Introduction to Capital Markets - Research Paper Example

Introduction to capital markets 1. For any company to fund its growth, any continuing corporation must have sourced for funds from somewhere. Apart from trade debt and bank, the key sources of financing include debt securities, plowback, private equity and equity securities (Yartey, 2006). Debt securities-A corporation can raise funds through debt securities. This is usually done by taking out such a debt security as a loan, popularly confirmed by a note in addition to offering security to the lender. The most common form of a corporate debt security is referred to as a bond; which basically is a promise to pay back the face value of the bond on maturity together with making periodic interest fees known as coupon rate (Palmiter, 2009). Plowback-Earnings is another important source of new funds which corporations use on capital projects. Instead of paying out dividends to shareholders, a company may decide to plowback the profits made back into the corporation. Plowback is basically reinvesting profits back into the business. It is an attractive way of raising capital since it is usually subject to the control of management. There is no approval required from the government for its use, as happens when a corporation seeks to raise funds via selling of stocks, bonds and securities. In addition, bonds and stocks have costs related to them, for instance, interest that is paid on bonds whereas profit retention avoids such costs (Tirole, 2010). Private equity-This is a source that is popular with small firms or start-ups that cannot raise funds through the stock exchange or rather do not desire to subject themselves to other financing options available. Thus they prefer raising capital via private equity, a process that basically comprises of private investors offering capital to a corporation in exchange for a given stake in the firm. A private equity company is a consortium of investors that pool their capital together for purposes of investment, mostly in other companies (Scanlan 1997). Equity securities-commonly referred to as stock is the fourth source of capital for corporations. Equity is basically an ownership stake in a business or property. Stock being the smallest form of new capital is of great importance to a firm in beginning a company and its early operations. A stock will offer an investor several legal rights such as ownership, sharing in earnings, transferability as well as the power to vote. Stocks are acquired through payment of cash (Jenkins 2013). 2. A financial market basically entails a market where entities and people can trade commodities, financial securities as well as the rest of fungible valuable items at transaction costs that are low and reflect demand and supply. The following are functions of financial markets; They borrow and lend-financial markets offer funds to various investors through lending funds at an interest commonly referred to as cost of borrowing. Secondly financial markets determine prices through setting or defining volatile or fixed prices for every kind of instrument trading in the market (Bailey, 2005).Thirdly financial markets collect and analyse information which is quite significant since it is utilised by market participants in valuing or estimating prices of a definite instrument. Fourthly financial markets are involved in risk-sharing through eliminating a kind of risk called systematic risk by diversifying investment. In addition, financial markets also provide liquidity due to their ability to directly and quickly convert securities into money without necessarily losing value during a given transaction. Lastly, financial markets also offer efficiency which generally is the ability of a market to reflect publicly held information on a given instrument (Madura, 2014). 3. Financial managers can identify the cost of capital of a corporation by taking the risk-free bond rate having the same duration like the term structure of the corporate liability, and then adding up a default premium (which usually rises as the amount of liability increases). Due to the fact that in several cases debt expenditure is a deductible expenditure, the cost of debt is calculated as an after tax expense so as to make it like the cost of equity. For firms that are profitable, debt is usually discounted using the tax rate. Basically the following formula can be used when computing cost of capital raised; (Rf+credit risk rate)(1-T),whereby Rf represents the risk free interest rate and T represents the rate of corporate tax(Brigham & Houston,2015). 4. Mutual funds are mostly called financial intermediaries since they specialize in collecting funds from various investors and investing the same in bonds and shares issued by different corporations. Thus a financial intermediary is generally an institution that exists between individuals having surplus cash and corporations that need the money. Yes ,it does make sense for an individual to invest in a mutual fund due to the following reasons; mutual funds provide lower costs, convenience and diversification (Haslem, 2003). Mutual funds’ convenience is definitely one of the key motives investors prefer them to offer the equity aspect of their portfolio, instead of purchasing individual stocks themselves. Investing in mutual funds also helps an investor to steer clear of some of complex decision making that is involved while picking shares (Besley & Brigham, 2007).Mutual funds also provide investors the opportunity to purchase into a particular industry, or purchase shares with a particular growth strategy like aggressive growth fund. Whereas the transaction costs of purchasing and selling shares are frequently prohibitively high for private investors, with mutual funds, the cost of trading is spread over each and every one of the investors registered in the fund, thus minimizing the expense per person (Besley & Brigham, 2011). 5. The term financial market broadly describes any marketplace whereby buyers and sellers take part in trading of assets like bonds, equities, derivatives and currencies. Apart from the stock and bond markets, the other examples of financial markets include; money markets, capital markets, and spot or cash markets .Money markets can be described as a section of the financial market where financial instruments with short maturities and high liquidity are traded. This market is used by traders as a way of borrowing as well as lending for a short term, from many days to less than a year. Capital markets on the other hand have institutions and individuals trading financial securities. Institutions and organizations in the private and public sectors frequently sell securities in this market so as to raise funds. Spot or cash markets are extremely sophisticated, with chances for either big gains or big losses. In this market, selling of goods takes place in cash with immediate delivery (Chen, 2010). 6. The opportunity cost of capital can be described as the anticipated rate of return usually forgone by avoiding other possible investment activities in selecting a specific utilisation of capital. More concisely, the cost of capital is the rate of return which investors could possibly earn from financial markets. The cost of capital is computed by use of 3 step procedure; the first step involves calculation or inferring the cost of every type of capital which is used by the corporation, namely equity and debt. Consequently, cost of capital=Risk-free rate+(Beta times Market Risk Premium).Secondly the proportion which equity and debt capital contribute to the whole enterprise is calculated, by use of the market values of total equity and debt so as to mirror the investments expected to earn the minimum return. The third step involves weighting components of every type of capital using the fraction that each one contributes to the whole capital structure (Farid, 2006). 7. Generally financial markets are markets in which financial securities can be bought and sold. They facilitate investing and financing by firms, government agencies and households. Secondly financial markets aid in the transfer of money from an individual or corporation having no investment opportunities (surplus units) to the ones that have them (deficit units).Financial institutions on the other hand comprise of credit unions, banks, building societies, stock brokerages and many others. These institutions are tasked with distribution of financial resources in a systematic manner especially to potential users. In addition financial institutions collect as well as provide money for the necessary individuals or sectors. Other financial institutions serve as middlemen and join the surplus and deficit units. There are also those institutions that are involved in the investment of funds on behalf of clients. Many government financial institutions are charged with supervisory and regulatory functions and have played a critical role in the fulfillment of management and financial requirements of various industries hence shaping the overall economic scene. Lastly the roles of such financial institutions as commodity markets, stock exchanges, options, currency and futures exchanges are extremely critical to the economy. This is because such institutions are tasked with the ownership and creation of financial claims. In addition, such institutions are tasked with the maintenance of liquidity in the markets as well as management of price fluctuations risks. They therefore, as an aspect of their different services offer investment opportunities and assist enterprises to generate money for different purposes (Burton & Nesiba, 2010). 8. Yes ABC Company should go ahead since they have a safe margin of 2.5%.If the cost of capital is 7% and the project offers a 9.5% return, then the company has a safe margin of 2.5% and should go ahead with the project. This is because the cost of capital is cheaper and the project has a viable rate of return. Collateralized Loan Obligations Collateralized Loan Obligations(CLOs) can be termed as a kind of securization whereby payments arising from several middle sized as well as huge business loans are usually pooled together in addition to being passed on to various categories of owners in different tranches. Basically a CLO is a kind of collateralized debt obligation (Antczak & Fabozzi, 2009). CLOs work by investing in a pool of largely syndicated superior secured loans, encompassing a broad range of industries and issuers. A collateral manager normally selects and manages loan portfolio, and can also keenly purchase and sell loans on the basis of their attractiveness. Thus, CLOs are tasked with the financing of this pool of loans using a capital structure that is made up of equity and debt. The returns of CLO are usually fuelled by difference arising out of the yields generated from a pool of loans and the cost incurred in acquiring debt. CLOs are believed to be attractive today since loan spreads are broad compared to CLO debt expenses. Finally loan defaults are minimal with a prediction of them remaining low in future; something that creates an extremely attractive environment as far as CLOs are concerned (Antczak & Fabozzi, 2009). 2.The US subprime crisis can be termed as a countrywide banking crisis that corresponded with the American recession of 2007 to June 2009.This crisis was majorly set off by a huge reduction in home prices, resulting to mortgage foreclosures and delinquencies together with devaluation of securities related to housing. Reduction in residential investment paved the way for recession and was trailed by massive reductions in business investment and household spending. Regions with mixture of huge household debts as well as big housing price reductions recorded significant spending reductions. Household debt expansion was funded by mortgage-backed securities(MBS) together with collateralized debt obligations(CDO),that originally provided attractive return rates because of the huge interest rates pegged on mortgages. Nevertheless, the low quality of credit finally resulted in massive defaults (Kolb, 2010). Whereas crisis elements initially became clearly visible in 2007, many key financial organizations collapsed in 2008 September, leaving considerable disruption in credit flow not only to individuals but also to businesses leading to the start of a severe worldwide recession. A chief strength of the structure of the CLO is the fact that commitment of the debt is usually for the transaction life only. Covenants of debt are cash flow based and not on the basis on the market value and thus the underlying loans price does not in any way have an effect on the CLO debt covenant. Covenants instead are on the basis of whether the assets are presently returning their income. Normally if an excess of threshold amount fails to pay, then the funds that could have been remitted to the equity remains in the deal, thus offering extra collateral improvement to the holders of debt. This kind of arrangement implies that in nearly all circumstances, debt holders are not able to implement a CLO to dispose their assets. Thus there is no record of a particular cash flow CLO, in 2008-2009 finance crisis where holders of debt were impaired (Antczak & Fabozzi, 2009). In 2008/2009, CLOs cash flows were stopped for 4 periods, and were consequently used to buy more collateral. Since the extra collateral assumed leveraged loans form, trading at discounted prices, the CLO finally was supported by additional assets more than it was initially at a minimal average cost. Currently, the CLO profits from over 50% extra income, whereas liability costs have remained unaffected. This increased financing space translates to more streams to the equity (Antczak & Fabozzi, 2009). Key advisers and President Obama in June 2009 introduced a sequence of several regulatory proposals addressing executive pay, consumer protection, capital requirements, and improved authority to regulate Federal Reserve so as to carefully wind-down systematically significant organizations and expanded guideline pertaining derivatives and shadow banking system. The CLO market has grown due to demand arising from 2012 when there was a reborn of the same. This has seen new issuing of CLO, leading to quadrupling of its volume from the earlier years, data from Royal Bank of Scotland shows. There has also been renewed interest from big names such as Nomura, RBS and Barclays which have all launched their 1st deals even before the global crisis as well as smaller ones like Och Ziff, Valcour and Onex who have for the first time ever ventured into the CLO market, all this indicating a jumping back of market confidence regarding CLOs as investment vehicles. In addition there has been a soaring of CLO issuance ,resulting in whole-year 2013 issuance of 81.9 billion dollars in the US, the biggest since the pre-crisis period of 2006-2007.In 2014,the CLO market in the US picked even further with 124.1 billion dollars being issued, readily exceeding the previous 1996 set record of 97 billion dollars. CLOs generally can be very good investment vehicles, to be managed by managers. CLOs can thus convey a stabilized flow of management fees for many years since they are not subjected to redemptions by investors (Kolb, 2010). 5. Unlike in 2000/2006 when there was irresponsible risky lending together with financial practices following the bogus ideology that, left alone, financial markets can suitably police themselves. Currently, however, there have been regulations that have been passed to tightly control the financial markets. Six years later, a lot of marked progress has been made, significantly turning around the economy. There has been a reduction in unemployment, home prices have risen up as well as availability of credit. However, to guard the economy against another financial crisis, much has to be done. The passed law ought to be enforced, something that will help in preventing banks from breaking the law. Secondly, there should be simpler and tougher capital requirements for banking institutions. Thus the proposed regulations regarding raising of capital requirements are a step in the right direction. Lastly there should be a Chairman of Federal Reserve who protects the interests of the public. S/he should deal with banks resolutely and not have any leanings with Wall Street (Kolb, 2010). Reference list Read More