Question

Agree or Disagree and Why?

Question: overview of financial instruments including but not limited to stocks, bonds, and derivative securities – i.e., securities that “derive” their value from other securities (examples include options, futures, swaps, etc.). Emphasis is also placed on the securities markets.

How the bond market works. The bond market is where investors go to trade (buy and sell) debt securities, prominently bonds, which may be issued by corporations or governments. It is also known as the debt or the credit market. Securities sold on the bond market are all various forms of debt. By buying a bond, credit, or debt security, you are lending money for a set period and charging interest, the same way a bank does to its debtors. (Morah, 2020). How the stock market works. The stock market is a place where investors go to trade equity securities such as common stocks and derivatives including options and futures. Stocks are traded on stock exchanges. Buying equity securities, or stocks, means you are buying a very small ownership stake in a company. While bondholders lend money with interest, equity holders purchase small stakes in companies on the belief that the company performs well and the value of the shares purchased will increase. (Morah, 2020). How can we solve for our “return on investment” in stocks and bonds? Return on Investment (ROI) is a financial metric of profitability that is widely used to measure the return or gain from an investment. ROI is a simple ratio of the gain from an investment relative to its cost. It is as useful in evaluating the potential return from a stand-alone investment as it is in comparing returns from several investments, stocks and bonds. (Beattie, 2019). The ROI calculation can be calculated by either of the two following methods. The first is this: ROI = (Net Return on Investment / Cost of Investment) x 100% The second is this: ROI = (Final Value of Investment – Initial Value of Investment) / Cost of Investment x 100% Where do stocks and bonds derive their value? Stockholders own a share of the company in which they are invested. Stocks are traded on an exchange and prices are set by the market. Stock prices are typically driven by financial results, company news and industry fundamentals. They are usually valued on a “multiple" basis. Stock investors generally invest in companies that they feel have superior growth prospects and are undervalued by the market. (Zucchi, 2019). Corporate bonds are traded in the bond market and prices are based on the financial fundamentals of the company issuing the bonds (most notably the strength of a company's balance sheet and the ability of the company to pay its obligations). Bonds have an inverse price and yield relationship, such that bonds sell at a premium when they are less risky (meaning the coupon is low) and at a discount when the risk is higher. (Zucchi, 2019). (Debra)

Answer 1

Overall I am in agreement with the above passage, but more clarification is required at some points:

1. "Stocks are usually valued on a “multiple" basis": This method is known as relative valuation. One more important method of valuation is DCF (discounted cash flow). DCF valuation can be further of 3 types: (a) DDM(dividend discount method) (b) FCFE (free cash flow for equity) (c) Free cash flow for firm. Each of these 3 DCF valuation methods can be used in different cases depending upon the dividend policy of the company, its CAPEX plans & stability of the leverage (debt & equity) of the company

2. "bonds sell at a premium when they are less risky (meaning the coupon is low) and at a discount when the risk is higher": Since the term coupon is mentioned, the risk-free rate of the country/currency in which the bond is issued needs to be mentioned. If the coupon rate < discount rate, then bond trades at a premium and vice versa