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MN10403: Lecture 5

The Capital Markets

Part 1

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Lecture Structure

• What are the Capital Markets?

• Who uses them?

• Characteristics of the instruments traded.

• Pricing of these instruments.

• Causes of price changes.

• Reading and analysing FM data.

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What are capital markets?

• In contrast to money markets, CMs provide funds for long-term use.

• Bonds (debt)

• Equities (company shares).

• Bond (debt) maturity 5 years – 20 years.

• Equity: no maturity specified: just continue as long as the company lasts.

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Bondholders versus equity holders.

• Corporations are owned by their investors (equity-holders and bond-holders).

• Bond-holders get first fixed claim on the firm’s cashflows (annual interest payments, plus redemption value at maturity)

• Equity-holders get what’s left (residual claimants): dividends (optional for firms) plus capital gains => shares more ‘risky’.

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The Importance of the Capital Markets

• Table 6.1 in textbook shows:

• In 2004-2005, net amounts of shares (new issues – repurchases): negative

• Dominance of fixed income securities• More than half of corporate sector

investment uses internal funds.• So is CM unimportant? No • Secondary market promotes primary

market.

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Importance of CM (continued)

• Firms use CM as a benchmark for yields on internal funds.

• The expected return on an internally funded project should exceed the opportunity cost (the level of yields on CM investments of the same risk).

• Existing shares affect the terms at which new shares can be offered (eg high current share price).

• Active secondary market => high liquidity of securities => investor confidence => keeps down cost of capital.

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Importance of CM (continued)

• CM assets are part of investors’ portfolio decision => part of investors’ wealth.

• Changes in CM affect changes in the economy (therefore, watched closely by CBs).

• More on the portfolio decision later!

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Characteristics of Bonds

• Issued with fixed period to maturity.

• 5 – 20 years.

• Residual maturity.

• Shorts (5 years Residual maturity)

• Mediums (15 years RM)

• Longs (> 15 years RM).

• Bonds pay a fixed rate of interest (coupon)

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Interest (coupon) of a bond:

• Normally receive 2 6-monthly instalments = ½ coupon rate.

• Par value of bond = £100.

• Coupon/par value = coupon rate.

• Eg govt bond treasury 8% 2015.

• £4 every 6 months to the registered owner until 2015.

• Guaranteed return!

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Difference between par value and market value

• Par value normally the price at which the bond is first issued.

• However, market conditions may change

• Eg market interest rates , price of bond ?

• Market interest rates , price of bond?

• Relationship between market interest rates and bond prices?

• See page 152

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Yield of a bond

• Running yield = return on a bond taking account only of coupon payments

• Redemption yield = return on a bond taking account of coupon cashflows and capital gain or loss at redemption.

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Price of a bond

• Buyers compare price of a bond with the return on equivalent instruments

• If market rates rise, people switch out of bonds, P : returns equalised in equilibrium

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Other types of bonds

• Callable: issuer can redeem them prior to specified redemption date.

• Putable: holder can sell them back to the issuer prior to redemption rate

• Convertibles: Corporate bonds, issued with the option for holder to convert into company shares (equities)

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Equity markets

• Shareholders: ‘paid’ after bondholders• Dividends (optional for the firm) plus

capital gains.• Shareholders enjoy all of the upside of the

firm’s volatile cashflows.• On the downside, bondholders can

liquidate company assets• => bonds safer than equity: affects returns

required by investors.

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Value of a firm

• Market value of bonds plus market value of equity.

• In long-run, value of firm should rise

• Value of bonds fixed

• Value of equity should rise.

• Proportion of debt and equity finance in a firm (debt-equity ration or gearing) affects variability of returns to shareholders.

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Required return on equity

• Risk-averse equity holders’ required return increases with risk.

• A share’s Beta is a measure of this risk.

Beta

Equity-holders’ reqd return

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Risk-free

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D/E

Cost of Debt:

Risk-free rate

Cost of equity

WACC

Shares in highly geared companies regarded as riskier than those in low geared companies: => higher return required.

Share’s one year return = (P1-P0 +D1)/P0 *100

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Example (all-equity firm)

• Shares in issue = 50 million• Market price £4• Market capitalisation = £200m• Earnings = £4m• Earnings per share = 8p• Distributed profit = £3m• Dividend per share = 6p• Payout ratio = 0.75• Dividend yield = 1.5 per cent• Earnings yield = 2 per cent• P/E ratio = 50

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Price-earnings ratio

• High or low: Expensive or cheap?

• Could be high due to being overvalued (conflicts with ideas of market efficiency)

• Could be high due to expected earnings growth.

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Equity market trading

• Secondary market dominates primary market:• So, are EM.s just glorified gambling?• Active SM transforms equities from very long-

term investments into highly liquid assets.• Accurate pricing of firms (efficient markets) =>

facilitates corporate control through takeovers.• Share prices affect wealth.• SM provides benchmark for new issues of

shares.• But …..

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Market efficiency versus inefficiency

• efficient markets: all available info currently incorporated into share prices:

• Immediate mkt reaction to news.

• Inefficient markets: slow reaction to news => market timing/ insider info/ FSA intervention.

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Efficient versus inefficient markets

• .

t

P

FSA test.

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Next Lecture

• Equity markets (chapter 6: continued)