1. Chapter 8– Bond Valuation and Structure of Interest RatesCopyright 2008 John Wiley & Sons 1 MT480 Unit 4 Chapters 8 and 9

2. Chapter 8– Bond Valuation and Structure of Interest RatesCopyright 2008 John Wiley & Sons 2 Capital Market Efficiency  Supply and demand for securities are better reflected in organized markets.  Any price balancing overall supply and demand for a security is market equilibrium price.  A security’s true value is price reflecting investors’ estimates of value of expected future cash flows.  In efficient capital market, security prices fully reflect knowledge and expectations of all investors at particular point in time.

3. Chapter 8– Bond Valuation and Structure of Interest RatesCopyright 2008 John Wiley & Sons 3 Capital Market Efficiency  If markets are efficient, investors and financial managers can believe securities are priced at or near true value.  The more efficient a security market, the more likely securities are priced at or near true value.  Overall efficiency of a capital market depends on its operational and informational efficiency.  Operational efficiency focuses on bringing buyers and sellers together at lowest possible cost.

4. Chapter 8– Bond Valuation and Structure of Interest RatesCopyright 2008 John Wiley & Sons 4 Capital Market Efficiency  Competition among investors is important driver of informational efficiency.  In an informationally efficient market, market prices adjust quickly to new information about a security as it becomes available.  Markets exhibit informational efficiency if market prices reflect all relevant information about securities at particular point in time.

5. Chapter 8– Bond Valuation and Structure of Interest RatesCopyright 2008 John Wiley & Sons 5 Corporate Bonds  Largest investors in corporate bonds are life insurance companies and pension funds.  Trades in this market tend to be in very large blocks of securities. Market for Corporate Bonds  Less than 1% of all corporate bonds are traded on exchanges.  Most secondary market corporate bond transactions take place through dealers in the over-the-counter (OTC) market.

6. Chapter 8– Bond Valuation and Structure of Interest RatesCopyright 2008 John Wiley & Sons 6 Corporate Bonds  Corporate bonds are long-term IOUs that represent claims against a firm’s assets. Types of Corporate Bonds  Debt instruments where the interest income paid to investors is fixed for the life of the contract are called fixed-income securities.  Three types of corporate bonds are – vanilla bonds, zero coupon bonds, and convertible bonds.

7. Chapter 8– Bond Valuation and Structure of Interest RatesCopyright 2008 John Wiley & Sons 7 Vanilla Bonds  Face value, or par value, for most corporate bonds is $1,000.  Bond’s coupon rate is calculated as annual coupon payment (C) divided by bond’s face value (F). Types of Corporate Bonds

8. Chapter 8– Bond Valuation and Structure of Interest RatesCopyright 2008 John Wiley & Sons 8 Zero Coupon Bonds  Corporations sometimes issue bonds with no coupon payments, only offering one payment at maturity.  Zero coupon bonds sell well below their face value (at deep discount) because they offer no coupons.  U.S. Treasury is most frequent and regular issuer of zero coupon securities. Types of Corporate Bonds

9. Chapter 8– Bond Valuation and Structure of Interest RatesCopyright 2008 John Wiley & Sons 9 Convertible Bonds  Convertible bonds are bonds that can be converted into shares of common stock at pre- determined ratio at discretion of bondholder.  Convertibility feature allows bondholders to share firm’s good fortunes if the firm’s stock rises above certain level. Types of Corporate Bonds

10. Chapter 8– Bond Valuation and Structure of Interest RatesCopyright 2008 John Wiley & Sons 10 Bond Valuation  The value, or price, of any asset is present value of its future cash flows.  To calculate bond’s price, follow same process as to value any financial asset.  Estimate expected future cash flows – these are the coupons that the bond will pay.

11. Chapter 8– Bond Valuation and Structure of Interest RatesCopyright 2008 John Wiley & Sons 11 Bond Valuation  If a bond’s coupon rate is equal to market rate, bond will sell at price equal to its face value; these are called par bonds. Par, Premium, and Discount Bonds  If a bond’s coupon rate is less than market rate, then bond will sell at price less than its face value; these are called discount bonds.  If a bond’s coupon rate is greater than market rate, then bond will sell at price more than its face value; these are called premium bonds.

12. Chapter 8– Bond Valuation and Structure of Interest RatesCopyright 2008 John Wiley & Sons 12 Bond Yields  A bond’s yield to maturity:  Discount rate that makes present value of coupon and principal payments equal to price of bond. Yield to Maturity  It is the yield that investor earns if bond is held to maturity, and all coupon and principal payments are made as promised.  A bond’s yield to maturity changes daily as interest rates increase or decrease.

13. Chapter 8– Bond Valuation and Structure of Interest RatesCopyright 2008 John Wiley & Sons 13 The Market for Stocks  Equity securities are a corporation’s certificates of ownership. Basic Facts  Households dominate holdings of equity securities, owning >36% of outstanding corporate equities.  Pension funds are largest institutional investors in equities (21%), followed by mutual funds (20%), and foreign investors (10%).

14. Chapter 8– Bond Valuation and Structure of Interest RatesCopyright 2008 John Wiley & Sons 14 The Market for Stocks  Outstanding shares of a stock are bought and sold among investors. Secondary Markets  From investor’s perspective, secondary markets provide marketability at a fair price for shares of securities they own.  Active secondary market enables firms to sell their new debt or equity issues at lower funding costs than can firms without secondary markets that sell similar securities.

15. Chapter 8– Bond Valuation and Structure of Interest RatesCopyright 2008 John Wiley & Sons 15 The Market for Stocks  In US, most secondary market transactions are done on one of the stock exchanges. The Efficiency of Secondary Markets  In terms of total volume of activity and total capitalization of firms listed, NYSE is the world’s largest and NASDAQ is the second largest.  In terms of number of companies listed and shares traded daily, NASDAQ is larger than NYSE.

16. Chapter 8– Bond Valuation and Structure of Interest RatesCopyright 2008 John Wiley & Sons 16 The Market for Stocks  Brokers bring buyers and sellers together to earn a fee, called a commission. The Efficiency of Secondary Markets - Brokered  Brokers’ extensive contacts provide a pool of price information that individual investors could not economically duplicate themselves.  By charging a commission less than cost of direct search, they give investors incentives to utilize information by hiring them as brokers.

17. Chapter 8– Bond Valuation and Structure of Interest RatesCopyright 2008 John Wiley & Sons 17 The Market for Stocks  NASDAQ is best-known example of dealer market. The Efficiency of Secondary Markets - Dealer  Electronic communications network (ECN) systems provide additional price information to investors. Increase marketability and competition, which should improve NASDAQ efficiency.

18. Chapter 8– Bond Valuation and Structure of Interest RatesCopyright 2008 John Wiley & Sons 18 The Market for Stocks  In an auction market, buyers and sellers confront each other directly and bargain over price. The Efficiency of Secondary Markets - Auction  NYSE is best-known example of auction market.  In NYSE, auction for a security takes place at a specific location on the floor of the exchange, called a post.

19. Chapter 8– Bond Valuation and Structure of Interest RatesCopyright 2008 John Wiley & Sons 19 Types of Equity Securities  Two types of equity securities 1) Common stock 2) Preferred stock Common Stock and Preferred Stock  Common stock represents basic ownership claim in a corporation.  One of the owners’ rights is to vote on all important matters that affect life of company, such as vote to elect board of directors, capital budget, or proposed merger or acquisition.

20. Chapter 8– Bond Valuation and Structure of Interest RatesCopyright 2008 John Wiley & Sons 20 Types of Equity Securities  Owners of common stock are not guaranteed any dividend payments; have lowest priority claim on firm’s assets in event of bankruptcy. Common Stock and Preferred Stock  Legally, common stockholders enjoy limited liability.

21. Chapter 8– Bond Valuation and Structure of Interest RatesCopyright 2008 John Wiley & Sons 21 Types of Equity Securities  Preferred stock owners are given priority over common stock owners with respect to dividends payments and claims against firm’s assets in event of bankruptcy or liquidation. Common Stock and Preferred Stock  Preferred stocks are generally viewed as perpetuities because they have no maturity.  Even though preferred stock is equity, owners have no voting privileges.

22. Chapter 8– Bond Valuation and Structure of Interest RatesCopyright 2008 John Wiley & Sons 22 Problem A8.4

23. Chapter 8– Bond Valuation and Structure of Interest RatesCopyright 2008 John Wiley & Sons 23 Problem A8.10

24. Chapter 8– Bond Valuation and Structure of Interest RatesCopyright 2008 John Wiley & Sons 24 Problem A8.20

25. Chapter 8– Bond Valuation and Structure of Interest RatesCopyright 2008 John Wiley & Sons 25 Problem A9.6

26. Chapter 8– Bond Valuation and Structure of Interest RatesCopyright 2008 John Wiley & Sons 26 Problem A9.8

27. Chapter 8– Bond Valuation and Structure of Interest RatesCopyright 2008 John Wiley & Sons 27 Problem A9.12

28. Chapter 8– Bond Valuation and Structure of Interest RatesCopyright 2008 John Wiley & Sons 28 Problem A9.16