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EXAMPLE

MicroCircuit Industries, a major microprocessor manufacturer, has just issued a 20-year bond with 12% coupon interest rate and a $1,000 par value that pays interest semiannually. Investors who buy this bond receive the contractual right to (1) $120 annual interest (the 12% coupon interest rate X $1000 par value), distributed as $60 at the end of each 6 months (1/2 X $120) for 20 years, and (2) the $1,000 par value at the end of year 20.

International Bonds Firms commonly issue bonds in the Eurobond market, which serves issuers and investors in bonds denominated in a variety of currencies. For example, General Motors may consider issuing a dollar-denominated bond to investors in the Eurobond market. Or it may consider issuing a bond denominated in Japanese yen to support its operations in Japan.

U.S. investors may use the Eurobond market to purchase bonds denominated in other currencies that are paying higher coupon rates than dollar-denominated bonds. However, they will be subject to exchange rate risk if they plan to convert the coupon and principal payments into dollars in the future.

An equity security that represents ownership interest in the issuing firm.

common stock

Collectively, units of ownership interest, or equity, in a corporation.

preferred stock

A special form of ownership having a fixed periodic dividend that must be paid prior to payment of any common stock dividends.

Stocks

Stock is an equity security which represents ownership interest in the issuing firm. Whereas bonds are issued by both governments and businesses, stock is issued only by business firms. The two forms of stock are common and preferred.

Common and Preferred Stock Shares of common stock are units of ownership interest, or equity, in a corporation. Common stockholders expect to earn a return by receiving dividends, by realizing gains through increases in share price, or both. Preferred stock is a special form of ownership that has features of both a bond and common stock. Preferred stockholders are promised a fixed periodic dividend that must be paid prior to payment of any dividends to the owners of common stock. In other words, preferred stock has priority over common stock when the firms dividends are disbursed.

International Stocks Many large U.S. firms issue stock in international equity markets. They may be able to sell all of their stock offering more easily by placing some of the stock in foreign markets, if there is not sufficient demand in the United States. In addition, they may be able to increase their global name recognition in countries where they conduct business by selling some of their newly issued stock in those foreign markets.

Investors commonly invest in stocks issued by foreign firms. They may believe that a particular foreign stock's price is undervalued in the foreign market. Alternatively, they may believe that a foreign country has much greater potential economic growth than can be found at home. Investors may also invest in foreign stocks to achieve international diversification. To the extent that most U.S. stocks

are highly influenced by the U.S. economy, U.S. investors can reduce their exposure to potential weakness in the U.S. economy by investing in stocks of foreign firms whose performance is insulated from U.S. economic conditions.

Summary of Securities

A summary of the money market and capital market securities that we have described is provided in Table 2. All types of firms that need short-term funds issue commercial paper as a means of obtaining funds. They also invest in the other money market securities (such as Treasury bills) when they have temporary funds available.

Investors invest in all the kinds of securities disclosed in the table. In general, they tend to focus on the money market securities if they wish to invest their funds for a very short period of time and to choose capital market securities when they can invest their funds for long periods. The money market securities provide a relatively low expected return, but offer some liquidity and generate a positive return until the investor determines a better use of funds.

The capital market securities offer more potential for higher returns, but their expected returns are subject to a higher degree of uncertainty (risk). Because the capital markets facilitate the exchange of long-term securities, they help to finance the long-term growth of government agencies and firms. Institutional investors play a major role in supplying funds in the capital markets. In particular, institutional investors such as commercial banks, insurance companies, pension funds, and bond mutual funds are major investors in the primary and secondary markets for bonds. Insurance companies, pension funds, and stock mutual funds are major investors in the primary and secondary markets for stocks.

REVIEW QUESTIONS

RQ-6 What is the meaning of the term risk-free rate?

RQ-7 Explain why firms that issue a corporate bond must promise investors a higher return than that available on a Treasury security that has the same maturity.

RQ-8 How does stock differ from bonds in terms of ownership privileges?

 
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