1. 5-1 Unit 3 Assignment Price Earnings Ratio = Price of Shares/Earnings Per Share Given: Net Income = $459 million Shares Outstanding = 76.8 million Price per share = $78.62 Earnings per share = 459/76.8 = 5.9766 Price Earnings ratio = 78.62/5.9766 = 13.16 = 13.16

2. 5-2 CHAPTER 5 Financial Markets and Institutions ❂ The Capital Allocation Process ❂ Financial markets ❂ Financial institutions ❂ Stock Markets and Returns ❂ Stock Market Efficiency

3. 5-3 The Capital Allocation Process In a well-functioning economy, capital flows efficiently from those who supply capital to those who demand it. Suppliers of capital – individuals and institutions with “excess funds”. These groups are saving money and looking for a rate of return on their investment. Demanders or users of capital – individuals and institutions who need to raise funds to finance their investment opportunities. These groups are willing to pay a rate of return on the capital they borrow.

4. 5-4 How is capital transferred between savers and borrowers? Direct transfers Investment banking house Financial intermediaries

5. 5-5 What is a market? A market is a venue where goods and services are exchanged. A financial market is a place where individuals and organizations wanting to borrow funds are brought together with those having a surplus of funds.

6. 5-6 Types of financial markets Physical assets vs. Financial assets Money vs. Capital Primary vs. Secondary Spot vs. Futures Public vs. Private

7. 5-7 The importance of financial markets Well-functioning financial markets facilitate the flow of capital from investors to the users of capital. Markets provide savers with returns on their money saved/invested, which provides them money in the future. Markets provide users of capital with the necessary funds to finance their investment projects. Well-functioning markets promote economic growth. Economies with well-developed markets perform better than economies with poorly-functioning markets.

8. 5-8 What are derivatives? How can they be used to reduce or increase risk? A derivative security’s value is “derived” from the price of another security (e.g., options and futures). Can be used to “hedge” or reduce risk. For example, an importer, whose profit falls when the dollar loses value, could purchase currency futures that do well when the dollar weakens. Also, speculators can use derivatives to bet on the direction of future stock prices, interest rates, exchange rates, and commodity prices. In many cases, these transactions produce high returns if you guess right, but large losses if you guess wrong. Here, derivatives can increase risk.

9. 5-9 Types of financial institutions Commercial banks Investment banks Mutual savings banks Credit unions Pension funds Life insurance companies Mutual funds Hedge funds

10. 5-10 Physical location stock exchanges vs. Electronic dealer-based markets Auction market vs. Dealer market (Exchanges vs. OTC) NYSE vs. Nasdaq Differences are narrowing

11. 5-11 Stock Market Transactions Apple Computer decides to issue additional stock with the assistance of its investment banker. An investor purchases some of the newly issued shares. Is this a primary market transaction or a secondary market transaction? Since new shares of stock are being issued, this is a primary market transaction. What if instead an investor buys existing shares of Apple stock in the open market – is this a primary or secondary market transaction? Since no new shares are created, this is a secondary market transaction.

12. 5-12 What is an IPO? An initial public offering (IPO) is where a company issues stock in the public market for the first time. “Going public” enables a company’s owners to raise capital from a wide variety of outside investors. Once issued, the stock trades in the secondary market. Public companies are subject to additional regulations and reporting requirements.

13. 5-13 Historical stock market performance, S&P 500 (1968-2004)

14. 5-14 Where can you find a stock quote, and what does one look like? Stock quotes can be found in a variety of print sources (Wall Street Journal or the local newspaper) and online sources (Yahoo!Finance, CNNMoney, or MSN MoneyCentral).

15. 5-15 What is the Efficient Market Hypothesis (EMH)? Securities are normally in equilibrium and are “fairly priced.” Investors cannot “beat the market” except through good luck or better information. Levels of market efficiency Weak-form efficiency Semistrong-form efficiency Strong-form efficiency

16. 5-16 Weak-form efficiency Can’t profit by looking at past trends. A recent decline is no reason to think stocks will go up (or down) in the future. Evidence supports weak-form EMH, but “technical analysis” is still used.

17. 5-17 Semistrong-form efficiency All publicly available information is reflected in stock prices, so it doesn’t pay to over analyze annual reports looking for undervalued stocks. Largely true, but superior analysts can still profit by finding and using new information.

18. 5-18 Strong-form efficiency All information, even inside information, is embedded in stock prices. Not true--insiders can gain by trading on the basis of insider information, but that’s illegal.

19. 5-19 Conclusions about market efficiency Empirical studies suggest the stock market is: Highly efficient in the weak form. Reasonably efficient in the semistrong form. Not efficient in the strong form. Insiders have made abnormal (and sometimes illegal) profits. Behavioral finance Incorporates elements of cognitive psychology to better understand how individuals and markets respond to different situations.

20. 5-20 Implications of market efficiency You hear in the news that a medical research company received FDA approval for one of its products. If the market is semi-strong efficient, can you expect to take advantage of this information by purchasing the stock? No – if the market is semi-strong efficient, this information will already have been incorporated into the company’s stock price. So, it’s probably too late …

21. 5-21 Implications of market efficiency A small investor has been reading about a “hot” IPO that is scheduled to go public later this week. She wants to buy as many shares as she can get her hands on, and is planning on buying a lot of shares the first day once the stock begins trading. Would you advise her to do this? Probably not. The long-run track record of hot IPOs is not that great, unless you are able to get in on the ground floor and receive an allocation of shares before the stock begins trading. It is usually hard for small investors to receive shares of hot IPOs before the stock begins trading.

22. 5-22 CHAPTER 6 Interest Rates Determinants of interest rates Determinants of interest rates The term structure and yield curves The term structure and yield curves  Investing overseas

23. 5-23 What four factors affect the level of interest rates? Production opportunities Time preferences for consumption Risk Expected inflation

24. 5-24 “ Nominal ” vs. “ Real ” rates r= represents any nominal rate r*= represents the “ real ” risk-free rate of interest. Like a T- bill rate, if there was no inflation. Typically ranges from 1% to 4% per year. r RF = represents the rate of interest on Treasury securities.

25. 5-25 Determinants of interest rates r = r* + IP + DRP + LP + MRP r =required return on a debt security r*=real risk-free rate of interest IP=inflation premium DRP=default risk premium LP=liquidity premium MRP=maturity risk premium

26. 5-26 Premiums added to r* for different types of debt IPMRPDRPLP S-T Treasury L-T Treasury S-T Corporate L-T Corporate

27. 5-27 Example – Default Risk Premium 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%, I 1-4 = 2.8%, I 5- = 3.75%, MRP = 0, LP = 0.75% r = r* + IP + DRP + LP + MRP.

28. 5-28 Example – Default Risk Premium r C8 = r* + IP 8 + MRP 8 + DRP 8 + LP 8 8.3%= 2.5% + (2.8%  4 + 3.75%  4)/8 + 0.0% + DRP 8 + 0.75% 8.3%= 2.5% + 3.275% + 0.0% + DRP 8 + 0.75% 8.3%= 6.525% + DRP 8 DRP 8 = 1.775%.

29. 5-29 Example - Expected Interest Rate 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%, I 1 = 2%, I 2 = 4 % and I 3 = 4% r = r* + IP + DRP + LP + MRP. Since these are Treasury securities, DRP = LP = 0.

30. 5-30 Example 1 (Expected Interest Rate) r T2 = r* + IP 2. IP 2 = (2% + 4%)/2 = 3%. r T2 = 3% + 3% = 6%. r T3 = r* + IP 3. IP 3 = (2% + 4% + 4%)/3 = 3.33%. r T3 = 3% + 3.33% = 6.33%.

31. 5-31 Hypothetical yield curve An upward sloping yield curve. Upward slope due to an increase in expected inflation and increasing maturity risk premium. Years to Maturity Real risk-free rate 0 5 10 15 1 10 20 Interest Rate (%) Maturity risk premium Inflation premium

32. 5-32 What is the relationship between the Treasury yield curve and the yield curves for corporate issues? Corporate yield curves are higher than that of Treasury securities, though not necessarily parallel to the Treasury curve. The spread between corporate and Treasury yield curves widens as the corporate bond rating decreases.

33. 5-33 Illustrating the relationship between corporate and Treasury yield curves 0 5 10 15 015101520 Years to Maturity Interest Rate (%) 5.2% 5.9% 6.0% Treasury Yield Curve BB-Rated AAA-Rated

34. 5-34 Pure Expectations Hypothesis The PEH contends that the shape of the yield curve depends on investor ’ s expectations about future interest rates. If interest rates are expected to increase, L-T rates will be higher than S-T rates, and vice-versa. Thus, the yield curve can slope up, down, or even bow.

35. 5-35 An example: Observed Treasury rates and the PEH MaturityYield 1 year 6.0% 2 years6.2% 3 years6.4% 4 years6.5% 5 years6.5% If PEH holds, what does the market expect will be the interest rate on one-year securities, one year from now? Three-year securities, two years from now?

36. 5-36 One-year forward rate (1.062) 2 = (1.060) (1+x) (1.062) 2 = (1.060) (1+x) 1.12784/1.060= (1+x) 1.12784/1.060= (1+x) 6.4004%= x 6.4004%= x PEH says that one-year securities will yield 6.4004%, one year from now. Notice, if an arithmetic average is used, the answer is still very close. Solve: 6.2% = (6.0% + x)/2, and the result will be 6.4%. 0 1 2 6.0%x% 6.2%

37. 5-37 Three-year security, two years from now (1.065) 5 = (1.062) 2 (1+x) 3 (1.065) 5 = (1.062) 2 (1+x) 3 1.37009/1.12784= (1+x) 3 6.7005%= x 6.7005%= x PEH says that three-year securities will yield 6.7005%, two years from now. 0 1 2 3 4 5 6.2%x% 6.5%

38. 5-38 Conclusions about PEH Some would argue that the MRP ≠ 0, and hence the PEH is incorrect. Most evidence supports the general view that lenders prefer S-T securities, and view L-T securities as riskier. Thus, investors demand a premium to persuade them to hold L-T securities (i.e., MRP > 0).

39. 5-39 Other factors that influence interest rate levels Federal reserve policy Federal budget surplus or deficit Level of business activity International factors

40. 5-40 Risks associated with investing overseas Exchange rate risk – If an investment is denominated in a currency other than U.S. dollars, the investment ’ s value will depend on what happens to exchange rates. Country risk – Arises from investing or doing business in a particular country and depends on the country ’ s economic, political, and social environment.

41. 5-41 Country risk rankings Top 5 countries (least risk) RankCountryScore 1Switzerland95.2 2Luxembourg93.9 3United States93.7 4Norway93.7 5United Kingdom93.6 Bottom 5 countries (most risk) RankCountryScore 169Afghanistan11.0 170Liberia9.4 171Sierra Leone9.3 172North Korea8.9 173Somalia8.2 Source: “ Country Ratings by Region, ” Institutional Investor, www.institutionalinvestor.com, September 2004.