Chapter 1 – Financial Markets and Institutions Student Notes Chapter 1 – Financial Markets and Institutions Overview Introduction to financial markets Introduction to financial institutions Review of terms Financial Markets Channel through which financial assets are exchanged. Process also known as funds intermediation. Surplus Units – suppliers of funds, because they spend less than they receive. Households are the only net supplier of funds. Deficit Units – users of funds, because they spend more than they receive. Households, corporations, and governments can all be deficit units. Financial Markets Money Markets – markets that trade debt instruments with maturities of up to one year. Treasury bills, commercial paper, federal funds, negotiable CDs, repurchase agreements, and banker’s acceptances. Capital Markets – markets that trade equity and debt instruments with maturities of more than one year. Stocks, bonds, and mortgages. Primary Markets – markets in which corporations raise funds through new issues of securities, such as stocks and bonds. 1
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Chapter 1 – Financial Markets and Institutions Student Notes
Chapter 1 – Financial Markets and Institutions
Overview
Introduction to financial markets
Introduction to financial institutions
Review of terms
Financial Markets
Channel through which financial assets are exchanged. Process also known as funds intermediation.
Surplus Units – suppliers of funds, because they spend less than they receive. Households are the only net supplier of funds.
Deficit Units – users of funds, because they spend more than they receive. Households, corporations, and governments can all be deficit units.
Financial Markets
Money Markets – markets that trade debt instruments with maturities of up to one year.
Treasury bills, commercial paper, federal funds, negotiable CDs, repurchase agreements, and banker’s acceptances.
Capital Markets – markets that trade equity and debt instruments with maturities of more than one year.
Stocks, bonds, and mortgages.
Primary Markets – markets in which corporations raise funds through new issues of securities, such as stocks and bonds.
May be first-time issues by firms initially going public, the sale of additional new shares of an already publicly traded firm, or first time debt issuances.
Secondary Markets – markets in which existing securities are traded. Organized Exchanges – physical meeting place and communication facilities are
provided for members to conduct their transactions.
Over-the-Counter (OTC) markets – no central location. Financial claims can be traded by phoning an OTC dealer or by using a computer system.
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Chapter 1 – Financial Markets and Institutions Student Notes
Efficiency – Simply the idea that the market accurately prices the securities that are traded in them. Markets can be weak, semi-strong, or strong form efficient.
Regulation – Most important regulator is the Securities and Exchange Commission (SEC).
Globalization – Increased integration. It is becoming easier to acquire information about foreign companies and invest accordingly.
Financial Institutions
Institutions – serve as intermediaries because markets are not perfect.
Depository Institutions – receive deposits and make loans.
Commercial Banks – most dominant depository institution.
Savings Institutions – take in deposits and provide mortgage loans.
Credit Unions – take in deposits and provide retail loans.
Nondepository Financial Institutions – do not accept deposits from consumers.
Finance Companies – Spans a variety of fringe companies.
Consumer finance companies
Business finance companies
Sales finance companies
Nondepository Financial Institutions (cont.)
Mutual Funds – primary investment tool of many households.
Securities Firms – multiproduct firms that usually specialize in several market related activities.
Examples include brokerage houses, underwriters, investment banks, and market makers.
Nondepository Financial Institutions (cont.)
Hedge Firms – sells shares to upscale investors and are allowed to invest in risky assets. Largely unregulated.
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Chapter 1 – Financial Markets and Institutions Student Notes
Insurance Companies – receive money from premiums and invest in financial securities.
Pension Funds – Governments and companies allow employees to invest money in securities.
Competition – U.S. banks face increasing foreign competition.
Consolidation – Banks continue to consolidate as regulations have relaxed.
Global Expansion – U.S. banks, insurance companies, and securities firms have expanded into foreign countries in recent years.
Key Trends Affecting Banks
Service Proliferation – rapidly expanding services.
Rising Competition – financial service firms entering other markets.
Government Deregulation – fewer restrictions.
Technological Change – ATMs, Point of Sale terminals, online payments, etc.
Consolidation and Geographic Expansion – roll-up of the industry continues.
Convergence – the movement of financial institutions across product lines.
Globalization – largest banks compete with each other internationally.
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Chapter 2 – Determination of Interest Rates Student Notes
Chapter 2 – Determination of Interest Rates
Overview
Introduction to interest rates
Interest rate theories
Economic forces that affect rates
Interest Rates – the price of borrowing money.
Relevance of Interest Rates
Direct influence on the valuation of debt securities.
Indirect influence on nearly all other financial instruments. ie. Stocks, exchange rates, derivative securities.
Loanable Funds Theory – rates are determined by the interaction between supply and demand for funds.
Demand:
Individuals and Households
Businesses
Governments
Foreign Demand
Aggregate Demand
Supply:
Individuals and Households – only net saver of funds
Businesses
Governments
Foreigners
Equilibrium Rate
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Chapter 2 – Determination of Interest Rates Student Notes
Factors that Cause the Supply Curve to Shift
Wealth – as total wealth increases, the supply curve shifts out.
Risk – as the risk decreases, the supply curve shifts out.
Near-Term Spending Needs – when participants have fewer spending needs, the supply curve shifts out.
Monetary Expansion – policy objects to allow expansion, the supply curve shifts out.
Economic Conditions – as domestic economic conditions improve relative to other countries, foreign inflows increase and the supply curve shifts out.
Factors that Cause the Demand Curve to Shift
Economic Conditions – during periods of economic growth, market participants borrow more heavily. The increase in demand increases the interest rate.
Economic Forces that Affect Interest Rates
Economic Growth – demand increases with growth and rates rise.
Asian Crisis – Funds fled to more stable markets, driving rates down.
Summary – Economic forces affect supply and demand of money.
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Chapter 2 – Determination of Interest Rates Student Notes
Interest Rates Over Time
General Decline – we have seen a general decline in interest rates since the early 1980s.
Volatility – Rates were particularly volatile in the early 80s.
Fed changed policies in the early 80s creating instability.
Fed regained control in the late 80s and have been relatively stable.
Key Interest Rates
Federal Reserve Discount Rate – The rate the Fed charges banks that borrow from it.
Federal Funds Rate – the rate banks charge when they make short-term loans to each other.
Treasury Bills – short-term government securities. Commonly used as a benchmark “real” interest rate.
Prime Rate – a base rate that large, money center banks charge their best customers.
London Interbank Offer Rate (LIBOR) – the rate that European banks charge each other.
Mortgage Rates – reflect conditions in financial markets, in general.
Forecasting Interest Rates
Economic Models – estimating the statistical relationships between measures of the output of goods and services in the economy and the level of interest rates.
Flow-of-Funds Accounting – shows the movement of savings through the economy in a structured and comprehensive manner.
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Chapter 3 – Structure of Interest Rates Student Notes
Chapter 3 – Structure of Interest Rates
Overview
Factors Affecting Yields Among Securities
Term Structure
Uses of the Term Structure
Factors Affecting Yields Among Securities
Inflation – actual or expected inflation.
Real Interest Rates – the interest rate that would exist on a security if no inflation were expected over the holding period of a security.
Fisher Effect – the relationship among nominal interest rates, real interest rates, and expected inflation.
Nominal Rate = Real Rate + Expected Inflation
Base Interest Rate – Treasury securities.
Credit (Default) Risk – the risk that a security’s issuer will default on that security by missing an interest or principal payment.
Liquidity – The risk that a security can be sold at a fair market price in a short period of time.
Tax Status – Taxable securities must pay a higher yield than similar tax exempt securities.
Municipal Securities – Free of federal taxes and may be free of state and local taxes.
im = ic(t – tf)
im= ic(t – tf – ts)
Term to Maturity – The length of time until the principal amount borrowed becomes payable.
Special Provision – call features, convertibility options, and other provisions will influence the yield of the security.
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Chapter 3 – Structure of Interest Rates Student Notes
Actual Yield Differentials
Term Structures of Interest Rates – the relationship between yield and term to maturity on securities that differ only in length of time to maturity; graphically approximated by the yield curve.
Pure Expectations Theory – the yield curve reflects the market’s current expectations of future short-term rates.
Liquidity Premium Theory – investors will hold long-term maturities only if they are offered a premium to compensate for future uncertainty.
Preferred Habitat Theory – the shape of the yield curve is determined by future interest rates and a risk premium, to induce market participant to shift out of their preferred habitat.
Segmented Markets Theory – the shape of the yield curve is determined by supply of and demand for securities within each maturity sector.
Research Results
Uses of the Term Structure
Forecast Interest Rates – they yield curve can be used to assess the general expectations of investors and borrowers about future interest rates.
Forecast Business Cycle – provides information about the market expectations of future business activity.
Investment Decisions – investors can take advantage of different rates and ride the yield curve to make a profit.
Financing Decisions – by assessing the prevailing rates on securities for various maturities, firms can estimate the rates to be paid on bonds with different maturities.
Impact of Debt Management – Treasury decisions about debt financing can impact the yield curve.
Historical Review – Upward sloping.
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Chapter 4 – Functions of the Fed Student Notes
Chapter 4 – Functions of the Fed
Chapter Objectives
Explain the U.S. Federal Reserve System
Introduce monetary tools used by the Fed
Other monetary policy issues
History
Established in 1913 to control bank panics.
12 largely autonomous Federal Reserve banks were established.
Providing the Money Supply – prints and issues currency.
Maintaining the Safety of the Financial System
Facilitation of the Payments System
Conducting Monetary Policy
Monitoring International Financial Transactions
Organization
Federal Reserve District Banks – 12 banks
Member Banks – All chartered banks must be members.
Board of Governors – Key administrative body
Regulate commercial banks
Control monetary policy
Federal Open Market Committee (FOMC) – directs the open market actions of the Fed.
Advisory Committees – Advises on consumer issues.
Monetary Policy Tools
Open Market Operations – buying or selling of Treasury securities.
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Chapter 4 – Functions of the Fed Student Notes
Purchase of Treasuries – Fed uses cash to buy Treasuries, usually from banks.
Sale of Treasuries – Fed sells a portion of its Treasuries, usually to banks.
Technical Operations – carried out through trading desk at New York Fed.
o Policy Directive
o Straight (outright) transactions
o Repurchase Agreements
o Agency Operations
Adjusting the Discount Rate – it is the rate a financial institution must pay to borrow reserve deposits from the Fed.
Adjusting the Reserve Requirement Ratio – determines the amount of money that financial institutions must keep on hand.
Miscellaneous
Fed Emphasis on Money Supply
Monetary Control Act of 1980 (DIDMCA)
Global Monetary Policy
Single European Policy
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Chapter 5 – The Fed and Monetary Policy Student Notes
Inflation – the continuous rise in the average price level. Usually caused by an external economic shock in the supply of a crucial material. When confronted with a supply shock, the fed has two options:
Nonaccommodation
Accommodation
High Employment (or low unemployment) – between 4% and 6% is considered full capacity.
Economic Growth – increase in an economy’s output of goods and services.
Stability in Foreign Currency Exchange Rates – widely fluctuating exchange rates increases uncertainty into the economy.
Trade-offs and Conflicts Among Policies
Raise the rate of growth in the money supply by providing more reserves.
Reduce the rate of monetary expansion by reducing the reserves in the banking system.
Recent Federal Reserve Policy
1970 – 1979: Targeting the Fed Funds Rate.
1979 – 1982: Targeting the banking system’s nonborrowed reserves.
1983 – Present: Back to the Fed Funds Rate.
Economic Indicators Monitored by the Fed
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Chapter 5 – The Fed and Monetary Policy Student Notes
Indicators of Economic Growth – Gross Domestic Product (GDP)
Indicators of Inflation
Producer and Consumer Price Indices
Other Indicators – Commodity prices
Lags in Monetary Policy
Recognition Lag – the lag between the time a problem arises and the time it is recognized.
Implementation Lag – the lag from the time a serious problem is recognized until the time the Fed implements a policy to resolve it.
Impact Lag – the lag until the policy has its full impact on the economy.
Assessing the Impact of Monetary Policy
Forecasting Money Supply Movements
Improved Communication from the Fed.
Market Reaction to Reported Money Supply Levels.
Anticipating Reported Money Supply Levels.
Market Reaction to Discount Rate Adjustments
Integrating Monetary and Fiscal Policies
History – Generally, both the Fed and the government have been concerned with maintaining economic growth and low unemployment.
Combining Policy Effects
Monetizing the Debt – Action by the Fed to counteract the effects of sales of Treasury securities by the Treasury.
Global Effects of Monetary Policy
Impact of the Dollar – a weak dollar increases exports, which stimulates economy and may drive up inflation.
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Chapter 5 – The Fed and Monetary Policy Student Notes
Transmission of Interest Rates
Fed Policy during the Asian Crisis
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Chapter 7 – Bond Markets Student Notes
Chapter 6 Money Markets
Detail the participants and their roles.
Explain different money market securities
Examine valuations.
Money MarketsCharacteristics of the Money Market
Debt instruments that have a maturity of 1 year or less.
Highly liquid financial claims with negligible risk of loss.
Transaction size are very large (usually $1,000,000 to $10,000,000)
No formal organization, such as the NYSE for the equity markets.
Money Market ParticipantsParticipants
Commercial Banks – Most important class of buyers and sellers of money market instruments.
Federal Reserve System – open-market operations.
U.S. Treasury – finance the federal deficit.
Corporations – use to balance their cash position.
Money Market Mutual Funds – purchase 1/3 of commercial paper.
Pension funds the other institutions
Money Market SecuritiesSecurities
Treasury Bills – U.S. Treasury Department issues various types of debt to finance the national debt.
Treasury Bill Auction – systematic, regular procedure.
o Competitive bids
o Noncompetitive bids
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Chapter 7 – Bond Markets Student Notes
Estimating the Yield
Estimating the discount
Commercial Paper – short-term, unsecured promissory note.
Ratings – Moody’s and Standard & Poor’s
Placement – with institutions
o Directly placed paper
o Dealer-placed paper
Secondary Market – secondary trading is limited.
Backing Commercial Paper – not asset backed.
Slightly higher return than Treasury securities.
Finance companies are frequent issuers.
Estimating the Yield
Negotiable Certificates of Deposit (NCDs) – A bank time deposit that is negotiable.
Placement – corporate treasuries
Premium – often, rate is above T-bill yield
Repurchase Agreements (Repos) – sale of a short-term security with the condition that the seller will buy it back at a predetermined price.
Estimating the Yield
Federal Funds – commercial banks borrow and lend excess reserve balances to each other.
Banker’s Acceptances – a bank accepts the responsibility to repay a loan to its holder. Facilitates international trade.
Steps involved
Money Market SecuritiesFinal Notes
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Chapter 7 – Bond Markets Student Notes
Institutional use
Valuation
Limited price movements
Risk
Globalization of Money Markets
Performance of Foreign Money Market Securities
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Chapter 7 – Bond Markets Student Notes
Chapter 7 Objectives
To identify the different types of Treasury securities
To identify the characteristics of municipal securities
To outline the types of corporate debt securities
Treasury Securities
Treasury Bills – Treasury securities with a maturity of less than one year. These are sold on a discount basis.
Treasury Notes – Securities with maturities between 2 and 10 years. These are coupon securities.
Treasury Bonds – Securities with maturities greater than 10 years. These are coupon securities.
Treasury Inflation Protection Securities (TIPS) – A Treasury coupon security (either note or bond) whose coupon rate is tied to the rate of inflation.
Primary Market – Treasuries are sold in frequent well-publicized auctions.
¤ Competitive bids
¤ Noncompetitive bids
Secondary Market – over-the-counter market where a group of dealers offer continuous bid and as prices on outstanding Treasuries.
Stripped Treasury Securities – Separating all coupon and principal payments into individual securities. For instance, a 10-year semiannual note would convert into 21 separate STRIPS.
Quotations – The bid price and the ask price are quoted per hundred of dollars of par value.
Salomon Brothers scandal – Salomon took over a Treasury bond auction.
Brady Bonds – U.S. Treasury department restructuring program for delinquent LDC debt.
Federal Agency Securities
Federal Agencies – generally, a private company that was originated by the federal government.
¤ The Farm Credit System
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Chapter 7 – Bond Markets Student Notes
¤ Housing Credit Agencies
¤ Export-Import Bank
¤ Student Loan Marketing Association (Sallie Mae)
¤ Small Business Administration (SBA)
Municipal Bonds
State and local government bonds
General obligation bonds – provide basic services.
Revenue bonds – used to finance a specific revenue-producing project.
Corporate Bonds
Corporate Bonds – debt contracts requiring borrowers to make periodic payments of interest an to repay principal at the maturity date.
Characteristics
¤ Sinking-fund provision – requires the bond retire a specific dollar amount of bonds each year.
¤ Protective Covenants – Limit dividends or additional debt.
¤ Call Provisions – an option of the issuer to retire bonds before their maturity.
¤ Bond Collateral
Mortgage bonds
Equipment Trust Certificates
Collateral Bonds
Debentures
¤ Zero- Coupon Bonds – Do not pay coupons.
¤ Variable-Rate Bonds – Coupon is tied to an interest rate rather than fixed.
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Chapter 7 – Bond Markets Student Notes
¤ Convertibility – allows investors to exchange the bond for a stated number of shares of the firm’s common stock.
Junk Bonds – Corporate bonds with high default risk.
¤ Market Size – 25% of outstanding corporate bonds are junk.
Credit Risk – the likelihood that a borrower will default on the loan.
Mortgage-Backed Securities
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Chapter 9 – Mortgage Markets Student Notes
Pass-Throughs – payments of principal and interest on pools of mortgages are passed through to holders of securities in the pool.
Government National Mortgage Association (GNMA Ginnie Mae) – pass throughs on a pool of federally insured mortgage loans.
Federal National Mortgage Association (Fannie Mae) – issues a variety of pass-through securities similar to Ginnie Mae’s.
Publicly Issued Pass-Through Securities (PIP) – issued by private institutions.
Federal Home Loan Mortgage Corporation (Freddie Mac) – assists lenders with securitization of conventional mortgages.
¤ Participation Certificates (PCs) – different from Ginnie Mae’s in that:
Contain conventional mortgages
Not federally insured
Various interest rates
Much larger pools
Collateralized Mortgage Obligations – consists of a series of related debt obligations, called tranches, which pay various borrowers with different priorities.
Other Mortgage-Backed Securities
¤ Mutual Funds – several mutual funds have been established to buy Ginnie Mae securities.
¤ Fannie Mae or Freddie Mac debt – general obligation securities are basically secured by mortgages.
¤ Mortgage-Backed Securities – Pass throughs
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Chapter 11 – Stock Valuation and Risk Student Notes
Chapter 10 – Stock Markets
Overview
Types and locations of trading
Trading mechanics and arrangements
Public placements
Monitoring of firms
Globalization
Background on Common Stock
Common Stock – represents basic ownership claim in a corporation.
Owners expect capital gains and possibly dividends.
Value – based on expected future cash flows.
Trading Locations
Organized Exchanges – consist of physical locations where buyers and sellers meet on a trading floor.
¤ Auction System – trading mechanism placing competing buyers and sellers against each other.
Over-the-Counter (OTC) – dispersed traders linked via a computer system.
¤ Negotiated System – individual buyers negotiate with individual sellers.
Stock (Organized) Exchanges – consist of physical locations where buyers and sellers meet on a trading floor.
¤ New York Stock Exchange (NYSE) – most popular stock exchange.
Specialists – market makers in a stock.
Commission brokers – execute orders for customers.
Floor brokers – execute orders for other exchange members.
Floor traders – trade solely for themselves.
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Chapter 11 – Stock Valuation and Risk Student Notes
Over-the-Counter (OTC) – dispersed traders linked via a computer system.
¤ NASDAQ – a computer network linking thousands of market-making participants.
¤ Other OTC Markets – subscriber markets where trading is via the telephone.
OTC Bulletin Board (OTCBB)
Pink Sheets
Alternative Trading Systems – electronic communications networks or crossing networks that link two parties for direct trading of stocks.
Types of Transactions
Long Purchase – purchasing securities with the expectation that it will increase in value.
Margin Trading – the use of borrowed funds to purchase securities. Purchased securities are used a collateral.
¤ Initial Margin – minimum amount that must be provided by investor at time of purchase.
¤ Maintenance Margin – minimum amount that an investor must maintain in the margin account.
¤ Margin Call – notification of the need to add cash to a margin account.
Short Selling – selling borrowed securities with the expectation that the price will fall.
Trading Mechanics
Types of Orders – price and conditions of an order.
¤ Market order – an order to buy or sell stock at the best price available when the order is placed.
¤ Limit order – an order to buy at or below a specified price. Or, sell at or above a specified price.
fill-or-kill order
day order
good-’till-canceled (GTC) order
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Chapter 11 – Stock Valuation and Risk Student Notes
¤ Stop-loss order – an order to sell a stock when its price reaches or drops below a specified level.
Trading Arrangements
Retail Stock Trading – buying and selling of stocks by individuals.
Institutional Trading – buying and selling by financial institutions such as mutual funds and pension funds.
¤ Block Trades – trades of at least 10,000 shares or market value of $200,000 or greater.
¤ Program Trades – buying and/or selling of a large number of different stocks simultaneously.
Asset allocation trades
Index arbitrage
Stock Indexes
Dow Jones Industrial Average – stock market average made up of 30 high-quality industrial stocks.
Standard and Poor’s (S&P) – measures the current price of a group of stocks.
New York Stock Exchange Composite – current price of the stocks listed on the NYSE.
Other Indexes – AMEX, Nasdaq, Value Line, Wilshire 5000
Preferred Stock
Debt/Equity hybrid – represents ownership in a company but pays a fixed dividend amount.
Preferential treatment – preferred dividends are paid before common dividends can be paid and cumulate if they are not paid. Bankruptcy preference as well.
Nonparticipating – usually no voting rights.
Institutional tax advantages – other companies are able to deduct preferred dividends received. Not attractive for individual investors.
Public Placement of Stock
Initial Public Offerings (IPOs) – the first issuance of common stock by a firm to the public.
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Chapter 11 – Stock Valuation and Risk Student Notes
¤ Venture Capital (VC) – firms that invest in private companies with the expectation of taking them public.
¤ Underwriters – an investment bank must be hired to take the company pubic.
¤ Details – price range, number of shares, lockup period, and other details must be established and filed with the SEC.
¤ Road Show – managers and underwriters travel to different cities to meet with institutional investors to sell the company.
¤ Offering – the underwriter sets the price the number of shares and begins trading when the market opens.
“Building the Book”
¤ Initial Return – typically, the return on the first day is substantial.
Flipping – process of selling soon after trading has begun.
¤ Lockup Agreement – underwriter restricts managers, VCs, and other insiders from selling their shares for at least six months.
¤ Long-run Performance – generally poor.
Secondary Stock Offerings – an initial offering of stock by a firm that has other stock already publicly held.
Shelf-Registration – a company must register stock offerings with the SEC. Once the registration is complete, the company waits for favorable market conditions.
Monitoring of Firms
Shareholder Activism – shareholders take an active role in managing the company.
¤ CALPERS
¤ Socially conscious mutual funds
Corporate Monitoring
¤ Acquisition – poorly run companies become targets.
¤ Barriers
Anti-takeover Amendments
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Chapter 11 – Stock Valuation and Risk Student Notes
Poison Pills
Golden Parachutes
Self-Monitoring
¤ Stock Repurchases – a firm purchases its own stock when it believes it is undervalued.
¤ Leveraged Buyouts – use of debt financing to purchase the company.
Globalization of Stock Markets
International Investment Performance – performance varies among countries and through time.
Investing in foreign stocks
¤ Indirect investment
Purchase shares of U.S. based MNC
Purchase international mutual fund
¤ Direct investment
Purchasing stocks on foreign exchanges
Purchase stocks of foreign companies trading on U.S. exchanges.
Purchasing American Depository Receipts (ADRs)
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Chapter 11 – Stock Valuation and Risk Student Notes
Chapter 11 – Stock Valuation and Risk
Overview
Stock Valuation Methods
Estimating the Required Return and Growth Rate
Other Factors that Affect Stock Prices
Stock Performance Measurement
Stock Market Efficiency
Stock Valuation Methods
Discounted Cash-Flow Valuation Techniques – the present value of some expected cash flows.
Dependent on two estimated inputs:
¤ Growth Rates
¤ Discount Rates
Dividend Discount Model – value of stock is the present value of all future dividends.
¤ Zero Growth Model – Dividends stay the same each year.
¤ Infinite Constant Growth Model – Dividends grow at roughly the same percent each year.
¤ Supernormal Growth Model – Dividends grow at higher rate for a period of time before settling into a constant growth.
Present Value of Operating Cash Flows – Deriving the value of the total firm from operating cash.
Present Value of Free Cash Flows – Deriving the value using free cash.
Relative Valuation Techniques – provides information about how the market is currently valuing stock at several levels.
¤ Contends that valuing firms is accomplished by a comparison to other firms.
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Chapter 11 – Stock Valuation and Risk Student Notes
¤ Provides information current valuation but it does not provide guidance on whether current valuations are appropriate.
Price to Earnings (P/E) Ratio – determine how many dollars one is willing to pay for a dollar of expected earnings.
Price to Cash Flow (P/CF) Ratio – cash flow values are generally less prone to manipulation than earnings.
Price to Sales (P/S) Ratio – strong sales growth is a requirement for a growth company. Little chance of manipulation.
Estimating the Inputs
Required Rate of Return – will be the discount rate for most cash flow models.
¤ Risk-Free Rate – the absolute minimum rate an investor should require.
¤ Expected Inflation – if investors expect inflation, they should increase their required nominal risk-free rate.
¤ Risk Premium – the risk associated with a specific stock or portfolio of stocks.
Growth Rates – estimates of the growth rate of cash flows, earnings, and dividends are required.
¤ Estimating Growth from Fundamentals – dividend growth is determined by the growth rate of earnings and the payout ratio.
¤ Estimating Growth based on History – time-series growth rates should provide a trend and the amount of variability.
Factors that Affect Stock Prices
Economic Factors
¤ Interest Rates – generally, an inverse relationship exists between stock prices and the level of interest rates.
¤ Exchange Rates – currency strength affect market prices in many ways.
Market-Related Factors
¤ Anomalies – January effect, small firm effect, day of the week effect, etc.
Firm-Specific Factors
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Chapter 11 – Stock Valuation and Risk Student Notes
¤ Dividends – indication about the future of the company.