6.7Summary

The capital markets are used by both rms and governments to raise funds for long-

term use, though most investment by rms is nanced by retained prots. Firms can

issue corporate bonds and various types of shares, while governments issue bonds.

Ordinary company shares entitle their holders to a share of the rm’s prots and

thus pay variable dividends. They should also experience capital growth over time.

Bonds usually pay a xed rate of interest at pre-determined intervals. Both bonds and

shares are traded on a stock exchange and their price uctuates in response to supply

and demand. In the short run the supply of both is xed and price uctuations are

therefore the result of changes in demand. Our conventional theory says that the

price people are willing to pay for such securities reects the value which they place

upon the future income from those securities, given the level of risk associated with

them. The value placed upon the future income depends upon what can be earned

elsewhere and thus varies with changes in interest rates. In the case of shares, the

value placed on the income depends upon the income itself, which can change as a

result of the rm’s protability.

In practice, share and bond prices are affected by a wide range of inuences

whose relevance is that they lead investors to expectchanges in interest rates, risk

or prots.

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Further reading

Questions for discussion

1	What are the advantages to (a) lenders and (b) borrowers of an active ‘secondary’ market for securities?

2	Why does the calculation of a ‘present value’ of a security involve discounting?

3	Which of the following would be likely to show the greatest short-run price volatility:a short-dated bond, a long-dated bond, a share in a microelectronics company? Explain your choice.

4	When market interest rates are 10 per cent, what relationship would you expect between the price and redemption yields of two 8 per cent bonds, one maturing in three years, the other maturing in ten years?

5	Give two reasons why institutions like banks prefer to hold short-dated rather than long-dated bonds.

6	Distinguish between a ‘quote-driven’ market and an ‘order-driven’ market.

7

You are advising a friend who is considering selling some of her shares in Wyndham Wines plc. Their current price is £2.50. They have a -coefcient of 1.1 and the rmhas shown a steady growth in earnings of 6 per cent p.a. in recent years. The current risk-free rate is 5 per cent p.a. while the market risk premium is 10 per cent. The last dividend payment was 20p. What advice would you give and why?

8	You aim to reduce the capitalrisk of your portfolio by increasing your holdings of government bonds. Given a choice between ‘Treasury 5%, 2020’ and ‘Exchequer 12%, 2007’, which would you choose and why?

9	Explain the terms: dirty price, clean price, accrued interest, interest yield, redemption yield.

10	Explain the terms: market capitalisation, dividend yield, P/E ratio.

Further reading

Bankof England, ‘Upgrading the Central Gilts Ofce’, Bank of England Quarterly Bulletin,

37 (4), February 1998

D Blake, Financial Market Analysis(London: McGraw-Hill, 2e, 2000) chs. 5 and 6

M Buckle and J Thompson, The UK Financial System(Manchester: Manchester UP, 4e, 2004)

chs. 8 and 9

D Cobham (ed) Markets and Dealers: The Economics of the London Financial Markets

(London: Longman, 1992)

P G A Howells and K Bain, The Economics of Money, Banking and Finance: A European Text

(Harlow: Financial Times Prentice Hall, 3e, 2005) chs. 16 and 17

JM Keynes, The General Theory of Employment, Interest and Money(London: Macmillan,

1936)

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Chapter 6 • The capital markets

M Livingston, Money and Financial Markets(Oxford: Blackwell, 3e, 1996) chs. 10 and 19

MH Miller and F Modigliani, ‘Dividend policy, growth and the valuation of shares’, Journal of

Business, 34, 1961, pp. 411–33

K Pilbeam, Finance and Financial Markets(London: Macmillan, 2e, 2005) chs. 6 and 9

R Vaitilingam, The Financial Times Guide to Using the Financial Pages(Harlow: Pearson

Education, 4e, 1996)

www.dmo.gov.uk

www.londonstockexchange.com

http://en.wikipedia.org/wiki/Financial_market

Answers to exercises

6.1	(a) £54.35, (b) £156.25.
6.2	(a) £108.47, (b) £96.08.
6.3	(a) £4.60, (b) £3.83, (c) £4.79.

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CHAPTER7