Financial Markets and Institutions, Dispense di Mercato Finanziario

Scarica Financial Markets and Institutions e più Dispense in PDF di Mercato Finanziario solo su Docsity! 1 FINANCIAL MARKETS The financial system is a complex structure designed to meet the financial needs of the different economic agents and consists in 4 elements, each must be regulated: 1. Markets: place of exchange of instruments. 2. Financial instruments: contracts between the deficit and the surplus parties. 3. Intermediaries: institution specialized in production and trading of instruments. 4. Regulation: supervisory authority that ensure all works effectively and efficiently. The main function of financial system is to channel funds between people with surplus of funds (Lenders) to people with necessity and lacking funds (Borrowers). LENDERS BORROWERS Households Business firms Business firms Government Government Households Foreigners Foreigners There exist: - Direct finance: the transfer between lender and borrower is direct, they sign the same contract. - Indirect finance: the transfer between lender and borrower occurs indirectly through the intermediary (e.g. bank), they sign two different contracts. Indirect finance A financial intermediary, say the bank, plays in the middle between lender and borrower. The balance sheet of the intermediary stays between the deficit and surplus units’ balance sheets: the bank is creditor of the deficit unit (borrower) and debtor of the surplus unit (lender). The intermediaries are also called transforming intermediaries because they are able to transform short-term loans (by the lender) into long-term loans (for the borrower), and so to transform the maturity of the assets. The intermediaries are very important for: - Transaction costs Financial intermediaries make profit by reducing transaction costs developing expertise and taking advantage of economies of scale (standardization of contracts). Low transaction costs ensure liquidity service to customers whenever they need. - Risk sharing Intermediaries reduce exposure of investors to risk throughout risk sharing: they create and sell low-risk assets to one party to buy higher risk assets from another party. This is a asset transformation in terms of risk. 2 - Asymmetric information Information asymmetry is when information is not entirely shared between individuals in the economic process: the lender only has the market and public information, whereas the borrower has complete information. It is very difficult for the lender to evaluate the risk but the intermediary has more skills in doing this. Asymmetric information might lead to: 1. Adverse selection: problem in the pre-contractual phase. For example, if the bank is not able to divide safe and risky borrowers, it applies all borrowers the same average interest rate: it can be a convenient for risky borrowers but a problem for safe ones. Safe borrowers might go away and there remain only risky borrowers and the average interest rate applied might have bad consequences. 2. Moral hazard: problem in the post-contractual phase, due to opportunism. It is mostly in the insurance: the individual that is insuranced does not act the prevention to avoid accidents. Financial institutions Markets and institutions are primary channels to allocate capital in our society. Proper capital allocation leads to growth in: - Societal wealth - Income - Economic opportunity Financial institutions (FIs) are bodies through which suppliers channel money to users of funds They are distinguished by: - whether they accept insured deposits - depository and non-depository financial institutions - whether they receive contractual payments from customers 5 The structure of the financial markets is divided by different criteria. § Basing on its function 1. Primary markets: securities are issued and traded for the first time, so each exchange enlarge the number of outstanding securities. 2. Secondary markets: securities were previously issued and already in circulation, they are transferred between operators. § Basing on time-horizon 1. Money market: short-term assets: less than one year of residual life. Useful for soon liquidity provided. 2. Capital market: more than one year of residual life. It includes bond market (debt) and stock market (participation). Useful for long-term financial goals. § Based on the characteristics of transactions 1. Retail market: small amount of assets, no minimum or maximum trading quantities. 2. Wholesale market: large trading, minimum or maximum trading quantities. § Based on the negotiation methods 1. Order-driven market (Auction market): price is determined by comparing purchasing and selling proposals by anonymous operators. 2. Quote-driven market: price is determined by the market makers (an intermediary) who acts as a direct counterpart to all operators showing the quotation (price). In the order-driven markets it is possible to define a single market price, while in quote- driven markets the market maker defines different prices for purchases and sales: bid (or money) – price at which mm decides to buy something - and ask (or letter) - price at which mm decides to sell something. In an order-driven, market operators can indicate in their negotiation proposal the price at which they are willing to buy or sell a particular security, while in quote-driven markets operators can only choose to accept the market maker's price. Order-driven markets guarantee transparency but quote-driven markets guarantee liquidity because order will be actually realized. § Based on the settlement methods (transfer of the securities against payment of the price, after the negotiation). 1. Spot (or Cash) market: after the agreement, exchange is settled immediately. 2. Forward market: after the agreement, exchange is settled at a future predetermined date. § Based on the regulation 1. Regulated market: there is the figure of a market manager who defines the rules and procedures by which instruments negotiable on the market are selected (e.g. stock exchanges). 2. Unregulated market over the counter (OTC): all exchanges outside regulated markets, e.g. an investor directly contact another investor to sells securities. 6 Money markets The security in the money market are: - Short-term (one-year maximum) - Highly liquid with low default risk - Close to being money - Wholesale market because sold in large denomination (1.000.000$ or more) The Money Market provides a place for warehousing surplus fund for short period of time for investors and low-cost source of temporary funds for borrowers. Corporations and governments use these markets to solve cash-timing problems, because the timing of cash inflows and outflows are not well synchronized. Money Market participates operate on both sides and are: - The U.S. Treasury (always a borrower) - The Federal Reserve (sells securities to reduce money supply, buys securities to expand it). - Commercial banks - Money market mutual funds - Brokers and dealers - Corporations - Other financial institutions - Individuals Money Market instruments: - Treasury Bills: issued by US Treasury, have 28-day maturities up to 12 months maturities. The minimum denomination is now $100. There are no interests, they are issued at a discount from the par value: the price is lower than the face value at the maturity date. T- Bills have virtually zero-default-risk because they are short-term and US Government can always print new money. For European countries is not the same. The secondary market for the T-bills is the largest of any U.S money market securities: market is deep (many buyers and sellers) and liquid (low transaction costs). T-bills have low interest rates and do not compensate investors for inflation. - Federal Funds: held at Federal Reserve Banks, composed by national banks. They are short-term funds transferred between financial institutions, usually for a period of one day, and are used to meet short-term needs to meet reserve requirements. The Federal Reserve cannot directly control Federal Funds rate, it just can influence it adjusting the level of reserve: Federal Reserve buys securities, investors sells, money supply increases and the interest rate decreases. - Repurchase Agreements: similar to the market for Fed funds, but non-banks can participate. A firm sells Treasury securities, but agrees to buy them back at a certain date (usually 3–14 days later) for a certain price. There are Overnight repos (1-day maturity) or Term repos (longer maturity). - Commercial Papers: unsecured promissory notes, issued by corporations, with a maximum 270-days maturity. Commercial paper used increased in 1980s because costs of bank loans increased. Since they are unsecured, only the largest corporations make them and the interest rate reflects the firm’s level of risk. There is no secondary market. 7 - Negotiable Certificates of Deposit: bank-issued security that documents a deposit and specifies the interest rate and maturity date. Denomination ranges from $100’000 to $10 millions. They are negotiable in the secondary market. The Certificates of Deposit are opposed to the Demand Deposits since the former have a specified maturity date, the latter can be withdrawn at any time. - Banker’s acceptance: time draft payable to a seller of goods, with payment guaranteed by a bank. Time draft issued by a bank are orders for the bank to pay a specified amount of money to the owner of the time draft on a given date. - Eurodollars: Dollars-denominated deposits held in foreign banks. The market is essential since many foreign contracts call for payment is US dollars due to the stability of the dollar. The Eurodollar has increased since the investors receive a higher return in Eurodollar market than in the domestic market. Some large London banks acts as brokers in the interbank Eurodollar market: the Fed funds are used by banks to make a temporary short fall in their reserve, Eurodollars are an alternative. Banks around the world buy and sell overnight funds in this market and different rates are generated overnight: LIBID (London interbank bid rate), the rate banks pay to buy funds, LIBOR (London interbank offer rate), the rate banks offer to sell funds, time deposits with fixed maturities. Capital Market The securities have an original maturity greater than one year, typically for long-term financing or investments. The best-known capital market securities are stocks and bonds. The primary issuers of securities are federal and local governments (for debt) and corporations (equity and debt) and the largest purchasers are households and financial indstitutions. Capital market trading occurs on the: - Primary Market: initial sale is the IPO (Initial Public Offer); - Secondary Market: on regulated or unregulated (over-the-counter) exchanges. Bonds are securities that represent debt owned by the issuer to the investor, and typically have specified payments on specific dates. The par (face value) is the amount paid by the issuer at the maturity, the coupon rate is the interest rate paid by the issuer usually fixed for the duration of the bond. If the payments are not met, the holder has a claim of the issuer. There are long-term government bonds (T-bonds), municipal bonds, corporate bonds, etc… Treasury issues T-Notes (1 to 10-years maturity) and T-Bonds (10 to 30-years maturity). The face value is $100. They have zero-default risk since Government can always print money to payoff the debt. They are considered risk-free so they have low interest rate, although inflation risk is still present. The primary market of T-notes and T-bonds is through competitive and non-competitive single-bid auctions - 2-year notes are auctioned monthly; - 3, 5 and 10-year notes are auctioned quarterly; - 30-year bonds are auctioned semi-annually; Most secondary trading occurs directly through brokers and dealers. 10 Interest rate risk Prices and returns more volatile for long-term bonds: the longer the maturity, the higher the interest-rate risk, i.e. the risk when the interest rate on the market increases the price decreases. There is no interest-rate risk for bonds whose maturity equals holding period. The reinvestment risk occurs when an investor’s holding period is longer than the bond’s term to maturity, It occurs if investor holds a series of short bonds over long period of investment and the proceeds from the short term bond need to be reinvested at a future interest rate that is uncertain. If the interest rate increases on the market, the price of the bond decrease, so the investor gains from reinvesting his money. If the interest rate decreases on the market, the price of the bond increase, so the investor loses from reinvesting his money. When the interest rate changes, the price changes. A precise metric is needed to assess this interest-rate risk. If two bonds have the same term to maturity, it doesn’t mean that they have the same interest rate risk because this depends also on the time of the coupon payments (CP). Duration The duration is the average lifetime of a debt security’s stream of payments: i.e. how long it takes (e.g. in years) for the investors to repaid the bond price by the bond’s cash flows. 𝐷𝑈𝑅 =:𝑡 ∗ N 𝐶𝑃! (1 + 𝑖)! ∑ 𝐶𝑃!(1 + 𝑖)! " !#$ P " !#$ The longer the maturity of a bond, the higher the duration. The higher the interest rate of a bond, the lower the duration. The higher the coupon rate of a bond, the lower the duration. Duration is additive: the duration of a portfolio of securities is the weighted-average of the durations of the individual securities, with the weights equalling the proportion of the portfolio invested in each security. The variation in the price of a bond is: %Δ𝑃 = 𝑃!($ − 𝑃! 𝑃! = −𝐷𝑈𝑅 ∗ Δ𝑖 1 + 𝑖 If the interest rate increases, the change in the price follows this formula and the new price will be 𝑃!($ = 𝑃! ∗ %Δ𝑃 The higher the duration of a security, the higher the percentage change in the market price of the security for a given change in interest rates. So, the higher the duration of a security, the higher its interest-rate risk. 11 Bond Market Corporate bonds Corporate bonds are long-term obligations issued by corporations, typically with a face value of $1,000, although sometimes it can be $5,000 or $10,000. They pay interest semi-annually and cannot be redeemed anytime the issuer wishes, unless a specific clause states this (call option). The degree of risk varies with each bond, even from the same issuer. Following suite, the required interest rate varies with level of risk. They are sold in - Primary markets are identical of Municipal Bonds. - Secondary markets: exchange markets or OTC. At one time bonds were sold with attached coupons that the owner of the bond clipped and mailed to the firm to receive interest payments: these were called bearer bonds because payments were made to whoever had physical possession of the bonds. Bearer bonds have been now replaced by registered bonds, which do not have coupons but, instead, the owner must register with the firm to receive interest payments. Since bondholders cannot look to managers for protection when the firm gets into trouble, they must impose rules and restrictions on managers to protect the bondholders’ interests: these are known as restrictive covenants. They can limit dividends the firm can pay (to conserve cash for interest payments to bondholders), the ability of the firm to issue additional debt… Typically, the interest rate is lower the more restrictions are placed on management, because the bonds will be considered safer by investors. Most corporate bonds include a call provision, which states that the issuer has the right to force the holder to sell the bond back to the firm. The call provision requires a waiting period and the price at which the bond is re-bought (call price) is usually higher than par price. Investors don’t like call provisions but firms do because: - The firm could call the provision whenever the price rise above the call price, limiting the bondholder’s potential earnings from the appreciation. - Firms can adhere to a sinking fund provision, a requirement in the bond agreement that the firm pay off a portion of the bond issue each year. This reduces the probability of default when the issue matures, and the firm can reduce the bond’s interest rate. - Firms may have to retire a bond issue if the covenants of the issue restrict the firm from some activity (e.g. limiting issue of new debt). Because bondholders do not generally like call provisions, callable bonds must have a higher yield than noncallable bonds: despite the higher cost, firms still issue callable bonds because of their flexibility. Some corporate bonds can be converted into equity: they are similar to stock options, but usually more limited. Most convertible bonds can be converted into a certain number of common shares at the discretion of bondholder. Issuing convertible bonds is a way firms avoid sending a negative signal to the market. 12 The types of corporate bonds differ by the type of collateral that secures the bond and by the order in which the bond is paid off if the firm defaults. 1. Secured bonds: collateral attached. a. Mortgage bonds: used to finance specific projects with real property pledged as collateral. b. Equipment trust certificates: secured by tangible not-real-estate property (e.g. heavy equipment, airplanes…) 2. Unsecured bonds: no collateral attached. a. Debentures: long-term bonds backed only by the creditworthiness of the issuer. In the event of default, the bondholders must go to Court. b. Subordinated debentures: lower priority to claim then debenture in case of default. c. Variable-rate bonds: their interest rate is tied to another market interest rate (e.g. Treasury bonds’ rate) and is adjusted periodically. All corporate bonds are rated according to their default risk by companies. The most famous are Moody’s, Standard & Poor’s and Fitch. The bonds can have investment (From AAA to BBB) or speculative (below BBB) grade. Junk bonds are speculative grade bonds: they are considered sub-investment grade debt and pay an higher interest rate to compensate investor’s risk. International bonds International bonds have higher return and permit a better diversification. There are some complexities though: - Higher risk: political risks are higher and there is a potential capital flight in lesser developed markets (e.g. Greek crisis in Europe); - Lower recourse in the event of non-repayment; - Foreign exchange rate movements can significantly impact returns. International bond markets involve unregistered bonds that are internationally syndicated, offered simultaneously to investors in several countries, and issued outside of the jurisdiction of any single country. We can identify: - Eurobonds are long-term bonds issued outside the country of the currency in which they are denominated; - Foreign Bonds are long-term bonds issued outside of the issuer’s home country; - Sovereign Bonds are government issued debt. 15 The election of the board of directors might be by - cumulative voting: one vote per share multiplied by the number of available director positions with the votes being distributed in whatever proportion the shareholder prefers: it permits minority stockholders to have some real weight in the election. - straight voting: the vote occurs one director at time: each share is entitled to one vote per director seat. The preferred stock is a hybrid security that has characteristics of both bonds and common stock: generally, it has fixed dividends that are paid quarterly. Generally, it does not have voting rights unless dividend payments are missed. Preferred stockholders can be non-participating (the dividend is fixed regardless any increase in firm’s profit) or participating (dividend might increase according to firm’s profits). Preferred stock can be non-cumulative (missed dividends will be never paid) or cumulative. Primary stock markets are markets in which corporations raise funds through new issues of stock. The new stock securities are sold to investors in exchange of money most of the time through investment banks using best efforts underwriting or commitment underwriting. With the best effort underwriting, the bank does not guarantee a price the issuer but act as a distribution agent, obtaining a fee. With commitment underwriting, the bank guarantees the corporation a price for newly issued securities. The investment bank purchases the stock from the issuer for a guaranteed price (net proceed) and sell it to the public at a higher price (gross proceed): the difference is the underwriter’s spread, the compensation for the expenses and risk incurred by the bank. A syndicate is a group of investment banks working in concert to issue stock; the lead underwriter is the originating house. An initial public offering (IPO) is the first public issue of financial instruments by a firm. A seasoned offering is the sale of additional securities by a firm whose securities are already publicly traded. The pre-emptive rights give existing stockholders the ability to maintain their proportional ownership: if new stocks are created, they have to be firstly offered to existing stockholder in order to give them the possibility to maintain their share of ownership. Secondary stock markets are the markets in which stocks, once issued, are traded among investors. The U.S. has several major stock markets - New York Stock Exchange Euronext (NYSE/Euronext) - National Association of Securities Dealers Automated Quotation (NASDAQ) - Bats/Direct Edge (former ECNs) Securities in the secondary stock market are exchanged through brokers or firms acting as intermediaries. There are - Organized exchanges: implies a specific trading location or computer systems (ECNs). Listing requirements exclude small firms. The most known is NYSE. - Over-the-counter exchanges: they are completely computer-based. Important market for thinly-traded securities, i.e. that don't trade very often: dealers are market-makers and without them the equity would be difficult to trade. The most known is NASDAQ. 16 The choice of market listings is different: – NYSE has extensive listing requirements (e.g. firm market value and trading volume); – NASDAQ requirements are cheaper and can be met by smaller firms with less active trading. NYSE Euronext Trading occurs at a specific place on the floor of the exchange called a trading post. Each stock has a special market maker called a specialist or Designated Market Maker (DMM) that maintains liquidity for the stock at all times. Three types of transactions occur at trading posts: - Market order: order to transact at the best price available when the order reaches the trading post; - Limit order: order to transact at a specific price, the transaction is made only if the current price is close to the limit price. - Specialists transact for their own account NYSE has defined program trading, the simultaneous buying and selling of a portfolio of at least 15 different stocks valued at more than $1 million using computer programs to initiate the trades. It has been criticized for the impact on stock market prices and for increasing volatility. As a result for these increase in volatility, circuit breakers has been introduced on trading, limitation on trading when the Dow Jones fall deeply; they give investors time to make informed choices during periods of high market volatility. NASDAQ It was the world’s first electronic market and has no physical trading floor. It provides continuous trading for the most active stocks traded over-the-counter (OTC). It is primarily a dealer market where many dealers would act as market makers even for a single stock, quoting bid and ask price. A small order execution system (SOES) provides automatic order execution for orders of less than or equal to 1,000 shares. Pink sheets are smaller stock listed in the NASDAQ market. Electronic communication networks (ECNs) Normal trading occurs between 9:30 a.m. and 4:00 p.m. (eastern standard time). Extended-hours trading occurs through computerized alternative trading systems (ATSs) a.k.a. ECNs. BATS (Better Alternative Trading System) has now become the third largest exchange, after NYSE and NASDAQ. Advantages: - Transparency: everyone can see unfilled orders. - Cost reduction: smaller spreads. - Faster execution because fully automated. - After-hours trading. Disadvantages: 17 - Work well only with stocks with substantial volume (not thinly-traded stocks). - Many ECNs competing for volume, which can be confusing. - Major exchanges are fighting ECNs, with an uncertain outcome. A stock market index is the composite value of a group of secondary market-traded stocks There can be 1. Price-weighted index: components are weighted by the stock price. a. Dow Jones Industrial Average (DJIA), composed of 30 companies, is the most widely known stock market index. 2. Value-weighted indexes: components are weighted by the market capitalization (number of outstanding stocks * current price of a stock) a. NYSE Composite b. Standard & Poor’s 500 c. NASDAQ Composite d. Wilshire 5000 Exchange Traded Funds (ETFs) They are a recent innovation to help keep transaction costs down while offering diversification. They represent a basket of securities, listed and traded on a major exchange as individual stocks. They are indexed to a specific portfolio (e.g., the S&P 500) and not actively managed, that’s why management fees are low (not zero). Their value is based on the underlying net asset value of stock held in the index basket: the exact content of basket is public, so valuation is certain (no space for arbitrage). ETFs are similar to stock index mutual fund since they track the performance of some underlying index but they differ since ETFs trade like stocks, so they allow for limit orders… Value of a stock Note that: - Investing in stocks confers ownership; - Returns are earned in 2 ways: dividends or increase in stock price; - Highly risk due to volatility and no guarantees; - Stockholder have claim on all assets and some voting rights; - Stock can be common or preferred; Computing the price of stocks is more difficult than for the bonds because we don’t know about cash flows (dividends, selling prices…) and the selling date. So there is a lot of uncertainty. § One-period valuation model Simplest model for only one period of holding, just taking the expected dividend and expected price over the next year. The discount rate is the rate requested by investors for other instruments with similar risk. 20 Forward contracts Forward contracts are agreements by two parties to engage in a financial transaction at a future point in time. The contract can be written however the parties want, but the contract usually includes: - Exact assets to be delivered - Location of delivery - Price paid for the assets - Date when the assets and cash will be exchanged Interest-Rate Forward Contract involves future sell or future purchase of debt instruments. These contracts include: - Specification of the debt instrument that can be delivered - Amount of debt instruments - Price (expressed in interest rates) of the bond - Date of delivery Long Position → Agree to buy securities at future date Hedges by reducing interest rate risk from its decreases and increases in price. Short Position → Agree to sell securities at future date Hedges by reducing price risk from its decreases and increases in interest rates. Forward contracts have • Advantages: F o Flexibility: contracts are not standardized but parties decide how to build the contract. • Disadvantages o Lack of liquidity: the flexibility of the contract makes it hard to find a counter-party or to deal the desired price. o Default risk: requires information to screen good from bad risk. Futures contracts Futures contracts are agreements between two parties that engage a financial transaction at a future point in time. They are traded on Exchanges. The hedging is very similar to forward but there are differences. The financial future contract specifies the delivery of type of security at future date. If the interest rate rises, long contract has loss and short contract has profit. 21 We can define two types of hedging: - Micro hedge → hedging the value of a specific asset. - Macro hedges → hedging, for example, the entire value of a portfolio, or general prices for production inputs. Futures are more successful than forward because: - Futures are more liquid: because they are standardizes and easily traded. - Delivery of range of securities reduces the chance that a trader can corner the market: more than one asset is eligible for delivery. - The presence of the Clearing House that compensates eventual losses reduces the default risk. The working of the Clearing House is guaranteed by the Margins Mechanism: buyers and sellers put an initial deposit (called margin requirement). The futures are marked to market daily and the variations (profit/losses) are compensated. - No need to deliver the asset thanks to the cash netting of position, the different position is net with money. A particular aspect of financial derivatives, in particular about futures, is the leverage effect. The leverage effect is the possibility to carry out an investment, which concerns a high amount of financial resources, with a limited use of capital. The main economic advantage is the multiplication of the performance of the investment; less the initial margin with respect to the contract value, the greater will be the lever effect. The Leverage is calculated as 𝐿𝑒𝑣𝑒𝑟𝑎𝑔𝑒 = 𝐶𝑜𝑛𝑡𝑟𝑎𝑐𝑡 𝑣𝑎𝑙𝑢𝑒 𝑀𝑎𝑟𝑔𝑖𝑛 Where the margin is the real amount of money that you deposit to the future contract at the beginning of the investment. Financial institution managers, particularly those that manage mutual funds, pension funds, and insurance companies, also need to assess their stock market risk, the risk that occurs due to fluctuations in equity market prices. One instrument to hedge this risk is stock index futures, contracts to buy or sell a particular stock index, starting at a given level. 22 Contracts exist for most major indexes, including the S&P 500, Dow Jones Industrials, Russell 2000, etc. The best stock futures contract is generally determined by the highest correlation between returns to a portfolio and returns to a particular index. Portfolio is protected from downside risk, the risk that the value in the portfolio will fall. However, to accomplish this, the manager has also eliminated any upside potential. An hedging strategy that protects again downside risk, but does not sacrifice the upside is using options. Option contracts Options contract are rights to buy (call) or sell (put) a specific asset at a specific price (strike price) until the expiration date (American options) or on the expiration date (European options). Options are available on many financial instruments, such as individual stocks, stock indexes, futures… An investor buys an option contract paying a premium so that he will have the right to buy/sell at the strike price determined by the contract. Buyer Seller Call option RIGHT to buy OBLIGATION to sell Put option RIGHT to sell OBLIGATION to buy Therefore, options permit hedging. Buying put option contracts is the same hedging strategy of selling of futures. The advantage of option is that if the interest rate increases (and price goes down), the buyer of the put option (i.e. the seller of the asset) will gain whereas if it decreases the buyer of option do not exercise the right and only loses the premium paid. The disadvantage is the paying of a premium. The differences between futures and options 25 1. Stock (equity) funds (21%) 2. Bond funds (26%) 3. Hybrid funds (8%) 4. Money market funds (21%) Stock funds In addition to common equity, the objective of funds can be: - Capital Appreciation Funds seek rapid increase in share price, not being concerned about dividends: these types of funds are riskier because they choose firms that grows rapidly. - Total Return Funds seek a balance of current income and capital appreciation: it concentrates mainly in more large established firms. - World Equity Funds invest primarily in foreign firms. - Other types in Value, Growth, investing in a particular industry… Bonds funds - Strategic Income Funds invest primarily in U.S. corporate bonds, seeking a high level of current income. - Government Bond Funds invest in U.S. Treasury, as well as state and local government bonds. - Others include World Bond Funds… Hybrid funds Combine stocks and bonds into a single fund. They account for about 5% of all mutual fund accounts. Money Market Mutual funds Open-end funds that invest only in money market securities. They offer check-writing privileges: you can have check with no fees. Net assets have grown dramatically. Although money market mutual funds offer higher returns than bank deposits, the funds are not federally insured and are relatively safe assets. Index Funds Another special class of mutual funds that contain the stock of the index it is mimicking. For example, an S&P 500 index fund would hold the equities comprising the S&P 500. They offer benefits of traditional mutual funds without the fees of the professional money manager. Managers buy securities in proportions similar to those included in a specified major index and, due to little research or management, there are lower management fees and higher returns than actively managed funds. In 2013 there were 373 index funds managing about $1.3 trillion. Exchange traded funds (ETFs) are also designed to replicate market indexes: - They are traded on exchanges at prices determined by the market; - Management fees are lower than actively traded funds; - Unlike index funds, ETFs can be traded during the day, sold short, and purchased on margin. 26 According to the fee structure of investment funds, we can have - Load funds (class A shares): change an upfront fee for buying the shares (unlike no-load funds). - Deferred load funds (class B shares): charge a fee when the shares are redeemed. - If no front/back fees are applied, it is a class C shares fund. Other fees charges by mutual funds include: - Contingent Deferred Sales charge: a back end fee that may disappear totally after a specific period; - Redemption fee: back end load; - Exchange fee: a fee (low) for transferring money between funds in the same family; - Account Maintenance fee: if the account balance is too low; - 12b-1 fee: pay marketing, advertising, and commissions. The average annual fees and expenses in 2012 they were 0.77% for equity and 0.61% for bonds. These expenses have continued to fall due to investor knowledge and competition with index funds and ETFs. Hedge Funds Hedge funds are a special type of mutual fund that received considerable attention following the collapse of Long-Term Capital Management. They are different from typical mutual funds, as follows: - High minimum investment, around $1 million; - Long-term commitment of funds required; - High fees: typically 1% of assets plus 20% of profits; - Highly levered; - Little current regulation. They use more aggressive trading strategies than MFs such as short selling, leverage, program trading, arbitrage and the use of derivatives. HF are investment pools that solicit funds from wealthy individuals and other investors (e.g., commercial banks) and invest these funds on their behalf. They are similar to MFs, but - smaller funds under $100 million in assets are not required to register with the SEC (Security Exchange Commission). - are subject to less regulatory oversight than MF; - can take significantly more risk than MF; - do not have to make their activities public to third parties and thus offer a high degree of privacy; - avoid regulation by limiting the number of investors to less than 100 and by requiring investors to be “accredited”: accredited investors have net worth over $1 million or annual income over $200,000 if single (or $300,000 if married) The classification of HF based on the risk: 1. More risk: market directional, these funds seek high returns using leverage, usually investing basing on anticipated events. 2. Moderate risk: market neutral or value orientation, these funds favour a longer-term investment strategy with moderate risk. 27 3. Risk avoidance: market neutral, these funds aims to consistent returns with low risk. HF’s fees are: - Management fees: % of assets under management and range between 1.5% and 2%; - Performance fees: give fund managers a share of any positive returns earned o average is 20%, but vary depending on the HF; o hurdle rate: benchmark that must be realized before a performance fee can be assessed; o high-water mark: when a manager does not receive a performance fee unless the value of the fund exceeds the highest NAV it has previously achieved; Offshore HFs are attractive to investors because they provide anonymity and are not subject to U.S. taxes. HF may engage in arbitrage that holds prices aligned with the fundamental value, by adding liquidity to the market. Investment Banks Investment banks assist the initial sale of assets in the primary market, security dealers and brokers assist the sale in the secondary market. Venture capital firms acts in the pre-market. Investment banks, intermediaries that help firms to raise funds, are not ordinary banks. They perform a variety of crucial functions in financial markets • Underwriter of initial sale of stocks and bonds; • Deal maker in mergers, acquisitions, and spin-offs; • Middleman in the purchase and sale of companies; • Private broker to the very wealthy. 30 Firm’s life cycle and access to finance Crowdfunding Crowdfunding involves an open call, mostly through dedicated platforms on the Internet, for the provision of financial resources, either in form of donation or in exchange for the future product or some form of reward. Crowdfunding platform can be: • Donation-based: project funding motivated by philanthropy or sponsorship, without any other remuneration for crowdfunders; • Reward-based: financing provided in the expectation of a reward or prize (material or not); • Lending-based: debt contracts between lender and borrower; • Equity-based: the investor becomes a stockholder of the company; • Royalty-based: contributors receive a percentage of revenue from the business once it starts generating revenues. In the crowdfunding scenario we have three main actors: 1. Capital seekers: small businesses in need of funds that must - Share information; - Promote Business idea; - Present financial data. 2. Crowdfunding platform 31 3. Backers: investors whose risks are - Asymmetric information; - Default risk; - Fraud risk (firm decided not to conclude the project); - Liquidity risk (mostly in equity-based platform). Venture capital / Business Angel Venture capital (VC) is a professionally managed pool of money used to finance new and – often – high-risk firms. VC usually purchases an equity stake in the start-up and become active in its management. Institutional venture capital firms find and fund the most promising new firms; they can be organized in different way depending, for example, on the country. In US venture capital operates through limited partnerships and in Europe through close end funds (collect money and invest it in new firms). VC can be created by some financial institutions (financial venture capital firms) or by some large corporates (corporate venture capital firms). Debts (by banks) It is a source of indirect finance and it is the most used form. SMEs have limited external funding capacity compared to larger firms, that’s why they are more dependent on bank loans and more exposed to financial turmoil. They have difficulties when trying to access to bank finance due to - information asymmetry; - high administrative costs for small-scale lending - high risk perception; - lack of collateral. Initial public offerings Initial public offerings (IPOs) are the first time debt (bonds) and equity (stocks) are issued. New issues from a firm whose debt or equity is already traded are called seasoned equity offerings (SEOs) Investment Banks Investment banks perform a variety of crucial functions in financial markets - Underwrite the initial sale of stocks and bonds (IPOs SEOs) - Deal maker in mergers and acquisitions They evaluate bond and stock issues’ price by computing the present value of all future cash flows. Mutual Funds has an indirect role in SMEs access to funds since they can - Invest in crowdfunding platforms; - Invest in venture capital close and fund; - Buy new stock or new bond issued by start-ups.