Financial Instruments  and Markets CHAPTER 5 McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rig...
Financial Executive As Marketing Executive <ul><li>Financial executives need to raise money to finance the current operati...
Packaging <ul><li>Packaging cash flows involves security design. </li></ul><ul><li>Designing securities requires knowledge...
Financial Markets <ul><li>Financial markets describes the distribution system by which cash-deficit entities engage in tra...
Financial Instruments <ul><li>Companies do not face major constraints when choosing financial instruments. </li></ul><ul><...
Three Variables <ul><li>When designing a financial instrument, a financial executive works with three variables. </li></ul...
Bonds <ul><li>Debt instruments offer fixed claims. </li></ul><ul><li>Equity offers residual claims. </li></ul><ul><li>Hybr...
Relative Size <ul><li>Historically, 60% of business financing has come from retained earnings and depreciation.  </li></ul...
Bond Characteristics <ul><li>Par value </li></ul><ul><li>Coupon rate </li></ul><ul><li>Maturity date </li></ul><ul><li>Sin...
Call Provisions <ul><li>Right to retire bonds prior to maturity. </li></ul><ul><li>Call price is typically a modest premiu...
Covenants <ul><li>Contractual terms to protect bondholders by impacting management decisions. </li></ul><ul><li>Examples: ...
Rights in Liquidation <ul><li>Rights of absolute priority </li></ul><ul><ul><li>Government in respect to taxes past due </...
Secured Creditors <ul><li>Secured credit involves collateral. </li></ul><ul><li>In liquidation, proceeds from the sale of ...
Bonds as an Investment <ul><li>Bonds are not safe. </li></ul><ul><li>Real vs. nominal returns. </li></ul><ul><li>See Table...
TABLE 5-1 Rate of Return on Selected U.S. Securities,  1900 - 2007
Bond Ratings <ul><li>Rating agencies rate bonds for risk. </li></ul><ul><li>Analysts use techniques discussed in earlier c...
Table 5-2 Selected S&P Debt-Rating Definitions
Table 5-2 ( continued )
Junk Bonds <ul><li>Investment grade is “BBB” and above. </li></ul><ul><li>Junk bonds, aka speculative or high yield bonds,...
Common Stock <ul><li>A residual income security. </li></ul><ul><li>Shareholders are represented through a board of directo...
Checks on Management <ul><li>Management might control the board. </li></ul><ul><li>Checks against this: </li></ul><ul><ul>...
Trends <ul><li>Europe and Japanese framework involves “old boy” relationships. </li></ul><ul><li>European firms have come ...
Common Stock as an Investment <ul><li>Total return = dividend yield + capital appreciation. </li></ul><ul><li>Between 1928...
Equity Premium <ul><li>Stocks returned 6.3% more than government bonds between 1900 and 2007. </li></ul><ul><li>The real r...
FIGURE 5-1 If Your Grandmother Had Invested only a Dollar in 1900; Nominal Returns on U.S. Assets 1900-2007
FIGURE 5-2 Distribution of Annual Return on Stocks And Bonds, 1928-2007
FIGURE 5-2 (Continued) Source: Professor Aswath Damodaran’s Web site,   pages.stern.nyu.edu/~adamodar/ .
Preferred Stock <ul><li>Hybrid security, mixing features of both debt and equity. </li></ul><ul><li>Promises annual fixed ...
Cumulative Preferred <ul><li>Preferred shareholders have higher priority than common shareholders. </li></ul><ul><li>Commo...
Perspectives on Common <ul><li>Some managers view preferred as cheap equity, because the dividends are fixed even when ear...
Financial Markets <ul><li>Three illustrative cases: </li></ul><ul><li>A startup </li></ul><ul><li>A candidate for an IPO <...
Private Equity Financing <ul><li>Startup, too risky for bank lending and too small for to attract the attention of investo...
Venture Capitalists <ul><li>Wealthy investors, often referred to as “angel investors.” </li></ul><ul><li>Professional vent...
Private Equity Partnerships <ul><li>Structured as limited partnerships with a specified duration such as 10 years. </li></...
Value and Investment Horizon <ul><li>Private equity partnerships induce managers to work for them, creating value over the...
FIGURE 5-3 Venture Capital Investment in U.S. Companies
Relative Share <ul><li>In 2007, venture capital constituted about one tenth of total private equity financing which totale...
Initial Public Offerings <ul><li>Six years ago, Genomic Devices  </li></ul><ul><ul><li>raised $15 million from venture cap...
Investment Banking <ul><li>“ Bake off” to assess proposals from investment banks and choose one. </li></ul><ul><li>Winning...
IPO Risks <ul><li>Syndicate acts as wholesaler. </li></ul><ul><li>Offer price set hours before stock goes public. </li></u...
Seasoned Issues <ul><li>Multinational firm wants to raise $200 million in new debt, using a U.S. “shelf registration.” </l...
Private Placement <ul><li>Large corporations can avoid registering with the SEC by placing debt privately with one or more...
Rule 144a <ul><li>In the past, privately place debt was not especially liquid. </li></ul><ul><li>SEC Rule 144a now allows ...
International Markets <ul><li>Large corporations use foreign financial markets because they want the contract to be in a f...
Reserve Requirements  and Bearer Bonds <ul><li>Financial firms operating in international markets need not hold reserves w...
Issue Costs <ul><li>For privately negotiated transactions, the issue cost amounts to the investment banking fee. </li></ul...
Representative Cost Comparisons <ul><li>2.2% for straight debt. </li></ul><ul><li>3.8% for convertible bonds. </li></ul><u...
Efficient Markets <ul><li>A recurring issue in raising new capital is timing. </li></ul><ul><li>Managers devote considerab...
Controversial Issues <ul><li>Evidence about market efficiency has been overstated. </li></ul><ul><li>Working assumption is...
What is an Efficient Market? <ul><li>Issue is how competitive prices respond to new information. </li></ul><ul><li>How lon...
FIGURE 5-4 Time Series of the Mean Price Index of the Shares of 161 Target Firms Involved in Successful Tender Offers Sour...
Efficiency in Degrees <ul><li>A market is  </li></ul><ul><ul><li>weak-form efficient when prices fully reflect all informa...
Empirical Evidence <ul><li>Markets are not strong form efficient. </li></ul><ul><li>With limited exceptions, markets are s...
Implications of Efficiency <ul><li>When market are semi-strong form efficient, a series of statements hold true. </li></ul...
Conclusions to Draw <ul><li>Managers have private information about their own companies, and can justifiably make timing d...
Managing Risk <ul><li>Companies use derivatives to manage risk and incentivize managers. </li></ul><ul><li>Volatile foreig...
Forward Markets <ul><li>You can buy spot today for immediate delivery. </li></ul><ul><li>You can contract today at a prede...
FIGURE 5A-1 Forward Market Hedge
FIGURE 5A-1 (Continued)
FIGURE 5A-1 (Continued)
Hedging in Forward Markets <ul><li>If a multinational firm based in the U.S. makes a sale for  €1 million, with collection...
Hedging with Options <ul><li>Forward contracts are obligations to accept delivery, if long or to deliver if short, at a pr...
Hedging a Euro-A/R <ul><li>If the firm uses a put option to hedge its  €1 million, then it protects against a drop in the ...
FIGURE 5A-2 Option Market Hedge
FIGURE 5A-2 (Continued)
FIGURE 5A-2 (Continued)
Limitations of  Financial Market Hedging <ul><li>What makes hedging difficult? </li></ul><ul><li>There is an active forwar...
Valuing Options <ul><li>In theory, the value of an option depends upon: </li></ul><ul><ul><li>The current price of the und...
Upcoming SlideShare
Loading in …5
×

Chap005

430 views
354 views

Published on

Published in: Economy & Finance, Business
0 Comments
0 Likes
Statistics
Notes
  • Be the first to comment

  • Be the first to like this

No Downloads
Views
Total views
430
On SlideShare
0
From Embeds
0
Number of Embeds
3
Actions
Shares
0
Downloads
17
Comments
0
Likes
0
Embeds 0
No embeds

No notes for slide

Chap005

  1. 1. Financial Instruments and Markets CHAPTER 5 McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
  2. 2. Financial Executive As Marketing Executive <ul><li>Financial executives need to raise money to finance the current operations and future growth of their companies. </li></ul><ul><li>To do so they must market the future cash flows of their firm. </li></ul><ul><li>Marketing entails the packaging of cash flows in order to fetch the highest price possible. </li></ul>
  3. 3. Packaging <ul><li>Packaging cash flows involves security design. </li></ul><ul><li>Designing securities requires knowledge of different financial instruments. </li></ul><ul><li>This chapter focuses on </li></ul><ul><ul><li>financial instruments </li></ul></ul><ul><ul><li>markets </li></ul></ul>
  4. 4. Financial Markets <ul><li>Financial markets describes the distribution system by which cash-deficit entities engage in transactions with cash-surplus entities. </li></ul><ul><li>Besides businesses, the entities in question include government agencies, universities, pension funds, endowments, individuals, commercial banks, insurance companies … </li></ul><ul><li>Money markets vs. capital markets distinguishes short-term vs. long-term contracts. </li></ul>
  5. 5. Financial Instruments <ul><li>Companies do not face major constraints when choosing financial instruments. </li></ul><ul><li>Instruments must appeal to investors and meet the needs of the company. </li></ul><ul><li>SEC does not pass judgment on the merits of a security, although some states do have merit regulation (blue sky laws). </li></ul><ul><li>SEC regulations require adequate disclosure before purchase. </li></ul>
  6. 6. Three Variables <ul><li>When designing a financial instrument, a financial executive works with three variables. </li></ul><ul><li>Investors’ claims on future cash flows </li></ul><ul><li>Investors’ right to participate in company decisions </li></ul><ul><li>Investors’ claims on company assets in the event of liquidation </li></ul>
  7. 7. Bonds <ul><li>Debt instruments offer fixed claims. </li></ul><ul><li>Equity offers residual claims. </li></ul><ul><li>Hybrids, such as convertible debt, combine both. </li></ul><ul><li>Bonds are fixed income securities. </li></ul><ul><li>Bonds promise interest income and repayment of principal at maturity. </li></ul><ul><li>Bonds are sold to the public in small increments, such as $1000, and can be traded on an exchange after issue. </li></ul>
  8. 8. Relative Size <ul><li>Historically, 60% of business financing has come from retained earnings and depreciation. </li></ul><ul><li>34% of external financing has come from corporate bonds. </li></ul><ul><li>19% has come from loans from banks and other financial firms. </li></ul><ul><li>In 2007, small manufacturing firms rely on bank loans for 36% of their financing, vs. 8% for larger firms. </li></ul>
  9. 9. Bond Characteristics <ul><li>Par value </li></ul><ul><li>Coupon rate </li></ul><ul><li>Maturity date </li></ul><ul><li>Sinking fund for periodic repayment of principal </li></ul><ul><ul><li>Direct payment to creditors via repurchase or retirement at par value </li></ul></ul><ul><li>Variable rate vs. fixed rate bonds. </li></ul>
  10. 10. Call Provisions <ul><li>Right to retire bonds prior to maturity. </li></ul><ul><li>Call price is typically a modest premium above par. </li></ul><ul><li>Delayed call prevents retirement before some date. </li></ul><ul><li>Call options help companies </li></ul><ul><ul><li>take advantage of declines in interest rates and </li></ul></ul><ul><ul><li>rearrange capital structure </li></ul></ul><ul><li>Investors require a premium for call provisions. </li></ul>
  11. 11. Covenants <ul><li>Contractual terms to protect bondholders by impacting management decisions. </li></ul><ul><li>Examples: </li></ul><ul><ul><li>Lower limit on current ratio </li></ul></ul><ul><ul><li>Upper limit on D/E ratio </li></ul></ul><ul><ul><li>Required approval by bondholders before major acquisition or sale of assets </li></ul></ul><ul><li>Bondholders have no direct say in a company unless it defaults on its interest, sinking fund, or covenant obligations. </li></ul>
  12. 12. Rights in Liquidation <ul><li>Rights of absolute priority </li></ul><ul><ul><li>Government in respect to taxes past due </li></ul></ul><ul><ul><li>Senior creditors </li></ul></ul><ul><ul><li>General creditors </li></ul></ul><ul><ul><li>Subordinated creditors </li></ul></ul><ul><ul><li>Preferred shareholders </li></ul></ul><ul><ul><li>Common shareholders </li></ul></ul>
  13. 13. Secured Creditors <ul><li>Secured credit involves collateral. </li></ul><ul><li>In liquidation, proceeds from the sale of collateral only go to the secured creditor, up to the amount of the secured credit. </li></ul><ul><li>Any residual goes into the pot shared by the pool of investors. </li></ul><ul><li>If the sale of collateral is insufficient, the secured creditor becomes a general creditor for the balance. </li></ul>
  14. 14. Bonds as an Investment <ul><li>Bonds are not safe. </li></ul><ul><li>Real vs. nominal returns. </li></ul><ul><li>See Table 5-1 </li></ul><ul><li>Can you infer the long-run default premium on corporate bonds? </li></ul><ul><li>Can you infer the real long-run return to bonds? </li></ul>
  15. 15. TABLE 5-1 Rate of Return on Selected U.S. Securities, 1900 - 2007
  16. 16. Bond Ratings <ul><li>Rating agencies rate bonds for risk. </li></ul><ul><li>Analysts use techniques discussed in earlier chapters, such as debt ratios and coverage ratios. </li></ul><ul><li>See Table 5-2 in text for examples. </li></ul>
  17. 17. Table 5-2 Selected S&P Debt-Rating Definitions
  18. 18. Table 5-2 ( continued )
  19. 19. Junk Bonds <ul><li>Investment grade is “BBB” and above. </li></ul><ul><li>Junk bonds, aka speculative or high yield bonds, are below investment grade. </li></ul><ul><li>Junk bond market is an alternative to bank and insurance company loans for smaller, less prominent companies. </li></ul><ul><li>Junk bonds have been used to finance mergers and acquisitions. </li></ul>
  20. 20. Common Stock <ul><li>A residual income security. </li></ul><ul><li>Shareholders are represented through a board of directors, through which they exercise control. </li></ul><ul><li>The degree of control is variable, in terms of the fraction of share ownership required to control the board. </li></ul>
  21. 21. Checks on Management <ul><li>Management might control the board. </li></ul><ul><li>Checks against this: </li></ul><ul><ul><li>Product market competition </li></ul></ul><ul><ul><li>Need for external financing </li></ul></ul><ul><ul><li>Market for corporate control </li></ul></ul><ul><li>In Europe, banks take equity positions and exercise direct control, more so than in the US. </li></ul><ul><li>Japanese keiretsu has same effect as in Europe. </li></ul>
  22. 22. Trends <ul><li>Europe and Japanese framework involves “old boy” relationships. </li></ul><ul><li>European firms have come to shift source of funding public markets instead of banks. </li></ul><ul><li>Japanese boards have begun to focus more on stock returns, thereby leading to less cross-share holdings. </li></ul>
  23. 23. Common Stock as an Investment <ul><li>Total return = dividend yield + capital appreciation. </li></ul><ul><li>Between 1928 and 2007, dividend yields on large common stocks were 3.9%, and capital appreciation was 7.5%. </li></ul><ul><li>In general stocks are a hedge against inflation. </li></ul><ul><ul><li>1970s were an exception to the rule, when stocks returned 5.2%, and inflation grew at 11.7%. </li></ul></ul>
  24. 24. Equity Premium <ul><li>Stocks returned 6.3% more than government bonds between 1900 and 2007. </li></ul><ul><li>The real return to stocks over this period was 8.5%. </li></ul><ul><li>See Figure 5-1 for cumulative return representation. </li></ul><ul><li>See Figure 5-2 for depiction of volatility. </li></ul>
  25. 25. FIGURE 5-1 If Your Grandmother Had Invested only a Dollar in 1900; Nominal Returns on U.S. Assets 1900-2007
  26. 26. FIGURE 5-2 Distribution of Annual Return on Stocks And Bonds, 1928-2007
  27. 27. FIGURE 5-2 (Continued) Source: Professor Aswath Damodaran’s Web site, pages.stern.nyu.edu/~adamodar/ .
  28. 28. Preferred Stock <ul><li>Hybrid security, mixing features of both debt and equity. </li></ul><ul><li>Promises annual fixed dividend = coupon rate x par value. </li></ul><ul><li>Dividend discretionary. </li></ul><ul><li>Dividend is not tax deductible, in contrast to interest payments. </li></ul>
  29. 29. Cumulative Preferred <ul><li>Preferred shareholders have higher priority than common shareholders. </li></ul><ul><li>Common shareholders receive no dividend until preferred shareholders are paid in full, including past arrears. </li></ul><ul><li>Control features of preferred stock vary from required approval to no voice at all unless dividend payments are in arrears. </li></ul>
  30. 30. Perspectives on Common <ul><li>Some managers view preferred as cheap equity, because the dividends are fixed even when earnings grow. </li></ul><ul><li>Other managers view preferred as debt with a tax disadvantage . </li></ul>
  31. 31. Financial Markets <ul><li>Three illustrative cases: </li></ul><ul><li>A startup </li></ul><ul><li>A candidate for an IPO </li></ul><ul><li>A multinational </li></ul>
  32. 32. Private Equity Financing <ul><li>Startup, too risky for bank lending and too small for to attract the attention of investors in public markets. </li></ul><ul><li>Funding options include loans against stable cash flows such as A/R, personal savings, friends and family, venture capitalists, and strategic investors (large firms who provide seed money but who with potential acquisition on their minds). </li></ul>
  33. 33. Venture Capitalists <ul><li>Wealthy investors, often referred to as “angel investors.” </li></ul><ul><li>Professional venture capital companies, who make high risk investments in entrepreneurial businesses capable of rapid growth and high investment returns. </li></ul><ul><li>Big stakes, active role in management, investment horizon of 5-6 years (5-10x). </li></ul><ul><li>View many proposals and are highly selective. </li></ul>
  34. 34. Private Equity Partnerships <ul><li>Structured as limited partnerships with a specified duration such as 10 years. </li></ul><ul><li>General partner is the private equity firm, which raises a pool of money from limited partners, such as institutional investors and insurance companies. </li></ul><ul><li>Limited partners have limited liability. </li></ul><ul><li>Typical fee structure is 2 and 20, the sum of a management fee and carried interest. </li></ul>
  35. 35. Value and Investment Horizon <ul><li>Private equity partnerships induce managers to work for them, creating value over the long-run without having to manage to short-run fluctuations. </li></ul><ul><li>The horizon is long-run, but not the very long-run, so managers are under pressure to create a cash exit event for private equity investors. </li></ul><ul><li>See Figure 5-3. </li></ul>
  36. 36. FIGURE 5-3 Venture Capital Investment in U.S. Companies
  37. 37. Relative Share <ul><li>In 2007, venture capital constituted about one tenth of total private equity financing which totaled about $302 billion. </li></ul><ul><li>The majority of private equity funds engage in leveraged buyouts, using D/E ratios of 3 to 4. </li></ul>
  38. 38. Initial Public Offerings <ul><li>Six years ago, Genomic Devices </li></ul><ul><ul><li>raised $15 million from venture capitalists, </li></ul></ul><ul><ul><li>had two more rounds of funding ($40 million), and </li></ul></ul><ul><ul><li>needs a $25 million equity infusion to keep growing now that it’s successful. </li></ul></ul><ul><li>IPO can provide additional equity along with an exit route for venture investors. </li></ul>
  39. 39. Investment Banking <ul><li>“ Bake off” to assess proposals from investment banks and choose one. </li></ul><ul><li>Winning investment bank becomes the “managing underwriter” and begins to </li></ul><ul><ul><li>advise the company on security design </li></ul></ul><ul><ul><li>register the issue with the SEC (30-90 days) </li></ul></ul><ul><ul><li>orchestrates a “road show” </li></ul></ul><ul><ul><li>assembles an underwriting syndicate who engage in book building </li></ul></ul>
  40. 40. IPO Risks <ul><li>Syndicate acts as wholesaler. </li></ul><ul><li>Offer price set hours before stock goes public. </li></ul><ul><li>Company bears price risk during the registration process. </li></ul><ul><li>Syndicate bears risk associated with unsold shares, which they cannot sell above the offer price. </li></ul>
  41. 41. Seasoned Issues <ul><li>Multinational firm wants to raise $200 million in new debt, using a U.S. “shelf registration.” </li></ul><ul><li>Shelf registration is a general purpose registration, good up to two years, that allows the firm to get quick approval for the use public markets. </li></ul><ul><li>A single underwriter often buys the entire issue. </li></ul><ul><li>Competitive bids lower the issue costs. </li></ul>
  42. 42. Private Placement <ul><li>Large corporations can avoid registering with the SEC by placing debt privately with one or more institutional investors. </li></ul><ul><li>The private placement market might be half the size of the public market, excluding bank loans. </li></ul><ul><li>Attractive option if public investors not especially receptive for reasons of complexity or familiarity. </li></ul>
  43. 43. Rule 144a <ul><li>In the past, privately place debt was not especially liquid. </li></ul><ul><li>SEC Rule 144a now allows for trading of privately placed debt among institutional investors. </li></ul><ul><li>Result is two parallel markets for corporate securities, one public and the other among institutional investors. </li></ul>
  44. 44. International Markets <ul><li>Large corporations use foreign financial markets because they want the contract to be in a foreign currency, they can get a better terms than in the U.S. </li></ul><ul><li>Foreign markets often impose fees and restrictions on foreign investors. </li></ul><ul><li>International markets allow the currency specified in the transaction to be outside the control of issuing country’s monetary authority. </li></ul>
  45. 45. Reserve Requirements and Bearer Bonds <ul><li>Financial firms operating in international markets need not hold reserves with a central bank such as the Fed. </li></ul><ul><li>Unlike the U.S., which requires registration of ownership, bonds can be issued to anonymous bearers, who can collect interest payments and avoid paying tax. </li></ul><ul><li>Bearer bonds are cheaper for issuers. </li></ul><ul><li>Have international markets stripped away protective regulation? </li></ul>
  46. 46. Issue Costs <ul><li>For privately negotiated transactions, the issue cost amounts to the investment banking fee. </li></ul><ul><li>For public issues, there are also legal, accounting, and printing fees. </li></ul><ul><li>Investment bankers often underprice issues to quell investors’ concerns about information asymmetries. </li></ul><ul><ul><li>Implicit dilution cost to shareholders. </li></ul></ul>
  47. 47. Representative Cost Comparisons <ul><li>2.2% for straight debt. </li></ul><ul><li>3.8% for convertible bonds. </li></ul><ul><li>7.1% for secondary offerings of public companies. </li></ul><ul><li>11% for IPOs. </li></ul><ul><li>Economies of scale: </li></ul><ul><ul><li>for equity 3% @ $100 million becomes 20% for $500,000. </li></ul></ul><ul><ul><li>For debt, range can be 0.9% to 10%. </li></ul></ul>
  48. 48. Efficient Markets <ul><li>A recurring issue in raising new capital is timing. </li></ul><ul><li>Managers devote considerable time and energy into predicting future price trends in financial markets. </li></ul><ul><li>Should managers abandon prediction and timing because markets fully reflect all available information correctly into prices? </li></ul>
  49. 49. Controversial Issues <ul><li>Evidence about market efficiency has been overstated. </li></ul><ul><li>Working assumption is that markets are more or less efficient. </li></ul><ul><li>Degree of efficiency is an empirical question. </li></ul>
  50. 50. What is an Efficient Market? <ul><li>Issue is how competitive prices respond to new information. </li></ul><ul><li>How long does it take for news to impact prices? </li></ul><ul><li>Ederington-Lee analysis of interest rate and foreign exchange markets is that for news releases, the answer is 10-40 seconds. </li></ul><ul><li>See Figure 5-4. </li></ul>
  51. 51. FIGURE 5-4 Time Series of the Mean Price Index of the Shares of 161 Target Firms Involved in Successful Tender Offers Source: Michael Bradley, “Interfirm Tender Offers and the Market for Corporate Control,” Journal of Business 53, no.4 (1980).
  52. 52. Efficiency in Degrees <ul><li>A market is </li></ul><ul><ul><li>weak-form efficient when prices fully reflect all information about past prices </li></ul></ul><ul><ul><li>Semi-strong form efficient when prices fully reflect all publicly available information </li></ul></ul><ul><ul><li>strong form efficient when prices fully reflect all information, public or private. </li></ul></ul>
  53. 53. Empirical Evidence <ul><li>Markets are not strong form efficient. </li></ul><ul><li>With limited exceptions, markets are semi-strong form efficient. </li></ul><ul><li>Typical investors should not expect to earn abnormal returns trading on publicly available information, especially if they pay brokerage commissions. </li></ul><ul><li>Future studies might uncover inefficiencies not generally known about at present. </li></ul>
  54. 54. Implications of Efficiency <ul><li>When market are semi-strong form efficient, a series of statements hold true. </li></ul><ul><li>Publicly available information has no predictive power in respect to market prices. </li></ul><ul><li>Best forecast of future price is current price adjusted for trend. </li></ul><ul><li>It is pointless to time the purchase or sale of the firm’s securities. </li></ul><ul><li>Investors cannot expect to earn positive risk-adjusted returns. </li></ul>
  55. 55. Conclusions to Draw <ul><li>Managers have private information about their own companies, and can justifiably make timing decisions based on such information. </li></ul><ul><li>Managers should not make timing decisions based on their personal beliefs about where markets are headed, if those beliefs are based on public information alone. </li></ul>
  56. 56. Managing Risk <ul><li>Companies use derivatives to manage risk and incentivize managers. </li></ul><ul><li>Volatile foreign exchange markets </li></ul><ul><li>Use of forward and option markets to deal with this volatility </li></ul><ul><li>Use of employee stock options for compensation. </li></ul>
  57. 57. Forward Markets <ul><li>You can buy spot today for immediate delivery. </li></ul><ul><li>You can contract today at a predetermined price for future delivery. </li></ul><ul><li>You can use forward markets to speculate, by betting on the future spot price, using today’s known forward price. </li></ul><ul><li>See Figure 5A-1. </li></ul>
  58. 58. FIGURE 5A-1 Forward Market Hedge
  59. 59. FIGURE 5A-1 (Continued)
  60. 60. FIGURE 5A-1 (Continued)
  61. 61. Hedging in Forward Markets <ul><li>If a multinational firm based in the U.S. makes a sale for €1 million, with collection expected in 180 days, it is exposed to currency risk. </li></ul><ul><li>It can hedge this risk by using a forward contract to buy dollars today with the corresponding euro value equal to €1 million. </li></ul><ul><li>Any gain from a future move in the euro spot rate will be exactly offset by a loss on the forward contract, and vice versa. </li></ul>
  62. 62. Hedging with Options <ul><li>Forward contracts are obligations to accept delivery, if long or to deliver if short, at a pre-specified price. </li></ul><ul><li>Options are rights, but not obligations to either take delivery or to deliver, at a pre-specified (exercise) price. </li></ul><ul><li>Call options confer the right to buy. </li></ul><ul><li>Put options confer the right to sell. </li></ul>
  63. 63. Hedging a Euro-A/R <ul><li>If the firm uses a put option to hedge its €1 million, then it protects against a drop in the value of the euro. </li></ul><ul><li>An option allows the firm to benefit if the euro strengthens against the dollar. </li></ul><ul><li>The cost of this additional flexibility is the option premium. </li></ul><ul><li>See Figure 5A-2. </li></ul>
  64. 64. FIGURE 5A-2 Option Market Hedge
  65. 65. FIGURE 5A-2 (Continued)
  66. 66. FIGURE 5A-2 (Continued)
  67. 67. Limitations of Financial Market Hedging <ul><li>What makes hedging difficult? </li></ul><ul><li>There is an active forward market in the currency. </li></ul><ul><li>Either the amount and/or timing of the foreign currency cash flow are uncertain. </li></ul><ul><li>The cash flows themselves depend on the exchange rate. </li></ul><ul><li>The cash flows are part of a long-term stream. </li></ul><ul><li>Is it even necessary to hedge in fair markets? </li></ul>
  68. 68. Valuing Options <ul><li>In theory, the value of an option depends upon: </li></ul><ul><ul><li>The current price of the underlying asset </li></ul></ul><ul><ul><li>The option’s time to maturity </li></ul></ul><ul><ul><li>The option’s strike price </li></ul></ul><ul><ul><li>The interest rate </li></ul></ul><ul><ul><li>The expected volatility on the underlying asset </li></ul></ul><ul><ul><li>But not the expected future value of the underlying asset </li></ul></ul>

×