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Rotman Commerce
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RSM332H1
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Jennifer So
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Rotman Commerce

RSM332H1

Jennifer So

Fall

Description

Capital Market Theory
Lecture 1
Finance = process which individual investors
and firms allocate resources over time by
using financial assets
Financial System
Households are primary provider of
funds
o Objective: allocate their income/savings to carious assets to maximize the utility of life-
time consumption
o Real Assets =
o Financial Assets =
o Liabilities [ex. Credit cards, car loans, mortgages]
o Net Worth = asset – liabilities
Business & Gov primary user of funds
Intermediaries – connection
o Financial Intermediaries [ex. banks, insurance companies, pension funds, mutual funds]
o Market Intermediaries [ex. investment dealers, brokers]
3 ways funds are moved:
o Direct transfer = saver to borrower (non-market)
Problems: Search costs [finding person to lend], Double co-incidence of wants,
Contracting costs [contract to get $ back], Default [crook? Enforce contract?],
Liquidity [want money early?], Asymmetric Information [adverse selection],
Moral Hazard [change decision after]
o Direct Intermediation = market based transaction through intermediary
o Indirect Claims through a financial intermediary = financial intermediary takes funds
from a saver and lend those funds off
Financial Intermediaries
Banks
o Take deposits and are “pooled” in the bank
o Bank takes pooled funds and lends them to household/business as loans/mortgages
o Transform original nature of savers money able to perform b/c experts at risk
assessment/financial contracting/monitoring activities
Deposit in small amounts with little risk
Loans/Mortgage: large sums, borrowed for long time, risky purpose
Insurance Companies
o Sell policies & collect premiums (based on policy type and size + admin fees)
o Invest premiums so that accumulated value in future will grow to meet anticipated
claims risk shared among all policy holders
o Allows the household, business, gov to engage in risky activities
Pension Funds/Plans
o Payments made over entire working life
o Accumulated value in pension can be used by person in retirement
o Managers collect funds to invest diverse portfolios
o Major source of capital, fueling investment in R&D, capital equipment, resource
exploration, and ultimately contribution in substantial way to growth in the economy
Mutual Funds o Give small investors access to diversified professionally-managed portfolios of securities
o Called Denomination b/c mutual fund makes investments available in smaller, more
affordable amounts of money
Financial Instruments
Public Debt (government) & Private Debt (household, non-financial corporations)
Contracts = connect households to production side of the economy
o Debt Instruments [ex. Commercial paper, banker acceptance, treasury bills, mortgage
loans, bonds, debentures]
o Equity Instruments [ex. Common stock, preferred stock]
Marketable Vs. Non-marketable
o Characteristics of marketable securities: can be traded between or among investors
after their original issue in public markets and before they mature or expire
o Characteristic of Non-marketable securities: cannot be traded between or among
investors, may be redeemable [ex. Saving account, term deposits, GIC, saving bonds]
Market Capitalization = total market value of a company’s equity/stock shares
Money Market Securities = short-term debt securities that are pure discount notes *ex. Banker’s
acceptances, commercial paper, treasury bills]
Capital Market Securities = long-term debt or equity securities with maturities > 1 year [ex.
Bonds, debentures, common stock, preferred stock]
Financial Markets
Primary Market = involves issue of new securities by the borrower in return for cash from
investors [ex. IPO]
Secondary Market = involves buyers and sellers of existing securities, funds flow from buyer to
seller (not capital formation occurs)
o Exchanges or Auction Markets = involved bidding process at specific location [ex. TSX]
o Dealer or Over the Counter (OTC) Markets = do not have physical location and consist of
dealers who trade directly with one another [ex. Bond Market]
o Money Markets and Bond market are global = domestic equity market
Goals of Corporation
Shareholder wealth maximization is considered most appropriate to guide officers & directors,
focuses on genuine profit, reflects into future (better than profit maximization b/c not focused
on accounting profit, not short term gain.)
Conflict arises when stakeholders have differing goals
Direct Agency Costs = arise when suboptimal decision are made by manager when the act in a
manner is the best for investors
Indirect Costs = incurred by corporation in attempt to avoid direct agency costs
Lecture 2
Time value of money (TVM) opportunity cost
o Based on idea that money today ≠ to amount tom (b/c invest)
Moving money from future to today = Discounting
Moving money from today to future = Accumulating
Interest Rate = Discount Rate = Required Rate = cost of money
(1+r)T
Is known as the
Future Value Factor 𝟏
𝟏 𝒓 𝑻
Is known as the Discount
𝐶 is negative b/c Factor
it represent an
investment ∑
Compound Interest
Simple Interest = is paid or received only on the initial investment amount (only 1 time period)
o Annual interest $1000 x 0.08 = $ 80 per year
Compound Interest = interest is added to amount then new interest calculated
o Compound interest $1000 X (1.08) = $1469
Re-arranged from:
𝐹𝑉𝑛 𝑃𝑉 𝑘 𝑛
Re-arranged from:
𝑛
𝐹𝑉𝑛 𝑃𝑉 𝑘
Annuities & Perpetuities
Annuity = financial instrument that pays income in a
series of payments for the same amount over a
regular interval
o Ordinary Annuity = payment at end of the
period
EX. Invest $500 at end of each year
for next 4 years earn 10% each year.
C = PMT = Answer: (using Future Value4 FV =
Payment 500(1.1) + 500(1.1) + 500(1.1) +
500 = $2320.50
o Annuity Due = payment at the beginning of
the period
Perpetuity = payments are infinite Relationship between Annuity Due & an Ordinary Annuity
Annuity due = ordinary annuity + 1 more period
Perpetuities
Stream of cash flows that goes on forever C = periodic cash
flow
[Ex. Common stock, preferred stock, consol bonds] R = discount rate
Growing/Shrinking Annuities & Perpetuities
Grow/shrink at constant rate g each period
No longer have constant payment each period but constant growth rate
PMT =1PMT (1+0) k = discount
PMT = PMT (1+g) = PMT (1+g) 2 g = growth rate
2 1 0 3
PMT =3PMT (1+2) = PMT (1+g0
[ ( ) ]
Positive growth rates (g>0) yield growing annuities
Negative growth rates (g<0) yield shrinking annuities
Notice that if g=0, the above equation = present value of an ordinary annuity
reffectiveeffective
Compounding annual interest rate
Interest on interest
rs= stated/quoted
interest rate
m = # of compounding
Payment & Compounding Periods Differ periods
When number of payments per year is different from number of compounding periods per year
then must calculate the interest rate per payment period reffectiveffective annual interest rate
r stated or quoted interest rate
s=
m = # of corresponding periods per
year
f = the payment frequency per year
Calculating Balance Outstanding
Mortgages or Loans
Mortgage = a loan involving equal ‘blended’ payments (interest and principal) over a specified
payment period
o Term = the period for which investors can ‘lock in’ at a fixed rate
o Amortization Period = period over which loan is to be repaid
Note: 1 payment more principle than interest, last payment more interest than principle
Calculating Monthly Payments: solve for C from ‘Balance O/S’ formula
Loan Amortization = blended payment loan is repaid in equal periodic payments
Amount of principal and interest varies each period
Solve: [1] calculate annual payments solve for PMT (for below eqn)
[2] calculate the balance O/S after the first year, solve for PV
Lecture 3
Bonds
Fixed income security is a financial (and contractual) obligation of an entity that entitle the
holders to receive a pre-determined stream of future cash flows
Failure to pay month payment or at maturity => default
Classified based on maturity:
o Less than 1 yr => Bills or Paper
o 1 yr < Maturity < 7 yrs => Notes
o <7 yrs => Bonds
Characteristics:
1. Fixed face or par value, paid to holder of bond at maturity
2. A fixed coupon, which specifies the interest payable over the life of the bond (annual or
semi-annual)
3. A fixed maturity date
Term-to-maturity: the time remaining to the bond’s maturity date
Coupon Rate: the annual % interest paid on the bond’s face value
o
o If coupon is paid 2 times a year, divide the annual coupon by 2
Valuation:
o When same dollar amount of money received each period, the series of payments is
called annuity (ie. Bond is another type of annuity)
o Coupons paid in arrears = meaning although the dollar amount of the coupon payment
may be known in advance it is paid at the end of the period [ ]
o Bond’s market price is equal to the PV of its expected cash flows discounted (irr) at its
yield to maturity
∑
P = price (in $), c = coupon payment, n = # of periods, t = time period when payment received, r
= period interest rate
To adjust for semi-annual payment (annual semi-annual) *change when question says semi-
annual*
1. Size of coupon payment (divide by 2)
2. Number of periods (multiply by 2)
3. Yield-to-maturity (divide by 2)
Ex. Market price of 5 yrs, $1000 bond, 4% coupon, YTM is 6%
[answer: size coupon = 3%, number of periods = 10, YTM = 3%]
Yield measures your return if the bond is held to maturity
o If sold before maturity could be possible Capital Gain or Capital Loss
o Notes: if Interest rate ↓ = Bond price ↑
o Holding Period Return => answer gives % made or loss Capital Gains
Yield + Income
Yield = Holding
Period Return
To find annualized rate of return during investment:
1. Find current price using bond valuation formula
2. Find purchase price using bond valuation formula
3. HPR = [Current Price + 2*(C*value)- Purchase Price] / Purchase Price
4. Square root HPR result subtract by 1
Above steps equals this formula
[ ]
Cash Vs. Quoted Price
Finding cash price of when given quoted price => difference is amount added onto the quoted
price, it is paid to seller as he sold when extra # of days after last coupon payment
Yield To Maturity (YTM) = interest rate that will make the PV of a bond’s cash flows equal to its market
price + accrued interest (ie. Equal to irr)
Most popular measure used in the market
To find YTM must [1] determine expected cash flows [2]search by trial and error for the interest
rate that will make the present value of cash flows equal to the market price (ie. Find irr) Use bond valuation formula for many periods, use for few periods
Yield Spread = difference between YTM of 2 different rated bonds, it represents a default-risk
premium investors demand for investing in more risky securities
o Spread ↑ when pessimism increase in economy
o Spread ↓during times of expansion
Coupon – YTM Relationship
Relationship determines if bond will sell at a premium, discount or par
o Discount rate > Coupon rate => sell bond at cheaper rate to compensate for cheaper
rate [ Coupon rate < YTM, Price < Face Value priced at discount]
o Discount rate = Coupon rate => issue at par [Coupon Rate = YTM, Price = Face value
priced at Par]
o Discount rate < Coupon rate => adjust bond price will be issued at premium [Coupon
Rate > YTM, Price > Face Value Priced at Premium]
Bonds always mature at par value [Bond = Face value @ maturity]
Risk Premiums & Yield Spreads
Yield on bonds differ from the risk free rate b/c additional risk or features associated with those
instruments
Relationship expressed as: (rf = risk free rate, spread required for default risk)
Reasons for Yields
Default Risk higher this risk, the higher the required YTM
o Risk of not being able to get $ at maturity
o Covenants = conditions set before hand to reduce risk
o Positive Covenants = things firm agrees to do [ex. Supply periodic financial statements,
maintain ratios]
o Negative Covenants = things firm agrees not to do [ex. Restrict amount of debt firm can
take on, prevent firm form acquiring or disposing of assets]
o Debt ratings: Investment Grade (AAA, AA, A, BBB), Junk/High Yield (BB, B, CCC, CC, D,
Suspended)
Individual bond issues are rated, not issuers
6 factors in rating: core profitability, asset quality strategy & management
strength, balance sheet strength, business strength, miscellaneous issues
Liquidity lower the liquidity, higher the YTM
o Bigger spread less liquid bond, more bonds issued more liquid
o Traded OTC, meaning no central clearing system which make competition for sales
higher
o Means larger bid-ask spread a significant friction cost
o Short-term & higher rated bonds have greater liquidity
o Trading in the long-term debt of speculative companies can incur huge liquidity costs
Options & Other Embedded Features increase or decrease YTM depending on benefit
o Option favours lender, reduces risk premium
o Option favours borrowers, increases risk premium
o Call feature: allows the issuer to redeem or pay off the bond prior to maturity, usually at
a premium
o Retractable bonds: allows the holder to sell the bonds back to the issuer before maturity
o Extendible bonds: allows the holder to extend the maturity of the bond o Convertible bonds: can be converted into common stock at a pre-determined
conversion price
Bps / o Sinking funds: funds set aside by the issuer to ensure the firm is able to redeem the
100 bond at maturity
o Collateralized bonds: have physical assets pledged against the interest payments in the
event of default
Yield spread compensate investors for taking additional risk
The Price-Yield Relationship
Higher discount rate (YTM)is associated with a lower price
Prices set by supply/demand and YTM which is changing in response to changes in price
Bond prices fall as interest rates fall interest rate risk is biggest risk affecting bondholders
Effects on Relationship
1. Longer maturity has more effect on yield when YTM changes
YTM ↓ = ↑ Price
[ex. Bond1 5 yrs, bond2 10 yrs, decrease 3% has larger increase on the 10yr]
2. Lower coupon rate the greater the impact
[ex. Has larger impact on zero coupon than 6%, 6% larger impact than 9%]
3. Increase % impact does not equal Decrease % impact [ie. not linear]
Interest Rate Risk & Price Volatility
Sensitivity of bond prices to changes in interest rate is measure of bond’s interest rate risk
Return of a bond is a function of:
o Coupon payments
o Reinvestment income
o Repayment of principal
Bond’s interest rate risk affected by:
1. Yield to maturity
2. Term to Maturity
3. Size of Coupon
Inverse relationship between price & yield maturity
Impact of coupon rate
o the lower the coupon rate, the greater is the bond’s price sensitivity to changes in
interest rates
o the lower the current coupon payments the more you are dependent on the deferred
repayment of principal to provide return
o Implication: zero coupon bonds have more sensitivity to interest rate changes than
bonds bearing a coupon rate and trading at the same yield
Impact of Term (maturity)
o the longer the bond’s maturity, the greater is the bond’s price sensitivity to changes in
interest rates (or the longer the duration)
Impact of the Yield to Maturity
o The higher the YTM , the lower the price volatility
o High yields translate into high current opportunity costs – those deferred coupon
payments are not worth as much when yields are high
Duration
Effect of 3 factors of interest rate risk called Duration = measure change in bond price due to
change in yield
When different coupon rate & maturity use this to find out which on is better Duration higher: YTM lower, longer maturity, coupon lower
Approximating the % Price change of a bond with a change in interest rate
1. Macaulay Duration = weighted average maturity of the bond’s cash flows (coupon
payments and principal) discounted to their present value) gives us term expressed in
years, weights are discounted cash flows in each period
2. Modified Duration = extension of Macaulay duration used to measure the expected %
change in price of bind given 100bps (1%) change in yield
Finding duration of a complex portfolio of payments (single cash flow)
1. Find the PV of each year’s total payment
2. Divide by the portfolio’s total PV (weigh the payment)
3. Multiply it this by the time the payment is due.
4. Add them
∑
Duration/Price Relationship
To estimate the %

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