Securities Analysis 3FB3 February 25 th, 2014

Transcription

1 Chapter 2: Financial Markets and Instruments 2.1 The Money Market The money market is a subsector of the fixed income market. It consists of ST debt securities that usually are highly marketable. Many of these securities trade in high denominations so they are out of reach of individual investors. However, money market funds (mutual funds) are easily accessible to small investors. Treasury Bills Treasury bills (t bills) are the most marketable of all Canadian money market instruments. Simplest form of borrowing, government raises money by selling bills to public. At maturity, holder receives a payment equal to FV from government. The difference in purchase price and maturity value constitute investor s earnings. T bills with initial maturities of 3, 6, 12 months are issued biweekly. Sales are conducted by auction where chartered banks and authorized dealers can submit only competitive bids. A competitive bid is a an order for a given quantity of bills at a specific offered price. Order is filled only if the bid is high enough relative to other bids to be accepted. Non competitive bid is an unconditional offer, such bids can be submitted only for bonds. They are purchased by charted banks, investment deals, Bank of Canada, and individuals who get them on secondary market. They are highly liquid. Offered in denominations of $1000, $5000, $25000, $100000, and $1 million. Certificates of Deposit and Bearer Deposit Notes Certificate of deposit time deposit with a chartered bank. They may not be withdrawn on demand. Bank pays interest and principal to depositor at end of fixed term. A similar time deposit for smaller amount is a guaranteed investment certificate (GIC). These are nontransferable, unless over $100,000, then negotiable. Bearer deposit notes (BDNs) are these marketable CDs. Commercial Paper Commercial paper is when large well known companies issue their own ST unsecured debt notes, instead of borrowing from banks. Usually backed by a bank line of credit. Maturities range up to one ear, longer maturities would require registration under the Ontario Securities Act. Usually under one or two months and minimum denominations of $50,000. Considered a fairly safe asset. Banker s Acceptances BA s start as an order to a bank by a bank s customer to pay a sum of money at a future date, typically within 6 months. Similar to postdated cheque. In return for a stamping fee, bank endorses order for payment and assumes responsibility for ultimate payment to holder of the acceptance, making it second only to t bills in terms of default security. Can now be traded in secondary markets. Acceptances sell at a discount from the face value of the payment order, just as T bills sell at a discount from pay value, with a similar calculation for yield. Eurodollars

2 [Type text] [Type text] [Type text] Eurodollars are US dollar denominated deposits at foreign banks or foreign branches of American banks. Most Eurodollar deposits are for large sums, most are time deposits of less than six months. A variation on the Eurodollar time deposit is the Eurodollar certificate of deposit. A Eurodollar CD resembles a US domestic bank CD, except it is the liability of a non US branch of a bank (typically London branch). The advantage of Eurodollar CDs over Eurodollar time deposits is that the holder can sell the asset to realize its cash value before maturity. Eurodollar CDs are less liquid and riskier than US CDs, thus offer a higher yield. Firms also issue Eurodollar bonds, dollar denominated bonds in Europe, but bonds are not a money market investment because of their long maturities!! *Money market items have short maturities, thus a bond isn t in the money market* Eurocurrency: instruments denominated in all major currencies when located outside the country of currency. I.e. euro Canadian dollars, when issued in Canadian dollar denominations. Repos and Reverses Dealers in government securities use repurchase agreements (repos or RPs) as a form of ST, usually overnight borrowing. A term repo is essentially an identical transaction, except that the term of the implicit loan can be 30 days or more. Repos are considered very safe in terms of credit risk, because loans are backed by government securities. A reverse repo is when the dealer finds an investor holding government securities and buys them, agreeing to sell them back at a specified higher price on a future date. Brokers Call Loans People buy stocks on margin and thus borrow part of funds to pay for stocks from broker, broker in turn borrows the funds from bank, agreeing to repay immediately on call, if bank requests it. Rate paid on these loans is usually closely related to rate on ST t bills. The LIBOR Market The London Interbank Offered Rate (LIBOR) is the rate at which large banks in London are willing to lend money among themselves. Become the premier ST interest rate quoted in European money market. Yields on Money Market Instruments Most money market securities are low risk, but not risk free. T Bill Yields T bill yields are not quoted in the financial pages as effective annual rates of return. Instead, the bond equivalent yield is used. $1000 par value T bill sold at $960 with a maturity of half year, 182 days. $40 * (360/182) = $80.22 $80.22 / $960 = bond equivalent yield of percent per year The bond equivalent yield is not an accurate measure of the effective annual rate of return. Half year holding period return on bill: 4.17 percent 40/960 = The compound interest annualized rate of return, or effective annual yield is therefore: (1.0417) 2 1 =.0851 = 8.51%

3 We can highlight the source of the discrepancy between the bond equivalent yield and the effective annual yield by examining the bond equivalent yield formula r BEY = (1000 P / P) * (365 / n) P is bond price, n is maturity of the bill in days The annualization technique uses simple interest rather than compound interest, multiplication by 365/n does not account for the ability to earn interest on interest, which is the essence of compounding. The quoted yields for US T bills use a formula similar. The resulting yield is known as the bank discount yield. Part of the difference in yields between Canadian and US bills can be attributed to the method of quoting yields. A convenient formula relating the bond equivalent yield to the bank discount yield is R BEY = (365 * d) / 360 ( d * n) Where d is the discount yield. To find true market price of a bill, when give three months T bill BEY, rearrange first equation: P = 1000 / [1+r BEY * (n/365)] This first deannualizes the BEY to obtain the actual proportional interest rate, then discounts the pay value of 1000 to obtain sale price. The BEY is the bill s yield over its life, assuming it is purchased for auction bid price and annualized using simple interest techniques. This yield uses a simple interest procedure to annualize, known as annual percentage rate (APR) 2.2 The Bond Market Bond market is composed of longer term borrowing instruments. This includes Government of Canada bonds, provincial and municipal bonds, corporate bonds, and mortgage securities. Bonds can be callable, this allows the issuer to redeem the bond at par value, or at a stated premium prior to maturity. These instruments are sometimes said to make up the fixed income capital market, because most of them promise either a fixed stream of income or a stream of income determined according to a specific formula. More straight forward to call these securities either debt instruments or bonds. Government of Canada Bonds Nonmarketable securities are known as Canada Savings Bonds (CSBs) or Canada Premium Bonds (CPBs), issued every year starting Nov 1. They bear little interest rate risk. The CSBs are perfectly liquid, can be cashed any time prior to maturity at FC plus accrued interest. CPBs can only be cashed in Nov of succeeding years, so somewhat like 365 day deposits. Government of Canada bonds, Canadas, or Canada bonds, are longer term marketable debt securities issued by the federal government. Varying maturities, up to 40 years. Considered part of money market when term is less than three years! Canada bonds are generally non callable and make semiannual coupon payments. Yield to maturity is calculated by determining the semi annual yield and then doubling it, rather than compounding it for two half year periods. This use of a simple interest technique to annualize means that the yield is quoted on an annual percentage rate (APR) basis, rather than an effective annual yield. The APR method in this context is also called the BEY. Current yield = Annual coupon income / price

4 [Type text] [Type text] [Type text] Provincial and Municipal Bonds These are considered extremely safe assets, even though not as safe as comparable Canada bonds. Thus, a small yield spread can be observed in the figure between Canada bonds and provincial bonds, as well as between the bonds of various provinces. US municipal bonds are exempt from federal income tax and from state and local tax in the issuing state. Thus, quoted yield is an after tax yield. This explains why the quoted yields on municipals are lower than the quoted (before tax) yields on other, comparable bonds. Tax advantage is not available to Canadian investors, so US municipal bonds would not be attractive. Corporate Bonds Corporate bonds enable private firms to borrow money directly from the public. These are similar in structure to government issues, but differ in terms of degree of risk. Default risk is a real consideration in corporate bonds. Secured bonds have a specific collateral back them in the event of a firm bankruptcy, unsecured bonds are called debentures and have no collateral, and subordinated debentures have a lower priority claim to the firm s assets in the event of bankruptcy. Corporate bonds usually come with options attached. Callable bonds give the firm the option to repurchase the bond from the holder at a stipulated call price. Retractable and extendible bonds give the holder the option to redeem the bonds earlier and later than the stated maturity date. Convertible bonds give the bondholder the option to convert each bond into a stipulated number of shares of stock. International Bonds A Eurobond is a bond denominated in a currency other than that of the country in which it is issued. I.e. Euroyen bonds yen denominated bonds sold outside Japan. Think simply as international bond. Many firms also issue bonds in foreign countries in currency of investors, i.e. yankee bond is a dollar denominated bond sold in US by non US issuer. I.e. Samurai bonds are yen denominated bonds sold in Japan by non Japanese issuers. Mortgages and Mortgage Backed Securities Variable rate mortgage require the borrower pay an interest rate that varies with some measure of the current market interest rate. This contract shifts the risk of fluctuations in interest rates from the lender to the borrower. Banks are willing to offer lower rates on variable rate mortgages than on conventional fixed rate mortgages. A mortgage backed security (MBS) is either an ownership claim in a pool of mortgages or an obligation secured by such a pool. Mortgage lenders originate loans and then sell packages of these loans in the secondary market. MBSs are called pass throughs. MBSs can be traded like any other bond, the cash flow can be considered risk free, even if individual borrowers default on their mortgages, because the National Housing Act (NHA) ensures the timely payment of principal and interest. However, they do not guarantee the rate of return. 2.3 Equity Securities Common Stock as Ownership Shares

5 Common stocks, equity securities, or equities, represent ownership shares in a corporation. Members of BOD are elected at annual meeting. Shareholders who do not attend the annual meeting can vote by proxy, empowering another party to vote in their name. Several mechanisms to alleviate agency problems: compensation schemes that link success of manager to that of firm, oversight by the BOD and outsiders like security analysis, the threat of a proxy contest in which unhappy shareholders attempt to replace current management team, and threat of takeover by another firm. Special type of common stock, restricted shares, have no voting rites, or only restricted coting rights, but otherwise participates fully in the financial benefits of share ownership. They sometimes carry different financial benefits for their holders. They also have some legal protection in case of tender offers. A corporation whose stock is not publicly traded is said to be closely held. Here, owners of firm also take an active role in its management. Characteristics of Common Stock 2 most important characteristics of common stock as an investment are its residual claim and limited liability features. Residual claim means that shareholders are last in line of all those who have a claim on the assets and income of the corp. Claim to the part of operating income left over after interest and taxes. Management can either pay residual as cash dividends to shareholders or reinvest to increase value of shares. Limited liability greatest amount shareholders can lose in event of failure of corp is their original investment. Stock Market Listings High yield dividend stocks are not necessarily better investments than low yield stocks. Total return to an investor comes from dividends and capital gains, or appreciation in the stock value. Low yield dividend firms presumably offer greater prospects for capital gains. The price earnings ratio is the ratio of the closing stock price to last year s earnings per share. Board lots shares traded in bunches of 100 shares. A board lot consists of 1000 shares for stocks selling before $5, while it falls to 25 shares for stocks above $100. Preferred Stock Preferred stock has features similar to both equity and debt. Like a bond, it promises to pay to its holder a fixed amount of income every year. In this sense, it is similar to an infinite maturity bond, that is, a perpetuity. Also, it does not convey voting power regarding the management of the firm. Although, it is an equity investment in the sense that failure to pay the dividend does not precipitate corporate bankruptcy. They are usually cumulative, unpaid dividends cumulate and must be paid in full before any dividends are paid to common stock holders. Also differs from bonds in terms of tax treatment, PS payments are treated as dividends rather than interest, and are thus not tax deductible expenses for the firm. *Interest paid on bonds is tax deductible for firms. *Dividends are taxed for firms. However, corporations may exclude dividends received from domestic corporations in the computation of their taxable income.

6 [Type text] [Type text] [Type text] Preferred dividends are taxed like common dividends for individual investors, giving them a higher after tax yield than bonds with the same pretax yield. They rank after bonds in event of corporate bankruptcy, but still sell at lower yields than corporate bonds. Issued in variations similar to those of corporate bonds, i.e. can be callable. Income Trusts Income trusts also have debt and equity features. It holds an underlying asset or group of assets that generate income. It is a variation on the structure of a REIT/royalty trust. Notion has been expanded to industries where income is considered to be reliable and predictable and there are minimal capital spending requirements that would act as a drain on CF, such as hotel or food service industries. Parent corporation would cooperate in the creation of a trust that issues units to the public. Proceeds from the unit sales are used to purchase common shares and debt that represent the capital base of the operating division. Principal motive is tax treatment, which is favorable to investors and underlying operating division. Income generated is flower to investors virtually tax free. Use of high leverage, thus high yield debt, is typically part of design, it s a degree of risk that may not be recognized by investors. A prospectus precedes the primary issue. The trust functions like a closed end mutual fund. Major attraction for investors is the promise of a high yield. Structure that passed along cash tax free threatened to deprive the government of increasing tax revenues. Depository Receipts American Depository Receipts, ADRs, are certificates traded in US markets that represent ownership in shares of a foreign company. Created to make it easier for foreign firms to satisfy US security registration requirements. 2.4 Stock and Bond Market Indices Stock Market Indices Dow Jones Industrial Average and the TSX are the best known measures of the performance of the US and Canadian stock markets. Foreign stock exchange indices, such as the Nikkei Average of Tokyo and the Financial Times Index of London are fast becoming household names. Toronto Stock Exchange Indices The S&P/TSX Composite Index is Canada s best known stock market indicator. Contains over 270 of the largest securities traded on the TSX. The TSX Composite is a market valueweighted index. It is constructed to reflect an investment in each company proportional to its total market capitalization, giving considerably more weight to large, highly valued stocks. The TSX Composite is computed by calculating the total market value of the stocks in the index and the total market value of those stocks on the previous day or trading, always excluding control blocks. The % increase in the total market value from one day to the next represents the increase in the index. The ROR of the index is thus equal to the ROR that an investor holding a portfolio of all the stocks in the index would earn. However, the index does not reflect cash dividends paid out by those stocks.

7 The TSC is described by a variety of indices; all calculated by S&P, including capped indices, etc. I.e. TSX 60, TSX MidCap, TSX SmallCap Investors today can purchase shares in mutual funds that hold shares in proportion to their representation in the S&P/TSX Composite. These index funds yield a return equal to that of the TSX index and so provide a low cost passive investment strategy for equity investors. Dow Jones Averages The Dow Jones Industrial Average of 30 large blue chip corporations has been computed since The Dow is a price weighted average, which means it is computed by adding the prices of the 30 companies and dividing by a certain number. A price weighted average reflects the performance of a portfolio that holds an equal number of shares in each of the companies in the index. Following a stock split, the divisor must be reduced to a value that leaves the average unaffected by the split. Divisor of DJIA has fallen to about 17, from 20. Other US Market Value Indices The New York Stock Exchange publishes a market value weighted composite index of all NYSE listed stocks. The National Association of Securities Dealers published an index of 3000 over the counter firms traded on the Nasdaq market. The ultimate US equity index so far computed is the Wilshire 5000 index of the market value of all NYSE and American Stock Exchange (AMEX) stocks, plus actively traded Nasdaq stocks. Despite name, includes about 6000 stocks. Vanguard offers an index mutual fund, the Total Stock Market Portfolio, that enables investors to match the performance of the Wilshire 5000 index, and a small stock portfolio that matches the MSCI (Morgan Stanley Capital International) US small capitalization 1750 index. Equally Weighted Indices Place equal weight on each return, corresponds to an implicit portfolio strategy that places equal dollar values on each stock. This is in contrast to both price weighting (which requires equal numbers of shares of each stock) and market value weighting (which requires investments in proportion to outstanding value). Equally weighted indices do not correspond to buy and hold portfolio strategies. Foreign and International Stock Market Indices The popular indices are broader than the Dow Jones average and most are value weighted. Most important are the Nikkei, FTSE (footsie), Hang Seng, and DAX. Nikkei 225 is priceweighted, Nikkei 300 is value weighted. FTSE is published by the Financial Times of London and is a value weighted index of 100 largest London Stock Exchange corporations. The leading compendium of international indices is produced by MSCI. It computes over 50 country indices and several regional indices. Bond Market Indicators Scotia Capital publishes the main Canadian bond market indices. In the US, the most wellknown groups of indices are Merrill Lynch, Lehman Brothers, and Salomon Brothers. All

8 [Type text] [Type text] [Type text] computed monthly and all measure total returns as the sum of capital gains plus interest income derived from the bonds during the month. 2.5 Derivative Markets One of the biggest developments in financial markets recently has been the growth of futures and options markets. The payoffs of these depend on the values of other assets, such as commodity prices, bond and stock prices, or market index values. Thus they are sometimes called derivative assets, or contingent claims. Options A call option gives its holder the right to purchase an asset for a specified price, called the exercise or strike price, on or before a specified expiration date. Each option contract is for the purchase of 100 shares. The holder of the call need not exercise the option. When the market price exceeds the exercise price, the option holder may call away the asset for the exercise price and reap a profit equal to the difference between the stock price and the exercise price. Calls provide greater profits when stock prices increase and thus represent bullish investment vehicles. A put option gives its holder the right to sell an asset for a specified exercise price on or before a specified expiration date, even if the market price of the asset is lower than the put price. Profits on put options increase when the asset value falls. The Montreal Exchange is also known as the Canadian Derivatives Exchange. The prices of call options decrease in successive rows for a given expiration date, corresponding to progressively higher exercise prices. The right to purchase a share at a given exercise price is worth less as the exercise price increases. Put options have parallel strike prices and times to maturity; their prices increase with the exercise price. Option prices increase with time to expiration. I.e. right to buy something at whatever price until January is worth less than the same right until February. Most options have short expiration dates, usually less than a year. Also options called LEAPS (LT equity anticipation securities) have much longer expiration dates, two to three years at issue. Futures Contract The futures contract calls for delivery of an asset or its cash value at a specified delivery or maturity date for an agreed upon price, called the futures price, to be paid at contract maturity. The long position is held by the trader who commits to purchasing the commodity on the delivery date. The trader who takes the short position commits to delivering the commodity at contract maturity. The trader holding the long position profits from price increases. $1 million * (price at expiration futures agreed upon price) The short position s profit equals the long position s loss. Stock index options several call and put option contracts are quoted on the S&P/TSX 60 stock index. Index options differ from stock options because they are cash settlement options. If the value of the index rises above the exercise price, then the holder of a call option on the S&P/TSX 60 index receives, upon exercise, a cash amount equal to $200 times the difference between the stock index and exercise price.

9 Stock index options are listed as Canadian equity options. Not to be confused with index futures, or options on futures. Futures are also quoted on commodities such as grains, meats, fruits, fuels, and case and precious metals. The right to purchase the asset at an agreed upon price, as opposed to the obligation, distinguishes call options from long positions in futures contracts. A futures contract obliges the long position to purchase the asset at the futures price, the call option conveys the right to purchase the asset at the exercise price. Call options must be purchased, futures investments may be entered into without cost. The purchase price of an option is called the premium. Other Derivative Assets: Warrants, Swaps, and Hybrid Securities Warrants are like call options, with the difference being that the holder receives the shares upon exercise from the firm that issued them, rather than from another investor. Thus, unlike call options, warrants increase the number of outstanding shares of a corporation and its capital, while diluting the equity of its shareholders. They also trade on regular stock exchanges and have longer expiration dates. A swap is an agreement b/w two parties to exchange a set of liabilities, like the obligation to pay a stream of future interest payments in a given currency and rate. Swaps are brokered by intermediaries and the terms of representative agreements are quoted in the over the counter market. Some firms have issued instruments that are a combination of a bond and a call option on a stock index.