4.3 _______ Capital Market Participants ____________________________________ 56
_________ Activity 4.1 ____________________________________________________ 57
4.4 _______ Background on Bonds _________________________________________ 57
_________ 4.4.1 Why issue bonds? ________________________________________ 57
_________ Activity 4.2 ____________________________________________________ 59
_________ 4.4.2 Issuers of bonds _________________________________________ 59
4.5 _______ Main Features of Bonds _______________________________________ 60
_________ 4.5.1 Indenture and covenants __________________________________ 60
_________ 4.5.2 Maturity _________________________________________________ 60
_________ 4.5.3 Par value ________________________________________________ 61
_________ 4.5.4 Current yield ____________________________________________ 61
_________ 4.5.5 Yield to maturity _________________________________________ 61
_________ 4.5.6 Duration ________________________________________________ 62
_________ 4.5.7 Coupon rate _____________________________________________ 62
_________ Activity 4.3 ____________________________________________________ 64
4.6 _______ Provisions for Paying off Bonds ________________________________ 65
_________ 4.6.1 Call and refunding provision ______________________________ 65
_________ 4.6.2 Prepayments _____________________________________________ 66
_________ 4.6.3 Sinking fund provision ____________________________________ 66
_________ 4.6.4 Conversion privilege ______________________________________ 66
_________ 4.6.5 Put provision ____________________________________________ 66
4.7 _______ Types of Bonds ______________________________________________ 67
_________ 4.7.1 Secured bonds ___________________________________________ 67
_________ 4.7.2 Unsecured bonds _________________________________________ 67
_________ 4.7.3 Junk bonds ______________________________________________ 67
_________ 4.7.4 Callable bonds ___________________________________________ 68
_________ 4.7.5 Non-refundable bonds ____________________________________ 68
_________ 4.7.6 Putable bonds ___________________________________________ 68
_________ 4.7.7 Perpetual debentures _____________________________________ 68
_________ 4.7.8 Zero-coupon bonds _______________________________________ 69
_________ 4.7.9 Convertible bonds ________________________________________ 69
_________ 4.7.10 Adjustable bonds ________________________________________ 69
_________ 4.7.11 Structured securities _____________________________________ 69
4.8 _______ Corporate Bond Risks _________________________________________ 70
4.9 _______ International Bond Markets ____________________________________ 71
4.10 ______ Importance of International Bond Markets ______________________ 71
_________ Activity 4.4 ____________________________________________________ 72
4.11 ______ Summary _____________________________________________________ 72
_________ R ef erences ___________________________________________________ 74
Unit Five: Bond Valuation
5.0 _______ Introduction __________________________________________________ 75
5.1 _______ Objectives ____________________________________________________ 76
5.2 _______ Bond Valuation Process _______________________________________ 76
_________ 5.2.1 Impact of the discount rate on bond valuation _______________ 77
_________ Activity 5.1 ____________________________________________________ 78
_________ 5.2.2 Impact of the timing of payments on bond valuation __________ 78
_________ 5.2.3 Valuation of bonds with semiannual payments _______________ 78
_________ 5.2.4 Relationships between coupon rates, required return ___________
_________ and bond price ________________________________________________ 79
_________ Activity 5.2 ____________________________________________________ 81
5.3 _______ Explaining Bond Price Movements ______________________________ 81
_________ 5.3.1 Factors that affect the risk-free rate _________________________ 82
_________ 5.3.2 Factors that affect the credit risk premium ___________________ 83
_________ Activity 5.3 ____________________________________________________ 84
_________ 5.3.3 Sensitivity of bond prices to interest rate movements _________ 84
_________ Activity 5.4 ____________________________________________________ 88
_________ Activity 5.5 ____________________________________________________ 92
5.4 _______ Summary _____________________________________________________ 93
_________ R ef erences ___________________________________________________ 94
Unit Six: Risks Associated with Investing in Bonds
6.0 _______ Introduction __________________________________________________ 95
6.1 _______ Objectives ____________________________________________________ 96
6.2 _______ Interest Rate Risk _____________________________________________ 96
_________ 6.2.1 Reason for the inverse relationship between changes in interest _
_________ rates and bond price __________________________________________ 97
_________ Activity 6.1 ____________________________________________________ 97
_________ 6.2.2 Bond features that affect interest rate risk ___________________ 98
_________ Activity 6.2 ___________________________________________________ 100
6.3 _______ Yield Curve Risk _____________________________________________ 100
6.4 _______ Call and Prepayment Risk _____________________________________ 100
6.5 _______ Reinvestment Risk ____________________________________________ 101
6.6 _______ Credit Risk __________________________________________________ 102
_________ 6.6.1 Default risk _____________________________________________ 102
_________ 6.6.2 Credit spread risk _______________________________________ 102
_________ 6.6.3 Downgrade risk _________________________________________ 103
_________ Activity 6.3 ___________________________________________________ 104
6.7 _______ Liquidity Risk ________________________________________________ 104
6.8 _______ Currency Risk (Exchange Rate Risk) ____________________________ 105
6.9 _______ Inflation or Purchasing Power Risk ____________________________ 105
6.10 ______ Volatility Risk ________________________________________________ 105
6.11 ______ Event Risk ___________________________________________________ 106
6.12 ______ Sovereign Risk _______________________________________________ 107
_________ Activity 6.4 ___________________________________________________ 107
6.13 ______ Summary ____________________________________________________ 108
_________ R ef erences __________________________________________________ 109
Unit Seven: Equity Markets
7.0 _______ Introduction _________________________________________________ 111
7.1 _______ Objectives ___________________________________________________ 112
7.2 _______ Private Equity ________________________________________________ 112
_________ 7.2.1 Motivations for private equity _____________________________ 112
_________ 7.2.2 Venture capital funds ____________________________________ 112
7.3 _______ Public Equity ________________________________________________ 113
7.4 _______ Equity Markets _______________________________________________ 113
7.5 _______ Participation in Stock Markets _________________________________ 114
_________ 7.5.1 How investor decision affect stock prices ___________________ 114
_________ 7.5.2 Investor reliance on information __________________________ 114
_________ Activity 7.1 ___________________________________________________ 114
7.6 _______ Initial Public Offerings (IPO) _________________________________ 115
_________ 7.6.1 Process of going public __________________________________ 115
_________ 7.6.2 Abuses in the IPO market ________________________________ 115
7.7 _______ Secondary Stock Offerings ____________________________________ 116
7.8 _______ Stock Repurchases ___________________________________________ 117
_________ Activity 7.2 ___________________________________________________ 117
7.9 _______ Stock Exchanges ______________________________________________ 118
_________ 7.9.1 Organised exchanges ____________________________________ 118
_________ 7.9.2 Over-the-counter market (OTC) ___________________________ 118
_________ 7.9.3 Organised versus over-the-counter trading _________________ 118
7.10 ______ Globalisation of Stock Markets ________________________________ 119
7.11 ______ Emerging Stock Markets _______________________________________ 119
_________ Activity 7.3 ___________________________________________________ 120
7.12 ______ Summary ____________________________________________________ 120
_________ R ef erences __________________________________________________ 121
Unit Eight: Stock Valuation and Risk
8.0 _______ Introduction _________________________________________________ 123
8.1 _______ Objectives ___________________________________________________ 124
8.2 _______ Stock Valuation Methods ______________________________________ 124
_________ 8.2.1 Price-earnings method ___________________________________ 124
_________ 8.2.2 Dividend Discount Method _______________________________ 125
_________ Activity 8.1 ___________________________________________________ 127
_________ 8.2.3 Adjusting the dividend discount method ____________________ 127
_________ 8.2.4 Free cash flow method ___________________________________ 129
8.3 _______ Required Rate of Return on Stocks _____________________________ 129
_________ 8.3.1 Capital Asset Pricing Model (CAPM) ______________________ 129
_________ 8.3.2 Arbitrage Pricing Theory (APT) ___________________________ 130
_________ Activity 8.2 ___________________________________________________ 131
8.4 _______ Factors that Affect Stock Prices ________________________________ 131
_________ 8.4.1 Economic factors ________________________________________ 131
_________ 8.4.2 Market-related factors ___________________________________ 132
_________ 8.4.3 Firm-specific factors _____________________________________ 132
_________ Activity 8.3 ___________________________________________________ 134
8.5 _______ Stock Market Efficiency _______________________________________ 134
_________ 8.5.1 Weak-form efficiency ____________________________________ 134
_________ 8.5.2 Semi-strong form efficiency _______________________________ 134
_________ 8.5.3 Strong-form efficiency ___________________________________ 135
_________ Activity 8.4 ___________________________________________________ 135
8.6 _______ Summary ____________________________________________________ 135
_________ R ef erences __________________________________________________ 136
Unit Nine: Mortgage Markets
9.0 _______ Introduction _________________________________________________ 137
9.1 _______ Objectives ___________________________________________________ 138
9.2 _______ Background on Mortgages _____________________________________ 138
9.3 _______ How Mortgage Markets Facilitate the Flow of Funds _____________ 138
_________ Activity 9.1 ___________________________________________________ 139
9.4 _______ Criteria used to Measure Creditworthiness ______________________ 139
_________ 9.4.1 Level of equity invested by the borrower ___________________ 139
_________ 9.4.2 Borrower’s income level _________________________________ 139
_________ 9.4.3 Borrower’s credit history _________________________________ 139
9.5 _______ Classifications of Mortgages __________________________________ 140
_________ 9.5.1 Prime versus subprime mortgages _________________________ 140
___________ 9.5.2 Insured versus conventional mortgages ___________________________ 1 4 0
___________ Activity 9.2 ________________________________________________________ 1 4 0
9.6 _______ Types of Residential Mortgage _________________________________ 140
_________ 9.6.1 Fixed-rate mortgages _____________________________________ 141
_________ 9.6.2 Adjustable-rate mortgages ________________________________ 141
_________ Activity 9.3 ___________________________________________________ 141
_________ 9.6.3 Graduated-payment mortgages ____________________________ 142
_________ 9.6.4 Growing-equity mortgages ________________________________ 142
_________ 9.6.5 Second mortgages _______________________________________ 142
_________ 9.6.6 Shared-appreciation mortgages ____________________________ 142
_________ 9.6.7 Equity participation mortgages ____________________________ 143
_________ 9.6.8 Reverse annuity mortgages (RAM) _________________________ 143
_________ 9.6.9 Balloon payment mortgages _______________________________ 143
_________ Activity 9.4 ___________________________________________________ 144
9.7 _______ Mortgage Loan Amortization __________________________________ 144
_________ Activity 9.5 ___________________________________________________ 147
9.8 _______ Valuation and Risk of Mortgages _______________________________ 147
9.9 _______ Risks from Investing in Mortgages ______________________________ 148
_________ 9.9.1 Credit risk ______________________________________________ 148
_________ 9.9.2 Interest rate risk ________________________________________ 148
_________ 9.9.3 Prepayment risk _________________________________________ 148
_________ Activity 9.6 ___________________________________________________ 149
9.10 ______ Mortgage-backed Securities ____________________________________ 149
9.11 ______ The Securitisation Process ____________________________________ 149
9.12 ______ Risk of Mortgage-backed Securities _____________________________ 150
_________ 9.12.1 Credit risk of MBS _____________________________________ 150
_________ 9.12.2 Interest rate risk of MBS ________________________________ 150
_________ 9.12.3 Prepayment risk of MBS ________________________________ 150
_________ Activity 9.7 ___________________________________________________ 151
9.13 ______ Summary ____________________________________________________ 151
_________ R ef erences __________________________________________________ 152
Unit Ten: Foreign Exchange Markets
10.0 ______ Introduction _________________________________________________ 153
10.1 ______ Objectives ___________________________________________________ 154
10.2 ______ Foreign Exchange Markets ____________________________________ 154
10.3 ______ Functions of Foreign Exchange Markets _________________________ 155
10.4 ______ Types of Foreign Exchange Market ____________________________ 155
_________ 10.4.1 The spot market ________________________________________ 155
_________ 10.4.2 The futures market _____________________________________ 155
10.5 ______ Foreign Exchange Market Participants __________________________ 155
_________ Activity 10.1 __________________________________________________ 157
10.6 ______ Foreign Exchange Rates _______________________________________ 157
_________ 10.6.1 Exchange rate quotations ________________________________ 157
_________ 10.6.2 Why are exchange rates important? ______________________ 158
_________ 10.6.3 How is foreign exchange traded? _________________________ 158
_________ Activity 10.2 __________________________________________________ 158
10.7 ______ Types of Exchange Rate Regimes _______________________________ 159
_________ 10.7.1 Fixed (pegged) exchange rate system ______________________ 159
_________ 10.7.2 Floating exchange rates _________________________________ 159
_________ Activity 10.3 __________________________________________________ 160
10.8 ______ Factors Affecting Exchange Rates _______________________________ 161
_________ 10.8.1 Relative price levels _____________________________________ 161
_________ 10.8.2 Tariffs and quotas ______________________________________ 161
_________ 10.8.3 Preferences for domestic versus foreign goods _____________ 161
_________ 10.8.4 Productivity ____________________________________________ 162
_________ 10.8.5 Differential inflation rates _______________________________ 162
_________ 10.8.6 Differential interest rates ________________________________ 162
_________ 10.8.7 Central bank intervention _______________________________ 162
_________ Activity 10.4 __________________________________________________ 163
10.9 ______ Forecasting Exchange Rates ___________________________________ 163
_________ 10.9.1 Technical forecasting ___________________________________ 163
_________ 10.9.2 Fundamental forecasting ________________________________ 163
_________ 10.9.3 Market-based forecasting ________________________________ 164
_________ 10.9.4 Mixed forecasting ______________________________________ 164
_________ Activity 10.5 __________________________________________________ 165
10.10 _____ Forms of Exposure to Exchange Rate Risk _______________________ 165
_________ 10.10.1 Transaction exposure __________________________________ 165
_________ 10.10.2 Translation exposure __________________________________ 165
_________ 10.10.3 Economic exposure ____________________________________ 166
10.11 _____ Exchange Rate Risk Management Techniques ____________________ 166
_________ 10.11.1 Forward contracts _____________________________________ 166
_________ 10.11.2 Currency futures contracts _____________________________ 167
_________ 10.11.3 Currency swaps _______________________________________ 167
_________ 10.11.4 Forward rate agreements _______________________________ 168
_________ 10.11.5 Currency options contract ______________________________ 168
_________ Activity 10.6 __________________________________________________ 169
10.12 _____ Summary ____________________________________________________ 169
_________ R ef erences __________________________________________________ 170
Unit Eleven: The International Financial System
11.0 ______ Introduction _________________________________________________ 171
11.1 ______ Objectives ___________________________________________________ 172
11.2 ______ Intervention in the Foreign Exchange Market ____________________ 172
_________ 11.2.1 Unsterilised intervention ________________________________ 172
_________ 11.2.2 Sterilised intervention __________________________________ 173
_________ 11.2.3 Depreciation of the domestic currency ____________________ 174
_________ 11.2.4 Appreciation of the domestic currency ____________________ 174
_________ Activity 11.1 __________________________________________________ 175
11.3 ______ Balance of Payments _________________________________________ 175
_________ 11.3.1 Current account ________________________________________ 175
_________ 11.3.2 Capital account _________________________________________ 175
11.4 ______ Exchange Rate Regimes in the International Financial System ______ 176
_________ 11.4.1 Intervention in the foreign exchange market under a __________
_________ fixed exchange rate regime ____________________________________ 176
_________ 11.4.2 Shortcomings of fixed exchange rate systems ______________ 179
_________ Activity 11.2 __________________________________________________ 179
11.5 ______ Currency Board System _______________________________________ 179
11.6 ______ Do llarisation ________________________________________________ 180
11.7 ______ Managed Floating Exchange Rates ______________________________ 180
11.8 ______ Capital Controls _____________________________________________ 181
_________ 11.8.1 Controls on capital outflows _____________________________ 181
_________ 11.8.2 Controls on capital inflows ______________________________ 181
_________ Activity 11.3 __________________________________________________ 182
11.9 ______ Summary ____________________________________________________ 183
_________ R ef erences __________________________________________________ 184
Overview
Module Overview
T
his module is written for investment managers and other corporate decision
makers who wish to sharpen their skills in undertaking financial decisions.
The module introduces you to the main functions of financial markets in an
economy. Financial markets have the basic function of facilitating the movement
of funds from those with surplus funds to those who are short of funds. Well
functioning financial markets are critical to economic prosperity of nations
while malfunctioning financial markets can contribute to misallocation of
resources, which ultimately stifle economic growth.
The synopsis of the broad areas covered by this course is given below:



Zimbabwe Open University
Unit One introduces you to the functions and roles of the financial
system and explains the importance of financial intermediation and
disintermediation within the global financial system.
In Unit Two we discuss the roles of financial markets and financial
institutions.
In Unit Three we describe the key features of money markets and
1
Money and Capital Markets








2
Module MBAZ510
demonstrate the valuation process of a variety of money market
securities.
Unit Four introduces you to bond markets and discusses the main
purpose of bond markets in an economy.
Unit Five delves into bond valuation and outlines the factors that affect
bond prices.
Unit Six covers the various risks investors face when investing in bonds.
In Unit Seven we discuss the importance of equity markets in an
economy and describe the globalisation of equity markets.
In Unit Eight we explain the various methods of valuing stocks and
outline the various factors that affect stock prices.
In Unit Nine we describe the functions of mortgage markets and analyses
the valuation and risk of mortgages.
In Unit Ten we look at the operations of foreign exchange markets and
discuss the various factors that affect exchange rates.
Unit Eleven is about the various interventionist measures taken by central
banks around the world for purpose of creating a stable international
financial system.
Zimbabwe Open University
Unit One
Functions and Roles of the
Financial System in the Global
Economy
1.0 Introduction
T
he success of any economy depends greatly on the smooth functioning
of the financial system. The financial system helps in the efficient allocation
of financial resources between surplus units and deficit units within the economy.
In this unit, we introduce you to the components, functions and nature of the
financial system. Further, we examine its linkage with the global economy.
Money and Capital Markets
Module MBAZ510
1.1 Objectives
By the end of this unit, you should be able to:








define what a financial system is
describe the functions of the financial systems in the global
economy
explain how the financial system assists in generating new
jobs, building our savings to meet tomorrow’s financial
needs and boosting the people’s standard of living
explain the channels through which funds flow between
lenders and borrowers within the global system
discuss the nature and characteristics of financial assets
explain how financial assets are created and destroyed
by decision-makers within the financial system
analyse the importance of financial intermediation and
disintermediation within the global economy
evaluate the factors tying together all financial markets
1.2 The Financial System
Madura, J. (2010) defines a financial system as a collection of financial
markets, institutions, laws, regulations, and techniques through which bonds,
stocks, and other securities are traded, interest rates are determined, and
financial services are produced and delivered around the world.
1.2.1 Functions of the financial system
The primary task of the financial system is to allocate scarce financial resources
from surplus units to deficit units. This in turn facilitates the exchange of goods
and services in any economy. Further, the financial system allows investors to
secure funds to purchase industrial machinery and equipment meant to boost
industrial production.
1.3 Flows within the Global Economic System
Rose and Marguis (2006) suggest that the basic function of the economic
system is to allocate scarce resources such as land, labour, management skill,
4
Zimbabwe Open University
Unit 1
Functions and Roles of the Financial System in the Global Economy
and capital, to produce the goods and services needed by society. The global
economy generates a flow of goods and services in return for a flow of
payments. Figure 1.1 below illustrates the circular flow of income, payments
and production in the global economic system.
Figure 1.1: Circular flow of Income, Payments, and Production in the
Global Economy
Source: Peter S .Rose and Milton H. Marguis (2006): Money and Capital
Markets
The flow of productive services from the consuming units is compensated
with a flow of income from the producing units. The consuming units in turn
use this income to purchase goods and services from the producing units and
payment of taxes to government. This circular flow of income, payments and
production is interdependent and never ending, and what drives the economic
system.
Activity 1.1
is your understanding of a financial system?
? 1.2. What
Explain the primary task of financial markets.
3.
Zimbabwe Open University
Discuss how the circular flow of income concept work in
real life?
5
Money and Capital Markets
Module MBAZ510
1.4 The Role of Markets in the Global Economic
System
Most economies around the world rely principally upon markets to carry out
the complex task of allocating scarce resources. The marketplace determines
what goods and services will be produced and in what quantities through the
price mechanism. Markets also distribute income by rewarding superior
producers with increased profits, higher wages, and other economic benefits.
1.5 Types of Market
There are essentially three types of market within the global economic system.
These are:



factor markets that allocate factors of production (land, labour,
entrepreneurship, and capital) and distribute income (wages, rent) to
the owners of productive resources
consuming units that use most of their income from factor markets to
purchase goods and services in the product markets
financial markets that channel savings to those individuals and institutions
needing more funds for spending than are provided by their current
incomes
Figure 1.2 below illustrates the interconnectedness of these broad types of
market within the global economic system
6
Zimbabwe Open University
Unit 1
Functions and Roles of the Financial System in the Global Economy
Figure 1.2 Types of Market: Source: Peter S .Rose and Milton H.
Marguis (2006) Money and Capital Markets
1.6 Financial Assets
Madura, J. (2010) defines financial assets as claims against the income or
wealth of a business firm, household, or unit of government, represented usually
by a certificate, receipt, computer record file, or other legal document, and
usually created by or related to the lending of money.
Financial assets are attractive financial instruments because these promise
future returns to their owners and serve as a store of value (purchasing power).
1.6.1 Characteristics of financial assets
The following are some of the characteristics of financial assets:


Zimbabwe Open University
financial assets do not depreciate like physical goods, and their physical
condition or form is usually not relevant in determining their market
value
these instruments have little or no value as a commodity and their cost
of transportation and storage is low
7
Money and Capital Markets
Module MBAZ510

financial assets are fungible, that is, they can easily be changed in form
and substituted for other assets
1.6.2 Different kinds of financial assets
The different kinds of financial assets include equities, debt securities and
derivatives.
Equities represent ownership shares in a business firm and are claims against
the firm’s profits and against proceeds from the sale of its assets. Common
stock and preferred stock are examples of equities.
Debt securities entitle their holders to a priority claim over the holders of
equities to the assets and income of an economic unit. They can be negotiable
or nonnegotiable. Examples include bonds, notes, accounts payable, and
savings deposits.
Derivatives are a form of financial instruments whose value is derived from
the price of the underlying asset. Examples include futures contracts, options,
and swaps.
1.6.3 How financial assets are created
Deficit units normally create financial assets by issuing financial liabilities (debt)
or stock (equities) to surplus units in order to finance their operations. This is
referred to as external financing as the financial resources are sourced from
outside the firm.
1.7 Financial Assets and the Financial System
The financial system provides the essential channel necessary for the creation
and exchange of financial assets between savers and borrowers so that real
assets can be acquired.
Rose and Marguis (2006) argue that the act of borrowing or of issuing new
stock simultaneously gives rise to the creation of an equal volume of financial
assets.
All financial assets are recorded as a liability or claim on some other economic
unit’s balance sheet. The equation is written as:
Volume of financial assets created for lenders = Volume of liabilities issued by
borrowers
8
Zimbabwe Open University
Unit 1
Functions and Roles of the Financial System in the Global Economy
For the balance sheet of any economic unit, the following holds:
Total assets = total liabilities + net worth
Total assets represent real and financial assets.
For the whole economy and financial system, the following equation holds:
Total financial assets = total liabilities
So, for the economy as a whole, the following holds:
Total real assets = total net worth
Given the above, society increases its wealth only by saving and increasing
the quantity of its real assets. These assets enable the economy to produce
more goods and services in the future.
Activity 1.2
types of market exist in the global economy?
? 1.2. What
Describe the characteristics of financial markets.
3.
4.
5.
Explain clearly the different kind of assets listed in section
1.6.2.
Describe how financial assets are created in the financial
system.
Discuss the relationship between financial assets and the
financial system.
1.8 The Evolution of Financial Transactions
Financial systems change constantly in response to shifting demands from the
public, the development of new technology, and changes in laws and
regulations.
The transfer of funds from savers to borrowers can be accomplished in at
least three different ways as shown in Figures 1.3, 1.4 and 1.5 below.
Zimbabwe Open University
9
Money and Capital Markets
Module MBAZ510
Figure 1.3: Direct finance
Source: Peter S .Rose and Milton H. Marguis (2006) Money and Capital
Markets
In direct financing, intermediaries are not involved in the transference of funds
from surplus business units (lenders) to deficit business units (borrowers).
The borrowers directly issue primary securities to lenders for cash. These
securities represent direct claims against borrowers.
Although this form of financing is simple, it is difficult to match lenders and
borrowers with complementary needs. In addition, lenders are faced with
default risk and may therefore demand high premium for their money thereby
making this type of financing relatively expensive.
10
Zimbabwe Open University
Unit 1
Functions and Roles of the Financial System in the Global Economy
Figure 1.4: Semi-direct finance
Source: Peter S .Rose and Milton H. Marguis (2006): Money and Capital
Markets
Semi-direct financing involves direct lending with the aid of market makers
who assist in the sale of direct claims against borrowers. These market makers
include security brokers, dealers and investment bankers. The involvement of
market makers reduces search and matching costs. However, this type of
financing is still risky and matching of borrowers and lenders is still required.
Zimbabwe Open University
11
Money and Capital Markets
Module MBAZ510
Figure 1.5: Indirect financing
Source: Peter S .Rose and Milton H. Marguis (2006: Money and Capital
Markets
In this type of financing, financial intermediaries such as banks, insurance
companies, credit unions, mutual funds, pension funds, finance companies
play a critical role of matching lenders and borrowers and transform the primary
securities into secondary securities. This financial intermediation of funds makes
this type of financing attractive to both lenders and borrowers as it is relatively
less risky and cheaper.
1.9 Disintermediation of Funds
Rose and Marguis (2006) define financial disintermediation as the withdrawal
of funds from a financial intermediary by the ultimate lenders (surplus business
units) and the lending of those funds directly to the ultimate borrowers (deficit
business units). It involves the shifting of funds from indirect finance to direct
and semi-direct finance. This is clearly illustrated in Figure 1.6 below:
12
Zimbabwe Open University
Unit 1
Functions and Roles of the Financial System in the Global Economy
Figure 1.6: Financial disintermediation
Source: Peter S .Rose and Milton H. Marguis (2006): Money and Capital
Markets
Listed below are some of the new forms of financial disintermediation which
have appeared in recent years:


Activity 1.3
Initiation by financial intermediaries: Some banks are selling off some
of their loans because of difficulties in raising capital.
Initiation by borrowing customers: Some borrowing customers learned
how to raise funds directly from the open market, taking advantage of
technological advancement.
financial intermediation and financial
? 1.2. Define
disintermediation.
The transfer of funds from savers to borrowers can be
3.
Zimbabwe Open University
accomplished in at least three different ways. Discuss
these three forms of financing.
Explain the motivations for financial intermediation. What
are theeconomic implications associated with this type
of financing?
13
Money and Capital Markets
Module MBAZ510
1.10Financial Markets and the Financial System
Financial markets and the financial system are critical channels for savings
and investment in any economy.
The three main forms of savings in any economy are represented by the
following:



Households’ current income less tax payments less consumption
expenditures
Businesses’ retained earnings
Governments’ current revenues less expenditures
The nature of investment in any economy takes any of the following:



Households purchasing of homes
Businesses’ expenditures on capital goods and inventories
Governments building/maintaining public facilities
The financial markets enable the exchange of current income for future income
and the transformation of savings into investment so that production,
employment, and income can grow, and living standards can improve.
The suppliers of funds to the financial system expect not only to recover their
original funds but also to earn additional income as a reward for waiting and
assuming risk.
Activity 1.4
between savings and investment. Explain how
? 1.2. Distinguish
the two are critical to economic growth.
Describe how savings and investment are created in any
3.
economy.
Discuss how financial markets facilitate savings and
investment in any economy.
1.11 The Global Financial System
Marc Levinson (2006) describes the global financial system as the financial
system consisting of institutions and regulators that act on the international
level as opposed to those that act on a national or regional level. The main
players are the global institutions such as the International Monetary Fund,
Bank for International Settlements, central banks and other private institutions.
14
Zimbabwe Open University
Unit 1
Functions and Roles of the Financial System in the Global Economy
1.12 Functions of the Global Financial System
The following are some of the functions performed by the global financial
system:
Savings function: The global system of financial markets and institutions
provides a conduit for the public’s savings.
Wealth function: The financial instruments sold in the money and capital
markets provide an excellent way to store wealth.
Liquidity function: Financial markets provide liquidity for savers who hold
financial instruments but are in need of money.
Credit function: Global financial markets furnish credit to finance consumption
and investment spending.
Payments function: The global financial system provides a mechanism for
making payments for goods and services, in the form of currency, checking
accounts, debit cards, credit cards, digital cash, etc.
Risk protection function: The financial markets offer protection against
life, health, property, and income risks, by permitting individuals and institutions
to engage in both risk-sharing and risk reduction.
Policy function: The financial markets are a channel through which
governments may attempt to stabilise the economy and avoid inflation.
The financial services that are most widely sought by the public include:






Activity 1.5
Payments services
Advisory services
Insurance services
Credit services
Hedging services
Agency services
the global financial system.
? 1.2.3. Define
List the key players in the global financial system.
Discuss the functions performed by the global financial
4.
Zimbabwe Open University
markets.
Outline the key financial services widely sought by the
public.
15
Money and Capital Markets
Module MBAZ510
1.13Factors Tying all Financial Markets Together
Rose and Marguis (2006) observed that the following are some of the factors
that help to weld financial markets together:
Credit, the common commodity: The shifting of borrowers among markets
helps to weld the financial system together and to balance the costs of credit
in the different markets.
Speculation and arbitrage: Speculators who gamble on their market
forecasts and arbitrageurs who watch for profitable arbitrage opportunities
help to level out prices and maintain price consistency among the markets.
Perfect and efficient markets: Financial markets are closely tied to one
another due to their near perfection and efficiency.
Financial markets in the real world: In the real world however, market
imperfection and information asymmetry exist.
1.14The Dynamic Financial System
The global financial system is rapidly changing. In particular, the trend towards
the global integration of financial systems has been aided by the gradual
deregulation of financial institutions and services as well as the increasing
harmonisation of their regulations together with rapid technological
advancement.
The results have been increasingly intense competition, many new financial
services, increased risk, and a wave of mergers among financial institutions.
1.15 Bank-dominated versus Security-dominated
Financial Systems
Less-developed financial systems are often bank-dominated financial systems,
in which banks and other similar institutions dominate in supplying credit and
attracting savings.
The more mature systems today are becoming security-dominated financial
systems, in which traditional intermediaries play lesser roles and growing
numbers of borrowers sell securities to the public to raise the funds they need.
16
Zimbabwe Open University
Unit 1
Functions and Roles of the Financial System in the Global Economy
Activity 1.6
in detail the main factors that tie all financial
? 1. Describe
markets together.
2.
3.
Discuss the factors that have led to the globalization of
financial markets, and the consequences thereof.
Distinguish between bank-dominated and securitydominated financial systems. Which one is more
preferable to the other?
Explain your answer.
1.16Summary
A financial system is a collection of financial markets, institutions, laws,
regulations and techniques through which securities are traded. The primary
task of the financial system is to allocate scarce financial resources from surplus
units to deficit units. It facilitates the circular flow of income, payments and
production of goods and services in any economy. All economies around the
world rely on financial markets to carry out the complex task of allocating
scarce financial resources. Ultimately, financial markets provide the essential
channel for the creation and exchange of financial assets between savers and
borrowers. Through financial intermediation, financial markets are critical
channels for savings and investment in any economy. The interconnectedness
of financial markets has led to the emergence of the global financial system,
which consists of institutions and regulators that act on an international level.
The dynamism of the financial system continues to be caused by rapid
technological advancement, changing consumer tastes, stiff competition among
other factors.
Zimbabwe Open University
17
Money and Capital Markets
Module MBAZ510
References
Levinson, M. (2006). Guide to Financial Markets. 4th Edition. London:
Profile Books Limited.
Madura, J. (2010). Financial Markets and Institutions. 9th Edition. Florida:
South- Western College.
Mishkin, F.S. & Eakins, S.G. (2006). Financial Markets and Institutions.
5th Edition. New York: Pearson Addison Wesley.
Rose, P.S. and Marguis, M.H. (2006). Money and Capital Markets. New
York: McGraw-Hill Professional.
18
Zimbabwe Open University
Unit Two
The Roles of Financial Markets
and Financial Institutions
2.0 Introduction
I
n this unit, we are going to look at the different types of financial market,
type of securities traded within financial markets and the different players
within the financial markets.
Money and Capital Markets
Module MBAZ510
2.1 Objectives
By the end of this unit, you should be able to:




describe the types of financial market that facilitate the flow
of funds
explain the type of securities traded within financial markets
discuss the role of financial institutions within financial
markets
identify the type of financial institutions that facilitate
transactions in financial markets
2.2 What is a Financial Market?
Madura, J. (2010) defines a financial market as a market in which financial
assets such as stocks and bonds can be purchased or sold. Funds are
transferred in financial markets when one party purchases financial assets
previously held by another party. Financial markets facilitate the flow of funds
and thereby allow financing and investing by households, firms and government
agencies.
2.3 The Role of Financial Markets and Institutions
Frank J. Fabozzi (2008) asserts that financial markets transfer funds from
those who have excess funds to those who need funds. Households and
businesses that supply funds to financial markets earn a return on their
investment, which return is necessary to ensure that funds are supplied to the
financial markets. If funds are not supplied, the financial markets would not
be able to play their intermediation role.
Those participants who receive more money than they spend are referred to
as surplus units (investors). They provide their net savings to the financial
markets. Those participants who spend more money than they receive are
referred to as deficit units (or borrowers). They access funds from financial
markets so that they can spend more money than they receive.
Many deficit units such as firms and government agencies access funds from
financial markets through issuing securities. Securities represent a claim on
20
Zimbabwe Open University
Unit 2
The Roles of Financial Markets and Financial Institutions
the issuer. Debt securities represent debt (also called credit, or borrowed
funds) incurred by the issuer. Deficit units issue the securities to surplus units
and pay interest to the surplus units on a periodic basis. Debt securities have
a maturity date, when the surplus units can redeem them, receiving the principal
from the issuer. Equity securities (also called stocks) represent equity or
ownership in the issuer. Some businesses issue equity securities as an alternative
way of raising funds.
Issuing securities enables corporations and government agencies to obtain
money from surplus units and thus to spend more money than they receive
from normal operations.
2.4 Types of Financial Markets
There are many different types of financial markets, and each market can be
distinguished by the maturity structure and trading structure of its securities.
Each financial market is created to satisfy particular preferences of market
participants. For example, some participants may want to invest funds for a
short-term period, whereas others want to invest for a long-term period. Some
participants are willing to tolerate a high level of risk when investing, whereas
others need to avoid risk. Some participants that need funds prefer to borrow,
whereas others prefer to issue stock.
2.4.1 Money versus capital markets
The financial markets that facilitate the transfer of debt securities are commonly
classified by the maturity of the securities. Those financial markets that facilitate
the flow of short-term funds (with maturities of one year or less) are known as
money markets, while those that facilitate the flow of long-term funds are
known as capital markets.
2.4.2 Primary versus secondary markets
Money market securities are debt securities that have a maturity of one year
or less. They have a relatively high degree of liquidity, due to their short-term
maturities, and because they typically have an active secondary market. Whether
referring to money market securities or capital market securities, it is necessary
to distinguish between transactions in the primary market and transactions in
the secondary market. Primary markets facilitate the issuance of new securities.
Secondary markets facilitate the trading of existing securities, which allows
for a change in the ownership of the securities. Primary market transactions
Zimbabwe Open University
21
Money and Capital Markets
Module MBAZ510
provide funds to the initial issuer of securities while secondary market
transactions do not. The issuance of new corporate stock is a primary market
transaction, while the sale of existing corporate stock holdings by one investor
to another is a secondary market transaction.
An important characteristic of securities that are traded in secondary markets
is liquidity, which is the degree to which securities can easily be liquidated
(sold) without a loss of value. Some securities have an active secondary
market, meaning that there are many willing buyers and sellers of the security
at a given point in time. Investors prefer liquid securities so that they can easily
sell the securities whenever they want (without a loss in value). If a security is
illiquid, investors may not be able to find a willing buyer for it in the secondary
market and may have to sell the security at a large discount just to attract a
buyer.
Activity 2.1
types of financial market are in existence around the
? 1. What
globe?
2.
3.
4.
5.
6.
Discuss possible ways firms and governments raise funds
to finance their operations.
What is the importance of financial markets in any
economy?
Distinguish between money markets and capital markets.
Distinguish between primary and secondary markets.
Describe the activities that take place in each type of
market.
Describe the characteristics of a security that makes it
attractive to investors.
2.5 How Financial Markets Facilitate Corporate
Finance
The financial markets attract funds from investors and channel them to
corporations. They serve as the means by which corporations finance their
existing operations and their growth. The money markets enable corporations
to borrow funds on a short-term basis so that they can support their working
22
Zimbabwe Open University
Unit 2
The Roles of Financial Markets and Financial Institutions
capital requirements. The capital markets enable corporations to obtain longterm funds to support corporate expansions. Figure 2.1 illustrates this process.
Investors
(Including
financial
institutions)
$ Invested
Securities
Financial
markets and
institutions
$ Invested
Securities
Corporations
$ Invested
Corporate
financing of
existing
operations and
expansions
Figure 2.1: How financial markets facilitate corporate finance and
investment management
Madura Jeff (2010): Financial Markets and Institutions, 9th Edition
2.6 How Financial Markets Facilitate Investment
Figure 2.1 above further illustrates how financial markets facilitate investment
activities in any economy. Investment management involves decisions by
investors regarding how to invest their funds. The financial markets offer
investors a wide variety of investment opportunities. A major part of investment
management is deciding which securities to purchase. When investing in stock,
investors assess the financial management of various firms. They look for
firms that are currently undervalued and have the potential to improve. The
market price of the stock serves as a measure of how well each publicly
traded firm is being managed by its managers.
Activity 2.2
how financial markets channel funds to
? 1. Explain
corporations.
2.
3.
Describe how financial markets provide funds to investors.
How do dealers on the market judge the health of a firm?
2.7 Securities Traded in Financial Markets
Madura, J. (2010) and Fabozzi, F. J. (2008) postulate that each type of
security tends to have specific return and risk characteristics. The term risk is
Zimbabwe Open University
23
Money and Capital Markets
Module MBAZ510
used here to represent the uncertainty surrounding the expected return. The
more uncertain the expected return, the greater the risk is.
Investors differ with respect to the risk they are willing to incur, the amount of
liquidity they desire, and their tax status, making some types of securities
more desirable to some investors than to others. Normally, investors attempt
to balance the objective of high return with their particular preference for low
risk and adequate liquidity. Some investors are much more willing than others
to invest in risky securities, as long as the potential return is sufficiently high.
Securities can be classified as money market securities, capital market securities
and derivative securities.
2.7.1 Money market securities
Money market securities are debt securities that have a maturity of one year
or less. They generally have a relatively high degree of liquidity. They tend to
have a low expected return but also a low degree of risk. Common types of
money market securities include Treasury Bills, Commercial Paper, Negotiable
Certificates of Deposit and Banker’s Acceptances.
2.7.2 Capital market securities
Securities with a maturity of more than one year are called capital market
securities. These are commonly issued to finance the purchase of capital assets,
such as buildings, equipment or machinery. Three common types of capital
market securities are bonds, mortgages, and stocks.
2.7.3 Derivative securities
These are a certain type of financial instruments whose value is derived from
the market value of the underlying assets. Examples include options, swaps,
forward contracts and futures contracts.
2.8 Valuation of Securities in Financial Markets
Each type of security generates a unique stream of expected cash flows to
investors. Further, each security has a unique level of uncertainty surrounding
the expected cash flows that it will provide to investors and therefore
surrounding its return. The valuation of a security is measured as the present
value of its expected cash flows, discounted at a rate that reflects the uncertainty.
24
Zimbabwe Open University
Unit 2
The Roles of Financial Markets and Financial Institutions
Since the cash flows and the uncertainty surrounding the cash flows for each
security are unique, the value of each security is unique.
2.9 Market Efficiency
Because securities have market-determined prices, their favourable or
unfavourable characteristics as perceived by the market are reflected in their
prices. When security prices fully reflect all available information, the markets
for these securities are referred to as efficient.
In an efficient market, securities are rationally priced. If a security is clearly
undervalued based on public information, some investors will capitalise on
the discrepancy by purchasing the security. This strong demand for the security
will push the security’s price higher until the discrepancy no longer exists. The
investors’ actions to capitalise on discrepancies typically ensure that securities
are properly priced, based on the information that is available.
Activity 2.3
does the term “risk” mean with reference to financial
? 1. What
securities?
2.
3.
4.
5.
What differentiate investors with respect to risk?
Distinguish between the three common types of securities.
How are securities valued?
What distinguish efficient markets?
2.10Global Financial Markets
Financial markets are continuously evolving throughout the world to improve
the transfer of funds from surplus units to deficit units. The financial markets
are much more developed in some countries than in others. Further, they also
vary in terms of the volumes of funds that are transferred from surplus units to
deficit units and the types of funding that are available. Some countries have
had financial markets for a long time, but other countries have converted to
market-oriented economies and established financial markets relatively recently.
Capital flows are often restricted through lack of depth and vibrancy in the
less developed capital markets.
Zimbabwe Open University
25
Money and Capital Markets
Module MBAZ510
2.11 International Corporate Governance Relating to
Financial Markets
Since financial markets channel funds from surplus units to deficit units, they
can function only if surplus units are willing to provide funds to the markets. If
there is a lack of information about the securities traded in the market, or a
lack of safeguards to ensure that investors are treated fairly, surplus units will
not participate. Consequently, the financial markets will not be liquid.
Financial markets have evolved slowly in some developing countries for several
reasons. First, the issuers of debt securities do not provide much financial
information to indicate how they intend to repay the investors who would buy
the securities. Second, regulatory agencies provide very little enforcement to
ensure that the financial information provided by the issuers is correct. Third,
businesses that do not repay the investors are rarely prosecuted. Fourth, courts
in these countries do not provide an efficient system of recourse that investors
can rely upon in litigation cases to recover owed funds.
2.12Global Integration
Many financial markets are globally integrated, allowing participants to move
funds out of one country’s markets and into another’s. Foreign investors serve
as key surplus units in our domestic economy by purchasing money and capital
market securities issued in our financial markets. With these more integrated
financial markets, the performance of our local financial markets are greatly
affected by movements in other financial markets and by any macroeconomic
development in foreign countries.
2.13Role of the Foreign Exchange Market
International financial transactions normally require the exchange of currencies.
The foreign exchange market facilitates the exchange of currencies. Many
commercial banks and other financial institutions serve as intermediaries in
the foreign exchange market by matching up participants who want to exchange
one currency for another. Some of these financial institutions also serve as
dealers by taking positions in currencies to accommodate foreign exchange
requests (Mishkin, F.S. & Eakins, S.G. (2006).
Like securities, most currencies have a market-determined price (exchange
26
Zimbabwe Open University
Unit 2
The Roles of Financial Markets and Financial Institutions
rate) that changes in response to supply and demand conditions. If there is a
sudden shift in the aggregate demand for a given currency by corporations,
government agencies and individuals, or a shift in the aggregate supply of that
currency for sale, the price will change. Currency appreciation and currency
depreciation affect the performance of financial markets.
Activity 2.4
how corporate governance issues affect the
? 1. Discuss
development of financial markets.
2.
Explain how the performance of local financial markets
can be positively or negatively affected by external factors.
2.14Role of Financial Institutions
Frank J. Fabozzi (2008) argues that if financial markets were perfect, all
information about any security for sale in primary markets including the
creditworthiness of the security issuer would be continuously and freely
available to investors. In addition, all information identifying investors interested
in purchasing securities as well as investors planning to sell securities would
be freely available. Further, all securities for sale could be broken down or
unbundled into any size desired by investors, and security transaction costs
would not be necessary.
In practice, financial markets are imperfect to the extent that security buyers
and sellers do not have full access to relevant information. Individuals who
have funds available normally do not have a means of identifying creditworthy
borrowers to whom they could lend their funds. In addition, they do not have
the expertise to assess the creditworthiness of potential borrowers. Financial
institutions are needed to resolve the problems caused by market imperfections.
They accept funds from surplus units and channel the funds to deficit units.
Without financial institutions, the information and costs of financial market
transactions would be excessive. Financial institutions can be classified as
depository and non-depository institutions.
Zimbabwe Open University
27
Money and Capital Markets
Module MBAZ510
2.15Role of Depository Institutions
Depository institutions accept deposits from surplus units and provide credit
to deficit units through loans and purchases of securities. They are popular
financial institutions for the following reasons:





they offer deposit accounts that can accommodate the amount and
liquidity characteristics desired by most surplus units;
they repackage funds received from deposits to provide loans of
the size and maturity desired by deficit units;
they accept the risk on loans provided;
they have more expertise than individual surplus units in evaluating
the creditworthiness of deficit units; and
they diversify their loans among numerous deficit units and therefore
can absorb defaulted loans better individual than surplus units could.
2.16 Role of Non-depository Financial Institutions
Non-depository institutions generate funds from sources other than deposits
but also play a major role in financial intermediation. These institutions are
briefly described below:
2.16.1 Finance companies
Most finance companies obtain funds by issuing securities, then lend the funds
to individuals and small businesses. The functions of finance companies and
depository institutions overlap.
2.16.2 Mutual funds
These sell shares to surplus units and use the funds received to purchase a
portfolio of securities. They are the dominant non-depository financial
institutions when measured in total assets. Some mutual funds concentrate
their investment in capital market securities, such as stocks or bonds. Others,
known as money market mutual funds, concentrate in money market securities.
Typically, mutual funds purchase securities in minimum denominations that are
larger than the savings of an individual surplus unit. By purchasing shares of
mutual funds and money market mutual funds, small savers are able to invest
in diversified portfolio of securities with a relatively small amount of funds.
28
Zimbabwe Open University
Unit 2
The Roles of Financial Markets and Financial Institutions
2.16.3 Securities firms
These provide a variety of functions in financial markets. Some securities use
their information resources to act as brokers, executing securities transactions
between two parties.
In addition to brokerage services, securities firms also provide investment
banking services. Some securities firms place newly issued securities for
corporations and government agencies. This task differs from traditional
brokerage activities because it involves the primary market. When securities
firms underwrite newly issued securities, they may sell the securities for a
client at a guaranteed price, or they may simply sell the securities at the best
price they can get for their client.
Furthermore, securities firms often act as dealers, making a market in specific
securities by adjusting their inventory of securities.
They also offer advisory services on mergers and other forms of corporate
restructuring.
2.16.4 Insurance companies
These provide individuals and firms with insurance policies that reduce the
financial burden associated with death, illness, and damage to property. They
charge premiums in exchange for the insurance that they provide. They invest
the funds that they receive in the form of premiums until the funds are needed
to cover insurance claims. They commonly invest the funds in stocks or bonds
issued by government. In this way, they finance the needs of deficit units and
thus serve as important financial intermediaries.
2.16.5 Pension funds
Many corporations and government agencies offer pension plans to their
employees. The employees, their employers, or both periodically contribute
funds to the plan. Pension funds provide an efficient way for individuals to
save for their retirement. The pension funds manage the money until the
individual withdraw the funds from their retirement accounts. The money that
is contributed to individual retirement accounts is commonly invested by the
pension funds in stocks or bonds issued by corporations or bonds issued by
government agencies. In this way, pension funds finance the needs of deficit
units and thus serve as important financial intermediaries.
Zimbabwe Open University
29
Money and Capital Markets
Module MBAZ510
2.17Comparison of Roles among Financial Institutions
The role of financial institutions in facilitating the flow of funds from individual
surplus units (investors) to deficit units is illustrated in Figure 2.1. Surplus units
are shown on the left side while deficit units are shown on the right side.
Three different flows of funds from surplus units to deficit units are in the
diagram. One set of flows represents deposits from surplus units that are
transformed by depository institutions into loans for deficit units. A second set
of flows represents purchases of securities (commercial papers) issued by
finance companies that are transformed into finance company loans for deficit
units. A third set of flows reflects the purchases of shares issued by mutual
funds, which are used by the mutual funds to purchase debt and equity securities
of deficit units.
The deficit units also receive funding from insurance companies and pension
funds as shown in the diagram.
30
Zimbabwe Open University
Unit 2
The Roles of Financial Markets and Financial Institutions
Deposits
Surplus
Units
Purchase
Depository
Institutions
Finance
Companies
Securities
Purchase
Shares
Policy
Holders
Employers
and
Employees
Mutual
Funds
Premiums
Insurance
Companies
Employee
Pension
Funds
Deficit Units
(Firms, Government
Agencies,
Individuals)
Contributions
Figure 2.2 Comparison of roles among financial institutions
Source: Jeff Madura (2010) Financial Markets and Institutions, 9th
Edition
Zimbabwe Open University
31
Money and Capital Markets
Module MBAZ510
Activity 2.5
between perfect and imperfect markets. Explain
? 1. Distinguish
why the existence of imperfect markets creates a need for
2.
3.
4.
financial intermediaries.
Compare the main sources and uses of funds for finance
companies, insurance companies and pension funds.
Explain the general difference between depository and nondepository institution sources of funds.
Explain how financial intermediation contributes to the
smooth operations of financial markets.
2.18 Summary
Financial markets facilitate the transfer of funds from surplus units to deficit
units. Because funding needs vary among deficit units, various financial markets
have been established. The primary market allows for the issuance of new
securities, while the secondary market allows for the sale of existing securities.
Money markets have developed in response to market players who need
short-term funds, stable returns and low risky investments. Capital markets
carter for those savers and investors who prefer long-term funds, high returns
in return for high risk involved. The theory of efficient and perfect market
does not hold, therefore, financial institutions play a critical role of solving the
problem of imperfect financial markets. These institutions are ordinarily grouped
into depository and non-depository institutions and these facilitate the financing
of deficit units.
32
Zimbabwe Open University
Unit 2
The Roles of Financial Markets and Financial Institutions
References
Chisholm, A. M. (2009). Introduction to International Capital Markets.
2nd Edition. London: John Wiley & Sons.
Choudhry, M. (2001). The Bond and Money Markets. London: ButterHeinemann.
Choudhry, M. et al. (2010). Capital Market Instruments: Analysis and
Valuation. 3rd Edition. London: Palgrave Macmillan.
Fabozzi, F. J. (2008). Handbook of Finance, Volume 1. New York: John
Wiley & Sons.
Howells, P and Bain, K. (2007): Financial Markets and Institutions.
5th Edition. London: Prentice Hall.
Levinson, M. (2006): Guide to Financial Market: 4th Edition. London: Profile
Books
Limited.
Madura, J. (2010): Financial Markets and Institutions. 9th Edition. Florida:
SouthWestern College.
Mishkin, F.S. & Eakins, S.G. (2006): Financial Markets and Institutions.
5th Edition. New-York: Pearson Addison Wesley.
Zimbabwe Open University
33
Blank page
Unit Three
Money Markets
3.0 Introduction
M
oney market securities are short-term instruments with an original
maturity of less than one year. These securities trade in the money
markets. They include treasury bills, commercial paper, repurchase agreements,
bankers’ acceptances and negotiable certificates of deposits. Many participants
in the money markets both buy and sell money market securities. In this unit,
we are going to look at the functions of money markets and the various
instruments traded in the money markets.
Money and Capital Markets
Module MBAZ510
3.1 Objectives
By the end of this unit, you should be able to:



describe the features of the most popular money market
securities
explain how money markets are used by institutional
investors
explain the valuation of money market securities
3.2 Money Markets
Mishkin & Eakins (2006) argue that the term “money market” is actually a
misnomer because money (currency) is not traded in the markets. However,
the securities that are traded on the money market are short-term and highly
liquid and close to being money, hence the term, “money market”.
3.2.1 Why do we need money markets?
Mishkin & Eakins (2006) argue that, in theory, money markets are not
necessary because the banking industry exists primarily to provide short-term
loans to borrowers and to accept short-term deposits from savers. Banks
have therefore an efficiency advantage in gathering information, an advantage
that should eliminate the need for the money markets. Thanks to continuing
relationships with customers, banks should be able to offer loans more cheaply
than diversified markets, which must evaluate each borrower every time a
new security is offered. Furthermore, short-term securities offered for sale in
the money markets are neither as liquid nor as safe as deposits placed in
banks.
This line of argument further states that banking industry exists primarily to
mediate the asymmetric information problem between saver-lenders and
borrower-spenders, and banks can earn profit by capturing economies of
scale while providing this service. However, the banking industry is subject to
more regulations and governmental costs than are the money markets. In
situations where the asymmetric information problem is not severe, the money
markets have a distinct cost advantage over banks in providing short-term
funds.
36
Zimbabwe Open University
Unit 3
Money Markets
Activity 3.1
?
Critically analyse the proposition that money markets are
not necessary in cases where an efficient banking industry
exists.
3.2.2 Functions of money markets
A well developed secondary market for money market instruments makes
the money market an ideal place for firms or financial institutions to warehouse
surplus funds until the time they are needed.
Money markets are used to facilitate the transfer of short-term funds from
individuals, corporations, or governments with excess funds to those with
deficit funds. Even investors who focus on long-term securities tend to hold
some money market securities. Money markets enable financial participants
to maintain liquidity.
Market issuers include sovereign governments, which issue treasury bills,
corporations issuing commercial paper, and banks issuing bills of exchange
and certificates of deposit. Investors are attracted to the market because the
instruments are highly liquid and carry relatively low credit risk. Investors in
the money market include banks, local authorities, corporations, money market
investment funds and individuals. However, the money market is essentially a
wholesale market and the denominations of individual instruments are relatively
large.
The means by which money markets facilitate the flow of funds are illustrated
in Figure 3.1 below. Governments issue treasury bills and use the proceeds to
finance their budget deficits. Corporations issue money market securities and
use the proceeds to support their existing operations or to expand their
operations. Financial institutions issue money market securities and bundle
the proceeds to make loans to households and corporations. Thus the funds
are channeled to support household purchases, such as cars and homes, and
to support corporate investments in buildings and machinery. Governments
and some corporations commonly pay off their debts from maturing money
market securities with the proceeds from issuing new money market securities.
In this way, they are able to finance expenditures for long periods of time even
though money market securities have short-term maturities. Overall, money
markets allow households, governments and corporations to increase their
expenditures, thus the markets finance economic growth.
Zimbabwe Open University
37
Money and Capital Markets
Module MBAZ510
Government
Agencies
Spending on
Government
Programs
Corporations
Spending to
support Existing
Business
Operations or
Expansions
Buy T-Bills
$
Households,
Corporations, and
Government
Agencies That Have
Short-term Funds
Available
Buy money market
securities
Loans
Financial
Intermediaries
$
Buy money
market securities
Households
Spending on cars
homes, credit
cards etc.
Figure 3.1 How Money Markets Facilitate the Flow of Funds
Source: Madura, J. (2010): Financial Markets and Institutions, 9th Edition
3.3 Money Market Securities
Money market securities have at least five basic characteristics in common,
and these are listed below:





they are usually sold in large denominations
they have low default risk
they mature in one year or less from their original issue date
they are relatively liquid
their market values are relatively stable
Money market transactions do not take place in any one particular location
or building. Instead, traders usually arrange purchases and sales between
participants over the phone and complete them electronically.
38
Zimbabwe Open University
Money Markets
Unit 3
Because of this characteristic, money market securities usually have an active
secondary market. This means that after the security has been sold initially, it
is relatively easy to find buyers who will purchase it in the future. An active
secondary market makes money market securities very flexible instruments
to use to fill short term financial needs.
The cash instruments traded in the money market include the following:






Treasury bills
Time Deposit
Certificate of Deposit
Commercial Paper
Bankers’Acceptance
Negotiable Certificates of Deposits
The instruments above fall into one of two main classes of money market
securities: those quoted on a yield basis and those quoted on a discount basis.
These two terms are discussed in section 3.4 below.
Activity 3.2
how governments and firms use money markets
? 1. Explain
to finance capital projects of a long-term nature.
2.
“The success of money markets depends on how strong
and active the secondary market is”. Discuss.
3.4 Securities Quoted on a Yield Basis
The following are some of the securities which are quoted on a yield-basis:
3.4.1 Money market deposits
These are fixed-interest term deposits of up to one year with banks and
securities houses. They are also known as time deposits or clean deposits.
They are not negotiable so cannot be liquidated before maturity. The interest
rate on the deposit is fixed for the term and related to the inter-bank rate of
the same term. Interest and capital are paid on maturity. The effective rate on
a money market deposit is the annual equivalent interest rate for an instrument
with a maturity of less than one year.
Zimbabwe Open University
39
Money and Capital Markets
Module MBAZ510
3.4.2 Certificates of deposit
Certificates of Deposits (CDs) are receipts from banks for deposits that have
been placed with them. The deposits themselves carry a fixed rate of interest
related to the inter-bank rate and have a fixed term to maturity, so cannot be
withdrawn before maturity. However, the certificates themselves can be traded
in a secondary market, that is, they are negotiable. CDs are therefore very
similar to negotiable money market deposits, although their yields are below
the equivalent deposit rates because of the added benefit of liquidity.
Banks, merchant banks and building societies issue CDs to raise funds to
finance their business activities. On issue a CD is sold for face value, so the
settlement proceeds of a CD on issue always equal its nominal value. The
interest is paid, together with the face amount, on maturity. The interest rate is
sometimes called the coupon, but unless the CD is held to maturity this will
not equal the yield, which is of course the current rate available in the market
and varies over time.
3.5 Securities Quoted on a Discount Basis
The remaining money market instruments are all quoted on a discount basis,
and so are known as ‘discount’ instruments. This means that they are issued
on a discount to face value, and are redeemed on maturity at face value.
Treasury bills, bills of exchange, bankers’ acceptances and commercial paper
are examples of money market securities that are quoted on this basis: that is,
they are sold on the basis of a discount to par. The difference between the
price paid at the time of purchase and the redemption value (par) is the interest
earned by the holder of the paper. Explicit interest is not paid on discount
instruments. Rather, interest is reflected implicitly in the difference between
the discounted issue price and the par value received at maturity.
Activity 3.3
?
40
Explain the differences between securities quoted on a yield
basis and those quoted on a discount basis.
Zimbabwe Open University
Unit 3
Money Markets
3.5.1 Treasury bills (T-bills)
These are short-term debt securities issued by governments through their central
banks to borrow money from the money market to finance government
operations. Treasury bills have 91-day, 182-day, 270-day or 360-day
maturities.
Treasury bills are attractive to investors because they are backed by the
government and therefore are virtually free of credit (default) risk. Another
attractive feature of T-bills is their liquidity, which is due to their short maturity
and strong secondary market. Depository institutions commonly invest in Tbills so that they can retain a portion of their funds in assets that can easily be
liquidated if they suddenly need to accommodate deposit withdrawals. Other
financial institutions also invest in T-bills in the event that they need cash because
cash outflows exceed cash inflows.
Pricing Treasury bills
T-bills do not pay interest but are priced at a discount from their par value.
The price that an investor will pay for a T-bill with a particular maturity is
dependent on the investor’s required rate of return on that T-bill. That price is
determined as the present value of the future cash flows to be received. Since
the T-bill does not generate interest payments, the value of a T-bill is the
present value of the par value. Thus, investors are willing to pay a price for a
one year T-bill that ensures that the amount they receive a year later will
generate their desired return.
Example 3.1
A T-bill with $10 million face value issued for 91 days will be redeemed on
maturity at $10 million. If the three-month yield at the time of issue is 5.25%,
the price of the bill at issue is:
10m
P = 1 + 0.0525 × 91 
365 

= $9,870,800.69
Interest rate on discount instruments is quoted as a discount rate rather than a
yield. This is the amount of discount expressed as an annualized percentage
of the face value, and not as a percentage of the original amount paid. By
definition, the discount rate is always lower than the corresponding yield. If
the discount rate on a bill is d, then the amount of discount is given by:
Zimbabwe Open University
41
Money and Capital Markets
Module MBAZ510
d value = M × d ×
n
B
Where M = face value
d = discount rate
n = maturity period
B = base year
Example 3.2
A T-bill with $10 million face value is issued for 91 days at a discount rate of
30%. Calculate the discount value.
Solution
d value = M × d ×
n
B
d value = 10,000,000 × 30% ×
91
365
= $747,945.21
The price P paid for the bill is the face value minus the discount amount, given
by:

 N sm  
 d  365  

P = 100 × 1 − 
100 





If we know the yield on the bill then we can calculate its price at issue by using
the simple present value formula, as shown in:
42
Zimbabwe Open University
Unit 3
Money Markets
P=
M

 N sm 
1 + r  365 



Example 3.4
A 91-day $100 Treasury bill is issued with a yield of 4.75%. What is its issue
price?
Solution
P=
100

 91 
1 + 0.0475 365 



= $98.83
The discount rate d for T-bills is calculated using the following formula:
d = (1 − P ) ×
B
n
The relationship between discount rate and true yield is given by:
d=
r=
Zimbabwe Open University
r
n

1 + r × B 
d
n

1 − d × B 
43
Money and Capital Markets
Module MBAZ510
Example 3.5
A T-bill with a remaining maturity of 39 days is quoted at a discount of 4.95%.
What is the equivalent yield?
Solution
r=
=
d
n

1 − d × B 
0.0495
39 

1 − 0.0495 × 365 
= 4.976%
Estimating the yield
As explained earlier, T-bills do not offer coupon payments but are sold at a
discount from par value. Their yield is influenced by the difference between
the selling price and the purchase price. If an investor purchases a newly
issued T-bill and holds it until maturity, the return is based on the difference
between the par value and the purchase price. If the T-bill is sold prior to
maturity, the return is based on the difference between the price for which the
bill was sold in the secondary market and the purchase price. The annualized
yield from investing in a T-bill (YT) can be determined as:
YT =
SP − PP 365
×
PP
n
Where
SP = Selling Price
PP = Purchase Price
n = number of days of the investment (holding period)
Example 3.6
An investor purchases a T-bill with a six-month (182-day) maturity and
$10,000 par value for $9,600. If this T-bill is held to maturity, its yield is:
44
Zimbabwe Open University
Unit 3
Money Markets
YT =
$10,000 − $9,600 365
×
= 8.36%
$9,600
182
If the T-bill is sold prior to maturity, the selling price and therefore the yield
are dependent on market conditions at the time of the sale.
Suppose the investor plans to sell the T-bill after 120 days and forecasts a
selling price of $9,820 at that time. The expected annualized yield based on
this forecast is:
YT =
$9,820 − $9,600 365
×
= 6.97%
$9,600
120
Estimating the T-bill discount
Some business periodicals quote the T-bill discount along with the T-bill yield.
The T-bill discount represents the percent discount of the purchase price from
par value for newly issued T-bills and is computed as:
T-bill discount =
Par − PP 360
×
Par
n
A 360-day year is used to compute the T-bill discount.
Using the information from the previous example, the T-bill discount is:
T-bill discount =
$10,000 − $9,600 360
×
= 7.91%
$10,000
182
For a newly issued T-bill that is held to maturity, the T-bill yield will always be
higher than the discount. The difference occurs because the purchase price is
the denominator of the yield equation, while the par value is the denominator
of the T-bill discount equation, and the par value will always exceed the
purchase price of a newly issued T-bill. In addition, the yield formula uses a
365-day year versus a 360-day year for the discount computation.
Zimbabwe Open University
45
Money and Capital Markets
Module MBAZ510
Activity 3.4
an investor purchased a six-month T-bill with a
? 1. Assume
$10,000 par value for $9,000 and sold it 90 days later for
$9,100. What is the yield?
Newly issued three-month T-bills with a par value of
$10,000 sold for $9,700. Compute the T-bill discount.
3.
You paid $98,000 for a $100,000 T-bill maturing in 120
days. If you hold it until maturity, what is the T-bill yield?
What is the T-bill discount?
4.
A money market security that has a par value of $10,000
sells for $8,816.60. Given that the security has a maturity
of two years, what is the investor’s required rate of return?
5.
(a) Determine how the annualized yield of a T-bill would
be affected if the purchase price is lower. Explain the logic
of this relationship.
(b) Determine how the annualized yield of a T-bill would be
affected if the selling price is lower. Explain the logic of this
relationship.
(c) Determine how the annualized yield of a T-bill would be
affected if the number of days is shorter, holding the
purchase price and selling price constant. Explain the logic
of this relationship.
2.
3.5.2 Commercial paper
Commercial paper securities (CP) are unsecured promissory notes, issued
by corporations that mature in no more than 270 days. Because these securities
are unsecured, only the largest and most creditworthy corporations issue
commercial papers. The interest rate the corporation is charged reflects the
firm’s level of risk.
Companies’ short-term capital and working capital requirements are usually
sourced directly from banks, in the form of bank loans. CP is an alternative
short-term funding instrument, which is available to firms that have a sufficiently
strong credit rating. The issuer of the note promises to pay its holder a specified
amount on a specified maturity date. CP normally has a zero coupon and
trades at a discount to its face value. The discount represents interest to the
investor in the period to maturity. CP is typically issued in bearer form, although
some issues are in registered form.
46
Zimbabwe Open University
Unit 3
Money Markets
Originally the CP market was restricted to borrowers with high credit rating,
and although lower-rated borrowers do now issue CP, sometimes by obtaining
credit enhancements or setting up collateral arrangements, issuance in the
market is still dominated by highly rated companies. The majority of issues
are very short-term, from 30 to 90 days to maturity. It is extremely rare to
observe paper with a maturity of more than 270 days or nine months. This is
because of regulatory requirements.
Although there is a secondary market in CP, very little trading activity takes
place since investors generally hold CP until maturity. This is to be expected
because investors purchase CP that matches their specific maturity
requirements. When an investor wishes to sell paper, it can be sold back to
the dealer, or when the issuer has placed the paper directly in the market (and
not via an investment bank), it can be sold back to the issuer.
Commercial paper programmes
The issuers of CP are often divided into two categories of company, financial
institutions and non-financial companies. The majority of CP issues are by
financial companies. Financial companies include not only banks but the
financing arms of firms.
Most of the issuers have strong credit ratings, but lower-rated borrowers
have tapped the market, often after arranging credit support from a higherrated company, such as a letter of credit from a bank, or by arranging collateral
for the issue in the form of high-quality assets such as Treasury bonds. CP
issued with credit support is known as credit-supported commercial paper,
while paper backed with assets is known as asset-backed commercial paper.
Although banks charge a fee for issuing letters of credit, borrowers are often
happy to arrange for this, since by so doing they are able to tap the CP
market. The yield paid on an issue of CP will be lower than a commercial
bank loan.
Issuers often roll over their funding and use funds from a new issue of CP to
redeem a maturing issue. There is a risk that an issuer might be unable to roll
over the paper where there is a lack of investor interest in the new issue. To
provide protection against this risk, issuers often arrange a stand-by line of
credit from a bank, normally for all of the CP programmes, to draw against in
the event that it cannot place a new issue.
Methods of issuance
There are two methods by which CP is issued, known as direct-issued or
Zimbabwe Open University
47
Money and Capital Markets
Module MBAZ510
direct paper and dealer-issued or dealer paper. Direct paper is sold by the
issuing firm directly to investors, and no agent bank or securities house is
involved. It is common for financial companies to issue CP directly to their
customers, often because they have continuous programmes and constantly
roll over their paper.
It is therefore cost-effective for them to have their own sales arm and sell their
CP direct. The treasury arms of certain non-financial companies also issue
direct paper. Dealer paper is paper that is sold using a banking or securities
house intermediary.
Commercial paper yields
Commercial paper is a discount instrument. Thus CP is sold at a discount to
its maturity value, and the difference between this maturity value and the
purchase price is the interest earned by the investor. The CP day-count base
is 365 days. The paper is quoted on a discount yield basis, in the same manner
as Treasury bills. The yield on CP follows that of other money market
instruments and is a function of the short-dated yield curve. The yield on CP
is higher than the T-bill rate; this is because of the credit risk that the investor
is exposed to when holding CP, for tax reasons (in certain jurisdictions interest
earned on T-bills is exempt from income tax) and because of the lower level
of liquidity available in the CP market. CP also pays a higher yield than
certificates of deposit (CD), because of the lower liquidity of the CP market.
Example 3.7
A 60-day CP note has a nominal value of $100,000. It is issued at a discount
of 7.5% per annum. The discount is calculated as:
Dis =
$100,000(0.075 × 60)
= $1,232.88
365
The issue price for the CP is therefore $98,768, that is, ($100,000 - $1,232).
The money market yield on this note at the time of issue is:
 365 × 0.075 
 × 100% = 7.954%

 365 − (0.075 × 60) 
48
Zimbabwe Open University
Unit 3
Money Markets
Another way to calculate this yield is to measure the capital gain (the discount)
as a percentage of the CP’s cost, and convert this from a 60-day yield to a
one-year (365-day) yield, as shown below:
Example 3.8
ABC plc wishes to issue CP with face value of $100,000 with 90 days to
maturity. The investment bank managing the issue advises that the discount
rate should be 9.5%. What should the issue price be, and what is the money
market yield for investors?
Dis =
100,000(0.095 × 90)
= 2,342
365
The issue price will be 100,000 – 2,342 = $97,658.
The yield to investors will be:
2,342 365
×
× 100% = 9.725%
97,658 90
Activity 3.5
an investor purchased 6-month commercial paper
? 1. Assume
with a face value of $1 million for $940,000. What is the
2.
3.
4.
yield?
The price of 182-day commercial paper is $7,840. If the
annualized yield is 4.04%, what will the paper pay at
maturity?
The price of $8000 face value commercial paper is $7930.
If the annualized yield is 4%, when will the paper mature?
Explain why commercial papers are usually unsecured.
3.5.3 Negotiable certificates of deposit (NCDs)
These certificates are issued by large commercial banks and other depository
institutions as a short-term source of funds. Negotiable Certificates of Deposits
Zimbabwe Open University
49
Money and Capital Markets
Module MBAZ510
are typically too large for individual investors. These are sometimes purchased
by money market funds that have pooled individual investors’ funds. Thus
money market funds allow individuals to be indirect investors in NCDs, creating
a more active NCD market.
NCDs must offer a premium above the T-bill yield to compensate for less
liquidity and safety. The premiums are generally higher during recessionary
periods. The premiums also reflect the market’s perception about the safety
of the financial institution.
Yield
NCDs provide a return in the form of interest along with the difference between
the price at which the NCD is redeemed (or sold in the secondary market)
and the purchase price. Given that an institution issues an NCD at par value,
the annualized yield that it will pay is the annualized interest rate on the NCD.
If investors purchase this NCD and hold it until maturity, their annualized yield
is the interest rate. However, the annualized yield can differ from the annualized
interest rate for investors who either purchase or sell the NCD in the secondary
market instead of holding it from inception until maturity.
Example 3.9
An investor purchased an NCD a year ago in the secondary market for
$970,000. He redeems it today upon maturity and receives $1,000,000. He
also receives interest of $40,000. His annualized yield (YNCD) on this investment
is calculated as follows:
Y NCD =
=
SP − PP + INTEREST
PP
$1,000,000 − $970,000 + $40,000
$970,000
= 7.22%
3.5.4 Repurchase agreements (repo)
With a repurchase agreement (repo), one party sells securities to another with
an agreement to repurchase the securities at a specified date and price. In
50
Zimbabwe Open University
Unit 3
Money Markets
essence, the repo transaction represents a loan backed by the securities. If
the borrower defaults on the loan, the lender has claim to the securities. A
reverse repo refers to the purchase of securities by one party with an
agreement to sell them. Thus, a repo and a reverse repo can refer to the same
transaction but from different perspectives.
Estimating the yield
The repo rate is determined by the difference between the initial selling price
of the securities and the agreed-on repurchase price, annualized with a 360day year.
Example 3.10
An investor initially purchases securities at a price (PP) of $9,852,217, with
an agreement to sell them back at a price (SP) of $10,000,000 at the end of
a 60-day period. The yield (or repo rate) on this repurchase agreement is:
Repo rate =
=
1.
SP − PP 365
×
PP
n
$10,000,000 − $9,852,217 365
×
$9,852,217
60
= 9.12%
3.5.5 Bankers’ Acceptances (BA)
A banker’s acceptance is an order to pay a specified amount of money to the
bearer on a given date. They are used to finance goods that have not yet been
transferred from the seller to the buyer. A banker’s acceptance indicates that
a bank accepts responsibility for a future payment. These are commonly used
for international trade transactions.
An exporter that is sending goods to an importer whose credit rating is not
known will often prefer that a bank act as a guarantor. The bank therefore
facilitates the transaction by stamping ACCEPTED on a draft, which obligates
payment at a specified point in time. In turn, the importer will pay the bank
what is owed to the exporter along with a fee to the bank for guaranteeing the
payment.
Zimbabwe Open University
51
Money and Capital Markets
Module MBAZ510
The following are the steps for using bankers’ acceptances:
i.
ii.
iii.
iv.
v.
The importer requests its bank to send an irrevocable letter of credit to
the exporter
The exporter receives the letter, ships the goods, and is paid by
presenting to its bank the letter along with the proof that the merchandise
was shipped
The exporter’s bank creates a time draft based on the letter of credit
and sends it along with the proof of shipment to the importer’s bank
The importer’s bank stamps the time draft “accepted” and sends the
bankers’ acceptance back to the exporter’s bank so that the exporter’s
bank can sell it on the secondary market and collect payment
The importer deposits funds at its bank sufficient to cover the banker’s
acceptance when it matures
Exporters can hold a banker’s acceptance until the date at which payment is
to be made, but they frequently sell the acceptance before then at a discount
to obtain cash immediately. The investor who purchases the acceptance then
receives the payment guaranteed by the bank in the future. The investor’s
return on a banker’s acceptance, like that on commercial paper, is derived
from the difference between the discounted price paid for the acceptance and
the amount to be received in the future.
Maturities on banker’s acceptances often range from 30 to 270 days. Because
there is a possibility that a bank will default on payment, investors are exposed
to a slight degree of credit risk. Thus, they deserve a return above the T-bill
yield as compensation.
Because acceptances are often discounted and sold by the exporting firm
prior to maturity, an active secondary market exists. Dealers match up
companies that wish to sell acceptances with other companies that wish to
purchase them. A dealer’s bid price is less than its ask price, which creates
the spread, or the dealer’s reward for doing business.
Importance of banker’s acceptances
The following are some of the advantages of banker’s acceptance:
i.
ii.
iii.
52
The exporter is paid immediately. This is important when delivery times
are long after shipment
The exporter is shielded from foreign exchange rate risk because the
local bank pays in domestic currency
The exporter does not have to assess the creditworthiness of the
importer because the importer’s bank guarantees payment
Zimbabwe Open University
Unit 3
Money Markets
Activity 3.6
is the difference between money market instruments
? 1. What
quoted ‘on a discount basis’’ and ‘on a yield basis?
2.
3.
4.
a.
b.
c.
d.
5.
Suppose that one-month treasury bills and one-month CDs
are both quoted as having a rate of return of 5%. Which
gives the higher return to an investor?
John purchased an NCD a year ago in the secondary
market for $980,000. The NCD matures today at a price
of $1 million, and John receives $45,000 in interest. What
is John’s return on the NCD?
CBZ Bank arranged a repurchase agreement in which it
purchased securities for $4.9 million and will sell the
securities back for $5 million in 40 days. What is the yield
or repo rate to CBZ Bank?
Explain how each of the following would use bankers’
acceptances:
Exporting firm
Importing firm
Commercial bank
Investors
Based on what you know about repurchase agreements,
would you expect them to have a lower or higher annualized
yield than commercial paper? Explain.
3.6 Summary
The main money market securities are treasury bills, commercial paper,
bankers’ acceptances, repurchase agreements, negotiable certificates of
deposits. These securities vary according to the issuer. Consequently, their
perceived degree of credit risk can vary. Therefore, the quoted yields at any
given point in time vary among money market securities. Financial institutions
manage their liquidity by participating in money markets. They may issue
money market securities when they experience cash shortages and need to
boost liquidity. They can also sell holdings of money market securities to obtain
cash. The value of a money market security represents the present value of
future cash flows generated by that security.
Zimbabwe Open University
53
Money and Capital Markets
Module MBAZ510
References
Chisholm, A. M. (2009). Introduction to International Capital Market.
2nd Edition. London: John Wiley and Sons.
Choudhry, M. (2001). The Bond and Money Markets. London: ButterHeinemann.
Choudhry, M. et al (2010). Capital Market Instruments: Analysis and
Valuation. 3rd Edition. London: Palgrave Macmillan.
Fabozzi, F. J. (2008): Handbook of Finance, Volume 1. New York: John
Wiley & Sons.
Howells, P and Bain, K. (2007). Financial Markets and Institutions.
5th Edition. London: Prentice Hall.
Levinson, M. (2006): Guide to Financial Markets. 4th Edition. London:
Profile Books
Limited.
Madura, J. (2010). Financial Markets and Institutions: 9th Edition. Florida:
SouthWestern College.
Mishkin, F.S. and Eakins, S.G. (2006). Financial Markets and Institutions.
5th Edition. New York: Pearson Addison Wesley.
54
Zimbabwe Open University
Unit Four
Bond Markets
4.0 Introduction
I
n the previous unit, we discussed short-term securities that are traded in
money markets. In this unit, we will talk about one of the several securities
that are traded in the capital market. Capital markets are markets for securities
with an original maturity that is greater than one year. These securities include
bonds, mortgages and stocks.
Money and Capital Markets
Module MBAZ510
4.1 Objectives
By the end of this unit, you should be able to:







describe the main purpose of capital markets
identify the key participants in the bond markets
explain why firms issue bonds
discuss the various categories of bonds
describe the basic features of a bond
analyse the provisions for redeeming bonds
explain how bond markets have become globally
integrated
4.2 Purpose of Capital Markets
Firms and individuals use the capital markets for long-term investments. The
primary reason that firms and individuals choose to borrow long-term is to
reduce the risk that interest rates will rise before they pay off their debt. Firms
that issue capital market securities and investors who buy them have very
different motivations from those who operate in the money markets. Firms
and individuals use the money markets primarily to warehouse funds for shortterm periods of time until a more important need or a more productive use for
the funds arises.
4.3 Capital Market Participants
The primary issuers of capital market securities are central and local
governments and corporations. Central governments issue long-term bonds
to fund national debts, while local government agencies also issue bonds to
finance capital projects.
Corporations issue both bonds and stock. One of the most difficult decisions
a firm faces can be whether it should finance its growth with debt or equity.
The distribution of a firm’s capital between debt and equity is its capital structure.
Firms may enter the capital markets because they do not have sufficient capital
to fund their investment opportunities. Alternatively, firms may choose to enter
the capital markets because they want to preserve their capital to protect
56
Zimbabwe Open University
Unit 4
Bond Markets
against unexpected needs. In either case, the availability of efficiently functioning
capital markets is crucial to the continued health of the business sector.
Activity 4.1
?
1.
2.
3.
4.
What would you say is the purpose of capital markets?
Who are the participants on the capital markets?
What is capital structure?
“Firms that issue capital market securities and investors
who buy them have very different motivations from those
who operate in the money markets”. Explain these different
motivations.
4.4 Background on Bonds
Moorad Choudhry (2001) states that the word “bond” means contract,
agreement, or guarantee. All these terms are applicable to the securities known
as bonds. An investor who purchases a bond is lending money to the issuer,
and the bond represents the issuer’s contractual promise to pay interest and
repay principal according to specified terms.
Bonds were a natural outgrowth of the loans that early bankers provided to
finance wars starting in the Middle Ages. As governments’ financial appetites
grew, bankers found it increasingly difficult to come up with as much money
as their clients wanted to borrow. Bonds offered a way for governments to
borrow from many individuals rather than just a handful of bankers, and they
made it easier for lenders to reduce their risks by selling the bonds to others if
they thought the borrower might not repay.
Bonds are debt securities which entitle the owner to receive interest payments
during the life of the bond and repayment of principal, without having ownership
or managerial control of the issuer.
4.4.1 Why issue bonds?
Bonds are never an issuer’s only source of credit. All businesses and
government entities that choose to sell bonds have already borrowed from
banks, and many have received financing from customers, suppliers or
Zimbabwe Open University
57
Money and Capital Markets
Module MBAZ510
specialised finance companies. The principal reason for issuing bonds is to
diversify sources of funding. The amount any bank will lend to a single borrower
is limited. By tapping the vastly larger base of bond market investors, the
issuer can raise far more money without exhausting its traditional credit lines
with direct lenders.
Bonds also help issuers carry out specific financial-management strategies.
These include the following:
58

Minimising financing costs: Leverage, the use of borrowed money,
enables profit-making businesses to expand and earn more profit than
they could from equity funds. Firms generally prefer bonds to other
forms of leverage, such as bank loans, because the cost is lower and
the funds can be repaid over a longer period. A bond issue may or may
not increase the issuer’s leverage, depending upon whether the bonds
increase the total amount of borrowing or merely replace other forms
of borrowing.

Matching revenue and expenses: Many capital investments, such
as a toll bridge or a copper smelter, take years to complete but are then
expected to produce revenue over a lengthy period. Bonds offer a way
of linking the repayment of borrowings for such projects to anticipated
revenue.

Promoting inter-generational equity: Governments often undertake
projects, such as building roads or buying park land, that create longlasting benefits. Bonds offer a means of requiring future taxpayers to
pay for the benefits they enjoy, rather than putting the burden on current
taxpayers.

Controlling risk: The obligation to repay a bond can be tied to a
specific project or a particular government agency. This can insulate
the parent corporation or government from responsibility if the bond
payments are not made as required.

Avoiding short-term financial constraints: Governments and firms
may turn to the bond markets to avoid painful steps, such as tax
increases, redundancies or wage reductions that might otherwise be
necessary owing to a lack of cash.
Zimbabwe Open University
Unit 4
Bond Markets
Activity 4.2
?
1.
2.
Why do firms generally prefer bonds to other forms of
credit?
Discuss how bonds help firms carryout their specific
financial management strategies.
4.4.2 Issuers of bonds
The following are the basic types of entities that issue bonds.
National governments
Bonds backed by the full faith and credit of national governments are called
sovereign bonds. These are generally considered the most secure type of
bond. A national government has strong incentives to pay on time in order to
retain access to credit markets, and it has extraordinary powers, including the
ability to print money and to take control of foreign currency reserves, that
can be employed to make payments.
Lower levels of governments
Bonds issued by a government at the sub-national level, such as municipality,
are called semi-sovereigns. Semi-sovereign bonds are generally riskier than
sovereigns because government agencies such as municipalities have no power
to print money or to take control of foreign exchange.
Government agencies and investment banks
An asset-backed security is a type of bond on which the required payments
are made out of the income generated by specific assets, such as mortgage
loans or future sales. Some asset-backed securities are initiated by government
agencies, others by private-sector entities. These sort of securities are
assembled by an investment bank, and often do not represent the obligations
of a particular issuer.
Corporations
Corporate bonds are issued by a business enterprise, whether owned by
private investors or by a government. Most corporate bonds have a face
value of $1,000 and pay interest semiannually. The degree of risk varies widely
among issues because the risk of default depends on the company’s health,
Zimbabwe Open University
59
Money and Capital Markets
Module MBAZ510
which can be affected by a number of variables.
4.5 Main Features of Bonds
The following characteristics are associated with corporate bonds:
4.5.1 Indenture and covenants
The promises of the issuer and the rights of the bondholders are set forth in
great detail in a bond’s indenture. Bondholders would have great difficulty in
determining from time to time whether the issuer was keeping all the promises
made in the indenture. This problem is resolved for the most part by bringing
in a trustee as a third party to the bond or debt contract. The indenture identifies
the trustee as a representative of the interests of the bondholders. As part of
the indenture, there are affirmative covenants and negative covenants.
Affirmative covenants set forth activities that the borrower promises to do.
The most common affirmative covenants are (1) to pay interest and principal
on a timely basis, (2) to pay all taxes and other claims when due, (3) to
maintain all properties used and useful in the borrower’s business in good
condition and working order, and (4) to submit periodic reports to a trustee
stating that the borrower is in compliance with the loan agreement. Negative
covenants set forth certain limitations and restrictions on the borrower’s
activities. The more common restrictive covenants are those that impose
limitations on the borrower’s ability to incur additional debt unless certain
tests are satisfied.
4.5.2 Maturity
The term to maturity of a bond is the number of years the debt is outstanding
or the number of years remaining prior to final principal payment. The maturity
date of a bond refers to the date that the debt will cease to exist, at which time
the issuer will redeem the bond by paying the outstanding balance. The maturity
date of a bond is always identified when describing a bond. For example, a
description of a bond might state ‘‘due 12/1/2020.’’
There are three reasons why the term to maturity of a bond is important:
Reason 1:
Term to maturity indicates the time period over which the bondholder can
expect to receive interest payments and the number of years before the principal
will be paid in full.
60
Zimbabwe Open University
Unit 4
Bond Markets
Reason 2:
The yield offered on a bond depends on the term to maturity. The relationship
between the yield on a bond and maturity is called the yield curve.
Reason 3:
The price of a bond will fluctuate over its life as interest rates in the market
change. The price volatility of a bond is a function of its maturity (among other
variables). More specifically, by holding all other factors constant, the longer
the maturity of a bond, the greater the price volatility resulting from a change
in interest rates.
4.5.3 Par value
The par value of a bond is the amount that the issuer agrees to repay the
bondholder at or by the maturity date. This amount is also referred to as the
principal value, face value, redemption value, and maturity value.
Note that a bond may trade below or above its par value. When a bond
trades below its par value, it is said to be trading at a discount. When a bond
trades above its par value, it is said to be trading at a premium.
4.5.4 Current yield
Current yield is the effective interest rate for a bond at its current market
price. This is calculated by a simple formula:
Annual dollar coupon interest
Current price
If the price has fallen since the bond was issued, the current yield will be
greater than the coupon; if the price has risen, the yield will be less than the
coupon.
4.5.5 Yield to maturity
This is the annual rate the bondholder will receive if the bond is held to maturity.
Unlike current yield, yield to maturity includes the value of any capital gain or
loss the bondholder will incur when the bond is redeemed. This is the most
widely used figure for comparing returns on different bonds.
Zimbabwe Open University
61
Money and Capital Markets
Module MBAZ510
4.5.6 Duration
Duration is a number expressing how quickly the investor will receive half of
the total payment due over the bond’s remaining life, with an adjustment for
the fact that payments in the distant future are worth less than payments due
soon. This complicated concept can be grasped by looking at two extremes.
A zero-coupon bond offers payments only at maturity, so its duration is precisely
equal to its term. A hypothetical ten-year bond yielding 100% annually lets
the owner collect a great deal of money in the early years of ownership, so its
duration is much shorter than its term. Most bonds fall in between. If two
bonds have identical terms, the one with the higher yield will have the shorter
duration, because the holder is receiving more money sooner.
4.5.7 Coupon rate
The coupon rate, also called the nominal rate, is the interest rate that the
issuer agrees to pay each year. The annual amount of the interest payment
made to bondholders during the term of the bond is called the coupon. The
coupon is determined by multiplying the coupon rate by the par value of the
bond. That is,
Coupon = coupon rate × par value
The coupon rate also affects the bond’s price sensitivity to changes in market
interest rates. Holding other factors constant, the higher the coupon rate, the
less the price will change in response to a change in market interest rates.
Zero coupon bonds
Not all bonds make periodic coupon payments. Bonds that are not contracted
to make periodic coupon payments are called zero-coupon bonds. The holder
of a zero-coupon bond realises interest by buying the bond substantially below
its par value (i.e., buying the bond at a discount). Interest is then paid at the
maturity date, with the interest being the difference between the par value and
the price paid for the bond. So, for example, if an investor purchases a zerocoupon bond for $70, the interest is $30. This is the difference between the
par value ($100) and the price paid ($70).
Step-up notes
There are securities that have a coupon rate that increases over time. These
securities are called step-up notes because the coupon rate ‘‘steps up’’ over
time. For example, a 5-year step-up note might have a coupon rate that is 5%
62
Zimbabwe Open University
Unit 4
Bond Markets
for the first two years and 6% for the last three years. Or, the step-up note
could call for a 5% coupon rate for the first two years, 5.5% for the third and
fourth years, and 6% for the fifth year. When there is only one change (or step
up), as in the first example, the issue is referred to as a single step-up note.
When there is more than one change, as in the second example, the issue is
referred to as a multiple step-up note.
Deferred coupon bonds
There are bonds whose interest payments are deferred for a specified number
of years. That is, there are no interest payments for the deferred period. At
the end of the deferred period, the issuer makes periodic interest payments
until the bond matures. The interest payments that are made after the deferred
period are higher than the interest payments that would have been made if the
issuer had paid interest from the time the bond was issued. The higher interest
payments after the deferred period are to compensate the bondholder for the
lack of interest payments during the deferred period. These bonds are called
deferred coupon bonds.
Floating-rate securities
The coupon rate on a bond need not be fixed over the bond’s life. Floatingrate securities, sometimes called variable-rate securities, have coupon payments
that reset periodically according to some reference rate. The typical formula
(called the coupon formula) on certain determination dates when the coupon
rate is reset is as follows:
Coupon rate = reference rate + quoted margin
The quoted margin is the additional amount that the issuer agrees to pay above
the reference rate. For example, suppose that the reference rate is the 1month London inter-bank offered rate (LIBOR). Suppose that the quoted
margin is 100 basis points. Then the coupon formula is:
Coupon rate = 1-month LIBOR + 100 basis points
So, if 1-month LIBOR on the coupon reset date is 5%, the coupon rate is
reset for that period at 6% (5% plus 100 basis points).
Accrued interest
Bond issuers do not disburse coupon interest payments every day. Typically,
coupon interest is paid every six months. In some countries, interest is paid
annually. For mortgage-backed and asset-backed securities, interest is usually
Zimbabwe Open University
63
Money and Capital Markets
Module MBAZ510
paid monthly. The coupon payment is made to the bondholder of record.
Thus, if an investor sells a bond between coupon payments and the buyer
holds it until the next coupon payment, then the entire coupon interest earned
for the period will be paid to the buyer of the bond since the buyer will be the
holder of record. The seller of the bond gives up the interest from the time of
the last coupon payment to the time until the bond is sold. The amount of
interest over this period that will be received by the buyer even though it was
earned by the seller is called accrued interest.
The bond buyer must pay the bond seller the accrued interest. The amount
that the buyer pays the seller is the agreed upon price for the bond plus accrued
interest. This amount is called the full price. (Some market participants refer
to this as the dirty price.) The agreed upon bond price without accrued
interest is simply referred to as the price. (Some refer to it as the clean
price.)
A bond in which the buyer must pay the seller accrued interest is said to be
trading cum-coupon (‘‘with coupon’’). If the buyer forgoes the next coupon
payment, the bond is said to be trading ex-coupon (‘‘without coupon’’).
There are exceptions to the rule that the bond buyer must pay the bond seller
accrued interest. The most important exception is when the issuer has not
fulfilled its promise to make the periodic interest payments. In this case, the
issuer is said to be in default. In such instances, the bond is sold without
accrued interest and is said to be traded flat.
Activity 4.3
?
64
1.
2.
3.
4.
5.
a.
b.
Describe the characteristics associated with corporate
bonds.
What is a coupon rate?
How does the coupon rate influence the bond price?
Distinguish between current yield and yield to maturity.
Explain the following terms:
dirty price
clean price
Zimbabwe Open University
Unit 4
Bond Markets
4.6 Provisions for Paying off Bonds
The issuer of a bond agrees to pay the principal by the stated maturity date.
The issuer can agree to pay the entire amount borrowed in one lump sum
payment at the maturity date. That is, the issuer is not required to make any
principal repayments prior to the maturity date. Such bonds are said to have
a bullet maturity.
Fixed income securities backed by pools of loans (mortgage-backed securities
and asset-backed securities) often have a schedule of partial principal payments.
Such fixed income securities are said to be amortizing securities. For many
loans, the payments are structured so that when the last loan payment is made,
the entire amount owed is fully paid.
Another example of an amortizing feature is a bond that has a sinking fund
provision. This provision for repayment of a bond may be designed to pay all
of an issue by the maturity date, or it may be arranged to repay only a part of
the total by the maturity date.
An issue may have a call provision granting the issuer an option to retire all or
part of the issue prior to the stated maturity date. Some issues specify that the
issuer must retire a predetermined amount of the issue periodically. Various
types of call provisions are discussed in sections 4.6.1 to 4.6.5.
4.6.1 Call and refunding provision
An issuer generally wants the right to retire a bond issue prior to the stated
maturity date. The issuer recognizes that at some time in the future interest
rates may fall sufficiently below the issue’s coupon rate so that redeeming the
issue and replacing it with another lower coupon rate issue would be
economically beneficial. This right is a disadvantage to the bondholder since
proceeds received must be reinvested in the lower interest rate issue. As a
result, an issuer who wants to include this right as part of a bond offering must
compensate the bondholder when the issue is sold by offering a higher coupon
rate, or equivalently, accepting a lower price than if the right is not included.
The right of the issuer to retire the issue prior to the stated maturity date is
referred to as a call provision. If an issuer exercises this right, the issuer is
said to ‘‘call the bond.’’ The price which the issuer must pay to retire the issue
is referred to as the call price or redemption price.
When a bond is issued, typically the issuer may not call the bond for a number
of years. That is, the issue is said to have a deferred call. The date at which
the bond may first be called is referred to as the first call date.
Zimbabwe Open University
65
Money and Capital Markets
Module MBAZ510
4.6.2 Prepayments
For amortizing securities that are backed by loans that have a schedule of
principal payments, individual borrowers typically have the option to pay off
all or part of their loan prior to a scheduled principal payment date. Any
principal payment prior to a scheduled principal payment date is called a
prepayment. The right of borrowers to prepay principal is called a prepayment
option.
Basically, the prepayment option is the same as a call option. However, unlike
a call option, there is not a call price that depends on when the borrower pays
off the issue. Typically, the price at which a loan is prepaid is par value.
4.6.3 Sinking fund provision
An indenture may require the issuer to retire a specified portion of the issue
each year. This is referred to as a sinking fund requirement. The alleged purpose
of the sinking fund provision is to reduce credit risk. This kind of provision for
debt payment may be designed to retire all of a bond issue by the maturity
date, or it may be designed to pay only a portion of the total indebtedness by
the end of the term. If only a portion is paid, the remaining principal is called
a balloon maturity.
4.6.4 Conversion privilege
A convertible bond is an issue that grants the bondholder the right to convert
the bond for a specified number of shares of common stock. Such a feature
allows the bondholder to take advantage of favorable movements in the price
of the issuer’s common stock. An exchangeable bond allows the bondholder
to exchange the issue for a specified number of shares of common stock of a
corporation different from the issuer of the bond.
4.6.5 Put provision
An issue with a put provision included in the indenture grants the bondholder
the right to sell the issue back to the issuer at a specified price on designated
dates. The specified price is called the put price. Typically, a bond is putable
at par if it is issued at or close to par value. For a zero-coupon bond, the put
price is below par.
The advantage of a put provision to the bondholder is that if, after the issuance
date, market rates rise above the issue’s coupon rate, the bondholder can
force the issuer to redeem the bond at the put price and then reinvest the put
bond proceeds at the prevailing higher rate.
66
Zimbabwe Open University
Unit 4
Bond Markets
4.7 Types of Bonds
Bonds are not as standardised as stocks. An increasing variety of bonds is
available in the marketplace. In some cases, an issuer agrees to design a bond
with the specific characteristics required by a particular institutional investor.
Such a bond is then privately placed and is not traded in the bond markets.
Bonds that are issued in the public markets generally fit into one or more of
the following categories.
4.7.1 Secured bonds
Secured bonds are ones with collateral attached. Mortgage bonds are used
to finance a specific project. For example, a building may be the collateral for
bonds issued for its construction. In the event that the firm fails to make
payments as promised, mortgage bondholders have the right to liquidate the
property in order to be paid. These bonds are less risky comparable to
unsecured bonds. As a result, they will have a lower interest rate.
4.7.2 Unsecured bonds
Debentures are long-term unsecured bonds that are backed only by the general
creditworthiness of the issuer. No specific collateral is pledged to repay the
debt. In the event of default, the bondholders must go to court to seize assets.
Collateral that has been pledged to other debtors is not available to the holders
of debentures. Debentures have lower priority than secured bonds if the firm
defaults. As a result, they will have a higher interest rate than otherwise
comparable to secured bonds.
Subordinated debentures are similar to debentures except that they have a
lower priority claim. This means that in the event of a default, subordinated
debenture holders are paid only after non-subordinated bondholders have
been paid in full. As a result, subordinated debenture holders are at greater
risk of loss.
4.7.3 Junk bonds
One of the most important bond-market developments in recent years is the
issuance of debt by entities with weak credit ratings. Such bonds are called
high-yield debt or below-investment-grade debt. They are better known to
the public as junk bonds.
Some bonds that carry investment-grade ratings when they are issued may in
Zimbabwe Open University
67
Money and Capital Markets
Module MBAZ510
future trade as high-yield bonds because the issuer’s financial condition has
deteriorated. These are known as fallen angels. When the condition of the
issuer of a below-investment-grade bond improves significantly, the bond may
gain an investment-grade rating. In this case, traders refer to it as a rising star.
4.7.4 Callable bonds
The issuer may reserve the right to call the bonds at particular dates. A call
obliges the owner to sell the bonds to the issuer for a price, specified when
the bond was issued, that usually exceeds the current market price. The
difference between the call price and the current market price is the call
premium. A bond that is callable is worth less than an identical bond that is
non-callable, to compensate the investor for the risk that it will not receive all
of the anticipated interest payments. Borrowers prefer to have this provision
attached to their bonds as it enables them to refinance debt at cheaper levels
when market interest rates have fallen significantly below the level they were
at the time of the bond issue.
A call provision is a negative feature for investors, as bonds are only paid off
if their price has risen above par. Although a call feature indicates an issuer’s
interest in paying off the bond, because they are not attractive for investors,
callable bonds pay a higher yield than non-callable bonds of the same credit
quality and maturity.
4.7.5 Non-refundable bonds
These may be called only if the issuer is able to generate the funds internally,
from sales or taxes. This prohibits an issuer from selling new bonds at a lower
interest rate and using the proceeds to call bonds that bear a higher interest
rate.
4.7.6 Putable bonds
Putable bonds give the investor the right to sell the bonds back to the issuer at
par value on designated dates. This benefits the investor if interest rates rise,
so a putable bond is worth more than an identical bond that is not putable.
4.7.7 Perpetual debentures
Also known as irredeemable debentures, perpetual debentures are bonds
that will last forever unless the holder agrees to sell them back to the issuer.
68
Zimbabwe Open University
Unit 4
Bond Markets
4.7.8 Zero-coupon bonds
Zero-coupon bonds do not pay periodic interest. Instead, they are issued at
less than par value and are redeemed at par value, with the difference serving
as an interest payment. Zeros are designed to eliminate reinvestment risk, the
loss an investor suffers if future income or principal payments from a bond
must be invested at lower rates than those available today. The owner of a
zero-coupon bond has no payments to reinvest until the bond matures, and
therefore has greater certainty about the return on the investment.
4.7.9 Convertible bonds
Under specified conditions and strictly at the bondholder’s option, convertible
bonds may be exchanged for another security, usually the issuer’s common
shares. The prospectus for a convertible issue specifies the conversion ratio,
the number of shares for which each bond may be exchanged. A convertible
bond has a conversion value, which is simply the price of the common shares
for which it may be traded. The buyer must usually pay a premium over
conversion value, to reflect the fact that the bond pays interest until and unless
it is converted. Convertibles often come with hard call protection, which
prohibits the issuer from calling the bonds before the conversion date.
4.7.10 Adjustable bonds
There are many varieties of adjustable bonds. The interest rate on a floatingrate bond can change frequently, usually depending on short-term interest
rates. The rate on a variable-rate bond may be changed only once a year, and
is usually related to long-term interest rates. A step-up note will have an
increase in the interest rate no more than once a year, according to a formula
specified in the prospectus. Inflation-indexed bonds seek to protect against
the main risk of bond investing: the likelihood that inflation will erode the value
of both interest payments and principal. Capital-indexed bonds apply an
inflation adjustment to interest payments as well as to principal. Interest-indexed
bonds adjust interest payments for inflation, but the value of the principal itself
is not adjusted for inflation. Indexed zero-coupon bonds pay an inflationadjusted principal upon redemption.
4.7.11 Structured securities
Bonds that have options attached to them are called structured securities.
Callable, putable and convertible bonds are simple examples of structured
securities.
Zimbabwe Open University
69
Money and Capital Markets
Module MBAZ510
Another traditional example is a warrant bond, a bond which comes with a
warrant entitling the holder to buy a different bond under certain conditions at
some future date.
Many structured securities are far more complex, featuring interest rates that
can vary only within given limits and can change at an exponential rate or can
even cease to be payable altogether in certain circumstances. The prices of
such instruments can be difficult to calculate and depend heavily on the value
attached to the option features.
4.8 Corporate Bond Risks
Corporate bonds hold additional risks for investors when compared with
sovereign bonds. Issuers frequently take steps to reduce the risk bondholders
must bear in order to sell them at lower interest rate. There are three common
ways of doing this:
70

Covenants are legally binding promises made at the time a bond is
issued. A simple covenant might limit the amount of additional debt that
the issuer may sell in future, or might require it to keep a certain level of
cash at all times. Covenants are meant to protect bondholders not only
against default, but also against the possibility that management’s future
actions will lead ratings agencies to downgrade the bonds, which would
reduce the price in the secondary market.

Bond insurance is frequently sought by issuers with unimpressive credit
ratings. A bond insurer is a private firm that has obtained a top rating
from the main ratings agencies. An issuer pays it a premium to guarantee
bondholders that specific bonds will be serviced on time. With such a
guarantee, the issuer is able to sell its bonds at a lower interest rate.

Sinking funds ensure that the issuer arranges to retire some of its
debt, on a prearranged schedule, prior to maturity. The issuer can do
this either by purchasing the required amount of its bonds in the market
at specified times, or by setting aside money in a fund overseen by a
trustee, to ensure that there is adequate cash on hand to redeem the
bonds at maturity.
Zimbabwe Open University
Unit 4
Bond Markets
4.9 International Bond Markets
The bond markets have long since ceased to be domestic markets. As
restrictions on the cross-border flow of capital have been reduced or
eliminated, investors have increasingly been able to buy bonds regardless of
the national origin of the issuer and the currency of issue.
The issuance of bonds outside the issuer’s home country can occur in two
different ways:

Foreign bonds are issued outside the issuer’s home country and are
denominated in the currency of the country where they are issued.

Eurobonds are denominated in neither the currency of the issuer’s
home country nor that of the country of issue, and are generally subject
to less regulation. Thus a sterling-denominated bond offered in London
by a Japanese firm would be considered a foreign bond, and the same
security offered in London but denominated in dollars or Swiss francs
would be called a eurobond.
4.10 Importance of International Bond Markets
Why would an issuer choose an international issue rather than a domestic
one?
First, it may wish to match its borrowing to the income that is intended to pay
for that borrowing. A Zimbabwean firm intending to build an electrical
generation plant in UK, for example, might borrow in British Pounds rather
than in euros because the electricity will be priced and sold in pounds.
Second, the greater liquidity of the main bond markets, particularly in
developed economies, means that borrowers from other countries can often
obtain lower interest rates than at home, even after taking currency risk into
account. This is particularly true for issuers from countries where financial
markets are underdeveloped and investors’ willingness to purchase localcurrency bonds is limited.
Third, an international issue is often undertaken to establish the issuer’s
reputation among international investors, to ease the way for future borrowings
or share offerings.
Zimbabwe Open University
71
Money and Capital Markets
Module MBAZ510
Activity 4.4
?
1.
2.
3.
4.
5.
6.
7.
8.
What is a bond indenture? What is the function of a
trustee, as related to the bond indenture?
Explain the use of a sinking fund provision. How can it
reduce the investors’ risk?
What are protective covenants? Why are they needed?
Explain the use of call provisions on bonds. How can a
call provision affect the price of a bond?
What are the advantages and disadvantages to a firm
that issues low or zero coupon bonds?
Are variable-rate bonds attractive to investors who expect
interest rates to decrease? Explain. Would a firm that
needs to borrow funds consider using variable-rate bonds
if it expects that interest rates will decrease? Explain.
Explain why convertible bonds are usually issued by firms
at a higher price than other bonds?
Consider the following two bond issues:
Bond A: 5% 15-year bond
Bond B: 5% 30-year bond
Neither bond has an embedded option. Both bonds are
trading in the market at the same yield.
Which bond will fluctuate more in price when interest
rates change? Why?
4.11 Summary
The three major users of bond markets are governments, firms and individuals.
Bond markets are used mainly for long-term investments. Governments issue
bonds mainly to finance their national debts while firms issue bonds to finance
their capital projects. These entities use bonds as additional sources of funds
and enable them to diversify their sources of funds. Bonds are not as
standardised as stocks. There is an increasing variety of bonds in the
marketplace, and these include; secured bonds, unsecured bonds, junk bonds,
callable bonds, non-refundable bonds, convertible bonds, perpetual bonds,
zero-coupon bonds, adjustable bonds and many others. The main
characteristics associated with bonds include indenture and covenants, coupon
72
Zimbabwe Open University
Unit 4
Bond Markets
rates, maturity, duration, current yields, par value. Corporate bonds carry
additional risk compared to sovereign bonds. Corporate bond issuers take
steps such as covenants, bond insurance and sinking fund provisions to reduce
the attendant risks. In response to the advent of globalisation, bond markets
have since assumed an international outlook. This facility now enables
multinational corporations to issue bonds in global markets.
Zimbabwe Open University
73
Money and Capital Markets
Module MBAZ510
References
Choudhry, M. et al (2010). Capital Market Instruments: Analysis and
Valuation. 3rd Edition. London: Palgrave Macmillan.
Frank J. Fabozzi (2007). Fixed Income Analysis. 2nd Edition. John Wiley
& Sons.
Levinson, M. (2006). Guide to Financial Markets. 4th Edition. London:
Profile Books Limited.
Madura, J. (2010). Financial Markets and Institutions. 9th Edition. Florida:
SouthWestern College.
Mishkin, F.S. and Eakins, S.G. (2006). Financial Markets and Institutions.
5th Edition. New York: Pearson Addison Wesley.
74
Zimbabwe Open University
Unit Five
Bond Valuation
5.0 Introduction
T
he values of bonds can change substantially over time. Hence, financial
institutions that consider buying or selling bonds closely monitor their
values. In this unit, we will discuss the bond valuation process and the factors
that influence bond prices.
Money and Capital Markets
Module MBAZ510
5.1 Objectives
By the end of this unit, you should be able to:
 explain how bonds are priced
 identify the factors that affect bond prices
 discuss the sensitivity of bond prices to interest rates is
dependent on particular bond characteristics
5.2 Bond Valuation Process
Bond valuation is conceptually similar to the valuation of capital budgeting
projects, businesses, or even real estate as reflected in the formula given below.
The appropriate price reflects the present value of the cash flows to be
generated by the bond in the form of periodic interest (coupon) payments and
the principal payment to be provided at maturity.
According to Madura (2010) and Mishkin & Eakins (2006), the current price
of a bond should be the present value (PV) of its remaining cash flows as
shown below:
PV of bond =
Where
C
C
C + Par
+
+ ...... +
1
2
(1 + k )
(1 + k )
(1 + k ) n
C = coupon payment provided in each period
Par = par value or face value
K
= required rate of return per period used to discount the bond
n
= number of periods to maturity
Example 5.1
Consider a bond that has a par value of $1,000 which pays $100 at the end
of each year in coupon payments, and has three years remaining until maturity.
Assume that the prevailing annualized yield on other bonds with similar
characteristics is 12%. In this case, the appropriate price of the bond can be
determined as follows. The future cash flows to investors who would purchase
this bond are $100 in year 1, $100 in year 2, and $1,100 (computed as $100
in coupon payments plus $1,000 par value) in year 3. The appropriate market
price of the bond is its present value:
76
Zimbabwe Open University
Unit 5
Bond Valuation
PV of bond =
$100
$100
$1,100
+
+
1
2
(1.12)
(1.12)
(1.12) 3
= $89.29+$79.72+$782.96
= $951.97
5.2.1 Impact of the discount rate on bond valuation
The discount rate selected to compute the present value is critical to accurate
valuation. The appropriate discount rate for valuing any asset is the yield that
could be earned on alternative investments with similar risk and maturity. Figure
5.1 below shows the impact of a discount rate on bond valuation.
Figure 5.1 Relationship between discount rate and present value of
$10,000 payment to be received in 10 years.
Source: Frederic S. Mishkin & Stanley G. Eakins (2006): Financial
Markets and Institutions, 5th Edition; Pearson Addison Wesley
Investors usually require higher returns on riskier securities. They therefore
use higher discount rates to discount the future cash flows of these securities.
Consequently, a high-risk security will have a lower value than a low risk
security even though both securities have the same expected cash flows.
Zimbabwe Open University
77
Money and Capital Markets
Module MBAZ510
Activity 5.1
should one closely monitor the values of bonds?
? 1.2. Why
When should investors use higher discount rates?
3. What is the relationship between magnitude risk and expected
return?
5.2.2 Impact of the timing of payments on bond valuation
The market price of a bond is also affected by the timing of the payments
made to bondholders. Funds received sooner can be reinvested to earn
additional returns. A dollar to be received soon has a higher present value
than one to be received later.
5.2.3 Valuation of bonds with semiannual payments
In reality, most bonds have semiannual payments. The present value of such
bonds can be computed as follows. First, the annualized coupon should be
split in half because two payments are made per year. Second, the annual
discount rate should be divided by 2 to reflect two-six month periods per
year. Third, the number of periods should be doubled to reflect two times the
number of annual periods. Incorporating these adjustments, the present value
is determined as follows:
PV of bond with semiannual payments =
C/2
C/2
C / 2 + Par
+
+ ... +
1
2
[1 + (k / 2)]2 n
[1 + (k / 2)] [1 + (k / 2)]
Where C/2 = the semiannual coupon payment
k/2= the periodic discount rate used to discount the bond
2n = in the denominator exponent to reflect the doubling of periods
Example 5.2
As an example of the valuation of a bond with semiannual payments, consider
a bond with $1,000 par value, a 10 percent coupon rate paid semiannually,
and three years to maturity. Assuming a 12 percent required return, the present
value is computed as follows:
78
Zimbabwe Open University
Unit 5
Bond Valuation
PV
of
bond
50
50
50
50
50
50 + 1,000
+
+
+
+
+
1
2
3
4
5
(1.06)
(1.06)
(1.06)
(1.06)
(1.06)
(1.06) 6
=
= $950.82
5.2.4 Relationships between coupon rates, required return
and bond price
Bonds that sell at a price below their par value are called discount bonds. The
larger the investor’s required rate of return relative to the coupon rate, the
larger the discount of a bond with a particular par value.
Example 5.3
Consider a zero-coupon bond with 3 years remaining to maturity and $1,000
par value. Assume the investor’s required rate of return on the bond is 13%.
The appropriate price of this bond can be determined by the present value of
its future cash flows:
PV of bond=
$0
$0
$1,000
+
+
1
2
(1.13)
(1.13)
(1.13) 3
= $693.05
The very low price of this bond is necessary to generate a 13% annualized
return to investors. If the bond offered coupon payments, the price would
have been higher because those coupon payments would provide part of the
return required by investors.
Example 5.4
Consider another bond with a similar par value and maturity that offers a 13%
coupon rate. The appropriate price of the bond would now be:
Zimbabwe Open University
79
Money and Capital Markets
Module MBAZ510
PV of bond=
$130
$130
$1,130
+
+
1
2
(1.13)
(1.13)
(1.13)3
= $1,000
Notice that the price of this bond is exactly equal to its par value. This is
because the entire compensation required by investors is provided by the
coupon payments. This type of bond is called a par value bond, where the
coupon rate is the same with the required rate of return.
Example 5.5
Finally, consider a bond with a similar par value and term to maturity and
coupon rate that offers a coupon rate of 15%, which is above the investor’s
required rate of return. The appropriate price of this bond as determined by
its present value is:
$150
$150
$1,150
PV of bond = (1.13)1 + (1.13) 2 + (1.13) 3
= $1,047.22
The price of this bond exceeds its par value because the coupon payments
are large enough to offset the high price paid for the bond and still provide a
13% annualized return.
The above examples show the following relationships:
a)
b)
c)
80
If the coupon rate of a bond is below the investor’s required rate of
return, the price of the bond should be below the par value. This type
of bond is called a discount bond.
If the coupon rate equals the investors’ required rate of return, the
price of the bond should be the same as the par value. This type of
bond is called a par value bond.
If the coupon rate of a bond is above the investors’ required rate of
return, the price of the bond should be above the par value. This is an
example of a premium bond.
Zimbabwe Open University
Unit 5
Bond Valuation
Activity 5.2
how bond price is affected by the timing of the coupon
? 1. Explain
payments.
2. Discuss the relationship between coupon rates, required rates
of return and bond prices.
3. Explain the following terms:
· discount bonds
· par value bonds
· premium bonds
5.3 Explaining Bond Price Movements
The price of a bond should reflect the present value of future cash flows
based on a required rate of return. Since the required rate of return on a bond
is primarily determined by the prevailing risk-free (R f ), which is the yield on
a treasury bond with the same maturity, and the credit risk premium (RP) on
the bond, the general price movements of bonds can be modeled as:
∆Pb = f (∆R f , ∆RP )
Where ∆Pb = a percentage change in the price of a bond
∆R f = a percentage change in the prevailing risk-free return
∆RP = a percentage change in the credit risk premium
Notice how the bond price is affected by a change in the risk-free rate or the
risk premium. An increase in the risk-free rate on bonds results in a higher
required rate of return on bonds and therefore causes bond prices to decrease.
Thus, bonds are exposed to interest rate risk or the risk that their market
value will decline in response to a rise in interest rates. An increase in the
credit (default) risk premium also results in a higher required rate of return on
bonds and therefore causes bond prices to decrease.
The following are some of the factors that affect the risk-free rate or default
risk premiums and consequently affect bond prices:
Zimbabwe Open University
81
Money and Capital Markets
Module MBAZ510
5.3.1 Factors that affect the risk-free rate
The long-term risk free rate is driven by inflationary expectations (INF),
economic growth (ECON), the money supply (MS), and the budget deficit
(DEF). This is expressed as follows:
∆ R f = f ( ∆ INF , ∆ ECON , ∆ MS , ∆ DEF )
+
+
-/+
+
Where ∆INF = a change in inflationary expectations
∆ECON = a change in economic growth
∆MS = a change in money supply
∆DEF = a change budget deficit
The general relationships are summarized below:
Impact of inflationary expectations
If the level of inflation is expected to increase, there will be upward pressure
on interest rates and therefore, on required rate of return on bonds.
Conversely, a reduction in the expected level of inflation results in downward
pressure on interest rates, and therefore on the required rate of return on
bonds.
Impact of economic growth
Strong economic growth tends to place upward pressure on interest rates,
while weak economic conditions place downward pressure on rates. Any
signals about future economic conditions will affect expectations about future
interest rate movements and cause bond markets to react immediately. For
example, any economic announcements that signal stronger than expected
economic growth tend to reduce bond prices. Investors anticipate that interest
rates will rise, thereby causing a decline in bond prices. Therefore, they sell
bonds, which places immediate downward pressure on bond prices.
Conversely, any economic announcements that signal a weaker than expected
economy tend to increase bond prices, because investors anticipate that
interest rates will decrease, causing bond prices to rise. Therefore, investors
buy bonds, which places immediate upward pressure on bond prices. This
explains why sudden news of a possible economic recession can cause the
bond market to rally.
82
Zimbabwe Open University
Unit 5
Bond Valuation
Impact of money supply growth
Increased money supply results in an increased supply of loanable funds. If
demand for loanable funds is not affected, the increased money supply should
place downward pressure on interest rates, causing bond portfolio managers
to expect an increase in bond prices and thus to purchase bonds based on
such expectations.
Impact of budget deficit
An increase in the annual budget deficit over the previous year results in a
higher level of borrowing by Governments, which can place upward pressure
on the risk-free interest rate. Increased borrowing by government can result
in a higher required return on government bonds. An increase in borrowing by
governments can indirectly affect the required rate of return and therefore the
yield on all types of bonds.
5.3.2 Factors that affect the credit risk premium
According to Frank J. Fabozzi (2007), the credit risk premium tends to be
larger for corporate or municipal bonds than for money market securities
issued by a given corporation because the probability of a corporation
experiencing financial distress is higher for a bond with a longer term to
maturity. Strong economic growth tends to improve a firm’s cash flows and
reduce the probability that the firm will default on its debt payments.
Conversely, weak economic conditions tend to reduce a firm’s cash flows
and increase the probability that it will default on its bonds. The credit risk
premium is relatively low when economic growth is strong. When the economy
is weak, however, the credit risk premium is higher, as investors will provide
credit in such periods only if they are compensated for the high degree of
credit risk.
The price of a bond can also be affected by factors specific to the issuer of
the bond, such as a change in its capital structure. If a firm that issues bonds
subsequently obtains additional loans, it may be less capable of making its
coupon payments, and its credit risk increases. Consequently, investors would
now require a higher rate of return if they were to purchase those bonds in the
secondary market, which would cause the market value (price) of the bonds
to decrease. If the bond market is efficient, this would suggest that bond
prices fully reflect all available public information. Thus, any new information
about a firm that changes its perceived ability to repay its bonds could have
an immediate effect on the price of the bonds.
Zimbabwe Open University
83
Money and Capital Markets
Module MBAZ510
Activity 5.3
the impact of a decline in interest rates on:
? 1.i. Explain
an investor’s required rate of return
ii. the present value of existing bonds
iii. the prices of existing bonds
2. Why is the relationship between interest rates and bond prices
important to financial institutions?
3. How would a financial institution with a large bond portfolio
be affected by falling interest rates? Would it be affected more
than a financial institution with a greater concentration of bonds
(and fewer short-term securities)? Explain.
4. If the coupon rate of a bond is above its required rate of
return, would its price be above or below its par value?
Explain.
5. Is the price of a long-term bond more or less sensitive to a
change in interest rates than the price of a short-term security?
Explain.
5.3.3 Sensitivity of bond prices to interest rate movements
The sensitivity of the price of a bond to interest rate movements is dependent
on the characteristics of the bond. Investors can measure the sensitivity of the
price of their bonds to interest rate movements, which will indicate the potential
damage to their bond holdings in response to an increase in interest rates.
Two common methods for assessing the sensitivity of bonds to a change in
the required rate of return on bonds are (1) bond price elasticity and (2)
duration.
Bond price elasticity
The sensitivity of bond prices (P) to changes in the required rate of return (k)
is commonly measured by the bond price elasticity (Pe), which is estimated
as:
Pe = Percent change in P
Percent change in k
84
Zimbabwe Open University
Unit 5
Bond Valuation
Table 5.1 below compares the price sensitivity of 10-year bonds with $1,000
par value and four different coupon rates: 0%, 5%, 10% and 15%. Initially,
the required rate of return (k) on the bonds is assumed to be 10%. The price
of each bond is therefore the present value of its future cash flows, discounted
at 10%. The initial price of each bond is shown in column 2. The top panel
shows the effect of a decline in interest rates that reduces the investors’ required
return to 8%. The prices of the bonds based on an 8% required return are
shown in column 3. The percentage change in the price of each bond resulting
from the interest rate movements is shown in column 4.
The bottom panel shows the effect of an increase in interest rates that increases
the investors’ required return to 12%.
The price elasticity for each bond is estimated in Table 5.1 according to the
assumed change in the required rate of return. Note that the price sensitivity
of any particular bond is greater for declining interest rates than for rising
interest rates. The bond price elasticity is negative in all cases, reflecting the
inverse relationship between interest rate movements and bond price
movements.
Zimbabwe Open University
85
Money and Capital Markets
Module MBAZ510
Table 5.1: Sensitivity of 10 year bonds with different coupon rates to
interest rate changes
EFFECTS OF A DECLINE IN THE REQUIRED RATE OF RETURN
(1)
(2)
(3)
(4)=[(3)-(2)]/(2)
(5)
(6)=(4)/(5)
BONDS
WITH
COUPON
RATE OF:
INITIAL
PRICE
OF
BONDS
WHEN
k=10 %
PRICE OF
BONDS
WHEN
PERCENTAGE
CHANGE IN
BOND PRICE
PERCENTAGE
CHANGE IN k
BOND PRICE
ELASTICITY
0%
$386
$463
+19.9%
-20.0%
-0.995
5
693
799
+15.3
-20.0
-0.765
10
1000
1134
+13.4
-20.0
-0.670
15
1307
1470
+12.5
-20.0
-0.625
e
(P )
k=8%
EFFECTS OF AN INCREASE IN THE REQUIRED RATE OF RETURN
(1)
(2)
(3)
(4)=[(3)-(2)]/(2)
(5)
(6)=(4)/(5)
BONDS
WITH
COUPON
RATE OF:
INITIAL
PRICE OF
BONDS
WHEN
k=10 %
PRICE OF
BONDS
WHEN
PERCENTAGE
CHANGE IN
BOND PRICE
PERCENTAGE
CHANGE IN k
BOND PRICE
ELASTICITY
0%
$386
$322
-16.6
+20.0%
-0.830
5
693
605
-12.7
+20.0
-0.635
10
1000
887
-11.3
+20.0
-0.565
15
1307
1170
-10.5
+20.0
-0.525
(Pe )
k=12%
Source: Jeff Madura (2010), Financial Markets and Institutions, 9th
Edition; Joe Sabatino Publishers
86
Zimbabwe Open University
Unit 5
Bond Valuation
Influence of coupon rate on bond price sensitivity
A zero-coupon bond, which pays all of its proceeds to the investor at maturity,
is most sensitive to changes in the required rate of return because the adjusted
discount rate is applied to one lump sum in the distant future. Conversely, the
price of a bond that pays all of its yield in the form of coupon payment is less
sensitive to changes in the required rate of return because the adjusted discount
rate is applied to some payments that occur in the near future. The adjustment
in the present value of such payments in the near future due to a change in the
required rate of return is not as pronounced as an adjustment in the present
value of payments in the distant future.
Influence of maturity on bond price sensitivity
As interest rates (and therefore required rates of return) decrease, long-term
bond prices (as measured by their present value) increase by a greater degree
than short-term bond prices because the long-term bonds will continue to
offer the same coupon rate over a longer period of time than short-term bonds.
Of course, if interest rates increase, prices of the long-term bonds will decline
by a greater degree.
Duration
An alternative measure of bond price sensitivity is the bond’s duration, which
is a measurement of the life of the bond on a present value basis. The longer
a bond’s duration, the greater its sensitivity to interest rate changes. A commonly
used measure of a bond’s duration (DUR) is:
n
C t (t )
∑ (1 + k )
DUR = t =n1
Ct
∑ (1 + k )
t =1
t
t
Where Ct = coupon or principal payment generated by the bond
t
k
= time at which the payments are provided
= bond’s yield to maturity, which reflects the required rate
of return by investors
The numerator of the duration formula represents the present value of future
payments, weighted by the time interval until the payments occur. The longer
the intervals until payments are made, the larger the numerator, and the larger
the duration. The denominator of the duration formula represents the discounted
future cash flows resulting from the bond, which is the present value of the
bond.
Zimbabwe Open University
87
Money and Capital Markets
Module MBAZ510
Example 5.6
The duration of a bond with $1,000 par value and a 7% coupon rate, three
years remaining to maturity, and a 9% yield to maturity is:
$70
$70( 2) $1,070(3)
+
+
1
(1.09)
(1.09) 2
(1.09) 3
DUR =
$70
$70
$1,070
+
+
1
2
(1.09)
(1.09)
(1.09) 3
= 2.80 years
By comparison, the duration of a zero-coupon bond with a similar par value
and yield to maturity is:
$1,000(3)
(1.09) 3
DUR =
$1,000
(1.09) 3
= 3 years
The duration of a zero-coupon bond is always equal to the bond’s term to
maturity. The duration of any coupon bond is always less than the bond’s
term to maturity because some of the payments occur at intervals prior to
maturity.
Activity 5.4
explain the two common methods of assessing the
? 1. Briefly
sensitivity of bonds to a change in the required rate of return
on bonds.
2. Review how the bond price elasticity is measured.
3. Briefly explain why the duration of any coupon bond is always
less than the bond’s term to maturity.
88
Zimbabwe Open University
Unit 5
Bond Valuation
Duration of a portfolio
Bond portfolio managers commonly attempt to immunise their portfolio, that
is, insulate it from the effects of interest rate movements. A first step in this
process is to determine the sensitivity of their portfolio to interest rate
movements. Once the duration of each individual bond is measured, the bond
portfolio’s duration (DURp) can be estimated as:
m
DURp = ∑ w j DUR j
j =1
Where
m = number of bonds in the portfolio
wj = bond j’s market value as a percentage of the portfolio market value
DURj = bond j’s duration
In other words, the duration of a bond portfolio is the weighted average of
bond durations, weighted according to relative market value. Financial
institutions concerned with interest rate risk may compare their asset duration
to their liability duration. A positive difference means that the market value of
the institution’s assets is more rate sensitive than the market value of its
liabilities. Thus, during a period of rising interest rates, the market value of the
assets would be reduced by a greater degree than that of the liabilities. The
institution’s real net worth (market value of net) would therefore decrease.
Modified duration
The duration measurement of a bond or a bond portfolio can be modified to
estimate the impact of a change in the prevailing bond yield on bond prices.
The modified duration (DUR*) is estimated as:
DUR* =
DUR
(1 + k )
where k represents the prevailing yield on bonds.
The modified duration can be used to estimate the percentage change in the
price of the bond in response to a 1 percentage point change in bond yields.
For example, assume that bond X has a duration of 8, while bond Y has a
duration of 12. Assuming that the prevailing bond yield is 10 percent, the
modified duration is estimated for each bond:
Zimbabwe Open University
89
Money and Capital Markets
Module MBAZ510
Bond X
DUR* =
Bond Y
8
(1 + 0.10)
= 7.27
DUR* =
12
(1 + 0.10)
= 10.9
Given the inverse relationship between the change in bond yields and the
response in bond prices, the estimate of modified duration should be applied
such that the bond price moves in the opposite direction from the change in
bond yields. According to the modified duration estimates, a 1 percentage
point increase in bond yield (from 10% to 11%) would lead to a 7.27%
decline in the price of bond X and a 10.9% decline in the price of bond Y. A
0.5 percentage point increase in yield (from 10% to 10.5%) would lead to a
3.635% decline in the price of bond X (computed as 7.27 x 0.5) and a
5.45% decline in the price of bond Y (computed as 10.9 x 0.5). The percentage
increase in bond prices in response to a decrease in bond yields is estimated
in the same manner.
The percentage change in the price of a bond in response to a change in yield
can be expressed more directly with a simple equation:
%∆P = - DUR*× ∆y
Where
%∆P = percentage change in the bond’s price
∆y = change in yield
The equation above simply expresses the relationship discussed in the
preceding paragraphs mathematically. For example, the percentage change in
price for bond X for an increase in yield of 0.2 percentage point would be:
%∆P = - 7.27 × 0.002
= - 1.45%
Thus, if interest rates rise by 0.2%, the price of bond X will drop 1.45%.
Similarly, if interest rates decrease by 0.2%, the price of bond X will increase
by 1.45% according to the modified duration estimate.
90
Zimbabwe Open University
Unit 5
Bond Valuation
Estimation errors from using modified duration
If investors rely strictly on modified duration to estimate the percentage change
in the price of a bond, they will tend to overestimate the price decline associated
with an increase in rates and underestimate the price increase associated with
a decrease in rates.
Bond convexity
A more complete formula to estimate the percentage change in price in response
to a change in yield will incorporate the property of convexity as well as
modified duration.
The estimated modified duration suggests a linear relationship in the response
of the bond price to a change in bond yields. This is shown by the straight line
in Figure 5.3 below. For a given 1 percentage point in bond yields from the
initially assumed bond yield of 10%, the modified duration predicts a specific
change in bond price. However, the actual response of the bond’s price to a
change in bond yields is convex and is represented by the curve in Figure 5.3.
Notice that if the bond yield (horizontal axis) changes slightly from the initial
level of 10%, the difference between the expected bond price adjustment
according to the modified duration estimate (the straight line in Figure 5.3)
and the bond’s actual price adjustment (the convex curve) is small.
Bond
Price
Curves (actual) relationship
between bond yield and bond prices
relationship
Linear
between bond yields
and prices based on
the modified-duration
estimate: slope
reflects a specific
percent change in
bond price for every
1.0 percentage point
change in yield
Figure 5.3: Relationship between Bond Yields and Prices
Source: Frederic S. Mishkin & Stanley G. Eakins (2006): Financial Markets
and Institutions, 5th Edition; Pearson Addison Wesley
Zimbabwe Open University
91
Money and Capital Markets
Module MBAZ510
For relatively large changes in the bond yield, however, the bond price
adjustment as estimated by modified duration is less accurate. The larger the
change in the bond yield, the larger the error from estimating the change in
bond price in response to the change in yield.
Since a change in the price of the bond in response to a change in yield is
positively related to the maturity of the bond, convexity is also more
pronounced for bonds with a long maturity. The prices of low- or zero-coupon
bonds are more sensitive to changes in yields. Similarly, bond convexity is
more pronounced for bonds with low (or no) coupon rates.
Activity 5.5
?
1.
2.
3.
4.
a.
b.
c.
5.
6.
7.
8.
92
Explain the concept of bond price elasticity.
Determine how the bond elasticity would be affected if the
bond price changed by a larger amount, holding the change in
the required rate of return constant.
An analyst recently suggested that there will be a major
economic expansion, which will favorably affect the prices of
high-rated fixed rate bonds, because the credit risk of bonds
will decline as corporations improve their performance.
Assuming that the economic expansion occurs, do you agree
with the analyst’s conclusion? Explain.
Assume the following information for an existing bond that
provides annual coupon payments:
Par value = $1 000
Coupon rate = 11%
Maturity = 4 years
Required rate of return by investors = 11%
What is the present value of the bond?
If the required rate of return by investors were 14% instead
of 11%, what would be the present value of the bond?
If the required rate of return by investors were 9%, what
would be the present value of the bond?
Assume that you require a 14% return on a zero-coupon bond
with a par value of $1 000 and 6 years to maturity. What is the
price you should be willing to pay for this bond?
Determine how the duration of a bond would be affected if
the coupons are extended over additional time periods.
A bond has a duration of 5 years and a yield to maturity of
9%. If the yield to maturity changes to 10%, what should be
the percentage price change of the bond?
Describe how bond convexity affects the theoretical linear
price-yield relationship of bonds. What are the implications of
bond convexity for estimating changes in bond prices?
Zimbabwe Open University
Unit 5
Bond Valuation
5.4 Summary
The value of a bond is the present value of future cash flows generated by that
security, using a discount rate that reflects the investor’s required rate of return.
The discounted value of bond payments declines when a higher discount rate
is applied. Bond prices are affected by the factors that influence interest rate
movements, including economic growth, money supply, changes in credit risk
and so on. Two methods commonly used in measuring the sensitivity of bond
portfolios to interest rate movements are bond price elasticity and duration.
Zimbabwe Open University
93
Money and Capital Markets
Module MBAZ510
References
Chisholm, A. M. (2009). Introduction to International Capital Markets.
2nd Edition. London: John Wiley and Sons.
Choudhry, M. et al (2010). Capital Market Instruments: Analysis and
Valuation. 3rd Edition. London: Palgrave Macmillan.
Frank J. Fabozzi (2007). Fixed Income Analysis. 2nd Edition. John Wiley
and Sons.
Levinson, M. (2006). Guide to Financial Markets. 4th Edition. London: Profile
Books Limited.
Madura, J. (2010). Financial Markets and Institutions. 9th Edition Florida:
South- Western College.
Mishkin, F.S. & Eakins, S.G. (2006). Financial Markets and Institution.
5th Edition New York: Pearson Addison Wesley.
94
Zimbabwe Open University
Unit Six
Risks Associated with Investing
in Bonds
6.0 Introduction
A
rmed with an understanding of the basic features of bonds, we now turn
to the risks associated with investing in bonds. These risks include interest
rate risk, call and prepayment risk, yield curve risk, reinvestment risk, credit
risk, liquidity risk, exchange-rate risk, volatility risk, inflation or purchasing
power risk, event risk and sovereign risk. These risks are discussed in this
unit.
Money and Capital Markets
Module MBAZ510
6.1 Objectives
By the end of this unit, you should be able to:










discuss the various risks associated with investing in bonds
explain why there is an inverse relationship between a
change in interest rates and bond prices
identify the relationships among a bond’s coupon rate,
yield required by the market, and price relative to par
value (that is, discount, premium, or par value)
explain the relationship among the price of a callable bond,
the price of an option-free bond, and the price of the
embedded call option
outline the factors that affect the reinvestment risk of a
security;
give the disadvantages of a callable and prepayable
security to an investor
explain why prepayable amortizing securities expose
investors to greater reinvestment risk than non-amortizing
securities
describe the types of credit risk: default risk, credit spread
risk, and downgrade risk
discuss the various forms of event risk
describe the components of sovereign risk
6.2 Interest Rate Risk
The price of a typical bond will change in the opposite direction to the change
in interest rates or yields. That is, when interest rates rise, the bond price will
fall; when interest rates fall, the bond price will rise. For example, consider a
6%, 20-year bond. If the yield investors require to buy this bond is 6%, the
price of this bond would be $100. However, if the required yield increased to
6.5%, the price of this bond would decline to $94.4479. Thus, for a 50 basis
point increase in yield, the bond price declines by 5.55%. If, instead, the yield
declines from 6% to 5.5%, the bond price will rise by 6.02% to $106.0195.
Since the price of a bond fluctuates with market interest rates, the risk that an
investor faces is that the price of a bond held in a portfolio will decline if
market interest rates rise. This risk is referred to as interest rate risk and is the
major risk faced by investors in the bond market.
96
Zimbabwe Open University
Unit 6
Risks Associated with Investing in Bonds
6.2.1 Reason for the inverse relationship between changes
in interest rates and bond price
The reason for this inverse relationship between bond price change and the
change in interest rates (or change in market yields) is as follows. Suppose
investor X purchases a hypothetical 6% coupon 20-year bond at a price
equal to par (100). The yield for this bond is 6%. Suppose that immediately
after the purchase of this bond two things happen. First, market interest rates
rise to 6.50%, so that if a bond issuer wishes to sell a bond priced at par, it
will require a 6.50% coupon rate to attract investors to purchase the bond.
Second, suppose investor X wants to sell the bond with a 6% coupon rate. In
attempting to sell the bond, investor X would not find an investor who would
be willing to pay par value for a bond with a coupon rate of 6%. The reason
is that any investor who wanted to purchase this bond could obtain a similar
20-year bond with a coupon rate 50 basis points higher, 6.5%.
What can the investor do? The investor cannot force the issuer to change the
coupon rate to 6.5%, neither can the investor force the issuer to shorten the
maturity of the bond to a point where a new investor might be willing to
accept a 6% coupon rate. The only thing that the investor can do is adjust the
price of the bond to a new price where a buyer would realize a yield of 6.5%.
This means that the price would have to be adjusted down to a price below
par. It turns out the new price must be $94.4479. While we assumed in our
illustration an initial price of par value, the principle holds for any purchase
price. Regardless of the price that an investor pays for a bond, an instantaneous
increase in market interest rates will result in a decline in bond price.
Suppose that instead of a rise in market interest rates to 6.5%, interest rates
decline to 5.5%. Investors would be more than happy to purchase the 6%
coupon 20-year bond at par. However, investor X realizes that the market is
only offering investors the opportunity to buy a similar bond at par with a
coupon rate of 5.5%. Consequently, investor X will increase the price of the
bond until it offers a yield of 5.5%. That price turns out to be $106.0195.
Activity 6.1
the various risks associated with investing in
? 1. Explain
bonds.
2.
Zimbabwe Open University
Explain why there is an inverse relationship between
changes in interest rates and bond prices.
97
Money and Capital Markets
Module MBAZ510
6.2.2 Bond features that affect interest rate risk
Bond price sensitivity to change in market interest rates (that is, a bond’s
interest rate risk) depends on various features of the issue, such as maturity,
coupon rate, and embedded options.
The impact of maturity
Holding all other factors constant, the longer the bond’s maturity the greater
the bond price sensitivity to change in interest rates. For example, we know
that for a 6% 20-year bond selling to yield 6%, a rise in the yield required by
investors to 6.5% will cause the bond price to decline from $100 to $94.4479,
a 5.55% price decline. Similarly for a 6% 5-year bond selling to yield 6%, the
price is 100. A rise in the yield required by investors from 6% to 6.5% would
decrease the price to $97.8944. The decline in the bond price is only 2.11%.
The impact of coupon rate
Holding all other factors constant, the lower the coupon rate the greater the
bond price sensitivity to change in interest rates. For example, consider a 9%
20-year bond selling to yield 6%. The price of this bond would be $134.6722.
If the yield required by investors increases by 50 basis points to 6.5%, the
price of this bond would fall by 5.13% to $127.7605. This decline is less than
the 5.55% decline for the 6% 20-year bond selling to yield 6% discussed
above.
An implication is that zero-coupon bonds have greater price sensitivity to
interest rate changes than same-maturity bonds bearing a coupon rate and
trading at the same yield.
The impact of embedded options
The value of a bond with embedded options will change depending on how
the value of the embedded options changes when interest rates change. As
interest rates decline, the price of a callable bond may not increase as much
as an otherwise option-free bond (that is, a bond with no embedded options).
To understand why, let us decompose the price of a callable bond into two
components, as shown below:
price of callable bond = price of option-free bond minus price of
embedded call option
98
Zimbabwe Open University
Unit 6
Risks Associated with Investing in Bonds
The reason for subtracting the price of the embedded call option from the
price of the option-free bond is that the call option is a benefit to the issuer
and a disadvantage to the bondholder. This reduces the price of a callable
bond relative to an option-free bond.
Now, when interest rates decline, the price of an option-free bond increases.
However, the price of the embedded call option in a callable bond also increases
because the call option becomes more valuable to the issuer. So, when interest
rates decline both price components increase in value, but the change in the
price of the callable bond depends on the relative price change between the
two components. Typically, a decline in interest rates will result in an increase
in the price of the callable bond but not by as much as the price-change of an
otherwise comparable option-free bond.
Similarly, when interest rates rise, the price of a callable bond will not fall as
much as an otherwise option-free bond. The reason is that the price of the
embedded call option declines. So, when interest rates rise, the price of the
option-free bond declines but this is partially offset by the decrease in the
price of the embedded call option component.
The impact of the yield level
Because of credit risk (discussed later), different bonds trade at different
yields, even if they have the same coupon rate, maturity, and embedded
options. How then, holding other factors constant, does the level of interest
rates affect bond price sensitivity to changes in interest rates? As it turns out,
the higher a bond yield, the lower the price sensitivity.
To see this, we compare a 6% 20-year bond initially selling at a yield of 6%,
and a 6% 20-year bond initially selling at a yield of 10%. The former is initially
at a price of $100, and the latter $65.68. Now, if the yield for both bonds
increases by 100 basis points, the first bond trades down by 10.68 points
(10.68%) to a price of $89.32. The second bond will trade down to a price
of 59.88, for a price decline of only 5.80 points (or 8.83%). Thus, we see
that the bond that trades at a lower yield is more volatile in both percentage
price change and absolute price change, as long as the other bond
characteristics are the same. An implication of this is that, for a given change
in interest rates, price sensitivity is lower when the level of interest rates in the
market is high, and price sensitivity is higher when the level of interest rates is
low.
Zimbabwe Open University
99
Money and Capital Markets
Module MBAZ510
Activity 6.2
the bond features that affect interest rate risk.
? 1.2. Identify
Describe the relationship between bond price and bond
3.
4.
a.
b.
maturity.
What impact does coupon rate have on bond price?
Explain the relationship between bond prices and:
embedded options
the yield level
6.3 Yield Curve Risk
We know that if interest rates or yields in the market change, the price of a
bond will change. One of the factors that will affect how sensitive bond price
is to changes in yield is the bond’s maturity. A portfolio of bonds is a collection
of bond issues typically with different maturities. So, when interest rates change,
the price of each bond issue in the portfolio will change and the portfolio’s
value will change.
There is not one interest rate or yield in the economy. There is a structure of
interest rates. One important structure is the relationship between yield and
maturity. The graphical depiction of this relationship is called the yield curve.
When interest rates change, they typically do not change by an equal number
of basis points for all maturities.
The point here is that portfolios have different exposures to how the yield
curve shifts. This risk exposure is called yield curve risk. The implication is
that any measure of interest rate risk that assumes that the interest rates changes
by an equal number of basis points for all maturities (referred to as a ‘‘parallel
yield curve shift’’) is only an approximation.
6.4 Call and Prepayment Risk
A bond may include a provision that allows the issuer to retire, or call, all or
part of the issue before the maturity date. From the investor’s perspective,
there are three disadvantages to call provisions:

100
The cash flow pattern of a callable bond is not known with certainty
because it is not known when the bond will be called.
Zimbabwe Open University
Unit 6
Risks Associated with Investing in Bonds


Because the issuer is likely to call the bonds when interest rates
have declined below the bond’s coupon rate, the investor is exposed
to reinvestment risk, i.e., the investor will have to reinvest the
proceeds when the bond is called at interest rates lower than the
bond’s coupon rate.
The price appreciation potential of the bond will be reduced relative
to an otherwise comparable option-free bond. (This is called price
compression.)
Because of these three disadvantages faced by the investor, a callable bond is
said to expose the investor to call risk. The same disadvantages apply to
mortgage-backed and asset-backed securities where the borrower can prepay
principal prior to scheduled principal payment dates. This risk is referred to
as prepayment risk.
6.5 Reinvestment Risk
Jabozzi (2007) defines reinvestment risk as the risk that the proceeds received
from the payment of interest and principal (i.e., scheduled payments, called
proceeds, and principal prepayments) that are available for reinvestment must
be reinvested at a lower interest rate than the security that generated the
proceeds. We already saw how reinvestment risk is present when an investor
purchases a callable or principal prepayable bond. When the issuer calls a
bond, it is typically done to lower the issuer’s interest expense because interest
rates have declined after the bond is issued. The investor faces the problem of
having to reinvest the called bond proceeds received from the issuer in a
lower interest rate environment.
When dealing with amortizing securities (that is, securities that repay principal
periodically), reinvestment risk is even greater. Typically, amortizing securities
pay interest and principal monthly and permit the borrower to prepay principal
prior to schedule payment dates. Now the investor is more concerned with
reinvestment risk due to principal prepayments usually resulting from a decline
in interest rates, just as in the case of a callable bond. However, since payments
are monthly, the investor has to make sure that the interest and principal can
be reinvested at no less than the computed yield every month as opposed to
semiannually.
With an understanding of reinvestment risk, we can now appreciate why zerocoupon bonds may be attractive to certain investors. Because there are no
coupon payments to reinvest, there is no reinvestment risk. That is, zeroZimbabwe Open University
101
Money and Capital Markets
Module MBAZ510
coupon bonds eliminate reinvestment risk. Elimination of reinvestment risk is
important to some investors. That is, the plus side of the risk equation. The
minus side is that, the lower the coupon rate the greater the interest rate risk
for two bonds with the same maturity. Thus, zero-coupon bonds of a given
maturity expose investors to the greatest interest rate risk.
6.6 Credit Risk
An investor who lends funds by purchasing a bond issue is exposed to credit
risk. There are three types of credit risk:
a)
b)
c)
default risk
credit spread risk
downgrade risk
6.6.1 Default risk
Default risk is defined as the risk that the issuer will fail to satisfy the terms of
the obligation with respect to the timely payment of interest and principal.
Studies have examined the probability of issuers defaulting. The percentage
of a population of bonds that is expected to default is called the default rate.
If a default occurs, this does not mean the investor loses the entire amount
invested. An investor can expect to recover a certain percentage of the
investment. This is called the recovery rate. Given the default rate and the
recovery rate, the estimated expected loss due to a default can be computed.
6.6.2 Credit spread risk
Even in the absence of default, an investor is concerned that the market value
of a bond will decline and/or the price performance of a bond will be worse
than that of other bonds. To understand this, recall that the price of a bond
changes in the opposite direction to the change in the yield required by the
market. Thus, if yields in the economy increase, the price of a bond declines,
and vice versa.
The yield on a bond is made up of two components: (1) the yield on a similar
default-free bond issue and (2) a premium above the yield on a default-free
bond issue necessary to compensate for the risks associated with the bond.
The risk premium is referred to as a yield spread. The part of the risk premium
or yield spread attributable to default risk is called the credit spread.
102
Zimbabwe Open University
Unit 6
Risks Associated with Investing in Bonds
The price performance of a non-Treasury bond issue and the return over
some time period will depend on how the credit spread changes. If the credit
spread increases, investors say that the spread has ‘‘widened’’ and the market
price of the bond issue will decline. The risk that an issuer’s debt obligation
will decline due to an increase in the credit spread is called credit spread
risk.
6.6.3 Downgrade risk
While portfolio managers seek to allocate funds among different sectors of
the bond market to capitalize on anticipated changes in credit spreads, an
analyst investigating the credit quality of an individual issue is concerned with
the prospects of the credit spread increasing for that particular issue. But how
does the analyst assess whether he or she believes the market will change the
credit spread associated with an individual issue?
One tool investors use to gauge the default risk of an issue is the credit ratings
assigned to issues by rating companies, popularly referred to as rating agencies.
According to Jabozzi (2007), a credit rating is an indicator of the potential
default risk associated with a particular bond issue or issuer. It represents in a
simplistic way the credit rating agency’s assessment of an issuer’s ability to
meet the payment of principal and interest in accordance with the terms of the
indenture.
Bonds rated triple A (AAA or Aaa) are prime grade; double A (AA or Aa)
are of high quality grade; single A issues are called upper medium grade,
and triple B are lower medium grade. Lower-rated bonds are said to have
speculative grade elements or to be distinctly speculative grade.
Bond issues that are assigned a rating in the top four categories (that is, AAA,
AA, A, and BBB) are referred to as investment-grade bonds. Issues that
carry a rating below the top four categories are referred to as non-investmentgrade bonds or speculative bonds, or more popularly as high yield bonds or
junk bonds.
Once a credit rating is assigned to a debt obligation, a rating agency monitors
the credit quality of the issuer and can reassign a different credit rating. An
improvement in the credit quality of an issue or issuer is rewarded with a
better credit rating, referred to as an upgrade; deterioration in the credit rating
of an issue or issuer is penalised by the assignment of an inferior credit rating,
referred to as a downgrade. An unanticipated downgrading of an issue or
issuer increases the credit spread and results in a decline in the price of the
Zimbabwe Open University
103
Money and Capital Markets
Module MBAZ510
issue or the issuer’s bonds. This risk is referred to as downgrade risk and is
closely related to credit spread risk.
Activity 6.3
the two major forms of reinvestment risk for those
? 1. Explain
investing in callable bonds.
2.
3.
4.
5.
Discuss the three major disadvantages of call provisions
with reference to bonds.
Explain the three types of credit risk.
Investors are exposed to credit risk when they purchase
a bond. However, even if an issuer does not default on
its obligation prior to its maturity date, there is still a
concern about how credit risk can adversely impact the
performance of a bond. Explain.
A Zimbabwean portfolio manager is considering investing
in Japanese government bonds denominated in yen. What
are the major risks associated with this investment?
6.7 Liquidity Risk
When an investor wants to sell a bond prior to the maturity date, he or she is
concerned with whether or not the bid price from broker/dealers is close to
the indicated value of the issue. For example, if recent trades in the market for
a particular issue have been between $90 and $90.5 and market conditions
have not changed, an investor would expect to sell the bond somewhere in
the $90 to $90.5 range.
According to Choudhry and Pienaar (2010), liquidity risk is the risk that the
investor will have to sell a bond below its indicated value, where the indication
is revealed by a recent transaction. The primary measure of liquidity is the size
of the spread between the bid price (the price at which a dealer is willing to
buy a security) and the ask price (the price at which a dealer is willing to sell
a security). The wider the bid-ask spread, the greater the liquidity risk.
104
Zimbabwe Open University
Unit 6
Risks Associated with Investing in Bonds
6.8 Currency Risk (Exchange Rate Risk)
A bond whose payments are not in the domestic currency of the portfolio
manager has unknown cash flows in his or her domestic currency. The cash
flows in the manager’s domestic currency are dependent on the exchange
rate at the time the payments are received from the issuer. For example,
suppose a portfolio manager’s domestic currency is the U.S. dollar and that
manager purchases a bond whose payments are in Japanese yen. If the yen
depreciates relative to the U.S. dollar at the time a payment is made, then
fewer U.S. dollars can be exchanged.
The risk of receiving less of the domestic currency when investing in a bond
issue that makes payments in a currency other than the manager’s domestic
currency is called exchange rate risk or currency risk.
6.9 Inflation or Purchasing Power Risk
Inflation risk or purchasing power risk arises from the decline in the value of a
security’s cash flows due to inflation, which is measured in terms of purchasing
power. For example, if an investor purchases a bond with a coupon rate of
5%, but the inflation rate is 3%, the purchasing power of the investor has not
increased by 5%. Instead, the investor’s purchasing power has increased by
only about 2%. For all but inflation protection bonds, an investor is exposed
to inflation risk because the interest rate the issuer promises to make is fixed
for the life of the issue.
6.10 Volatility Risk
In the previous discussion of the impact of embedded options on the interest
rate risk of a bond, it was said that a change in the factors that affect the value
of the embedded options will affect how the bond price will change. Earlier,
we looked at how a change in the level of interest rates will affect the price of
a bond with an embedded option. But there are other factors that will affect
the price of an embedded option.
A major factor affecting the value of an option is ‘‘expected volatility.’’ In the
case of an option on common stock, expected volatility refers to ‘‘expected
price volatility.’’ The relationship is as follows: the greater the expected price
volatility, the greater the value of the option. The same relationship holds for
options on bonds. However, instead of expected price volatility, for bonds it
Zimbabwe Open University
105
Money and Capital Markets
Module MBAZ510
is the ‘‘expected yield volatility.’’ The greater the expected yield volatility, the
greater the value (price) of an option.
Now let us tie this into the pricing of a callable bond. We repeat the formula
for the components of a callable bond below:
Price of callable bond = Price of option-free bond minus Price of
embedded call option
If expected yield volatility increases, holding all other factors constant, the
price of the embedded call option will increase. As a result, the price of a
callable bond will decrease (because the former is subtracted from the price
of the option-free bond).
To see how a change in expected yield volatility affects the price of a putable
bond, we can write the price of a putable bond as follows:
Price of putable bond = Price of option-free bond + Price of embedded
put option
A decrease in expected yield volatility reduces the price of the embedded put
option and therefore will decrease the price of a putable bond. Thus, the
volatility risk of a putable bond is that expected yield volatility will decrease.
The risk that the price of a bond with an embedded option will decline when
expected yield volatility changes is called volatility risk.
6.11 Event Risk
Occasionally the ability of an issuer to make interest and principal payments
changes dramatically and unexpectedly because of factors including the
following:



a natural disaster (such as an earthquake or hurricane) or an industrial
accident that impairs an issuer’s ability to meet its obligations
a takeover or corporate restructuring that impairs an issuer’s ability
to meet its obligations
a regulatory change that impairs an issuer’s ability to meet its
obligations (regulatory risk)
These factors are commonly referred to as event risk.
106
Zimbabwe Open University
Unit 6
Risks Associated with Investing in Bonds
6.12Sovereign Risk
When an investor acquires a bond issued by a foreign entity the investor faces
sovereign risk.
This is the risk that, as a result of actions of the foreign government, there may
be either a default or an adverse price change even in the absence of a default.
This is analogous to the forms of credit risk described in the previous section
- credit risk spread and downgrade risk. That is, even if a foreign government
does not default, actions by a foreign government can increase the credit risk
spread sought by investors or increase the likelihood of a downgrade. Both
of these will have an adverse impact on the bond price.
Sovereign risk consists of two parts. First is the unwillingness of a foreign
government to pay. A foreign government may simply repudiate its debt. The
second is the inability to pay due to unfavorable economic conditions in the
country. Historically, most foreign government defaults have been due to a
government’s inability to pay rather than unwillingness to pay.
Activity 6.4
why a callable bond’s price would be expected
? 1. Explain
to decline less than an otherwise comparable option-free
2.
3.
4.
Zimbabwe Open University
bond when interest rates rise?
Explain how certain types of event risk can result in
downgrade risk.
Comment on the following statement: ‘‘Sovereign risk is
the risk that a foreign government defaults on its
obligation.’’
A portfolio manager is considering the purchase of a new
type of bond. The bond is extremely complex in terms of
its embedded options. Currently, there is only one dealer
making a market in this type of bond. In addition, the
manager plans to finance the purchase of this bond by
using the bond as collateral. The bond matures in five
years and the manager plans to hold the bond for five
years. Because the manager plans to hold the bond to its
maturity, he has indicated that he is not concerned with
liquidity risk. Explain why you agree or disagree with the
manager’s view that he is not concerned with liquidity
risk.
107
Money and Capital Markets
Module MBAZ510
Smith and Jane Brody are assistant portfolio
? 5. John
managers. The senior portfolio manager has asked them
·
·
·
a)
b)
to consider the acquisition of one of two option-free bond
issues with the following characteristics:
Issue 1 has a lower coupon rate than Issue 2
Issue 1 has a shorter maturity than Issue 2
Both issues have the same credit rating.
Smith and Brody are discussing the interest rate risk of
the two issues. Smith argues that Issue 1 has greater
interest rate risk than Issue 2 because of its lower coupon
rate. Brody counters by arguing that Issue 2 has greater
interest rate risk because it has a longer maturity than
Issue 1.
Which assistant portfolio manager is correct with respect
of their selection to the issue with the greater interest rate
risk? Explain your answer.
Suppose that you are the senior portfolio manager. How
would you suggest that Smith and Brody determine which
issue has the greater interest rate risk?
6.13 Summary
Bonds are debt securities associated with a multitude of risks, which include
interest rate risk, credit risk, volatility risk, prepayment risk, event risk, sovereign
risk, currency risk, reinvestment risk, liquidity risk, among others. The price
of a bond changes inversely with a change in market interest rates. Interest
rate risk refers to the adverse price movement of a bond as a result of a
change in market interest rates; for the bond investor typically it is the risk that
interest rates will increase. A bond’s interest rate risk depends on the features
of the bond: maturity, coupon rate, yield, and embedded options. All other
factors constant, the longer the bond’s maturity, the greater is the bond price
sensitivity to changes in interest rates.
108
Zimbabwe Open University
Unit 6
Risks Associated with Investing in Bonds
References
Chisholm, A. M. (2009). Introduction to International Capital Markets.
2nd Edition. London: John Wiley and Sons.
Choudhry, M. et al (2010). Capital Market Instruments: Analysis and
Valuation. 3rd Edition. London: Palgrave Macmillan.
Frank J. Fabozzi (2007). Fixed Income Analysis. 2nd Edition.John Wiley
and Sons.
Levinson, M. (2006). Guide to Financial Markets. 4th Edition. London:
Profile Books Limited.
Madura, J. (2010). Financial Markets and Institutions. 9th Edition. Florida:
South-Western College.
Mishkin, F.S. & Eakins, S.G. (2006). Financial Markets and Institution.
5th Edition. New York: Pearson Addison Wesley.
Zimbabwe Open University
109
Blank page
Unit Seven
Equity Markets
7.0 Introduction
E
quity markets facilitate the flow of funds from individuals or institutional
investors to corporations. Thus, they enable corporations to finance their
investments in new or expanded business ventures. They also facilitate the
flow of funds between investors. In this unit, we are going to describe stock
offerings and explain how participants in the stock market monitor firms that
have publicly traded stock.
Money and Capital Markets
7.1 Objectives
Module MBAZ510
By the end of this unit, you should be able to:





explain how stock markets facilitate secondary market
trading
describe investor participation in the stock markets
outline the process of initial public offerings
discuss the process of secondary offerings
describe the globalisation of stock markets
7.2 Private Equity
When a firm is created, its founders typically invest their own money in the
business. The founders may also invite some family or friends to invest equity
in the business. This is referred to as private equity, as the business is privately
held, and the owners cannot sell their shares to the public.
7.2.1 Motivations for private equity
A public offering of stock may be feasible only if the firm has a large
shareholder-base to support an active secondary market. With an inactive
secondary market, the shares would be illiquid. Investors will be forced to
sell their shares at a discount from the fundamental value. In addition, there
are many fixed costs associated with going public, which might be prohibitive
for a firm that is raising only a small amount of funds.
7.2.2 Venture capital funds
Private firms that need huge equity investments but are not yet in a position to
go public may obtain funding from venture capitalists. Venture capitalists receive
money from wealthy investors who are willing to maintain the investment for a
long-term period, such as 5 or 10 years. These investors are not allowed to
withdraw their money before a specified deadline.
The venture capital market brings together the private businesses that need
equity funding and the venture capitalists that can provide funding. One way
of doing this is through venture capital conferences where each business briefly
makes its pitch as to why it will be very successful if it receives equity funding.
Alternatively, businesses may submit proposals to venture capitalists.
112
Zimbabwe Open University
Unit 7
Equity Markets
Terms of a venture capital deal
Once a venture capitalist has identified a viable business, it negotiates the
terms of its investment, including the amount being invested. It will set out
clear requirements that the firm must meet such as providing detailed periodic
reports. It may also insist on seconding its members on the board of directors
of that firm to monitor business operations.
Exit strategy
Once the business gets well established within the agreed time frame, the
venture capitalists have to exit the business and look for new businesses. One
common exit strategy is to sell its equity stake to the public after the business
engages in a public stock offering. Alternatively, the investors may cash out if
the company is acquired by another firm. Thus, venture capitalists serve as a
bridge for financing the business until the business either goes public or is
acquired.
7.3 Public Equity
When a firm goes public, it issues stock in the primary market in exchange for
cash. Going public has two effects on the firm. First, it changes the firm’s
ownership structure by increasing the number of owners. Second, it changes
the firm’s capital structure by increasing the equity investment in the firm,
which allows the firm to either pay off some its debt or expand its operations.
7.4 Equity Markets
The stock markets are like other financial markets in that they link surplus
units with deficit units. Firms issue new stock so that they will have sufficient
funds to expand their operations. The massive growth in the stock market has
enabled many firms to expand to a much greater degree and has allowed
investors to share in the profitability of firms.
In addition to the primary market, which facilitates new financing for firms,
there is also a secondary market that allows investors to sell the stock they
previously purchased to other investors who want to buy the stock. Thus, the
secondary market creates liquidity for investors who invest in stocks. Investors
also receive periodic dividends from the firms in which they invest.
Zimbabwe Open University
113
Money and Capital Markets
Module MBAZ510
7.5 Participation in Stock Markets
Investors are normally in two groups, that is, individual and institutional
investors. Institutional investors hold large amounts of stock as they have
huge financial resources. Their collective sales or purchases usually significantly
affect stock market prices.
7.5.1 How investor decision affect stock prices
Investors make decisions to buy a stock when its market price is below their
valuation, which means they believe the stock is undervalued. They may sell
their holdings of a stock when the market price is above their valuation. Thus,
stock valuation drives their investment decisions. Investors commonly disagree
on how to value stock. Some investors may believe a stock is undervalued
while others believe it is overvalued. This difference in opinion allows for
market trading, as this ensures that there will be buyers and sellers of the
same stock at a given point in time. The law of supply and demand for shares
determines the ultimate market prices of shares. However, stock transactions
between investors in the secondary market do not affect the capital structure
of the issuer, but merely transfer shares from one investor to another.
7.5.2 Investor reliance on information
Investors respond to the release of new information that affects their opinion
about a firm’s future performance. Generally, favorable news about the firm’s
performance will make investors believe that the firm’s stock is undervalued
at its prevailing price. The demand for shares of that stock will increase, placing
upward pressure on the price. Unfavorable news will have the opposite effect.
Activity 7.1
?
1.
2.
3.
4.
5.
114
What purpose do equity markets serve?
Explain what is meant by private equity.
Under what circumstances is a public offering of stock
feasible?
Why would people or firms prefer to go for private equity?
Explain how investor decisions affect stock prices.
Zimbabwe Open University
Unit 7
Equity Markets
7.6 Initial Public Offerings (IPO)
This is a first-time offering of shares by a specific firm to the public. An IPO is
commonly used not only to obtain new funding but also to offer some founders
and venture capitalists a way to cash out their investment.
7.6.1 Process of going public
Firms that engage in an IPO are not well known to investors, and must therefore
provide detailed information about their operations and financial condition.
Securities firms are normally hired to serve as lead underwriters for the IPO.
The lead underwriter is involved in the development of the prospectus and the
pricing and placement of the shares.
Developing a prospectus
The lead underwriter develops a detailed prospectus that provides information
about the firm which includes financial statements and a discussion of the risks
involved. It is intended to provide potential investors with the information they
need to decide whether or not to invest in the firm. Once the prospectus is
developed, the issuing firm and the lead underwriter extensively engage on
promotional activities. Institutional investors are the main target of these
promotional programs because they usually buy large blocks of shares at the
time of the IPO.
Pricing
The lead underwriter determines the so-called offer price at which the shares
will be offered at the time of the IPO. The price that investors are willing to
pay per share is influenced by prevailing market and industry conditions. During
the road show, the lead underwriter solicits indications of interest in the IPO
by institutional investors as to the number of shares that they demand at various
possible offer prices. This process is referred to as book-building. As a result
of the bookuilding process for setting an offer price, many institutional investors
pay a lower price than they would have been willing to pay for the shares. In
other cases, an auction process is used for IPOs, and investors pay whatever
they bid for the shares. The top bidder’s order is accommodated first, followed
by the next highest bidder, and so on, until all shares are issued.
7.6.2 Abuses in the IPO market
The following are some of the common abuses in the IPO Market:
Zimbabwe Open University
115
Money and Capital Markets
Module MBAZ510
Spinning
This occurs when the underwriter allocates shares from IPO to corporate
executives who may be considering an IPO or other business that will require
the help of a securities firm. The underwriter hopes that the executives will
remember the favor and hire the securities firm in the future.
Laddering
When there is substantial demand for an IPO, some brokers engage in
laddering; that is, they encourage investors to place first-day bids for the
shares that are above the offer price. This helps to build upward price
momentum. Some investors may be willing to participate to ensure that the
broker will reserve some shares of the next hot IPO for them.
Excessive commissions
Some brokers charge excessive commissions when demand is high for an
IPO. Investors are willing to pay the price because they could normally recover
the cost from the return on the first day. Since the underwriter set an offer
price significantly below the market price that would occur by the end of the
first day of trading, investors are willing to accommodate the brokers. The
gain to the brokers is a loss to the issuing firm, however, because its proceeds
were less than they would have been if the offer price had been set higher.
7.7 Secondary Stock Offerings
A secondary offering is a new stock offering by a specific firm whose stock is
already publicly traded. Firms engage in secondary stock offerings to raise
more equity so that they can more easily expand their operations. Many
secondary offerings cause the market price of the shares to decline on the day
of the offering, which reflects the new price at which the increased supply of
shares in the market is equal to the demand for the shares. Because of the
potential for a decline in the equilibrium price of all its shares, a firm considering
a secondary stock offering generally monitors stock market movements. It
prefers to issue new stock when the market price of its outstanding shares is
relatively high and the general outlook for the firm is favorable. Under these
conditions, it can issue new shares at a relatively high price, which will generate
more funds for a given amount of shares issued.
116
Zimbabwe Open University
Unit 7
Equity Markets
7.8 Stock Repurchases
The notion of asymmetric information means that a firm’s managers have
information about the firm’s future prospects that is not known by the firm’s
investors. When firms believe that their stock is undervalued, they can use the
firm’s excess cash to purchase a portion of its shares in the market at a relatively
low price based on their valuation of what the shares are really worth. Firms
tend to repurchase some of their shares when share prices are at very low
levels.
Just as firms may issue new shares, they may also undertake to acquire their
own shares from willing sellers, a process known as a repurchase or a buyback. A repurchase may be undertaken for several reasons:
a)
b)
c)
d)
e)
a firm may wish to repurchase all of its own shares and become a
privately owned corporation
a partial share repurchase is often used to boost a sagging share price,
particularly because it signals to the market that the company’s own
managers, who presumably know its prospects best, consider the shares
undervalued
a repurchase gives the firm a way to return excess capital to shareholders.
Many countries give favourable tax treatment to gains from the sale of
securities, known as capital gains. In such a case, taxable shareholders
will benefit if capital is returned via a share repurchase rather than through
a dividend
some firms repurchase shares for the purpose of using them in employee
compensation programmes
some repurchase offers are aimed at investors who own only a small
number of shares in order to reduce the expense of dealing with small
shareholders
Activity 7.2
the key steps involved in the IPO.
? 1.2. Describe
Describe the common abuses in the IPO market.
3.
4.
Zimbabwe Open University
Explain the process of secondary stock offering.
Why do firms engage in stock repurchases?
117
Money and Capital Markets
Module MBAZ510
7.9 Stock Exchanges
Stock exchanges are usually in two forms, namely organized exchanges and
over-the-counter exchanges.
7.9.1 Organised exchanges
Organised exchanges have a trading floor where floor traders buy and sell
securities for their clients. These brokers can match orders of buyers and
sellers. In addition, these traders can buy and sell stock for their own account
and thereby create more liquidity for the stock. In other words, each trader
can act as both a seller and a buyer. The trading that takes place on the floor
of an exchange resembles an auction.
7.9.2 Over-the-counter market (OTC)
This market is not organized in the sense of having a building where trading
takes place. Unlike the organized exchanges, the OTC market does not have
a trading floor. Instead, the buy and sell orders are completed through a
telecommunications network. Because there is no trading floor, it is not
necessary to buy a seat to trade on this exchange. Stocks not listed on the
organised exchanges are traded in the OTC market. Like the organised
exchanges, the OTC markets also facilitate secondary market transactions.
7.9.3 Organised versus over-the-counter trading
Whereas organised exchanges have specialists who facilitate trading, overthe-counter markets have market makers. Rather than trading stocks in an
auction format, they trade on an electronic network where bid and ask prices
are set by the market makers.
Stock exchanges provide a more organised way to trade shares. They are
generally superior to the OTC market for several reasons. First, they bring
many investors together, offering greater liquidity and thus making it possible
to obtain better prices. Second, the exchange is able to obtain and publish the
prices at which trades have occurred or are being offered, giving investors an
important source of information not available on the OTC market. Third, the
exchanges have rules and procedures to ensure that parties live up to their
commitments.
118
Zimbabwe Open University
Unit 7
Equity Markets
7.10Globalisation of Stock Markets
Stock markets are becoming globalised in the sense that barriers between
countries have been removed or reduced. Firms in need of funds can tap
foreign markets, and investors can purchase foreign stocks. This strategy may
represent an effort by a firm to enhance its global image.
Listing stock on a foreign stock exchange not only enhances the stock’s liquidity
but may also increase the firm’s perceived financial standing. Furthermore, it
can also protect a firm against hostile takeovers because it disperses ownership
and makes it more difficult for other firms to gain a controlling interest.
Listing on a foreign stock exchange entails some costs, such as expenses for
converting financial data in an annual report into a foreign currency and making
financial statements compatible with the accounting standards used in that
country.
In general, more investors are attracted to stock markets in countries that
provide voting rights and legal protection for shareholders, strictly enforce the
laws, do not tolerate corruption, and impose stringent accounting requirements.
These conditions encourage investors to have more confidence in the stock
market and allow for greater pricing efficiency. In addition, companies are
attracted to the stock market when there are many investors, because they
can easily raise funds in the market under these conditions.
7.11 Emerging Stock Markets
Stock markets in developing economies are relatively new and small and may
not be as efficient as those in developed economies. Hence, some stocks
may be undervalued, a possibility that has attracted investors to these markets.
Furthermore, insider trading is more prevalent in these emerging stock markets
because rules against it are not enforced.
Although international stocks can generate high returns, they may also exhibit
high risk. Some of the emerging stock markets are often referred to as casinos
because of the wild gyrations in prices that sometimes occur. Large price
swings are common because the small number of shares allows large trades
to jolt the equilibrium price. In addition, valid financial information about firms
is sometimes lacking, causing investors to trade according to rumors. Trading
patterns based on continual rumors are more volatile than trading patterns
based on factual data.
Zimbabwe Open University
119
Money and Capital Markets
Module MBAZ510
Activity 7.3
is the danger of issuing too much stock? What is
? 1. What
the role of the securities firm that serves as the underwriter,
2.
3.
4.
5.
6.
and how can it ensure that the firm does not issue too
much stock?
Discuss the concept of asymmetrical information. Explain
why it may motivate firms to repurchase some of their
stock.
Explain why the stock price of a firm may rise when the
firm announces that it is repurchasing its shares.
Compare and contrast organised exchanges and overthe-counter exchange markets.
Explain the pros and cons of globalised foreign stock
markets.
Explain the potential benefits and dangers of investing in
emerging stock markets.
7.12Summary
Equity represents the interests of shareholders in a firm. This equity can either
be private or public. The issuance of shares and purchases of these shares are
done in equity markets. The initial issuance of shares is done in primary equity
markets while trading in existing shares is done in secondary equity markets.
These equity markets provide an essential facility for the optimal allocation of
capital and resources for firms. Investors with excess financial resources are
enabled, through the stock exchange, to buy shares from issuing firms, which
in turn use those funds to expand their business operations. Stock markets
serve to encourage savers to invest their savings and thereby contribute to
long-term capital formation in an economy. Like any other financial markets,
stock exchange markets have assumed a global outlook. These global stock
exchange markets now make it easy for firms to diversify their sources of
funds into foreign markets. Of late, emerging stock markets have proved to
be attractive to foreign investors owing to the arbitrage opportunities associated
within these markets.
120
Zimbabwe Open University
Unit 7
Equity Markets
References
Chisholm, A. M. (2009). Introduction to International Capital Markets.
2nd Edition. London: John Wiley and Sons.
Choudhry, M. et al (2010). Capital Market Instruments: Analysis and
Valuation. 3rd Edition. London: Palgrave Macmillan.
Frank J. Fabozzi (2007). Fixed Income Analysis. 2nd Edition. John Wiley
and Sons.
Levinson, M. (2006). Guide to Financial Markets. 4th Edition. London:
Profile Books Limited.
Madura, J. (2010). Financial Markets and Institutions. 9th Edition. Florida:
South-Western College.
Mishkin, F.S. & Eakins, S.G. (2006). Financial Markets and Institution.
5th Edition. New York: Pearson Addison Wesley.
Zimbabwe Open University
121
Blank page
Unit Eight
Stock Valuation and Risk
8.0 Introduction
T
here are many different methods of valuing stocks. Fundamental analysis
relies on fundamental financial characteristics (such as earnings) of the
firm and its corresponding industry that are expected to influence stock values.
Technical analysis relies on stock price trends to determine stock values. The
focus of this unit is on fundamental analysis. Fundamental analysis commonly
uses the price-earnings method, the dividend model, or the free cash flow
model to value stocks.
Money and Capital Markets
Module MBAZ510
8.1 Objectives
By the end of this unit, you should be able to:





explain methods of valuing stocks
describe the required rate of return on stocks
identify the factors that affect stock prices
measure the various risks associated with stocks
discuss the concept of stock market efficiency
8.2 Stock Valuation Methods
Investors conduct valuations of stocks when making their investment decisions.
They consider investing in undervalued stocks and selling their holdings of
stocks that they consider to be overvalued. There are many different methods
of valuing stocks. Fundamental analysis relies on fundamental financial
characteristics (such as earnings) of the firm and its corresponding industry
that are expected to influence stock values. Technical analysis relies on stock
price trends to determine stock values.
8.2.1 Price-earnings method
A relatively simple method of valuing a stock is to apply the mean priceearnings (PE) ratio of all publicly traded competitors in the respective industry
to the firm’s expected earnings for the next year.
Example 8.1
Consider a firm that is expected to generate earnings of $3 per share next
year. If the mean ratio of share price to expected earnings of competitors in
the same industry is 15, then the valuation of the firm’s shares is:
Valuation per share = (Expected earnings of firm per share) x (Mean Industry
PE ratio
= $3 x 15
= $45
The logic of this method is that future earnings are an important determinant of
a firm’s value. Although earnings beyond the next year are also relevant, this
124
Zimbabwe Open University
Unit 8
Stock Valuation and Risk
method implicitly assumes that the growth in earnings in future years will be
similar to that of the industry.
Reasons for different valuations
The price-earning method has several variations, which can result in different
valuations. For example, investors may use different forecasts for the firm’s
earnings or the mean industry earnings over the next year. The previous years’
earnings are often used as a base for forecasting future earnings, but the recent
year’s earnings do not always provide an accurate forecast of the future.
A second reason for different valuations when using the PE method is that
investors disagree on the proper measure of earnings. Some investors prefer
to use operating earnings or exclude some usually high expenses that result
from one time events.
A third reason is that investors may disagree on which firms represent the
industry norm. Some investors use a narrow industry composite composed
of firms that are very similar (in terms of size, lines of business etc) to the firm
being valued; others prefer a broad industry composite. Consequently, even
if investors agree on the firm’s forecasted earnings, they may still derive different
values for that firm as a result of applying different PE ratios.
8.2.2 Dividend Discount Method
This method states that the price of a stock should reflect the present value of
the stock’s future dividends, or:
∞
Price =
Dt
∑ (1 + k )
t =1
Where
t
t
=
period
Dt
=
dividend in period t
K
=
discount rate
The model can account for uncertainty by allowing Dt to be revised in response
to revised expectations about a firm’s cash flows, or by allowing k to be
revised in response to changes in the required rate of return by investors.
Zimbabwe Open University
125
Money and Capital Markets
Module MBAZ510
Example 8.2
Consider a stock that is expected to pay a dividend of $7 per share per year
forever. This constant dividend represents a perpetuity, or an annuity that
lasts for ever. The present value of the cash flows (dividend payments) to
investors in this example is the present value of a perpetuity. Assuming that the
required rate of return (k) on the stock of concern is 14%, the present value
of the future dividend is:
PV of stock =
=
D
k
$7
0.14
= $50 per share
Unfortunately, the valuation of most stocks is not this simple because their
dividends are not expected to remain constant forever. If the dividend is
expected to grow at a constant rate, however, the stock can be valued by
applying the constant-growth dividend discount model:
PV of stock =
D1
(k − g )
Where D1 = the expected dividend per share to be paid over the next year
k
= the required rate of return by investors
g
= the rate at which the dividend is expected to grow
Example 8.3
If a stock is expected to provide a dividend of $7 per share next year, the
dividend is expected to increase by 4% per year, and the required rate of
return is 14%, the stock can be valued as:
PV of stock =
=
126
$7
(0.14 − 0.04)
$70 per share
Zimbabwe Open University
Unit 8
Stock Valuation and Risk
Limitations of the dividend discount model
The dividend discount model may result in an inaccurate valuation of a firm if
errors are made in determining the dividend to be paid over the next year, or
the growth rate, or the required rate of return by investors. The limitations of
this method are more pronounced when valuing firms that retain most of their
earnings, rather than distributing them as dividends, because the model relies
on the dividend as the base for applying the growth rate.
Activity 8.1
computing the price of a stock with the dividend
? 1. When
discount model, how would the price be affected if the
2.
required rate of return is increased? Explain the logic of
this relationship.
When computing the price of a stock using the constantgrowth discount model, how would the price be affected if
the growth rate is reduced? Explain the logic of this
relationship.
8.2.3 Adjusting the dividend discount method
The dividend discount model can be adapted to assess the value of any firm,
even those that retain most or all of their earnings. From the investor’s
perspective, the value of the stock is:


the present value of the future dividends to be received over the
investment horizon
the present value of the forecasted price at which the stock will be sold
at the end of the investment horizon
To forecast the price at which the stock can be sold, investors must estimate
the firm’s earnings per share (after removing any nonrecurring effects) in the
year that they plan to sell the stock. This estimate is derived by applying an
annual growth-rate to the prevailing annual earnings per share. Then, the
estimate can be used to derive the expected price per share at which the
stock can be sold.
Zimbabwe Open University
127
Money and Capital Markets
Module MBAZ510
Example 8.4
Assume that a firm currently has earnings of $12 per share. Future earnings
can be forecasted by applying the expected annual growth rate to the firm’s
existing earnings (E):
Forecasted earnings in n years = E(1+G)n
Where
G
= the expected growth rate of earnings
n
= the number of years until the stock is to be sold
If investors expect that the earnings per share will grow by 2% per year and
expect to sell the firm’s stock in three years, the earnings per share in the three
years are forecasted to be:
Earnings in three years =
$12 x (1+0.02)3
=
$12 x 1.0612
=
$12.73
The forecasted earnings per share can be multiplied by the PE ratio of the
firm’s industry to forecast the future stock price. If the mean PE ratio of all
other firms in the same industry is 6, the stock price in three years can be
forecasted as follows:
Stock price in 3 years = (Earnings in 3 years) x (PE ratio of industry)
= $12.73 x 6
= $76.38
This forecasted stock price can be used along with expected dividends and
the investor’s required rate of return to value the stock today. If the firm is
expected to pay a dividend of $4 per share over the next 3 years, and if the
investors’ required rate of return is 14%, the present value of expected cash
flows to be received by the investor is:
$4
$4
$4
$76.38
PV= (1.14)1 + (1.14) 2 + (1.14) 3 + (1.14)3
= $3.51 + $3.08 + $2.70 + $51.55
= $60.84
128
Zimbabwe Open University
Unit 8
Stock Valuation and Risk
Limitations of the adjusted dividend discount model
This model may result in an inaccurate valuation if errors are made in deriving
the present value of dividends over the investment horizon or the present
value of the forecasted price at which the stock can be sold at the end of the
investment horizon. Since the required rate of return affects both of these
factors, the use of an improper required rate of return will lead to inaccurate
valuations.
8.2.4 Free cash flow method
For firms that do not pay dividends, a more suitable valuation may be the free
cash flow model, which is based on the present value of future cash flows.
The first step is to estimate the free cash flows that will result from operations.
Second, subtract existing liabilities to determine the value of the firm. Third,
divide the value of the firm by the number of shares to derive a value per
share.
Limitations of the model
The limitation of this model is the difficulty of obtaining an accurate estimate of
free cash flow per period. One possibility is to start with forecasted earnings
and then add a forecast of the firm’s noncash expenses and capital investment
and working capital investment required to support the growth in the forecasted
earnings. Obtaining accurate earnings forecasts can be difficult, however. Even
if earnings can be forecasted accurately, the flexibility of accounting rules can
cause major errors in estimating free cash flow based on earnings.
8.3 Required Rate of Return on Stocks
Valuation of firms based on discounted cash flows requires the use of a required
rate of return by investors who invest in that stock. This required rate of
return reflects the risk-free interest rate plus a risk premium. Two commonly
used models for deriving the required rate of return are the capital asset pricing
model and the arbitrage pricing model.
8.3.1 Capital Asset Pricing Model (CAPM)
This model is used to estimate the required rate of return for any firm with
publicly traded stock. The model is based on the premise that the only important
risk of a firm is systematic risk, or the risk that results from exposure to general
Zimbabwe Open University
129
Money and Capital Markets
Module MBAZ510
stock market movements. CAPM is not concerned with unsystematic risk,
which is specific to an individual firm, because investors can avoid that risk by
holding diversified portfolios.
The CAPM suggests that the return of an asset (Rj) is influenced by the
prevailing risk-free rate (Rf), the market return (Rm), and the covariance
between Rj and Rm as follows:
R j = Rf + âj(Rm – Rf)
Where the beta, âj
= COV(Rj, Rm)/VAR(Rm).
Example 8.5
Consider a firm that has a beta of 1.2, the prevailing risk-free rate is 6% and
the market risk premium is 7%. The required rate of return on the firm is:
Rj = 6% + 1.2(7%)
= 14.4%
The firm’s required rate of return is 14.4%, so its estimated future cash flows
would be discounted using a discount rate of 14.4% to derive the firm’s present
value.
8.3.2 Arbitrage Pricing Theory (APT)
This model differs from the CAPM in that it suggests that a stock’s price can
be influenced by a set of factors in addition to the market. The factors may
possibly reflect economic growth, inflation, and other variables that could
systematically influence asset prices. The following model is based on the
arbitrage pricing theory:
m
E(R) =
âo +
∑β F
t =1
i
i
Where E(R) = expected return of asset
âo
130
=
a constant
Fi ..Fm =
values of factors 1 to m
âi
sensitivity of the asset return to particular factor
=
Zimbabwe Open University
Unit 8
Stock Valuation and Risk
The model suggests that in equilibrium, expected returns on assets are linearly
related to the covariance between asset returns and the factors. This is distinctly
different from the CAPM, where expected returns are linearly related to the
covariance between asset returns and the market.
Activity 8.2
using the CAPM, how would the required rate of
? 1. When
return on a stock be affected if:
a.
b.
c.
2.
the risk-free rate is lower?
the market return is lower?
the beta is higher?
Clearly outline the distinction between the CAPM and APT
models.
8.4 Factors that Affect Stock Prices
Stock prices are mostly driven by three types of factors: economic factors,
market-related factors and firm-specific factors.
8.4.1 Economic factors
A firm’s value should reflect the present value of its future cash flows. Investors
consider various economic factors that affect a firm’s cash flows when valuing
a firm to determine whether its stock is over-or-undervalued.
Impact of economic growth
An increase in economic growth is expected to increase the demand for
products and services produced by firms and therefore increase a firm’s cash
flows and valuation. Participants in the stock markets monitor economic
indicators such as employment, gross domestic product, retail sales, and
personal income because these indicators may signal information about
economic growth and therefore affect cash flows. In general, unexpected
favorable information about the economy tends to cause a favorable revision
of a firm’s expected cash flows and therefore places upward pressure on the
firm’s value.
Impact of interest rates
One of the most prominent economic forces driving stock market prices is
Zimbabwe Open University
131
Money and Capital Markets
Module MBAZ510
the risk-free interest rate. Investors should consider purchasing a risky asset
only if they expect to be compensated with a risk premium for the risk incurred.
High interest rates should raise the required rate of return and therefore reduce
the present value of future cash flows generated by a stock. However, interest
rates commonly rise in response to an increase in economic growth, so stock
prices may rise in response to an increase in expected cash flows even if
investors’ required rate of return rises. Conversely, lower interest rates should
boost the present value of cash flows and therefore boost stock prices.
However, lower interest rates commonly occur in response to weak economic
conditions, which tend to reduce expected cash flows of firms. Overall, the
effect of interest rates should be considered along with economic growth and
other factors to offer a more complete explanation of stock price movements.
Impact of exchange rates
Exchange rate movements affect stock prices. Foreign investors prefer to
purchase our domestic firms’ shares when the local currency is weak and sell
them when it is strong. Foreign demand for local shares may be higher when
the local currency is expected to strengthen, other things being equal.
A multinational corporation’s consolidated reported earnings will be affected
by exchange rate fluctuation even if the company’s cash flows are not affected.
8.4.2 Market-related factors
Market-related factors also drive stock prices. A key market-related factor
is the investor sentiment, which represents the general mood of investors in
the stock market. Since stock valuations reflect expectations, in some periods
the stock market performance is not highly correlated with existing economic
conditions. For example, even though the economy is weak, stock prices
may rise if most investors expect that the economy will improve in the near
future. That is, there is a positive sentiment because of optimistic expectations.
The reverse is true in the case of negative sentiments. For example, investors
might have a negative outlook on the economy even though the economy may
be strong.
8.4.3 Firm-specific factors
A firm’s stock is affected not only by macroeconomic and market conditions
but also by firm-specific conditions. Some firms are more exposed to conditions
within their own industry than to general economic conditions, so participants
monitor industry sales forecasts, entry into the industry by new competitors
132
Zimbabwe Open University
Unit 8
Stock Valuation and Risk
and price movements of the industry’s products. Stock market participants
may focus on announcements by specific firms that signal information about a
firm’s sales growth, earnings, or other characteristics that may cause a revision
in the expected cash flows to be generated by that firm.
Change in dividend policy
An increase in dividends may reflect the firm’s expectation that it can more
easily afford to pay dividends. A decrease in dividends may reflect the firm’s
expectation that it will not have sufficient cash flow.
Earnings surprises
Recent earnings are used to forecast future earnings and therefore to forecast
a firm’s future cash flows. When a firm’s announced earnings are higher than
expected, some investors raise their estimates of the firm’s future cash flows
and therefore revalue its stock upward. Conversely, an announcement of lower
than expected earnings can cause investors to reduce their valuation of a
firm’s future cash flows and its stock.
Acquisitions and divestitures
The expected acquisition of a firm typically results in an increased demand for
the target’s stock and therefore raises the stock price. Investors recognise
that the target’s stock price will be bid up once the acquiring firm attempts to
acquire the target’s stock. Divestitures tend to be regarded as a favourable
signal about a firm if the divested assets are not related to the firm’s core
business. The typical interpretation by the market in this case is that the firm
intends to focus on its core business.
Expectations
Investors do not necessarily wait for a firm to announce a new policy before
they revalue the firm’s stock. Instead, they attempt to anticipate new policies
so that they can make their move in the market before other investors. In this
way, they may be able to pay a lower price for a specific stock or sell the
stock at a higher price. For example, they may use the firm’s financial reports
or recent statements by the firm’s executives to speculate on whether the firm
will adjust its dividend policy. The disadvantage of trading based on incomplete
information is that the investors may not properly anticipate the firm’s future
policies.
Zimbabwe Open University
133
Money and Capital Markets
Module MBAZ510
Activity 8.3
the three broad categories of factors that affect
? 1. Identify
stock prices?
2.
Explain how each of these factors influences stock prices.
8.5 Stock Market Efficiency
If stock markets are efficient, the prices of stocks at any point in time should
fully reflect all available information. As investors attempt to capitalise on new
information that is not already accounted for, stock prices should adjust
immediately. Investors commonly overreact or under react to information.
This does not mean markets are inefficient unless the reaction is biased. In this
case, investors who recognize the bias will be able to earn abnormally high
risk-adjusted returns.
The degree to which markets are efficient (that markets are perfect in that
they fully reflect all relevant information, and that all assets are priced fairly) is
divided into three forms. The three forms of market efficiency are classified
based upon the type of information from which an individual could or could
not derive abnormal profits. The three forms are weak-form efficiency, semistrong form efficiency, and strong-form efficiency.
8.5.1 Weak-form efficiency
Weak-form efficiency suggests that security prices reflect all trade-related
information, such as historical security price movements and volume of
securities trades. Thus, investors will not be able to earn abnormal returns on
a trading strategy that is based solely on past price movements.
8.5.2 Semi-strong form efficiency
Semi-strong form efficiency suggests that security prices fully reflect all public
information. The difference between public information and market-related
information is that public information also includes announcements by firms,
economic news or events, and political news or events. Thus, if semi-strong
form efficiency holds, weak-form efficiency must hold as well. It is possible,
however, for weak-form efficiency to hold, while semi-strong form efficiency
does not. In this case, investors could earn abnormal returns by using the
relevant information that was not immediately accounted for by the market.
134
Zimbabwe Open University
Unit 8
Stock Valuation and Risk
8.5.3 Strong-form efficiency
This suggests that security prices fully reflect all information, public or private,
from any and all sources. This implies that not even insider trading information
would be useful.
Inside information gives insiders such as employees or board members an
unfair advantage over other investors. Insiders who are aware of favorable
news about the firm that is not yet disclosed to the public may consider
purchasing shares or advising their friends to purchase the firm’s shares. Though
such acts are illegal, they still happen and can create market inefficiencies.
Activity 8.4
the concept of market efficiency.
? 1.2. Explain
Discuss the feasible existence of the three forms of stock
market efficiency in your country’s stock exchange.
8.6 Summary
Stocks are commonly valued using the price-earnings (PE) method, the
dividend discount model, or the free cash flow model. The PE method applies
the industry PE ratio to the firm’s earnings to derive its value. The dividend
discount model estimates the value as the present value of expected future
dividends. The free cash flow model is based on the present value of future
cash flows. Stock prices are affected by those factors that affect future cash
flows or the required rate of return by investors. Stock market efficiency
implies that stock prices reflect all available information and there are three
forms of market efficiency, namely, weak-form efficiency, semi-strong form
efficiency and strong-form efficiency.
Zimbabwe Open University
135
Money and Capital Markets
Module MBAZ510
References
Chisholm, A. M. (2009). Introduction to International Capital Markets.
2nd Edition. London: John Wiley and Sons.
Choudhry, M. et al (2010). Capital Market Instruments: Analysis and
Valuation. 3rd Edition. London: Palgrave Macmillan.
Frank J. Fabozzi (2007). Fixed Income Analysis. 2nd Edition. John Wiley
and Sons.
Levinson, M. (2006). Guide to Financial Markets. 4th Edition. London:
Profile Books Limited.
Madura, J. (2010). Financial Markets and Institutions. 9th Edition. Florida:
South-Western College.
Mishkin, F.S. and Eakins, S.G. (2006). Financial Markets and Institution.
5th Edition. New York: Pearson Addison Wesley.
136
Zimbabwe Open University
Unit Nine
Mortgage Markets
9.0 Introduction
I
n this unit, we discuss mortgage markets where borrowers; individuals, and
businesses, can obtain long-term collateralized loans. The mortgage markets
form a subcategory of the capital markets because mortgages involve longterm funds. However, the mortgage markets differ from the stock and bond
markets in that the usual borrowers in the capital markets are government
entities and businesses, whereas the usual borrowers in the mortgage markets
are individuals. Further, mortgage loans are made for varying amounts and
maturities, depending on the borrowers’ needs, features that cause problems
for developing a secondary market.
Money and Capital Markets
Module MBAZ510
9.1 Objectives
By the end of this unit, you should be able to:





provide a background on mortgages
describe the functions of mortgage markets
discuss the common types of residential mortgages
analyse the valuation and risk of mortgages
explain mortgage-backed securities
9.2 Background on Mortgages
Mishkin & Eakins (2006) define a mortgage as a form of debt created to
finance investment in real estate. The debt is secured by the property, so if the
property owner does not meet the payment obligations, the creditor can seize
the property. Financial institutions such as building societies serve as
intermediaries by originating mortgages. They consider mortgage applications
and assess the creditworthiness of the applicants. The mortgage represents
the difference between the down payment and the value to be paid for the
property. The mortgage contract specifies the mortgage rate, the maturity,
and the collateral that is backing the loan.
9.3 How Mortgage Markets Facilitate the Flow of
Funds
Financial intermediaries originate mortgages and finance purchases of residential
properties. The financial intermediaries that originate mortgages obtain their
funding from household deposits. They also obtain funds by selling some of
the mortgages that they originate directly to institutional investors in the
secondary market. Overall, mortgage markets allow households and firms to
increase the purchases of residential property, commercial property and
consequently, financing economic growth.
138
Zimbabwe Open University
Unit 9
Mortgage Markets
Activity 9.1
between mortgage markets and other capital
? 1. Distinguish
markets.
2.
Explain how mortgage markets facilitate the flow of funds
in any economy.
9.4 Criteria used to Measure Creditworthiness
When mortgage originators consider mortgage applications, they review
information that reflects the prospective borrower’s ability to repay the loan.
The following are three important criteria that are used to measure a borrower’s
repayment ability:
9.4.1 Level of equity invested by the borrower
The down payment represents the equity invested by the borrower. The lower
the level of equity invested, the higher the probability that the borrower will
default. One proxy for this factor is the loan-to-value ratio, which indicates
the proportion of the property’s value that is financed with debt. When
borrowers make relatively small down payments, the loan-to-value ratio is
higher, and borrowers have less to lose in the event that they stop making
their mortgage payments.
9.4.2 Borrower’s income level
Borrowers who have a lower level of income relative to the periodic loan
payments are more likely to default on their mortgages. Income determines
the amount of funds that borrowers have available per month to make mortgage
payments. Income levels change over time, however, so it is difficult for
mortgage lenders to anticipate whether prospective borrowers will continue
to earn their monthly income over the life of the mortgage, especially given the
high frequency of layoffs.
9.4.3 Borrower’s credit history
Other conditions being similar, borrowers with a history of credit problems
are more likely to default on their loans than those without credit problems.
Zimbabwe Open University
139
Money and Capital Markets
Module MBAZ510
9.5 Classifications of Mortgages
Mortgages can be classified in various ways, but two important classifications
are prime versus subprime mortgages and insured versus conventional
mortgages.
9.5.1 Prime versus subprime mortgages
Mortgages can be classified according to whether the borrower meets the
traditional lending standards. Borrowers who obtain prime mortgages satisfy
the traditional lending standards. Subprime mortgages are offered to borrowers
who do not qualify for prime loans because they have relatively lower income
or high existing debt, or can make only a small down payment. Subprime
mortgages usually attract higher interest rates to compensate for the risk of
default.
9.5.2 Insured versus conventional mortgages
Mortgages are classified as either insured or conventional. Insured mortgages
are originated by mortgage lenders but are guaranteed by government agencies.
The government agency guarantees to pay off the mortgage loan if the borrower
defaults. Conventional mortgages are not government insured but can be
privately insured. The insurance premium paid for such private insurance is
often passed on to borrowers, thus making them relatively more expensive.
Activity 9.2
the criteria used to assess the creditworthiness
? 1. Describe
of potential borrowers.
2.
3.
Differentiate between prime and subprime mortgages.
Explain why conventional mortgages are relatively
expensive when compared to insured mortgages.
9.6 Types of Residential Mortgage
Various types of residential mortgages are available to home owners, including
the following:
140
Zimbabwe Open University
Unit 9
Mortgage Markets






Fixed-rate mortgages
Adjustable-rate mortgages
Graduated-payment mortgages
Growing-equity mortgages
Second mortgages
Share-appreciation mortgages
9.6.1 Fixed-rate mortgages
A fixed-rate mortgage locks in the borrower’s interest rate over the life of the
mortgage. The periodic interest payment received by the mortgage lender is
constant regardless of how market rates change over time. Mortgage lenders
who hold portfolios of fixed-rate mortgages are exposed to interest rate risk
because they commonly use funds obtained from short-term deposits to make
long-term mortgage loans. If interest rates change over time, the mortgage
lenders’ cost of obtaining funds will increase. The return on the fixed-rate
mortgage loans will be unaffected, however, causing its profit margin to
decrease. Borrowers with fixed-rate mortgages do not suffer from the effects
of rising interest rates, but they also fail to benefit from declining rates. Although
they can attempt to refinance (obtain a new mortgage to replace the existing
mortgage) at the lower prevailing market interest rate, they will incur transaction
costs such as closing costs and origination fees.
9.6.2 Adjustable-rate mortgages
These allow the mortgage interest rate to adjust to market conditions. Some
adjustable-rate mortgages contain a clause that allows mortgage holders to
switch to a fixed rate within a specified period, such as one to five years after
the mortgage is originated. The fixed rate is typically higher than the adjustable
rate at any given point in time when a mortgage is originated.
Activity 9.3
?
Zimbabwe Open University
Compare and contrast fixed-rate mortgages and adjustablerate mortgages.
141
Money and Capital Markets
Module MBAZ510
9.6.3 Graduated-payment mortgages
These allow the borrower to initially make small payments on the mortgage;
the payments increase on a graduated basis over the first 5 to 10 years and
then level off. These types of mortgages are tailored for borrowers who
anticipate higher income and thus the ability to make larger monthly mortgage
payments as time passes. In a sense, they are delaying part of their mortgage
payment.
9.6.4 Growing-equity mortgages
These are similar to graduated-payment mortgages in that the monthly payments
are initially low and increase over time. However, they differ in that the payments
never level off but continue to increase throughout the life of the loan.
9.6.5 Second mortgages
Second mortgages are loans that are secured by the same real estate that is
used to secure the first mortgage. The second mortgage is junior to the original
loan. This means that should a default occur, the second mortgage holder will
be paid only after the original loan has been paid off, if sufficient funds remain.
The purpose of second mortgages is to give borrowers a way to use the
equity they have in their homes as security for another loan. An alternative to
the second mortgage would be to refinance the home at a higher loan amount
than is currently owed. The cost of obtaining a second mortgage is often
much lower than refinancing.
Interest rates on second mortgages are higher because their priority claim
against the property in the event of default is behind that of the first mortgage.
The higher interest rate reflects greater compensation as a result of the higher
risk incurred by the provider of the second mortgage.
9.6.6 Shared-appreciation mortgages
When interest rates are high, the monthly payments on mortgage loans are
also high. That prevents many borrowers from qualifying for loans. To help
borrowers qualify and to keep loan volume high, lenders created the sharedappreciation mortgages.
A shared-appreciation mortgage allows a home purchaser to obtain a mortgage
at a below-market interest rate. In return, the lender providing the attractive
loan rate will share in the appreciation of the home. The precise percentage of
142
Zimbabwe Open University
Unit 9
Mortgage Markets
appreciation allocated to the lender is negotiated at the origination of the
mortgage.
9.6.7 Equity participation mortgages
In a shared-appreciation mortgage, the lender shares in the appreciation of
the property. In an equity participation mortgage, an outside investor rather
than the lender shares in the appreciation of the property. This investor will
either provide a portion of the purchase price of the property or supplement
the monthly payments. In return, the investor receives a portion of any
appreciation in the property. As with the shared-appreciation mortgages, the
borrower benefits being able to qualify for a larger loan than without such
help.
9.6.8 Reverse annuity mortgages (RAM)
The reverse annuity mortgage is an innovation method for retired people to
live on the equity they have in their homes. The contract for a RAM has the
bank advancing funds on a monthly schedule. This increasing-balance loan is
secured by the real estate. The borrower does not make any payments against
the loan. When the borrower dies, the borrower’s estate sells the property to
retire the debt.
The advantage of the RAM is that it allows retired people to use the equity in
their homes without the necessity of selling it.
9.6.9 Balloon payment mortgages
A balloon-payment mortgage requires only interest payments for a three- to
five year period. At the end of this period, the borrower must pay the full
amount of the principal (the balloon payment). Because no principal payments
are made until maturity, the monthly payments are lower. Realistically, though,
most borrowers have not saved enough funds to pay of the mortgage in three
to five years, the balloon payment in effect forces them to request a new
mortgage. Therefore, they are subject to the risk that mortgage rates will be
higher at the time they refinance the mortgage.
Zimbabwe Open University
143
Money and Capital Markets
Module MBAZ510
Activity 9.4
the various types of residential mortgage available
? Describe
to homeowners.
9.7 Mortgage Loan Amortization
Mortgage loan borrowers agree to pay a monthly amount of principal and
interest that will fully amortize the loan by its maturity. “Fully amortize” means
that the payments will pay off the outstanding indebtedness by the time the
loan matures. During the early years of the loan, the lender applies most of the
payments to the interest on the loan and a small amount to the outstanding
principal balance. Many borrowers are surprised to find that after years of
making payments, their loan balance has not dropped appreciably.
Example 9.1
Consider a 30-year (360-month) $100,000 mortgage at an annual interest
rate of 8%. Insurance and taxes are ignored in this example. The amortization
schedule for this mortgage is shown below:
144
Zimbabwe Open University
Unit 9
Mortgage Markets
Table 9.1: Amortization Schedule for a 30-year $100,000 Mortgage at
8%
Payment
Payment of
Payment of
Total
Remaining
1
$666.66
$67.10
$733.76
$99,932.90
2
$666.21
$67.55
$733.76
$99,865.35
……………………………………………………………………………………………….
100
$604.22
$129.54
$733.76
$90,504.68
101
$603.36
$130.40
$733.76
$90,374.28
……………………………………………………………………………………………….
200
$482.01
$251.75
$733.76
$72,051.18
201
$480.34
$253.42
$733.76
$71,797.76
……………………………………………………………………………………………….
300
$244.52
$489.24
$733.76
$36,188.12
301
$241.25
$492.51
$733.76
$35,695.61
……………………………………………………………………………………………….
359
$9.68
$724.08
$733.76
$728.91
360
$4.85
$728.91
$733.76
$0.00
A breakdown of the monthly payments into principal versus interest is shown
above. Note that a larger proportion of interest is paid in the earlier years and
a larger portion of principal in the later years.
Example 9.2
A 30-year mortgage at 8% requires monthly payments of approximately $734.
The same mortgage for 15 years would require monthly payments of $956.
Total payments for the 30-year loan would be $264,155 versus $172,017
for the 15-year mortgage. Total payments are lower on mortgages with shorter
lives, due to the more rapid amortization and lower cumulative interest. In
addition, mortgages with shorter maturities are subject to less interest rate
risk than longer-term ones.
Zimbabwe Open University
145
Money and Capital Markets
Module MBAZ510
Example 9.3
You obtain a 30-year loan at 8% on the $95,000 you need to finance your
new condo. The price of the condo is $100,000 minus a $5,000 down payment.
Calculate the fixed monthly payment.
To compute fixed-amount loan payments, you must equate the present value
of the stream of payments you will pay to the amount of the loan. In equation
form:
Loan amount = P(PVIFAi,n)
Where:
Loan amount = amount loaned by the bank = $95,000
i = interest rate on the loan
= 0.08
n = term of the loan
= 30
Thus, $95,000 = Pann(PVIFA8%,30)
$95,000= Pann(11.2578)
Pann
=
$95,000
11.2578
Pann = $8,439
Pann =
$8,439
12months
= $703 per month
146
Zimbabwe Open University
Unit 9
Mortgage Markets
Activity 9.5
the required monthly payment on an $80,000
? 1. Compute
30-year fixed-rate mortgage with a nominal interest rate
2.
3.
of 5.80%. How much of the payment goes toward
principal and interest during the first year?
Compute the face value of a 30-year fixed-rate
mortgage with a monthly payment of $1,100, assuming
a nominal interest rate of 9%. If the mortgage requires
5% down, what is the maximum house price?
Consider a 30-year fixed-rate mortgage for $100,000
at a nominal rate of 9%. If the borrower pays an
additional $100 with each payment, how fast will the
mortgage be paid off?
9.8 Valuation and Risk of Mortgages
Since mortgages are commonly sold in the secondary market, they are
continually valued by investors. The market price (PM) of a mortgage should
equal the present value of its future cash flows:
n
PM =
C + Prin
∑ (1+ k)
t
t =1
Where
C
= the interest payment
Prin
= the principal payment made each period
k
= the required rate of return by investors
Similar to bonds, the market value of a mortgage is the present value of the
future cash flows to be received by the investor. Unlike bonds, however, the
periodic cash flows commonly include a payment of principal along with an
interest payment.
Zimbabwe Open University
147
Money and Capital Markets
Module MBAZ510
9.9 Risks from Investing in Mortgages
Given the uncertainty of the factors that influence mortgage prices, future
mortgage prices and returns are uncertain. The uncertainty that financial
institutions face from investing in mortgages is due to credit risk, interest rate
risk, and prepayment risk.
9.9.1 Credit risk
Credit risk (default risk) represents the size and likelihood of a loss that
investors will experience if borrowers make late payments or even default.
Whether investors sell their mortgages prior to maturity or hold them until
maturity, they are exposed to credit risk. The probability that a borrower will
default is influenced both by economic conditions and by the characteristics
specific to the borrower that lenders use to assess a borrower’s
creditworthiness.
9.9.2 Interest rate risk
The values of mortgages tend to decline in response to an increase in interest
rates. Mortgages are long term but are commonly financed by some financial
institutions with short-term deposits. Such mortgages can also generate high
returns when interest rates fall, but the potential gains are limited because
borrowers tend to refinance (obtain new mortgages at the lower interest rate
and repay their mortgages) when interest rates decline. Investors holding fixedrate mortgages to maturity may not experience some loss due to a change in
interest rates, but may still incur opportunity costs of what the investors might
have earned if they had invested in other securities.
Mortgage lenders can limit their exposure to interest rate risk by selling
mortgages shortly after originating them. They can also limit their exposure by
maintaining adjustable-rate residential mortgages. Alternatively, they could
invest in fixed-rate mortgages that have a short time remaining until maturity.
9.9.3 Prepayment risk
It is the risk that a borrower may prepay the mortgage in response to a decline
in interest rates. In this case, the investor receives a payment to retire the
mortgage and has to reinvest at the prevailing lower interest rates. Thus, the
interest rate on the new investment will be lower than the rate that would have
been received on the retired mortgages. Prepayment risk is high in environment
of declining interest rates. Lenders can insulate themselves against prepayment
148
Zimbabwe Open University
Unit 9
Mortgage Markets
risk by selling mortgages shortly after originating them or invest in adjustablerate mortgages.
Activity 9.6
the major risks associated with investing in
? 1. Outline
mortgages.
2.
3.
Explain why the values of mortgages tend to decline in
response to increasing interest rates.
Explain the various ways used to manage these risks.
9.10Mortgage-backed Securities
As an alternative to selling their mortgages outright, financial institutions can
engage in securitisation, or the pooling and repackaging of loans into securities
called mortgage-backed securities (MBS; or pass-through securities). These
securities are then sold to investors, who become the owners of the loans
represented by those securities. Although securitisation has enhanced the
secondary market for mortgages, it also contributed to the credit crisis that
occurred in 2008 in the USA and UK and other western economies.
9.11 The Securitisation Process
When mortgages are securitised, a financial institution such as a securities firm
combine individual mortgages together into packages in tranches based on
their risk level. Securitisation allows the institution to sell smaller mortgage
loans that could not be easily sold in the secondary market on an individual
basis. These repackaged mortgages become more attractive to the large
institutional investors. The issuer of the MBS assigns a trustee to hold the
mortgages as collateral for the buyers of the securities. After the securities are
sold, the financial institution that issued the MBS receives interest and principal
payments on the mortgages and transfers (passes through) the payments to
the investors that purchased the securities.
The MBS are assigned risk ratings by credit rating agencies and investors use
these ratings in making their decisions whether to invest in these securities.
The mortgages in a highly rated (low risk) tranche are expected to generate
Zimbabwe Open University
149
Money and Capital Markets
Module MBAZ510
more favourable payments. The tranches containing subprime mortgages are
assigned a lower credit rating (high risk).
9.12Risk of Mortgage-backed Securities
Some institutional investors are willing to purchase MBS representing risky
mortgages because they expect to earn a higher return. Like mortgages, MBS
are subject to credit risk, interest rate risk and prepayment risk.
9.12.1 Credit risk of MBS
If homeowners are unable to make their payments on some mortgages that
were packaged to create MBS, this reduces the total payments that will be
received by the institutional investors that purchased the securities. Investors
in MBS can suffer major losses if there are many defaults on the underlying
mortgages represented by the MBS.
9.12.2 Interest rate risk of MBS
The interest and principal payments to owners of MBS can vary over time.
For example, if a higher-than-normal proportion of the mortgages backing
the securities are prepaid in a specific period, the payments received by the
financial institutions will be passed through to the security owners.
9.12.3 Prepayment risk of MBS
The primary source of prepayment risk associated with a mortgage pool results
from a borrower’s right to prepay a mortgage in part or in full without penalty,
which alters the expected life of mortgages depending upon market rates.
150
Zimbabwe Open University
Unit 9
Mortgage Markets
Activity 9.7
mortgage loans once had balloon payments; now
? 1. Most
most current mortgage loans fully amortize. What is the
2.
3.
4.
5.
difference between a balloon loan and an amortizing
loan?
Mortgage lenders with fixed-rate mortgages should
benefit when interest rates decline, yet research has
shown that this favorable impact is dampened. By what?
Explain why some financial institutions prefer selling the
mortgages they originate.
Compare the secondary market activity for mortgages
to the activity for other capital market instruments (such
as stocks and bonds).
Explain how a mortgage company’s degree of exposure
to interest rate risk differs from that of other financial
institutions.
9.13Summary
Mortgages are long-term loans secured by real estate. Both individuals and
businesses obtain mortgage loans to finance real estate purchases. A variety
of mortgages are available to meet the needs of most borrowers. These are
fixed-rate mortgages, adjustable-rate mortgages, graduated-payment
mortgages, shared-appreciation mortgages, second mortgages and many
others. The valuation of a mortgage is the present value of its expected future
cash flows, discounted at a discount rate that reflects the uncertainty
surrounding the cash flows. The major risks associated with mortgages include
credit risk, interest rate risk and prepayment risk.
Zimbabwe Open University
151
Money and Capital Markets
Module MBAZ510
References
Chisholm, A. M. (2009). Introduction to International Capital Markets.
2nd Edition. London: John Wiley and Sons.
Choudhry, M. et al (2010). Capital Market Instruments: Analysis and
Valuation. 3rd Edition. London: Palgrave Macmillan.
Frank J. Fabozzi (2007). Fixed Income Analysis. 2nd Edition. John Wiley
and Sons.
Levinson, M. (2006). Guide to Financial Markets. 4th Edition. London:
Profile Books Limited.
Madura, J. (2010). Financial Markets and Institutions. 9th Edition. Florida:
South-Western College.
Mishkin, F.S. and Eakins, S.G. (2006). Financial Markets and Institution.
5th Edition. New York: Pearson Addison Wesley.
152
Zimbabwe Open University
Unit Ten
Foreign Exchange Markets
10.0Introduction
T
he price of one currency in terms of another is called the exchange rate.
Determining the relative values of different currencies is the role of foreign
exchange markets. The foreign exchange markets underpin all other financial
markets. They directly influence each country’s foreign-trade patterns,
determine the flow of international investment and affect domestic interest
and inflation rates. In this unit, we will discuss the functions of foreign exchange
markets and the factors determining exchange rates.
Money and Capital Markets
Module MBAZ510
10.1Objectives
By the end of this unit, you should be able to:






explain the functions of foreign exchange markets
identify the key participants in the foreign exchange
market
analyse the roles of key participants in the foreign
exchange market
describe how various factors affect exchange rates
demonstrate how to forecast exchange rates
discuss exchange rate risk management techniques
10.2Foreign Exchange Markets
Madura (2010) contends that the foreign exchange market is by far the largest
market in the world. Even though major currencies are traded like commodities,
the foreign exchange market is distinguished from both the commodity or
equity markets by having no fixed base. The foreign exchange market exists
through communications and information systems consisting of telephones,
the internet or other means of instant communications. It is not located in a
building, nor is it limited by fixed trading hours, but is truly a 24-hour global
trading system. It knows no barriers and trading activity in general moves
with the sun from one major financial center to the next; so that around the
clock a foreign exchange market is active somewhere in the world. Because
of this decentralisation, the total size of the foreign exchange market can only
be guessed at.
The foreign exchange market is an over-the-counter market where buyers
and sellers conduct business. It is a global network of buyers and sellers of
currencies with a foreign exchange transaction being a contract to exchange
one currency for another currency at an agreed rate on an agreed date. Today,
what began as a way of facilitating trade across country borders has grown
into one of the most liquid, hectic, and volatile financial markets in the world—
where banks (and many hedge funds) are the major players and have the
potential of generating huge profits, or losses.
154
Zimbabwe Open University
Unit 10
Foreign Exchange Markets
10.3Functions of Foreign Exchange Markets
The foreign-exchange markets underpin all other financial markets. They
directly influence each country’s foreign-trade patterns, determine the flow of
international investment and affect domestic interest and inflation rates. They
operate in every corner of the world, in every single currency. Collectively,
they form the largest financial market.
10.4Types of Foreign Exchange Market
The foreign-exchange markets comprise two main different types, which
function separately yet are closely interlinked.
10.4.1 The spot market
Currencies for immediate delivery are traded on the spot market. A tourist’s
purchase of foreign currency is a spot-market transaction, as is a firm’s decision
immediately to convert the receipts from an export sale into its home currency.
Large spot transactions among financial institutions, currency dealers and large
firms are arranged mainly on the telephone, although electronic broking services
have gained considerable importance. The actual exchange of the two
currencies is handled through the banking system and generally occurs two
days after the trade is agreed, although some trades are settled more quickly.
Small spot transactions often occur face to face, as when a currency dealer
converts individuals’ local currency into foreign currency.
10.4.2 The futures market
The futures markets allow participants to lock in an exchange rate at certain
future dates by purchasing or selling a futures contract. For example, a
Zimbabwean firm expecting to receive ZAR10 million might purchase Rand
futures contracts. This would effectively guarantee that the rands the firm
receives can be converted into Zimbabwean dollars at an agreed rate,
protecting the firm from the risk that the South African rands will lose value
against the dollar before it receives the payment.
10.5Foreign Exchange Market Participants
According to Mishkins & Eakins (2006), to “make a market” means to be
Zimbabwe Open University
155
Money and Capital Markets
Module MBAZ510
willing and ready to buy and sell currencies. Market makers are those market
participants that both buy and sell currencies. According to market practice,
a market maker, dealer, or trader will generally quote a two-way price to
another market maker. (The terms dealer and trader are used interchangeably
when referring to market makers.) For market makers, reciprocity is standard
practice. They constantly make prices to one another, and market makers are
primarily banks.
Price takers are those market participants seeking to either buy (bid) or sell
(offer) currencies and are usually corporations, fund managers, or speculators.
For price takers, there is no reciprocity inasmuch as they won’t quote a price
to other market participants.
The major participants in the market play a number of roles depending on
their need for foreign exchange and the purpose of their activities:








156
International money center banks are market makers and deal with
other market participants.
Regional banks deal with market makers to meet their own foreign
exchange needs and those of their clients.
Central banks are in the market to handle foreign exchange transactions
for their governments, for certain state-owned entities, and for other
central banks. They also pay or receive currencies not usually held in
reserves and stabilize markets through intervention.
Investment banks, like money center banks, can be market makers
and deal with other market participants.
Corporations are generally price takers and usually enter into foreign
exchange transactions for a specific purpose, such as to convert trade
or capital flows or to hedge currency positions.
Brokers are the intermediaries or middlemen in the market, and as
such do not take positions on their own behalf. They act as a mechanism
for matching deals between market makers. Brokers provide market
makers with a bid and/or offer quote left with them by other market
makers. Brokers are bound by confidentiality not to reveal the name of
one client to another until after the deal is done.
Investors are usually managers of large investment funds and are a major
force in moving exchange rates today. They may engage in the market
for hedging, investment, and/or speculation.
Regulatory authorities, while not actually participants in the market,
impact the market from time to time. This sector includes government
and international bodies. Most of the market is self-regulated, with
guidelines of conduct being established by groups such as the Bank for
International Settlement (BIS) and the IMF. National governments can
Zimbabwe Open University
Unit 10
Foreign Exchange Markets
and do impose controls on foreign exchange by legislation or market
intervention through the central banks.
Activity 10.1
do you differentiate the foreign exchange market
? 1. How
from other markets?
2.
3.
4.
Who are the key participants in the foreign exchange
markets?
Explain the functions of the foreign exchange markets.
Distinguish between the spot and futures market with
reference to foreign exchange transactions.
10.6Foreign Exchange Rates
There are two kinds of exchange rate transactions. The predominant ones,
called spot transactions, involve the immediate (two-day) exchange of bank
deposits. Forward transactions involve the exchange of bank deposits at
some specified future date. The spot exchange rate is the exchange rate for
the spot transaction, and forward exchange rate is the exchange rate for the
forward transaction. If the forward rate is above the spot rate, it contains a
premium. If the forward rate is below the spot rate, it contains a negative
premium (also called a discount).
10.6.1 Exchange rate quotations
The direct exchange rate specifies the value of a currency in local currency
terms. For example, the U.S dollar may have a value of ZW$150.00, expressed
as USD/ZWD=150, while the Malawian Kwacha may have a value of
ZW$0.005, expressed as KWA/ZWD=0.005.
The indirect exchange rate specifies the number of units of a foreign currency
equal to a unit of the local currency. For example, using the same figures
above, ZWD/USD=0.00667 and ZWD/KWA=200. Note that the indirect
exchange rate is the reciprocal of the direct exchange rate.
A cross-exchange rate is the exchange rate between two foreign currencies.
It reflects the amount of one foreign currency per unit of another foreign
currency.
Zimbabwe Open University
157
Money and Capital Markets
Module MBAZ510
10.6.2 Why are exchange rates important?
Exchange rates are important because they affect the relative price of domestic
and foreign goods. The dollar price of French goods to an American is
determined by the interaction of two factors: the price of French goods in
euros and the euro/dollar exchange rate.
When a country’s currency appreciates (rises in value relative to other
currencies), the country’s goods abroad become more expensive and foreign
goods in that country become cheaper (holding domestic prices constant in
the two countries). Conversely, when a country’s currency depreciates, its
goods abroad become cheaper and foreign goods in that country become
more expensive.
Appreciation of a currency can make it harder for domestic manufacturers to
sell their goods abroad and can increase competition at home from foreign
goods because they cost less.
10.6.3 How is foreign exchange traded?
You cannot go to a centralised location to watch exchange rates being
determined. Currencies are not traded on exchanges such as Stock Exchanges.
Instead, the foreign exchange market is organised as an over-the-counter
market in which several hundred dealers (mostly banks) stand ready to buy
and sell deposits denominated in foreign currencies. These dealers are in
constant telephone and computer contact, the market is very competitive,
and it functions no differently from a centralised market.
Activity 10.2
what a foreign exchange rate is.
? 1.2. Define
Explain why foreign exchange rates are important in any
3.
4.
a.
b.
c.
158
economy.
Distinguish between spot and forward exchange rates.
Define the following:
direct exchange rate
indirect exchange rate
cross exchange rate
Zimbabwe Open University
Unit 10
Foreign Exchange Markets
10.7Types of Exchange Rate Regimes
There are two types of exchange rate regimes: the fixed (pegged) exchange
rate system and the floating exchange rate system.
10.7.1 Fixed (pegged) exchange rate system
This is when a country ties or pegs the value of its currency to a stable foreign
currency. Under this regime, governments use foreign exchange controls (such
as restrictions on the exchange of the currency) as a form of indirect intervention
to maintain the exchange rate of their currency. However, such countries have
no complete control over their local interest rates because their interest rates
must be aligned with the interest rates of the currency to which their currencies
are pegged.
Advantages of fixed exchange rate regime


Fixed rates of exchange enforce a discipline on domestic economic
policies.
Fixed exchange rates lead to reduced uncertainty regarding goods prices
and lower risk premiums on interest rates. This, in turn, leads to better
investment decisions abroad.
Disadvantages of fixed exchange rate regime


With fixed exchange rates, there is the problem of the rate at which it is
fixed. As with any other form of government intervention, incorrect
decisions regarding the exchange rate impose heavy costs on the
economy.
Fixed exchange rate systems are asymmetrical in the sense that they
force action on deficit countries, which are likely to respond with barriers
to trade, interfering with comparative advantage as the basis for trade,
lowering efficiency of resource use and lowering rates of economic
growth.
10.7.2 Floating exchange rates
A system with no boundaries in which exchange rates are market determined
but are still subject to government intervention is called a dirty float. This can
be distinguished from a freely floating system, in which the foreign exchange
market would be totally free from government intervention.
Advantages of floating exchange rate regime
These are as follows:
Zimbabwe Open University
159
Money and Capital Markets
Module MBAZ510

These allow continuous adjustment to change in the relative real strengths
of economies.
These allow countries to retain control over their own monetary policy.
Hence, a floating exchange rate system reduces the number of policy
targets governments are attempting to achieve and improves the balance
between targets and instruments.
With floating rates, the country is insulated against external shocks of
all kinds.
There will be less need for a country to hold international reserves.
Floating rates will tend towards long-run equilibrium and be relatively
stable. Speculation is assumed to be stabilising.





Disadvantages of floating exchange rate regime
The disadvantages are:







Changes in exchange rates are not a good way to overcome balance of
payments problems.
Floating rate systems have an inflationary bias because there is an
asymmetrical effect between countries with depreciating and
appreciating currencies.
Speculation may be destabilising.
Thus, floating exchange rate systems are likely to be unstable and
produce a great deal of uncertainty for traders.
If falling exchange rates do not work to solve balance of payments
problems quickly, reserves will still be needed in a floating system.
The market exchange rate will be determined by the whole balance of
payments (capital and current accounts) but this may not be in the longterm interest of the economy.
Floating exchange rates allow manipulation of exchange rates in a
country’s own interests and this leads to competitive devaluations and
attempts to export unemployment to other countries.
Activity 10.3
the strengths and weaknesses of the:
? Discuss
a.
fixed exchange rate system
b.
160
floating exchange rate system
Zimbabwe Open University
Unit 10
Foreign Exchange Markets
10.8Factors Affecting Exchange Rates
There are various factors that affect or determine exchange rates in an economy.
Anything that increases the demand for domestic goods relative to foreign
goods tends to appreciate the domestic currency because domestic goods
will continue to sell well even when the value of the domestic currency is
higher. Similarly, anything that increases the demand for foreign goods relative
to domestic goods tends to depreciate the domestic currency because
domestic goods will continue to sell well only if the value of the domestic
currency is lower.
Some of the factors are discussed below.
10.8.1 Relative price levels
When prices of domestic goods rise, (holding prices of foreign goods constant),
the demand for domestic goods falls and the domestic currency tends to
depreciate so that domestic goods can still sell well. By contrast, if prices of
foreign goods rise so that the relative prices of domestic goods fall, the demand
for domestic goods increases, and the domestic currency tends to appreciate
because domestic goods will continue to sell well even with a higher value of
the domestic currency. In the long run, a rise in a country’s price level
(relative to the foreign price level) causes its currency to depreciate, and
a fall in the country’s relative price level causes its currency to appreciate.
10.8.2 Tariffs and quotas
Barriers to free trade such as tariffs (taxes on imported goods) and quotas
(restrictions on the quantity of foreign goods that can be imported) can affect
the exchange rate. Suppose a country imposes a tariff or a quota on foreign
goods. These trade barriers increase the demand for domestic goods, and
the domestic currency tends to appreciate because domestic goods will still
sell well even with a higher value of the domestic currency. Increasing trade
barriers causes a country’s currency to appreciate in the long run.
10.8.3 Preferences for domestic versus foreign goods
Increased demand for a country’s exports causes its currency to appreciate
in the long run; conversely, increased demand for imports causes the domestic
currency to depreciate. If the South Africans develop an appetite for
Zimbabwean goods, the increased demand for our domestic goods (exports)
tends to appreciate our domestic currency because our domestic goods will
Zimbabwe Open University
161
Money and Capital Markets
Module MBAZ510
continue to sell well even at a higher value. Likewise, if Zimbabweans decide
that they prefer South African goods to domestic goods, the increased demand
for imports tends to depreciate the domestic currency.
10.8.4 Productivity
If one country becomes more productive than other countries, businesses in
that country can lower the prices of domestic goods relative to foreign goods
and still earn a profit. As a result, the demand for domestic goods rises, and
the domestic currency tends to appreciate. If, however, its productivity lags
behind that of other countries, its goods become relatively more expensive,
and the currency tends to depreciate. In the long run, as a country becomes
more productive relative to other countries, its currency appreciates.
10.8.5 Differential inflation rates
A well-known theory about the relationship between inflation and exchange
rates, Purchasing Power Parity (PPP), suggests that the exchange rate
will, on average, change by a percentage that reflects the inflation differential
between two countries.
10.8.6 Differential interest rates
Interest rate movements affect exchange rates by influencing the capital flows
between countries. An increase in domestic interest rates relative to foreign
interest rates may attract foreign investors, especially if the higher interest
rates do not reflect an increase in inflationary expectations. Increased demand
for domestic interest-bearing securities will result in increased demand for the
domestic currency thereby causing its appreciation. In the reverse situation,
opposite forces occur, resulting in upward pressure on the foreign currency
and downward pressure on the value of the domestic currency.
10.8.7 Central bank intervention
A country’s government can intervene in the foreign exchange market to affect
a currency’s value. Direct intervention occurs when a country’s central bank
sells or buys some of its currency reserves to defend the value of its currency.
Central bank intervention may significantly affect the foreign exchange markets
in two ways. First, it may slow the momentum of adverse exchange rate
movements. Second, foreign exchange market participants may reassess their
foreign exchange strategies if they believe the central bank will continue to
intervene.
?
162
Zimbabwe Open University
Unit 10
Foreign Exchange Markets
Activity 10.4
the key factors that determine exchange rates in any
? Discuss
economy.
10.9Forecasting Exchange Rates
Market participants who use foreign exchange derivatives tend to take positions
based on their expectations of future exchange rates. Speculators may take
positions in foreign exchange derivatives to benefit from the expectation that
certain currencies will strengthen. Thus, the initial task is to develop a forecast
of specific exchange rates. Most forecasting techniques can be classified as
one of the following:




Technical forecasting
Fundamental forecasting
Market-based forecasting
Mixed forecasting
10.9.1 Technical forecasting
Technical forecasting involves the use of historical exchange rate data to predict
future values. For example, the fact that a given currency has increased in
value over four consecutive days may provide an indication of how the currency
will move tomorrow. Technical forecasting of exchange rates is similar to
technical forecasting of stock prices. If the pattern of currency values over
time appears random, then technical forecasting is not appropriate. Unless
historical trends in exchange rate movements can be identified, examination
of past movements will not be useful for indicating future movements.
10.9.2 Fundamental forecasting
Fundamental forecasting is based on fundamental relationships between
economic variables and exchange rates. Given current values of these variables
along with their historical impact on currency’s value, corporations can develop
exchange rate projections. For example, high inflation in a given country can
lead to depreciation in its currency. Of course, all other factors that may
influence exchange rates should also be considered.
Zimbabwe Open University
163
Money and Capital Markets
Module MBAZ510
10.9.3 Market-based forecasting
Market-based forecasting, the process of developing forecasts from market
indicators, is usually based on either the spot rate of the forward rate.
Use of the spot rate
Assume that the British Pound is expected to appreciate against the American
dollar in the very near future. This will encourage speculators to buy the pound
with dollars today in anticipation of its appreciation, and those purchases
could force the pound’s value up immediately. Conversely, if the pound is
expected to depreciate against the dollar, speculators will sell off pounds now,
hoping to purchase them back at a lower price after they decline in value.
Such action could force the pound to depreciate immediately. Thus, the current
value of the pound should reflect the expectation of the pound’s value in the
very near future. Corporations can use the spot rate to forecast, since it
represents the market’s expectation of the spot rate in the near future.
Use of the forward rate
The forward rate can serve as a forecast of the future spot rate, because
speculators would take positions if there was a large discrepancy between
the forward rate and expectations of the future spot rate. For instance, suppose,
the 30-day forward rate of the British pound is $1.40 and the general
expectation of speculators is that the future spot rate of the pound will be
$1.45 in 30 days. Given the future spot rate of $1.45 against the prevailing
forward rate of $1.40, speculators will buy pounds 30 days forward at $1.40
and then sell them when received in 30 days at the spot rate existing then. If
their forecast is correct, they earn $0.05 per pound. If a large number of
speculators implement this strategy, the substantial forward purchases of
pounds will cause the forward rate to increase until this speculative demand
stops. Once the forward rate equals the future spot rate, this speculative
transaction stops as there if no profit to be gained.
10.9.4 Mixed forecasting
Because no single forecasting technique has been found to be consistently
superior to the others, some multinational corporations use a combination of
forecasting techniques. Various forecasts for a particular currency value are
developed using several forecasting techniques. Each of the techniques used
is assigned a weight so that the weights total 100 percent. The techniques
thought to be more reliable are assigned higher weights. The actual forecast
of the currency by the multinational corporation will be a weighted average of
the various forecasts developed.
164
Zimbabwe Open University
Unit 10
Foreign Exchange Markets
Activity 10.5
do you think it is important to forecast foreign
? 1. Why
exchange rates?
2.
Describe the four main techniques used in forecasting
exchange rates.
10.10 Forms of Exposure to Exchange Rate Risk
By way of explanation, foreign exchange exposure is the risk of financial impact
due to changes in foreign exchange rates and, in general, there are three types
of foreign exchange exposures: transaction exposure, translation exposure
and economic exposure.
10.10.1 Transaction exposure
Transactions exposures principally impact a company’s profit and loss and
cash flow and result from transacting business in a currency or currencies
different from the company’s home currency. For example, consider the position
of a British exporting company selling in the U.S. market and entering into a
contract to supply goods over the next year. Payment is to be made in dollars
within a stated period after the delivery of the goods. The British company
bases its sterling prices on its current production costs in the UK, but to
convert these into dollar prices must assume an exchange rate for sterling
against the dollar. The company is said to be long in dollars (it has net assets
in dollars in the form of the future payments to be received in dollars).
The risk facing a company long in a foreign currency is that the foreign currency
will weaken between the signing of the contract and the settlement of the
account. A company that owes money in a foreign currency is said to be short
in that currency (it has net liabilities in the foreign currency). The risk it faces is
that the value of the foreign currency will rise before it pays its debts. Market
participants who are either long or short in a foreign currency have an open
position in the market.
10.10.2 Translation exposure
Translation exposure covers the case of a parent company with subsidiaries
in other countries, where there is a need to produce a financial statement
showing the position of the whole group of companies. If the accounts of the
Zimbabwe Open University
165
Money and Capital Markets
Module MBAZ510
subsidiaries involve foreign currency-denominated assets and liabilities (on
balance sheets or in income statements), the translation of these into the group
statement may involve foreign exchange exposure.
10.10.3 Economic exposure
Economic exposure, like transaction exposure, relates to cash flows but is
concerned with the impact on the present value of future cash flows of all
changes associated with the depreciation or appreciation of a currency. As an
example, consider more closely the British exporter selling its goods in the
US. Remember that the risk the firm faces is that the value of the US dollar
will fall. Suppose, however, that there is inflation in the US and thus that the
firm is able to sell its product for an increasing number of dollars. Suppose
further that the fall in the value of the dollar that occurs is just equal to the
difference in the rate of inflation in the two countries (relative purchasing power
parity holds). In this case, the firm will be no worse off overall. There would
be transaction exposure because a fixed quantity of dollars would at a given
time exchange for fewer pounds. However, there would be no economic
exposure because the firm would have benefited from the difference in inflation
rates that had caused the dollar to fall in value. Thus, one way of comparing
the two types of exposure is to say that transaction exposure arises from
changes in nominal exchange rates while economic exposure derives from
changes in real exchange rates (when purchasing power parity does not hold).
10.11 Exchange Rate Risk Management Techniques
A variety of techniques have been developed to help firms counter foreign
exchange risk (to allow companies to cover themselves against risk, or to
move from an open to a closed position in the market). These may be divided
into internal techniques, which relate to the accounting systems and the payment
and invoicing procedures used by companies, and external techniques, which
concern the development of new instruments and markets. This unit
concentrates on the market techniques here. They include the use of forward
exchange markets, the use of derivatives markets such as those in financial
futures and options, swap deals and short-term borrowing in a foreign currency.
10.11.1 Forward contracts
Forward contracts are a common hedging product and are used by importers,
exporters, investors, and borrowers. They are valuable to those with existing
166
Zimbabwe Open University
Unit 10
Foreign Exchange Markets
assets or liabilities in foreign currencies and to those who want to lock in a
specific foreign exchange rate in the future. For example, corporations that
must receive or pay foreign currencies in the future because of their normal
business activities usually prefer to transfer the risk that the values of these
currencies will change during the intervening period. They can use the bank
forward market to establish today, the exchange rate between two currencies
for a value date in the future. Generally, when corporations contract to pay to
or receive from a bank foreign currency in the future, no money is exchanged
until the settlement on the value date.
While forwards may be used to hedge payables and receivables, corporations
will also hedge other assets and liabilities on a company’s balance sheet. The
value dates of forward contracts are often constructed to match up with the
expected dates of receipts for a foreign payment, or payment of a foreign
currency obligation. A forward contract can be tailored to meet a client’s
specific needs in terms of delivery dates and amount. In addition to transacting
with clients, banks actively trade forward currency commitments among
themselves, as well. In essence, forwards provide certainty in the uncertain
world of currency movements by locking in a specific rate, and as the forward
markets are quite liquid, the bid/offer spreads are relatively low for the major
currencies.
10.11.2 Currency futures contracts
Currency futures contract is an alternative to the forward contract, which is a
standardised contract that specifies an amount of a particular currency to be
exchanged on a specified date and at a specified exchange rate. A firm can
purchase a futures contract to hedge payables in a foreign currency by locking
in the price at which it could purchase that specific currency at a particular
point in time. To hedge receivables denominated in a foreign currency, it could
sell futures, thereby locking in the price at which it could sell that currency. A
futures contract represents a standard number of units. Currency futures
contracts also have specific maturity (or settlement) dates from which the firm
must choose. They differ from forward contracts in that they are standardised,
whereas forward contracts can specify whatever amount and maturity date
the firm desires. Forward contracts have this flexibility because they are
negotiated with commercial banks rather than on a trading floor.
10.11.3 Currency swaps
A currency swap is an agreement that allows one currency to be periodically
swapped for another at specified exchange rates. It essentially represents a
Zimbabwe Open University
167
Money and Capital Markets
Module MBAZ510
series of forward contracts. Banking institutions facilitate currency swaps by
serving as the intermediary that links two parties with opposite needs.
Alternatively, banks may be willing to take the position counter to that desired
by a particular party. In such a case, they expose themselves to exchange rate
risk unless the position they have assumed will offset existing exposure.
10.11.4 Forward rate agreements
Forward rate agreements allow two parties to exchange interest-payment
obligations, and if the obligations are in different currencies there is an
exchange-rate component to the agreement.
10.11.5 Currency options contract
Another instrument used for hedging is the currency options. Its primary
advantage over forward and futures contract is that it provides a right rather
than an obligation to purchase or sell a particular currency at a specified price
within a given period.
A currency call option provides the right to purchase a particular currency at
a specified price (called the exercise price) within a specified period. This
type of option can be used to hedge future cash payments denominated in a
foreign currency. If the spot rate remains below the exercise price, the option
will not be exercised, because the firm could purchase the foreign currency at
a lower cost in the spot market. A fee or premium must be paid for options,
however, so there is a cost to hedging with options, even if the options are not
exercised.
A put option provides the right to sell a particular currency at a specified price
(exercise price) within a specified period. If the spot rate remains above the
exercise price, the option will not be exercised, because the firm could sell the
foreign currency at a higher price in the spot market. Conversely, if the spot
rate is below the exercise price at the time the foreign currency is received,
the firm can exercise its put option.
168
Zimbabwe Open University
Unit 10
Foreign Exchange Markets
Activity 10.6
is always worse off when its currency is weak
? 1. “A(fallscountry
in value).” Is this statement true, or untrue? Explain
2.
3.
4.
5.
6.
7.
your answer.
If the European price level rises by 5% relative to the
price level in the United Sates, what does the theory of
purchasing power parity predict will happen to the value
of the euro in terms of dollars?
If the demand for a country’s exports falls at the same
time that tariffs on imports are raised, will the country’s
currency tend to appreciate or depreciate in the long
run?
Assume that a certain country has a very strong economy,
putting upward pressure on both inflation and interest
rates. Explain how these conditions could put pressure
on the value of its domestic currency, and determine
whether the domestic currency will rise or fall.
Under what circumstances might speculators perform
the role normally played by arbitrageurs in foreign
exchange markets – that of removing inconsistencies
among prices? (Note: consider the relationship between
forward and future spot rates of exchange.)
Consider the relative advantages and disadvantages of
using forward contracts, futures contracts and options
as means of speculation.
Discuss the three main forms of exchange rate exposures
and explain the various risk management techniques used
to manage the same.
10.12 Summary
The foreign exchange market is by far the largest of all financial markets. It
has no fixed base but exists through communications and information systems
consisting of telephones, internet and other means of instant communications.
The rapid growth in international trade between countries contributed to the
growth of the foreign exchange market. The market forces of supply and
demand for currencies determine movements in exchange rates, ultimately
determining the values of currencies. Participants in the foreign exchange
market are exposed to transaction exposure, translation exposure and economic
exposure. Forward contracts, currency swaps and forward rate agreement
are some of the hedging instruments against these exposures.
Zimbabwe Open University
169
Money and Capital Markets
Module MBAZ510
References
Chisholm, A. M. (2009). Introduction to International Capital Markets.
2nd Edition. London: John Wiley and Sons.
Choudhry, M. et al (2010). Capital Market Instruments: Analysis and
Valuation. 3rd Edition London: Palgrave Macmillan.
Frank J. Fabozzi (2007). Fixed Income Analysis. 2nd Edition. John Wiley
and Sons.
Levinson, M. (2006). Guide to Financial Markets. 4th Edition. London:
Profile Books Limited.
Madura, J. (2010). Financial Markets and Institutions. 9th Edition. Florida:
South-Western College.
Mishkin, F.S. and Eakins, S.G. (2006). Financial Markets and Institution.
5th Edition. New York: Pearson Addison Wesley.
170
Zimbabwe Open University
Unit Eleven
The International Financial System
11.0 Introduction
T
he international financial system now plays a more prominent role in
economic events around the world. In this unit, we are going to discuss
the different types of intervention in the foreign exchange markets, the concept
of dollarisation and currency board system. In addition, we will explain the
balance-of-payment surpluses and deficits and how these affect economic
performance of countries.
Money and Capital Markets
Module MBAZ510
11.1 Objectives
By the end of this unit, you should be able to:





explain the different types of intervention in the foreign
exchange markets
discuss the concept of dollarisation and the currency
board system
describe how the fixed and managed exchange rate
systems work
explain how the balance-of-payment surpluses and
deficits affect the economic performance of countries
analyse the pros and cons of capital controls on economic
performance
11.2 Intervention in the Foreign Exchange Market
Foreign exchange markets, like other financial markets, are not free of
government intervention. Central banks regularly engage in international financial
transactions called foreign exchange interventions in order to influence
exchange rates.
11.2.1 Unsterilised intervention
This is the intervention in which a central bank allows the purchase or sale of
domestic currency to have an effect on the monetary base and hence on the
money supply. A central bank’s purchase of domestic currency and
corresponding sale of foreign assets in the foreign exchange market leads to
an equal decline in its international reserves and the monetary base.
172
Zimbabwe Open University
Unit 11
The International Financial System
Table 11.1: Simultaneous purchase of domestic currency and sale of
foreign assets (unsterilised intervention)
Central Bank System
Assets
Liabilities
Foreign assets
Currency in circulation -$1billion
International reserves -$1 billion
International reserves are holdings of assets denominated in foreign currency.
Monetary base is made up of currency in circulation plus reserves. The central
bank’s purchase of domestic currency has the effect of reducing its international
reserves and currency in circulation.
A central bank’s sale of domestic currency to purchase foreign assets in the
foreign exchange market results in an equal increase in its international reserves
and the monetary base.
11.2.2 Sterilised intervention
A foreign exchange intervention with an offsetting open market operation that
leaves the monetary base unchanged is called a sterilised foreign exchange
intervention. This is when the central bank does not want the purchase or sale
of domestic currency to affect the monetary base and the money supply in the
economy. All it has to do is to counter the effect of the foreign exchange
intervention by conducting an offsetting open market operation in the
government bond market. For example, a central bank’s purchase (sale) of
domestic currency and corresponding sale (purchase) of foreign assets in the
foreign exchange market leads to an equal decline (increase) in its international
reserves and the monetary base. This can be countered by the open market
purchase (sale) of the domestic government bonds, which would increase
(decrease) the monetary base by the same amount. The net effect is that the
monetary base would remain unchanged.
Zimbabwe Open University
173
Money and Capital Markets
Module MBAZ510
Table 11.2: Sterilised intervention
Central Bank System
Assets
Liabilities
Foreign assets
Monetary base
international reserves -$1 billion
currency in circulation + reserves 0
Government bonds +$1 billion
11.2.3 Depreciation of the domestic currency
An unsterilised intervention in which domestic currency is sold to purchase
foreign assets leads to a gain in international reserves, an increase in the money
supply, and a depreciation of the domestic currency. The increase in the money
supply reduces the interest rate on domestic currency deposits relative to
foreign deposits. The decrease in the expected return on domestic deposits
relative to foreign deposits will mean that people will want to buy more foreign
deposits, and the exchange rate will decline.
This, of course, holds under the assumption that foreign and domestic deposits
are perfect substitutes that is, equally desirable.
11.2.4 Appreciation of the domestic currency
An unsterilised intervention in which domestic currency is purchased by selling
foreign assets leads to a drop in international reserves, a decrease in the money
supply, and an appreciation of the domestic currency. The decrease in the
money supply raises the interest rate on domestic currency deposits relative
to foreign deposits. The increase in the expected return on domestic deposits
relative to foreign deposits will mean that people will want to buy more domestic
deposits, and the exchange rate will rise.
This, of course, holds under the assumption that foreign and domestic deposits
are perfect substitutes that is, equally desirable.
174
Zimbabwe Open University
Unit 11
The International Financial System
Activity 11.1
do central banks regularly intervene in foreign
? 1. Why
exchange markets?
2.
3.
4.
Explain the different types of intervention in the foreign
exchange markets.
What are international reserves?
Describe actions and activities that can lead to an
appreciation or depreciation of currencies.
11.3 Balance of Payments
Because international financial transactions such as foreign exchange
interventions have considerable effect on the economy, it is worth knowing
how these transactions are measured. This is done using the balance of
payments, a bookkeeping system for recording all receipts and payments that
have a direct bearing on the movement of funds between nations that result
from private and government transactions. The two important items in the
balance of payments are the current and capital accounts.
11.3.1 Current account
This shows international transactions that involve currently produced goods
and services. The most important item in this account is the trade balance, the
difference between merchandise exports and imports (i.e. the net receipts
from trade. When merchandise imports are greater than exports, we have a
trade deficit. If exports are greater than imports, we have a trade surplus.
11.3.2 Capital account
This is another important item in the balance of payments. These are the net
receipts from capital transactions. Flows of capital into a country are registered
as receipts, whereas outflows are registered as payments. A positive capital
account means that, on net, capital is flowing into a country. Because the
balance of payments must balance, the net change in government international
reserves that a government (as represented by its central bank) uses to finance
international transactions equals the current account plus the capital account.
That is,
Zimbabwe Open University
175
Money and Capital Markets
Module MBAZ510
Current account + capital account = net change in government international
reserves
This equation shows why the current account receives so much attention from
economists and the media. It tells us whether the country (private sector and
government combined) is increasing its claims on foreign wealth or whether
foreigners are increasing their claims on a country’s domestic wealth. The
account tells us that a negative current account balance (i.e. a deficit) must be
matched either by a positive capital account (net capital inflow) or a negative
net change in international reserves, both of which involve an increase in claims
of foreigners on a country’s wealth.
11.4 Exchange Rate Regimes in the International
Financial System
Exchange rate regimes in the international financial system are of two basic
types: fixed and floating. In a fixed exchange rate regime, the values of
currencies are kept pegged relative to one currency (called the anchor
currency) so that exchange rates are fixed. In a floating exchange rate
regime, the values of currencies are allowed to fluctuate against one another.
However, countries often attempt to influence their exchange rates by buying
and selling currencies, so in this case the regime is referred to as a managed
float regime (or a dirty float).
11.4.1 Intervention in the foreign exchange market under a
fixed exchange rate regime
Figure 11.1 below describes a situation in which the domestic currency is
fixed relative to an anchor currency and is initially overvalued. The schedule
for the expected return on foreign deposits RF1 intersects the schedule for the
expected return on domestic deposits RD1 at exchange rate E1, which is lower
than the par (fixed) value of the exchange rate E par. To keep the exchange rate
at E par, the central bank must intervene in the foreign exchange market to
purchase domestic currency by selling foreign assets, and this action, like an
open market sale, means that the monetary base and the money supply decline.
Because the exchange rate will continue to be fixed at E par, the expected
future exchange rate remains unchanged, and so the schedule for the expected
return on foreign deposits remains at RF1. However, the purchase of domestic
currency, which leads to a fall in the money supply, also causes the interest
rate on domestic deposits iD to rise. This increase in turn shifts the expected
176
Zimbabwe Open University
Unit 11
The International Financial System
return on domestic deposits RD to the right. The central bank will continue
purchasing domestic currency and selling foreign assets until the RD curve
reaches RD2 and the equilibrium exchange rate is E par at point 2.
In conclusion, when the domestic currency is overvalued, the central bank
must purchase domestic currency to keep the exchange rate fixed, but as a
result it loses international reserves.
RD2
Exchange Rate, Et
(foreign currency/
domestic currency)
RD1
RF1
E par …………………………………………………… 2
E 1 . ………………………………..
RD2
iD1
1
iD2
Expected Return (in domestic currency terms)
Figure 11.1 Intervention in the case of an overvalued exchange rate
Source: Jeff Madura (2010), Financial Markets and Institutions, 9th
Edition; Joe Sabatino Publishers
Figure 11.2 below describes a situation in which the domestic currency is
fixed relative to an anchor currency and is initially undervalued. It shows how
a central bank intervention keeps the exchange rate fixed at E par when the
Zimbabwe Open University
177
Money and Capital Markets
Module MBAZ510
exchange rate is initially undervalued, that is, when RF1 and the initial RD1
intersect at exchange rate E1, which is above Epar. Here the central bank must
sell domestic currency and purchase foreign assets, and this works like an
open market purchase to raise the money supply and to lower the interest
rate on domestic deposits iD. The central bank keeps selling domestic currency
and lowers iD until RD shifts all the way to RD2, where the equilibrium exchange
rate is at E par – point 2 in figure 11.2.
Exchange Rate, Et
(foreign currency/
domestic currency)
E1
E par
RD2
RD1
………………………………………………
RF1
1
…………………………… 2
iD2
iD1
Figure 11.2 Intervention in the case of an undervalued exchange rate
Source: Jeff Madura (2010), Financial Markets and Institutions, 9 th
Edition; Joe Sabatino Publishers
When the domestic currency is undervalued, the central bank must sell domestic
currency to keep the exchange rate fixed, but as a result it gains international
reserves.
If a country’s currency has an overvalued exchange rate, its central bank’s
attempts to keep the currency from depreciating will result in a loss of
178
Zimbabwe Open University
Unit 11
The International Financial System
international reserves. If the country’s central bank eventually runs out of
international reserves, it cannot keep its currency from depreciating, and the
devaluation must occur, meaning that the par exchange rate is reset as a
lower level.
If, by contrast, a country’s currency has an undervalued exchange rate, its
central bank’s intervention to keep its currency from appreciating leads to a
gain of international reserves. Because the central bank might not want to
acquire these international reserves, it might want to reset the par value of its
exchange rate at a higher level (a revaluation).
11.4.2 Shortcomings of fixed exchange rate systems
Fixed exchange rate systems can lead to foreign exchange crises involving a
speculative attack on a currency; i.e. massive sales of a weak currency or
purchases of a strong currency to cause a sharp change in the exchange rate.
Activity 11.2
do you understand by the term “balance of
? 1. What
payments”?
2.
3.
Explain the two components constituting the balance of
payments of any country.
Describe the conditions under which a devaluation or
revaluation is possible in any economy.
11.5 Currency Board System
A currency board system is one in which the domestic currency has 100%
backing in foreign reserves and in which the note-issuing authority, whether
the central bank or the government, adopts a fixed exchange rate against a
particular foreign currency and then stands ready to exchange domestic
currency for foreign currency at that rate whenever the public requests it.
A currency board is just a variant of a fixed exchange rate regime in which the
commitment to the fixed exchange rate is especially strong because the conduct
of monetary policy is in effect put on autopilot and is completely taken out of
the hands of the central bank and the government. The central bank no longer
Zimbabwe Open University
179
Money and Capital Markets
Module MBAZ510
has the ability to print money and thereby cause inflation. In addition, the
central bank losses its lender of last resort function.
11.6 Dollarisation
Dollarisation involves the adoption of another country’s currency, and it is a
more extreme version of fixed exchange rate than is a currency board. A
currency board can be abandoned, allowing a change in the value of the
currency, but a change of value is impossible with dollarisation. A dollar bill is
always worth one dollar whether it is held in the U.S. or outside of it.
Dollarisation, like a currency board, prevents a central bank from creating
inflation. Another key advantage is that it completely avoids the possibility of
a speculative attack on the domestic currency (because there is none) that is
still a danger even under a currency board arrangement. However, like a
currency board, dollarisation does not allow a country to pursue its own
monetary policy or have a lender of last resort. One additional disadvantage
of dollarisation not characteristic of a currency board is that; because a country
adopting dollarisation no longer has its own currency, it loses the revenue that
a government receives by issuing money, which is called seigniorage. Because
governments (or the central banks) do not have to pay interest on their
currency, they earn revenue (seigniorage) by using this currency to purchase
income-earning assets such as bonds. If an emerging-market country dollarises
and gives up its currency, it needs to make up this loss of revenue somewhere,
which is not always easy for a poor country.
11.7 Managed Floating Exchange Rates
Although exchange rates are currently allowed to change daily in response to
market forces, central banks have not been willing to give up their option of
intervening in the foreign exchange market. Preventing large changes in exchange
rates makes it easier for firms and individuals purchasing or selling goods
abroad to plan into the future.
Furthermore, countries with surpluses in their balance of payments frequently
do not want to see their currencies appreciate because it makes their goods
more expensive abroad and foreign goods cheaper in their country. Because
an appreciation might hurt sales for domestic businesses and increase
unemployment, surplus countries have often sold their currency in the foreign
exchange market and acquired international reserves.
180
Zimbabwe Open University
Unit 11
The International Financial System
Countries with balance-of-payments deficits do not want to see their currency
lose value because it makes foreign goods more expensive for domestic
consumers and can stimulate inflation. To keep the value of the domestic
currency high, deficit countries have often bought their own currency in the
foreign exchange market and given up international reserves.
The current international financial system is a hybrid of a fixed and a flexible
exchange rate system. Rates fluctuate in response to market forces but are
not determined solely by them. Furthermore, many countries continue to keep
the value of their currency fixed against other currencies.
11.8 Capital Controls
Capital controls have been an important element in the currency crises that
rocked the world from time immemorial. Politicians and economists have
advocated that capital mobility in emerging market countries should be
restricted with capital controls in order to avoid financial instability. Are capital
controls a good idea?
11.8.1 Controls on capital outflows
Capital outflows can promote financial instability in emerging market countries
because when domestic residents and foreigners pull their capital out of a
country, the resulting capital outflow forces a country to devalue its currency.
Empirical evidence indicates that controls on capital outflows are seldom
effective during a crisis because the private sector finds ingenious ways to
evade them and has little difficulty moving funds out of the country. Furthermore,
capital flight may even increase after controls are put into place because
confidence in the government is weakened. Controls on capital outflows often
lead to corruption, as government officials get paid off to look the other way
when domestic residents are trying to move funds abroad. Controls on capital
outflows may lull governments into thinking they do not have to take the steps
to reform their financial systems to deal with the crisis, with the result that
opportunities are lost to improve the functioning of the economy.
11.8.2 Controls on capital inflows
Although most economists find the arguments against controls on capital
outflows persuasive, controls on capital inflows receive more support.
Supporters argue that if speculative capital cannot come in, then it cannot go
Zimbabwe Open University
181
Money and Capital Markets
Module MBAZ510
out suddenly and create a crisis. Capital inflows can lead to a lending boom
and excessive risk taking on the part of banks, which then helps trigger a
financial crisis.
Controls on capital inflows have the undesirable feature that they may block
from entering a country funds that would be used for productive investment
opportunities. Although such controls may limit the fuel supplied to lending
booms through capital flows, over time they produce substantial distortions
and misallocation of resources as households and businesses try to get around
them. These controls can lead to corruption. Capital controls cannot be
effective in today’s environment, in which trade is open and where there are
many financial instruments that make it easier to get around these controls.
On the other hand, there is a strong case for improving bank regulation and
supervision so that capital inflows are less likely to produce a lending boom
and encourage excessive risk taking by banking institutions. For example,
restricting banks in how fast their borrowing could grow might have the impact
of substantially limiting capital inflows. Supervisory controls of this type,
focusing on the sources of financial fragility rather than the symptoms, can
enhance the efficiency of the financial system rather than hampering it.
Activity 11.3
a central bank buys its domestic currency in the foreign
? 1. Ifexchange
market but conducts an offsetting open market
2.
3.
4.
182
operation to sterilise the intervention, what will be the
impact on international reserves, the money supply, and
the exchange rate?
If the central bank buys its domestic currency in the foreign
exchange market but does not sterilise the intervention,
what will be the impact on international reserves, the
money supply, and the exchange rate?
If a country’s par exchange rate was undervalued during
the Bretton-Woods fixed exchange rate regime, what kind
of intervention would that country’s central bank be
forced to undertake, and what effect would it have on its
international reserves and the money supply?
How can a large balance-of-payments surplus contribute
to the country’s inflation rate?
Zimbabwe Open University
Unit 11
The International Financial System
a country wants to keep its exchange rate from
? 5. “Ifchanging,
it must give up some control over its money
6.
7.
8.
9.
10.
11.
12.
supply”. Is this statement true, false, or uncertain? Explain
your answer.
Why can balance-of-payments deficits force some
countries to implement a contractionary monetary policy?
How can persistent balance-of-payments deficits stimulate
world recession?
Are capital controls on capital outflows a good idea?
Explain.
Discuss the pros and cons of capital controls on capital
inflows.
Define the concept “dollarisation”, and discuss its pros
and cons.
Discuss the pros and cons of a currency board and
contrast it from dollarisation.
If the balance in the current account increases by $2 billion
while the capital account is off $3.5 billion, what is the
impact on governmental international reserves?
11.9 Summary
The economies of the rest of the world have become interlinked and
interdependent. The international financial system now plays a more prominent
role in economic events around the world. In this unit, we discussed how
fixed and managed exchange rate systems work and how they can provide
substantial profit opportunities for financial institutions. Central banks regularly
engage in international transactions known as foreign exchange interventions
in order to influence exchange rates. These foreign exchange interventions
have considerable effect on the economy. The international financial system
comprises two types of exchange rate regime, namely, the fixed exchange
rate system and the floating exchange rate system. A currency board is an
extension of a fixed exchange rate in which a domestic currency has 100%
backing in foreign reserves. Dollarisation is an extreme version of a fixed
exchange rate regime, in which a country’s local currency is abandoned in
place of a stable foreign currency.
Zimbabwe Open University
183
Money and Capital Markets
Module MBAZ510
References
Chisholm, A. M. (2009). Introduction to International Capital Markets.
2nd Edition London: John Wiley and Sons.
Choudhry, M. et al (2010). Capital Market Instruments: Analysis and
Valuation. 3rd Edition London: Palgrave Macmillan.
Frank J. Fabozzi (2007). Fixed Income Analysis. 2nd Edition John Wiley
and Sons.
Levinson, M. (2006). Guide to Financial Markets. 4th Edition London:
Profile Books Limited.
Madura, J. (2010). Financial Markets and Institutions. 9th Edition Florida:
South-Western College.
Mishkin, F.S. and Eakins, S.G. (2006). Financial Markets and Institution.
5th Edition New York: Pearson Addison Wesley.
184
Zimbabwe Open University
Blank page