Financial Markets and Institutions 1st part, Appunti di Economia E Tecnica Dei Mercati Finanziari

Scarica Financial Markets and Institutions 1st part e più Appunti in PDF di Economia E Tecnica Dei Mercati Finanziari solo su Docsity! Financial Markets and Institutions – Financial markets (bond and stock markets) and financial intermediaries (banks, insurance companies, pension funds) have the basic function of getting people such as you and Walter together by moving funds from those who have a surplus of funds (Walter) to those who have a shortage of funds (you) but have an idea. Overview of the Financial System Financial markets perform the essential economic function of channeling funds from households, firms, and governments that have saved surplus funds by spending less than their income (Lender-Savers) to those that have a shortage of funds because they wish to spend more than their income(Borrower- Spenders). (i.e. couple that wants to buy a house asks for a mortgage, bank gives money that belong to savers and will get back afterwards.)  Aim to improve economic efficiency: Growth, Consumption smoothing, risk pooling. It allows people to meet their needs. Financial markets are critical for producing an efficient allocation of capital (wealth, either financial or physical, that is employed to produce more wealth), which contributes to higher production and efficiency for the overall economy. - In Direct Finance, borrowers borrow funds directly from lenders in financial markets by selling them securities (also called financial instruments, basically financial assets), which are claims on the borrower’s future income or assets. Securities are assets for the person who buys them, but they are liabilities (IOUs or debts) for the individual or firm that sells (issues) them. i.e. stock market (u directly by the share of a firm); bond market (contract between you and owner of the bond) - Indirect Finance. Borrowers borrow indirectly from lenders via financial intermediaries, which issue financial instruments that are claims on the borrower’s future income or assets. i.e. (loan from a bank, u get resources of depositors, u do not have a contract with them, the bank is the mean). Structure of Financial Markets A firm or an individual can obtain funds in a financial market in two ways. 1. Debt Markets (>50 trillion dollars in 2009); debt instrument, such as a bond or a mortgage, which is a contractual agreement by the borrower to pay the holder of the instrument fixed dollar amounts at regular intervals (interest and principal payments) until a specified date (the maturity date), when a final payment is made -Pay interest + principal (payment) based on cash flows of people/firms -Money Market: short term (maturity<1year). Money market very liquid because largely traded, in particular by banks and corporations, earn surplus. - Capital Market: Long term (maturity>10year) -Capital Market: Intermediate (maturity 1<x<10). Capital market kept by insurances, and pensions funds because little uncertainty. 2. Equity Markets (>20 trillion dollars in 2009); The second method of raising funds is by issuing equities, such as common stock, which are claims to share in the net income (income after expenses and taxes) and the assets of a business. -Ownership claim in a firm, pays dividends The main disadvantage of owning a corporation’s equities rather than its debt is that an equity holder is a residual claimant ; that is, the corporation must pay all its debt holders before it pays its equity holders. The advantage of holding equities is that equity holders benefit directly from any increases in the corporation’s profitability or asset value because equities confer ownership rights on the equity holders. a. Primary Market is a financial market in which new issues of a security, such as a bond or a stock, are sold to initial buyers by the corporation or government agency borrowing the funds (company goes public, u r the first to buy it) - New security issues sold to initial buyers - Typically involves an investment bank who underwrites the offering An important financial institution that assist this initial sale of securities is investment bank. It guarantees a price for a corporation’s securities, it underwrites securities. b. Secondary Market is a financial market in which securities that have been previously issued can be resold. (buy other people’s stock; it is important because it gives market information about a company) - securities previously issued are bought and sold - Secondary markets organized in 2 ways: 1. Exchanges, where buyers and sellers meet in one central location to conduct trades. include the NYSE Exchange, and the 2. Nasdaq OTC (over the counter market) dealers in different locations, with inventory, ready to buy and sell to whoever. Securities brokers and dealers are crucial to a well-functioning secondary market. Brokers are agents of requirements for financial intermedi- aries. Their bookkeeping must follow certain strict principles, their books are sub- ject to periodic inspection, and they must make certain information available to the public.) - Restrictions on assets and activities (on taking risky activitiesThere are restrictions on what financial inter- mediaries are allowed to do and what assets they can hold. One way of doing this is to restrict the financial intermediary from engaging in certain risky activities. i.e. Insurance companies are allowed to hold common stock, but their holdings cannot exceed a cer- tain fraction of their total assets. ) - Deposit insurance (The government can insure people’s deposits so that they do not suffer great financial loss if the financial intermediary that holds these deposits should fail. Ie.e. Federal Deposit Insurance Corporation (FDIC) 1934, Insures each depositor at a commercial bank, savings and loan association, or mutual savings bank up to a loss of $250,000 per account. ) - Limits on competition(i.e. banks opening branches into other states) - Restrictions on interest rates, 1986, the Federal Reserve System had the power under Regulation Q to set maximum interest rates that banks could pay on savings deposits. These regulations were instituted because of the widespread belief that unrestricted interest- rate competition helped encourage bank failures during the Great Depression. Types of Financial Intermediaries (3 categories) 1. Depository institutions – FI accept dposits from individuals and institutions that make loans. Institutions: commercial bank (issue checkable,savings and time deposits), S&Ls (savings deposits or shares, time and checkable d), Credit Unions (funds from shares) 2. Contractual savings institutions, acquire funds at periodic intervals on a contractual basis. They can predict with accuracy how much they will have to pay, tend to invest in the long run. 3. Investment intermediaries Investment Banks Despite its name, an investment bank is not a bank or a financial intermediary in the ordinary sense; that is, it does not take in deposits and then lend them out. Instead, an investment bank is a different type of intermediary that helps a corporation issue securities. First it advises the corporation on which type of securities to issue (stocks or bonds); then it helps sell (underwrite) the securities by purchasing them from the corporation at a predetermined price and reselling them in the market. Interest Rates and Bond Valuation Interest rates are among the most important variables in the economy. We will talk about:
─ Measuring Interest Rates
─ The Distinction Between Real and Nominal Interest Rates
─ The Distinction Between Interest Rates and Returns
─ Measuring Interest Rate Risk

Definition of Interest Rate Present Value
Calculating the rate of return/interest rate of an investment requires one to engage in present value analysis
Present Value: allows to value a financial instrument which promises streams of cash flows at different points in time. Here we focus on debt, which promises a certain stream of payment (unlike equities, where dividends are uncertain). look picture to the right Finance is all about present values. It’s all receiving payments or making payments in the future, but we make choices today.

what does the price of a bond reflect? Trading depends on present values, an investor is thinking of how much a bond is worth, thinks about its present values.
If Price below present value: u make money if u buy the bond. People buy and price will rise
If price above pv: u lose money if u buy. Lot of people sell, price drops.
Credits
1. A simple loan,- Simple Loan (repay principal and interest at once) - which we have already discussed, in which the lender provides the borrower with an amount of funds, which must be repaid to the lender at the maturity date along with an additional payment for the inter- est.
2. A coupon bond- Coupon Bond (pays interest yearly/semi annually and face value is repaid at the end) - pays the owner of the bond a fixed interest payment (coupon payment) every year until the maturity date, when a specified final amount (face value or par value) is repaid. (see EXAMPLE) - Corporation or agency issues the bond - maturity date - coupon rate, dollar amount of the yearly coupon payment expressed as a % of face value
3. A fixed-payment loan - Fixed Payment Loan (repay principal and interest with several constant dollar (monthly) payments) -(which is also called a fully amortized loan) in which the lender provides the borrower with an amount of funds, which must be repaid by making the same payment every period (such as a month), consisting of part of the principal and interest for a set number of years.
4.A discount bond (also called a zero-coupon bond) is bought at a price below its face value (at a discount), and the face value is repaid at the maturity date. Unlike a coupon bond, a discount bond does not make any interest payments; it just pays off the face value. Price is the face value discounted. (Exercise 2) the price of the bond has dropped because interest rate has gone up. If u bought bond when i was 10% now we are unhappy because our bond is valued less, we have a loss. The amount is the same, the investment is safe, the 100 dollar is sure, but the value of the 100 dollars depends on the interest rate. Duration - It measures the risk of an investment. the asset until it expires we take the coupon and discount them by an unknown interest rate and we set everything equal to the price. We find iYTM. (if we know interest rate it is the opportunity cost, in this case we don’t know the value of the interest rate, this is a way to check!!!) yield to maturity, the interest rate that equates the present value of cash flows received from a debt instrument with its value today. YTM can be used to compute the return on all fixed income instruments, 1. Simple Loan: An important point to recognize is that for simple loans, the simple interest rate equals the yield to maturity. Hence the same term i is used to denote both the yield to maturity and the simple interest rate 2. Fixed payment loans: (to find it we equate today’s value of the loan with its present value) 3. Coupon Bond: Because coupon bonds also have more than one cash flow payment, the present value of the bond is calculated as the sum of the present values of all the coupon payments plus the present value of the final payment of the face value of the bond. the larger ‘F’ I get, the higher the yield to return. I can compare iYTM with the actual i and decide whether to invest or not. If price higher than face value, it means that this difference is the sum of the returns guaranteed by the coupons. If price smaller than the face value, it means that we have more return. if 100(=P) = 2(=C)/(1+iYTM)+ 2/(1+iYTM)^2….+ 2+F/(1+iYTM)^100  iYTM= C/F!! 2) Strategy for Computing return ROR > g itself represents how much money u made or loss. It is called Capital Gain (or plusvalenza in italian). Just for the sake by buying at P and selling at P’ in addition to coupons.. the price at which we buy and then sell might be risky and sometimes we might incur in a capital loss. The price of a coupon bond could be driven down by an increase in the interest rate. If I sell the bond at a lower price (i has increased) I have a capital loss. Duration Formula !! gives capital loss. Changes in price to changes in interest rates. ROR= (10+(P’-100))/100 = 10%+ ? depends if price is ><= 100 Distinction Between Real and Nominal Interest Rates Real interest rate ─ Interest rate that is adjusted for expected changes in the price level (expected inflation ) r = i – πe (fisher equation) if inflation is really high we are put at risk. If i = 10% and inflation = 12%, this investment is actually negative. We earn 10% interest but we are losing in terms of goods.
─ Real interest rate more accurately reflects true cost of borrowing. This is because the return we care about is in terms of purchasing power
─ When the real rate is low, there are greater incentives to borrow and less to lend Distinction Between Real and Nominal Interest Rates Real interest rate r = i – πe We usually refer to this rate as the ex ante real rate of interest because it is adjusted for the expected level of inflation . After the fact, we can calculate the ex post real rate based on the observed level of inflation . If i=5%and π e =0%then ir =5%−0%=5% If i=10%and π e =20%then ir =10%−20%=−10% If inflation is higher than we expected to be we make loss. If smaller it is a better investment. When investing we need to consider not only inflation itself but also the level of risk of changing. Why do Interest Rate Change? Changes in Interest Rates In the early 1950s, short-term Treasury bills were yielding about 1%. By 1981, these yields rose to 15% and higher. They then dropped back to 1% by 2003. In 2007, rates jumped up to 5%, only to fall back to near zero in 2008. Interests varies a lot over time. Taking these things into account how will it behave in the future? We need to think about interest rate as determined by supply and demand forces. Determinantsof Asset Demand (I) An asset is a store of value. Items such as money, bonds, stocks, art, land, houses, farm equipment, and manufacturing machinery are all assets. When thinking of whether to buy a certain asset an individual must consider, among other things, these factors: 1. Savings/Wealth (nonhuman assets) , the total resources owned by the individual, including all assets 2. Expected return of the asset (the return expected over the next period ) (relative to alternative assets) 3. Risk of the asset (the degree of uncertainty associated with the return ) relative to alternative assets
4. Liquidity of the asset (ease/speed with which an asset can be sold, i.e., turned into cash) Determinants of Asset Demand (2) Holding everything else constant (ceteris paribus) (for 1,2,3,4): 1. Savings/Wealth: an increase in savings/wealth increases the demand of an asset Richer people/businesses or people/businesses that save more have more to invest. They demand more assets. 2. (Real) Expected return: An increase in an asset’s (real) expected return raises demand of the asset When return is higher people find it more profitable to buy the asset. As a result, its demand goes up (this implies, among other things, that demand falls in the asset’s price) 3. Risk: an increase in the risk of an asset reduces the asset’s demand We typically think that people are risk averse. As a result, higher risk reduces the attractiveness of the asset and thus its demand. To see this more formally, we can use a measure of risk called the standard deviation. The standard deviation of returns on an asset is calculated as follows. First you need to calculate the expected return, Re; then you subtract the expected return from each return to get a deviation; then you square each deviation and mul- tiply it by the probability of occurrence of that outcome; finally, you add up all these weighted squared deviations and take the square root. The formula for the standard deviation, the higher the SD, the higher the risk Market equilibrium occurs when the amount that people are willing to buy (demand) equals the amount that people are willing to sell (supply) at a given price Excess supply occurs when the amount that people are willing to sell (supply) is greater than the amount people are willing to buy (demand) at a given price (the bonds price will drop until either suppliers stop supplying or demand will grab them) Excess demand occurs when the amount that people are willing to buy (demand) is greater than the amount that people are willing to sell (supply) at a given price (lots of ppl want bond, i twill push up price of the existing bond, price will go up until suppliers supply demand or buyers stay out of the marke, there will anyways be a reductionin such gap) I* is the interest for demand to be equal to supply. We have to look at the interception points as things change. Changes in Equilibrium Interest Rates To study changes in interest rate, we just need to study actual shifts in the curves. First, we examine shifts in the demand for bonds. Then we will turn to the supply side. increase in savings, demand curve moves to the right and the interest rate will go down. Savings or wealth could go up in an economy because i.e.(1) increase in subsidies, detax the return on savings, reduce taxes on bonds. Stimulate savings. If the gov has a plan to do so, you can plan your moves. But also (2)if people live longer, they need to work more to have savings. Changes in population changes savings. Last but not least, (3)financial globalization: allowing savers from places like china to invest and buy bonds in the US or EU. If u allow them to invest, demand for bond increases. Increase in savings, parallel shift to the right! Price of bonds increases, i will drop. Market for zcb, suppose stocks become very profitable, now savers have a better attractive: if they invest I get 1%, if I get stock I get 10%. Thus demand for bonds goes down. Costly to borrow for the firm. The conclusion we have reached is that in a business cycle expansion with growing wealth, the demand for bonds rises and the demand curve for bonds shifts to the right. Using the same reasoning, in a recession, when income and wealth are falling, the demand for bonds falls, and the demand curve shifts to the left. During financial crisis, risk of default, risk goes up, demand for bonds decreases, thus the interest rate on italian debt goes up. It is the so called spread, the excess cost of borrowing. Increase in perceived riskiness, induces people to borrow less, to make it more attractive you need to lower P and increase i. An increase in the riskiness of bonds causes the demand for bonds to fall and the demand curve to shift to the left. An increase in the riskiness of alternative assets causes the demand for bonds to rise and the demand curve to shift to the right Increase in budget deficit of the gov (gov has to funds things, i.e. pay wages, build infrastructures, to get the resources it borrows, but now excess supply of bonds. Price has to drop, interest rate goes up, people are interested in bonds, gov issues, but it has to pay higher interest rate then before), or increase in the profitability of an investment (firms want to borrow, they issue lots of bonds, supply increases but to make equilibrium price has to go down and interest rate goes up, thus people more likely to be interested in bonds and hence increase in bonds acquired) increase in the supply of bonds. Supply curve shifts to the right. Therefore, in a business cycle expansion, the supply of bonds increases, and the supply curve shifts to the right. Likewise, in a recession, when there are far fewer expected profitable investment opportunities, the supply of bonds falls, and the supply curve shifts to the left. The Fisher Effect 1. If expected inflation rises from 5% to 10%, the expected return on bonds relative to real assets falls and, as a result, the demand for bonds falls (real return has dropped, so people don’t find bonds attractive) 2. The rise in expected inflation also means that the real cost of borrowing has declined, causing the quantity of bonds supplied to increase (cheaper for firms to issue the bonds) 3. When the demand for bonds falls and the quantity of bonds supplied increases, the equilibrium interest rate rises 4. Since the bond price is negatively related to the interest rate, this means that bond prices will drop empirically the shifts are almost of the same size. In the data when expected inflation goes up i goes up but the quantity of bonds doesn’t change very much . fisher effect refers to the fenomenon that if inflation increases by 1% then the nominal interest rate will increase by the same size. Our supply-and-demand analysis has led us to an important observation: When expected inflation rises, interest rates will rise. If u tie ur hands and reduce inflation expectations, u will reduce the cost of borrowing. In a business cycle expansion, the amounts of goods and services being produced in the economy increase, so national income increases. businesses will be more willing to borrow (to invest they need to borrow, thus supply will have to go up), because they are likely to ha ve many profitable investment opportunities for which they need financing. at a given bond price, the quantity of bonds that firms want to sell (that is, the supply of bonds) will increase. This means that in a business cycle expansion, the supply curve for bonds shifts to the right. Expansion in the economy will also affect the demand for bonds. As the business cycle expands, wealth is likely to increase, and the theory of asset demand tells us that the demand for bonds will rise as well. new equilibrium reached at the intersection of Bd2 and B s 2 must also move to the right, they move in the same direction, expansion!!quantity of bonds must increase, while with respect of the interest it depends on the shift, if supply expands less then interest rate goes down, if supply shifts more than demand the interest rate goes up. . However, depending on whether the supply curve shifts more than the demand curve, or vice versa, the new equilibrium interest rate can either rise or fall. The supply-and-demand analysis used here gives us an ambiguous answer to the question of what will happen to interest rates in a business cycle expansion. the interest rate tends to rise during business cycle expansions and falls during recessions, which is what the supply- and- demand diagram indicates. Money Markets: Short term safe investments In its 2009 annual report, Microsoft listed $25 billion in short-term securities on its balance sheet, plus $6 billion in cash equivalents. Microsoft does not keep this in its local bank. But where? In Money Markets! Microsoft doesn’t go to the bank and has a deposit account, it goes to money market and buys money market securities. A new technology makes oil drilling more profitable. What happensThe term “money market” is a misnomer. Money (currency) is not actually traded in the money markets. The securities in the money market are short term with high liquidity; (u trade special kind of assets) A new technology makes oil drilling more profitable. What happenstherefore, they are close to being money. The Money Markets Defined 1. Money market securities are usually sold in large denominations ($1,000,000 or more) 2. They have low default risk 3. They mature in one year or less from their issue date, although most mature in less than 120 days Money market transactions do not take place in any one particular location or building. Instead, traders usually arrange purchases and sales between participants over the phone and complete them electronically. Because of this characteristic, money market securities usually have an active secondary market. Why Do We Need Money Markets? In theory, the banking industry should handle the needs for short-term loans and accept short-term deposits. Banks also have an information advantage on the credit-worthiness of participants. However, banks are heavily regulated. This creates a cost advantage for money markets over banks. The banking industry exists primarily to mediate the asymmetric information problem between saver-lenders and borrower-spenders, and banks can earn profits by capturing economies of scale while providing this service. However, the banking industry is subject to more regulations and governmental costs than are the money markets. These regulation restrain banks from supplying money, one regulation is that of interest rate control then Banks must put aside a portion of their deposits in the form of reserves that are held without interest at the Federal Reserve. Cost Advantages A new technology makes oil drilling more profitable. What happens Reserve requirements create additional expense for banks that money markets do not have (if a bank has deposits of 100, 10% must be deposited in the central bank with no interest rate, this is a cost), they are costly, thus reduce the profitability of an account, in money morket this deposit doesn’t have reserve requirement. A new technology makes oil drilling more profitable. What happens Regulations on the level of interest banks could offer depositors led to a significant growth in money markets, especially in the 1970s and 1980s. When interest rates rose, depositors moved their money from banks to money markets to earn a higher interest rate. When blu lone above red line, the interest rate is higher than what the bank can pay to the deposit, it is a period in which u want to go to mm rather than bank. The Purpose of Money Markets A new technology makes oil drilling more profitable. What happens Demand of money market assets. Money Markets provide a place for storing safely surplus funds for short periods of time (i.e. microsoft; u wouldn’t commit capital in mm for a long time, no long term investment, they want short safe investment, this is on the lending side), on the borrowing side: firm/government that have revenue right after, those that need short terms funds. A new technology makes oil drilling more profitable. What happensSupply of money market assets. Money Markets provide a place for borrowing low- cost in the short run A new technology makes oil drilling more profitable. What happensCorporations and U.S. government use these markets sometimes on the demand and sometimes on the supply side. ─ Gov’t much more often on the supply side A new technology makes oil drilling more profitable. What happensThe timing of cash inflows and outflows are not well synchronized. Money markets provide a way to solve these cash-timing problems. Commercial banks hold a percentage of U.S. government securities second only to pen- sion funds. This is partly because of regulations that limit the investment opportunities available to banks. Not all commercial banks deal in the secondary money market for their customers. The ones that do are among the largest in the country and are often referred to as money center banks. The biggest money center banks include Citigroup, Bank of America, J.P. Morgan, and Wells Fargo. Money Market Instruments ─ Treasury Bills ─ Federal Funds ─ Repurchase Agreements ─ Negotiable Certificates of Deposit ─ Commercial Paper ─ Banker’s Acceptance Money Market Instruments: Treasury Bills A new technology makes oil drilling more profitable. What happens T-bills have 28-day maturities through 12- month maturities. Short terms bonds issued by a government. The government does not actually pay interest on Treasury bills. Instead, they are issued at a discount from par (their value at maturity). The investor’s yield comes from the increase in the value of the security between the time it was purchased and the time it matures. Price at which you buy it’s below its face value. A new technology makes oil drilling more profitable. What happens Discounting: When an investor pays less for the security than it will be worth when it matures, the increase in future price provides a return. This is common to short-term securities because they often mature before the issuer can mail out interest checks. - Risk Treasury bills have virtually zero default risk because even if the government ran out of money, it could simply print more to redeem them when they mature. The risk of unexpected changes in inflation is also low because of the short term to maturity. The market for Treasury bills is extremely deep and liquid. A deep market is one with many different buyers and sellers. Money Market Instruments: Treasury Bills Discounting Example A new technology makes oil drilling more profitable. What happensYou pay $996.37 for a 28-day T-bill. It is worth $1,000 at maturity. What is its discount rate? (F-P)/F it is a convention!! and 360/n annualises the 28 rates of return I multiply monthly interest rate by almost 12 (360/12) A new technology makes oil drilling more profitable. What happensYou pay $996.37 for a 28-day T-bill. It is worth $1,000 at maturity. What is its annualized yield? this one is the right yield to maturity formula. We take year to be 365/6 Money Market Instruments: Repurchase Agreements A new technology makes oil drilling more profitable. What happensThese work similarly to the market for fed funds, but nonbanks can participate. A new technology makes oil drilling more profitable. What happens A firm sells Treasury securities, but agrees to buy them back at a certain date (usually 3–14 days later) for a certain price. (vendo a un prezzo più basso di quello che ripagherai) A new technology makes oil drilling more profitable. What happensThis set-up makes a repo agreements essentially a short-term collateralized loan. A new technology makes oil drilling more profitable. What happensThis is one market the Fed may use to conduct its monetary policy, whereby the Fed purchases/sells Treasury securities in the repo market. The Use of Repurchase Agreements Government securities dealers frequently engage in repos. The dealer may sell the securities to a bank with the promise to buy the securities back the next day. This makes the repo essentially a short-term collateralized loan. Securities dealers use the repo to manage their liquidity and to take advantage of anticipated changes in interest rates. REPOs is like borrowing, i get money today I give them back after. repos are collateralized with Treasury securities, they are usually low-risk investments and therefore have low interest rates. Money Market Instruments: Negotiable Certificates of Deposit A new technology makes oil drilling more profitable. What happens A bank-issued security that documents a deposit and specifies the interest rate and the maturity date A new technology makes oil drilling more profitable. What happens Denominations range from $100,000 to $10 million It is exactly like a bond. Money Market Instruments: Commercial Paper A new technology makes oil drilling more profitable. What happensUnsecured promissory notes, issued by corporations, that mature in no more than 270 days. A new technology makes oil drilling more profitable. What happensThe use of commercial paper increased significantly in the early 1980s because of the rising cost of bank loans. The next slide shows actual commercial paper rates and the prime rates 1990 through 2010. Although the two track closely in terms of movements, notice that difference between the two remains roughly 200 basis points. red finance cheaper than the blue line by going to the bank. Cheaper finance through commercial paper, not everyone issues commercial papers because u need to be a large reputable firm that ppl trust. Money Market Instruments: Banker’s Acceptances A new technology makes oil drilling more profitable. What happensAn order to pay a specified amount to the bearer on a given date if specified conditions have been met, usually delivery of promised goods. A new technology makes oil drilling more profitable. What happensThese are often used when buyers / sellers of expensive goods live in different countries. Money Market Instruments: Banker’s Acceptances Advantages 1. Exporter paid immediately 2. Exporter shielded from foreign exchange risk 3. Exporter does not have to assess the financial security of the importer 4. Importer’s bank guarantees payment 5. Crucial to international trade The Bond Market In this chapter, we focus on longer-term securities: bonds. Bonds are fixed income instruments with maturities that exceed one year. These include Treasury bonds, corporate bonds, mortgages, and the like. Subset of the Capital Market (the latter includes also Equity markets) Debt Market Participants Primary issuers of bonds: ─ Federal and local governments ─ Corporations Largest purchasers of securities: ─ You and me Types of Bonds Bonds are securities that represent debt owed by the issuer to the investor, and typically have specified payments on specific dates . Types of bonds we will examine include long-term government bonds (T-bonds), municipal bonds, and corporate bonds. Treasury Notes and Bonds The U.S. Treasury issues notes and bonds to finance its operations. The following table summarizes the maturity differences among the various Treasury securities. No default risk (gov not willing or able to pay) since the Treasury can print money to payoff the debt. When it comes to gov bonds, default risk is very rare, different from corporations that default (go bankrupt), because it can produce the money needed for repayment. (problem for european countries, they can’t print euros!).If you cannot print, hence no control of the currency it is more likely that the gov defaults,but it is still unlikely  you can raise taxes! (a firm can’t raise taxes) Very low interest rates, often considered the risk-free rate, but for long term bonds the relevant risk is inflation Treasury Bond Interest Rates: Bills vs. Bonds Short- term rates are more volatile than long-term rates. Short-term rates are more influenced by the current rate of inflation. Investors in long-term securities expect extremely high or low inflation rates to return to more normal levels, so long-term rates do not typically change as much as short-term rates. (yield higher for lt because of possible high inflation, in order to hold the bond on higher inflation we need higher yield) Treasury Bonds: Recent Innovation (TIPS)Treasury Inflation-Indexed Securities: the principal amount is tied to the current rate of inflation to protect investor purchasing power. The inflation-indexed bonds have an interest rate that does not change throughout the term of the security. It spesifies payments that depend on inflation rates. The spread between AAA and BBB rated bonds has averaged 1.15% over the last 10 years. As the financial crisis unfolded investors seeking safety caused the spread to hit a record 3.38% in December 2008. BBB above AAA because BBB are riskier! 2 bonds issued by same company have different risk because some of them are secured: if company doesn’t have money u can grab assets. Corporate Bonds: Characteristics of Corporate Bonds Registered Bonds ─ Replaced “bearer” bonds (because bearer it made tracking interest income difficult.) they do not have coupons. Instead, the owner must register with the firm to receive interest payments ─ IRS can track interest income this way Restrictive Covenants (if firm profitability < threshold, creditor can stop any new investment, or any dividend payment. It can stop management from using resources of the firm) There is lower risk for creditor. This arrangement implies that the managers will be more interested in protecting stockholders than they are in protecting bondholders. ─ Mitigates conflicts with shareholder interests ─ May limit dividends, new debt, ratios, etc. ─ Usually includes a cross-default clause Call Provisions (right to buy back) ─ Allow company to avoid restrictive covenants ─ Higher yield (1) which states that the issuer has the right to force the holder to sell the bond back. (2) If interest rates fall, the price of the bond will rise. If rates fall enough, the price will rise above the call price, and the firm will call the bond. investors do not like call provisions. Issuers of bonds include call provisions is to make it possible for them to buy back their bonds according to the terms of the sinking fund. A sinking fund is a requirement in the bond indenture that the firm pay off a portion of the bond issue each year. (3) firms may have to retire a bond issue if the covenants of the issue restrict the firm from some activity that it feels is in the best interest of stockholders. (4) firm may choose to call bonds if it wishes to alter its capital structure. A maturing firm with excess cash flow may wish to reduce its debt load if few attractive investment opportunities are available.  Because bondholders do not generally like call provisions, callable bonds must have a higher yield than comparable noncallable bonds. Conversion ─ Some debt may be converted to equity ─ Similar to a stock option, but usually more limited Secured Bonds Secured bonds are ones with collateral attached. ─ Mortgage bonds Because these bonds have specific property pledged as collateral, they are less risky than comparable unsecured bonds. As a result, they will have a lower interest rate. ─ Equipment trust certificates are bonds secured by tangible non-real-estate property, such as heavy equipment or airplanes Unsecured Bonds ─ Debentures ─ Subordinated debentures ─ Variable-rate bonds Junk Bonds ─ Debt that is rated below BBB ─ Often, trusts and insurance companies are not permitted to invest in junk debt ─ Michael Milken developed this market in the mid-1980s, although he was subsequently convicted of insider trading Corporate Bonds: Debt Ratings Rating Agencies Rate the Safety of Bonds Credit Ratings provide relevant information for investors See now the rating scale for Moody’s. Both Standard and Poor’s and Fitch have similar debt rating scales. Investing in Bonds A new technology makes oil drilling more profitable. What happensBonds are the most popular alternative to stocks for long-term investing. A new technology makes oil drilling more profitable. What happensEven though the bonds of a corporation are less risky than its equity, investors still have risk: price risk and interest rate risk, which were covered in chapter 3 A new technology makes oil drilling more profitable. What happensBut there is also default risk! Investing in Bonds