Introduction to capital markets


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Introduction to capital markets

  1. 1. IntroductionCapital Markets - JSGabinera 1
  2. 2.  Asset • any possession that has value in an exchange Tangible asset • The value depends on particular physical properties (e.g. buildings, land, or machinery) Intangible assets • Represent legal claims to some future benefit • Examples include financial assets, financial instruments, or securities Investor • The owner of the financial asset Capital Markets - JSGabinera 2
  3. 3.  Financial assets include • A bond issued by the PH Bureau of Treasury • A bond issued by Manila Electric Company • A bond issued by the City of Makati • A bond issued by the government of France • An automobile loan • A home mortgage loan • Common stock issued by Microsoft Corporation Capital Markets - JSGabinera 3
  4. 4.  Debt versus Equity Claims • Debt instrument  the claims of the holder of a financial asset in a fixed dollar / pesos amount • Equity claim (residual claim)  obligates the issuer of the financial asset to pay the holder an amount based on earnings, if any, after holders of debt instruments have been paid • Fixed income instruments  both debt and preferred stock that pays a fixed dollar / peso amount Capital Markets - JSGabinera 4
  5. 5.  The Value of a Financial Asset • Valuation  The process of determining the fair value or price of a financial asset • Fundamental principle of valuation  The value of any financial asset is the present value of the cash flow expected Capital Markets - JSGabinera 5
  6. 6.  The Value of a Financial Asset • Estimating the cash flow  Cash flow – the cash that is expected to be received each period from investing in a particular financial asset  the type of financial asset and the characteristics of the issuer determine the degree of certainty  U.S. government never defaults on the debt instruments  Other debt instrument are not know with certainty Capital Markets - JSGabinera 6
  7. 7.  The Value of a Financial Asset • Estimating the cash flow  Three reasons why cash flow of debt instruments is not known: 1. The issuer might default 2. Provisions included in most debt instruments grant the issuer and/or the investor the right to change how the borrowed funds are repaid 3. The interest rate the issuer pays can change over the time the borrowed funds are outstanding Capital Markets - JSGabinera 7
  8. 8.  The Value of a Financial Asset • The appropriate interest rate for discounting the cash flow is determined by addressing: 1. What is the minimum interest rate the investor should require? • The interest rate available in the financial market on a default-free cash flow 2. How much more than the minimum interest rate should the investor require? • Should reflect the risks associated with realizing the cash flow expected Capital Markets - JSGabinera 8
  9. 9. Capital Markets - JSGabinera 9
  10. 10.  The Value of a Financial Asset • Various types of risk include: • Credit risk (Default risk)  the risk that the issuer or borrower will default on the obligation • Purchasing power risk (Inflation risk)  the risk attached to the potential purchasing power of the cash flow expected • Foreign exchange risk  the risk that the exchange rate will change adversely Capital Markets - JSGabinera 10
  11. 11.  The Role of Financial Assets • Two principal economic functions:  Financial assets transfer funds from those parties who have surplus funds to invest to those who need funds to invest in tangible assets  Financial assets transfer funds in such a way as to redistribute the unavoidable risk associated with the cash flow generated by tangible assets among those seeking and those providing the funds Capital Markets - JSGabinera 11
  12. 12.  The Role of Financial Assets • Financial intermediaries  Entities who seek to transform the final liabilities into different financial assets preferred by the public Capital Markets - JSGabinera 12
  13. 13.  Properties of Financial Assets 1. Moneyness 2. Divisibility and denomination 3. Reversibility 4. Term to maturity 5. liquidity 6. Convertibility 7. Currency 8. Cash flow and return predictability 9. Complexity 10. Tax status Capital Markets - JSGabinera 13
  14. 14.  Properties of Financial Assets • Moneyness  Money – financial assets which act as a medium of exchange or in settlement of transactions  Near money – financial assets, although not money, closely approximate money in that they can be transformed into money at little cost, delay, or risk Capital Markets - JSGabinera 14
  15. 15.  Properties of Financial Assets • Divisibility and denomination  Divisibility –the minimum size at which a financial asset can be liquidated and exchanged for money  The smaller the size, the more the financial asset is divisible Capital Markets - JSGabinera 15
  16. 16.  Properties of Financial Assets • Reversibility  Reversibility (round-trip cost) – the cost of investing in a financial asset and then getting out of it and back into cash again  Bid-ask spread –the difference between the price at which a market maker is willing to sell a financial asset and the price at which a market maker is willing to buy the financial asset  The variability of the price as measured by some measure of dispersion of the relative price over time Capital Markets - JSGabinera 16
  17. 17.  Properties of Financial Assets • Bid-ask spread can be related to two main forces: 1. The variability of the price as measured by some measure of dispersion of the relative price over time 2. Thickness of the market – the prevailing rate at which buying and selling orders reach the market maker Capital Markets - JSGabinera 17
  18. 18.  Properties of Financial Assets • Term to maturity  The length of the interval until the date when the instrument is scheduled to make its final payment, or the owner is entitled to demand liquidation  Demand instruments – instruments for which the creditor can ask for repayment at any time  e.g. checking accounts and many savings accounts  Even a financial asset with a stated maturity may terminate before its stated maturity. Capital Markets - JSGabinera 18
  19. 19.  Properties of Financial Assets • Liquidity  Serves an important and widely used function, although no uniformly accepted definition is presently available  Liquidity closely related to whether a market is thick or thin. Thinness always increases the round-trip cost, even of a liquid financial asset Capital Markets - JSGabinera 19
  20. 20.  Properties of Financial Assets • Convertibility  The timing, costs, and conditions for conversion are clearly spelled out in the legal descriptions of the convertible security at the time of issuance Capital Markets - JSGabinera 20
  21. 21.  Properties of Financial Assets • Cash flow and return predictability  The predictability of the expected return depends on the predictability of the cash flow  Nominal expected return – the dollars expected to be received but does not adjust those dollars to take into consideration changes in their purchasing power  Real expect return – the nominal expected return after adjustment for the loss of purchasing power of the financial asset as a result of inflation Capital Markets - JSGabinera 21
  22. 22.  Properties of Financial Assets • Complexity  Combination of two or more simpler assets  To find the true value one must “decompose” the asset into its component parts and price each component separately Capital Markets - JSGabinera 22
  23. 23.  Properties of Financial Assets • Tax Status  Tax rates differ from:  Year to year  Country to county  Among municipal units within a country  Financial asset to financial asset Capital Markets - JSGabinera 23
  24. 24.  Financial market • Where financial assets are exchanged • In most economies financial assets are created and subsequently traded in some type of organized financial market structure Capital Markets - JSGabinera 24
  25. 25.  The Role of Financial Markets • 3 additional economic functions:  Price discovery process - the interactions of buyers and sellers in a financial market determine the price of the traded asset  Provide a mechanism for an investor to sell a financial asset  Reduces the search and information costs of transacting Capital Markets - JSGabinera 25
  26. 26.  The Role of Financial Markets • Search costs  Represent explicit costs • Information costs  Incurred in assessing the investment merits of a financial assets Capital Markets - JSGabinera 26
  27. 27.  Classification of Financial Markets • Types of financial claims  Debt market  Equity market  Stock market  Fixed income market  Common stock market Capital Markets - JSGabinera 27
  28. 28. Capital Markets - JSGabinera 28
  29. 29.  Classification of Financial Markets • Maturity of the claims  Money market - a financial market for short-term financial assets (< 1 year)  Capital market - the financial market for longer maturity financial assets (> 1 year) Capital Markets - JSGabinera 29
  30. 30. Capital Markets - JSGabinera 30
  31. 31.  Classification of Financial Markets • Whether the financial claims are newly issued  Primary market - the market for newly issued financial assets  Secondary market - the market, where after a certain period of time, the financial asset is bought and sold among investors Capital Markets - JSGabinera 31
  32. 32.  Globalization of Financial Markets • The integration of financial markets throughout the world into an international financial market Capital Markets - JSGabinera 32
  33. 33.  Globalization of Financial Markets • Factors contributing to the integration of financial markets  Deregulation or liberalization of markets and the activities of market participants in key financial centers of the world  Technological advances for monitoring world markets, executing orders, and analyzing financial opportunities  Increased institutionalization of financial markets Capital Markets - JSGabinera 33
  34. 34.  Globalization of Financial Markets • Institutionalization of financial markets  The shifting of the financial markets in the U.S. and other major industrialized countries from dominance by retail investors to institutional investors • Emerging markets  Participation in the financial markets of developing economies Capital Markets - JSGabinera 34
  35. 35. Capital Markets - JSGabinera 35
  36. 36. • Derivative instruments  Some contracts give the contract holder either the obligation or the choice to buy or sell a financial asset  Such contracts derive their value from the price of the underlying financial asset  Options contracts  Futures contracts  Forward contracts swap agreements  Cap and floor agreements Capital Markets - JSGabinera 36
  37. 37.  Four major asset classes: • Common stocks • Bonds • Cash equivalents • Real estate Capital Markets - JSGabinera 37
  38. 38.  Assetclasses expanded by separating foreign securities U.S. securities: • U.S. common stocks • Non-U.S. (or foreign) common stocks • U.S. bonds • Non-U.S. (or foreign) bonds • Cash equivalents • Real estate Capital Markets - JSGabinera 38
  39. 39.  U.S. common stocks classified as asset classes: • Large capitalization stocks • Mid capitalization stocks • Small capitalization stocks • Growth stocks • Value stocks*market capitalization = total market value of its common stock outstanding Capital Markets - JSGabinera 39
  40. 40.  U.S. bonds classified as asset classes: • U.S. government bonds • Investment-grade corporate bonds • High-yield corporate bonds • U.S. municipal bonds • Mortgage-backed securities • Asset-backed securities Capital Markets - JSGabinera 40
  41. 41.  Non-U.S. stocks and bonds classified as asset classes: • Developed market foreign stocks • Developed market foreign bonds • Emerging market foreign stocks • Emerging market foreign bonds Capital Markets - JSGabinera 41
  42. 42.  Characteristics of emerging markets: • Have economies that are in transition but have started implementing political, economic, and financial markets reforms in order to participate in global capital market • May expose investors to significant price volatility attributable to political risk and the unstable value of their currency • Have a short period over which their financial markets have operated Capital Markets - JSGabinera 42