Corporate Finance - Chapter 1- Introduction to the Financial System

7/30/2019 Corporate Finance - Chapter 1- Introduction to the Financial System

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Chapter 1- Introduction to the Financial System.

1 - Risk

Financial riskrisk of debt instrument not being repaid or risk to shareholders resulting from the

use of debt ( isi c ki li rode dire toi, kan to pren ene debt instrument, example ene loan, ena dejaene risk associer ar li, c repayment plus interest payment, alor si demain to pena assez cash flow

to pa pu capave repay to loan)

Interest rate risk unpredictability of future interest rate. If we look at bonds, they give us

interest. Bond investors cross their fingers that market interest rates will fall, so that the price of

their bond will rise. If they are unlucky and the market interest rate rises, the value of their

investment falls. But all bonds are not equally affected by changing interest rates. How much

interest rate risk a bond has depends on how sensitive its price is to interest rate changes. Thissensitivity directly depends on two things: the time to maturity and the coupon rate. (Pu interest

rate risk, ene bond ki pas long-term 30 ans pa pu ena em risk eke ne bond ki lor short term 1 ans)

Exchange rate risk is the natural consequence of international operations in a world where

relative currency values move up and down. It also refers to the unpredictability of future

exchange rate. There are three different types of exchange rate risk, or exposure: short-run

exposure, long-run exposure, and translation exposure.

Short-Run Exposure

The day-to-day fluctuations in exchange rates create short-run risks for international firms. Most

such firms have contractual agreements to buy and sell goods in the near future at set prices.

When different currencies are involved, such transactions have an extra element of risk.

Long-Run Exposure

In the long run, the value of a foreign operation can fluctuate because of unanticipated changes

in relative economic conditions.

Translation Exposure

When a U.S. company calculates its accounting net income and EPS for some period, it must

translate everything into dollars. This can create some problems for the accountants when

there are significant foreign operations. In particular, two issues arise:

1. What is the appropriate exchange rate to use for translating each balance sheet account?

2. How should balance sheet accounting gains and losses from foreign currency translation behandled?


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Risk measures

1- the variability of the rate of return

2- the extent to which the rate of return is varying

3- the extent of deviations of individuals return from the percentage.

Higher SD = higher risk

Lower SD = lower risk

2 - Liquidity

- Ease and speed with which a financial instrument can be turned into cash without loss or at low cost. Gold

is a relatively liquid asset. Liquidity actually has two dimensions: ease of conversion versus loss of value.

Any asset can be converted to cash quickly if we cut the price enough. A highly liquid asset is therefore one

that can be quickly sold without significant loss of value. An illiquid asset is one that cannot be quickly

converted to cash without a substantial price reduction.

(liquidity pu sak financial instrument li different, si to ena ene conte savings dan ene la bank, to nek tire to

cash dan moins ki 5-10 mins, mai si to ena actions, to pa pu ggn sa valeur la osi vite, coz to bzn met ene sell

order, aster ena dimoune pas pu envie aster ek li pu pren time pu to ggn cass la)

Financial assets = illiquid assets capital assets = liquid assets

Rf

Deposits

Govt Bonds

Corporate

Bonds

Preferred

stock

Ord

shares

Options

Return

Risk


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3Real Value certainty

Some assets are more liable to face inflation in times of inflation, in other words, it is the capacity of the

assets to keep its value in time of inflation. (e.g. real estate)

4

Expected return

Return = Risk Free + Risk Premium

For some financial claims, there can be an explicit cash return to the holder, for example deposit accounts.

5Terms to maturity

It refers to the remaining time for a financial instrument. When the financial instrument arrives at maturity,

the investor gets back the amount invested. For the case of bonds, it is the time between when the bond isissued and when it matures (maturity date), at which time the issuer must redeem the bond by paying the

principal (or face value). In the case of shares, they have no maturity date, and for bank deposits, it starts

from zero.

Financial claims

Debt Equity

A debt instrument = contractual agreement,

Borrower agree to make regular payments of a until a

Specified date when the debt matures. On maturity,

The debt is repaid.

Examples of debt: deposits, loan, bill, bond

- Claim to a share in net income

- In finance, in general, you can think of equity as

ownership in any asset after all debts associated

with that asset are paid off.

- Equity holders are paid dividend if company

makes profit.

- Equity holders are only entitled to the residual

value, the portion left after creditors are paid. The

value of this residual portion is the shareholders

equity in the firm, which is just the value of the

firms assets less the value of the firms liabilities

- Shareholders bear the risk of the company.

- Shareholders are the owners and have voting

rights


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Deposit

Loan by an individual or company to a financial institution such as a bank.

It is also identical to the money an investor transfers into a bank's savings or checking accounts.

Loan

Sum of money lent to a company or individual by financial institutions such as a bank. A loan may be for a

specific, one-time amount or can be available as open-ended credit up to a specified ceiling amount. A loan

entails interest payment.

Bill

- short term paper claim issued by companies or the government.

- bill is paid at a discount to face value when an investor buys a bill.

- At maturity, the issuer pays the investor the face value of the bill.

Bond

- Claim that normally pays a fixed rate of interest until maturity date and at maturity date, the bond issuer

pays the bondholder the amount investment at face value. It represent long-term debt instrument. Bonds can

be issued by the government or a company, a bond has the following features:

1- coupon - The stated interest payment made on a bond.

2- face value - The principal amount of a bond that is repaid at the end of the term. Also known as par value.

3- coupon rate - The annual coupon divided by the face value of a bond.

4maturity - Specified date on which the principal amount of a bond is paid.

Structure of financial markets.

Financial markets function as both primary and secondary markets for debt and equity securities. The term

primary market refers to the original sale of securities by governments and corporations. The secondary

markets are those in which these securities are bought and sold after the original sale. Equities are, of course,

issued solely by corporations. Debt securities are issued by both governments and corporations.


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1-Primary and secondary markets

Primary MarketInitial Market Authority

- New issue (initial public offering) of both debt and equity sold to initial buyers.

- Facilitates the financing of firms and raising takes place for the first time.

Secondary Market

- Mere transfer of ownership

- Trade existing securities

- increase liquiditycan buy shares and sell easily

- all fresh issue of shares, e.g.: issue amount today and amount later

- allow price determination of new issues.

- provide current state of wealth of the company: no. of shares x price

- performs role in setting the price of primary market issue.

2

Dealers and Auction market

There are two kinds of secondary markets: auction markets and dealer markets. Generally speaking, dealers

buy and sell for themselves, at their own risk.

Dealers market

Dealer markets in stocks and long-term debt are called over-the-counter (OTC) markets. Most trading in debt

securities takes place over the counter.

-Two prices are quoted (buying price and selling price)buy at lower price and sell at a higher price

- Market maker e.g. banks in foreign exchange marketbuy and sell currencies

- difference between buying price and selling price is profit

- Govt bonds sell on OTC sell govt bonds to banks and other sell from bank

there can be no intermediaries.

- DEM marketshares sold on OTC


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Auction Market- Quote driven market

Auction markets differ from dealer markets in two ways. First, an auction market or exchange has a physical

location (like Wall Street). Second, in a dealer market, most of the buying and selling is done by the dealer.

The primary purpose of an auction market, on the other hand, is to match those who wish to sell with those

who wish to buy. Dealers play a limited role.

- goes to the bidder

- open out any market need to go through brokers (part of commission goes to SEM where the aim is to

make a profit. The broker gets the remaining commission)

- Nowadays with technological developmentetradingbidding takes place online where registration is

made through a website

e- trading advantageless costly and no commission to brokers.

- Disadvantage- price is not discovered well and cannot negotiate price.

Money and capital markets

Money Market

- market for short-term financial assets

- The maturity of short-term financial assets that trade in the money market is one year or less.

- Mainly wholesale marketslarge size transactions takes place

Most money-market securities are also highly marketable or liquid, meaning that it is easy and cheap to sell

the asset for cash. This property, too, is an attractive feature of securities used as temporary investments untilcash is needed. Treasury bills are the most liquid asset.

Capital Market

- Market for long-term financial instruments

- ex: shares, govt bonds, corporate bonds.

- is composed of both the primary and secondary markets.

Corporate Finance - Chapter 1- Introduction to the Financial System

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