Principles of Financial
Analysis
Week 3: Lecture 3
Lecturer: Chara Charalambous
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Learning Goals
• Financial Managers must understand the
environment and markets within which
businesses operate : the markets where firms
raise funds, securities are traded and stock
prices are established as well as the
institutions that operate in these markets.
Lecturer: Chara Charalambous
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The Financial Markets
• People, governments and organizations very often
need to borrow money to fund investments:
companies need to explore their activities built
new factories, offices or produce innovated
products. Individuals need to buy houses, cars,
yachts e.t.c
• While other individuals or firms have surplus of
funds.
• People and organisations needs to borrow money
have to brought together with those having
surplus funds in the financial markets.
Lecturer: Chara Charalambous
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Lecturer: Chara Charalambous
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What is a market?
• A market is a place where goods and services are
exchanged.
• A financial market is a place where individuals and
organizations wanting to borrow funds are brought
together with those having a surplus of funds.
• Physical asset markets (real markets): are those in
which autos, real estate, computers and machineries
are traded.
• Financial asset markets deal with stocks (shares),
bonds, mortgages.
Financial markets are mechanisms by
which borrowers and lenders get together
Lecturer: Chara Charalambous
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Major Types of Markets
Different markets serve different types of
customers, or operate in different parts of the
country. Major types of markets are:
1. Debt Markets. Loans are traded: contracts that
specifies the amounts and the times a
borrower must repay the funds given by the
lender. Equity Markets are those where stock
of corporations are traded. Stock gives
ownership to shareholders and the right to
have share on profits through dividends.
Lecturer: Chara Charalambous
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2. Money Markets: are the markets providing
debt securities with maturities of less than
one year. The main function of this market is
to give liquidity to businesses, individuals or
governments to meet short-term needs for
cash. Capital Markets are the markets for
long-term debt and corporate stocks and their
main function is to give the opportunity to
transfer cash surpluses or deficits to future
years. For example without the availability of
mortgages most people could not afford to
buy houses when they are young and just
starting their careers.
Lecturer: Chara Charalambous
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3. Mortgage Markets: deal with loans on residential,
commercial, and industrial real estate, and on
farmland. Consumer Credit Markets involve loans
on autos and machines, as well as loans for
education, vacations, and so forth.
4. World, National, Regional and Local Markets also
exist. Thus depending on an organization’s size and
scope of operations, it may be able to borrow all
around the world, or it may be limited to a strictly
local, even neighbourhood market.
5. Primary Markets: are the markets in which
corporations and governments raise new capital.
For example they sell new issue of ordinary shares
to raise capital. This is a primary market transaction
Lecturer: Chara Charalambous
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Secondary Markets are markets in which existing
previously issued securities are traded between
investors. The New York Stock Exchange is a
secondary market because it deals with already
issued-existing shares and bonds. The corporation
or government whose securities are being traded
is not involved in a secondary market transaction
and thus does not receive any funds from such a
sale.
6. Spot Markets and Future Markets: are terms that
refer to whether the assets are being bought or
sold for “on the spot” which means delivery
immediately or for delivery at some later date,
such as six months or a year into the future.
Lecturer: Chara Charalambous
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Financial Institutions
Lecturer: Chara Charalambous
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Financial Institutions
1. Commercial banks which are the traditional
“department stores of finance” serve a wide variety of
savers and those with needs for funds.
Note that commercial banking organizations are different from
investment banks because commercial banks lend money, whereas
investment banks help companies raise capital from other parties.
2. Savings and loan associations which have traditionally
served individual savers and residential and commercial
mortgage borrowers, take the funds of many small
savers and then lend this money to home buyers and
other types of borrowers.
3. Mutual Funds are investment companies that accept
money from savers, and then use these funds to buy
various types of financial assets like stocks, long – term
bonds, short term debt issued by businesses or
government
units.
They
provide
investment
diversification.
Lecturer: Chara Charalambous
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4. Credit unions are cooperate associations whose members have
a common link, such as being employees of the same firm.
Members savings are loaned only to other members generally
for auto purchases, home improvements e.t.c. Credit unions are
often the cheapest source of funds available to individual
borrowers.
5. Pensions funds are retirement plans funded by corporations or
government agencies for their workers and managed primarily
by the trust departments of commercial banks or by life
insurance companies. Pension funds invest mainly in long-term
financial instruments like bonds, stocks, mortgages and real
estate.
6. Life insurance companies take savings in the form of annual
payments, then invest theses funds in stock, bonds, real estate,
and mortgages and finally make payments to the beneficiaries
of the insured parties. Also recently they offer tax savings plans
which provides benefits to the participants when they retire.
Lecturer: Chara Charalambous
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Direct Transfer from saver-to-borrower
A business sells its stocks or bonds directly to
savers – investors, without going through any
financial institution
Savers –
Investors
Funds – Euros /Dollars
Stocks or Bonds
Borrowers
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Indirect Transfer through Investment Banking House
The company sells its shares or bonds to the investment bank which
in turn sells these same securities to the investors. The business’s
securities and the savers money just ‘pass through’ the investment
banking house .The investment bank buy and hold the securities for a
period of time and so it is taking the risk not to be able to resell them
to savers for as much as it paid.
Funds $/€
Funds $/€
Securities
Savers
Investment Banks
Securities
Borrowers
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Indirect Transfer through Financial Intermediary(FI)
Transfers can also be made through a financial intermediary: Bank, Pension Fund co
or Insurance co. Here the intermediary gets funs from savers by issuing its own
securities and then it uses the money to lend out or to purchase another business’s
securities. For example a saver might gives dollars to a bank receiving from it a
certificate of deposit and then the bank might lend the money to a small business in
the form of a mortgage loan.
Funds $ /€
Savers
securities
Funds $ /€
Financial Intermediary:
Banks &
Pension Funds
Insurance Co.’s
Finance Co.’s
securities
Borrowers
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The Stock Exchanges
Secondary markets: previously issued securities
are traded.
It is here that the prices of firms’ stocks are
established and because the primary goal of
managerial finance is to maximize the firm’s stock price
is important area of study.
• There are two basic types of stock markets: (1)
organized exchanges, which include the New York
Stock Exchange (NYSE), the American Stock Exchange
(AMEX) and several regional exchanges and (2) the
less formal over the counter market.
Lecturer: Chara Charalambous
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1. Organized Security Exchanges
Characteristics :
The Organized Security Exchanges are tangible physical
entities where auction markets are conducted in ‘listed’
securities.
Each of the larger ones occupies its own building, has
specifically designated members, and has an elected
governing body – its board of governors.
Members are said to have “seat” on the exchange,
although everybody stands up.
These seats, which are brought and sold, give the holder
the right to trade on the exchange.
Most of the larger investment banking houses operate
brokerage departments, that own seats on the exchanges
and designate one or more of their officers as member.
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Exchange members meet in a large room equipped with
telephones and other electronic equipment (faxes,
computers e.t.c.) that enable each member to
communicate with his/her company’s offices
throughout the country.
Like other markets, security exchanges facilitate
communication between buyers and sellers. The
exchange members with sell orders offer the shares for
sale and they are bid for by the members with buy
orders. Thus the exchanges are operate as auction
markets.
Lecturer: Chara Charalambous
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2. The Over – the – Counter Market
Over the counter means there is no location does not
exist physically and consists of a network of brokers and
dealers: financial instruments that are not listed or
available on an officially recognized exchange (such as the
NYSE – New York Stock Exchange), are traded in direct
negotiation between buyers and sellers. Trading takes
place telephonically or electronically.
Participants banks, brokers and foreign exchange dealers
are connected by computers, telephones and telex and
operates in most financial centers globally. Because the
over the counter market is so highly integrated globally, it
can operate 24 hours a day – when one major market is
closed, another major market is open to facilitate trade
occurring 24 hours a day moving from one major market
to another.
Lecturer: Chara Charalambous
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– Over-the-counter market=NASD
National Association of Security Dealers
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• The Over – the – Counter Market has been created because
there are stocks that are not treated often, perhaps because
they are stocks of new or small companies. And thus few buy
and sell orders come in and is difficult to much them. For that
reason these stocks are not conducted on the organized
exchanges.
• To solve this problem some brokerage firms keep an
inventory of such stocks (they ‘make market’) - they buy
when individual investors want to sell and sell when investors
want to buy.
• In contrast to the organized exchanges the OTC does not
operate as an auction market. The dealers who make a
market in a particular stock continuously quote a price at
which they are willing to buy the stock (the bid price) and a
price at which they will sell shares (the asked price). So prices
are adjusted based on supply and demand and they can been
read on computer screens all around the world. The spread
between bid and asked prices is the dealer’s profit.
Lecturer: Chara Charalambous
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The Cost of Money
• In a well-functioning economy, capital flows
efficiently from those who supply capital to those
who demand it.
• Suppliers of capital : individuals and institutions
with “excess funds”. These groups are saving
money and looking for a rate of return on their
investment.
• Demanders or users of capital : individuals and
institutions who need to raise funds to finance
their investment opportunities. These groups are
willing to pay an interest rate on the capital they
borrow.
Lecturer: Chara Charalambous
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• The interest rate is the price paid to borrow
debt capital, whereas in the case of equity
capital, investors expect to receive dividends
and capital gains.
• The four most fundamental factors affecting
the demand and supply of investment capital
and therefore the cost of money are:
production opportunities, time preferences
for consumption, risk and inflation.
Lecturer: Chara Charalambous
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The Determinants of Market Interest Rates
Quoted Interest Rate n a debt security = k
k = k*+IP+DRP+LP+MRP
• k= quoted or nominal rate of interest on a given security.
There are many different securities, hence many different
nominal interest rates
• k* (k star)= the real risk-free rate of interest
• IP=inflation premium
• DRP= default risk premium
• LP=liquidity or marketability premium
• MRP=maturity risk premium
Lecturer: Chara Charalambous
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The Determinants of Market Interest Rates
• K* = The real risk – free rate of interest is defined as the
interest rate that would exist on a riskless security if no
inflation were expected .The real risk free rate changes
over time depending on economic conditions especially:
(1) on the rate of return corporations and other
borrowers are willing to pay to borrow funds and (2) on
peoples’ time preferences for current versus future
consumption (increase or decrease in the future?)
• IP = Inflation Premium: Inflation has a major impact on
interest rates because it crush down the purchasing
power of the euro or any other currency and lowers the
real rate of return on investments.
Lecturer: Chara Charalambous
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The Determinants of Market Interest Rates
• DRP = Default Risk is the risk that a borrower will default (failure to
pay) on a loan, which means not to pay the interest or the principal,
also affects the market interest rate on a security: the greater the
default risk, the higher the interest rate lenders charge. Default Risk
Premium is the difference between the nominal interest rate on a
government bond and that on a corporation bond with similar
maturity.
• LP = Liquidity Premium generally is defined as the ability to convert
an asset to cash and receive the amount initially invested on a
reasonable level. Financial assets are considered more liquid than
real assets – land, equipment- and short term financial assets are
more liquid than long term. Because liquidity is important investors
include LP when interest rates are established.
• MRP = The prices of bonds decline whenever interest rates rise and
for this reason they have an element of risk called interest rate risk.
The longer the maturity of the bond the greater the interest rate risk.
Therefore a Maturity Risk Premium must be taken in account when
interest rates are calculated.
Lecturer: Chara Charalambous
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Other factors that influence Interest Rate
Levels
1. Central Bank Policy is the policy which controls the
supply. If the CB wants to control growth in the
economy it slows growth in the money supply. When
money supply goes down interest rates goes up
2. Government Deficits. If the government spends more
than it takes in from tax revenues, it runs a deficit,
and that deficit must be covered either by borrowing
or by printing money. If the government borrows, this
added demand for funds pushes up interest rates. The
larger the government deficit, other things held
constant, the higher the level of interest rates.
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3. Foreign Trade Balance. Businesses and
individuals around the world buy from and sell to
people and firms in other countries. If we buy
more than we sell, we are said to be running a
foreign trade deficit. When trade deficits occur
they must be financed and the main source of
financing is debt. Therefore the larger our deficit
the more we must borrow and as we increase our
borrowing this drives up borrowing rates. Also
foreigners are willing to hold a country’s debt
only if the
interest rate on this debt is
competitive with interest rates in other countries.
Lecturer: Chara Charalambous
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Income Tax System
• The government places taxes to citizens and
organizations of two categories: (1) tax laws
that are applicable to individuals and (2) tax
laws that are applicable to organizations.
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1. Individual Income Taxes
• Individuals pay taxes on wages and salaries,
on investment income and on the profits of
proprietorships and partnerships.
• Our tax rates are progressive – that is, the
higher one’s income, the larger the
percentage paid in taxes.
Lecturer: Chara Charalambous
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2. Corporate income taxes
• Corporate tax or company tax refers to a tax
imposed on entities not individuals. Such taxes
may include income taxes, capital gains
taxes(profit from selling an asset more than its
purchase price), or other taxes for example on
dividends received from other companies. The
tax is generally calculated on net taxable income,
which is generally in the financial statement
income .The rate of tax varies by authority and is
frequently progressive.
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