Financial Markets and Institutions PDF

Calculation of Future Value Problem Set  You plan to invest $10,000 today in exchange  Calculate the present value of $5,000 received five for a fixed payment at the end of six years. If...

Calculation of Future Value Problem Set  You plan to invest $10,000 today in exchange  Calculate the present value of $5,000 received five for a fixed payment at the end of six years. If years from today if your investments pay:  10 percent compounded annually the appropriate annual interest rate on the  10 percent compounded semiannually investment is 8 percent compounded  10 percent compounded quarterly. annually, what is the future value of this investment? © McGraw Hill 2-22 © McGraw Hill 2-23 Chapter 4 Suppose you can save $2,000 annually for the next ten years in an account earning 7 percent annually. How much will you have at the end of Money Markets the tenth year if you make the first deposit today? Copyright © 2022 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill. © McGraw Hill 2-24 Learning Goals Money Markets  Money market Money markets trade debt securities or  Define money markets. instruments with less than one year of maturity.  Identify the major types of money market securities.  Examine the process used to issue Treasury securities. Money market instruments have the following characteristics:  List the main participants in money markets.  They are generally sold in large denominations ($1m to  Examine the extent to which foreign investors participate in $10m units).  They have low default risk. U.S. money markets.  They must have an original maturity of one year or less. © 2022 McGraw-Hill Education. 5-2 © 2022 McGraw-Hill Education. 5-3  Money Market Instruments Treasury Bills (T-Bills)  Treasury bills—short-term obligations issued by the U.S. government.  Federal funds—short-term funds transferred between financial institutions,  T-Bills are short-term debt obligations issued by the usually for no more than one day. U.S. government to cover government budget deficits  Repurchase agreements—agreements involving the sale of securities by and to refinance maturing government debt one party to another with a promise to repurchase the securities at a specified date and price. Main tool used by the Federal Reserve to implement monetary  Commercial paper—short-term unsecured promissory notes issued by a policy. company to raise short-term cash. Original maturities are 4, 13, 26, and 52 weeks.  Negotiable certificates of deposit—bank-issued time deposits that specify an interest rate and maturity date and are negotiable (saleable on a Issued in denominations of multiples of $100. secondary market). T-bills can be bought and sold in a secondary market through  Banker’s acceptances—time drafts payable to a seller of goods, with payment guaranteed by a bank. government securities dealers. almost default risk-free, with little interest rate or liquidity risk. © 2022 McGraw-Hill Education. 5-4 © 2022 McGraw-Hill Education. 5-5 The New Issue and Secondary Secondary Market for T-Bills Market Trading Process for T-Bills A treasury bill auction is the formal process by which the U.S.  Secondary market for T-bills is the largest of any U.S. Treasury sells news issues of T-bills.  Government securities dealers, financial and nonfinancial money market security corporations, and individuals submit bids.  24 FIs are designated as ‘primary government securities  Bids may be competitive or non-competitive. dealers’ and purchase most of the T-bills sold Competitive bids specify the amount of par value of bills desired and the discount yield rather than the price. competitively at auction, creating an active secondary  Generally used by large investors and government securities market dealers and make up most of the auction market. Non-competitive bids are limited to $5m for a single bidder and specify only the desired amount of the bills' face value.  Usually represent a small portion of total T-bills auctioned, but allow small investors to participate in the T-bill auction market. © 2022 McGraw-Hill Education. 5-6 © 2022 McGraw-Hill Education. 5-7 YIELDS ON MONEY MARKET SECURITIES For many money market securities, returns are measured by a method that does not allow them to be evaluated using the time value of money equations. Returns are measured in different ways. Some A 28-day T-bill costs $996.73 and is worth use a 360-day year, while others use a 365-day year. $1,000 at maturity. What are the Discount Yield,  Bond Equivalent Yields: For money market securities, the bond Bond Equivalent Yield, and EAR? equivalent yield is the product of the periodic rate and the number of periods in a year.  Effective Annual Return (EAR): the true annual rate earned. The bond equivalent yield on money market securities with a maturity of less than one year can be converted to an effective annual interest return (EAR).  Discount Yields Some money market instruments (e.g., Treasury bills and commercial paper) are bought and sold at discounts. Yields on these securities use a 360-day year rather than a 365- day year.  Federal Funds Repurchase Agreements  Federal funds (fed funds) are short-term loans between  A repurchase agreement (repo or RP) is an agreement involving the Purchase of securities by one party (the repo financial institutions, usually for a period of one day. buyer) to another party (the repo seller) with a promise to  For example, commercial banks trade fed funds in the form of sell the securities at a specified price and on a specified excess reserves held at their local Federal Reserve Bank. date in the future.  Federal funds are single-payment loans—they pay interest Most repurchase agreements are collateralized only once, at maturity One-day maturity repos are called overnight repos  The Fed funds rate is the interest rate for borrowing Fed repos with longer maturities are called term repos. funds. © 2022 McGraw-Hill Education. 5-10 © 2022 McGraw-Hill Education. 5-11 Asset-Backed Commercial Paper Commercial Paper (ABCP)  Commercial paper is an unsecured short-term promissory  Asset-backed commercial paper (ABCP) is paper note issued by a corporation to raise short-term cash, often backed by assets of the issuing firms. to finance working capital requirements.  Investors generally hold commercial paper from the time of issue until  The financial assets are typically a mix judged to have a maturity. Thus, there is no active secondary market for commercial paper. low risk of bankruptcy by a rating agency.  Like Treasury bills, yields on commercial paper are quoted on a discount basis  issued in denominations from $100,000 to $1 million.  Many credit rating firms rate commercial paper issues (e.g., Standard & Poor’s, Moody’s, and Fitch Ratings). The better the credit rating on a commercial paper issue, the lower the interest rate. © 2022 McGraw-Hill Education. 5-12 © 2022 McGraw-Hill Education. 5-13 Negotiable Certificates of Deposit Banker’s Acceptances  A negotiable certificate of deposit (CD) is a bank-  A banker’s acceptance (BA) is a time draft payable to a issued time deposit that specifies an interest rate and seller of goods, with payment guaranteed by a bank. maturity date and is negotiable (i.e., salable) in the Many BAs arise to finance foreign trade in goods that have secondary market. A negotiable CD can be traded any yet to be shipped from a foreign exporter (seller) to a number of times in secondary markets; therefore, the domestic importer (buyer). original buyer is not necessarily the owner at maturity Foreign exporters often prefer that banks act as guarantors for payment before sending goods to domestic importers.  Bearer instruments: whoever holds the CD when it The bank signifying its obligation to pay the foreign exporter matures receives the principal and interest. (or its bank) on a specified date should the importer fail to pay for the goods. Like T-bills and commercial paper, banker’s acceptances are sold on a discounted basis. © 2022 McGraw-Hill Education. 5-14 © 2022 McGraw-Hill Education. 5-15  Money Market Participants International Aspects of Money Markets  U.S. money markets are the largest and most active in the world, but money markets across the world have been growing in size and importance  Two forms of growth include the following: 1. U.S. money market securities bought and sold by foreign investors 2. Foreign money market securities © 2022 McGraw-Hill Education. 5-16 © 2022 McGraw-Hill Education. 5-17 The Eurodollar Market Eurocommercial Paper The U.S. dollar is used for many international financial contracts, leading foreign entities to hold funds in dollars outside the United States. Eurocommercial Paper: An unsecured, short-term loan issued These dollar-denominated deposits held in foreign banks are called by a bank or corporation in the international money market Eurodollar deposits(Eurodollar CDs), and the market in which they denominated in a currency that differs from the domestic currency trade is called the Eurodollar market. of the market where the paper is issued. The Eurodollar market is simply a market in which dollars are held An example would be Eurodollar commercial paper outside the United States. Banks around the world now use this denominated in U.S. dollars but issued in the Japanese debt market as a source of overnight funding. market with a short maturity period. Eurodollars are not subject to US Federal Reserve regulations because they are held outside the United States. Large banks in London organized the interbank Eurodollar market.  The rate offered for sale on Eurodollar funds is known as the London Interbank Offered Rate (LIBOR). 5-18 © 2022 McGraw-Hill Education. 5-19 Chapter 6 Bond Markets End of Main Content Copyright 2022 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.  Bond Market in KSA  Sukuk and bonds can be traded like any other securities through brokers during trading hours. They can also be traded over the counter (OTC), which means this occurs outside the formal exchange environment and without oversight by the End of Main Content regulator. https://www.saudiexchange.sa/wps/portal/saudiexchange/trading/ market-services/sukuk-and-bonds Copyright 2022 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC. © McGraw Hill 6-26 6-27 Learning Goals Chapter 5  Identify the major characteristics of common stock. Stock Markets Identify the major characteristics of preferred stock   Know who the major stock market participants are.  Examine the process by which common stock is issued in primary stock markets.  Describe the major secondary stock markets.  Recognize the major stock market indexes.  Explain the three forms of market efficiency  Describe the major characteristics of international stock markets. Copyright © 2022 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill. © 2022 McGraw-Hill Education. 8-2 The Stock Markets: Chapter Stock Market Securities: Overview Common Stock  Corporate stock serves as a source of financing for firms  Common stock is the fundamental ownership claim in a  Secondary stock markets are the most closely watched public or private corporation, and many characteristics and reported of all financial security markets differentiate it from other types of securities:  Stock market movements are sometimes seen as predictors of economic activity and performance.  Dividends  corporate stocks may be the most widely held of all  Residual claim financial securities.  Limited liability  Two types of corporate stock exist:  Voting rights 1. Common stock 2. Preferred stock  All public corporations issue common stock, but few issue preferred stock © 2022 McGraw-Hill Education. 8-3 © 2022 McGraw-Hill Education. 8-4  Common Stock: Dividends return equation  While common stockholders can potentially receive unlimited dividend payments if the firm is highly profitable, they have no special or guaranteed dividend rights.  The payment and size of dividends are determined by the board of directors of the issuing firm.  A corporation does not default if it misses a dividend payment to common stockholders. Common stockholders have no legal recourse if dividends are not received, even if a company is highly profitable and chooses to use these profits to reinvest in new projects and firm growth.  In fact, many firms pay no dividends but instead reinvest In the return equation, reinvesting earnings instead of paying dividends all of their net earnings in the firm. affects both capital gains and dividends. When earnings are reinvested, the dividend decreases. However, reinvesting earnings generally leads to a relatively larger increase in capital gains. © 2022 McGraw-Hill Education. 8-5 The return to a stockholder over a period A. corporation has after-tax earnings that would allow a $2  If a stockholder purchased a stock at the beginning of the year dividend per share to be paid to its stockholders. If these for $50 and sold it at the end of the year for $50, the dividends are paid, the firm will be unable to invest in new stockholder's ordinary income tax rate would be 30 percent, projects, and its stock price, currently $50 per share, and the capital gains tax rate would be 20 percent. In this probably will not change. case, the return to the stockholder is all in the form of ordinary The return to the firm’s stockholders in this case is: income (dividends). Thus, the after-tax rate of return to the stockholder would be 4% (1 – 0.30) = 2.8%. Common Stock: Residual Claim  Rather than pay dividends, the firm can use the earnings to invest in new projects that will  Common stockholders have the lowest priority claim on a increase the overall value of the firm such that the corporation’s assets. stock price will rise to $52 per share. The return to the firm’s stockholders in this case is:  In the event of bankruptcy, they have a residual claim. Only after all senior claims are paid (i.e., payments owed to creditors such as the firm’s employees, bondholders, the government (taxes), and preferred stockholders)  Investing in common stock is riskier than bonds due to the residual claim. The return to the stockholder is all in the form of capital gains, which are taxed at a rate of 20 percent. Thus, the after-tax rate of return to the stockholder is 4% (1 – 0.20) = 3.2%. © 2022 McGraw-Hill Education. 8-10 Common Stock: Limited Liability Common Stock: Voting Rights Limited liability means that stockholder losses are  While common stockholders do not exercise control over the limited to their original investment. firm’s daily activities, they do exercise control over the firm’s activities indirectly through the election of the board of directors. Common stockholders' wealth is not affected by the  Stockholders also vote on major changes in the firm (e.g., mergers corporation's bankruptcy. and dividend changes). o Some corporations are structured as dual-class firms, with two classes of common stock having different voting and dividend rights. Family-owned or controlled corporations often use dual- class firms to raise capital through the public market by issuing new shares. o To retain voting control over the firm, the family or group issues the dual classes of stock, keeping the high voting stock for themselves and selling the limited voting shares to the public. © 2022 McGraw-Hill Education. 8-11 8-12 Common Stock: Voting Rights Voting Rights : cumulative voting Shareholders have the privilege of voting to elect the board of directors at the company's annual meeting 1. All directors up for election are voted on at the same time.  Two commonly used methods for electing a board of 2. The number of votes assigned to each stockholder is calculated by multiplying the number of shares held by the number of directors. directors to be elected. o cumulative voting 3. A shareholder can assign all votes to one candidate or spread o straight voting them over multiple candidates for the board. Voting Rights : Straight voting Common Stock: Proxy Votes 1. the vote on the board of directors occurs one director at  Most shareholders do not attend annual meetings a time.  A proxy is a voting ballot sent by a corporation to its 2. the number of votes eligible for each director is the stockholders number of shares outstanding.  Stockholders can allow someone else to vote their shares by signing a proxy statement  When returned to the issuing firm, a proxy allows stockholders to vote by absentee ballot or authorizes representatives of the stockholders to vote on their behalf © 2022 McGraw-Hill Education. 8-15 © 2022 McGraw-Hill Education. 8-16  Preferred Stock  is a hybrid security with bonds and common stock characteristics.  Preferred stock is similar to common stock in that it represents  Suppose you own a preferred stock that promises an ownership interest in the issuing firm, but like a bond, it pays to pay an annual dividend of 5 percent of the par a fixed periodic (dividend) payment. (face) value of the stock (received in quarterly  Preferred stock is senior to common stock but junior to bonds. installments). If the par value of the stock is  preferred stockholders are paid only when profits have been $100, the preferred stockholder will receive: generated, and all debt holders have been paid (but before common stockholders are paid).  Like common stock, if the issuing firm does not have sufficient profits to pay the preferred stock dividends, preferred stockholders cannot force the firm into bankruptcy.  Corporations prefer preferred stock because missed dividends don't lead to bankruptcy like missed bond interest. Types of Preferred Stock Market Participants  Nonparticipating preferred stock: The dividend is not  Holders of corporate stock: affected by the firm’s profitability.  Households are the single largest holders  Participating preferred stock: The preferred  Mutual funds and foreign investors stockholders may receive a special dividend if corporate Households indirectly invest in corporate stock through investments profits are high enough in a given year. in mutual funds and pension funds  Cumulative preferred stock means that any missed dividend payments go into arrears and must be made up before any common stock dividends can be paid  noncumulative preferred stocks do not go into arrears and are never paid © 2022 McGraw-Hill Education. 8-19 © 2022 McGraw-Hill Education. 8-20 Primary Stock Markets Primary Stock Markets (Continued)  Primary stock markets Are markets in which corporations raise funds through new stock issues.  An initial public offering (IPO) is the first public  The new stock securities are sold to initial investors issue of a financial instrument by a firm (suppliers of funds) in exchange for funds (money) that the issuer (user of funds) needs.  A seasoned offering is the sale of additional  Most primary market transactions go through investment securities by a firm whose securities are currently banks. Which serves as the intermediary between the issuing publicly traded corporations (fund users) and ultimate investors (fund suppliers) in securities.  Preemptive rights before a seasoned offering of stock  A primary market sale may be a first-time issue by a private can be sold to outsiders, the new shares must first be firm going public. offered to existing shareholders to give them the ability to  These first-time issues are also referred to as initial public maintain their proportional ownership offerings (IPOs) 8-21 © 2022 McGraw-Hill Education. 8-22  Secondary Stock Markets: Primary Market Stock Transaction Stock Exchanges  Secondary stock markets are the markets in which stocks, once issued, are traded by investors  funds are exchanged, usually with the help of a securities broker or firm acting as an intermediary between the buyer and seller of the stock  Original issuer of the stock is not involved in this transfer of stocks or funds  Two major stock markets are the following: 1. New York Stock Exchange Euronext (NYSE Euronext) 2. National Association of Securities Dealers Automated Quotation (NASDAQ) system © 2022 McGraw-Hill Education. 8-23 © 2022 McGraw-Hill Education. 8-24 Secondary Stock Markets The NASDAQ and OTC Market  The New York Stock Exchange  Securities not sold on one of the organized exchanges  Worldwide, the NYSE is the most well-known of all the are traded over the counter (OTC) organized exchanges  OTC markets do not have a physical trading floor; rather, transactions are completed via an electronic market  First to create a truly global stock market  Tadawul  NASDAQ was the world’s first electronic stock market  Saudi Exchange market  Primarily a dealer market, where dealers are the market https://www.saudiexchange.sa/wps/portal/saudiexchange/rules- guidance/capital-market-overview/Equities?locale=ar makers who stand ready to buy or sell particular securities  Tadawul opens Sunday to Thursday 10 am to 3 pm © 2022 McGraw-Hill Education. 8-25 © 2022 McGraw-Hill Education. 8-26 Choice of Market Listing Stock Market Indexes  Firms listed with the NYSE must meet the listing  A stock market index is the composite value of a group of secondary requirements of the exchange market-traded stocks  Requirements are extensive  Movements in a stock market index provide investors with information on movements of a broader range of secondary market  Reasons a NYSE listing is attractive to a firm: securities.  Improved marketability of the firm’s stock  Publicity for the firm  Improved access to the financial markets  Firms that do not meet the requirements of the NYSE exchange listings trade on the NASDAQ  Most NASDAQ firms are smaller, of regional interest, or unable to meet the listing requirements of the organized exchanges  Over time, many NASDAQ firms apply for NYSE listing © 2022 McGraw-Hill Education. 8-27  Stock Market Indexes Stock Market Indexes Dow Jones Industrial Average (DJIA) NYSE Composite Index  The Dow Jones Industrial Average (the DJIA or the Dow) is the  Index to provide a comprehensive measure of the most widely reported stock market index. The Dow was first performance of the overall NYSE market. published in 1896 as an index of 12 industrial stocks.  The index consists of all common stocks listed on the NYSE.  In choosing companies to be included in the DJIA, the editors look  In addition to the composite index, NYSE stocks are for the largest companies with a history of successful growth and divided into four subgroups: industrial, transportation, with interest among stock investors. utility, and financial companies.  The indexed value of each group is also reported  The DJIA only includes 30 companies, so some critics say it daily. doesn't show how hundreds of other stock prices are moving. However, the 30 securities in the DJIA are chosen to represent the broad stock market. 8-29 © 2022 McGraw-Hill Education. 8-30 Stock Market Indexes Stock Market Indexes The Standard & Poor’s 500 Index  The NASDAQ Composite Index  Standard & Poor’s established the S&P 500 Index(a value-  NASDAQ Composite Index consists of stocks traded through weighted index) consisting of the stocks of the top 500 of the NASDAQ that are industrials, banks, and insurance largest U.S. corporations listed on the NYSE and the NASDAQ. companies  The NYSE stocks included in the S&P 500 Index account for  All stocks traded through the NASDAQ in these three over 80 percent of the total market value of all stocks listed on industries are included. the NYSE.  Thus, movements in the S&P 500 Index are highly correlated with those of theNYSE Composite Index © 2022 McGraw-Hill Education. 8-31 © 2022 McGraw-Hill Education. 8-32 Stock Market Indexes Economic Indicators  The Wilshire 5000 Index  Stock market indexes might be used to forecast future 1. Firm is headquartered in the U.S. economic activity 2. Stock is actively traded in a U.S.-based stock market 3. Stock has widely available price information (which rules  An increase (decrease) in stock market indexes today out the smaller OTC stocks from inclusion) potentially signals the market’s expectation of higher (lower) corporate dividends and profits and, in turn, higher  Since it includes every public firm, it is highly representative (lower) economic growth of the overall market However, because it is so diverse, determining which sectors or asset classes are moving the market is impossible  Stock prices are one of the 10 variables included in  the broadest stock market index and possibly the most the index of leading economic indicators used by the accurate reflection of the overall stock markets Federal Reserve as it formulates economic policy  Contains virtually every stock that meets three criteria: © 2022 McGraw-Hill Education. 8-33 © 2022 McGraw-Hill Education. 8-34  Market Efficiency Market Efficiency  The current market price of a stock equals the present value Three measures are commonly used to measure the degree of its expected future dividends. However, when an event of stock market efficiency: occurs that unexpectedly changes interest rates or a 1. Weak form market efficiency (past prices) characteristic of the company, the current market price of a  Current stock prices reflect all historic price and volume stock can temporarily diverge from its fair present value. information about a company (old news and trends don’t predict today’s or future stock prices)  When market traders determine that a stock is undervalued 2. Semi-strong Form Market Efficiency (public information) (i.e., the current price of the stock is less than its fair present  Current stock prices reflect all public information including past value), they will purchase the stock, thus driving its price up, information and vice versa 3. Strong form market efficiency (private and public  Market efficiency refers to the degree (and speed) with information) which stock prices reflect information about the firm and  Current stock prices fully reflect all information about the firm, both factors that affect firm value public and private All imply that there is no set of information that allows investors to make more than the fair (required) rate of return on a stock © 2022 McGraw-Hill Education. 8-35 © 2022 McGraw-Hill Education. 8-36 International Aspects of Stock Stock Market Regulations Markets  The main emphasis of SEC regulation is on full and fair disclosure of information on securities issues  The Capital Market Law in KSA  https://cma.org.sa/en/RulesRegulations/CMALaw/Pages/default.a spx © 2022 McGraw-Hill Education. 8-37 © 2022 McGraw-Hill Education. 8-38 International Aspects of Stock International Aspects of Stock Markets Markets  International stock markets are attractive to investors because some risk can be eliminated by holding stocks issued by corporations in foreign countries  International diversification can also introduce risk in the following manners:  Information about foreign stocks is less complete and timely than that for U.S. stocks  Foreign exchange risk  Political (sovereign risk) 8-39 © 2022 McGraw-Hill Education. 8-40  American Depository Receipts American Depository Receipts (ADRs) (ADRs)  An ADR is a certificate that represents ownership of a  Three main types of ADR issuances  Level 1 ADRs are the most common and most basic of the ADRs foreign stock  only traded on the over-the-counter (OTC) market and have the least  Typically created by a U.S. bank, which buys stock in foreign amount of regulatory requirements corporations in their domestic currencies and places them with a  The companies issuing these ADRs do not have to abide by U.S. custodian. The bank then issues dollar ADRs backed by the shares standards, nor do they have to issue annual reports. of the foreign stock  Companies with shares trading under a Level 1 program may decide  FIs purchase foreign stocks and then issue dollar-denominated to upgrade their program to a Level 2 or Level 3 program to gain better American Depository Receipts (ADRs) in the U.S. exposure in U.S. markets.  The ADR is a claim to foreign stock.  Level 2 ADRs can be listed on the major stock exchanges, but they have more regulatory requirements than Level 1 ADRs  Level 3 ADRs represent the most respected ADR level a foreign company can achieve in the U.S. markets  required to share any news that it distributes within its home country with U.S. investors. © 2022 McGraw-Hill Education. 8-41 © 2022 McGraw-Hill Education. 8-42 Learning Goals Chapter 6  Understand what foreign exchange markets and foreign exchange rates are. Foreign Exchange Markets  Understand the history of and current trends in foreign exchange markets.  Distinguish between a spot foreign exchange transaction and a forward foreign exchange transaction.  Calculate return and risk on foreign exchange transactions.  Describe the role of financial institutions in foreign exchange transactions.  Identify the factors that determine the supply and demand of the currency. Copyright © 2022 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill. © 2022 McGraw-Hill Education. 9-2 Overview of Foreign Exchange Overview of Foreign Exchange Markets Markets  When a country's currency depreciates, it means that the currency’s value falls compared to other currencies. This  When products, services, or assets are sold in a makes the country's goods cheaper for foreign buyers and foreign currency, the resulting cash flows are foreign goods more expensive for foreign sellers. processed in foreign exchange (FX) markets.  If the foreign currency declines (or depreciates) in value relative to the  There are two relevant prices involved in international U.S. dollar over the period between the time a foreign investment is trade. The price of the good or service purchased and the made and the time it is liquidated, the dollar value of the cash flows price of the currency received will fall.  A foreign exchange rate is the price at which one currency (e.g., the U.S. dollar) can be exchanged for  When a country's currency appreciation (rises) in value another currency (e.g., the Swiss franc) in the foreign relative to other currencies, it means that the country's goods exchange markets are more expensive for foreign buyers and foreign goods are  These transactions expose U.S. corporations and cheaper for foreign sellers. investors to foreign exchange risk as the cash flows  If the foreign currency rises (or appreciates) in value relative to the are converted into and out of U.S. dollars U.S. dollar, the dollar value of the cash flows received on the foreign investment increases. 9-3 9-4  Background and History of Background and History of Foreign Exchange Markets Foreign Exchange Markets  During most of the 1800s, FX markets operated under a gold system  The agreement resulted in the establishment of the International Monetary Fund (IMF) and the World Bank  Currencies were linked to gold  Countries cannot print money without having gold  In 1960s  The US has the majority of the world’s gold  The Vietnam War caused a deficit in the US which led to printing more money that was not backed by enough gold  1944, the Bretton Woods Agreement (End of World War II)  Unstable currency  The dollar was the main currency to exchange and was pegged to  Increase demand for gold gold  The dollar’s value was fixed at $35 per ounce of gold.  In 1973 (Nixon Shock)  The system was based on the willingness of foreign countries to hold  Devaluation of the dollar dollars and backed by the willingness of the U.S. to exchange dollars  End of the Bretton Woods Agreement for gold.  Freely floating exchange rates (Supply and demand) © 2022 McGraw-Hill Education. 9-6 The Introduction of the Euro The Introduction of the Euro  The euro has had a big impact in Europe and globally. In the early 2000s, the United States had an increasing national debt,  The euro is the name of the European Union’s single currency. high consumer spending, and a large current account deficit. During this time, the euro’s value rose by 35 percent against  It started trading on January 1, 1999, when exchange rates among the currencies of the original 12 participating countries were the U.S. dollar. fixed, although domestic currencies(e.g., the Italian lira and French  As a result, Russia’s Central Bank said it was considering franc) continued to circulate alongside the euro. replacing some U.S. dollars in its reserves with euros. Asian central banks hinted that they would soon do the same. The  However, the euro did not begin to replace domestic currencies in Chinese Central Bank had already substituted some of its dollars circulation until January 1, 2002 for euros.  After its launch, the value of the euro went down. This was partly  Due to these actions, the euro was the world’s second most because people were unsure if the European Central Bank could important currency for international transactions. In 2019, successfully manage a common currency for different 88% of all foreign exchange transactions were denominated in economies. dollars, while 32% were denominated in euros. 9-7 © 2022 McGraw-Hill Education. 9-8 Dollarization Dollarization  Dollarization Using a foreign currency alongside or  If another country plans to use the U.S. dollar as its official instead of the local currency. currency, the Fed recommends that they inform the Fed in Dollarization can occur when private agents prefer the advance about the additional notes they will need. foreign currency over the domestic currency.  Major advantage is the promotion of fiscal discipline and thus greater financial stability and lower inflation  After the gold standard and the Bretton Woods Agreement were  The biggest economies to have officially dollarized are Panama abandoned, many countries stabilized currency by pegging the local (since 1904), Ecuador (since 2000), The U.S. dollar, the euro, currency to a major convertible currency. the New Zealand dollar, the Swiss franc, the Indian rupee,  Other countries abandoned their local currency in favor of exclusive and the Australian dollar are the only currencies used by use of the U.S. dollar (or another major international currency, such other countries for official dollarization. as the euro)  and El Salvador (since 2001). © 2022 McGraw-Hill Education. 9-9 © 2022 McGraw-Hill Education. 9-10  Free-Floating Yuan Foreign Exchange Transactions On July 21, 2005, the Chinese government stopped pegging its currency, the yuan, to the U.S. dollar. They introduced a "managed"  Two types of FX rates and FX transactions: floating system based on a group of foreign currencies. This change 1. Spot FX transactions involve the immediate exchange of was in response to pressure from Western countries, which argued that currencies at the current (or spot) exchange rate ‫عر‬‫الس‬ China's currency system gave it an unfair advantage in global ‫الحالي النسويه بين البنوك تأخذ يومين‬ markets. 2. Forward FX transaction is the exchange of currencies at a specified exchange rate (or forward exchange rate) at  Due to the undervalued yuan, Chinese exports became cheaper. This some specified date in the future ‫ن‬‫ل م‬‫س اق‬‫تقبلي ب‬‫مس‬ had a negative impact on the manufacturing industry in other ‫سنه‬ countries, especially the United States.  Members of the U.S. Congress, concerned about the decline in American employment, warned of potential high tariffs on Chinese  Example is an agreement today (at time 0) to exchange dollars products unless China altered its foreign exchange strategy. for pounds at a given (forward) exchange rate in three months  Typically written for one-, three-, or six-month periods © 2022 McGraw-Hill Education. 9-11 © 2022 McGraw-Hill Education. 9-12 Measuring Risk and Return on FX Foreign Exchange Transactions Transactions  Of the $6.6 trillion in average daily trading volume in the FX  The risk involved with a spot FX transaction is that the markets in 2019, 30.1% involved spot transactions while value of the foreign currency may change relative to 69.9% involved forward and other transactions the U.S. dollar over a holding period  The main reason for this increase in the use of forward  When a company adds foreign currency assets and relative to spot foreign exchange transactions is the liabilities to its balance sheet, it takes on foreign increased ability to hedge foreign exchange risk with exchange risk. forward foreign exchange contracts  When issuing a foreign currency-denominated liability or  As a country’s exchange rate increases, its exports may buying a foreign-currency-denominated asset, FI will do become more expensive, and imports may be relatively so only if the expected return is positive. cheaper.  FIs, and particularly commercial banks, are the main participants in the FX markets 9-13 © 2022 McGraw-Hill Education. 9-14 Exchange Rate of the U.S. Dollar FX Risk: Example with Various Foreign Currencies © 2022 McGraw-Hill Education. 9-15 © 2022 McGraw-Hill Education. 9-16  FX Risk: Example (Continued) Hedging Foreign Exchange Risk  Managers hedge to manage their exposure to currency risks, not  To hedge, the U.S. firm could have entered into a forward: to eliminate it  If the U.S. firm had entered into a one-month forward contract  While it reduces possible losses, it also reduces possible gains selling the Swiss franc on March 13, 2020, at the same time it  The dollar value of foreign currency assets is at risk from falling purchase the spot francs, the U.S. firm would have been exchange rates and the dollar value of foreign currency liabilities is guaranteed an exchange rate of 1.0502 U.S. dollars per Swiss at risk from rising foreign currency values. franc on delivering the francs to the buyer in one month’s time  Net exposure is the value of exposed assets minus the value of  If the U.S. firm had sold francs one month forward at 1.0502 on exposed liabilities. March 13, 2020, it would have largely avoided the $43,800 loss  If it is positive, the firm has a net exposure to falling exchange rates.  By selling 3 million francs forward, it would have received 1.0502 x Sf 3 million = $3,150,600 at the end of the month, suggesting a  if negative the firm’s dollar value will be reduced by rising foreign currency values. small net loss of $3,150,600 - $3,156,300 = $5,700 on the combined spot and forward transactions © 2022 McGraw-Hill Education. 9-17 © 2022 McGraw-Hill Education. 9-18 Hedging Foreign Exchange Risk On-Balance-Sheet Hedging  FI can better control the scale of its FX net exposure in two major ways:  Matching its $100 million foreign asset position with $100 1. On-balance-sheet hedging involves making changes in the on- million of foreign liabilities balance-sheet assets and liabilities to protect the FI’s profits from FX risk 2. Off-balance-sheet hedging (Hedging with Forwards) involves no on-balance-sheet changes, but rather involves taking a position in forward or other derivative securities to hedge FX risk  By directly matching its foreign asset and liability book, FI can lock in a positive return or profit spread whichever direction exchange rates change over the investment period © 2022 McGraw-Hill Education. 9-19 © 2022 McGraw-Hill Education. 9-20 Off-balance-sheet hedging Off-balance-sheet hedging (Hedging with Forwards) (Hedging with Forwards)  FI might have chosen to remain with a currency mismatch on the balance sheet but it could hedge by taking a position in the  by selling the expected proceeds on the pound loan forward or other derivative markets for foreign currencies. forward at a known (forward FX) exchange rate today, the  Instead of waiting until the end of the year to transfer pounds FI removes the future spot exchange rate uncertainty and back into dollars at an unknown spot rate, the FI can enter into thus the uncertainty relating to investment returns on the a contract to sell forward its expected principal and interest British loan. earnings on the loan at today’s known forward exchange rate for dollars/pounds, with delivery of pound funds to the buyer of the forward contract taking place at the end of the year. © 2022 McGraw-Hill Education. 9-21 © 2022 McGraw-Hill Education. 9-22  Role of Financial Institutions in FX Factors that Determine the Supply Transactions and Demand of the Currency  Relative inflation rates:  The foreign exchange market is largely an interbank OTC  The country with the higher inflation rate will tend to see its currency market that operates 24 hours a day. devalue relative to other countries with lower inflation rates.  Banks are some of the world’s largest and most active  Relative real interest rates currency traders.  Countries with higher real rates will attract more capital and have higher currency values.  The majority of interbank exchange trading is now done electronically.  Relative economic growth rates  Countries with higher real growth rates will tend to attract more capital.  Demand for a country’s goods and services and financial assets.  The higher the demand, the greater a country’s currency is likely to be. © 2022 McGraw-Hill Education. 9-23 © 2022 McGraw-Hill Education. 9-24 Mutual Funds and Hedge Funds Chapter 7  Mutual funds and hedge funds are financial institutions that pool the financial resources of individuals and companies and invest those resources in (diversified) portfolios of assets Alternative (stocks and bonds). Investment  Single share of MF could represent ownership in over a thousand different companies Markets  MF provide opportunities for small investors to invest in a liquid and diversified portfolio of financial securities. Copyright © 2022 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill. © 2022 McGraw-Hill Education. 17-2 Mutual Fund Prospectuses and Types of Mutual Funds (MF) Objectives  The mutual fund industry usually has two sectors: short-term funds and long-term funds.  The return to MF investors can vary widely, depending on the objective of the fund, fees charged on the fund, and general  short-term funds: market conditions. money market mutual funds (MMMFs)  Regulations require that MF managers specify the investment.Funds that invest in a mix of money market securities objectives of their funds in a prospectus available to potential )T-Bills, CDs, and commercial paper( investors (includes a list of the securities that the fund holds)  In 1998, the Securities and Exchange Commission (SEC) adopted a new procedure in which key sections of all fund  long-term funds: prospectuses must be written in “plain English” instead of overly legal language Fixed-income hybrid Equity  Rules are intended to better enable investors to compare funds funds funds return-risk trade-offs from investing in different MFs Funds that invest in Funds debt Funds that invest in both stock and securities, such as preferred and.bond securities.bonds.common stock © 2022 McGraw-Hill Education. 17-12  Other Types of Investment Other Types of Mutual Funds Company Funds A fund for which the supply of shares is not fixed but Open-end mutual can increase or decrease daily with purchases and redemptions fund long-term mutual funds. In these funds, managers buy of shares. stocks to match a big stock index. Index Funds Specialized investment companies that have a fixed supply of Closed-end investment These funds need less work to manage, which helps.outstanding shares companies keep costs down and might bring in more money than A closed-end investment company that specializes in investing Real estate investment other kinds of funds..in mortgages, property, or real estate company shares trust (REIT) ETFs are traded on a stock exchange at prices that are determined by the market A fund that sells a fixed number of redeemable shares that are Unit investment redeemed on a set termination date trust (UIT) Investor Returns from Mutual Mutual Fund Costs Fund Ownership  Mutual funds charge shareholders a price or fee for the services they provide (i.e., management of a diversified portfolio of  An investor's return from investing in mutual fund (MF) shares comes financial securities) from three main parts of the underlying MF assets.  Two types of fees are incurred by investors: 1. Portfolio earns income and dividends on those assets 1. Sales loads 2. Capital gains occur when the MF sells an asset at prices higher than the original purchase price of the asset  Load fund has an up-front (one-time) sales or commission charge that the investor must pay 3. Selling additional mutual fund shares can increase the fund's  provide the investor with more personal attention and advice on fund value. The profits from these sales can grow the investment, selection benefiting all shares in the fund.  No-load fund does not charge up-front sales or commission charges on the sale of MF shares to investors 2. Fund operating expenses  Annual fees are charged to meet operating costs (e.g., administration and shareholder services) © 2022 McGraw-Hill Education. 17-11 © 2022 McGraw-Hill Education. 17-16 Growth of Mutual Fund Industry, 1940 - 2019  Households own the majority of both long- and short-term funds  Owned 50.5% of long-term mutual funds in 2016  Owned 36.6% of short-term mutual funds in 2016  As of 2019, 45.5% of all U.S. households owned mutual funds  Typical fund-owning household has $150,000 invested in four mutual funds 17-9 © 2022 McGraw-Hill Education. 17-4  Number of Mutual Funds, Selected Characteristics of 1980 through 2019 Household Owners of Mutual Funds © 2022 McGraw-Hill Education. 17-8 © 2022 McGraw-Hill Education. 17-10 Hedge Funds  Hedge funds (HFs) Are investment pools that invest funds for Hedge Funds (wealthy) individuals and other investors (e.g., commercial banks). Investment funds are similar to mutual funds because they pool money from investors and invest it together. Hedge funds are not subject to many of the rules  These funds do not have to follow the many rules that mutual that apply to mutual funds. This allows them to funds do, which protect individual investors. For example, there are no rules requiring them to maintain a certain level of cash or to allow use aggressive strategies that mutual funds shares to be redeemed at any time.  They also do not need to share details about their activities with cannot. outside parties, providing a high level of privacy for their investors. Hedge funds have avoided regulations by limiting the number of investors to less than 100 individuals 17-25 Types of Hedge Funds(More risky Hedge Funds (Continued) funds) Are the most aggressive and may produce profits in many types of  Hedge funds (HFs) with less than $100 million in assets do not market environments. register with the Securities and Exchange Commission. Because of Funds in this group are classified by objectives such as: this, we cannot track their actual data independently, as the information is self-reported. 1. Aggressive growth funds invest in stocks expected to grow earnings  Estimated that in 2019, there were over 9,400 hedge funds in the U.S., rapidly. These stocks often have high price-to-earnings ratios and low or no dividends. More risky funds with assets of $3.32 trillion 2. Emerging market funds invest in equity or debt securities from markets with higher inflation and volatile growth. 3. Macro funds seek to profit from global economic changes driven by government policy shifts that affect interest rates. They invest in equities, bonds, currencies, and commodities. 4. Market timing funds shift investments based on the manager’s outlook for the economy or market. 5. Short-selling funds sell stocks to buy them back later at a lower price. They do this when they believe the stocks are overpriced or if the companies will fall short of earnings expectations. © 2022 McGraw-Hill Education. 17-26 Types of Hedge Funds(Moderate risk funds) Types of Hedge Funds(Risk-avoidance ) Are more traditional funds, similar to mutual funds, with only a portion of the portfolio being hedged. Funds in this group are classified by objectives, such as: Are also more traditional funds, emphasizing consistent but moderate returns while avoiding risk. 1. Distressed securities funds buy equity, debt, or trade claims, at deep discounts, of companies in or facing bankruptcy or Funds in this group are classified by objectives such as: reorganization. 2. Funds of funds mix hedge funds and other pooled investment Moderate risk 1. Income funds invest with the primary focus on yield or current vehicles. funds income rather than solely on capital gains. 3. Opportunistic funds change their investment strategy as 2. Market neutral–arbitrage funds attempt to hedge market risk by opportunities arise to profit from events such as IPOs, sudden price taking offsetting positions, often in different securities of the same changes resulting from a disappointing earnings announcement, and issuer, for example, long convertible bonds and short the firm’s Risk-avoidance hostile takeover bids. equity. funds 4. Multistrategy funds take a diversified investment approach by 3. Market neutral–securities hedge funds invest equally in long and implementing various strategies simultaneously to realize short- and short equity portfolios in particular market sectors. long-term gains. 4. Value funds invest in securities perceived to be selling at deep 5. Special-situation funds invest in event-driven situations such as discounts relative to their intrinsic values. mergers, hostile takeovers, reorganizations, or leveraged buyouts. Highest-paid Hedge Fund Fees on Hedge Funds Managers, 2019  Hedge fund managers generally charge two types of fees: management fees and performance fees. 1. Management fees: as with mutual funds, management fees are computed as a percentage of the total assets under management (usually between 1.5% and 2.0%) 2. Performance fees are unique to hedge funds. Performance fees give the fund manager a share of any positive returns on a hedge fund. © 2022 McGraw-Hill Education. 17-28 © 2022 McGraw-Hill Education. 17-29