Stocks and Bonds - Term Paper Example

Running Head: Stocks and Bonds STOCKS AND BONDS I. Stocks Definition of stocks as ownership of a corporation 2. Price of the stock as present value of future dividends and final price of stock 3. Entitlement of stockholders to dividends and voting rights. 4. Definition of the stock market as a venue for the sale and purchase of stocks 5. Implications of going public, the costs and benefits of initial public offering II. Bonds 1. Definition of bonds as long-term interest-bearing debt instruments 2. Price of the bond as the present value of interest payments and final payment 3. Difficulties of bond pricing in conditions of illiquidity 4. Advantage of bonds in its tax deductibility III. Stocks and Bonds 1. Debt and equity financing not direct substitutes of each other 2. Equity financing alleviates risk of pure debt financing IV Other Investments 1. Mutual Funds as diversified and professionally managed investment 2. Stock Options as the right, but not the obligation, to buy or sell an underlying security at a set price for a given period of time 3. Derivative as securities that have value derived from an underlying security STOCKS AND BONDS Submitted by: Submitted to: Abstract Stocks and bonds are the major sources of corporate financing, as well as the most important vehicles of investment for individual and institutional investors. Stocks represent ownership in the corporation and entitle the investor to the rights of an owner to receive dividends, elect board members and vote on major issues. Bonds are long-term debt instruments that pay the investor periodic dividends and return of principal at the end of the maturity period. Investing and financing in varying proportions of stocks and bonds is the way by which corporations and investors balance their risks and returns, since stocks and bonds have different kinds of costs and different methods of compensation. Aside from stocks and bonds, other investment instruments are mutual funds, stock options, and other financial derivative securities, which are briefly defined and described here. STOCKS AND BONDS STOCKS A stock is ownership of a corporation represented by shares that are a claim on the corporation’s earnings and assets (Downes, John & Goodman, Jordon Elliot, p. 556, Barron’s Educational Series). The price of a stock is the equivalent of the present value of all future dividends; it is also the present value of a dividend stream for the number of years it would have been held, plus the present value of the anticipated price of the stock after that time period (Block, Stanley B. & Hirt, Geoffrey A., p. 284, McGraw-Hill Irwin). Common stocks entitle the shareholder to received dividends in stocks and bonds, and to vote in the election of directors and other matters taken up at shareholder meetings or by proxy (Downes, John & Goodman, Jordon Elliot, p. 556, Barron’s Educational Series). The stock market is the general term referring to the organized trading of securities through the various exchanges and the over-the-counter market (Downes, John & Goodman, Jordon Elliot, p. 563, Barron’s Educational Series). It is likely that the role played by the market in gathering and disclosing information may be more important for large firms because their stocks are traded more often and are followed by many analysts (Demirguc-Kunt, Asli & Maksimovic, Vojislav, p. 49, Finance & Development). Small firms may not benefit as much from stock market development, at least initially, because their access may be limited by high fixed issuance costs (Demirguc-Kunt, Asli & Maksimovic, Vojislav, p. 49, Finance & Development). Even the stock of small firms that are listed on an exchange may not be traded as often as the stock of larger firms, since it may be more costly for traders to acquire information about the prospects of small firms (Demirguc-Kunt, Asli & Maksimovic, Vojislav, p. 49, Finance & Development). There are implications for stock-based compensation for management, which has steadily increased over the last decade (Kadan, p. 451, Review of Financial Studies). At the same time, higher bankruptcy risk is indeed correlated with more use of stock in executive compensation (Kadan, Ohad & Swinkels, Jeroen M.., p. 451, Review of Financial Studies). The higher bankruptcy risk should be associated with a higher tendency by firms to compensate their executives by stock instead of stock options (Kadan, Ohad & Swinkels, Jeroen M., p. 453, Review of Financial Studies). Most companies start out by raising equity capital from a small number of investors, with no liquid market existing if these investors wish to sell their stock (Ritter, J.R., p. 1, Contemporary Finance Digest). If a company prospers and needs additional equity capital, at some point the firm generally finds it desirable to “go public” by selling stock to a large number of diversified investors (Ritter, J.R., p. 1, Contemporary Finance Digest). These companies usually go public by listing at the stock exchange and undertaking an initial public offering, or IPO, which is the corporation’s first offering of stock to the public (Downes, John & Goodman, Jordon Elliot, p. 260, Barron’s Educational Series). The IPO usually presents an opportunity for the existing investors and participating venture capitalists to make big profits, since for the first time their shares will be given a market value reflecting expectations for the company’s future growth (Downes, John & Goodman, Jordon Elliot, p. 260, Barron’s Educational Series). Once the stock is publicly traded, this enhanced liquidity allows the company to raise capital on more favourable terms than if it had to compensate investors for the lack of liquidity associated with a privately-held company (Ritter, J.R., p. 1, Contemporary Finance Digest). With the benefits of public listing, there are certain ongoing costs associated with the need to supply information on a regular basis to investors and regulators for publicly-traded firms (Ritter, J.R., p. 1, Contemporary Finance Digest). There are direct and indirect costs; the direct costs include the legal, auditing, and underwriting fees (Ritter, J.R., p. 1, Contemporary Finance Digest). The indirect costs are the management time and effort devoted to conducting the offering, and the dilution associated with selling shares at an offering price that is, on average, below the price prevailing in the market shortly after the initial public offering (Ritter, J.R., p. 1, Contemporary Finance Digest). In going public, an issuing firm will typically sell 20-40% of its stock to the public (Ritter, J.R., p. 2, Contemporary Finance Digest). The issuer will hire investment bankers to assist in pricing the offering and marketing the stock; then in cooperation with outside counsel, the investment banker will also conduct a due diligence investigation of the firm, write the prospectus, and file the necessary documents with the Securities and Exchange Commission. (Ritter, J.R., p. 2, Contemporary Finance Digest) BONDS A bond is any interest-bearing or discounted government or corporate security that obligates the issuer to pay the bondholder a specified sum of money, usually at specific intervals, and to repay the principal amount of the loan at maturity (Downes, John & Goodman, Jordon Elliot, p. 54, Barron’s Educational Series). The price of a bond is equal to the present value of regular interest payments discounted by the yield to maturity added to the present value of the principal (also discounted by the yield to maturity) (Block, Stanley B. & Hirt, Geoffrey A., p. 52, McGraw-Hill Irwin). In fixed-income markets, a common and systematic source of bond pricing discrepancy arises because of the illiquidity of certain bonds (Meng, Lei & Ap Gwilym, Owain, p. 70, The Journal of Derivatives). Liquidity is the ability to trade a security quickly and with little cost. (Meng, Lei & Ap Gwilym, Owain, p. 70, The Journal of Derivatives). Practitioners define liquidity as the availability to investors of two-way markets in reasonable size over an extended period without undue disruption or difficulties in establishing fair value (Meng, Lei & Ap Gwilym, Owain, p. 70, The Journal of Derivatives). One source of illiquidity is demand-supply pressure; it arises because not all buyers and sellers are present in the market all the time (Meng, Lei & Ap Gwilym, Owain, p. 70, The Journal of Derivatives). At certain times, natural buyers (sellers) cannot buy (sell) a financial asset quickly because the natural sellers (buyers) are not immediately available (Meng, Lei & Ap Gwilym, Owain, p. 70, The Journal of Derivatives). Finally, it must be mentioned that the use of bonds, a debt instrument, has its greatest benefit in its potential optimal tax advantage, since interest paid to creditors is tax deductible. (Romer, David, p. 164, Journal of Money, Credit and Banking). STOCKS AND BONDS Because stock markets provide a means of diversifying risks, mitigate conflicts of interest among different creditors, and improve information glow and corporate governance, equity and debt financing are, in general, not perfect substitutes for each other (Demirguc-Kunt, Asli & Maksimovic, Vojislav, p. 49, Finance & Development). Nevertheless, firms with high levels of debt may have increased their probability of bankruptcy sufficiently that they may enter into overly risky projects, thus harming their creditors (Demirguc-Kunt, Asli & Maksimovic, Vojislav, p. 48, Finance & Development). If there were a well-functioning stock market, issuance of equity would mitigate the incentive problems, slowing the firm to borrow more (Demirguc-Kunt, Asli & Maksimovic, Vojislav, p. 48, Finance & Development). OTHER INVESTMENTS Mutual Funds. A mutual fund is a fund operated by an investment company that raises money from shareholders and invests it in stocks, bonds, options, futures, currencies, or money market securities (Downes, John & Goodman, Jordon Elliot, p. 352, Barron’s Educational Series). The advantage of mutual funds is that it offers the investors the advantages of diversification and professional management (Downes, John & Goodman, Jordon Elliot, p. 556, Barron’s Educational Series). Stock options. Stock options give the owner the right, but not the obligation, to buy or sell an underlying security at a set price for a given period of time (Block, Stanley B. & Hirt, Geoffrey A., p. 570, McGraw-Hill Irwin). Options are a popular investment medium, offering an opportunity to hedge positions in other securities, to speculate in stocks with relatively little investment, and to capitalize on changes in the market value of options contracts themselves through a variety of options strategies (Downes, John & Goodman, Jordon Elliot, p. 563, Barron’s Educational Series). Derivatives. Derivatives, or derivative securities, are securities that have value derived from an underlying security, whether bond, stock, or some other instrument (Block, Stanley B. & Hirt, Geoffrey A., p. 570, McGraw-Hill Irwin). For instance, equity options are derivatives because they derive value from equities or stocks; likewise, futures contracts on government bonds or Treasure bills derive their value from those government securities, and futures contracts on gold or wheat have those commodities as determinants of their basic value (Block, Stanley B. & Hirt, Geoffrey A., p. 570, McGraw-Hill Irwin). Suggested Areas of Future Research Much of the literature on stocks, bonds, and other investments has examined the behaviour of these instruments during periods of normal economic environments. There is not sufficient data available, however, during periods of recession or depression, since these periods do not last very long in the case of mature and established economies where the more sophisticated financial instruments trade. As of 2008, the most serious financial crisis, that began due to mismanagement of mortgage debt and misuse of derivative securities has plunged the United States, and then the world, into a deep and possibly long-term recession. It is an opportunity also to study the dynamics of derivative debt instruments such as credit debt swaps, the cause of the present crisis, in greater detail. The repercussions of indiscriminate use of these instruments must be met with stricter regulation so that future crises of this sort will be alleviated. Another area of study that is suggested for future research is the prospects for equity investment with the looming prospect of possible nationalization of industries and companies that have been bailed out by government funding. At present, government-extended financing is viewed in the nature of debt financing. However, since trillions of dollars have been released to bail out corporations owned by private stock holders, it is an interesting question as to whether or not the government-extended financing would be converted to equity if the corporations could not defray the cost of the borrowing. If the government becomes majority stockholder of these major corporations, individual shareholders will find their share of dividends and their voting rights suddenly diluted. This will theoretically cause the market price of stocks to dive. It is interesting to research the implications for equity investment in the light of this situation. Bibliography Block, Stanley B. & Hirt, Geoffrey A., p. 284, McGraw-Hill Irwin Demirguc-Kunt, Asli & Maksimovic, Vojislav, p. 48-49, Finance & Development Downes, John & Goodman, Jordon Elliot, p. 556, Barron’s Educational Series Kadan, Ohad & Swinkels, Jeroen M., pp. 451-453, Review of Financial Studies Meng, Lei & Ap Gwilym, Owain, pp. 70-80, The Journal of Derivatives Romer, David, p. 164, Journal of Money, Credit and Banking Read More