SECURITIES AND MARKETS

The objective of any financial decision, whether it is a financing or investment decision, should be to maximize owners’ wealth. For a corporation this translates into maximizing the market value of the ownership interest—the value of the stock. So a financial manager’s decisions must be made with an eye on the value of the firm’s stock and the markets in which the stock is traded.

If a firm needs funds, should it issue stock or borrow? If it issues new stock, will present investors lose? If it borrows, what interest rate will its lenders—the investors in its bonds—require? How soon could the loan be paid off? How soon should it be paid off?

If a firm has funds to invest, should financial managers invest it until it is needed? In what kind of financial instrument? What characteristics must the investment vehicle have? What types of risk must they take on with their investment?

Financial managers must understand the wide range of securities available and the markets in which they are bought and sold. This provides an overview of both. Its purpose is twofold. First, we acquaint you with the terms and definitions we use in this book. Then, we give you an idea how markets for securities function so that you will know how security prices are determined.

SECURITIES

A security is a document that gives the owner a claim on future cash flows. A security may represent an ownership claim on an asset (such as a share of stock) or a claim on the repayment of borrowed funds, with interest (such as a bond). The document may be a piece of paper (such as a stock certificate or a bond) or an entry in a register (which may, in turn, be a computer record). A securities market is an arrangement for buying and selling securities. It may be a physical location or simply a computer or telephone network.

Securities are classified into three groups: money market securities, capital market securities, and derivative securities—based on their maturity and the source of their value. The word “maturity” is often used loosely to refer to the length of time before repayment of a debt.

Other terms using the word “maturity” are more specific. The maturity date of a security is the pre-set date on which the amount borrowed (called the face value, the par value, the principal, or the maturity value) is repaid. The security is said to mature on its maturity date. The original maturity is the time between the date a security is issued and its maturity date.

Money Market Securities

Money market securities are short-term indebtedness. By “short term” we usually imply an original maturity of one year or less. The most common money market securities are Treasury bills, commercial paper, negotiable certificates of deposit, and bankers acceptances.

Treasury bills (T-bills) are short-term securities issued by the U.S. government; they have original maturities of either four weeks, three months, or six months. Unlike other money market securities, T-bills carry no stated interest rate. Instead, they are sold on a discounted basis: Investors obtain a return on their investment by buying these securities for less than their face value and then receiving the face value at maturity. T-Bills are sold in $10,000 denominations; that is, the TBill has a face value of $10,000.

Commercial paper is a promissory note—a written promise to pay—issued by a large, creditworthy corporation. These securities have original maturities ranging from one day to 270 days and usually trade in units of $100,000. Most commercial paper is backed by bank lines of credit, which means that a bank is standing by ready to pay the obligation if the issuer is unable to. Commercial paper may be either interest bearing or sold on a discounted basis.

Certificates of deposit (CDs) are written promises by a bank to pay a depositor. Nowadays they have original maturities from six months to three years. Negotiable certificates of deposit are CDs issued by large commercial banks that can be bought and sold among investors. Negotiable CDs typically have original maturities between one month and one year and are sold in denominations of $100,000 or more. Negotiable certificates of deposit are sold to investors at their face value and carry a fixed interest rate. On the maturity date, the investor is repaid the amount borrowed, plus interest.

Eurodollar certificates of deposit are CDs issued by foreign branches of U.S. banks, and Yankee certificates of deposit are CDs issued by foreign banks located in the United States. Both Eurodollar CDs and Yankee CDs are denominated in U.S. dollars. In other words, interest payments and the repayment of principal are both in U.S. dollars. Bankers’ acceptances are short-term loans, usually to importers and exporters, made by banks to finance specific transactions. An acceptance is created when a draft (a promise to pay) is written by a bank’s customer and the bank “accepts” it, promising to pay. The bank’s acceptance of the draft is a promise to pay the face amount of the draft to whomever presents it for payment. The bank’s customer then uses the draft to finance a transaction, giving this draft to her supplier in exchange for goods. Since acceptances arise from specific transactions, they are available in a wide variety of principal amounts. Typically, bankers’ acceptances have maturities of less than 180 days. Bankers’ acceptances are sold at a discount from their face value, and the face value is paid at maturity. Since acceptances are backed by both the issuing bank and the purchaser of goods, the likelihood of default is very small.

Money market securities are backed solely by the issuer’s ability to pay. With money market securities, there is no collateral; that is, no item of value (such as real estate) is designated by the issuer to ensure repayment. The investor relies primarily on the reputation and repayment history of the issuer in expecting that he or she will be repaid.