Roles of Financial Markets and Institutions Essay

Roles of Financial Markets and Institutions Essay.

This continuing exercise focuses on the interactions of a single manufacturing firm (Carson Company) in the financial markets. It illustrates how financial markets and institutions are integrated and facilitate the flow of funds in the business and financial environment. At the end of every chapter, this exercise provides a list of questions about Carson Company that require the application of concepts learned within the chapter, as related to the flow of funds.

Carson Company is a large manufacturing firm in California that was created 20 years ago by the Carson family.

It was initially financed with an equity investment by the Carson family and ten other individuals. Over time, Carson Company has obtained substantial loans from finance companies and commercial banks. The interest rate on the loans is tied to market interest rates, and is adjusted every six months. Thus, Carson’s cost of obtaining funds is sensitive to interest rate movements. It has a credit line with a bank in case it suddenly needs to obtain funds for a temporary period.

It has purchased Treasury securities that it could sell if it experiences any liquidity problems.

Carson Company has assets valued at about $50 million and generates sales of about $100 million per year. Some of its growth is attributed to its acquisitions of other firms. Because of its expectations of a strong U.S. economy, Carson plans to grow in the future by expanding its business and through acquisitions. It expects that it will need substantial long-term financing, and plans to borrow additional funds either through loans or by issuing bonds. It is also considering the issuance of stock to raise funds in the next year. Carson closely monitors conditions in financial markets that could affect its cash inflows and cash outflows and thereby affect its value.

a.In what way is Carson a surplus unit?

Carson invests in Treasury securities and therefore is providing funds to the Treasury, the issuer of those securities.

b.In what way is Carson a deficit unit?

Carson has borrowed funds from financial institutions.

c.How might finance companies facilitate Carson’s expansion?

Finance companies can provide loans to Carson so that Carson can expand its operations.

d.How might commercial banks facilitate Carson’s expansion?

Commercial banks can provide loans to Carson so that Carson can expand its operations.

e.Why might Carson have limited access to additional debt financing during its growth phase?

Carson may have already borrowed up to its capacity. Financial institutions may be unwilling to lend more funds to Carson if it has too much debt.

f.How might securities firms facilitate Carson’s expansion?

First, securities firms could advise Carson on its acquisitions. In addition, they could underwrite a stock offering or a bond offering by Carson.

g.How might Carson use the primary market to facilitate its expansion?

It could issue new stock or bonds to obtain funds.

h.How might it use the secondary market?

It could sell its holdings of Treasury securities in the secondary market.

i.If financial markets were perfect, how might this have allowed Carson to avoid financial institutions?

It would have been able to obtain loans directly from surplus units. It would have been able to assess potential targets for acquisitions without the advice of investment securities firms. It would be able to engage in a new issuance of stock or bonds without the help of a securities firm.

j.The loans that Carson has obtained from commercial banks stipulate that Carson must receive the banks’ approval before pursuing any large projects. What is the purpose of this condition? Does this condition benefit the owners of the company?

The purpose is to prevent Carson from using the funds in a manner that would be very risky, as Carson may default on its loans if it takes excessive risk when using the funds to expand its business. The owners of the firm may prefer to take more risk than the lenders will allow, because the owners would benefit directly from risky ventures that generate large returns. Conversely, the lenders simply hope to receive the repayments on the loan that they provided, and do not receive a share in the profits. They would prefer that the funds be used in a conservative manner so that Carson will definitely generate sufficient cash flows to repay the loan.

Chapter Two Flow of Funds Exercise

How the Flow of Funds Affects Interest Rates

Recall that Carson Company has obtained substantial loans from finance companies and commercial banks. The interest rate on the loans is tied to market interest rates, and is adjusted every six months. Thus, its cost of obtaining funds is sensitive to interest rate movements. Given its expectations that the U.S. economy will strengthen, Carson plans to grow in the future by expanding its business and through acquisitions. Carson expects that it will need substantial long-term financing to pay for this growth, and it plans to borrow additional funds either through loans or by issuing bonds. The company is considering the issuance of stock to raise funds in the next year.

a.Explain why Carson should be very interested in future interest rate movements.

The future interest rate movements affect Carson’s cost of obtaining funds, and therefore may affect the value of its stock.

b.Given Carson’s expectations, do you think that the company anticipates that interest rates will increase or decrease in the future? Explain.

Carson expects the U.S. economy to strengthen, and therefore should expect that interest rates will increase (assuming other things held constant).

c.If Carson’s expectations of future interest rates are correct, how would this affect its cost of borrowing on its existing loans and on future loans?

Carson’s cost of borrowing will increase, because the interest rate on prevailing and future loans would be tied to market interest rates.

d.Explain why Carson’s expectations about future interest rates may affect its decision about when to borrow funds and whether to obtain floating-rate or fixed-rate loans.

If Carson expects rising interest rates, it may prefer to lock in today’s interest rate for a period that reflects the length of time that it will need funds. In this way, the cost of funds borrowed would be insulated from the changes in market interest rates.

Chapter Three Flow of Funds Exercise

Influence of the Structure of Interest Rates

Recall that Carson Company has obtained substantial loans from finance companies and commercial banks. The interest rate on the loans is tied to the six-month Treasury bill rate (and includes a risk premium) and is adjusted every six months. Thus, Carson’s cost of obtaining funds is sensitive to interest rate movements. Because of its expectations that the U.S. economy will strengthen, Carson plans to grow in the future by expanding its business and through acquisitions. Carson expects that it will need substantial long-term financing to finance its growth, and plans to borrow additional funds either through loans or by issuing bonds. It is also considering the issuance of stock to raise funds in the next year.

a.Assume that the market’s expectations for the economy are similar to those of Carson. Also assume that the yield curve is primarily influenced by interest rate expectations. Would the yield curve be upward sloping or downward sloping? Why?

The yield curve would be upward sloping to reflect the expectations or rising interest rates along with a liquidity premium for debt securities with longer maturities.

b.If Carson could obtain more debt financing for 10-year projects, would it prefer to obtain credit at a long-term fixed interest rate, or at a floating rate. Why?

The prevailing interest rate would be lower on loans than on the bonds, but the interest rate on loans would increase over time if market interest rates rise. Therefore, Carson may be willing to lock in the cost of debt by issuing bonds rather than be subjected to the uncertainty if it obtains floating-rate loans.

c.If Carson attempts to obtain funds by issuing 10-year bonds, explain what information would help to estimate the yield it would have to pay on 10-year bonds. That is, what are the key factors that would influence the rate it would pay on the 10-year bonds?

The key factors are the risk-free rate on 10-year bonds, the risk premium, and any special provisions on the bond. The yield to be offered is equal to a risk-free rate on ten-year bonds plus a risk premium to reflect the possibility of Carson’s default, plus an adjustment for any special features of the bond.

d.If Carson attempts to obtain funds by issuing loans with floating interest rates every six months, explain what information would help to estimate the yield it would have to pay over the next ten years. That is, what are the key factors that would influence the rate it would pay over the 10-year period?

The key factors are the risk-free rate on six-month T-bills, and the risk premium. The cost of debt in this case changes over time, and is dependent on how T-bill rates move over time. e.An upward-sloping yield curve suggests that the initial rate that financial institutions could charge on a long-term loan to Carson would be higher than the initial rate that they could charge on a loan that floats in accordance with short-term interest rates. Does this imply that creditors should prefer to provide a fixed-rate loan rather than a floating-rate loan to Carson? Explain why Carson’s expectations of future interest rates are not necessarily the same as those of some financial institutions.

Roles of Financial Markets and Institutions Essay

Financial Markets and Return Essay

Financial Markets and Return Essay.

Problem 1 (BKM, Q3 of Chapter 7) (10 points1) What must be the beta of a portfolio with E( rP ) = 20.0%, if the risk free rate is 5.0% and the expected return of the market is E( rM ) = 15.0%? Answer: We use E( rP ) = β P *(E( rM ) – r f ) + r f . We then have: 0.20 = β P *(0.15-0.05) + 0.05. Solving for the beta we get: β P =1.5.

Problem 2 (BKM, Q4 of Chapter 7) (20 points) The market price of a security is $40. Its expected rate of return is 13%. The risk-free rate is 7%, and the market risk premium is 8%.

What will the market price of the security be if its beta doubles (and all other variables remain unchanged)? Assume that the stock is expected to pay a constant dividend in perpetuity. Hint: Use zero-growth Dividend Discount Model to calculate the intrinsic value, which is the market price. Answer: First, we need to calculate the original beta before it doubles from the CAPM. Note that: β = (the security’s risk premium)/(the market’s risk premium) = 6/8 = 0.

75. Second, when its beta doubles to 2*0.75 = 1.5, then its expected return becomes: 7% + 1.5*8% = 19%. (Alternatively, we can find the expected return after the beta doubles in the following way.

If the beta of the security doubles, then so will its risk premium. The current risk premium for the stock is: (13% – 7%) = 6%, so the new risk premium would be 12%, and the new discount rate for the security would be: 12% + 7% = 19%.) Third, we find out the implied constant dividend payment from its current market price of $40. If the stock pays a constant dividend in perpetuity, then we know from the original data that the dividend (D) must satisfy the equation for a perpetuity: Price = Dividend/Discount rate 40 = D/0.13 ⇒ D = 40 * 0.13 = $5.20 Last, at the new discount rate of 19%, the stock would be worth: $5.20/0.19 = $27.37. The increase in stock risk has lowered the value of the stock by 31.58%. Problem 3 (BKM, Q16 of Chapter 7) (10 points)

A share of stock is now selling for $100. It will pay a dividend of $9 per share at the end of the year. Its beta is 1.0. What do investors expect the stock to sell for at the end of the year if the market expected return is18% and the risk free rate for the year is 8%? Answer: Since the stock’s beta is equal to 1, its expected rate of return should be equal to that of D + P1 − P0 , therefore, we can solve for P1 as the market, that is, 18%. Note that: E(r) = P0 9 + P1 − 100 the following: 0.18 = ⇒ P1 = $109. 100 Problem 4 (15 points) Assume two stocks, A and B. One has that E( rA ) = 12% and E( rB ) = 15.%. The beta for stock A is 0.8 and the beta for B is 1.2. If the expected returns of both stocks lie in the SML line, what is the expected return of the market and what is the risk-free rate? What is the beta of a portfolio made of these two assets with equal weights?

Answer: Since both stocks lie in the SML line, we can immediately find its slope or the risk premium of the market. Slope = (E(rM) – rF) = ( E(r2) – E(r1))/( β2- β1) = (0.15-0.12)/(1.2-0.8) = 0.03/0.4= 0.075. Putting these values in E(r2) = β2*(E(rM) – rF) + rF one gets: 0.15 = 1.2*0.075 + rF or rF =0.06=6.0%. The Expected return of the market is then given by (E(rM) – 0.06) = 0.075 giving: E(rM) = 13.5%. If you create a portfolio with these two assets putting equals amounts of money in them (equally weighted), the beta will be βP = w1*β1+w2*β2= 0.5*1.2+0.5*0.8 = 1.0. Problem 5 (15 points) You have an asset A with annual expected return, beta, and volatility given by: E( rA ) = 20%, β A =1.2, σ A =25%, respectively. If the annual risk-free rate is r f =2.5% and the expected annual return and volatility of the market are E( rM )=10%, σ A =15%, what is the alpha of asset A? Answer: In order to find the alpha, α A , of asset A we need to find out the difference between the expected return of the asset E( rA ) and the expected return implied by the CAPM which is r f + β A (E(rM) – r f ).

That is, express its expected return as: α A = E( rA ) – r f + β A (E( rM ) – r f )). Since we know the expected return of the market, the beta of the asset with respect to the market, and the risk-free rate, alpha is given by: α A = E( rA ) – β A (E( rM ) – r f ) – r f = 0.20 – 1.2(0.1 – 0.025) – 0.025
= 0.085 = 8.5%.

2

Problem 6 (BKM, Q23 of Chapter 7) (20 points) Consider the following data for a one-factor economy. All portfolios are well diversified. _______________________________________ Portfolio E(r) Beta ———————————————————-A 10% 1.0 F 4% 0 ———————————————————-Suppose another portfolio E is well diversified with a beta of 2/3 and expected return of 9%. Would an arbitrage opportunity exist? If so, what would the arbitrage strategy be? Answer: You can create a Portfolio G with beta equal to 1.0 (the same as the beta for Portfolio A) by taking a long position in Portfolio E and a short position in Portfolio F (that is, borrowing at the risk-free rate and investing the proceeds in Portfolio E). For the beta of G to equal 1.0, the proportion (w) of funds invested in E must be: 3/2 = 1.5

The expected return of G is then: E(rG) = [(−0.50) × 4%] + (1.5 × 9%) = 11.5% βG = 1.5 × (2/3) = 1.0 Comparing Portfolio G to Portfolio A, G has the same beta and a higher expected return. This implies that an arbitrage opportunity exists. Now, consider Portfolio H, which is a short position in Portfolio A with the proceeds invested in Portfolio G: βH = 1βG + (−1)βA = (1 × 1) + [(−1) × 1] = 0 E(rH) = (1 × rG) + [(−1) × rA] = (1 × 11.5%) + [(− 1) × 10%] = 1.5% The result is a zero investment portfolio (all proceeds from the short sale of Portfolio A are invested in Portfolio G) with zero risk (because β = 0 and the portfolios are well diversified), and a positive return of 1.5%. Portfolio H is an arbitrage portfolio.

Problem 7 (10 points) Compare the CAPM theory with the APT theory, explain the difference between these two theories? Answer: APT applies to well-diversified portfolios and not necessarily to individual stocks. It is possible for some individual stocks not to be on the SML. CAPM assumes rational behavior for all investors; APT only requires some rational investors: APT is more general in that its factor does not have to be the market portfolio. Both models give the expected return-beta relationship. 3

Financial Markets and Return Essay