Wednesday, May 21, 2008

Lecture 8 - Financial Markets (Bond and Stock Markets)

See packet page 26.

A bond is one specific kind of security.

Bonds are issued by corporations and the government. Fed govt bonds are much lower risk. But corporations and state and local govts can default (Orange County CA, Alabama?).

Stock is partial ownership. It gives the right to vote and may pay dividends. Synonymous with equity financing. The stock market is relatively volatile.

Stock price earnings do not always match corporate earnings. Some justify the stock prices because they reflect future earnings. But that didn't pan out.

Bond holders get paid first, before equity (stock) holders.

Bonds vs Stocks (missing slide?)
The main disadvantage of owning an equity rather than bond is that equity holder is residual claimant. The firm must pay all its debt holders before it can pay its equity holders.

Advantage of holding an equity is that equity holders benefit directly from any increase in the corp's profits or asset value. Debt holders do not share in this benefit beccuase their payments are fixed.

Market capitalization of stocks in the US fluctuates between $1 and $20 trillion, depending...

Financial Intermediaries

Financial Intermediaries pool savings and channel them as loans. Ex: Banks, S&L, credit unions. Fixed rate loans and increasing interest rates (along with the 90-92 recession) caused the S&L crisis. Mutual S&L - depositors are owners. Insurance, pension funds and mutual funds.

Loans account for 55% of business external financing. Small and mid sized businesses don't have the good reputation required to sell stocks or bonds.

There has been many banking innovations in recent years. Regulation Q, commercial paper (now dried up), etc.

Section #4 on packet page 28 was not covered at this time

Bond Markets and Interest Rates

A bond is a debt instrument that promises to make periodic payments (interest payments) until the maturity date, when a specified final amount (face value) is repaid. A bond is essentially an IOU.

3 pieces of information on (coupon) bond certificates: (i) issuing agency or institutions (ii) maturity date (iii) coupon rate & face value.

Most important examples: Treasury securities: T-bills (maturity < 1 year), T-notes (maturity < 10 yrs), T-bonds (10<maturity<30).

General Rule: Bond prices and interest rates always move in opposite direction.

Present Discount Value (PDV)

If you have $1 today and you deposit it for 1 year at 10%. At the end of the year, you have 1+0.10 = 1.10.

Therefore, $1.10 in 1 year is equivalent to $1 today. We say that the present discount value of $1.10 in 1 year is $1.

1.10/(1+0.1) = 1

At the end of the second year, you have $1.10+0.10*1.10 = 1.10(1+0.1) = 1.102=1.21. Therefore, the PDV of 1.21 in 2yrs is 1.

Generally, PDV of $F in N years = F/(1+i)N

The larger N is, the smaller the PDV. The value of a billion dollars in 200 years is very little today.

N up, PDV down. i up, PDV down.

Bond Pricing

Consider a three-year bond with a face value of $100 and a coupon rate of 10%. How do we determine the bond pricing?

(i) Assume market interest rate = i = 10%

Pb = 10/(1+0.1) + 10/(1+0.1)2 + 110/(1+0.1)3 = 100

Why is the bond price, in this case, the same as the face value? Because the coupon rate is the same as the market interest rate.

Next, assume a case where 1 year has passed. In this case,

Pb = 10/(1+0.1) + 110/(1+0.1)2 = 100!

(ii) Now, assume the market interest rate has gone up to i=12%

Pb = 10/(1+0.12) + 110/(1+0.12)2 = 96.62

Since the market interest rate is higher than the coupon rate, the bond is worth less.

This supports our general rule: When interest rates go up, bond prices fall.

(iii) If the market interest rate falls to i=8%,

Pb = 10/(1+0.08) + 110/(1+0.08)2 = 103.57

As interest rates rise, bond prices fall.

Clearly, if you think interest rates are going up, you shouldn't buy bonds. The longer the maturity, the more you will lose if rates go up. Thus, long term bonds carry a risk in the case where you want to sell before maturity. Even if you keep it to maturity, there is an opportunity loss - you could have done something better with the money.

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