Financial Markets (M. Rossolini), Appunti di Finanza

Scarica Financial Markets (M. Rossolini) e più Appunti in PDF di Finanza solo su Docsity! 1 Financial Markets Lecture notes, 1st year, AY 2019-20, INTECO, Sara Cucaro Prof. Monica Rossolini Introduction Mishkin and Eakins, “Financial Markets and Institutions” Chapters: 1, 2 Financial markets are markets in which funds are transferred from people who have an excess of available funds to people who have a shortage. These promote greater economic efficiency and an efficient allocation of capital by channeling funds from people who do not have a productive use for them (lack of investment opportunities) to those who do (in fact, poorly performing financial market → one reason for which many countries remain desperately poor). To move these funds, transferring money from lenders/savers to borrowers, is the main aim of the financial system and of the main actors involved. Financial markets also improve the well-being of consumers, allowing them to time their purchases better. Reallocation of resources → transfer of purchasing power between different economic units: between surplus operators (with positive financial balance, as households with funds to invest) and deficit operators (with negative financial balance, as governments, consumers needing funds, also households that need to borrow). Depends on the financial needs. The financial system is composed of: • Financial markets; • Financial institutions. Observe a firms’ lifecycle: We observe an initial concept and seed (starting phase in which lots of funds are needed). In this phase, is more difficult for the company to get a loan, because of credit worthiness. In this stage, there exist different possible ad-hoc grants, including crowdfunding. How do financial systems perform these functions? Money Markets - Bond Markets - Stock Markets - Financial derivatives - Securities industry, Investment Banks. 2 Overview of the Financial System The financial system is a complex structure designed to meet the financial needs of the different economic agents and consists of 4 elements: • Markets: place of exchange of financial instruments; • Financial Instruments: contracts relating to rights and services of a financial nature (for example, corporate bonds, stocks, futures, etc.). Think of a corporate bond: it provides an agreement between two counterparts, the issuer (the company) that needs money for investment opportunities and the agent with surplus of funds looking for investment opportunities. • Intermediaries: institutions specialized in the production and trading of financial instruments. In our system, the most important financial intermediary is represented by banks; • With the related regulations that must ensure that the functions assigned to them are carried out effectively and efficiently (SUPERVISORY AUTHORITIES). The financial system is complex first because it contains different elements (markets, financial instruments, financial intermediaries and regulations), but also because all these elements must be regulated, and their financial needs satisfied by moving founds from people with surplus of funds to players with shortage of funds. Example of regulations: a recent regulation of the banking system to increase bank capital requirements so that they’re able to absorb the needs of the borrowers without affecting the stability of the financial system in case of economic downturn. In case of economic downturns, the borrower may have difficulties in the repayment of its loan. This generates losses for the bank, but it should be able to absorb such losses without impacting the financial system. The government regulates financial systems for two main reasons: 1. Increase the information available to investors → because of asymmetric information in financial markets, investors may be subject to adverse selection and moral hazard problems that may hinder the efficient operation of financial markets. Government regulation may increase the efficiency of financial markets by increasing the amount of information available to investors. 2. Ensure the soundness of the financial system → asymmetric information can lead to the widespread collapse of financial intermediaries, referred to as a financial panic. Providers of funds to financial intermediaries may not be able to assess whether the institutions holding their funds are sound, and may not pull their funds if they have doubts about the overall health of financial intermediaries. To protect the economy from financial panics, the US government has for example implemented six types of regulations: • Restrictions on Entry (to be allowed to set up as financial intermediary, individuals or groups need to obtain a charter from the state or the federal government); • Disclosure (make certain information public); • Restrictions on Assets and Activities (i.e. on which actions intermediaries as allowed to make and what assets may be hold). For example: commercial banks and depository institutions are not allowed to hold common stocks because stock prices experience substantial fluctuations; • Deposit insurance (government ensures people’s deposits, for example FDIC, Federal Deposit Insurance Corporation); • Limits on Competition; • Restrictions on Interest Rate. Among regulatory agencies in the US: SEC (Securities and Exchange Commission) for organized exchanges and financial markets, requires disclosure of information, restricts insider trading. 5 therefore are defined as asset-transforming: they are able to transform a short-term financial liability (deposit, short term financing) in a long-term financial assets (credits, long maturity). This process of financial intermediation is actually the primary means of moving funds from lenders to borrowers. It is a more important source of finance than securities markets (such as stocks, at least in Europe). Needed because of: o transactions costs, o risk sharing, o and asymmetric information. Transactions Costs 1. Financial intermediaries make profits by reducing transactions costs; 2. Reduce transactions costs by developing expertise and taking advantage of economies of scale. If you have to manually prepare a contract and check on the trustworthiness of your counterpart is first of all time-consuming, then you have costs for preparing the contract (a lawyer). The bank uses the same contract for many operations, so employs economies of scale for the contract costs. A financial intermediary’s low transaction costs mean that it can provide its customers with liquidity services, services that make it easier for customers to conduct transactions. 1. Banks provide depositors with checking accounts that enable them to pay their bills easily; 2. Depositors can earn interest on checking and savings accounts and yet still convert them into goods and services whenever necessary. Risk Sharing Another benefit made possible by the FI’s low transaction costs is that they can help reduce the exposure of investors to risk, through a process known as risk sharing: • FIs create and sell assets with lesser risk to one party in order to buy assets with greater risk from another party • This process is referred to as asset transformation, because in a sense risky assets are turned into safer assets for investors In other words, financial intermediaries create and sell assets with risk characteristics that people are confortable with, and then use the acquired funds to purchase assets that may bear more risk. Low transaction costs allows financial intermediaries to share risk at low cost, enabling them to earn a profit on the spread between the returns they earn on risky assets and the payments they make on the assets they’ve sold (risky assets are turned into safer assets for investors) → asset transformation. Financial intermediaries also help by providing the means for individuals and businesses to diversify their asset holdings → low transaction costs allow them to buy a range of assets, pool them, and then sell rights to the diversified pool to individuals. Diversification entails investing in a collection (portfolio) of assets whose returns do not always move together, with the result that overall risk is lower than for individual assets. Asymmetric Information: Adverse Selection and Moral Hazard Another reason FIs exist is to reduce the impact of asymmetric information: → Information asymmetry is a condition in which information is not shared in its entirety between individuals who are part of the economic process: a part of the agents involved, therefore, has more information than the rest of the participants and can take advantage of this configuration. 6 For an individual is very difficult to assess the trustworthiness of a counterpart, or the level of risk of a financial instrument. Financial institutions have more skills in the analysis of counterparts (more information), have the possibility to verify if in the past the borrower paid regularly its debts, etc. The two main market failures in presence of information asymmetry are: • Adverse selection • Moral hazard Adverse selection is a problem regarded to the pre-contractual phase (before the transaction occurs) and arises because of the gap between the information held by the company and that held by the consumer. If a bank is not able to distinct safer borrowers from riskier borrowers, the bank may decide to apply to all the borrowers an average interest rate. This interest rate may be a good opportunity for riskier borrower, but a too high cost for a safer borrower. The consequence of not reducing this adverse selection is that the safe borrower changes bank, and only riskier borrowers remain. Therefore, this average interest rate will probably not be enough to cover the risk, and negative consequences for the bank’s balance sheet. → i.e. occurs when the potential borrowers who are the most likely to produce an undesirable (adverse) outcome – the bad credit risks – are the ones who most actively seek out a loan and are thus most likely to be selected. Because adverse selection makes it more likely that loans might be made to bad credit risks, lenders may decide not to make any loans even though there are good credit risks in the marketplace. Moral hazard is a post-contractual opportunism (after the transaction occurs) that occurs especially during insurance relationships. The consumer, entered in a contract that compensates him in the event of some damages, is induced to reduce preventions against such damages or to overuse the availability of resources due to him. For example, if a driver knows that all the expenses of a car incident will be due to him, will be more careful then if having an insurance. → Moral hazard in financial markets is the risk (hazard) that the borrower might engage in activities that are undesirable (immoral) from the lender’s point of view, because they make it less likely that the loan will be paid back. Because moral hazard lowers the probability that the loan will be repaid, lenders may decide that they would rather not make a loan. Moral hazard leads to conflicts of interest, in which one party in a financial contract has incentives to act in its own interest rather than in the interests of the other party. Successful financial intermediaries have higher earnings on their investments than small savers, because they are better equipped than individuals to screen out bad credit risks from good ones, thereby reducing losses due to adverse selection. In addition, financial intermediaries have high earnings because they develop expertise in monitoring the parties they lend to, thus reducing losses due to moral hazard. The result is that financial intermediaries can afford to pay lender-savers interest or provide substantial services and still earn a profit. 7 The main players: Financial Institutions Markets and institutions are primary channels to allocate capital in our society. Proper capital allocation leads to growth in: 1. Societal wealth 2. Income 3. Economic opportunity Financial Institutions → institutions through which suppliers channel money to users of funds. Financial Institutions are distinguished by: • whether they accept insured deposits • depository versus non-depository financial institutions • whether they receive contractual payments from customers More specifically, we can say that they fall into three categories, being (a) depository institutions (banks), (b) contractual savings institutions and (c) investment intermediaries. These three types of financial institutions are more detailed as follows, by a description of their primary liabilities (i.e. sources of funds). 10 Problems: • Monitoring costs. Suppliers do not necessarily have the expertise to monitor the users. • Liquidity. There is a mismatching between the long-term nature of the instruments issued by users and the need of liquidity of the suppliers of funds. The supplier can’t guarantee the liquidity of its funds. • Price risk. The price of these assets may decrease on the market, so when the supplier sells the instrument it may be at a much lower price. Flow of funds in a world with FIs Advantages: • The Financial Institution finances itself with long-term equity and debt securities (long-term maturity), groups the funds suppliers and has a greater incentive to use expertise and monitor the ultimate users. • Asset-transformation: FIs purchase instruments issued by users and finance such instruments to suppliers in form of deposits and insurance policies. …therefore, regarding financial institutions What’s the difference between depository vs. non-depository FIs? • Depository institutions: institutions financing themselves mainly by deposits. For example: commercial banks, savings associations, savings banks, credit unions; • Non-depository institutions: finance their activities with other sources of finance. o Contractual: insurance companies, pension funds, o Non-contractual: securities firms and investment banks, mutual funds. Why do FIs benefit suppliers of funds? • Reduce monitoring costs • Increase liquidity and lower price risk • Reduce transaction costs (→ economies of scale, the average cost of collecting relevant information is lower than for individual investors, costs of operations is also lower since they manage many) • Provide maturity intermediation (→ provide long-term maturity raising funds with short-term one) • Provide denomination intermediation (→ especially for mutual funds, because, by pooling many investors’ funds, small savers overcome constraints to buy an asset imposed by large minimum denomination size) • Reduce asymmetric information o Moral hazard o Averse selection 11 Another reason FIs exist is to reduce the impact of asymmetric information. One party lacks crucial information about another party, impacting decision-making. We usually discuss this problem along two fronts: adverse selection and moral hazard. • Adverse Selection o Before transaction occurs o Potential borrowers most likely to produce adverse outcome are ones most likely to seek a loan o Similar problems occur with insurance where unhealthy people want their known medical problems covered • Moral Hazard o After transaction occurs o Hazard that borrower has incentives to engage in undesirable (immoral) activities making it more likely that won’t pay loan back o Again, with insurance, people may engage in risky activities only after being insured o Another view is a conflict of interest FIs are able to lower the production cost of information by using the information for multiple services: bank accounts, loans, auto insurance, retirement savings, etc. This is called economies of scope. But, providing multiple services may lead to conflicts of interest, perhaps causing one area of the FI to hide or conceal information from another area (or the economy as a whole). This may actually make financial markets less efficient! FIs benefit the overall economy: o Conduit through which Federal Reserve (or European Central bank) conducts monetary policy. Depository institutions, being a main source of exchange, play a fundamental part in determining monetary policy. o Provides efficient credit allocation o Provide for intergenerational wealth transfers o Provide payment services However, which are the RISKS faced by FIs? • Credit risk • Foreign exchange • Country or sovereign risk • Interest rate risk • Market risk (→ especially when the FI holds long-term positions, subject to an asset-price risk) • Off-balance-sheet (→ manage a strong equilibrium between assets and liabilities) • Liquidity • Technology • Operational • Insolvency (→ risk incurred when the FI has not enough capital to offset a sudden loss incurred as a result of one of the previous risks) 12 DIRECT FINANCE: the role of Financial Markets Direct-Indirect: 1. Direct Finance – Borrowers borrow directly from lenders in financial markets by selling financial instruments which are claims on the borrower’s future income or assets 2. Indirect Finance – Borrowers borrow indirectly from lenders via financial intermediaries (established to source both loanable funds and loan opportunities) by issuing financial instruments which are claims on the borrower’s future income or assets Why are financial markets important? Financial markets are critical for producing an efficient allocation of capital, allowing funds to move from people who lack productive investment opportunities to people who have them. Financial markets also improve the well-being of consumers, allowing them to time their purchases better. The function of financial markets. The financial markets represent the so-called direct circuit to transfer the financial resources in the economic system. They represent the place where direct exchanges take place (stocks, bonds, etc.) between lenders (savers) and borrowers (companies, institutions, etc.). The markets therefore have the functions of: • allowing the financing of the people with shortage of funds like the companies (borrowers of funds) • allowing the savings investment of people with surplus of funds (lenders/savers) • pricing (evaluation) of traded instruments (defined by the supply and demand in the financial market) • Facilitating the negotiation of traded instruments • There are also markets dedicated not to the transfer of funds, but to risk negotiation (derivative markets) The direct circuit and the budgets of the operators. In this case, we’re taking out the financial intermediary’s balance sheet. In this case, surplus units and deficit units are directly connected. In the direct circuit, deficit and surplus units meet thanks to the work of some intermediaries. When we talk of direct finance, it’s not completely true that the financial intermediary does not participate in the process. In this case, the financial intermediaries doesn’t take the financial risk in their balance sheet but allow the meeting between the operators in surplus and those in deficit. These are brokers and dealers. They don’t take risk, only collect a commission for the service offered. The broker, for example, may be an individual or a firm that executes buy/sell orders issued by a third. On the other hand, dealers are people or firms who buy and sell securities for their own account, whether through a broker or otherwise. A dealer acts as a principal in trading its own account. They are remunerated through a price spread → they acquire securities in their own account, re-sell securities, and when re-selling apply a price spread. 15 Based on the characteristics of transactions… Retail Market Retail markets include transactions involving modest amounts of financial instruments. A retail market is generally identifiable as such due to the absence of minimum trading quantities or their limited amount. For example: electronic bond market (min. 1000 euros in Italy, aimed at small investors). Wholesale Market In a wholesale market, trades characterized by significant size cuts and the prohibition of trading quantities below a certain threshold (minimum trading lot) take place. For example, relative to the bond markets, for specialized investors there is a segment of the bond market for exchange of bond instruments with a threshold of 2.5 million euros. Based on Negotiation Methods… Auction Market (ORDER DRIVEN) The price is determined by comparing the trading orders (purchase proposals and sale proposals) entered by different operators, which respectively request and offer a specific security. The order driven expression that is associated with the auction markets recalls the fact that in this system the price is determined by the comparison of orders related to a homogeneous set of operators. QUOTE DRIVEN Market It is a market where a subject, generally an intermediary (market maker), acts as a direct counterpart to all the other operators, committing to buy from anyone who wants to sell and sell to anyone who wants to buy, but declaring the prices at which they intend to buy and sell . Given that the price is no longer driven by the orders of the operators but is defined by the market maker that shows the quotations (quotas), the markets of market makers are called quote driven markets. Summarizing, the market with auction mechanism is based on anonymous orders, that compared define the prices. The quote-driven refers to the presence of a specialized financial intermediary defining the prices of instruments. Order and quote driven market: which differences? Compared to order-driven markets, where it is possible to define a single market price, in quote-driven markets the market maker defines different prices for purchases and sales (bid price to buy and ask price to sell, or money and letter). Furthermore, while in an order-driven market operators can indicate in their negotiation proposal the price at which they are willing to buy or sell a particular security, in market maker markets operators can only choose to adhere to the market maker's proposals, where prices are already set by the same market maker. 16 Based on the settlement methods… Settlement of a negotiation means the phase in which the parties to a negotiation, after having found the agreement on the quantity and price at which to exchange a particular security, proceed to transfer the securities against payment of the price. Spot Market These markets are also referred to as "cash market", since trade is settled quickly with respect to the trading day. It is a public financial market in which financial instruments or commodities are traded for immediate delivery (decide the price and transfer the security at the same moment). Forward Market In the forward markets, it is envisaged that, after the agreement, the parties will effectively give place to the exchange at a predetermined future date (term). The characteristic of foreseeing a period of time between the time of the agreement and the time of settlement is typical of derivative financial instruments. This is an over-the-counter marketplace that sets the price of a financial instrument or asset for future delivery → set the price of a transaction that will be done at a future date. Based on the degree of regulation… Regulated Market (or exchange) A market is defined as regulated when there is the figure of a market manager who defines the rules and procedures by which instruments negotiable on the market are selected, defines the requirements that operators must have to be admitted to trading and, in general, defines the rules of operation of the market. Stock exchanges are typical examples of regulated markets. Unregulated Market over the counter (OTC) It accepts all exchanges of securities that take place outside regulated markets (decentralized, unregulated, taking place through phones, emails, etc.). An example of trading outside regulated markets is one in which an investor comes into contact directly with another investor to whom he sells securities. Given that the exchange did not take place on the stock exchange but through direct contact with investors, trading is considered to have taken place on the unregulated market. For example, some particular types of financial derivatives, as interest rate swaps, are traded on unregulated OTC market. The major part of securities are traded in regulated markets, such as NY stock exchange, Borsa Italiana, etc. In the OTC market, dealers are in computer contact. For example, the U.S. government bond market is set up as OTC market: around 40 dealers establish a “market” in these securities by standing ready to buy and sell U.S. government bonds. 17 Question time 4/05 Which are the risks and rewards of investing in the stock market as compared to the bond market? In the stock investments we have more volatility, because your returns depend on the firm’s performance. Moreover, when you own a stock you are a residual claimant, so your interest if the company fails comes after the interest of the bond owners. The dividend, investing in the stock market, is not guaranteed, since it’s the company that decides if the profits would be re-invested in the company or distributed among stock-holders. When you invest in a bond, you are sure that you will receive the coupon: if this doesn’t happen, the company goes in default being not able to repay its loan (bankruptcy). Rewards are different in these two cases: • Stock markets: dividends and capital gains, being the difference in price. • Bond market: coupon (for coupon bonds) and difference in price (capital gain) if we, for example, sell the bond to a higher price than the purchasing price. Moreover, when you invest in the stock market you are an equity owner, so being the owner of a part of the company, while when you invest in the bond market you are a bond holder, since you don’t participate to the capital of the company. Why might you be willing to make a loan to your neighbor by putting funds in a saving account earning a 5% interest rate at the bank and having the bank lend her the fund at a 10% interest rate rather than lend her the funds yourself? In other words, you would get 10% by directly lending the money, or 5% by doing so through an intermediary. 1. Risk: because if your neighbor is insolvent you get the 5% through the intermediary anyways; 2. Contract: even if you can lend money to your neighbor at 10% interest rate, you have to pay legal fees, prepare the contract and conditions, and probably the initial 10% decreases to about 5%. It’s easier for an investor to use the bank deposit at a certain 5%, being sure of the safety of the investment. In order to support firms access to finance and in particular small and medium sized enterprises, many governments developed public credit guarantee schemes (in Italy it is called Fondo Centrale di Garanzia, activated in 2000). These guarantee schemes are also used in the last months to deal with the economic effects of the pandemic. In normal times, do they operate by using a direct or indirect circuit? Which are the reasons of this choice? What is a credit guarantee scheme? Is a public money fund providing guarantee to a company when the company asks for a loan to a bank. Especially for small-medium firms, the bank asks for the so-called “collateral”, being a guarantee. In moments of particular difficulty, this fund is increased since, in general, the credit worthiness of firms decrease and banks have difficulties in providing loans. Therefore, the government decides to increase this power guarantee. The used circuit is the indirect one: the public money are sent through the banking system. This is for initial assessment and eligibility of firms, avoid corruption, but also for credit mitigation, a sort of risk sharing, and avoid moral hazard. 10% of the risk remains in any case to the bank, but the rest is absorbed in the fund. It’s important to avoid a behavior of moral hazard from the bank side: if all the risk was covered by the Fondo Centrale di Garanzia, then the bank would concede loans to every firm. To avoid this, at the maximum the warranty is 90%. For the pandemic, being an emergency situation, this has however increased to 100%. How could the government provide direct finance? By rewarding high-quality projects, funds without repayment, direct loans. However, it has been demonstrated that the indirect circuit is more efficient. 20 • Discounting: When an investor pays less for the security than it will be worth when it matures, and the increase in price provides a return. This is common to short-term securities because they often mature before the issuer can mail out interest checks. T-bills have virtually zero default risk, because even if the government runs out of money it can simply print new money. For European countries is not the same. The risk of an unexpected change in inflation is also low, because of their short term nature. The secondary market for the T-bills is the largest of any U.S money market securities. It is deep, with many buyers and sellers, and very liquid, with low transaction costs. Consequently, T-bills have very low returns, sometimes earnings do not compensate investors for inflation. Federal Funds Fed funds has nothing to do with Federal Government: the term comes from the fact that these funds are held at federal reserve banks, composed of national banks. • Short-term funds transferred (loaned or borrowed) between financial institutions, usually for a period of one day. • Used by banks to meet short-term needs for reserve requirements. Fed fund rates are called “effective rates”. The federal reserve can’t directly control fed fund rates: it can indirectly influence them by adjusting the level of reserve. If the goal is to increase money in financial system, the federal reserve buys securities, so investors sell and put money in reserves and interest rates decrease. On the opposite, to reduce money in the financial system federal reserves sell securities, investors buy and their deposits are reduced, so the interest rates increase. Repurchase agreements • These work similar to the market for fed funds, but non-banks can participate. • A firm sells Treasury securities, but agrees to buy them back at a certain date (usually 3–14 days later) for a certain price. The dealer may sell the security to a bank with the promise to buy the security back. This makes repo essentially a short-term collateralized loan for the bank and short-term investment opportunities for dealers. We talk about: • Overnight repos: one day maturity repos • Term repos: longer maturity Commercial papers • Unsecured promissory notes, issued by corporations, that mature in no more than 270 days. • The use of commercial paper increased significantly in the early 1980s because of the rising cost of bank loans. Because these securities are unsecured, only the largest corporations issue commercial papers. The interest rate reflects the corporation level of risk. More than 60% of commercial papers is sold directly from seller to buyer: there is no strong secondary market. Negotiable Certificates of Deposit • A bank-issued security that documents a deposit and specifies the interest rate and the maturity date, from 1 to 4 months; • Denominations range from $100,000 to $10 million; • It is negotiable in the secondary market. Certificates of deposit are a term securities as opposed to demand deposits: terms securities have a specified maturity date, demand deposits can be withdrawn at any time. 21 Banker’s acceptance • A banker’s acceptance is a time draft payable to a seller of goods, with payment guaranteed by a bank; • Time drafts issued by a bank are orders for the bank to pay a specified amount of money to the bearer of the time draft on a given date. Eurodollars • Eurodollars represent Dollar-denominated deposits held in foreign banks. • The market is essential since many foreign contracts call for payment in U.S. dollars, due to the stability of the dollar relative to other currencies. The Eurobond is “a debt instrument that's denominated in a currency other than the home currency of the country or market in which it is issued. Eurobonds are frequently grouped together by the currency in which they are denominated, such as eurodollar or Euro-yen bonds. Since Eurobonds are issued in an external currency, they're often called external bonds. Eurobonds are important because they help organizations raise capital while having the flexibility to issue them in another currency”1. Eurocurrencies, a variant of Eurobonds, are foreign currencies deposited in banks outside the home market, i.e., held in banks located outside of the country which issues the currency. For example, a deposit of US dollars held in a bank in London, would be considered eurocurrency, as the US dollar is deposited outside of its home market. The Euro- prefix does not refer exclusively to the "euro" currency or the "eurozone", as the term predates the creation of the euro. Instead, it can be applied to any combination of deposits in a foreign bank outside of its home market e.g. a deposit denominated in Japanese yen held in a Swiss bank is a Euroyen deposit2. The most important of the Eurocurrencies are Eurodollars, which are U.S. dollars deposited in foreign banks outside the United States or in foreign branches of U.S. banks. Because these short-term deposits earn interest, they are similar to short-term Eurobonds. American banks borrow Eurodollar deposits from other banks or from their own foreign branches, and Eurodollars are now an important source of funds for American banks. Note that the euro, the currency used by countries in the European Monetary System, can create some confusion about the terms Eurobond, Eurocurrencies, and Eurodollars. A bond denominated in euros is called a Eurobond only if it is sold outside the countries that have adopted the euro. In fact, most Eurobonds are not denominated in euros but are instead denominated in U.S. dollars. Similarly, Eurodollars have nothing to do with euros, but are instead U.S. dollars deposited in banks outside the United States. The Eurodollar market has continued to grow consistently because depositors receive a higher rate of return on a dollar deposit in the Eurodollar market than in the domestic market. Some large London banks act as brokers in the interbank Eurodollar market. Remember that the fed funds are used by banks to make up temporary shortfalls in their reserves. Eurodollars are an alternative. In these markets, different rates are generated: o London interbank bid rate (LIBID) ─ The rate paid by banks buying funds o London interbank offer rate (LIBOR) ─ The rate offered for sale of the funds o Time deposits with fixed maturities ─ Largest short term security in the world 1 https://www.investopedia.com/terms/e/eurobond.asp 2https://en.wikipedia.org/wiki/Eurocurrency#:~:text=Eurocurrency%20is%20currency%20held%20on,outside%20of%2 0its%20home%20market. 22 Comparing Money Market Securities Common characteristics: • Large denominations, low default risk, short maturities • They are quite different in terms of liquidity (secondary market): some money market securities have an excellent secondary market, others have a poor one. In the following figure we can take a look to money market securities outstanding in 1990, 2004, 2007, 2010 and 2013. We observe a strong increase until 2007, and then a large decrease. In 2013, T-bills and certificates of deposits are the most used money market instruments, followed by Fed funds and commercial papers. Interest rates on money market securities (1990- 2013). These change over time, but are very close among different types of money market securities. This depends on the fact that the characteristics of different securities are very similar. 25 The following table summarizes the maturity differences among the various Treasury securities. Federal governments’ notes and bonds are free of default risk. • No default risk since the Treasury can print money to payoff the debt (Is it the same for European countries?) • Very low interest rates since they have no default risk, often considered the risk-free rate (although inflation risk is still present). In the following graph, we can see that investors have found themselves earning less than the rate of inflation in some years. Interest Rate on Treasury Bonds and the Inflation Rate, 1973–2013 (January of each year) The primary market of T-notes and T-bonds is similar to that of T-bills; the U.S. Treasury sells T-notes and T- bonds through competitive and noncompetitive single bid auctions: • 2-year notes are auctioned monthly • 3-, 5-, and 10-year notes are auctioned quarterly (Feb, May, Aug, and Nov) • 30-year bonds are auctioned semi-annually (Feb and Aug) Most secondary trading occurs directly through brokers and dealers. Municipal bonds • Securities issued by local, county, and state governments • Used to finance public interest projects (schools, utilities, etc.) • They are exempt from municipal taxation. We can calculate US Tax-free municipal interest rate = taxable interest rate  (1 − marginal tax rate) There exist two types of municipal bonds: o General obligation bonds (are backed by the full faith and credit of the issuing municipality) o Revenue bonds (are sold to finance specific revenue generating projects) 26 General obligation bonds don’t have specific assets pledged as securities or specific sources of revenues allocated for their repayments, they are backed by the full credit of the issuing municipality. Revenue bonds are specific to finance projects. NOT default-free (e.g., Orange County California experienced default, was not able to repay) . Defaults in 1990 amounted to $1.4 billion in this market. Primary markets • firm commitment underwriting: a public offering of Munis made through an investment bank, where the investment bank guarantees a price for the newly issued bonds by buying the entire issue and then reselling it to the public. • best efforts offering: a public offering in which the investment bank does not guarantee a firm price. • private placement: bonds are sold on a semi-private basis to qualified investors (generally FIs). Secondary markets: Municipals trade infrequently due mainly to a lack of information on bond issuers. 27 The Interest Rates Mishkin and Eakins, “Financial Markets and Institutions” Chapter 3 The introduction to Yield to Maturity Present Value The concept of present value (or present discounted value) is based on the commonsense notion that a dollar of cash flow paid to you one year from now is less valuable to you than a dollar paid to you today. If I pay 100 dollars today, what is the today’s value of this payment? It is 100 dollars. However, if these 100$ have to be paid in one year, their value today has to be calculated (present value analysis). The term present value (PV) can be extended to mean the PV of a single cash flow or the sum of a sequence or group of cash flows. Different debt instruments have very different streams of cash payments to the holder (known as cash flows), with very different timing. Think for example of a corporate bond issued by Unicredit with a face value of 1000 euros. Each 6 months, the bond pays a cash flow (coupon) of 100 euros. Then we have another bond, issued by Intesa San Paolo of face value 1000 euros, that pays each 6 months 500 euros. What is the interest rate of the return of these two investments? For calculating it, I need to apply the present value because these two corporate bonds have different cash payments, although in this case we have the same timing. All else being equal, debt instruments are evaluated against one another based on the amount of each cash flow and the timing of each cash flow. This evaluation, where the analysis of the amount and timing of a debt instrument’s cash flows lead to its yield to maturity or interest rate, is called present value analysis. Which are the cash flows in a bond instrument? We consider the initial price paid when the bond was bought, the coupon (cash payment at certain timing) and the face value, that is the amount of money that the borrower repays to you at the end of the maturity. Moreover, the timing is a fundamental part to be considered in our analysis. The final aim of the present value analysis is to calculate the interest rate of the operation, that we call yield to maturity. There are four basic types of credit instruments which incorporate present value concepts: 1. Simple Loans require payment of one amount which equals the loan principal plus the interest. 2. Fixed-Payment Loans are loans where the loan principal and interest are repaid in several payments, often monthly, in equal dollar/euro amounts over the loan term. An example of fixed payment loans is mortgage: when you subscribe a mortgage you repay every month a part of the principal and the interest rate calculated on your debt. Also called fully-amortized loan. 3. Coupon bond: pays the owner of the bond a fixed interest payment (coupon payment) every year until the maturity date, when a specified final amount (face value or par value) is repaid. 4. Discount bond (Zero coupon bond): is bought at a price below its face value, and the face value is repaid at the maturity date. In this case, there is not a coupon but these bonds are at a price below the face value: the return for the bond holder is given by the difference between the purchasing price and the face value. These four types of instruments require payments at different times: Simple loans and discount bonds make payment only at their maturity dates, whereas fixed-payment loans and coupon bonds have payments periodically until maturity. 30 Discount Bond YTM → One-Year Discount Bond ( P = $900, F = $1000) In this case, the YTM is calculated as in the previous example, as the price paid ($900) equal to the face value of $1000 divided by 1 plus YTM. In this case we have no future cash payments, because in the discount bonds the only component of your return is given by the difference between the price and the face value. Relationship Between Price and Yield to Maturity In this example, we have Yields to Maturity on a 10% Coupon Rate Bond Maturing in 10 Years (Face Value = $1,000). This table presents the price of bonds and the different YTM depending on the price of the bond. Why does YTM depend on the price of the bond? Look for example at the “Coupon Bond YTM” example. Remember that the value of i depends on the price P, the value of each coupon payment, face value and time. Being YTM the interest rate that equates today’s value with present value of all future payments, when the price of the bond changes also YTM changes. If P = 1000, YTM = 10%. Why? Because in this case the return of this investment is given by the coupon rate (10%) and the difference in present value between face value and price, being two components of the return. When the price equals the face value, the only component of the return is given by the coupon rate. Therefore, in this case, the YTM equals the coupon rate. When the price of the bond is lower than the face value, for example $900, the total return of your investment (YTM) depends both from the 10% relative to the coupon bond but also on the difference between the price of the bond and the face value, because the YTM is a return considering that you hold your investment until the maturity, so you can buy this bond for a lower price but you are sure that, at the end of the period, you receive $1000 as repayment. However, if the price of the bond is higher than the face value, for example $1200, the YTM is lower than the coupon rate: because on one side you gain 10% through the coupon, but on the other you lost something given the fact that you paid more than the face value. Three interesting facts: 1. When bond is at par (price = face value), yield equals coupon rate 2. Price and yield are negatively related 3. Yield greater than coupon rate when bond price is below par value (therefore, face value) 31 The distinction between Real and Nominal Interest Rates (book) So far, in our discussion of interest rates, we have ignored the effects of inflation on the cost of borrowing. The interest rate considered so far makes no allowance for inflation and is referred to as the nominal interest rate. We distinguish it from the real interest rate, the interest rate that is adjusted by subtracting expected changes in the price level (inflation) so that it more accurately reflects the true cost of borrowing. This real interest rate is more precisely referred to as: • Ex ante real interest rate → adjusted for expected changes in the price level; • Ex post real interest rate → how well a lender has done in real terms after the fact has happened. → When the real interest rate is low, there are greater incentives to borrow and fewer incentives to lend. The Duration The relationship among Interest Rates and Returns How well a person does by holding a bond or any other security over a particular time period is accurately measured by the return, or rate of return. For any security, the rate of return is defined as the payments to the owner plus the change in its value, expressed as a fraction of its purchase price. However, the return on a bond will not necessarily equal the interest rate on that bond. The return on a bond held from tiem t to time t+1 can be written as: Where R = return from holding the bond from time t to time t + 1, Pt = price of the bond at time t, Pt+1 = price of the bond at time t +1, C = coupon payment. A convenient way to rewrite the return formula is to recognize that it can be split into two separate terms: Where: Where the current yield is the coupon payment over the purchase price, and the rate of capital gain is the change in the bond’s price relative to the initial purchase price. Current yield (CY) is an approximation for YTM - easier to calculate, being equal to the coupon over the price. However, only in some conditions it is a good approximation for YTM. For this reason, we should be aware of its properties: 32 1. If a bond’s price is near par and has a long maturity, then CY is a good approximation. 2. A change in the current yield always signals change in same direction as yield to maturity, but not necessarily with the same magnitude. If the price decreases, for example going to $900, the current yield changes and increases since we have $100/$900 where $100 is the coupon. However, this increase is not necessarily of the same magnitude of the current yield. Yield on a Discount Basis → calculation of the yield when we have a discount bond. In this case, the formula we have to apply is different. We subtract from the face value the price, divide by the face value, and then multiply the result for 360 (convention for an annual period of time) over the number of effective days to maturity. In conclusion, several key findings are generally true for all bonds: • The only bond whose return equals the initial yield to maturity is one whose time to maturity is the same as the holding period; • A rise in interest rates is associated with a fall in bond prices, resulting in capital losses on bonds whose terms to maturity are longer than the holding period. • The more distant a bond’s maturity, the greater the size of the price change associated with an interest-rate change. • The more distant a bond’s maturity, the lower the rate of return that occurs as a result of the increase in the interest rate. • Even though a bond has a substantial initial interest rate, its return can turn out to be negative if interest rates rise. 35 Duration «the average lifetime of a debt security’s streams of payments» Duration is calculated as the average lifetime: we calculate an average at the time of each cash payment (t) weighted for the weight of each cash payment. In the second part of the formula we have the present value of each cash payment divided for the sum of all the cash payments of the bond instruments. But what is the sum of the present value of all the future cash payments of this bond, being the denominator? It is equal to the price of the bond. In other words, we have • the present value of each coupon → 𝐶𝑃𝑡 (1+ⅈ)𝑡 • divided for the price of the bond → ∑ 𝐶𝑃𝑡 (1+ⅈ)𝑡 𝑛 𝑡=1 . This multiplied for each period, then summed we obtain the duration. The term 𝐶𝑃𝑡 (1+ⅈ)𝑡 ∑ 𝐶𝑃𝑡 (1+ⅈ)𝑡 𝑛 𝑡=1 ⁄ is the calculated weight. Example. Calculating Duration on a $1,000 Ten-Year 10% Coupon Bond When Its Interest Rate Is 10%. Each cash payment, being 10% of $1000, is $100. The tenth year, obtain $100 plus the face value. Then we calculate the present value of each cash payment. In column (3) the first number is the present value of the first year: simply, 100 divided by 1 plus 10 % interest rate. The second year, I calculate 100 divided by 1 + 10% raised to two, because is the second year, I have to go back for 2 years to calculate the present value. In (4) we calculate the weight dividing each cash payment in (3) for the sum of the present value of all these cash payments, which is the price of the bond (1000). We make the same calculation for each cash payment. 36 In (5) we calculate the weighted maturity, multiplying the time (for example 1) for the weights calculated in (3) and then divided 100. I do the same thing for each line of this table. The sum of these weighted maturities is our duration, in this case 6.75850. Remember that this is expressed in years, so the duration is 6.75 years. The duration represents how long it takes, in years, for an investor to be repaid of the bond’s price by the bond’s total cash flows. Is the time that you, as investor, need to repay the investment. Higher are the coupons received, shorter is the duration since you receive a part of the investment before the end of maturity. Example. Calculating Duration on a $1,000 Ten-Year 10% Coupon Bond When Its Interest Rate Is 20%. Simply apply i = 20%. The PV in previous example was higher because interest rate was lower. Key facts about duration 1. All else equal, when the maturity of a bond lengthens, the duration rises as well; 2. All else equal, when interest rates rise, the duration of a coupon bond fall; 3. The higher the coupon rate on the bond, the shorter the duration of the bond; 4. Duration is additive: the duration of a portfolio of securities is the weighted-average of the durations of the individual securities, with the weights equaling the proportion of the portfolio invested in each security. 37 Duration and Interest-Rate Risk How can we use duration to measure the interest-rate risk? The variation in price of a bond equals minus duration multiplied by the change in interest rate divided by 1 + initial interest rate. Therefore, when the interest rate increases of 1%, the price decreases by 6.15%. This is the difference between price at t + 1 and price at time t. We must calculate this number to obtain the effective price decrease. This means that, to find the new price, we have to multiply -6.15% by the initial price to obtain the effective price decrease (effective change) of this bond. To conclude: • The greater the duration of a security, the greater the percentage change in the market value of the security for a given change in interest rates; • Therefore, the greater the duration of a security, the greater its interest-rate risk. Then, to calculate the specific impact, we have to apply the formula. 40 The Bond Markets Mishkin and Eakins, “Financial Markets and Institutions” Chapter 12 Corporate Bonds Corporate bonds are long-term obligations issued by corporations. • Typically have a face value of $1,000, although some have a face value of $5,000 or $10,000; • Pay interest semi-annually; • Cannot be redeemed anytime the issuer wishes, unless a specific clause states this (call option); • Degree of risk varies with each bond, even from the same issuer. Following suite, the required interest rate varies with level of risk. Primary and secondary markets for corporate bonds: • Primary markets are identical to that of Municipal that we described previously; • Secondary markets o the exchange market (e.g., bond division of the NYSE) o the over-the-counter (OTC) market At one time bonds were sold with attached coupons that owners of bond clipped and made to the firm to receive interest payments. These were called “bearer bonds” because payments were made to whoever had physical possession of the bond. These are now replaced by Registered Bonds: owners must register to the firm to receive interest payments. • Registered Bonds → Replaced “bearer” bonds Since bond holders can’t look to managers for protection when the firm is in trouble, they must include rules and restrictions to protect the bond-holder interests. These are called Restrictive Covenants. • Restrictive Covenants o Mitigates conflicts with shareholder interests o May limit dividends, new debt, ratios, etc. Most corporations include a call provision, which states that the issuer has the right to force the holder to sell the bond back. The call provision usually requires a time period between the time the bond is initially issued and the time when it can be called. The price bond-holders pay for the bond is usually set at the bond pair price or slightly higher. Call Provision is also a mechanism to adhere to a sinking fund provision. Sinking fund is a requirement that the firm pays off a portion of the bond issue each year. This reduces risk of default. A third reason is to pursue the interests of stockholders: suppose that a firm needed to buy additional funds to expand its storage facilities. If the firm’s bond carried a restriction about adding debt, the firm would have to retire its existing bond before issuing new bonds. Finally, a firm may decide to retire its existing bond to modify its capital structure. • Call Provisions o Higher required yield o Mechanism to adhere to a sinking fund provision o Interest of the stockholders o Alternative opportunities Some debt may be converted to equity. They are similar to a stock option, but usually more limited. Most convertible bond state that the bond can be converted into a certain number of common shares, at the discretion of the bond holders. 41 • Conversion o Some debt may be converted to equity o Similar to a stock option, but usually more limited A variety of corporate bonds available are usually distinguished by the type of collateral that secures the bond and by the order which the bond is paid off if the firm defaults. • Secured Bonds → with collateral attached. o Mortgage bonds, used to finance specific projects; o Equipment trust certificates, secured by tangible not-real estate properties, such as airplanes or equipment. • Unsecured Bonds o Debentures → long-term unsecured debt instrument, Since debentures have no collateral backing, debentures must rely on the creditworthiness and reputation of the issuer for support. Both corporations and governments frequently issue debentures to raise capital or funds. o Subordinated debentures, similar to debentures but have a lower priority to claim. These bondholders are paid only after not subordinated bondholders. o Variable-rate bonds, interest rate is linked to other market interest rates, such as the rate of treasury bonds. Bond rating All bonds are rated by various companies according to their default risk. The three major bond 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 (i.e., junk) grade. A bond with a rating AAA has the highest possible. Those equal or above Standard & Poor’s BBB (or Moody’s BAA) are considered investment grade. Those below, speculative or junk bonds. • Junk Bonds o Debt that is rated below Standard & Poor’s BBB (or Moody’s BAA) o Often, trusts and insurance companies are not permitted to invest in junk debt Summary of the bond’s credit rating: 42 The degree of risk ranges from low-risk (AAA) to higher risk (BBB). Any bonds rated below BBB are considered sub-investment grade debt. BBB bonds bear higher interest rates to compensate their risk. Corporate Bond Interest Rates, 1973–2012 (End of year) Bond market participants • The major issuers of debt market securities are federal, state and local governments, and corporations; • The major purchasers of capital market securities are households, businesses, government units, and foreign investors. 45 Bond Terminology Bond pricing is, in theory, no different than pricing any set of known cash flows. Once the cash flows have been identified, they should be discounted to time zero at an appropriate discount rate. Let’s use a simple example to illustrate the bond pricing idea. What is the price of two-year, 10% coupon bond (semiannual coupon payments) with a face value of $1,000 and a required rate of 12%? Solution: 1. Identify the cash flows: o $50 is received every six months in interest (because the payment is semiannual! Remember that the coupon rate is always expressed on an annual basis, so if you have a semiannual payment you need to divide by two your coupon rate). o $1000 is received in two years as principal repayment (face value). 2. Find the present value of the cash flows (calculator solution). Note that we have 4 periods, since each period is a semester. o N = 4, FV = 1000, C = 50, i = 6% o Compute the PV. PV = 965.35 The equation we have to solve is the following: For each period we have a cash payment (50), divided for 1 + discount rate, raised for the number of semester identifying the time period. The last period we add also the face value in denominator. Annual, semi-annual payments. → (similar) 46 This example can be easily computed in excel: We divided the interest rate on a semiannual basis, so we don’t have problems in denoting periods as 1, 2, 3 and 4. We have the cash payment for each period. For each cash payment we consider the denominator (1 + i)^t. Then, the PV for each cash payment is obtained as the amount of each cash payment divided by (1 + i)^t. The sum of present values of all cash payments, being 965.35, is the current price of this bond. We can calculate the duration by adding these two columns: The investor will recover its investment in 3.71 semesters. To get the duration on an annual basis, we have to divide 3.71 by 2. Therefore, 1.85 years. Why not in 2 years as the maturity period? Thanks to the coupon payments. We can use this information to calculate the impact of a change in interest rate on the price. Remember that minus duration multiplied by the change in interest rate give us a measure of the effect of a change in interest rate on the bond’s price. 47 The accrued interest Investing in Bonds. Bonds are the most popular alternative to stocks for long-term investing. In the following figure, we can observe the amount issued in terms of bonds and stocks. From 1993 to 2012, there are relevant differences in terms of amounts, being amount of bonds really high in comparison. Even though the bonds of a corporation are less risky than its equity, investors still have risk: price risk and interest rate risk. Exercise. Suppose there are two bonds you are considering: a. If both bonds had a required rate of return of 10%, what would the bonds’ prices be? b. Explain what it means when a bond is selling at a discount, a premium, or at its face amount (par value). Based on results in (a) would you consider both bonds to be selling at a discount, premium, or at par? c. Re-calculate the prices of the bonds if the required return falls to 9%? To solve (a), we need to calculate the present value of each bond, considering the PV of each cash payment. For example, on excel: And so on. Note that we have semiannual payments, so each time (t) is referred to a semester and we have to consider half of the coupon rate for each semester. In fact, each payment for Bond A is equal to 60, being 6% of the face value of $1000 (or $120 coupon divided by 2). Our discount rate is 0.05 (10%, divided by 2). 50 The Stock Markets Mishkin and Eakins, “Financial Markets and Institutions” Chapter 13 Definition and functioning In August of 2004, Google went public, auctioning its shares in an unusual IPO format. The shares originally sold for $85 / share and closed at over $100 on the first day. At the end of 2012, shares are trading on Nasdaq at over $707 / share. Today, the value is about $846 / share. Recall that, when we talk about financial markets, we distinguish between primary and secondary markets: • Primary stock markets allow suppliers of funds to raise equity capital; • Secondary stock markets are the most closely watched and reported of all financial markets. The NY Stock Exchange and NASDAQ are secondary markets. Stockholders are the legal owners of a corporation consistent with the percentage of stock held. A share of stock in a firm represents ownership. Investors can earn return from stocks in two different ways: either the price of the stock rises over time, or the firm pays dividends. Stocks are riskier than bonds, since stockholders have lower priority than bondholders when the firm is in trouble: dividends are less assured and stock prices increases are not guaranteed. Despite this risk, the amount of earnings can be very high, whereas it is very unlikely to earn so much when investing in bonds. Another distinction between stocks and bonds is that stocks do not mature. Stockholders: • have a right to share in the firm’s profits (e.g., through dividends); • are residual claimants, in other words have the right to all the residual income left over when all other claimants have been satisfied; • have limited liability; • have voting rights (e.g., to elect board of directors, whether new shares should be issued). There are two types of stock: common stock and preferred stock. → Common stock is the fundamental ownership claim in a public or private corporation. Dividends are discretionary and are thus not guaranteed. Common stockholders have the lowest priority claim in the event of bankruptcy (i.e., a residual claim). Only after all senior claims have been satisfied, the common stockholders are entitled to what assets are left. Senior claimers are, for example: former employees, bondholders, government taxes, preferred stockholders. One of the most important characteristics is that of limited liability. Limited liability implies that common stockholders can lose no more than their original investment. Common stockholders control the firm’s activities indirectly by exercising their voting rights in the election of the board of directors. The typical voting rights arrangement is to assign one vote per share of common stocks. However, some corporations are organized as dual-class firms. Dual-class firms have two classes of common shares outstanding, with different voting rights assigned to each class. Two methods are usually used: cumulative voting and straight voting. • With cumulative voting, the number of votes assigned to each stockholder equals the number of shares held multiplied by the number of directors to be elected. These votes can be concentrated or spread. This voting procedure permits minority stockholders to have some real say on the choice of directors. • With straight voting: the votes on the board of directors occur one director at a time. The number of votes eligible for each director is the number of shares standing. This means that a majority owner with say 50% of total shares can elect the entire board of directors. 51 → Preferred stock is a hybrid security that has characteristics of both bonds and common stock. • Generally has fixed dividends that are paid quarterly; • Generally does not have voting rights unless dividend payments are missed. Less than 25% of new equity issues are preferred stock, and only about 5% of all capital is raised using preferred stock. This may be because preferred dividends are not tax-deductible to the firm but bond interest payments are. Consequently, issuing preferred stock usually costs the firm more than issuing debt, even though it shares many of the characteristics of a bond. We can have nonparticipating versus participating preferred stocks: • Nonparticipating means that the preferred stock dividend is fixed regardless of any increase or decrease in the issuing firm’s profits; • Participating means that actual dividends paid in any year may be greater than the promised divided. Then, we can have cumulative versus noncumulative preferred stocks: • If a preferred stock is noncumulative, missed dividends do not go into array and are never paid. These are an attractive for investors, since usually have some special features, for example voting rights. Stock Market Value. The market value, as we can see, reached a peak in 2007 and then, after the crisis, decreased dramatically in 2009. However, in 2013 became higher than the pre-crisis period. Different Types of Stock Markets Primary Markets Primary markets are markets in which corporations raise funds through new issues of stock, most of the time through investment banks. Like the primary sale of bonds, the investment bank can conduct a primary market sale of stock using a firm commitment underwriting or a best effort underwriting. • Investment banks act as distribution agents in best efforts underwriting. The underwriter does not guarantee a price to the issuer, but acts as distribution agent obtaining a fee. • Investment banks act as principals in firm commitment underwriting. The investment bank guarantee the corporations a price for the newly issued securities, by buying the whole issue at a fixed price for the corporate issuer. The investment bank purchase the stocks for a fixed price called net proceeds and resell it to investors to a higher price, called gross proceeds. The difference between these two is compensation for the expenses and risk incurred by the investment bank, called underwriter’s spread. gross proceeds – net proceeds = underwriter’s spread 52 A syndicate is a group of investment banks working in concert to issue stock; the lead underwriter is the originating house. • An initial public offering (IPO) is the first public issue of financial instruments by a firm. • A seasoned offering is the sale of additional securities by a firm whose securities are already publicly traded. o preemptive rights give existing stockholders the ability to maintain their proportional ownership. This means that before a seasoned offering of stocks can be sold to outsiders, the new share must first be offered to initial shareholders so that they can maintain the proportional ownership in corporation. Secondary Markets Secondary stock markets are the markets in which stocks, once issued, are traded among investors. The U.S. has several major stock markets: o the New York Stock Exchange Euronext (NYSE/Euronext) o the National Association of Securities Dealers Automated Quotation (NASDAQ) o Bats/Direct Edge (former ECNs) Once a transaction occurs in a secondary market, the exchange happens usually through a security broker or firm as intermediary between the buyer and seller of stocks. Secondary markets could be organized exchanges or over-the-counter markets. → Organized exchanges NYSE is best known, with daily volume around 4 billion shares, with peaks at 7 billion. “Organized” used to imply a specific trading location. But computer systems (ECNs) have replaced this idea. Others include the Nikkei (Tokyo), LSE (London Stock Exchange), DAX (international). Listing requirements exclude small firms. To have a stock listed for trading on one of the organized exchanges, a firm must file an application and meet certain criteria set by the exchange designed to enhance trading. → Over-the-counter markets Securities not sold in the organized stock exchanges, such as the NYSE, are traded over-the-counter. OTC markets don’t have a physical trading floor, transations are concluded through electronic markets. Best example is NASDAQ, which is primarly a dealer market, where dealers are market makers and stand ready to make a market buying and selling securities. Today, about 3,000 different securities are listed on NASDAQ. It is an important market for thinly-traded securities—securities that don’t trade very often. Without a dealer ready to make a market, the equity would be difficult to trade. NYSE Euronext Example of organized exchange. Trading occurs at a specific place on the floor of the exchange called a trading post. Each stock has a special market maker called a specialist or Designated Market Maker (DMM) that maintains liquidity for the stock at all times. Three types of transactions occur at trading posts • a market order is an order to transact at the best price available when the order reaches the trading post; • a limit order is an order to transact at a specified price. The transaction is made only if the current price is near to the limit price; • specialists transact for their own account. 55 Finding the value of Stocks Investing in Stocks. Let’s recall some characteristics of stocks: 1. Represents ownership in a firm. A stockholder owns a portion of a firm defined by the percentage of outstanding stock held. 2. Investors can earn a return in two ways (frequently from both): • Price of the stock rises over time; • Dividends are paid to the stockholder. 3. Stockholders have claim on all assets (residual claimants). 4. Right to vote for directors and on certain issues. 5. Two types: • Common stocks - Right to vote; - Receive dividends. • Preferred stocks - Receive a fixed dividend (relatively stable price); - Do not usually vote; - Hold a claim on assets that has a priority respect to common stocks, but after creditors as bondholders. Computing the price of Common Stocks Valuing common stock is, in theory, no different from valuing debt securities: • determine the cash flows, • discount them to the present. Generally however, valuing stocks is more difficult than valuing bonds, because to determine stock cash flows is not easy: we are not sure about the amount of dividends for each year, or about the exact selling price for our stock, and don’t know the exact date at which we will sell the stock on the market → higher uncertainty than bond evaluation. We will review different methods for valuing stock, each with its advantages and drawbacks. The simplest model we can use is the one-period valuation model. The one-period valuation model Simplest model, just taking using the expected dividend and price over the next year. We consider only one period and we use in the evaluation expected divided and expected price over the next year. So, price at time 0 is the discounted value of the divided at time 1 and the present value of the price expected for the next year. Also in this case, the discount factor is 1 + discount rate, remember that the discount rate is the return expected by request by investors that invest in similar instruments (similar level of risk). Where P0 = the current price of the stock. The zero subscript refers to time period zero, or the present. Div1 = the dividend paid at the end of year 1. ke = the required return on investments in equity. P1 = the price at the end of the first period. This is the assumed sales price of the stock. What is the price for a stock with an expected dividend and price next year of $0.16 and $60, respectively? Use a 12% discount rate. 56 Based on your analysis, you find that the stock is worth $53.71. Since the stock is currently available for $50 per share, you would choose to buy it. Why is the stock selling for less than $53.71? It may be because other investors place a different risk on the cash flows or estimate the cash flows to be less than you do. The Generalized Dividend Valuation Model When investing in stocks, however, the holding period should be a long-term period, not only one year. The one period dividend valuation model can be extended to any number of periods. Today’s price equals the sum of present values of dividends for each year of holding, plus the present value of the final price (selling price). For a long time period, although it’s easier to estimate dividends, is really difficult to estimate the selling price. This is however not a problem: if we have a very long period, the present value of selling price is very small and we can also decide not to consider the final price in our evaluation. What is the PV of a share of stock sells for 50$, 75 years from now using a 12% discount rate. 50$/(1.12)^75=0.01$. → This means that the current value of a share of stock can be found as simply the present value of future dividend stream, without considering the selling price. Most general model, but the infinite sum may not converge. Rather than worry about computational problems, we use a simpler version, known as the Gordon growth model. The Gordon Growth Model Same as the previous model, but it assumes that dividend grow at a constant rate, g. That is, Where D0 = the most recent dividend paid, g = the expected constant growth rate in dividends, ke = the required return on an investment in equity. We can calculate the current stock price considering only the divided at time 1, the discount rate and a constant growth rate for dividends in the long run. Without estimating each dividend for each year. 57 The model is useful, with the following assumptions: 1. Dividends are assumed to continue growing at a constant rate forever. Actually, as long as they are expected to grow at a constant rate for an extended period of time (even if not forever), the model should yield reasonable results. This is because errors about distant cash flows become small when discounted to the present. 2. The growth rate is assumed to be less than the required return on equity, 𝑘𝑒 (being the discounted rate applied). Myron Gordon, in his development of the model, demonstrated that this is a reasonable assumption. In theory, if the growth rate were faster than the rate demanded by holders of the firm’s equity, in the long run the firm would grow impossibly large. There is another method that we can apply when other methodologies are difficult to apply. For example, if a firm is not paying dividends, or erratic and unpredictable dividends, we can’t apply the Gordon Growth Model. The Price Earnings Ratio The price earnings ratio (PE) is a widely watched measure of how much the market is willing to pay for $1.00 of earnings from the firms. The price of the stock is given by: E = expected earnings per share Firms in the same industry are expected to have similar PE ratios in the long run. The value of a firm’s stock can be found by multiplying the average industry PE for the expected earnings per share of a specific firm. A high PE has two interpretations: 1. A higher-than-average PE may mean that the market expects earnings to rise in the future. This would return the PE to a more normal level. 2. A high PE may alternatively indicate that the market feels the firm’s earnings are very low risk and is therefore willing to pay a premium for them. If the industry PE ratio for a firm is 16, what is the current stock price for a firm with earnings for $1.13 / share? → Price = 16 × $1.13 = $18.08 The current stock price should be 18.08$. If on the market the price is $15, for example, probably this stock is underestimated and in the future, if our estimation is correct, the price will probably rise and it’s a good opportunity of investment. If, on the other hand, on the market the price is $20, probably this stock is now overestimated and in the future the price will decrease. All these forecasting are correct if the assumptions are respected. 60 • short position: an asset which must be delivered to a third party as a future date, or an asset which is borrowed and sold, but must be replaced in the future. In the future, you will have to buy this asset, and don’t know the future price. Hedging risk involves engaging in a financial transaction that offsets a long position by taking an additional short position, or offsets a short position by taking an additional long position. For example, if you have a stock portfolio of assets, you have a long position: the risk is that price decreases in the future. If a financial institution has bought a security and has therefore taken a long position, it conducts a hedge by contracting to sell that security (take a short position) at some future date. Alternatively, if it has taken a short position by selling a security that it needs to deliver at a future date, then it conducts a hedge by contracting to buy that security (take a long position) at a future date. How can you hedge? You can have an opposite position, so you can offset a long position by taking an additional short position, which could be selling the hazards at some future date. You fix today the selling price of your assets, and in this way you eliminate the price risk of your investments. Another example: you have taken a short position selling a security that you need to deliver at the future date, you can hedge your short position by adding a long position. Forward Markets Forward contracts are agreements by two parties to engage in a financial transaction at a future point in time. Although the contract can be written however the parties want, the contract usually includes: • The exact assets to be delivered by one party, including the location of delivery; • The price paid for the assets by the other party; • The date when the assets and cash will be exchange. We focus on forward contracts being linked only to debt instruments and call interest-rates forward contracts those forward contracts in which is involved the future sale or future purchase of a debt instrument. Interest-Rate Forward Contract (forward contracts linked to debt instruments): 1. Debt instrument that can be delivered (specification of exact asset); 2. Amount of debt instruments; 3. Price (expressed in interest rates) of the bond; 4. Date of delivery. An example: First National Bank agrees to deliver $5 million in face value of 6% Treasury bonds maturing in 2032. On the other side, Rock Solid Insurance Company agrees to pay $5 million for the bonds. FNB (the seller) and Rock Solid (the buyer) agree to complete the transaction one year from today at the FNB headquarters in town. We can suppose that FNB had these bonds in its portfolio, therefore held these bonds in the past, and therefore is exposed to an interest rate risk: if interest rates in the future increase, the price of the bonds decreases. Therefore, in the spot portfolio the FNB has a long position. To hedge this long position, the FNB has to add a short position for the same bond with a forward contract. And for this reason perhaps it agrees to sell this bond at a future date, with the forward contract. Entering in this contract, FNB has eliminated the interest rate risk. We can suppose that Rock Solid will receive 5 million dollars as a premium, and therefore will have these to invest in this bond (decides to wait one year, by fixing the interest rate). We can define the two different positions: 61 • Long Position (Rock Solid Insurance Company) o Agree to buy securities at future date; o Hedges by locking in future interest rate of funds coming in future, avoiding rate decreases • Short Position (FNB) o Agree to sell securities at future date o Hedges by reducing price risk from increases in interest rates if holding bonds (which is what we supposed before). First National Bank owns $5 million of T-bonds that mature in 2032. Because these are long-term bonds, you are exposed to interest-rate risk. How do you hedge this risk? Enter into a forward contract with Rock Solid Insurance company, where Rock Solid agrees to buy the bonds for $5m. • First National Bank is hedged against interest-rate increases; • Rock Solid, on the other hand, has protected itself against rate declines; • Both parties can gain or lose, since we don’t know which way rates will actually go in one year. Forward Contracts: Pros & Cons Pros Cons 1. Flexible: forward contracts are not standardized, so the parties can decide how to build their contract. 1. Lack of liquidity: hard to find a counter-party and thin or non-existent secondary market. The flexibility of the contract sometimes makes it impossible to conclude at the desired price and find a counter-party. 2. Subject to default risk: requires information to screen good from bad risk. Suppose that in one year the interest rate increases, so the price decreases. The buyer, for example in previous example, could decide to default the forward contract because the cost is too high (and buying directly the contract on the market at a lower price is more convenient). Expensive processes in national courts. 62 Financial futures markets Financial futures contracts are similar to forward contracts in that they are an agreement by two parties to engage in a financial transaction at a future point in time. However, they differ from forward contracts in several significant ways that overcome some of the liquidity and default problems of forward markets. Their main characteristics are: • Specifies delivery of type of security at future date; • i ↑, long contract has loss, short contract has profit; • Hedging similar to forwards; • Traded on Exchanges. An example: • Underlying asset: Treasury bond Face Value $100.000. • One party decides to sell one $100.000 June future contract at a price of 115 ($115.000). The seller agrees to deliver 100.000 face value for $115.000. • Another to buy one $100.000 June future contract at a price of 115 ($115.000). You agree to buy 100.000 face value for $115.000. Payoff for buyer and seller: On the y axis we have profit and loss, on the horizontal axis we have the T-bond price at a future date. Remember that with this future contract the buyer and seller agreed to buy and sell respectively the T-bonds at the price of $115. If at a future date the interest rate on the market changes and the price of the bond changes buyer and seller could have profit or losses. An example: if the interest rates on the market decrease from 6% to 4%, the new price of the T-bonds on the market will be equal to 120. This means that the buyer must buy, on the base of the future contract, the T- bonds at the price of 115. But the real price the market price for these T-bonds is 120, so this means that the buyer has a profit. For the sender this represents a loss, since s/he has subscribed this future contract and the price has now decreased. If interest rates increase (from 6% to 8%) the Tbond price decreases (from 115 to 110). The buyer has a loss, and the seller has a profit equal to +500. 65 Margins example The 5 August 2016 a trader sells 2 FTSE/Mib future contracts: price 27,865. The position is closed the 7 August 2016. The margin requirement is the 7.75% of the value of each contract (1 point of future price = 5 euros). Compute the margin requirement and the marked to market: 05/08/16 (transaction price) 05/08/16 (settlement price) 06/08/16 07/08/16 27,865 27,845 27,890 27,895 Margins example (5 is the value of one index point, while 2 because you sell two contracts). The initial marginal requirement is: Everyday the margin mechanism defines the marked to market. At the end of the first day, we consider the settlement price. The delta is negative, since the price of the future decreases from the transaction price to the settlement price. To calculate the marked to market for the 5/08: compute the delta future price in index point (-20), multiply for the value of each index point, for 2 because we manage 2 future contracts. Why is it positive (+200)? Because you are the seller, and if the price of the future decreases you obtain a profit since you can sell your contracts at a higher price compared to the price in the market. The opposite happens for 06/08, the seller experiences a loss. This happens every day and modifies the amount of money in your account. Leverage Effect Another important aspect relative to financial derivatives, and in particular to future contracts, is the leverage effects. It is the possibility to carry out an investment, which concerns a high amount of financial resources, with a limited use of capital. → Main economic advantage: the multiplication of the performance of the investment; less the initial margin with respect to the contract value, the greater will be the lever effect. Leverage = Contract value/Margin Where the margin represents the amount of money actually deposited (invested) in the future contract at the beginning of the investment. 66 For example: • An investor buys a XY future contract; price 33. (1 point=100 euro) • Margin requirement 272,25 Euro (33*100*8,25%). • The value of the contract is 3.300 Euro (33*100), but the investor deposits only 272,25 Euro; • After 1 day future contract price 34 (profit 100 euro, one index point). Stock Index Futures Financial institution managers, particularly those that manage mutual funds, pension funds, and insurance companies, also need to assess their stock market risk, the risk that occurs due to fluctuations in equity market prices. One instrument to hedge this risk is stock index futures. Stock index futures are contracts to buy or sell a particular stock index, starting at a given level. Contracts exist for most major indexes, including the S&P 500, Dow Jones Industrials, Russell 2000, etc. The “best” stock futures contract to use is generally determined by the highest correlation between returns to a portfolio and returns to a particular index. Example of portfolio Hedging → Rock Solid has a stock portfolio worth $100 million, which tracks closely with the S&P 500. The portfolio manager fears that a decline is coming and what to completely hedge the value of the portfolio over the next year. If the S&P is currently at 1,000, how is this accomplished? • Value of the S&P 500 Futures Contract = 250 × index o currently 250 × 1,000 = $250,000 • To hedge $100 million of stocks that move 1 for 1 (perfect correlation) with S&P currently selling at 1000, you would: o sell $100 million of index futures = 400 contracts • Suppose after the year, the S&P 500 is at 900 and the portfolio is worth $90 million o futures position is up $10 million • If instead, the S&P 500 is at 1100 and the portfolio is worth $110 million. o futures position is down $10 million • Either way, net position is $100 million Note that the portfolio is protected from downside risk, the risk that the value in the portfolio will fall. However, to accomplish this, the manager has also eliminated any upside potential. Now we will examine a hedging strategy that protects again downside risk, but does not sacrifice the upside. Of course, this comes at a price! 67 Options Options are contracts that give the purchaser the right to buy (call option) or sell (put option) an instrument at the exercise (strike) price up until expiration date (American) or on expiration date (European). The seller of the option is obligated to sell or buy if the purchaser exercises the right. The buyer can also decide not to exercise the option, letting the option expire. To have this option, the buyer has to pay a premium. On the base of the expiration date, we have two types of options: • American option: the buyer can exercise at any time the option, up to the expiration date; • European option: the buyer can exercise the option only at the expiration date. Options are available on a number of financial instruments, including individual stocks, stock indexes, futures, etc. We have the two main contracts, call and put, which can be summarized as follows: Common aspects: strike price, premium. Hedging with Options: • Buy same number of put option contracts as would sell of futures, in order for example to offset a long position; • Disadvantage: pay premium; • Advantage: protected if i increases, gain on contract; • if i falls, additional advantage if macro hedge: avoids accounting problems, no losses on option. Options vs. Futures → Profits and losses on options vs. futures contracts. 70 However, in between these two possibilities for both companies, there may be a Swaps Bank helping both. Assume that the swaps bank advices the two clients, telling Company A to accept the fixed 7% rate and Company B to accept the variable LIBOR + 1% rate. How can a swap bank give them the rate they want? We will identify two swaps: the bank will help the two, and still make some money in the middle, with an evaluation of risk on each side. A swap is just “changing one thing for another”, in this case interest rates. • To Company B, the Swaps bank proposes: o We pay you LIBOR; o You pay us 8.5% fixed. • To Company A, the Swaps bank proposes: o We give you 8% fixed; o You pay us LIBOR. This is just an agreement to swap the interest rate on what’s called a notional amount of 5 million. There are no new cash changing hands, no 5 million going bank and forth. Every 6 months, the Swaps bank will swap the difference with Company B between LIBOR and 8.5% on 5 million, and same with Company A on their agreed swap. First of all, the Swaps Bank is making money: it receives 8.5% from Company B and pays 8% to Company A, receives LIBOR from Company A and pays LIBOR to Company B, both on 5 million. Basically, whatever LIBOR is, the Swaps bank is making 0.5% as profit, provided Companies keep paying. Are the Companies happy? • Company B wanted to pay the lowest possible fixed rate. The Bank B offered 10%, while with the swap basically LIBOR cancels, leaving just +1%. Therefore what Company B is actually paying, through a combination between Bank B and the Swaps Bank, 8.5% + 1% or 9.5% fixed. This may seem not much, but over 5 million, say over 10 years, that’s worth having. • Company A always wanted to pay the lowest possible variable rate. Bank A offered the LIBOR rate. As a result of the swap, paying LIBOR but receiving 8% while paying 7% (fixed in both cases) gives a fixed 1% saving on 5 million. Company A is now paying LIBOR – 1% for the whole term of the loan. Ultimately, Company A is paying a variable rate of interest which is lower than the proposed LIBOR. 71 It works because of comparative advantage. What the Swap bank knows, because it knows both clients, is that they can borrow at different terms, depending on their credit history and many other factors just as people with mortgages and loans. The ability of Swaps banks is to spot the gap. However, there is some risk. The Swaps bank needs to be quite sure that both clients are able to meet their obligations under the Swap and will need to take some securities, it’s called collateral. How does this help the retail market? Swaps banks help to bring down borrowing costs for everybody, not just for companies but also on mortgages. However, my mortgage as a normal person is probably not worth enough for a Swaps bank to make some profit, may be expensive. The existence of swaps is one of the reasons why mortgages interest rates are potentially higher than would otherwise be. 72 Mutual Fund Industry Suppose you wanted to start savings for retirement, but you can only afford to invest $100 / month. How do you develop a diversified portfolio? Mutual funds are one potential answer. Mutual funds pool the resources of many small investors by selling them shares and using the proceeds to buy securities. The manager creates the mutual fund portfolio by pooling all the resources together. There are five principal benefits of mutual funds: 1. Liquidity intermediation: investors can quickly convert investments into cash. If you buy a CoD and you need your funds before the maturity, you have transaction costs (early redemption fees) and you have to disinvest all the initial investment. For mutual funds, you can disinvest whenever you want and, if you invest short-term funds, you usually have no redemption fees (may exist for long- term); 2. Denomination intermediation: investors can participate in equity and debt offerings that, individually, require more capital than they possess. Small investors can invest in mutual funds that invest in turn in the money market, which to be accessed by them as individuals would require much more capital. 3. Diversification: investors immediately realize the benefits of diversification even for small investments. All the money collected are invested in different geographical areas, different durations, etc. Therefore, the investor’s share represents a part of this diversified portfolio. 4. Cost advantages: the mutual fund can negotiate lower transaction fees than would be available to the individual investor. 5. Managerial expertise: many investors prefer to rely on professional money managers to select their investments. Total Industry Net Assets, Number of Funds, and Number of Shareholder Accounts: Observe that the industry has grown very rapidly: note in fact the difference in net assets between 1970 and 2006. In terms of number of funds, in 1980 we had 564 funds, and in 2006 we had 8117. Same increase for the number of accounts. 75 → Bond Funds. We can have different types: • Strategic Income Funds invest primarily in U.S. corporate bonds, seeking a high level of current income. • Government Bond Funds invest in U.S. Treasury, as well as state and local government bonds. • Others include World Bond Funds, etc. The next figure shows the distribution of assets among the bond fund classifications. → Hybrid Funds combine stocks and bonds into a single fund. They account for about 5% of all mutual fund accounts. → Money Market Mutual Funds are open-end funds that invest only in money market securities. They offer check-writing privileges (checks without fees), and their net assets have grown dramatically, as seen in the next graph. 76 Although money market mutual funds offer higher returns than bank deposits, the funds are not federally insured. The chart shows the distribution of assets in Money Market Mutual Funds, which are relatively safe assets. So, where do MMMF invest? → Index Funds. It’s a special class of mutual funds that do fit into any of the categories discussed so far. The fund contains the stock of the index it is mimicking. For example, an S&P 500 index fund would hold the equities comprising the S&P 500. Offers benefits of traditional mutual funds without the fees of the professional money manager. In 2013 there were 373 index funds managing ~ $1.3 trillion: • index funds are funds in which managers buy securities in proportions similar to those included in a specified major index; • index funds involve little research or management, which results in lower management fees and higher returns than actively managed funds. Exchange traded funds (ETFs) are also designed to replicate market indexes: • traded on exchanges at prices determined by the market; • management fees are lower than actively traded funds; • unlike index funds, ETFs can be traded during the day, sold short, and purchased on margin. Fee Structure of Investment Funds On the base of the fee structure, we can have different types of funds: • Load funds (class A shares) charge an upfront fee for buying the shares. No-load funds do not charge this fee. • Deferred load (class B shares) funds charge a fee when the shares are redeemed. • If the particular fund charges no front or back end fees, it is referred to as class C shares. Other fees charges by mutual funds include: • contingent deferred sales charge: a back end fee that may disappear altogether after a specific period. • redemption fee: another name for a back end load • exchange fee: a fee (usually low) for transferring money between funds in the same family. • account maintenance fee: charges if the account balance is too low. • 12b-1 fee: fee to pay marketing, advertising, and commissions. 77 Average annual fees and expenses paid by mutual fund investors: These expenses have continued to fall due to investor knowledge and competition with index funds and ETFs. Hedge Funds A special type of mutual fund that received considerable attention following the collapse of Long Term Capital Management. Different from typical mutual funds, as follows: • High minimum investment, averaging around $1 million; • Long-term commitment of funds is required; • High fees: typically 1% of assets plus 20% of profits; • Highly levered; • Little current regulation. HFs use more aggressive trading strategies than MFs such as short selling, leverage, program trading, arbitrage, and the use of derivatives. Hedge funds (HFs) are investment pools that solicit funds from wealthy individuals and other investors (e.g., commercial banks) and invest these funds on their behalf. They are similar to MFs, but smaller funds under $100 million in assets are not required to register with the SEC (Security Exchange Commission). These are subject to less regulatory oversight than mutual funds and generally can (and do) take significantly more risk than MFs. Moreover, do not have to publicly disclose their activities to third parties and thus offer a high degree of privacy HFs avoid regulation by limiting the number of investors to less than 100 and by requiring investors to be “accredited” → accredited investors have net worth over $1 million or annual income over $200,000 if single (or $300,000 if married). The following is a classification of hedge funds on the basis of risk: 80 The services provided during this process include: • Giving Advice. Most firms do not issue capital market securities very frequently. Over 80% of expenses are covered by using profits retained from previous earnings. As a result, the financial managers of most firms are not familiar on how to proceed with new securities offerings. Investment banks may provide advice to firms contemplating a sale. The advice may not only regard which securities are more convenient to be issued, but also when to issue them (for example, competitors have released securities, better to wait), therefore the timing of their offering. The most important advice is at what price → firms always want to obtain the higher possible price, but investment banks do not want to overprice the stocks, because in most underwriting agreements they will buy the entire issue at that price and then resell it through their brokerage houses. They earn a profit by selling at a slightly higher price than they buy from the issuing firm. If the issuing price is too high, the investment bank will not be able to resell and will suffer a loss. • Filing Documents. Assistance while filling the required Securities Exchange Commission documents. • Underwriting, Best Efforts, or Private Placement. At a specified time and date, the issuer will sell all the issue to the investment bank at the agreed price. Underwriting stocks and bonds. Using Investment Bankers to Distribute Securities to the Public. The goal of underwriting is for all of the shares in an offering to be spoken for. However, this may not occur. • Fully subscribed: all shares are spoken for before the issue date; • Undersubscribed: underwriting syndicate (sales agent) unable to generate interest in all of the available shares; • Oversubscribed: interest in more shares than are available (may lead to rationing). Alternatives to underwriting the security offering are: • Best Efforts: An alternative to a firm commitment, the underwriter does not buy the issue, but rather makes its “best effort ” to sell the entire issue. The IB sells the securities on a commission basis, not guanteeing regarding the price they should receive. In this case, there is no risk of mispricing the 81 security, no need for the time-consuming task of establishing the market value of the security. The investment bank deals on the price the customer asks. If the security fails to sell, the offering can be cancelled. • Private Placements: The entire issue is sold to a small, select group of investors. This is rarely done with equity issues. An advantage is that, being not sold to the wide public, the security does not get to be registered with the security exchange commission as long as some restrictive requirements are satisfied. The IB help in this case is of advice, for example by counselling on the issue or identifying potential purchasers. The buyer in private placements must be large enough to purchase a large number of securities at one time. Another service offered by IB is to help with the sale of corporations or corporate divisions, the so-called Equity Sales: when a firm sells an entire division (or maybe the entire company), enlisting the aid of an investment banker. • Assists in determining the value of the division or firm and find potential buyers (business worth) • Develop confidential financial statements for the division for prospective buyer (confidential memorandum). This means that they develop a prospectus with all financial information required for a buyer to make an offer. It’s confidential because the buyer signs a preliminary agreement, by accepting not to share the memorandum with third parties (may be object of competition). • Prepare a letter of intent issued by a prospective buyer to continue, assist with due diligence, and help reach a definitive agreement. This letter outlines preliminary returns and defines a buyer’s intent to proceed with the acquisition. The IB will negotiate the terms of the agreement on the seller’s behalf and will help to analyze the other competing offers. The IB may even add structure financing to obtain a better offer. Once the letter of intent has been accepted by the seller, the definitive agreement is shaped, in order to define a legally binding contract. Merger and Acquisitions Investment bankers may assist both acquiring firms and potential targets (although not both in the same deal). Since 1960s, IBs have been acting in the merger and acquisitions market. • Merger → occurs when two firms combine to form one new company. Both firms support the merger and usually both contribute to the new management team. • Deal may be a hostile takeover, where the target does not wish to be acquired. Investment bankers will assist in all areas, including deal specifics, lining up financing, legal issues, etc. Securities Brokers and Dealers Securities brokers and dealers conduct their business in secondary markets, act as intermediaries in the selling and purchase of securities. Their function is to match buyers with sellers, a function for which they have paid brokerage conditions. In contrast to brokers, dealers link buyers and sellers by standing ready to buy and sell securities at a given price. Therefore, dealers pool inventories of securities and make profits by selling these securities for a slightly higher price than they paid for them → that is, on the spread between the bid and ask price. This is a high-risk business, because dealers hold securities that can rise or fall in price. In recent years, several firms specializing in bonds have collapsed. Brokers, on the other hand, are not as exposed to risk because they do not hold the securities in their business dealings. Securities firms with brokerage services offer several types of services: • Brokerage Service • Other services 82 The main brokerage service can be divided in: Full-Service Brokers versus Discount Brokers • Full Service Brokers: offer clients research and investment advice, but usually charge a higher commission on trades. They will often make weekly and monthly reports and recommendations to the customers, in an effort to encourage them to invest in certain securities. • Discount Broker: provides facilities to buy/sell securities but offers no advice. Many on-line discount brokerage firms do have significant research available. They simply execute trade on request. Securities Orders: when you call a brokerage house to buy or sell a security, you essentially have three options: • Market Order: buy or sell security at current price; • Limit Order: you specify the most you are willing to pay (buy) or the least you are willing to accept (sell) for a security; • Short Sales: sell a security you don’t own with the intent of buying it back at a later date (hopefully at a lower price). Other Services provided by brokers: • Insurance against loss of actual security documents. This guarantee is not against loss in value, only against loss of the security themselves; • Margin credit for purchasing equity with borrowed funds. This credit refers to the loans of the brokerage house to help investors buy securities. For example, if you are certain that the entire corporation stock is going to raise rapidly when a new computer chip is introduced, you could increase the amount of stock you can buy by borrowing from the brokerage house; • Other services driven by market demand (e.g., the Merrill Lynch cash management account). The activities of securities dealers are a bit different: • Hold inventories of securities on their own account; • Provide liquidity to the market by standing by ready to buy or sell securities (market maker); • Especially important for thinly traded securities. Understanding the role of a corporate and investment bank in financing the economy Suppose there are two companies, trying to finance one shared project. As part of its strategic advisory business, the corporate investment bank advices its client which has strong expertise in, say, renewable energy but limited borrowing capacity, to join forces with another complementary company. Rather than a simple partnership, suppose the bank recommends the creation of a common subsidiary, a joint venture. The bank agrees to lend a strong portion of their capital needs, but for the rest the two companies will seek for investment in the sector. This will not be made by signing a contract with each investor, but by issuing a single contract, being a bond on the capital market. This will have unique characteristics: rate and maturity date like a traditional loan. But what interest will they have to pay on the loan? FINANCING is the CIB second core business. • May lend capital directly to the companies; • Or organize indirect financing by providing its client with access to capital markets where funding is available through institutional investors. These will have the possibility to buy a bond issued by the bank on the behalf of its client, the issuer. The CIB will advice its client on the rate to apply based on a number of parameters: 1. Financial solidity of the issuer; 85 • Fraud risk (that the capital seeker decides not to conclude the project) • Liquidity risk (when you invest in equity platforms, you become a stockholder, but if you need to sell your stocks in a specific moment you can’t, because there is no secondary market). Crowdfunding is developed in different countries in different ways. In the following chart we can see the number of active platforms for each country. The red line is the platform per capita: the number of platforms per 1 million of inhabitants. For example, since in Italy there are more or less 60 million people and there are 57 platforms, the ratio is around 1. Now we analyze the rapid growth and expansion phase, when we have the startup. Venture capital/Business angel Venture capital (VC) is a professionally managed pool of money used to finance new (i.e., start-up) and often high-risk firms. The use of venture capital is frequent in start-ups: • VC usually purchases an equity stake in the start-up • usually become active in management of the start-up • institutional venture capital firms find and fund the most promising new firms. Venture capital firms may be organized in different ways depending on the country, for example: o can be organized as venture capital limited partnerships (US)/or as close end funds (EU), i.e. a closed fund that collects money and then invests them in new firms. o financial venture capital firms o corporate venture capital firms In general, even if the startup is newly born and high-risk, since the VC becomes active in its management, it’s possible to re-sell the stake of this firm at an higher price. The VC can be created by some financial institutions, for example banks, that dedicate a close end fund to the financing of start-ups, or by some corporates that want to invest in other firms. 86 Debt (Banks & Microfinance) depends of guarantee Debts, in particular those issued by banks, is a form of indirect finance. It is one of the most used sources of finance, the level of dependency on bank financing is very high for large firms, but especially for SMEs (Small and Medium size Enterprises). In fact, SMEs: • have limited external funding capacity compared to larger firms • They are more dependent on bank loans and are more exposed to financial turmoil. • Four main reasons why they have difficulties when trying to access to bank finance: o information asymmetry (to evaluate SMEs is more difficult than large firms); o high administrative costs for small-scale lending; o high risk perception; o and lack of collateral (more difficult in providing collateral as guarantee for bank debt). In this sense, a useful instrument is provided by the public credit guarantee scheme (in Italy, “Fondo Centrale di Garanzia”). Initial Public Offerings Initial public offerings (IPOs) are the first time debt (bonds) and equity (stocks) are issued. It’s the first time a firm decides to issue bonds or stock. New issues from a firm whose debt or equity is already traded are called seasoned equity offerings (SEOs).This is the second, third, etc. time. Investment banks perform a variety of crucial functions in financial markets o Underwrite the initial sale of stocks and bonds (IPOs SEOs) o Deal maker in mergers and acquisitions Investment banks play many roles in both the primary and secondary markets. We will focus on their role in three areas: Underwriting Stocks and Bonds, Equity Sales, Mergers and Acquisitions. How do IBs evaluate bond and stock issues? • Remember our lectures about «How to find the value of bond and stock»; • The value of a financial instruments is given by the present value of all future net cash flows generated by the investment. What’s the role of mutual funds in SMEs access to finance? They have a very important indirect role: mutual funds can decide to invest in crowdfunding platforms, or venture capitalist close end fund, and therefore support new funding for high-risk firms. Or, for example, they can decide to buy new stocks and bonds issued in an IPO. 87 Class exercises: trivial questions & answers How does the presence of asymmetric information in the direct selling market lead to consumers not buying the products? Since an individual may not be able to assess the trustworthiness of a deficit agent offering a product, being a time-consuming task and because of asymmetric information, the consumer may decide not to buy the product. The asymmetric information therefore impacts its decision-making reasoning. For example, a surplus agent not able to distinguish between different deficit agents may decide to apply to all of them the same average conditions. Since this may discourage safer agents, only riskier ones may remain, and the consumer may end up not buying any product (adverse selection). How do financial intermediaries solve the problem of adverse selection? Financial intermediaries are able to reduce asymmetric information, and therefore to assess more easily the trustworthiness of a deficit agent differencing riskier borrowers from safer ones. This is possible because of acquired expertise that makes this assessment easier than it would be for an individual. In this way, instead of applying average conditions to all borrowers, the surplus agent is able to use its economic resources more efficiently. Explain the link between well-performing financial markets and economic growth. Name one channel through which financial markets might affect economic growth and poverty. A well-performing financial market impacts economic growth since it permits to match the financial needs of agents being in a surplus position (therefore, looking for investment opportunities) with those being in deficit (need of financing). In this way, the circulation of financial resources encourages a more efficient allocation of capital. This is exactly one way in which financial markets may help reducing poverty: for example through microfinance, the access to credit may be, for many, a way to escape the “poverty trap”. You have paid 980.30 dollars for an 8% coupon bond with a face value of 1,000 dollars that mature in five years. You plan on holding the bond for one year. If you want to earn a 9% rate of return on this investment, what price must you sell the bond for? Is this realistic? Since the face value is 1000 dollars, I get a cash flow of 80 dollars holding the bond for one year (8% coupon). To get a 9% return on my initial investment of 980,3 dollars means that I want to receive revenues for 1068,527 dollars. If I subtract the first coupon revenue received, I must sell the bond for 988,527 dollars to get revenues equal to my initial investment of 980,3 plus 9% rate of return. This could be realistic since, at the end of the five years, the new buyer will get 1000 (1080 minus 80 for the first year). On the other hand, the return after five years is very low (11,473, being approximately 1,16%) and may not even cover the rate of inflation. Therefore, I would conclude that this is not realistic. 90 ARBITRAGE = The elimination of riskless profit opportunities in the futures market Futures contacts are marked to market every day. What does that mean? At the end of every trading day, the change in the value of the futures contract is added to or subtracted from the margin account. If a portfolio manager believes stock prices will fall and knows that a block of funds will be received in the future, then he should… sell stock index futures short. Options on individual stocks are referred to as… stock options. You have $12,500 to invest and you are considering investing in Fund X. The fund charges a front-end load of 3 percent and an annual expense fee of 2.25 percent of the ending asset value over the year. You believe the fund's gross rate of return will be 8 percent per year. If you make the investment, what should your investment be worth in one year? What is the purpose of index funds? How does this differ from other equity mutual funds? Why are index funds growing in popularity? The purpose of index funds is to mimic the performance of the underlying index such as the S&P500. Their purpose is to provide investors with a rate of return similar to the stock market as a whole. Other equity mutual funds are actively managed; that is, funds managers conduct research and pick individual stocks they believe will perform better than the market as a whole. Index funds now comprise about 25 percent of long-term funds. They are increasingly popular because they have very low expense ratios and because the performance of managed funds (after expenses) has not been sufficiently better than index funds to warrant incurring the higher fees. Also, more widespread education about market efficiency has probably encouraged more investors to choose indexing. Why is capital a more important measure of the size of a securities firm than the amount of assets? What other measures would be useful, given the diversity of this industry? The size of investment banking and securities trading is not properly measured by industry assets because, unlike loans or insurance policies, investment bankers and securities firms need not permanently hold securities. Their purpose is to turn them over quickly. Equity capital measures a firm's ability to turn over large issues, since firms will only risk limited amounts of their capital at one time. Other measures may include these: • Level of underwriting volume in particular categories • Number of brokers/dealers, availability of electronic trading (securities firms trading activities) • Number of corporate relationships (M&A and consulting activities) • Amount of global presence such as overseas offices and foreign transactions 91 What are the risks an investor would face when making an investment in corporate bonds? → Interest rate risk, default risk, lack of liquidity (risk of not finding a potential buyer) Degree of risk depends on the health of the issuing company. Call provisions: the issuer has the right to claim the bond back → sinking funds (made in the interest of bond-holders) What are the limitations of the dividend discount model? Hard to estimate the required return (ke), growth of dividends is hard to estimate (Gordon assumes constant rate but which one?), the dividends amounts depend on future growth opportunities and management’s concern over future cash flows What are the risks faced by investors investing in stocks in emerging markets? Risk of lack of liquidity, foreign exchange rate risk, volatility risk, government risk 1. Might be hard to resell the securities you invest in in the emerging market 2. emerging markets are likely to have unstable currencies 3. unstable markets present unstable prices and rates 4. government (or central banks) is the financial agency that is less likely to default, but in a new and unstable market it might incur in crises and affect any other financial agency Suppose that the pension you are managing is expecting an inflow of funds of $200 million next year and you want to make sure that you will earn the current interest rate of 9% when you invest the incoming funds in long term bonds. How would you use the future market to do this? Future contract where I engage in a long position in order to purchase $200 million worth of long term bonds at 9% interest rate How would you use the options market to accomplish the same thing as in the previous question? What are the advantages and disadvantages of using an option contract rather than a future contract? I can purchase a call option I have the right to choose whether to actually buy the bonds in the future or not, but my profit will be lower wrt that of a future contract bc to buy an option contract I have to pay a premium Consider a put contract on a T-bond with an exercise price of 101,375. The contract represents $100,00 of bond principal and has a premium of $750. The actual T-bond price is currently 100.03125. how can you arbitrage this situation? Arbitrage: exploitation of riskless profit opportunities in the market Put contract: right to sell the t-bond at 101,375, where the actual price is 100,031 I pay a premium of 750$ 101375-100031.25-750 = 1343.75-750 = 593.75 92 Exam questions (A.Y. 2019-2020) • Classification of markets: explain how markets can be distinguished (Spot vs Forward, Money vs Capital, Retail vs Wholesale, etc.) • Illustrate the Gordon growth model. • Yield to maturity: which one between BOND A and BOND B has the higher ytm (both same face value, same coupon rate, different prices, coupon B being higher). • Yield to Maturity to a zero-coupon bond. • Meaning of hedging (and example). • Compare two coupon bonds with same duration: are they similar? Are they equivalent? • Clean and dirty price, accrued interest. Which one will be asked by a bank? And which is displayed in newspapers? • How to evaluate a Bond through its duration. May be: different factors in evaluating a bond. • Risks incurred when buying a bond. • Discount rate and EAR: explanation. → the two formulas P-F/F e P-F/P. • Risks of investing in emerging markets. • Bond duration: differences between coupons and zero-coupon bond. • Valuation of stocks (generalized valuation model/possible problems and solutions). • Crowdfunding: does it work? • Business cycle and financing ways for firms. • How is it possible to use the Gordon Growth model in predicting/analyzing a financial crisis? → changes in g and ke. • Definition of duration, how does it relate to the change in the price of a bond and how to make comparisons between bonds with duration.