Security Analysis
Overview of Financial Market
Environment and Conditions
The Role of Financial Markets and
Institutions
 A financial markets
 Market with assets (securities, financial instruments)
 Sell and buy …
 Transfer of funds…
 Deficit subjects
 Surplus subjects
 Financial Market: a market in which financial assets
(securities) such as stocks and bonds can be
purchased or sold
 Financial intermediation – financial savings to investments
 Payment system
 Means of manage risk
Role of Financial Markets
 Transfer funds from those who have excess
funds to those who need funds.
 Students – student loan
 Families – mortgages
 Business – finance they growth
 Government – finance their expenditures
 One side supply funds the other side demand
funds
 Earn return but only if fund is available in financial
market
Role of Financial Markets
 Surplus units – lenders, investors
 Receive more money than they spend
 Deficit units – borrowers
 Spend more money than they receive
 This relation is formally organized by
securities
 Agreement between lender and borrower
 Claim on the issuer
Role of Financial Markets
 Debt securities
 Represent debt incurred by issuer – credit, borrowed funds
 Deficit units issue the securities to surplus units and…
 …pay interest to surplus unit on a periodic basis (such as
every six months)
 Characteristics:
 Maturity date
 Face value
 Fixed or variable interest rate
 Equity securities
 Represent equity or ownership in the issuer – stocks
 Deficit unites issue the stocks to surplus money…
…spend more money than they receive from normal operations
Role of Financial Markets
 Debt instruments
 Bonds, mortgages, mortgage-backed securities
 Contractual agreement by the borrowers to pay the
holder of the instrument fixed amounts at regular
intervals until a specific date (maturity day), when a final
payment is made.
 The maturity of a debt instrument is the number of
years until that instrument’s expiration date.
 Debt instrument is
 Short – terms or
 Long - term
Role of Financial Markets
 Equities
 Common stocks
 Which are claims to share in the net income (income after
expenses and taxes) and the assets of a business.
 If you own one share of common stock in a company that has
issued one million shares, you are entitled to 1 one-millionth of
the firm’s net income and 1 one-millionth of the firm’s assets.
 Equities often make periodic payments to their holders
 Dividends
 They are considered long-term securities because they
have no maturity day.
 Owning stocks means that you own a portion of the firm
and thus have the right to vote on issues important to the
firm and elect its directors.
Role of Financial Markets
 Advantages and disadvantages
 Debt vs. equities
 Disadvantages of equities
 Equity holder is residual claimant
 Advantages of equities
 Holders benefit directly from any increases in the
corporation’s profitability or asset value
Type of Financial Markets
 Money versus Capital Markets
 Short-Term, < 1 Year
 High Quality Issuers
 Debt Only
 Primary Market Focus
 Liquidity Market--Low
Returns
 Long-Term, >1Yr
 Range of Issuer Quality
 Debt and Equity
 Secondary Market Focus
 Financing Investment--
Higher Returns
Type of Financial Markets
 Primary versus Secondary Markets
 New Issue of Securities
 Exchange of Funds for
Financial Claim
 Funds for Borrower; an IOU
(I owe you) for Lender
 Trading Previously Issued
Securities
 No New Funds for Issuer
 Provides Liquidity for Seller
Type of Financial Markets
 Securities brokers and dealers are crucial to
a well-functioning secondary market
 Brokers
 Dealers
Type of Financial Markets
 Because over-the-counter dealers are in computer
contact and know the prices set by one another, the
OTC market is very competitive and not very
different from a market with an organized exchange.
 Stock Exchange
 Visible Marketplace
 Members Trade
 Securities Listed
 New York Stock
Exchange
 NASDAQ (2006)
 OTC
 Wired Network of
Dealers
 No Central, Physical
Location
 All Securities Traded
off the Exchanges
 Forex
How Financial Markets Facilitate
Corporate Finance
 Three segments of finance
 Corporate finance
 How much funding to obtain and how to invest a proceeds to
expand their operation
 Investment management
 Make a decision about form of financing and investing
 Debt vs. Equity financing or investing
 Financial markets and institutions
 Attract fund from investors and channel the funds to
corporation
 Money market – borrow on short term basis
 Support existing operations
 Capital market – obtain long term funds
 Support corporate expansion
How Financial Markets Facilitate
Corporate Finance
Source: Madura, J.: Financial Markets and Institutions, 9th Edition
Securities Traded in Financial Markets
 Return
 Expected return from investment
 Ex post
 Ex ante
 Mean of return
 Risk
 Uncertainty surrounding the expected return
 More uncertainty surrounding the expected return more risk
 Standard deviation or variance
 Coefficient of variation = expected risk (standard deviation)/ expected return
(mean)
 Amount of liquidity
 Tax status
 Normally
 High return with particular preference of low risk and adequate amount of
liquidity
Securities Traded in Financial Markets
 Money market securities
 Only debt securities
 Capital market securities
 Bonds
 Mortgages and Martgage-Backed securities
 Stocks
 Derivative securities
 Speculation
 Speculation on movement in value of underlying assets
without having to purchase those assets
 Leverage effect
 Hedging
 Commodities
 Foreign currencies
Money market
Stocks
Bond
Commodity - gold
Valuation of Securities in Financial
Markets
 Each type of security generates a unique
stream of expected cash flows to investors
 Capital gain, income
 Each security has a unique level of
uncertainty surrounding the expected cash
flows
 Valuation of securities = present value (PV)
of its expected cash flows
 Discounted at a rate that reflects the uncertainity
Impact of Information on Valuations
Source: Madura, J.: Financial Markets and Institutions, 9th Edition
Financial Market Regulation
 Many regulations were enacted in response to
fraudulent practices before the Great Depression
 Asymmetric Information
 Adverse Selection
 Morale Hazard
 In financial markets, one party often does not know
enough about the other party to make accurate
decision
 Lack of information creates problems in the financial system
on two fronts:
 Before and after transaction
Financial Market Regulation
 Adverse selection
 The problem created by asymmetric information before the
transaction occurred.
 This occurs when the potential borrowers who are the most
likely to produce undesirable (adverse) outcome – the bad
credit risk – are the ones who most actively seek out a loan
and are thus more likely to be selected.
 Because adverse selection makes it more likely that loans
might be made to bad credit risks, lenders may decide not
to make any loans even though there are good credit risks
in the market place.
Financial Market Regulation
 Moral hazard
 It is the problem created by asymmetric information after
the transaction occurred.
 Moral hazard in financial markets is the risk (hazard) that
the borrower might engage in activities that are undesirable
(immoral) from the lender’s point of view, because they
make it less likely that the loan will be paid back.
 Because moral hazard lowers the probability that the loan
will be repaid, lenders may decide that they would rather
not make a loan.
 Moral hazard leads to conflicts of interest
Financial Market Regulation
 Six types of regulations.
 1. Restriction on entry
 2. Disclosure
 3. Restriction on Assets and Activities
 4. Deposit insurance
 5. Limits on Competition
 6. Restriction on Interest Rate
 Disclosure
 Incorrect information - poor investment decision
 Attempt to ensure that businesses disclosure accurate information
 Disclosure information is available only a small set of investors that have major
advantage
 Goal to provide all investors with aqual access to information
 Regulatory Response to Financial Scandals
 2001 – 2002
 Sarbanes-Oxley Act
 The limited financial disclosure by firms is a major reason why there is much
uncertainty surrounding their valuations
Global Financial Markets
 Improve of international transfer of funds between
surplus and deficit units
 Some countries have had financial market form a
long time but there are also new market of transitive
economies – emerging markets
 Slow develop of financial markets in developing
countries
 Lack of information
 Low confidence in markets
 Rare of prosecution
 Low efficiency of fund channeling
Perfect market E. Fama 1970’s
 Characteristic of perfect markets
 All information about any securities are available
 You can buy any size of security
 No existence of transactional costs
 → financial intermediaries are not necessary
 Markets are imperfect
 Information are not perfectly and freely available
 Surplus unit are not able to identify
creditworthiness of borrowers
 Individual contracts are expensive
Direct and Indirect Financing
Role of Financial Institutions
 Financial institutions
 Depositary Institutions
 Non-depository Financial Institutions
Why are financial intermediaries and
indirect finance so important?
 Transaction Costs
 Transaction costs, the time and money spent in carrying
out financial transactions, are a major problem for people
who have excess funds to lend.
 Financial intermediaries can substantially reduce
transaction costs because they have developed expertise
in lowering them, and because their large size allow them
to take advantage of economies of scale.
 For example
 A bank knows how to find a good lawyer to produce loan
contract, and this contract can be used over and over again in
this loan transactions, thus lowering the legal cost per
transaction.
Why are financial intermediaries and
indirect finance so important?
 Risk Sharing
 Another benefit made possible by the low transaction costs
of financial institutions is that they can help reduce the
exposure of investors risk.
 Financial intermediaries do this through the process known
as risk sharing.
 They create and sell assets with risk characteristics that
people are comfortable with. The intermediaries then use
the funds they acquire by selling these assets to purchase
other assets that may have far more risk.
 Asset transformation
Depository Insitutions
 Accept deposit → provide credit → purchase
securities
 Offer deposit account
 Repackage funds to provide loans
 Accept risk
 Expertise available
 Diversification
Commercial
Banks
$5 Trillion
Total Assets
Savings
Institutions
$1.3 Trillion
Total Assets
Credit Unions
$.5 Trillion
Total Assets
Types of Depository Financial Institutions
Pension
Funds
Types of Nondepository Financial Institutions
Securities
Firms
Mutual
Funds
Financial
Companies
Insurance
Companies
Nondepository Financial Institutions
 Focused on capital market
 Longer-term, higher risk intermediation
 Less focus on liquidity
 Less regulation
 Greater focus on equity investments
Comparison of Role among Financial
Institutions
Source: Madura, J.: Financial Markets and Institutions, 9th Edition
Summary of Institutional Sources and
Uses of Funds
 Source: Madura, J.: Financial Markets and Institutions, 9th Edition
Consolidation of Financial Institutions
 Rapid growth of mutual funds and pension
funds
 Increased consolidation of financial
institutions via mergers
 Increased competition between financial
Institutions
 Growth of financial conglomerates
Typical Structure of a Financial
Conglomerate
Source: Madura, J.: Financial Markets and Institutions, 9th Edition