Chapter Two: Financial Markets and Instruments

 Contents
 Meaning
 Functions of Financial Markets
 Classification of Financial Markets
A. Money Market(meaning, why money markets,
characteristics, purpose, participants and instruments)
B. Capital Market
C. Derivative Market
D. Foreign Exchange Market
Financial Markets
Meaning
 Generally speaking, there is no specific place or location
to indicate a financial market.
 Wherever a financial transaction takes place, it is
deemed to have taken place in the financial market.
 Hence financial markets are pervasive in nature since
financial transactions are themselves very pervasive
throughout the economic system.
 For instance, issue of equity shares, granting of loan by
term lending institutions, deposit of money into a bank,
purchase of debentures, sale of shares and so on.
 However, financial markets can be referred to as
those centers and arrangements which facilitate
buying and selling of financial assets, claims
and services.
 Sometimes, we do find the existence of a specific
place or location for a financial market as in the
case of stock exchange.
 Financial Markets refers to all institutions and
procedures that provide facilities for transactions in
financial instruments.
 Financial market is a situation in which transaction
(exchange) of financial instruments is conducted.
The transaction is basically borrowing and lending
type where financial dealings are taken place.
 A financial market is a market that deals
financial assets.
 Functions of Financial Markets
 Financial markets serve the following six basic functions.
1. Borrowing and Lending: Financial markets permit the transfer
of funds (purchasing power) from one agent to another for
either investment or consumption purposes.
2. Price Determination: Financial markets provide vehicles by
which prices are set both for newly issued financial assets
and for the existing stock of financial assets.
3. Information Aggregation and Coordination: Financial markets act
as collectors and aggregators of information about
financial asset values and the flow of funds from
lenders to borrowers.
 Functions of Financial Markets
4. Risk Sharing: Financial markets allow a transfer of risk
from those who undertake investments to those who
provide funds for those investments.
5. Liquidity: Financial markets provide the holders of financial
assets with a chance to resell or liquidate these assets.
6. Efficiency: Financial markets reduce transaction costs and
information costs.
 In attempting to characterize the way financial markets
operate, one must consider both the various types of
financial institutions that participate in such markets and
the various ways in which these markets are structured.
CLASSIFICATION OF FINANCIAL MARKETS

1. Organized Market

1.1 Capital Market

1.1.1 Industrial Securities
a. Primary markets
b. Secondary markets
1.1.2. Govt. Securities markets
1.1.3. Long Term Loans markets
1.2. Money Market
1.2.1 Call Money Market
1.2.2. Commercial bill Market
1.2.3. Treasury bill market
1.2.4. Short term loan market
2. Unorganized Market
2.1. Money Lenders
2.2 Indigenous bankers
 A. THE MONEY MARKET
 The term money market is actually a misnomer.
 Money-Currency-is not traded in the money markets.
 Because the securities traded are short term and highly liquid
and are close to being money.
 The money market, therefore, is a component of the financial
markets for assets involved in short-term borrowing and lending
with original maturities of one year or shorter time frames.
 In theory this market should not exist, as banks are assumed to
have an efficiency advantage in gathering information.
 However, in situations where asymmetric information problem
is not severe, the money markets have a remarkable cost
advantage over banks in providing short-term funds.
 Why Money Markets
 Money markets have a cost advantage over banks
because of two facts.
1. Reserve requirement by central banks of a country
reduces the total amount of investible funds received
from depositors by setting a minimum reserve
requirement to commercial banks.
2. Interest rate restrictions are used avoid competition
among banks. This substantially reduce the
competitiveness of the banking industry with money
markets which do not worry about such restrictions
especially during the times of high inflation
 The above two have contributed immensely for the
development of money markets.
Characteristics of The Money Market

 The money market securities have three basic common characteristics:

1. They are usually sold in large denominations. Money
Market Mutual funds can mitigate (alleviate) this
problem
2. They have low default risk
3. They mature in one year or less from their original
issue date. Most money market instruments mature in
less than 120 days
 Money market transactions do not take place in one particular location
or building rather traders usually arrange purchase and sales between
participants over a phone and complete them electronically.
 Because of this money market securities usually have an active
secondary market.
Characteristics …

 Money markets are wholesale markets: most

transactions are very large as a result this large size
most individual investors cannot invest their money
directly in the money markets.
 To solve this problem dealers and brokers, operating in
trading rooms of large banks and brokerage houses,
bring customers together.
 Despite the wholesale nature of the market, innovative
securities and trading methods help investors enjoy the
benefits of money market securities.
 The Purpose of the Money Markets

 Active secondary markets makes money market

securities very flexible instruments to use to fill
short term financial needs that is the only
reason why most organizations in countries
having well-developed financial markets report
them as cash on their balance sheets.
 The well developed secondary market for money
market instruments makes the money market an
ideal place for economic units to warehouse
surplus funds temporarily.
 Similarly, the money markets provide a low cost
source of funds to firms, governments (state and
local), and intermediaries that need a short-term
infusion of funds.
 Money market funds provide a means to invest idle
funds and to reduce opportunity cost of lost
interest income because of not investing.
 Most investors in the money markets do not
want unusually high returns on their money
market funds, rather they use them as an
interim investment that provides a higher
return than holding money in a bank.
 Participants of the Money Market

 An obvious way to discuss the participants of the

money market would be to list those who lend and
borrow in the money market.
 However, this approach do not work here because,
money market participants involve in both sides of the
market.
 For instance, a bank may borrow huge amount of funds
via Certificates of Deposits (CDs), and at the same time
it will advance short-term loans to its clients.
 Nevertheless, in the following sections we will discuss
the principal players of the money market.
Central banks

 Central Banks are frequently engaged in

injection and absorption of money supply in the
economy using a tool known as open market
operations.
 The central bank’s responsibility for money
supply makes them the single most influential
participant in the money market.
 Commercial Banks

 CBs hold a large percentages of government securities than

any other institutions in many countries including Ethiopia.
 Commercial banks in Ethiopia are the dominant players in the
country’s money market.
 In many countries regulations prohibit CBs from investing in
high risk corporate bonds and stocks that have a higher rate of
returns but entail huge associated risks.
 As money markets instruments provide an almost risk less
investment opportunity with an added advantage of high
liquidity, the CBs are major issuers of money market
instruments.
 Businesses

 Many business firms buy and sell securities in

the money market to finance their short-term
capital needs as well as to warehouse their
excess funds.
 Many large corporations and firms engage in
both sides of the market as money market
investments are substantial in size.
 Investment and Securities Firms

1. Investment Companies: are large diversified

brokerage firms that are active in the market
to trade on behalf of their commercial
accounts.
 They are very important to the liquidity of the
money market because they ensure that both
buyers and sellers can readily market their
securities.
2. Finance Companies: lend funds to individuals
 Investment and Secu…

3. Insurance Companies: property and casualty

insurance companies must maintain the liquidity
because of their unpredictable need for funds.
 Such firms, therefore, should invest some amount
of their investment funds in money market
securities to raise cash during emergency
situations.
4. Pension Funds: these companies invest a portion
of their cash in money markets so that they can
take advantage of investment opportunities that
they may identify in the stock or bond markets.
 Individuals

 With the special help of the money market

mutual funds individual investors with
relatively small amounts of cash to invest can
get an access to invest on large denomination
money market instruments.
 Money Market Instruments
 Many number of money market instruments are
available to meet the needs of a wide range of
participants in the money market.
 The following sections discuss the following major
ones:
1. Treasury bills
2. Federal Funds
3. Repurchase Agreements
4. Negotiable Certificates of Deposits (CDs)
5. Commercial Papers
6. Bankers Acceptances
7. Eurodollars
 T-bills

 T-bills are one of the debt securities that a government

issues having a great advantage of liquidity.
 The Treasury Bill market is the only active primary market
in Ethiopia.
 Tenders are offered periodically by the Central Bank.
 The government offers 28‐day, 91 day and 182‐day bills.
 A sample of the amounts offered and yields on T‐Bills is
shown in the table that appear in the following slide.
 any one can participate in the auction of Treasury Bills
with the minimum amount of birr 5000.
T-bills…
 Most money market instruments do not pay interest.
Rather the investor pays less for the security than it will be
worth when it matures, and the increase in price provides a
return.
 In simple terms, short-term securities are issued at discount
and redeemed at par. This is because they often mature
before the issuer can mail out interest checks.
 The yield on an investment is found by computing the
increase in value in the security during its holding period.
 i.e. the annualized yield on the investment is found using
the following formula:
 Valuation of T-bills

For example, let's say you buy a 91 days T-bill priced at

$9,800. Essentially, the government writes you an IOU (I
owe you) for $10,000 that it agrees to pay back in 91 days.
 You will not receive regular payments as you would with a
coupon bond, for example.
 Instead, therefore, the value to you that you will get comes
from the difference between the discounted value you
originally paid and the amount you receive back ,10,000.
 In this case, the T-bill pays a 2.04% interest rate of return
($200/$9,800 = 2.04%) over a 91days period. The
annualized yield on investment can be:
 T-bills risk

 T-bills virtual have zero default risk because even if the government
runs out of cash it could print money sufficient to cover liability.
 For this reason, t-bill rate are usually considered as the risk free rate of
return when valuing different securities.
 The very short term nature of them prevents investors from suffering
inflation risk because of unexpected price changes.
 The t-bills in countries having good financial market conditions is
deep and liquid.
 Deep: presence of many buyers and sellers of a security in a market.
 Liquid: when securities can be transferred from on investor to
another quickly and without incurring substantial transaction costs.
 T-bills Auction
 When the government body responsible for issuing T-bills
announce the demand for issuance of bills of various types,
buyers will submit bids instantly.
 Winners will be selected using two popular methods:
1. Competitive Bids: investors will state the amount/size of
securities and the price they want to take them.
Then the treasury accepts the bids of investor offering the
highest price first and subsequently move down wards until the
total requirement for funds is exhausted.
1. Noncompetitive Bids: investors in this class only offer the
size of the investment they want to take on and the price for
the bids will be set as the weighted average of competitive bids
accepted.
 2. Federal Funds(interbank lending)
 Are short-term funds transferred among financial institutions usually
for a period of one day.
 One of the regulation tools that central banks can use to ensure the
investor protection and liquidity in the financial sector is setting a
minimum reserve requirement for banks that a certain portion of their
funds collected from savers in the national bank account without
earning interest.
 To meet these reserve requirements, banks must maintain adequate
deposits in their central bank account. At the end of daily transactions
some banks may fall short of the requirements while some ended up
with excess funds in their accounts.
 Therefore banks with shortages will borrow from banks having excess
funds for overnight. The government can indirectly control the federal
funds market by altering the reserve requirement.
 Terms of Federal Funds
 Terms of agreements for federal funds is one day and frequently referred to
as overnight investments.
 Banks analyze their reserve position on a daily basis and either borrow or
invest in these funds, depending on whether they have excess or deficit
reserves.
 A bank with excess money will call up on its correspondent banks having
reciprocal accounts and sell its excess funds to bank(s) that offer highest rate.
 When the dealing concludes the investor bank immediately transfers the
contracted amount to borrowers account in the central bank using electronic
communications.
 The next day, the funds are transferred back, and the process begins again.
 The federal funds are short-term unsecured loans as deals are completed by
oral communications of participants.
 Repurchase Agreements (Repos)
 Repos are much like federal funds except that non banks can
participate. In repos a firm can sell treasury securities by
agreeing to buy them back at a specified future date.
 Most repos have a short-term maturity usually from 3 to 14
days. However, there are also markets for 1-3 months repos.
 Government security dealers usually engage in repos. The
dealers may sell it to a bank with a promise that it will buy the
securities back the next day this makes repo a short-term
collateralized loan.
 Because of their collateralized nature they hold low risk of
default and ultimately have low interest rate returns.
 Central banks also engage in repos market to conduct the
monetary policy.
Negotiable Certificates of Deposits (CDs)

 CD is a bank-issued security that documents a deposit and

specified the interest rate and the maturity date.
 As the maturity date is specified a CD is a Term Security as
opposed to Demand Deposit.
 A negotiable CD is a bearer instrument that whoever holds
the instrument at the date of maturity can receive the
principal and interest. The CD can be bought and sold in
the secondary market until maturity.
 The maturity of CDs usually ranges from1-4 months.
 CDs charge a rate slightly higher than T-bills because that
have a slightly greater chance of default.
 CDs are usually denominated in higher currency values.
 Commercial Papers (CPs)
 CP securities are unsecured promissory notes issued by
corporations that mature in no more than 270 days (9
months).
 Since these securities are unsecured, only largest and most
creditworthy corporations issue them.
 The interest charged tells the issuer firm’s perceived level of risk
by the market.
 Just like T-bills CPs are issued at discount and mature on face
value.
 Most of the commercial papers issued are through direct
placements, selling CPs directly to buyers without the aid of
dealers, while the remaining issue is completed through the use
of dealers in the commercial papers market.
 Bankers Acceptances
 A bankers acceptance is an order to pay a specified amount of
money to the bearer on a given date.
 This type of money market instrument have been put in to
practice since 12th century that it is the oldest of all commercial
banks.
 This securities are essential in the international trades and are
used to finance goods that have not yet been transferred from
seller to buyer.
 They promote expansion of international trade among buyers
and sellers placed at different corners of the world.
 They are issued at discount and paid in face amount just like
commercial papers and T-bills and have maturity period between
30 to 180 days.
 Steps for Using Banker’s Acceptance
1. The importer requests its bank to send a binding letter of
credit to the exporter.
2. The exporter receives the letter, ships the goods, and is paid by
presenting to its bank the letter along with the shipping
documents.
3. The exporter bank creates a time draft based on the letter
of credit and sends it along with proof of shipment to
importer’s bank.
4. The importer’s bank stamps the time draft “ACCEPTED” and
sends the banker’s acceptance back to the exporter’s bank so
that the exporter’s bank can sell it on the secondary market to
collect payment.
5. The importer deposits funds at its bank suffiecient to cover
the banker’s acceptance when it matures.
 Advantages of Banker’s Acceptance

 These money market instruments are crucial for

international trade and have the following advantages.
1. Ease international transaction by giving both parties
guarantee and make them feel properly protected from
losses.
2. The exporter can be paid quickly.
3. The exporter is protected from foreign exchange risk
because the local bank pays it in local currencies.
4. The exporter is not expected to assess the
creditworthiness of the importer because the importer’s
bank guarantees payment.
 Eurodollar
 Many contracts from various countries around the world
require payments be made in U.S. Dollars due to dollar’s
stability.
 For this reason many companies and governments choose
to hold dollars.
 Before cold war, these currency deposits were made in
New York money center banks.
 Starting from cold war, with the fear that these deposits
may be expropriated some large London based banks
responded by offering to hold dollar denominated deposits
in British banks.
 These deposits are then named as Eurodollars.
 Eurodollar
 The Eurodollar market continued to grow for the following reasons:
1. Depositors can receive higher returns on dollar deposits in the Eurodollar
markets than in the domestic markets.
2. Borrowers can be able to receive a more favorable rate in the Eurodollar
markets than in the domestic markets.
 Some large London based banks act as brokers in the inter-bank Eurodollar
markets.
 It has to be noted that the Eurodollar market is the replacement of the
federal funds that banks from around the world buy and sell overnight
funds in this market.
 The rate paid by banks borrowing from Eurodollar market are called
London Interbank Bid rate LIBID.
 Funds are offered for sale in Eurodollar market at a rate called London
Interbank offer rate LIBOR. The difference between the LIBID and
LIBOR is the proceed to the dealer.
Money Issuer Buyer Usual Secondary
market Maturity Market
security
T-Bills Government Consumers and 4 weeks -1 Excellent
companies year

Federal Banks Banks 1-7 days none

Funds
Repos Business and Businesses and 1-15 days Good
banks banks

CDs Large Banks Businesses 14-120 Good

days
CPs Finance Businesses 1-270 days Poor
Companies and
businesses
B. CAPITAL MARKETS
 Money market instruments:
Minimum risk
Homogenous
Issued and held to adjust liquidity
 Capital market instruments :

Terms, conditions, and risk vary substantially

Definition: capital market instruments are defined as long term
instruments with an original maturity of greater than one
year.
Proceeds from the sale of capital market instruments are usually
invested in assets of a permanent nature such as
industrial plants, equipment, buildings, and inventory.
Functions of the Capital Markets
 In the capital markets, the motive of firms issuing or
buying securities is very different from in the money
market.
 In the money markets, firms are warehousing idle funds
until needed for some business activity or borrowing
temporarily until cash is collected.
 Firms buy capital goods such as plant and equipment
to produce some product to earn profit.
 Most of these investments are central to the firm’s core
business activities.
 Capital goods normally have a long economic life,
ranging from a few years to 10, 20, or 30 years or more.
 Capital assets usually are not highly marketable.
 As a result, firms like to finance capital goods with
long term debt or equity to lock in their borrowing
cost for the life or the project and to eliminate the
problems associated with periodically refinancing
assets.
 Thus, when issuing debt for capital expenditures, firms
often try to match the expected asset life with the
maturity of the debt.
Capital Market Participants
 Capital market bring together BORROWERS and
SUPPLIERS OF LONG TERM FUNDS.
The market also allows people who hold previously issued
securities to trade those securities for cash in the
secondary capital markets.
Individuals and households may invest DIRECTLY in
the capital markets but, more likely, they purchase
stocks and bonds through financial institutions such as
commercial banks, insurance companies, mutual funds
and pension funds.
Financial intermediaries purchase funds from individuals and
others, and then issue their own securities in exchange.
I. The Bond Market : Overview of the Bond Markets

 A bond is a promise to make periodic coupon

payments and to repay principal at maturity; breach
of this promise is an event of default, or
 Bond is a debt investment in which an investor loans money to
an entity (corporate or governmental) that borrows the funds
for a defined period of time at a fixed interest rate.
 carry original maturities greater than one year so
bonds are instruments of the capital markets
 issuers are corporations and government units
 Bonds are used as a means of financing variety of
projects and activities by companies, municipalities,
state, local and foreign governments.
 Bonds are commonly referred to as fixed-income
securities and are one of the three main financial asset
classes, along with stocks and cash equivalents.
 The place where bonds and other debt instruments are
sold is called the debt market.
 Basics of Bonds
 Corporate borrowers issue bonds both to raise finance for
major projects and to cover ongoing and operational
expenses.
 Bonds are also issued by public authorities, credit institutions,
companies and supranational(Multinational) institutions in the
primary markets.
 The most common process of issuing bonds is through
underwriting.
 In underwriting, one or more security firms or banks, forming a
syndicate/association, buy an entire issue of bonds from an
issuer and re-sell them to investors.
 The security firm takes the risk of being unable to sell on the
issue to end investors.
Eg. Types of Bonds ( based the type of issuers)
Bond Market Instruments Outstanding, 1994-1999 ($Bn)

10000

8000

6000

4000

2000

0
1994 1995 1996 1997 1998 1999

Treas bonds Muni securities Corp bonds Total

Treasury Notes and Bonds

 T-notes and T-bonds issued by the U.S. treasury to

finance the national debt and other federal government
expenditures
 Backed by the full faith and credit of the U.S.
government and are default risk free
 Pay relatively low rates of interest (yields to maturity
 Given their longer maturity, not entirely risk free due to
interest rate fluctuations
 Pay coupon interest (semiannually), notes have
maturities from 1-10 yrs, bonds 10-30 yrs
Municipal Bonds (munis)

 Securities issued by state and local governments to

fund either temporary imbalances between operating
expenditures and receipts or to finance long-term
capital outlays for activities such as school
construction, public utility construction or
transportation systems
 Tax receipts or revenues generated are the source of
repayment
 Attractive to household investors because interest
(but not capital gains) are tax exempt
Corporate Bonds

 All long-term bonds issued by corporations

 Minimum denominations publicly traded corporate
bonds is $1,000
 Generally pay interest semiannually
 Bond indenture
 legalcontract that specifies the rights and obligations of
the bond issuer and the bond holder
 Types of Bonds(Based on the features)
51

 Traditional- basic types that have been

around for years. Listed in terms of their key
characteristics and priority of lender’s claim.
 Contemporary bonds- newer, more
innovative types: changing capital market
conditions and investor preferences have
spurred further innovations in bond financing
in recent years, and will probably continue to
do so.
 Types of Bonds
52
 Types of Bonds
53
 Corporate Bonds
54

 All long-term bonds issued by corporations

 Minimum denominations publicly traded corporate
bonds is $1,000
 Generally pay interest semiannually
 The coupon interest rate on a bond represents the
percentage of the bond’s par value that will be paid
annually, typically in two equal semi-annual payments, as
interest.
 The bondholders, who are the lenders, are promised the
semiannual interest payments, and, at maturity,
repayment of the principal amount.
 Legal Aspects of Corporate Bonds
55

 The bond indenture is a legal document that

specifies both the rights of the bondholders and
the duties of the issuing corporation.
 Included in the indenture are:
1. Descriptions of the amount and timing of all
interest and principal payments
2. Various standard and restrictive provisions,
and
3. Sinking-fund requirements
4. Security interest provisions
 Legal Aspects of Corporate Bonds
56

 Standard debt provisions in the bond indenture

specify certain record keeping and general business
procedures that the bond issuer must follow.
Standard debt provisions do not normally place a
burden on a financially sound business.
 The borrower must:
(1) Maintain satisfactory accounting records in
accordance with GAAP
(2) Periodically supply audited financial statements
(3) Pay taxes and other liabilities when due
(4) Maintain all facilities in good working order.
 Legal Aspects of Corporate Bonds
57

 Restrictive debt provisions are contractual

clauses in a bond indenture that place operating
and financial constraints on the borrower.
 These help protect the bondholder against
increases in borrower risk.
 Without them, the borrower could increase
the firm’s risk but not have to pay increased
interest to compensate for the increase risk.
 Legal Aspects of Corporate Bonds
58

 The most common restrictive covenants do the ff:

(1) Require a minimum level of liquidity- to ensure
against loan default.
(2) Prohibit the sale of accounts receivable to
generate cash- to prevent long-run cash shortage
if proceeds were used to meet current
obligations.
(3) Impose fixed asset restrictions, i.e. maintain a
specified level of fixed assets- to guarantee its
ability to repay the bonds.
 Legal Aspects of Corporate Bonds
59

 The most common restrictive agreements do the ff:

(4) Constraint subsequent borrowing
- Additional long-term debt may be prohibited,
or
- Additional borrowing may be subordinated to
the original loan. Subordination means that
subsequent creditors agree to wait until all claims
of the senior debt are satisfied.
(5) Limit the firm’s annual cash dividend payments
to a specified percentage or amount.
 Legal Aspects of Corporate Bonds
60

 The violation of any standard or restrictive

provision by the borrower gives the
bondholders the right to demand immediate
repayment of the debt.
 Generally,bondholders evaluate any violation
to determine whether it jeopardizes the loan.
They may then decide to demand immediate
repayment, continue the loan, or alter the
terms of the bond indenture.
 Legal Aspects of Corporate Bonds
61

 Other restrictive covenants are sometimes included

in bond indentures…
 Sinking fund requirements are restrictive
provisions often included in bond indentures that
provide for the systematic retirement of bonds
prior to their maturity.
 To carry out this requirement, the corporation
makes semi-annual or annual payments that are
used to retire bonds by purchasing them in the
marketplace.
 Legal Aspects of Corporate Bonds
62

 Other restrictive covenants are sometimes

included in bond indentures…
 Collateral/Security interest. The bond
indenture identifies any collateral (security)
pledged against the bond and specifies how it is
to be maintained. The protection of bond
collateral is crucial to guarantee the safety of a
bond issue.
 Legal Aspects of Corporate Bonds
63

 Other restrictive covenants are sometimes included

in bond indentures…
 A trustee is a third party to a bond indenture who
is a paid individual, corporation, or (most often) a
commercial bank trust department that acts as a
“watchdog” on behalf of the bondholders.
 The trustee can take specific actions on behalf
of the bondholders if the terms of the indenture
are violated.
 Cost of Bonds to the Issuer
64

 Cost of bond financing > short-term

borrowing
 Major factors affecting the cost, i.e. interest
rate paid by the bond issuer:
 Maturity

 Size of the offering

 Issuer’s risk

 Cost of money
 Cost of Bonds to the Issuer
65

 The longer the bond’s maturity, the higher the

interest rate (or cost) to the firm.
 Long-term debt pays higher interest rates than
short-term debt
 The longer the maturity of bond, the less accuracy
there is in predicting future interest rates; so the
greater the bondholder’s risk of giving up an
opportunity to lend money at a higher rate.
 The longer the term, the greater the chance that the
issuer might default.
 Cost of Bonds to the Issuer
66

 The larger the size of the offering, the lower

will be the interest cost of borrowing (in %
terms).
 Bond flotation and administration costs per
dollar borrowed are likely to decrease with
increasing offering size.
 But the risk to the bondholders may increase,
because large offerings result in greater risk
of default.
 Cost of Bonds to the Issuer
67

 The greater the default risk of the issuer, the

higher the cost of the issue (interest rate).
 Some of this risk can be reduced through the
inclusion of appropriate restrictive provisions in
the bond indenture.
 Bondholders must be compensated with higher
returns for taking greater risk.
 Bond buyers frequently rely on bond ratings to
determine the issuer’s overall risk.
 Cost of Bonds to the Issuer
68

 The cost of money in the capital market is the

basis for determining a bond’s coupon interest
rate.
 The
rate on US Treasury securities of equal
maturity is used as the lowest-risk cost of
money.
 Tothat basic rate is added a risk premium
that reflects the above factors: maturity,
offering size, and issuer’s risk.
 General Features of a Bond Issue
69

 Features sometimes included in a corporate

bond issue:
 Conversion feature
 Call feature
 Stock purchase warrants
 These provide the issuer or the purchaser with
certain opportunities for replacing or retiring
the bond or supplementing it with some type of
equity issue.
 General Features of a Bond Issue
70

 The conversion feature of convertible bonds allows

bondholders to exchange their bonds for a specified
number of shares of common stock.
 Bondholders will exercise this option only when the
market price of the stock is greater than the
conversion price, to provide the bondholder with a
profit.
 Inclusionof the conversion feature by the issuer
lowers the interest cost.
 Also provides for automatic conversion of the bonds
to stock if future stock prices appreciate noticeably.
 General Features of a Bond Issue
71

 A call feature, which is included in most corporate

issues, gives the issuer the opportunity to repurchase
the bond prior to maturity at the call price.
 The call feature can be exercised only during a
certain period.
 Asa rule, the call price exceeds the par value of a
bond by an amount equal to 1-year’s interest.
 Ex. A $1,000 bond with 10% coupon interest rate
will be callable for $1,100.
[$1,000 + (10% x $1,000)]
 General Features of a Bond Issue
72

 The call premium is the amount by which

the call price exceeds the bond’s par
value, usually equal to one year of
coupon interest. This compensates
bondholders for having the bond called
away from them prior to maturity.
Tothe issuer, it is the cost of calling the
bonds.
 General Features of a Bond Issue
73

 Furthermore, the call feature enables an issuer to call

an outstanding bond (i.e. exercise the call feature)
when interest rates fall and issue a new bond at a
lower interest rate.
 When interest rates rise, the call privilege will not be
exercised, except possibly to meet sinking fund
requirements.
 To sell a callable bond in the first place, the issuer
must pay a higher interest rate than on noncallable
bonds of equal risk.
 To compensate bondholders for the risk of having
the bonds called away from them.
 General Features of a Bond Issue
74

 Bonds also are occasionally issued with stock

purchase warrants attached to them to make them
more attractive to investors.
 Warrants are instruments that give their holders the
right to purchase a certain number of shares of the
same firm’s common stock at a specified price during
a specified period of time.
 Including warrants typically allows the issuer to raise
debt capital at a lower cost (i.e. pay slightly lower
interest cost than would otherwise be required).
Types of Corporate Bonds

 Bearer bonds
 coupons attached that are presented by the holder to
the issuer for interest payments when due
 Registered bonds
 theowner of the bond is recorded by the issuer and
coupon payments are mailed to the registered owner
 Term bonds
 entire issue matures on a single date
 Serial bonds
 mature on a series of dates (continued)
Types of Corporate Bonds

 Mortgage bonds
 issued to finance specific projects which are pledged as
collateral
 Debentures
 backed solely by the general credit of the issuing firm
and unsecured by specific assets or collateral
 Subordinated debentures
 unsecureddebentures that are junior in their rights to
mortgage bonds and regular debentures (continued)
Types of Corporate Bonds

 Convertible bonds
 may be exchanged for another security of the issuing firm at the
discretion of the bond holder
 Stock Warrant
 give the bond holder an opportunity to purchase common stock at
a specified price up to a specified date
 Callable bonds
 allow the issuer to force the bond holder to sell the bond back to
the issuer at a price above the par value (call price)
 Sinking Fund Provisions
 bonds that include a requirement that the issuer retire a certain
amount of the bond issue each year
Primary and Secondary Markets for Corp Bonds

 Primary sales of corporation bonds occur through

either a public sale (issue) or a private placement.
 Two secondary markets
 The exchange market
 The over-the-counter (OTC) market

 OTC electronic market dominates trading in

corporation bonds
 Interpreting Bond Quotations
79

 The financial manager needs to stay abreast of the

market values of the firm’s outstanding securities:
 Traded on an organized exchange

 Over the counter, or

 In international markets.

 Existing and prospective investors of the firm’s

securities also need to monitor the prices of the
securities they own because these prices represent
the current value of their investment.
 Interpreting Bond Quotations
80

 Information on bonds, stocks, and other securities is

contained in quotations
 Current price data
 Statistics on recent price behavior
 These are readily available for actively traded bonds
and stocks.
 Up-to-date quotes obtained electronically

 Available from stockbrokers

 Widely published in news media, e.g. business

sections of daily newspapers.
 Interpreting Bond Quotations
81

 Most active fixed-coupon corporate bonds quotations include:

 Company name
 Bond’s coupon interest rate
 Bond’s maturity date- allows investors to differentiate
between the various bonds issued by a corporation.
 Last price at which the bond traded
Note:
Most corporate bonds are issued with a par or face value of
$1,000. All bonds are quoted as a % or par. Ex. GM’s last
price of 103.143 for the day is 103.143 x $1,000 = $1,031.43.
Bond Ratings

 Bonds are rated by the issuer’s default risk

 Large bond investors, traders and managers evaluate
default risk by analyzing the issuer’s financial
ratios and security prices.
 Two major bond rating agencies are Moody’s and
Standard & Poor’s (S&P)
 Bonds assigned a letter grade based on perceived
probability of issuer default.
 Bond Ratings
83

 Normally there is an inverse relationship between

the quality of a bond and the rate of return that it
must provide bondholders.
 High-quality (high-rated) bonds provide lower
returns than lower-quality (low-rated) bonds.
 This reflects the lender’s risk-return trade-off.
 When considering bond financing, the
financial manager must be concerned with the
expected ratings of the bond issue, because
these ratings affect salability and cost.
Bond Credit Ratings

Explanation Moody’s S&P

Investment grade categories:
Best quality; smallest degree of risk Aaa AAA
High quality; slightly more long-term Aa1 AA+
risk than top rating Aa2 AA

Upper medium grade; possible A1 AA-

impairment in the future A2 A+
A3 A-
Medium grade; lack outstanding Baa1 BBB+
investment characteristics Baa2 BBB
Baa3 BBB-

(continued)
 International Bond Issues
85

 Companies and governments borrow internationally

by issuing bonds in the Eurobond market and the
foreign bond market.
 Both give borrowers the opportunity to obtain large
amounts of long-term debt financing quickly, in the
currency of their choice and with flexible repayment
terms.
 International Bond Issues
86

 A Eurobond is issued by an international borrower and sold

to investors in countries with currencies other than the
currency in which the bond is denominated.
 Ex. A $-denominated bond issued by a US corporation and sold to
Belgian investors.
 An ETB Ethiopian Co. bond sold in US.
 In contrast, a foreign bond is issued in a host country’s
financial market, in the host country’s currency, by a foreign
borrower.
 Ex. A Swiss franc-denominated bond issued in Switzerland by a US
company.
 A US co. issues in Ethiopian Birr in Ethiopia.
Ethiopia Credit Rating
(http://www.tradingeconomics.com/ethiopia/rating )

S&P Moody's Fitch Trading Economics(TE)

B stable B1stable Bstable 31stable

TE S&P Moody's Fitch
100 AAA Aaa AAA Prime
95 AA+ Aa1 AA+ High grade
90 AA Aa2 AA
85 AA- Aa3 AA-
80 A+ A1 A+ Upper medium
75 A A2 A grade
70 A- A3 A-
65 BBB+ Baa1 BBB+ Lower medium grade
60 BBB Baa2 BBB
55 BBB- Baa3 BBB-
50 BB+ Ba1 BB+ Non-investment
45 BB Ba2 BB grade
speculative
40 BB- Ba3 BB-
35 B+ B1 B+ Highly speculative
30 B B2 B
25 B- B3 B-
20 CCC+ Caa1 CCC Substantial risks

15 CCC Caa2 Extremely speculative

10 CCC- Caa3 In default with little

CC Ca prospect for recovery
5 C C

0 D / DDD In default
CAPITAL MARKETS
2. Stock Markets
2.1. Primary markets
Forms of Issues
1.Underwriting or direct sale
2.Private placement or Public issue
Public issuance needs SEC registration and the
following documents needed
1. Registration Statement
2. Red herring prospectus
3. Prospectus
2.2. Secondary Markets
 Capital market is a market in which individual and
institutional investors trade long-term financial
securities (Debt and Equity) among themselves.
 Organizations/institutions in the public and private
sectors also often sell securities on the capital
markets in order to raise funds.
 Places where equity securities are traded are called
stock markets.
 Primary Markets
91

 In case of the underwriting, the underwriter does not

guarantee a price to the issuer & act more as a placing or
distribution agent.
 In a firm commitment underwriting, the investment
bank purchases the stock from the issuer for net proceeds
& resells them at gross proceeds, with the difference
between gross & net proceeds being the underwriter spread
or the compensation.
 Investment banks help sell & distribute a new issue called
a syndicate.
 The lead bank in the syndicate called originating houses
directly negotiate with the issuing corporations on behalf
of the syndicate.
92

 Share of stock issued through a syndicate of the

investment banks spreads the risk associated with the
sale of the stock among several investment banks.
 A syndicate also results in a larger pool of potential
outside investors, increasing the probability of a
successful sale & widening the scope of the investors
base.
 A primary market sale may be a first-time issue by a
private firm going public called initial Public
Offerings (IPOs) or it can be issuance of new stock
by a firm which already placed its some shares in
primary markets.
93
 A primary sales, stocks can be issued through either a
public sale where the stock is offered to the general
investing public or a private placement where the stock is
sold privately to the limited number of large investors.
 In public sale of stock, the investment bank must get SEC
approval by being registered.
 The process starts with the preparation of the registration
statement to be filled with the SEC.
 The registration statement includes information on the
 nature of the issuer’s business,
 the key provisions & features of the security to be
issued,
 risks involved with the security &
 background on the management.
94

 The purpose of the registration statement is to fully

disclose all information about the firm &the securities
issued to the public.
 At the same time, the issuing company & its investment
bank prepare a preliminary version of the public
offering’s prospectus (an official document giving details
about a stock offering, or a proposed project) called the
red herring prospectus (preliminary business
prospectus: a preliminary prospectus for a new stock
issue, filed with the Securities and Exchange Commission,
that does not include the offering price of the shares or the
size of the issue).
 The red herring prospectus is similar to the
registration statement but is distributed to potential
equity buyers.
 It is the preliminary version of the official or final
prospectus that will be printed upon SEC registration of
the issue.
 A preliminary prospectus filed by a company with the Securities and
Exchange Commission (SEC), usually in connection with the
company’s initial public offering.
 A red herring prospectus contains most of the information pertaining
to the company’s operations and prospects, but does not include key
details of the issue such as its price and the number of shares offered.
 The term “red herring” is derived from the bold disclaimer in red on
the cover page of the preliminary prospectus.
 The disclaimer states that a registration statement relating to the
securities being offered has been filed with the SEC but has not yet
become effective, the information contained in the prospectus is
incomplete and may be changed, the securities may not be sold and
offers to buy may not be accepted before the registration statement
becomes effective.
 No price or issue size is stated in the red herring.
96

 After the submission of the registration statement ,the

SEC has some days to request additional information
or changes to the registration statement. The period of
review is called waiting period.
 Once, the SEC registers the issue, the issuer with its
investment bankers sets the final selling price on the
shares, prints the official prospectus describing the
issue & sends it to all potential buyers of the issue.
97

 In order to reduce time & cost of registration, shelf

registration allows firms that plan to offer multiple
issues of stock over some years period to submit one
registration statement as described above called mass
registration statement.
 This registration statement summarizes the firm’s
financing plans for the years.
 Thus, the securities are shelved for up to the years
under consideration until the firm is ready to issue
them.
98

 Once, the issuer & its investment bank decide to issue

shares during the two-year shelf registration period,
they prepare & file a short-form statement with the
SEC.
 Upon SEC approval, the shares can be priced &
offered to the public usually within one or two days of
deciding to take the shares “off the shelf ”.
 Thus, shelf registration helps a firm to get stocks
onto the market quickly without the time lag
associated with full SEC registration.
 Secondary Stock Markets
99

 Secondary markets are markets in which stocks, once

issued, are traded.
 The following are the major Secondary stock markets:

Stock Exchanges & their Trading Process

 Are physical places in which stocks are traded.

 Include New York Stock Exchange (NYSE) & the

American Stock Exchange (AMEX).
 All transactions occurring on the NYSE occur at a specific
place on the floor of the exchange called trading post.
 Each stock is assigned a special market maker called a
specialist , with the power to arrange the market for the
stock.
100

 The specialist has an obligation to stabilize the order flow &

prices for the stock in time when the market become turbulent
or when there is large imbalance with the sell order.
 Three types of transactions can occur at given post:

(1) brokers trade on behalf of customers at the market price

(market order)
(2) limit(restrict) orders which are left with a specialist to be
executed
(3)specialists transact for their account.
The specialist buys the stock to stabilize its price.
101

The American Stock Exchange (AMEX)

 Located at New York, AMEX lists stocks of smaller firms that
are of national interest.
The National Association of Securities Dealers Automated Quotation (NASDAQ)
 Securities not sold in the organized exchanges such as NYSE
& AMEX, are traded over the counter.
 It does not have a physical trading floor where transactions
are completed via an electronic market.
 It is primarily a dealer market, in which dealers are the market
makers who buy & sell particular securities.
102

 Unlike the NYSE & AMEX, many dealers will make a market
for a single stock i. e quote the bid (buy) & ask (sell) price.
 There are no limits on the number of stocks a NASDAQ
market maker can trade nor on the number of market makers in
a particular stock.
 Besides, the original underwriter of a new issue can also
become the dealer in the secondary market.
 Unlike the NYSE which seeks the separation between
underwriters & dealers, anyone who meets the fairly low
capital requirements for the market makers on the NASDAQ
can register to be a broker-dealer.
103

 An individual wanting to make a trade contacts his/her broker.

The broker, then, contacts a dealer in the particular security to
conduct the transaction.
 In contrast to NYSE & AMEX, the NASDAQ structure of
dealers & brokers results in the NASDAQ being a negotiated
market where Quotes from several dealers are usually
obtained before a transaction is made.
 When a request for trade is received, a dealer will use the
computer to find the dealers providing the inside quotes- the
lowest ask & the highest bid.
104

 The dealer may also request the quotes of every market

maker in the stock. Then, the dealer initiating the trade will
then contact the dealer offering the best price & execute
the order.
 Then, the dealer will confirm the transaction with the
investor’s broker & the customer will be charged the quote
plus a commission for the broker’s services.
 However, on line trading services now allow investors to
trade directly with a securities dealer without going through
personal broker.
 Firms that do not meet the requirements for exchange
listing trade on the NASDAQ.
 Thus, most NASDAQ firms are smaller firms with newly
registering public issues with brief history of trading .
ECN’s: Electronic Crossing Networks

 Internet based trade networks: e.g. Instinet (the largest)

 Customers can meet directly (no broker)
 Used mostly by professional money managers
 Advantage:
 fewer intermediaries
 Transparency
 Faster Execution
 After-hours trading
 Disadvantage:
 less liquidity since Only large blocks of securities are traded (Fewer
people to trade with)
 Fastest growing markets