MONEY MARKETS
MONEY MARKET
The money market is the trade in short-term debt investments
WHO USES MONEY MARKETS?
A. COMPANIES
When companies need to raise money to cover their payroll or running cost
B. BANKS
When long-term loans is not covered by deposits from saving accounts
C. INVESTORS
When seeking to invest large sums of money at relatively low risk
TYPES OF MONEY MARKET INSTRUMENTS
1. COMMERCIAL PAPER
It is a short-term debt obligation of a private-sector firm or a government-
sponsored corporations.
2. BANKERS’ ACCEPTANCE
An acceptance is a promissory note issued by a non-financial firm to a bank in
return for a loan.
3. TREASURY BILLS
It is often referred to as T-bills, are securities with a maturity of one year or less,
issued by national governments.
4. GOVERNMENT AGENCY NOTE
It may issue or guarantee these bonds—to finance activities related to public
purpose.
5. LOCAL GOVERNMENT NOTES
It is issued by, provincial or local governments, and by agencies of these
governments.
6. INTERBANK LOANS
It is a loans extended from one bank to another with which it has no affiliation.
7. TIME DEPOSITS
Another name for certificates of deposit or CDs, are interest bearing bank deposits
that cannot be withdrawn without penalty before a specified date.
8. REPOS
It is a contract whereby the seller of securities agrees to buy them back at a
specified future date and price usually on a short-term basis.
CAPITAL MARKETS
CAPITAL MARKET
Financial market in which longer-term debt (original maturity of one year or greater) and
equity instruments are traded and include bonds, stocks, and mortgages.
CAPITAL MARKET PARTICIPANTS
1) National and Local Government
National government issues long-term notes and bonds to fund the national debt.
Local governments issues notes and bonds to finance capital projects.
2) Corporations
Issue both bonds and stock to finance capital investment expenditures and fund
other investment opportunities.
CAPITAL MARKET TRADING
1) Primary market – where new issues of stocks and bonds are introduced.
Investment funds, corporations, and individual investors can all purchase
securities offered in primary market.
When firms sell securities for the very first time, the issue is an initial public
offering (IPO).
2) Secondary market – where the sale of previously issued securities takes place,
There are two types of exchanges in the secondary market for capital securities:
organized exchanges and over-the-counter exchanges.
TYPES OF CAPITAL MARKETS
A. BONDS – any long-term promissory note issued by the firm.
Bond certificate – tangible evidence of debt issued by a corporation or a
governmental body and represents a loan made by investors to the issuer.
TRADING PROCESS FOR CORPORATE BONDS
Most often, corporate bonds are offered publicly through investment banking
firms as underwriters. Normally, the investment bank facilitates this transaction
using a firm commitment underwriting.
Sell Bonds Sell Bonds
Underwriter
Corporation Investors
(investment bank)
Pays Bid Price Pays Offer Price
Other arrangements:
1) Competitive Sale – the investment bank can purchase the bonds through
competitive bidding against other investment banks or by directly negotiating
with the issuer.
2) Negotiated Sale – a single investment bank obtains the exclusive right to
originate, underwrite and distribute the new bonds through a one-on-one
negotiation process.
3) Best Efforts Underwriting Basis – the investment bank incurs no risk of
mispricing the security since it simply seeks to sell the securities at the best
market price it can get for the issuing firm.
ADVANTAGES:
1) Long-term debt is generally less expensive than other forms of financing because
(a) investors view debt as a relatively safe investment alternative and demand a
lower rate of return, and (b) interest expenses are tax deductible.
2) Bondholders do not participate in extraordinary profits; the payments are limited
to interest.
3) Bondholders do not have voting rights.
4) Flotation costs of bonds are generally lower than those of ordinary (common)
equity shares.
DISADVANTAGES:
1) Debt (other than income bonds) results in interest payments that, if not met, can
force the firm into bankruptcy.
2) Debt (other than income bonds) produces fixed charges, increasing the firm’s
financial leverage. Although this may not be a disadvantage to all firms, it
certainly is for some firms with unstable earnings streams.
3) Debt must be repaid at maturity and this at some point involves a major cash
outflow.
4) The typically restrictive nature of indenture covenants may limit the firm’s future
financial flexibility.
BONDS FEATURES AND PRICES
Par Value – face value of the bond that is returned to the bondholder at maturity.
Coupon Interest Rate – percentage of the par value of the bond that will be paid
out annually in the form of interest.
Maturity – length of time until the bond issuer returns the par value to the
bondholder and terminates the bond.
Indenture – agreement between the firm issuing the bonds and the bond trustee
who represents the bondholders.
Current Yield – ratio of the annual interest payment to the bond’s market price.
Yield to Maturity – bond’s internal rate of return; discount rate that equates the
present value of the interest and principal payments with the current market price
of the bond.
Principal Payment −Price of the Bond
Approximate Yield= Annual Interest Payment + Maturity
Number of Years ¿ .6
Credit Quality Risk – chance that the bond issuer will not be able to make timely
payments.
Bond Ratings – involve a judgment about the future risk potential of the bond provided
by rating agencies. Bond ratings are favorably affected by:
a) A low utilization of financial leverage;
b) Profitable operations;
c) A low variability of past earnings;
d) Large firm size;
e) Little use of subordinated debt.
TYPES OF BONDS
a. Unsecured Long-Term Bonds
Debentures – unsecured long-term debt and backed only by the reputation
and financial stability of the corporation.
Subordinated Debentures – claims of bondholders of subordinated
debentures are honored only after the claims of secured debt and
unsubordinated have been satisfied.
Income bonds – requires interest payments only if earned and non-
payment of interest does not lead to bankruptcy.
b. Secured Long-Term Bonds
Mortgage Bonds – bond secured by a lien on real property.
a) First Mortgage Bonds – have the senior claim on the secured
assets if the same property has been pledged on more than one
mortgage bond.
b) Second Mortgage Bonds – have the second claim on assets and
are paid only after the claims of the first mortgage bonds have been
satisfied.
c) Blanket or General Mortgage Bonds – all the assets of the firm
are used as security for this type of bonds.
d) Closed-end Mortgage Bonds – forbid the further use of the
pledged assets security for other bonds.
e) Open-end Mortgage Bonds – allow the issuance of additional
mortgage bonds using the same secured assets as security.
f) Limited Open-end Mortgage Bonds – allow the issuance of
additional bonds up to a limited amount at the same priority level
using the already mortgaged assets as security.
OTHER TYPES OF BONDS
1) Floating Rate or Variable Rate Bonds – one in which the interest payment
changes with market conditions.
2) Junk or Low-Rated Bonds – bonds rated BB or below. The major participants of
this market are new firms that do not have an established record of performance,
although in recent years, junk bonds have been increasingly issued to finance
corporate buyouts.
3) Eurobonds – bonds payable or denominated in the borrower’s currency, but sold
outside the country of the borrower, usually by an international syndicate of
investment bankers.
4) Treasury Bonds – carry the “full-faith-and-credit” backing of the government
and investors consider them among the safest fixed-income investments in the
world.
B. ORDINARY (COMMON) EQUITY SHARES – form of long-term equity that
represents ownership interest of the firm. Ordinary equity shareholders are called
residual owners because their claim to earnings and assets is what remains after
satisfying the prior claims of various creditors and preferred shareholders.
FEATURES OF ORDINARY EQUITY SHARES
1) Par value/No par value – ordinary equity share may be sold with or without par
value. Par value of ordinary equity share is the stated value attached to a single
share at issuance.
2) Authorized, issued, and outstanding – authorized shares the maximum number
of shares that a corporation may issue without amending its charter. Issued shares
is the number of authorized shares that have been sold. Outstanding shares are
those shares held by the public.
3) No maturity – ordinary equity share has no maturity and is a permanent form of
long-term financing. A tender offer is a formal offer to purchase shares of a
corporation.
4) Voting rights – each share of ordinary equity generally entitles the holder to vote
on the selection of directors and in other matters. Shareholders unable to attend
the annual meeting to vote may vote by proxy. A proxy is a temporary transfer of
the right to vote to another party.
TWO COMMON SYSTEMS OF VOTING:
Majority voting – voting system that entitles each shareholder to cast one
vote for each share owned.
Cumulative voting – voting system that permits the shareholder to cast
multiple votes for a single director.
5) Book value per share – the accounting value of an ordinary equity share is equal
to the ordinary share equity (ordinary share plus paid-in capital plus retained
earnings) divided by the number of shares outstanding.
6) Numerous rights of stockholders
a) Right to vote on specific issues as prescribed by the corporate charter.
b) Right to receive dividends if declared by the firm’s board of directors.
c) Right to share in the residual assets in the event of liquidation.
d) Right to transfer their ownership in the firm to another party.
e) Right to examine the corporate banks.
f) Right to share proportionally in the purchase of any new issuance of
equity shares. This is known as the pre-emptive right.
Valuation – ordinary or common equity share valuation is complicated by the
uncertainty of future returns and/or changes in the share’s price.
C. PREFERRED SHARES – class of equity shares which has preference over ordinary
(common) equity shares in the payment of dividends and in the distribution of
corporation assets in the event of liquidation.
The issuance of preferred shares is favored when the following conditions prevail:
1. Control problems exist with the issuance of ordinary shares.
2. Profit margins are adequate to make of additional leverage attractive.
3. Additional debt poses substantial risk.
4. Interest rates are low lowering the cost of preferred share.
5. The firm has a high debt ratio, suggesting infusion of equity financing is needed.
FEATURES OF PREFERRED SHARES
1) Par value – face value that appears on the stock certificate.
2) Dividends – percentage of the par value and are commonly fixed and paid
quarterly but are not guaranteed by the issuing firm.
3) Cumulative and Noncumulative dividends – dividends payable to preferred
shares are either cumulative or noncumulative; most are cumulative.
4) No definite maturity date – preferred share is usually intended to be a permanent
part of a firm’s equity and has no definite maturity date.
5) Convertible preferred share – owners of convertible preferred share have the
option of exchanging their preferred share for ordinary (common) equity share
based on specified terms and conditions.
6) Voting rights – preferred share does not ordinarily carry voting rights.
7) Participating features – participating preferred share entitles its holders to share
in profits above and beyond the declared dividend, along with ordinary (common)
equity shareholders. Most preferred share issues are nonparticipating.
8) Protective features – preferred share issues often contain covenants to assure the
regular payment of preferred share dividends and to improve the quality of
preferred share.
9) Call provision – gives the issuing corporation the right to call in the preferred
share for redemption.
10) Maturity – today, most new preferred share has a sinking fund and thus an
effective maturity date.
Preferred Share Valuation – is relatively simple if the firm pays fixed dividends at the
end of each year. If this condition holds, then the stream of dividend payments can be
treated in perpetuity and be discounted by the investor’s required rate of return on a
preferred share issue.
The intrinsic value of a share of preferred share ( Po ) is the sum of the present
values of future dividends discounted at the investor’s required rate of return.
Dp
Po =
Kp
where D p = per share cash dividend
K p = investor’s required rate of return on preferred share.
