Week 2 Sep 4 2024_compressed.pdf

ECON 123 - Week 2 Financial Economics Michael Oyson CFA 1 TOP US MBA Programs 2 Michael Oyson CFA - Econ 123 (Financial Economics) F. M. Osborne - 1950s Wanted to do some back-testing. Use statistics instead of just mere chart-reading or technical analysis Responded to a 1947 book, Technical Analysis of Stock Trends, by Robert Edwards and John Magee. The book looked at price trends, volume, introduced terms such as “reversals,” “necklines” etc. And this book ushered a spree of hiring of technical analysts in Wall Street. Basically, Osborne felt there was a need to use statistics to see if there are real patterns. Osborne (Mar/Apr 1959 issue of the Journal of Operations Research) - percentage change (similar to Samuelson). He said analysts looked at price levels (instead of price changes) and saw patterns where there were none. Holbrook Working - patterns in stock movements were largely the result of statistical error. 3 Michael Oyson CFA - Econ 123 (Financial Economics) Finance becoming ruled by theory - 1950s Contrast between Harvard’s business case style approach to economics vs other school’s theory-based. Objection was that the VNM utility theory was unrealistic and did not describe the way real people made economic decisions. Friedman published The Methodology of Positive Economics (dismissal of the skepticism of theory) in 1953. 1) Individuals behave as if they calculated and compared expected utility and as if they knew the odds. E.g. billiard players could write down physics but play as if they did. 2) Empirical study was important but theory had to come first. The institutionalists were of the view that the assumptions were unrealistic and that man was not really a “lightning calculator of pleasures and pains.” Response of Friedman was: So what? 3) Friedman argued that the realism of assumptions in economic models is less important than the accuracy of the model’s predictions. He suggested that economists should not worry if the assumptions of a model are unrealistic. In contrast, the more traditional views placed greater emphasis on the realism of assumptions. All scientific theories were unrealistic oversimplifications, but it was by simplifying the complexity of reality down to patently unrealistic models that science progressed. Social scientists don’t have the luxury of testing theories like the physical scientists do with their controlled experiments. 4 Michael Oyson CFA - Econ 123 (Financial Economics) Finance becoming ruled by theory - 1950s “The relevant question to ask about the assumptions of a theory was not whether they are descriptively realistic, for they never are, but whether they are sufficiently good approximations for the purpose in hand. And this question can be answered only by seeing whether the theory works, which means whether it yields sufficiently accurate predictions.” - Friedman 5 Michael Oyson CFA - Econ 123 (Financial Economics) What is rational behavior High point of this theorising was the Arrow-Debreu paper in the 1950s : rebuilt the economic equilibrium theory - i.e. the mathematical proof of the existence of Adam Smith’s invisible hand. This paper excited the economists at that time and inspired them to take the mathematical approach towards economics. 6 Michael Oyson CFA - Econ 123 (Financial Economics) Arrival of M&M - Case Method vs Math (1950s) Having said that, Harvard vs MIT/Carnegie - Case Method vs Theoretical. Harvard - Finance was a business school endeavour - a mix of common sense, judgement, not mathematics or theory. HBS was founded in 1908 by an economist who believed that the School should be practical and not be obsessed with theories. The second dean did not have a graduate degree and came from the Harvard Law School. Hence the case method. Merton Miller - a young econ prof at Carnegie Tech sat through a class on finance taught in the Harvard case method style. “When we took up a case number one in the case book, I remember being struck that the solution was not obvious to me. After the instructor explained it, however, I said, Yeah. That’s right; that makes sense. Then we came to case two, and said, Okay, I remember how we solved case one, and so the answer must be this. And of course it was different. I couldn’t sense any connection from one case to the next. Everything was, as they say on railway tickets, good for this train and this day only. For me, as an economist, it was very frustrating to have no sense of a theory of corporate finance to tie all the material together.” Miller decided to build his theory at Carnegie Tech’s Graduate School of Industrial Administration (GSIA) established in 1949. GSIA revamped its program to make engineering and business education rooted in scientific and mathematical rigor over rule of thumb approach. They hired economists, operations research experts and behavioral scientists. Carnegie made a push to the study of finance in the image of modem mathematical economics. 7 Michael Oyson CFA - Econ 123 (Financial Economics) Arrival of M&M - Case Method vs Math Modigliani and Miller felt that finance should be like economics that build models based on math. And the study they took on was CORPORATE FINANCE Capital structure irrelevance: It does not matter whether a company finances itself with debt or equity; the total value of the firm remains the same. Implication: The firm’s value is determined by its operating income and the risk of its underlying assets, not by how it is financed. This proposition challenges the traditional view that an optimal capital structure exists.. They also said it was irrelevant where a company got its money - whether by selling shares, or reinvesting earnings. Dividend Irrelevance Theory: the dividend policy of a firm is irrelevant to its value. The value of the firm is determined solely by its earning power and investment decisions, not by the way it distributes earnings (dividends versus retained earnings). It was irrelevant whether corporations paid out leftover cash in dividends or held on to it. They disagreed with the view of Graham and Dodd that argued that given two equivalent companies “the one paying the larger dividend will always sell at the higher price.” Miller: “the pizza delivery man comes to Yogi Berra after the game and says, Yogi, how do you want this pizza cut, into quarters or eighths? Yogi says, cut into eight pieces. I'm feeling hungry tonight.” Cost of capital calculation: How does one measure the economic cost of capital (which they never figured out how to calculate), which had already been used in business schools but no one knew how to measure it. (it was as simple as take the rate of interest on its bonds and then add a risk premium of a percentage or two to account for the uncertainty of the investment. In other words , the risk premium was arbitrary. MM said “in a rational and perfect economic environment, stock prices are determined solely by real considerations - in this case the earning power of the firm’s assets and its investment policy - and not how the fruits of the earning power are ‘packaged’ for distribution.” MM 1) doesn’t matter how money is raised 2) it doesn't matter whether it gives the money to shareholders. 8 Michael Oyson CFA - Econ 123 (Financial Economics) Jack Treynor - foundation for CAPM MM defined the cost of capital as the opportunity cost of not putting money into the shares of a different firm in the equivalent class. But never defined what it really meant. Are you being paid for taking risk or rather uncertainty? Came Treynor: the risk that mattered most was the market risk. Investors should receive a risk premium on an asset “proportional to the covariance of the investment with the total value of all investments in the market.” ie. the relevant risk is how sensitive a particular investment was to the movements of the total market. The more sensitive, the higher the premium. Treynor Ratio: The Treynor Ratio allows investors to assess how well a portfolio compensates for its exposure to market risk - excess return of a portfolio per unit of systematic risk (beta). A higher Treynor Ratio indicates a better risk-adjusted return, meaning the portfolio delivers more return per unit of market risk. It is particularly useful when comparing portfolios that are part of a diversified investment strategy. Paved the way for the security market line that was developed by Sharpe. 9 Michael Oyson CFA - Econ 123 (Financial Economics) William Sharpe (1960s) - Beta Then came William Sharpe in 1960 who was working at RAND (the center of OR in Santa Monica) and was looking for a topic for his dissertation at UC Berkeley. He simplified Markowitz approach to portfolio selection (Markowitz calculated covariances of every security- how the members of each possible pair were expected to move in relation to each other vs Sharpe’s covariance between an individual stock with the market as a whole) 1964 paper, "Capital Asset Prices: A Theory of Market Equilibrium under Conditions of Risk" published in OR Journal of Management Science. This model provides a framework for understanding the relationship between the risk of an asset and its expected return. Birth of Capital Asset Pricing Model (CAPM). 10 Michael Oyson CFA - Econ 123 (Financial Economics) William Sharpe (1960s) - Beta Bottomline: A security that doesn’t drop as much as the overall market when times are bad is a valuable thing; so valuable that rational investors would be willing to pay more for it. (and thus accept a lower rate of return in the long run for it) than a security that bounced around or more volatile than the market. He represented this a B in his dissertation, which later on transmuted to beta. The Sharpe Ratio allows investors to compare the risk-adjusted performance of different investments or portfolios. A higher Sharpe Ratio indicates better risk-adjusted returns. 11 Michael Oyson CFA - Econ 123 (Financial Economics) Sharpe ratio Suppose: Expected return (Rp) = 10.0% Risk-free rate (Rf) = 2.5% Standard deviation (𝜎) = 6.0% Sharpe ratio = 1.25% The Sharpe Ratio shows how much return you're getting for the amount of risk taken. 12 Michael Oyson CFA - Econ 123 (Financial Economics) Which portfolio is better? Portfolio A: Portfolio B: Expected return (Rp) = 14.0% Expected return (Rp) = 11.0% Risk-free rate (Rf) = 3.0% Risk-free rate (Rf) = 3.0% Standard deviation (𝜎) = 8.0% Standard deviation (𝜎) = 4.0% Sharpe ratio = 1.38% Sharpe ratio = 2.0% 13 Michael Oyson CFA - Econ 123 (Financial Economics) University of Chicago - Rise of Academic Finance UChicago - founded in 1889 (a decade before HBS) but was an obscure outpost for economists. Until mid 1950s, considered “almost moribund.” W. Allen Wallis became dean and James Lorie became associate Dean of the business school. UChicago received a multimillion grant from Ford Foundation to reform business education along the mathematical bent of Carnegie Tech. Differentiated itself from Harvard. - Not a training school for ministers but a research institution. First business school to grand Doctorates. Arrival of Miller from Carnegie Tech to UChicago when the new era of business education at UChicago began. Miller brought his amalgam of economics and finance to UC and felt the debate in the economic world was “M&M vs T ‘them. The goal was not to attack chartists, rather to demonstrate how well the market worked. 14 Michael Oyson CFA - Econ 123 (Financial Economics) University of Chicago - The environment 1) Strong belief in efficient markets. E.g. George Stigler: A student was walking with Stigler around campus and the student said “There’s a US20 bill. Stigler replied: No,if it were real, it would have been picked up already. (Stigler was devoted to the idea they markets got things right). 2) Disillusioned with government’s attempt to managed the economy as they had seen while working in Washington in the 1930s. 3) Influence of Friedrich Hayek’s The Road to Serfdom - appalled at the adulation of economists of the role of government given what he had seen in the socialist “Red Vienna” of the 1920s and the Nazi Takeover. Milton Friedman became the leading voice and the spokesperson. 15 Michael Oyson CFA - Econ 123 (Financial Economics) University of Chicago - The environment 4) Friedman’s commanding presence in the faculty helped attract more and better students (Eugene Fama and Myron Scholes) to the Business School. Friedman also published two important works in the 1960s - Monetary History of the United States, 1857-1960. Bottomline: Friedman believed that markets worked better than the government and that markets were perfect. 5) Arrival of strong computing power of IBM 709, which arrived in UChicago around 1960. 6) Founding of Center for Research on Security Prices (CRSP) - offered comprehensive historical data on stock prices, returns, and other financial metrics. 16 Michael Oyson CFA - Econ 123 (Financial Economics) Eugene Fama (1960s): Empirical Evidence Nobel Prize (2013): Contributions: a) efficient market hypothesis; b) back-testing/empirical based study; c) event-study. His work on efficient market lent support to CAPM. A) That markets are competitive and efficient; and B) systematic risk (beta) is a key driver of expected returns (the expected return of a stock should be directly related to its beta). C) expanded CAPM (Fama-French Three-Factor model, adding size and value to explain returns).. 17 Michael Oyson CFA - Econ 123 (Financial Economics) Eugene Fama (1960s): Empirical Evidence Eugene Fama - arrival at UC in 1960 (MBA). “Sophisticated traders (chart readers and fundamentalists alike) could be relied upon to attack any nonrandom patterns in the market and, in the process make money off them, make them go away. That meant any chart-reading successes were of necessity fleeting.” “In a dynamic economy there will always be new information which causes intrinsic value to change over time. As a result, people who can consistently predict the appearance of new information and evaluate its effects on intrinsic values will usually make larger profits than can people who do not have this talent.” Having said that he also believed that superior analysts, if they were many their existence, would insure that actual market prices are, on the basis of all available information, best estimates of intrinsic value. => Birth of efficient market hypothesis. “In an efficient market, the actions of the many competing participants should cause the actual price of a security to wander randomly about its intrinsic value. 18 Michael Oyson CFA - Econ 123 (Financial Economics) Fama’s testing of CAPM Fama’s work on CAPM put seriousness to finance and the approach of business schools. The primary role of the capital market is allocation of ownership of the economy's capital stock. In general terms, the ideal is a market in which prices provide accurate signals for resource allocation: that is a market in which firms can make production and investment decisions and investors choose among the securities that represent ownership of firms activities under the assumption that security prices at any time fully reflect all available information. A market in which prices always fully reflect available information is called efficient.” - Fama, “Efficient Capital Markets: A Review of Theory and Empirical Work (May 1970). Support for efficient markets model is extensive. He not only argued that it was hard to outsmart the market, the market got prices right. 19 Michael Oyson CFA - Econ 123 (Financial Economics) Birth of Academic Finance Fama published with Merton Miller the textbook - The Theory of Finance - birth of academic Finance. No longer were economists grouped with psychologists or sociologists. They belonged to a real science and even had an annual Nobel Prize to call their own. In economics, the core tenet was that people were rational. In finance, it was that financial markets were rational. Finance satisfied Thomas Kuhn’s requirements of a true science: Thomas Kuhn listed in his book (Physicist working at the Stanford Center For Advanced Study In The Behavioral Sciences) the characteristics of a true science: a) agreement on fundamentals, b) unintelligibility to outsiders, c) communication by means of journal articles rather than books, d) a profound lack of interest in history. 20 Michael Oyson CFA - Econ 123 (Financial Economics) Fama’s Joint Hypothesis - Empirical Testing Fama’s work on CAPM put seriousness to finance and the approach of business schools. Joint Hypothesis: A) The market is efficient. And B) The asset pricing model used in the test is correct. If a test rejects market efficiency: unclear if due to market inefficiency (prices not reflecting all information) or because the asset pricing model used is incorrect or incomplete. In simple terms: when testing a model like CAPM to see if it works well in predicting returns, one is also testing if the market is efficient and behaves as the model assumes. If the model doesn’t seem to work, one cannot conclude if the problem is with the model itself or with the assumption that the market is efficient. 21 Michael Oyson CFA - Econ 123 (Financial Economics) Back-testing and event studies What do you mean by efficient market? Fama defined what he meant by efficient market. Fama refined it to be a) weak - old random walk hypothesis (you could not beat the market using data on the market’s past movements. b) semi-strong meant that you couldn't beat it using any publicly available information. c) strong - a market so perfect that even investors with access to private information couldn't outsmart it. UChicago continued to do more studies. “Event study” to test market efficiency - price movements after stock splits, dividends, etc. and testing how quickly the market reacted to this information. 85% to 90% of the news in annual corporate earnings report had already found its way into prices - through spadework by analysts, educated guesses by investors - before the reports were released. 22 Michael Oyson CFA - Econ 123 (Financial Economics) Wall Street, listen! Business week wrote an article “It’s easier to win than lose” (1965) “For sizable area of Wall Street - mutual fund, security analysts, investment advisers, and the like – the study should prove unsettling. Everybody in this area makes his money to one degree or another by selling his skill to less expert investors. Now, the Chicago study says that a random investment, one where no skill at all is applied, would prove profitable most of time.” Point: support of EMH 23 Michael Oyson CFA - Econ 123 (Financial Economics) Empirical study at UChicago Merrill Lynch asked the help of the UChicago to support their claim in a 1946 article that stated that stocks were an appropriate investments for regular folks. Born the Center for Research on Security Prices (CRSP) that compiled 35 years of price and dividend data on every stock every traded on the NYSE. Business week wrote an article: The Chicago study says that “a random investment, one where no skill at all is applied, will prove profitable most of the time.” Lawrence Fisher and James Lorie of CRSP: If you bought a stock from 1926 through 1960 and reinvested dividends - ave return (after brokerage comms but before taxes) - was 9%. But the 9% could actually be attained by monkeys with darts. I.e. no evidence that mutual funds select stocks better than by the random method (1965). 24 Michael Oyson CFA - Econ 123 (Financial Economics) Michael Jensen: Alpha and Test EMH Contribution: Provides a for assessing performance of investment managers using risk-adjusted returns (esp debate over value vs passive management). -Looked at more than 100 mutual funds: return when adjusted for risk, significantly trailed those of the market. All the skills of the mutual fund managers and analysts, and all the money they spend gathering information, could only get them to par. “One must realise that these analysts are extremely well-endowed. Moreover, they operate in the securities markets everyday and have wide-ranging contacts and associations in both the business and the financial communities. Thus, the fact that they are apparently unable to forecast returns accurately enough to recover their research and transactions costs is a striking piece of evidence in favor of the strong form of the efficient market hypothesis.” 25 Michael Oyson CFA - Econ 123 (Financial Economics) Investment Funds - Active vs Passive Debate Can funds outperform than the market? Recall in 1932 - Alfred Cowles said that evidence can be cited that the average return from professional advice and continued supervision is very low? The mutual fund industry had grown so much that it was getting hard for investors to pick mutual funds as investment stocks because the industry has become the market itself. 1959 - Financial Analyst Journal (Ed Renshaw, UC Ph Econ Student, and Paul Feldstein, MBA student wrote an article saying that “unmanaged investment fund -based on the Dow- would provide a straightforward, low-cost alternative). But it didn't get a lot of traction. A few months later - John B Armstrong (pseudonym of John C, Bogle, who worked at Wellington Management Co.) in the same journal argued that this was not correct. The four oldest mutual funds - Massachusetts Investors Trust, Investors Incorporated (Putnam), State Street, and Wellington - had all outperformed the Dow since 1930 with less volatility than the overall market. 26 Michael Oyson CFA - Econ 123 (Financial Economics) Ben Graham 1934 - Benjamin Graham (prof at Columbia taught Security Analysis, turned his lecture into a textbook) and his student (David Dodd) wrote Security Analysis - which rechristened “statisticians” with “analysts.” This book became the bible of this new profession. Pushed for a deeper analysis of stocks, financial statements, and value investing. Later, Graham published another book,The Intelligent Investor - Mr Market, Liquidation value. Mr. Market is a metaphor for the stock market, which Graham described as a manic-depressive individual whose mood swings between optimism and pessimism. 27 Michael Oyson CFA - Econ 123 (Financial Economics) Ben Graham "In the short run, the market is a voting machine but in the long run, it is a weighing machine." "The function of the analyst is to define the company's earning power in terms of past experience and future expectations, and to translate this knowledge into the present value of its shares." "The true investor scarcely ever has to sell his shares, and at all other times he is free to disregard the current price quotation. He needs to pay attention to market prices only to the extent that they provide him with an opportunity to buy wisely when prices fall sharply, and to sell wisely when they advance a great deal." "The idea of liquidation value is fundamental to value investing. It is the amount that can be realized by selling all of a company's assets and paying off all its liabilities. If a stock is selling persistently below its liquidation value, there is often a good reason to consider buying it. 28 Michael Oyson CFA - Econ 123 (Financial Economics) Ben Graham “Neither the financial analysts as a whole nor the investment funds as a whole can expect to beat the market because in a significant sense they (or you) are the market market.” ”Analysts do in fact render and important service to the community in their study and evaluation of common stocks.But this service shows itself not in spectacular results achieved by their individual selections but rather in fixing at most times and for most talks of a price level which fairly represents their comparative values as established by the known facts and reasonable estimates about the future.” 29 Michael Oyson CFA - Econ 123 (Financial Economics) Performance at what risk? After the great crash, the stock market boomed and Graham’s value investing approach was viewed as irrelevant. The search for growth became the main preoccupation of the security analyst.” Question: Growth at what risk? But the market did so well in 1960s -funds such as Fidelity Capital (run by Chinaman Gerry Tsai) and Fidelity Trend (run by the son of Crosby Johnson II, head of Fidelity) did so well that the goal of competitors was to beat Fidelity. Outperformance was the goal. 40% return bs 15% by the Dow (Arthur Weisenberg & Co study). How was this possible? Speculative stocks. John Birmingham Jr (FAJ, The Quest for performance, 1966) “Improved performance of certain institutions in the management of their funds is a natural outcome of better trained, more energetic, younger men in command. Question: “Performance at what risk? Re-emergence of beta and alpha. (Treynor ratio, Sharpe Ratio) 30 Michael Oyson CFA - Econ 123 (Financial Economics) Performance measurements: Sharpe and Treynor Ratios SHARPE RATIO TREYNOR RATIO Measures the excess return per unit Measures the excess return per unit of of total risk, where total risk is defined systematic risk, where systematic risk is as the standard deviation of the defined as the beta of the investment. investment's returns. Uses systematic risk (beta). More appropriate for evaluating the Looks at total risk (standard deviation performance of a portfolio that is part of a of returns) - both systematic and larger, well-diversified portfolio where systematic risks. More only systematic risk is relevant. Treynor comprehensive in considering all Ratio focuses specifically on sources of risk. market-related risk. 31 Michael Oyson CFA - Econ 123 (Financial Economics) Birth of institutional investing - Wells Fargo Formally proposed by Arthur Lipper II -”stock average fund” that would hold the 30 Dow Stocks. Wells Fargo put this into action with a vision of a retail mutual fund but the courts said no. Wells had hired Sharpe, Scholes, Jensen to help them. LegaL Loophole: managing institutional funds (son of Samsonite looking for someone to manage the money). Wells eventually launched an S&P 500 fund for pension funds and big institutional investors that held stocks according to their weight in the index. But what about retail investors? No investment vehicle for this. John Bogle who was at Wellington at that time (sell funds to investors without a load, so it didn’t count as distribution, and running an unmanaged mutual fund did not count as management. And he suggested an index fund. 32 Michael Oyson CFA - Econ 123 (Financial Economics) Birth of Index Fund - Passive Fund Management John Bogle, the founder of The Vanguard Group, launched the first index fund for individual investors, known as the Vanguard 500 Index Fund, in 1976. This fund was designed to track the performance of the S&P 500 Index, which represents a broad cross-section of the U.S. stock market. SEC approved in 1976 The Vanguard 500 Index Fund was revolutionary: low-cost, passive investment strategy vs high-fee actively managed funds (that Bogle viewed as often underperforming). Bogle’s index fund had the premise that it is better to accept the market return rather than try to beat it through active stock picking, which is in line with the the EMH. The success of the Vanguard 500 Index Fund helped to popularize index investing and laid the foundation for the widespread adoption of passive investment strategies in the investment industry. 33 Michael Oyson CFA - Econ 123 (Financial Economics) More… Bogle’s idea was helped by Princeton economist, Malkiel, Random Walk Down Wall Street (1973), and Paul Samuelson’s 1974 essay in the Journal of Portfolio Management Princeton economist, Malkiel, Random Walk Down Wall Street (1973):: “A blindfolded monkey throwing darts at a newspaper’s financial pages could select a portfolio that would do just as well as one carefully selected by experts.” “The theory of random walks holds that the movements of stock prices from day to day do not reflect any pattern and that there is no way of knowing where prices will go tomorrow.” “The indexing strategy is essentially a buy-and-hold strategy, and one of its chief advantages is that you avoid the substantial transactions costs involved in trying to trade in and out of the market.” Bogle’s Fortune 1976 Fortune article - “Index funds - an idea whose time is coming” “In the long run, market returns are determined by the fundamentals of the economy and by broad corporate profitability. Indexing is the only strategy that guarantees an investor will earn his or her fair share of those returns.” “The idea that you can beat the market is a fallacy. The market’s price is always the best estimate of fair value.” “The index fund is a form of passive investing, based on the idea that the market is efficient and it’s extremely difficult to beat it.” Paul Samuelson: “In 1974, I endorsed the creation of the first index fund, a fund that would simply hold the S&P 500 stocks, rather than trying to outguess the market.” (most portfolio decision makers should go out of business and he pleaded for someone anyone to launch an index fund for small investors). 34 Michael Oyson CFA - Econ 123 (Financial Economics) EMH vs Regulations Debate on whether government should regulate corporate actions EMH: School of Economics => School of Business => Wall Street => Corporate Boardroom Key question: Will corporate managers look after the interest of shareholders? “The directors of such companies…being the managers of other people's money than their own, it cannot be well expected that they should watch over it with the same actions vigilance with which the partners in a private co-partnery frequently watch over their own. Negligence and profusion therefore must always prevail, more or less, in the management of the affairs of such a company.” - Adam Smith Wealth of Nations, 1776) 35 Michael Oyson CFA - Econ 123 (Financial Economics) Regulations and Corporate Governance Rise of large corporations in the 1920s to finance large projects; rules were relaxed. But the issue was: will corporations look after the interest of shareholders “The power of corporate management is becoming practically absolute, while social controls upon this power remain almost embryonic.’ - Adolf Berle Jr. (Columbia professor, 1927). Berle 1932 book: The Modern Corporation and Private Property (showed how powerful the 200 largest american corporations had become, controlling 49% of nonbank corporate wealth at that time). Q: will corporate managers do the right thing for the shareholder?Are competitive forces enough to keep the actions of these corporate managers in check? “The only remedy they concluded was for control of big corporations to develop into a purely neutral democracy, balancing a variety of claims by various groups in the community and assigning to each portion of the income stream on the basis of public policy rather than private cupidity.” - Berle 36 Michael Oyson CFA - Econ 123 (Financial Economics) Corporate Governance Berle’s book “will perhaps rank with Adam Smith’s Wealth of Nations as the first detailed description in admirably clear terms of the existence of a new economic epoch.” - Jerome Frank (Yale Law Review, later SEC Chairman) FDR took this to hear => approval by Congress of the Securities and Exchange Acts of 1933 and 1934, creating the SEC and the modern securities law. Companies welcomed this. Charlie Wilson (GM President, candidate for Defense Secretary under President Eisenhower): “I cannot conceive of one because for years I thought what was good for our country was good for General Motors and vice versa. The difference did not exist.Our company is too big. It goes with the welfare of the country.” 37 Michael Oyson CFA - Econ 123 (Financial Economics) Debate: More or less regulations? John Kenneth Galbraith likened American corporate executives to Soviet apparatchiks: “the bureaucratic administrators of a vast system geared toward overconsumption and waste.” But Aaron Director, from the UC Law School disagreed. The Antitrust law made no economic sense. James Buchanan and Gordon Tullock (Univ of Virginia, alumni of UC): Regulation was bad and free markets good. Milton Friedman (brother in law of Director) became the spokesperson of the demerits of regulation. 38 Michael Oyson CFA - Econ 123 (Financial Economics) EM is the solution - not regulations “There is one and only one social responsibility of business - to use its resources and engage in activities designed to increase its profits so long as it stays within the rules of the game, which is to say, engages in open free competition without deception or fraud.” - Friedman. Corporate executives who purported to strive towards some higher goal or not only treating their shareholders but “undermining the basis of free society.” Came Michael Jensen (Univ of Rochester). Jensen was hired by the university to jumpstart its finance program. His view: EM solved the conflict between the “principals (owners/shareholders) and “agents” (corporate managers). The stock market could be relied upon to fully reflect all available information. 39 Michael Oyson CFA - Econ 123 (Financial Economics) Why Jensen’s view: Companies whose executives failed to act in shareholders’ interest would be punished with lower prices. The job of monitoring executives’ behavior was thus left to Wall Street and this monitoring - which reduced agency costs and made corporations behave more efficiently - provided a rational explanation for why mutual funds and brokerage firms expended millions of dollars analyzing stocks when it was impossible to beat the market. Jensen wanted to rely upon the stock market’s collective judgment to resolve conflicts of interest that plagued scholars, executives, and shareholders for generations Joel Stern (UC MBA grad, Chase Manhattan): influenced by MM that shareholders could see through accounting machinations. What moved markets was not earnings or even expected earnings but “expected cash flow that is above and beyond the anticipated investment requirement of the business.” Recall MM: Were they likely to deliver higher returns to shareholders than the shareholder could expect to make a similar levels of risk elsewhere in the market. 40 Michael Oyson CFA - Econ 123 (Financial Economics) Shareholder value Alfred Rappaport (Northwestern University) coined the term “shareholder value” in an article in Harvard Business Review. To figure out this shareholder value, Rappaport suggested one had to measure the expected return from any corporate investment against the cost of capital. And to compute the cost of capital, Rappaport recommended to use Ibbotson-Sinquefield equity risk premium and Barr Rosenberg's measure of beta. Mergers: Good or bad as check if corporate managers are creating shareholder value? Henry Manne (Univ of Rochester, UC Law School alumnus): M&A good for shareholder value in his 1965 essay in the Journal of Political Economy. 41 Michael Oyson CFA - Econ 123 (Financial Economics) Leave it to the market “Only the takeover scheme provides some assurance of competitive efficiency among corporate managers and thereby affords strong protection to the interests of vast numbers of small non-controlling shareholders. Compared to this mechanism, the efforts of the SEC and the courts to protect your holders through the development of a fiduciary duty concept and the shareholders’ derivative suit seems small indeed.” - Manne. Bad managers will be punished by lower stock prices, making it more likely that their companies will be acquired. However, Manne did not offer a proof of this assertion. M&A boomed until the 1980s when legislation clamped down on it (Rudy Giuliani). 42 Michael Oyson CFA - Econ 123 (Financial Economics) More Then Jensen moved to Harvard in 1984 and reformed their way of thinking. His course, Organizational Behavior, became the most popular elective. “The takeover market provides a unique powerful and impersonal mechanism to accomplish the major restructuring and redeployment of assets continually required by changes in technology and consumer preference.” - Jensen, NYT 1985. “By resolving the central weakness of the large public corporation - the conflict between owners and managers or the controlling use of corporate resources - these new organizations are making remarkable gains and operating efficiency, employee productivity and shareholder value.” - Jensen, Harvard Business Review, 1989 A critic summarised Jensens’ view: “The great advantage of Jensenism is that, when combined with uncritical acceptance of the efficient markets religion, it amounts to a unified field theory of economic regulation: all-knowing financial markets will guide real investment decisions toward the optimum; and with the proper set of incentives owners and managers will follow this guidance without reservation. - Doug Henwood, 1998 43 Michael Oyson CFA - Econ 123 (Financial Economics) Psychology and Economics Daniel Kahneman and Amos Tversky: made significant contributions to our understanding of human decision-making and judgment. Best known for their work on cognitive biases and heuristics - mental shortcuts that often lead to irrational decisions. Kahneman and Tversky's research: people are not always rational decision-makers and are often influenced by emotions, biases, and other cognitive factors. Common heuristics and biases: 1) Availability heuristic: People tend to judge the likelihood of an event based on how easily they can recall similar events from memory. 2) Representativeness heuristic: People often judge the probability of an event by how well it fits into a certain category or stereotype. 3) Anchoring bias: People often rely too heavily on the first piece of information they receive when making decisions. 4) Framing effect: The way a problem is presented can significantly influence the decision made. 5) Loss aversion: People tend to prefer avoiding losses to acquiring equivalent gains. 44 Michael Oyson CFA - Econ 123 (Financial Economics) More… “People rely on a limited number of heuristic principles which reduce the complex tasks of assessing probabilities and predicting values to simpler judgmental operations in general these heuristics are quite useful but sometimes they lead to severe and systematic errors. - Kahneman and Tversky (1974). Bottomline: humans aren't constantly calculating statistical man, but they aren’t idiots either they follow shortcuts and rules of thought that sometimes work. and sometimes don't. 45 Michael Oyson CFA - Econ 123 (Financial Economics) Prospect Theory Prospect theory (very mathematical), developed by Daniel Kahneman and Amos Tversky in 1979, is a behavioral economic theory that describes how people make decisions under conditions of uncertainty. It contrasts with expected utility theory, in which decisions are made based on the probability of a certain outcome and the utility of that outcome.Prospect theory refers to a series of empirical observations made by Kahneman and Tversky (1979) in which they asked people about how they would respond to certain hypothetical situations involving wins and losses, allowing them to characterize human economic behavior. Loss aversion is key to prospect theory. People tend to overestimate the probability of unlikely events and underestimate the probability of more likely events. This leads to a non-linear weighting of probabilities, which affects decision-making. Prospect theory suggests that people make decisions based on the potential value of losses and gains rather than the final outcome, and that people evaluate these losses and gains using heuristics. The theory also suggests that losses have a greater impact on people than gains of the same magnitude, a concept known as loss aversion.Losses are psychologically more significant than gains of the same size. This means people tend to avoid losses more aggressively than they seek equivalent gains. Thaler explored how prospect theory could explain the behavior of Mr H who mows his own lawn even though his neighbor’s son could be willing to do it for $8 but would not be willing to mow his neighbor's lawn for $20. Or the man who joins a tennis clement pays a $300 membership fee and then develops tennis elbow but keeps playing through the pain because he doesn't want to waste his $300. Another example: Concert Ticket: US$40 vs US$500. Rains.Will they stay? 46 Michael Oyson CFA - Econ 123 (Financial Economics) Framing Framing: In one experiment, he asked participants how much they would be willing to pay for a beer. The participants were divided into two groups. One group was asked how much they would pay for a beer if they were at a beach on a hot day. The other group was asked how much they would pay for a beer if they were at a fancy resort. The results showed that the participants were willing to pay more for a beer at the fancy resort than at the beach, even though the beer was exactly the same in both scenarios. This is because the context, or the "framing" of the situation, influenced their willingness to pay. 47 Michael Oyson CFA - Econ 123 (Financial Economics) Mental Accounting Mental accounting: a way people categorize, or mentally account for, economic outcomes. Thaler conducted an experiment in which participants were given a hypothetical scenario in which they could win or lose money. Thaler also found that people tend to categorize money differently depending on its source. For example, people are more likely to spend money that they perceive as a windfall, such as a tax refund or a gift, than they are to spend money that they have earned through work. Mental accounting is the idea that people think about money differently depending on the circumstances. For example, if the price of gas goes down, they may begin to buy premium gas, leading them to ultimately spend the same amount, rather than taking advantage of the savings offered by the lower price. 48 Michael Oyson CFA - Econ 123 (Financial Economics) Heuristic Availability heuristic: Tversky and Kahneman identified several consistent biases in the way people make judgments, finding that people often rely on easily recalled information, rather than actual data, when evaluating the likelihood of a particular outcome, a concept known as the “availability heuristic.” For example, people may think shark or bear attacks are a common cause of death if they’ve read about one such attack, but the incidents are actually very rare. Prospect theory: framing and loss aversion influence the choices people make. For example, if presented with an opportunity to win $250 guaranteed or gamble on a 25% chance of winning $1,000 and a 75% chance of winning nothing, most people will choose the sure win. But if presented with the chance to lose $750 guaranteed or a 75% chance to lose $1,000 and a 25% chance to lose nothing, most people will risk losing $1,000, hoping for the slim chance that they will lose nothing at all. This classic example demonstrates that people are more willing to take a greater statistical risk if it means avoiding a $1,000 loss versus obtaining a $1,000 win, which contradicts expected utility theory. https://news.uchicago.edu/explainer/what-is-behavioral-economics 49 Michael Oyson CFA - Econ 123 (Financial Economics) Nudge Thaler observed that he and a friend were willing to forgo a drive to a sporting event due to a snowstorm because they had been given free tickets. But had they purchased the tickets themselves, they would have been more inclined to go, even though the tickets would have been valued at the same price regardless, and the danger of driving in the snowstorm unchanged. This is an example of the “sunk cost fallacy”—the idea that people are less willing to give up on projects they have personally invested in, even if it means more risk. Thaler is also known for popularizing the concept of the “nudge,” a conceptual device for leading people to make better decisions. A “nudge” takes advantage of human psychology and a number of other concepts in behavioral economics, including mental accounting—the idea that people treat money differently based on context. For example, people are more willing to drive across town to save $10 on a $20 purchase than $10 on a $1,000 purchase, even though the effort expended and the amount of money saved would be the same. The sunk-cost fallacy is the idea that people will continue to invest in a losing project simply because they are already heavily invested, even if it means risking more losses. 50 Michael Oyson CFA - Econ 123 (Financial Economics) Rational Expectations Herbert Simon (Carnegie Tech): He argued decades before K&T that because people don't have unlimited time and brain power to devote the decision making they take shortcuts and follow rules of thumb. Humans don't “optimize” as a mathematical economist of the day theorized; but “satisfice” (a blending of “satisfy” and “suffice”). Simon hired John Muth to do an experiment (Muth was a student of M&M): but had a different conclusion. “Our economic models do not assume enough rationality.” Rational Expectations Hypothesis. Most proposed not that every last individual or corporation made rational guesses about the future but then one average out the guess is about the future made by participants in an economy they came to look a lot like a predictions of the most sophisticated economic models 51 Michael Oyson CFA - Econ 123 (Financial Economics) Human Omniscience? John Muth: work on rational expectations, a theory that has had a significant impact on macroeconomics. 1961 paper, "Rational Expectations and the Theory of Price Movements". Individuals make decisions based on all available information and adjust their expectations in response to new information. In other words, people's expectations are essentially correct on average, and they learn from past mistakes. In contrast to prevailing Keynesian view that people's expectations were often incorrect and could be systematically biased. Muth's theory has had a profound influence on the development of macroeconomics and has been used to explain various economic phenomena, such as inflation and unemployment. It led to the understanding that policy interventions, such as monetary or fiscal policy, may not have the intended effects if people anticipate and react to these policies. Muth's concept of rational expectations became a cornerstone in modern macroeconomic models, influencing the development of the New Classical Economics and Real Business Cycle Theory. Robert Lucas -student at CT popularised the hypothesis 52 Michael Oyson CFA - Econ 123 (Financial Economics) More Why not initially accepted a) Challenged the prevailing Keynesian view of the economy, which was widely accepted at the time. The Keynesian view held that people's expectations were often incorrect and could be systematically biased, and that government intervention was necessary to correct these biases and stabilize the economy. b) The idea that people's expectations were essentially correct on average seemed counterintuitive and even absurd to many economists. It contradicted the conventional wisdom that people were often irrational and could be systematically misled by economic events. c) The theory of rational expectations required a high level of mathematical sophistication and was difficult to understand and apply. This made it challenging for many economists to accept and incorporate into their work. d) The implications of the theory were far-reaching and challenged many established economic models and theories. This led to resistance from those whose work was based on these models and theories. 53 Michael Oyson CFA - Econ 123 (Financial Economics) Carnegie Tech: Key figures 1. Herbert A. Simon (1916–2001): Field: Decision Theory, Behavioral Economics, Artificial Intelligence. Contributions: Simon was a polymath whose work spanned economics, cognitive psychology, computer science, and artificial intelligence. He is best known for his theory of bounded rationality, which challenges the notion that individuals make perfectly rational decisions. Simon argued that decision-making is limited by the information available, the cognitive limitations of the mind, and the finite amount of time people have to make decisions. Nobel Prize: He was awarded the Nobel Prize in Economics in 1978 for his pioneering research into the decision-making process within economic organizations. 2. Franco Modigliani (1918–2003): Field: Macroeconomics, Financial Economics. Contributions: Modigliani is known for several key contributions, including the Modigliani-Miller theorem on corporate finance and the life-cycle hypothesis of savings, which explains how individuals plan their consumption and savings behavior over their lifetime. His work had a significant impact on understanding financial markets and economic policy. Nobel Prize: He was awarded the Nobel Prize in Economics in 1985 for his work on household savings and the dynamics of financial markets. 3. Allan H. Meltzer (1928–2017): Field: Monetary Economics, Macroeconomics. Contributions: Meltzer was a prominent monetary economist known for his extensive work on the history of the Federal Reserve and his contributions to monetary policy analysis. He was a leading figure in monetarism and a co-founder of the Shadow Open Market Committee, which provided alternative views on U.S. monetary policy. Influence: Meltzer's work influenced both academic research and policy-making, particularly in the areas of inflation and monetary control. 3. Richard Cyert (1921–1998): Field: Behavioral Economics, Organizational Theory. Contributions: Cyert, along with James G. March, co-authored the influential book "A Behavioral Theory of the Firm" (1963), which challenged the traditional economic view of the firm by introducing behavioral concepts into economic analysis. Their work emphasized the importance of internal organizational processes and decision-making behavior within firms. 4. Edward C. Prescott (1940–2022): Field: Macroeconomics, Economic Dynamics. Contributions: Prescott was a key figure in the development of Real Business Cycle (RBC) theory, which uses models based on rational expectations and microeconomic foundations to explain economic fluctuations. His work, often in collaboration with Finn Kydland, challenged Keynesian views of business cycles and emphasized the role of technology shocks and other real factors in driving economic variability. Nobel Prize: Prescott shared the Nobel Prize in Economics in 2004 with Finn Kydland for their contributions to dynamic macroeconomics, particularly the time consistency of economic policy and the driving forces behind business cycles. 54 Michael Oyson CFA - Econ 123 (Financial Economics) University of Chicago: Key figures Eugene Fama: Eugene Fama is a Nobel laureate economist and professor at the University of Chicago Booth School of Business. He is known for his work on the efficient market hypothesis, which states that asset prices fully reflect all available information. Myron Scholes: Myron Scholes is a Nobel laureate economist and professor at the University of Chicago Booth School of Business. He is known for his work on the Black-Scholes-Merton model, a mathematical model for pricing options. Richard Thaler: Richard Thaler is a Nobel laureate economist and professor at the University of Chicago Booth School of Business. He is known for his work on behavioral economics, which integrates insights from psychology into economic analysis. Merton Miller: Merton Miller was a Nobel laureate economist and professor at the University of Chicago Booth School of Business. He is known for his work on corporate finance and the Modigliani-Miller theorem. George Stigler: George Stigler was a Nobel laureate economist and professor at the University of Chicago Booth School of Business. He is known for his work on the economics of information and industrial organization. Milton Friedman: Milton Friedman was a Nobel laureate economist and professor at the University of Chicago Booth School of Business. He is known for his work on monetary economics and his advocacy of free-market capitalism. 55 Michael Oyson CFA - Econ 123 (Financial Economics) UC Berkeley: Key figures George Akerlof - Awarded the Nobel Prize in Economics in 2001 for his work on asymmetric information, particularly his famous paper "The Market for Lemons," which explored how quality uncertainty can lead to market failures. 56 Michael Oyson CFA - Econ 123 (Financial Economics) University of Rochester: Key figures Michael C. Jensen: Area of Expertise: Corporate finance, agency theory, organizational behavior. Contributions: Jensen is one of the most influential finance scholars of the 20th century. He co-authored the seminal paper on the theory of the firm with William Meckling, introducing agency theory to the study of corporate governance. His work on performance measurement and incentives has had a lasting impact on both academic research and corporate practice. 57 Michael Oyson CFA - Econ 123 (Financial Economics) MIT: Key figures Paul Samuelson: Paul Samuelson was an American economist who was the first American to win the Nobel Memorial Prize in Economic Sciences. He was a professor at MIT from 1940 to 2010. Samuelson is known for his work on the mathematical foundations of economics, particularly his development of the neoclassical synthesis of Keynesian and neoclassical economics. Franco Modigliani: Franco Modigliani was an Italian-American economist and professor at MIT from 1962 to 1988. He was awarded the Nobel Memorial Prize in Economic Sciences for his work on the life-cycle hypothesis of saving and the Modigliani-Miller theorem. Robert Merton: Robert Merton is an American economist and professor at MIT. He was awarded the Nobel Memorial Prize in Economic Sciences for his work on the Black-Scholes-Merton model of options pricing. 58 Michael Oyson CFA - Econ 123 (Financial Economics) University background Eugene Fama: Ph.D.: University of Chicago. Contributions: Known as the "father of modern finance," Fama developed the Efficient Market Hypothesis (EMH), which posits that asset prices fully reflect all available information. Robert Shiller: Ph.D.: MIT. Contributions: Co-recipient of the Nobel Prize in Economic Sciences with Fama, Shiller is known for his work on behavioral finance, which challenges the EMH and introduces the concept of market bubbles and investor psychology. Michael Jensen: Ph.D.: University of Chicago: Contributions: Known for his work on agency theory and the development of the theory of the firm, Jensen’s work also includes research on market efficiency and corporate governance. Fischer Black. Ph.D.: MIT. Contributions: Co-developer of the Black-Scholes model for options pricing, Black’s work has had a profound impact on modern financial theory and the understanding of efficient markets. Myron Scholes: Ph.D.: MIT. Contributions: Co-creator of the Black-Scholes model, Scholes’s work is foundational in the field of financial economics and has influenced theories on market efficiency and pricing. Robert Merton: Ph.D.: MIT. Contributions: Known for his work on financial engineering and risk management, Merton’s contributions to the Black-Scholes model and the study of financial markets are highly influential. Milton Friedman: PhD University of Chicago 1946. Undergraduate: Rutgers University Paul Samuelson: PhD 1941. University of Chicago. Undergrad. Same. 1935. Franco Modigliani: Ph. MIT. 1953. Undergrad University of Rome 1944. 59 Michael Oyson CFA - Econ 123 (Financial Economics) Module 2: Investments “The higher the risk, the higher the return required.” 60 Michael Oyson CFA - Econ 123 (Financial Economics) Real Assets vs Financial Assets Investment - Current commitment of money or other resources in the expectation of reaping future benefits. Real assets - Physical assets. assets used to produce goods and services (e.g. real estate, infrastructure, machinery, art and collectibles, natural resources). It has intrinsic value. Financial assets - Typically non-physical assets. Assets that arise from contractual agreements on future cash flows or from owning equity instruments of another entity (e.g. stocks, bonds, mutual funds, certificates of deposits, derivatives, cryptocurrencies, bank deposits, exchange-traded funds or ETFs and real investment trusts or REITS). Lacks any intrinsic value. Sources: CFI, Bodie 61 Michael Oyson CFA - Econ 123 (Financial Economics) Real assets vs Financial assets Real Assets Financial Assets Nature Physical Typically non-physical Source of value Intrinsic or inherent value Depends on the contractual agreement or performance of the underlying asset Liquidity Not very liquid; At times lack More liquid given existence of of proper marketplace financial markets where they can be sold Risks Physical damage or Market risk arising from price depreciation volatility and default risk Ownership Direct control over the asset Claim on future cash flows Inflation More protection against May or may not offer inflation inflation against inflation 62 Michael Oyson CFA - Econ 123 (Financial Economics) Financial Assets Types a) Fixed income/Debt securities - An investment that provides a return through fixed periodic interest payments and the eventual return of principal at maturity. Pay a specified cash flow over a specific period. Promise either to pay a fixed stream of income or a stream of income that is determined according to a specified formula. Investment performance least closely tied to the financial condition of the issuer. b) Equity/ Common stock - Represents an ownership share in a corporation. Not promised any particular payment. Performance of equity is directly tied to the success of the firm. Riskier than debt. c) Derivatives - Securities providing payoffs that depend on the values of other assets such as bond or stock prices. E.g. options, futures contracts. Value derived from the prices of other assets. 63 Michael Oyson CFA - Econ 123 (Financial Economics) Module 2: Investments Fixed Income Instruments or Debt Securities 64 Michael Oyson CFA - Econ 123 (Financial Economics) Fixed income securities Fixed income securities are a broad class of very liquid and highly traded debt instruments, the most common of which is a bond. They generally provide returns in the form of regular interest payments and repayments of the principal when the security reaches maturity. - Source: CFI 65 Michael Oyson CFA - Econ 123 (Financial Economics) Fixed income securities Fixed income refers to the interest payments that an investor receives. Based on the creditworthiness of the borrower and current interest rates. The longer the maturity, the higher the interest. Note: not all interest rates on fixed income are fixed. Some are based on an underlying benchmark or index (e.g. LIBOR). Examples of fixed income with variable interest rates include adjustable rate mortgages, floating rate bonds. Source: CFI 66 Michael Oyson CFA - Econ 123 (Financial Economics) Why invest in fixed income 1 Liquidity: Easily tradable 2 Stability: Provide a steady and predictable stream of income through regular interest payments and return of principal upon maturity 3 Income Generation: Fixed-income securities provide you with a reliable source of income in the form of periodic interest payments 4 Diversification: Fixed-income bonds can perform differently under various market conditions Source: CFI, RCBC 67 Michael Oyson CFA - Econ 123 (Financial Economics) Why invest in fixed income 5 Preservation of Capital: Especially those issued by stable governments. Investing in these securities can help you preserve capital, making them attractive if you're the type of investor looking to protect your wealth 6 Liability matching: Matching of income and obligation (eg pension funds) 7 Regulatory Support from SEC/BSP: Enhances market transparency, liquidity, and investor confidence Downside: lower return, limited cash access, interest rate risk Source: CFI, RCBC 68 Michael Oyson CFA - Econ 123 (Financial Economics) Bonds are lower risk vs equity Different from equities, or stocks. Fixed income securities do not represent an ownership interest in a company, but they confer a seniority of claim, as compared to equity interests, in cases of bankruptcy or default. Payments of interest and repayment of principal (amount borrowed) are a higher priority claim on the company’s earnings and assets compared with the claim of common shareholders. Since fixed-income claims rank above shareholder claims in the capital structure, a company’s fixed-income securities have, in theory, lower risk than their common shares. - Source: CFI, CFA Institute 69 Michael Oyson CFA - Econ 123 (Financial Economics) Basic features of a bond Issuer Maturity Par value (or principal) Coupon rate and frequency Currency denomination 70 Michael Oyson CFA - Econ 123 (Financial Economics) Basic features of a bond Principal - the amount the issuer agrees to pay the bondholder when the bond matures. Coupon rate - the interest rate that the issuer agrees to pay to the bondholder each year. The coupon rate can be a fixed rate or a floating rate. Bonds may offer annual, semi-annual, quarterly, or monthly coupon payments depending on the type of bond and where the bond is issued. Yield-to-maturity - the discount rate that equates the present value of the bond’s future cash flows until maturity to its price. Yield-to-maturity can be considered an estimate of the market’s expectation for the bond’s return. Bond covenants - legally enforceable rules that borrowers and lenders agree on at the time of a new bond issue. Affirmative covenants enumerate what issuers are required to do, whereas negative covenants enumerate what issuers are prohibited from doing. 71 Michael Oyson CFA - Econ 123 (Financial Economics) Examples of Fixed income instruments Bonds - Loans made by investors to an issuer, with the promise of repayment of the principal amount at the established maturity date, as well as regular coupon payments (generally occurring every six months), which represent the interest paid on the loan. Money Market Instruments - Considered the safest short-term debt instrument. Short-term and highly marketable. E.g. commercial paper, banker’s acceptances, certificates of deposit (CD), repurchase agreements (“repo”) and the most traded, US Government Treasury Bills). the safest short-term debt instrument, Treasury bills are issued by the US federal government. With maturities ranging from one to 12 months. Low risk. Asset-Backed Securities (ABS) - Asset-backed Securities (ABS) are fixed income securities backed by financial assets that have been “securitized,” such as credit card receivables, auto loans, or home-equity loans. ABS represents a collection of such assets that have been packaged together in the form of a single fixed-income security. Preferreds - Sometimes called Subordinated Debt, these type of fixed income securities rank lower on the capital stack. Preferred fixed income securities may not pay their coupon or principal should the creditworthiness of the issuer deteriorate. This risk is called loss-absorption and hence Preferreds are sometimes viewed as a hybrid security between fixed income and equities. Derivatives - Financial contracts that have different payoffs depending on how other securities behave. These are called “Derivatives” and in fixed income, we see these derivatives such as swaps, options and structured products. Source: CFI 72 Michael Oyson CFA - Econ 123 (Financial Economics) More… Certificates of deposit - a bank time deposit Commercial paper - short-term unsecured debt issued by large corporations (may mature up to 270 days, usually in multiples of USD100,000) to the public, rather than borrowing from the banks. To finance payroll, inventory, R&D. Commercial paper differs from corporate bonds in several ways. CP is always issued at a discount, has a fixed, short-term maturity, and is an unsecured funding vehicle. Bankers’ acceptance - an order to a bank by a customer to pay a sum of money at at future date (usually used in international trade) Eurodollars - dollar-denominated deposits at foreign banks or foreign branches of American banks Repurchase agreements - short-term sales of securities with an agreement to repurchase the securities at a higher price 73 Michael Oyson CFA - Econ 123 (Financial Economics) More… Treasury bills - short-term government securities issued at a discount from face value and returning the face amount at maturity. Issued with initial maturities of 4, 13, 26 or 52 weeks. Treasury bills do not pay semi-annual interest like most other bonds. Instead, interest is received at maturity. 74 Michael Oyson CFA - Econ 123 (Financial Economics) Treasury bill Source: WSJ 75 Michael Oyson CFA - Econ 123 (Financial Economics) US T-bill Example: You want to buy USD1000 T-bill DTM = 180 days Interest rate = 1.5% Then Price = 99.25 (per 100) But since you’re buying USD1000 T-bill, price is 992.50 76 Michael Oyson CFA - Econ 123 (Financial Economics) PH - Fixed income options Source: Metrobank 77 Michael Oyson CFA - Econ 123 (Financial Economics) PH T-bill Source: China Bank 78 Michael Oyson CFA - Econ 123 (Financial Economics) T-bill: Sample calculation Source: Juan Finance 79 Michael Oyson CFA - Econ 123 (Financial Economics) Retail T-bond - sample calculation Source: Juan Finance 80 Michael Oyson CFA - Econ 123 (Financial Economics) Treasury note: Sample calculation Source: Juan Finance 81 Michael Oyson CFA - Econ 123 (Financial Economics) Treasury Bonds Source: Juan Finance 82 Michael Oyson CFA - Econ 123 (Financial Economics)

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