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Capital and Financial Market Bond and Stock Market

Capital and Financial Market Bond and Stock Market. Hall and Lieberman, 3 rd edition, Thomson South-Western, Chapter 13. Overview . Bond market Concepts: Principal / yield / maturity date How much is a bond worth? Why do bond prices differ? How will bond value responding to inflation?

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Capital and Financial Market Bond and Stock Market

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  1. Capital and Financial MarketBond and Stock Market Hall and Lieberman, 3rd edition, Thomson South-Western, Chapter 13

  2. Overview • Bond market • Concepts: Principal / yield / maturity date • How much is a bond worth? • Why do bond prices differ? • How will bond value responding to inflation? • Stock market • Issue and Valuation of stock • Price Earnings (PE) ratio • Explain the stock price • Gamble and investment • Fair bet / unfair bet • Risk and investment • Portfolio for diversification

  3. Financial Assets and Financial Market • Financial asset: • A promise to pay future income in some form, such as future profits or future interest • traded in financial markets • Financial assets generate future payments • Valued in total present value • Two types of financial market • Bond market • Stock market

  4. Part I The Bond Market • One of the methods to finance the production is selling bonds • Bond is a promise to pay a specific sum of money at some future date • This amount of money is principal (face value) • Most common amount: $10,000 • The date at which a bond’s principal will be paid to bond’s owner is Maturity Date

  5. The Bond Market • Pure discount bond • Promises no payments except for principal it pays at maturity • Coupon payments • Series of periodic payments that a bond promises before maturity • Yield • Rate of return a bond earns for its owner

  6. How Much is a Pure Discount Bond Worth? • Value of a bond with a face value of $10,000 which matures in exactly one year and has an interest rate of 10% is • Bond will sell for $9,091

  7. How Much Is A Coupon Payment Bond Worth? • Bond with a principal of $10,000, a five-year maturity and an annual coupon payment of $600 has a present value of • Total present value is what bond is worth • Price at which it will trade • As long as buyers and sellers use the same discount rate of 10% in their calculations

  8. How To Calculate Yield? • Suppose bond matures in one period PBOND = PV = FV/(1+r) Yield is implied by (1+r) = FV/PV • If bond matures T periods from now PBOND = PV = FV/(1+r)T Annual yield is implied by (1+r) = ( FV/PV ) 1/T • The higher the price of any given bond the lower the yield on that bond

  9. Bond’s Yield: Example • Suppose FV = $10,000; PBOND = $9500; Maturity in one period Then, yield is (1+r) = FV/PV = (10,000/9,500) = 1.053 Implying that annual interest rate r = 0.053

  10. Primary and Secondary Bond Markets • Bond is traded in two different types of markets • Primary market • Market in which newly issued bonds are sold for first time • Secondary market • Market in which previously issued bonds are sold

  11. Primary and Secondary Bond Markets • Bond issuers are not directly participants in secondary market trading • but they are affected by what happens in secondary market • Price of newly issued bonds in the primary market will rise if a similar bond’s price rises in secondary market rises • If a bond’s yield falls in the secondary market, yield of similar newly issued bonds in the primary market will fall as well

  12. Why Do Bond Prices (and Bond Yields) Differ? • Each bond traded everyday has its own unique yield • Why doesn’t each bond sell at a price that makes its yield identical to the yield on any other bond? • A bond—like any asset—is worth the total present value of its future payments

  13. Why Do Bond Prices (and Bond Yields) Differ? • To put a value on riskier bonds, markets participants use a higher discount rate than on safe bonds • Leads to lower total present values and lower prices for riskier bonds • With lower prices, riskier bonds have higher yields • Higher risk, higher yield, lower price

  14. Why Do Bond Prices (and Bond Yields) Differ? • Riskiness is only one reason that bond prices and bond yields differ • Other reasons include • Differences in maturity dates • Differences in frequency of coupon payments • Because one bond is more widely traded (and therefore easier to sell on short notice) than another

  15. Rating on Bonds • According to the likelihood of default, bonds are rated in the following(Moody’s Investor’s Services estimate): • U.S. Treasury bond - the least risky • Aaa Corporate bond • Aa Corporate bond • A Corporate bond • Baa Corporate bond • Ba Corporate bond • B Corporate bond - higher risk

  16. Figure 1(a) How does bond market respond to rising inflation expectations? PV Supply of FV = 10,000 bonds Initial equilibrium sets price implied r = 0.053 $9,500 D; low inflation Bonds issued

  17. Figure 1(b) How does bond market respond to rising inflation expectations? PV Supply of FV = 10,000 bonds With higher inflation, $10,000 one year from now will be worth less, so demand shifts left $9,500 D; low inflation Bonds issued

  18. Figure 1(c) How does bond market respond to rising inflation expectations? PV Supply of FV = 10,000 bonds New lower equilibrium price implied r = 0.081 $9,500 $9,250 D; low inflation D; high inflation Bonds issued (1+ r) = (FV/PV) = (10000/9250) = 1.081

  19. Part II The Stock Market • A share of stock promises its owner future payments • By issuing a share of stock, a corporation brings in new ownership of the firm itself • When a corporation issues a bond, it is borrowing funds and promising to pay them back

  20. The Stock Market – issuing new shares of stock • When a firm wishes to raise money in the stock market, it gets in touch with an investment bank • Prospectus • Worked out by the firm and investment bank • Inform potential investors of risks involved about • Nature of the firm’s business • Number of shares to be sold, etc • must be reviewed by Securities and Exchange Commission • Principal regulatory agency that oversees financial markets • If approved, shares will be sold to the public

  21. The Stock Market – issuing new shares of stock • If it is the first-ever offering of shares by this firm, sale will be called an initial public offering (IPO) • In practice, it’s usually large institutional investors, such as mutual funds, who first purchase new shares • A mutual fund is a Corporation that specializes in owning shares of stock in other corporations

  22. Primary and Secondary Stock Markets • Only time a corporation receives any income from a trade in its stock is when the corporation itself sells the stock in the primary stock market • Thereafter, stock is traded in secondary market, in which previously issued shares are sold and resold • Price changes in secondary market affect price a firm can get from selling shares in primary market

  23. Direct and Indirect Ownership of Stock • Many people own shares of stock directly • Can also own stock indirectly by purchasing shares of a mutual fund • Or through retirement accounts that are managed by their employers • Stock ownership in United States is growing rapidly

  24. Valuing a Share of Stock • Value of a share in a firm is equal to • Total present value of firm’s after tax profits divided by number of shares outstanding • Note that we are valuing a share of stock by future profits, not by dividends

  25. Valuing a Share of Stock • Important conclusions about factors that can affect a stock’s value • An increase in current profits increases value of a share of stock • An increase in anticipated growth rate of profits increases value of a share of stock • A rise in interest rates—or even an anticipated rise in interest rates—decreases value of a share of stock • An increase in perceived riskiness of future profits decreases value of a share of stock

  26. Fundamental Value of Stocks • Stock price should be the present value of the stream of future earnings per share (E) PV = Pstock = E/r • Price Earnings (PE) ratio: Pstock/E = (1/r) • Very high PE ratios imply having to pay a lot per $ of expected earnings

  27. Reading the Stock Pages • Wall Street Journal and other newspapers report on changes in different stock market averages or indexes • The most popular average is Dow Jones Industrial Average • Tracks prices of 30 of largest companies in United States, including Boeing, Microsoft, and Wal-Mart • Another popular average is the much broader Standard & Poor’s 500 • Tracks stock prices of 500 large corporations

  28. Explaining Stock Prices • Stock prices are determined by supply and demand • Supply • On any given day, the number of FedExCp shares in existence is just the number that FedExCp has issued previously, up until that day • Therefore, no matter what happens to the price today, the number of shares remains unchanged • But, it does not mean that this is the number of shares that people want to hold • Demand • Value of a share of stock to any owner is equal to total present value of its future after-tax profits • At any given moment, there is an array of estimates of a stock’s total present value

  29. 1. The supply curve is vertical at 298 million – the total number of shares FedEx has issued. Price per Share 2. The downward-sloping demand curve shows how many shares the public wantsto hold at each price. 3. The equilibrium is at point A, where people want to hold all the shares in existence. Shares in FedEx Figure 2(a): The Market for FedEx S $78 A 64 50 D 298 million

  30. Explaining Stock Prices • Only at equilibrium price of $64 are people satisfied holding the number of shares they are actually holding • Where supply and demand curves intersect • Stocks achieve their equilibrium price almost instantly • Can have confidence that price of a share at any time is the equilibrium price • Cannot be caused by shifts in the supply curve • Must be caused by shifts in demand

  31. Price per Share Shares in FedEx Figure 2(b): An Increase in Demand for Shares of FedEx S $80 64 D2 D1 863 million

  32. Explaining Stock Prices • What causes these sudden shifts in demand for a share of stock? • Anything that causes large groups of individuals to change their estimates of total present value of future profits will shift demand curve • When stock prices move dramatically, it is usually because new information has become available

  33. Part III Gambling vs. Investing • Expected return Pi = probability that outcome i happens Ri = Return when outcome i happens C = investment costs N outcomes Probabilities add up to 1 Expected Return = Σ Pi Ri - C N i=1

  34. Gambling vs. investing Fair bet: Expected return is zero Coin flip: Pay C = $1 to play Heads: Receive R1 = $2, P1 =.5 Tails: Receive R2 = $0, P2 = .5 Expected Return = P1R1 + P2 R2 - C = .5*2 + .5*0 - 1 = 0

  35. Gambling • Unfair bet: Gambler: Expected return <0 Casino: Expected return >0 • Example : slot machines pay 92¢ per $ bet • Expected return for customer = -8¢ • Expected return for Casino = 8¢ • Lottery • Expected return for customer = -50¢/$ • Expected return for Lottery = 50¢/$

  36. Gambling • Cards, Horses • Gambler: Expected return depends on skill • Casino: Expected return >0 on average or else they rent the space (poker) • Casinos will not offer games that have negative expected return to the Casino

  37. What proportion of ISU college students gamble? Overall 56% Males 61% Females 49% Gamblers spent 64% < $20/month 18% $20-$60/month 18% > $60/month Average $33 per month T. Hira and K. Monson. “A social learning perspective of gambling among college students”

  38. Why do ISU students gamble? Entertainment 65% To win money 30% Women more likely to say “for entertainment” Men more likely to say “to win” T. Hira and K. Monson. “A social learning perspective of gambling among college students”

  39. Risk From Uncertainty • Future payment is not guaranteed sometimes • There is uncertainty in your investment • The higher the risk, the higher the payoff • Goal: maximize the expected future return by choosing one or some among a bunch of financial assets, given the same risk • Or reduce the risk to the least given the same expected return

  40. The Higher the Risk, the Higher the Payoff • Investment on A is less risky than investment on B, but has a lower expected return from investment • tradeoff

  41. Diversification - Portfolio • Holding several assets can lower risk without sacrificing return • The mixed portfolio yields higher utility—same expected return, lower variance

  42. Diversification • How can you low the risk? • Mutual fund • Financial intermediary holds a portfolio of stock. • Individual investors buy shares of the portfolio • Holding assets over a long period can lower risk - Higher average return wins out • Warren Buffet: Asked when is the best time to sell stock…………Never

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