Slides MFI Chap. 2

2. Financial Investments 2.1.
Money market instruments

Money Market Characteristics: - trading of short-term securities that are usually very liquid (close to the notion of money) - traded securities: - have a low default risk - are usually bought and sold in large denominations - have maturities that range from one day to one year (more often three months or less) - electronic trading - secondary markets are very active for most of the instruments - because of the high amounts traded, the main market participants are central banks, commercial banks, treasuries and large firms
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2. Financial Investments 2.1. Money market instruments

Purpose of the money markets: manage short-term cash needs (liquidity) In theory, commercial banks could replace the money markets in the task of managing liquidity: - they have a better knowledge of the clients characteristics - can benefit from efficiency gains when processing information But the existence of the money markets can be justified: - commercial banks have to comply with regulatory requirements and pay several costs - e.g., minimum reserve requirements, solvability and capital ratios) - commercial banks have some advantages when dealing with asymmetric information problems - when those problems are not serious, the costs are the most relevant issue
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The investments in money market securities do not produce high returns but, nonetheless, the returns are higher than those of the alternative investments (bank deposits). Money markets enable to reduce the opportunity costs of having very liquid assets. - most of the trading (more than 90%) have maturities less than a month The investments in the money market are mainly caused by precaution issues: - mutual funds - treasuries - firms in the process of liquidation
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Money market participants: 1) Governments (treasuries) - management of the taxes cycle - issue Treasury Bills 2) Central banks - open market operations in order to control the economys money supply - management of the yield curve - suggestion: take a look at the dynamic yield curve 3) Commercial banks - issue deposit certificates and repurchase agreements (repos) - hold the greatest part of the debt securities issued by the treasuries - manage the liquidity and trade on clients behalf
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4) Large firms - relevant because they issue most of the commercial paper The individual investors can access the money markets via money market mutual funds - mutual funds pool the resources of many individual investors and purchase money market securities on their behalf
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Interbank money market - subset of bank-to-bank money transactions that take place in the money market The euro-zone money market is increasingly indexed to the reference rate euro overnight index average (EONIA) - overnight trades with no collateral - 49 European banks
1,000 0,900 0,800 0,700 0,600 0,500 0,400 0,300 0,200 0,100 0,000
04 /0 1 /2 01 18 0 /0 1 /2 01 01 0 /0 2 /2 01 15 0 /0 2 /2 01 01 0 /0 3 /2 01 15 0 /0 3 /2 01 29 0 /0 3 /2 01 12 0 /0 4 /2 01 26 0 /0 4 /2 01 10 0 /0 5 /2 01 24 0 /0 5 /2 01 07 0 /0 6 /2 01 21 0 /0 6 /2 01 05 0 /0 7 /2 01 19 0 /0 7 /2 01 02 0 /0 8 /2 01 16 0 /0 8 /2 01 30 0 /0 8 /2 01 13 0 /0 9 /2 01 27 0 /0 9 /2 01 11 0 /1 0 /2 01 0
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Instruments traded in the money markets: 1) Treasury Bills (T-Bills): - the most marketable of all money instruments - maturities up to one year - issued below par (discount from the stated maturity value) - with no default risk - with low inflation-risk (unexpected inflation changes) because of the short-term maturity - very liquid secondary market with low transaction costs - during the last years, treasuries have been issuing bills with longer maturities (role of the financial crisis)
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2) Commercial paper - issued by large, well-know companies - minimum maturity varies from country to country (from one day to two years) - usually issued below par - good alternative to the bank loans (lower costs) - used as bridge financing - temporary loan that will eventually be replaced by a more permanent financing - usual in events such as a merger or acquisition - secondary market is not very relevant - buy-and-hold strategy is the most common - national markets remain separated (large differences in the fiscal and legal framework)
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3) Certificates of Deposit (CD) - security issued by a bank - represent a deposit with a specific rate of interest and maturity date - can be bought / sold before the maturity date - the investor who holds the deposit certificate at the maturity date gets the capital and interest (similar to bonds) - maturity usually from one to 4 months - the interest rate is slightly higher than the treasury bills rate (reflecting a superior default risk)
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4) Repurchase agreements (repos) - sale of securities (e.g., treasury bills) together with an agreement to buy back the same securities at a later date by a price agreed in advance. - usually it is a short-term agreement, from 1 to 14 days, although it can reach 3 months - very safe in terms of credit risk because the loans are backed by the securities - the monetary authorities (e.g., ECB) buy/sell securities to the commercial banks with a repurchase agreement taking place usually 2 weeks later - it is a short-term loan with a collateral - agents can manage liquidity and profit from changes in interest rates
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5) Eurodollars - dollars-denominated deposits at foreign banks or foreign branches of American banks - these banks are not regulated by the Federal Reserve - most are of deposits less than 6 months maturity - are used by the banks as an alternative to the loans made by the monetary authorities - the banks may buy/sell overnight amounts denominated in dollars - in the London market, those amounts are traded at the LIBID (London Interbank Bid Rate) and at the LIBOR (London Interbank Offer Rate) rates - it is an highly competitive market
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The interest rates of the all these securities tend to move in the same direction at the same time and by similar amounts - short-term securities with low risk and are traded in a competitive market (close substitutes)
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OPEC I
OPEC II
87 market crash LTCM
Subprime mortgage crisis
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2. Financial Investments 2.2. Bonds

A. Key concepts: Bond: security that is issued in connection with a borrowing arrangement - the borrower issues (i.e., sells) a bond to the lender for some amount of cash - the issuer makes specified payments to the bondholder at specified dates Coupon: payments of interest to the bondholder for the life of the bond Par value (or face value): repayment of the debt to the bondholder when the bond matures Coupon rate: it determines interest payment - the annual payment equals the coupon rate times the bonds par value
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Bond market - it is one of the capital markets where investors trade long-term securities (maturities longer than 1 year) - issuers sell securities to obtain long-term financing - the market participants are the households, the firms and the treasuries - there has been efforts to harmonize the bond markets of the eurozone (e.g., trading platforms) in order to create a homogeneous market - the fixed-income bonds are the most important in the market - several bond maturities: - treasuries issue bonds with maturities from 1 to 30 years - corporate issues have shorter maturities typically
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B. Types of Bonds: 1) Treasury bonds - finance the public debt - have no default risk but have interest rate risk (role of the inflation) - the USA government issues T-Bills (maturities up to 1 year), T-notes (maturities up to 10 years) and T-Bonds (from 10 to 30 years) - represent the most important segment of the bond market - more than 50% in the euro-zone - securities used in open market operations - very active secondary market, with high liquidity - some treasuries have been issuing inflation-indexed bonds - e.g., USA, France, Italy, Greece, United Kingdom, Sweden
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1) Treasury bonds - prior to the current crisis, the differences between the bond returns issued by the euro-zone countries have somewhat been reduced: - the expectation of variations in the exchange rate has ended as a risk factor - the fiscal treatment of treasury bonds has been harmonized - there are still some risk factors such as the credit risk and the liquidity risk
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2) Corporate bonds - private firms borrow money directly from the public - the risk and promised return depend on the probability of default - in the euro-zone, the bonds issued by banks are very important - the European bond markets have become increasingly integrated during the last years - many institutional investors no longer have restrictions about investing in foreign bonds since the introduction of the euro - firms and treasuries compete for financing resources in the market - there are still some important barriers to market development - information problems concerning the corporate bond segment - the corporate bond segment is less liquid - lack of hedging instruments - economic growth is cyclical and that affects the market
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Callable bonds: allow the issuer to repurchase the bond at a specified call price before the maturity rate - if a company issues a bond with a high coupon rate when the market interest rates are high, and then the interest rates fall, the firm may want to redeem the bond before the maturity date in order to reduce its interest payments - to compensate investors for the risk, callable bonds are issued with higher coupons than noncallable bonds Puttable bonds: gives the option to the bondholder to extend or retire the bond - if the bonds coupon rate is lower than current market yields, for instance, the bondholder will choose to reclaim the principal which can then be invested at (more favourable) current yields
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Convertible bonds: give bondholders an option to exchange each bond for a specified number of shares of common stock of the firm - conversion ratio gives the number of shares for which each bond may be exchanged Floating-rate bonds: have a variable coupon that is equal to a money market reference rate plus a quoted spread - e.g., current T-bill rate (or euribor rate) plus 0.2% Asset-backed bonds: the income from a specified group of assets is used to service the debt Indexed bonds: make payments that are tied to a general price index or the price of a particular commodity - e.g., Treasury Inflation Protected Securities (TIPS) issued by the US Treasury - the interest rate on these bonds is a risk-free real rate
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3) International bonds Foreign bonds: issued by a borrower from a country other than the one in which the bond is sold - the bond is denominated in the currency of the country in which is marketed - e.g., dollar-denominated bond sold by a German firm in the US Eurobonds: issued in the currency of one country but sold in other national markets - e.g., Eurodollar, i.e., dollar-denominated bonds sold outside the US (not just in Europe)
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C. Bond Pricing To value a security, we have to discount its expected cash flows by the appropriate discount rate Bond value = Present value of coupons + Present value of par value
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Bond Value =
t =1
Coupon Par Value + (1 + r )t (1 + r )T
with a constant coupon we have then
1 (1 + r )T 1 Bond Value = Coupon * + Par value * T r ( 1 + r)

where T: maturity rate r: discount rate
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For example, for a 30-year maturity bond with a par value of 1000, semiannual coupon payments and a coupon rate of 8% - then this bond pays 60 semiannual coupon payments of 40 each - if the market interest rate is also 8% annually (i.e., r = 4% per sixmonth-period)
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1 (1 + 4% ) Bond Value = 40 * 4%
60
1 + 1000 * (1 + 4% )60
Because, in this example, the coupon rate equals the market interest rate:
1 (1 + 4% ) Bond Value = 40 * 4%
60
1 = 1000 = Par value = Price + 1000 * (1 + 4% )60
If the interest rate were not equal to the bonds coupon rate, the bond would not sell at par value.
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The bond price will rise (fall) as market interest rates fall (rise). - present value of bonds payments is obtained by discounting at a higher interest rate - interest rate fluctuations represent the main source of risk in the bond market
Bond price at given market interest rate 3000
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2500 2000 1500 1000
Bond price ()
500 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 Interest rate (%)
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An important property of bond prices: convexity - The shape of the curve implies than an increase in the interest rate results in a price decline that is smaller than the price gain resulting from a decrease of equal magnitude in the interest rate - the price curve becomes flatter at higher interest rates - i.e., progressive increases in the interest rate result in progressively smaller reductions in the bond price
Bond price at given market interest rate 3000
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2500 2000
Bond price ()
1500 1000
500 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 Interest rate (%)
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The longer the maturity of the bond, the greater the sensitivity of its price to fluctuations in the interest rate - the longer the period which the bondholders money is tied up, the greater the loss (gain) caused by a rise (fall) of the interest rate - this is why the short-term treasury bills are considered the safest asset - no default risk and low interest rate risk
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D. Bond Yields 1) Yield to maturity - the discount rate that makes the present value of the bonds payments equal to its price - measure of the average rate of return that will be earned on a bond if it is bought now and held until maturity - standard measure of the total rate of return For example, the yield to maturity of a 8% coupon, 30-year bond selling at 1276.76 would be the rate r in the equation:
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1 (1 + r )60 1000 1276.76 = 40 * + 60 r (1 + r )

Solution: r = 3% per half-year, or 6.09% per year (compound interest)
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The bonds yield to maturity is the internal rate of return on an investment in the bond - can be interpreted as the compound rate of return over the life of the bond under the assumption that all bond coupons can be reinvested at that yield Yield to maturity depends only on the bonds coupon, current price, and par value at maturity - can be easily calculated You may use the function of Excel to calculate the yield to maturity: = YIELD (settlement date, maturity date, annual coupon rate, bond price, redemption value as percent of par value, number of coupon payments per year)
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Source: Mauldin and Tepper (2011)
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2) Current yield - annual coupon divided by bond price - may differ from the yield to maturity
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Current yield =
80 = 6.27% per year 1276.76
For this bond, which is selling at a premium over the par value (1276.76 rather than 1000), the coupon rate (8%) exceeds the current yield (6.27%) which exceeds the yield to maturity (6.09%) The yield to maturity accounts for the built-in capital loss on the bond (we buy for 1276.76 something that at maturity will be worth only 1000) For premium bonds (i.e., price > par value), the coupon rate is higher than the yield to maturity For discount bonds (i.e., price < par value), the relationship is reversed
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3) Yield to call
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It is the yield of the bond if you were to buy and hold the security until the call date The blue line is the value at various market interest rates of a straight (i.e., noncallable) bond
Interest rate
When interest rates fall, the present value of the bonds scheduled payments rises, but the call provision allows the issuer to repurchase the bond at call price At high market interest rates, the values of the straight and callable bonds converge At very low market rates, the bond is called so its value is simply the call price
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It is more important to calculate the bonds yield to call rather than its yield to maturity if the bond is likely to be called The yield to call is calculated just like the yield to maturity except that the time until call replaces time until maturity and the call price replaces the par value Example: a 8% coupon, 30-year maturity bond sells for 1150 and is callable in 10 years at a call price of 1100. Its yield to maturity and yield to call would be calculated using the following inputs:
Yield to call Coupon payment Number of semiannual periods Final payment Price Annual Yields (effective)
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Yield to maturity 40 60 periods 1000 1150 6.94%

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40 20 periods 1100 1150 6.5%

E. Bond Prices over Time A bond will sell at par value when its coupon rate equals the market interest rate - the investor receives fair compensation for the time value of money in the form of the coupon payments - no further capital gain is necessary to provide fair compensation But, when the coupon rate is lower than the market interest rate, the coupon payments alone will not provide investors the same return they could earn elsewhere in the market - investors also need to earn price appreciation on their bonds - the bonds would have to sell below par value to provide a built in capital gain on the investment
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Example: a bond was issued several years ago when the interest rate was 7% so the bonds coupon annual coupon rate was set at 7% - the bond pays its coupon annually - now, with three years left in the bonds life, the interest rate is 8% per year The bonds fair market price is the present value of the remaining annual coupons plus payment of par value:
70 * 1 (1 + 8% ) 1 + 1000 * = 974,23 8% (1 + 8% )3
3
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In another year, after the next coupon is paid, the bond would sell at
70 * 1 (1 + 8% ) 1 + 1000 * = 982,17 8% (1 + 8%)2
2
So, the total return over the year would equal the coupon payment plus capital gain, or 70 + (982.17 974.23) = 77.94 77,94 = 8% The rate of return would be exactly the current rate of the market: 974,23
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When bond prices are set according to the present value formula, any discount (premium) from par value provides an anticipated capital gain (loss) that will augment (reduce) a below (above)-market coupon rate enough to provide a fair total rate of return As the bond approach maturity, they will converge to the par value because fewer of these below or above-market coupons remain.
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To summarize, each bond offers investors the same rate of return - although the capital gain versus income components may differ - if not, investors will try to sell low-return securities thereby driving down the prices until the total return at the now lower price is competitive with other securities
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Holding-period return is the rate of return over a particular period and depends on the market price of the bond at the end of that holding period When the yield to maturity is unchanged over the period, the rate of return on the bond will equal that yield as we have seen But when yields fluctuate, so will a bonds rate of return - unanticipated changes in market rates will result in unanticipated bond returns and, because of that, a bonds holding period return can be better or worse than the yield at which initially sells Example: a 30-year bond paying an annual coupon of 80 and selling at par value of 1000; the initial yield to maturity is 8% - afterwards, if it falls below 8% the bond price will increase; suppose the price increases to 1050
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Holding - period return =

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80 + (1050 1000 ) = 13% > 8% 1000

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An increase (decline) in the bonds yield to maturity acts to reduce (increase) its price, which means that the holding-period return will be less (greater) than the initial yield
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F. Default risk and bond pricing Default risk: is the investors risk of loss arising from a bonds issuer who does not make payments as promised Bond default risk is measured by rating agencies such as Moodys, Standard & Poors and Fitch
Moodys Aaa Aa A Baa Ba B Caa C Master in Finance Standard & Poors AAA AA A BBB BB B CCC D Fitch AAA AA A BBB BB B CCC D Prime: capacity to pay interest and principal is extremely strong High grade: capacity to pay interest and principal is very strong Upper medium grade: capacity to pay interest and principal is strong Lower medium grade: capacity to pay interest and principal is adequate Non-investment grade / speculative Highly speculative Substantial risks / extremely speculative / in default with little prospect for recovery In default Jlio Lobo
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Bond indenture - there are conflict of interests between the bondholders and the stockholders - it is the contract between the issuer and the bondholder which specifies a set of restrictions (called covenants) that protect the rights of the bondholders Covenants: Sinking fund: the firm agrees to periodically repurchase some proportion of the outstanding bonds prior to maturity - help ensure that the payment of the par value does not create a cash flow crisis Subordination clauses: restrict the amount of additional borrowing - additional debt must be subordinated to existing debt: senior bondholders will be paid first in the event of bankruptcy
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Dividend restrictions: limit the dividends firms may pay - forces the firm to retain assets rather than pay them out to stockholders Collateral: a specific asset pledged against possible default - if the collateral is property, the bond is called a mortgage bond - if the collateral takes the form of other securities held by the firm, the bond is called a collateral trust bond
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The Yield to Maturity and Default Risk As the bond becomes more subject to default risk its price will fall and therefore its promised yield to maturity will rise
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Credit Default Swap (CDS): an insurance policy on the default of a bond - was designed to allow lenders to buy protection against losses on loans - the seller of the CDS will compensate the buyer in the event of a loan default or other credit event - the buyer of the CDS makes a series of payments to the seller and, in exchange, receives a payoff if the loan defaults
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G. The yield curve Yield curve: a graph of the yields to maturity as a function of terms to maturity across bonds - also called the term structure of interest rates - rising yield curves are most commonly observed - interest rate risk vs. financing costs
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Yield curve theories 1) The expectations theory - yields to maturity are determined solely by expectations of future short-term interest rates - the slope of the yield curve is attributable to expectations of changes in short-term rates - relatively high (low) yields on long-term bonds reflect expectations of future increases (decreases) in short-term rates Example:
Returns to two two-year investment strategies
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- forward rate: the inferred short-term rate of interest for a future period that makes the expected total return of a long-term bond equal to that of rolling over short-term bonds
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(1 + yn )n = (1 + yn1 )n1 (1 + f n )
Example: - two-year maturity bonds offer yields to maturity of 6% - three-year bonds have yields of 7%
(1 + 7% )3 = (1 + 6% )2 (1 + f 3 )
f 3 = 9.02%
- the forward rate for the third year will be 9.02%
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2) The liquidity preference theory - shorter term bonds have more liquidity than longer term bonds, in the sense they offer greater price certainty - investors demand a risk premium on long-term bonds because these bonds are subject to greater interest rate risk than short-term bonds - the yield curve will be upward-sloping even in the absence of any expectation of future increases in interest rates - liquidity premium: the extra expected return demanded by investors as compensation for the greater risk of longer term bonds - the liquidity premium is measured by the spread between the forward rate of interest and the expected short rate
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Liquidity premium = f n E (rn )

- issuers of bonds may also be willing to pay high yields on long-term bonds because it allows them to lock in an interest rate
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3) The preferred habitat theory Different bond investors prefer one maturity length over another - bond investors care about both maturity and return - they are only willing to buy bonds outside of their maturity preference if a risk premium for the maturity range is available
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A synthesis The combination of varying expectations, liquidity premiums and maturity preferences can result in a wide array of yield-curve profiles - an upward-sloping curve does not in and of itself imply expectations of higher future interest rates because slope can result either from expectations, from risk premiums or from maturity preferences
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H. Interest rate risk Interest rate sensitivity
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D C B A
1. bond prices and yields are inversely related: as yields increase (fall), bond prices fall (increase) 2. an increase in a bonds yield to maturity results in a smaller price change than a decrease in yield of equal magnitude
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D C B A
3. prices of long-term bond tend to be more sensitive to interest rate changes than prices of short-term bonds 4. the sensitivity of bond prices to changes in yields increases at a decreasing rate as maturity increases, i.e., interest rate risk is less than proportional to bond maturity - while bond B has six times the maturity of bond A, it has less than six times its interest rate sensitivity
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D C B A
5. interest rate risk is inversely related to the bonds coupon rate, i.e., prices of low-coupon bonds are more sensitive to changes in interest rates than prices of high-coupon bonds - bond B has a higher coupon than that of bond C and is sensitive to changes in yields less
6. the sensitivity of a bonds price to a change in its yield is inversely related to the yield to maturity at which the bond currently is selling - bond C has a higher yield to maturity than bond D and is less sensitive to changes in yields
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Duration Macaulays duration: a measure of the effective maturity of a bond, defined as the weighted average of the times to each coupon or principal, with weights proportional to the present value of the payment
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wt =
CFt / (1 + y ) Bond price

t
y: bonds yield to maturity
D = t.wt
t =1
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Duration is a measure of the interest rate sensitivity of a bond portfolio - when the interest rate varies, the percentage change in a bonds price is proportional to its duration
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(1 + y ) P = D. P 1+ y
- bond price volatility is proportional to the bonds duration Practitioners use the modified duration defined as
D* =
D : 1+ y
P = D * y P
- the percentage change in bond price is just the product of modified duration and the change in the bonds yield to maturity
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Example: A bond with maturity of 30 years has a coupon of 8% (paid annually) and a yield to maturity of 9%. Its price is 897.26 and its duration is 11.37 years. What will happen to the bond price if the bonds yield to maturity increases to 9.1%?
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P = D * .y.P P = 11.37 .0.001* 897.26 = 9.36 1.09
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2. Financial Investments 2.3. Stocks

Stock Market Characteristics: - it is the most popular market - it is one of the capital markets, i.e., where takes places the trading of long-term securities (maturities over one year) - from the perspective of the issuers, it is used to obtain long-term financing - from the perspective of the investors, it is used to make long-term investments (savings) - the main market participants are households, treasuries and firms - common stocks represent ownership shares in a corporation (capital owned by the corporation itself) - stocks vs. bonds: voting rights, maturity, seniority
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Common stock vs. preferred stock
Common Stock Ownership Voting rights Own a portion of the firm Can vote on company matters Grant rights on buying new shares when company issues new stock (to keep percentage of company they own the same) Not guaranteed and paid only when company has excess profits. Never paid before preferred dividends Preferred Stock Own a portion of the firm No voting rights usually
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Do not have pre-emptive rights
Pre-emptive rights
Return on capital (dividends)
Guaranteed: fixed dividend per share that is set down in advance of purchase. Paid before any distributions to common stock holders Paid after debtors but before common stockholders if company goes bankrupt
Asset claims
Last in line for claiming assets in the event of bankruptcy
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Valuing stocks To compute the value of a stock is a very difficult task Unlike most goods and services distributed by the economy, stocks have no direct intrinsic value - they are only instruments representing other, possible valuable, rights - those rights suffer from uncertainty There are several asset pricing models which creates a indeterminacy problem:
After decades of empirical research, the evidence is generally inconsistent with those models that make reasonably sharp predictions about asset return behavior, leaving financial economists with neither good models of prices nor accepted models of return behavior (Brav and Heaton, 2003, p. 526) () there is no accepted theory by which to understand the worth of stocks and no clearly predictable consequences to changing ones investments (Shiller, 1984, p. 464).
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Valuing stocks A. Valuation methods based on the balance sheet 1) Book-value per share
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Book - value per share =
Total Shareholder Equity - Preferred Equity Total Outstanding Shares
It only takes into account the past of the corporation (Equity). 2) Fair market value - estimate of the corporation market value (including assets and liabilities) based on a what a knowledgeable, willing and unpressured buyer would probably pay to a knowledgeable, willing and unpressured seller in the market. If the value is higher than the shares market price, there are incentives for the acquisition of the corporation.
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Valuing stocks B. Valuation methods based on discounted cash flows Assets value - sum of the present value of the expected future cash flows it will generate The rate used to discount future cash flows reflects: - investors temporal preferences - capital productivity - inflation - uncertainty When we want to estimate the value of stocks, the cash flow to consider is the dividend. - But what if the corporation does not pay any dividends?
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The retained earnings will likely generate higher dividends in the future - pay the debts - invest in financial or real assets (e.g., acquire other corporations) - share repurchase - capital budgeting (resource allocation) 1) Dividend discount model
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P0 =
t 1+ r) t =1 (
Dt
1a) A special case: the Gordon-Shapiro model
P0 =
D1 rg
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Dividend discount model: the Gordon-Shapiro model Over the long run, no company can grow faster than the economy
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Source: Burham (2005)
Example: Microsofts growth rate has slowed toward that of the US economy
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Dividend discount model: the Gordon-Shapiro model Assumptions: Constant dividend nominal growth rate Constant required return rate Dividends growth rate is lower than the required return rate Long-term analysis Questions: Estimate of the long-term dividend growth rate Estimate of the required return rate Effect of the business cycles on the variables of the model Effect of the inflation on the variables of the model Relation between the price and the dividend yield and growth
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We can rearrange the Gordon-Shapiro model
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r=
g=
D1 +g P0
Change in Earnings New Investment * Return on New Investment = = Earnings Earnings
g=
Earnings * Retention Rate * Return on New Investment = Earnings
g = Retention Rate * Return of New Investment

If a firm wants to increase its share value - should cut its dividend and invest more or - should cut investment and increase its dividends? The answer will depend on the profitability of the firms investments - cutting the firms dividend to increase investment will raise the stock price if the new investments have a positive impact on the firms value
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Dividend discount model: the Gordon-Shapiro model Limitations: - value that is very sensitive to the estimated rate of dividends growth more suitable: - When we have a stable dividend payout - Firms/industries with stable growth 1b) A two stage dividend discount model with constant long-term growth:
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P0 =
t =1
t =n
Dt Pn + t (1 + r1 ) (1 + r1 ) n
Pn =
Dn +1 r2 g
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Two stage dividend discount model Limitations: - length of the abnormal growth period - abrupt transition from the first stage to the second stage more suitable for situations in which the cash flows sources have the tendency to disappear: - Patents - abnormal returns caused by barriers to entry (e.g., economies of scale, legal barriers) 1c) H model:
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P0 =
D0 * H * ( g a g n ) D0 (1 + g n ) + r gn r gn
Master in Finance
Jlio Lobo

Forecasting dividends requires forecasting: - the firms earnings - dividend payout rate - future number of shares But - future earnings depend on interest expenses - interest rates depend on how much the firm borrows - the dividend payout rate and the future number of shares depend on whether the firm uses a portion of its earnings to repurchase shares Borrowing and repurchase decisions are at managements discretion - can be difficult to forecast reliably There are two methods that allow us to avoid these difficulties.
Master in Finance
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Jlio Lobo

Valuing stocks C. Total Payout and Free Cash Flow Valuation Models An increasing number of firms have replaced dividend payouts with share repurchases. This practice brings consequences to the dividend model: - the more cash the firm uses to repurchase shares, the less is available to pay dividends - by repurchasing shares, the firm decreases its share count C1. Total payout model - ignores the firms choice between dividends and share repurchases - values all of the firms equity rather than a single share
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Master in Finance
Jlio Lobo

C1. Total payout model - values all of the firms equity rather than a single share - to compute the share price we have to divide the value by the number of shares outstanding - discount the total payouts that the firm makes to shareholders - dividends and share repurchases
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P0 =
PV (Future Total Dividends and Repurchases ) Shares Outstanding 0
C2. The Discounted Free Cash Flow Model - it is used to determine the total value of the firm to all investors - ignores the impact of the firms borrowing decisions on earnings - focuses on the cash flows to all the firms investors, both debt and equity holders
Enterprise Value = V 0 = PV (Future Free Cash Flow of Firm
Master in Finance
)
Jlio Lobo

Valuing stocks D. Valuation methods based on market multiples Price earnings ratio (PER)
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PER =
Market Value per Share Earnings per Share (EPS)
Stock price estimate = Industry PER * Expected earnings per share

There are other market multiples: - PBV = Price / Book Value per share - PCF = Price / Cash flow per share - PS = Price / Sales per share
Master in Finance
Jlio Lobo

Problems when valuing stocks 1) Errors in estimating growth rates - it is difficult to maintain high growth rates because of the increase in the competition - the price is very sensitive to the growth estimate 2) Errors in estimating risk - the variables of an equilibrium model have to be estimated - the CAPM has been empirically and theoretically challenged but the arbitrage theory is not a valid alternative yet
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Master in Finance
Jlio Lobo

3) Errors in estimating dividends - the dividend payout is difficult to estimate because it depends on the future investment opportunities and on the choices of the board of directors among other variables - the changing expectations concerning the growth of the economy may make necessary to review the initial estimates - the changes in prices in the short-term may result from the review of the estimates of the relevant variables 4) Limitations of multiples - firms are not identical - does not take into account the important differences among firms - It does not help us to determine if an entire industry is overvalued - ex. Internet boom of the late 1990s
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Jlio Lobo

Equity risk premium There are several concepts of equity risk premium: 1) historical equity premium - historical differential return of the stock market over treasuries 2) expected risk premium - expected differential return of the stock market over treasuries 3) required risk premium - incremental return of the market portfolio over the risk-free rate required by an investor in order to hold the market portfolio 4) implied risk premium - the required equity premium that arises from a pricing model and from assuming that the market price is correct The historical equity premium has been extraordinary high: about 4% per year in real terms (Siegel, 2008).
Master in Finance
138
Jlio Lobo

The observation of the historical equity risk premium suggests that: - the investors are risk-averse - the investors risk-aversion varies over time - tends to be higher in times of greater uncertainty - when stock prices enter an extended phase of upward (downward) movement, the historical risk premium will climb (drop) to reflect past returns - implied premiums will tend to move in the opposite direction since higher (lower) stock prices generally translate into lower (higher) returns The equity premium risk with such high values as observed is one of the main puzzles in finance: - the investors would have to be extremely risk averse to justify annual risk premium of around 4% (some authors find values around 6% per year).
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140
Source: Siegel (2008)
The equity risk premium: - the historical equity premium has been very high in the last 200 years - averaged 1.4%, 3.4% and 5.9%, respectively, in each of the subperiods - in the all period it averaged 4% (= 6.8% - 2.8%) in real terms - the abnormally high equity premium since 1926 is not sustainable - with such very low real returns on bonds, firms financed their capital investments at a low cost which increased returns to shareholders
Master in Finance
Jlio Lobo
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Source: Damodaran (2009)
Source: Wikipedia
The implied equity risk premium: - the implied equity risk premium computed from a bietapic asset pricing model - the equity premium understood as an indicator of risk aversion has remained positive and varying with time - the lower risk aversion coincided with the peak of the technology bubble in the end of 1999
Master in Finance
Jlio Lobo
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Source: Siegel (2008)
The high value of the historical US equity premium does not result from a selection bias or a survivorship bias problem - despite the major disasters that affected many of these countries, such as war, hyperinflation, and depressions, all 16 countries offered substantially positive, after-inflation stock returns - the US results are not a special case
Master in Finance
Jlio Lobo

Possible explanations for the equity risk premium puzzle: 1) Selection bias - equity risk premium in the US is exceptionally high because it is an atypical economy, unusually successful - in fact, in other markets the equity premium risk tends to be lower but, as we have seen, is still too high to be justified only by the stocks risk 2) Insurance against catastrophes - the observed risk of the shares in the past does not include the possibility of a very sharp drop in prices (the catastrophe) - an high equity premium risk reflects the possibility of such an event
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Master in Finance
Jlio Lobo

Possible explanations for the equity risk premium puzzle: 3) Tax reasons - the lowering of taxes on capital income could justify higher prices and, consequently, the high observed historical risk premiums - however, the observed variation on taxes is not sufficient to explain the puzzle 4) Preference for stable consumption and income - the share price tends to be procyclical: - the market rises in times of higher economic growth and falls in times of recession when it is also more likely to fall the labor income (unemployment) - if economic agents have a preference for stable income over time, they will require a higher risk premium for holding shares
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Master in Finance
Jlio Lobo

Possible explanations for the equity risk premium puzzle: 5) Myopic loss aversion - explanation from the field of behavioral finance - the investors are more sensitive to losses than to gains (loss aversion) and have difficulty in dealing with the consequences of longterm investments (financial myopia) - investors evaluate their portfolios over too short periods of time and become very sensitive to losses in these periods - therefore, they require a higher return for holding stocks than the ones predicted by the rational models to compensate them for these losses
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2. Financial Investments 2.1.

Money market instruments

Faculdade de Economia do Porto

2. Financial Investments 2.1. Money market instruments

Faculdade de Economia do Porto

2. Financial Investments 2.1. Money market instruments

Faculdade de Economia do Porto

2. Financial Investments 2.1. Money market instruments

Faculdade de Economia do Porto

2. Financial Investments 2.1. Money market instruments

Faculdade de Economia do Porto

2. Financial Investments 2.1. Money market instruments

Faculdade de Economia do Porto

2. Financial Investments 2.1. Money market instruments

Faculdade de Economia do Porto

2. Financial Investments 2.1. Money market instruments

Faculdade de Economia do Porto

2. Financial Investments 2.1. Money market instruments

Faculdade de Economia do Porto

2. Financial Investments 2.1. Money market instruments

Faculdade de Economia do Porto

2. Financial Investments 2.1. Money market instruments

Faculdade de Economia do Porto

2. Financial Investments 2.1. Money market instruments

87 market crash LTCM

Subprime mortgage crisis

Faculdade de Economia do Porto

2. Financial Investments 2.2. Bonds

Faculdade de Economia do Porto

2. Financial Investments 2.2. Bonds

Faculdade de Economia do Porto

2. Financial Investments 2.2. Bonds

Faculdade de Economia do Porto

2. Financial Investments 2.2. Bonds

Faculdade de Economia do Porto

2. Financial Investments 2.2. Bonds

Faculdade de Economia do Porto

2. Financial Investments 2.2. Bonds

Faculdade de Economia do Porto

2. Financial Investments 2.2. Bonds

Faculdade de Economia do Porto

2. Financial Investments 2.2. Bonds

Faculdade de Economia do Porto

2. Financial Investments 2.2. Bonds

Coupon Par Value + (1 + r )t (1 + r )T

with a constant coupon we have then

1 (1 + r )T 1 Bond Value = Coupon * + Par value * T r ( 1 + r)

Faculdade de Economia do Porto

2. Financial Investments 2.2. Bonds

1 = 1000 = Par value = Price + 1000 * (1 + 4% )60

Faculdade de Economia do Porto

2. Financial Investments 2.2. Bonds

2500 2000 1500 1000

500 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 Interest rate (%)

Faculdade de Economia do Porto

2. Financial Investments 2.2. Bonds

500 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 Interest rate (%)

Faculdade de Economia do Porto

2. Financial Investments 2.2. Bonds

Faculdade de Economia do Porto

2. Financial Investments 2.2. Bonds

1 (1 + r )60 1000 1276.76 = 40 * + 60 r (1 + r )

Faculdade de Economia do Porto