CRITERIA FROM THE POINT OF VIEW OF INVESTORS AND ISSUERS

CRITERIA FROM THE POINT OF VIEW

OF INVESTORSAND ISSUERS

to arrange to have a bond issued, there will be three

groups of investors who are potential buyers:

1. Investors who are absolutely certain that they will

hold the bond until maturity. Such investors will

discount the promised interest and redemption

payments,

less the cost of custody of the bond, at

the minimum rate of interest they wish to obtain

from an investment in bonds of this type and quality,

in order to ascertain whether the bond is attractive

to them at the intended issue price. If the bond is

offered for sale by tender, the investor can calculate

in this way how much he should offer for it.

2.Investors who must expect to have to sell the bond

before maturity because they may need cash. In order

to reach a decision as to whether or not to buy the

bond, these investors will in principle proceed in

the same way as the first group of investors except

that in their calculations the expected net sales

proceeds of the bond will take the place of the

redemption payments.

3. Investors who if they buy the bond will hold it only

until such time as in their opinion a favourable

situation for switching their investment has arisen.

This third group also uses the net sales proceeds

instead of the redemption amount in making the

necessary calculations. In contrast to the second

and also the first group, these investors are at all

times interested in information about the business

situation of the issuer, since this information will

help to determine when they should sell the bond.

Investors of the third group therefore have to deduct

from the interest they will receive not only the

cost of custody of the bond but also the cost of

continuous information in order to be able to calculate

whether or at what price they should accept the issuer's

offer.

When an issue is placed, parts of it will normally be

taken up by all three groups of investors. The objectives

of the groups of investors and their relative strengths

determine the price at which the bond can be sold. The

investors'decisions will be influenced by the following

six factors: the type of bond it is  (especially the terms of issue

and the maturity date);the minimum rate of interest which investors require from bonds of this type;the financial standing of the issuer;

the net sales proceeds expected by investors;

-  the cost of custody of the bond; and

the cost of obtaining continuous information.

The objective of the issuer is easier to ascertain than

that of the investors: his aim is the lowest possible

market transaction costs" and "sales proceeds" where

the market price is constant. In contrast to the net

sales proceeds, the transaction costs are determined

entirely by the state of organization of the stock

market in the wider sense of the term, as are flotation

costs,

custody costs, continuous information costs and

the cost of servicing a security.

If these five market-organization-determined  cost

categories were all zero, the investor would have to

consider only the interest and the redemption moneys -

or instead of the latter the net sales proceeds, which

would be the same as the redemption moneys - and similarly

the issuer would also have to consider only the interest

and redemption payments. The cost of capital would then

always be the same, as far as this bond was concerned,

as the actual amount of interest that the various

investors obtained from the bond. To put it another way,

the losses caused by friction due to the way the market

was organized would have disappeared. This situation would

fully meet the objective of the issuer: if investors

demanded a certain minimum rate of interest from an issue,

the cost of the capital would be only as high as that

interest and no higher. The investment programmes of a

potential issuer with a given capacity for meeting

certain interest and redemption payments would stand the

best possible chance of being implemented. This situation

would also be very much in the investor's interest: in

no other circumstances would it be easier for the investor

to obtain satisfaction of his yield demands on the issuer.

So the sum of these five cost categories, which are

determined by the organization of the market, constitutes

a good criterion for assessing stock markets from the

point of view of investors and issuers.

 This result was reached using, for the sake of

simplicity, two assumptions which can now be dropped.

We will first abandon the assumption that the coupon

rate of interest is always the same as the market

rate of interest of the bond in question. Net sales

proceeds are then no longer determined by transaction

costs alone but, more realistically, by changes in

the earning power of the issuer and changes in market

rates of interest as well. In a world in which the 

services of issuing, dealing, keeping custody of

securities,providing information and servicing

securities were free, the average yield received by

all the investors who together had held a certain

proportion of the bond issue from the time of placing

until the time of redemption would equal the cost of

the capital to the issuer. Differences between the

yields to individual investors and the cost of capital

would reflect changes of the issuer's earning power

and fluctuations in the market rate of interest, factors

which are not governed by the structure of stock markets

but by the general economic situation, by the sector

in which the issuer operates and by investors' ability

to form an opinion with the help of a given amount of

publicity. If we further drop the assumption that only

bonds are involved and bring shares, dividend-right

certificates, warrants - in short, securities of

every kind - into the analysis, the foregoing two

sentences still apply, with the sole modification that

instead of a clearly stipulated term of life there is

usually an unlimited period of existence. In this more

real world the sum of the five market-organization-

determined cost categories still remains the criterion

for judging stock markets. The procedural efficiency

of a stock market can be measured by the sum of

these five costs.

This criterion is applicable to issuers and investors

in their totality, not to individuals. An individual

issuer may for example obtain special advantages

for himself by using exaggerated reporting to paint

his earnings position rosier than it really is. The

same can be said of investors who spread rumours.

All issuers of similar securities will eventually be

penalized by such action because their capital will

become more expensive, owing to the fact that the more

unreliable the published financial data prove to be,

the lower and less certain will be the distributions

and net sales proceeds expected by investors.

Although the subject matter of this study is the

structure of the secondary markets, our considerations

so far have also included new issue transactions. But

the method we have chosen can equally well be applied

exclusively to secondary markets. In place of the

issuer proper we have the seller of securities already

in circulation, in place of the issue price we have

the market price and in place of the flotation costs

we must consider the transaction costs of the seller

and buyer. The seller is interested in obtaining the

highest possible net proceeds. But the buyer will only

pay him a price that gives him - the buyer - a chance

of obtaining his minimum yield, taking into account

the expected dividends or interest, the transaction

costs in connexion with the purchase and in connexion

with a possible future sale, the costs of being provided

with information on a continuous basis, and the cost of

custody of the securities. For the seller this price

is reduced by his transaction costs. Given the buyer's

minimum yield and the anticipated amount of the

interest or dividends payments, the seller will be

more pleased the lower the present and future trans-

action costs, custody costs and continuous information

costs are. His ideal is a secondary market on which

the sum of these three costs and the cost of servicing

securities are, and will remain, zero.

For the buyer procedural efficiency of this kind

would seem at first sight to be irrelevant, since he

can adapt his yield requirement not only to the type

and quality of the stock on offer but also to the

amount and the degree of uncertainty of the procedure-

influenced costs. But, as explained above, whether and

to what extent an issue is successful depends on these

costs.

The lower the costs, the greater the choice

open to the buyer on the secondary market. Moreover,

every buyer is a potential seller. So even from the

point of view of the investors who participate in

dealings on the secondary market procedural efficiency

is a suitable criterion for assessing the quality of

the market. In contrast to the general case, the

procedural efficiency of the secondary market is

measured by the total of four, not five, cost categories,

since flotation costs no longer need to be taken into

account.

 the source by Dr.Hartmut Schmidt