BFC1001 Lecture Notes - Lecture 8: The Bond Buyer, Capital Market, Current Liability
8 Aug 2018
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Topic 8 Lecture Notes
1
Debt & Markets (Debt Securities)
When financing through debt securities, corporates and governments are in effect
borrowing money. This is done by issuing (creating/originating) debt securities and then
selling them.
- Upon sale, the issuer receives capital from the buyer and agrees to pay the buyer or
subsequent holder a return over the life of the security.
- At the end of the life of the security (upon maturity), the issuer returns the capital to
the holder of the security.
∴, debt securities are liabilities to the issuer & are assets to the investor who buy them.
Financing through debt securities is typically a form of direct finance.
Therefore, borrowing in the MM and Bond Market is cheaper than the equivalent
borrowing from a bank.
Lifecycle 1:
Company A (deficit unit) needs capital. Company B (surplus unit) has capital.
Company A issues/creates debt securities.
These debt securities are sold to company B for capital (a price).
Over the life of the security, company A provides a return to company B (usually
interest).
Upon maturity, company A returns the capital to company B.
Lifestyle 2:
Initial sale of security occurs from company A to company B in the primary market.
Over the life of the security, company B sells the security to company C (another
surplus unit) for capital.
Company A must now provide a return to company C (the current security holder).
Upon maturity, company A returns the capital to company C.
The Debt Securities Market:
The Debt Securities Market (credit market) is the largest capital market in the world.
The Debt Securities Market can be split into two types of markets:
- Money Market (MM)
- Bond Market / Fixed-Interest Market
Both markets are wholesale markets; where buyers and sellers are financial institutions,
non-financial institutions and governments that trade in millions and billions of debt
securities.
Primary distinctions b/w the MM & Bond Market:
- MM securities are called discount securities and have a maturity of < 12 months
Occurs in
the primary
market
Occurs in the
secondary
market
Topic 8 Lecture Notes
2
- Bond Market securities are called bonds and have a maturity of > 12 months
- Discount securities are traded over-the-counter (OTC) [privately]
- Bonds are traded OTC and on public exchanges
- Bonds make periodic (usually semi-annually) interest payments called coupons to
the current security holder prior to maturity
- Discount securities don’t pay coupons. Rather, the return is earned by the buyer
paying a discounted price on the face value during the purchase price and later
receiving the full face value upon maturity.
Face value = nominal or dollar value of the security given by the issuer
For example, the security’s face value is $100 at the time of sale. The investor will
pay $90 and receive $100 from the issuer upon maturity.
The Money Market:
The prime role of the money market is to provide the economy with short-term liquidity.
When capital is needed by corporates and governments, it can be obtained quickly,
easily and at a relatively low cost through short-term borrowing.
Short term liquidity provided by the MM is essential to:
- Trade: the exchange of goods and services.
Buyers can get the capital required to pay sellers from short term discount securities.
Businesses can get the capital required to pay short term costs. For example, they
need capital for when the shipment of stock comes in and they are able to repay this
capital once the stock is sold.
- Working capital management: current assets such as inventory can be financed
through current liabilities such as discount securities.
Characteristics of discount securities that promote liquidity and allow for the effective
transfer of capital from surplus units to deficit units are:
- Low default risk and transaction costs
- Large denominations (large dollar values) with standardised attributes (standard
face value, risk, discount rate, etc. [$1 mil, not $1.473 mil. 5%, not 5.3765%])
- Short term, standardised maturities (30, 90 or 180 days, not 58.6 days)
- High marketability & a deep pool of buyers and sellers
Examples of discount securities and their issuers –
treasury notes (Federal gov.),
commercial paper (State gov.),
repurchase agreements (State gov.)
Pricing Discount Securities:
The discounted price that will be paid by the investor is simply a discounted future value
that they will receive upon maturity.
P = discounted price paid by investor
F = face value at maturity (given to investor)
y = yield of security p.a
n = number of days until maturity
becomes
Document Summary
When financing through debt securities, corporates and governments are in effect borrowing money. This is done by issuing (creating/originating) debt securities and then selling them. Upon sale, the issuer receives capital from the buyer and agrees to pay the buyer or subsequent holder a return over the life of the security. At the end of the life of the security (upon maturity), the issuer returns the capital to the holder of the security. , debt securities are liabilities to the issuer & are assets to the investor who buy them. Financing through debt securities is typically a form of direct finance. Therefore, borrowing in the mm and bond market is cheaper than the equivalent borrowing from a bank. These debt securities are sold to company b for capital (a price). Over the life of the security, company a provides a return to company b (usually interest). Upon maturity, company a returns the capital to company b.
