Financial markets, credit and banking (I part), Dispense di Economia E Tecnica Dei Mercati Finanziari

Scarica Financial markets, credit and banking (I part) e più Dispense in PDF di Economia E Tecnica Dei Mercati Finanziari solo su Docsity! 1 FINANCIAL MARKETS, CREDIT AND BANKING (I PART) FUNDAMENTALS OF FINANCIAL MARKETS AND INSTITUTIONS Why study financial markets and institutions? Markets and institutions (intermediaries) are primary channels to allocate capital in our society. Proper capital allocation leads to: - Economic growth If an economy wants to achieve the potential growth rate a mechanism must exist to best allocate capital which is a limited resource, it is important to evaluate the risks of each options. Markets and institutions have been created to facilitate transfers funds from economic agents with a surplus funds to economic agents in need of funds. An economy, in order to maximize the growth potential, must create a method to attract savers excess funds and then allocate those funds with the best users possible otherwise idle cash is not used as productively as possible. Funds must be transferred at the low possible price in order to allow the greatest economic growth. - Individual and social wealth Financial markets funds transferees LENDER – SAVERS 1. Households 2. Business firms 3. Government 4. Foreigners BORROWER – SPENDER 1. Business firms 2. Government 3. Households 4. Foreigners Financial markets and institutions allow transfer of funds from personal business which have some investments opportunities to one who have them. There are 4 categories to consider that can be both spenders and savers meanwhile, for simplicity even if they can be both lenders and borrowers we assume that typically households are lenders (they saving flows to financial markets which consist of banks that links lenders to borrowers) while governments, business firms and foreigners (depend on import – export balance) are borrowers. Institutional sectors and financial balances We can start from the left with different financial instruments that savers can invest directly or indirectly into the economy in terms of loans: - Pension funds 2 - Certificate of deposits - Savings deposits - Chequing deposits (very different in function of maturity and to ask money back) - Securities (stock – bond) - Insurances - Asset management program (funds) On the right it is possible to see the loans: - Large business loans - Small business loans - Venture capital loans - Construction loans (to the government for infrastructures) - Investment loans Six parts of the financial system 1. MONEY To pay for purchases and store wealth. - Money has changed from gold/silver coins to paper currency to electronic funds. There has been a strong change in the meaning of money during history, the first non currency was created by King Alyattes in Lydia now a part of Turkey around 600 B.C. Coins then are transformed into banknotes in 1661 (anno domini), the first credit card was introduced in 1946 and now the is always less and less cash. - Cash can be obtained from an ATM anywhere in the world. - Bills are paid and transactions are checked online 2. FINANCIAL INSTRUMENTS To transfer resources from savers to investors and to transfer risk to those best equipped to bear it. Risk and information are key in the financial markets and for this reason this point is very important. They have been created by financial markets in order to let economic agents with surplus funds to enter in contact with economic agents that are in need of funds by bonds or stocks. - Buying and selling individual stocks used to be only for the wealthy. - Today we have mutual funds and other stocks available through banks or online. - Putting together a portfolio is open to everyone (now the system is more democratic respecting to the past). 5 The financial intermediary imposing its balance sheet, it makes the financial resources transformation, it allows bank to collect short term financial resources to grand medium long term loans. - Units in surplus: prefer short-term and low risk financial assets - Units in deficit: prefer medium-long term and higher risk financial liabilities UNITS IN SURPLUS (+) FINANCIAL ASSETS (-) FUNCTIONS OF FINANCIAL SYSTEM All trade in the goods market pass through the real sectors and the financial sectors. Financial sector in important in macroeconomics because of its role because it puts saving in the circle again. Savings return in the circle in the form of consumer loans, business loans of loans to government and foreigners. Savings are channelled into the financial sectors because individuals buy financial assets as stocks or bonds or others and back into the spending stream. Back to each financial assets it is important to know that there is the related financial liability, financial assets such as stocks and bonds are obligations (financial liabilities of the issuers). What does financial system do? It links savers (on the left) with investors (on the right). It helps immobilising and allocate savings efficiently and effectively, it has a crucial role in the economic process through saving investment process called capital formation. - It helps to monitor corporate performance, - It provides a mechanism to manage uncertainty and control risks, - It provides portfolio adjustment facilities - It provides transfers across borders - It helps lowering transaction costs - It increases returns to motivate people to save more “A financial system contributes to the acceleration of economic development, it contributes to growth through technical progress”. UNITS IN DEFICIT (-) (+) FINANCIAL LIABILITIES FINANCIAL INTERMEDIARY Medium – long term FINANCIAL ASSETS Short – term FINANCIAL LIABILITIES 6 FINANCIAL MARKETS - Financial markets are one type of channel through which funds flow. Any market place where trading of securities occurs including stock markets, bond markets and derivative markets over others. They allocate liquidity for businesses and entrepreneurs, they create security products for who has excess money to invest and give them to who need money. - The market is a complex organization and it is always characterized by variously operating rules. They range from regulated markets (covered by special general rules and supervision, see Law of Finance (TUF: testo unico della finanza), legislative Decree 58/1998) to so-called over the counter markets (OTC: literally “over the counter) where people trade commodities (in particular derivatives) without a central exchange. - Markets can be restricted to particular categories of traders or open to the public and in particular to end-investors (traders). Another distinction is between wholesale and retail markets. - Markets can be distinguished with regard to the mode of trading o Markets quote driven: prices are determined by quotations made by market makers, dealers or specialists. It is also known and price driven markets where dealers feel orders from their own inventories or by matching them with other orders. o Markets order driven: all buyers and sellers displayed the price at which they want to sell or buy a particular security as well as the amount of security desired. o Hybrid markets: participants have the option to choose between human brokers to execute transaction or fully automated things to execute transactions. • Primary and secondary market Primary markets: markets in which users of funds (corporations and governments) raise funds by issuing financial instruments (stocks and bonds). Markets that tie spending and investments decisions of deficit units with financial decisions of the surplus units. They are markets where firms and other borrowers create and sell new securities in order to raise cash to fund positive net present value projects or to meet other social goals in case of non profit fund raisers. The financial crisis reduces the primary markets issues. Ex: government bonds auctions – placements of private issuers (public offerings of seasoned stocks). Secondary markets: markets where financial instruments are traded among investors. It exists to provide liquidity and price information to investors. Ex: Nyse – Nasdaq – Italian Stock Exchange The secondary market does not provide new resources to deficit units, but is it critical to: - Ensure liquidity to the investors - Permit to make possible the investment/divestment of institutional and private investors. • Money vs capital market Money markets: markets that trade debt securities with maturities of one year or less (US and Italian Trasury bills) with little or no risk of capital loss, but low returns. Capital markets: markets that trade debt (bonds) and equity (stock) instruments with maturities of more than one year with substantial risk of capital loss, but higher promised return. 7 • Foreign Exchange (FX) markets The majority of the world businesses involves foreigners business transactions. It is important for companies recognise the best investment opportunity maybe located around Europe while the higher potential growth rate may stay in Asia. As international transactions are nowadays increasing, the risk they carry is one of the biggest that a firm has to face. When a national current account deficit surpasses the 5% of GDP a correction occurs in currency value. Before the financial crisis US was able to consistently run current account deficit above 5% because foreigners were willing to supply funds to US markets. Part of the reason for this is the usage of Us dollars as global reserve currency, currency manipulation of foreign banks also contribute to stress dollars and for instance foreign central bank continue to purchase dollars to keep local currency down for the export sectors. Us economy and dollars continue to be global generator and this fact help the dollar to keep his position. Excess supply of dollar available precipitate and drop, this drop generates a high inflation and lead to higher commodities prices globally FX markets (forex – FX – currency market): is a global decentralized or over-the-counter market for the trading of currencies. It determines the foreign exchange rate for every currency. (Ex: euro for US dollar). Two effects: Spot FX: the immediate exchange of currencies at current exchange rates (settlement usually two business days after the trade). Forward FX: the exchange of currencies in the future on a specific date and at a pre-specified exchange rate. • Derived security markets Derivative security is a contract which derives its value from underline assets or market conditions. - A financial security whose payoff is linked to (derived from another security of commodity) - Generally an agreement to exchange a standard quantity of assets at a set price on a specific date in the future. - The main purpose of the derivatives markets is to transfer risk between market participants. Some participants called agers enter these contracts to reduce their risks in the underline cash markets while others called speak daters use derivative contracts to bet on price movements. They are highly leveraged instruments and leverage allows agers to reduce their risks and speak daters to obtain the higher return with the minimum capital investment. Ex – derivative securities: Many options, future contracts (exchange listed derivatives are in general liquid and do not involve counterparts) Forward contracts, forward rate agreements, swaps (counter derivatives have a counterpart that negotiate them and there are default risks) 10 - Non depository institutions: it is a government or private organization such as building society, insurance company and union trust, it acts as intermediary between borrowers and savers but it does not accept a deposit. o Contractual: insurance companies, pension funds o Non-contractual: securities firms and investment banks, mutual funds Primary assets and liabilities of financial intermediaries Type of intermediary Primary liabilities (sources of funds) Primary assets (uses of funds) DEPOSITARY INSTITUTIONS (BANKS) Commercial banks Deposits Business and consumer loans, mortgages, US government securities and municipal bonds Savings and loan associations Deposits Mortgages loans that borrowers claim Mutual savings banks Deposits Purchase value securities and make Mortgages loans Credit unions Deposits Consumer loans (membership loans such as Church) CONTRACTUAL SAVINGS INSTITUTIONS (non depository) Life insurance companies Premium from policies Corporate bonds and mortgages Life and casualty insurance companies Premium from policies Purchase security paying in advance premium and then make Municipal bonds, corporate bonds and stock, US government securities. Pension funds, government retirement funds Employer and employee contribution Corporate bonds and stock, transform wealth for the future OTHER TYPES OF INVESTMENT INTERMEDIARIES Finance companies Commercial paper, stocks, bonds The borrow directly for banks or savers and make consumer and business loans Money funds Indirect Shares Purchase Stocks, bonds Money market mutual funds Offers indirect Shares Purchase/Offer indirect shares and provide Money market instruments Financial intermediary or investment intermediary is an entity that acts as the middleman between two parties in a financial transaction, such as commercial banks, investment banks, mutual funds or pension funds. - Many savers are willing to risk some of their funds in the capital markets but not all. For at least some of their wealth savers deserve a different type of claim than the ultimate borrower wishes to offer. Assets transformers such as banks have evolved to meet this need by offering low risks claims to savers. - Others types of institutions have evolved to meet special needs of savers such as life insurance companies, life and casual insurance companies and pensions funds. The structure of FSs Sintentic view of the structure of financial system which may be defined as a set of institutions, instruments and markets which promotes savings and channels them to their most efficient use. It consists of individual (savers), intermediaries, markets and users of savings (investors). 11 How the flow of money moves from one actor to the others. On the left side we have savers while on the right we have borrowers. On the top we have asset transformers while on the bottom we have institutional investors that use the market in order to make money arriving to borrowers. Why do FIs exist? Funds suppliers generally get a lot of benefits, they reduce transaction costs due to economies of scale. Economies of scale on transaction costs - Search costs - Screening costs - Costs to produce financial contracts - Monitoring costs Provision of liquidity services Risk sharing provision - Asset transformation: maturity intermediation is when a financial institution grants a saver a different maturity investment than the maturity institution own claim from borrowers and this is an asset transformation. - Portfolio diversification Asymmetric information - Screening and monitoring aimed to minimize informational asymmetries. Of course there is a reduction of asymmetric information due to these activities of screening and monitoring. ! The low return is the price of investing in a financial institution because you have some guarantees and certainties that you can’t have in other situations as capital market. Risks faced by financial institutions Financial risks - Credit - Foreign exchange - Country or sovereign - Interest rate - Market (price and volatility) - Liquidity (miss match in maturity of assets and liabilities) - Off-balance-sheet (contingent assets or liabilities, they don’t appear in the balance sheet, difficult to identify) - Bank insolvency Operational risks - Technology - Human errors and frauds - Legal and compliance - Reputation - Natural disasters 12 Ex - Enron Corporation was an American energy, commodities, and services company based in Houston, Texas. At the end of 2001, it was revealed that Enron's reported financial condition was sustained by institutionalized, systematic, and creatively planned accounting fraud, known since as the Enron scandal. Enron has since become a well-known example of willful corporate fraud and corruption (unreported losses because transfered). The scandal also brought into question the accounting practices and activities of many corporations in the United States. Financial assets/contracts Cash, deposits, stocks, bonds, treasury bonds and bills, derivatives, etc. Within the financial system, the exchange of funds is based on instruments such as deposits, bonds, government bonds and so on. These contractual instruments are called “financial assets”. Definition: “A contractual relationship in which both performances are denominated in a given currency, and expire at different times. A financial asset implies a transfer of purchasing power in different moments. Financial contracts: based on private information (bilateral) and based on public transformation”. Underlying nature of financial contracts: - Debt (loans, mortgages, consumers loans, bonds, commercial papers) - Stock (ordinary shares, preferred stocks) - Insurance (life insurance, casualty insurance) - Derivatives (options, swaps, futures) Maturity of financial contracts - Short-term: maximum 1 year (treasury bills, Italian BOTs, commercial papers, interbank deposits) o Risks: high liquidity and low risk of default - Medium-long term (mortgages, corporate bonds, government bonds, consumer loans) o Risks: high risk of default and low liquidity Risks of financial assets The types of risks to which the investor is exposed are the following: - Financial: counterparty insolvency, adverse price changes, adverse exchange and interest rates, lack of liquidity - Non-financial: legal, human, political Financial assets and information The evaluation of the various types of risks during the life of financial contracts depends on the information available to the parties involved. The information is both input and output of intermediaries and financial markets. It is an input as the decision-making processes of the operators are based on information (grant or not grant credit, to buy or not to buy a security). It is also output because the price of each financial asset incorporates information, as it is the result of the decision making process itself (remember market efficiency). 15 pension funds. To this end, the correct and transparent administration and management of pension funds. Agcm (Competition Authority and the market) Supervises the agreements restricting competition on abuse of dominant position and merger filing. European system of Financial Supervision (ESFS) This system consists of the - European Systemic Risk Board (ESRB) - the three European Supervisory Authorities (ESA) o ESMA based in Paris o EBA (European Banking Authority)based in London (after Brexit, Paris will be the new location) o EIOPA (European Insurance and Occupational Pensions Authority) based in Frankfurt. The ESRB monitors and evaluates potential threats to financial stability that arise from macro- economic developments and from developments within the financial system as a whole (“macro- prudential supervision”). 16 INTEREST RATES AND THEIR DETERMINANTS Interest rates Interest rates are very often spot by common people to represent time value of money, so think of them as compensation you get because you commit your money in an investment for a given amount of time. It represents what you expect to receive from your investment (reward). We know from financial news and personal knowledge about markets and economic development that interest rates are particularly low and over the past decade unconventional monetary policies have been undertaken by the key global central banks so that interest rates have fallen even below zero (in this case notions about interest rates as time value don’t follow their rules). In the ages when “ZIRP” (zero-interest rate Policy) or “NIRP” (negative-interest rate Policy) are the norm rather than the exception across the globe and among all key international Central Banks, common people and investors alike are challenged in what the common-sense notion of “Interest Rates” actually means. For over a decade now the notion of Interest Rates as “time-value” of money has been challenged by aggressive and unprecedented steps taken by global Central Banks to counter phenomena such as low inflation, low growth, high-debt. Because Notions of interest rates as value of money are so challenge and put into questions by reality when interest rates are low of equal zero what we have to ask is How to interpret them? It is important as such to lay down a solid framework thus to offer more solid grounding to the notion of what Interest Rates really are and what they actually mean in today’s world within an environment where zero-rates are the norm. In the following slides several approaches will be offered in order to put into a broader and more meaningful context the notion of Interest Rates, their role and their meaning. Interest rate fundamentals NOMINAL INTEREST RATE: they are used to determined the fair present value and price of the very large set of securities (financial instruments), we will see how current price of a security can be thought to be a present value of a future payments that is we are owner of the security we will receive. Nominal interest rates: the interest rates actually observed in financial markets. - Used to determine fair present value and prices of securities. Any security’s current price can be thought of as the Present Value (value today) of a future payment (more often referred to as “cash flow”) that the owner of the security will receive. The determinant of today’s “fair” present value of a future cash flow is precisely the “interest rate”. 17 Nominal interest rates are normally reported into tables where for each specific length of time (days, months, years) the relevant rate is presented. These tables offer the measure of the specific interest rates for the time. You see key interest rates in the table from the given tenner in a specific date. For instance, this is the table for the Nominal Interest Rates for United States Government Debt Instruments (Treasuries). Nominal interest rates are also oftentimes reported as curves (into datapoint plots where for a given date they chart the interest rate corresponding to a specific “length of time”. Such length of time is referred to as maturity. Interest rates plotted on charts, in particular charts like this one, report the yield curve with specific dates, x-axis we have residual maturity while on y-axis we have benchmark interest rates. Different colours give us the possibility to identify maturity associated with its interest rate compared with the benchmark. US Yield curve of March 17, 2020 Nominal interest rates can be ideally broken down into two components: 1. Opportunity cost (securities’ rates are dependent on rates available on competing investments so think of interest rates paid by security as relative to what other security pay): all securities’ rates are dependent on rates available on competing investments. These rates will be a function of the underlying supply and demand of funds available and competing on the entire spectre of securities. 2. Adjustments for individual security characteristics (adjustment factors): it accounts individual characteristics of each security (default risk so the risk that each security can go in default, maturity so the amount of time, liquidity risk so how likely you are to find a seller or buyer if you want to sell or buy a given security, payment terms so what it means to invest in a security only once a year for every three month). Because these characteristics are different for different securities, we have different interest rates on each. REAL INTEREST RATES If I think of my nominal interest rate as the sum of two components one of which is the purchasing power how can I think my interest rate? Nominal interest rate can be though as the sum of real interest rate that reward you for your decision to postpone your current expenditure decision. If we move “under the bonnet” we can further break-down Nominal Interest Rates. Question: “What is the purchasing power I need to be rewarded with if I decide to postpone current expenditure decisions?” - By how much my current stock of money needs to “grow” over a specific timeframe if I want to keep my purchasing power unchanged through time? 20 Based on such Classification, Central Banks can determine an accounting scheme (of the likes Corporations use to determine their own Account Statement and their Balance-sheet) based on which each category of Institutional Agents manages their own Stock and Flow of money. This enables the Central Authority to “trace” and “detect” the dynamics of Supply and Demand of money based of whether the agent is on the “Surplus” and “Deficit” each Institutional Agent shows from time to time. Central bank can decide how to fix deference interest rates at a given time. Loanable funds theory – Net Supply & Demand of funds in US (2016) Institutional agents defined by Federal Reserve in 2016 - we can see how institutional groups supply and demand funds and what is their position at the end of the time. Households supply more with respect to what the ask for (families save money). Non-financial demand more funds that what they saved, and it means that families lend some money to corporations and likewise government demanded also more funds with respect to what they collect through taxes. A negative number in the last column represents a net demand of funds. The household (consumer sector) is one of the largest suppliers or loanable funds, while businesses (financials and non-financials) demanded the most funds. Corporations make investments in order to continue their operations. SUPPLY SIDE Loanable funds theory – supply side (determinants of household savings) Household savings is very important to understand in order to determine why families behave in this wave. - Income and wealth: the greater the wealth or income, the greater the amount saved. - (Cultural) attitudes about saving versus borrowing (behaviour can be different from one country to another) - Credit availability: the greater the amount of easily obtainable consumer credit the lower the need to save (families save less where it is easier to obtain credit). - Job security and belief in soundness of entitlements (job insecurity create more savings) - Interest rates: savings increase with higher interest rates. - Tax policy: taxation on savings and/or passive interests on loans/mortgages deductibility after households attitude towards savings (the deductibility of tax in industries respect to not reducibility of households). Saving rate for European Households in 2017 X-axis we have all the different countries (Italy is equal to 1.0). behaviours of households with regard to savings rate has a key impact on the amount over loanable funds that households put into play within economic system. 21 Different behaviours across families have impact on economic system. Investment rate for European Households in 2017 The basic idea is that is families invest more they save less so investments made by household show a large degree of variance (less than the one in savings), change is something between 5 while concerning saving we have 24 between lowest and highest. Income (Y) is primarily used for consumption (C) - Generally, Y > C and it follows that Y - C = S - S may be not a residual variable (ex: some agents define S and adapt C as a function of Y) - S is used to fund the investment process (I) Loanable Funds theory – Supply side (determinants of foreign funds invested in US) Exploit attractiveness of United States which are: - Relative interest rates and returns on global investments (it seems to growth faster). - Expected exchange rate changes (end to encourage foreigners to invest in US) - Safe haven status of US investments (low political and economic risk) - Foreign central bank investments in the US (foreign central banks buy dollars and keep them as a sort of protection). Deeper analysis of foreign investors in US on the supply side. Foreign funds suppliers examine the same factors as U.S. suppliers except that they must also factor in expected changes in currency values, global interest rates, different tax rates and sovereign risk. There is typically some built in demand for U.S. investments however because the U.S. is considered a safe haven, i.e., a country with relatively low political and economic risk and a stable currency. Effect on interest rates from a shift in the supply curve for loanable funds The effect on interest rates from a shift in the supply curve for loanable funds. In particular, the effect of the increase in the supply of loanable funds. What happens to the quantity of funds supplied while you are changing the corresponding interest rates. Supply increases and so the line (SS) shift downward and it means that the point of encounter is now lower and so the new interest rate is lower. 22 Factors that affect the supply for loanable funds for a financial security All the factors consider can happen together and change the situation of lines. Ex: concerning total wealth of a family, it will increase but the impact on interest rate would be inverse (it will increase) A direct impact on equilibrium interest rates means that as the factor increases (decreases) the equilibrium interest rate increases (decreases). An inverse impact means that as the factor increases (decreases) the equilibrium interest rate decreases (increases). DEMAND SIDE Loanable Funds theory – Demand side (Determinants Government Demand for funds) Governments borrow heavily in the markets for loanable funds. On the demand side we have governments which is the larger demander of money because they need to fund everything. National debt should be financed, when there is a debt coming to maturity the government react increasing that debt by issue new bonds. - The US Federal Government raised $23,19 trillion in 2016 - US National debt was $19,21 trillion in 2016. National debt (and interest payments on the national debt) have to be financed in large part by additional borrowing. Governments tend to fund temporary imbalances between operating revenues (taxes) and budgeted expenditures (school constructions, public infrastructures, public health systems, etc.). At present, the eruption of the Covid-19 pandemic is triggering precisely such a rush to raise fresh capital through issuance of new debt instruments (ex: new hospitals must be built). Governments (especially highly indebted ones like Italy) normally (in favourable periods, not now) tend to reduce their outstanding debt and this should reduce the potential for crowding out and/or dependence on foreign investment flows (sometimes it is possible that a government asks for money but no one wants to give them to it so some countries result to be weaker than others). Governments tend to increase their level of debt the lower the “cost” of it goes. Red: the yield on the 10 years US Treasury Debt Note. Blue: stock of total Federal Debt in US Lower the level for debt and higher the outstanding amount of the total debt. 25 Higher expected inflation leads to higher nominal rates. It increases over time the given set of goods. An investor who buys a financial asset must earn a higher interest rate when inflation increases to compensate for the increased cost of forgoing consumption of real goods and services today and buying these more highly priced goods and services in the future. 2. Real risk-free interest rate (R F R) and the fisher effect = It is the interest rate that would exist on a risk-free security if no inflation were expected over the holding period of a security. The real risk-free rate on an investment is the percentage change in the buying power of a dollar. Higher society’s preference to consume today and higher the real risk-free rate. 3. Default risk premium (DRP) = It is the risk that a security issuer will fail to make its promised interest and principal payments to the buyer of a security. The higher the default risk, the higher the interest rate that will be demanded by the buyer of the security to compensate him or her for this default risk exposure. 4. Liquidity risk premium (LRP): It impact the overall level of interest rates. A highly liquid asset is one that can be sold at a predictable price with low transaction costs. If a security is illiquid, investors add a liquidity risk premium to the interest rate of the security that reflects its relative liquidity. 5. Special covenants and provisions (SCP)– bond convertibility, callability, taxation Ex: a convertible feature of a security offers the older the opportunity to exchange one security for another type of the issuer’s securities at a pre-set price. The convertible security holder required a lower interest rate than a comparable unconvertible security holder. 6. Term to maturity premium (MP): interest rates can be related to the term to maturity of a security. This relationship is called yield curve (or term structure of interest rates). The term structure of interest rates compares interest rates on securities, assuming all characteristics are equal except maturity. The change in required interest rates as the maturity of a security changes is called maturity premium. On the right is a chart plotting the premium (spread) that AAA and Baa corporate debt securities pay in excess of US Federal Debt instruments. This is a simple way to gauge the Default Risk Premium (DRP) for an aggregate group of similar Debt Securities through time versus a conventional benchmark. Measure of default risk premium under a default risk securities (Aaa: less risky security while Baa means high risky security). The difference between them is called spread or premium because if risk is higher compensation will be higher too. 26 On the right is a chart plotting the premium (spread) that long- dated US Treasury debt (blue) carries over the 3-month US Treasury Bill. This is a simple – albeit approximative – way to gauge the Liquidity Risk Premium (LRP) for debt instrument issued by the same issuer whose key difference is their time to Maturity. Two securities issue by same issuer, 10 years with respect to 3 months, yield interest paid is higher to investor that invest in 10 years security and the reason why is that the three month security is more liquid and have shorter-term. Term structure of Interest Rates: YIELD CURVE Let us now take a deeper dive into the theories which are most widely used to interpret the possible reasons as to why the datapoint – plot called “Yield Curve” is shaped the way we observe it. Here, we will adopt different approaches that are oftentimes “blended together” to come up with sensible interpretations of why in a certain moment in time (ex: today) the Term Structure of Interest Rate is shaped one way or another. a) Upward sloping Longer time to maturity higher the yield to maturity. b) Downward sloping (inverted) Longer time to maturity lower the yield to maturity. c) Flat For each expected maturity you have the same yield to maturity We will now examine the three key Explanatory Theories for the shape of the Term Structure of Interest Rates: 1- Unbiased Expectations theory 2- Liquidity Premium Theory 3- Market Segmentation Theory 1- UNBIASED EXPECTATIONS THEORY (UET) The long term interest rates is the yield metric average of the current and expected future short- term rate governing the period between now and the end of our investment. As such, the return for holding a four-year bond to maturity should equal the expected return for investing in four successive one-year bonds. In other words and in a more formalized mathematical way, we say that the long term interest rate is the geometric average of the current and expected future short term rates governing each Holding Period between now (t=1) and the end of our investment horizon (t=T). 27 If you hold 4 year bond for the entirely of its life (4 years), 4 year return must be equal to the product of the returns earn if you invest in 4 successful 1-year bond. Current long-term interest rates are geometric averages of current and expected future short- term interest rate. : long term interest rates : short term interest rates What long term interest rates means in terms of expected rates in the future of shorter dated securities. The non-arbitrage condition postulated by the UET mandates that the compounded return obtained through a 4-years straight investment must be equal to the product of the shorter-period returns (takes as example 1-year bonds). Ex – Arbitrage: if the expected one year rates are 6%, 7% and 8% for the next three years respectively, and the three year is 5%, how could one make money on this relationship? - Using the text’s terminology: 1R1 = 6% E(2r1) = 7% E(3r1) = 8% 1R3 = 5% - The average of the short term one-year rates is 7% and it means [(6% + 7% + 8%)/3], but the three year rate is only 5%. One could borrow any given amount such as $1000 for the full three years and invest that money one year at a time and rolling over the investment for three years. The borrowing cost per year is 5% and the average rate of return is 7%. This is a riskless arbitrage under the given assumptions that would force the three-year rate and the average of the one year rates to converge. Ex: The current one-year T-bill rate is 0.43 percent and the expected one-year rate 12 months from now is 1.40 percent. According to the unbiased expectations theory, what should be the current rate for a two-year Treasury security? 2- LIQUIDITY PREMIUM THEORY (LPT) It is nothing more than the unbiased expectations theory to which we add liquidity premium that tend to grow the longer the length of our investment. 30 - Simple interest: interest earned on an investment is not reinvested. - Compound interest: interest earned on an investment is reinvested, most common (it means multiplication) They are two key concepts which are very important for the whole program. Lump sum payment: a single cash flow at the beginning and end of the investment horizon with no other cash flows exchanged. Annuity: a series of equal cash flows received at fixed intervals over the investment horizon. Lump sum – Present value Lump sum – Future value Discount future payments using current interest rates to find the present value (PV) The future value (FV) of a lump sum received at the beginning of the investment horizon Relation: Interest rates with Present and Future values How present values and future values behave with respect to interest rates. Higher interest rates higher the future value of an investment while considering the present value we can say that higher interest rates means lower value. 31 DEBT INSTRUMENTS AND BOND MARKETS Talk about debt instruments, they are important for the way the global economic system is designed. The bond markets is going through a major revolution because the turbulence of corona virus underline the importance of this market (understand how Global Central Bank are responding to major disruptions, always remember that liquidity is a fundamental part). SIMPLE BALANCE SHEET - Assets and liabilities - Capital structure Consider the graph of the balance sheet, each unit in the financial system has running its own balance sheet. Assets on one side (current and non-current), liabilities (claims that other have to words this specific institutions) on the other side and under them we have equity capital (share capital as public corporations + retained earnings (the part of the profit which is not distributed to shareholders but stay in the company)). Combination of assets, liabilities and equity is called capital structure, the way the balance sheet is made up and changes from company to company also considering the industrial sector. We consider above all banking sectors. To distinguish debt (bonds) and equity (stocks) is key to understand the difference between the two components. Generic corporate capital structure and investment dynamics When we talk about debt we are talking about something less risky than equity capital that guarantees a low return under the form of interest and guarantee no ownership right and they are temporal (they don’t last forever). Equity capital is higher risk and offer higher return under the form of dividends or increase in capital, those who invested in equity capital become owners and the title is permanent (it means that it last). 32 Generic corporate capital structure Thought of a pyramid and on the top we have debt capital while on the bottom equity capital. Both categories are divided in groups. Different types of both debt and equity based on the legal terms of contracts (debts are contracts) upon which each category is built. Some of them have some advantages with respect to others. Shares are divided above all according to different claims they have. BOND TYPES Bonds are commonly referred to as fixed-income securities and are one of the main asset classes, along with stocks, derivatives and cash equivalents. A bond is a debt investment in which an investor loans money to an entity (corporate or governmental) that borrows the funds for a defined period of time at a fixed interest rate. Owners of bonds are debtholders, or creditors, of the issuer. We have lenders and borrowers, these two individuals are the simplification of surplus unit (lender, in general households) and the deficit unit (borrower, in general governments or corporations). The lender will claim (because of contractual term) interests and the payment at maturity of the face value of obligation. Rights embedded in bonds Scheme of how bonds and loans behave depending on some key characteristics. - Focus on the coupons and the way they are paid (if we have no coupons, we are speaking about zero coupon bonds while in other cases it can be a fixed amount of the face value or it can be variable depending on some market parameter). - If we analyse the way principal reimbursement is handled, we can have a single payment at maturity, or it can be repaid through the amortization plan. - Considering again scheme of capital structure, debts can be senior or junior. It means they have different contractual terms (in the case of senior debts they are stronger while for junior they are less strong, it concerns the repayments of debt at maturity. In case of default senior debt are safer because they are repaid before junior debt, but this is also the reason why interests are lower for senior debt). 35 • CONVERTIBLE BONDS In previous case bond were converted into shares at the discretion of the issuer (bond holder had higher interest renouncing on the control of when the bond could be converted), while now the bond can be converted at the discretion of the bond holder (the investor can decide for the behaviour of the bond). A bond that can be converted into a predetermined amount of the company’s equity at certain times during its life, at the discretion of the bondholder. Lower yield, compared to equivalent bonds because they are safer (investor can control his own investment). The issuer must define:- - Type of issue (into what convert its investments): direct (new shares) or indirect (existing shares) - Conversion rate: number of stocks against bonds - Conversion period: continuous or fixed (when to convert the bond) The investor is “long” a call option. Through its purchase, the investor gives away fixed returns (this is why lower yields) on its bond investment in favour of potentially higher returns should be converted into stocks. Convertible bonds vs non-convertible bonds: the value of a convertible bond will increase as the value of firm assets grow because of the increase in value of its embedded conversion option. This is the option that investor is long. Investor has to buy this option and it has the overall return of the convertible option. Ex: a convertible bond investor holds bonds issued by company A. The conversion rate is equal to 5:1 (5 bonds for 1 new stock). Suppose that the bonds are trading at 105 in the market and the stock of the same company at 489 euros. Is the conversion profitable? Value of the 5 bonds if converted into shares = 105 * 5 = 525 euro. The conversion is not profitable because the market price of the stock should increase above 525 euros. There should be a very high interest rate to convert the bond into shares. Key bond risk Underline drivers for the overall bond return. Interest rates paid on the coupon to maturity are refunction of some underline determinants, credit risk, liquidity risk and market risk. - Credit risk: at issuance and throughout its contractual life, the yield (overall return so coupon plus principle) of an obligation reflects the credit worthiness of its issues. - Liquidity risk: at issuance and throughout its contractual life, the yield of an obligation reflects the liquidity (the possibility to sell the bond if you own it or buy it if you want) of the obligation. - Rate (market) risk: at issuance and throughout its contractual life, the yield on an existing obligation will tend to reflect/move/follow the overall movements of the broader debt market. 36 CREDIT RISKS Bond ratings: the three major rating agencies are Moody’s, Standard & Poor’s (S&P) and Fitch. Bonds are rated by perceived default risk. Bonds may be either investment or speculative (junk) grade. A rating is an assessment made by agencies that define mathematically the perceived default risk of an entity through the definition of some rates. Will the issuing entity being still alive by the time in which the bond come due? It is exactly the overall assessment that such a rating agency assign to each issuer. Notice they are divided into investment grade and speculative one. Alphabet letters and numbers respects probabilities calculated on balance sheet. Lower possibility that the player will be alive, higher the return. The higher the credit risk, higher the interest investors demand to put money into those investments. Not all investors can buy speculative grade, the number of potential investors is smaller and interests are higher (number of investors in investment grade is higher and for this reason interests are lower). Default See the probability of default based on Moody’s ratings and also S&P over one year depending on credit worthiness. Lower it is and higher is the probability of default. Higher probability of default, higher the yield investment demand in order to invest in that type of investment Survivorship Complementary to default risk. Percentage that different degree of security concerning bonds can be alive when the time due arrives. Probability to sill existing at year 10, lower you move into the matrix in terms of rating and time the higher the change that the company will not be alive. 37 Migration It shows the likely migration of an issuing entity that might incurred over time. Ex: BBB issuer has an 89% to be and remain a BBB issuer over the next three years. The chance to increase and became A is 5.79% while the chance to be downgraded is 5.53% and become a BB. If the rate increases the yield decrease because risk decrease and vice versa if rate decreases. Treasury Bills, Notes and Bonds – USA Types of bond instruments issued by United States Treasury which is the office within the US government which is in charge to issue instruments. - Treasury-bills are short-term securities maturing in one year or less. T-bills are sold at discount and redeemed at par. - Treasury-notes have original maturities from 1 to 10 years. - Treasury-bonds have original maturities > 10 years (maximum of 30 years). - Issued in minimum denominations (multiples) of 100 USD. - May be either fixed-coupon or inflation-indexed coupons. - Trade is very active in the secondary markets (great dealer to investors to buy and sell) - Prices are quoted as percentage of face value, as clean prices. (stocks trade in dollars while bonds trade in percentage of the face value which is the value of the contract, after the bond is issued and go from primary to secondary market the face value does not change but the price changes). Summary of all the basic characteristics of those instruments issued in US by US Treasury. In particular consider discounts and treasury inflation protecting security (TIPS) which measure the inflation rate and adjust principle to it. 40 Look at the mechanism that allows treasury to issue a bond. The Italian treasury adopt three different types of auction. 1. The simplest auction is the one used for BTP ITALIA (BTP indexed to Italian inflation rate), the government will issue the demanded quantity of the debt instrument at a predefined price. BTP ITALIA if investors need to buy or submit request for a billion euro they set debt instruments for that price. 2. Marginal auction 3. Competitive auction Marginal auction – Italian Debt Placement system for government securities with a maturity of over 12 months. The marginal auction process determines marginal price at which successful bidders are entitled to be assigned the submitted amount of the issue. Each participant may submit a maximum of 5 different requests in term of price. The minimum required is 500,000 euros, while the maximum amount that can be requested is equal to the quantity offered by the Treasury at auction. The marginal price is determined by meeting the offers from the highest price until the quantity demanded is equal to that offer. The price of the last bid that is accepted determines the marginal price. The prices offered vary from a minimum amount of one-thousandth for CTZ and one cent for other stocks. Ex: The treasury decides to issue 10-years BTP for EUR 70.000.000 through marginal auction with no indication of minimum price. All bidders submit a combination of quantity/price to the issuer. The issuer then ranks offers in a descending order, with the offers with higher price (lower Required Rate of Return) ranking first. Quantities are assigned up to the total issue size. The marginal price is 97,75 because that is the price where the sum of proposed quantities and prices “clear” the EUR 70.000.000 auctioned. The marginal price is the price that all successful bidders will have to pay to be assigned the demanded quantities. From bidder A to bidder E compete to buy that investment and obviously they want to pay less possible while treasury is not happy when people try to pay less. All the bidders submit the combination of quantity price, high rate of return is listed before. 90.000.000 were demanded by only 70.000.000 were received at the end, A and B and C take them while D and E are not allotted because marginal price is 97.75%. 41 Italian treasury bonds/bills – breakdown How Italian debt is broken down across the various types of debt instruments issued by Italian treasury. The vast majority is made up by BTPs (long dated) and the overall outstanding debt in the secondary market is close to 2 trillion euros. Accrued interest and prices Explain the difference between accrued interests and also clean and dirty price. Accrued interest must be paid by the buyer of a bond to the seller of a bond if the bond is purchased between interest payment dates. Remember (NOT FORGET) coupons pay by debt interest are rewarded investor for each day in which the investment is maintained (ex: 2 years bond, you are rewarded of daily basis for your investment and the coupon can be paid once or twice a year but the calculation of interest is daily. You don’t see it in the current account). The price of the bond with accrued interest is called the full price or the dirty price (or invoice price) or tel-quel price, the price is calculated in percentage without accounting for accrued interest is the clean price. Accrued interest on bonds Accrued interest on semi-annual coupon bonds is calculated as The full (or dirty) price of a Treasury-note or Treasury-bond is the sum of the clean price (Vb) and the accrued interest. Ex – dirty price calculation A bond has a maturity term of 10 years, annual coupons equal to 5% of the nominal value which is equal to 100 euros. The clean price of the bond is 105 euro and its remaining life is 3 years and 8 months. The number of days elapsed from the last coupon payment is equal to 123. We divide the number of days elapsed (123) for the number of days constituting the period covered by the coupon (in this case the calendar year = 365 days). The accrued interest is equal to the ratio of the latter multiplied by the value of the coupon (5 euro). The accrued interest will be equal to (123/365) for 5 euro or 1,64 euro. The sum of the clean price (105 euro) plus the accrued interest (euro 1,64) is equal to the dirty price: 106,64 euro. Treasury STRIPS Debt instruments issued in the US, considering yield curve we have talked about the fact that maturity on secondary market does not cover all bonds. STRIPS help us to fill in the gap, it is possible to strip away coupons from existing coupon bearing securities. Imagine 10 years treasury notes that pays one coupon every 6 months (20 coupons on this security), cut coupons paid on the second semester of the 8th year and make zero coupon out of it, you can dethatch one coupon 42 from a coupon bearing bond and make a out of zero coupon for that coupon. It allows to build a security out of existing coupon bearing debt instrument. Separate trading of Registered Interest and Principal Securities (STRIPS), treasury zero bonds or treasury zero-coupon bonds. Financial institutions and government securities brokers and dealers create STRIPS from treasury notes and treasury bonds. US zero-coupon STRIPS allow investors to hold the interest and principal components of eligible treasury notes and bonds as separate securities. STRIPS offer no interest payment, investors receive payment only a maturity. Ex: a treasury notes with 10 years remaining to maturity consists of a single principal payment, due at maturity, and 20 interest payments, one every six months over a 10 year duration. When this note is converted to STRIPS form, each of the 20 interest payments and the principal payment becomes a separate security. Corporate bonds markets We have considered bonds issued by government but we have also corporations which are important because they also need to raise money. - Primary markets (new issues are sold to investors) - Secondary markets (it is less active comparing with government), existing bonds are sell or buy among investors. o Exchange market so a regulated market (ex: bond division of the NYSE) o Over the counter market, not regulated but investors exchange without following precise regulations (OTC market) - Bond ratings o Three major bond rating agencies are Moody’s – Standard and Poor’s and Fitch. o Bonds are rated by perceived default risk o Bonds may be either investment or speculative (junk) grade based on whether their rating are above or below BBB. BOND MARKETS Investigate the market and its different types of debt instruments. Debt instrument markets o Capital markets are markets for debt instruments with original issue maturities of more than one year. o Money markets involve debt instruments with original maturities of one year or less. o Bonds are long-term debt obligations issued on the capital market by corporations and government units. o Bills are short-term debt obligations issued by on the money market corporations and government units. 45 BONDS MARKETS • Bonds and bond markets Capital markets are markets for equity and debt instruments with original issue maturities of more than one year (long term maturity). - Bonds are long-term debt obligations issued by corporations and government units. - Bond markets are markets in which bonds are issued and traded. o Corporate bonds (issued by financial and non-financial corporations) o Treasury notes (T-notes) and bonds (T-bonds) o Municipal bonds (Munis) – municipal entities especially in US raise funds to satisfy funding needs in the Municipal markets. • Bond market participants Governments and corporations are issuers in the bond markets but also purchasers as families and other financial institutions can offer their funds in exchange of debt instruments. A key player is sovereign funds which are special entities sponsored by wealthy governments and Norway or Arabic countries. The major issuers of debt market securities are federal, state, local governments and corporations. The major purchasers of capital market securities are households, financial institutions, businesses, government units and foreign investors. - Business and financial firms (ex: banks, insurance companies, mutual funds) are the major suppliers of funds for Munis and corporate bonds. - Foreign investors (SWFs) and governments are the major suppliers of funds for T-notes and T-bonds. Ex – Real case 1 Over the course of 2019, rampant risk-appetite and low interest rates fuelled a race to issue new debt instruments from Corporations. Saudi Aramco’s private company. Nominal interest rates are affected by different factors and one of these is riskiness and time to maturity (length of borrowing period). The company has to pay high spread the longer the maturity on the debt instrument goes. Ex – Real case 2 During 2019 many US and non-US corporations issued a slew of new cheap to fund repurchases of their own – and more expensive – shares (shares buy-back). Because of very low interest rates many global companies as Apple and Walt Disney raise very large amount of debt because the low interest rate they have to pay to borrow money from the market was a very strong incentive to buy back their bonds. 46 • Bond market indexes Managed by major investment banks and/or by leading global index managers (Bloomberg, S&P indices). Reflect both the monthly capital gain and loss on bonds plus any interest (coupon) income earned. Changes in values of bond indexes can be used by bond traders to evaluate changes in the investment attractiveness of bonds of different types and maturities. Similar to what happens in the stock market, bond market indexes are less known, but they are very important too. They have the average return and riskiness of a basket of similar bonds: if you group up similar bonds following some characteristics as geographic area or riskiness, you come up with a bond market index. This index represents the increasing value of that basket and allows the bond traders to value the whole basket. Bond market indexes – Corporate Activity Bond indices are often correlated to a large variety of phenomena in the Financial and Corporate markets. The example shows how high yields (issuer rating < BBB) correlate with Average Leverage Ratio for European Corporate Buyouts. Measure impact of changes in high yield (synonym of ratings below BBB to junk market). The lower the expected return the higher the use of debt and this is why period of long-term interest rates make economic agents behave in an unusual way. • International bonds and markets Why an Italian player try to issue a bond in a non-Italian market? The reason is debt broader the market lowers the price of your debt is. Your aim is to minimize the cost, it is very probable that you will be able to pay a little less with respect to your local market. Conversely, investors go on the international market because they may find higher returns and better diversification. This also brings to higher risks as political risks as an Italian to buy Argentinian bonds. Foreign exchange rate also impacts the return at maturity, so you are not sure of the overall maturity if you keep the investment for the entire contractual maturity. 47 Motivations for international bond investing - Potentially higher returns - Better diversification Additional complexities in international bond investing - Higher risk: political risks higher and potential for capital flight in lesser developed markets, Greek crisis in Europe in an example. - Lower recourse in the event of non-repayments. - Foreign exchange rate movements can significantly impact returns. International bond markets are commonly divided into two categories - Eurobonds are internationally syndicated, unregistered long-term bonds issued outside the country of the currency in which they are denominated (ex: US$-denominated bond issued in Singapore by a German Corporation is a Eurodollar bond). Euroyen, Eurosteling bonds are also possible. THEY ARE NOT BONDS NOMINATED IN EUROPE. - Foreign bonds (Yankee, Samurai, Bulldog) are long-term bonds issued outside of the issuer’s home country. They can be registered to the local market authority (S.E.C. in the U.S.A. ex: US$-denominated bond issued in the US by a Brazilian Corporation). They can be desirable for foreign investors because for example when an Italian company issue a bond in Japan a Japanese investors can buy that bond. International bonds and markets – Foreign bond issuance made by a sovereign issuer Italian government issue in 2007 register in US a sales commission (CONSOB) in dollars. It is issued in favour of US investors; it became legally for US investors to invest in it because it is registered in US country. International bonds and markets – Focus on Eurobond market A bond denominated in a currency other than the currency of the country or market in which it is issued. Usually, a Eurobond is issued by an international syndicate and categorized according to the currency in which it is denominated. A Eurodollar bond that is denominated in US dollars and issued in Japan by an Australian company would be an example of a Eurobond. The Australian company in this example could issue the Eurodollar bond in any country other than the US. Eurobonds are attractive financing as they give issuers the flexibility to choose the country in which to offer their bond according to the country’s regulatory constraints. They may also denominate their Eurobond in their preferred currency. Eurobonds are attractive to investors as they have small par values and high liquidity. 50 positive earnings and such earnings can be distributed in the form of dividends based on company’s policy about investor remuneration: it means that the company can distribute the whole earnings or it can decide to retain a part of them and in this way it is internal financed). For this reason we can say that dividends are discretionary and thus not guaranteed. - Total compensation: dividend (given to shareholders) + capital gains (difference between purchase price and sell price of a common stock. We speak about capital loss if the investments were not so good) - Common stockholders have the lowest priority claim in the event of bankruptcy (residual claim). - Limited liability (investors are limited liable) implies that common stockholders can lose no more than their original investment. - Administrative rights: common stockholders control the firm’s activities directly or indirectly by exercising their voting rights in the election of the board of directors. - A proxy vote allows stockholders to vote by absentee ballot (ex: by internet or by mail authorized other investors to vote). PREFERRED SHARES Cumulative or non-cumulative preferred stocks (with seniority in the distribution of dividends or seniority in case or reimbursement but limited voting rights). These shares constitute capital of a given company but the investor in preferred stock is paid his own annual dividends before common shareholders (preferred shares are safer than common shares). The difference between cumulative or non-cumulative is that is terms allow accumulation or non-accumulation of skipped dividends: it means if for two years the company has decided not to pay dividends for two years if the share is cumulative the third year the shareholders will receive dividends of the three years while if it is non-cumulative the investor will receive just the dividend of the 3rd year. - The wizard of Omaha strikes again Warren Buffet in 2011 during the national financial crisis that made those years non-dissimilar to present days Warren Buffett invested 5 billion in dollars in the bank of America, they decided to invest in two preferred shares (shares in this case that granted them fixed dividends and then they received also warrants to buy 700 million shares). They were able to cash in fixed dividends paid for their preference shares and they were also able to purchase in 2017 million shares in the bank of America at the lower price with respect to real price (7 dollar for each while in general they cost more than twice). Out of an investment of 5 billion they make a profit of more than twice. STOCKS WITH NO VOTING RIGHTS Stocks without voting rights (azioni di risparmio in Italy and only for listed companies). Prohibition of vote the board of directors but they can only joy the dividends whenever they are paid. Similar to bondholders who are not liable to vote, so they are thought as bondholders because they are passive investors who are not able to influence management of the company. 51 STOCKS IN FAVOUR OF EMPLOYEES The company bylaws may allow the assignment of stocks in favour of employees up to the amount of company earnings. Those stakeholders maybe become more actively (it is a way to motivate employees) involved into the management of the company because they can gain from this. It is not strange that part of the annual compensation of employees is given as shares. The issuance of “employees stocks” mandates the company to increase its capital by an amount equal to the face value of newly issued stock multiplied by the number new shares. TRACKING (OR TARGETED) STOCKS They are not very common in Europe, they are shares issued by a business unit of a company (when a company is very large one unit or line of it which is independent from the others can issue shares specific for them in order to attract investors that maybe want to invest in that part of the company). - Their issuance and performance (dividends and liquidation) are related to that of a given company’s business unit. The bylaws defined the costs and revenues that are attributable to that specific sector. - Risk: the individual company unit might be fine, but the company wraps up the year with an overall loss. The law states that dividends cannot be distributed to tracking stocks in case of absence of earnings at the “parent” company level. The problem is that sometimes it is possible that dividends are not paid to these shareholders or on the other side they can be paid using cash reserves (not positive profit). - The bylaws define the administrative rights for this type of stocks. BONUS STOCKS (SCRIP-ISSUES) Instead of pay dividends, cash are deposited in the bank account in the form of company share, the reason is that is your profit is not positive you have no enough cash funds to pay dividends even you have decided to distribute them so you give new shares to existing shareholders in order to increase equity capital. Shares have a lower price now in order to increase the number of investors attracted by them (Ex: a lot of I-phone in the market but not a lot of buyers so the price will drop and this is similar to what happens for bonus stocks). - A bonus issue, also known as a scrip issue or a capitalization issue, is an offer of free additional shares to existing shareholders. A company may decide to distribute shares as an alternative to increasing the dividend pay-out. For example, a company may give one bonus share for every five shares held. - Companies give away bonus shares to shareholders when companies are short of cash and shareholders expect a regular income. Shareholders may sell the bonus shares and meet their liquidity needs. Bonus shares may also be issued to restructure company reserves. Issuing bonus shares does not involve actual cash flow: it increases the company’s share capital but not its net assets as capital reserves get converted into new shares. - Companies low on cash may issue bonus shares rather than cash dividends as a method of providing income to shareholders. Because issuing bonus shares increases the issued share capital of the company, the company is perceived as being bigger than it really is, making it more attractive to investors. In addition, increasing the number of outstanding shares decreases the stock price, making the stock more affordable for retail investors. 52 Examples Royal Dutch Share, HSBC, UK Hong Kong base international investment bank. All of them have decided not to pay cash dividends but script dividends. How company motivates and operates in order to actually distribute dividends. Stock split vs bonus shares Stock split is chiefly meant to infuse additional liquidity into shares by increasing the number of shares at a more affordable price (you can buy on a secondary market but each share is 2000 dollars, if you are a retail investor you will spend a maximum of 1000 so you can split an existing share into two shares of 1000 each in this way the total number of shares will increase but not the cash reserve). In contrast, bonus shares the company pays out of the cash reserve, originally constitute part of the equity capital is depleted. - Stock splits and bonus shares have many similarities and differences. When a company declares a stock split, the number of shares increases, but the investment value remains the same. Companies typically declare a stock split as a method of infusing additional liquidity into shares, increasing the number of shares trading and making shares more affordable to retail investors. - When a stock is split, there is no increase or decrease in the company's cash reserves. In contrast, when a company issues bonus shares, the shares are paid for out of the cash reserves, and the reserves deplete. American depositary receipts (ADRs) They were very common during 80s and 90s not now because they meant to allow non-US companies to list themselves (offer their shares) on the US secondary markets (the biggest in the world) through depository receipts. GDR are similar to ADR but the difference is that the first one is traded internationally in the world to increase capital of the company. - A US-$ denominated title representing ownership of a foreign stock, listed on a U.S. secondary Stock Market and issued by an International Bank. - ADRs are meant to facilitate direct investment from U.S. investors into foreign corporations at times when information dissemination on non-U.S. Corporations was not timely and hard to source. - A U.S. bank would typically buy shares of a foreign company on a foreign stock market in their foreign currency, place them with a custodian bank and then issue a US-$ denominated certificate representing ownership on those shares. - Each ADR is a claim on a specific number of shares. - GDRs (Global Depository Receipts) are similar to ADRs but are traded globally. - GDRs and ADRs do not increase the original Corporation’s capital but they enhance market participants ability to invest into it, thus potentially increasing its perceived visibility and market value. - Depending on the degree of transparency and regulation they follow, there can be Level I, Level II and Level III ADRs, the former being the least transparent/traded and the latter the more transparent/widely traded over regulated markets. 55 STOCK MARKETS PRIMARY STOCK MARKETS Difference between primary and secondary market is very important. Surplus and deficit parts can exchange stock of money from unit in surplus to unit in deficit. When transfer money you have dynamic supply and demand, the moment that transfer money happens you are witnesses primary market situation where corporations raise funds under the form of equity capital, this is typically assisted by investment banks which help the transfer of money asset from a surplus unit into a deficit unit. Primary markets are markets in which corporations raise funds through new issues of stock, most of the time through investment banks. - Investment banks act as distribution agents in best-effort underwriting when investment bank acts as distributor agent, it is simply bridging the needs of the company and the needs of the investors - Investment banks act as principals in firm commitment underwriting when the investment bank buys the new shares and will then release them to end investors (asset managers, banks, insurance companies, family offices…), the banks take on the risks of successful of issuance - 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. The moment is which a private held company sells a part of capital to new investors and in this ways the company spread the number of investors around corporations (Ex: Uber was private but in 2019 it becomes public). - A seasoned offering is the sale of additional securities by a firm whose securities are already publicly traded. Net transfer of wealth between units in primary market, it is a sale of additional securities by a firm whose securities are already publicly traded. o Pre-emptive rights give existing stockholders the ability to maintain their propositional ownership thus avoiding the otherwise inevitable dilution effect that ensues a seasoned offering. - A red herring prospectus is a preliminary version of the prospectus that describes a new security issue. - Shelf registration allows firms to offer multiple issues of stock over a two-year period with only one registration statement. Common in Us, speedy process that allows companies to go public, to help green light and pre-approval to issue more shares in season offerings within a specific time frame without one registration statement. Corporations that are already listed on a public market tend to raise more capital after they go public at the first time. IPO (blue) is typically more publicized in the press but in reality, the use of market for capital by corporations is more intense once they are already on the market. The reason is that if you are already in the marketplace investors already know who you are and it could be much more easier know how worth wide you are while if you are new investors should investigate your balance sheet. 56 A relic from the past: Google IPO tombstone In 2004 Google went public (listed for the first time its shares on the open market), this document is the digital version of cover page of filing document where you can find definition of types of share issued: common stock class A and number of shares issued in the market. Choice of market listings: There is not just one primary market but different markets, in particular these are the most important for both primary and secondary. When you are a company and you have to list shares for the first time you should take into consideration requirements and bigger, they are, longer is the procedure to access it: - NYSE has extensive listing requirements (ex: firm market value and trading volume) - NASDAQ requirements are cheaper and can be met by smaller firms with less active trading. Massive IPO for Saudi oil giant Aramco reportedly stalled by indecision over where to list shares. - Saudi Aramco’s IPO, exported to be the largest ever, has been stalled by indecision over where to list shares of the world’s biggest energy company. The Wall Street Journal reported. - Aramco CEO Amin Nasser recently told CNBC his company is ready to list this year, but waiting for a final decision on the listing venue from the Saudi government. - Officials have warned that a listing on the NYSE, Crown Prince Mohammed bin Salman’s preferred venue, carries heightened legal risk, according to the journal. Ex – Uber IPO value ride-hailing giant at $82.4 Billion This ride company want to go public and they use a lot of time to choose the right market to enter into. The valuation of a company can achieve better terms depending on the market. In terms of IPO technology, Uber confront with others reach higher points. 10 billion in capital and they are thought as cash move from surplus to deficit. SECONDARY STOCK MARKETS Secondary stock markets are the markets in which stocks, once issued, are traded among investors. Primary markets when companies issue stock while the same markets become secondary markets when financial assets are exchanged among investors (assets traded already existed, created in the primary markets). Trading can be quote (or price) driven, order-driven or a combination of the two. - Quote (price) driven: the bid/ask prices are automatically formed by the exchange sorting quotes (prices) submitted by Market Makers/Dealers and other market participants. 57 - Order-driven: the bid/ask prices are only those directly submitted by authorised market makers or dealers on their desired sizes (oders). Ex – ordinary share of Italian bank Intesa Sanpaolo (ISP.IM) as per Borsa Italiana (LSE London sales exchange group) trading system. For any submitted order quantity, (Q.TA: quantity) bis (red) / ask (green) prices are transmitted by highest-to-lowest bid and lowest-to-highest ask by the exchange trading system. Quote driven of Italian bank: prices from highest to lowest in the red column and the contrary on the green one. The US has several major stock markets - The New York Stock Exchange Euronext (NYSE/Euronext) o The NYSE/Euronext Exchange was purchased by ICE in 2013 - The National Association of Securities Dealers Automated Quotation (NASDAQ) - Bats/Direct Edge (former ECNs). Secondary markets where shares can be listed after they went public on a marketplace. How do you buy and sell stocks in the secondary market? Three types of transactions occur at trading posts. An order in an instruction that you transmit to market regulator (entity) about your desire to buy or sell a given quantity of a security. Specialists transact for their own account. - A market order is an order to transact (buy or sell) at the best price available when the order reaches the trading post. - A limit order is an order to transact (buy or sell) at a specified price. If you want to buy 10 shares you can set the price or transmit the order and the market infrastructures tell you the price already decided. Program trading is the simultaneous buying and selling of a portfolio of at least 15 different stocks valued at more than $1 million using computer programs to initiative the trades. This is typical of institutional investors, if you are a fund manager and the portfolio you manage have hundreds of listed shares it allows to you to take large investments. Circuit breakers give investors time to make informed choices during periods of high market volatility. Circuit breakers operate both for broad market indices (S&P500) and single name stocks. Stock market quotes Recap of terms that can be found to offer investors with information about securities. Example of Google – 25 dollars per share in 2004 while now it costs more than 1 thousand dollars. So, there is a very high capital appreciation. Imagine if you bot Google shares and then the investment would have a very high return. On top of this you are in the position of receive dividends benchmarked to the initial purchasing price. 60 - EPS: previous-year earnings, current-year expected earnings, following-year expected (earning per share, bottom line of income statement divided for the number of shares presented in the equity capital) Price earnings growth ratio can be obtained comparing the price earnings ratio with annual earnings per share growth. Quick comparable tool to access whether the company has high or low growth potential as a good investment, low PEG means high growth potential. PEG à P/EPS divided by its growth rate. Stocks with low PEG ratio are usually as “good” investments due to their growth potential. Low PEG ratio points to higher growth potential for the stock price. Market multiples are not only available for single stocks as one would expect but also for broader stock market indices. Wall street journal indexes: Stock market indices are baskets of stocks belonging to at time very different industrial sectors. As such, comparing indices among themselves based on multiples might not be particularly sensible. Market participants make the case that this is useful to get a quick gauge of the overall attractiveness of the market a whole (key when comparing countries is the PE ratio which is always used) Historically, when a market index “trades” at high level of P/EPS, the annualized gain in the subsequent 12 months are low. The opposite holds when P/EPS are low (expected returns are close to 25% higher). Price earning ratio (x axis) proves that when the market is expensive the growth potential is lower. US corporations tend to deploy a lot of their annual profits to buy-back (Cancel) their own shares with the goal to reward their shareholders and buying back companies boost their P/EPS ratios. During 2018 Us companies has bought back hundreds of billion of dollars of their own cash and they use these cash to buy back shares of their. If you are an existing investor on those shares the value will increase. When the taxation regime for dividend return and capital gain return is NOT identical, investors and corporations alike will favour the most tax-efficient for the investor remuneration. For the US, stock buy backs clear winners as capital gain tax rate < dividend gain tax rate. Capital investors use is by far greater respect to amount at which they pay back dividends (both of them are performed annually). 61 There exist broader market indices which investors can invest directly into (Ex: ETS) to exploit the mechanical push-up certain industrial sectors benefit from corporate buy backs. The strong impact of buy backs can be seen in this chart where blue line exceeds black line. In 2020 it is possible to see that the difference is very high the reason is push up made by dividends to indexes. Stock buyback hit an all-time high in 2018 when the tax code reform enacted by the Trump Administration made the case for massive buy-back operations in the US. Apple use 1/3 (64 billion dollars) of the actual Italian whole stock exchange market value to buy back their bonds. Chart from public date to show the quantity of dollars used in buy backs from key US large companies. Bottom there is Apple who has spent 260 billion dollars to buy back shares and they have reduced a lot in this way the number of existing shares so the existing ones have an higher value. Large scale buy back means available shares shrinks Investors pay particular attention to specific corporation buyback policy. Large-scale buyback means that the pool of shares available for trading shrinks, which makes remaining shares more “scares”, hence more “valuable” Companies have lower numbers of share used to spread earnings so the amount of earning per share increases. Such scarcity also plays key role on company-specific market multiples and P/E ratio in particular. By reducing the # of outstanding shares via buy-back, Corporations have fewer shares to spread their annual earnings on. In turn, this means that Earning- Per-Share goes optically up, thus reducing the overall P/EPS ratio. This is particularly important for key Market Investors (Value vs Growth investors) Stock valuation – Pros and Cons of market multiplier models - Pros: ratios are easy to compute, and analysis is easily understood - Cons: problems with selecting the peer group of “comps” 62 INVESTMENT STYLES (value approach vs growth approach) A value investor - Select securities with low P/E ratio and sizable dividends - Invests in large undervalued companies belonging to mature sectors - Often invests after negative shocks and in bearish market conditions (in these periods it is possible to buy at discount because off the overall situation) - Is not ready to pay a high price on the basis of future expected growth - Prefers securities with a fair current return - Seeks a rather low but constant performance A growth investor (specular opposite to value investors) … - Selects securities with high P/E ratio. A significant part of the earnings is retained to finance the firm’s growth. (Ex – Google: the capital appreciation between 2004 and 2020 is enormous and this is the capital approach) - Renounces to sizable dividends in the short time - Is ready to pay more than the current EPS as he’s confident the issuer of the selected security is going to show high growth rate (more risky capital to have higher return). - Often invests in bullish market conditions and during speculative market phases. - Looks for high returns, taking into account considerable drops. - Prefers stock with rather low PEG. STOCK MARKET INDEXES A stock market index is the composite value of a group of secondary market-traded stocks Two methodologies to calculate the price index value: - Price-weighted index: the Dow Jones Industrial Average (DJIA), composed of 30 companies, is the most widely know stock market index - Value-weighted indexes: It consider market capitalization: NYSE composite Standard & Poor’s 500 NASDAQ composite Wilshire 5000 Does the stock market forecast the economy? It is not really true that stock markets forecast the economy. In grey there are three of US recessions (period in which GDP goes down for two consecutive quarters) and the market goes down obviously but before the level of markets were high so it does not predict anything unfortunately it is not easy to understand when a recession is coming. 65 Example 2 The longer the investment horizon (assume you invest for 20 years), the wider the difference between simple and compound interests accrual. The 80 dollars cash every year (green bar) do not grow unless you invest each of 80 dollars for the remaining number of years. Red circle to year number 5 corresponds to the coupon you cash in year number 5 (the 80 dollars you receive in year number 5 will be equal to 25% at maturity and in order to attain 366% each coupon contributes the earlier the cashing in and the reinvestment). Focus on return –EX ANTE and EX POST Equation at the beginning is always the same but depending on which factors you consider given and unknown you have realized expected rate of returns and required rate of returns but also the period of time. When you solve the security (in general a bond) price formula for the discount rate you are implicitly assuming the cash flows will be reinvested at the discount rate. At maturity, the assumption will prove correct or wrong depending of whether interim cash flows have or have not been actually reinvested for the remainder of a security’s life at the discount rate. Therefore, the use of the Realized Return formula is reasonable only when you have no other information about the actual reinvestment rates and you assume the same constant rate has been used through time. In the real world, on an Ex-ante basis (expected return) term structure rates are used to estimate the expected reinvestment rate for each cash flow. On an ex-post basis (Realized return), actual reinvestment rates for each cash flow as normally used to perform the calculation. 66 STOCK VALUATION Models based on relative measures - Market multiples (price earnings) - Enterprise value multiples (same logic but different metrics) Discount-based models will adapt the first formula to stocks because they have infinite potential investment arisen - No growth - Constant growth - Non-constant growth - No dividend Stock valuation – Estimated value and market price - Undervalued: intrinsic value > market price - Fairly valued: intrinsic value = market price - Overvalued: intrinsic value < market price Stock valuation – Models based on relative measures Models based on relative valuations are based on comparison among companies in order to identify overvalued or undervalued stocks. This model represents the one used by analysts at the beginning of their analysis. Relative valuation models operate by comparing the company in question to other similar companies. These methods generally involve calculating multiples or ratios and comparing them to the multiples of other comparable firms. Generally, this type of valuation is a lot easier and quicker to do than the absolute valuation methods, which is why many investors and analysts start their analysis with this method. Stock valuation via relative measures - Multiplier model (or market multiple) These models are based chiefly on share price multiples or enterprise value multiples (the two different ingredients are market price and enterprise value) - The price multiples model estimates the intrinsic value of a common share dividing its price by some fundamental variable, such as earnings per share, cash flow (dividends) or book value. The fundamental variable may be stated on a forward basis (forecast EPS for next year) or a trailing basis (EPS for the past year). - Enterprise value (EV) multiples have the form of EV/Value Of The Fundamental Two possible choices for the denominator are EBITDA (earnings before interest, taxes, depreciation and amortization) and total revenue (taken from income statement). The numerator is the enterprise value: it is a measure of a company’s total market value. An estimate of common share value can be calculated indirectly. 67 Stock valuation via relative measures – Multiplier model: key price multiples 1. Price earnings (P/E): stock price divided by the earnings per share. 2. Dividend yield: dividend per share divided by the stock price. 3. Price to book value (P/BV): stock price divided by book value per share. This is more an accounting multiple because it compares stock in the marketplace with the book value of the share. The equity capital (common equity) is nothing but the product of the number of existing shares by their nominal value which is the value found in the balance sheet. Compare this accounting measure with market price it is possible to understand if the company is fairly priced or over/under valued. P/E ratio and dividend yield of US market indexes. Remember market indexes can be thought as yielding price earnings and dividends. It is possible to use it to make comparison around the global. Within the indexes it is easier and more meaningful to make comparison. 1. P/E (price earnings) Market price/EPS - Price: usually the current one, but also its annual average - EPS: previous-year earnings, current-year expected earnings, following-year expected earnings. It is the most used in the market to see profitability of shares, put current market price at numerator while the denominator is the current year or expected earning for coming year. In order to make this P/E ratio consistent with models it is useful to think of price earning per share as measure of how long you, as an investor, need to wait for the corporation (you want to invest into) to generate quarterly earnings per share that generate market income that equals the market price to pay today to buy your stock. Higher the ratio longer the time you have to wait to repay your investment for this reason high ratio means high risk. It can be thought of as measure of how long (how many quarters) you – as an investor – need to wait for the corporation under observation to generate quarterly earnings per share (EPS) thus to equal the market price you pay today to buy your stock. The higher the P/EPS ratio, the longer you need to “wait” for the company whose share you bought to “repay” your investment via Earning Generation. NB: high P/EPS – high risk PEG It means a low P/E ratio is synonymous of good investment because it has a high growth potential. 70 Stock valuation – discount based: non-constant dividend growth The company will growth dividend in non constant session (more similar to reality). Dividends you earn will first growth at the beginning with higher speed and then, after given period of year it will start to grow in a normal way with respect to previous super normal growth. 1. Find the present value (PVsn) of dividends (d) during the finite period of time (T) of “super normal” dividend growth (gsn) by discounting each one by the company required rate of return (r) 2. Find the present value (PVn) by dividend paid at the end of super normal growth period: a. Finding the present value of dividends (d) during the subsequent period (perpetuity) of normal dividend growth (gn) by using the perpetuity formula with the company required rate of return (r) b. Discounting the value a. by the company required rate of return (r) overt the period (T) of “super normal” dividend growth. 3. Add (Psn: step one) and (Pn: step two) The present value of a stock (Pt) assuming non-constant (super-normal) growth in dividends can be written as: It is possible to see the difference and separation between step one and step two in order to better understand them. PVm (first step) and PVn (step two) and then the step 3 is to sum up them. Stock valuation – discount based: no dividend The Gordon model can be adapted to calculate the present value of a stock (Pt) that pays no dividends which can be written as: Such a model is related to stock that pay no dividends. Think about Tesla (innovative electric car maker has never paid dividends). Price of stock pay no dividends is equal to the value of the company divided for the numer of shares. The discount factor is the WACC (cost of capital of the company), if the cash flows growth at a constant g (growth rate) the formula converge infinite cash flow to free cash flow paid at t+1 divided by WACC – g. Formula identical to the one used for constant growth factor over infinite string of period. Ex – Gordon model Imagine that in T you observe the following data: - Price: 20 - Dividend: 1 - g: 3% (r: 1/20 + 3%= 8%) If in T+1 r decreases to 6% the stock price will increase to 1*(1+3%) / (6% - 3%) = 34,33 71 What is the effect of a reduction of dividends (1 vs 0,8)? Assume that the return r will be still 8%: P = 0,8 * (1+3%) / (8% - 3%) = 16,48 The decrease of dividends will cause the reduction of stock price. That’s why news on expected earnings/dividends is relevant. Numerator (cash flow) goes down and denominator stays flat so the price of stays stable. Sensitivity of Gordon Model to g Gordon model it is sensible to real and relative value of g when g is close to r. The Gordon growth model is very sensitive to a required rate of return when it is too close to the dividend growth rate. In this example below, stock B has a dividend growth rate of 6% and Stock A has a 7% dividend growth rate. Both stocks pay a $1 dividend and have a required rate of return of 8%, yet the 1% difference in dividend growth rates markes stock B twice as valuable as Stock A. - Value of stock B = $1 * 1,06 / (0,08 – 0,06) = $53 - Value of stock A = $1 * 1,07 / (0,08 – 0,07) = $107 The two stocks seems to be identical but the change in g drives to a difference in price, stock B as one half of stock evaluation because g is different and this difference is more relevant because it is very close to r which is 0,8. However, when the dividend growth rate is less than the required rate of return (which thing is rather normal), then the difference in the value of two stocks is much smaller. For example, suppose Stock B grows dividends at 1% and Stock A grows dividends 2% a year. Both stocks pay a $1 dividend and have a required rate of return of 8%. As shown in the calculation below, the difference in the values of stock A and Stock B in the low dividend growth scenario is modest – only about 15%. - Value of stock B = $1 * 1,01 / (0,08 – 0,01) = $14,43 - Value of stock A = $1 * 1,02 / (0,08 – 0,02) = $17 Limitations of the Gordon model The main limitation of the Gordon growth model lies in its assumption of a constant growth in dividends per share. It is very rare for companies to show constant growth in their dividends due to business cycles and unexpected financial difficulties or successes. Therefore, is limited to firms showing stable growth rates as Coca Cola, McDonald’s because they belong to steady industrial factors. The second issue has to do with the relationship between the discount factor and the growth rate used in the model. If the required rate of return is less than the growth rate of dividends per share (rare but it could be), the result is negative value, rendering the model worthless. Also, if the required rate of return is the same (quite equal) as the growth rate, the value per share approaches infinity. How to estimate g Historical growth of dividends. Consider a company and go in the past of 5 years consider that in the analysis it stays constant. Define the “plowback” ratio, b, as the fraction of retained earnings. The growth rate of earnings is the plowback ratio times the return on equity: g = b*ROE G is put in the Gordon model to determine the price of desired stock. 72 Equity valuation – returns The return on a stock with zero dividend growth, if purchased at current price P0, can be written as: Calculate required return consider the price at which you have paid it The return on a stock with constant dividend growth, if purchased at price P0, can be written as: Stock has constant dividend growth and r will be given by the dividend paid in year 1 divided for the purchased price plus the growth in dividend. Exercise – a company recently paid a $0,30 dividend. The dividend is expected to grow at 10,5% rate. With stock market price currently being $23,45, what is the return shareholders are expecting? Sum up – pros and cons of the two methods in stock valuation Multiplier models - Ratios are easy to compute, and analysis is easily understood (it gives straightforward information to analysts) - Problems with selecting a peer group of “comparable” (ex: not compare McDonald’s with Tesla because even if ratios are right, they are internally different, so the comparison has no value) Present value models - Theoretically appealing, provide a direct computation of intrinsic value - Input uncertainty can lead to poor estimates of value (to be meaningful all values should be calculate in the right way). BOND VALUATION Adapt the same formula but into the bond world where infinity does not exist. It means that the term will change the formula to incorporate the concept of redemption (maturity) and therefore the yield that originate for the combination of coupon and principle reimbursement at maturity. The present value of a bond (Vb) – with annual coupon – can be written as: The starting equation is this one with adaptation. Vb = interest coupon multiplied by the sum for T period for the present value divided 1+r which is the yield to maturity plus the par value (in general 1000 dollars) divided by the yield maturity in time T which is the redemption date. 75 Time to maturity Assuming 0,5 % increase in yield (from 7 to 7.5), if rate goes up prices will not necessarily go down because numerator increase. But consider another bond with different maturity the old price and the new price will certainly be lower for all the bonds but the rate of change between old and new price will increase in a logarithms factor. The change in market interest rate will impact security price with a larger but at decreasing rate based on how long the contractual maturity of your security is. Coupon Assume r and t don’t change but you compare bond with identical r and t which one having different coupons (blue: low coupon while red: high coupon). We state that for any change in market interest rates the impact on the security price will be smaller the bigger the size of the coupon. Higher the coupon lower the impact of change in interest rate. Impact of coupon on price volatility Assume to see a change from 7 to 6,5 and without calculation we assume that lower interests trigger higher prices and in fact price old and price new show that price new is higher than price old. Change in market rate will be translated into larger percentage change in bond value the lower the coupon rate. Impact of r on price volatility The response in price change is not equal in the face of the same absolute change in interest rate. For a given time to maturity with a given contractual maturity the price volatility (% change in price that is subsequent to a change in yield to maturity) is inversely related to the level of initial interest rate. If interest rate goes up from 2 to 5% and they go up from a 10 to 13% it means the absolute value is the same but the impact on the price will be different and non-proportional, in other words price will change more the lower the level of the initial interest rate. Greater the interest rate changes by the same amount, the response in price on the price yield curve will be smaller the higher the initial level of interest rate. 76 DURATION AND MODIFIED DURATION To combine in once single indicator the impact on price or better on the volatily of bond price when these 3 elements one by one change we will use the metric of duration. - Duration is the weighted-average time to maturity (measured in years) on a financial debt security. - Duration captures all of the three risk factors affecting security price (coupon, maturity, interest rate). Because bond prices move inversely to rates, duration can be thought of as the fulcrum of a seesaw on whose arms “rates” and “price” sit. Depending on the size of the duration for each bond, identical changes in market rates will trigger different price responses on each different bond. See how Bond A exhibits a smaller increase in its price vs Bond B when rates decrease by the same amount because of Bond A having a smaller duration than Bond B. Duration on bond A is different from the duration of bond B. Duration A is smaller with respect to duration B, when the price goes up, the bond with smaller duration goes up by less than what happens on bond B (fulcrum is moved more on the left side) See how Bond A exhibits a larger increase in its price vs Bond C when rates decrease by the same amount because of Bond A having a greater duration than bond C. Bond A has greater duration than bond C, rates goes down again changes in A is higher than the bond C because duration is higher. Greater duration means greater risk and so greater volatility in the price of security that has higher duration. Behaviour of bond price when the three ingredients change: - Duration and coupon interest: the higher the coupon payment, the lower the bond’s duration. - Duration and yield to maturity: the higher the yield to maturity, the lower the bond’s duration. The higher the denominator the lower the bond duration. - Duration and contractual maturity: duration increases with maturity but at a decreasing rate. The impact on the bond price by a change in yield to maturity will be greater the longer the maturity but at decreasing rate. 77 What happens to duration when one parameter changes (others don’t) Change of one of our key ingredients in the equation. - Coupon size increases duration decreases. - Coupon frequency increases duration decreases - Yield to maturity increases and duration decreases - Time to maturity decreases and duration decreases Formula of duration Duration (Dur) for a fixed income security that pays interest annually can be written as: Duration can be calculated starting from the usual formula. Define duration as average of the time expressed in years weighted by the cash flow happening in time t divided by P0 which is the purchasing price of security. Duration and volatility a. If the coupon is 6% and YTM is 6% it means without making calculation that this bond is aimed to have coupon greater than yield to maturity so it is a premium bond (you will pay this in the marketplace more than its par value). List years at the beginning because duration is a number of years (weighted average of years). Then write cash flow happening in each year (ex: 6% coupon for each year in this case but at year 4 you have redemption). Calculate then PV of each cash flow discounting it every time which is the price of the bond (1.035,46 dollars). Step 4 is the calculation of percentage value of each PV on the price (make the ratio to understand it). Finally, in step 5 you multiply t (column 1) by a factor which is weighted average of coupon price. Coupon helps you to have some money back before the end of contractual maturity for this reason duration is smaller than the contractual maturity of four years. 80 Special cases (no immunization, unhedged interest rate risk) No immunization means you are unedge against interest rates risk. If you don’t set your investment period equal duration but you just buy the bond and invest for a period of time which is different from duration you are taking a risk position (you are exposed to volatility in the price of your security that will not be compensated by the change in interest rates but you have a speculative position). a. If an investor chooses a bond with a duration longer than their investment horizon, he (the investor) is confident interest rates will fall. As such, his pre-tax nominal realized yield will be improved by falling interest rates because the gain in sale price will more than outweigh the loss in reinvestment income. b. Likewise, if an investor chooses a bond with a duration shorter than their investment horizon, he is betting interest rates will rise. As such, his realized yield will be improved by rising interest rates because the loss in sale price will be smaller than the gain in extra reinvestment coupon income throughout the initial investment horizon. From duration to modified duration To better estimate what is key for us as investors it is used the modified duration. More duration means greater risk but you as an investor you are not happy to only know that bond you are investing into is riskier but how much you are risk. Duration used is expressed in years and it is called as Macaulay duration by the name of mathematician. Duration expressed in years is informative and allow you to compare bonds with different characteristics by standardized them. Duration is not helpful to investigate the degree of risk in case for example of a shock. Move to modified duration for this reason, to have better estimation of risks. You take the first order derivative with respect to r and you rearrange the formula to obtain much useful thermometer of how the price of the security will change when a shock delta r happens in market rate. Modified duration (DurMod) can be used to predict price changes when rates r suffers an instantaneous small shock. We can define (DurMod) as: Based on the above, expression see before can be rewritten as: Duration-based prediction errors Because of duration being the first-order derivative with respect to r (YTM) of the bond price function. What does it mean geometrically? it graphically represents nothing but the point of tangency between the actual, convex price/yield function and the duration-modelled segment tangent to it. As such, the modelled change in price (read on the straight line) will become progressively less accurate the wider the change in r. That is when the concept of Convexity comes in handy. 81 Duration compared to the bond price P duration will be very different considering two prices different. When the change in r in very wide, the price you estimate is very different from the true one, so you are losing information because you are getting far from the tangency point. Duration model can be help with corrected factors. CONVEXITY By taking the second order derivative with respect to r of the price expression and rearranging its result, we obtain the so-called convexity: y: yield to maturity P: actual price t: time C: cash flow Duration is measured in years (weighted average) while modified duration can be thought as a tangency point. Convexity is the degree of curvature of the segment you are predicted (the prediction that you make in the model becomes better suited to estimate the % change in price when interest rate change). You are adjusting the straight-line segment that was tangent to the true relationship by a corrective factor, estimate more accurate. Convexity (CX) measures the change in slope of the price-yield curve around interest rate level r. Convexity can be therefore usefully added to the original price-change estimation made using only the duration (first order derivative) to obtain a better, more reliable estimated percentage price change of a bond given an interest rate (exogenous) change. If the shock in rate in great the forecast is useless unless it includes convexity. Because the price/yield relationship is a convex function, convexity (being a second-order derivative) cannot be negative. As such, convexity suggest that for a coupon- bearing bond its price will rises more for a rate decline than it falls for a rate increase of equal magnitude. Hence, between two bonds with the same duration, the one with a higher convexity is more valuable. Two bonds, the bond with bold convexity and the other with doth convexity. If interest rates go from 4% to 8% the price change from measured on the line of the more convex bond (doth) will be a bit more than the price change for the solid line. The greater decrease in price suffered by the bond with less convexity. MORE CONVEXITY IS BETTER. 82 Example – Convexity Key ingredients for a bond to calculate convexity. 4 years bond with 100%-euro price which is par bond because its coupon rate is equal to YTM. Step by step to calculate convexity which can be seen as angular coefficient. 1. List 4 annual periods 2. Put the CF that happen on each period 3. Calculate PV of each cash flow 4. Calculate product of t x (t+1) 5. Multiply step 4 by step 3 (just a product) 6. Calculation of convexity (= to result) The estimation is improved by the corrective factor arriving at -3,10%. Without convexity we would expect -3,17%. Positive factor that we add to the original duration increases the accuracy of forecast and helps to better protect the portfolio. 85 o Hedging: entering into a derivatives contract to reduce the risk associated with positions or commitments in their line of business. Mitigate effects of exposure to adverse movements (interest rates, stock movements, exchange rate movement…) o Creation of synthetic securities: to change the nature of a financial position without bearing the costs of selling the portfolio and repurchase another one. Transform characteristics of different securities, it is possible that one loan which has fix rates through the combination of it with derivative can be transformed into floating rate loan. Paying a small amount of money which can be the premium of the option of margin requirement, investors can take a position on the underlying asset by investing a small amount of money. Without having the necessity of buying the whole underlying asset. According to the marketability/standardization Exchange based contracts - Traded in regulated exchanges. Italian derivative market or Urbex in Europe which is very developed held by German stock exchange. - Standardized contracts. Characteristics well defined and clear, they have specific underlying asset, it is not possible to find whatever type of assets in the market, but they are well-defined. - Early termination priori to contract expiry. Possibility to conclude the position and perform an opposite transaction. I buy future and I can change my position simply deciding to sell my asset before the maturity. Over the counter contracts (OTC contracts) - Traded largely through computer and/or phones. Contract are not traded in organized markets but built on the basis of specific needs of counterparty. They are created by financial intermediaries which are involved in the negotiation of trading. - Customized contracts. Contracts are built on the basis of specific requirements of counterparties in terms of maturity, underlying assets, way of settlement and so on. - Private negotiations. Since it is not an organized market it is not possible to observe prices related to trading of OTC derivatives. For this reason, these types of contracts are not so transparent as the others. - Early termination more difficult. Related to the fact the contracts are not standardized and for this reason when you want to sell you derivative it is not easy to find a counterparty that will accept conditions decided. Data collected from the Bank for International Settlements (BIS) First line graphs Total amount of options traded in exchanges is about 61 trillion of US dollars at the end of 2019. Notional value of exchange rate future was at the end of 2019 35 trillion of US dollars. It is important to say what is the meaning of notional amount/value of a derivative? Think about nominal value of the contractual, the contractual value of a specific derivative is different from the price at which you can buy or sell a given derivative. 86 It is possible to have data to notional amount (contractual value) and also information about the market value. These two values are completely different, but it is important to understand how much they are different one from the other. Second line graphs It is possible to see what kind of underlying assets are much more important. Then, observe the importance of OTC markets and observe that the value at the end of 2019 of the market having underlying assets as stocks, currencies and so on 6 hundred trillion US. OTC related to commodities and swaps you can observe that credit derivatives and others started to have an enormous growth which was reduced by crisis of 2008. These contracts are very customized, and they lack transparency and early termination for this reason is difficult. Another fact is that counterparties are exposed to the risk of default of counterparty (ex: the seller will default before maturity rate and this will cause a loss). Exchange-traded options notional amounts Exchange-traded futures notional amounts OTC currency, interest rate and equity linked derivatives notional amounts OTC commodity, derivatives and credit default swaps notional amounts OTC derivatives reform - Since 2008, new regulations on both sides of the Atlantic make the promotion of Central Counter Parties (CCPs) which acts as counterparty of derivatives trades and mitigate the counterparty risk. - CCPs are regulated and supervised financial institutions, aimed to replace the bilateral relationships in OTC derivative markets and consequent counterparty risk. - CCPs create centralized multilateral relationships. The sellers of OTC derivatives sell the contracts to the CCP and the buyers buys the contract from the CCP. The CCP can stipulate the required collateral to both counterparties and monitor the positions of the two parties under the regulatory rules. 87 - In 2011 in the US was enacted the Wall Street Reform and Consumer Protection Act (widely termed the “Dodd-Frank act” or DFA). - In Europe, in 2011 was enacted the European Markets Infrastructure regulation (EMIR). Similar regulations were developed in other continents. In Asia similar regulation were enacted with the same aim as in Europe and USA. OPTIONS Option contracts An option is a contract that gives the holder the right, but not the obligation to buy or sell the underlying asset at a specified price (exercise price or strike price) with a specified period of time (maturity). Two counterparties defined conditions at which the contract will be settled so they define assets, maturity and price. - A call option is an option that gives the purchaser the right, but not the obligation, to buy the underlying assets from the writer of the option at a specified exercise price (or up to) a specified date. The buyer has the right to buy the underlying asset. - A put option is an option that gives the purchaser the right, but not the obligation, to sell the underlying asset to the writer of the option at a specified exercise price on (or up to) a specified date. The buyer has the right to sell the underlying asset. To acquire the right to buy or sell at strike price the buyers should pay a premium in advance to the seller of the asset. The seller of the right cash it and obliged to sell or buy the asset. Underlying assets They can be financial or not has already seen and they can be over the counter or exchanged. Speaking about OTC options it is common to hear the expression EXOTIC OPTION which means over the counter option very specific in terms of characteristics and very customized. - Stocks - Foreign currencies - Stock index - Interest rates - Commodities Contractual specifications - Typology: European or American style - Maturity date (short in case of exchange trade option, it can go from very short as weekly) - Exercise or strike price at which the right of buy or sell can be exercise - Type of settlement: physical or in cash. - Premium (the up-front fee). Distinguish between European options and American ones. American styles options have the right to buy or sell the option before maturity and so immediately starting from the purchase of the option the buyer can exercise his or her right to buy or sell the option. It is not the case in Europe where the right to buy or sell can be exercise only in a given date which is contractually identify. Given the difference it is possible to understand American Style will have higher premium with respect to Europe ones because they provide the right to sell or buy whenever the owner wants. 90 - TIME VALUE = option premium – intrinsic value Intrinsic value equal to zero means that what the buyer pays is just the value of time. The value of options PREMIUM = time value + intrinsic value The time value of an option is the portion of an option’s premium that is linked to the amount of time remaining until the expiration of the option contract. The longer the amount of time for market conditions to work to an investor’s benefit, the greater the time value. The longer the time before the expire option contract the better will Examples 1. In this case we have quotes for call option with maturity in May, strike price equal to 6 $ and premium equal to 3.30 $ and the underlying price is 8.79 euro. Since market price is above strike price this call option is IN THE MONEY. Suppose in this case we want to understand what the time value of this option is. The May call is in the money, so it has a positive intrinsic value while the co-premium is equal to 3.30 and you want to buy 100 contracts, so it becomes 330$ and it gives the right to take an exposition to 100. The intrinsic value is equal to 279 $, we know the premium, so it is possible to calculate the time value which is 51$. The May put is out of the money because the market price is well above the strike price and therefore the intrinsic value of this put is equal to zero. 2. Now suppose that the day after the purchase of the May call option, the market price of the underlying stock goes to $10. The premium will rise but by how much? It will increase by (10-8.79) = 1.21$. Assuming that the time value remains the same, the value of the premium rises to 4.51$. At this point, the buyer of the call option can sell it at 4.51$ with a profit equal to 1.21$ * 100 = 121$. Let’s now discuss about the leveraged nature of derivatives. Remember that in organized markets early termination is facilitated by continuous trading. If the investor buys spot the stock at 8.79$ he spends 879$ for 100 stocks. If the stock price rises to 10$ per stock, then the profit is equal to 121$ should the investor sell the stocks. Therefore, the return on the investment can be calculated as 121/879*100 = 13.77%. Using the option market, the return will be 121/330*100 = 36.67%. This means being leveraged. What will happen to the May call premium if the market price of the stock drop to 7$ the next day (assuming that the time value remains constant)? 91 Profit and loss payoff for put option used for hedging purposes How is it possible to implement an agent strategy use put option? Blue line buys the stock at 9 euro so gain if the market price goes above 9 and lose if it goes below. You are warred about possible losses on your stock position and you are scared market price could decrease over next 3 month. How can you protect yourself? You can buy a put option on the same underlying stock with strike price equal to 9 euro and maturity equal to 3 months. The put option will be in the money any time the market price will be below 9 euro, any profits generated by put option will be offset the loss. The combination of stock held and put option combination purchased is represented by green line, in such a situation the investor will profit by price increases and limit his exposition to losses equal to premium paid. You can create synthetic position, combination of stock held and put option bought create a synthetic call option. Factors affecting options’ premium - Changes in the underlying asset price. These price changes have opposite effects on calls and puts. For instance, as the value of the underlying security rises, a call will generally increase whereas the value of a put will generally decrease in price. - The strike price determines whether or not an option has any intrinsic value. An option’s premium (intrinsic value plus time value) generally decreases as the option becomes further in the money and decreases as the option becomes more deeply out of the money. - The effect of volatility: higher volatility estimated reflect greater expected fluctuations (in either direction) in underlying price levels. As price volatility increases, the chance that the underlying asset changes in value increases, this expectation generally results in higher option premiums for puts and calls alike. Volatility is risky for investors, higher volatility higher changes they can have but it is desirable in terms of option because higher volatility means higher probability to make profits. - Exercise day (maturity) the greater the time to maturity, the greater the opportunity for the underlying asset price to change favourably; thus, the time value for the option increases. - In general, as interest rates rise, call premiums will increase and put premiums will decrease. - The effect of variations in the interest rate on the option price is due to the fact that interest rates have an impact on forward prices of underlying assets and their current prices. Generally, an increase in interest rates increases the premium of a call option and decreases the premium of a put option. Factors affecting options prices VARIABLES CALL OPTION PUT OPTION Underlying asset price Positive Negative Strike price Negative Positive Time to expiration Volatility Positive Positive Interest rates Positive Negative Dividends Negative Positive 92 Options’ pricing The Black-Scholes option pricing model (1973) is the model most commonly used to price and value options is a function of: - The spot price of the underlying asset - The exercise price on the option - The option’s exercise date - The price volatility of the underlying asset - The risk-free rate of interest Options’ dictionary - Tick size: minimum change (in $ and euro) of the premium - Open interest: the total number of option contracts outstanding at the beginning of the day or total number of options outstanding at the end of the day. It provides information about the size of the market for potential investors (buyers or sellers). - A clearinghouse (CCP) is the institution that oversees trading on the exchange and guarantees all trades made within the exchange. - Margin requirement: writer of the option (seller). Guarantee bond made in the case of option contract only the seller of the contract because there is possibility of default by the writer that can cause a loss on the buyer of the option. - Option settlement: o Physical delivery (investors do not take delivery in general, but they simply exchange or trade the premium of the option) o Cash settlement (exchanges of underlying assets are not possible, the difference between market price and strike price is paid by seller of call option if it is in the money). Caps, floors and collars They are OTC options on interest rates, major users of these contracts are financial institutions which use them to edge their exposure to interest rates risk both on liabilities and assets side. They can be used also for speculative reasons. They are call and put and a combination of them. Financial institutions use options on interest rates to hedge interest rate risk - Cap is a call option on interest rates, often with multiple exercise dates. At a given exercise date, there is a settlement of what is eventually due by the seller of this contract. - Floor is a put option on interest rates, often with multiple exercise dates. - Collar is a position taken simultaneously in a cap and a floor (usually it is not a sum of the, but it consists in buying a cap and selling a floor or the contrary). This combination is made to minimize cost of one of them. Interest rate caps, floors and collars Interest rate cap two parties agrees about a cap rate which remains fix throughout the length of the contract and the contract implies that the if market interest rate are above the cup rate then the seller has to pay the buyer of the cup rate for the difference between market interest rate and cap rate. 95 Settlement and closure prior settlement - Physical settlement vs cash settlement As for options there is a distinction, physical settlement allows for the delivery of the asset at maturity. This is possible in general for commodities or securities as stocks or bonds, but it is not possible for stock index or interest rate. In the second case obviously only the cash settlement is allowed, the counterparties will simply calculate the difference between prevailing market price of underlying asset at maturity and agreed price and the difference is paid by counterparties. - Exit strategy prior settlement As contracts are traded in a regulated and organized market is possible to offset initial position with an opposite transaction. Ex: if I bought future contract, I can close my position by selling the equivalent amount of future contract held. If I am short with future contract, I can offset my position by buying an equivalent amount of future contract and in this case, I close my position. The possibilities of offset position depend on marketability of these contracts and of course the liquidity of future market itself. Standardization of future contracts Futures contracts ensure their liquidity by being highly standardized (it means that it is well specified the kind of underlying asset or financial instrument), usually by specifying: - The underlying asset or instrument - The type of settlement, either cash settlement or physical settlement - The amount and units of the underlying asset per contract - The currency in which the futures contract is quoted. - The tick, the minimum permissible price fluctuation (it is not possible to have whatever fluctuation but any change in the price will be according to a minimum tick) - In the case of physical commodities not only the quality of the underlying goods but also the manner and location of delivery are specified. - The margin requirements which is nothing else that collaterals/deposit posted by both counterparties of future contracts that have to be deposit in margin account heading by clearinghouse. Much more volatile assets require higher margins and the opposite is true for underlying assets having low price volatility. Margins exist because they offer protection to counterparty which is exposed to more risks (they are useful to edge and protect counterparty from the risk of default of a daily basis). - The last trading dates (maturity). Maturity can be weekly, monthly, quarterly but usually in exchange trading of future contracts medium and long maturity can be found in OTC markets while in other cases for future contracts maturity in short term. Example – www.borsaitaliana.it Italian stock exchange (Borsa Italiana) has a specific segment which is dedicated to derivative (option market in Italy has been already seen) for future contracts. MiniFuture are future contracts on the FTSE MIB stock index which is the most important one in the Italian Stock exchange and they are thought to retail future contracts. MiniFuture has as underlying assets the Italian stock index which is equal to 1 euro and the minimum price variance of the proposal is 5 index point which is the tick (in the FTSE MIB). In each trading session, the closest deadline and the first subsequent deadline are simultaneously quoted with reference to the cycle March, June, September and December. 96 Each contract expires on the third Friday of the expiration month. The minimum price variance of the proposals concerning the contract itself is set at five index points. The miniFutures on FTSE MIB provides for settlement by cash settlement (no delivery of the financial instruments that make up the FTSE MIB index) - Suppose that today you go long on the Italian stock index with the purchase of 2 minifutures with maturity June 19, 2020 and the FTSE MIB equals 15,466. The value of the 2 contracts is = 15.466 * 2 *1= € 30,932 If on the month of expiry the stock index is equal to 16,500, then the value of the 2 minifutures corresponds to 33,000 € The profit is equal to 33,000-30,932= 2,068€ Suppose the margin required to open the position is equal to 5 % of the value of the 2 contracts = 1,546.6 €. Therefore, investing 1546.6€ (the margin) you obtained 2,068 € profit Futures contracts’ margins Clearinghouses require counterparties to open margin account into which they deposit money used as guarantee. The clearinghouse (central counterparty) of future contract acts as buyers of future contracts sold by the seller and seller of future contracts sold to buyer of future contract and by doing this clearing house create margins. Margins are proportioned to price volatility of underlying assets and so the margin is going to offer protection against the possible losses incurred by counterparty on daily basis. - An initial margin is a deposit required on futures trades to ensure that the terms of the contracts will be met. - The maintenance margin is the margin a futures trader must maintain once a future position is taken: o If losses occur such that margin account funds fall below the maintenance margin, the customer is required to deposit additional funds in the margin account to keep the position open. Future contract terms Future contracts on 30-years treasury bond which is the underlying asset and then there is the maturity of this one and the face value. Specifications about derivable instruments in case of physical delivery and of course the ones regarding the initial (initiate position) and maintenance margin (balance that at minimum has to be kept in the margin account). Typically, financial intermediaries (banks, investment companies…) are member of the clearinghouse and they required to open their margin account. When financial intermediaries act as brokers for their customers facilitating the purchase of future contracts the brokerage house requires the margin to be posted for future position open. 97 Long and short positions We saw the contract of specification of treasury bond, the investor can take short or long position on future and deposit an initial margin requirement per each future contract having a nominal value equal to 100,000 $ (leverage nature of future contract is seen here). T-bond futures quote sheet and marking to market Understand the price of the future when the deal is made, and position is open. In this case the investor decides to open a future position with maturity in June 2014 and open the price in future which is 98.45 (percentage price that we pay for each 100- face value of underlying asset). The value of future position is equal to $98.500 (face value was equal to 100,000 dollars). In this case investor decides to take a long position on June contract at the opening price of 98.5 or in dollar terms 98,500 paying initial requirement of 2,530 dollars. How the mark to market works and margin account is working? Open the position is 98,500 and a balance of margin account equal to 2,530. The day after the trade was made the price of T-bond was 98.3125 which means that the future contract is worth 98,312.50 dollars. This will also determine a loss for the investors belong on the future contract equal to 1,312.50 dollars because the dollar value of future contract has decreased below the price which was agreed when the future position was open and long position was taken. Because of the mark to market this 187.50 is going to be debited on the margin account and it will make the new balance of margin account equal to 2,342.50 dollars. Again, this balance is above the maintenance margin required so no margin call will be made to investors. Make the same thing for what happen of Tuesday but at the end the balance is equal to 1,500 dollars and it is below the maintained margin requirement the clearinghouse which negotiate trade for customers is going to make a margin call in order to reach initial margin requirements. What happens if the investors do not deposit what is decide in the call margin? The clearing house will sell the future contract to someone else and to return to investors the balance of the margin account (1,030 dollars). Higher fluctuation higher is going to be the margin requirements.