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Unit 3 AssignmentUnit 3 Assignment

Price Earnings Ratio = Price of Shares/Earnings Per Price Earnings Ratio = Price of Shares/Earnings Per ShareShare

Given:Given:Net Income = $459 millionNet Income = $459 million

Shares Outstanding = 76.8 millionShares Outstanding = 76.8 million

Price per share = $78.62Price per share = $78.62

Earnings per share = 459/76.8 = 5.9766Earnings per share = 459/76.8 = 5.9766

Price Earnings ratio = 78.62/5.9766Price Earnings ratio = 78.62/5.9766

= 13.16= 13.16

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CHAPTER 5CHAPTER 5Financial Markets and Financial Markets and

InstitutionsInstitutions

❂ The Capital Allocation ProcessThe Capital Allocation Process❂ Financial marketsFinancial markets❂ Financial institutionsFinancial institutions❂ Stock Markets and ReturnsStock Markets and Returns❂ Stock Market EfficiencyStock Market Efficiency

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The Capital Allocation The Capital Allocation ProcessProcess

In a well-functioning economy, capital flows In a well-functioning economy, capital flows efficiently from those who supply capital to those efficiently from those who supply capital to those who demand it.who demand it.

Suppliers of capital – individuals and institutions Suppliers of capital – individuals and institutions with with ““excess fundsexcess funds””. These groups are saving . These groups are saving money and looking for a rate of return on their money and looking for a rate of return on their investment.investment.

Demanders or users of capital – individuals and Demanders or users of capital – individuals and institutions who need to raise funds to finance their institutions who need to raise funds to finance their investment opportunities. These groups are willing investment opportunities. These groups are willing to pay a rate of return on the capital they borrow.to pay a rate of return on the capital they borrow.

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How is capital transferred between How is capital transferred between savers and borrowers?savers and borrowers?

Direct transfersDirect transfers

Investment banking Investment banking househouse

Financial Financial intermediariesintermediaries

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What is a market?What is a market?

A market is a venue where goods and services are A market is a venue where goods and services are exchanged.exchanged.

A financial market is a place where individuals and A financial market is a place where individuals and organizations wanting to borrow funds are brought organizations wanting to borrow funds are brought together with those having a surplus of funds.together with those having a surplus of funds.

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Types of financial Types of financial marketsmarkets

Physical assets vs. Financial assetsPhysical assets vs. Financial assets

Money vs. CapitalMoney vs. Capital

Primary vs. SecondaryPrimary vs. Secondary

Spot vs. FuturesSpot vs. Futures

Public vs. PrivatePublic vs. Private

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The importance of financial The importance of financial marketsmarkets

Well-functioning financial markets facilitate the flow of Well-functioning financial markets facilitate the flow of capital from investors to the users of capital.capital from investors to the users of capital.

Markets provide savers with returns on their money Markets provide savers with returns on their money saved/invested, which provides them money in the future.saved/invested, which provides them money in the future.

Markets provide users of capital with the necessary funds to Markets provide users of capital with the necessary funds to finance their investment projects.finance their investment projects.

Well-functioning markets promote economic growth.Well-functioning markets promote economic growth.

Economies with well-developed markets perform better Economies with well-developed markets perform better than economies with poorly-functioning markets.than economies with poorly-functioning markets.

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What are derivatives? How can they be What are derivatives? How can they be used to reduce or increase risk?used to reduce or increase risk?

A derivative securityA derivative security’’s value is s value is ““derivedderived”” from the from the price of another security (e.g., options and price of another security (e.g., options and futures). futures).

Can be used to Can be used to ““hedgehedge”” or reduce risk. For or reduce risk. For example, an importer, whose profit falls when the example, an importer, whose profit falls when the dollar loses value, could purchase currency dollar loses value, could purchase currency futures that do well when the dollar weakens. futures that do well when the dollar weakens.

Also, speculators can use derivatives to bet on Also, speculators can use derivatives to bet on the direction of future stock prices, interest rates, the direction of future stock prices, interest rates, exchange rates, and commodity prices. In many exchange rates, and commodity prices. In many cases, these transactions produce high returns if cases, these transactions produce high returns if you guess right, but large losses if you guess you guess right, but large losses if you guess wrong. Here, derivatives can increase risk.wrong. Here, derivatives can increase risk.

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Types of financial Types of financial institutionsinstitutions

Commercial banksCommercial banks

Investment banksInvestment banks

Mutual savings banksMutual savings banks

Credit unionsCredit unions

Pension fundsPension funds

Life insurance companiesLife insurance companies

Mutual fundsMutual funds

Hedge fundsHedge funds

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Physical location stock exchanges Physical location stock exchanges vs. Electronic dealer-based marketsvs. Electronic dealer-based markets

Auction market Auction market vs. Dealer market vs. Dealer market (Exchanges vs. (Exchanges vs. OTC)OTC)

NYSE vs. NasdaqNYSE vs. Nasdaq

Differences are Differences are narrowingnarrowing

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Stock Market Stock Market TransactionsTransactions

Apple Computer decides to issue additional stock Apple Computer decides to issue additional stock with the assistance of its investment banker. An with the assistance of its investment banker. An investor purchases some of the newly issued investor purchases some of the newly issued shares. Is this a primary market transaction or a shares. Is this a primary market transaction or a secondary market transaction? secondary market transaction?

Since new shares of stock are being issued, this is a Since new shares of stock are being issued, this is a primary market transaction. primary market transaction.

What if instead an investor buys existing shares What if instead an investor buys existing shares of Apple stock in the open market – is this a of Apple stock in the open market – is this a primary or secondary market transaction?primary or secondary market transaction?

Since no new shares are created, this is a secondary Since no new shares are created, this is a secondary market transaction. market transaction.

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What is an IPO?What is an IPO?

An initial public offering (IPO) is where a An initial public offering (IPO) is where a company issues stock in the public market company issues stock in the public market for the first time.for the first time.

““Going publicGoing public”” enables a company enables a company’’s s owners to raise capital from a wide variety owners to raise capital from a wide variety of outside investors. Once issued, the of outside investors. Once issued, the stock trades in the secondary market. stock trades in the secondary market.

Public companies are subject to additional Public companies are subject to additional regulations and reporting requirements. regulations and reporting requirements.

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Historical stock market Historical stock market performance, S&P 500 (1968-performance, S&P 500 (1968-

2004)2004)

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Where can you find a stock quote, Where can you find a stock quote, and what does one look like?and what does one look like?

Stock quotes can be found in a variety of print sources (Stock quotes can be found in a variety of print sources (Wall Wall Street JournalStreet Journal or the local newspaper) and online sources or the local newspaper) and online sources (Yahoo!Finance, CNNMoney, or MSN MoneyCentral).(Yahoo!Finance, CNNMoney, or MSN MoneyCentral).

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What is the Efficient Market What is the Efficient Market Hypothesis (EMH)?Hypothesis (EMH)?

Securities are normally in equilibrium and are Securities are normally in equilibrium and are ““fairly priced.fairly priced.””

Investors cannot Investors cannot ““beat the marketbeat the market”” except through except through good luck or better information.good luck or better information.

Levels of market efficiencyLevels of market efficiencyWeak-form efficiencyWeak-form efficiencySemistrong-form efficiencySemistrong-form efficiencyStrong-form efficiencyStrong-form efficiency

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Weak-form efficiencyWeak-form efficiency

CanCan’’t profit by looking at past trends. A recent t profit by looking at past trends. A recent decline is no reason to think stocks will go up (or decline is no reason to think stocks will go up (or down) in the future. down) in the future.

Evidence supports weak-form EMH, but Evidence supports weak-form EMH, but ““technical technical analysisanalysis”” is still used. is still used.

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Semistrong-form Semistrong-form efficiencyefficiency

All publicly available information is reflected in All publicly available information is reflected in stock prices, so it doesnstock prices, so it doesn’’t pay to over analyze t pay to over analyze annual reports looking for undervalued stocks. annual reports looking for undervalued stocks.

Largely true, but superior analysts can still profit Largely true, but superior analysts can still profit by finding and using new information.by finding and using new information.

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Strong-form efficiencyStrong-form efficiency

All information, even inside information, is All information, even inside information, is embedded in stock prices. embedded in stock prices.

Not true--insiders can gain by trading on the basis Not true--insiders can gain by trading on the basis of insider information, but thatof insider information, but that’’s illegal.s illegal.

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Conclusions about market Conclusions about market efficiencyefficiency

Empirical studies suggest the stock market Empirical studies suggest the stock market is:is:

Highly efficient in the weak form.Highly efficient in the weak form.Reasonably efficient in the semistrong form.Reasonably efficient in the semistrong form.Not efficient in the strong form. Insiders have Not efficient in the strong form. Insiders have made abnormal (and sometimes illegal) profits.made abnormal (and sometimes illegal) profits.

Behavioral financeBehavioral financeIncorporates elements of cognitive psychology Incorporates elements of cognitive psychology to better understand how individuals and to better understand how individuals and markets respond to different situations.markets respond to different situations.

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Implications of market Implications of market efficiency efficiency

You hear in the news that a medical You hear in the news that a medical research company received FDA research company received FDA approval for one of its products. If the approval for one of its products. If the market is semi-strong efficient, can you market is semi-strong efficient, can you expect to take advantage of this expect to take advantage of this information by purchasing the stock?information by purchasing the stock?

No – if the market is semi-strong efficient, No – if the market is semi-strong efficient, this information will already have been this information will already have been incorporated into the companyincorporated into the company’’s stock price. s stock price. So, it So, it’’s probably too late … s probably too late …

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Implications of market Implications of market efficiencyefficiency

A small investor has been reading about a A small investor has been reading about a ““hothot”” IPO that is scheduled to go public later this IPO that is scheduled to go public later this week. She wants to buy as many shares as she week. She wants to buy as many shares as she can get her hands on, and is planning on buying can get her hands on, and is planning on buying a lot of shares the first day once the stock a lot of shares the first day once the stock begins trading. Would you advise her to do this?begins trading. Would you advise her to do this?

Probably not. The long-run track record of hot IPOs is Probably not. The long-run track record of hot IPOs is not that great, unless you are able to get in on the not that great, unless you are able to get in on the ground floor and receive an allocation of shares before ground floor and receive an allocation of shares before the stock begins trading. It is usually hard for small the stock begins trading. It is usually hard for small investors to receive shares of hot IPOs before the stock investors to receive shares of hot IPOs before the stock begins trading.begins trading.

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CHAPTER 6CHAPTER 6Interest RatesInterest Rates

Determinants of interest ratesDeterminants of interest rates The term structure and yield curvesThe term structure and yield curves Investing overseasInvesting overseas

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What four factors affect the What four factors affect the level of interest rates?level of interest rates?

Production Production opportunitiesopportunities

Time preferences Time preferences for consumptionfor consumption

RiskRisk

Expected inflationExpected inflation

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““NominalNominal”” vs. vs. ““RealReal”” ratesrates

rr = represents any nominal rate= represents any nominal rate

r*r* = represents the = represents the ““realreal”” risk-free rate of risk-free rate of interest. Like a T-bill rate, if there was no interest. Like a T-bill rate, if there was no inflation. Typically ranges from 1% to 4% per inflation. Typically ranges from 1% to 4% per year.year.

rrRFRF = represents the rate of interest on Treasury = represents the rate of interest on Treasury securities.securities.

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Determinants of interest Determinants of interest ratesrates

r = r* + IP + DRP + LP + MRPr = r* + IP + DRP + LP + MRP

r r == required return on a debt securityrequired return on a debt security

r*r* == real risk-free rate of interestreal risk-free rate of interest

IPIP == inflation premiuminflation premium

DRPDRP == default risk premiumdefault risk premium

LPLP == liquidity premiumliquidity premium

MRPMRP == maturity risk premiummaturity risk premium

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Premiums added to r* for Premiums added to r* for different types of debtdifferent types of debt

IP MRP DRP LP

S-T Treasury

L-T Treasury

S-T Corporate

L-T Corporate

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Example – Default Risk Example – Default Risk PremiumPremium

The real risk-free rate, r*, is 2.5 percent. Inflation is expected to average 2.8 percent a year for the next 4 years, after which time inflation is expected to average 3.75 percent a year. Assume that there is no maturity risk premium. An 8-year corporate bond has a yield of 8.3 percent, which includes a liquidity premium of 0.75 percent. What is its default risk premium?

Given: r* = 2.5%, I1-4 = 2.8%, I5- = 3.75%, MRP = 0, LP = 0.75%

r = r* + IP + DRP + LP + MRP. 

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Example – Default Risk Example – Default Risk PremiumPremium

rC8 = r* + IP8 + MRP8 + DRP8 + LP8

8.3% = 2.5% + (2.8% 4 + 3.75% 4)/8 + 0.0% + DRP8 + 0.75%

8.3% = 2.5% + 3.275% + 0.0% + DRP8 + 0.75%

8.3% = 6.525% + DRP8

DRP8 = 1.775%.

 

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Example - Expected Interest Example - Expected Interest RateRate

The real risk-free rate is 3 percent. Inflation is expected to be 2 percent this year and 4 percent during the next 2 years. Assume that the maturity risk premium is zero. What is the yield on 2-year Treasury securities? What is the yield on 3-year Treasury securities?

Given: r* = 3%, I1 = 2%, I2 = 4 % and I3 = 4%

r = r* + IP + DRP + LP + MRP. Since these are Treasury securities, DRP = LP = 0.

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Example 1 (Expected Interest Example 1 (Expected Interest Rate)Rate)

rT2 = r* + IP2.IP2 = (2% + 4%)/2 = 3%.rT2 = 3% + 3% = 6%. rT3 = r* + IP3.IP3 = (2% + 4% + 4%)/3 = 3.33%.rT3 = 3% + 3.33% = 6.33%.

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Hypothetical yield curveHypothetical yield curve

An upward An upward sloping yield sloping yield curve.curve.

Upward slope due Upward slope due to an increase in to an increase in expected inflation expected inflation and increasing and increasing maturity risk maturity risk premium.premium.Years to

Maturity

Real risk-free rate

0

5

10

15

1 10 20

InterestRate (%)

Maturity risk premium

Inflation premium

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What is the relationship between the What is the relationship between the Treasury yield curve and the yield Treasury yield curve and the yield

curves for corporate issues?curves for corporate issues?

Corporate yield curves are higher than that of Corporate yield curves are higher than that of Treasury securities, though not necessarily parallel Treasury securities, though not necessarily parallel to the Treasury curve.to the Treasury curve.

The spread between corporate and Treasury yield The spread between corporate and Treasury yield curves widens as the corporate bond rating curves widens as the corporate bond rating decreases.decreases.

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Illustrating the relationship Illustrating the relationship between corporate and Treasury between corporate and Treasury

yield curvesyield curves

0

5

10

15

0 1 5 10 15 20

Years toMaturity

Interest Rate (%)

5.2%5.9%

6.0%TreasuryYield Curve

BB-Rated

AAA-Rated

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Pure Expectations Pure Expectations HypothesisHypothesis

The PEH contends that the shape of the yield curve The PEH contends that the shape of the yield curve depends on investordepends on investor’’s expectations about future s expectations about future interest rates.interest rates.

If interest rates are expected to increase, L-T rates If interest rates are expected to increase, L-T rates will be higher than will be higher than S-T rates, and vice-versa. Thus, the yield curve can S-T rates, and vice-versa. Thus, the yield curve can slope up, down, or even bow.slope up, down, or even bow.

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An example:An example:Observed Treasury rates and the Observed Treasury rates and the

PEHPEH

MaturityMaturity YieldYield1 year1 year 6.0% 6.0%

2 years2 years 6.2%6.2%3 years3 years 6.4%6.4%4 years4 years 6.5%6.5%5 years5 years 6.5%6.5%

If PEH holds, what does the market expect will If PEH holds, what does the market expect will be the interest rate on one-year securities, be the interest rate on one-year securities, one year from now? Three-year securities, one year from now? Three-year securities, two years from now?two years from now?

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One-year forward rateOne-year forward rate

(1.062)(1.062)22 = (1.060) (1+x)= (1.060) (1+x) 1.12784/1.0601.12784/1.060 = (1+x)= (1+x) 6.4004%6.4004% = x= x

PEH says that one-year securities will yield 6.4004%, PEH says that one-year securities will yield 6.4004%, one year from now. one year from now. Notice, if an arithmetic average is used, the answer is Notice, if an arithmetic average is used, the answer is still very close. Solve: 6.2% = (6.0% + x)/2, and the still very close. Solve: 6.2% = (6.0% + x)/2, and the result will be 6.4%.result will be 6.4%.

0 1 2

6.0% x%

6.2%

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Three-year security, two years Three-year security, two years from nowfrom now

(1.065)(1.065)55 = (1.062)= (1.062)22 (1+x) (1+x)33

1.37009/1.127841.37009/1.12784 = (1+x)= (1+x)33

6.7005%6.7005% = x= x

PEH says that three-year securities will yield PEH says that three-year securities will yield 6.7005%, two years from now.6.7005%, two years from now.

0 1 2 3 4 5

6.2% x%

6.5%

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Conclusions about PEHConclusions about PEH

Some would argue that the MRP ≠ 0, and hence Some would argue that the MRP ≠ 0, and hence the PEH is incorrect.the PEH is incorrect.

Most evidence supports the general view that Most evidence supports the general view that lenders prefer S-T securities, and view L-T lenders prefer S-T securities, and view L-T securities as riskier.securities as riskier.

Thus, investors demand a premium to persuade Thus, investors demand a premium to persuade them to hold L-T securities (i.e., MRP > 0).them to hold L-T securities (i.e., MRP > 0).

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Other factors that influence Other factors that influence interest rate levelsinterest rate levels

Federal reserve policyFederal reserve policy

Federal budget surplus or deficitFederal budget surplus or deficit

Level of business activityLevel of business activity

International factorsInternational factors

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Risks associated with Risks associated with investing overseasinvesting overseas

Exchange rate risk – If an Exchange rate risk – If an investment is denominated investment is denominated in a currency other than U.S. in a currency other than U.S. dollars, the investmentdollars, the investment’’s s value will depend on what value will depend on what happens to exchange rates.happens to exchange rates.

Country risk – Arises from Country risk – Arises from investing or doing business investing or doing business in a particular country and in a particular country and depends on the countrydepends on the country’’s s economic, political, and economic, political, and social environment.social environment.

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Country risk rankingsCountry risk rankings

Top 5 countries (least risk)

Rank

Country Score

1 Switzerland 95.2

2 Luxembourg 93.9

3 United States 93.7

4 Norway 93.7

5 United Kingdom

93.6

Bottom 5 countries (most risk)

Rank

Country Score

169 Afghanistan 11.0

170 Liberia 9.4

171 Sierra Leone 9.3

172 North Korea 8.9

173 Somalia 8.2Source: “Country Ratings by Region,” Institutional Investor, www.institutionalinvestor.com, September 2004.