MSO402: INTRODUCTION

TO F I N AN C I AL
M AN AG E M E N T

FINANCIAL MARKETS &

SECURITIES

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Financial Markets and Securities

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Role of Financial Markets
• Transfer funds from surplus units to deficit units.

• Deficit units such as firms and government agencies access funds

from financial markets by issuing securities.

• Sources of funds:
• Debt securities
• Equity securities The Bond: The bond is a piece of paper (
or nowadays, just an electronic record) that
says how much money was borrowed,
how much extra money (interest) will be paid,
and when the borrowed money will be fully paid back.

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Equities
∗ Claim on Income
∗ Claim on Assets
∗ Right to Control
∗ Voting Rights
∗ Pre-emptive rights,
∗ Limited Liability
Its Advantages:
∗ Permanent Capital, ∗ Increases the borrowing base, ∗ Dividend
payment discretion
Its Dis-advantages:
∗ More costly, More risky, Earnings dilution, Ownership
Its Types:
∗ Blue Chip
∗ Growth
∗ Income
∗ Cyclical
∗ Defensive
∗ Speculative
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Debt

∗ Difference between Debentures and Bonds

∗ Interest Rate/Coupon Rate
∗ Debentures at premium, discount and par
∗ Redemption
∗ Sinking fund
∗ Buyback (Call-feature)
∗ Indenture/Debenture Trust deed
Its Types:
∗ Security: Secured and Unsecured, Naked (Junk Bonds)
∗ Yield: Current Yield and Yield to maturity
∗ Convertibility: NCD. PCD and FCD

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Which one is cheaper?

Debt is a cheaper source of financing than equity as:

∗ Debt is repaid on a priority basis.
∗ They enjoy a fixed rate of interest therefore it is less
uncertain.
∗ Company pays off even if there is a loss.
∗ Equity shareholders are paid at the end, their dividends and
capital gains are uncertain and they are not paid if the company
incurs a loss.

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Primary & Secondary Market
• Primary markets facilitate the issuance of new securities.

• Secondary markets facilitate the trading of existing securities,

which allows for a change in the ownership of the securities.

• Many types of debt securities have a secondary market, so that

investors who initially purchased them in the primary market do
not have to hold them until maturity.

• Primary market transactions provide funds to the initial issuer of

securities; secondary market transactions do not.

• An important characteristic of securities that are traded in

secondary markets is liquidity.

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Securities traded in the financial markets

• Money market securities

• Sale of debt securities that have a maturity of one year or less
• High degree of liquidity: active secondary market
• low expected return but also a low degree of credit (default) risk
• Treasury bills, commercial paper (issued by corporations), and negotiable
certificates of deposit (issued by depository institutions).

• Capital market securities

• Sale of long-term securities
• Finance the purchase of capital assets, such as buildings, equipment, or
machinery
• Common types of capital market securities: bonds, stocks, and mortgages

• Derivative securities
• Financial contracts whose values are derived from the values of underlying
assets .
• Investors to engage in speculation and risk management.

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 Securities traded in the financial markets
• Mortgage Backed securities
Mountain Savings Bank originates 100 residential mortgages for home buyers and will service the
mortgages by processing the monthly payments. However, the bank does not want to use its own funds
to finance the mortgages. It issues mortgage-backed securities that represent this package of mortgages
to eight financial institutions that are willing to purchase all of these securities. Each month, when
Mountain Savings Bank receives interest and principal payments on the mortgages, it passes those
payments on to the eight financial institutions that purchased the mortgage-backed securities and thereby
provided the financing to the homeowners. If some of the homeowners default on their payments, the
payments, and thus the return on investment earned by the financial institutions that purchased the
mortgage-backed securities, will be reduced. The securities they purchased are backed (collateralized)
by the mortgages. In many cases, the financial institution that originates the mortgage is not accustomed
to the process of issuing mortgage-backed securities. If Mountain Savings Bank is unfamiliar with the
process, another financial institution may participate by bundling Mountain’s 100 mortgages with
mortgages originated by other institutions. Then the financial institution issues mortgage-backed
securities that represent all the mortgages in the bundle. Thus any investor that purchases these
mortgage-backed securities is partially financing the 100 mortgages at Mountain Savings Bank and all
the other mortgages in the bundle that are backing these securities.

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Funding for Start-up businesses
• Bootstrapping
• Minimal external funding, relying on revenue and careful cost management.
• Rely on personal savings & friends and family.
• Offers maximum control but can limit growth speed.

• Angel Investors
• Individuals who invest their own money in startups.
• Mentorship, networking opportunities, validation.
• Eg: Ratan Tata, Kunal Bahl & Rohit Bansal, Vani Kola, Indian Angels Network

• Venture Capital
• Invest in startups with high growth potential in exchange for equity.
• Strategic guidance, with significant control and clear exit strategy.
• Eg: Accel India: Swiggy, Flipkart, Razorpay, UrbanClap
• Eg: Sequoia: Zomato, Byju’s, Oyo Rooms, Freshworks

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Funding for Start-up businesses
• Crowdfunding
• Allow you to raise small amounts of money from a large number of people
• In exchange for rewards or pre-orders.

• Incubators and Accelerators

• Offer seed funding, mentorship, and resources in exchange for equity.
• Additional resources like office space, mentorship, and networking
opportunities.
• Structured support
• Eg: Y Combinator (YC) India, Techstars Bangalore, T-Hub

• Grants & Competitions

• Revenue-Based Financing

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 Bonds

• Bonds are debt instruments issued by the government, NGO,

corporation or municipality.
• Investor purchasing a bond – acts as a lender.
• Example: A 3-year bond with a principal payment of Rs 1,000 and
an annual coupon rate of 10% has the following cash flows:

Rs 100 Rs 100 Rs 100 Rs 100 + 1000

Cashflow
• Maturity
t=0 t=1 t=2 t=3
• Coupon Rate
• Principal

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Bonds – Features (Bond Indenture)

• Variants in interest rate payments – fixed or floating

• Transferable
• Covenants – restrict the total borrowings of the borrower, clause on cash
flows, interest coverage ratio
• Secured/ Unsecured
• Subordinated bond
• Callable bond
• Bond Terminology

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National Bonds
• Zero coupon bonds are issued that make no coupon
payments.
• On this bond, investors receive par value at the maturity date but
receive no interest payments until then.
• Bond has a coupon rate of zero.
• These bonds are issued at prices considerably below par value
• The investor’s return comes solely from the difference between the
issue price and the payment of par value at maturity.
• Treasury Bill (T-Bills) are zero coupon bonds

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National Bonds
• Treasury bills
• These are short-term debt instruments issued by the Government of
India and are presently issued in three tenors, namely, 91-day, 182-
day and 364-day.
• Treasury bills are zero coupon securities and pay no interest.
• Instead, they are issued at a discount and redeemed at the face
value at maturity.
• For example,
• a 91-day Treasury bill of ₹100/- (face value) may be issued at say
₹ 98.20, that is, at a discount of say, ₹1.80 and would be
redeemed at the face value of ₹100/-.
(100−𝑃) 365
• % of yield generated can be calculated as Yield = × ×
𝑃 91
100 = 7.35%

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 National Bonds
• If a bond is purchased between coupon payments, the buyer must pay the
seller for accrued interest, the prorated share of the upcoming semiannual
coupon.
𝐴𝑛𝑛𝑢𝑎𝑙 𝑐𝑜𝑢𝑝𝑜𝑛 𝑝𝑎𝑦𝑚𝑒𝑛𝑡 𝐷𝑎𝑦𝑠 𝑠𝑖𝑛𝑐𝑒 𝑙𝑎𝑠𝑡 𝑐𝑜𝑢𝑝𝑜𝑛 𝑝𝑎𝑦𝑚𝑒𝑛𝑡
Accrued interest = ×
2 𝐷𝑎𝑦𝑠 𝑠𝑒𝑝𝑎𝑟𝑎𝑡𝑖𝑛𝑔 𝑐𝑜𝑢𝑝𝑜𝑛 𝑝𝑎𝑦𝑚𝑒𝑛𝑡𝑠
Example:
• Suppose that the coupon rate is 8% with the par value of Rs.1000.
• Then the annual coupon is Rs. 80 and the semiannual coupon payment is
Rs. 40. Because 30 days have passed since the last coupon payment, the
accrued interest on the
=40×30/182=𝑅𝑠. 6.59
• If the quoted price of the bond is Rs. 990, then the invoice price will be Rs.
990 + 6.59 = Rs. 996.59.

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International Bonds
• Bonds denominated in currencies other than the borrower’s
home country.
• Bonds issued by the borrower outside its home country,
irrespective of its denomination.
• Two Categories:
• Foreign Bonds – Indian corporations issuing bonds denominated
in foreign currencies.
• Yankee Bonds
• Samurai Bonds
• Bulldog Bonds
• Euro Bonds – Indian corporations issue rupee-denominated
bonds in foreign countries.
• Eurodollar
• Euroyen

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Features of the Bond

• Primary Market versus Secondary Market

• Bonds can be issued at premium or discount.
• Investor’s return differ from the bond’s stated interest rate or
coupon:
• Yield to Maturity – is the discount rate implied by the bond’s
market price & its promised cash flows. It is quoted on an annual
basis.

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Bond Valuation

• Time Value of principal & coupons

• Risks:
• Interest
• Inflation
• Credit
• Timings/ Callability
• Liquidity
• Currency

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 Bond Pricing

• Bond Value
𝑇
𝐶𝑜𝑢𝑝𝑜𝑛 𝑃𝑎𝑟 𝑉𝑎𝑙𝑢𝑒
𝑃𝑜 = ෍ +
(1 + 𝑟)𝑡 (1 + 𝑟)𝑡
𝑡=1
Example: An 8% coupon, 30-year maturity bond with par value of $1,000 paying
60 semiannual coupon payments of $40 each. Suppose that interest rate is 8%
annually, Then find the value of the bond? What happens when the interest rate is
5%?

Suppose the bond is a zero-coupon bond!

𝑃𝑎𝑟 𝑉𝑎𝑙𝑢𝑒
Valuation: 𝑃𝑜 =
(1+𝑟)𝑡

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Yield to Maturity

• That return which the investor will earn by buying a bond at stipulated price
and holding it until maturity.
• It’s the IRR
𝑃𝑟𝑜𝑚𝑖𝑠𝑒𝑑 𝐶𝑎𝑠ℎ 𝐹𝑙𝑜𝑤𝑠
𝑃𝑜 = ෍
(1 + 𝑌𝑇𝑀)𝑡
𝑡

The zero-coupon bond with face value of Rs 1,000, was priced at Rs 93.325
at the date of purchase. What is the YTM?

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Yield to Maturity

• YTM is typically expressed as an annual percentage rate (APR).

• It is determined using the following formula:

𝐹𝑉 − 𝑃𝑉
𝐶+
𝑌𝑇𝑀 = 𝑡
𝐹𝑉 + 𝑃𝑉
2
C – Interest/coupon payment
FV – Face value of the security
PV – Present value/price of the security
t – How many years it takes the security to reach maturity

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 Yield to Maturity

• Assume that there is a bond on the market priced at Rs. 850 and that the
bond comes with a face value of Rs. 1,000 (a common face value for
bonds). On this bond, yearly coupons are Rs. 150. The coupon rate for the
bond is 15% and the bond will reach maturity in 7 years.

1000 − 850
150 +
𝑌𝑇𝑀 = 7 = 18.53%
1000 + 850
2

• The approximate YTM on the bond is 18.53%.

• Advice the investor if he should buy the bond if the required rate of investor
is 12%?

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