FINANCE AND MONEY

Structure of the Course

• Chapter 1: Overview about Finance and Money
• Chapter 2: Time Value of Money
• Chapter 3: Interest Rate
• Chapter 4: Financial Markets
• Chapter 5: Financial Intermediaries
• Chapter 6: Corporate Finance
• Chapter 7: State Budget
• Chapter 8: Central Bank and Monetary Policy
Materials
• Chapter 2, Mishkin, F. S. (2019). The economics of money,
banking and financial markets, Global Edition, (12th ed.),
Pearson.

• Chapter 2, 7 & 8, Keown, A., Martin, J. and Petty, J. (2019).

Foundations of Finance, Global Edition, (10th ed.), Pearson.
Chapter 4: Financial Markets
1. Overview of Financial Markets
2. Structure of Financial Markets
3. Financial Instruments: Fixed-Income Securities
4. Financial Instruments: Equity Securities
5. Financial Instruments: Derivatives
1. Overview of Financial Markets
v The Financial System:

Income > expense Income < expense

1. Overview of Financial Markets
v The Financial System:
• Direct Finance:
Borrowers borrow funds directly from Lenders in financial
markets by selling the lenders securities.
 1. Overview of Financial Markets
v The Financial System:
• Direct Finance:
- Transaction cost:
The time and money spent in carrying out financial transactions
- Asymmetric information:
? B
A
Những công ty cần vốn, marketing để
tăng khả năng đầu tư vốn, riskier
borrower thường vay được vốn tốt
hơn vì họ đầu tư marketing ? C
Adverse Sau khi đã vay được vốn
Moral Hazard nhưng sử dụng không
Selection đúng mục đích đã hứa
vd: gambling
1. Overview of Financial Markets
v The Financial System:
• Indirect Finance:
Borrowers borrow funds indirectly from Lenders through a Financial
intermediary that stands between the lenders and the borrowers.
1. Overview of Financial Markets
v The Financial System:
• Indirect Finance:
- Low rate of return
- Not easy to approach funds
1. Overview of Financial Markets
v The Financial Market:
• Definition:
A financial market is a market in which financial assets
(securities) can be purchased or sold.

• Function:
Allow funds to move from people who lack productive
investment opportunities to people who have such opportunities.
Þ Produce an efficient allocation of capital.
Þ Generate higher production and efficiency for the overall economy.
2. Structure of Financial Markets
v Based on the characteristics of instruments
• Debt Market:
The market where debt instruments are bought and sold.
Fixed income (bonds)
-> Equity (gain/loss) - thu nhập k fixed
-> Derivative
• Equity Market:
The market where equity instruments are bought and sold.

• Derivative Market:
The market where derivative contracts are bought and sold.
2. Structure of Financial Markets
v Based on the characteristics of instruments

• In debt and equity markets, actual claims are bought and sold
for immediate cash payments.

• In derivative markets, investors make agreements that are

settled later.
2. Structure of Financial Markets
v Based on term (maturity) of instruments:
• Money Market:
A financial market in which only short-term debt instruments
(original maturity terms of less than one year) are traded.

• Capital Market:
A financial market in which longer-term debt instruments
(original maturity terms of one year or greater) and equity
instruments are traded.
2. Structure of Financial Markets
v Based on term (maturity) of instruments:
• Money Market:
A financial market in which only short-term debt instruments
(original maturity terms of less than one year) are traded.

• Capital Market:
A financial market in which longer-term debt instruments
(original maturity terms of one year or greater) and equity
instruments are traded.
2. Structure of Financial Markets
v Based on term (maturity) of instruments:
• Money Market:
- A wholesale market with large trading volume.
- Participants are normally creditworthy institutions:
Commercial banks, Governments, Corporations, Government-sponsored
enterprises, Money market mutual funds, etc.
- Highly liquid, low risk, low rate of return.
- Purpose of trading: liquidity
- An OTC market.
2. Structure of Financial Markets
v Based on term (maturity) of instruments:
• Capital Market:
- A retail market with varying trading volume.
- Individuals can participate in the capital market.
- Higher risk and higher rate of return than money market.
- Purpose of trading: rate of return
- Can be either OTC or exchange market.
 2. Structure of Financial Markets
v Based on the flow of funds:
• Primary Market:
A financial market in which securities are bought and sold for the
first time.
• Secondary Market:
A financial market in which people can buy and sell existing
securities.

Securities Securities
Borrowers Investor 1 Investor 2
$$$ $$$
2. Structure of Financial Markets
v Based on term (maturity) of instruments:
• Primary Market:
- In this market, the firm selling securities actually receives the
money raised.
+ IPO: Initial Public Offering
+ SEO: Seasoned Equity Offering
- The primary markets for securities are not well known to the
public because the selling of securities to initial buyers often
takes place behind closed doors.
+ Investment bank as an underwriter.
2. Structure of Financial Markets
v Based on the flow of funds:
• Secondary Market:
- In this market, the issuing firm does not receive any new
financing: securities are simply transferred from one investor to
another investor.
- Brokers and Dealers help facilitate stock trading.
- Function:
+ Provide liquidity to financial instruments.
+ Determine the price of the security sold in the primary market.
2. Structure of Financial Markets
v Based on the way of trading securities:
• Exchanges:
A financial market in which buyers and sellers of securities meet
in one central location to conduct trades.
Eg: NYSE (New York Stock Exchange), HNX (Hanoi Stock Exchange),…
• Over-the-counter Markets:
A financial market in which market participants trade over the
telephone, facsimile or electronic network instead of a physical
trading floor.
Eg: NASDAQ (National Association of Securities Dealers Automated
Quotations System), …
3. Financial Instruments: Fixed-Income
v Money Market Instruments:
• Definition:
Money market securities are debt securities with a maturity of
one year or less
• Characteristics:
+ Liquid
+ Low expected return
+ Low degree of risk
3. Financial Instruments: Fixed-Income
v Money Market Instruments:
• Types:
- Treasury Bills (T-Bills)
- Negotiable Certificate of Deposits (NCDs)
- Commercial Papers
- Banker’s Acceptance
- Repurchase Agreement
3. Financial Instruments: Fixed-Income
v Money Market Instruments:
• Treasury Bills (T-Bills):
- Issued by the Federal Government, to finance national debt and
new deficits.
- Sold through an auction.
- Generally viewed as having zero-default risk => Risk-free asset
- After initial sale, they have an active secondary market.
- T-bills are sold at a discount from par value: do not pay interest
3. Financial Instruments: Fixed-Income
v Money Market Instruments:
• Treasury Bills (T-Bills):
- Pricing T-bills:
The price is dependent on the investor’s required rate of return:
Par Value
P! =
1+i

+ To price a T-bill with a maturity less than one year, the annualized return
can be reduced by the fraction of the year in which funds would be invested.
3. Financial Instruments: Fixed-Income
v Money Market Instruments:
• Treasury Bills (T-Bills):
Exercise 1:
A one-year Treasury bill has a par value of $10,000. Investors
require a return of 7 percent on the T-bill. What is the price
investors would be willing to pay for this T-bill?
Exercise 2:
A 6-month Treasury bill has a par value of $10,000. Investors
require a return of 8 percent on the T-bill. What is the price
investors would be willing to pay for this T-bill?
3. Financial Instruments: Fixed-Income
v Money Market Instruments:
• Treasury Bills (T-Bills):
- Estimating T-bill discount:
The T-bill discount represents the percentage discount of the
purchase price from par value for newly issued T-bills:
𝑃𝑎𝑟 𝑉𝑎𝑙𝑢𝑒 − 𝑃𝑢𝑟𝑐ℎ𝑎𝑠𝑒 𝑃𝑟𝑖𝑐𝑒 360
𝑇 − 𝑏𝑖𝑙𝑙 𝑑𝑖𝑠𝑐𝑜𝑢𝑛𝑡 = 𝑥
𝑃𝑎𝑟 𝑉𝑎𝑙𝑢𝑒 𝑛

Exercise 3:
A newly issued 6-month (182-day) T-bill with a par value of $10,000 is
purchased for $9,800. Calculate the T-bill discount.
3. Financial Instruments: Fixed-Income
v Money Market Instruments:
• Treasury Bills (T-Bills):
- Estimating the Yield to the holder:
The Yield reflects the rate of return for the creditor by holding the
financial instrument.

- The annualized yield:

𝑆𝑒𝑙𝑙𝑖𝑛𝑔 𝑃𝑟𝑖𝑐𝑒 − 𝑃𝑢𝑟𝑐ℎ𝑎𝑠𝑒 𝑃𝑟𝑖𝑐𝑒 365
𝑌𝑖𝑒𝑙𝑑 !"#$%% = 𝑥
𝑃𝑢𝑟𝑐ℎ𝑎𝑠𝑖𝑛𝑔 𝑃𝑟𝑖𝑐𝑒 𝑛

+ n = number of days of investment (holding period)

3. Financial Instruments: Fixed-Income
v Money Market Instruments:
• Treasury Bills (T-Bills):
- Estimating the Yield to the holder:
If a newly-issued T-bill is purchased and held until maturity, the
yield is based on the difference between par value and the
purchase price.

𝑃𝑎𝑟 𝑉𝑎𝑙𝑢𝑒 − 𝑃𝑢𝑟𝑐ℎ𝑎𝑠𝑒 𝑃𝑟𝑖𝑐𝑒 365

𝑌𝑖𝑒𝑙𝑑 !"#$%% = 𝑥
𝑃𝑢𝑟𝑐ℎ𝑎𝑠𝑖𝑛𝑔 𝑃𝑟𝑖𝑐𝑒 𝑛
3. Financial Instruments: Fixed-Income
v Money Market Instruments:
• Treasury Bills (T-Bills):
Exercise 4:
An investor buys a 3-month (91-day), $100,000 par value
Treasury bill for $98,500. What is the annualized yield for this
investor? What is the quoted discount for the T-bill?
Exercise 5:
Suppose the investor plans to sell the bill in one month (30 days)
at a price of $99,250. What is the expected annual yield for this
investor? What is the expected annual yield for the buyer of the
bill if he decides to keep T-bill until maturity?
3. Financial Instruments: Fixed-Income
v Money Market Instruments:
• Negotiable Certificate of Deposits (NCDs):
- NCDs are interest-bearing securities issued by banks to raise
money for loans.
- Denominations: $100,000 and above (Large Time Deposits)
- They have maturities of one year or less.
- NCDs offer a premium above the T-bill yield to compensate for
less liquidity and safety. Premiums are generally higher during
recessionary periods.
- NCDs have a secondary market
3. Financial Instruments: Fixed-Income
v Money Market Instruments:
• Commercial Papers (CPs):
- Are unsecured debt issued by corporations with good credit
ratings to finance short-term debt (e.g. inventories)
- Most buyers are large institutions.
- Are typically established for a maturity range from 0 to 90 days.
- Inactive secondary market.
3. Financial Instruments: Fixed-Income
v Money Market Instruments:
• Commercial Papers (CPs):
3. Financial Instruments: Fixed-Income
v Money Market Instruments:
• Commercial Papers (CPs):
3. Financial Instruments: Fixed-Income
v Money Market Instruments:
• Banker’s Acceptance (BAs):
- A bankers' acceptance (BA) is a short-term credit investment
created by a non-financial firm and guaranteed by a bank to
make payment.
- Are commonly used for international trade transactions.
- Exporters frequently sell an acceptance before the payment
date.
- Have an active secondary market facilitated by dealers.
- Acceptances are traded at discounts from face value in the
secondary market.
3. Financial Instruments: Fixed-Income
v Money Market Instruments:
• Repurchase Agreement (Repo):
- One party sells securities to another with an agreement to
repurchase them at a specified date and price.
- Transactions amounts are usually for $10 million or more
- Common maturities are from 1 day to 15 days and for one,
three, and six months.
- There is no secondary market for repos.
3. Financial Instruments: Fixed-Income
v Capital Market Instruments: Bonds
• Definition:
A bond is a contractual agreement between the issuer and the
bondholders.
=> The Borrower (Issuer) promises to pay its holders:
- A pre-determined and fixed amount of interest per year
- The face value of the bond at maturity.
3. Financial Instruments: Fixed-Income
v Capital Market Instruments: Bonds
• Features:
- Face (Par) Value
- Coupon rate
- Maturity
3. Financial Instruments: Fixed-Income
v Capital Market Instruments: Bonds
• Characteristics:
- From Lender’s perspective:
+ Claims on Assets and Income of the issuer:
o Have an expiration time.
o Receive periodic interest payments and the principal amount at
maturity.
o If payments on bonds are not made on time: the creditors can legally
classify the firm as insolvent and force it into bankruptcy.
o Claims of debt must be honoured before those of equity.

+ Do not have ownership interest in the organization.

3. Financial Instruments: Fixed-Income
v Capital Market Instruments: Bonds
• Characteristics:
- From Borrower’s perspective:
+ Debt is a liability:
o The issuer must promise to make regularly scheduled interest payments
and to repay the original amount borrowed on time.
o If payments on bonds are not made: liquidation or reorganization - two
of the possible consequences of bankruptcy.
+ Payment of interest is considered a cost of doing business
and fully tax deductible.
+ Lower cost of capital.
3. Financial Instruments: Fixed-Income
v Capital Market Instruments: Bonds
• Types of Bonds:
- Based on the issuers:
+ Government Bonds: Treasury Bonds and Municipal Bonds
+ Corporate Bonds
- Based on the interest rate:
+ Fixed-rate Bonds
+ Floating-rate Bonds
+ Zero-coupon Bonds
3. Financial Instruments: Fixed-Income
v Capital Market Instruments: Bonds
• Bond Ratings:
- An assessment of the creditworthiness of the issuer.
+ Creditworthiness: how likely the issuer is to default and which protection
creditors have in the event of a default.
+ Concerned only with the possibility of default (default risk).
- Credit-rating organizations:
+ Standard & Poor’s (S&P)
+ Moody’s Investor Services (Moody’s)
+ Fitch IBCA (Fitch)
3. Financial Instruments: Fixed-Income
v Capital Market Instruments: Bonds
• Bond Ratings:
- An assessment of the creditworthiness of the issuer.
+ Creditworthiness: how likely the issuer is to default and which protection
creditors have in the event of a default.
+ Concerned only with the possibility of default (default risk).
- Credit-rating organizations:
+ Standard & Poor’s (S&P)
+ Moody’s Investor Services (Moody’s)
+ Fitch IBCA (Fitch)
 3. Financial Instruments: Fixed-Income
v Capital Market Instruments: Bonds
• Bond Ratings:
- The lower the rating, the
higher the chance of default.
- The lower the bond rating,
the higher the interest rate
demanded by investors.
- A bond’s credit rating can
change as the issuer’s
financial strength improves
or deteriorates.
 3. Financial Instruments: Fixed-Income
v Capital Market Instruments: Bonds
• Bond Ratings: Moody's Rating Default Spread (%)

Aaa 0.0000
- Access the link: Aa1 0.3377
Aa2 0.4222
https://pages.stern.nyu.edu/~adamodar/New_ Aa3 0.5143
A1 0.5987
Home_Page/datafile/ctryprem.html A2 0.7216
A3 1.0209
Baa1 1.3587
Baa2 1.6197
Baa3 1.8730
Ba1 2.1263
Ba2 2.5562
Ba3 3.0628
B1 3.8304
B2 4.6824
B3 5.5345
Caa1 6.3789
Caa2 7.6608
Caa3 8.5052
Ca 10.2093
3. Financial Instruments: Fixed-Income
v Capital Market Instruments: Bonds
• Valuation of Bond:
- Valuation of a bond is the process of determining its intrinsic
(economic) value.
+ Intrinsic value: the present value of the asset’s expected future cash flows.
- Principle of Asset valuation:
“Asset’s expected future cash flows will be discounted back to the
present, using the investor’s required rate of return, to determine the
fair value that the asset should be purchased or sold”
3. Financial Instruments: Fixed-Income
v Capital Market Instruments: Bonds
• Valuation of Bond:
- Basic factors determining an asset’s value:
3. Financial Instruments: Fixed-Income
v Capital Market Instruments: Bonds
• Valuation of Bond:
- Valuation Formula:

+&"ℎ -'./ +&"ℎ -'./ +&"ℎ -'./

!""#$ 0#12.3 1 0#12.3 2 0#12.3 8
= !
+ "
+ ⋯ + #
%&'(# 1#7(21#3 1#7(21#3 1#7(21#3
51 + 9 51 + 9 51 + 9
1&$# .- 1#$(18 1&$# .- 1#$(18 1&$# .- 1#$(18

Exercise 6:
You purchased an asset that is expected to provide $5,000 cash flow per year
for 4 years. If you have a 6 percent required rate of return, what is the value of
the asset for you?
3. Financial Instruments: Fixed-Income
v Capital Market Instruments: Bonds
• Valuation of Bond:

,"(-"# -&./)#0 ,"(-"# -&./)#0 ,"(-"# -&./)#0 ;&1

!"#$ -)12"$ 1 -)12"$ 2 -)12"$ # %&'()
= ! + " + ⋯+ #+ #
%&'() 1)6(21)$ 1)6(21)$ 1)6(21)$ 1)6(21)$
41 + 8 41 + 8 41 + 8 41 + 8
1&0) "7 1)0(1# 1&0) "7 1)0(1# 1&0) "7 1)0(1# 1&0) "7 1)0(1#

- In which:
+ Coupon Payment = (Coupon Rate * Par Value)/Number of payments per year
+ n = number of payments = Number of payments per year * Maturity
+ Required rate of return = Risk-free rate of interest + Risk premium for compensation
3. Financial Instruments: Fixed-Income
v Capital Market Instruments: Bonds
• Valuation of Bond:
Exercise 7:
La Fiesta Restaurants issued bonds that have a 4 percent coupon interest rate,
$1000 par value. Interest is paid annually. The bonds mature in 12 years. If
your required rate of return is 6 percent, what is the value of a bond to you?

Exercise 8:
Consider a bond issued by Toyota with a maturity date of 2022 and a stated
annual coupon rate of 3.4 percent. In 2017, with 5 years left to maturity,
investors owning the bonds were requiring a 2.7 percent rate of return.
Calculate the value of the bonds, knowing that Toyota pays interest to its
bondholders on a semiannual basis with a face value of $1000.
4. Financial Instruments: Equity
v Capital Market Instruments: Common Stocks
• Definition:
Common stock is a certificate that indicates ownership in a
corporation.
Þ The Common Stockholder can receive:
+ Dividend payments from the issuing firm.
+ Capital gain from difference between purchasing and selling price.
4. Financial Instruments: Equity
v Capital Market Instruments: Common Stocks
• Features:
- Par Value
- Book Value
- Market Value
- Intrinsic Value
- Dividends
4. Financial Instruments: Equity
v Capital Market Instruments: Common Stocks
• Characteristics:
- From Stockholders’ perspective:
+ Claims on Income and Assets of the issuer:
o Do not have maturity date
o Common stockholders are residual owners: they receive what is left
after all other claims on the firm’s income and assets have been
satisfied.
+ Limited Liability
+ Voting right:
o Elect the board of directors
o Approve any change in the corporate charter
4. Financial Instruments: Equity
v Capital Market Instruments: Common Stocks
• Characteristics:
- From Firm’s perspective:
+ Payment of dividend is not a liability of the firm:
o Payment of dividends is at the discretion of the BoD.
o A corporation cannot default on an undeclared dividend: non-payment of
dividends does not result in bankruptcy.
+ The payment of dividends is not a business expense and not
deductible for corporate tax purposes.
+ Higher cost of capital:
o Common stockholders require higher returns for their higher risk
position.
4. Financial Instruments: Equity
v Capital Market Instruments: Common Stocks
• Valuation of Common Stock:
- Difficulties:
(1) With common stock, no promised cash flows are known in
advance.
(2) The life of the investment is essentially forever because common
stock has no maturity.
(3) There is no way to easily observe the rate of return that the
market requires.
4. Financial Instruments: Equity
v Capital Market Instruments: Common Stocks
• Valuation of Common Stock:
- Starting point: Cash Flow in 01 period
Imagine that you are considering buying a share of stock today and plan to
sell the stock in one year. You somehow know that the stock will be worth
$70 at that time. You predict that the stock will also pay a $10 per share
dividend at the end of the year. If you require a 25 percent return on your
investment, what is the most you would pay for the stock?
- Present Value:
𝐷' + 𝑃'
𝑃& =
1+ 𝑟
4. Financial Instruments: Equity
v Capital Market Instruments: Common Stocks
• Valuation of Common Stock:
- We have:
𝐷# + 𝑃#
𝑃" =
1+ 𝑟
- Hence:
𝐷 +𝑃
𝐷" + 1# + 𝑟# 𝐷" 𝐷# P#
𝑃! = = + # +
1+ 𝑟 1 + 𝑟 (1 + 𝑟) (1 + 𝑟)#
4. Financial Instruments: Equity
v Capital Market Instruments: Common Stocks
• Valuation of Common Stock:
- Repeat the procedure:
𝐷$ + 𝑃$
𝑃# =
1+ 𝑟
- Hence:
𝐷$ + 𝑃$
𝐷" 𝐷# 1+ 𝑟
𝑃! = + +
1 + 𝑟 (1 + 𝑟)# (1 + 𝑟)#
𝐷" 𝐷# 𝐷$ 𝑃$
= + # + $ +
1 + 𝑟 (1 + 𝑟) (1 + 𝑟) (1 + 𝑟)$
4. Financial Instruments: Equity
v Capital Market Instruments: Common Stocks
• Valuation of Common Stock:
- Stock’s Present value:
𝐷" 𝐷# 𝐷$ 𝐷% 𝑃&
𝑃! = + + + + ⋯+
1 + 𝑟 (1 + 𝑟)# (1 + 𝑟)$ (1 + 𝑟)% (1 + 𝑟)&

When n → ∞:
𝐷" 𝐷# 𝐷$ 𝐷%
𝑃! = + #
+ $
+ %
+⋯
1 + 𝑟 (1 + 𝑟) (1 + 𝑟) (1 + 𝑟)
4. Financial Instruments: Equity
v Capital Market Instruments: Common Stocks
• Valuation of Common Stock:
- Case 1: Zero-growth Dividend.
For a zero-growth share of common stock, this implies that:
𝐷" = 𝐷# = 𝐷$ = ⋯ = 𝐷

Per-share value:
𝐷
𝑃! =
𝑟
4. Financial Instruments: Equity
v Capital Market Instruments: Common Stocks
• Valuation of Common Stock:
- Case 2: Constant-growth Dividend.
The dividend of the firm always grows at a steady rate, g.
Let 𝐷! be the dividend just paid, then the next dividends will be:
𝐷' = 𝐷& ∗ 1 + g
𝐷( = 𝐷' ∗ 1 + g = 𝐷& ∗ 1 + 𝑔 (

𝐷) = 𝐷( ∗ 1 + g = 𝐷& ∗ 1 + 𝑔 )

…
𝐷* = 𝐷*"' ∗ 1 + g = 𝐷& ∗ 1 + 𝑔 *
4. Financial Instruments: Equity
v Capital Market Instruments: Common Stocks
• Valuation of Common Stock:
- Case 2: Constant-growth Dividend.
Per-share Value:
𝐷& ∗ 1 + g 𝐷"
𝑃& = =
𝑟−g r − g
in which:
𝐷! = Dividend payment in period 1
r = required rate of return by stockholders
g = constant growth rate of dividend payments
4. Financial Instruments: Equity
v Capital Market Instruments: Common Stocks
• Valuation of Common Stock:
Exercise 9:
The Paradise Prototyping Company has a policy of paying a $10 per share
dividend every year. If this policy is to be continued indefinitely, what is the
value of a share of stock if the required return is 20 percent?
Exercise 10:
The next dividend for the Gordon Growth Company will be $4 per share.
Investors require a 16 percent return on companies such as Gordon. Gordon’s
dividend increases by 6 percent every year. Based on the dividend growth
model, what is the value of Gordon’s stock today? What is the value in four
years?
4. Financial Instruments: Equity
v Capital Market Instruments: Common Stocks
• Valuation of Common Stock:
- Case 3: Nonconstant-growth Dividend.
Growth rates are “supernormal” over some finite length of time.
Exercise 11:
A company currently not paying dividends and will pay a dividend for
the first time after 5 years. The dividend will be $.50 per share. You
expect that this dividend will then grow at a rate of 10 percent per year
indefinitely. The required return on companies such as this one is 20
percent. What is the price of the stock today?
4. Financial Instruments: Equity
v Capital Market Instruments: Common Stocks
• Valuation of Common Stock:
- Case 3: Nonconstant-growth Dividend.
Exercise 12:
Chain Reaction, Inc., has been growing at a phenomenal rate of
30 percent per year because of its rapid expansion and explosive
sales. You believe this growth rate will last for three more years
and will then drop to 10 percent per year. If the growth rate then
remains at 10 percent indefinitely, what is the total value of the
stock? Total dividends just paid were $5 million, and the required
return is 20 percent.
4. Financial Instruments: Equity
v Capital Market Instruments: Common Stocks
• Valuation of Common Stock:
- Case 3: Nonconstant-growth Dividend: Two-stage Growth
The dividend will grow at a rate of 𝑔" for t years and then grow
at a rate of 𝑔# thereafter forever.

Per-share Value:
𝐷" 1 + g" ' 1 𝐷+,'
𝑃! = ∗ 1− ' + ∗
𝑟 − g" 1+𝑟 1+𝑟 + 𝑟 − g(
4. Financial Instruments: Equity
v Capital Market Instruments: Common Stocks
• Valuation of Common Stock:
- Case 3: Nonconstant-growth Dividend: Two-stage Growth
Exercise 13:
The Highfield Company’s dividend is expected to grow at 20
percent for the next five years. After that, the growth is expected
to be 4 percent forever. If the required return is 10 percent, what’s
the value of the stock? The dividend just paid was $2.
4. Financial Instruments: Equity
v Capital Market Instruments: Preferred Stocks
• Definition:
Preferred stock is an equity security that gives its holders certain
privileges over common stockholders.
ÞThe Preferred stockholders can receive:
+ A fixed periodic payment of dividend as stated.
4. Financial Instruments: Equity
v Capital Market Instruments: Preferred Stocks
• Characteristics:
- From Preferred Stockholders’ perspective:
+ Claims on Income and Assets of the issuer:
o Do not have maturity date.
o Holders of the preferred shares must receive a dividend before holders
of common shares are entitled to anything.
o In the case of bankruptcy, the preferred stock claim is honored after
that of bonds and before that of common stock.
+ No voting right.
4. Financial Instruments: Equity
v Capital Market Instruments: Preferred Stocks
• Characteristics:
- From Firm’s perspective:
+ Payment of dividend is not a liability of the firm:
o Non-payment of preferred dividends does not result in bankruptcy.

+ The payment of dividends is not a business expense and not

deductible for corporate tax purposes.
4. Financial Instruments: Equity
v Capital Market Instruments: Preferred Stocks
- Preferred stock is also referred to as a hybrid security as it has
features of both common stock and bonds.
- Preferred stock is similar to common stocks in that:
+ It has no fixed maturity date
+ The non-payment of dividends does not result in bankruptcy of the firm
+ The dividends are not deductible for tax purposes.
- Preferred stock is similar to corporate bonds in that:
+ The dividends are typically a fixed amount
+ There are no voting rights.
5. Financial Instruments: Derivatives
v Derivative contracts
• Definition:
Derivatives are financial contracts whose values are derived from
the values of underlying assets.
• Characteristics:
- The derivative is a contract
- The contract always refers to an underlying asset
- The value of the contract depends on the value of the
underlying asset.
5. Financial Instruments: Derivatives
v Derivative contracts
• Definition:
Derivatives are financial contracts whose values are derived from
the values of underlying assets.
• Characteristics:
- The derivative is a contract
- The contract always refers to an underlying asset
- The value of the contract depends on the value of the
underlying asset.
5. Financial Instruments: Derivatives
v Derivative contracts
• Types of Derivatives:
- Forward Contract
- Futures Contract
- Option Contract
- Swap Contract
5. Financial Instruments: Derivatives
v Derivative contracts: Forward
• Definition:
Forward contracts are contracts that allow the purchase or sale of
a specified underlying asset on a specified future date at a fixed
price that is agreed today.
• Characteristics:
- Traded on OTC market.
- Is customizable and can be tailored to a specific commodity,
amount, and delivery date.
5. Financial Instruments: Derivatives
v Derivative contracts: Forward
• Forward Payoffs:
5. Financial Instruments: Derivatives
v Derivative contracts: Futures
• Definition:
Futures contracts are standardized contracts that allow the purchase or
sale of a specified underlying asset at a specified price and date.
• Characteristics:
- Traded on a futures exchange, which is highly regulated at the
national level.
- Clearing house:
+ Daily settlement of gains and losses (mark-to-market process).
+ Buyers and sellers need to make deposit (10% of futures price) before
entering the transaction.
5. Financial Instruments: Derivatives
v Derivative contracts: Options
• Definition:
An options contract offers the buyer the right, but not obligation,
to buy or sell the underlying asset at a fixed price either on a
specific expiration date or at any time prior to the expiration date.
• Characteristics:
- Is standardized and traded on an exchange.
- Option premium must be paid at the beginning of the contract
5. Financial Instruments: Derivatives
v Derivative contracts: Options
• Call Option:
- Definition:
A call option gives the holder the right, but not the obligation, to
buy the underlying security at the strike price on or before
expiration.
- Investors would buy a call option if they expect the price of the
underlying asset will increase in the future.
5. Financial Instruments: Derivatives
v Derivative contracts: Options
• Call Option Payoffs:
5. Financial Instruments: Derivatives
v Derivative contracts: Options
• Put Option:
- Definition:
A put option gives the holder the right, but not the obligation, to
sell the underlying security at the strike price on or before
expiration.
- Investors would buy a put option if they expect the price of the
underlying asset will decrease in the future.
5. Financial Instruments: Derivatives
v Derivative contracts: Options
• Put Option Payoffs: