Principles of Managerial Finance 9th Edition

1
Principles of Managerial Finance9th Edition

• Chapter 2

Institutions, Securities, Markets and Rates
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Learning Objectives

• Understand the relationship between financial
  institutions and markets, and the role of the
  money market.
• Describe the key characteristics and types of
  corporate bonds.
• Differentiate between debt and equity capital.
• Discuss the rights, characteristics, and features
  of both common and preferred stock.

3
Learning Objectives

• Review the operation of the capital market,
  particularly the securities exchanges and the
  role of the investment banker.
• Describe the interest rate fundamentals and the
  basic relationship between risk and rates of
  return.

4
Financial Institutions Markets

• Firms that require funds from external sources
  can obtain them in three ways
• through a bank or other financial institution
• through financial markets
• through private placements
• This chapter will focus on financial institutions
  and markets

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Financial Institutions Markets
Financial Institutions

• Financial institutions are intermediaries that
  channel the savings of individuals, businesses,
  and governments into loans or investments.
• The key suppliers and demanders of funds are
  individuals, businesses, and governments.
• In general, individuals are net suppliers of
  funds, while businesses and governments are net
  demanders of funds.

6
Financial Intermediaries in the U.S.
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The Changing Role of Financial Institutions
DIDMCA

• A revolution in the financial services industry
  began with the passage of the Depository
  Institutions Deregulation and Monetary Control
  Act of 1980.
• This legislation was crafted and passed as a
  result of the tumultuous conditions in the
  financial markets during the late 1970s which
  resulted in rapid disintermediation.

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The Changing Role of Financial Institutions
DIDMCA

• DIDMCA (1980) actually consisted of two parts
  Depository Institutions Deregulation and Monetary
  Control.
• DID was designed to do a number of things
• curtail regulation Q (interest rate ceilings)
• increase various sources of funding available to
  banks
• expand the scope and activity of SLs by allowing
  them to invest in other than home mortgages

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The Changing Role of Financial Institutions
DIDMCA

• The monetary control (MC) portion of DIDMCA was
  designed to extend the Feds control to thrifts
  and nonmember banks by extending reserve
  requirements and other controls to them.
• This permitted both greater competition for
  deposits and more flexibility in terms of the
  types of investments various institutions could
  make.

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Financial Markets

• Financial markets provide a forum in which
  suppliers of funds and demanders of funds can
  transact business directly.
• The two key financial markets are the money
  market and the capital market.
• Transactions in short term marketable securities
  take place in the money market while transactions
  in long-term securities take place in the capital
  market.

11
Financial Markets

• Whether subsequently traded in the money or
  capital market, securities are first issued
  through the primary market.
• The primary market is the only one in which a
  corporation or government is directly involved in
  and receives the proceeds from the transaction.
• Once issued, securities then trade on the
  secondary markets such as the New York Stock
  Exchange or NASDAQ.

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Financial Markets
13
Claims to Wealth

• While real assets include the direct ownership
  of tangible assets such as land or buildings,
  financial assets represent claims against the
  income and assets of those who issued the
  claims.
• Types of financial assets include stocks, bonds,
  and bank deposits.
• Some financial assets, such as stocks and bonds,
  can be traded in the secondary markets while
  others, such as bank deposits, cannot.

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The Relationship between Financial Institutions
and Financial Markets
Indirect finance
Direct finance
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The Money Market

• The money market exists as a result of the
  interaction between the suppliers and demanders
  of short-term funds (those having a maturity of a
  year or less).
• Most money market transactions are made in
  marketable securities which are short-term debt
  instruments such as T-bills and commercial paper.
• Money market transactions can be executed
  directly or through an intermediary.

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Money market instrument

• Treasury bill
• Bankers acceptance
• Negotiable certificate of deposit
• Commercial paper
• Federal funds

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The Money Market

• The international equivalent of the domestic
  (U.S.) money market is the Eurocurrency market.
• The Eurocurrency market is a market for
  short-term bank deposits denominated in U.S.
  dollars or other marketable currencies.
• The Eurocurrency market has grown rapidly mainly
  because it is unregulated and because it meets
  the needs of international borrowers and lenders.

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Corporate Bonds

• Bonds are long-term debt instruments issued by
  corporations.
• Corporate bonds typically pay interest
  semiannually, pay fixed coupon interest, have a
  par or face value of 1,000 and have an original
  maturity of 10 to 30 years.
• Furthermore, they have a prior claim on the
  firms assets (in from of stockholders) but do
  not represent ownership in the firm.

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Corporate Bonds
Legal Aspects

• The bond indenture specifies the conditions
  under which it has been issued.
• It outlines both the rights of bondholders and
  duties of the issuing corporation.
• It also specifies the timing of interest and
  principal payments, any restrictive covenants,
  and sinking fund requirements.

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Corporate Bonds
Legal Aspects

• Common standard debt provisions in the
  indenture typically include
• the maintenance of satisfactory accounting
  records
• periodically furnishing audited financial
  statements
• the payment of taxes and other liabilities when
  due
• the maintenance of all facilities in good working
  order
• identification of any collateral pledged against
  the bond

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Corporate Bonds
Legal Aspects

• Common restrictive provisions (or covenants) in
  the indenture typically include
• the maintenance of a minimum level of liquidity
• prohibiting the sale of accounts receivable
• the imposition of certain fixed asset investments
• constraints on subsequent borrowing
• limits on annual cash dividend payments

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Corporate Bonds
Legal Aspects

• An additional restrictive provision often
  included in the indenture is a sinking fund
  requirement, which specifies the manner in
  which a bond is systematically retired prior to
  maturity.
• Sinking funds typically dictate that the firm
  make semi- annual or annual payments to a trustee
  who then purchases the bonds in the market.

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Corporate Bonds
Cost of Bonds

• In general, the longer the bonds maturity, the
  higher the interest rate (or cost) to the firm.
• In addition, the larger the size of the
  offering, the lower will be the cost (in
  terms) of the bond.
• Finally, the greater the risk of the issuing
  firm, the higher the cost of the issue.

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Corporate Bonds
General Features

• The conversion feature of convertible bonds
  allows bondholders to exchange their bonds for a
  specified number of shares of common stock.
• Bondholders will exercise this option only when
  the market price of the stock is greater than
  the conversion price.
• A call feature (callable bond), which is
  included in most corporate issues, gives the
  issuer the opportunity to repurchase the bond
  prior to maturity at the call price.

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Corporate Bonds
General Features

• In general, the call premium is equal to one
  year of coupon interest and compensates the
  holder for having it called prior to maturity.
• Furthermore, issuers will exercise the call
  feature when interest rates fall and the issuer
  can refund the issue at a lower cost.
• Issuers typically must pay a higher rate to
  investors for the call feature compared to
  issues without the feature.

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Corporate Bonds
General Features

• Bonds also are occasionally issued with stock
  purchase warrants attached to them to make them
  more attractive to investors.
• Warrants give the bondholder the right to
  purchase a certain number of shares of the same
  firms common stock at a specified price during
  a specified period of time.
• Including warrants typically allow the firm to
  raise debt capital at a lower cost than would be
  possible in their absence.

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Variety of Corporate Debt
Secured Bond
Mortgage Bonds

• Mortgage bonds are backed by real estate and/or
  the physical assets of the corporation.
• The real assets pledged will have a market value
  greater than the bond issue.
• If the company defaults on the bonds, the real
  assets are sold off to pay off the mortgage bond
  holders.

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Variety of Corporate Debt
Equipment Trust Certificates
Secured Bond

• Equipment trust certificates are very similar to
  automobile loans.
• When you borrow money for your new car, you make
  a down payment. Then you make your monthly
  installment payments.
• At no time throughout the life of the loan is
  your car worth less than the outstanding amount
  of the loan.

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Variety of Corporate Debt
Equipment Trust Certificates
Secured Bond

• Many railroad and transportation companies use
  equipment trust certificates to meet their
  financing needs. airline trustee
  investor
• Usually, 20 of the purchase price is put down by
  the company in the form of a down payment. Then
  the balance is paid off over 15 years.

lease
fund
ETC
Serial payment
fund
buy
Airplane manufacturer
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Variety of Corporate Debt
Equipment Trust Certificates

• When the company is finished paying off the loan,
  it receives clear title from the trustee.
• If the company defaults on its loan, the
  equipment is sold off and the bond holders are
  paid off.

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Variety of Corporate Debt
Equipment Trust Certificates

• Equipment Trust Certificates are serial bonds.
• That is, each time a payment is made, a portion
  of that payment is interest and a portion of that
  payment is principal.
• In this way, as previously stated, the loan
  amount never exceeds the collateral value.

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Variety of Corporate Debt
Debentures
Unsecured Bond

• Debentures are unsecured promissory notes that
  are supported by the general creditworthiness of
  the issuing company.
• Because no assets are pledged, these bonds are
  riskier than collateralized bonds.
• As a result, they are often referred to as
  subordinate debt and carry higher interest rates
  and/or other features to make them more desirable
  to investors.

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Variety of Corporate Debt
Unsecured Bond
Income Bonds

• Income bonds will only pay interest if income is
  earned by the issuing company and only to the
  extent that income is earned.
• Income bonds are the only bonds issued where
  failure to pay the interest in a timely fashion
  does not lead to immediate default.
• As a result, income bonds are considered to be
  extremely risky.

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Variety of Corporate Debt
Income Bonds

• In general, income bonds are issued by a company
  in bankruptcy.
• The company facing bankruptcy will meet with its
  creditors (usually bond holders) and agree to
  issue new income bonds in exchange for the old
  bonds.
• Because failure to pay interest would land the
  company back into bankruptcy court, the creditors
  agree that interest will only be paid to the
  extent earned.

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Variety of Corporate Debt
Convertible Bonds

• Convertible bonds are one type of hybrid
  security.
• They are like bonds in that they pay a fixed rate
  of interest and have a maturity date.
• They are also like stock because they give the
  investor an option to convert the bond into a
  specified number of shares of stock.
• The market price of a convertible bond therefore
  depends both on the firms stock price and
  prevailing interest rates.

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Variety of Corporate Debt
Variable Interest Rate Bonds (floating-rate bonds)

• Variable interest rate bonds are bonds with
  coupon rates that vary with changes in short-term
  interest rates (like adjustable rate mortgages).
• Usually, the interest rate is pegged to another
  rate such as U.S. Treasury bills.
• In general, the market price of a variable rate
  bond will be less volatile.
• On most bonds, an increase in interest rates will
  result in a decrease in market price.

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Variety of Corporate Debt
Discount and Zero Coupon Bonds

• A zero coupon bond pays no coupon interest from
  year to year the way most bonds do.
• Investors earn their returns by purchasing the
  bonds at deep discounts from the bonds face
  value, and then receiving the full face value at
  maturity.
• Since the return on a zero depends strictly on
  the issuing firms ability to pay the face value
  at maturity, only the most creditworthy firms are
  able to issue them.

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Variety of Corporate Debt
High-Yield (Junk) Bonds

• High-yield bonds are not a different type of bond
  -- simply a bond of lower quality.
• Bonds rated BB (SP) or Ba (Moodys) or lower are
  considered to be junk.
• Junk bonds are usually debentures and are
  subordinated to the firms other debt.
• In general, junk bonds pay around 3 to 4 percent
  higher yields to investors than higher-grade
  bonds.

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Variety of Corporate Debt
Extendible Notes

• Extendible Notes Short-tern ( 1-5 years) note
  renewable at the option of holders in the new
  market rate.

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Variety of Corporate Debt
Putable Bonds

• Putable bond bonds redeemable at par value at
  the option of holder ??????????,??????????????????
  ???

41
Retiring Debt
Serial-Bonds

• A serial bond is simply one in which some of the
  bonds in the issue mature or are retired each
  year rather than all at once.
• Serial bonds are usually used by companies to
  finance costly equipment, or by municipalities to
  finance capital improvements.
• Also, the assets financed are usually used as
  collateral to secure the bonds.

42
Retiring Debt
Sinking Funds

• A sinking fund is simply a series of periodic
  payments to retire part of a debt issue.
• In most cases, the periodic payments plus the
  interest earned on those deposits retire the debt
  at maturity.
• In some cases, the firm sets aside funds and
  randomly selects bonds to be called.
• Strong sinking funds set aside a large amount to
  be retired (say 10 per year).

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Retiring Debt
Sinking Funds

• Weak sinking funds will leave most of the issue
  outstanding until maturity.
• This is sometimes referred to as a balloon
  payment.
• Bonds with strong sinking funds are generally
  considered to be less risky than those with weak
  sinking funds.

44
Retiring Debt
Repurchasing Debt

• Firms that have outstanding bonds which have
  substantially declined in price and are selling
  at a discount are sometimes repurchased by the
  issuer in the open market.
• Thus, a firm with bonds selling at 500 with a
  face value of 1000 can cut their financing costs
  in half.
• However, this decision must be weighed against
  any alternative uses for the cash used to execute
  the repurchase. also the subsequent financing
  needs.

When interest rate
45
Retiring Debt
Eurobond Foreign bond
Callable Bonds

• A call feature gives the issuer the right (or
  option) to retire a debt issue prior to maturity.
• Issuers tend to call bonds that were issued
  during a period of high interest rates because it
  gives them the opportunity to refund the debt at
  a lower rate.
• To protect investors, callable bonds usually
  require the issuer to pay a call premium which
  amounts to one year of extra interest expense
  (but usually declines over time).
• putable bond holders have the option to redeem
  it at par at every 1 to 5 years or when firms
  liquidate, MA,

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Bond Risk
Sources of Risk

• Default Risk
• Risk that the interest will not be paid
• Risk that the principal will not be paid
• Risk that the price of the bond will decline due
  to poor company prospects
• Inflation Risk
• Call Risk
• Interest Rate Risk.

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Corporate Bonds
Bond Ratings
Junk bond
48
The Nature of Equity Capital
Contrasting Debt Equity
49
The Nature of Equity Capital
Voice in Management

• Unlike bondholders and other credit holders,
  holders of equity capital are owners of the firm.
• Common equity holders have voting rights that
  permit them to elect the firms board of
  directors and to vote on special issues.
• Bondholders and preferred stockholders receive no
  such privileges.

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The Nature of Equity Capital
Claims on Income Assets

• Equity holders are have a residual claim on the
  firms income and assets.
• Their claims can not be paid until the claims of
  all creditors, including both interest and
  principle payments on debt have been satisfied.
• Because equity holders are the last to receive
  distributions, they expect greater returns to
  compensate them for the additional risk they bear.

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The Nature of Equity Capital
Maturity

• Unlike debt, equity capital is a permanent form
  of financing.
• Equity has no maturity date and never has to be
  repaid by the firm.

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The Nature of Equity Capital
Tax Treatment

• While interest paid to bondholders is
  tax-deductible to the firm, dividends paid to
  preferred and common stock holders is not.
• In effect, this lowers the cost of debt relative
  to the cost of equity as a source of financing to
  the firm.

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Common Stock
Stockholder Rights
Voting Rights
Nonvoting common stock Super-voting common stock
In general, voting rights are relatively
meaningless since share ownership is very widely
dispersed among a large number of individual
shareholders. As a result, directors and top
management are relatively well-insulated.
This has begun to diminish to some extent in
recent years due to the rapid expansion of large
institutional investors such as mutual funds and
insurance companies.
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Common Stock
Stockholder Rights

• Voting Rights
• traditional voting

Under traditional voting, each share owned gives
the shareholder the right to vote for one
individual for each seat on the board of
directors.
Under this system, if the majority of
shareholders vote as a block, the minority could
never elect a director.
55
Common Stock
Stockholder Rights

• Voting Rights
• traditional voting
• cumulative voting

This system empowers minority stockholders by
permitting each stockholder to cast all of his or
her votes for one candidate for the firms board
of directors.
56
Common Stock
Stockholder Rights

• Voting Rights
• traditional voting
• cumulative voting
• Example

Under traditional voting, a shareholder with 100
shares can vote 100 shares for each of 5 members
of the board of directors.
Under cumulative voting, a shareholder with 100
shares can vote 500 shares for just one member
running for the board of directors.
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Common Stock
Stockholder Rights

• Voting Rights
• Preemptive Rights

A preemptive right gives a shareholder the right
to maintain his or her proportionate share of the
company by requiring that all new shares issued
must be done so through a rights offering.
Under a rights offering, a shareholder who owns
10 of the shares outstanding has the right to
purchase 10 of any additional shares issued.
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• Rights offering the firm gives existing
  shareholders a right to purchase additional
  shares at pro rata basis at price lower than the
  market

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Common Stock
Stockholder Rights

• Ownership
• Outstanding shares issued shares-treasury shares
• Additional shares that can be issued in the
  future authorized shares outstanding shares

Privately owned Closely owned Publicly owned
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Common Stock
Stockholder Rights

• Voting Rights
• Preemptive Rights
• Proxies

Proxies are frequently used in the voting process
since many smaller stockholders do not attend the
annual meeting. Shareholders must sign a proxy
statement giving their votes to another party who
will then vote their shares.
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Common Stock
Dividends

• Payment of dividends is at the discretion of the
  Board of Directors.
• Dividends may be made in cash, additional shares
  of stock, and even merchandise.
• Stockholders are residual claimants -- they
  receive dividend payments only after all claims
  have been settled with the government, creditors,
  and preferred stockholders.

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Common Stock
International Stock Issues

• The international market for common stock is not
  as large as that for international debt.
• However, cross-border trading and issuance of
  stock has increased dramatically during the past
  20 years.
• Much of this increase has been driven by the
  desire of investors to diversify their portfolios
  internationally.

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Common Stock
International Stock Issues
Stock Issued in Foreign Markets

• A growing number of firms are beginning to list
  their stocks on foreign markets.
• Issuing stock internationally both broadens the
  companys ownership base and helps it to
  integrate itself in the local business scene.

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Common Stock
International Stock Issues
Foreign Stocks in U.S. Markets

• Only the largest foreign firms choose to list
  their stocks in the U.S. because of the rigid
  reporting requirements of the U.S. markets.
• Most foreign firms instead choose to tap the U.S.
  markets using ADRs -- claims issued by U.S. banks
  representing ownership shares of foreign stock
  trading in U.S. markets.

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Preferred Stock

• Preferred stock is an equity instrument that
  usually pays a fixed dividend and has a prior
  claim on the firms earnings and assets in case
  of liquidation.
• The dividend is expressed as either a dollar
  amount or as a percentage of its par value.
• Therefore, unlike common stock a preferred
  stocks par value may have real significance.
• If a firm fails to pay a preferred stock
  dividend, the dividend is said to be in arrears.

no par value
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Preferred Stock

• In general, and arrearage must be paid before
  common stockholders receive a dividend.
• Preferred stocks which possess this
  characteristic are called cumulative preferred
  stocks. v.s. non-cumulative P.S.
• Preferred stocks are also often referred to as
  hybrid securities because they possess the
  characteristics of both common stocks and bonds.
• Preferred stocks are like common stocks because
  they are perpetual securities with no maturity
  date.

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Preferred Stock
Convertible Restrictive covenant

• Preferred stocks are like bonds because they are
  fixed income securities. Dividends never change.
• Because preferred stocks are perpetual, many have
  call features which give the issuing firm the
  option to retire them should the need or
  advantage arise.
• In addition, some preferred stocks have mandatory
  sinking funds which allow the firm to retire the
  issue over time.
• Finally, participating preferred stock allows
  preferred stockholders to participate with common
  stockholders in the receipt of dividends beyond a
  specified amount.

68
Preferred Stocks Bonds Contrasted

• Preferred stocks are riskier than bonds from the
  investor perspective because
• Bond terms are legal obligations
• The investor cannot expect the firm to redeem
  preferred stock for a preset face value. It must
  be sold in the market at an uncertain price.
• Preferred stock prices are therefore more
  variable and thus riskier than bond prices.

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Disadvantages of Preferred Stock

• Preferred stock offers no protection from
  inflation.
• Preferred stock tends to be less marketable than
  either bonds or common stock resulting in a large
  bid-ask spread.
• Inferior position to bondholders.
• Yields are insufficient for most (non-corporate)
  investors to justify risk.

70
Securities Exchanges

• role
• Financing
• Investment
• Efficient market
• Price discovery
• Liquidity

P
S
D
Q
71
Securities Exchanges
Organized Exchanges

• Organized securities exchanges are tangible
  secondary markets where outstanding securities
  are bought and sold.
• They account for over 60 of the dollar volume
  of domestic shares traded.
• Only the largest and most profitable companies
  meet the requirements necessary to be listed on
  the New York Stock Exchange.

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Securities Exchanges
Organized Exchanges

• Only those that own a seat on the exchange can
  make transactions on the floor (there are
  currently 1,366 seats).
• Trading is conducted through an auction process
  where
• specialists make a market in selected
  securities.
• As compensation for executing orders,
  specialists make
• money on the spread (ask price - bid price).
• Bid price dealers highest purchasing price
• Ask price dealers lowest selling price

73
Securities Exchanges
Organized Exchanges
Requirements NYSE AMEX shares held by
public 1,100,000
400,000 stockholders with 100 shares
2,000 1,200 pretax income
(latest year)
2,500,000 750,000 pretax income
(prior 2 years)
2,000,000 N/A MV of public shares
held 18,000,000
300,000 tangible assets
16,000,000 4,000,000
74
Securities Exchanges
Over-the-Counter Exchange

• The over-the-counter (OTC) market is an
  intangible market for securities transactions.
• The OTC is a computer-based market where dealers
  make a market in selected securities and are
  linked to buyers and sellers through the NASDAQ
  System.
• Dealers also make money on the spread.

75
Securities Price Quotations
Bond Quotations
76
Securities Price Quotations
Stock Quotations
77
Functions of Investment Bankers
Underwriting, Private Placement Best Efforts
not in the text book

• Corporations typically raise debt and equity
  capital using the services of investment bankers
  through public offerings.
• When underwriting a security issue, an
  investment bankers guarantees the issuer will
  receive a specified amount of money from the
  issue.
• The investment banker purchases the securities
  from the firm at a lower price than the planned
  resale price.

78
Functions of Investment Bankers
Underwriting, Private Placement Best Efforts

• When underwriting an issue, the investment
  banker bears the risk of price changes between
  the time of purchase and the time of resale.
• With a private placement, the investment banker
  arranges for the direct sale of the issue to
  one or more individuals or firms and receives a
  commission for acting as the intermediary in the
  transaction.
• When a firm issues securities on a best efforts
  basis, compensation is based on the number of
  securities sold.

79
Functions of Investment Bankers
Advising

• Underwriters also act as advisors and
  consultants for corporations.
• They can assist firms in planning both the
  timing of an issue and the amount and features
  of an issue.
• They also can assist in evaluating mergers and
  acquisitions.

80
Other Aspects of Investment Banking
Selecting an Investment Banker

• An investment banker may be selected through
  competitive bidding, where the banker or group
  of bankers that bids the highest price for an
  issue is chosen for the underwriting.
• With a negotiated offering, the investment
  banker is merely hired rather than awarded the
  issue through a competitive bid.

81
Other Aspects of Investment Banking
Syndicating the Underwriting

• Underwriting syndicates are typically formed
  when companies bring large issues to the market.
• Each investment banker in the syndicate normally
  underwrites a portion of the issue in order to
  reduce the risk of loss for any single firm and
  insure wider distribution of shares.
• The syndicate does so by creating a selling
  group which distributes the shares to the
  investing public.

82
Other Aspects of Investment Banking
Registration Requirements

• Before a new security can be issued, the firm
  must file a registration statement with the SEC
  at least 20 days before approval is granted.
• One part of the registration statement called
  the prospectus details the firms operating and
  financial position.
• However, a prospectus may be distributed to
  potential investors during the approval period
  as long as a red herring is printed on the front
  cover.

83
Other Aspects of Investment Banking
Registration Requirements

• As an alternative to filing cumbersome
  registration statements, firms with more than
  150 million in outstanding stock can use a
  procedure called shelf registration.
• This allows the firm to file a single document
  that covers all issues during the subsequent 2
  year period.
• As a result, the approved securities are kept
  on the shelf until the need for or market
  conditions are appropriate for issue.

84
Other Aspects of Investment Banking
Pricing Distributing an Issue

• In general, underwriters wait until the end of
  the registration period to price securities to
  ensure marketability.
• If the issue is fully sold, it is considered an
  oversubscribed issue if not fully sold, it
  is considered undersubscribed.
• In order to stabilize the issue at the initial
  offering price as it is being offered for sale,
  investment bankers often place orders to
  purchase the security themselves.

85
Other Aspects of Investment Banking
Cost of Investment Banking Services

• Investment bankers earn their income by
  profiting on the spread.
• The spread is difference between the price paid
  for the securities by the investment banker and
  the eventual selling price in the marketplace.
• In general, costs for underwriting equity is
  highest, followed by preferred stock, and then
  bonds.
• In percentage terms, costs can be as high as 17
  for small stock offerings to as low as 1.6 for
  large bond issues.

86
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87
Other Aspects of Investment Banking
Private Placements

• Although diminishing in frequency, firms can
  also negotiate private placements rather than
  public offerings.
• Private placements can reduce administrative and
  issuance costs for firms since registration and
  approval from the SEC is not required.
• However, they do pose problems for purchasers
  since the securities cannot not be resold via
  secondary markets.

88
Risk Structure of Interest Rates
k1nominal interest rate kreal interest
rate IPexpected inflation RP1risk
premium k1kIPRP1 kIPrfrisk-free
rate
Default risk premium Liquidity risk premium Tax
risk premium Interest rate risk
premium Contractual provisions
Interest rate risk Price risk Reinvestment
risk Price risk if maturity Price risk
if coupon interest rate Price risk
if market rate
89
Interest Rates Required Returns
Term Structure of Interest Rates

• The term structure of interest rates relates the
  interest rate to the time to maturity for
  securities with a common default risk profile.
• Typically, treasury securities are used to
  construct yield curves since all have zero risk
  of default.
• However, yield curves could also be constructed
  with AAA or BBB corporate bonds or other types
  of similar risk securities.

90
Interest Rates Required Returns
Term Structure of Interest Rates
Impact of Inflation
91
Interest Rates Required Returns
Term Structure of Interest Rates
Yield Curves
92
Theories of Term Structure
Expectations Hypothesis

• This theory suggest that the shape of the yield
  curve reflects investors expectations about the
  future direction of inflation and interest
  rates.
• Therefore, an upward-sloping yield curve
  reflects expectations of higher future
  inflation and interest rates.
• In general, the very strong relationship between
  inflation and interest rates supports this
  theory.

93
Theories of Term Structure
Liquidity Preference Theory

• This theory contends that long term interest
  rates tend to be higher than short term rates
  for two reasons
• long-term securities are perceived to be riskier
  than short-term securities
• borrowers are generally willing to pay more for
  long-term funds because they can lock in at a
  rate for a longer period of time and avoid the
  need to roll over the debt.

94
Theories of Term Structure
Market Segmentation Theory

• This theory suggests that the market for debt at
  any point in time is segmented on the basis of
  maturity.
• As a result, the shape of the yield curve will
  depend on the supply and demand for a given
  maturity at a given point in time.

95
Risk Premiums
Issue Issuer Characteristics

• Default Risk
• Interest rate Risk
• Liquidity Risk
• Contractual Provisions
• Tax Risk

return
Risk and return
risk