bff1001 week 6
The ways that corporations raise debt are varied:
this could be for short term purposes so it would use MONEY MARKETS by issuing short term debt instruments for instance (this would be suitable for working capital management purposes). for long term purposes (as in the case of capital budgeting) the corporation can raise funds in CAPITAL DEBT MARKETS-the most important being BOND MARKETS, with issues of long-term debt instruments (eg. bonds).
capital structure
which mix of debt and equity will provide optimal financing for the long-term projects the corporation is planning to undertake? This mix of debt and equity is called the CAPITAL STRUCTURE of the firm.
4 Terms of the bond contract
A bond consists of two cash flows: The bond pays periodic interest payments (coupons) to the bond holder. At maturity, the bond pays the bondholder the principal, face value or par value of the bond. The size of the coupon (interest) payments is determined by the coupon rate. Here's an example: If the coupon rate is 7.00% per annum, a bond with a face value of $1000 will pay $70 in interest each year. Because bond coupons are usually paid semi-annually, each coupon payment will be $35. The bond's term to maturity is the number of years over which the bond contract extends. In Australia, where semi-annual compounding is normally assumed, a 7.00% bond with a face value of $1000 and a term to maturity of 10 years will make 20 coupon payments of $35 each. A bond's price is the present value of its coupons plus the present value of its face value:
4 Negotiable certificates of deposit
A negotiable CD is a bank term deposit that is negotiable. These are designed by banks to attract large corporate deposits. Corporations buy CDs to earn a low-risk return on the corporation's excess cash. A secondary market exists, meaning that CDs can be bought or sold at any time. The yield on a CD is negotiated between the buyer and the bank. The yields on CDs will be similar to the yields on other similar short term money market securities. Yields also depend upon the default risk and liquidity of the CD
2 Repurchase agreements
A repurchase agreement or repo is an agreement involving the sale of a security with the condition that the seller will buy it back at a predetermined price. The securities involved are Commonwealth Government Securities and semi-government bonds (ie. instruments issued by the government). These as used as collateral (guarantee in case of default). Repos are typically made for one day and usually no longer than a week. The purpose of repos include: to provide a cheap funding source, place to park short-term surplus cash, a means to cover short-term liquidity shortfalls of financial institutions From the point of view of the seller, the repo is a source of short-term funds (like a short term loan). From the point of view of the buyer, repos are a short-term investment.
Zero coupon bonds
Another type of bond is the 'zero coupon bond'. Zero coupon bonds do not pay coupons to their holders. These bonds sell at a discount to their face value. At maturity, the holder receives the face value. The holder's return is the difference between the price paid (which is less than face value) and the bond's face value. The price of a zero coupon bond is the present value of its face value: W83_PricingZeroCouponsFormula Where: Fn is the face value of the bond i is the interest rate per period n is the number of period For a challenge, answer this question yourself: What is the price of a zero coupon bond with $5000 face value, semi-annual compounding and five years to maturity given the current market interest rate of 10%? Provide your answer here.
Bank accepted bills (BABs)
Bank bills have a long history. Nowadays, most bank bills are bank accepted bills. A bank accepted bill (BAB) is a time draft drawn on and accepted by a commercial bank. The bank promises to pay the holder of the bill its face value at maturity. This promise ensures that BABs trade as equals on the market. BABs are among the most important instruments in the money market. note These are NOT issued by banks (unlike negotialble certificates of deposit). The bank provides a guarantee to make it easier for the borrower to raise funds.
Bond characteristics
Collateral Debentures are unsecured bonds (in the US and Australia-in other countries they have a different definition or used interchangeably). Sinking funds provision Some corporate bonds have sinking fund provisions. This provision requires the corporation to place funds with a trustee to retire a portion of the debt issue each year. The trustee may retire the bonds by purchasing them on the market, or calling for them if a call provision is also present in the bond contract. Convertible bond Convertible bonds are hybrids that can be converted into equity at the holder's discretion. Their convertibility feature permits the holder to share in the good fortune of the firm if the stock price rises above a certain level. It is to the investor's advantage to convert when the market value of the stock exceeds the market value of the notes. Credit wrapping Credit wrapped bonds are issued by companies with lower credit ratings. These are usually companies with predictable earnings but high gearing (high levels of debt). The credit wrapping lowers the yields on these bonds and can represent interest savings for the issuer.
main participants in money markets
Commercial banks; The Reserve Bank of Australia (RBA)-Australia's central bank; The Commonwealth government; and Corporations.
3 Commercial paper
Commercial paper is the name for unsecured promissory notes issued by large corporations. Firms of high credit rating issue commercial paper as an alternative to borrowing from a bank. Commercial paper is a substantial part of the money market in Australia. Firms issuing commercial paper can sell it either through an underwritten or non-underwritten offer. Underwriting guarantees the issue will be taken up by investors. However, non-underwritten issues are cheaper for the firm because commissions are not paid to an underwriter.
1 Bond markets overview
Firms like to match the expected life of an asset with the maturity of the debt. The capital debt markets allow firms and governments to issue long term debt securities. Market participants: Capital markets bring together borrowers and suppliers of long-term funds. The largest purchasers (investors) of capital market securities are individuals and households. The largest issuers of long term debt instruments are the Commonwealth and state governments and corporations. Types of bonds: Commonwealth Government Securities (CGS): Commonwealth Government Securities (CGS) are treasury bonds and notes backed by the credit of the Commonwealth government. Treasury bonds are coupon instruments whereas treasury notes are discount securities. T-bonds are considered default risk free. New issues are sold by tender and have five and 13 year maturities. In Australia the issuance process is conducted by the RBA. The bid with the lowest yield is accepted first. Corporate bonds: Corporate bonds are issued by companies and represent debt contracts requiring payment of interest periodically (coupons) and repayment of principal at maturity (face value). Corporate bonds are usually issued in denominations of $1000 and pay coupon interest semi-annually. Offshore bonds: Many companies and governments obtain financing in countries other than their home country. Most bonds are issued in major currencies like the US dollar, Euro and Yen. Offshore bond issuance among Australian corporate entities increased from $60 billion to more than $460 billion between 1994 and 2009. More recent data is available here. Eurobonds are offshore bonds issued in a country different from the one in whose currency the bond is denominated. For example, a bond issued by an American corporation in Japan that pays interest and principal in dollars.
Characteristics of money market instruments
Instruments traded in money markets are referred to as money market instruments; their characteristics include: Short term to maturity -less than 1 year; Low default risk; High marketability/liquidity; Large denominations; Low per-dollar transaction costs. Money market instruments have these characteristics because: Investors are looking for safe, short-term investments, money market instruments are issued by economic units with the highest credit standing. Temporary investments need to be very marketable in case the money is needed unexpectedly. It only costs $3 in fees to trade a 'line' of securities in Austraclear... this could be a transaction worth up to $100 billion!
Valuation of money market instruments
Money market instruments are sold at a discount (discount instruments), meaning at a price lower than face value (P lower than F, with F being the principal borrowed). The pricing formula to be used for money market intruments is as follows: money market instrument Here's a problem for you to solve: Calculate the price for a 180-day T-note purchased at a 9% asked yield if the bill has a face value of $100 000. thinking Does this formula use SIMPLE or COMPOUND interest? hmmm...let me think!!
role of money markets
Money markets are wholesale markets where trades are typically valued at more than $1 million. Transactions on the money markets are called 'open market transactions' because of their impersonal and competitive nature. There are no established customer relationships. In Australia, settlement usually takes place through the clearinghouse Austraclear or the RBA's Information and Transfer System (RITS). The most important economic function performed by the money markets is providing a way for economic units to undertake liquidity management. Money markets allow economic units to manage the mismatches that occur between cash payments and cash receipts and thereby solve their liquidity problems.
3 Bond pricing
The price of a bond is the present value of the bond's cash flows. Before we can apply the present value formula to the bond's cash flows, we need to understand the nature of these cash flows. Fortunately, this is easy. A bond's cash flows consist of a series of regular interest payments called coupons, which are in fact an ordinary annuity, and a lump sum repayment of principal. Hence, the price of a bond can be found by adding the PV of annuity of coupon payments and the PV of principal repaid at maturity. The yield to maturity (YTM) is the yield promised to the bondholder if the bond is held to maturity and all coupons are reinvested at the promised yield. The YTM is also the rate that equates the present value of the bond's cash flows with its price.
5 Types of money market instuments
There are several money market instruments, including treasury bills, commercial paper, bankers' acceptances, (bank accepted bills) certificates of deposit, bills of exchange, repurchase agreements, asset-backed securities.
1 Treasury notes
Treasury notes (T-notes) are issued to finance the operations of the Commonwealth Government. T-notes issued recently have had maturities of one year or less. Because of government surpluses, no T-notes were issued in the years 2003 to 2009. However, in 2009 and 2010, the issuance of T-notes recommenced. T-notes are auctioned by the Australian Office of Financial Management (AOFM). Bids, usually by large investors, are submitted competitively. The bid with the lowest yield is accepted first. Any remaining T-notes are sold to subsequent bidders. T-notes are sold on a discount basis and pay no coupons. What does this mean? This should make sense once you've completed you reading. Investigate before class to make sure you understand what a discount instrument is.
distinction between DEBT and EQUITY:
When the corporation takes on DEBT it has a contractual obligation to pay back the amount it has borrowed-it OWES principal and interest to the lender. If the corporation raises funds through EQUITY issues (shares) it provides OWNERSHIP to shareholders. The focus this week is on debt instruments only.
money markets
are a collection of markets each trading a different short-term financial security.