MFIN1151 Lecture Notes - Topic 1 - Introduction and Appendix - Complete PDF

Topic 1. Introduction to Financial Markets, Institutions, and Instruments And Appendix: Time Value of Money and Financial Calculator Operation...

Topic 1. Introduction to Financial Markets, Institutions, and Instruments And Appendix: Time Value of Money and Financial Calculator Operation Complete Version © McGraw Hill, LLC 1  Topics Covered 1. Major Players in the Financial Markets 2. Major Financial Instruments Overview 3. Financial Instruments in Details Appendix: Time Value of Money and Financial Calculator Operation © McGraw Hill, LLC 2  1. Major Players in the Financial Markets © McGraw Hill, LLC 3  Major Players in the Financial Markets Business Firms Typically, they are demanders of capital. They raise capital by issuing the securities (such as bonds or stocks) to pay for investments. The income generated provides the returns to investors who purchase the securities issued by the firm. Households Typically, they are suppliers of capital. They purchase the securities issued by firms or government (such as bonds or stocks) to earn returns. Governments They can be either demanders or suppliers of capital. It depends on the relationship between tax revenue and government expenditures. The government borrow funds to cover its budget deficit (e.g., issuing Treasury bills, notes, and bonds). © McGraw Hill, LLC 4  Major Players in the Financial Markets Financial Institutions and Intermediaries (connectors of demanders and suppliers of capital) Commercial banks: take deposits and lend loans to businesses and households Investment banks (sell-side): specialize in the sale of new securities, such as stocks and bonds, to the public (institutional investors and individual investors) Asset management firms (buy-side): institutional investors who manage assets for individual investors, such as pension funds, mutual funds, hedge funds, etc. Venture capital firms and private equity firms: invest in start-up companies in return for an ownership stake in the firm. They commonly take an active role in the management of a start-up firm (called activism). Angel investors focus on very early stage of a start-up. Insurance companies: provide financial protection or reimbursement against losses. © McGraw Hill, LLC 5  2. Major Financial Instruments Overview © McGraw Hill, LLC 6  Financial Instruments Overview The 3 major categories of financial instruments are: Fixed income securities Stock or equity securities Derivatives securities © McGraw Hill, LLC 7  Fixed-Income Securities It is a debt instrument that pays a fixed amount of interest (coupon payments) and principal back to investors over a pre-specified period. It can be divided into money market and capital market fixed income securities based on its length of maturity. Money market: short-term (shorter than 1 year), e.g., Treasury bills, certificate of deposit, and commercial papers Capital market: long-term (longer than 1 year), e.g., Treasury notes and bonds, state and local muni bonds, and corporation bonds © McGraw Hill, LLC 8  Stock or Equity Securities It represents an ownership in the corporation. Equity holders are not promised any particular payment. They receive dividends if firm pays (dividends can vary depending on firm performance, and some firms never pay dividends intentionally). If the firm is successful, the value of equity will increase and the equity holders have capital gain; if not, it will decrease. Two types of stocks: common stock and preferred stock © McGraw Hill, LLC 9  Derivatives Securities They are securities providing returns that depend on the values of other assets such as stocks and bonds. The primary use of derivatives is to hedge risks or transfer risks to other parties. Commonly used derivatives include options, forwards, futures, and swap. © McGraw Hill, LLC 10  3. Financial Instruments in Details © McGraw Hill, LLC 11  Financial Instruments in Details Fixed Income Money Market Instruments Treasury Bills (T-bills) Certificates of Deposit (CDs) Commercial Paper (CP) Fixed Income Capital Market Instruments Treasury Notes and Bonds (T-notes and T-bonds) Treasury Inflation-Protected Securities (TIPS) Municipal Bonds (Munis) Corporate Bonds Equity Common Stocks Preferred Stocks Derivatives Forwards and Futures Options Swaps © McGraw Hill, LLC 12  Fixed Income Money Market Instruments 1. Treasury Bills (T-bills, or just bills, for short) T-bills are short-term debt issued by the U.S. Department of Treasury. They mature in 4, 8, 13, 17, 26, and 52 weeks T-bills have no coupon payments. The return arises from the difference between purchase price and face value. They must be sold at a discount price, i.e., cheaper than the par value. These securities are widely regarded as very low-risk investments. More official information: https://treasurydirect.gov/marketable-securities/treasury-bills/ © McGraw Hill, LLC 13  Fixed Income Money Market Instruments 2. Certificates of Deposit (CDs) They are short-term debt issued by banks. They are time deposits with banks. The bank pays interest and principal to the depositor only at the maturity of the CD. Holders must wait until maturity to obtain funds (withdrawal penalty). The maturity varies, with a 14-day minimum maturity. © McGraw Hill, LLC 14  Fixed Income Money Market Instruments 2. Certificates of Deposit (CDs) Holder can trade in a secondary market if the owner needs to cash in CD before it matures. CDs are treated as bank deposits by the Federal Deposit Insurance Corporation, so they are insured for up to $250,000 by FDIC in the event of a bank insolvency. Question: given that your deposits are insured up to $250,000 at each bank and you have $1 million to deposit, should you always split $1 million into 4 parts and buy 4 CDs from 4 different banks? Hint: what is the incentive of depositing $1 million at a single bank? © McGraw Hill, LLC 15  Fixed Income Money Market Instruments 2. Certificates of Deposit (CDs) The picture below is a screenshot of CDs of Chase Bank on 8/17/2024 https://www.chase.com/personal/savings/bank-cd Typically, a higher interest rate is associated with a longer maturity and a larger amount of saving. When you buy a large-value CD (e.g., $1 mil) from a single bank, you can even negotiate with the bank to get a favorable interest rate. The higher risk is associated with higher return. © McGraw Hill, LLC 16  Fixed Income Money Market Instruments 2. Certificates of Deposit (CDs) The picture below is a screenshot of CDs of Chase Bank on 8/17/2024 Question: why the 3-month interest rate is higher than 9-month one? Hint: the Fed © McGraw Hill, LLC 17  Fixed Income Money Market Instruments 2. Certificates of Deposit (CDs) Question: why the 3-month interest rate is higher than 9-month one? Answer: when short-term interest rates are higher than long-term rates, it is referred as an inverted yield curve. This happens when the market expects the Federal Reserve (the Fed) will cut its Federal Funds Rate in the near future due to the change of economic conditions. Federal Funds Rate is a fundamental interest rate that affects almost all the interest rates in the market. © McGraw Hill, LLC 18  Background Knowledge on Federal Funds Rate Banks are required to maintain a certain amount of cash, known as a reserve, with the central bank. The reserve requirement for a bank at any time depends on its outstanding assets and liabilities. At the end of a day, some banks have surplus funds in their accounts above the requirement while others have shortage for funds. This leads to borrowing and lending transactions overnight to meet the requirement. In the United States, the central bank is the Federal Reserve (the Fed) and the overnight rate is called the federal funds rate. This overnight rate is monitored and controlled by the Federal Reserve, which employs monetary policy tools in an attempt to raise or lower it. Question: Why does the Fed change the federal funds rate? https://fred.stlouisfed.org/series/FEDFUNDS © McGraw Hill, LLC 19  Background Knowledge on Federal Funds Rate Question: Why does the Fed change the federal funds rate? Answer: The Fed uses changes in the federal funds rate as a monetary tool to achieve its dual goals: ▪ promoting maximum sustainable employment (enhancing economic growth) ▪ maintaining stable prices (controlling inflation) Two goals of the Fed: https://www.federalreserve.gov/monetarypolicy/monetary-policy-what-are- its-goals-how-does-it-work.htm Question: When does the Fed raise or lower the federal funds rate? © McGraw Hill, LLC 20  Background Knowledge on Federal Funds Rate The Fed raises the federal funds rate when it aims to cool down an overheating economy or control inflation. This is achieved by increasing the cost of borrowing, discouraging borrowing and spending, while simultaneously encouraging saving by offering higher returns on deposits. Both help reduce the demand for consumption goods and alleviate inflationary pressure on their prices. The Fed lowers the federal funds rate when it aims to stimulate economic activities during periods of economic weakness or recession. Lower interest rates make it cheaper to borrow, which can boost investments, consumer spending, and job creation. Fun facts: Bank of Canada, Bank of France, Bank of Italy, Bank of Japan are central banks. Bank of America and Bank of China are not central banks. © McGraw Hill, LLC 21  Yields of T-bill and CD Rule of thumb in investments: higher risk is associated with high required rate of return CD typically has a higher risk and a higher yield (return) than T-bill During crisis, what happened to T-bill and CD’s yield? During crisis, investors lost confidence in banks. CDs are considered riskier. The yield spread gets larger during every economic recession or financial crisis. © McGraw Hill, LLC 22  Yields of T-bill and CD Yield spread (i.e., return difference) between 3-month CD and T-bill rates © McGraw Hill, LLC 23  Fixed Income Money Market Instruments 3. Commercial Paper (CP) They are short-term debt issued by firms. A typical firm is a net borrower of both long-term funds (for capital investments such as R&D) and short-term funds (for working capital management such as payroll and accounts payable). Large companies issue their own long-term debt (corporate bond) and short-term debt notes (commercial paper) directly to the public. Maturities are typically 1-2 months CP has a minimum denominations of $100,000 and is typically held by money market mutual funds. CP is usually issued at a discount to its face value and matures at its face value. © McGraw Hill, LLC 24  Fixed Income Capital Market Instruments 1. Treasury Notes and Bonds (T-notes and T-bonds) The U.S. Department of Treasury borrows mid-term and long-term debt by selling Treasury notes and Treasury bonds. T-notes and T-bonds pay coupons semi-annually and they pay their face value or par value (mostly $1,000) at maturity. The purchase price can be either greater than, equal to, or less than par value. The difference between T-notes and T-bonds is maturity. T-notes have maturities from 1 year to 10 years, whereas T-bonds have maturities from 10 to 30 years © McGraw Hill, LLC 25  Fixed Income Capital Market Instruments 1. Treasury Notes and Bonds (T-notes and T-bonds) Examples of T-bonds © McGraw Hill, LLC 26  Fixed Income Capital Market Instruments 1. Treasury Notes and Bonds (T-notes and T-bonds) The highlighted bond matures in May 2020. The coupon paid by the bond is 1.5% of par value ($1,000), so $15 in annual coupon payments will be made in two semiannual installments of $7.50 each. The bid price at which the bond can sold to a dealer (i.e., the price at which the dealer buys from the investor) is 100.3047 (This is the decimal equivalent of 10039/128. The minimum tick size, or price increment in the Treasury-bond market, is generally of 1/128 a point). Bonds prices are quoted as a percentage of par value. Thus, the bid price is 100.3047% of the $1,000 par value bond, or $1,003.047. © McGraw Hill, LLC 27  Fixed Income Capital Market Instruments 1. Treasury Notes and Bonds (T-notes and T-bonds) Similarly, the asked (or ask) price at which the bond can purchased from a dealer (i.e., the price at which the dealer sells to the investor) is 100.3203% of par value, or $1,003.203. The 0.1719 change means that the asked price on this day increased by 0.1719% of par value from the previous day’s close price. Finally, the asked yield to maturity based on the asked price is 1.394%. It is the annualized rate of return to an investor who buys the bond at the asked price and holds it until maturity. It accounts for both coupon income as well as the capital gain, i.e., the difference between the purchase price and its face value of $1,000 at maturity. There are two ways for bond investor to earn positive return from bond investment: coupon payment and capital gain (i.e., buy bond at a bond price that is lower than par value) © McGraw Hill, LLC 28  Fixed Income Capital Market Instruments 2. Treasury Inflation-Protected Securities (TIPS) A special type of Treasury notes and bonds issued by the U.S. Department of Treasury. The par value (and coupon) is adjusted in proportional to increases in the Consumer Price Index (CPI). The yields on TIPS should be considered as a real or inflation- adjusted interest rate. Question: TIPS face value is $1000 at the issuance with coupon rate of 4.5%. Suppose CPI increases by 10%, what’s the new face value and annual coupon payment? © McGraw Hill, LLC 29  Fixed Income Capital Market Instruments 2. Treasury Inflation-Protected Securities (TIPS) Question: TIPS face value is $1000 at the issuance with coupon rate of 4.5%. Suppose CPI increases by 10%, what’s the new face value and annual coupon payment? Answer: face value = $1000(1+10%) = $1100 coupon = 4.5%*$1100 = $49.5 © McGraw Hill, LLC 30  Fixed Income Capital Market Instruments 3. Municipal bonds (Munis) A mid-term or long-term debt issued by state or local governments Coupons from munis are exempt from federal income taxation, and from state and local taxation in the issuing state. However, capital gains are taxable if the bonds mature or are sold for more than the investor’s purchase price Yields on munis are lower than taxable bonds with similar risk. Why? Question: Suppose my tax bracket is 28%. You have two investment options. The first is the taxable corporate bond of 6% return. The second is the tax-free muni of 4% return. Shall I prefer to earn a 6% taxable return or a 4% tax-free yield? What is the equivalent taxable yield of the 4% tax-free yield? © McGraw Hill, LLC 31  Fixed Income Capital Market Instruments 3. Municipal bonds (Munis) Comparing the rates of returns: t: the investor’s federal plus local marginal tax rate 𝑟𝑡𝑎𝑥𝑎𝑏𝑙𝑒 : the total before-tax rate of return on taxable bonds (such as corporate bonds) 𝑟𝑚𝑢𝑛𝑖 : the total rate of return on municipal bonds 𝑟𝑚𝑢𝑛𝑖 Equivalent taxable yield: 𝑟𝑡𝑎𝑥𝑎𝑏𝑙𝑒 = or 𝑟𝑚𝑢𝑛𝑖 = 𝑟𝑡𝑎𝑥𝑎𝑏𝑙𝑒 × (1 − 𝑡) 1−𝑡 Cutoff tax bracket: the tax rate at which the after-tax yield of the taxable 𝑟 bond is equal to yield on the municipal bond, i.e., 𝑡𝑐𝑢𝑡𝑜𝑓𝑓 = 1 − 𝑚𝑢𝑛𝑖 𝑟𝑡𝑎𝑥𝑎𝑏𝑙𝑒 © McGraw Hill, LLC 32  Fixed Income Capital Market Instruments 3. Municipal bonds (Munis) Question: Suppose my tax bracket is 28%. You have two investment options. The first is the taxable corporate bond of 6% return. The second is the tax- free muni of 4% return. Shall I prefer to earn a 6% taxable return or a 4% tax- free yield? What is the equivalent taxable yield of the 4% tax-free yield? Method 1: 6% taxable return: after tax return = 6%*(1-28%) = 4.32% 4% tax-free: after tax return = 4% I prefer the first investment to earn a 6% taxable return, because 4.32% > 4% or Method 2: equivalent taxable yield of the 4% tax-free return = 4% / (1-28%) = 5.55% I prefer the first investment to earn a 6% taxable return, because 6% > 5.55% © McGraw Hill, LLC 33  Fixed Income Capital Market Instruments 3. Municipal bonds (Munis) Question: How about someone with a tax bracket of 38%? Method 1: 6% taxable: after tax return=6%*(1-38%) = 3.72% 4% tax-free: after tax return=4% I prefer the second investment to earn a 4% tax-free return, because 3.72% < 4% or Method 2: equivalent taxable yield of the 4% tax-free return = 4% / (1-38%) = 6.45% I prefer the second investment to earn a 4% taxable return, because 6% < 6.45% Question: Who are more likely to buy munis, high tax-bracket or low tax-bracket investors? Answer: High tax-bracket investors © McGraw Hill, LLC 34  Fixed Income Capital Market Instruments 4. Corporate bonds A mid-term or long-term debt issued by firms. Corporate bonds are the means by which firms borrow money directly from the public. They are claims on fixed payments from a corporation. Investors typically receive semi-annual coupons over life of bond and receive face value ($1,000) when bond matures. Issuer Price Coupon Maturity Yield to Rating rate date maturity Company A 109.13 6.5% 7-15-2038 5.3% AA © McGraw Hill, LLC 35  Fixed Income Capital Market Instruments 4. Corporate bonds Price: The purchasing price of the bond. Bonds are sold and bought at values different from par value. The price quoted as a percent of par value. The bond is selling for 109.13% of its par value. If this bond has a $1,000 par value, it sells for $1091.30 ($1,000 * 109.13%). Coupon rate: This is the annual rate measured as the periodic payment divided by face value. If the coupon rate is 6.5%, then the coupon payment per year is $65 (= 6.5% x $1,000), or $32.5 per six months if the coupon is paid semi-annually. Yield to maturity (YTM): This is the bond’s annual discount rate or annual investment return rate that summarizes a bond’s overall investment value that you would receive if you purchased the bond today at the price and you held the bond to maturity. (It plays the role as discount rate in bond valuation.) Rating: A grade indicating credit quality. A higher bond rating means a higher bond quality and lower default risk, hence indicating a lower required rate of return. © McGraw Hill, LLC 36  Fixed Income Capital Market Instruments 4. Corporate bonds Risk a. Interest rate risk: when interest rate increases, bond price goes down. If you sell the bond before its maturity, you could possibly lose money. b. Default risk (credit risk): the risk that the borrower (the firm) cannot make required payment (i.e., coupon or par value) on their obligation. Corporate bonds are rated according to their default risk Moody's: Aaa, Aa, A, Baa, Ba, B, Caa, Ca, C, D[1,2,3] S&P: AAA, AA A, BBB, BB, B, CCC, CC, C, D[+,-] Fitch: AAA, AA, A, BBB, BB, B, CCC, CC, C, RD, D Investment grade (>=BBB or Baa); “Junk bonds” or speculative grade (