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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

Capital and Financial MarketBond and Stock Market

Hall and Lieberman, 3rd edition, Thomson South-Western, Chapter 13

overview
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
financial assets and financial market
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
part i the bond market
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
the bond market
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
how much is a pure discount bond worth
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
how much is a coupon payment bond worth
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
how to calculate yield
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
bond s yield example
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

primary and secondary bond markets
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
primary and secondary bond markets1
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
why do bond prices and bond yields differ
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
why do bond prices and bond yields differ1
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
why do bond prices and bond yields differ2
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
rating on bonds
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
figure 1 a how does bond market respond to rising inflation expectations
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

figure 1 b how does bond market respond to rising inflation expectations
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

figure 1 c how does bond market respond to rising inflation expectations
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

part ii the stock market
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
the stock market issuing new shares of stock
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
the stock market issuing new shares of stock1
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
primary and secondary stock markets
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
direct and indirect ownership of stock
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
valuing a share of stock
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
valuing a share of stock1
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
fundamental value of stocks
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
reading the stock pages
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
explaining stock prices
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
figure 2 a the market for fedex

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

explaining stock prices1
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
explaining stock prices2
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
part iii gambling vs investing
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

gambling vs investing
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

gambling
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¢/$
gambling1
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
what proportion of isu college students gamble
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”

why do isu students gamble
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”

risk from uncertainty
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
the higher the risk the higher the payoff
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
diversification portfolio
Diversification - Portfolio
  • Holding several assets can lower risk without sacrificing return
  • The mixed portfolio yields higher utility—same expected return, lower variance
diversification
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