FIM - Summary - Fabia PDF

FIM – SUMMARY OF THE THEORY CHAPTER 1 – WHY FIM IS RELEVANT TO STUDY ▪ Why are Financial Markets crucial in economy? 1. Channeling funds from savers to investors, promoting economic efficiency 2. Market activity affects: personal wealth, business firms, and economy ▪ Why regulate fina...

FIM – SUMMARY OF THE THEORY CHAPTER 1 – WHY FIM IS RELEVANT TO STUDY ▪ Why are Financial Markets crucial in economy? 1. Channeling funds from savers to investors, promoting economic efficiency 2. Market activity affects: personal wealth, business firms, and economy ▪ Why regulate financial markets? To increase the information available to investors and to ensure the soundness Activities in financial markets have direct effects on individual’s wealth, the behaviour of business and the efficiency of our economy. 3 financial markets deserve particular attention: Debt markets allow governments, corporations, and individuals to borrow (where interest rates are determined) Security = financial instrument which is a claim on the issuer’s future income or asset Bond = debt security that promises to make payments periodically for a specified amount of time interest rates (=costs of borrowing; great impact on the overall economy activity, because they affect not only consumers’ willingness to spend or save but also businesses’ investment decisions. Stock market = is the market where common stock (or just stock) are traded (which has a major effect on people’s wealth and on firms’ investment decisions) stock = A share of ownership in a cooperation that is a claim on the earnings and assets of the corporation primary market: company sells newly issued stocks to investor in order to raise capital secondary market: investors trade amongst investors. Foreign exchange market = is where international currencies trade and exchange rates are set (because fluctuation in the foreign exchange rate have major consequences for the US economy) ▪ Why are Financial Institutions crucial in economy? -> Corporations, organizations, and networks that operate the “market places” 1. Structure: helps funds move from savers to investors 2. Financial Crises: why do they happen? (“Great Recession” of 2007–09 was the worst financial crisis since the Great Depression (world war II) 3. Central Banks and the Conduit of Monetary Policy: role of Fed and foreign counterparts; Because monetary policy affects interest rates, inflation and business cycles, all of which have an important impact on financial markets and institutions, we need to understand how monetary policy is conducted by central banks in the US and abroad. 4. The International Financial System: international capital flows between countries affecting national economy. Need to understand exchange rates, capital controls, and the role of agencies such as the IMF 5. Banks and Other Financial Institutions: insurance companies, pension funds… Banks and other FIs channel funds from people who might not put them to productive use to people who can do so and thus play a crucial role in improving crisis, financial firms fail, which causes serve damage to the economy. 6. Financial Innovation: technological improvements and impact on financial product delivery 7. Managing Risk in Financial Institutions: risk management in financial institution 2. OVERVIEW OF THE FINANCIAL SYSTEM Overall Financial system A framework for describing set of markets, organizations, and individuals that engage in the transaction of financial instruments (securities), as well as regulatory institutions 1. Function of Markets The Basic function of FMs is to channel funds from households, firms and governments that have saved surplus funds by spending less than their income to those that have shortage of funds because their wish to spend more than their income. ▪ lender-savers who have an excess of funds (principally households but may also be business enterprises, government and foreigners) ▪ borrow-spenders who have a shortage of funds and must borrow to finance their spending. (principally businesses and governments, but may also be households and foreigners) Two forms of exchange (segments): ▪ indirect finance, which involves a financial intermediary that stands between the lender-savers and the borrower-spenders and helps transfer funds from one to the other. ▪ direct finance, in which borrowers borrow funds directly from lenders by selling them securities, also called financial instruments  ▪ Securities are assets for the person who buys them, but liabilities for the individual or firm who sells them. - Bond: Debt security that promises to make payments periodically from a specified period of time - Stock: Security that entitles the owner to a share of the company’s profits and assets Benefits of FMs: This channelling of funds improves the economic welfare of everyone in society. Because they allow funds to move from people who have no productive investment opportunities to those who have such opportunities, FMs contribute to economic efficiency. In addition, channelling funds directly benefits consumers by allowing them to time purchases better. ⋅ Opportunity to pay for loan – increase countries productivity ⋅ Providing efficient allocation of capital (investment opportunity) ⋅ Improved well-being of consumers 2. Structure of Markets/ classification Trading object: Issue a Debt (bonds, mortgage) Raising funds by issuing equity (stocks) Debt instrument: Contractual agreement by the Equities: Claims to share the net income and the borrower to pay the holder of the instrument assets of a business, such as common stocks. fixed amounts at regular intervals until a specific Dividends: Periodic payments received by the date, when a final payment is made. holder of an equity. (Holder earns a share of the borrower’s enterprise’s income (dividends)) Maturity of a debt: number of years until that Do not expire and their maturity is infinite. instrument’s expiration date. Hence, they are considered long term securities ▪ Short Term ( Dollar (paid in one year), because you could invest the dollar in a savings account that earns interest and have more than a dollar in one year. ▪ Discounting the future: calculate to present value ▪ Loan Principal: the amount of funds the lender provides to the borrower. ▪ Maturity Date: the date the loan must be repaid; the Loan Term is from initiation to maturity date. ▪ Interest Payment: the cash amount that the borrower must pay the lender for the use of the loan principal. ▪ Simple Interest Rate: the interest payment divided by the loan principal; the percentage of principal that must be paid as interest to the lender. Convention is to express on an annual basis, irrespective of the loan term. Simple loan of $100 3.2. Four Year: 0 1 2 3 n types of Credit Market $100 $110 $121 $133 100×(1+i)n Instruments Simple loan Yield to maturity: loans ▪Yield to maturity = interest rate that equates today’s value with present value of all future payments ▪Simple loan interest rate (I = 10%) Yield to maturity: bonds ▪ Coupon bond (coupon rate = 10% = C/F) fixed interest payment every year until the maturity date, when a specific final amount is repaid Discount bond (=zero-coupon bond): bought at a price below its face value (at a discount); face value is repaid at the maturity date; no interest ▪ Fixed coupon payments of $C ▪ One-year discount bond (P = $900, F = $1000) Fixed-payment loan (=fully amortized loan): same payment every period + interest for a set number of years (e.g. mortgage) 3.3.Yield to Maturity Yield to maturity = interest rate that equates today’s value with present value of all future payments Relationship Between Price and Yield to Maturity Three interesting facts in Table 3.1 1. When bond is priced at par (its face value), yield to maturity equals coupon rate 2. Price of a coupon and YTM are negatively related: if YTR price of bond (and other way around) 3. Yield greater than coupon rate when bond price is below par value Global perspective ▪ Now, we notice some yields on government bonds are negative! Investors are willing to pay more than they would receive in the future. ▪ Best explanation is that investors find the convenience of the bills worth something—more convenient than cash. But that can only go so far—the rates are only slightly negative. 3.4.Distinction between Real and Nominal Interest Rates What we have up to now been calling the interest rate makes no allowance for inflation, and it is more precisely referred to as the nominal interest rate, which is distinguished from the real interest rate, the interest rate that is adjusted by subtracting expected changes in the price level (inflation) so that it more accurately reflects the true costs of borrowing. Real interest rate: ir = i – pe We usually refer to this rate as the ex ante real rate of interest because it is adjusted for the expected level of inflation. After the fact, we can calculate the ex post real rate based on the observed level of inflation. The Fisher definition: The real interest rate is defined as the nominal interest rate minus the expected rate of inflation. It is both a better measure of the incentives to borrow and lend and a more accurate indicator of the tightness of credit market conditions than the nominal interest rate. When interest rate is low, there are greater incentives to borrow and fewer incentive to lend. Indexed bonds are bonds which are corrected with the inflation. Real = takes inflation (price level) into account, and is found by taking the nominal rate minus the expected inflation. Reflects more accurately the true cost of borrowing. When low, greater incentive to borrow. Nominal = doesn’t take inflation into account, so if you borrow €100 at 6%, you’ll expect to pay €6 interest Example: For example, suppose a bank lends a person $200,000 to purchase a house at a 3% rate. The 3% rate is the nominal interest rate, not factoring for inflation. Assume the inflation rate is 2%. The real interest rate the borrower is paying is 1%; the real interest rate the bank is receiving is 1%. The purchasing power of the bank only increases by 1%. 3.5.Distinction between Interest Rates and Returns Rate of Return = used when describing amount earned on an investment, including payouts and gains/losses Interest Rates = used in a forward-looking sense, as a return that is promised The return on a security: which tells you how well you have done by holding this security over a stated period of time, can differ substantially from the interest rate as measured by the YTM. Long-term bond prices have substantial fluctuations when interest rates change and thus bear interest-rate risk. The resulting capital gains and losses can be large, which is why long-term bonds are not considered to be safe assets with a sure return. Bonds whose, maturity is shorter than the holding periods also subject to reinvestment risk: Occurs if you hold a series of short bonds over a long holding period i at which you reinvest is uncertain As an investor, you gain from i ↑, you lose when i ↓ Rate of Return: we can decompose returns into two pieces: Key findings from Table 3.2 1. Only bond whose return = yield is one with maturity = holding period 2. For bonds with maturity > holding period, i ↑ P ↓ implying capital loss 3. Longer is maturity, greater is price change associated with interest rate change 4. The longer the maturity, the more return changes with change in interest rate 5. Bond with high initial interest rate can still have negative return if i ↑ Conclusion from Table 3.2 analysis 1. Prices and returns more volatile for long-term bonds because have higher interest-rate risk 2. No interest-rate risk for any bond whose maturity equals holding period Interest rate risk: A paper lost means that the interest rate increases which means that the value of a bond with the old interest rate is worth less. This is because when the bonds are bought a year later when the interest rate is higher, the YTM would be way higher. This risk is higher with long-term bonds. Prices and returns for long-term bonds are more volatile than those for shorter-term bonds. Price change of +20% within a year, with corresponding variations in return, are common for bonds more than 20 years away from maturity. 4. Why do interest rates change? Movement along curve due to price change alone 4.1.Determinants of Asset Demand In the early 1950s, short-term Treasury bills were yielding about 1%. By 1981, the yields rose to 15% and higher. But then dropped back to 1% by 2003. In 2007, rates jumped up to 5%, only to fall back to near zero in 2008. What causes these changes? Asset: Piece of property that stores value 1. Wealth (=total value of resources owned by individual) 2. Expected return (=over the next period) 3. Riskiness (=degree of uncertainty associated with this return) 4. Liquidity (=ease and speed an asset can be turned into cash) The quantity demanded of an asset differs by the following factors (-> need to be considered whether to buy a certain asset or not) Variable Change in Change in Variable Quantity Demanded Wealth ⇑ ⇑ Holding everything else constant an increase in wealth raises the quantity demanded of an asset (Positively related) Expected return ⇑ ⇓ An increase is an asset’s expected return relative to that of an alternative asset, holding everything else unchanged, raises the quantity demanded of the asset. (Positively related to the expected return on the asset relative to alternative assets) Risk ⇑ ⇓ Holding everything else constant if an asset’s risk rises relative to that of alternative assets, its quantity demanded will fall. (Negatively related to the Riskiness of the asset relative to alternative assets) Liquidity ⇑ ⇑ The more liquid an asset is relative to alternative assets, holding everything else unchanged the more desirable it is, and the greater will be the quantity demanded. Supply and Demand in the Bond Market Positively related to the Liquidity of the asset relative to alternative assets Expected interest rate ⇑ ⇓ Expected inflation ⇑ ⇓ Variable Change in Change Variable in Quantit y Supplie d Profitability of ⇑ ⇑ investments Expected inflation ⇑ ⇑ Government deficit ⇑ ⇑ 4.2.Supply and Demand in the Bond Market To understand the demand curve, supply and equilibrium Excess supply occurs when the quantity of bonds sullied exceeds the quantity of bonds demanded. Excess demand when it is vice versa. Because a bond is a demand for a loan, the quantity of bonds axis can also be called the loanable funds and with this argument the supply of bonds can be called the demand for loanable funds. Because supply and demand diagrams that explains how interest rates are determined in the bond market often use the loanable funds terminology, this analysis is frequently referred to as the loanable funds framework. In these diagrams we do not use the flow i.e. the money – but we determine it in amount of stocks, this is called the asset market approach 4.3.Changes in Equilibrium Interest Rates Market Conditions: ▪ Market equilibrium occurs when the amount that people are willing to buy (demand) equals amount that people are willing to sell (supply) at a given price; (BS = BD ) ▪ Excess supply occurs when the amount that people are willing to sell (supply) is greater than the amount people are willing to buy (demand) at a given price (BS>BD) ▪ Excess demand occurs when the amount that people are willing to buy (demand) is greater than the amount that people are willing to sell (supply) at a given price (BD>BS) The supply-and-demand analysis for bonds provides a theory of how interest rates are determined. It predicts that interest rates will change when there is a: Change in DEMAND -> Shift of Demand Curve: ▪ Increase in wealth increases demand for bonds (shift to right) ▪ Increase in expected interest rate lowers the demand for bonds (shift to left) ▪ This is because investors would rather wait for the interest rate to increase before buying bonds. You won’t invest today if you expect the interest rate to increase tomorrow ▪ Increase in expected inflation leads to decrease in demand (shift to left) ▪ Increase in riskiness of bonds relative to other assets leads to decrease in demand (shift to left) ▪ Increase in liquidity of bonds relative to other assets leads to increase in demand for bonds (shift to right) ▪ B^d = Bond Demand ▪ ER or i = expected interest ▪ R^e = expected return ▪ n^e = expected inflation ▪ Expected return on other assets increases, bond demand decreases (shift left) ▪ Expected return decreases, demand decreases (shift left) Change in SUPPLY -> Shift supply curve: ▪ Probability of investment increases, supply increases (shift to right) ▪ Expected inflation increases, supply increases (shift to right) ▪ Government deficit increases, supply increases 4.4 Cases 1. Fisher Effect: Describes the relationship between inflation and both real and nominal interest rates, and states that the real interest rate equals to the nominal interest rate minus the expected inflation rate. Therefore, real interest rates fall as inflation increases, unless nominal rates increase at the same rate as inflation. New equilibriums are formed when demand or supply shifts. For example, when expected inflation rises the supply goes up, and the demand goes down. You can also see what to effect on the interest will be, namely, higher. This is true because accordingly to the Fisher effect when expected inflation rises, interest rates will rise. (if an economy gets better following will happen ▪ If expected inflation rises from 5% to 10%, the expected return on bonds relative to real assets falls and, as a result, the demand for bonds falls. ▪ The rise in expected inflation also means that the real cost of borrowing has declined, causing the quantity of bonds supplied to increase. = 5 costs, 0% inflation – 5 real costs 5 costs, 2% inflation – cheaper ▪ When the demand for bonds falls and the quantity of bonds supplied increases, the equilibrium bond price falls. ▪ Since the bond price is negatively related to the interest rate, this means that the interest rate will rise. 2. Business Cycle, and Interest Rates (Three-Month Treasury Bills), 1951–2013 When the goods/services of a country increase, so does national income ▪ Welt: bc more employment (economy well – creates jobs) –> People: more money/ investments (buy more bonds) -> demand for goods, services increases (companies need more money) -> issue more bonds bond prices increase (curve moves to the right) ▪ When economy is doing well: interest rates go up ▪ Poor shape: IR decreases -> money gets cheaper ▪ Exam: draw and explain what happens when the economy does well/ suffers – Business Cycle expansion 3. Case: Low Japanese Interest Rates In November 1998, Japanese interest rates on six-month Treasury bills turned slightly negative. How can we explain that within the framework discussed so far? 1. Negative inflation lead to Bd ↑ ▪ Bd shifts out to right 2. Negative inflation lead to ↑ in real rates ▪ Bs shifts out to left 3. Business cycle contraction lead to ↓ in interest rates ▪ Bs shifts out to left ▪ Bd shifts out to left But the shift in Bd is less significant than the shift in Bs, so the net effect was also an increase in bond prices. 4.5 Profiting from Interest-Rate Forecasts Methods: 1. Supply and Demand for bonds: use Flow of Funds Accounts and judgement 2. Econometric Models: large in scale, use interlocking equations that assume past financial relationships will hold in the future Make decisions about assets to hold: ⋅ Forecast declining interest rate ! buy LT bonds ⋅ Forecast inclining interest rate ! buy ST bonds Make decisions about how to borrow: ⋅ Forecast declining interest rate ! borrow ST ⋅ Forecast inclining interest rate ! borrow LT 5. How Do Risk and Term Structure affect Interest Rates? 5.1.Risk Structure of Interest Rates Higher risk -> higher potential return Blue: first peak (highest interest – good for investors) Red: Triple A (highest companies, low risk) Green: risk is higher, but tax advantage = always move together (little differences) Shows important features of the interest-rate behavior of bonds: - Rates on different bond categories change from one year to the next. - Spreads on different bond categories change from one year to the next. Bonds with the same maturity will have different interest rates bc of 3 factors: The relationship among interest rates on bonds with the same maturity that arise because of these 3 factors is known as the risk structure of interest rates. 1. Default risk: the greater a bond’s default risk, the higher its interest rates relative to other bonds (When issuer is unable to pay money back) ▪ The spread between the interest rates on bonds with default risk and default-free bonds, called the risk premium, indicates how much additional interest people must earn in order to be willing to hold that risky bond. ▪ Reward you get bc you are willing to take a higher risk ▪ Response to an Increase in Default Risk on Corporate Bonds (graphic below) ▪ Treasury bonds = “no default risk” as government always can increase taxes to pay off its obligation ▪ Truly default-free bonds? No, Republicans threatened to let Treasury bonds default (1995-1996, 2011-2013), resulting in an impact on the bond market ▪ Risk premium = the spread between interest rates on bonds with default risk and default- free risk indicates how much additional interest people must earn in order to be willing to hold that risky bond. It’s a form of compensation for investors who tolerate the extra risk, compared to that of a risk-free asset, in a given investment.  ▪ Default risk important component of the size of the risk premium. Because of this, bond investors would like to know as much as possible about the default probability of a bond. How? Moody’s, Fitch or S&P - Aaa to C or AAA to D – Lowest risk to highest 2. Liquidity: assets than can quickly and cheaply be converted into cash if the need arises The greater a bond’s liquidity, the lower its interest rate ▪ Liquid: able to change investment into cash or buy more; The more Liq. the more desirable ▪ Good because: able to buy/ sell more at the good time ▪ Panic -> less liquidity -> markets drop Not wise to sell when panic, because lack of liq. And therefore bad price (year after price might double) ▪ Corporate bonds become less liquid compared T-bonds ! Outcome: risk premium rises ▪ The differences between interest rates on corporate bonds and Treasury bonds (that is, the risk premiums) reflect not only the corporate bond’s default risk but its liquidity too. This is why a risk premium is sometimes called a risk and liquidity premium. Liquidity (more to less): Treasury Bonds > Municipal Bonds > Corporate Bonds 3. Tax consideration: bonds with tax-exempt status will have lower interest rates than they otherwise would ▪ Municipal bonds tend to have lower rate than T-bonds, due they are exempt from federal income tax = has the same effect on the demand for municipal bonds as an increase in their expected return (Munis are not as liquid a Treasuries.) ▪ Instrument: Government is promoting to buy certain bonds and get TAX advantage for it (Treasury bonds are exempt from state and local income taxes, while interest payments from corporate bonds are fully taxable) (! Always higher risk) Corporate Bond Market Treasury Bond Market Outcome Default risk 1. Re on corporate bonds ↓, 1. Relative Re on Treasury bonds ↑, DT ↑, Risk Dc ↓, Dc shifts left DT shifts right premium, ic - 2. Risk of corporate bonds ↑, 2. Relative risk of Treasury bonds ↓, DT ↑, iT, rises Dc ↓, Dc shifts left DT shifts right PT ↑, iT ↓ 3. Pc ↓, ic ↑ Liquidity 1. Liquidity of corporate bonds ↓, Dc ↓, 1. Relatively more liquid Treasury Risk Dc shifts left bonds, DT ↑, DT shifts right premium, ic - 2. Pc ↓, ic ↑ 2. PT ↑, iT ↓ iT, rises Treasury, always lot of liquid, why? 1. They are the bench mark (not much risk) 2. because its so huge – can absorb shocks better  TAX Municipal Bond Market 1. Relative Re on Treasury bonds ↓, DT ↓, im < iT considerati 1. Tax exemption raises relative Re on DT shifts left on municipal bonds, 2. PT ↓ Dm ↑, Dm shifts right 2. Pm ↑ Case: The Global Financial Crisis and the Baa-Treasury Spread (related to default risk) In 2007 the subprime mortgage market collapsed, leading to large losses for Financial Institutions. The Quality of the Baa bonds was questioned, as the demand for lower-credit bonds fell, and a flight-to-quality followed. Demand for T-securities increased ! Result: Baa-treasury spread increased Case: Bush Tax Cut and Obama Repeal on Bond Interest Rates The 2001 tax cut called for a reduction in the top tax bracket, from 39% to 35% over a 10-year period.This reduces the advantage of municipal debt over T-securities since the interest on T- securities is now taxed at a lower rate. The Bush tax cuts were repealed under President Obama. Our analysis is reversed. The advantage of municipal debt increased relative to T-securities, since the interest on T-securities is taxed at a higher rate. 5.2.Term Structure – maturity (Bonds with different maturities tend to have different required rates, all else equal.) Besides explaining the shape of the yield curve, a good theory must explain why: 1. Interest rates for different maturities move together. (Expectations Theory: When short rates are low, they are expected to rise to normal level, and long rate = average of future short rates will be well above today's short rate; yield curve will have steep upward slope.) 2. Yield curves tend to have steep upward slope when short rates are low and a downward slope when short rates are high. (Expectations Theory: When short rates are high, they will be expected to fall in future, and long rate will be below current short rate; yield curve will have downward slope.) 3. Yield curve is typically upward sloping. (Market Segmentation Theory) Movements over Time of Interest Rates on U.S. Government Bonds with Different Maturities. Several theories of the term structure provide explanations of how interest rates on bonds with different terms to maturity are related. The expectations theory views LT interest rates as equalling the average of future ST interest rates expected to occur over. The life of the bond. By contrast, the market segmentation theory treats the determination of interest rates for each bond’s maturity as the outcome of supply and demand in that market only. Neither of these theories by itself can explain the fact that interest rates on bonds of different maturities move together over time and that yield curves usually upward. The three theories to explain this: 1. Expectation Theory: ▪ Key Assumption: Bonds of different maturities are perfect substitutes You can buy €1 of 1-y-bond now and again in one year, or buy €1 of 2-y-bond ad hold ! the expected wealth is the same (at the start) for both strategies, but the actual wealth might differ if rates change unexpectedly. ▪ Implication: Re on bonds of different maturities are equal ▪ Numerical example ▪ One-year interest rate over the next five years are expected to be 5%, 6%, 7%, 8%, and 9% ▪ Interest rate on two-year bond today: (5% + 6%)/2 = 5.5% ▪ Interest rate for five-year bond today: (5% + 6% + 7% + 8% + 9%)/5 = 7% ▪ Interest rate for one- to five-year bonds today: 5%, 5.5%, 6%, 6.5% and 7% ▪ Explains why yield curve has different slopes: ▪ When short rates are expected to rise in future, average of future short rates = int is above today's short rate; therefore, yield curve is upward sloping. ▪ When short rates expected to stay same in future, average of future short rates same as today’s, and yield curve is flat. ▪ Only when short rates expected to fall will yield curve be downward sloping. 2. Market segmentation theory – (C) – Bonds of different maturities aren’t substitutes at all (segmented market) ▪ Explains C due: people typically prefer S holding periods, so higher demand on ST bonds, so higher prices and lower interest rates on ST than on LT bonds. ▪ Doesn’t explain A & B due: it assumes LT and ST rates are determined independently 3. The liquidity premium theory combines the features of the other 2 theories, and by so doing is able to explain the facts just mentioned. It views LT interest rates as equalling the average of future ST interest rates expected to occur over the life of the bond plus a liquidity premium. This theory allows us to infer the market’s expectations about the movement of future ST interest rates from the yield curve. (LP = rate of return that an investor expects above other rates or returns in order to make an illiquid investment) – (A, B & C) – Bonds of different maturities are substitutes, but not perfect ones Investors prefer ST to LT bonds, implying that investors must be paid positive liquidity premium  to hold LT! ! ▪ Key Assumption: Bonds of different maturities are substitutes, but are not perfect substitutes ▪ Explains all facts: the upward sloped yield curve by liquidity premium for LT-bonds, and that the average of future ST as determinant for LT rate ▪ Explains fact 3—that usual upward sloped yield curve by liquidity premium for long-term bonds ▪ Explains fact 1 and fact 2 using same explanations as pure expectations theory because it has average of future short rates as determinant of long rate ▪ Implication: Modifies Pure Expectations Theory with features of Market Segmentation Theory Yield curve has a lot of information about very short-term and long-term rates, but says little about medium-term rates. (see interpretation in illustration above to the right) The Relationship Between the Liquidity Premium and Expectations Theories ▪ A steeply upward-sloping curve indicates that future ST rates are expected to rise ▪ A middy upward-sloping curve that ST rates are expected to stay the same ▪ A flat curve that ST rates are expected to decline slightly 5.3. Cases Interpreting Yield Curves for U.S. Government Bonds  80– normal, not much was happening 97 – bit to flat, close to normal 85 bit to steep, close to normal ▪ The steep downward curve in 1981 suggested that short-term rates were expected to decline in the near future. This played-out, with rates dropping by 300 bps in 3 months. ▪ The upward curve in 1985 and 2013 suggested a rate increase in the near future. ▪ The moderately upward slopes in 1980 and 1997 suggest that short term rates were not expected to rise or fall in the near term. ▪ The steep upward slope in 2013 suggests short term rates in the future will rise. The Term Structure as a Forecasting Tool The yield curve does have information about future interest rates, and so it should also help forecast inflation and real output production. - Rising (falling) rates are associated with economic booms (recessions) [chapter 4] - Rates are composed of both real rates and inflation expectations [chapter 3] 6. Are Financial Markets efficient? Preview Expectations of: ▪ Return, risk, and liquidity are central elements in the demand for assets ▪ Inflation have a major impact on bond prices and interest rates ▪ The likelihood of default are the most important factors that determines the risk structure of interest rates ▪ Future ST interest rates play a central role in determining the term structure of interest rates 6.1.The Efficient Market Hypothesis (EMH) ▪ The efficient market hypothesis states that current security prices will fully reflect all available information because in an efficient market, all unexploited profit opportunities are eliminated. The elimination of unexploited profit opportunities necessary for a financial market to be efficient does not require that all markets participants be well informed. ▪ When an unexploited profit opportunity arises on a security (so-called because, on average, people would be earning more than they should, given the characteristics of that security), investors will rush to buy until the price rises to the point that the returns are normal again. ▪ In an efficient market, all unexploited profit opportunities will be eliminated. ▪ Not every investor need be aware of every security and situation. As long as a few keep their eyes open for unexploited profit opportunities, they will eliminate the profit opportunities that appear because in so doing, they make a profit. ▪ All unexploited profit opportunities eliminated ▪ Efficient market condition holds even if there are uninformed, irrational participants in market ▪ At the start of a period, the unknown element is the future price: Pt+1. But, investors do have some expectation of that price, thus giving us an expected rate of return. (Exam: When we make an investment, we’ll get a future price and cash change Calculate what kind of return we want on our investment) (cash payments (C)) ▪ The Efficient Market Hypothesis views the expectations as equal to optimal forecasts using all available information. This implies: Assuming the market is in equilibrium: Re = R* Put these ideas together: efficient market hypothesis Rof = R* ▪ This equation tells us that current prices in a financial market will be set so that the optimal forecast of a security’s return using all available information equals the security’s equilibrium return. ▪ Financial economists state it more simply: A security’s price fully reflects all available information in an efficient market. ▪ Why efficient market hypothesis makes sense If Rof > R* → Pt ↑ → Rof ↓ If Rof < R* → Pt ↓ → Rof ↑ Until Rof = R* ▪ All unexploited profit opportunities eliminated ▪ Efficient market condition holds even if there are uninformed, irrational participants in market ▪ The EMH indicates that hot tips, investment advisers’ published recommendations, and technical analysis cannot help an investor outperform the market. The prescription for investors is to pursue a buy-and-hold strategy – purchase stocks and hold them for long periods of time. Empirical evidence generally supports these implications of the EMH in the stock market. ▪ The existence of market crashes and bubbles have convinced many financial economists that the stronger version of the EMH, which states that asset prices reflect that true fundamental (intrinsic) value pf securities, is not correct. It is far less clear that the stock market rashes show that the EMH is wrong. Even if the stock market crashes were driven by factors other than fundamental, the crashes do not clearly demonstrate that many pf the basic lessons of the EMH are no longer valid as long as the crashes could not have been predicted. 6.2.Evidence on the Efficient Market Hypothesis ▪ The evidence on the EMH is quite mixed. Early evidence on the performance of investment analysts and mutual funds: ▪ Investment analysts and mutual funds don't be able to consistently beat the market (note: insider trading!) ▪ whether stock prices reflect publicly available information - If information is already publicly available, a positive announcement about a company will not, on average, raise the price of its stock because this information is already reflected in the stock price. - Early empirical evidence confirms: favorable earnings announcements or announcements of stock splits (a division of a share of stock into multiple shares, which is usually followed by higher earnings) do not, on average, cause stock prices to rise. ▪ the random-walk behaviour of stock prices, that is, future changes in stock prices should, for all practical purposes, be unpredictable - If stock is predicted to rise, people will buy to equilibrium level; if stock is predicted to fall, people will sell to equilibrium level (both in concert with EMH)  - Thus, if stock prices were predictable, thereby causing the above behavior, price changes would be near zero, which has not been the case historically ▪ Or the success of so-called technical analysis, is the study past stock price data, searching for patterns such as trends and regular cycles, suggesting rules for when to buy and sell stocks 6.3.Evidence against market efficiency theory However, in recent years, evidence on the small-firms effect, the January effect market overreaction, excessive volatility, mean reversion, and that new information is not always incorporated into stock prices suggests that the hypothesis may not always be entirely correct. The evidence seems to suggest that the EMH may be a reasonable starting point for evaluating behaviour in FMs, but it may not be generalizable to all behaviours in FMs. Unfavorable Evidence: ▪ Small-firm effect: small firms have abnormally high returns ▪ January effect: high returns in January, due to Tax advantage if they sell in Dec and buy in Jan to drive up their stocks = inconsistent with random-walk behavior ▪ Market overreaction: recent research suggests that stock prices may overreact to news announcements and that the pricing errors are corrected only slowly. This violates the EMH because an investor could earn abnormally high returns, on average, by buying a stock immediately after a poor earnings announcement and then selling it after a couple of weeks when it has risen back to normal levels.) ▪ Excessive volatility: the stock market appears to display excessive volatility; that is, fluctuations in stock prices may be much greater than is warranted by fluctuations in their fundamental value. ▪ Mean reversion: Some researchers have found that stocks with low returns today tend to have high returns in the future, and vice versa. ▪ New information is not always immediately incorporated into stock prices Although generally true, recent evidence suggests that, inconsistent with the efficient market hypothesis, stock prices do not instantaneously adjust to profit announcements. Instead, on average stock prices continue to rise for some time after the announcement of unexpectedly high profits, and they continue to fall after surprisingly low profit announcements. 6.4.Implications for Investing 1. How valuable are published reports by investment advisors? ▪ YES. The EMH indicates that you should be skeptical of hot tips since, if the stock market is efficient, it has already priced the hot tip stock so that its expected return will equal the equilibrium return. ▪ Thus, the hot tip is not particularly valuable and will not enable you to earn an abnormally high return. 2. Should you be skeptical of hot tips?  ▪ As soon as the information hits the street, the unexploited profit opportunity it creates will be quickly eliminated. ▪ The stock’s price will already reflect the information, and you should expect to realize only the equilibrium return. 3. Do stock prices always rise when there is good news? ▪ NO. In an efficient market, stock prices will respond to announcements only when the information being announced is new and unexpected. ▪ So, if good news was expected (or as good as expected), there will be no stock price response. ▪ And, if good news was unexpected (or not as good as expected), there will be a stock price response. 4. Efficient Markets prescription for investor ▪ Investors should not try to outguess the market by constantly buying and selling securities. This process does nothing but incur commissions costs on each trade. ▪ Instead, the investor should pursue a “buy and hold” strategy—purchase stocks and hold them for long periods of time. This will lead to the same returns, on average, but the investor’s net profits will be higher because fewer brokerage commissions will have to be paid. ▪ It is frequently a sensible strategy for a small investor, whose costs of managing a portfolio may be high relative to its size, to buy into a mutual fund or tracker rather than individual stocks. Because the EMH indicates that no mutual fund can consistently outperform the market, an investor should not buy into one that has high management fees or that pays sales commissions to brokers but rather should purchase a no-load (commission-free) mutual fund that has low management fees. 6.5.Why the EMH Does Not Imply That Financial Markets Are Efficient A strong view of EMH states that (1) expectations are rational, and (2) prices are always correct and reflect market fundamentals. This has three important implications: 1. One investment is just as good as any other (stock picking is pointless) 2. Prices reflect all information 3. Cost of capital can be determined from security prices, assisting in capital budgeting decisions 6.6.Behavioral Finance The new field of behavioural finance applies concepts from other social sciences, such as anthropology, sociology, and particular psychology, to understand the behaviour of securities prices, Loss aversion, overconfidence, and social contagion can explain why trading volume is so high, stock prices get overvalued and speculative bubbles occur. 7. Why Do Financial Institutions Exist? Basic facts about the financial structure throughout the world  ▪ The financial system is a complex structure including many different institutions: banks, insurance companies, mutual funds, stock and bonds market ▪ This chart shows how nonfinancial business attain external funding in the US, Germany, Japan and Canada. The sources of financing are somewhat consistent except in the US. Facts about US financial structure 1. Stocks are not the most important source of external financing for businesses 2. Issuing marketable debt and equity securities is not the primary way in which businesses finance their operations 3. Indirect finance (involves intermediaries) > direct finance (raise funds directly from lenders in financial markets) 4. Financial intermediaries are the most important source of external funds used to finance businesses 5. The financial system is among the most heavily regulated sectors of economy 6. Only large, well-established corporations have easy access to securities markets to finance their activities 7. Collateral is a prevalent feature of debt contracts for households and businesses 8. Debt contractors are typically extremely complicated legal documents that place substantial restrictions on the behaviour of the borrowers Transaction costs Influence the financial structure as it can hinder flows of funds to people with productive investment opportunities. Financial intermediaries make profits by reducing transaction costs 1. Financial intermediaries can take advantage of economies of scale 2. and are better able to develop expertise to lower transaction costs, thus enabling their savers and borrowers to benefit from the existence of FMs.) Asymmetric Information: Agency theory = the analysis of how asymmetric information problems affect behaviour Assumption: Symmetric information – all parties to a transaction or contract have the same information, be that little or a lot. In many situations this is not the case -> Asymmetric information Asymmetric information results in 2 problems: 1. Adverse selection, which occurs before the transaction (One party in a transaction has better information than the other party. Potential borrowers most likely to produce adverse outcome are ones most likely to seek loan and be selected) 2. Moral hazard, which occurs after the transaction (refers to the risk of the borrower’s engaging in activities that are undesirable from the lender’s point of view) 7.1. Adverse selection  ▪ The Lemons Problem: How adverse selection influences Financial Structure (used cars) ▪ If we can’t distinguish between “good” and “bad”, we are willing to pay only an average of good and bad ▪ Result: good cars won’t be sold, bad will be overvalues and the used car market will function inefficiently ▪ Lemons problem in securities markets ▪ If we can’t distinguish between good and bad securities, we are only willing to pay on average price of the good and bad securities’ value ▪ Result: good securities are undervalued, and firms won’t issue them; bad securities are overvalued so there are too many issued ▪ Investors don’t want to buy bad securities, so markets don’t function well ▪ Explains fact 1 and 2 ▪ Explains fact 6: less asymmetric info for well-known firms, so smaller lemons problem ▪ Adverse selection interferes with the efficient functioning of FMs. Tools help reduce the adverse selection problem include: (1) private production and sale of information: free-rider problem interferes though (2) government regulation to increase information E.G.: annual audits of public corporations (Enron -> didn’t eliminate problem) (3) financial intermediation a. Analogy to solution to lemons problem provided by used car dealers b. Avoid free-rider problem by making private loans (explains fact 3 & 4) The free-rider problem occurs when people who do not pay for information take advantage of information that other people have paid for. This problem explains why financial intermediaries, especially banks, play a more important role in financing the activities of business than securities markets do. c. Large firms are more likely to use direct financing (explains fact 6) (4) collateral and net worth -> explains fact 7 The Enron Implosion ▪ Up to 2001, Enron appeared to be a very successful firm engaged in energy trading ▪ However, the firm had severe financial problems and hid them in complex financial structure which allowed them not to report them ▪ Even if Enron regularly filed records with the SEC, the problem wasn’t prevented ▪ Arthur Anderson (the auditor) plead guilty to obstruction of justice charges. With that plea, one of the largest and trusted auditors closed its doors forever 7.2. Moral hazard Principle-agent problem = Moral hazard in equity contracts is known as the principal-agent problem because managers (the agents) have less incentive to maximize profits than stockholders (the principals) as a result of separation of ownership by stockholders(principals) from control by managers (agents) The principal-agent problem explains why debt contracts are so much more prevalent in FMs than equity contracts. Example: Suppose you become a silent partner in an ice cream store, providing 90% of the equity capital ($9,000). The other owner, Steve, provides the remaining $1,000 and will act as the manager. If Steve works hard, the store will make $50,000 after expenses, and you are entitled to $45,000 of it. However, Steve doesn’t really value the $5,000 (his part), so he goes to the beach, relaxes, and even spends some of the “profit” on art for his office. How do you, as a 90% owner, give Steve the proper incentives to work hard? Tools to help reduce/solve the principal-agent problem include: (1) Production of information: monitoring (2) Government regulation to increase information: discourage/encourage behaviour  (3) Financial intermediation: e.g. Venture capital; intermediaries have special advantages in monitoring) (4) Debt contracts: most contracts require fixed amount of interest otherwise still subject to hazard How moral hazard influences financial structure in debt markets ▪ Debt is still subject to moral hazard ▪ In fact, it may create incentives to take on risky projects ▪ Most debt contracts require the borrower to pay a fixed amount (interest) and keep any cash flow above this amount ▪ E.G.: if a firm owes 100$ but only has 90$, it’s bankrupt. The firm has then nothing to lose by looking for risky projects to raise the needed cash. ▪ Tools to help solve Moral Hazard in debt contracts ▪ Net worth and collateral ▪ Monitoring and enforcement of restrictive covenants that ⋅ Discourage undesirable behavior ⋅ Encourage desirable behavior ⋅ Keep collateral valuable ⋅ Provide information ▪ Financial intermediation – banks and other intermediaries have special advantages in monitoring -> explains facts 1 to 4 7.3. Cases: 1. Case: Financial development and economic growth ▪ Financial repression leads to low growth ⋅ Poor legal system ⋅ Weak accounting standards ⋅ Government directs credit (state-owned banks) ⋅ Financial institutions nationalized ⋅ Inadequate government regulation ▪ Financial Crises 2. Mini-Case: should we kill all the lawyers? ▪ Lawyers are an easy target cause of problems  ▪ Most legal work is about contract enforcement ⋅ Establish and maintain important property rights ⋅ Without such rights, limited investments ⋅ The US has more lawyers per capita than any nation. Arguable the richest too ⋅ 3. Financial crises and aggregate economic activity ▪ Our analysis of the effects of adverse selection and moral hazard can also assist us in understanding financial crises, major disruptions in financial markets. The end result of most financial crises is the inability of markets to channel funds from savers to productive investment opportunities 4. Is China a counter-example? ▪ With a booming economy, China’s financial development is still very young ▪ Per capita income is around 10000$, but savings are around 40%, allowing China to build up capital stock as labor moves out of subsistence agriculture ▪ But, this will not work for long ▪ To continue its growth, China needs to allocate capital more efficiently. Many financial repression problems are being addressed by Chinese authorities today. 7.4. Conflicts of interest Conflicts of interest is a type of moral hazrd which arises when financial services providers or their employees are serving multiple interests and have incentives to misuse or conceal information needed for the effective functioning of FMs, thereby preventing them from channelling funds to parties with the most productive investment opportunities. Types of financial service activities have had the greatest potential for conflicts of interest: 1. Underwriting and research in Investment banking research is expected to be unbiased and accurate, reflecting facts about firm, but underwriters can better serve the firm is research is positive, so might have and influence on how they perform the research ! spinning; under-priced equity allocated to executives promising future business, when so wasn’t the case 2. Auditing and consulting in accounting firms auditors check assets for quality and accuracy under unbiased perspective, but consultants help with strategic moves against a fee 3. Credit assessment and consulting in rating agencies Rating agencies assign credit rating to help determine riskiness of a security, but consultants help with strategic moves against a fee Two major policy measures have been implemented to deal with conflict of interests: the Sarbanes- Oxley Act of 2002 and the Global Legal Settlement of 2002, which arose from a lawsuit by the New York attorney general against the 10 largest investment banks. ▪ Sarbanes-Oxley act of 2002 ▪ Established an oversight board to supervise accounting firms ▪ Increased the SEC’s budget for supervisory activities ▪ Limited consulting relationships between auditors and firms ▪ Enhanced criminal charges for obstruction ▪ Improved the quality of the financial statements and board ▪ Global Legal Settlement of 2002 ▪ Required investment banks to sever links between research and underwriting ▪ Spinning is explicitly banned ▪ Imposed a $1.4 billion fine on accused investment banks ▪ Added additional requirements to ensure independence and objectivity of research reports ▪ Will this work? ▪ Too early to determine ▪ There is much criticism over the cost involved with these separations. In other words, financial institutions can no longer take advantage of the economies of scope gained form relationships ▪ Some say that SOX has brought down the value of US Capital Markets 8. Why financial crises occur Financial crises = major disruptions in financial markets, characterized by sharp declines in asset prices and firm failures. Basis to understand and define financial crisis is asymmetrical information, which creates barriers between savers and firms with productive investment opportunities. So, when information flows experience a particularly large disruption, the markets stop working properly 8.1 Three stages of financial crises: (1) Initiation ▪ Credit Boom and Bust: ▪ Mismanagement of financial liberalization or innovation (elimination of restrictions, introduction of new types of loans or other financial products) ▪ Government safety nets weaken incentives for risk management as depositors ignore bank risk-taking ▪ Eventually loan losses accrue, and asset values fall, leading to a reduction in capital ▪ Financial Institutions cut back in leading, a process called deleveraging. Banking funding falls. ▪ As FI cuts back on lending, no one is left to evaluate firms, so Financial System looses its primary institution to address asymmetric information. ▪ Economic spending contracts as loans become scarce ▪ Asset-Price Boom and Bust: ▪ A pricing bubble starts, where assets exceed their fundamental values, and when it bursts and prices fall, corporate net worth falls as well. Moral hazard increases as firms have little to loose ▪ FIs also see a fall in their assets, leading again to deleveraging ▪ Increase in Uncertainty: ▪ Periods with high uncertainty can lead to crises, e.g. stock market crashes of failure of a major FI ▪ With information hard to come by, asymmetric information problems increase, reducing lending and economic activity (2) Banking crisis ▪ Bank panic & bank run: ▪ Panics occur when depositors are unsure which banks are insolvent, causing all depositors to withdraw all funds immediately ▪ As cash balances fall, FIs must sell assets quickly, further deteriorating their balance sheet ▪ Asymmetric information becomes severe – take years for a full recovery (3) Debt deflation ▪ Debt deflation: ▪ Caused by sharp decline in prices, where asset prices fall, but debt levels don’t adjust, increasing debt burdens ▪ Leads to increase in asymmetric information, which is followed by decreasing lending ▪ Economic activity remains depressed for a long time 8.2. Cases ▪ The Great Depression: ▪ In 1928 and 1929, stock prices doubled in the U.S. The Fed tried to curb this period of excessive speculation with a tight monetary policy. But this lead to a stock market collapse of more than 20% in October of 1929, and losing an additional 20% by the end of 1929. ▪ What might have been a normal recession turned into something far worse, when severe droughts in 1930 in the Midwest led to a sharp decline in agricultural production. ▪ Between 1930 and 1933, one-third of U.S. banks went out of business as these agricultural shocks led to bank failures. ▪ For more than two years, the Fed sat idly by through one bank panic after another. ▪ Adverse selection and moral hazard in credit markets became severe. Firms with productive uses of funds were unable to get financing. As seen in the next slide, credit spreads increased from 2% to nearly 8% during the height of the Depression in 1932. ▪ The deflation during the period lead to a 25% decline in price levels. ▪ The prolonged economic contraction lead to an unemployment rate around 25%. ▪ The Depression was the worst financial crisis ever in the U.S. It explains why the economic contraction was also the most severe ever experienced by the nation. ▪ Bank panics in the U.S. spread to the rest of the world, and the contraction of the U.S. economy decreased demand for foreign goods. ▪ The worldwide depression caused great hardship, and the resulting discontent led to the rise of fascism and WWII. ▪ The Global Financial Crisis 2007-2009: Three central factors: ▪ Financial innovation in mortgage markets ▪ Less-than-credit worthy borrowers found the ability to purchase homes through subprime lending ▪ Financial engineering developed new financial products to further enhance and distribute risk from mortgage lending ▪ Agency problems in mortgage markets ▪ Mortgage originators did not hold the actual mortgage, but sold the note in the secondary market ▪ Mortgage originators earned fees from the volume of the loans produced, not the quality ▪ In the extreme, unqualified borrowers bought houses they could not afford through either creative mortgage products or outright fraud (such as inflated income) ▪ The role of asymmetric information in the credit rating process  ▪ Agencies consulted with firms on structuring products to achieve the highest rating = clear conflict ▪ The rating system was hardly designed to address the complex nature of the structured debt designs ▪ The result was meaningless ratings that investors had relied on to assess the quality of their investments Who suffered loss: US residential housing, FIs BS, the “shadow” banking system, global financial markets, the failure of major financial firms Better to watch documentary about the two crises – also Fannie May and Freddie Mac 8.3 How does Collateralized Debt Obligations (CDOs) play a role in crisis? ⋅ A special purpose vehicle (SPV) is created to buy assets, create securities from those assets, and then sell those securities to investors. ⋅ In a CDO, the securities (or tranches) are created based on default priorities. The first defaults go to the lowest rated tranches. The highest rated tranches suffer defaults if most of the assets default. ⋅ Super senior – highest rated tranches ⋅ Senior – little more risk, but pays a higher interest rate ⋅ Mezzanine – bears more risk, but has even higher interest ⋅ Equity – first tranche that suffers losses from defaults ⋅ Bottom line - increased complexity of structured products can actually reduce the amount of information in financial markets. Makes you wonder who is willing to buy these in the first place! 12. The Bond Market 12.1 Capital Market Purpose: original maturity greater than one year, typically for long-term securities (stocks and bonds) Issuers: federal and local governments (debt), corporations (equity and debt), you and me 1. Primary market for initial sale (IPO) 2. Secondary market for Over-the-counter (bonds) Organized exchanges (stocks) 12.2 Relationship between Bond Prices and Bond Yields Bond price Yield ⇑ ⇓ ⇓ ⇑ Bond = fixed interest security represent debt owed by the issuer to the investor; when government issues a bond, the bond itself pays a fixed annual (exceed one year) amount of interest (coupon), can be paid in any currency. The yield is the interest rate on a bond. ⇒ The coupon is fixed, but the yield may vary inversely with the market price of a bond Ex: Consider 10-year government bond issued 2016. Nominal value €5000, pays annual (fixed) interest rate of €200 (coupon). The yield on the bond is calculated by formula: Yield = (interest on bond / market price on bond) *100 (200/5000) *100 = 4% This means that whoever holds the bond, will annually receive €200 in interest representing 4% yield if the bond has a face value of €5000. If the coupon would’ve been €500 instead, the yield would’ve been 10%. If the market price of the bond increases to €5500, due strong investor demand, the coupon remains the same, so the yield decreases: (200/5500) *100 = 3,4% If the market price of the bond falls to €4300, due speculative selling of bonds, the coupon remains the same, so the yield increases: (200/4300) *100 = 4,65% Nominal value/Face value/Par value = the stated value of an issued security, and disregards an item's market value. For stocks, it is the original cost of the stock shown on the certificate. For bonds, it is the amount paid to the holder at maturity, generally $1,000. 12.3 Treasury Bonds ▪ Treasury bonds = LT government bonds that make interest payments semi-annually, and the income received is only taxed at the federal level. They are known in the market as primarily risk- free; they are issued by the U.S. government with very little risk of default as they just can print money to pay off debt. Type Maturity Treasury bill Less than 1 year Treasury note 1-10 years Treasury bond 10-30 years ▪ Treasury Bonds: Recent Innovation ▪ Treasury Inflation – Indexed securities: the principal amount is tied to the current rate of inflation to protect investor purchasing power ▪ Treasury STRIPS: the coupon and principal payments are ‘stripped’ from a T-bond and sold as individual zero-coupon bonds ▪ Treasury Bonds: Agency bonds ▪ Although not technically Treasury securities, agency bonds are issued by government- sponsored entities, such as GNMA, FNMA and FHLMC ▪ The debt has an ‘implicit’ guarantee that the US government will not let the debt default. This ‘guarantee’ was clear during the 2008 bailout… ▪ Municipal bonds = issued by local, country, and state governments, used to finance public interest projects Tax-free municipal interest rate = taxable interest rate*(1-mariginal tax rate) ▪ Two types: General obligation bonds, Revenue bonds ▪ Municipal Bonds: Examples 1. Suppose the rate on a corporate bond is 9% and the rate on a municipal bond is 6,75%. Which should you choose? Answer: 6.75% = 9% x (1 – MTR) -> MTR = 25% If you are in a MTR above 25%, the municipal bond offers a higher after- tax cash flow 2. Suppose the rate on a corporate bond is 5% and the rate on a municipal bond is 3.5%. Which should you choose? Your MTR is 28%. Find the equivalent tax-free rate (ETFR) Answer: ETFR = 5% x (1 – MTR) = 5% x (1 – 0.28) -> ETFR = 3,36% If the actual municipal rate is above this -> chose the municipal rate ▪ Corporate bonds: ▪ Typically have a face value of €1000, although some have a face value of €5000 or €10000. ▪ Pay interest semi-annually (USD) or annually (EUR) ▪ Cannot be redeemed anytime issuer wishes, unless a specific clause states this (call option)  ▪ Degree of risk varies with each bond, even from the same issuer. A degree of risk ranges from low (AAA) to high (BBB). Any bonds rated below BBB are considered sub-investment grade debt ▪ Characteristics of Corporate Bonds ▪ Restrictive Covenants ⋅ Mitigates conflicts with shareholder interests ⋅ May limit dividends, new debt, ratios, etc ⋅ Usually includes a cross-default clause ▪ Conversion ⋅ Some debt may be converted to equity ⋅ Similar to a stock option, but usually more limited ▪ Secured bonds ⋅ Mortgage bonds ⋅ Equipment trust certificates ▪ Unsecured bonds ⋅ Debentures ⋅ Subordinated debentures ⋅ Variable-rate bonds ▪ Junk bonds ⋅ Debt that is rated below BBB ⋅ Often, trusts and insurance companies are not permitted to invest in junk debt ⋅ Michael Milken developed this market in the 1980s, although he was subsequently convicted of insider trading Corporate bonds = private debt instruments, specified maturity (LR tendency) ! capital market instruments Corporate stocks = private equity instruments, infinite maturity ! capital market instruments ▪ Convertible Bonds E.G.: 1000$ face of value ▪ Share price at issue of convertible = $20 ▪ Conversion premium = 25% ▪ Conversion period = 5 year ▪ Investor will convert bonds in shares if shares trade at $25 or higher ▪ Conversion will typically only happen near maturity of the bonds ▪ Financial guarantees for bonds Some debt issuers purchase financial guarantees to lower the risk of their debt. The guarantee provides for timely payment of interest and principal, and are usually backed by large insurance companies. Not all guarantees make sense: CDSs2 12. 4 Calculations Bond Yield Calculation  ▪ Bond yields are quoted using a variety of conventions, depending on both the type of issue and the market ▪ We’ll examine the current yield calculation that is commonly used for long-term debt ▪ What is the current yield for a bond with a face value of $1000, a current price of $921.01, and a current price of $921,01 and a coupon rate of 10,95%? ▪ Answer: I = C/P = 109,50/921,01 = 11,89% -> C(coupon) = 10,95% x 1000$ ▪ Bond pricing is, in theory, no different than pricing any set of known cash flows ▪ Once the cash flows have been identified, they should be discounted to time zero at an appropriate discount rate Finding the value of coupon bonds ▪ What is the price of two-year, 10% coupon bond (semi-annual payments) with a face value of $1000 and a required rate of 12%? ▪ Answer: Identify the cash flows ▪ $50 is received every six months in interest ▪ $1000 is received in two years as the principal repayment ▪ Find the present value of cash flows (TVM solver) ▪ N = 4, FV = 1000, PMT = 50, I = 6% ▪ PV -> 965,35 13. The Stock market ▪ Investing in stocks: 1. Represents ownership in a firm 2. Earn a return in two ways: a. price of the stock rises over time b. dividends are paid to stockholders 3. Stockholders have claim on all assets 4. Right to vote for directors and on certain issues 5. Two types: a. common stock (right to vote, receive dividends) b. preferred stock (receive a fixed dividend, do not usually vote) ▪ How Stocks are Sold: Organized exchange: Over-The-Counter: Type ▪ Auction markets with floor ▪ Multiple market makers set bid and specialists (floor traders) ask prices ▪ 25% of trades are filled directly by ▪ Multiple dealers for any given specialist security ▪ Remaining trades are filled through SuperDOT How ▪ NYSE -> daily volume around 4 ▪ NASDAQ -> best example stocks billion shares, with peaks at 7 ▪ Dealers stand ready to make a are sold billion market ▪ The term organized used to imply a ▪ Today, 3000 different securities are specific trading location. Although, listed on NASDAQ today, computer systems (ECNs) ▪ Others include the dealing/trading have replaced this idea rooms and banks ▪ Others include EURONEXT, Nikkei, ▪ Important market for thinly-traded LSE, DAX securities -> securities that don’t ▪ Listing requirements exclude small trade very often. Without a dealer firms ready to make a market, the equity would be difficult to trade ▪ Electronic Communication Networks (ENCs) = Allow brokers & traders to trade without a middleman.  ▪ Pros: transparency, cost reduction, faster, after-hours trading ▪ Cons: don’t work as well with thinly-traded stocks, many ECNs competing for volume which can be confusing, major exchanges are fighting ECNs with an uncertain outcome ▪ Exchange Traded Funds (ETFs) are a recent innovation to help keep transaction costs down while offering diversification. Represent a basket of securities or an index, exact content of basket is known so valuation certain, traded on a major exchange, management fees are low ▪ Computing the Price of Common Stock ▪ Valuing common stock is, in theory, no different from valuing debt securities: ⋅ determine the cash flows ⋅ discount them to the present ▪ Four methods: 1. One period valuation model o Simplest model, just taking using the expected dividend and price over the next year o Example: What is the price for a stock with an expected dividend and price next year of $0,16 and $60, respectively? 2. Generalized dividend valuation model o Most general model, but the infinite sum may not converge o Rather than worry about computational problems, we use a simpler version, known as the Gordon growth model 3. Gordon growth model o Same as the previous model, but it assumes that dividend grow at a constant rate G. 4. Price earnings valuation model o The price earnings ratio (PE) is a widely watched measure of how much market is willing to pay for $1,00 of earnings from the firms o If the industry PE ratio for a firm is 16, what is the current stock price for a firm with earnings for $1,13/share? o Answer: Price = 16 x $1.13 = $18.08 ▪ How the market sets security prices ▪ Generally speaking, prices are set in competitive markets as the price set by the buyer willing to pay the most for an item.  ▪ The buyer willing to pay the most for an asset is usually the buyer who can make the best use of the asset. ▪ Superior information can play an important role. ▪ Consider the following three valuations for a stock with certain dividends but different perceived risk ▪ Example: Bud, who perceives the lowest risk, is willing to pay the most and will determine the “market” price ▪ Errors in valuation: (significant impact on Gordon) ▪ Although the pricing models are useful, market participants frequently encounter problems in using them. Any of these can have a significant impact on price in the Gordon model ⋅ Problems with Estimating Growth ⋅ Problems with Estimating Risk ⋅ Problems with Forecasting Dividends ▪ Dividend growth rates ⋅ Stock prices for a security with D0= $2.00, ke=15% and constant GRs as listed ▪ Required returns ⋅ Prices for a security with D0 = $2,00, g = 5%, and required returns as listed ▪ Security valuation is not an exact science ▪ Considering different growth rates, required rates… is important in determining if a stock is a good value as an investment Cases: ▪ Case: The 2007 – 2009 Financial Crisis and the Stock Market ▪ The crisis started in 2007 and was the start of one of the worst bear markets ▪ The crisis lowered g in the Gordon Growth model – driving down prices ▪ Also impacts ke – higher uncertainty increases this value, again lowering prices ▪ The expectations were still optimistic at the start of the crisis. But, as the reality of the severity of the crisis was understood, prices plummeted. ▪ Case: 9/11, Enron and the Market ▪ Both 9/11 and the Enron scandal were big events in 2001 ▪ Both should lower g in the Gordon Growth model – driving down prices ▪ Also impacts ke – higher uncertainty increases this value, again lowering prices ▪ We did observe in both cases that prices in the market fell before going up again as confidence in the US market returned Stock Market Indexes ▪ Frequently used to monitor the behavior of a group of stocks ▪ Major indexes: Dow Jones Industrial Average, S&P 500 and NASDAG composite ▪ Hereunder: the 30 companies in the DJIA ▪ E.G. $1.00 invested in 1980 in the DJIA (around 800) would have grown to $16.40 in 2012 (around 1300) -> AGR of 8.8% Buying Foreign Stocks ▪ Useful from diversification perspective, but complicated. ▪ American Depository Receipts (ARDs) allow foreign firms to trade on US exchanges, facilitating their purchase. US banks buy foreign shares and issue receipts agains the shares in US markets Regulation of the Stock Market ▪ Primary mission of the SEC to protect investors and maintain the integrity of the securities markets.” ▪ The SEC brings around 500 actions against individuals and firms each year toward this effort. ▪ This is accomplished through the joint efforts of four divisions. 1. Division of Corporate Finance: responsible for collecting, reviewing, and making available all of the documents corporations and individuals are required to file 2. Division of Market Regulation: establishes and maintains rules for orderly and efficient markets 3. Division of Investment Management: oversees and regulates the investment management industry 4. Division of Enforcement: investigates violations of the rules and regulations established by the other divisions. Chapter 18 Most powerful banks EZB, FED, IMF < (based in Basel) = BIS - Bank of international settlements (=bank of central banks) – Decide what Bank capital (=Cash reserves) needs to be