1 MN10403: Lecture 5 The Capital Markets Part 1

2 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.

3 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.

4 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’.

5 The Importance of the Capital Markets Table 6.1 in textbook shows: In , 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.

6 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.

7 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!

8 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)

9 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% £4 every 6 months to the registered owner until Guaranteed return!

10 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

11 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.

12 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

13 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)

14 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.

15 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.

16 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 1 0 Risk- free

17. 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

18 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

19 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.

20 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 …..

21 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.

22 Efficient versus inefficient markets. t P FSA test.

23 Next Lecture Equity markets (chapter 6: continued)