Chapter 2 Introduction

1
Chapter 2Introduction

• This chapter will provide an introduction to
  financial markets and common financial
  instruments.
• Financial markets are where suppliers of capital
  (investors) interact with buyers (firms).
• Often this is done through intermediaries such as
  brokers.

2
Why Do People Invest?

• Investing is not just something other people do.
• College education is an investment.
• Investing is more than just hoping to make some
  money.
• It involves deferring present consumption in the
  hopes of higher future consumption.

3
Equity Capital

• Types of equity capital
• Preferred stock
• Common stock
• This course focuses more on common stock.
• No guarantee of dividend
• One share, one vote
• Shareholders vote on key issues such as
  composition of board of directors, choice of
  auditing firm, and others.

4
Why Purchase Common Stock?

• A purchaser is looking for at least one of two
  possibilities
• 1. Stream of dividend payments (current income)
• 2. Increase in stock price (capital gain)
• Holding period return
• (sales price purchase price) dividends x 100
• purchase price

5
Holding Period Return Example

• You purchased a share of McDonalds stock one
  year ago for 18.00.
• You earn 2.00 in dividends during the year.
• Today you sell the stock for 18.50.
• What is your holding period return?
• ((18.50 18) 2) / 18.00 .1389 x 100
  13.89 (before taxes)

6
Bonds

• Debt Financing for a firm ?promise to repay over
  a period of time.
• Receive repayment over time
• Semi-annual interest payments
• At maturity, amount is repaid (principal)
• This is a series of cash flows that has value
• Priced on an index relative to 100
• If a 1,000 bond sells for 102, it sells for
  1,020

7
How to Interpret Bond Information

• Bond Curr. Yld Vol Close Net Chg
• Hilton 71/4 04 7.2 40 101 1/2
• The Hilton bond pays 7.25 interest and matures
  in 2004.
• The annual interest divided by the current price
  is 7.2 percent. (Note this is not the return you
  will receive if you hold the bond till maturity.)
• 40,000 bonds were traded that day.
• The bond closed at 1,010 which is .50 higher
  than the previous day.

8
Capital Markets

• Represents a diverse group of investments
• Stock market
• Bond market
• Mortgage market
• Futures market

9
Stock Market

• New York Stock Exchange (NYSE)
• Founded in 1792
• Physical location on Wall Street in New York
• Approximately 2,800 companies offering securities
  here
• Membership offered in the form of seats

10
Stock Market

• Nasdaq
• National Association of Securities Dealers and
  Automated Quotations
• Not a physical location like the NYSE (over the
  counter)
• Represents a network of securities dealers
• Fastest growing securities market
• Makes use of market makershelp ensure
  liquidity of trading

11
Bond Market

• Corporate bonds can be traded through the NYSE
• Most bonds are traded over the counter
• Bond ratings
• The lower the letter, the greater the quality
• Quality refers to the risk of default
• Companies rating bonds
• Standard and Poors
• Moodys

12
Important Features of Bonds

• How are bond prices and interest rates related?
• As interest rates rise, bond prices fall.
• Some bonds are callable.
• Company can repurchase bonds at a certain price
  during a certain time.

13
Money Market

• Market for short-term debt instruments
• Certificates of Deposit ? issued by commercial
  banks)
• Commercial paper ? issued by large quality firms
  for up to 9 months
• Investors loan to large companies for a very
  short period of time (9 months or less).
• Treasury Bills
• Loans to the U.S. Treasury
• Zero-Coupon bonds
• Issued at a discountno interest payments

14
Mortgage Market

• Pooling of home mortgages by government agencies
• FNMA (Federal National Mortgage Association) and
  GNMA (Government National Mortgage Association)
  are two examples.
• Mortgages are packaged and resold as securities
  to investors.
• Investors are often large institutional investors
  like pension funds.

15
Raising Capital

• Primary market
• Initial Public Offering (IPO)
• Common stock is sold to underwriter (investment
  banker)
• Investment banker sells to clients
• Secondary market
• Investor to investor (through intermediaries)
  where most trading occurs

16
Features of Stock Trading

• Bid vs. Ask
• Bid is the price you will pay to own a share
• Ask is the price you would receive to sell your
  share
• Difference goes to broker
• Average NYSE trade takes 22 seconds
• Significant reliance upon computers
• Trading halt in June 2001

17
Hedging Risk

• We can add value by decreasing the risk
  (variability) of cash flows.
• The concept of insurance as hedging
• You buy insurance and if nothing happens to your
  house, you still have the house.
• If your house is damaged, insurance pays for it
  and the house is rebuilt.
• Health insurance, car insurance etc
• Is it a sophisticated, legal form of betting..?

18
Forward and Futures Contracts

• Spot price price paid for a commodity today
• Changes in commodity prices are always present,
  which are risks to buyer and seller
• Example Orange juice grower (seller) and
  restaurant owner (buyer)
• Prices help growers determine what and how much
  to produce and restaurants need to establish menu
  price
• Airline Fuel?

19
Forward Contracts

• An agreement to sell an asset at a fixed price
  for delivery in the future.
• Cash payment is not required until delivery.
• However, each party must trust the other to
  perform.
• The unique nature of each contract makes them
  difficult to sell to third parties.

20
Futures Contracts

• Similar to forward contracts, except
• Terms of contract are standardized, such as
  amounts and delivery dates.
• Clearinghouse acts as go-between to help ensure
  performance.
• Contracts are traded on the Chicago Board of
  Trade or Chicago Mercantile Exchange.
• Most contracts are never delivered ( only 5
  delivered).
• Parties take opposite positions to offset
  original position.

21
Foreign Exchange

• As international trade barriers are removed, more
  business is conducted away from home country.
• Nearly 65 of McDonalds 2002 revenues originated
  from outside the U.S.
• U.S. companies must report financial operations
  in U.S. currency.

22
Foreign Exchange Example

• You operate a hotel in France and accept the
  Euro.
• When the Euro strengthens, this means it takes
  fewer Euros to buy 1 worth of goods.
• As the Euro strengthens, your profits increase
  upon conversion.
• 100,000Euros x 1/1Euro 100,000
• 100,000Euros x 2/1Euro 200,000

23
Can we hedge this FOREX risk?

• Similar to commodities, we want to lock in a
  price for our Eurosan exchange rate at a
  future date.
• We can buy a forward or futures contract to
  accomplish this.
• Who would be on the other side of this
  transaction?
• A French company (or other company accepting the
  Euro) operating in the U.S.

24
Lenders to the Hospitality Industry

• Commercial banks
• Traditionally the largest lender (source of your
  money)
• Bank makes a spreaddifference between interest
  rate on loans and funding costs (ex rate on
  deposits, US prime rate, LIBOR)
• Interest principal x rate x time
• Types of loans
• Fully amortized (principal and interest)
• Interest only

25
Lenders to the Hospitality Industry

• Real Estate Investment Trusts (REITS)
• There are equity and mortgage REITS
• Special tax treatment if they pass through at
  least 95 percent of earnings to investors
• Insurance companies and pension funds
• Receive large monthly cash flows from premiums
  and contributions
• Try to match assets (loans) to liabilities
  (policies and pension needs)

26
Measures of Stock Market Performance

• Dow Jones Industrial Average
• Index of 30 large companies
• Weighted by stock price
• Standard and Poors 500 (SP 500)
• 500 companies
• Fairly common measure of overall stock market
  performance
• Movement is similar to the Dow

27
Some Stock Market Statistics

• Meanweighted average
• Mean Dow annual return (19502001) 9.01
• Mean SP 500 annual return 9.63
• Returns in a single year have varied from 30 to
  44
• This uncertainty around the mean is called
  variance
• Another measure is standard deviation, which is
  the square root of the variance

28
Some Stock Market Statistics

• Can we measure the relationship between two
  individual stocks, two stock indices, or an
  individual stock and a stock index?
• Correlation coefficient ? (rho)
• Range is from 1.0 to 1.0
• 1.0 is perfect positive correlation
• -1.0 is perfect negative correlation
• The Dow and the SP 500 are highly positively
  correlated