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Ch1 Finance is how $ is raised and used - affects businesses, government and individuals THREE areas: investment, financial management, financial markets and institutions Sole trader - 1 owner, unlimited liability Partnership - 2 or more owners, unlimited liability Company - limited liability Owners usually choose one best suited to them: important considerations are: - size - taxation - legal liability - ability to raise cash for finance Business life cycle: start, operate, expand •Asset value is determined by the future cash flows. •When determining the value of a company’s shares, the below should be considered: 1.the size of the expected cash flows 2.the timing of the cash flows 3.the riskiness of the cash flows.

Agency relationship - an agent acting on behalf of stockholder/principal interests •Stockholders (principals) hire managers (agents) to run the company Agency problem: can be a conflict between the interests of principal and agent (different/goals) this can result in agents not appropriately representing the best interests of principals. Business goal should be to maximise the value of shares Managers’ decisions affect the share price in many ways as the value of the share is determined by the future cash flows the company can generate. Managers can affect the cash flows by, for example, selecting what products or services to produce, what type of assets to purchase, or what advertising campaign to undertake. What affects share price: the company, the economy, economic shocks, the business environment, expected cash flows, and current market conditions.

● Agency costs: internal company expenses incurred due to the misalignment of interest between principals and agents ●

Direct costs: ○ Costs related to monitoring and assessing manager’s actions

● Indirect costs:

○ Costs related to increasing manager’s personal utility and corporate expenditure How to mitigate agency problems? ● Managerial compensation: offering incentives to align agent and principal’s interests. ● Corporate control: the threat of a takeover of control, resulting in better management. Three financial decisions managers are most concerned with: Capital budgeting - Identifying the productive assets the company should buy. Financing - Determining how the company should finance or pay for assets. Working capital - day-to-day management of a company’s current assets and liabilities to make sure that there is enough cash to cover operating expenses and there is spare cash to earn interest. The financial manager has to make decisions about the inventory levels or terms of collecting payments (receivables) from customers.

Capital structure: shows how a company is financed; it is the mix of debt and equity on the liability side of the balance sheet. It is important as it affects the risk and the value of the company. In general, companies with higher debt-to-equity proportions are riskier because debt comes with legal obligations to pay periodic payments to creditors and to repay the principal at

the end.

Ch2 Long term short term markets capital etc Two ways to transfer funds in an economy: Funds can flow directly through financial markets or indirectly through intermediation markets where funds flow through financial institutions first. •Suppose you own a security that you know can be easily sold in the secondary market, but the security will sell at a lower price than you paid for it. What would this mean for the security’s marketability and liquidity? As the price of the security is lower than that you paid for it, it has a lower degree of liquidity to you, the owner. That is because the security cannot now be sold without a loss in value to the owner. Marketability refers to the ease to which a security can be sold or converted to cash. The information in the problem does mention a drastically lower price and so we must conclude that the security’s marketability in not affected. Identify whether the following transactions are primary market or secondary market transactions. a. Jim Hendry bought 300 shares of AGL Energy through his share broker. SECONDARY b. Candy How bought $5,000 of AGL Energy bonds from the company. SECONDARY c. Hathaway Insurance Company bought 500,000 shares of AGL Energy when the company issued shares. PRIMARY Investment banking: Cranbourne Ltd is issuing 10,000 bonds, and its investment banker has guaranteed a price of $985 per bond. The investment banker sells the entire issue to investors for $10,150,000. a. What is the underwriting spread for this issue? b. What is the percentage underwriting cost? c. How much did Cranbourne raise? a. $300,000 ($10,150,000 – $985 x 10,000) b. 3.05 per cent ($30/$985) c. $9,850,000 ($985 x 10,000)

•What is the main difference between money markets and capital markets? Money markets are markets in which short-term debt instruments with maturities of less than one year are bought and sold. Capital markets are markets in which equity securities and debt instruments with maturities of more than one year are sold. •Why is it important to the broader economy to have an efficient and effective financial system? A well-developed financial system is critical for the operation of a complex economy such as that of Australia as it facilitates commercial, retail and government transactions in a timely, low

cost and reliable way. An economy cannot function efficiently without a competitive and sound financial system that gathers money and channels it into the best investment opportunities. An efficient and effective financial system will also produce actual and timely information to enable effective financial decision making, which is also important in the complex financial world of today.

Three trading strategies •Insider trading –Insider information (private information) •Fundamental analysis –Predict stock returns based on a set of accounting-based ratios (public information) •Technical analysis –Predicts stock returns based on past market data, i.e., past stock returns and trading volume

Strong

Semistrong

Weak

Insider Trading

X

$

$

Fundamental Analysis

X

X

$

Technical Analysis

X

X

X

•The financial system consists of financial markets and financial institutions. •These markets and institutions provide the structure to the financial system. •A well‐ developed financial system is critical for the operation of the economy. E.g. financial institution bank

The financial system moves money from lender‐savers to borrower‐ spenders. •Lender-savers = surplus spending units (SSU). –For example, households, some businesses and state and local governments. •Borrower‐ spenders = deficit spending units (DSU). –For example, businesses and the Commonwealth Government.

Direct financing •The lender‐ savers and the borrower‐ spenders deal ‘directly’ with one another. •Borrower‐ spenders sell securities, such as shares and bonds, to lender‐ savers in exchange for money. •Securities can be referred to as financial instruments and financial claims. Typical minimum direct transaction size is $1 million •To raise found: –companies can issue their own securities in the financial market –particularly in the capital market (share and bond). •Typically companies need help from experts to organise, issue and sell securities in the market.

•Investment banks specialise in helping companies sell new debt (bond) or equity (stock).

•Origination: the process of preparing a security issue for sale. •Underwriting: guarantees that the company will raise the funds it expects from its new security issue.

Types of financial assets: •Stocks •Bonds •Foreign currency •Derivative securities (forward, futures, option) Financial markets: •Money market: short term market. •Capital market: long term market. •Primary market: where companies initially sell new security issues (debt or equity). •Secondary market: where owners of securities can sell them to other investors.

Indirect

Services by financial institutions: •Offer the widest range of financial services to businesses. •Provide funding to companies through the purchase of shares and bonds in the direct finance markets.

•Also fund private companies through private financing.

Capital market efficiency: •Market prices fully reflect the knowledge and expectations of all investors at a particular point in time. •Overall efficiency depends on: –Operational efficiency: focuses on bringing all buyers and sellers together at the lowest possible cost. –Informational efficiency: market prices reflect all relevant information about securities at a particular point in time. Important because: •All securities of the same risk class should be priced to offer the same expected return. •This means that securities of similar risk will offer the same expected return. •This conclusion is important because it provides the basis for identifying the proper discount rate to use in applying the bond and share valuation models. •Strong-form efficiency: –The idea that all information about a security is reflected in its price. •Semistrong-form efficiency: –Holds only that all public information — information available to all investors — is reflected in security prices. •Weak-form efficiency: –Holds that all information contained in past prices of a security is reflected in current prices.

Ch3 Put - option to sell the underlying stock at a predetermined strike price until a fixed expiry date. The put buyer has the right to sell shares at the strike price, and if they decide to sell, the put writer is obliged to buy at that price.

Call - the right to buy at a strike price Ordinary vs preference shares

Difference in bond and share market: The bond market is a decentralised network of market participants, while the stock market is highly centralised consisting of only a few exchanges. Most secondary trading of corporate bonds occurs through dealers, although a few are traded on the ASX. The secondary market for corporate bonds is thin compared with the share markets. This means secondary market trades of corporate bonds are relatively infrequent. As a result, the bid-ask spread quoted by dealers of corporate bonds is quite high compared with those of other more marketable securities such as shares.

Money markets: –Where financial institutions and other businesses adjust their liquidity positions by borrowing or investing for short periods. –Reserve Bank of New Zealand (New Zealand's central bank) conducts monetary policy in the money markets. •The instruments traded in the money markets typically have:

–short‐term maturities –low default risk –active secondary markets. •Instruments have characteristics very similar to those of money (e.g., T-notes, commercial paper, certificate of deposit…).

Capital markets: •Capital markets bring together borrowers and suppliers of long-term funds. •Capital goods are financed with stock or long‐ term debt instruments. •Capital goods are the real assets used in production (e.g., plant and equipment). •Less marketable and higher default risk (vary widely) Functions: •The motive of firms for issuing or buying securities in capital markets is very different from those for acting in money markets. •Firms like to finance capital goods with long‐ term debt or equity to lock in their borrowing cost for the life of the project and to eliminate the problems associated with periodically refinancing assets. Participants: •The largest purchasers of capital market securities are: –individuals –households –foreign investors –financial institutions.

Major capital market instruments: •A financial instrument is classified as a capital market instrument if it has an original term to

maturity of one year or more. •Bonds: –Contractual obligations of a borrower to make periodic cash payments to a lender over a given number of years. –Government bonds –Corporate bonds •Shares: –Ordinary shares: •Equity shares that represent the basic ownership claim in a corporation (voting right). •Holders are entitled only to a residual claim against the firm’s cash flows or assets. •Limited liability applies. •Shares: –Preference shares: •Preferred shares generally does not carry voting rights •Holders receive preferential treatment with respect to: –dividend payments –the claim against the firm’s assets in the event of bankruptcy or liquidation.

Major issuers of capital markets: •Commonwealth Government (or Central Gov.): –Issue debt (e.g., notes and bonds) to finance operations or to refinance existing debt. –Cannot issue stock. •State Government: –Issue debt to finance their operation, but cannot issue stock. •Corporations: Issue both bonds and stock Size of bond markets •The long‐ term debt or bond markets are massive in scope, exceeding $1765.7 billion.

•The long‐ term government bond market (Commonwealth and semi‐ government) is the largest segment of the market. •During the past decade the bonds issued by non‐ resident (i.e. foreign) companies have grown exponentially.

Bond market turnover: •The secondary market for bonds is the market in which bonds are sold from one investor to another. •There are many reasons prompting market participants (e.g., banks) to undertake transactions in the secondary market. For example, banks are required by law to hold a portion of their assets in certain safe, liquid securities, in what is known as a reserve requirement –Institutions also hold securities in case they have a liquidity shortfall and require cash quickly. –Some institutions like to maintain a certain maturity profile for their bond portfolios. •superannuation funds generally prefer to hold long‐ term bonds cash management trusts prefer short‐ term bonds Commonwealth government securities •Central government debt •Treasury bonds and Treasury notes (T‐ notes) issued by the central government and are backed by the full faith and credit of the Commonwealth Government. •Considered to be free of default risk. •Interest received is tax-exempt State government bonds •Debt of state and local governments •In case of funding shortfalls, state and territory borrowing authorities issue bonds called semis (semi‐ government bonds) backed by their respective governments. •Varying degrees of default risk, rated similar to corporate debt

•Interest received is tax-exempt Corporate bonds •A corporate bond is a bond issued by a corporation •Are debt contracts requiring borrowers to make periodic payments of interest and to repay principal at the maturity date. •Default risk and tax Types of corporate bonds: callable, putable, convertible, disaster, income. Investors in corporate bonds: •The dominant purchasers of corporate bonds: –life insurance companies –superannuation funds –households –foreign investors. Corporate bonds are an attractive option because of the stability of their cash flows and the long-term nature of their liabilities

Primary market for corporate bonds: •New corporate bond issues may be brought to market by two methods: –Public sale: the bond issue is offered publicly in the open market to all interested buyers. –Private placement: the bonds are sold privately to a few investors.

Secondary market for corporate bonds: •Most secondary trading of corporate bonds occurs through dealers. •The market is thin compared with the markets for money market securities or corporate stock. •Corporate bonds are less marketable for two reasons: –They have special features, such as call provisions or sinking funds, that make them difficult to value. –They are long term, which makes them riskier.

Equity markets: •Equity securities, also known as shares and stocks, represent part ownership of a corporation. •Today in Australia and New Zealand, most equity securities are no longer (paper) certificates but ownership rights held on electronic databases. Equities are the most visible securities in most modern economies Primary equity markets: •New issues of securities are called primary offerings because they are sold in the primary market. •If the company has never before offered shares to the public, the primary offering is called an initial public offering (IPO). Secondary equity markets:Any trade of a security after its primary offering is said to be a secondary‐ market transaction. •When an investor buys 1,000 shares of ANZ Bank on the exchange, the proceeds of the sale do not go to ANZ but rather to the investor who sold the shares. •Almost all secondary‐ market equity trading is done on the exchange (e.g., NZX - New Zealand Stock Exchange).

Characteristics of equity markets: The function of secondary markets is to provide liquidity at fair prices. •Liquidity is the ease with which an asset may be converted to cash without a loss in value. •Transactions are done electronically. Equity trading: types of orders •Market order: an order to buy or sell at the best price available at the time the order reaches the market. –The order to buy shares at market when the quote was ‘Bid $3.21; Ask $3.22’ would be executed immediately at $3.22. •Limit order: an order to buy or sell at a limit price stated on the order. –A limit order to buy shares at $3.22. If the market moves up to $3.23, $3.24, $3.25, this order

would be completed only when the market moved back to $3.22

Derivative markets: •The derivatives markets provide significant benefits to financial market: –allows risk to be shared among market participants –can increase liquidity in any given market by increasing turnover and trading depth the transmission of information •A derivative security is a financial instrument whose value depends on, or is derived from, some underlying security. •Derivative securities generate substantial fee income for the financial institutions that invent and market them. •Most common types of derivative contracts are: –forward contract –futures contract –option contract.

Difference between futures and forward markets: •Futures contracts are: –traded on an organised exchange –standardised in quantities, delivery periods and grades of deliverable items •Forward contracts are: –traded in the informal OTC market –not standardised in quantities, delivery periods and grades of deliverable items.

Options: •A call option is an option to buy a certain asset by a certain date for a certain price (the strike price) •A put option is an option to sell a certain asset by a certain date for a certain price (the strike

price)

Terminologies of options: •Strike or exercise price: predetermined price. •Option premium: the price that an option buyer pays an option seller. •American option: the option can be exercised at any time before and including the expiry date. •European option: the option can be exercised only on the expiry date. Foreign exchange markets: •Firms that conduct business in foreign countries with different currencies face two additional risks: –Currency risk: the values of currencies fluctuating relative to each other. –Country risk (Political Risk): Loss due to political actions in the foreign country

Difficulties of international trade: •One of the two parties to the transaction will be forced to deal in a foreign currency. •No single country has total authority over all aspects of these transactions. •Countries may have different legal traditions. •Banks and other lending agencies often find it difficult to obtain reliable information on which to base credit decisions in many countries.

Two distinct international markets:•To facilitate these international transactions, there are two distinct kinds of international markets •International money and capital markets: –Provide the market for credit (international lending and borrowing). •FX markets: –Deal in the media of exchange or the means of payment.

Operations of foreign exchange m...