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Fixed Income Markets

- The market for the trading of securities paying a guaranteed yield. Examples of fixed-income securities
include bonds and preferred stock. The fixed-income market is lower risk and lower return than the
variable income market.
- The bond market (also known as the credit, or fixed income market) is a financial market where
participants can issue new debt, known as the primary market, or buy and sell debt securities, known as
the Secondary market, usually in the form of bonds. The primary goal of the bond market is to provide a
mechanism for long term funding of public and private expenditures. Traditionally, the bond market was
largely dominated by the United States, but today the US is about 44% of the market.
As of 2009, the
size of the worldwide bond market (total debt outstanding) is an estimated $82.2 trillion,
of which the
size of the outstanding U.S. bond market debt was $31.2 trillion according to Bank for International
Settlements (BIS), or alternatively $35.2 trillion as of Q2 2011 according to Securities Industry and
Financial Markets Association (SIFMA).

- Nearly all of the $822 billion average daily trading volume in the U.S. bond market
takes place
betweenbroker-dealers and large institutions in a decentralized, over-the-counter (OTC) market.
However, a small number of bonds, primarily corporate, are listed on exchanges.
- References to the "bond market" usually refer to the government bond market, because of its size,
liquidity, relative lack of credit risk and, therefore, sensitivity to interest rates. Because of the inverse
relationship between bond valuation and interest rates, the bond market is often used to indicate
changes in interest rates or the shape of the yield curve. The yield curve is the measure of "cost of
Types of bond markets
The Securities Industry and Financial Markets Association (SIFMA) classifies the broader bond market into five
specific bond markets.
Government & agency
Mortgage backed, asset backed, and collateralized debt obligation
Bond market participants
Bond market participants are similar to participants in most financial markets and are essentially either buyers (debt
issuer) of funds or sellers (institution) of funds and often both.
Participants include:
Institutional investors
Because of the specificity of individual bond issues, and the lack of liquidity in many smaller issues, the majority of
outstanding bonds are held by institutions like pension funds, banks and mutual funds. In the United States,
approximately 10% of the market is currently held by private individuals.

Market For Equity Securities

The term equity implies an ownership claim. Thus equity securities are certicates of ownership of a
corporation- the residual claim on a rms assets after all liabilities are paid. As owners, equity holders
have their right to share in the rms prots.
A) Equity Securities
Equity securities take several forms. As the name implies, common stock is the most prevalent
type of equity security. The term common stock usually means equity securities that have no special
dividend rights and have the lowest priority claim in the event of bankruptcy. Owners of preferred
stock, in contrast, usually receive preferential treatment over common stockholders when it comes to
receiving dividends or cash payos in bankruptcy. Most convertible securities are preferred stock or
corporate bonds that are convertible into the rms common stock.
1) Common stock
It represents the basic ownership claim in a corporation. The most distinguishing feature of common
stock is that it is the residual claim against the rms cash ows or assets. In the events of a rms
liquidation, common stockholders cannot be paid until claims of employees, the government, short-term
creditors, bondholders, and preferred stockholders are rst satised. After these prior claims are paid,
the stockholders are entitled to what is left over, the residual. (In general, common stock refers to a
share that has no preference in either dividend payments or bankruptcy).
Legally, common stockholders enjoy limited liability, meaning that their losses are limited to the
original amount of their investment. Limited liability also implies that the personal assets of shareholders
cannot be obtained to satisfy the obligations of the corporation. In contrast a sole proprietor is
personally liable for the rms obligations.
Dividends: Corporate payments to stockholders are called dividends. Common stock dividends
are not guaranteed, and a corporation does not default if it does not pay them. Dividends are paid
out of the rms after-tax cash ows. Because dividend income is taxable for most investors, corporate
dividends are doubly taxed- once when the corporation pays the corporate income tax, and once more
when the investors pay their personal income taxes. To avoid double taxation, some investors hold stocks
in growth companies that reinvest their accumulated earnings instead of paying larger dividends.

Voting Rights: While stockholders own the corporation, they do not exercise control over the rms
day-to-day activities. Control of the rm is in the hands of corporate managers who are supposed to
act in the interests of shareholders. Shareholders exercise control over the rms activities through the
election of a board of directors. Shareholders elect directors by casting votes at an annual meeting. As
a practical matter, most shareholders do not actually attend the meeting, voting instead by proxy, a
process in which shareholders vote by absentee ballot.
In general, one vote is attached to each share of stock, although there are exceptions, called dualclass
rms. During the 1980s many rms recapitalized with two classes of stock having dierent voting
rights. By issuing stock with limited voting rights compared to existing shares, the managers of a
rm can raise equity capital while maintaining voting control of the rm. Some people view dual-class
recapitalizations as attempts by managers to entrench themselves. Other proponents say that managers
of dual-class rms are free to pursue riskier, longer-term strategies that ultimately benet shareholders
without fear of reprisal if the short-term performance of the rm suers.
There are two procedures for electing directors: cumulative voting and straight voting. In
cumulative voting, all directors are elected at the same time and shareholders are granted a number
of votes equal to the number of directors being elected times the number of shares owned. Shareholders
are permitted to distribute their votes across directors as they wish. They may even decide to cast all
of their votes for one director.
In straight voting, directors are elected one-by-one. Thus, the maximum number of votes for each
director equals the number of shares owned. Under this scheme, it is dicult for minority shareholders
to obtain representation on the board of directors because any shareholder who owns even slightly over
50 percent of the shares can elect the entire board of directors.
Note: Classes of Stock: Many rms have more than one class of common shares, typically with
dierent voting rights. Some rms also issue restricted stock, which is non-voting. The main reason
for dual classes of stock has to do with retaining control of the rm. Issuing shares with limited voting
rights allows managers to raise equity capital without losing control of the rm.
2) Preferred Stock
Preferred stock represents ownership interest in the corporation, but as the name implies, it receives
preferential treatment over common stock with respect to dividend payments and the claim against the
rms assets in the event of bankruptcy or liquidation. In liquidation, preferred stockholders are entitled
to the issued price of the preferred stock plus accumulated dividends after other creditors have been paid
and before common stockholders are paid.
Dividends: Preferred stock is usually designated by the dollar amount of its dividends, which is a
xed obligation of the rm, similar to the interest payments on corporate bonds. Most preferred stock

is nonparticipating and cumulative. Preferred stock is nonparticipating in that the preferred
dividend remains constant regardless of any increase in the rms earnings. Firms can decide not to
pay the dividends on preferred stock without going into default. The cumulative feature of preferred
stock means, however, that the rm cannot pay a dividend on its common stock until it is has paid
the preferred stockholders the dividends in arrears. Some preferred stock is issued with adjustable rate.
Adjustable-rate preferred stock became popular in the early 1980s when interest rates were rapidly
changing. The dividends, here are adjusted periodically in response to changing market interest rates.
Voting: Generally, preferred stockholders do not vote for the board of directors; preferred shares
usually do not have voting rights. Exceptions to this general rule can occur when the corporation is
in arrears on its dividend payments. That is preferred shareholders are granted voting rights if some
specied number of dividends have not been paid.
Note: State Value: a preferred share normally has a stated liquidating value. For example, a share
of preferred stock might be identied as an 8% preferred indicating a dividend yield equal to 8%
of the stated value.
3) Convertible Securities
Convertible preferred stock can be converted into common stock at a predetermined ratio (such
as two shares of common for each share of preferred stock). By buying such stock, an investor can obtain
a good dividend return plus the possibility that, should the common stock rise in price, the investment
would rise in value.
Convertible bonds are bonds that can be exchanged for shares of common stock. However, until
conversion, they are corporate debt; thus their interest and principal payments are contractual obligations
of the rm and must be made lest the corporation default. Most convertible bonds are subordinated
debentures. Hence their holders have lower-ranking claims than most other debt holders, although their
claims rank ahead of stockholders.
Convertible bonds provide a means by which the corporation can issued debt and later convert it
to equity at a price per share that exceeds the stocks present market value. This feature is attractive
because it allows the corporation to sell stock at a higher future price.
B) Equity Markets
Households dominate the holding of equity securities, owning over 50 percent of outstanding corporate
equities. Pension funds (private and public) are the largest institutional holders of equity, followed by
mutual funds and foreign investors. These investors come to own equity securities through either primary

or secondary market transactions.
1) Primary Markets
New issues of securities are called primary oerings. The company can use the funds raised to expand
production, enter new markets, further research, and the like. If the company has never before oered a
particular type of security to the public, meaning the security is not currently trading in the secondary
market, the primary oering is called an unseasoned oering or an initial public oering (IOP).
Otherwise, if the rm already has similar securities trading in the secondary market, the primary issue
is known as a seasoned oering. All securities undergo a single primary oering in which the issuer
receives the proceeds of the oering and the investors receive the securities. Thereafter, whenever the
securities are bought or sold, the transaction occurs in the secondary market.
New issues of equity securities may be sold directly to investors by the issuing corporation, but they
usually are distributed by an investment banker in an underwritten oering, a private placement,
or a shelf registration. The most common distribution method is an underwritten oering in which
the investment banker purchases the securities from the company for a guaranteed amount known as
the net proceeds and then resells the securities to investors for a greater amount, called the gross
proceeds. The dierence between the gross proceeds and the net proceeds is the underwriters
spread, which compensates the investment banker for the expenses and risks involved in the oering.
The underwriters spread is inversely related to the size of the oering. In other words, the larger
the oering, the smaller the spread tends to be as a percentage of the amount of funds being raised by
the company. Second, the more uncertain the investment bankers are concerning the market price of
the equity securities being oered, the larger the underwriters spread tends to be. Shelf registrations
tend to have lower spreads than ordinary oerings, this is due to the fact that larger, more well-known
companies employ shelf registrations.
Some equity securities are distributed through private placements in which the investment banker
acts only as the companys agent and receives a commission for placing the securities with investors. In
addition, occasionally will place equity securities directly with its existing stockholders through a rights
oering. In a rights oering, a companys stockholders are given the right to purchase additional shares
at a slightly below-market price in proportion to their current ownership in the company. Stockholders
can exercise their rights or sell them.
In Shelf registration form, it permits a corporation to register a quantity of securities with the
SEC and sell them over a two-year period rather than all at once. Thus the issuer is able to save time
and money through a single registration. In addition, securities can be brought to market with little
notice, thereby providing the issuer with maximum exibility in timing an issue to take advantage of
favorable market conditions.

2) Secondary Markets
Any trade of a security after its primary oering is said to be a secondary market transaction. When
an investor buys 100 shares of IBM on the NYSE, the proceeds of the sale do not go to IBM but rather
to the investor who sold the shares.
The functions of secondary markets is to provide liquidity at fair prices. Investors nd some liquidityrelated
characteristics of a secondary market desirable because:
First, a secondary market is said to have depth if there exists orders both above and below the price
at which a security is currently trading. When a security trades in a deep market, temporary imbalances
of purchase or sales orders that would otherwise create substantial price changes encounter osetting,
and hence stabilizing, sale or purchase orders.
Second, a secondary market is said to have breadth if the orders that give the market depth exist
in signicant volume. The broader the market, the greater the potential for stabilization of temporary
price changes that may arise from order imbalances.
Third, a market is resilient if new orders pour in promptly in response to price changes that result
from temporary order imbalances. For a market to be resilient, investors must be able to quickly learn
of such price changes.
There are four types of secondary market: direct search, brokered, dealer, and auction
Direct search: In this case buyers and sellers must search each other out directly. Securities that
trade in direct search markets are usually bought and sold so infrequently that no third party, such as
a broker or a dealer, has an incentive to provide any kind of service to facilitate trading. The common
stock of small companies, especially small banks, trade in direct search markets. Buyers and sellers of
those issues must rely on word-of-mouth communication of their trading interest to attract compatible
trading partners. Because there is no economical way of broadcasting either quotations or transactions
prices, trades can occur at the same time at quite dierent prices, and transactions frequently occur
away from the best possible price.
Brokered: When trading in an issued becomes suciently heavy, brokers begin to oer specialized
search services to market participants. For a fee, called a commission, brokers undertake to nd compatible
trading partners and to negotiate acceptable transaction prices for their clients. Brokers, because
of their contact with many market participants, are able to know what constitutes a fair price. They
are able to arrange transactions closer to the best available prices than is possible in a direct search
market. Their extensive contacts provide them with a pool of price information that individual investors
could not economically duplicate. By charging a commission less than the cost of direct search, they
give investors an incentive to make use of that information.
Dealer: During the time a broker is searching out a compatible trading partner for a client, securities

prices may change and the client may suer a loss. However, if trading in an issue is suciently active,
some market participants may begin to maintain bid ad oer quotations of their own. Such dealers
buy for , and sell for, their own inventory at their quoted prices. Dealer markets eliminate the need for
time-consuming searches for trading partners, because investors know they can buy or sell immediately
at the quotes given by a dealer. Dealers earn their revenue in part by selling securities at an oer price
greater than the bid price they pay for the securities. Their bid-ask spread compensates them for
providing to occasional market participants the liquidity of an immediately available market, and also
for the risk dealers incur when they position an issue in their inventory.
Auction: Auction markets provide centralized procedures for the exposure of purchase and sale
orders to all market participants simultaneously. By so doing they virtually eliminate the expense of
locating compatible partners and bargaining for a favorable price.
C) Equity Trading
1) Over-The-Counter And NASDAQ
Securities not sold on one of the organized exchanges are traded over the counter (OTC). A stock
may not be listed on an exchange for several reasons, including lack of widespread investor interest,
small issue size, or insucient order ow.
The OTC stock market is primarily a dealer market. Since dierent OTC issues are not usually close
substitutes for each other, a dealer with limited capital can make a successful market even in a relatively
narrow range of stocks. As a result, there are a large number of relatively small OTC dealers. OTC
dealers, however, often concentrate their trading in particular industry groups or geographical areas.
A major development in the OTC market occurred in 1971 when the National Association of
Securities Dealers (NASD) introduced an automatic computer-based quotation system (NASDAQ).
The system provides continuous bid and ask prices for the most actively traded OTC stocks. Nasdaq is
basically an electronic pink sheet, and as such was compatible with the existing structure of the OTC.
There are three levels of access to the Nasdaq system. Level 3 terminals are available only to dealers
and allow dealers to enter bid and ask quotations for specic stocks into the system. These quotations,
together with information identifying the stock and the dealer, appear within seconds on the terminals
of other dealers and brokers. Level 2 terminals display all the dealer price quotations for a given stock,
but do not allow the quotations to be changed on the terminal. These terminals are available to brokers
and institutions. Level 1 terminals provide only the best bid and ask price (the inside quote) for a given
issue. These terminals are used by stockbrokers when quoting prices to customers.

2) Stock Exchanges
The New York Stock Exchange (NYSE), the preeminent securities exchange in the US, is an example
of an auction market. Other stock exchanges in the US include the American Stock Exchange located
in New York, the Pacic Stock Exchange in both San Francisco and Los Angeles, the Chicago Stock
Exchange, the Philadelphia Stock Exchange, the Boston Stock Exchange, and the Cincinnati Stock
Exchange. The Nasdaq and the NYSE account for most trading.
All transactions are completed within the structure of that exchanges market occur at a unique place
on the oor of the exchange, at a so called post.
There are three major sources of active bids and oerings in an issue available at a post: (1) oor
brokers executing customer orders, (2) limit price orders left with the specialist for execution, and (3)
the specialist in the issue buying and selling for his own account.
Orders from the public are telephoned or telexed from brokerage house to brokers located on the
oor of the NYSE, who bring the orders to the appropriate posts for execution. Most of these orders
are either market orders or limit orders.
A market order is an order to buy or sell at the best price available at the time the order reaches
the post.
A limit order is an order to buy or sell at a designated price (the limit price stated on the order)
or at any better price.
Specialists provide the third source of bid and oerings in listed securities. At least on the NYSE,
specialists are members of the exchange who combine the attributes of both dealers and order clerks.
Specialists have an armative obligation to maintain both bid and oer quotations at all times, good
for at least one round lot (usually 100 shares) of the issues in which they specialize. In this respect
specialists act as dealers, trading for their own account and at their own risk.

Common Stock Valuation
Evaluation of common stock is more dicult that a bond for the following reasons:
a) The promised cash ows are not known in advance
b) The life of a stock is forever, because common stock has no maturity
c) It is hard to observe the rate of return that the market requires.
With all of this, we still can look at ways to evaluate and determine the value of a stock.
A) Common Stock Cash Flows:
If we let P0 to be the current price of a stock, and dene P1 to be the price in one period, and if we
let D1 be the cash dividend paid at the end of the period, then:
P0 = (D1 + P1) = (1 + r)
where r is the required return in the market on this investment.
What about if you hold the stock for another period in the future. And suppose that we could know
the price in two periods, P2 and given an expectation or predicted dividend in two periods, D2, the stock
price in one period would be:
P1 = (D2 + P2) = (1 + r)
If we substitute the above expression in the price P0
We would get:
P0 = D1= (1 + r) + D2= (1 + r)2 + P1= (1 + r)
We can get the price in two periods:
P2 = (D3 + P3) = (1 + r)
Substituting in P0
we get:
P0 = D1= (1 + r) + D2= (1 + r)2 + D3= (1 + r)3 + P1= (1 + r)
we can push the timing as far as we would like, for a large periods of time, the last term becomes
negligible, or almost zero, so
P0 = D1= (1 + r) + D2= (1 + r)2 + D3= (1 + r)3 :::::::::::
So, the price today of a stock is the present value of all future dividends.
B) Common Stock Valuation: Some Special Cases
Few cases arise in terms of determining the value of a stock. The important point here is related to
the behavior of dividends over time. We have to make some assumptions about the growth, or how the
dividends grow over time. Three cases arise:
a) Zero Growth
b) Constant Growth of Dividends.
c) Non-Constant Growth Model
a) Zero Growth
That is when the dividends are all the same in every single period. That is exactly the same as the
case for a preferred stock, where cash payments (dividends are constant over time). In other words:
D1 = D2 = D3 = :::: = D = cons tan t:
So the value of the stock will be:
P0 = D= (1 + r) + D= (1 + r)2 + D= (1 + r)3 :::::::::::
Since dividends are the same, the stock could be regarded as an ordinary perpetuity with cash ow
equal to D every period.
So, we get the price of a stock to be:
P0 = D=r
where r is the required return.
b) Constant Growth of Dividends
Suppose that dividend grows at a steady rate, and call this rate g.
If we let D0 the dividend just paid, then the dividend next period D1 will be D1 = D0 (1 + g)
The dividend in two periods is:
D2 = D1 (1 + g) = D0 (1 + g)2
We could repeat this process to come with the dividend at any point in the future. For periods t in
the future we get:
Dt = D0 (1 + g)t
That is similar what is called a growing perpetuity, that where the cash ows grows at a constant
rate over time.
Reason behind that: Banks for example could take that as a policy to have a good performance for
their shareholders.
Now what happens to the price of the stock:
We know:
P0 = D1= (1 + r) + D2= (1 + r)2 + D3= (1 + r)3 :::::::::::
P0 = D0 (1 + g) =(1 + r) + D0 (1 + g)2 =(1 + r)2 + D0 (1 + g)3 =(1 + r)3 ::::::
As long as g < r we can write:
P0 = D0 (1 + g) =(r g) = D1= (r g)
This result goes by the name of Dividend Growth Model.
In general, from the model, we can get the price of the stock at any point of time, not just today,
that is the price of a stock at time t is:
Pt = Dt+1= (r g)
What about the formula for a growing perpetuity:
Present value = C1= (r g) = C0 (1 + g) =(r g)
c) Non-Constant Growth Model
The last case to be considered is the non-constant growth. The reason here is to allow for some
supernormal growth rates over some nite length of time.
Say a company will dividend for the rst time in ve years. Currently the company is not paying
dividend, only in ve years, it will do so. The dividend will be $0.50 per share. We expect this dividend
to grow by 10 percent indenitely after. The required return on companies such as this one is 20 percent.
Using the dividend growth model, we can determine the price of the stock, in period four.
P4 = D5= (r g) = $0:50=(0:20 0:10) = $5:00
That is the value of the stock in four years, so we can get its value in today, by using the present
value formula.
P0 = $5:00=(1:20)4 = $2:41
What about if the dividend are not zero in the rst few years.
Say, for example, a company pays the following dividend in the rst three years, by then dividend
grows at a constant rate afterward, how can we determine the present value, or price of a stock.
Year Expected Dividend
1 $1.00
2 $2.00
3 $2.00
And after the third year, dividend will grow at 5 percent per year. The required return is 10 percent.
First, we use the dividend growth model to determine the price in period three, based on the growth
g, and r.
P3 = D3(1 + g)= (r g) = $2:50 (1:05)=(0:10 0:05) = $52:50
Now we can calculate the total value of the stock, that is the present value of the dividends paid in
the rst three years, and the present value of the price at time three:
P0 = D1= (1 + r) + D2= (1 + r)2 + D3= (1 + r)3 + P3= (1 + r)3
P0 = $0:91 + 1:65 + 1:88 + 39:44 = $43:88
C) Components of the Required Return:
From the dividend growth model, we calculated that :
P0 = D1= (r g)
arrange that to solve for r:
r g = D1=P0 or r = g + D1=P0
That tells us that the total return, r, has two components:
a) D1=P0 is called the dividend yield, it is calculated as the expected cash divided by the current
price. (similar to the current yield on a bond).
b) g the growth rate on dividend. It is the rate at which the stock price grows too, and called capital
gains yield, that is the rate at which the investment grows.
r = Capital gains yield + Dividend yield.
Say, a stock sells for $20 per share, the next dividend will be $1 per share. If g is 10 percent. What
return does this stock oer.
Capital gains yield = 10%
Dividend yield =$1/$20=5%
Total return = 15%