Chapter 6 Rates of Return on Assets Types of Return 1 Fixed income assets promise to make periodic payments of a known amount on assigned dates a Calculating present value of fixed income assets i Present value current price annual cash flow promised annual rate of return ii This equation shows that there s an inverse relationships between the current price and the rate of return YTM on an asset 2 Variable return assets future payments dividends may change over time a Example corporate stock represents partial ownership of a business firm i Like most other assets there s an inverse relationship between present value and rate of return Interest Rates Stock Prices Inverse relationships between stocks and bonds If interest rates fall investors will usually get rid of their lower yielding bonds and invest more in equities driving stock prices upward Then lower market IR s lowers the overall capital costs of companies also causing the stock price to rise 2 factors that have an influence on all stock prices Stream of shareholder dividends a company is expected to pay in current and future periods E D o o Minimum rate of return required by a company s shareholders r Stock price formula SP D0 E D1 E D2 1 r 1 1 r 2 Shows SP D0 x 1 r r g A rise in expected dividends rise in stock prices per share A fall in the required risk adjusted rate of return r rise in stock prices per share If corporate dividends grow at a constant rate the formula for corporate stock prices is D0 current dividend g expected constant annual growth rate of dividends in the future r required rate of return Example company expects to pay a 2 50 dividend per share in the initial period then increase the amount of the future annual dividend by 5 each year The discount rate associated with the stock is 12 Holding Period Yield on Stock in this formula a 2 year asset SP 2 5 x 1 12 12 05 40 SP D0 E D1 E D2 SP2 1 h 1 1 h 2 1 h 2 From the previous example 40 0 2 1 h 1 2 1 h 2 50 1 h 2 16 5 Price Quotes on Corporate Stock Stock Close Information on stock is available to investors through the financial news in tables like this Yield 1 62 Volume in 1000 4 512 Change 0 15 52 wk lo 122 18 YTD Dividend Net Change 184 64 0 28 52 wk hi 185 63 26 18 3 00 PE 12 20 IBM Not all firms pay dividends on their stock ie Google These are mostly high tech and rapidly expanding firms o o More mature companies tend to pay out their earnings in dividends rather than retain them for future expansion o o o o o o o The Money Market the Market for Short Term Credit 1 year Where holders of temporary cash surpluses meet holders of temporary cash deficits Loans to meet purely short term cash needs Bridges the gap between receipts and expenditures of funds Chapter 10 Who s a lender who s a borrower o Big firms are often usually both Goal of Money Market safety liquidity Money market investors are sensitive to risk Key assets in the money market T Bills T Notes Federal Funds CDs Financial futures options contracts on bonds federal funds CDs etc Types of Risks faced by investors in the Money Market o Market risk or interest rate risk the danger that the asset s price will fall and interest rates rise leading to capital loss Usually only a problem if the investor s time horizon is shorter than the maturity of the asset Reinvestment risk the risk that earnings from a financial asset will have to be reinvested in lower yielding assets in the future Default risk the risk that the firm will fail to meet the promised scheduled payment s Inflation risk faced by lenders the risk that an increase in the prices of goods and services will reduce the purchasing power of their income Currency risk the possible loss due to unfavorable changes in the value of foreign currencies Ie if investor invests in the British market and the British pound falls relative to the USD that investor will have suffered as a result of the currency risk Political risk the possibility that changes in government regulations will result in a decreased rate of return on the investment Money market assets tends to be less risky than other assets bonds stocks real estate etc Except for inflation risks no market is immune to inflation risks Money market is a telephone computer market it has no centralized trading area like the stock market All about SPEED Money market s speed is largely based on its use of federal funds which can be traded and wired between lenders and borrowers immediately As opposed to clearinghouse funds funds transferred by check like when we write checks used credit debit cards etc o Checks and other cash items are delivered and passed through a clearinghouse from one depository institution to another Money market is aka the wholesale market for funds as opposed to the retail market because it s dominated by large funds trading large amounts of money Government the Money Market Government is one of the top issuers of money market debt US Treasury Bills Sold once a week by the US Treasury Department A key borrower Types of T Bills Regular series bills issued every week or month in competitive auctions with maturities of 1 3 6 or 12 months 6 month bill the largest amount of revenue for the US treasury Irregular series bills issued when Treasury has an emergency need for cash o o o o o o o o o o o o o o o o o o o o o o o o o o o o How T Bills are sold auction technique The marketplace sets bill and price yields Treasury announces a new bill issuance every Thursday and interested investors tender offers on a specific bill of a specific price these tenders are either competitive or non competitive Competitive bid a price interest rate high enough to win an allotment of bills Non competitive offers submitted that agree to pay the price determined by the auction After the auction once the non competitive T Bills have been subtracted from the competitive T Bills the highest competitive bidder receives bills and those competitive investors who have bid successively lower prices receive bills until the bills run out Once bills run out market clearing stop out price This price is the price that all successful bidders actually pay to the treasury Market interest rates on T bills are typically extremely low because of their extremely low risk Conditions in the T bill market tend to set the tone for other markets Like if there s a rise in T bill rates it s often taken as a rise in IRs related to other money market assets Principal holders of T Bills commercial banks nonfinancial