Week 3 Sep 11 2024 PDF - Financial Economics

Important interest rates Fed Funds Rate - interest rate that depository institutions (such as banks and credit unions) charge other depository institutions in the US for overnight lending of capital from their reserve balances on an uncollateralized basis. London Interbank Offer Rate (LIBOR) - lendi...

Important interest rates Fed Funds Rate - interest rate that depository institutions (such as banks and credit unions) charge other depository institutions in the US for overnight lending of capital from their reserve balances on an uncollateralized basis. London Interbank Offer Rate (LIBOR) - lending rate among banks in the London Market. Reflect the rate at which banks lend among themselves. LIBOR acts as a benchmarking base for short-term interest rates for prices of securities such as currency swaps, interest rate swaps, or mortgages. Note: Basis Point, often referred to as a Beep (using the notation bp) - measurement of one-hundredth of a percent. E.g 10bp is 0.10% 1 Michael Oyson CFA - Econ 123 (Financial Economics) Module 2: Investments Global Financial Crisis of 2008 2 Michael Oyson CFA - Econ 123 (Financial Economics) Securitization - Definition of terms Process of bundling or pooling a range of debt instruments into standardized securities backed by these loans with the aim of selling them for cash – turning a future cash flow into securities. The combined value of the debt-instrument bundle is used to convert the various types of bundled debts into a bond issue, which may in turn be bought by investors. It is a way for lenders to move debts and risk off their balance books and get cash. Securitization is the issuance or creation of bonds and other tradable securities that are backed by income generated by loans, assets, public works projects, and other sources of revenue. In other words, securitization is a process of taking illiquid assets, and turning them into a security through financial engineering. 3 Michael Oyson CFA - Econ 123 (Financial Economics) CDO and MBS Collateralized Debt Obligation (CDO) is a synthetic investment product that represents different loans bundled together and sold by the lender in the market. The holder of the collateralized debt obligation can, in theory, collect the borrowed amount from the original borrower at the end of the loan period. A collateralized debt obligation is a type of derivative security because its price (at least notionally) depends on the price of some other asset. Mortgage-backed Security (MBS) is a debt security that is collateralized by a mortgage or a collection of mortgages. An MBS is an asset-backed security that is traded on the secondary market, and that enables investors to profit from the mortgage business without the need to directly buy or sell home loans. Source: CFI 4 Michael Oyson CFA - Econ 123 (Financial Economics) Credit Default Swap (CDS) Credit default swap (CDS) is a type of credit derivative that provides the buyer with protection against default and other risks. The buyer of a CDS makes periodic payments to the seller until the credit maturity date. In the agreement, the seller commits that, if the debt issuer defaults, the seller will pay the buyer all premiums and interest that would’ve been paid up to the date of maturity. Systemic risk can be defined as the risk associated with the collapse or failure of a company, industry, financial institution, or an entire economy. It is the risk of a major failure of a financial system, whereby a crisis occurs when providers of capital, i.e., depositors, investors, and capital markets, lose trust in the users of capital, i.e., banks, borrowers, leveraged investors, etc. or in a given medium of exchange (US dollar, Japanese yen, gold, etc.). It is inherent in a market system, and hence unavoidable. Source: CFI 5 Michael Oyson CFA - Econ 123 (Financial Economics) Securitization by type Source: Investopedia 6 Michael Oyson CFA - Econ 123 (Financial Economics) Under the hood Source: Streetfin 7 Michael Oyson CFA - Econ 123 (Financial Economics) Collateralized Debt Obligation Source: WallStreetMojo 8 Steps in securitization ➔ Asset origination: Lender issues loans to borrowers. ➔ Create asset pools: The lender selects a pool of loans with similar characteristics, such as loan type, maturity, and credit quality. ➔ Create the special purpose vehicle (SPV): The lender establishes a separate legal entity called an SPV) or a special purpose entity - designed such that if the lender goes bankrupt, the assets held by the SPV won't be affected. ➔ Transfer the assets: Lender sells the pool of loans to the SPV, effectively removing the assets from its balance sheet. In return, the SPV pays the lender for the assets, often using funds raised from issuing securities. ➔ Tranching: The SPV divides the pool of loans into different risk classes, known as tranches. Each tranche has a different level of risk and return, catering to different investor risk appetites. The tranches are typically considered senior, mezzanine, and junior (or equity). Source: Investopedia 9 Michael Oyson CFA - Econ 123 (Financial Economics) Steps in securitization ➔ Credit enhancement: The SPV may use various credit enhancement techniques to make the securities more attractive to investors. ➔ Rating: The SPV hires credit rating agencies to assess the creditworthiness of each tranche. The rating agencies assign ratings to the tranches based on their perceived risk, with the senior tranches receiving the highest ratings and the junior tranches receiving the lowest. ➔ Marketing and sale: Securities are marketed and sold to investors through investment banks. ➔ Distribute cash flows: When borrowers make payments, the cash flows are collected by a servicer and distributed to the investors according to the terms of the securities. The senior tranches get priority over junior tranches in receiving payments. ➔ Monitoring and reporting: Throughout the life of the securities, the servicer monitors the performance of the underlying loans and provides regular reports to the investors. Source: Investopedia 10 Michael Oyson CFA - Econ 123 (Financial Economics) GFC phases - CDS spreads 11 Michael Oyson CFA - Econ 123 (Financial Economics) GFC - key events 12 Michael Oyson CFA - Econ 123 (Financial Economics) Financial intermediaries - definition of terms Financial intermediaries - institutions that facilitate the flow of funds between savers and borrowers. E.g. banks, investment companies, insurance companies, pension funds, venture capital firms, private equity firms, investment banks Investment companies - firms managing funds for investors. E.g. mutual funds, hedge funds Investment bankers - firms specialising in the sale of new securities to the public, typically by underwriting the issue Venture capital - set up to provide financing to early-stage, high-growth privately held firms with the objective of taking advantage of potential high returns Private equity - set up to provide financing to more mature, high-growth, established, privately held firms with the objective of taking advantage of potential high returns 13 More… Primary market - market in which new issues of securities are offered to the public in the form of e.g. initial public offerings Secondary market - market in which previously issued securities are trading among investors Initial public offering (IPO)- companies sell their shares to the public for the first time 14 Investment process - definition of terms Passive management - investment strategy that aims to replicate the performance of a specific market index or benchmark rather than attempting through security analysis to outperform it Active management - investment strategy where managers or investors make specific investment decisions with the goal of outperforming a market index or benchmark through search of mispriced securities or market timing 15 Investment process Source: Damodaran 16