Introduction to Financial Markets PDF Exam Paper

INTRODUCTION TO FINANCIAL MARKETS Prof. Dr. M. De Ceuster Written exam (18/20) explain concepts in an concise and correct way and explain their relationships with financial markets and institution...

INTRODUCTION TO FINANCIAL MARKETS Prof. Dr. M. De Ceuster Written exam (18/20) explain concepts in an concise and correct way and explain their relationships with financial markets and institutions compare financial concepts. give an overview of the role and the institutional structure of financial markets and institutions. reflect on financial problems. apply financial concepts in small exercises (Excel can be used but we do NOT provide cheat sheets with formulas.) COURSE CONTENT Unit Topic Reference Chapter 1 The Financial System 1 2 Money and Bond Analytics 7 3 Money and Bond Markets 7 4 Equity Markets 8 5 Risk and Return NA 6 Derivatives - Futures 14 7 Derivatives - Options 13 8 Exercises NA 9 Financial Intermediation 2&9 10 Commercial and Investment Banking 4 and 5 11 The Financial Crisis of 2008 10 12 Regulation and Supervision 6 UNIT 1 – THE FINANCIAL SYSTEM 1. THE ACTORS Haves or Havenots? The economy consists out of haves and havenots. 1. Haves possess capital and can lend it out (Lenders). Families, they have the money - wealth is created by families Financial industry (bank) - in between The hole idea of finance is to put the money the ‘haves’ have in extend and put it in productive use. They can put their money - Directly in the havenots or - Indirectly, which means there is most likely a financial institution involved. 1  2. Havenots have more needs than money and they will have to raise capital (borrowers). Corporates (fictional), government (one of the biggest havenots) Financial industry - in between, they receive money from families and give it as a loan to companies (money goes in, money goes out) The rest of the world è Debt is where the wealth is ! The main Actor: Households = the crucial players When a single household owns a house of 100 but at the same time has a remaining mortgage debt of 80, its net wealth is 20. (House is biggest assets most of the time.) Net wealth (netto vermogen) = assets – liabilities The Household Balance Sheet Household balance sheet = gives an overview of the assets and the liabilities of a single household. Example of a balance sheet of a typical family Left = assets, right = liabilities Real assets: tangible Financial assets: o stocks -> participation in de company, so it is the receipt that you get o Bonds -> a kind of loan o Mutual funds -> kind of portfolio of what you buy o Deposits -> term deposits: money on the bank for example for 2 months o Cash Mortgage loans -> a lot of families can only buy a house thanks to the bank, but they always want their money back so when you can’t pay anymore, they will take your home away from you Consumer loans -> you buy a car, computer screen and you pay over several months Balance sheet = overview of assets and liabilities Asset = bezit 2 Liabilities = schulden Equity = eigen vermogen Stock = aandeel, participation in a company Bond = obligatie, a kind of loan issued by the government or by other corporates (give a fixed rate during a fixed time frame) Issued = uitgegeven door Mutual funds = a kind of portfolio you buy (stocks and bonds, diversification) Mortgage loan = hypothecaire lening Consumer loan = aankoop spreiden in de tijd Kinds of assets An asset = a possession that has value in an exchange transaction. Tangible assets or real assets (materiële activa) = derive value (=ontlenen waarde) from their physical character and the utility they generate. Intangible assets (immateriële activa) = derive value from a legal claim to some future benefit. Financial assets (financiële activa) = are intangible assets that represent a claim to future cash. (Immateriële activa (merknamen, patenten) ontlenen hun waarde aan juridische rechten en intellectueel eigendom, terwijl financiële activa (aandelen, obligaties, derivaten, banktegoeden) waarde hebben door claims op toekomstige geldstromen.) Real versus Financial Assets Source: Credit Suisse, Global Wealth Report 2018 = different around the world Belgium: a brick in our stomach Asset Classes Traditional Common stock (=gewone aandelen) Bonds (=obligaties) Cash (and cash equivalents) (savings account for example) Alternative Real estate: buildings o Rent, buy/sell Commodities (=grondstoffen): dangerous financial risk (bv. Olieprijs) Private equity (=privaat vermogen): private bedrijven (niet-beursgenoteerd), a company of your neighbour 3  Hedge funds: for the wealthy investors (voor een beperkt aantal investeerders) = hedgefondsen zijn beleggingsfondsen die verschillende strategieën gebruiken om rendement te genereren voor hun investeerders Venture capital = risicokapitaal dat wordt geïnvesteerd in start-ups en jonge bedrijven met hoog groeipotentieel o (risicodragend kapitaal) -> similar to private equity Currencies (forex) VC: jonge, snelgroeiende bedrijven. PE: volwassen bedrijven Liabilities Mortgage loans (= hypothecaire leningen) Consumer loans (= consumentenkredieten) Tax debt (= belastingschuld) Growth Drivers in Net Wealth Value changes in assets and liabilities Net-income from labour, capital or transfers (i.e. pensions, social security-based income) Inheritances, gifts Stocks change in value: it changes your net wealth. All these things change your wealth - Wealth is something dynamic and it is very relative - If the stock markets grow with 50% in a year it’s suddenly much more wealthy and then the next year there is a big crash and the markets go down 70% -> all the wealth that was there suddenly evaporates - That is why people don’t like craches because they lose a lot of money Wealth creation “Assets put money in your pocket, whether you work or not, and liabilities take money from your pocket.” Robert Kiyosaki à You have to make a decision in the future do you want to be a poor dad or a rich dad. 4 Middle class are poor people with a home. When they are retired, they finally paid the mortgage, and they have a home. Rich: Collecting items that generate money for you. If you want to be rich you need to have a passive income, you need to have assets that generate money. Assets and liabilities for poor people are empty -> they work hard and get a salary and so they pay rent, food,… but keep nothing over because they have to spend everything The middle class think they are wealthy, but they aren’t… they actually are poor families with a home -> What does middle class families do? They ern some money (salary), it has all the expenses and there is something left over and so they buy a house, but therefore they take a mortgage loan And when they retire finally the house is theirs Not enough to cover financial independency. How to come out of this? To take risks. What makes the rich so different? They go real assets on their asset sheets and they generate cash, an income on their own -> they also work and get some salary, but a big part of their income is from the rent of apartments, houses, they have royalties,… If you really want to become rich, the stress needs to be on collecting assets that generate cash for you You need to become independent and build up these kinds of assets Wealth is Not Uniformly Distributed Africa is in a light color. It is very unequally distributed Wealth Distribution 5  In North America and Europe are the wealthiest people (Still there are also poor people) The largest middle class is China A lot of poor people in Africa, India, Asia-Pacific What does this really mean? VISIT: https://www.gapminder.org/dollar-street/matrix VISIT: https://www.gapminder.org/ignorance/ search for “Hans Rosling” on YouTube --> it opens your eyes how the world is structured Wealth Inequality Belgium: low inequality Emerging markets don’t populate this These emerging markets have a very high inequality like south Africa Final Thought 6 Do you fully realize that households are the ultimate owners of all assets in the economy? bearers of risk within the financial system? Households own all the assets = ultimate beneficial owners of the wealth but in the end, they bear all the risks (behind each corporate is an individual) Different kinds of risks: entrepreneur / employee. Entrepreneur: no guarantee, but likely he will become much more wealthy. è If you really want to become rich you have to have the guts to become an entrepreneur. 2. HOW DO THE BALANCE SHEETS OF OTHER ACTORS LOOK LIKE? Households have stocks of companies and companies take loans. The banks need to fund of course this loan so they in turn are getting your savings deposit. So everyone of this players is interconnected with each other. Corporates Werken met geleend geld = hopen dat de kost van het lenen lager is dan de winst die je ermee bekomt. Entrepreneurs like to work with borrowed money - he hopes that the cost of the borrowed money is lower than the profit margin you van make on it (leverage). Fixed assets: long term commitments. Liabilities (right side) Trade credit: The company bought something, but they didn’t pay immediately. They wait 30 or 60 days to pay so it’s still a debt. You have to pay some kind of interest when you loan from the bank. If you are a Equity holder it depends or you’re company makes profit or not than you get dividends if it doesn’t make profit than you get nothing. There are also other thinks like reserves… but not at market value balance sheet. Leverage = You take a loan from the bank to buy shares. Because you hope that you get profit and get more money. 1) Equity (eigen vermogen) - The shareholders -> they own the company - They have given money to the company, but they don’t have anything to say in the company - If we fund a company, we bring in cash from an individual to the company and we get stocks in return -> that is the equity that we form at the foundation 7  - Equity = claim of the shareholders 2) Debt - It is everything that the company borrowed and that can be under the form of loans, bonds, trade credit (handelskrediet)(= you borrowed something, but the company didn’t pay it immediately because they waited for 30-60 days to pay but it is still a debt from this company because they have to pay there bills but they take credit by delay the payment) - If you borrow money from the bank you will have to pay interests - If you are an equity holder it depends whether you’re company makes profit or not o If it makes profit you may get a dividend o If it doesn’t make profit you can’t get anything We put the shares at market value -> in the accounting system it can be different things That ratio is important, because people like to work with borrowed money but why? - The entrepreneur hopes that the cost of the borrowed money is lower than the profit marge that I can make with it -> leverage (=hefboomwerking) The costs of the loans are lower than what he earns when he takes a loan (= leverage) Assets (left side) Fixed assets = it has a long-term commitment. Tangible (trucks or buildings). Financial (you can have shares of another company) à One company can have shares in another company: Start off with a stake of 100 and controlling 800 of assets = that what’s called leverage. With little money I can control a lot more. We only hold 100, but we basically are responsible for 800 Leverage is het gebruik van geleend geld (vreemd vermogen) om het verwachte rendement van het eigen vermogen te verhogen (=hefboomeffect) Debt can be very interesting to use to lever up your profits to returns, it might help you to get control. 1) Fixed assets (= vaste activa) = it has a long term commitment 2) Current assets (= vlottende activa) Leverage Companies can be funded with shareholder funds (equity) consisting out of the original equity, rights issues and the retained profit. debt When companies use debt to finance their operations, they use leverage. Most companies use leverage to raise the ROE above the ROA. 8  ROE = return on equity i.e. profit/equity - That’s what the shareholders finds very interesting - ‘How much do I earn on the money that I as a shareholder invested’ ROA = return on assets i.e. profit/assets - That’s the return that you get with all the money you use The famous Dupont scheme uses the latter: ROE = ROA (return on assets) x LM (leverage multiplier) Example: A=300 E=100 D=200 Gearing ratio: 200/100 = 2 Leverage multiplier: 300/100 = 3 Example: A=100 E=50 D=50 Profit: 20 ROA: 20/100 = 20% ROE: 20/50 = 40% ROE = ROA x LM: 40 = 20 x 2 Financial sector – Bank Companies have +-70% debt Banks have a lot of debt! (much more, vb 97%), and little equity à Big leverage multiplier Assets for trading (shares): trading book (no intention to keep it) Banking book: granting loans A bank can do much more than a company. Their business model is taking money from anyone en give it to someone else. So the most of the money came from someone else. Before the crisis of 2008 the Dutch bank had exactly 3% of equity and finance it self’s with 97% of debts. 9 Your deposit is an asset for you but it’s a liability for the bank. Debt: possibilities where the funding can come from Interbank loans: lending money from other banks A trading book = our assets which the bank has on it’s balance sheet but actually they have it for trading. A trading book refers to the portfolio of financial instruments held by a financial institution or individual trader that are actively bought and sold for short-term gain, typically within a short timeframe such as daily or weekly. These instruments can include stocks, bonds, derivatives, currencies, and commodities. The purpose of a trading book is to generate profits through speculative trading activities rather than long-term investment strategies. the banking book = it’s about granting loans. A banking book refers to the portion of a bank's assets that are held for the purpose of earning interest income and are not actively traded è One of the businesses that banks want to do is of course to transform their deposits in something with heals a higher return. Deposits (0%) à loans / bond portfolio (government: earn 2%) A typical bank has a small part of equity and a lot more of debt A company has much more equity and much smaller debt Financial Sector – Mutual Fund (= beleggingsfonds) Mutual fund = some kind of portfolio manager who is gattering funds. ‘I will do the investments for you’ (Someone else buys for you). E.g. You give me a thousand euros and I will give you a certificate of your funds and I as a portfolio manager am going to invest that in al kind of financial products. It’s like a passing-through thing because the money comes in through the certificates and I put it back in the financial markets (invest in something/somewhere we agreed on). Financial Sector – Insurance Company 10 Insurance companies have 2 big branches. 1. Causality insurance (for example car incident) you get what you are paid for 2. You pay money to the insurance company, and they are invest that for you. They going to pay that in case of a debt (someone dies, and the insurance company pays that out) or you get that money after the insurance contract has finished (so when you retired). It’s some kind of investment product. The technical provisions is a crucial thing. This is the estimate of the contractual obligations that that the insurance company has. This might be of life insurances/causalities and that money have to invest that to be able to cover the loses and the pay out of the life insurance. The Government How does the balance sheet of a government look like? What would be on the liability side: the government debt. They make debt and put the debt on the next generations shoulders. They do whatever they want with. Assets: not a lot. Some government buildings. They have some stacks in banks. They can have negative equity. The government can rise there taxes so that the families (they own everything in the end) need pay more money to pay of their debt. Taxes = Power that no one haves except for the government 3. THE FINANCIAL SYSTEM Importance Economic growth is linked to financial development. The role of the financial system is to facilitate production, employment, and consumption. Resources are funnelled through the system so resources flow to their most efficient uses. Most dominating country in the world: financial – economic growth 17th century: The Netherlands 19th century: Brittain 20th century: US If the financial system breaks down, you’ve got a huge problem. This was the big fear in 2008. The Financial System (Semi-)Direct finance through financial markets Borrowers sell securities directly to lenders in the primary market. After issuance, these securities often can be traded in the secondary market. o Money markets o Capital markets 11  Direct finance provides financing for governments and corporations. Financial institutions come in between and they ask a fee = semi-direct) Indirect finance: through financial intermediaries (like a bank) = when the money from the haves is passing through the balance sheets of the financial institution (=debt) and they transform it in loans to it out to the havenots. An institution stands between lender and borrower. We get a loan from a bank or finance company to buy a car. In our terminology are the savers the haves and the borrowers the not haves. Create a different kind of financial system = shadow banking (legislation is to protect the depositors) Savers (haves) Borrowers (havenot) 1) Directly give the money (vb auto van je ouders: also (informal) transaction on the financial market) 2) Semi-direct (someone helps vb bank, dan betaal je een FEE (= vergoeding)) 3) Indirect finance (haves put money on the bank, bank gives loans to havenot) à In the real world most of the finance happens through semi-direct finance -> Investment bankers help corporates to raise the money Composition of the Financial System The pension funds are completely different in the Netherlands then here in Belgium. Belgium: People who work are paying the pensions for those who are retired. Netherlands: People who work build up their own pension. Emerging markets: banks are much more dominant 12  4. ROLE OF THE GOVERNMENT Discussion: should the government play a role in the market? Role of the Government in Financial Markets Financial markets play a prominent role in the economy. This calls for regulation if market failure (i.e. not producing services efficiently at the lowest cost) may arise. Disclosure regulation in order to prevent issuers from defrauding (actual or potential) investors by concealing (=verbergen) relevant information. Market conduct regulation a.k.a. financial activity regulation in order to prevent insider trading (= handel met voorkennis), in order to impose trading rules,... Financial institution regulation in order to prevent the default of financial intermediaries and in order to safeguard the payment system. Restrictions on foreign participants in order to control e.g. the money supply. Act as financial intermediary (e.g. credit support through loans and guarantees) Influence the markets through monetary policy (i.e. government sensu lato since this task is performed independently by the central bank.) Provide bail outs Banks are the most regulated industry in the world. Some role for the government is needed because if the financial market fail, the economy fails. Other Potential Roles of the Government Act as financial intermediary (e.g. credit support through loans and guarantees) Influence the markets through monetary policy (i.e. government sensu lato since this task is performed independently by the central bank.) Provide bail outs The last potential role has been actively used in the past but is under discussion. No bail out policies Systemically Important Financial Institutions (SIFIs) If a bank is interconnected to other banks that’s a problem. You don’t want to have a domino effect. The system will be at risk. Banks will not always be bailed out, but you must make sure that the bank is not too interconnected with other bank (domino effect). à list of bail outs where the government interferes 5. REVIEW QUESTIONS − Can you give examples of borrowers and − Explain the difference between equity and lenders? How is “net wealth” defined? debt? − How can assets be defined? − What is gearing? Can you compute the − Give examples how assets be categorized? gearing ratio based on a balance sheet? − Which asset classes are considered to be − Do households use leverage? traditional? − Can you depict the balance sheets of the financial players? 13 − Which asset classes are labelled as − Can you identify the main differences “alternative investments”? What are the between the balance sheet of a corporate major liabilities of households? vis-à-vis the balance sheet of a bank? − What are money markets? / What are − What items are special/unique for the capital markets? What are securities and balance sheet of insurance companies? what are their characteristics? What are How does direct financing work? primary and secondary markets? − What is the difference between direct - − Can you identify the growth drivers in net semi-direct and indirect finance? Can you wealth? give examples of “fee business”? − Under what conditions do you classify a − What is shadow banking? (see also chapter household as poor, middle class or rich? 2 pg 27) − Wealth is not distributed equally over the − Does the government have to play a role in globe. How can this be the financial system? If not, argue why? If visualised/illustrated? so, give some examples. − Do developed economies exhibit wealth − Should governments bail out banks if they inequality or is this only a characteristic of collapse? emerging markets? 14 UNIT 2 - FIXED INCOME MARKETS Financing Sources Equity instruments Debt instruments o Loans o Debt securities Loans and debt securities are known as “fixed income instruments”. Financial History Debt instruments are the oldest instruments in the world: IOU goes back to the time of the hunters-gatherers. The codex of Hammurabi (1780 BC) provided amongst others in loan concepts (including interest charges) and insurance/risk sharing contracts. 20% interest rate was quite common back then 16th century loan book 1. INTEREST RATES Interest rates are a whole multidimensional thing that’s hard to capture. Interest rates is a very difficult way to model. Interest In a world with positive interest rates, you will have to pay back more than the amount you borrowed. The rate of interest is the price of money. the price to ‘rent’ money the reward for the lender to postpone consumption if you postpone a consumption, you are giving someone else the opportunity to realize their dreams so get a reward for this = that’s the basic idea. In the economy you either consume or postpone consumption. Example: You can borrow 100K at 2.34% per annum for the next 2 years. Alternatively you can state that your borrow at 234 basis points per year. (Is 2 percentage points and 34 basis points). 15 This means you receive 100K now and that you will have to repay 2340 next year and 102340 within two years time. We always work with per annum (year) Procentpunten = basispoints (van 2% naar 3% is increase of 50%, also increase of 1 procentpunt) procentuele verandering vs number of digits that you’re adding) How much interest is a lender going to charge you? ⇨ The interest rate charged depends on the risks taken by the lender ⇨ Not everyone get charged the same rate, so you and your neighbour could get another interest rate from the bank This risks depend (at least) on the credit worthiness of the borrower. (=credit risk, default risk, counterparty risk) maturity of the debt. (horizon of 1 or 2 years: less uncertainty than in 20 years) Hence, we cannot speak about the interest rate. There will be a different interest rate per maturity and per borrower. Term Structure of Interest Rates Time to maturity Research from the Belgian Governement Curve = Term structure of interest rates Depends on which date What kind of graph do we get if we plot the “interest rate” that would be charged vis-a-vis a certain counterparty for maturities ranging from 1 day to 30 years? Notice this is a graph on a particular day, keeping all the loan characteristics constant except for the maturity of the loan. What would you get for a different, less credit worthy borrower? This graph is named the term structure of interest rates. Often people talk about a yield curve but this term as such is less precise as we will explain. X-as = time to maturity Y-as = interest rate Term structure of Interest Rates / Yield curve = this shows different interest rates for 1 obligor for 1 particular day. 16 Term Structure of Interest Rates (aka yield curve) They compare the short end with the long end AAA rated bonds = best bonds available (default risk is very low) so lower interest rate Long term interest rates are higher than short term interest rates (typically) Less credit worthy borrower: higher interest rate: will be the highest curve Monetary policy instrument = short term interest rates increase fast --> curve becomes downwards --> bad for the economy because taking out credit becomes more expensive --> less people take credit --> puts a break on the economy A whole kind of rating categories. If it goes down, it gets worse. Above the red line = investment grade. (Relatively good bonds) If the credit quality deteriorates (verslechtert), the market charges extra premia (if someone is likely to default, you want to earn more on it because you hope that in the portfolio at least the extra cost price you ask as interest rate will cover the potentional credit losses you have) Below the red line = much more speculative. Term Structure of Interest Rates Shapes 17  B is the normal one C is bad news Descending: for economists very interesting, but bad news for the economy. A recession is ahead Decomposition of an Interest Rate Demand and supply for loanable funds determine a short term risk free interest rate. This interest rate rewards the delay in consumption. It’s a demand for credit and the rules is the same. If demand is high and a lot of people want credit, you see the price of credit increasing. So the interest rates increase. If there is a lot of supply you see that of course for the people who want to borrow, there is plenty of money available so they can play out the banks against each other so the interest rate can be lower. The lender faces risks for which a compensation (premium) is required. - Maturity premium: A longer maturity of the debt instrument delays consumption more than a shorter maturity and hence the lender will ask for a maturity premium. This gives rise to a term structure of the real riskless interest rates. - Expected inflation premium: There is no guarantee that the purchasing power of the funds repaid in the future will be the same as the purchasing power of the funds lent out. Therefore the lender adds a(n expected inflation) premium to each risk free rate to obtain the term structure of nominal risk free interest rate. Of course the expected inflation premium can be different for different maturities. (E.g.: suppose that I’m giving you 100 euros say it is equivalent to 20 hamburgers and you are going to repay me n a year 100 euros but I expect that the price for hamburgers go from 5 to 6 euros. I would like to make sure after the disposal of that money that I get back the equivalent of the 20 hamburgers. So I would like get back 120 euros. The only way that I can do that is to put it into the interest rate. I need to get the value back.) - Credit spread: The lender will charge the borrowers with a credit spread for expected credit losses. Often this credit spread also embeds a liquidity premium. Of course, the credit spread can be different for different maturities and for different borrower qualities. This results in a term structure of nominal rates for risky assets. (=cover the risk of not getting paid back) Decomposition Other factors that we conveniently ignored. Special contractual provisions 18  E.g. o Seniority: my loan is superior to other loans standing in case of default wh ⇨ You give someone a privilege. This should lower the interest rate. o Embedded options: I don’t need your money anymore, I give you the bond back and you give me money back although it was a bond of 10 years. You have the right to stop the deal (= callable bond). You call it back ⇨ e.g. you borrow for 5% and the interest rates are decreasing so you stop the deal and start another deal for a lower interest rate by someone else ⇨ bcs of this advantage the interest rate will be lower Collateral arrangements = more secure, less risk (low interest rate) Differential tax treatment treatments = e.g. flower bonds: the government issued it, you can use them to pay of inheritance taxes at a much cheaper rate (advantage so lower interest rate) … Conclusion: The interest rate that we think off is a risk free interest rate, but we have to add all kind of premia because of the maturity, obliger, the expected inflation and that make the fact that’s not something in the world of THE interest rate but that you got a whole plethora of interest rates. Decomposition formula: Irvin Fisher stated the often used relationship between nominal and real interest rates. (1930) The nominal interest rates is something that we observe. We can estimate what the real interest rate in the economy is. You expect that it doesn’t change that much but the inflation expectation they might change much more. E.g. (1+7,1%) = (1+2%)(1+5%) 7,1% this is something you observe in the market (1+r nominal) = 1+r real+𝜋e+r real.𝜋𝑒 ignore this part (1 and r real.π𝑒) (1+r nominal) ≈ r real +π𝑒 Remarks: 𝜋e denotes the expected inflation, r stands for the interest rate. Most of the time, this Fisher equation is used to determine the real interest rate, given the observed nominal interest rates and an estimate of the expected inflation. Time Variation 19 Nominal risk-free rate so the inflation is into it. The colors are the dominated countries. Interest rates do spike and quite often due the inflation We have never thought of interest rate as a cost of storage --> the cost of storing money with the bank, but that has now become real life: Interest rates have been decreasing overtime. Now you can have a negative interest rate, if you loan the bank some money you have to pay the bank money which is ridiculous. 2. TIME VALUE OF MONEY = The capital idea in finance We can transport money to the future and from the future back to today = time value of money Preliminary Remark In order to understand fixed income instruments, we need to understand the time value of money. We introduce both simple interest rates à if you apply that many periods consecutively you end up with compounded interest rates What is the difference between “Simple interest rates” and “Compounded interest rates”? Simple interest rates (= enkelvoudige rentetarieven)-> you can say that you do not capitalize - you don’t calculate an interest rate during the maturity of the loan, you just calculate it at the end - you can never earn interest on interest, you can only earn interest at the principle - it’s being used in money markets -> financial markets that are short term in nature o Money markets - if the maturity of a product is less than one year when you issue the product. -> like a treasury bill is a short-term government bond E.g.: Treachery bill = a short-term government bond Compounded interest rates (= samengestelde rentevoeten) -> you allow interest of the first period to become capital and so to healed interest in the second period (concept of interest on interest is going to start to exist, it’s a convention) - if the maturity of a product is longer than one year it belongs to the capital market 20  o that’s when we use compounded interest E.g: Stocks: because it have no maturity really (dividends can be reinvested) or 10 or 30 year government bond (Bonds pay interest periodically, which can be reinvested to earn additional interest)… ⇨ this is what we call an interest rate convention -> no right or wrong since both of them are used in practice. ⇨ It depends on the maturity and what the agreements are Timeline Timeline = a linear representation of the timing of potential cash flows. Inflows = positive cash flows. Outflows = negative cash flows. Example: Assume that you are lending 10K today and that the loan will be repaid in two annual 6K payments. The idea is you see the negative amounts and positive amounts --> you prefer positive amounts = cash inflow When you have a negative amount = cash outflow Single Cash Flow Compounding (simple interest rate) 21 Example: Suppose that we invest 100 today at an interest rate of 10% p.a. (i.e. per annum). What will be the future value of our investment within 1 year? 100 × (1 + 10%) = 110 What will be the future value of our investment within 6 months’ time? 100 × (1 + 10% × 6/12) = 105 100 × (1 + 10% × 0.5) = 105 Remarks: - V0 represents the present value - VT refers to the future value at time T. - Both time and the interest rate are measured in years. - Pro rata = proportionating it with time (e.g. for 6 months) - T = time to maturity (e.g. 1 year or 6 months) - Simple interest rate – future value: VT = V0 × (1 + r × T ) 22 Single Cash Flow Discounting (simple interest rate) Let’s reverse the question. Suppose you receive 105 within 6 months and on the market the interest rate is 10% p.a. What is the present value of this future cash flow? Example: This is within 2 years. The interest rate is 10% per annum and you are going to get from me 120 within 2 years’ time. How much is the value of that 120 today? How much would you invest today to have 120 (=future value) after 2 years using a rule of simple compounding. Answer is 100 = the present value We simply rewrite our equation VT = V0 × (1 + r × T ) as Simple interest rate – present value: !" V0 = ($%& ( )) Single Cash Flow Annual Compounding Annual compounding = after 1 year you get a time-break. You calculate the interest rate that you earned and from that moment, that interest rate is realised for me and I’m investing that money as well as the original principle. So interest generates new interest. 23 Suppose you deposit €100 for one year at a rate of 10% p.a. How much will it amount to in one year? V1 = V0 × (1 + r × 1) = 100 × (1 + 10%) = 110. What happens if you leave the money in the account for another year? V2 = V1 × (1 + r ) = 110 × (1.1) = 121 You earned an EXTRA (!) €1 in year 2 with compound over simple interest. Single cash flow – annual compounding: Vt = V0 x (1 x r) t Graphically, we see the exponential nature of compounded interest rates arise. This is exponentially increasing (red arrow) The green line is the principle and the interest on the original amount so that is linear Over long periods of time this time value is devastating and really working enormously Single Cash Flow Discounting (with Annual Compounding) To determine the present value of a future cash flow, we compute Present value of a future cash flow: !" V0 = ($%&)^" Consequently, the present value of 1 210 which we receive within 2 years equals 1 000 if the interest rate on a two-year investment equals 10% p.a. with annual compounding (i.e. 10% p.a.a.c.). 3. MULTIPLE CASH FLOWS Value Additivity = (toegevoegde waarde) 24 Cash flows can only be summed if their values are expressed at the same moment! Example: Paul Draper has won a crossword competition and will receive the following set of cash flows over the next two years: Mr. Draper can currently earn 6 percent in his money market account. What is the present value of the cash flows? Computation: 2K after one year and 5K after 2 years Suppose that I only gave you the 2K, then what is the value of 2K today? --> today with positive interest it’s worth less I’m bringing the 5k back to today and then we have the present value of the second cash flow Rule N°1: E.p. If you have got 50 euros in your wallet and you got 50 euros at home: you have got 100 euros, so you are allowed to add amounts as of today, but in this case, he gets 2K after one year and 5K after 2 years, he definitely gets not 7K in terms of today è I cannot sum amounts of money that are located on a different spot on a time access. I can only sum money if I bring them to one particular time --> the two amounts in present value are the value of two cash flows measured at time zero so I can sum them! --> So Mr. Draper will NOT receive 7000 today. You need bring both values back at a same period. So today he earns 6 337 at the present value. à this isn’t what banks are doing if you want a loan 25 Bond Pricing Bond pricing= A financial instrument that gives rise to a stream of cash flows (CF) can be interpreted as a portfolio of single cash flow instruments. We know that present values are additive. We also know that each cash flow has to be discounted at it’s own interest rate. (Technically, we will use spot rates (see later). That’s why we use the symbol s.) I have to discount these cashflows at a correct interest rate. --> We said that there is a different interest rate for every maturity. That’s the reason why we do a term structure. So actually the interest rate of one year or two years don’t need to be the same. So in general you have to recognize that not all cashflows will be discounted at the same interest rate. = spot rates Bond princing: ,-$ ,-/ V0 = ($%.$)^$ + ($%./)^/ We can apply these principles to a coupon bond. What is the price of a 4 year 2% coupon bond with a face value of 1000? The coupons are paid annually. Assume a FLAT term structure with a discount rate of 6% p.a. (With bonds: If the market interest rates increase, the prices of bonds decrease!) 2% coupon bond --> the 2% defines the size of the cashflow and how much euros I’m going to get every year and we have that on a face value of 1000 So every year I get 2% on 1000€ and that is 20 (the cash flow) And the last year you het your money back and the interest rate so this is the cash flows Interest rates change every day --> so I have a bond for an investment of 2% per year and suppose that the interest rates have risen to an amount of 6% So the investor is going to discount with a market rate that in this case is increased to 6%, but the coupon doesn’t change If I apply the time travel machine, I’m going discount everything at 6% for four years so we become 861,4€ 26  Important lesson with bonds: If the market interest rates increase, what happens with the prices of bonds? They decrease because the market interest rates are in the dominator (=6%) and that makes the value of your bond smaller If the ECB is lowering these market interest rates, then what happens to the price of assets and bonds? They go up! If interest rates change, it will affect bond prices If interest rates go up, the price of bonds will decrease If interest rates go down, the price of bonds will increase In Excel: =pv(rate,nper,pmt,fv) i.e. =pv(0.06,4,20,1000) it give you that exact answer (861.40) but with a minus sign Present value in excel: it will reverse the sign if it is (+) the solution will be (-) and the other way around! Bond Pricing: The New Normal (60 basic points) Bond Pricing with a Negative Discount Rate In a world with negative interest rates. The coupon rate is fixed for that bond determines the cashflows (cashflow 2%) Market rate = Decreased to (-0,5%) What happens to “the bond price”? Determines how you have to An increase above the “par panalize (=straffen) the cash flows value” (nominale waarde) of 1000 nper = periods In Excel: =pv(rate,nper,pmt,fv) i.e. =pv(-0.005,4,20,1000) pmt = payment fv = future value If you contracted at 2%, but the market rate decreased to 0,5%, so the bond price will increase Students have problems with distinguish (onderscheiden) the coupon rate (20) from the market rate (0,5%) The coupon rate is fixed, you contracted it for every year so it’s always the same and it determines the cash 27 flows. But as the market rates determines how strong you have to penalize this cashflows Bond Pricing: Laws Prices and the interest rate are inversely related. If the interest rate increases/decreases, bond prices decrease/increase. If the coupon rate equals the (single) discount rate, the bond prices at par. o c=y → par o cy → above par coupon rate: is bringing you forward (with e.g. 2%) Discount rate: kicking you backwards (with e.g. 2%) (than the bond price = par value price of 1000) “par value” = the stated value, not the actual value. 4. YIELDS Yields (= opbrengsten)- with yields your turning the equation upside down What is a yield? Suppose that the price of the bond is 1101 today (V0) and the cashflows are 20 and I know that I have to discount the cashflows for 4 periods but the only thing I don’t know is the interest rates that is being used here. You can determine the interest that is being used on the market and it is always the same number (y) Yields of Single Cash Flow Instruments Leads to The return on a single cash flow that will be received at the end of period T is called a T-year spot rate. That explains why we use the symbol s. Yields of Multiple Cash Flows Instruments 28 We know that But what is the single “yield” that equates the present value of the future cash flows to the current market value of the instrument? Yields / Present value of future CF to current market value ,-$ ,-/ V0 = + +... ($%0)^$ ($%0)^/ - V0 = the current market price - Cash flows CF1 and CF2 and their timing are given - Hence the ‘yield’ is the only unknown (y), but it is the same number Yield-to-maturity = internal rate of return (= actuarial rate of return or overall yield) = the single return on a stream of cash flows. Determining the Yield to Maturity Suppose an investment of 339.03 will yield the following cash flows: CF1 = 50 ; CF2 = 150 ; CF3 = 70, CF4 = 100. --> I’m going to get this cashflows in the next 4 years We need to solve In Excel: =(values) i.e. =irr(-339.03,50,150,70,100) = 3.45% You have to ad dit as a range! (-) sign for what you have to pay (+) sign for what you will get “Values” has to be a range of numbers --> -price of the bond, +CF’s Alternatively you can use goal seek. 29 Unit 2 – Fixed Income Securities – Excel application 30 UNIT 3 – FIXED INCOME MARKETS - INSTITUTIONAL ASPECTS 1. RATINGS We have some players in fixed income markets that we should be aware of. first of all there is the havenots who needs funding so he wants to attract new financial sources. On the other hand you have the haves who have access of wealth. We know that this havenots can takeout a loan or bonds --> they can use fixed income instruments to fund their needs. If a company wants to take a loan. It’s extremely helpful if a third party who is unrelated to that company could tell to potential lenders something about that company. That’s the roll who rating agencies fulfil. The economic problem What do rating agencies do? Rating agencies (beoordelingskantoren) resolve the problem of a-symmetric information. In the past, investors had to pay rating agencies for the rating to know whether a company is actually a good company. So that A-symmetric information is eliminated. But that didn’t work Now, the companies that want to do bonds pay the rating agencies for their ratings themselves in order to appear more reliable to their investors. (Companies that do this to have to pay lower interest rates when taking loan because they come off more reliable and the lender is going to be sure that he will get the money that he still has to get back. Without a rating, to will have to pay a higher interest because the other party will not know how reliable they are) Investment grade = likelihood that you will not repay your dept in the future is very unlikely (good quality paper!) Speculative grade = likelihood of defaulting is much bigger. Default (D) = you are more than 90 days due to a certain payment ≠ bankrupt Sometimes companies with speculative grade will not be able to get a loan To get a rating, such agency has to screen you and they will do that based on the risk reports, annual accounts, business plans, interviews with CEO’s,… and they will come out with a rate. Some people say that rating agencies are not always that ethical. Because sometimes the rating is lower for companies who don’t pay for the service than companies who do pay to the rating agencies for the ratings. The rating agencies says that’s logical because if the company ask us to rate we have all the public information but we also have a lot of inside information about the strategy. = discussion. Also the rating agencies are American. Do we need European? 31 The rating agencies will always say that they give an opinion about credit quality and you don’t need to follow that --> so they aren’t responsible in the legal way for the ratings that they give = a lot of discussions. AA+ aa (-> Dubble A flat) AA - -> motifiers inhance the granuality of the ratings (further notification) Terminology Modifiers High grade or investment grade Speculative grade Two rating agencies have been asked to rate the same Split rating company but that they came up with a different rating. (happens more with special products) Credit watch and potential rating migration (It means that they are reconsidering/may change in the future because they have seen conditions that could lead to a change) Downgrade or upgrade Fallen angel. Companies that are downgraded are called “fallen angels” ⇨ Rating agencies are crucial to bring information to markets and avoid asymmetrical information. (but, we’re sceptical) 2. THE INSTRUMENTS Market taxonomy Maturity at issuance (= looptijd bij uitgifte) 1. Money markets = markets where instruments are being traded with a maturity at issuance of at most 1 year. 2. Capital markets = they group instruments with a maturity at issuance of more than 1 year. An instrument like a German government bond: First it has a maturity at issuance for 8 years and 7 years later for 1 year so it stay a capital market. It does not swap from the capital markets to the money markets. Important: These two segments work with different interest rate conventions The money markets will use simple interest rates The capital markets will use compounded interest rates Nature of the debt instrument 1. Loans = contracts with two parties. Loans are transferable but the correct legal procedures have to be followed ⇨ intuïtue personae 32  2. Bonds = securities which are issued by 1 borrower and are being bought by many investors. They can easily be transferred. Loans = contract intuit personae It’s only with that person I want to make a contract. Bonds you have many people who are able to invest in that bond, because it has become a bond Securities is a legal claim -> they don’t exist anymore in a material form. Geographical span 1. National/Domestic markets (i.e. transactions in local currency under supervision of local central bank) --> They are really on the Belgium market, or the Germans, French,… but under vision of the local authorities 2. International markets = mostly in 5 different countries, use different currency ⇨ therefore different tax treatment. o Eurobond market (has nothing to do with the €) (Euro means that it’s issued in a different currency of the home currency of the issuer) Typically a corporate that is issuing in four or five different countries and most of the time also in a different domination of currency than the local market and it will give you a different tax treatment o If you are taking a look at the Belgium corporate bond markets that in the newspaper you will find any bonds listed on the Belgian national market, they all go to the international bond market Nature of the counterparties 1. Wholesale market (institutional investors) = they are much bigger and more liquid 2. Retail market (retail investors) = individual customers Most of the time: retail investors will buy a diversified portfolio of a mutual fund and that mutual fund as a institution investors will actually buy the bonds in the fixed income markets Money market instruments (wholesale) What is the difference between “Private” and “Public” – money market instruments? Private money market instruments = instruments issued by non-governmental entities (financial and nonfinancial corporations). 1. Call money 2. Unsecured loans made between banks 3. Repurchase agreements, 4. Commercial paper (CP) 5. Large-denomination negotiable certificates of deposit 6. Banker’s acceptances 7. Money market funds. Public money market instruments = instruments issued by governmental entities. 33  T-bills (schatkistcertificaat) / CP (commercial paper) Call money Call money = the shortest type of loan that you can achieve --> you don’t see them Very short period borrowing between banks Overnight (O/N) transactions --> I just borrow the money for the period of the night (from 5PM till the morning) Spot next (S/N) transactions --> spot day – to the next day, so 1 full day Spot next week transactions --> from the spot day till the next week EONIA( =Euro overnight Index Average), SONIA(=Sterling Overnight Interbank Average Rate,... serve as benchmark interest rates, those are averages of what happens on those markets => everages of what happens on those markets (European overnight interest rate average -> it gives you a flavor of where this market is) Unsecured interbank funding / lending market Unsecured interbank funding = loans between banks maturing from 1 week to 1 year. International banking facility (onshore and offshore (in eurocurrency) transactions). In the US the interbank market is the called the Federal funds market [at the Federal funds rate]. EURIBOR serves as a benchmark interest rate. LIBOR-scandal had serious consequences. Example: 34  We used to have Libor instead of EURIBOR, but the size of the panel was a lot smaller. So what happens a few of the regular suspects (goldman, JP morgan ,…) They started to discuss what kind of interest they are going to give, they were trying to manipulate the panel. (=biasing) Secured lending using repurchase agreements A repo = consists out of the sale of a security with a commitment by the seller to buy the security back from the purchaser at a specific price at a designated future date. You’re selling securities but buying them back in a short period of time / in 1 transaction (!) Suppose that bank A is giving one million euros to bank B, but it is only willing to do that if bank B give for the same amount collateral in a specific way We are going to ask bank B to sell securities to bank A so If bank B sells securities to bank A, the securities go from bank B to bank A and A pays the securities so the money goes to B But B doesn’t really want to sell the securities so they kind of make a second agreement whereas A is going to sell the securities back to B but it will be at a slightly higher price because of the interest rate It can be in two transactions, but we can group them in one legal structure and that is a repurchase agreement = you are selling securities but buying them back within a short period of time A repo = if they want to have it in one transaction -> The ECB is using this a lot Eligible securities = the security can serve as collateral for such a repo A sell and buy back transaction = if they want to have two different transactions Is it better to invest in bonds or stocks? Best are governments bonds with not a lot of risks. Collateral as save as it can get. Because stocks can go up but can also go down in price. ECB uses eligible securities (=risk-free bonds) Before the crisis they were almost only government paper After the crisis that wasn’t enough security because banks didn’t have enough government paper because there was no money to invest. So they had to search for something else. So the ACT allowed it in the notion of a “haircut”. 35 Commercial paper (=flexible, for institutional investors for a short period) Commercial Paper (CP) = is a short term unsecured promissory note issued in the open market that represents the obligation of the issuing company. Used for seasonal financing of working capital, bridge financing,.. --> money markets Primary market based on best effort arrangements (i.e. no guaranteed placement) Hardly any secondary trading. Short term. In the US typically 90 days paper (Eligibility requirement). The term rarely exceeds 270 days. --> in Europe it has been extended Flexible way to raise papers with institutional investors for a short period of time Yields can be quoted on discount basis or in interest bearing form --> capital markets Best effort arrangement = the banks will to their best to place the securities, but they don’t guarantee it to the customer. Difference between “commercial paper” en “medium term notes”? (MTN) Medium term notes = a dept note that usually matures (is paid back) in 5-10 years, but the term may be less than 1 year or as long as 100 years. Simplified (short term) CP ratings Investment grade Speculative grade 36 P = prime NP = non prime (speculative grade) B = can be short term but also term rating! Certificate of deposit A certificate of deposit (CD) = represents a financial obligation issued by a depository institution (banks) that indicates a specific sum of money deposited at the issuing depository institution for a specific time period. Deposit insurance applies for small denominations = a retail customer buys a CD (=kasbon), then deposit insurance exists. If the bank defaults, then you can recover money from a special fund (up to €100.000). (for small retail depositors) Any denomination can be issued Can be negotiable or non-negotiable (i.e. not resellable in the market and can be redeemed at an early withdrawal penalty)(it means that you can sell it yes or no) --> Suppose that you are the bankers and I am buying a certificate of deposit from us, so I already have my portfolio but a certain moment I need money so I’m going to resell my certificate to another investor and that means that it is negotiable because we can easily transfer it without severr penelaties Large-denomination negotiable CDs have denominations of 10 million USD and more Flexible way for banks to finance themselves for a specific period of time Deposit insurance = a protection cover against losses accruing to bank deposits if a bank fails financially and has no money to pay its depositors and has to go in for liquidation. 3. PUBLIC MONEY MARKET INSTRUMENTS 37 Treasuries Names − In the US these instruments are known as Treasury Bills or simply T-Bills. − In Europe these instruments carry a variety of names: T-bill (UK), schatkistcertificaat (BE), Bon du Trésor (FR), Schatzwechsel (GE),.. − On the run issues = whether we are still issuing issues of that kind / the most recently issued. − Off the run issues = they’re not issuing new securities of that maturity / the older ones & are typically less liquid. This means whether we are still issuing securities of that kind, so take a treasury certificate of one year that is being issued and a week later the treasury is issuing new certificates well that one is still on the run because they are still issuing with that quotum quote approximate maturity of one year but if that goes down to 10 months that issue will be off the run because they are not issuing new securities of that maturity = Short term instruments (1 year) but they can take the form of securities and those are tradeable Maturities at issuance − 3, 6, 12 months (short term!) − Fungibility Primary market − Organized at auctions (aka tenders): the treasury will ask for banks to competitively bid to buy government paper. − American tender principle i.e. bid price auction (and hence not a uniform price auction (Dutch style)). Bank What they bid (this is How many basispoints they actually an interest rate) bid A 100 50 BSP (= 0,5%) B 100 60 BSP C 100 60 BSP D 100 70 BSP(=0,7%) Suppose we got a few banks and they bid all 100 million (=> is actually an interest rate (70 basispoints = 0,7%) The government can choose: If they only have to pay 50 basispoints, they will take the offer of the first bank Than they might say they want to except up to 300 million, so they get a higher interest rate than the first one American tender party = every party will get the interest rate that they themselves have bided A problem does arise if the government only needs 200 million than they need a mechanism and they are going to accept the 50 for sure, but they are only able to accept 100 million, so they are going to take half of both C&D − On the money market treasuries are discount securities = you pay the discounted value, this is a lower value than the nominal value and you get the nominal 38  value back at the maturity. So in the auction the banks bid the amount of money that they want to repay to the government at maturity. They don’t bid the amount that they want to pay. So the bidder pays 100/(1+0,1) = 90,9 4. CAPITAL MARKET INSTRUMENTS Long term loans Household debt − Mortgage loans Sometimes household debts have a fixed interest rate and sometimes they are variable, but what is the best? Should I borrow at a fixed rate or at a variable rate? --> In finance it’s not a question of best, bankers reformulate possibilities on the financial market; - In principle a fixed or floating rate are equivalent, but the risk you are taking is a lot different! - At a fixed rate the bank will have to do a lot of hedging - At a floating rate the risk is on your account, because if the interest rate increases your interest rate on your mortgage loan will increase as well è it’s a matter of risk Corporate debt − Investment credit (= loans up to 8 years is a typical maturity to buy property, plants, machinery… − Revolving credits (= credits where you can take out credit and if at a certain maturity you still need the money, then you roll it over to the next period) − Leasing Debt securities Debt securities − are issued by borrowers to obtain liquidity for their short-term or long-term needs. − embed the obligation of issuers-borrowers to make a certain promised stream of cash flows in the future. This does not imply that the size of the cash flows, nor the timing of the cash flows are always known at the issuance of the bond. The cash flows are at least determinable (at some point in time) based on a function the borrower and issuer agreed upon. Debt markets (a.k.a. fixed-income markets) are markets where debt securities trade. Some equity instruments such as preferred stock may be considered as well as a fixed income instrument (but nobody would call them bonds.) 39 -->The repayment of debt securities takes precedence over the payment streams to residual cash flow instruments. − Secured debt is backed by tangible assets (often called senior debt) = the senior debt will be paid first in case of default. ⇨ repo is form of secured debt − Unsecured debt (debentures (US)) ⇨ interbank loan is form of unsecured debt or subordinated debt you will be paid after all the ordinary debt holders have been paid Debt contracts specify events that precipitate (=leiden) default. - Non-payment of promised coupons - Non-payment of the balloon payment -> which means the single payment at the end of the maturity If a firm gets into default your actually at a certain point in time wiping out the equity holders so the founders of the company and the shareholders say sorry guys but there is nothing left so we as debt holders need to see what we can do now and they can do two things: Either they can unwind the firm and sell all the assets and divide everything that is left over , but it might be that they take over the firm and that they appoint new managers and that they become the shareholders Another solution is that the equity holders go to the bond holders and ask for some lee way and the might renegotiate the contract by extending the type of maturity and ask for extra two years or spread the payments in a different way over time,… In case of default, bondholders-> 90 days being due might be a trigger to default or if one of the coupons is not being paid,… it has to be defined in debt contracts − Have the right to take over the firm − Can re-negotiate the contract 40  Old Dutch bond ⬄ Traditional Bond Although bonds have been dematerialized, it is good to visualize a bond in its traditional form. Issued by one of the local agencies in holland that were restoring the dikes It’s now in the property of the university of Yale the black line is the face value The others are an amount of coupons which are attached to it and if one of the coupons was due the most important instrument which a bond holder had was a pair of scissors and they had to cut of the coupon and had to go to the bank and In return they got the 4 euros of an interest rate Bonds were in a material form, and they needed to go to banks to get their coupons Charactristics Nowadays: in a dematerialized form=> not written anymore. If it’s a semiannual coupon we split the coupon in two and we pay half of it after 6 months, half of it after a year so you get 2 payments a year (half of the coupon rate) (yield to maturity will be different) − Unique identifiers: CUSIP-code or ISIN-code (same firms, same maturity) − The name: issuer of the bond − Coupon style o Zero coupon = you don’t pay any coupon at all. 41  So you issue €90,9 and at maturity you pay back €100. You issue this bond below bar (€100 is par value) and you repay it at par. At that case there is no coupon, but there is a return/yield (the 10%). There is no intermediate cashflow, you just pay back more at the end. o Fixed coupon = each coupon represents a fixed %. o Floating rate note (FRN’s) (i.e. a reference rate + quoted margin/spread) = they have an interest rate payment which varies through time. (mostly used is Euribor + spread) At the beginning we determine the rate and we are paying this rate at the end of the 6 months 6 months. Over the next 6 months I would apply 0,75% plus 20 basispoints = 0,95%. At 1 year we look at the EURIBOR and we add it in basispoints to know what will be the interest rate for the next period. o FRN in arrears Euribor + spread I’m going to use this Euribor at the end of the period. You don’t know what’s the actual interest rate is. It can be in your advantage or disadvantage, time will tell o Multicoupon (e.g. step-up coupon bond) o Linkers (TIPS i.e. treasury inflation protected securities) = treasury bonds that are protected against inflation. The real interest rate + expected inflation = nominal rate. So when nominal rate is 3% and inflation is 7%, then you have a negative real interest rate. But here after the period they are going to take a look at the inflation and pay you out. The investor will get the guaranteed rate in real terms. − Coupon frequency o Annual (Eurozone) o Semi-annual (US, UK, Japan, Italy) A myriad of dates (minder belangrijk denk ik) Announcement date: date on which the bond is announced and offered to the public. Maturity date: date on which the principal amount is due. Issue date: the day on which the security is issued. Dated date: the day from which the first coupon starts to accrue interest (a.k.a. interest accrual date). First coupon date: date on which the first interest payment will take place. Previous coupon date: the day on which the last coupon was paid. If no coupon has been paid yet, the dated date is considered to be the previous coupon date. Settlement day: the day on which the parties will exchange cash and securities (important for valuation!). In general the trade day plus a number of working days. Workout Date: Based on the current price and call schedule for a bond, this is the date when the bond is most likely to be called or redeemed. Maturity Treasury (discount) bills (money market so maturity at issuance ≤ 1 year): SHORT term Treasury (coupon) notes (used in the US for maturities between 1 and 8-10 years): ML term 42  Treasury (coupon) bonds (used in the US for maturities more than 8-10 years; used in other countries for all debt securities with maturities > 1 year): LONG term Perpetual or undated bonds = if there is no maturity date and the bond lasts forever, then the money will never be paid back. However, there will be a coupon attached to it that will be paid each year. But the issuer can determine to stop the bond prematurely. Terminology is not consistent over countries and markets! Issued amount Jumbo bond = a very high value bond (colloquial). The size will vary from market to market. In some emerging markets it will be in the hundreds of millions of dollars, in developed markets it will be in the billions. The outstanding amount can be lower due to buy backs, calling of bonds, stripping,... Issue price (percentage paid at issuance) or spread at issuance (i.e. the spread in basis points over a benchmark Treasury Bond). The price had to be determined really on the last moment. - The issue price is the price at which a bond or other security is sold to investors at the time of issuance. This is usually expressed as a percentage of the bond's face value. - The spread at issuance is the difference (in basis points) between the yield of the newly issued bond and the yield of a benchmark Treasury bond of similar maturity. This spread reflects the additional risk and return over the "risk-free" rate provided by the benchmark Treasury bond. Redemption value Par amount, nominal amount or principal amount Face value of the bond Used to calculate the coupon Redemption value = what you get back at the end. Most of the time paid back at par. Expressed in percentage of the nominal amount Price at which the bond is redeemed on the maturity date Most of the time equal to the nominal amount Players Who issues the following bonds? Sovereign bonds are issued by the highest level of government in a country Subnational government debt a.k.a. municipal debt is issued by states, regions, provinces, counties, municipalities even local utility companies. Other bonds ⇨ supranationals (multilateral financial institutions) such as IMF, World Bank, EBRD, Asian Development Bank. Especially for infrastructure (when municipals are not allowed to issue bonds.) Corporates issue corporate bonds & Medium Term Notes (MTN’s) Corporate bonds General classification Public utilities (safer in general than industrials) 43  Transportation economics Banks and finance companies (are not always safe) Industrials (less safe) Bond indentures = promises of the issuer and rights of the investors. Covenants = restrictions imposed on management. Corporate bonds & security Mortgage = a pledge of a real property. In a mortgage bond the mortgage grants the bond holders a lien against the pledged assets. If you don’t pay out your loan, the banks take what’s theirs and the remaining money will go out to you. (Don’t assume that the rest of the world do/thinks likes you do, it’s not in every country: compare US with Belgium) Collateral = a pledge of personal property. The mortgage structure is more efficient. Collateral serves a purpose of safety A debenture bond = not secured by a specific pledge of property. A guaranteed bond = a bond of which the cash flows are guaranteed by a third party. (e.g. mother company puts herself as a guarantee to its subsidiaries) (is a risk to put yourself as a guarantee) Terminology Convertible bond = a small start-up and you suddenly sees an expansion in the firm, then he changes his bonds to stocks. Venture capitalists probably will use this. They keep the option that when things go well, they can grab a big part of the profit. Exchangeable bond = exchange one asset for another High yield bond = you get a big coupon because there is a lot of risk. So bonds with a speculative grade, not an investment grade. So the probability of default is higher, so some bonds will not repay. So a high yield is asked for this reason. Medium term notes Offered continuously Maturities from 9 months to 30 years. Best effort basis Shelf registration Often structured (e.g. inverse floaters,...) the coupon was defined as l spread You could also said let’s defined 3%-Euribor so it means the Euribor is increasing, your coupon rate is going down = floating rate note So it can be under zero (lending money and pay for it) inverse floaters 5. PRIMARY MARKET Primary market = the market where bonds are issued. You need to have a well function primary market (securities are created and sold for the first time. In this market, the issuer sells securities directly to investors) Objectives (according to the World Bank) Objectives for a functional primary market: 44  Ensure cost effectiveness Encourage participation from a large range of investors Maximize competition Minimize placement risk Foster transparency Distribution methods How do they do it? Depends from market to market 1. Auctions with a stop yield (transparent and cost effective) – for government bonds = let people bid and the lender is going to be the one who is pleased with the lowest interest rate. So you use competition to place your paper at the most favourable conditions. − Single price auction (to broaden participation and to reduce concentration in ownership) - All winning bidders pay the same price, which is the stop yield (the highest yield accepted) − Multiple price auction (i.e. price discriminatory auction with winner’s curse) – each winning bidder pays the price they bid 2. Syndication (reduce placement risk, but less transparent) – lager government bonds = a group of banks that group together, they use their sales forces to try to put as many paper into the market as they can. There is less competition after the syndicate has been formed. The competition is for the big banks to become the lead manager in the syndicate, so they will also try to bid the best conditions with the government. 3. Tap sales (of existing bonds) = this is more time independent. The instruments are being issued at the moment itself / from the tap. Primary dealers are active market makers. = a party that gets some advantages and in return they will take up some obligations. The Belgian government gives their primary dealers a monopoly ride on the primary market. They can buy paper not only in competitive auctions, but also in a not competitive ways (extra options/advantages). They promise that at any moment in time they quote bid-ask spread, so that investers always buy or sell Belgian government paper. = liquid market 6. SECONDARY MARKETS Secondary markets = this is where the primary dealers are animating. they are needed to build trust. Because if you can’t resell your securities, most people won’t invest in it. (previously issued securities are traded among investors) Objectives (according to the World Bank) Low transaction costs Continuous and wide disseminated price information Immediate execution of trades (sell or buy) Safe and rapid settlement Efficient custodial (bewaar) and safekeeping services (if you cannot resell your securities, most people are not willing to invest) Trading (see unit 4 – Equity) How is it being traded? Order driven markets Quote driven markets 45 Stripping Stripping = cutting cashflows loose and trade them separably (facevalue / coupon / coupon). So 1 PO (Principe Only) & 2 Interest Only (IO) Stripping and reconstitution Creation of coupon and principal strips: IO (=Interest only) and PO (=principal only) strips. This is representing a face value and you have a coupon after 1 year and a coupon after 2 years. Say that this is a face value of 100 and say that I have two coupons of 5. What will be the price of the bond? It is just discounting the cashflows so you will take the present value of 100 and say this is 93 and I take a present value of a coupon say this is 4 and the other one is 3,5. => in total this bond is being traded for 100,50. I’m cutting these 3 parts loose. Now instead of taking this total portfolio of cashflows, On the timeline this means you get 5 after one year, 5 after two years and you get your money back 100 --> that would be the cashflows. I’m cutting the cashflow loose. So I’m creating 3 separate financial instruments by stripping. These 3 instruments start their own life besides the coupon bond. Stripping and rebundlling is very important to ensure that the bonds are priced in line with the strips. Otherwise, people will take arbitrage opportunities, they will earn a riskless profit. = disrupts the overall efficiency and stability of the financial markets Bond indices Bond indices are much more difficult to create than equity indices: There is a larger number of bonds than stocks There is more variety in features The universe of bonds is constantly changing (bonds mature!) Duration (interest rate risk) changes over the life of the bond Some bonds are difficult to price 46 UNIT 4 – EQUITY MARKETS 1. SOME FINANCIAL HISTORY 1. Rise of commodity markets Around 1400 On market squares with a set of written market rules Family “Van Der Buerse” in Bruges -> they gave their name to the flamish word ‘Beurs’ Bruges loses its dominant role around 1480 -> because the ships couldn’t reach Bruges anymore but the concept of a market, where market rules were applied was very important 2. Antwerp (1485) Huis Den Rhyn: due to accessibility problems, the commodity market activity shifted from Bruges to Antwerp. 3. First trade exchange in the world: Antwerp --> Handelsbeurs Founded in 1531 The open square got a roof in 1853 Burned to the ground twice (1583, 1858) Hosted the Antwerp Stock Exchange till 1997 4. Antwerp Trade/Commodity exchange rather than a stock exchange it was not originally intended as a stock market but a commodity market to trade species and stuff 5. Thomas Gresham brings the idea to England = Thomas Gresham He brought the idea of exchanges to the UK 6. The London trade exchange 47  It’s a copy of the handelsbeurs in Antwerp 7. Antwerp came under Siege (1585) and the Scheldt was closed (1587) All the capital, smart people, money, all flat to Amsterdam 8. The Dutch republic introduced huge financial innovations Collateralized loans à loans with collateral, they had that idea “Lijfrente” i.e. annuities (= contracts in witch you pay a regular sum at fixed moments every month or quarter and they started to develop formulas to value that Actuarial methods were needed (Johan de Witt) -> he was smothered because he came in trouble of the politics Introduction of the first corporation that acted as a legal person and that issued shares. o They dutch build the first national corporation and they had the VOC (Verenigde oost-indische company) and traded with the indies, but they had a problem because trade was done in partnerships but they weren’t stable So they started to raise the idea to fund something so when you give your money to the VOC that you don’t get it back but you get some peace of paper back and that is a claim that you can only sell to someone else So the company who issued it and raised the capital was able to buy the goods and ships but so they were able to develop as a multinational corporation that required the share to be tradeable and so Amsterdam became the first stock market in the world in 1602 9. Verenigde Oostindische Compagnie (VOC) share (1602) with Dividends… This is how wan old stock/ bond of the VOC looked like The first dividend that was being paid, was being paid in spices that were brought along from the very far (not paid with money) 48  10. The First Stock Exchange in the World: Amsterdam 11. 9. Oldest Book on Stocks, Forwards and Options 2. EQUITY HOLDER AND THEIR RIGHTS Terminology Valdez and Molyneux use the following terminology Shares are equities in companies -> an equity : you go with a few people to a notary, you say you want to fund a company and you’re giving money to the company and the company in return gives shares and those prove the ownership of your company Stocks can be shares or bonds = old fashioned? We will use the word stock as a synonym of a share. We will never talk about a bond as being a stock. Equity In the past: equity securities used to be in bearer form (paper). Nowadays: they represent a nominative or a dematerialized ownership interest in a corporation. It’s just a registration at this moment and not a piece of paper anymore Shareholder rights Shareholders have pecuniary rights and membership rights. you are the owner of the company and all major decisions should be made by you and of course that is not practical quit often so the annual general meeting of the shareholders will appoint people who are responsible 49 for doing the business and first of all they will appoint a board of directors and they will appoint an executive committee (the CEO, CFO, CIO, COO,..) but the shareholders will be entitled to actually the firm itself so if we would stop with the company, what would we do? We would sell all the assets and payback all the debt and all the rest is for the shareholders --> there has to be distributable profit = which means if you take the result of this year and you take the result witch you carried over from the previous year. and if that together is positive, you may pay out dividends --> shareholders should be guaranteed their importance in the firm because we should be able to keep the power properties between each other in the future Pecuniary rights (money) − Entitled to the distributed profits of the firm (dividends) − Pro rata share of the remaining equity if the corporate is liquidated (residual claim) (bij kapitaalverhoging moet je jouw aandeelverhouding behouden) − Sometimes a pre-emptive right in case of new share issues à So that you keep your proportion of the shares within that kind of structure. à that will impact your piece of the pie when we distribute the profit − Bonus share (scrip issues) and stock split participation Membership rights Shareholders can come to the annual general meetin