FINC3131
Business Finance
Chapter 2,6,8
Financial Markets, Interest, Return and
Risk
1
The Capital Allocation Process
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In a well-functioning economy, capital flows efficiently
from those who supply capital to those who demand it.
Suppliers of capital – individuals, firms, institutions,
and government agency with “excess funds”. These
groups are saving money and looking for a rate of
return on their investment.
Demanders or users of capital – individuals, firms,
institutions, and government who need to raise funds
to finance their investment opportunities. These
groups are willing to pay a rate of return on the capital
they borrow.
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The Capital Allocation Process
3
Overview of Financial Markets
Types of Financial Markets
a. Money versus Capital Markets
b. Primary versus Secondary Markets
c. Organized versus Over-the-Counter
Markets
d. Spot versus Future Markets
4
Financial Markets 1
Financial markets: markets for trading financial securities.
 Primary market:
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Markets in which companies raise money by selling securities
to investors.
Every security sells only once in the primary market.
Initial public offering market: firms become publicly owned by
issuing (selling) shares to investors for the first time.
Secondary market:


Markets in which already issued securities trade.
Trading is primarily among investors. Issuers are usually not
involved.
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Financial Markets 2
 Money market: markets for trading of debt
securities with less than one-year maturity.
 Capital markets: market for trading of
intermediate-term and long-term debt and
common stock.
 Spot markets: securities are bought and sold
for ‘on-the-spot’ delivery.
 Futures markets: trading takes place now, but
full payment and delivery of the asset takes
place in the future, e.g., 6 months or 1-year.
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Types of Financial Institutions
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Commercial banks
Investment banks
Mutual savings banks
Credit unions
Pension funds
Life insurance companies
Mutual funds
Hedge funds
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Asset Sizes of Financial Institutions (in Billions
of Dollars)
8
Source: Board of Governors, Federal Reserve System, 2007.
What is a financial security?
 It’s a contract between the provider of funds
and the user of funds.
 The contract specifies the:
 amount of money that has been provided
 terms & conditions of how the user is going to repay
the provider


Provider: you (ordinary investor), the bank, venture
capitalist, etc.
User: entrepreneur or firm with good business
idea/product but with no (or insufficient) funds to
execute the idea.
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Simple example
 You start your firm by borrowing 7.5 million
dollars from a bank at 8 percent interest p.a.
 In return, your contract with the bank stipulates
that you will repay the bank in 10 equal yearly
installments. Each installment is approximately
1.118 million dollars every year.
 The loan that the bank has given you is a
financial security!
10
TVM and valuing
financial securities
 To an investor who owns a financial security
(e.g., the bank in the previous example), the
security is a stream of future expected cash
flows.
 A financial security’s value or price is simply
the Present Value of all future expected cash
flows generated by the security.
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Securities
a. Money Market Securities
Treasury Bill (T-bill); Commercial paper; negotiable
CD by banks
b. Capital Market Securities
Bonds and Mortgages, Stocks
c. Derivative Securities
Futures, Options, Swaps
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Common financial securities
Debt security
Equity security
1) Holder is a creditor of the firm.
No say in running of the firm.
1) Holder is an owner of the firm.
Have a say in running of the firm
(by voting).
2) Fixed payment.
2) Payment is not fixed. No
guaranteed cash flow from firm.
3) Receives payment before
anything is paid to equity holders.
3) Receives what’s left over after
all debt holders/creditors are paid.
4) If firm cannot pay, debt holders
will take over ownership of firm
assets.
4) If firm cannot pay debt holders,
loses control of firm to debt
holders.
5) Limited liability.
5) Limited liability.
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Equity securities (common stock)
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Equity security means common stock.
Common stock holders have control privileges, i.e.,
have a say in firm’s operating decisions.
•
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Exercise control privileges by voting on matters of importance
facing the firm. Voting takes place during shareholder
meetings.
Board of directors: Elected by shareholders to make
sure management acts in the best interests of
shareholders.
Common stock holders can expect two types of cash
flows:
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Dividends
Money received from selling shares
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Physical location stock exchanges
vs. Electronic dealer-based markets
 Auction market vs.
Dealer market
 NYSE vs. Nasdaq
15
What is an IPO?
 An initial public offering (IPO) is where a
company issues stock in the public market
for the first time.
 “Going public” enables a company’s
owners to raise capital from a wide variety
of outside investors. Once issued, the
stock trades in the secondary market.
 Public companies are subject to additional
regulations and reporting requirements.
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Stock Market Transactions

Apple Computer decides to issue additional stock
with the assistance of its investment banker. An
investor purchases some of the newly issued
shares. Is this a primary market transaction or a
secondary market transaction?
•

Since new shares of stock are being issued, this is a
primary market transaction.
What if instead an investor buys existing shares
of Apple stock in the open market – is this a
primary or secondary market transaction?
•
Since no new shares are created, this is a secondary
market transaction.
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Where can you find a stock quote,
and what does one look like?

Stock quotes can be found in a variety of print sources (Wall
Street Journal or the local newspaper) and online sources
(Yahoo!Finance, CNNMoney, or MSN MoneyCentral).
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Characteristics of Debt Securities
that Cause Their Yields to Vary
Default Risk
a. Rating Agencies
1.) Moody’s Investor Service
2.)
Standard and Poor’s Corporation
b. Accuracy of Credit Ratings
19
Exhibit 3.1 Rating Classification by Ratings
Agencies
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Characteristics of Debt Securities
that Cause Their Yields to Vary
Term to Maturity
•
•
maturity dates will differ between debt
securities
The term structure of interest rates defines
the relationship between term to maturity
and the annualized yield (Yield Curve)
21
Illustrating the relationship between
corporate and Treasury yield curves
Interest
Rate (%)
15
BB-Rated
10
AAA-Rated
5
Treasury
6.0% Yield Curve
5.9%
5.2%
Years to
0
Maturity
0
1
5
10
15
20
22
Other factors that influence interest
rate levels
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Federal reserve policy
Federal budget surplus or deficit
Level of business activity
International factors
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Risk and Return 1
 There is a positive relationship between
risk and return.
 To take on more risk, you demand a
higher rate of return.
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Risk and Return 2
 Financial securities are risky.
 When you buy a financial security, there is a
chance that you don’t receive the expected
cash flows.
 E.g., if you buy Delta’s bond, there is a chance
that Delta may not be able to pay the periodic
coupon or face value.
 How do you figure out the rate of return
that you would demand from buying a risky
financial security?
 (Incidentally, this rate of return you demand is
called the ‘required rate of return’. )
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Risk and Return 3
 In general, the required rate of return for
a financial security is given by:
Required rate of return
= risk-free rate + Risk Premium
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Risk and Return 4
 Risk premium: the additional rate of
return, above the risk-free rate, which
you demand because of the riskiness of
the financial security.
 The risk premium for a debt security is
different from the risk premium for an
equity security.
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Same thing, different names
In fact, the required rate of return on debt
security is also known as:
•
•
•
Cost of debt
Yield-to-maturity
Discount rate
28
Risk & return relationship
for equity security 1
 To find the risk premium for an equity
security, we make use of a theoretical
model in finance, called the Capital Asset
Pricing Model (CAPM, pronounced as
“cap M”).
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Risk & return relationship
for equity security 2
The CAPM says that the risk premium on
equity is defined as:
b(rm – rf )
tells you how sensitive a
stock is to movements
in a large, diversified
portfolio
expected return on
the diversified
portfolio
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Risk & return relationship
for equity security 3
Required rate of return for an equity
security
= risk-free rate + b(rm – rf )
 Required rate of return on equity is also
known as:
•
•
Cost of equity
Discount rate
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Beta
Measures a stock’s market risk, and
shows a stock’s volatility relative to the
market.
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Comments on beta
 If beta = 1.0, the security is just as risky as the
average stock (the market).
 If beta > 1.0, the security is riskier than
average.
 If beta < 1.0, the security is less risky than
average.
 Most stocks have betas in the range of 0.5 to
1.5.
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Calculating betas
 Well-diversified investors are primarily
concerned with how a stock is expected to
move relative to the market in the future.
 Without a crystal ball to predict the future,
analysts are forced to rely on historical
data. A typical approach to estimate beta is
to run a regression of the security’s past
returns against the past returns of the
market.
 The slope of the regression line is defined
as the beta coefficient for the security.
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Illustrating the calculation of beta
_
ri
20
.
15
.
10
Year
1
2
3
rM
15%
-5
12
ri
18%
-10
16
5
-5
.
0
-5
-10
5
10
15
20
_
rM
Regression line:
^
^
ri = -2.59 + 1.44 rM
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Summary
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Different types of Financial Markets
Financial institutions
Stock vs. Bonds
Risk vs. return
Practice assignment
questions 2-4; 6-8
Problems: 8-3 8-4 8-5 8-8 8-9 8-10
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