Financial System PDF

The Financial System Pre-Recorded Lecture, 1hr Workshop & 1hr Tutorial Assessments; - 30% Quiz on Topics 1-4 March 27 - 20% Group Assignment - Form groups 24 April and Submit May 5 - 50% Final Exam - 2hr Exam - Multiple choice and short answer Module 1 Introduction to Financial Systems What is a Fin...

The Financial System Pre-Recorded Lecture, 1hr Workshop & 1hr Tutorial Assessments; - 30% Quiz on Topics 1-4 March 27 - 20% Group Assignment - Form groups 24 April and Submit May 5 - 50% Final Exam - 2hr Exam - Multiple choice and short answer Module 1 Introduction to Financial Systems What is a Financial System? A financial system consists a complex network that comprises financial institutions, markets and instruments that together, provide financial services for the economy. Developed financial systems perform five financial functions. These systems facilitate the flow of money and credit between lenders, borrowers, investors and savers. Every country has financial system and every country needs to perform all five systems. The Structure of a Financial System The main components of a financial system include: Financial Institutions - The organisations that provide the financial services, often referred to as intermediaries) between lenders and borrowers through financial instruments, - These organisations help to match the borrowers with the appropriate type of funding and connecting them with investors. - The main types of financial institutions are; - Deposit-taking institutions, that make loans - Investment banks, that assist their large company clients access funds from the financial markets - Fund managers that manage investor’s funds. Financial Markets that arrange trading in securities, foreign exchange and derivative contracts. - Place where buyers and sellers come together. - Provide platform for businesses and individuals to access capital and to raise funds for investment expansion - Financial markets raise funds with help of financial instructions through financial securities to fund capital budgeting projects. Regulators that oversee the institutions and markets. - Regulated by gov and other regulatory bodies to ensure they operate fairly, to ensure transparency and safety in market. - Important to prevent fraud, protect investors, maintain stability in financial system. The 5 Functions of the Financial System Settlement Flow-of-Funds Risk-Transfer Promoting Efficiency Stability 1. The Settlement Function The provision and processing of payment instruments for the settlement of commercial transactions - A commercial transaction is an agreement between a buyer and seller to exchange an item or service for payment. A settlement occurs when a buyer exchanges money for a purchased item - Money includes cash or payment instruction. Banks predominantly participate in settlement function - Afterpay e.g. provide infrastructure and services necessary for secure (encrypted) transfer of funds between parties. Includes managing and clearing of settlement process By providing secure and reliable payment instruments, financial instructions help to reduce risk of fraud and provide a means for buyers and sellers to transact a settlement with confidence. Money performs three tasks as a medium of exchange, a store of value, a unit of account. 2. The Flow of Funds Function The financial system arranges the supply of funds and allocates them among users depending on the returns they pay and the risk they pose to suppliers. Funds are supplied by surplus units mostly as bank deposits and superannuation contributions. - They require compensation for forgoing the immediate use of the funds and for the risk the funds will not be compensated as agreed. The deficit units that require funds include households (money for housing loans), businesses and the government. Between those that have a surplus amount of money (e.g. people with money to invest) and a deficit amount of money (people want you to invest money with them) The financial system globalises and facilitates the flow of funds by bringing together savers and borrowers. The more efficient the financial markets are, the better the financial system is at facilitating this flow of money between surplus and deficit units. The financial systems helps allocate capital and does so by allocating capital to where it’s most productively used and does this by channeling funds to businesses and projects that are most likely to generate a return on investment. Borrowers need a potential, attractive return for them to provide money to deficit units. Funds should be channeled to their most beneficial use. Funds are supplied either: 1.Directly - Deficit units raise funds directly from surplus units through the issue of securities in the mkt - Securities are contracts issued by deficit units to raise funds. They specify their promised payments and can be traded in mkt. - E.g. buying shares directly from market. - Disintermediation. No intermediary. Often has no security 2.Indirectly - Where funds are supplied as deposits to financial institutions, which in turn, supply funds as loans to deficit units. - Where share purchasers deals with intermediary company. DIRECT FINANCING Arranged by financial markets (you) surplus company (needs funds) 3 Units (bank) > Deficit units 1 Arranged by deposit-taking Institutions INDIRECT FINANCING - Called intermediation when there is an intermediary. - Often involves security to ensure the lender gets their money back/is protected. Security is known as collateral. Only direct if they are ADIs or accepting deposit from the public. In Aus, indirect financing makes up the largest component of the flow of funds, with the majority of these funds being used to purchase residential property. Direct financing also contributes to wealth creation through the ownership of financial assets, the success of these investments is reflected through share price indices. If we combine direct and indirect financing, the two biggest components will be the property we own and the superannuation. 3. The Risk-Transfer Function Investors, businesses and financial institutions need ways to manage risk that arise in the financial system. Risk-transfer contracts (derivatives) are provided by financial institutions and markets Markets can be used for individuals and companies who want to transfer risk they have. Do this through financial market through a collective of derivative instruments. Main risks; - Default Risk; chance that financial obligations will not be met such as loan payment defaults. Resulting in risk for lender by borrower. - Market Risk; Possibility of loss arising from unexpected changes in market variables or conditions (int rate, exchange rate, share price) Effects all financial instruments; shares, bonds, commodities, derivatives. Market risk is inherent on fluctuations on financial markets. - Can be caused by economics, politics, etc. Risk Transfer: An Example (INSERT) - Most companies are more concerned about hedging price increasing than missing price decreases. - Example 2: Insurance, paying for insurance but not having to use it. Save cost for if crash were to occur as forgoing expenses alone would supersede this cost but lose on the fact no crash occurred and expenses did not need to be made. Risk Transfer Graph Risk Hedge PROFIT (derivative Contract) · price goes up risk exposure loss. If price yoes down profit made made If , , , · $0 LOSS Price of jet fuel Purrent Us Risk Exposure price $0 894 P/L. Risk heage cancels risk exposure 4. Promoting the Efficiency of the Financial Systems Three determinants of financial systems efficiency are; 1.Decision making that is mutually beneficial to the parties involved, and which is not impeded by: - Information asymmetry: - Arises when one party to a potential contract has an information advantage over the other party. - E.g. potential borrower knows more about their capacity to repay then the lender does. - Can lead to not mutually beneficial financial agreements at expense of the uninformed party, or to agreements not being made because of reluctance of the uninformed party to enter contract with informed party. - Can cause uninformed party to lose trust, not complete settlement. - One party knowing more info can lead to unethical behaviour. - Can occur between lenders and borrowers, investors and companies or buyers and sellers of financial assets - E.g. don’t disclose to bank that you have trouble repaying but want to get a loan or business doesn’t disclose full financial statements but individual wants to invest in company that they think is well performing. - More informed party may do this for the purpose of forgoing increased cost of perceived risk. - More efficient the market is = lower cost of borrowing - professional : lesschance into ↳ o e e Deis g Usingoff -.. - Incentive problems - Financial contracting is influenced by the incentives faced by the parties involved - Problematic if incentives motivate unethical behaviour; - E.g. - Remuneration arrangements - reward ST profits without considering LT consequence - Financial advisor receive commission from suppliers of investment products and directs clients to products which pay the advisor the highest commission. - Incentives offered to participants in financial system are problematic if encourage unethical behaviour - Individual faces moral hazard by acting on their own incentive rather than other party who they owe duty of care - E.g. of moral hazard; if no insurance, overprotecting house from burglary but with insurance, person behaves recklessly with not protection as they can say they will always have fallback of insurance. This is inefficient because it means they’re taking on risk - In context of financial system, moral hazard is crucial. Lenders and borrowers can have expectation that they’ll be bailed out if their investments fail. Borrowers take on more debt because they expect to be saved. Can be mitigated by regulatory oversight. Regulators may impose penalties or restrictions on financial instructions that engage in this risk behaviour. - System needs to ensure incentives are overcome or removed - One approach is where institutions have fiduciary duty to their customers - Another is practice of professional bodies that require members to adhere to code of ethics. - (all parties, surplus units, deficit units, investors, banks, institutions, insurance companies, all parties in financial systems should have access to accurate information and the incentives should align to ensure fair and efficient decision making.) 2.The pooling of funds from individual suppliers. - important to achieving economies of scale - Pooling is where we go from surplus to deficit units - Efficient for people to pool money together at same time and buy shares together. Bank play crucial role in pooling funds and allocating them to different borrowers or investments. 3. The emergence of new and reliable financial instruments, services and operating systems. - Important to have continuing renewal and reliable instrument services to increase efficiency and competitiveness of financial system - Cheque; inefficient, easy for fraud where as electronic payment, mobile payment, efficiency and security is higher. - New technology increases everyone’s access to financial services and decrease cost of services and provides new investment opportunities for organisations. Pooling of Funds Usually deficit units are seeking large amounts that will take a long period to repay where as surplus units normally want to supply small amounts for short periods So surplus ad deficit units have incompatible wants This can be overcome by the pooling of funds such as - A bank that accepts many small deposits and makes fewer larger value loans - A deficit units who issues many securities to many investors to raise a very large amount of funds. 5. The Financial System Stability Unstable financial systems experience crisis which disrupts flow of funds and activity in the economy, resulting in greater unemployment and loss of wealth Central banks assist with system stability by being ‘lender of last resort’ to solvent but illiquid banks There are international supervision guidelines, which aim to establish internationally consistent supervision arrangements and that are implemented by APRA The RBA (Reserve Bank of Aus) has responsibility for promoting stability in Australia’s financial system. Ensuring financial stability = ensuring there is no crisis in the financial system Stability keeps interest rates in check, inflation, money supply, growth of economy in check. Australia’s Financial Institutions Banks and funds managers (superannuation funds e.g.) dominant in terms of their assets. Basically in terms of who has the most money, funds in Australia. 1. Banks (authorised deposit taking institutions) - Banks are financial institutions authorised by ARPA to undertake banking businesses in.e accept deposits, loans, provide financial services - They include; - Four major banks (ANZ, CBA, NAB and Westpac) that provide services such as; - Credit unions and building societies that mainly serve households and - Investment banking services to large businesses 2. Shadow Banks - Non bank financial institutions that compete with big four - Merchant Banks; provide financing services to wholesale customers (businesses, particularly in areas of corporate finance e.g. if businesses borrow money for corporate financing) their role has largely been taken over by banks. E.g. JP Morgan - Finance Companies; mainly provide lease financing for motor vehicles and business equipment - Mortgage Originators; are lenders who fund loans from the proceeds of mortgage-backed their activities were curtailed by GFC. 3. Fund Managers - Fnud managers provide investment management services for their clients in return for fees - Super funds are long-term investment schemes for the purpose of generating income in retirement - Public unit trusts are voluntary investment vehicles that sell ‘units’ in their trust and then invest their funds. - Insurance companies manage funds as [art of their operations and some of their policies have an investment purpose. Australia’s Financial Markets Following 3 markets arrange direct financing Money Market; Trades short term debt securities that pay a single amount at maturity and are known as ’discount securities’. - E.g. certificates of deposit, treasury bills, commercial paper, repurchase agreements - Low risk, low return, amongst the most liquid assets available - Important for overall finance system for business and governments - Plays key role in management of monetary policy by RBA and RBA uses various tools in money market to influence interest rate and availability of credit rate in the economy. (RBA moves up or down its interest rates and does so in ST money market which impacts on broader economy) Bond Market; Trade long term debt securities that make regular interest payments and then repay their face value - Where companies and governments get money form - Issue and trade debt securities in form of bonds Share Market; Arrange trading in shares, which are perpetual equity securities that commonly pay dividends Foreign Exchange Market (FX); Enables transactions to be made in different currencies because it arranges trading in foreign currencies Derivative Contracts; (Such as futures and options) trade contracts that can be used to manage forms of financial risk and for speculation. The Financial Regulators APRA; Australian Prudential Regulation Authority - Prudential regulator of ADIs, insurance companies and superannuation fund trustees. - Seek to ensure an institutions is able to meet it’s obligations to it’s customers - Sets the rules RBA; Reserve Bank of Australia - Australia’s central bank (gov does not have influence on RBA) and has 6 main functions 1 Implementing monetary policy; RBA influences ST interest rates to contribute to it’s stability objective for inflation, unemployment and economic wellbeing 2 Issuing bank notes and coins 3 Acting as banker to the Commonwealth Government 4 Monitoring stability of the financial system; RBA work with other regulators and global agencies to avoid financial crisis, and monitors data to help identify threats to stability. 5 Regulating the payment system; through its Payments System Board, RBA is responsible for ensuring the payments system is safe and efficient. 6 Managing Australia’s reserves of foreign exchange ASIC; Australian Securities and Investments Commission - Enforces company and financial service laws to protect customers, investors and creditors (ASIC regulates conduct) - Enforcer of the rules - Investigators of fraud These bodies together with The Treasury (representing the government) form the Council of Financial Regulators The Treasury is where the government uses the treasury to buy and sell its money market and bond market instruments. - Not a regulator but as the government’s main economic department, it influences the framework for regulation Fundamental Concepts Forms of Finance; - Funds can be supplied as debt or equity form surplus to deficit. Companies usually deficit - Debt; - Borrowed funds = Credit - Commits borrower to make agreed interest and loan repayments - Provided indirectly by financial institutions and directly in security markets - Failure to repay loan = liquidation - Bank would be creditor to company - Amortising = principal and interest. - Equity - Eqiupty capital = funds invested in firm by owners - Raise equity through ordinary shares - source of permanent capital as funds are not repayable - Owners of ordinary shares can vote on board of directors and can receive dividends - Perpetuity, never expires Leverage - Use of debt by a firm is a form of leverage. Amount of leverage indicated by debt to equity ratio - Higher DtoE = greater leverage - Leverage can increase return on equity as debt is cheaper than equity - Leverage increases risk as increased debt - increase likelihood of insolvency (ability to pay debts when they fall due) & variability of returns. Company can stop paying dividends to prevent inso - Impact on investor risk and return: - increase risk and return to owners because of their cost represented by the interest payments - Leverage will make returns in good times better and returns in bad worse (increased variability) Minimal profit = average ROE, Good profit = Increased ROE, Break Even = Bad ROE ROE-DRF Return - Returns earned from supplying funds; - Periodic, int, cash payments (bank deposits, loans, bonds, money market instruments) - Periodic PMT of dividends - Change in value of financial assets (Cap gains and losses) - Returns usually expressed as yields - annual rate of growth ri(t 1)A - r : 194561 1735 = 5 5. %. - e Liquidity - Efficiency or ease with which an asset or security can be converted into ready cash without affecting its market price. - Indirect Financing; Bank deposit accounts offer suppliers of funds liquidity, but often little or no interest - Direct Financing; Provides liquidity when secondary markets enable the transaction of securities. - Why is liquidity valued? What happens to returns? - Indicates fair market value access suppliers of funds have to their money. Indicates the level of access lenders have to their money once it is invested. - Bank deposit accounts - Suppliers of funds place high value on liquidity and are willing to accept little to no interest as the cost of that liquidity. - Investments that lack liquidity - less attractive and riskier. Investors require higher compensation in form of increased expected returns in order to consider supplying funds. - Liquidity in shares shows by bid and offer range buyers want $44.45 and offers want $44.480. Someone is willing to bid for $44.45. This is called the spread and in this case, the spread is narrow by 3c. Shows this is high liquidity. Smaller spread encourages trades of securities and this promotes liquidation. Risk - Investment returns are exposed to risk - possibility that actual returns will be less than expected. - Suppliers of funds are risk-averse and so require higher returns to be induced into accepting risk - r = r(risk free) + r(risk premium) - 10 year treasuries are 10 year treasury bonds - Credit spread is difference in yields between Triple A bonds and US treasury bonds. This shows relative to 10 year treasury bonds, Triple AAA corporates are fairly narrow. - Trimble B rated debt, credit worthiness declines, risk premium increases. Credit spread would be higher. Credit spread gives idea of risk premium for different rated securities and is used as a measure of returns required on different securities. - How can risk and risk premiums be measured? Market values may indicate relative riskiness, risk assessments by rating agencies, credit spreads meaning the margin between the market yield for risky bonds and those of safe bonds. Time Value of Money - PV DMT - PMT)' = : 200000(0 pi =Po. 0 F +. 725 (2 16 ↓ = V(1 1) -M + 013) )0 + 200000 (1 : e I = $20 E Learning From History Stability and Financial Regulation - 1st half 20th century - financial regulations introduced to reduce crises - 1980s - Deregulation (loosening of regulations) to increase efficiency of financial services - lowered cost, improve convenience - Global Financial Crisis triggered reevaluation of need for regulations Mortgage-Backed Securities (MBS) - MBS are financial instruments created by pooling together large numbers of individual mortgage loans into single security - Then sold to investors, who receive portion of cash flows generated by underlying mortgages - Value of MBS is derived from value of underlying loans, and is directly tied to performance of underlying mortgages. Global Financial Crises (GFC) - GFC arose from subprime loan crisis in US 2007 - Banks pooled and assigned MBS but underestimated risk - Loans are subprime when they are made to borrowers with questionable repayment capacity like no loan deposit, falsified applications, low/irregular income, poor credit history. - They were assisted by rating agencies that inflated their ratings of MBS in order to increase their own fee income. - Assumptions: Defaulting loans would not produce losses because they were secured mortgages & property prices never decrease. - Subprime financed building boom and sales of reposed properties caused fall in property prices. - US Gov took measures to bail out their financial institutions to protect economy. - Crisis became global because of sharp contraction in flow of funds internationally. Example of asymmetric info - Mortgage brokers don’t explain loans and fact that repayments would increase substantiality to loan applicants. - Wall Street banks continued to market securities at low risk even after default rates rose in order to get them off their records - MBS/ Collateralised Debt Obligation (CDO) investors were unaware that underlying mortgages were high risk/subprime, they thought they were low risk. Example of Incentive Problems - Mortgage brokers fail to assess and verify borrowers repayment capacity. Big bonuses offered on adjustable loans - Wall Street banks willingness to buy any loans regardless of risk because of the intention of reselling them - Rating agencies “selling ratings for fees”, applying MBS ratings the banks want knowing that they would lose business otherwise - Investment advisors were meant to represent investors but were paid by someone to sell their securities. The Royal Commission - Royal Commission into misconduct in the banking, superannuation and financial services industry was established in Dec 2017 to investigate malpractice in Aus financial institutions. - Revealed a culture that fails to deal with moral hazard and information asymmetry and that has eroded public’s trust Tutorial Bigger companies can go direct to financial markets because the buyers of these bonds, will be well received by the market. Can measure trustworthiness through risk. But Apple have lower risk which means less chance a bond will default. Greater confidence that these coupon payments will be repaid Need to know measure of credit rating to guarantee security of investment repayments. Strong credit rating companies can go directly to the financial markets. Can forgo intermediaries as they can get strong pricing in financial markets. As credit rating decreases, need to go to ADIs or NBFI to raise capital. Credit Spread; Related to bonds market and risk associated with bonds. Yield = return - The spread is the gap is the difference of comparison of percentages or basis points between the different yield of economic bond markets. - The greater the spread of yield, the greater the risk. The faster the spread widens, the faster the momentum is of risk. - The yield can be shifted up as investors their bonds if the rate is becoming too high. As more are sold, the rate increases. The yield is shifted down when more people buy bonds in a specific economic market. Basis point is 0.01 percent, 100 basis points = 1% Module 2 Direct Financing Introduction - What is Direct Financing Direct financing raises funds for deficit units through the issuing of securities to investors in the financial markets. Deficit units provides means for bringing deficit and surplus units together Deficit units engage firms that assist them to issue securities. These are the investment banks (securities firms) who charge fees for their services Surplus units mostly supply funds to fund managers who invest the pooled funds and who also charge fees. (A) What are the roles of the main financial institutions that arrange the flow of funds (B) What are the preference mismatches they reconcile? Deficit Units; - Role; Engage investment banks or securities firms that assist them in the issue of securities - Preference; Deficit units typically prefer large amounts, for long and inflexible periods, are prepared to take risk and would like to pay as little as possible for funds. Surplus Units; - Role; Mostly supply funds to fund managers who invest in pooled funds - Preference; Surplus units typically prefer to supply small amounts, for short and/or flexible periods, are risk averse and would like high returns. The Role of Financial Institutions in Direct Financing · with indirect ↳ surplus & deficit Unit don't KNOW who each other are ↳ goes to bank other Direct e y.. , financing Institutions buying shares in Danks but stillwouldgther or fund When Qantas I manager listed time shares for first they would work with to ens aInvestmentbob ↓ bank to would 96 throug Is still It but buy shares direct- Mismatches Encountered in the Flow of Funds Whether the flow of funds is direct or indirect differences exist in preference of surplus and deficit units Why have primary and secondary market, why not always go direct? - Due to mismatch in surplus and deficit units (Amount of money, duration of borrow, risk tolerance, return on investment, deficit has certain preference and so does surplus. These preferences do not align with one another. Financial markets are to resolve this. What are the Main Costs Involved for Surplus and Deficit Units with Direct Financing? Deficit units; required to pay returns (interest) to surplus, who own their securities for the use of their funds. They will also pay fees on the investment bank they choose to assist them when they issue securities. The banks will take a commission for brokering the Initial Public Offerings. Surplus units; Typically supply funds through managers who charge fees for their investment management services. Means returns earned by investors are return achieved less fund manager fees and/or commissions. Therefore, returns paid by deficit units are greater than the returns earned by surplus to overcome surplus investment bank and fund manager fees, this difference represents the cost or spread of direct financing. Cash Flow Summary - Surplus Units; Provide money to deficit in exchange for interest or dividend and pay money to fund managers - Fund Managers; Take commission on what investment the surplus have - Investment Banks; Take commission for brokering IPO - Deficit Units; Take on money from surplus and pay Investment banks for IPO. What is Crowdfunding? New e.g. of direct financing - equity crowdfunding Companies pitch ideas to large numbers of potential investors Raise equity directly through online platform (online usually) New alternative to traditional sources e.g. banks Cut out IPO, fund manager, investment bank Good way to invest small amounts of money in exchange for equity Less expensive and time consuming than traditional fundraising methods Primary Markets What is the Primary Market? Usually where we issue shares 1st time. Still same market as secondary 1st - Dircet financing involves; 1. arrangements of the issuing of securities - this is their primary market 2 The subsequent trading of issues securities in the secondary market - The issuing of securities is subject to ASIC regulations, particularly when they are issued to retail investors - Most markets are wholesale only and are self-regulated by the Australian Financial Markets Association (AFMA) - If Qantas were to sell shares for the first time, they issue shares on the ASX but you cannot buy during that time, you cant buy directly form ASX, you buy from investment banker and money goes directly to Qantas. Once the shares are listed on the stock exchange, you would then purchase the shares through a broker through the ASX. Arrange the Issue of Securities - Aus Government securities are issued through a competitive tender - Biggest participator in primary market is Aus gov. Can’t buy shares in government but can by gov bonds and gov treasury bills through a tender offer while shares are usually issued through investment bank. - If i want to issue shares on market, this is done through a prospectus through an investment bank - Shares are mainly issued in Aus under contracts known as best efforts, with an investment bank arranging the issue. - They prepare a prospectus and market the issue - Earn fees, normally in the form of commission - They do not guarantee all the securities will be sold - this requires an additional standby underwriting contract. Rating Agencies - Ratings agencies are firms paid to provide expert opinion about level of credit risk for a security or financial institution - The 3 rating agencies are Standard & Poor’s (S&P), Moody’s & Fitch Ratings - Lowest risk securities are given the highest rating, ratings are reviewed and changed if required - Their role is overcome info asymmetry - Debt securities usually have to be rated before issue, and the rating influences the demand for the security. - Help judges quality of the investment Settlement and Clearing - When shares are bought for first time, they and the buyer details are recorded on the security registry - They can be maintained by the market’s clearinghouse or by a separate organisation - Securities and security registers, are electronic Secondary Markets - Market where individuals and fund managers can buy shares from other investors. - Trade, sell, buy more shares - ASX Australian Securities Exchange - What are secondary markets? - Where I would buy or sell securities from another investor - Trade requires buyer and seller to agree on; security being traded e.g. Qantas, the quantity e.g. amount of shares being purchased, the price; $ - Trading is easier and faster for standardised securities; meaning security has no optional features, either the company pays dividends or doesn’t. - Primary Market; Investor A > IPO (Investment Bank) > Qantas - Secondary Market; Investor A > ASX (Broker - Intermediary) > Investor B - Components of Secondary Markets 1 Trading Platform; The facility where trading occurs 2 Trading Rules and Protocols; Such as who can trade and how trades are expressed 3 Clearing and Settlement producedures which organise the exchange of the securities for payment. - Went form open outcry to computer based trading - Two types of secondary markets; a) Securities Exchanges > Order Driven > Brokers - Order driven; Buyer orders broker to us something e.g. shares. Broken will then post this on ASX and investor B would see order and decide to trade with Investor A. Can do this on Broker app now. ASX is Oder driven b) OTC (Over the Counter - Market predominantly for bonds and money markets, pretty much all direct financing market. No orders, instead Investor A would go directly to individual dealer and be given a quote) > Quote Driven > Dealers - Dealer has the inventory but broker gives the quote. - Dealers are financing institutions that trade securities on their own behalf as well as the individuals who are employed to do the trading. - Trading Arrangements - Secondary markets are either; 1) Orgainsed by securities exchange; where trades are arranged through brokers on behalf of clients 2) Conducted on an OTC basis with trading between dealers 1. Exchange Organised Markets - Exchanges were developed by share brokers to organise their trading - Brokers do not buy form or sell to their clients, they are agent through whom the clients can access the market. - Brokers may provide online systems to allow their clients to place orders - They earn a commission on completed trades - They must ensure clients can pay for the securities they purchase, and that they own the securities they sell. - Order Driven Markets - Trading is on the bases of orders from traders, so they are referred to as order driven markets - An order specifies; - A buying or sell in intention - The security - The quantity - The price - Th price can either be; - A limit price; specifies the max buying price, or min selling price which specifies minimum selling price OR - An at market price; which is the best available price - When brokers do not cancel limit orders (that have not yet resulted in a trade), they remain stored in the market’s central order book, and are observable and provide other traders with trading opportunities. - An important factor of exchange organised market is their transparency - Electornic trading systems records every trade & can be monitored by investors and market regulators. - Automated Trading Systems - These are dumpster based trading platforms for displaying and matching orders - ATSs have replaced an open-outcry because they are cheaper and keep record of transaction. - Brokers (or their clients through systems provided by brokers) enter orders online - the markets are location-less - The difference between the buyer share price and selling share price is known as the spread. 2. Over-The-Counter Markets - Dealers act as principals meaning they buy and sell on their own behalf. They own their own securities where as brokers only transact the deal. - They trade with each other and wholesale clients - Mostly through automated trading systems - They hold an inventory of securities (this is known as their position) and so are exposed to price risk - Retail Clients; Individual investors like households and individual. That buy and sell securities. Generally deal in ASX markets - Wholesale Clients; Institutional clients like banks and companies including governments, councils. Generally deal in OTC money and bond markets due to inflated price. - Quote Driven Markets - In OTC, investor will buy individual investment directly from dealer. Would go to dealer and ask for quote over the counter - Traditionally, OTC markets have been quote driven because dealers provide the bid and offer quotes (two-way quotes) - Dealers are known as market makers because they quite bids and offers and must be prepared to trade when their quotes are accepted. Making market by quoting a price - This also provides counterparties with transaction immediacy - Dealer Trading - Dealers earn a trading spread when traders sell to and buy from them, on a round-trip transaction - They aim to buy low and sell high - They would like to see a wide spread, but they must compete with other dealers - Dealers also initiate trades with others dealers in order to manage their position - Their desired position will have regard to its risk, the requirements of clients and to expected future price movements. $5 difference takesbest highest buyprice > $2aference is the i trading spread i Marketspe - Given above, there is a 2 Point Market Spread and between a 4 and 5 Point individual dealer spread. - Market Rules and Conventions - For OTC markets, rules are set by AFMA and include; - Trading hours - Pricing Practices - Trading Protocols - Transaction Sizes - The ASX also has rules regarding trading hours, the securities it trades - Market Information - Traders have a huge appetite for information relevant to security values - companies such as Bloomberg and Reuters supply information both real time and video data bases. - Listed companies are required by the ASX to provide price sensitive information in a timely fashion. - How Secondary Markets Assist Primary Markets - Two ways secondary assist primary; 1 To provide investors with liquidity and thus transform the maturity of funds in the market 2 To perform the price discovery process through which the market judges the value of the traded securities. - - Liquidity and Maturity Transformation - Investors have a preference for liquidity and are more likely to buy securities that can be subsequently sold in a liquid secondary market. - Liquidity is determined by; 1 Daily turnover/turnover ratio; (higher ratio=higher liquidity) 2 Bid-Ask Spread; Liquidity = narrow spread 3 Price Resilience; Liquidity varies inversely with the impact - Non liquid shares; 5 buyers, 5 sellers, 1000 shares total, $2 spread. - Price Discovery and It’s Uses - Markets generate prices (including market indices), interest rates and exchange rates that may be regarded as fair when they are a result of trading by informed traders. - Fair prices are performed by efficient and liquid markets - This information; - Allows investors to monitor the value of their investments - Informs potential issuers of securities of their expected proceeds. - Short Selling - Go to broker and borrow Qantas shares sell them at current market price - If correct and share price drops, investor goes and buys stock back and give stock back to person they borrow them to. - Lender will charge interest for borrowing shares. TUTORIAL NOTES How do Markets Become Informationally Efficient? - Efficient Market Hypothesis - EMH states that security markets efficiently use information to generate fair prices that move randomly. - Markets are info efficient when all info relevant to a security;s value is reflected in price. - Efficient Market Hypothesis distinguishes 3 different forms of informational efficiency; 1) Weak Form Efficiency; When prices embed previous price. Implies that in this market, studying previous prices and patterns will not identify opportunities for abnormally profitable trades. 2) Semi-Strong Form Efficiency; When prices reflect all publicly available info. Implies studying public info (newspapers, analyst reports, accounting statements) and patterns will not identify abnormally profitable trades. 3) Strong-Form Efficiency; When prices reflect all existing price-sensitive info. When this occurs, abnormally profitable trades cannot be made with insider information. - According to EMH security prices; - They resent fair value (when both sides benefit) - Adjust quickly in response to price sensitive info. - They change randomly since flow of new price sensitive info is random - Are best forecast by today’s market price. - Public company bound to continuous disclosure and thus must disclose new financial information - Share price will eventually flatten out when info is no longer new. 2) Fair Value Prices - Asset’s fair value is price that does not systematically advantage either the buyer or seller of the asset - The value of most financial assets depends on their uncertain future payments and so fair value is difficult to determine - Prices are based on available information. 3) Random Walk - Movement overtime in security’s price where an increase is equally likely to be followed by a fall as by a further increase. - Movements in share prices, interest rates and exchange rates generally display a random walk. - At any point in time prices have all available info. As we don’t know if next news will be good or bad, we cant tell if prices will go up or down and this is called a random walk - EMH plains random price movements by the random arrival of new information that alerts fair value 4) Forecasting and Excess Returns - According to EMH, all relevant info has been encorporated in security prices including anticipated movements, so price movements should be random in response to new info. - EMH implies traders should not be able to achieve excess returns over a sustained period. > Excess return is where returns are greater than what could be achieved by trading at fair prices. - Higher returns generated through market research. Funds would need to buy newsfeeds, hire financial economists but all for a cost. On average, higher return only compensates you for the costs of being informed. Can Investors Achieve Excess Returns - Prices established by efficient markets should be fair meaning individual traders should not be able to consistently earn excess returns through investment selections and timing decisions. - There evidence of anomalies - abnormal or excess returns not explained by the efficient market hypothesis, suggest markets are not always efficient. - As far as we know, anomalies are not enduring, and so their identification will not consistently deliver excess returns. 5) Some Evidence of Price Behaviour - Some studies identify anomalies e.g. the firm size effect (investing in smaller stocks will earn consistently higher returns and higher will not earn as consistent, higher returns) and the January effect (if you buy stock in January you generally get higher return) - Anomalies offer opportunities to earn excess returns but are eliminated by the trading that seeks to exploit them. A) Price Bubbles - With the benefit of hindsight, it is apparent that financial markets sometimes generate prices that are too high or low - Price bubbles are periods where prices exceed fair values and are followed by a sharp correction - Such as dot-com boom evidenced in the NASDAQ - Bubbles demonstrate that trader’s sentiment such as ‘irrational exuberance’ distorts their expectations - Bubbles are where market prices exceed intrinsic values E.g. Tulip mania (prices went up by 200 pounds, people came to realisation and the price dropped) Cryptocurrencies & NFTs - Bubble occurs when prices no longer reflect fundamental factors - Irrationality of the dollar auction; When the market rallies it is difficult to jump out of the bubble. B) Bull and Bear Markets - A bull market refers to long periods of generally rising prices and a bear market refers to periods where prices are generally falling - These generally reflect conditions in the economy, such as the business cycle. - During bull markets, the increase in share prices is not fully explained by the growth in corporate profits (and vice versa in bear market) - In an efficient market we shouldn’t see this. At start of bull market or end of bear, we should invest 6) Behavioural Finance - Anchoring; Tendency for individuals to rely too heavy on one piece of info when making decisions - Confirmation Bias; Seeking out info that confirms an existing belief and ignoring info that doesn’t - Overconfidence; Individual’s subjective confidence in their judgements in greater than the objective accuracy of those judgements. - Self-Attribution; Taking credit for positive outcomes but blaming external circumstances for negative ones. What is the Contribution of Behavioural Finance to an Understanding of Market Prices? - Behavioural Finance; The area of research that attempts to understand and explain how reasoning errors influenced investor decisions and market prices. - Understands how researchers don’t act rationally - Behavioural finance recognises investor behaviour is not always based on rational expectations and may be resultative of behavioural bias. - Could result in market prices not being traded at fair value - E.g. of behavioural finance Volatility and Market Risk - When you invest youre subject to risk and we measure this through volatility. - Volatility degree of movement in a variable and indicates market risk. - Low volatility - relatively smooth line - High Volatility - Greater spike in graph - Volatility represented through frequency distribution which records size and direction of price movements over long periods. Module 3 Authorised Deposit-Taking Institutions Part A. Introduction to Intermediation E.g. banks and play a big role in financial system. What is Intermediation? Intermediation or indirect financing is where financial institutions (mostly banks) acquire funds from surplus units, mainly as deposits and make loans to deficit units. ADIs are the only instructions authorised to undertake banking business We refer to all ADIs as banks, including credit unions and building societies ADIs facilitate the flow of funds between surplus and deficit units rather than directly through an exchange Benefits of Intermediation Banks manage mismatch of preferences between surplus and deficit They transform; - Many small deposit balances into fewer larger loans - Short term deposits into long-term loans - Deficit unit risk into risk that is acceptable by depositors - Returns that are acceptable by surplus to borrowing costs acceptable by deficit Banks face challenge of balancing demand for depositing to demand of loans Banks manage balance sheets by adjusting interest rates offering a range of deposits and loan products and managing liquidity and funding risk Banks earn a spread between interest rate they charge borrowers and rate they pay depositors Bank Balance Sheet Banks face a maturity mismatch between their assets (mostly long term loans) and liabilities (mostly short term deposits or securities) Maturity Mismatch Maturity Mismatch; Loans may have long time period whereas deposits at have a short time period. E.g. mortgages (loans) vs deposits (short term deposits and individual would make through a banking app which can be withdrawn quickly) - Banks need to match maturity dates of assets and liabilities as best they can - They need to ensure sufficient funds are available to meet short term obligations like deposit withdrawals, whilst also earning enough incomes from larger assets to cover costs Maturity mismatch poses two risks; - A liquidity risk of not having sufficient funds to withdraw - A funding risk of not being able to rollover maturing sources of funds. - As bank hold long term assets but have mainly short term deposits, they are vulnerable to a change in market conditions such as interest rates, which can effect their ability to obtain funding - E.g: loan money for 5%, pay 3% on deposits, have guaranteed income of 2% - If interest rates increase 6%, these deposits have to keep track of int rate - As loan rates are fixed, banks are paying a higher int rate on deposits and are receiving low interest. Rates on loan made. - This means banks are left with funding shortfall. Net Interest Income Bank earns net interest income: The interest received on bank assets minus the interest paid on bank liabilities - Can be expressed as a margin (or spread). The difference between the average interest rate earned and the average interest rate paid by banks on their funds. - Margin of the major banks has declined over period 1999 to 2022] - Bank fees (such as accounting servicing fees) also form part of the cost of intermediation. Net income represent the net revenue a bank makes on it’s interest earning activities, after deducting the interest paid on it’s funding services. Net Interest Income helps evaluate the profitability of a bank, and can indicate that a bank is effectively managing their funding and income sources. - Investors are looking for strong or weak net interest income. - If strong banks are effective at managing, - If weak they aren’t managing well and suggests challenges of liquidity, credit risk and interest rate risk. Primary driver of bank earnings Deposits in bank are used to finance the mortgages. - Banks pay interest on deposits and earn interest on loans. Interest income can be affected by interest rate changes, changes in credit quality of borrowers and shift in demand for loans and deposits. From 2000 to 2022, domestic banks’ major banks’ net interest margin, have decreased since 2000 mainly due to; 1 Low interest rates over last 20 years - Interest rates have increased in last year. Worldwide too due to global financial crisis in 1980 - As interest rates were low, this led to lower yields on loans and investments for banks whilst rates paid on deposits and other funding sources have remained relatively stable. - Low interest rate environment will have a low interest rate margin too 2 Competition - Banking industry has become increasingly competitive with new entrants - Big 4, fintech companies, online banks that have challenge traditional banks for market share - Put pressure on banks to lower int. Rates to attract and keep new and current customers 3 Regulatory Changes in Response to GFC - In response to GFC, regulators have implemented stricter capital and liquidity requirements for banks - Regulators require banks have to keep certain amount of capital in reserve incase investors or depositors would want money back. - Banks have thus shifted their funding sources to more expensive, less flexible forms of funding such as long term debt and equity 4 Changing Customer Preferences - Customers increasingly demanded more convenient and accessible banking services like global banking and digital payments - Banks have had to invest in technology and infrastructure to meet demands - Has put pressure in NIM Australia’s Banking System APRA (Australian Prudential Regulatory Authority) places ADIs into one of five subgroups; 1 Australian Owned ADIs; - Big Four who are financial conglomerates; Commonwealth, WBC, NAB, ANZ - Others including MQB 2 Foreign Subsidiary Banks; - Provide retail banking services - Oversees but have subsidiary in Australia - APRA allows you to do retail banking (individual households and clients) if you have a Subsidiary - E.g. ING, HSBC, Rabobank 3 Branches of Foreign Banks; - Provide investment banking services for business clients (importer/exporter that facilitates foreign transactions) - E.g. BNP, Paribas, Deutsche Bank 4 Restricted ADIs; - Operating under Limited Services like probation period - Banks or newly listed banks that operate and would eventually become possibly complete Australian owned ADIs. - E.g. Avenue Bank 5 Provides of Purchased Payment Facilities; - Facilitate payments - Not a strict bank, don’t borrow money or invest - e.g. PayPal APRA oversees and regulates finance banks and other financial institutions in Australia APRA promotes safety and soundness of financial system by setting prudential standards- setting standards the ensure financial instructions comply with them. Part B. The Sources of Bank Funding (Equity & Liabilities) Bank Balance Sheet Sources of Funding (Liabilities and Equity) owed money. Where they get their money from sources of funding - Retail deposits - Financial Markets - ST Debt - NCDs - LT Debt - Bonds - Securitisation - Equity In Aus Currently, most banks get only from domestic deposits, households, companies that keep money at bank as deposit. Then ST Debt, LT Debt, Equity, Securitisation and Term Funding Facilities. - Prior to GFC, major source of bank funding was the financing markets (ST Debt + LT Debt = financial markets) - Now fallen to around 28% as of mid 2022 The crisis in these markets caused banks to change their funding sources and domestic retail deposits are now seen as more reliable source of funding - Now around 60% as of mid 2022 - Banks paid higher interest rates to attract more deposits. E.g. banks have higher savings rates for savers, depositors to attract Banks rely more now on retail deposits Banks pay higher interest rates to attract more deposits Retail Deposits All bank accounts are; 1 Very safe; Risk taking by banks is constrained by APRA prudential supervision. Deposits up to $250K are insured by government. Increases stability and attractiveness - Banks play major role in stability of financial systems. Match deposits with surplus and deficit units and this is the governments guarantee that this system will be sustained long term. 2 Liquid; All deposits can be withdrawn by depositor 3 Pay Interest; and/or provide non cash benefits such as payment services. Fixed term and some savings accounts serve an investment purpose - 25% of SMSFs assets are bank deposits Defensive investments, meaning low interest and return and capital stability Attitudes to deposits changed as a result of heavy losses during GFC and by intro in 2008 of Aus Gov guarantee of deposits up to $250K Financial Markets Debt markets both domestic and overseas, are divided into short term and long term securities. Banks borrow from financial markets to; - Diversify their funding sources beyond deposits - Extend maturity of liabilities - Raise additional funds that can be lent out Funding decisions will be influenced by relative cost of funds, reliability of funding sources and regulatory requirements. Major banks tend not to borrow a lot of equity Major banks have ability to borrow offshore as they have higher credit rating than smaller domestic banks - Seen as too big to fail - Raise large amounts and so achieve economics of scale in relation to their issuing of costs This gives them a funding advantage over smaller competitors Short Term Debt ST Debt securities are usually unsecured promises by issuer to pay face value on maturity - No Interest payment, int embedded into face value. - Lender pays less to borrower and borrower pays more to include interest, risk at the end. - FV - PV = Interest Main ST Security issues by banks domestically is negotiable certificates of deposits (NCDs) such as treasury bills. Main offshore source is commercial paper, mostly in US dollars Banks rely less on ST markets since GFC to reduce their funding risk Negotiable Certificate of Deposit - A wholesale deposit ($5 mill or more) that has a fixed term with an agreed interest rate that can be traded in the money market. - It is effectively a promissory note where bank promises to repay the deposit with interest on the maturity date - NCDs cannot be withdrawn before maturity, but can be traded in the money market to provide the depositor with liquidity (can trade for cash) - Negotiable as they can be bought or sold in secondary market before they mature. - Higher interst rates than traditional savings rates with maturity from days to years with majority under a year. - Bought by institutional investors such as company and financial institutions - Not often traded by individual households. Long Term Debt Bond is a long term security where borrower makes regular interest repayments to their holder and pay face value upon maturity Banks issue domestic and offshore bonds Usually large amounts with terms of four to six years Most are unsecured though banks also issue smaller amounts of covered, hybrid and asset-backed bonds. Securitisation Residential Mortgage Backed Securities (RMBS or MBS) Issued through securitisation which is the process of assigning cash flows form illiquid assets (holding loans) to securities (MBS) that are sold to investors. Banks pol together their assets in forms of the mortgages they have and sell it through mortgage backed securities. Enables ADI to sell large bundle of their existing housing loans Securitisation is conducted by special purpose vehicles (SPVs) who issue mortgage backed securities. The loans become property of investors in the MBS - They receive most of the borrower’s repayments. Equity Equity comprises proceeds from he issue of shares and retained earnings, it is considered a permanent source of funds, given it doesn’t repay Shareholders require higher returns than debt holders given they face greater risk - Major banks ROE around 12-15% Equity strengthens a bank’s financial positions, protects debt holders including depositors and as such, APRA enforces minimum capital requirements. Part C: The Use of Funds Uses of Funds (assets) - Securities - Housing Loans - Other Loans; Household Loans & Business Loans Securities APRA requires 20% of bank assets to be held as cash and liquid securities - Include money market securities, government bonds, notes and coins, ES funds and loans to the overnight market. - Reason; store of liquidity (to help manage outflows), to trade in markets, to earn income on low risk/return investments. Housing Loans As of June 2022, - Loans to owner occupiers were 65% of housing loans - Most have a reducible structure (meaning loan is repaid over term) - Can have a range of optional features such as redraw facilities and mortgage offset accounts - Remaining 34% are investment loans (to help investor purchase property for rent) - Interest only loan has continued to fall overall (13.9% in 2021) however, represents 19% of new loans. Interest Only Loan; borrower’s repayments interest only and do not reduce principal - Borrower may intend to rollover loan at maturity or repay it by selling the property Return to the Investor; The net rental income (after all costs, including interest) and maybe capital gains or losses, form the change in the property’s value. When property’s net rental income is negative, the loss can be offset against other income in a practice known as negative gearing Negative Gearing; investor buys property and rents the property to receive rental income. If rental income is less than interest on loan and other expenses such as maintenance and management fees exceeds the rental income, then there would be a negative net rental income, less than cost of property - Investor can claim loss against taxable income which can reduce overall tax liability. - Controversial as wealthier society now get tax advantage. - Investor is making ST loss but relying on overall LT cost. Prudent Lending Standards (APRA) Other countries have poor lending practices and we don’t have this as APRA has prudent lending standards APRA guidelines to ensure banks maintain responsible lending practices National Consumer Credit Protection Act (NCCPA) APRA has authority to oversee and regulate lenders to ensure they’re acting in best interest of customers and financial system APRAs lending standards require lenders (banks) and banks have to assess Borrower’s ability to repay loan. This assessment is based on 1. Income 2. Expenses and 3.Other Financial Commitments Banks must verify income and expenses and including verifying payslips Ensures repayment capacity Can;t rely on theory of value increasing due to GFC Bank looks as borrowers ability to repay loan such as expenses; credit, school expenses Stress testing to assess ability to meet loan repayment in event of changes in financial situation e.g. job loss These standards are set to ensure loans are suitable for borrowers Housing Loans (Continued) Most widely used indicator of ousting interest rates is a lender’s standard variable rate (SVR) - SVR; is a type of interest rate charged on mortgages that fluctuates over time based on changes in the banks; base rate or market conditions - Most borrowers receive discounts which mean they pay less than the SVR e.g. SVR + 2% or SVR - 1% - Anything between 5-8% in Aus Important indication of lending quality is proportion of non-performing loans (Where borrowers are 90days or more behind on payments) - These have been low for decades ( 11 274 86-18088. , $1 , 274 86. Effective Interest Rate on Retail Deposits Y in reffective -) > - 0 06183 or. - periods - = ~ 1/2 C7 (nom-rate -rateloper , pl (A) , period) , , e 6 18%. NCDs Bank of China (Aus) Limited; Subsidiary of Bank of China. Does this in order to accept deposits - Can only accept deposits in Australia if there is an Australian subsidiary of the overseas company. - Bank of China Limited may only be conducting wholesale or banking business in Australia. - Bank of China Aus accepts retail deposits Term deposit investment is fixed NCD is a deposit for a fixed term but is negotiable meaning you can sell it in a secondary market. NCD = Simple interest Part C: The Use of Funds What are the 3 Main Purposes of Banks’ Holding of Securities? As a store of liquidity (to assist in managing the maturity mismatch between deposits and loans) As an inventory of securities to trade (in their role as dealers) As low-risk interest earning investments What is the Difference in Approaches of Banks When Lending to Small as Opposed to Large Business? When lending to small businesses, banks offer loans that are standardised in terms of the loan and application process and usually seek to secure the loan with a mortgage over the borrower’s property. Loans to large businesses, are arranged on a case by case basis, with an interest rate partially determined by the risk of the loan. The lender will generally seek security, though this may be in the form of a covenant or a negative pledge. Part A - Introduction to Intermediation 1. Intermediation 2. Benefits of Intermediation 3. Bank balance intro to assets and liabilities and identification of maturity mismatch 4. Net interest income - How banks make their money - Smaller spread = bank is better capable of managing their finances - Decrease in NII earned from GFC - Regulation of amount of cash kept on hand/liquid - Decrease in interest rates to remain competitive - Lower interest rates due to GFC - Changing customer preferences cause banks to invest in new infrastructure like more online services 5. Australian Banking Services/Types 1-5 Part B - Sources of Bank Funding 1. Bank Balance Sheet - Equities & Liabilities; - Retail Deposits - Financial markets - ST Debt - LT Debt - Securitisation - Illiquid assets sold to investors as mortgage backed loans. - Equity Part C - The Use of Funds 1. Bank Balance Sheet - Assets - Securities - Housing Loans - Other Loans; - Household Loans - Business Loans - Secure - Unsecured Calculations Calculation of Interest on Retail Deposits Compound interest basis; - FV = PV(1+r/n)^t/n -$10 PV r HN 0 = 06/365. 2(365) : FV 000 , 6% - (1 738 = %) = 10000 - $11, 274 86. 73. Int earned 11 = 274 86-10000. , $1 - 274 86. , Effective Interest Rate on Retail Deposits Annual or nominal rate is the amount quoted by the bank however as this compounds throughout the year, the effective rate is higher. - Reffective = ( F/P )^ (1/t) - 1 reffective -[(** )" -1) Using previous example FX = PV- t 86. 10000 2 = : 11 , 274 reflective 1486 : 0 86183 Or ~. PV ↑ = t - FV 1000 = 0 : -. 05/365 3(365) 1096 10. 1000 (1" b) $1 161 82 = , reflective :. (*) "t -I 16183) -. ~ 6 8512). : 5 13 %. 6 18 %. Negotiable Certificates of Deposit - NCDs Money market transactions use Simple interest - FV = PV(1+(r x days/days in year)) PV ↑ $10 , 000 000 : , 0 844 = F x. $10 - * , / 1 10 + x 9 5)) 188 493 15 ,. this to surplus as pays bank maturity. x60365 0 845 =. P) 10188493 150 =. (0 045 It. $10 ~ , x Hs) 034 267 87 ,. earned interest of : They have 1+ 10034267 87 -16008006 =. $34 267 07 - , p 844 10 , 188 , 493 15 = r F. When an NCD is sold, its price (P) is calculated as - PV = FV / (1 + (r x days/day in year )) F : 98/365 10000000 =. $1 , 000 , 000 : 0 = PV BUY : Pey-. 06 F (48/365) 1800000 (1 + 0 06 +. 000000 , interest earned $985 = 933) $990 - s : 485 , 421 77. = $4 817 15. , - , DV)) (r = + 421 17. , 233 32. 990133. 32 + try)) Housing Loans In a reducible loan, the loan payments, which form an annuity are calculated as; PMT (coupon) regular & loan amount ↑ PV * 6 :. n(t) R PMT 1) / 600000 = r = = 063/12 25(12) = 308 = 10 00003/12) e. $1 988 29 -. , * = ↓ : $575 008 0 866/12 ,. n(t) R 25(12) = = 300 , 0000 360) $3 918 : = ,. 45 1 basis Mint - What If RBA raises ratel 6 6% ~ new rate 575000.. R : I' , r + 8 15 %. It = 280 000 = 0 One month before ,. n(t) 072/12 25(12) = ; 0000-300) n A = $2 , 01: e 77 t BUTafter6 Years,6(2) = A = 2014. ↑ Perod 2 -(2) 85/' : * & 25 basis Points ; 100-300 = A. by.. 249 , 956 85. 4 = A maturity 204185) tig : pass meaning there are 228 remaining a Module 4 - Fixed Income RBA are a central bank. They oversee monetary policy and regulate banks and ensure financial stability. Money Market Identify and Explain the Contributions of the Money Market to the Financial System Part A. The Role of the Money Market The money market is the market for Short Term Debt Securities. Money market is the smallest of the markets we consider, but important due to it;s relationship with the banking system, with the RBA and as the market where Short Term Interest Rate Benchmarks are determined Biggest participants in the money market is the RBA. - RBA participates due to this being one of the ways they can control monetary policy.. - Through this they can manage the Australian dollar and our credit system It is not a retail market, meaning it does not serve household, but is mainly used by banks, the RBA and fund managers APRA regulates and supervises the financial markets and institutions financing moneymarketiation financing -Through direct Indirect - - The Role of the Money Market 1 Contribution to the Flow of Funds; Arranges direct financing through the issue of short term debt securities and is a low risk asset class for investors. - The money market enables direct financing in wholesale amounts through the issue of low risk, ST, tradable debt securities. 1 The largest issuers are the banks, who issue negotiable certificates of deposits (NCDs) 2 Banks also help companies borrow from the market through their acceptance of bills (Bank Accepted Bills - BABs) - Banks don’t issue these, they endorse the companies who issue them. Banks endorsing increases credit worthiness 3 State and Commonwealth governments also use the market. Aus Government issues short term securities called Treasury Notes. - Government issue these to help manage their short term cash flow needs specifically to fund government expenditure in the short term. - We have three different short term money market instruments as they are unique in that thy are issued by three different Instructions. - As these ST term instruments are expire over 30, 60, 90 day time periods, they are then rolled over and so financing can be provided for longer periods of time. Wouldn’t need to issue a new one, this is important for institutions that finance themselves - Fund managers have investment portfolios on behalf of clients and they invest in the ST term instruments in the money market to access Short Term gains and to add liquidity t the portfolio in addition to shares and long term bonds as these are illiquid. - The GFC highlighted how the financial markets have a need for risk assessment and regulation due to market stability and this is done through the money market. 2 Contributions to the Banking System; Provides the banking systems with a source of wholesale funds and a low risk market for their liquid reserves. - The money market holds the banking system’s liquid reserves including loans to the inter-bank overnight market and securities that can be used in repos with the RBA. Enables banks to meet their reserve requirements. Reserves can be fulfilled by participating in the money market - Banks use repurpose agreements where they sell securities to mainly RBA with an agreement to repurchase them later to provide ST funding. - The money market is a source of funds for banks. They raise funds through the issue of NCDs and it enables banks to sell the bills they accept to investors. 3 Benchmark Rates; Performs price discovery by identifying short term benchmark rates - A benchmark rate is important as in the financial market, its important for us to have a single rate to which we can anchor other rates from - A base rate is taken and this is used as an anchor any rates from - Money market assigned this anchor rate through The Bank Bill Swap rate (BBSW) which is a key financial rate over the short term. - BBSW is relatively new in Aus as a benchmark and is trustworthy and more accurate. We used to have LIBOR (London Inter Bank Offered Rate) but there was too much manipulation by dealers causing 9b$ worth of fines. LIBOR revealed vulnerability in global financial markets and highlighted the need for Aus to have top quality oversight and regulatory such as ASIC. They ensure we have fair practice in financial markets. - BBSW is the rate at which BABs and NCDs are transacted in the market. They are calculated for 1-6 month tenor - BBSW is administered by ASC Benchmarks LTD - BBSW is designed to measure the price at which Prime Bank eligible securities trade in the open market between 8:30 and 10am on a Sydney business day. Top NCDs would trade at these rates. 4 Relationship with the RBA; Enables the RBA to implement monetary policy and so influence the economy. - The money market is the main channel through which the RBA’s monetary policy is transmitted Part B. Money Market Securities - Less than 1 year, single FV PMT at end. Different between PV and FV is INT. Involves Short Term securities with maturity term less than a year and make a single face value payment at maturity They are issued at a discount to their face value - Investors earn a return by purchasing them and later reselling for a higher price, or by holding them until they mature and receiving their face value. Money market securities have low credit risk even though they are mostly unsecured. Issued by institutions that are very credit worthy, trustworthy e.g. government and banks 1) Bank Securities a) NCDs - Issued predominantly by financial institutions; mostly banks. - By banks issuing NCDs, it helps diversify their funding sources meaning they dont rely just on deposits - APRA participate and monitor the NCDs to ensure the safety and stability of the financial institutions along with the banks that issue the NCDs. - Funds deposited for fixed time - Tradeable certificate issued stating amount to be repaid on maturity date. Info - NCDs represent over 80% of money market securities. Weight demonstrates importance of facilitating ST financing and managing liquidity - Wholesale buyers of NCDs are then enabled to sell or trade the NCDs in 2nd market to enhance liquidity - They become a source of bank funds b) Bank Accepted Bills (BABs) - A legal commitment by a third party to stand behind a borrower’s obligation to pay the bill’s face value at the specified future date - Alternative source of funds for borrowers to a bank loan - Bank guarantee the bills (issued by commercial borrowers and accepted by banks) will be redeemed at maturity. - Not a source of bank funds. - BAB issues by company but company has lack of credibility and instrument is not as liquid as an NCD, therefore bank guarantees the BAB will be paid when it matures. As the bank guarantees this, this then becomes lower risk and more liquid meaning it can then be traded in the money market. - Serve as way for borrowers to access ST funds with benefit of endorsement from established bank for a commission - If payment cant be honoured, bank will step in and accept it - Attractive for borrowers looking for ST term financing, looking for lower cost loans - Reduces credit risk for investors of BABs and new credit risk depends on credit standing of accepting bank - Borrowers pay acceptance fee normally as an add no yield Info - Like loans, BAB process exposes bank’s to borrower’s credit risk but differs as accept can sell bills to investors in the money market so that the borrower’s funds are supplied by investors. - Bill acceptance numbers and BABs sold has fallen since GFC - BAB trades as an unsecured instrument but acceptor usually requires security for the borrower. Bill Facilities - Borrowers use bills to raise funds for longer periods than the bill term by using a bill facility; An agreement by acceptor to rollover bills on maturity date for an agreed period. - New bills are issued to raise funds to repay the maturing bills - Int PMTs are required at each rollover date, equal to FV less proceeds from replacement bill or FV of previous bill. - Useful for cash flow - People rollover instead of borrowing for the total period as borrowers may not know the total amount of money they’ll need for 270 days and can therefore only estimate for 90. 2) Treasury Notes - ST Securities issued by the Treasury on behalf of Cmwlth Gov - Help Gov meet ST finance needs - Issued through competitive tender where bids invited form money market dealers - Lowest bidders are successful given bids are expressed as yields - T-Notes are considered risk free and so trade below the Bank Bill Swap Rate. - Risk free as its highly unlikely that Aus gov will fail on debt obligations Procedure - As a registered market participant like a financial institution, they would go online submit a bid and whichever bid that pays the highest yield will be successful. 3) Other Non-Gov Issues Securities a) Commercial Paper; Raise ST funds for working capital, to finance debtors/inventory - Promissory notes issued by low risk, non financial companies - Trade at yields around or above BBSW, depending on issuer risk - Bank acceptance Bills are guaranteed by bank but commercial paper is not - Higher yield and can effect credit worthiness of issuing company b) Asset Backed Commercial Paper - Promissory notes issued by SPVs and secured by specified assets, mainly residential mortgages. - Issued by company - Can buy it form financial institution and if the company defaults, there will be a security linked to it 4) Repurchase Agreements - Repos are an arrangement to sell securities on the basis that they are repurchased at a later date at a higher agreed price - Provides short term finance for seller (the security issuer) from the buyer (cash provider) - Periods vary from intra-day, 1/2/3 day, to a number of months - MST repos use Commonwealth Gov bonds - They are used extensively by RBA but also by fund managers and bond dealers. - RBA involvement enables them to infer short term interest rates and manage stability in financial system. - Contract where deficit/seller/securities provider will sell asset like government bonds as collateral to surplus/buyer/cash provider, with the intention of buying it back from them the following day or over a short time period. The seller will repay buyer the funds for the bonds returned plus the interest for holding them. - Repo rate is interest paid - Ability for banks to use gov bonds as collateral in repos enhances market liquidity and supports efficient trading in these securities. - Diversity in participants use of repos identifies importance of having financial stability and liquidity - E.g. April 2027 Aus Treasury bonds used as the repo collateral to borrow 1 mil for 5 days -> Cost of funds or int rate is 2.25% Money Market - Retail Investments (ETFs) Where individual retail deposits are pooled so that they can take part in investing in higher return money market instruments like; - AAA - Australian High interest cash - BILL - iShares Core Cash ETF - ISEC - ishares Enhanced Cash ETF They offer advantages go like liquidity, diversification, ease of trading Describe the Money Market’s Trading and Settlement Arrangements Part C. Trading and Settlement Arrangements An OTC market is where money market instruments trade in OTC is where dealers trade on their own behalf in making a market for wholesale clients - The main dealers are the majors, foreign-owned banks, specialist investment and merchant banks - They trade from their own dealing rooms mostly by phone OTC markets provide flexibility, but provide risk including counter party risk form transacting with someone else. Trading protocols specified by AFMA Dealers hold an inventory of securities (and so can provide immediacy) and earn interest and trading income. Dealer s quote their bid and offer yields as a simple interest yield. - Usually spread is only a few basis points - Yields and prices are inversely related, they bid high and offer low - The yield is then used to calculate the settlement price, helps know efficiency of market - Buy at a higher yield = low price, sell at a lower yield - higher price Austraclear is the market’s clearinghouse and arranges settlement on a same day (T + 0) basis. They ensure we have smooth functioning of financial markets by management settlement clearing and transitioning Calculate and Analyse the Returns from Investments in Short Term Securities Part D. Investment Yields Main component of investment returns is the interest earned - this is implicit, since security prices trend up over time to their FV - If securities are held to maturity, interest is only return; Therefore, they earn the yield at which securities were purchased. Fixed income - income received in form of interest If security was held for full maturity, investor receives interest earned along with final face value of instrument. Becomes predictable stream of income for investors. Fin Maths Yield to Maturity (YTM); Analysing Holding Period Investment Yields - When securities are sold before maturity, the return to investors will conclude interest but may also include capital gains or losses. - Risk of capital loss is price risk - Capital gains and losses rise form changes in the market yield - If a security is sold at a lower yield (than purchased), a capital gain is achieved and vice versa - Sold at lower yield than purchased = Capital gain. OR Sold at higher yield than purchased = Capital Loss - Actual yield achieved is holding period yield and is usually different from the YTM at commencement Price Risk in Holding Period Yields - Price risk arises from random movements in int rates, it’s impact is reflect in security’s tick value - Tick Value is the change in price caused by a one basis point change in yield - it is the smallest change that can arise in the market value or a security. - Observe; Tick values and price risk ate greater for longer term securities * price risk can be avoided by holding security until maturity - Yield of 5% changing to 5.01% will cause a price decrease Explain the Influence of Monetary Policy on Shot Term Interest Rates Part E. Short-Term Interest rates and Monetary Policy Monetary Policy The main objective of monetary policy is low inflation with a target range of 2%-3% on average, over the medium term - Other objectives are low unemployment and stable economic growth - The RBA’s tool is the target cash rate; which it reviews at it’s monthly meeting and adjusts; - Upwards if inflationary pressures exceed it’s target - Downwards when the economy could grow faster without posing an inflation problem - Aus gov and RBA work together in mission to achieve economic and monetary policy objectives that benefit Australia 3 Objectives of Monetary Policy and the Principal Objective The RBA aims in the implementation of monetary policy are; - Low inflation, low unemployment, level of economic growth that is consistent with low finlation Its principal objective is low inflation, specifically to maintain an inflation rate of between 2-3% on average over the medium term. Relationship with the RBA Monetary policy exerts considerable influence on the economy through a complex transmission process. - First Phase; - Cash rate setting impacts Interest rates generally - Second Phase; - Interest rates generally impacts Economic activity and inflation setting Implementing Monetary-Policy Decisions RBA announces at 2:30pm on the 1st Tuesday of every month, except January, the board’s decision on the cash rate. If the cash rate is changed, the next day, it conducts market operations to ensure the new target is reached - To increase the cash rate, the RBA uses repos “sell securities” to withdraw funds from the interbank market and similarly, repos “buy securities” to decrease the cash rate. The Relationship Between the Cash Rate and the Main Short Term Interest Rates The main interest rates influenced by the cash rate are; 1 Bank Bill Swap Rate 2 Variable Rates on Housing Loans 3 Variable rates on Business Loans Influence of Monetary Policy on Short Term Interest Rates Business cycle and risk premiums impact short term rates but monetary policy has greatest influence The aim of monetary policy is to keep inflation within a zone of 2-3% over medium term. RBA is responsible for implementing this and does so by changing its cash rate target and by conducting market operations like repos buy and sell agreements to reinforce the movement in the cash rate to align with the new target rate. Changes to the cash rate influence interest rates general over a short time period, these impact the economy and inflation over a longer time period. Workshop Notes Part B. Money Market Securities Bank Securities 1) Negotiable Certificates of Deposits - Funds are deposited for a fixed time and a tradeable certificate is issued stating the amount to be repaid and maturity date - NCDs represent over 80% of securities in money market - Wholesale deposits become tradeable securities - They are a source of banks funding. - Formula - Example 1) 90 Day NCD with FV of $100 at yield of 6% p.a P 100 = 1 p = (6 86 99/365) + x. $98 54. 2) 90 Day NCD with FV of $100 at yield 3% p.a p 18 G = (0 83x 90/365) $99 27 1 P = +.. 2) Bank Accepted Bills - Alternative source of funds to borrowers apart from a bank loan - Bank guarantees the bills but are issued by commercial borrowers and accepted by banks\ - Redeemed at maturity - Not a source of bank funding as the money doesn’t come from them. - Formula; Price Paid (P) by an investor for BABs is calculated as; - Example ↑ 1 3% 1) A bank accepts a company’s 90 day bill with FV of $10mil for an acceptance fee of 130bps and sells it in the money market at 3%. What is the Price paid by buyer? What is amount received by borrower?. Ppaidby bUyer = D =10000000/365) $9 : , 926 5: , Methodand - Amount received by : p 18600000 = borrower : Bank acceptance fee (10 1 = -. $9 03 + 0 , =. 813) x 98/365) 926, 571 $31. 00 -$9 486 00 ,. $9 , 895 , 085 2) 3) 895 085 88 ,. , amount F/1 + paid by buyer of bl ol diny) (Mrate Amount received by borrower is forfee fund Acceptor = /1 ((Mrace DP) : + PV+accep = lang) He= Borrower PV-buyer P 3 90 days - Bill Facility Example 1) NAB agrees to establish a 270 day bill facility for a company using 90 day bank bills - FV is $5 mil ad company is charged acceptance fee of 95 basis points (0.95%) - First parcel is issued at market yield of 3%, second at 3.25% and third at 3.50% - What are the bill proceeds? What are the net cash flows for the company over the 270 days? x Bill proceeds 8- 98d P Pl * remember 5008 888 - , 7+ (0 03. 44 = , : 0 0895) 98/365] +. ↳ 951 , 771 88. bill rollover usee Initial #) as borrowed amount Pz 5006 088 = 1 P3 + (8 8323 x , 8 8845 98/365 x.. $4 - 948 , 758 88. 5000000 : -" ,888350. 0095 x 97 e difference Net Cash HOWS are all Int. PMTs The risk -Pay $5M-P2 = Pal $5M-P3 $54,268 $51 , 168 / f Receive P, u Rose new interest rate at each rollover as intial rate Pay $5M during no longer currenta feasible.' With P1U growing Intrakes the borrowers will lose more in Int us I ( 277 188 9f financing strategy that borrowers must = ( in this opposed bill to just borrowing a. longer period Part C. Trading and Settlement Arrangements Demonstration of the Dealer’s Spread - Example 1) Suppose a dealer buys a parcel of $50 million 90 day NCDs at their bid of 3.89% and sells the parcel a short time alter at their offer of 3.85%. The dealer’s buying price is? Their selling price is? How much have they made? I bod what they're willing1 Duy bills for 50000000 p = , bid 16 $49 ↓ ~ Potter · Round 6389 + 98/365 574 967 37 ,. , 50000 806 : -. ↓ /3. 8385 x 98/365) $49 , 529 , 886 Trip Profit : ~ =. 09 (sell) Offer $49 $4 , 529 886 89. , 838 7. , bid - (bub) price - $49 574 967 37 , ,. What is a Security’s Tick Value and how Does it Reflect the Price Risk of an Investment in the Security? The tick value is the change in a security’s price that arises from a one basis point change in the yield. It is an indication of price risk, with greater tick values (price changes) reflecting greater risk. Greater tick value means it is subject to grater price changes Tick values and price risk are positively related to the security’s term - Example: Tick Value 1) Compare the Tick Value of a $100million Parcel of 180 day BABs with that of a $100 Million parcel of 30 day BABs given the interest rate increased from 3.50% to 3.51% Part D. Yield Investments Yield to Maturity - Formula - Example #F 1) Demonstrate that a purchase of a $10million parcel of 90 day NCDs at 6.5% and held until maturity, will earn a YTM of 6.5% him rearranged) P, = roo 365) - > = $9 872 , 154 28. , (400000 2g 1) x -. - 0 865. 6 5%. Holding Period Yield (HPY) - Example 1) Suppose the 90 day security purchased at 6.5% for $9,842,254.28 was sold 20 days later at 6%. The holding period yield would be calculated as? How much has the investment earned? What are its components? Psell: , 1000000/305) $9 - = HPV V = 886 240 52 ,. , 18888888 I 9886240 54 1) 365 = 0 0816 or 8 16% :. -.. Investment has earned 8 16% 80 $43, 986 In => This has interest a capitul gain component... 2) Calculate the holding period yield, the accrued interest and the capital gains or loss form an investment in a 90 day bill with a face value of $50 million purchased at 3.20% and sold 30 days later at 3.30% Puy a) 50000000 = 1 +0 032. ↑ sell HPV(r) b) : 98/366) 50000000 = 30 nays/ er1 + + 0. 833 (1 + - = 60/362) P sell-Pbuy or = 738, 230 53 , 688 , 568 81.. 53 in 2. 98 % price of 30 over 30 day investment sry price days , 49688568 81. - = 832 assuming $179 market. We know interest accumulated was gain) Profit loss is : or Loss = 49 738 , 230 53 ,. price of beig in of 30 as interest. 58 accumulated - , - - - $179 , 794 121 , 662 52 119 , 744 58 $8 , 132 86 - Loss :. , Therefore capital Bell-Pany = - b) al in 794 58 we know investment made profit of 49738230 53 44608568 81 $121 662 52. yield remained. , lossi one a) FROM Cap Gain s 1) -. /$50680688 18 x68/365) ↓.. 49688568 81 - 1+ Cap Gain $49 , as 2) , ) 35 149738730 earned is change price end purchase yield = $49 = int interest = - ($5010 1.. mil. 032 x60/365) = - $8 , 132 06. (los) price a end of 38 ds 3) Suppose that the 90 day base bill swap rate just increased from 3.80% to 4.1%.What does this imply for the prospective investors, and the investors holding money market securities? - A rate rise is good for prospective investors since it increases the interest return from future investments. - It is bad for existing investors because it lowers their selling price (due to inverse relationship between prices and interest rates) if they choose to sell before maturity Module 5 - Fixed Income Bond Market Part 1 Part A. Introduction to the Bond Market Money Market = ST Bond Market = LT - Cash Rate = ST Int rate determined by RBA - A spread graph show s the difference of between the rate of the given investments. Fixed Income - Form of fixed income as they pay regular interest payments Introduction to the Bond market Long term Coupon Rate is dependent on market conditions and Fixed interest/coupon payments cash rates are at the time of the issue of the bond. Pay FV at maturity Many types but focus on Treasury Bonds Other issuers are state governments, companies (financial institutions), foreign entities. Bond issuing of non-government bonds and Australian bonds in Aus, increased after GFC - Gov bonds most popularly bought due to low risk and quality. These are safer investments for banks and investors - Majority of Aus bonds at AAA, AA and A fairly safe overall Non financial corporate bonds = Non banks = Qantas, BHP, Netflix etc. Contribution of the Bond Market Contribution to the flow of funds: enables wholesale borrowers to raise large sums for long periods and by being a defensive asset class for wholesale investors. - BILLIONS OF DOLLARS OVER 20-30 YEARS - Defensive asset they pay fixed interest which is safe and secure for investor. Lower risk lower return - Most Aus bonds are low credit risk (high ratings) due to being issued by stable, secure institutions. - Risk for institution to default on coupon payments of bonds - Market risks arise from changes in yields. Contribution to Price Discovery: revealing level of long term default free interest rates and credit spreads. Rather than discovering cost we discover the default interest rates. - Informs borrowers of cost and investors of return of long term funds. - Generally Aus Treasury Bonds have higher yields than US Gov bonds due to higher risk. Shouldn’t be much difference as both rated AAA, differences today are due to exchanged rates, imports, exports, economic conditions etc. 1 Default Free Interest rates; Revealed by trading Treasury Bonds, with the 3 year and 1 year yields being the benchmark rates - Market for Treasury Bonds is very liquid which enhances the quality of price discovery - Treasury Bonds are issued by gov and therefore assumed gov will not default on coupon int and FV of bonds. - Default free term is the risk free interest rate (CAPM) also used in Black Scholls Martin Model 2 Credit Risk Premium; Trading in semi-government and non-government bonds reveals the size of credit risk premiums which trade at higher yields than Treasury Bonds. - Credit Spreads (Yield Spreads) show margin above the default free rate a borrower has to pay because of their credit rating. - Credit spread narrow before GFC and increased durin - Risk premium is added to the default risk free rate Part B. Trading and Settlement Trading and Settlement A wholesale, over the counter market where dealers are market makers that operate according to the Australian Financial Markets Association protocols due to the large size, amount of bonds. Dealers; - Have their own supply of bonds - Trade by telephone or increasingly using system called Yieldbroker - clients trade with each other - Quote or post bid-offer yields on a semi annual compound basis - Trade with wholesale clients and each other Transaction occurs and then Settlement (incl. payment) is arranged by Austraclear on a T + 2 basis (transaction plus 2 days) Part C. Market Segments Australian Bond Issues GOV mayority state Qantas 1) Treasury Bonds - Gov issues bonds regardless of whether funding is required as it benefits financial system including price discovery - Main security is a fixed rate bond. Means coupon rate is fixed not the YTM. - Investors can choose from range of bond series If yield is greater than the coupon payment, the - Series is identified by its coupon rate and maturity date bond will be trading at a discount AKA less than - Series can be added and more bonds can be issued of existing series face value - Bond pays series of coupons and has fixed maturity date and face value. If yield is less than coupon, bond will trade at a - Gov issues bond to investors and they buy and sell in the market. premium AKA more than FV through term - The Issuing Process - Treasury bonds issued by the Gov/Australian Office for Financial Management (AOFM) via a tender process on Yieldbroker - Step 1; Announcement of bond series on offer, the coupon rate, amount to be sold and closing date and time for bids - Step 2; Bids are submitted electronically and successful bids (lowest yield/highest price) are notified shortly after close. 2) Semi-Government Bonds - Bonds issued by state borrowing authorities (NSW T-Corp) for the state or territory government or agencies - Bonds are medium or long term - Fixed or floating coupon rates - Yields exceeds Treasury bonds and vary between issuers depending on credit risk and liquidity - Issued through dealer panels often as a closed auction and these dealers make the secondary market. Can buy through auction or directly form dealer in secondary market 3) Non-Government Bonds - Mostly non resident and financial a) Financials; Mainly bonds issued by major banks - Most floating rate - Medium term av. 5 years - Were largest non gov issuer 2008-2012, then decline due to greater reliance by ADIs on deposits. b) Non Resident - Kangaroo Bonds; Bonds issued by highly rated foreign, international institutions in the Aus market. E.g. World Bank to raise only for purpose outside of their home country - Largest category of non-gov bonds - E.g. Emirates $450mil Kangaroo bonds in Aus, 10 year term, - Issues are driver by investor demand for highly rated and relatively high yielding AUD bonds - Issuers want to diversify funding sources, expand in new markets - Issuers mostly swap their AUD payments for USD c) Mortgage Backed Securities; Fund property loans, mostly residential - Impacted by GFC but increased since 2010 - Issued in Tranches were each tranche has a different payment structure, payment priority and credit rating - Most common are floating rate bonds based on the Bank Bill Swap rate and nominal maturity of 25 years - Payments form borrowers flow through to investors and so include principal and Interest d) Bonds Issued by Non Financial Companies; Issued by companies other than banks of FinIns like Qantas, Telstra, Woolworths - As it is expensive issue bonds, these issues are only done by firms who need relatively large amounts - Some lower rated issuers have their credit standing improved by credit wrapping such as guarantees by a third party - Like banks, Aus companies raise more funds from overseas than in domestic market. Rating Agencies Informed opinion on credit risk of a security from a ratings agency e.g. S&P Bonds are rated in order to be issued with the cost of the rating paid by issuer. - Ratings are revised and influence the yield at which the securities trade. Some ratings unreliable incentive problem due to issuer paying the rating agency AAA -> CC, C, D (Default) Grades; - Best quality - High quality - Upper Medium Grade - Investment Grade - Speculative Can also rate countries. Aus is AAA Sovereign ceiling is Country rating is the ceiling of the country’s issued bond rate Part F. Determinants of Long Term Interest Yields Determinants of Movements in Long Term Yields Gradual decrease in long term rates for past 20 years Due to increase in inflation rates The 10 year bond yield is the reference long term rate The Greatest influence on demand for bonds, and therefore bond yields if inflation rate An increase in expected inflation, erodes the expected purchasing power of a bond’s fixed payments as yields increase too. Government is participating in manipulation of short term interest rate by increasing the short term interest rates which has an impact on the long term interest rate The Fisher Effect Relationship between bond yields and the expected inflation rate represented by the Fisher Equation Nominal interest rate = real interest rate plus an expectation of the longer term inflation rate - r = market yield for long term rates - r real = the real interest rate (risk free rate) - P e = the expected long term inflation rate Given the real rate is stable, then changes in market yields reflect changes in the expected inflation rate. Other Influences of Bond Yield GFC saw investors shift demand away from riskier securities in a flight to quality resulting in decrease in Treasury Bond yields Changes in volatility and liquidity within markets will also influence risk premiums embedded in the real interest rate. Part D. Calculating Bond Prices Bond Pricing Basics Treasury bonds are priced using the AOFM formula and the Australian Financial Market Association’s pricing conventions. - They are quoted and sold at a percentage or YTM basis. Therefore bid yield is higher than the offer yield - Bid for high yield sell at low yield. Australian Office of Financial Management (AOFM) manages the Australian Government’s debt portfolio - being short term and long term debt. - Yield is a semi annual compound rate - Coupons paid twice a year, on dates/ months determined by bond’s maturity date - Prices are per $100 of face value to 3 dec. Bonds settle T+2 with the settlement price calculated using the yield agreed on the trade date. Can have maturity of 1 year or more Treasury bonds are still exposed to interest rate risk If I want price 6 months by Calculating a Bond’s Price on a Coupon Date maturity n 1 Price of a bond is the present value of its remaining payments discounted at the current market yield. < & 21 Bec Formula: This formula is only valid on two dates throughout the year, when the coupon paayments are made. , Coupons = ~ (M in (1 10023) 26 + 2B26 $64 0 75 - CV = 91 75(1 (823) - 6) -. P = P2 $69 92 = 0 + 180 (1 + 0. 823) FV- PMT -. 75(123) 16) + Price -. - ( 823) 1 24 -.. 4 6% =. 13 = $108 -. n (use Excel) Mi OV , - , Need Pl to be & 21 December 2024 later.. 25 penode par cr = 1 5 %. = 134. FV = $108 PMT + Example: Bond Prices and Movement in Yield premium p = 0 75. /1-(B3)26) P $185 - =. 33 + 100 (1 0153. remaining X2 to , 5)20) to 26 75 = P-05 =.. /Period, FI) negative & get annual rate = P(EXIe)) PV (Rate Maturity upon PMT-FV) will return neg and (f if want Example: Bond Prices and Movement in Yield HTM Yeld-(#) ". 100 (0 0875) $0 period I ! (V = 0 0075 = 0 023 1 5% n(t) 0 O. YTM(r) = remaining -.. 2) semi-annual Example: Bond Pricing P always periods - - = PMT e Price = "rgt $8 75. e value to be pss. Example: Settlement Prices a) cr = 0 0575 = 0. ↓ 3 80 = =. FV $187 = PMT. 6) car 01875 0 015 ·: At. ↳ n= are ()(V equal par P 2 = $2 875 - 3 P 8130) 875)1 $187 > - a). year Initially. 834 = n= : - P2(a+ 6 (V = 5 08. >. X).. PMT = $1 58.. P 0 P :. 025 5 (10756)+100 = 2 - $98 634. - , 835) %) pot 875)1 +. $96 cr = $2 5 r = 0 0275 r = 5 08 =. 676. (discount). 55 0. OL5 - 88 0 035 P= 2 o +. Y Change iof 188. (1025) %) + $2 5. $186.. : =. 8= 7. - F. 8 87875 PMT = 12 875 100(8 02873) = 5 75 = - 1 =. 37% -$100.: at par b) 18 year & n 26 (V = 0 025 = 5Y. ↑ = 0 075. :. 2:. V= 4 6 %. n = 13 => FV = $187 100 (0..PMT = $0 PV... 0075) 75 F. reinvestment we use coupons veinvested 0 = Coupon 11 =. - & 3% $23 635 In this case Uhpy = - Uhpy (EXCEL coupon rate = Rupon reinvest i Ve 12% = 8% 3 015 , semi annually. Total Rup = = ↑ 4 43%. = RATE PMT (maturity * I sit annae 3/4.85! e = $34 = Psell Pony Psell). -$3 10 % upon F , , 100/0 03) = =. 88956 3/1104) 4) = 5 I pened + = = 2 x investment ((23635 188)112 e Haupon $108 Pbuy $92 64 F 10 % = annuity formula = 75/A. = -FV 6 0075 0 023 69 92 = * coupon. = 26 = = - Excel $103.. HP4. 4 62989 ((34 : - +. 88956 + 92 64. 13 642 %. 105. 62909)"0 1) - x2 (rate , period upon , PMT) Module 6 - Fixed Income Bond Market Part 2 Part A. The Term Structure of Interest Rates This is a set of interest rates for a class of assets such as bonds, BABs, NCDs for a range of terms - The relationship between the interest rates of different financial instruments with different terms of time horizons. For example, we could examine the term structure of the BBSW by looking at its yield for securities with term of 30, 60, 90, 120, 150 and 180 days. A yield curve is a graph of the term structure of interest rates at a particular point in time. - Horizontal axis is time to maturity - Vertical is YTM rates - Each different plot is for the next longer term security - Plots interest rates against the maturity of debt instruments - It is upward sloping - The shorter term interest rates are lower than longer term interest rates which reflects the market expectation of things like market expectation and economic growth. - The level of long term bond yields ref