Chapter 2 Introduction

This chapter will provide an introduction to financial markets and common financial instruments. Financial markets are where suppliers of capital (firms) interact with buyers (investors). Often this is done through intermediaries such as brokers.

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Why Do People Invest?

Investing is not just something other people do. College education is an investment. Investing is more than just hoping to make some money. It involves deferring present consumption in the hopes of higher future consumption.

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Equity Capital

Types of equity capital

Preferred stock Common stock

This course focuses more on common stock.

No guarantee of dividend One share, one vote Shareholders vote on key issues such as composition of board of directors, choice of auditing firm, and others.

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Why Purchase Common Stock?

A purchaser is looking for at least one of two possibilities:

1. Stream of dividend payments (current income) 2. Increase in stock price (capital gain)

Holding period return:

(sales price purchase price) + dividends x 100 purchase price

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Holding Period Return Example

You purchased a share of McDonalds stock one year ago for $18.00. You earn $2.00 in dividends during the year. Today you sell the stock for $18.50. What is your holding period return? ($18.50 $18) + $2 / $18.00 = .1389 x 100 = 13.89% (before taxes)
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Hospitality Financial Management By Robert E. Chatfield and Michael C. Dalbor

Bonds

Held by lenders Receive repayment over time

Semi-annual interest payments At maturity, amount is repaid (principal)

This is a series of cash flows that has value Priced on an index relative to 100 If a $1,000 bond sells for 102, it sells for $1,020
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Hospitality Financial Management By Robert E. Chatfield and Michael C. Dalbor

How to Interpret Bond Information

Bond Hilton 73/4 04

Curr. Yld 7.2%

Vol 40

Close 101

Chg +1/2

The Hilton bond pays 7.75% interest and matures in 2004. The annual interest divided by the current price is 7.2 percent. (Note: this is not the return you will receive if you hold the bond till maturity.) 40,000 bonds were traded that day. The bond closed at $1,010 which is $.50 higher than the previous day.
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Hospitality Financial Management By Robert E. Chatfield and Michael C. Dalbor

Capital Markets

Represents a diverse group of investments

Stock market Bond market Mortgage market Futures market

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Stock Market

New York Stock Exchange (NYSE)

Founded in 1792 Physical location on Wall Street in New York Approximately 2,800 companies offering securities here Membership offered in the form of seats

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Stock Market

Nasdaq

National Association of Securities Dealers and Automated Quotations Not a physical location like the NYSE (over the counter) Represents a network of securities dealers Fastest growing securities market Makes use of market makershelp ensure liquidity of trading

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Bond Market

Corporate bonds can be traded through the NYSE Most bonds are traded over the counter Bond ratings
The lower the letter, the greater the quality Quality refers to the risk of default

Companies rating bonds

Standard and Poors Moodys

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Important Features of Bonds

How are bond prices and interest rates related?

As interest rates rise, bond prices fall. Company can repurchase bonds at a certain price during a certain time.

Some bonds are callable.

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Money Market

Market for short-term debt instruments

Certificates of Deposit Commercial paper

Investors

loan to large companies for a very short period of time (9 months or less).

Treasury Bills Loans to the U.S. Treasury

Zero-Coupon

bonds Issued at a discountno interest payments

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Mortgage Market

Pooling of home mortgages by government agencies

FNMA and GNMA are two examples. Mortgages are packaged and resold as securities to investors. Investors are often large institutional investors like pension funds.

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Raising Capital

Primary market

Initial Public Offering (IPO)

Common

stock is sold to underwriter (investment banker) Investment banker sells to clients 2003 scandal/settlement

Secondary market

Investor to investor, where most trading occurs

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Features of Stock Trading

Bid vs. ask

Bid is the price you will pay to own a share Ask is the price you would receive to sell your share Difference goes to broker

Average NYSE trade takes 22 seconds Significant reliance upon computers Trading halt in June 2001
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Hedging Risk

We can add value by decreasing the risk (variability) of cash flows. The concept of insurance as hedging:
You buy insurance and if nothing happens to your house, you still have the house. If your house is damaged, insurance pays for it and the house is rebuilt.

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Forward and Futures Contracts

Spot priceprice paid for a commodity today Change in commodity prices present, risk to buyer and seller Example: Orange juice grower (seller) and restaurant owner (buyer) Prices help growers determine what and how much to produce and restaurants need to establish menu price
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Forward Contracts

An agreement to sell an asset at a fixed price for delivery in the future. Cash payment is not required until delivery. However, each party must trust the other to perform. The unique nature of each contract makes them difficult to sell to third parties.

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Futures Contracts

Similar to forward contracts, except:

Terms of contract are standardized, such as amounts and delivery dates. Clearinghouse acts as go-between to help ensure performance. Contracts are traded on the Chicago Board of Trade or Chicago Mercantile Exchange.

Most contracts are never delivered. Parties take opposite positions to offset original position.
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Foreign Exchange

As international trade barriers are removed, more business is conducted away from home country. Nearly 65% of McDonalds 2002 revenues originated from outside the U.S. U.S. companies must report financial operations in U.S. currency.

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Foreign Exchange Example

You operate a hotel in France and accept the Euro. When the Euro strengthens, this means it takes fewer Euros to buy $1 worth of goods. As the Euro strengthens, your profits increase upon conversion. 100,000Euros x $1/1Euro = $100,000 100,000Euros x $2/1Euro = $200,000
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Can we hedge this risk?

Similar to commodities, we want to lock in a price for our Eurosan exchange rate at a future date. We can buy a forward or futures contract to accomplish this. Who would be on the other side of this transaction? A French company (or other company accepting the Euro) operating in the U.S.
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Lenders to the Hospitality Industry

Commercial banks
Traditionally largest lender Bank makes a spreaddifference between interest rate on loans and rate on deposits Interest = principal x rate x time Types of loans

Fully

amortized (principal and interest) Interest only

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Lenders to the Hospitality Industry

Real Estate Investment Trusts (REITS)

There are equity and mortgage REITS Special tax treatment if they pass through at least 95 percent of earnings to investors

Insurance companies and pension funds

Receive large monthly cash flows from premiums and contributions Try to match assets (loans) to liabilities (policies and pension needs)

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Measures of Stock Market Performance

Dow Jones Industrial Average

Index of 30 large companies Weighted by stock price

Standard and Poors 500 (S&P 500)

500 companies Fairly common measure of overall stock market performance Movement is similar to the Dow

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Some Stock Market Statistics

Meanweighted average

Mean Dow annual return (19502001) = 9.01% Mean S&P 500 annual return = 9.63%

Returns in a single year have varied from 30% to +44% This uncertainty around the mean is called variance Another measure is standard deviation, the square root of the variance

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Some Stock Market Statistics

Can we measure the relationship between two individual stocks, two stock indices, or an individual stock and a stock index? Correlation coefficient = Range is from 1.0 to +1.0 +1.0 is perfect positive correlation -1.0 is perfect negative correlation The Dow and the S&P 500 are highly positively correlated
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Hospitality Financial Management By Robert E. Chatfield and Michael C. Dalbor