Risk and return tradeoff
Bonds= risk free, lower return
Stocks=more risky, higher rate of return
Investors are risk averse, given and high risk bond and a low risk bond, if the return is the same, investors will take lower
In order to persuade investors to take risk needs to offer a higher rate of return
Balance sheet view of the firm
In finance, assets are equivalent to investments, which will bring future cash flows
What should my assets be? Which investments to make?
On the liability side, there are borrowings (A/P, short term and long term debts)
Where do I get my money from? (to make investments)
On the balance sheet:
Left hand= investment
It’s a choice between debt and equity
Shareholders own the firms (same as the owners own their houses, although they lend money to buy it)
Bonds are NOT a form of debt
Things that are not liabilities are equities (net assets) A=L+E
(i.e. if you sold the house you own, and paid off all the debts, then the remaining is your equity)
Retained earnings build up on equity
Debt vs equity
Equity comes from retained earnings and equity offerings (firm sells shares to market, new investors buy those shares,
they contribute to the firm, same way as banker lends to the firm) subscribe shares of the capital
IPO vs seasoned public offerings
Firm’s financing depends on other investors’ investment decisions (they get money from people who invest in their firm)
debts and equity
Shareholders= expecting returns
Firm’s financing decisions is always someone else’s investment decisions
Need to consider TVM (discounting to find present value)
R= discount rate, (opportunity) cost of capital
Opportunity cost of money tied on other investments
We use CAPM to determine the RRR given a level of risk => rate of return for equity investments
WACC=> blend of debt and equity the “r” (cost of capital)
Information changes people’s expectations about the future cash flows (matter to the value of the firm, and its shares)
Bond yield= risk
-Future contract (forward contract)
-Options Cost of capital is going to be the discount rate to decide on investments that the firm makes
US Treasury 10 Bonds 3.5% p.a.
‘Spread” 2.35% p.a.
Total= 5.85% rate of return for HW bond
Saved 0.05% from 2.4% spread p.a.
Right hand side of the balance sheet: financing decisions (raising money through issue bonds and shares)(someone else
is investing in me)
Left hand side of the balance sheet: investment decisions
The Efficient Markets Hypothesis may seem a bit theoretical, but it’s an important concept that we keep coming back to.
Most of the time it is convenient to assume that markets are (semi-strong) efficient (lots of our finance principles
depend on it e.g., CAPM), because if they are inefficient then we cannot say much with certainty. There are lots of good
reasons to believe that markets are fairly efficient, but we need to understand the implications if they are not…
The yield on Hutchison’s 10 year bond offered a ‘spread’ over 10-yr US Treasuries. (Spread from US treasury bill because
the company is riskier)
-Risk spread is the risk premium for the extra risk from treasury bills
-interests are determined by the market (from supply and demand)
-in order for people to lend more, HW has to offer more to get them lending to them due to its higher risk
-if interest rates go up, the PV of future cash flows are less valuable to us (therefore, the bond prices go down) (changing
of discount rate)
What is the ‘yield’ on 10-yr US Treasuries today (2013)?
US Treasury Bonds Rates
Maturity Yield Yesterday Last Week Last Month
3 Month 0.03 0.03 0.04 0.04
6 Month 0.09 0.09 0.09 0.09
2 Year 0.25 0.25 0.25 0.26
3 Year 0.37 0.38 0.40 0.38
5 Year 0.83 0.86 0.85 0.81
10 Year 1.96 2.00 1.99 1.90
30 Year 3.17 3.21 3.18 3.10
-Showing rates for today not a prediction of the future
-Different maturity (term, duration etc.) have different rates
-Curve is upward sloping, long term interest rate is higher than short term interest rate
-Means today if you invest long term, you will get a higher rate per annum
-Normally see that LT has higher rates
-maturity = term
-yield= amount of cash that returns to the owners of the security
What is the ‘yield curve’?
-Available today, the different yields for each maturity date -In finance, the yield curve is a curve showing several yields or interest rates across different contract lengths (2 month,
2 year, 20 year, etc...) for a similar debt contract. The curve shows the relation between the (level of) interest rate (or
cost of borrowing) and the time to maturity, known as the "term", of the debt for a given borrower in a given currency.
-US government can affect interest rates, which affect how much money people spend
-curve is opposite when government want to control hyperinflation, where short term borrowing is higher than
How does the 10-yr US Treasury bond % per annum yield get decided?
-Interest rates are so low because of the recession
-Trying to encourage consumers to borrow and spend back into the economy (reinvest)
How did/does Hutchison’s 10-yr bond % per annum yield get decided?
-Offered spread above the US treasury rate because Hutchison is riskier
-Investors require a reward for taking a risk - thus, risk premium given (better return)
-How was the interest rate decided? Supply and demand, looked at the market (markets set prices and
Canadian Bonds: (Corp, Fed, Prov. Mun)
Various people issue bonds
Different yield because need to reward investors for taking the risk
o If Hutchison borrowed more, interest rates will go up - increase supply, need demand
When market interest rates go up, coupon rate does not change - how does it affect bond prices?
Consumers know their coupons are less valuable in terms of PV - need to discount
(discount rate changes, cash flow does not)
Bond prices go down!
‘Fixed Income’ (fixed amount & schedule)
-Fixed = Coupon Rate = Fixed Interest
-Price will depend on market rate!
-Help companies raise the funds they need
-Sell bonds/stocks to investors (begin bidding) - go to investors to see demand
-Matching supplies and demand to set a price appropriate
-Spread tighten because there was more interest than Hutchison thought
-increasing supply through new shares
-Stock price was going down because …
Increasing supply, not willing to pay as much
- Worried that gold price would go down covering risk by hedging (fixed contract to sell gold at a fixed price)
-now the gold price is higher in market than the hedge contracts
-raising money to reverse hedge and removing insurance contracts
What is hedging? What was Barrick’s hedging program originally designed to do?
-Originally designed to dilute shares (i.e. more shareholders, fewer profits to be shared) - balanced with gains made by
eliminating hedging program -A hedge is an investment position intended to offset potential losses/gains that may be incurred by a
companion investment. In simple language, a hedge is used to reduce any substantial losses/gains suffered by an
individual or an organization.
A hedge can be constructed from many types of financial instruments, including stocks, exchange-traded funds,
insurance, forward contracts, swaps, options, many types of over-the-counter and derivative products, and
Why did they decide to stop the hedging?
-“He has been under pressure to get rid of the costly hedges, which have lowered profits and scared away shareholders
seeking full exposure to the rising price of gold.”
-Locked company into receiving a fixed price for some of its gold production - harder to defend future liability with
increasing gold price
-Will improve the valuation of two major growth projects and marketability and optics of world’s largest gold producer
-Should gold companies hedge? No, they should just be gold company and have full exposure
When Barrick makes a share offering, what happens? Who is buying? Who is selling? Who pays cash? Who receives
cash? Who decides the price? How does it affect Barrick?
-Only first issue of stocks will affect balance sheet - stock prices that fluctuate do not affect the balance sheet (second
hand shares) - no transaction with the actual company (its between other sellers and buyers)
Company issuing shares at $10 for 100 shares. When prices go down to $9 per share, it doesn’t affect the company’s
balance sheet, because it’s already raised the money. no cash flow (the transactions will take place within the second
hand shares market)
-Barrick 2013: http://www.globeinvestor.com/servlet/Page/document/v5/data/stock?id=ABX-T
-Optional: Excellent 2010 Update on Barrick Hedging http://www.theglobeandmail.com/report-on-business/rob-
Financial market: place where buyers and sellers trade financial assets, market for financial instruments
How do financial markets set prices? Are financial markets ‘efficient’?
-Financial Market = seller and buyers meet to exchange financial instruments (i.e. stocks or bonds) → TSX
What does it mean to say that a financial market (capital market) is ‘efficient’?
Whether prices adjust quickly a