FINC314 Lecture Notes - Lecture 1: Market Liquidity, Longrun, Financial Market Efficiency

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fuchsiabadger483

29 Aug 2016

School

University of Delaware

Department

Finance

Course

FINC314

Professor

Danby Peter

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Document Summary

The impact of secondary markets on corporations and the economy. As discussed in the previous exploratory note, financial markets are structures or mechanisms of exchange through which funds flow from those with a surplus (suppliers of funds) to those with a deficit (users of funds). But, it is the secondary markets with which we are concerned in this final note tonight. The degree to which an asset or security can be quickly bought or sold in the market without affecting the asset"s price. Market liquidity refers to the extent to which a market, such as a country"s stock market or a city"s real estate market, allows assets to be bought and sold at stable prices. Cash is the most liquid asset, while real estate, fine art and collectibles are all relatively illiquid. A security, stock or bond assets that are much more liquid can convert into cash within a few days.

Related Questions

Can you tell me What does this article tell us about the bond markets performance and the interest rate environment?

Long-Term Government Bonds Shine as Fed Goes Slow

Pimco, Vanguard funds with focus on long-term debt beat out other bond funds in the 1st quarter

For investors, one of the best bets of 2016 has been a wager via U.S. Treasurys on falling interest rates.

A Pimco long-term government-bond fund was the best performer among bond funds in the first quarter. Above, Pimco offices in Newport Beach, Calif. PHOTO: MIKE BLAKE/REUTERS

The $460 million Pimco Extended Duration Fund posted a total return of 11.8% in the first quarter, making it the best performer among 2,015 U.S.-based bond mutual funds, according to data from Morningstar. Total return reflects price gains plus periodic payments.

The runner-up was $1.3 billion Vanguard Extended Duration Treasury Index Fund, which returned 11.7% during the quarter, according to Morningstar.

Both funds posted their best returns since the last quarter of 2014 and have extended those gains in the early days of the second quarter. Duration refers to a fundâs exposure to interest-rate risk, meaning its prices will rise more when rates fall and fall more when rates rise.

Analysts have warned repeatedly that bets on duration are risky, given the long decline in interest rates over recent years. The gains are striking at a time when stocks and other riskier assets have rebounded from an early-year selloff that at one point left the Dow industrials down 10%. The Dow fell 20.55 points, or 0.1%, on Monday, but is up 0.8% for the year.

While safer securities such as U.S. Treasurys and German bunds tend to decline in price when stocks and low-rated corporate bonds rally, many analysts say the simultaneous rise of safer and riskier assets this spring is tied to the unexpectedly slow pace of policy tightening by the Federal Reserve, along with signs the global economy continues its slow healing.

MORE IN MARKETS

A Measure of Stock-Market âFearâ Just Hit an All-Time High

Spreads Point to Growing Stress in Japanese Government Bond Market

By One Measure, U.S. Rates Are Already Negative

At the same time, many investors are concerned that the rally in stocks, bonds and commodities off Feb. 11 lows may have gone too far too fast.

âWe are still stuck in low growth,ââ Jack Flaherty,portfolio manager at money manager GAM, which has over $119 billion in global assets under management. âIt may be time to lighten up a bit and pauseâ on purchases of riskier assets, he said.

The uncertainty is why many investors are buying long-term U.S. government bonds, even though analysts have warned that slim yields leave bondholders vulnerable to potentially large capital losses if interest rates do rise.

The average U.S. equity mutual fund posted a total return of minus-0.4% between January and March, according to Morningstar. The average return for all U.S.-based bond funds tracked by Morningstar was 2.1% for the period. Quarter-end data for all funds are typically finalized in the early days of the following period.

âIt has been a good start for bond funds,ââ said Jeff Tjornehoj, head of Americas research at Lipper. That performance âmay be hard to repeat this quarter.â

Stock funds on average returned 4.4% in the fourth quarter last year, according to Morningstar. Bond funds posted a negative 0.1% return in the final quarter of 2015.

U.S. Treasury bonds overall have posted a total return of 3.6% this year through Friday, according to data from Barclays. U.S. bonds sold by lower-rated firms, or junk bonds, have returned 3.8% over the same period. S&P 500 has returned 0.8%, according to FactSet.

The Vanguard fund passively tracks an index of long-term Treasury bonds. The fund âwill tend to have extreme resultsâboth on the up and down sideââ given its focus on buying government bonds with very long-term maturity, said a representative of Vanguard in a written statement.

The Pimco fund is actively managed by three fund managers at Pacific Investment Management Co.: Stephen Rodosky, Michael Cudzil and Josh Thimons. A representative at Pimco declined to comment.

The Pimco fund attracted $19.7 million of new cash between January and February, topping the $11.9 million it obtained for the whole year of 2015, according to the latest data from fund tracker Lipper.

The Vanguard fund attracted $20.4 million of new cash during the first two months of the year, after suffering a net withdrawal of $115.7 million in 2015, according to Lipper.

The Vanguard fund posted a loss of 20.9% in 2013, according to Morningstar, when worries about the Fed reducing bond purchases rattled the bond market. The Pimco fund lost 21.2% that year.

But U.S. bond yields have largely been on a downward trend since the financial crisis. The two funds both posted an annualized return of about 17% on average over the past five years through Friday, according to Morningstar.

These assumptions are necessary for the M&M theory on capital structure.

For the Proposition M&M II beginning on page 498, still in a perfect capital market which includes no taxes, M&M state that the cost of capital of EQUITY increases with the firm's market value debt-equity ratio. But, when you examine this Proposition more closely, for a new investment the cost of capital will equal the weighted average of the firm's equity and debt costs. What does this mean in practical terms? It means that M&M "loosens" a part of the Proposition I, and admit that the cost of equity does increase as the debt-equity ratio increases. But, if you examine this closely, it means that the OVERALL cost of capital, captured in the WACC stays constant. And, the pre-tax WACC is the same as the after-tax WACC, since there is no tax! If the WACC stays constant while the equity cost increases, this means that the debt costs are going down,relatively; on the contrary, if the equity costs are going down, then the debt costs are going up. This is shown on page 500 in Figure 14.1. And, of course, the weights count.

But, in the real-world, the M&M Propositions do not hold....corporations and individuals do have taxes, and do have transactions costs for debt and equity...buying bonds and stocks, for example.

So, as we have learned, the Beta coefficient for equity does increase as the amount of debt level increases (due to increasing risks of default of interest payments or repayment of the bonds at maturity)...and the costs of debt increase, but as we weight those, the WACC actually varies, based on the real-world that includes taxes....we normally see the WACC being a U-shaped curved that varies as a function of the debt to equity ratio.

That is the background for this Written Assignment. Dr. Steadman

) Discuss the MM Proposition I and MM Proposition II (definition, assumptions, results and implications)? Remember, at the MBA level, more is better. But, to the point, and no "hot air."

Franco Modigliani and Merton Miller (M & M) are two very famous financial economists that both won the Nobel Prize in Economics for their work in the finance area, particularly in capital structure theories (see the Description of this in the box on page 504 of your text). In their famous 1958 article (see footnote on page 490), they argued that with perfect capital markets, the total value of a firm should not depend on its capital structure. In other words, the total value of a firm would be the same with all equity, or financing with 100% debt. This is the basic MM Proposition I stated on p.493. But, as you should see, the "perfect capital markets" assumes 3 key assumptions, including no taxes or transactions costs dealing with equity or debt. Additionally, a key assumption is that individuals and firms can trade the same set of securities at competitive market prices equal to the present value of their future cash flows. These assumptions are necessary for the M&M theory on capital structure. For the Proposition M&M II beginning on page 498, still in a perfect capital market which includes no taxes, M&M state that the cost of capital of EQUITY increases with the firm's market value debt-equity ratio. But, when you examine this Proposition more closely, for a new investment the cost of capital will equal the weighted average of the firm's equity and debt costs. What does this mean in practical terms? It means that M&M "loosens" a part of the Proposition I, and admit that the cost of equity does increase as the debt-equity ratio increases. But, if you examine this closely, it means that the OVERALL cost of capital, captured in the WACC stays constant. And, the pre-tax WACC is the same as the after-tax WACC, since there is no tax! If the WACC stays constant while the equity cost increases, the figure also shows that the debt costs are also going up; similarly, if the equity costs are going down, then the debt costs are going down also as the debt-to-value decreases. This is shown on page 500 in Figure 14.1. And, of course, the weights of debt and equity (0/100, 25/75, 50/50, 75/25, 100/0) count. But, in the real-world, the M&M Propositions do not hold....corporations and individuals do have taxes, and do have transactions costs for debt and equity...buying bonds and stocks, for example. So, as we have learned, the Beta coefficient for equity does increase as the amount of debt level increases (due to increasing risks of default of interest payments or repayment of the bonds at maturity)...and the costs of debt increase, but as we weight those, the WACC actually varies, based on the real-world that includes taxes....we normally see the WACC being a U-shaped curved that varies as a function of the debt to equity ratio.

Questions:

1. Discuss the MM Proposition I and MM Proposition II (definition, assumptions, results and implications)? Remember, at the MBA level, more is better. But, to the point, and no "hot air."

2. Assume you are doing a financial analysis for Kroger Inc. Here is one of the income statements that you analyze (all figures in $ Millions):

Which year does Kroger Incorporation have the highest tax shield and why? Be very specific.

Year	2006	2005	2004
Total Sales	60,553	56,434	53,791
Cost of goods sold	45,565	42,140	39,637
Selling, general & admin expenses	11,688	12,191	11,575
Depreciation	1265	1256	1209
Operating Income	2035	847	1370
Other Income	0	0	0
EBIT	2035	847	1370
Interest expense	510	557	604
Earnings before tax	1525	290	766
Taxes (35%)	534	102	268
Net Income	991	189	498

FINC314 Lecture Notes - Lecture 1: Market Liquidity, Longrun, Financial Market Efficiency

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