chap005

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Financial Instruments and Markets

Financial Instruments and Markets

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McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

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Financial ExecutiveAs Marketing Executive

Financial ExecutiveAs Marketing Executive

• Financial executives need to raise money to finance the current operations and future growth of their companies.

• To do so they must market the future cash flows of their firm.

• Marketing entails the packaging of cash flows in order to fetch the highest price possible.

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PackagingPackaging

• Packaging cash flows involves security design.

• Designing securities requires knowledge of different financial instruments.

• This chapter focuses on – financial instruments– markets

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Financial MarketsFinancial Markets• Financial markets describes the distribution

system by which cash-deficit entities engage in transactions with cash-surplus entities.

• Besides businesses, the entities in question include government agencies, universities, pension funds, endowments, individuals, commercial banks, insurance companies …

• Money markets vs. capital markets distinguishes short-term vs. long-term contracts.

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Financial InstrumentsFinancial Instruments

• Companies do not face major constraints when choosing financial instruments.

• Instruments must appeal to investors and meet the needs of the company.

• SEC does not pass judgment on the merits of a security, although some states do have merit regulation (blue sky laws).

• SEC regulations require adequate disclosure before purchase.

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Three VariablesThree Variables

• When designing a financial instrument, a financial executive works with three variables.

1. Investors’ claims on future cash flows

2. Investors’ right to participate in company decisions

3. Investors’ claims on company assets in the event of liquidation

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BondsBonds• Debt instruments offer fixed claims.• Equity offers residual claims.• Hybrids, such as convertible debt,

combine both.• Bonds are fixed income securities.• Bonds promise interest income and

repayment of principal at maturity.• Bonds are sold to the public in small

increments, such as $1000, and can be traded on an exchange after issue.

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Relative SizeRelative Size• Historically, 60% of business financing has

come from retained earnings and depreciation.

• 34% of external financing has come from corporate bonds.

• 19% has come from loans from banks and other financial firms.

• In 2007, small manufacturing firms rely on bank loans for 36% of their financing, vs. 8% for larger firms.

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Bond CharacteristicsBond Characteristics

• Par value

• Coupon rate

• Maturity date

• Sinking fund for periodic repayment of principal– Direct payment to creditors via repurchase or

retirement at par value

• Variable rate vs. fixed rate bonds.

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Call ProvisionsCall Provisions• Right to retire bonds prior to maturity.• Call price is typically a modest premium above

par.• Delayed call prevents retirement before some

date.• Call options help companies

– take advantage of declines in interest rates and

– rearrange capital structure• Investors require a premium for call provisions.

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CovenantsCovenants• Contractual terms to protect bondholders

by impacting management decisions.• Examples:

– Lower limit on current ratio– Upper limit on D/E ratio– Required approval by bondholders before

major acquisition or sale of assets

• Bondholders have no direct say in a company unless it defaults on its interest, sinking fund, or covenant obligations.

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Rights in LiquidationRights in Liquidation

• Rights of absolute priority– Government in respect to taxes past due– Senior creditors– General creditors– Subordinated creditors– Preferred shareholders– Common shareholders

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Secured CreditorsSecured Creditors

• Secured credit involves collateral.• In liquidation, proceeds from the sale of

collateral only go to the secured creditor, up to the amount of the secured credit.

• Any residual goes into the pot shared by the pool of investors.

• If the sale of collateral is insufficient, the secured creditor becomes a general creditor for the balance.

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Bonds as an InvestmentBonds as an Investment

• Bonds are not safe.

• Real vs. nominal returns.

• See Table 5-1

• Can you infer the long-run default premium on corporate bonds?

• Can you infer the real long-run return to bonds?

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TABLE 5-1 Rate of Return on Selected U.S. Securities, 1900 - 2007

TABLE 5-1 Rate of Return on Selected U.S. Securities, 1900 - 2007

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Bond RatingsBond Ratings

• Rating agencies rate bonds for risk.

• Analysts use techniques discussed in earlier chapters, such as debt ratios and coverage ratios.

• See Table 5-2 in text for examples.

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Table 5-2 Selected S&P Debt-Rating DefinitionsTable 5-2 Selected S&P Debt-Rating Definitions

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Table 5-2 (continued)Table 5-2 (continued)

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Junk BondsJunk Bonds

• Investment grade is “BBB” and above.

• Junk bonds, aka speculative or high yield bonds, are below investment grade.

• Junk bond market is an alternative to bank and insurance company loans for smaller, less prominent companies.

• Junk bonds have been used to finance mergers and acquisitions.

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Common StockCommon Stock

• A residual income security.

• Shareholders are represented through a board of directors, through which they exercise control.

• The degree of control is variable, in terms of the fraction of share ownership required to control the board.

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Checks on ManagementChecks on Management• Management might control the board.• Checks against this:

– Product market competition– Need for external financing– Market for corporate control

• In Europe, banks take equity positions and exercise direct control, more so than in the US.

• Japanese keiretsu has same effect as in Europe.

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TrendsTrends

• Europe and Japanese framework involves “old boy” relationships.

• European firms have come to shift source of funding public markets instead of banks.

• Japanese boards have begun to focus more on stock returns, thereby leading to less cross-share holdings.

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Common Stock as an InvestmentCommon Stock as an Investment

• Total return = dividend yield + capital appreciation.

• Between 1928 and 2007, dividend yields on large common stocks were 3.9%, and capital appreciation was 7.5%.

• In general stocks are a hedge against inflation.– 1970s were an exception to the rule, when

stocks returned 5.2%, and inflation grew at 11.7%.

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Equity PremiumEquity Premium

• Stocks returned 6.3% more than government bonds between 1900 and 2007.

• The real return to stocks over this period was 8.5%.

• See Figure 5-1 for cumulative return representation.

• See Figure 5-2 for depiction of volatility.

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FIGURE 5-1 If Your Grandmother Had Invested only a Dollar in 1900; Nominal Returns on U.S. Assets 1900-2007

FIGURE 5-1 If Your Grandmother Had Invested only a Dollar in 1900; Nominal Returns on U.S. Assets 1900-2007

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FIGURE 5-2 Distribution of Annual Return on StocksAnd Bonds, 1928-2007

FIGURE 5-2 Distribution of Annual Return on StocksAnd Bonds, 1928-2007

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FIGURE 5-2 (Continued)FIGURE 5-2 (Continued)

Source: Professor Aswath Damodaran’s Web site, pages.stern.nyu.edu/~adamodar/.

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Preferred StockPreferred Stock

• Hybrid security, mixing features of both debt and equity.

• Promises annual fixed dividend = coupon rate x par value.

• Dividend discretionary.

• Dividend is not tax deductible, in contrast to interest payments.

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Cumulative PreferredCumulative Preferred

• Preferred shareholders have higher priority than common shareholders.

• Common shareholders receive no dividend until preferred shareholders are paid in full, including past arrears.

• Control features of preferred stock vary from required approval to no voice at all unless dividend payments are in arrears.

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Perspectives on CommonPerspectives on Common

• Some managers view preferred as cheap equity, because the dividends are fixed even when earnings grow.

• Other managers view preferred as debt with a tax disadvantage.

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Financial MarketsFinancial Markets

• Three illustrative cases:

1. A startup

2. A candidate for an IPO

3. A multinational

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Private Equity FinancingPrivate Equity Financing

• Startup, too risky for bank lending and too small for to attract the attention of investors in public markets.

• Funding options include loans against stable cash flows such as A/R, personal savings, friends and family, venture capitalists, and strategic investors (large firms who provide seed money but who with potential acquisition on their minds).

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Venture CapitalistsVenture Capitalists• Wealthy investors, often referred to as

“angel investors.”• Professional venture capital companies,

who make high risk investments in entrepreneurial businesses capable of rapid growth and high investment returns.

• Big stakes, active role in management, investment horizon of 5-6 years (5-10x).

• View many proposals and are highly selective.

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Private Equity PartnershipsPrivate Equity Partnerships

• Structured as limited partnerships with a specified duration such as 10 years.

• General partner is the private equity firm, which raises a pool of money from limited partners, such as institutional investors and insurance companies.

• Limited partners have limited liability.• Typical fee structure is 2 and 20, the sum

of a management fee and carried interest.

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Value and Investment HorizonValue and Investment Horizon

• Private equity partnerships induce managers to work for them, creating value over the long-run without having to manage to short-run fluctuations.

• The horizon is long-run, but not the very long-run, so managers are under pressure to create a cash exit event for private equity investors.

• See Figure 5-3.

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FIGURE 5-3 Venture Capital Investment in U.S. CompaniesFIGURE 5-3 Venture Capital Investment in U.S. Companies

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Relative ShareRelative Share

• In 2007, venture capital constituted about one tenth of total private equity financing which totaled about $302 billion.

• The majority of private equity funds engage in leveraged buyouts, using D/E ratios of 3 to 4.

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Initial Public OfferingsInitial Public Offerings

• Six years ago, Genomic Devices – raised $15 million from venture capitalists, – had two more rounds of funding ($40 million),

and – needs a $25 million equity infusion to keep

growing now that it’s successful.

• IPO can provide additional equity along with an exit route for venture investors.

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Investment BankingInvestment Banking

• “Bake off” to assess proposals from investment banks and choose one.

• Winning investment bank becomes the “managing underwriter” and begins to – advise the company on security design– register the issue with the SEC (30-90 days)– orchestrates a “road show”– assembles an underwriting syndicate who

engage in book building

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IPO RisksIPO Risks

• Syndicate acts as wholesaler.

• Offer price set hours before stock goes public.

• Company bears price risk during the registration process.

• Syndicate bears risk associated with unsold shares, which they cannot sell above the offer price.

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Seasoned IssuesSeasoned Issues• Multinational firm wants to raise $200

million in new debt, using a U.S. “shelf registration.”

• Shelf registration is a general purpose registration, good up to two years, that allows the firm to get quick approval for the use public markets.

• A single underwriter often buys the entire issue.

• Competitive bids lower the issue costs.

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Private PlacementPrivate Placement

• Large corporations can avoid registering with the SEC by placing debt privately with one or more institutional investors.

• The private placement market might be half the size of the public market, excluding bank loans.

• Attractive option if public investors not especially receptive for reasons of complexity or familiarity.

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Rule 144aRule 144a

• In the past, privately place debt was not especially liquid.

• SEC Rule 144a now allows for trading of privately placed debt among institutional investors.

• Result is two parallel markets for corporate securities, one public and the other among institutional investors.

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International MarketsInternational Markets• Large corporations use foreign financial

markets because they want the contract to be in a foreign currency, they can get a better terms than in the U.S.

• Foreign markets often impose fees and restrictions on foreign investors.

• International markets allow the currency specified in the transaction to be outside the control of issuing country’s monetary authority.

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Reserve Requirements and Bearer Bonds

Reserve Requirements and Bearer Bonds

• Financial firms operating in international markets need not hold reserves with a central bank such as the Fed.

• Unlike the U.S., which requires registration of ownership, bonds can be issued to anonymous bearers, who can collect interest payments and avoid paying tax.

• Bearer bonds are cheaper for issuers.• Have international markets stripped away

protective regulation?

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Issue CostsIssue Costs

• For privately negotiated transactions, the issue cost amounts to the investment banking fee.

• For public issues, there are also legal, accounting, and printing fees.

• Investment bankers often underprice issues to quell investors’ concerns about information asymmetries.– Implicit dilution cost to shareholders.

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Representative Cost ComparisonsRepresentative Cost Comparisons

• 2.2% for straight debt.• 3.8% for convertible bonds.• 7.1% for secondary offerings of public

companies.• 11% for IPOs.• Economies of scale:

– for equity 3% @ $100 million becomes 20% for $500,000.

– For debt, range can be 0.9% to 10%.

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Efficient MarketsEfficient Markets

• A recurring issue in raising new capital is timing.

• Managers devote considerable time and energy into predicting future price trends in financial markets.

• Should managers abandon prediction and timing because markets fully reflect all available information correctly into prices?

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Controversial IssuesControversial Issues

• Evidence about market efficiency has been overstated.

• Working assumption is that markets are more or less efficient.

• Degree of efficiency is an empirical question.

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What is an Efficient Market?What is an Efficient Market?

• Issue is how competitive prices respond to new information.

• How long does it take for news to impact prices?

• Ederington-Lee analysis of interest rate and foreign exchange markets is that for news releases, the answer is 10-40 seconds.

• See Figure 5-4.

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FIGURE 5-4 Time Series of the Mean Price Index of the Shares of 161 Target Firms Involved in Successful Tender Offers

FIGURE 5-4 Time Series of the Mean Price Index of the Shares of 161 Target Firms Involved in Successful Tender Offers

Source: Michael Bradley, “Interfirm Tender Offers and the Market for Corporate Control,” Journal of Business 53, no.4 (1980).

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Efficiency in DegreesEfficiency in Degrees

• A market is – weak-form efficient when prices fully reflect all

information about past prices– Semi-strong form efficient when prices fully

reflect all publicly available information– strong form efficient when prices fully reflect

all information, public or private.

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Empirical EvidenceEmpirical Evidence

• Markets are not strong form efficient.• With limited exceptions, markets are semi-

strong form efficient.• Typical investors should not expect to earn

abnormal returns trading on publicly available information, especially if they pay brokerage commissions.

• Future studies might uncover inefficiencies not generally known about at present.

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Implications of EfficiencyImplications of Efficiency

• When market are semi-strong form efficient, a series of statements hold true.

• Publicly available information has no predictive power in respect to market prices.

• Best forecast of future price is current price adjusted for trend.

• It is pointless to time the purchase or sale of the firm’s securities.

• Investors cannot expect to earn positive risk-adjusted returns.

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Conclusions to DrawConclusions to Draw

• Managers have private information about their own companies, and can justifiably make timing decisions based on such information.

• Managers should not make timing decisions based on their personal beliefs about where markets are headed, if those beliefs are based on public information alone.

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Managing RiskManaging Risk

• Companies use derivatives to manage risk and incentivize managers.

• Volatile foreign exchange markets

• Use of forward and option markets to deal with this volatility

• Use of employee stock options for compensation.

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Forward MarketsForward Markets

• You can buy spot today for immediate delivery.

• You can contract today at a predetermined price for future delivery.

• You can use forward markets to speculate, by betting on the future spot price, using today’s known forward price.

• See Figure 5A-1.

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FIGURE 5A-1 Forward Market HedgeFIGURE 5A-1 Forward Market Hedge

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FIGURE 5A-1 (Continued)FIGURE 5A-1 (Continued)

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Hedging in Forward MarketsHedging in Forward Markets

• If a multinational firm based in the U.S. makes a sale for €1 million, with collection expected in 180 days, it is exposed to currency risk.

• It can hedge this risk by using a forward contract to buy dollars today with the corresponding euro value equal to €1 million.

• Any gain from a future move in the euro spot rate will be exactly offset by a loss on the forward contract, and vice versa.

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Hedging with OptionsHedging with Options

• Forward contracts are obligations to accept delivery, if long or to deliver if short, at a pre-specified price.

• Options are rights, but not obligations to either take delivery or to deliver, at a pre-specified (exercise) price.

• Call options confer the right to buy.

• Put options confer the right to sell.

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Hedging a Euro-A/RHedging a Euro-A/R

• If the firm uses a put option to hedge its €1 million, then it protects against a drop in the value of the euro.

• An option allows the firm to benefit if the euro strengthens against the dollar.

• The cost of this additional flexibility is the option premium.

• See Figure 5A-2.

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FIGURE 5A-2 Option Market HedgeFIGURE 5A-2 Option Market Hedge

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Limitations of Financial Market Hedging

Limitations of Financial Market Hedging

• What makes hedging difficult?• There is an active forward market in the

currency.• Either the amount and/or timing of the foreign

currency cash flow are uncertain.• The cash flows themselves depend on the

exchange rate.• The cash flows are part of a long-term stream.• Is it even necessary to hedge in fair markets?

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Valuing OptionsValuing Options

• In theory, the value of an option depends upon:– The current price of the underlying asset– The option’s time to maturity– The option’s strike price– The interest rate– The expected volatility on the underlying

asset– But not the expected future value of the

underlying asset