Riassunti international financial markets, Sintesi del corso di Mercato Finanziario

Scarica Riassunti international financial markets e più Sintesi del corso in PDF di Mercato Finanziario solo su Docsity! INTERNATIONAL FINANCIAL MARKETS: FINANCIAL MARKETS = they are markets in which funds are transferred from people who have an excess of available funds to people who have a shortage (Ex. such as bond and stock markets). They are crucial to promoting greater economic efficiency by channelling funds from people who do not have a productive use for them to those who do. * Well-functioning financial markets are a key factor in producing high economic growth; e. poorly performing financial markets are one reason that many countries in the world remain desperately poor. Activities in financial markets also have direct effects on personal wealth, the behaviour of businesses and consumers, and the cyclical performance of the economy. DEBT MARKETS AND INTEREST RATES: SECURITY = or financial instrument, is a claim on the issuer’s future income or assets (any financial claim or piece of property that is subject to ownership). BOND = is a debt security that promises to make payments periodically for a specified period of time. Debt markets, also often referred to generically as the bond market, are especially important to economic activity because they enable corporations and governments to borrow in order to finance their activities; the bond market is also where interest rates are determined. INTEREST RATE = is the cost of borrowing or the price paid for the rental of funds. Many types of interest rates are found in the economy. Interest rates are important on a number of levels: e On a personal level, high interest rates could deter you from buying because the cost of financing it would be high. Conversely, high interest rates could encourage you to save because you can earn more interest income by putting aside some of your earnings as savings. e On a more general level, interest rates have an impact on the overall health of the economy because they affect not only consumers' willingness to spend or save but also businesses’ investment decisions. Changes in interest rates have important effects on individuals, financial institutions, businesses, and the overall economy. THE STOCK MARKET: COMMON STOCK or just STOCK = represents a share of ownership in a corporation + It is a security that is a claim on the earnings and assets of the corporation. Issuing stock and selling it to the public is a way for corporations to raise funds to finance their activities. The STOCK MARKET, in which claims on the earnings of corporations (shares of stock) are traded, is the most widely followed financial market in almost every country that has one + it is often called simply “the market”. lt received the most attention from the media because it is the place where people can get rich or poor quickly. lt is also an important factor in business investment decisions because the price of shares affects the amount of funds that can be raised by selling newly issued stock to finance investment spending. A higher price for a firm's shares means that it can raise a larger amount of funds, which can be used to buy production facilities and equipment. THE FOREIGN EXCHANGE MARKET: For funds to be transferred from one country to another, they have to be converted from the currency in the country of origin into the currency of the country they are going to. The FOREIGN EXCHANGE MARKET is where this conversion takes place, so it is instrumental in moving funds between countries. lt is also important because it is where the foreign exchange rate is determined = the price of one country's currency in terms of another's. WHY STUDY FINANCIAL INSTITUTIONS? FINANCIAL INSTITUTIONS = are what make financial markets work > Without them, financial markets would not be able to move funds from people who save to people who have productive investment opportunities. They thus play a crucial role in improving the efficiency of the economy. FUNCTION OF FINANCIAL MARKETS: Financial markets perform the essential economic function of channelling funds from households, firms, and governments that have saved surplus funds by spending less than their income to those that have a shortage of funds because they wish to spend more than their income. The LENDER-SAVERS = are those who have saved and are lending funds (they are at the left side of the figure). The principal lender-savers are households, but business enterprises and the government (particularly state and local government), as well as foreigners and their governments, sometimes also find themselves with excess funds and so lend them out. The BORROWER-SPENDERS = are those who must borrow funds to finance their spending (they are at the right side of the figure). The most important borrower-spenders are businesses and the government (particularly the federal government), but households and foreigners also borrow to finance their purchases of cars, furniture, and houses. The arrows show that funds flow from lender-savers to borrower-spenders via two routes: 1- In DIRECT FINANCE = where borrowers borrow funds directly from lenders in financial markets by selling them securities = also called financial instruments, which are claims on the borrower's future income or assets. They are assets for the person who buys them, but they are liabilities (IOUs or debts) for the individual or firm that sells/issues them. 2- In INDIRECT FINANCE = where borrowers and lenders are link through an INTERMEDIARY,. INDIRECT FINANCE FUNDS Financial ‘FUNDS Intermediarias SaNnI Lender-Savers Borrowar-Spenders 1. Housenolde 1. Businese firms 2 Business firms FUNDS Fnca FUNDS 2. Government 3. Govemment 3. Households 4. Forelgnars 4. Foreigners DIRECT FINANCE Financial markets allow funds to move from people who lack productive investment opportunities to people who have such opportunities. They are critical for producing an efficient allocation of capital (wealth, either financial or physical, that is employed to produce more wealth), which contributes to higher production and efficiency for the overall economy. Well-functioning financial markets also directly improve the well-being of consumers by allowing them to time their purchases better. STRUCTURE OF FINANCIAL MARKETS: They are composed by: Debt and equity markets + A firm or an individual can obtain funds in a financial market in two ways: First way: The first and the most common method is to issue a debt instrument, such as a bond or a mortgage, which is a contractual agreement by the borrower to pay the holder of the instrument at fixed amounts at regular intervals (interest and principal payments) until a specified date (the maturity date), when a final payment is made. The MATURITY OF A DEBT INSTRUMENT = is the number of years (term) until that instrument’s expiration date. A debt instrument can be: * short-termif its maturity is less than a year (<1); * intermediate term, if its maturity is between 1 and 10 years (1 to 10); * long-term if its maturity is 10 years or longer (> 10). Second way: The second method of raising funds is by issuing equities, such as common stock, which are claims to share in the net income (income after expenses and taxes) and the assets of a business. Equities often make periodic payments (dividends) to their holders and are considered long-term securities because they have no maturity date. In addition, owning stock means that you own a portion of the firm and thus have the right to vote on issues important to the firm and to elect its directors. e The main disadvantage of owning a corporation's equities rather than its debt is that an equity holder is a residual claimant = the corporation must pay all its debt holders before it pays its equity holders. e The advantage of holding equities is that equity holders benefit directly from any increases in the corporation’s profitability or asset value because equities confer ownership rights on the equity holders. Debt holders do not share in this benefit because their payments are fixed. Primary _and secondary markets > A PRIMARY MARKET = is a financial market in which new issues of a security, such as a bond or a stock, are sold to initial buyers by the corporation or government agency borrowing the funds. A SECONDARY MARKET = is a financial market in which securities that have been previously issued can be resold. When an individual buys a security in the secondary market, the person who has sold the security receives money in exchange for the security, but the corporation that issued the security acquires no new funds. A corporation acquires new funds only when its securities are first sold in the primary market. Nonetheless, secondary markets serve two important functions: 1- they make it easier and quicker to sell these financial instruments to raise cash = they make the financial instruments more liquid. The increased liquidity of these instruments then makes them more desirable and thus easier for the issuing firm to sell in the primary market. 2- they determine the price of the security that the issuing firm sells in the primary market. The investors who buy securities in the primary market will pay the issuing corporation no more than the price they think the secondary market will set for this security. The higher the security's price in the secondary market, the higher the price that the issuing firm will receive for a new security in the primary market, and hence the greater the amount of financial capital it can raise. Conditions in the secondary market are therefore the most relevant to corporations issuing securities. INTERNATIONALIZATION OF FINANCIAL MARKETS: The growing internationalization of financial markets has become an important trend > The extraordinary growth of foreign financial markets has been the result of both large increases in the pool of savings in foreign countries and the deregulation of foreign financial markets, which has enabled foreign markets to expand their activities. information problems, thereby allowing small savers and borrowers to benefit from the existence of financial markets. Financial intermediaries play a key role in improving economic efficiency because they help financial markets channel funds from lender-savers to people with productive investment opportunities. Without a well- functioning set of financial intermediaries, it is very hard for an economy to reach its full potential. Economies of scope and conflicts of interest > Another reason why financial intermediaries play such an important role in the economy is that by providing multiple financial services to their customers, such as offering them bank loans or selling their bonds for them, they can also achieve ECONOMIES OF SCOPE = they can lower the cost of information production for each service by applying one information resource to many different services. Although the presence of economies of scope may substantially benefit financial institutions, it also creates potential costs in terms of CONFLICTS OF INTEREST = are a type of moral hazard problem that arises when a person or institution has multiple objectives (interests) and, as a result, has conflicts between those objectives. They are especially likely to occur when a financial institution provides multiple services, the potentially competing interests of those services may lead an individual or firm to conceal information or disseminate misleading information. A substantial reduction in the quality of information in financial markets increases asymmetric information problems and prevents financial markets from channelling funds into the most productive investment opportunities, consequently, the financial markets and the economy become less efficient. TYPES OF FINANCIAL INTERMEDIARIES: There are 3 categories of financial intermediaries (depository institutions, contractual savings institutions, investments intermediaries): DEPOSITORY INSTITUTIONS (BANKS): they are financial intermediaries that accept deposits from individuals and institutions and make loans. These institutions include commercial banks and the so-called thrift institutions (thrifts): savings and loan associations, mutual savings banks, and credit unions. Commercial banks > These financial intermediaries raise funds primarily by issuing checkable deposits = deposits on which checks can be written, savings deposits = deposits that are payable on demand but do not allow their owner to write checks, and time deposits = deposits with fixed terms to maturity. They then use these funds to make commercial, consumer, and mortgage loans and to buy securities and municipal bonds. Savings and Loan Associations (S&Ls) and Mutual Savings Banks > These depository institutions obtain funds primarily through savings deposits (often called shares) and time and checkable deposits. In the past, these institutions were constrained in their activities and mostly made mortgage loans. Credit Unions > These financial institutions are typically very small cooperative lending institutions organized around a particular group: union members, employees of a particular firm, and so forth. They acquire funds from deposits called shares and primarily make consumer loans. Type of Intermediary Primary Liabilities |Primary Assets (Sources of Funds) |(Uses of Funds) Depository Institutions (banks) Commercial banks Deposits Business and consumer loans, mortgages, U.S. governmeni securities, ‘and municipal bonds S&L associations Deposits Mortgages Mutual savings banks Deposits Mortgages Credit unions Deposits Consumer loans CONTRACTUAL SAVINGS INSTITUTIONS: Contractual savings institutions, such as insurance companies and pension funds, are financial intermediaries that acquire funds at periodic intervals on a contractual basis. Because they can predict with reasonable accuracy how much they will have to pay out in benefits in the coming years, they do not have to worry as much as depository institutions about losing funds quickly. As a result, the liquidity of assets is not as important a consideration for them as it is for depository institutions, and they tend to invest their funds primarily in long-term securities such as corporate bonds, stocks, and mortgages. Life Insurance Companies + they insure people against financial hazards following a death and sell annuities (annual income payments upon retirement). They acquire funds from the premiums that people pay to keep their policies in force and use them mainly to buy corporate bonds and mortgages. They also purchase stocks but are restricted in the amount that they can hold. Fire and Casualty Insurance Companies > These companies insure their policyholders against loss from theft, fire, and accidents. They are very much like life insurance companies, receiving funds through premiums for their policies, but they have a greater possibility of loss of funds if major disasters occur. For this reason, they use their funds to buy more liquid assets than life insurance companies do. Pension Funds and Government Retirement Funds + Private pension funds and state and local retirement funds provide retirement income in the form of annuities to employees who are covered by a pension plan. Funds are acquired by contributions from employers and from employees, who either have a contribution automatically deducted from their pay checks or contribute voluntarily. The largest asset holdings of pension funds are corporate bonds and stocks. Type of Intermediary Primary Liabilities | Primary Assets (Sourcesof Funds) |(Uses of Funds) Contractual savings institutions Life insurance companies Premiums from Corporate bonds and policies mortgages Fire and casualty Premiums from Municipal bonds, insurance companies policies corporate bonds and stock, and U.S. government securities Pension funds, Employer and Corporate bonds and government retirement ‘employee stock funds contributions INVESTMENT INTERMEDIARIES: This category of financial intermediaries includes finance companies, mutual funds, money market mutual funds, and investment banks. Finance Companies + they raise funds by selling commercial paper (a short-term debt instrument) and by issuing stocks and bonds. They lend these funds to consumers (who make purchases of such items as furniture, automobiles, and home improvements) and to small businesses. Mutual Funds > they acquire funds by selling shares to many individuals and use the proceeds to purchase diversified portfolios of stocks and bonds. They allow shareholders to pool their resources so that they can take advantage of lower transaction costs when buying large blocks of stocks or bonds. In addition, they allow shareholders to hold more diversified portfolios than they otherwise would. Shareholders can sell (redeem) shares at any time, but the value of these shares will be determined by the value of the mutual fund's holdings of securities. Because these fluctuate greatly, the value of mutual fund shares does, too; therefore, investments in mutual funds can be risky. Money Market Mutual Funds > These financial institutions have the characteristics of a mutual fund but also function to some extent as a depository institution because they offer deposit-type accounts. Like most mutual funds, they sell shares to acquire funds that are then used MEASURING INTEREST RATES: Different debt instruments have very different streams of cash payments to the holder (known as cash flows), with very different 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. PRESENT VALUE: The concept of present value (or present discounted value) is based on the common-sense 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 > This notion is true because you can deposit a dollar in a savings account that earns interest and have more than a dollar in one year. Example - simple loan: In this loan, the lender provides the borrower with an amount of funds (called the principal) that must be repaid to the lender at the maturity date, along with an additional payment for the interest. $100 for one year Interest = 10$ Simple interest rate (i)= 10/100 = 10% At the end of the year, you will have 100 + 10 = $110 > $100 X (1+0,0) = 110$ If you proceed for another year, at the end of the second year you will have $110 X (1+0,10) = 121$ >$100 X (1+0,10) X (1+0,10) = $100 X (1+0,10) = 121$ Generally, $100 X (1+i)" Today Year Year Year Vear 0 1 2 3 n I J | | | T 7 7 T 1 $100 sno $121 $133 $100 x {1 + 0.10]? The process of calculating today's value of dollars received in the future is called discounting the future. We can generalize this process by writing today's (present) value of $100 as PV, writing the future cash flow of $133 as CF, and replacing 0,10 (the 10% interest rate) by i. This leads to the following CF formula: PV=— (1+i) The concept of present value is extremely useful because it enables to figure out today's value of a credit market instrument at a given simple interest rate i by just adding up the present value of all the future cash flows received. Also, it allows to compare the value of two instruments with very different timing of their cash flows. FOUR TYPES OF CREDIT MARKET INSTRUMENTS: In terms of the timing of their cash flows, there are four basic types of credit market instruments: 1- A SIMPLE LOAN > in which the lender provides the borrower with an amount of funds, which must be repaid to the lender at the maturity date along with an additional payment for the interest. 2- A FIXED-PAYMENT LOAN (also called a fully amortized loan) + in which the lender provides the borrower with an amount of funds, which must be repaid by making the same payment every period (such as a month), consisting of part of the principal and interest for a set number of years. 3- A 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. The coupon payment is so named because the bondholder used to obtain payment by clipping a coupon off the bond and sending it to the bond issuer, who then sent the payment to the holder. It is identified by three pieces of information: first is the corporation or government agency that issues the bond; second is the maturity date of the bond; third is the bond'’s coupon rate = the dollar amount of the yearly coupon payment expressed as a percentage of the face value of the bond. 4- A DISCOUNT BOND (also called a zero-coupon bond) is bought at a price below its face value (at a discount), and the face value is repaid at the maturity date. Unlike a coupon bond, a discount bond does not make any interest payments; it just pays off the face value. 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. YIELD TO MATURITY: Of the several common ways of calculating interest rates, the most important is the YIELD TO MATURITY = the interest rate that equates the present value of cash flows received from a debt instrument with its value today. Simple loan + its yield to maturity is easy to calculate. Basically, the present value of the future payments must equal today's value of a loan. Example: If Pete borrows $100 from his sister and next year, she wants $110 back from him, what is the yield to maturity on this loan? pv=- CF (1+i)” PV = amount borrowed = 100$ CF = cash flow in one year = 110$ n=number of years = 1 $100 = 110/ (1+i) (1+i)100 = 110 (1+i) = 110/100 (1+i)=1,1 i= 1,1-1=0,10 = 10% > The yield to maturity on the loan is 10%. Today Year o 1 $100 $110 For simple loans, the simple interest rate equals the yield to maturity. Hence the same term i is used to denote both the yield to maturity and the simple interest rate. Fixed-payment loan > it has the same cash flow payment every year throughout the life of the loan. On a fixed-rate mortgage, the borrower makes the same payment to the bank every month until the maturity date, when the loan will be completely paid off. To calculate the yield to maturity for a fixed-payment loan, we equate today's value of the loan with its present value. Because the fixed- payment loan involves more than one cash flow payment, the present value of the fixed-payment loan is calculated as the sum of the present values of all cash flow. _FP_ FP =—_+4 IV 4 1+i éÒ The same reasoning applied to any coupon bond demonstrates that if the coupon bond is purchased at its par value, the yield to maturity and the coupon rate must be equal. lt is straightforward to show that the valuation of a bond and the yield to maturity are negatively related. As i, the yield to maturity, rises, all denominators in the bond price formula must necessarily rise. Hence a rise in the interest rate as measured by the yield to maturity means that the value and therefore the price of the bond must fall. Another way to explain why the bond price falls when the interest rate rises is that a higher interest rate implies that the future coupon payments and final payment are worth less when discounted back to the present; hence the price of the bond must be lower. The third fact, that the yield to maturity is greater than the coupon rate when the bond price is below its par value, follows directly from facts 1 and 2. When the yield to maturity equals the coupon rate, then the bond price is at the face value; when the yield to maturity rises above the coupon rate, the bond price necessarily falls and so must be below the face value of the bond. One special case of a coupon bond, because its yield to maturity is particularly easy to calculate is called a PERPETUITY, or a CONSOL = it is a perpetual bond with no maturity date and no repayment of principal that makes fixed coupon payments of $C forever. ce ic Pce= Pc = price of the perpetuity (consol) C = yearly payment ic = yield to maturity of the perpetuity (consol) One nice feature of perpetuities is that you can immediately see that as ic goes up, the price of the bond falls. __C ic=7 Pc Example: What is the yield to maturity on a bond that has a price of $2.000 and pays $100 annually forever? __C ic=- Pc C = yearly payment = $100 Pc = price of perpetuity (consol) = $2,000 ic = 100/2.000 = 0,05 = 5% > The yield to maturity would be 5%. lt describes the calculation of the yield to maturity for a perpetuity, also provides a useful approximation for the yield to maturity on coupon bonds. When a coupon bond has a long term to maturity, it is very much like a perpetuity, which pays coupon payments forever > This is because the cash flows in the future have such small present discounted values that the value of a long-term coupon bond is very close to the value of a perpetuity with the same coupon rate. Thus, ic will be very close to the yield to maturity for any long-term bond. For this reason, ic, the yearly coupon payment divided by the price of the security, has been given the name CURRENT YIELD and is frequently used as an approximation to describe interest rates (yields to maturity) on long-term bonds. Discount bond > The yield-to-maturity calculation for a discount bond is similar to that for the simple loan. For any, one-year discount bond, the yield to maturity can be written as ._F_P if È P F = face value of the discount bond P = current price of the discount bond In other words, the yield to maturity equals the increase in price over the year F - P divided by the initial price P. In normal circumstances, investors earn positive returns from holding these securities and so they sell at a discount, meaning that the current price of the bond is below the face value. Therefore, F - P should be positive, and the yield to maturity should be positive as well. However, this is not always the case. An important feature of this equation is that it indicates that for a discount bond, the yield to maturity is negatively related to the current bond price. This is the same conclusion that we reached for a coupon bond. SUMMARY: The concept of present value tells you that a dollar in the future is not as valuable to you as a dollar today because you can earn interest on this dollar. Specifically, a dollar received n years from now is worth only $1/ (1+i)" today. The present value of a set of future cash flows on a debt instrument equals the sum of the present values of each of the future cash flows. The yield to maturity for an instrument is the interest rate that equates the present value of the future cash flows on that instrument to its value today. Because the procedure for calculating the yield to maturity is based on sound economic principles, this is the measure that financial economists think most accurately describes the interest rate. Our calculations of the yield to maturity for a variety of bonds reveal the important fact that current bond prices and interest rates are negatively related: When the interest rate rises, the price of the bond falls, and vice versa. NEGATIVE INTEREST RATES? JAPAN FIRST, THEN THE UNITED STATES, THEN EUROPE (CASE STUDY): We normally assume that the yield to maturity must always be positive. A negative yield to maturity would imply that you are willing to pay more for a bond today than you will receive for it in the future. A negative yield to maturity therefore seems like an impossibility because you would do better by holding cash that has the same value in the future as it does today. Events in Japan in the late 1990s and then in the United States during the 2008 global financial crisis and finally in Europe in recent years have demonstrated that this reasoning is not quite correct. In November 1998, the yield to maturity on Japanese six-month Treasury bills became negative, at -0.004%. In September 2008, the yield to maturity on three-month U.S. T-bills fell very slightly below zero for a very brief period. Interest rates that banks are paid on deposits they keep at their central banks became negative first in Sweden in July 2009, followed by Denmark in July 2012, the Eurozone in June 2014, Switzerland in December 2014, and Japan in January 2016. Negative interest rates have rarely occurred in the past. How could this happen in recent years? > a dearth of investment opportunities and very low inflation can drive interest rates to low levels, but these two factors can't explain the negative yield to maturity. The answer is that despite negative interest rates, large investors and banks found it more convenient to hold Treasury bills or keep their funds as deposits at the central bank because they are stored electronically. For that reason, investors and banks were willing to accept negative interest rates, even though in pure monetary terms the investors would be better off holding cash. » calculate the present value of each of the zero-coupon bonds when the interest rate is 10% (column 3 in the figure); » in the column 4 divide each of these present values by $1.000, the total present value of the set of zero-coupon bonds, to get the percentage of the total value of all the bonds that each bond represents. Note that the sum of the weights in column (4) must total 100%, as shown at the bottom of the column. » To get the effective maturity of the set of zero-coupon bonds, add up the weighted maturities in column (5) and obtain the figure of 6,76 years. TABLE 3.3. Calculating Duration on a $1,000 Ten-Year 10% Coupon Bond When TABLE 3.4 Calculating Duration on a S1,000 Ten-Year 10% Coupon Bond When Its Interest Rate Is 10% Its Interest Rate Is 20% (O) (o) @ 0) (5) n (O) a (O) 6 Present Value. Weights (% Present Value Weight (% Cash Payments (PI)of Cash oftotal PV/= Weighted Maturity Cash Payments (PMof Cash oftatal PU= Melghted (Zero-Coupon —Payments PM$1,000) (1 x 4100 (Zero-Coupon —Payments”—PU/SSB0.76) —Maturity(1x Year Bonds) ($) —(i=10%)($) (o) (years) Year Bonds) ($) —(?=20%)($) (0) 4/100 (years) 1 100 9091 9091 0.09091 1 10 8138 14245 2 100 8264 8264 a 10 (ET 3 100 76.18 7.518 3 10 amar 4 100 6830 6830 hi 100 4823 5 100 6209 5 10 40.19 6 100 56. 5644 033884 6 100 3349 7 100 5132 5.182 7 10 2791 8 100 46.65 4665 8 100 2326 9 100 1988 9 100 4241 4241 10 100 ss, 5 10 1,000 38.554 Total 1,000.00 100.000 5 nm 10 1615 i "0; 1 Total 580.76 100,000 Duration is a weighted average of the maturities of the cash payments and can be written as: = CP, CP, DUR = L'aria rm DUR = duration t = years until cash payment is made CPt = cash payment (interest plus principal) at time t i = interest rate n = years to maturity of the security AII else being equal, the longer the term to maturity of a bond, the longer its duration. When the interest rate is higher, the cash payments in the future are discounted more heavily and become less important in present-value terms relative to the total present value of all the payments. The relative weight for these cash payments drops, and so the effective maturity of the bond falls. AII else being equal, when interest rates rise, the duration of a coupon bond falls. The duration of a coupon bond is also affected by its coupon rate. The explanation is that a higher coupon rate means that a relatively greater amount of the cash payments is made earlier in the life of the bond, and so the effective maturity of the bond must fall. AII else being equal, the higher the coupon rate on the bond, the shorter the bond's duration. Duration is additive: One additional fact about duration makes this concept useful when applied to a portfolio of securities + So, if we calculate the duration for two different securities, it should be easy to see that the duration of a portfolio of the two securities is just the weighted average of the durations of the two securities, with the weights reflecting the proportion of the portfolio invested in each (additive property of duration). Example for portfolio securities: A manager of a financial institution is holding 25% of a portfolio in a bond with a five-year duration and 75% in a bond with a 10-year duration. What is the duration of the portfolio? (0,25x5) + (0,75x10) = 1,25+7,5 = 8,25years In sum, calculations of duration for coupon bonds have revealed four facts: 1. The longer the term to maturity of a bond, everything else being equal, the greater its duration. 2. When interest rates rise, everything else being equal, the duration of a coupon bond falls. 3. The higher the coupon rate on the bond, everything else being equal, the shorter the bond's duration. 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 reflecting the proportion of the portfolio invested in each. DURATION AND INTEREST-RATE RISK: Duration is a particularly useful concept because it provides a good approximation, particularly when interest-rate changes are small, for how much the security price changes for a given change in interest rates, as the following formula indicates: vape-DURX-DL %AP = (Pt+1 - Pt)>Pt = percentage change in the price of the security from t tot +1= rate of capital gain DUR = duration i = interest rate Example 1: A pension fund manager is holding a 10-year 10% coupon bond in the fund's portfolio, and the interest rate is currently 10%. What loss would the fund be exposed to if the interest rate rises to 11% tomorrow? DUR = duration = 6,76 Ai = change in interest rate = 0,11 - 0,10= 0,01 i = current interest rate = 0,10 Y%AP = - 6,76* (0,01/ 1+0,10) Y%AP = - 6,76* (0,01/ 1,10) Y%AP = - 6,76* (0,01) %AP = - 0,0676 = 6,76% (The approximate percentage change in the price of the bond) + the duration of a 10-year 10% coupon bond is 6,76 years. Example 2: Now the pension manager has the option to hold a 10-year coupon bond with a coupon rate of 20% instead of 10%. As mentioned earlier, the duration for this 20% coupon bond is 5,98 years when the interest rate is 10%. Find the approximate change in the bond price when the interest rate increases from 10% to 11%. DUR = duration = 5,98 Ai = change in interest rate = 0,11 - 0,10= 0,01 i = current interest rate = 0,10 Y%AP = - 5,98* (0,01/ 1+0,10) Y%AP = - 5,98 * (0,01/ 1,10) Y%AP = - 5,98* 0,01 %AP = - 0,0598 > 5,98% (This time the approximate change in bond price. This change in bond price is much smaller than for the higher-duration coupon bond). The pension fund manager realizes that the interest-rate risk on the 20% coupon bond is less than on the 10% coupon bond, so he switches the fund out of the 10% coupon bond and into the 20% coupon bond. The greater the duration of a security, the greater the percentage change in the market value of the security for a given change in Risk > (the degree of uncertainty associated with the return) of one asset relative to alternative assets. The degree of risk or uncertainty of an asset’s returns also affects demand for the asset. This risk is measure by the STANDARD DEVIATION = is a statistic that measures the dispersion of a dataset relative to its mean and is calculated as the square root of the variance > is a measure of how spread-out numbers are. The standard deviation of returns on an asset is calculated as follows: 1- calculate the expected return = Re; 2- subtract the expected return from each possible return to get a deviation; 3- square each deviation and multiply it by the probability of occurrence of that outcome; 4- add up all these weighted squared deviations and take the square root. The higher the standard deviation, o, the greater the risk of an asset. 0=\/p1(R1-R)+p2(R2-R}+...+pn(Rn-%) Example: Consider the following two companies and their forecasted returns for the upcoming year: Fly-by-night Feet-on-the- ground Outcome 1 Probability 50% 100% Return 15% 10% Outcome 2 Probability 50% 0% Return 5% n/a What is the standard deviation of the returns on the Fly-by-Night Airlines and Feet-on-the-Ground Bus Company, with the return outcomes and probabilities described above? Of these two stocks, which is riskier? Fly-by-night: o=\p1(R1-%)+p2(R2-R? Re = (p1) (R1) + (p2) (R2) pl = probability of occurrence of return 1 = 1/2 = 0,50 R1 return in state 1 = 15% = 0,15 p2 = probability of occurrence of return 2 = 1/2 = 0,50 R2 = return in state 2 = 5% = 0,05 Re = expected return = (0,50) (0,15) + (0,50) (0,05) = 0.10 o=0,50(0,15-0,10)°+0,50(0,05—0,10} 0=\0,50(0,05)°+0,50(—-0,05)° o=Y0,50(0,0025)+0,50(0,0025) 6=y0,00125+0,00125 o=v0,0025 0=0,05 3 5% Feet-on-the-ground: o=\p1(R1-%) Re = (pl) (R1) pl = probability of occurrence of return 1 = 1,0 R1 = return in state 1 = 10% = 0,10 Re = expected return = (1,0) (0,10) = 0,10 6=y1,0(0,10--0,10)? o=v/1 o=13 1% Clearly, Fly-by-Night Airlines is a riskier stock because its standard deviation of returns of 5% is higher than the 1% standard deviation of returns for Feet-on- the-Ground Bus Company, which has a certain return. A risk-averse person prefers stock in the Feet-on-the-Ground (the sure thing) to Fly-by-Night stock (the riskier asset), even though the stocks have the same expected return, 10%. By contrast, a person who prefers risk is a risk preferer or risk lover. We assume people are risk-averse, especially in their financial decisions. Holding everything else constant, if an asset’s risk rises relative to that of alternative assets, its quantity demanded will fall. Example 2: Consider the following two companies and their forecasted returns for the upcoming year: Google AT&T Outcome 1 Probability 50% 20% Return 15% 6% Outcome 2 Probability 30% 5% Return 1% 10% Outcome 3 Probability 20% 5% Return 2% 3% What is the standard deviation of the returns on the Google and AT&T, with the return outcomes and probabilities described above? Of these two stocks, which is riskier? Google: 0=\p1(R1-R)+p2(R2-R}+p3(R3-R) Re = (p1) (R1) + (p2) (R2) + (p3) (R3) pl = probability of occurrence of return 1 = 50% =0,50 R1 = return in state 1 = 15% = 0,15 p2 = probability of occurrence of return 2 = 30% = 0,30 R2 = return in state 2 = 7% = 0,07 P3 = probability of occurrence of return 3 = 20% =0,20 R3 = return in state 3 = 2% = 0,02 Re = expected return = (0,50) (0,15) + (0,30) (0,07) + (0,20) (0,02) = 0,075+0,021+0,004 = 0,10 0=v\0,50(0,15-0,10)°+0,30(0,07—0,10)°+0,20(0,02—0,10)? 0=0,50(0,057+0,30(-0,03)°+0,20(--0,08)° 0=/0,50(0,0025)+0,30(0,0009)+0,20 (0,0064) 0=0,00125+0,00027+0,00128 0=0,0028 0=0,0529 > 5,29% > this is the stock that is riskier to invest in. AT&T: 6=\p1(R1-R)+p2(R2-R}+p3(R3-R) DEMAND CURVE: To clarify our analysis, let's consider the demand for one-year discount bonds, which make no coupon payments but pay the owner the $1.000 face value in a year. If the holding period is one year, the return on the bonds is known absolutely and is equal to the interest rate as measured by the yield to maturity. This means that the expected return on this bond is equal to the interest rate i, which is: i=Re=(F-P)/P interest rate = yield to maturity Re = expected return F = face value of the discount bond P = initial purchase price of the discount bond This formula shows that a particular value of the interest rate corresponds to each bond price. If the bond sells for $950, the interest rate and expected return are (1000- 950)/950 = 0,053 = 5,3% At this 5,3% interest rate and expected return corresponding to a bond price of $950, let us assume that the quantity of bonds demanded is $100 billion. At a price of $900, the interest rate and expected return are (1000-900)/900 = 0,111 = 11,1% The quantity of bonds demanded at the price of $900 has risen to $200 billion. Because the expected return on these bonds is higher, with all other economic variables (such as income, expected returns on other assets, risk, and liquidity) held constant, the quantity demanded of bonds will be higher as predicted by the theory of portfolio choice. Continuing with this reasoning, the quantity of bonds demanded will be greater. Similarly, at the lower prices, the quantity of bonds demanded will be even higher. The curve Bd, which connects these points, is the demand curve for bonds. lt has the usual downward slope, indicating that at lower prices of the bond (everything else being equal), the quantity demanded is higher. SUPPLY CURVE: An important assumption behind the demand curve for bonds is that all other economic variables besides the bond's price and interest rate are held constant > We use the same assumption in deriving a supply curve, which shows the relationship between the quantity supplied and the price when all other economic variables are held constant. The Bs curve, which connects these points, is the supply curve for bonds. It has the usual upward slope found in supply curves, indicating that as the price increases (everything else being equal), the quantity supplied increases. Prica of Bonde. P ($) 1,000 6=0%) Ha ‘950 |--3- (= 53%) ‘900 €=-111%) P* - 850 W'= 176%) ‘800 © = 25.086) 750 |--1_ 0-33.3%) Quantity of Bonds, 8 (S billions) FIGURE 4.1 Supply and Demand for Bonds Equilibrium in the bond market occurs at point C, the intersection of the demand curve 8° and the bond supply curve 8°. The equilibrium price is P° = $850, and the equilibrium interest rate is * = 17.6%. MARKET EQUILIBRIUM: MARKET EQUILIBRIUM = it occurs when the amount that people are willing to buy (demand) equals the amount that people are willing to sell (supply) ata given price. In the bond market, this is achieved when the quantity of bonds demanded equals the quantity of bonds supplied: Bd = Bs. Pe = equilibrium price (850$) = quantity demanded equals the quantity supplied, is called the equilibrium, or market-clearing, price. ie = interest rate in equilibrium point (17,6%) = it corresponds to the equilibrium price and is called the equilibrium, or market-clearing, interest rate. The quantity of bonds supplied exceeds the quantity of bonds demanded, is called A CONDITION OF EXCESS SUPPLY, because people want to sell more bonds than others want to buy, the price of the bonds will fall. As long as the bond price remains above the equilibrium price, an excess supply of bonds will continue to be available, and the price will continue to fall. This decline will stop only when the price has reached the equilibrium price, where the excess supply of bonds has been eliminated. When the price of bonds is below the equilibrium price, the quantity demanded is greater than the quantity supplied, this is called A CONDITION OF EXCESS DEMAND. People now want to buy more bonds than others are willing to sell, so the price of bonds will be driven up. The excess demand for bonds is eliminated by the price rising to the equilibrium level. When the interest rate is below the equilibrium interest rate, the price of the bond is above the equilibrium price, and an excess supply of bonds will result. The price of the bond then falls, leading to a rise in the interest rate toward the equilibrium level. Similarly, when the interest rate is above the equilibrium level, an excess demand for bonds occurs, and the bond price will rise, driving the interest rate back down to the equilibrium level. SUPPLY-AND-DEMAND ANALYSIS: A supply-and-demand diagram can be drawn for any type of bond because the interest rate and price of a bond are always negatively related for all kinds of bonds. An important feature of the analysis is that supply and demand are always in terms of stocks (amounts at a given point in time) of assets, not in terms of flows (amounts per a given unit of time). The asset market approach to understanding behaviour in financial markets is the dominant methodology used by economists because correctly conducting analyses in terms of flows is very tricky, especially when encounter inflation. CHANGES IN EQUILIBRIUM INTEREST RATES: Difference between movements along a demand (or supply) curve and shifts in a demand (or supply) curve: MOVEMENTS ALONG A CURVE = When quantity demanded (or supplied) changes as a result of a change in the price of the bond (or, equivalently, a change in the interest rate), we have a movement along the demand (or supply) curve. A SHIFT IN THE CURVE = A shift in the demand (or supply) curve, by contrast, occurs when the quantity demanded (or supplied) changes at each given price (or interest rate) of the bond in response to a change in some other factor besides the bond's price or interest rate. When one of these factors changes, causing a shift in the demand or supply curve, there will be a new equilibrium value for the interest rate. interest rate to rise. Increased liquidity of bonds results in an increased demand for bonds, and the demand curve shifts to the right. Similarly, decreased liquidity of alternative assets lowers the demand for bonds and shifts the demand curve to the left. ‘Change in Quantity Change in _—Demanded at Each Shift in Variable Variable Bond Price Demand Curve Bxpected interest rate 1 S P Sa 82 89 SHIFTS IN THE SUPPLY OF BONDS: Certain factors can cause the supply curve for bonds to shift, among them these: Expected profitability of investment opportunities: The more profitable plant and equipment investments that a firm expects it can make, the more willing it will be to borrow to finance these investments. When the economy is growing rapidly, as in a business cycle expansion, investment opportunities that are expected to be profitable abound, and the quantity of bonds supplied at any given bond price will increase. Therefore, in a business cycle expansion, the supply of bonds increases, and the supply curve shifts to the right. Likewise, in a recession, when far fewer profitable investment opportunities are expected, the supply of bonds falls, and the supply curve shifts to the left. Price of Bonds, P. 1,000 An increase in the supply of "©". Bondi shfis the bond supply curve rightward. A LI LL Too 200 30 400 RO SM 700 Quantity of Bands, 8 FIGURE 4.3 Shift in the Supply Curve for Bonds When the supply of bonds increases, the supply curve shifts to the right. Expected inflation: The real cost of borrowing is more accurately measured by the real interest rate, which equals the (nominal) interest rate minus the expected inflation rate. For a given interest rate (and bond price), when expected inflation increases, the real cost of borrowing falls; hence the quantity of bonds supplied increases at any given bond price. An increase in expected inflation causes the supply of bonds to increase and the supply curve to shift to the right. Conversely, a decrease in expected inflation causes the supply of bonds to decrease and the supply curve shifts to the left. Government budget: The activities of the government can influence the supply of bonds in several ways. Higher government deficits increase the supply of bonds and shift the supply curve to the right. On the other hand, government surpluses, decrease the supply of bonds and shift the supply curve to the left. State and local governments and other government agencies also issue bonds to finance their expenditures, and this can affect the supply of bonds as well. TABLE 4.3 Factors That Shift the Supply of Bonds SUMMARY Variable Change in Change in Quantity | Shift in Supply Curve Variable —Supplied at Each Bond Price 1 î ® Two important things to keep in mind: 1- When you examine the effect of a variable change, remember we are assuming that all other variables are unchanged = we are making use of the ceteris paribus assumption. 2- Remember that the interest rate is negatively related to the bond price, so when the equilibrium bond price rises, the equilibrium interest rate falls. Conversely, if the equilibrium bond price moves downward, the equilibrium interest rate rises. CASE STUDY - CHANGES IN THE INTEREST RATE DUE TO EXPECTED INFLATION: THE FISHER EFFECT The following figure shows the effect of an increase in expected inflation on the equilibrium interest rate. Figure 4.4 Response to a Change in Expected Inflation Price of Bonds, P Step 2. and shifts the bond supply curvo righiward ... Step 3. causing the price of bonds to fall and the equilibrium interest rale lo riso. Step 1. A risein expected infiation shifts the bond demand curve leftward ... Quantity of Bonds, 8 If expected inflation rises, the expected return on bonds relative to real assets falls for any given bond price and interest rate. As a result, the demand for bonds falls, and the demand curve shifts to the left, from Bd1 to Bd2. The rise in expected inflation also shifts the supply curve. At any given bond price and interest rate, the real cost of borrowing has declined, causing the quantity of bonds supplied to increase, and the supply curve shifts to the right, from Bs1 to Bs2. When the demand and supply curves shift in response to the change in expected inflation, the equilibrium moves from point 1 to point 2, the intersection of Bd2 and Bs2. The equilibrium bond price has fallen from P1 to P2, and because the bond price is negatively related to the interest rate, this means that the interest rate has risen. Managers of financial institutions obtain interest-rate forecasts either by hiring their staff economists to generate forecasts or by purchasing forecasts from other financial institutions or economic forecasting firms. Several methods are used to produce interest-rate forecasts: One of the most popular is based on the supply and demand for bonds framework and it is used by financial institutions. Using this framework, analysts predict what will happen to the factors that affect the supply of and demand for bonds—factors such as the strength of the economy, the profitability of investment opportunities, the expected inflation rate, and the size of government deficits and borrowing. They then use the supply-and-demand analysis to come up with their interest-rate forecasts. A variation of this approach makes use of the Flow of Funds Accounts produced by the Federal Reserve. These data show the sources and uses of funds by different sectors of the American economy. By looking at how well the supply of credit and the demand for credit by different sectors match up, forecasters attempt to predict future changes in interest rates. Forecasting done with the supply and demand for bonds framework often does not make use of formal economic models but rather depends on the judgment or “feel” of the forecaster. An alternative method of forecasting interest rates makes use of econometric models, models whose equations are estimated with statistical procedures using past data. These models involve interlocking equations that, once input variables such as the behaviour of government spending and monetary policy are plugged in, produce simultaneous forecasts of many_variables including interest rates. The basic assumption of these forecasting models is that the estimated relationships among _ variables will continue to hold up in the future. Given this assumption, the forecaster makes predictions of the expected path of the input variables and then lets the model generate forecasts of variables such as interest rates. Managers of financial institutions rely on these forecasts to make decisions about which assets they should hold: * A manager who believes a forecast that long-term interest rates will fall in_ the future would seek to purchase long-term bonds for the asset account because the drop-in interest rates will produce large capital gains. *. Conversely, if forecasts say that interest rates are likely to rise in the future, the manager will prefer to hold short-term bonds or loans in the portfolio in order to avoid potential capital losses on long-term securities. Forecasts of interest rates also help managers decide whether to borrow long- term or short-term: * If interest rates are forecast to rise in the future, the financial institution manager will want to lock in today's low interest rates by borrowing long- term; * if the forecasts say that interest rates will fall, the manager will seek to borrow short-term in order to take advantage of low interest-rate costs in the future. FORECASTING INTEREST RATES: Financial economists are hired to forecast interest rates because businesses need to know what the rates will be in order to plan their future spending, and banks and investors require interest-rate forecasts in order to decide which assets to buy. Interest-rate forecasters predict what will happen to the factors that affect the supply and demand for bonds and for money—factors such as the strength of the economy, the profitability of investment opportunities, the expected inflation rate, and the size of government budget deficits and borrowing. They then use the supply-and-demand analysis to come up with their interest-rate forecasts. RISK STRUCTURE OF INTEREST RATES: Interest rates on different categories of bonds differ from one another in any given year, and the spread (or difference) between the interest rates varies over time. 3 factors that affect the risk structure of interest rates are: Default risk > One attribute of a bond that influences its interest rate is its RISK OF DEFAULT = it occurs when the issuer of the bond is unable or unwilling to make interest payments when promised or to pay off the face value when the bond matures. Bonds with no default risk are called DEFAULT-FREE BONDS. The spread between the interest rates on bonds with default risk and default-free bonds, both of the same maturity, called the RISK PREMIUM = it indicates how much additional interest people must earn to be willing to hold that risky bond. The supply-and-demand analysis of the bond market can be used to explain why a bond with default risk always has a positive risk premium and why the higher the default risk is, the larger the risk premium will be. Figure 5.2 Response to an Increase in Default Risk on Corporate Bonds Step2. and shit the demand curve for Treasury bones to Price of Bonds, P__'horgnt Quanti of Corporate Rende Quantty of Treasury Bonds (8) Corporate bond market 1) Deiault-roe (U.S. Treasuiy) bond market pre ‘Sr cOIROIAe veisuS Treasuny 30 A bond with default risk will always have a positive risk premium, and an increase in its default risk will raise the risk premium. Because default risk is so important to the size of the risk premium, purchasers of bonds need to know whether a corporation is likely to default on its bonds. This information is provided by CREDIT-RATING AGENCIES = they are investment advisory firms that rate the quality of corporate and municipal bonds in terms of the probability of default. Bonds with relatively low risk of default are called INVESTMENT-GRADE SECURITIES and have a rating of Baa (or BBB) and above. Bonds with ratings below Baa (or BBB) have higher default risk and have been aptly dubbed SPECULATIVE-GRADE OR JUNK BONDS + Because these bonds always have higher interest rates than investment-grade securities, they are also referred to as HIGH-YIELD BONDS. 2. Purchase a two-year bond and hold it until maturity. Because both strategies must have the same expected return if people are holding both one- and two-year bonds, the interest rate on the two-year bond must equal the average of the two one-year interest rates. Example: The current interest rate on a one-year bond is 9%, and you expect the interest rate on the one-year bond next year to be 11%. What is the expected return over the two years? What interest rate must a two-year bond have to equal the two one-year bonds? The expected return over the two years will average 10% per year ([9% + 11%]/2 = 10%). The bondholder will be willing to hold both the one- and two- year bonds only if the expected return per year of the two-year bond equals 10%. Therefore, the interest rate on the two-year bond must equal 10%, the average interest rate on the two one-year bonds. Graphically, we have: Toduy Yeur Yeur 0 1 2 Du dirla nio_=o = 0%—____»— Interest rate of int on an n-period bond must be: tt ii ++ + iL; > n lt states that the n-period interest rate equals the average of the one period interest rates expected to occur over the n-period life of the bond. The expectations theory is an elegant theory that explains why the term structure of interest rates (as represented by yield curves) changes at different times. When the yield curve is upward sloping, the expectations theory suggests that short-term interest rates are expected to rise in the future. In this situation, in which the long-term rate is currently higher than the short-term rate, the average of future short-term rates is expected to be higher than the current short-term rate, which can occur only if short-term interest rates are expected to rise. When the yield curve is inverted (slopes downward), the average of future short-term interest rates is expected to be lower than the current short-term rate, implying that short-term interest rates are expected to fall, on average, in the future. Only when the yield curve is flat does the expectations theory suggest that short-term interest rates are not expected to change, on average, in the future. The expectations theory also explains fact 1, which states that interest rates on bonds with different maturities move together over time. Historically, short-term interest rates have had the characteristic that if they increase today, they will tend to be higher in the future. Hence a rise in short- term rates will raise people's expectations of future short-term rates. Because long-term rates are the average of expected future short-term rates, a rise in short-term rates will also raise long-term rates, causing short- and long-term rates to move together. The expectations theory also explains fact 2, which states that yield curves tend to have an upward slope when short-term interest rates are low and are inverted when short-term rates are high. When short-term rates are low, people generally expect them to rise to some normal level in the future, and the average of future expected short-term rates is high relative to the current short-term rate. Therefore, long- term interest rates will be substantially higher than current short- term rates, and the yield curve would then have an upward slope. Conversely, if short-term rates are high, people usually expect them to come back down. Long-term rates would then drop below short-term rates because the average of expected future short-term rates would be lower than current short-term rates, and the yield curve would slope downward and become inverted. The expectations theory is an attractive theory because it provides a simple explanation of the behaviour of the term structure, but unfortunately it has a major shortcoming: It cannot explain fact 3, which says that yield curves usually slope upward. The typical upward slope of yield curves implies that short-term interest rates are usually expected to rise in the future. In practice, short-term interest rates are just as likely to fall as they are to rise, and so the expectations theory suggests that the typical yield curve should be flat rather than upward-sloping. THE MARKET SEGMENTATION THEORY > it can account for fact 3 but not the other two facts. lt sees markets for different-maturity bonds as completely separate and segmented. The interest rate for each bond with a different maturity is then determined by the supply of and demand for that bond, with no effects from expected returns on other bonds with other maturities. The key assumption in market segmentation theory is that bonds of different maturities are NOT SUBSTITUTES AT ALL, so the expected return from holding a bond of one maturity has no effect on the demand for a bond of another maturity. This theory of the term structure is at the opposite extreme to the expectations theory, which assumes that bonds of different maturities are perfect substitutes. The argument for why bonds of different maturities are not substitutes is that investors have strong preferences for bonds of one maturity but not for another, so they will be concerned with the expected returns only for bonds of the maturity they prefer. This might occur because they have a particular holding period in mind, and if they match the maturity of the bond to the desired holding period, they can obtain a certain return with no risk at all. Conversely, if you were putting funds away for your young child to go to college, your desired holding period might be much longer, and you would want to hold longer-term bonds. In this theory, differing yield curve patterns are accounted for by supply-and-demand differences associated with bonds of different maturities. Because in the typical situation the demand for long-term bonds is relatively lower than that for short-term bonds, long-term bonds will have lower prices and higher interest rates, and hence the yield curve will typically slope upward. Although it can explain why yield curves usually tend to slope upward, it has a major flaw in that it cannot explain facts 1 and 2: * because it views the market for bonds of different maturities as completely segmented, there is no reason for a rise in interest rates on a bond of one maturity to affect the interest rate on a bond of another maturity. Therefore, it cannot explain why interest rates on bonds of different maturities tend to move together (fact 1). * because it is not clear how demand and supply for short- versus long-term bonds change with the level of short-term interest rates, the theory cannot explain why yield curves tend to slope upward when short-term interest rates are low and to be inverted when short-term interest rates are high (fact 2). if short-term interest rates are expected to stay the same on average in the future, long-term interest rates will be above short-term interest rates, and yield curves will typically slope upward. SUMMARY: The liquidity premium theory is the most widely accepted theory of the term structure of interest rates because it explains the major empirical facts about the term structure so well. It combines the features of both the expectations theory and the market segmentation theory by asserting that a long-term interest rate will be the sum of a liquidity (term) premium and the average of the short-term interest rates that are expected to occur over the life of the bond. The liquidity premium theory explains the following facts: * Interest rates on bonds of different maturities tend to move together over time. * Yield curves usually slope upward. When short-term interest rates are low, yield curves are more likely to have a steep upward slope, whereas when short-term interest rates are high, yield curves are more likely to be inverted. The theory also helps us predict the movement of short-term interest rates in the future: e A steep upward slope of the yield curve means that short-term rates are expected to rise; e a mild upward slope means that short-term rates are expected to remain the same; * a flat slope means that short-term rates are expected to fall moderately; e an inverted_ yield curve means that short-term rates are expected to fall sharply. THE EFFICIENT MARKET HYPOTHESIS: Expectations are important in the financial system because: * Expectations of returns, risk, and liquidity impact asset demand; e Inflationary expectations impact bond prices; * Expectations not only affect our understanding of markets, but also how financial institutions operate. To understand how expectations affect securities prices, we need to look at how information in the market affects these prices. To do this we examine the EFFICIENT MARKET HYPOTHESIS (also referred to as the theory of efficient capital markets) = which states that prices of securities in financial markets fully reflect all available information. The rate of return from holding a security equals the sum of the capital gain on the security (the change in the price) plus any cash payments, divided by the initial purchase price of the security: Pt+1-Pt+C Pt R= R = rate of return on the security held from time t to timet+1 Pt + 1 = price of the security at time t + 1, the end of the holding period Pt = the price of the security at time t, the beginning of the holding period C = cash payment (coupon or dividend payments) made in the periodttot+1 Because the current price and the cash payment C are known at the beginning, the only variable in the definition of the return that is uncertain is the price next period, Pt+1. Denoting the expectation of the security's price at the end of the holding period as Pet+1, the expected return Re is: - P°t+1-Pt+C Pt R° The efficient market hypothesis views expectations as equal to optimal forecasts using all available information = An optimal forecast is the best guess of the future using all available information. This does not mean that the forecast is perfectly accurate, but only that it is the best possible given the available information. P°t+1=P%t+1 which in turn implies that the expected return on the security will equal the optimal forecast of the return: r°=R°% The supply-and-demand analysis of the bond market shows us that the expected return on a security will have a tendency to head toward the equilibrium return that equates the quantity demanded to the quantity supplied. Supply-and-demand analysis enables us to determine the expected return on a security with the following equilibrium condition: The expected return on a security Re equals the equilibrium return R*, which equates the quantity of the security demanded to the quantity supplied: r°=R'. We can derive an equation to describe pricing behaviour in an efficient market by using the equilibrium condition to replace Re with R*, in this way we obtain that rR°=R' > This equation tells us that current prices in a financial market will be set so that the optimal forecast of a security’s return using all available information equals the security's equilibrium return > Financial economists state it more simply: A security's price fully reflects all available information in an efficient market. Example: Suppose that a share of Microsoft had a closing price yesterday of $90, but new information was announced after the market closed that caused a revision in the forecast of the price for next year to go to $120. If the annual equilibrium return on Microsoft is 15%, what does the efficient market hypothesis indicate the price will go to today when the market opens? (Assume that Microsoft pays no dividends.) _P't+1-Pt+C_ Pt RI R' Rof = optimal forecast of the return = 15% = 0.15 R* = equilibrium return = 15% = 0,15 Pof t+1 = optimal forecast of price next year = $120 Pt = price today after opening C = cash (dividend) payment = 0 o15=120—P10 015 Pt Pt (0,15) = 120 - Pt Pt + Pt (0,15) = 120 - Pt + Pt Pt + Pt (0,15) = 120 In recent years, the theory has begun to show a few cracks, referred to as anomalies, and empirical evidence indicates that the efficient market hypothesis may not always be generally applicable. Small-Firm Effect > Many empirical studies have shown that small firms have earned abnormally high returns over long periods of time, even when the greater risk for these firms has been taken into account. January Effect + Over long periods of time, stock prices have tended to experience an abnormal price rise from December to January that is predictable and hence inconsistent with random-walk behaviour. Some financial economists argue that the January effect is due to tax issues. Investors have an incentive to sell stocks before the end of the year in December because they can then take capital losses on their tax return and reduce their tax liability. Then when the new year starts in January, they can repurchase the stocks, driving up their prices and producing abnormally high returns. Market Overreaction > Recent research suggests that stock prices may overreact to news announcements and that the pricing errors are corrected only slowly. This violates the efficient market hypothesis because an investor could earn abnormally high returns, on average, by buying a stock immediately after a poor earnings announcement and then selling it after a couple of weeks when it has risen back to normal levels. Excessive Volatility > A closely related phenomenon to market overreaction is that the stock market appears to display EXCESSIVE VOLATILITY = fluctuations in stock prices may be much greater than is warranted by fluctuations in their fundamental value. Mean Reversion > Some researchers have also found that stock returns display MEAN REVERSION: Stocks with low returns today tend to have high returns in the future, and vice versa. Hence stocks that have done poorly in the past are more likely to do well in the future because mean reversion indicates that there will be a predictable positive change in the future price, suggesting that stock prices are not a random walk. Other researchers have found that mean reversion is not nearly as strong in data after World War Il and so have raised doubts about whether it is currently an important phenomenon. The evidence on mean reversion remains controversial. New Information Is Not Always Immediately Incorporated into Stock Prices > Although it is generally found that stock prices adjust rapidly to new information, as is suggested by the efficient market hypothesis, recent evidence suggests that inconsistent with the efficient market hypothesis, stock prices do not instantaneously adjust to profit announcements. Instead, on average stock prices continue to rise for some time after the announcement of unexpectedly high profits, and they continue to fall after surprisingly low profit announcements. OVERVIEW OF THE EVIDENCE ON THE EFFICIENT MARKET HYPOTHESIS: The evidence seems to suggest that the efficient market hypothesis may be a reasonable starting point for evaluating behaviour in financial markets. However, there do seem to be important violations of market efficiency that suggest that the efficient market hypothesis may not be the whole story and so may not be generalizable to all behaviour in financial markets. WHY THE EFFICIENT MARKET HYPOTHESIS DOES NOT IMPLY THAT FINANCIAL MARKETS ARE EFFICIENT: Many financial economists take the efficient market hypothesis one step further in their analysis of financial markets. Not only do they believe that expectations in financial markets are rational = (equal to optimal forecasts using all available information) but they also add the condition that prices in financial markets reflect the true fundamental (intrinsic) value of the securities. In other words, all prices are always correct and reflect market fundamentals (items that have a direct impact on future income streams of the securities) and so financial markets are efficient. This stronger view of market efficiency has several important implications in the academic field of finance: 1. it implies that in an efficient capital market, one investment is as good as any other because the securities’ prices are correct. 2. it implies that a security’s price reflects all available information about the intrinsic value of the security. 3. it implies that security prices can be used by managers of both financial and non-financial firms to assess their cost of capital (cost of financing their investments) accurately and hence that security prices can be used to help them make the correct decisions about whether a specific investment is worth making. This stronger version of market efficiency is a basic tenet of much analysis in the finance field. The efficient market hypothesis may be misnamed, however. It does not imply the stronger view of market efficiency but rather just that prices in markets like the stock market are unpredictable. BASIC FACTS ABOUT FINANCIAL STRUCTURE THROUGHOUT THE WORLD: The financial system is complex in both structure and function throughout the world. It includes many types of institutions: banks, insurance companies, mutual funds, stock and bond markets, and so on—all of which are regulated by government. The financial system channels trillions of dollars per year from savers to people with productive investment opportunities. If we take a close look at financial structure all over the world, we find 8 basic facts that we need to explain to understand how the financial system works: 1. Stocks are not the most important source of external financing for businesses. 2. Issuing marketable debt and equity securities is not the primary way in which businesses finance their operations. 3. Indirect finance, which involves the activities of financial intermediaries, is many times more important than direct finance, in which businesses raise funds directly from lenders in financial markets. 4. Financial intermediaries, particularly banks, are the most important source of external funds used to finance businesses. 5. The financial system is among the most heavily regulated sectors of the economy. 6. Only large, well-established corporations have easy access to securities markets to finance their activities. 7. Collateral is a prevalent feature of debt contracts for both households and businesses +Collateral is property that is pledged to a lender to guarantee payment in the event that the borrower is unable to make debt payments. Collateralized debt (also known as secured debt to contrast it with unsecured debt, such as credit card debt, which is not collateralized) is the predominant form of household debt and is widely used in business borrowing as well. 8. Debt contracts typically are extremely complicated legal documents that place substantial restrictions on the behaviour of the borrower. An important feature of financial markets is that they have substantial transaction and information costs. An economic analysis of how these costs affect financial markets provides us with explanations of the eight facts, about the individuals or firms seeking to finance their investment activities. One way to get this material to saver-lenders is to have private companies collect and produce information that distinguishes good from bad firms and then sell it. The system of private production and sale of information does not completely solve the adverse selection problem in securities markets, however, because of the FREE-RIDER PROBLEM = it occurs when people who do not pay for information take advantage of the information that other people have paid for. Government Regulation to Increase Information > The government could, for instance, produce information to help investors distinguish good from bad firms and provide it to the public free of charge. This solution, however, would involve the government in releasing negative information about firms, a practice that might be politically difficult. A second possibility is for the government to regulate securities markets in a way that encourages firms to reveal honest information about themselves so that investors can determine how good or bad the firms are, Financial Intermediation >Because it is hard for individuals to acquire enough information about used cars, most used cars are not sold directly by one individual to another. Instead, they are sold by an intermediary, a used-car dealer who purchases used cars from individuals and resells them to other individuals. Used-car dealers produce information in the market by becoming experts in determining whether a car is a peach or a lemon. Once they know that a car is good, they can sell it with some form of a guarantee: either a guarantee that is explicit, such as a warranty, or an implicit guarantee, in which they stand by their reputation for honesty. People are more likely to purchase a used car because of a dealer's guarantee, and the dealer is able to make a profit on the production of information about automobile quality by being able to sell the used car at a higher price than the dealer paid for it. If dealers purchase and then resell cars on which they have produced information, they avoid the problem of other people free riding on the information they produced. Just as used-car dealers help solve adverse selection problems in the automobile market, financial intermediaries play a similar role in financial markets. A financial intermediary, such as a bank, becomes an expert in producing information about firms, so that it can sort out good credit risks from bad ones. Then it can acquire funds from depositors and lend them to the good firms. Because the bank is able to lend mostly to good firms, it is able to earn a higher return on its loans than the interest it has to pay to its depositors. The resulting profit that the bank earns gives it the incentive to engage in this information production activity. The analysis of adverse selection indicates that financial intermediaries in general—and banks in particular, because they hold a large fraction of nontraded loans—should play a greater role in moving funds to corporations than securities markets do. Collateral and Net Worth + Adverse selection interferes with the functioning of financial markets only if a lender suffers a loss when a borrower is unable to make loan payments and thereby defaults. * Collateral, property promised to the lender if the borrower defaults, reduces the consequences of adverse selection because it reduces the lender’s losses in the event of a default. If a borrower defaults on a loan, the lender can sell the collateral and use the proceeds to make up for the losses on the loan. e Net worth (also called equity capital), the difference between a firm’s assets (what it owns or is owed) and its liabilities (what it owes), can perform a similar role to that of collateral. If a firm has a high net worth, then even if it engages in investments that cause it to have negative profits and so defaults on its debt payments, the lender can take title to the firm's net worth, sell it off, and use the proceeds to recoup some of the losses from the loan. In addition, the more net worth a firm has in the first place, the less likely it is to default, because the firm has a cushion of assets that it can use to pay off its loans. Hence, when firms seeking credit have high net worth, the consequences of adverse selection are less important, and lenders are more willing to make loans. SUMMARY: So far, we have used the concept of adverse selection to explain seven of the eight facts about financial structure introduced earlier: * The first four emphasize the importance of financial intermediaries and the relative unimportance of securities markets for the financing of corporations; * the fifth, that financial markets are among the most heavily regulated sectors of the economy; * the sixth, that only large, well-established corporations have access to securities markets; * the seventh, that collateral is an important feature of debt contracts. HOW MORAL HAZARD AFFECTS THE CHOICE BETWEEN DEBT AND EQUITY CONTRACTS: Moral hazard is the asymmetric information problem that occurs after the financial transaction takes place, when the seller of a security may have incentives to hide information and engage in activities that are undesirable for the purchaser of the security. Moral hazard has important consequences for whether a firm finds it easier to raise funds with debt than with equity contracts. MORAL. HAZARD IN EQUITY CONTRACTS: THE PRINCIPAL-AGENT PROBLEM EQUITY CONTRACTS = such as common stock, are claims to a share in the profits and assets of a business. They are subject to a particular type of moral hazard called the PRINCIPAL- AGENT PROBLEM = when managers own only a small fraction of the firm they work for, the stockholders who own most of the firm's equity (called the principals) are not the same people as the managers of the firm, who are the agents of the owners. This separation of ownership and control involves moral hazard, in that the managers in control (the agents) may act in their own interest rather than in the interest of the stockholder-owners (the principals) because the managers have less incentive to maximize profits than the stockholder-owners do. The principal-agent problem would not arise if the owners of a firm had complete information about what the managers were up to and could prevent wasteful expenditures or fraud. The principal-agent problem, which is an example of moral hazard, arises only because a manager, has more information about his activities than the stockholder does—that is, information is asymmetric. TOOLS TO HELP SOLVE THE PRINCIPAL-AGENT PROBLEM: Production of Information: Monitoring + the principal-agent problem arises because managers have more information about their activities and actual profits than stockholders do. One way for stockholders to reduce this moral hazard problem is for them to engage in a particular type of information production, the monitoring of the firm’s activities: auditing the firm frequently and checking on what the management is doing. The problem is that the monitoring process can be expensive in terms of time and money, as reflected in the name economists give it, COSTLY STATE VERIFICATION = it makes the equity contract less desirable, restrict the borrowing firm from engaging in certain risky business activities, such as purchasing other businesses). 2. Covenants to encourage desirable behaviour: Restrictive covenants can encourage the borrower to engage in desirable activities that make it more likely that the loan will be paid off (ex. it requires the breadwinner in a household to carry life insurance that pays off the mortgage upon that person's death). Restrictive covenants of this type for businesses focus on encouraging the borrowing firm to keep its net worth high because higher borrower net worth reduces moral hazard and makes it less likely that the lender will suffer losses. These restrictive covenants typically specify that the firm must maintain minimum holdings of certain assets relative to the firm'’s size. 3. Covenants_to keep collateral valuable > Because collateral is an important protection for the lender, restrictive covenants can encourage the borrower to keep the collateral in good condition and make sure that it stays in the possession of the borrower. This is the type of covenant ordinary people encounter most often. 4. Covenants to provide information > Restrictive covenants also require a borrowing firm to provide information about its activities periodically in the form of quarterly accounting and income reports, thereby making it easier for the lender to monitor the firm and reduce moral hazard. This type of covenant may also stipulate that the lender has the right to audit and inspect the firm’s books at any time. Debt contracts are often complicated legal documents with numerous restrictions on the borrower’'s behaviour (fact 8): Debt contracts require complicated restrictive covenants to lower moral hazard. Financial Intermediation > Financial intermediaries (particularly banks) have the ability to avoid the free-rider problem as long as they make primarily private loans = they are not traded, so no one else can free- ride on the intermediary's monitoring and enforcement of the restrictive covenants. The intermediary making private loans thus receives the benefits of monitoring and enforcement and will work to shrink the moral hazard problem inherent in debt contracts. The concept of moral hazard has provided us with additional reasons why financial intermediaries play a more important role in channelling funds from savers to borrowers than marketable securities do, as described in facts 3 and 4. SUMMARY: The presence of asymmetric information in financial markets leads to adverse selection and moral hazard problems that interfere with the efficient functioning of those markets. Tools to help solve these problems involve the private production and sale of information, government regulation to increase information in financial markets, the importance of collateral and net worth to debt contracts, and the use of monitoring and restrictive covenants. A key finding from our analysis is that the existence of the free-rider problem for traded securities such as stocks and bonds indicates that financial intermediaries (particularly banks) should play a greater role than securities markets in financing the activities of businesses. Economic analysis of the consequences of adverse selection and moral hazard has helped explain the basic features of our financial system and has provided solutions to the eight facts about the financial structure. TABLE 7.1 Asymmetric Information Problems and Tools to Solve Them SUMMARY Asymmetrie Information Explains Fact Problem Tools to Solve It Number Adwerse selection Private production and E information nment regulation to Financial intermediation 3,4,6 Gollateral and net worth "i Moral hazard in equity contracts Production of information: 1 (principal-agent problem) monitoring Government regulation to 5 inerease information Financial intermediation 3 Debt contracts 1 Moral hazard in debt contracts Note: List of facts a CONFLICTS OF INTEREST: WHAT ARE CONFLICTS OF INTEREST AND WHY DO WE CARE? Although the presence of ECONOMIES OF SCOPE = they can lower the cost of information production for each service by applying one information resource to many different services, may substantially benefit financial institutions, it also creates potential costs in terms of CONFLICTS OF INTEREST = they are a type of moral hazard problem that arise when a person or institution has multiple objectives (interests) and, as a result, has conflicts among those objectives. They are especially likely to occur when a financial institution provides multiple services. The potentially competing interests of those services may lead individuals who work for financial institutions to conceal information or disseminate misleading information. We care about conflicts of interest because a substantial reduction in the quality of information in financial markets increases asymmetric information problems and prevents financial markets from channelling funds into the most productive investment opportunities. Consequently, the financial markets and the economy become less efficient. WHY DO CONFLICTS OF INTEREST ARISE? Three types of financial service activities have led to prominent conflicts-of-interest problems in financial markets in recent years: underwriting and research in investment banks, auditing and consulting in accounting firms, and credit assessment and consulting in credit-rating agencies. Underwriting and Research_in Investment Banking > Investment banks perform two tasks: They research companies issuing securities, and they underwrite these securities by selling them to the public on behalf of the issuing corporations. Investment banks often combine these distinct financial services because information synergies are possible = information produced for one task may also be useful in the other task. A conflict of interest arises between the brokerage and underwriting services because the banks are attempting to simultaneously serve two client groups—the security-issuing firms and the security-buying investors. These client groups have different information needs. Issuers benefit from optimistic research, whereas investors desire unbiased research. However, the same information will be produced for both groups to take advantages of economies of scope. When the potential revenues from underwriting greatly exceed the brokerage commissions from selling, the bank will have a strong incentive to alter the information provided to investors to favour the issuing firm's needs or else risk losing the firm's business to competing investment banks. Another common practice that exploits conflicts of interest is SPINNING = it occurs when an investment bank allocates hot, but under-priced, initial PUBLIC OFFERINGS - IPOs = shares of newly issued stock, to executives of other companies in return for their companies’ future business with the investment banks. Auditing and Consulting in Accounting Firms > Traditionally, an auditor checks the books of companies and monitors the quality of the information produced WHAT IS A FINANCIAL CRISIS? A fully functioning financial system is critical to a robust economy. The financial system performs the essential function of channelling funds to individuals or businesses with productive investment opportunities. If capital goes to the wrong uses or does not flow at all, the economy will operate inefficiently or go into an economic downturn. AGENCY THEORY AND THE DEFINITION OF A FINANCIAL CRISIS: Academic finance literature calls the analysis of how asymmetric information problems can generate adverse selection and moral hazard problems, agency theory = it provides the basis for the definition of a financial crisis. Asymmetric information problems act as a barrier to financial markets channelling funds efficiently from savers to households and firms with productive investment opportunities and are often described by economists as financial frictions. When financial frictions increase, it is harder for lenders to ascertain the creditworthiness of borrowers. FINANCIAL CRISIS = it occurs when information flows in financial markets experience a particularly large disruption, with the result that financial frictions and credit spreads increase sharply, and financial markets stop functioning. Then economic activity will collapse. DYNAMICS OF FINANCIAL CRISES: Three stages: STAGE ONE: INITIAL PHASE > Financial crises can begin in several ways: credit and asset-price booms and busts or a general increase in uncertainty caused by failures of major financial institutions. Credit Boom and Bust: it occurs when an economy introduces new types of loans or other financial products = financial innovation, or when countries engage in financial liberalization = the elimination of restrictions on financial markets and institutions. In the long run, financial liberalization can promote financial development and lead to a well-run financial system that allocates capital efficiently. However, financial liberalization has a dark side: In the short run, it can prompt financial institutions to go on a lending spree, called a credit boom. Unfortunately, lenders may not have the expertise, or the incentives, to manage risk appropriately in these new lines of business. Even with proper management, credit booms eventually outstrip the ability of institutions and government regulators to screen and monitor credit risks, leading to overly risky lending. Government safety nets, such as deposit insurance, weaken market discipline and increase the moral hazard incentive for banks to take on greater risk than they otherwise would. Because lender-savers know that government-guaranteed insurance protects them from losses, they will supply even undisciplined banks with funds. Banks and other financial institutions can make risky, high-interest loans to borrower-spenders. They will walk away with nice profits if the loans are repaid, and rely on government deposit insurance, funded by taxpayers, if borrower-spenders default. Without proper monitoring, risk taking grows unchecked. Eventually, losses on loans begin to mount, and the value of the loans (on the asset side of the balance sheet) falls relative to liabilities, thereby driving down the net worth (capital) of banks and other financial institutions. With less capital, these financial institutions cut back on their lending to borrower-spenders, a process called deleveraging. Furthermore, with less capital, banks and other financial institutions become riskier, causing lender-savers and other potential lenders to these institutions to pull out their funds. Fewer funds mean fewer loans to fund productive investments and a credit freeze: The lending boom turns into a lending crash. When financial institutions stop collecting information and making loans, financial frictions rise, limiting the financial system’s ability to address the asymmetric information problems of adverse selection and moral hazard. As loans become scarce, borrower-spenders are no longer able to fund their productive investment opportunities and they decrease their spending, causing economic activity to contract. Asset-Price Boom and Bust: Prices of assets such as equity shares and real estate can be driven by investor psychology well above their fundamental economic values = their values based on realistic expectations of the assets’ future income streams. The rise of asset prices above their fundamental economic values is an asset-price bubble. Asset-price bubbles are often also driven by credit booms, in which the large increase in credit is used to fund purchases of assets, thereby driving up their price. When the bubble bursts and asset prices realign with fundamental economic values, stock and real estate prices tumble, companies see their net worth (the difference between their assets and their liabilities) decline, and the value of collateral they can pledge drops. As a result, financial institutions tighten lending standards for borrower-spenders and lending contracts. The asset-price bust also causes a decline in the value of financial institutions’ assets, thereby causing a decline in their net worth and hence a deterioration in their balance sheets, which causes them to deleverage, steepening the decline in economic activity. Increase in Uncertainty: With information hard to come by in a period of high uncertainty, financial frictions increase, reducing lending and economic activity. STAGE TWO: BANKING CRISIS +>Deteriorating balance sheets and tougher business conditions lead some financial institutions into insolvency, when net worth becomes negative. Unable to pay off depositors or other creditors, some banks go out of business. lf severe enough, these factors can lead to a bank panic, in which multiple banks fail simultaneously. The source of the contagion is asymmetric information. In a panic, depositors, fearing for the safety of their deposits (in the absence of or with limited amounts of deposit insurance) and not knowing the quality of banks’ loan portfolios, withdraw their deposits to the point that the banks fail. Uncertainty about the health of the banking system in general can lead to runs on banks, both good and bad, which will force banks to sell off assets quickly to raise the necessary funds. These fire sales of assets may cause their prices to decline so much that the bank becomes insolvent, even if the resulting contagion can then lead to multiple bank failures and a full-fledged bank panic. With fewer banks operating, information about the creditworthiness of borrower-spenders disappears. Increasingly severe adverse selection and moral hazard problems in financial markets increase financial frictions and deepen the financial crisis, causing declines in asset prices and the failure of firms throughout the economy that lack funds for productive investment opportunities. Eventually, public and private authorities shut down insolvent firms and sell them off or liquidate them. Uncertainty in financial markets declines, the stock market recovers, and balance sheets improve. Financial frictions diminish and the financial crisis subsides. With the financial markets able to operate well again, the stage is set for an economic recovery. STAGE THREE: DEBT DEFLATION +>lf, however, the economic downturn leads to a sharp decline in the price level, the recovery process can be short-circuited. joked that he “would like to know what those damn things are worth." In other words, the increased complexity of structured products can actually reduce the amount of information in financial markets, thereby worsening asymmetric information in the financial system and increasing the severity of adverse selection and moral hazard problems. Agency Problems in the Mortgage Markets> The mortgage brokers that originated the loans often did not make a strong effort to evaluate whether the borrower could pay off the loan, since they would quickly sell (distribute) the loans to investors in the form of mortgage-backed securities. This originate- to-distribute business model was exposed to the principal-agent problem in which the mortgage brokers acted as agents for investors (the principals) but did not have the investors’ best interests at heart. Once the mortgage broker earns his or her fee, why should the broker care if the borrower makes good on his or her payment? The more volume the broker originates, the more he or she makes. Not surprisingly, adverse selection became a major problem. Risk-loving investors lined up to obtain loans to acquire houses that would be very profitable if housing prices went up, knowing they could “walk away," = default on their loans, if housing prices went down. The principal-agent problem also created incentives for mortgage brokers to encourage households to take on mortgages they could not afford or to commit fraud by falsifying information on a borrower's mortgage applications in order to qualify them for mortgages. Compounding this problem was lax regulation of originators, who were not required to disclose information to borrowers that would have helped them assess whether they could afford the loans. The agency problems went even deeper. Commercial and investment banks, which were earning large fees by underwriting mortgage-backed securities and structured credit products like CDOs, also had weak incentives to make sure that the ultimate holders of the securities would be paid off. Financial derivatives, financial instruments whose payoffs are linked to (i.e., derived from) previously issued securities, also were an important source of excessive risk taking. Large fees from writing financial insurance contracts called credit default swaps, which provide payments to holders of bonds if they default, also drove units of insurance companies like AIG to write hundreds of billions of dollars’ worth of these risky contracts. Asymmetric Information and Credit-Rating Services > Credit-rating agencies, who rate the quality of debt securities in terms of the probability of default, were another contributor to asymmetric information in financial markets. The rating agencies advised clients on how to structure complex financial instruments, like CDOs, at the same time they were rating these identical products. The rating agencies were thus subject to conflicts of interest because the large fees they earned from advising clients on how to structure products they were rating meant that they did not have sufficient incentives to make sure their ratings were accurate. The result was wildly inflated ratings that enabled the sale of complex financial products that were far riskier than investors recognized. Effects of the 2007-2009 Financial Crisis: Consumers and businesses alike suffered as a result of the 2007-2009 financial crisis. The impact of the crisis was most evident in five key areas: the U.S. residential housing market, financial institutions’ balance sheets, the shadow banking system, global financial markets, and the headline-grabbing failures of major firms in the financial industry. Residential Housing Prices: Boom and Bust > The subprime mortgage market took off after the recession ended in 2001. By 2007, it had become over a trillion-dollar market. The development of the subprime mortgage market was encouraged by politicians because it led to a “democratization of credit” and helped raise U.S. homeownership rates to the highest levels in history. The asset-price boom in housing, which took off after the 2000-2001 recession was over, also helped stimulate the growth of the subprime mortgage market. High housing prices meant that subprime borrowers could refinance their houses with even larger loans when their homes appreciated in value. With housing prices rising, subprime borrowers were also unlikely to default because they could always sell their house to pay off the loan, making investors happy because the securities backed by cash flows from subprime mortgages would have less risk and higher returns. The growth of the subprime mortgage market, in turn, increased the demand for houses and so fuelled the boom in housing prices, resulting in a housing price bubble. Further stimulus to the housing market came from low interest rates on residential mortgages, which were the result of several different forces: * First was the huge capital inflows into the United States from countries like China and India. * Second was congressional legislation that encouraged Fannie Mae and Freddie Mac to purchase trillions of dollars of mortgage-backed securities. * Third was easy Federal Reserve monetary policy to lower interest rates. The resulting low cost of financing housing purchases then further stimulated the demand for housing, pushing up housing prices. (A highly controversial issue is whether the Federal Reserve was to blame for the housing price bubble, and this is discussed in the Inside the Fed box). As housing prices rose and profitability for mortgage originators and lenders was high, the underwriting standards for subprime mortgages fell to lower and lower standards. High-risk borrowers were able to obtain mortgages, and the amount of the mortgage relative to the value of the house, the loan-to-value ratio (LTV), rose. Borrowers were often able to get piggyback, second, and third mortgages on top of their original 80% loan-to-value mortgage, so that they had to put almost no money down. When asset prices rise too far out of line with fundamentals—in the case of housing, how much housing costs if purchased relative to the cost of renting it, or the cost of houses relative to households' median income—they must come down. Eventually, the housing price bubble burst. With housing prices falling after their peak in 2006, the rot in the financial system caused by questionable lending practices began to be revealed. The decline in housing prices led to many subprime borrowers finding that their mortgages were “underwater"—that is, the value of the house fell below the amount of the mortgage. When this happened, struggling homeowners had tremendous incentives to walk away from their homes and just send the keys back to the lender. Defaults on mortgages shot up sharply, eventually leading to millions of mortgages in foreclosure. Deterioration_of Financial Institutions’ Balance Sheets > The decline in U.S. housing prices led to rising defaults on mortgages. As a result, the value of mortgage-backed securities and CDOs collapsed, leaving banks and other financial institutions with a lower value of assets and thus a decline in net worth. With weakened balance sheets, these banks and other financial institutions began to deleverage, selling off assets and restricting the availability of credit to both households and businesses. With no one else able to step in to collect information and make loans, the reduction in bank lending meant that financial frictions increased in financial markets. Run on the Shadow Banking System > The sharp decline in the value of mortgages and other financial assets triggered a run on the shadow banking system, composed of hedge funds, investment banks, and other non- depository financial firms, which are not as tightly regulated as banks. Funds from shadow banks flowed through the financial system and for many years supported the issuance of low-interest-rate mortgages and auto loans. These securities were funded primarily by repurchase agreements (repos), short- term borrowing that, in effect, uses assets like mortgage-backed securities as collateral. Rising concern about the quality of a financial institution's balance sheet led lenders to require larger amounts of collateral, known as haircuts. With rising defaults on mortgages, the value of mortgage-backed securities fell, which then led to a rise in haircuts. At the start of the crisis, haircuts were close to zero, but they eventually rose to nearly 50%. The result was that the same amount of collateral would allow financial institutions to borrow only half as much. Thus, to raise funds, financial institutions had to engage in fire sales and sell off their assets very rapidly. Because selling assets quickly requires lowering their price, the fire sales led to a further decline in financial institutions’ asset values. This decline lowered the value of collateral further, raising haircuts and thereby forcing financial institutions to scramble even more for liquidity. The result was similar to the run on the banking system that PURPOSE OF THE CAPITAL MARKET: Firms that issue capital market securities and the investors who buy them have very different motivations than those who operate in the money markets. Firms and individuals use the money markets primarily to warehouse funds for short periods of time until a more important need or a more productive use for the funds arises. By contrast, firms and individuals use the capital markets for long-term investments (maturity greater than 1 year). The primary reason that individuals and firms choose to borrow long-term is to reduce the risk that interest rates will rise before they pay off their debt. CAPITAL MARKET PARTICIPANTS: The primary issuers of capital market securities are federal and local governments and corporations: * The federal government issues long-term notes and bonds to fund the national debt. e State and municipal governments also issue long-term notes and bonds to finance capital projects, such as school and prison construction. e Governments never issue stock because they cannot sell ownership claims. e. Corporations issue both bonds and stock. One of the most difficult decisions a firm face can be whether it should finance its growth with debt or equity. The distribution of a firm's capital between debt and equity is called its capital structure. Corporations may enter the capital markets because they do not have sufficient capital to fund their investment opportunities. Alternatively, firms may choose to enter the capital markets because they want to preserve their capital to protect against unexpected needs. In either case, the availability of efficiently functioning capital markets is crucial to the continued health of the business sector. The largest purchasers of capital market securities are households. Frequently, individuals and households deposit funds in financial institutions that use the funds to purchase capital market instruments such as bonds or stock. CAPITAL MARKET TRADING: Capital market trading occurs in either the primary market or the secondary market: * The primary market is where new issues of stocks and bonds are introduced. Investment funds, corporations, and individual investors can all purchase securities offered in the primary market. A primary market transaction is where the issuer of the security actually receives the proceeds of the sale. When firms sell securities for the very first time, the issue is an initial public offering - IPO. Subsequent sales of a firm's new stocks or bonds to the public are simply primary market transactions (as opposed to an initial one). * A secondary market is where the sale of previously issued securities takes place. They are critical in capital markets because most investors plan to sell long-term bonds at some point before they mature. There are two types of exchanges in the secondary market for capital securities: ORGANIZED EXCHANGES (it has a building where securities trade; its securities include stocks, bonds, options and futures) and OVER-THE-COUNTER EXCHANGES. TYPES OF BONDS: BONDS = are securities that represent a debt owed by the issuer to the investor. Bonds obligate the issuer to pay a specified amount at a given date, generally with periodic interest payments. The PAR, FACE, OR MATURITY VALUE OF THE BOND = is the amount that the issuer must pay at maturity. The COUPON RATE = is the rate of interest that the issuer must pay, and this periodic interest payment is often called the COUPON PAYMENT. This rate is usually fixed for the duration of the bond and does not fluctuate with market interest rates. If the repayment terms of a bond are not met, the holder of a bond has a claim on the assets of the issuer. Long-term bonds traded in the capital market include long-term government notes and bonds, municipal bonds, and corporate bonds. TREASURY NOTES AND BONDS: The U.S. Treasury issues notes and bonds to finance the national debt. The difference between a note and a bond is that notes have an original maturity of 1 to 10 years while bonds have an original maturity of 10 to 30 years. Federal government notes and bonds are free of default risk because the government can always print money to pay off the debt if necessary. This does not mean that these securities are risk-free. TREASURY BOND INTEREST RATE: Treasury bonds have very low interest rates because they have no default risk. TREASURY SECURITIES: TYPE: MATURITY: Treasury bill Less than 1 year Treasury note 1 to 10 years Treasury bond 10 to 30 years Treasury Inflation-Protected Securities (TIPS): In 1997 the Treasury Department began offering an innovative bond designed to remove inflation risk from holding treasury securities. The inflation-indexed bonds have an interest rate that does not change throughout the term of the security. However, the principal amount used to compute the interest payment does change based on the consumer price index. At maturity, the securities are redeemed at the greater of their inflation-adjusted principal or par-amount at original issue. The advantage of inflation-indexed securities, also referred to as inflation protected securities, is that they give both individual and institutional investors a chance to buy a security whose value won't be eroded by inflation. These securities can be used by retirees who want to hold a very low-risk portfolio. They are offered by the Treasury with maturities of 5, 10, and 30 years. Treasury STRIPS: In addition to bonds, notes, and bills, in 1985 the Treasury began issuing to depository institutions bonds in book entry form called Separate Trading of Registered Interest and Principal Securities - STRIPS (the security is issued and accounted for electronically). It_separates the periodic interest payments from the final principal repayment. When a Treasury fixed- principal or inflation-indexed note or bond is “stripped," each interest payment and the principal payment becomes a separate zero-coupon security. Each component has its own identifying number and maturity and can be held or traded separately. STRIPS are also called zero-coupon securities because the only time an investor receives a payment during the life of each STRIPS component is when it matures. Agency Bonds: Congress has authorized a number of U.S. agencies, also known as government-sponsored enterprises (GSEs), to issue bonds. Since the tax-free municipal bond rate (3,75%) is higher than the equivalent tax-free rate (3,6%), choose the municipal bond. There are two types of municipal bonds: 1. General obligation bonds do not have specific assets pledged as security or a specific source of revenue allocated for their repayment. Instead, they are backed by the “full faith and credit” of the issuer = it means that the issuer promises to use every resource available to repay the bond as promised. Most general obligation bond issues must be approved by the taxpayers because the taxing authority of the government is pledged for their repayment. 2. Revenue bonds are backed by the cash flow of a particular revenue-generating project. RISK IN THE MUNICIPAL BOND MARKET: Municipal bonds are not default-free. Unlike the federal government, local governments cannot print money, and there are real limits on how high they can raise taxes without driving the population away. CORPORATE BONDS: When large corporations need to borrow funds for long periods of time, they may issue bonds. Most corporate bonds have a face value of $1.000 and pay interest semi-annually (twice per year). Most are also callable = meaning that the issuer may redeem the bonds prior to maturity after a specified date. The BOND INDENTURE = is a contract that states the lender's rights and privileges and the borrower's obligations. Any collateral offered as security to the bond holders is also described in the indenture. The degree of risk varies widely among different bond issues because the risk of default depends on the company's health, which can be affected by a number of variables. The interest rate on corporate bonds varies with the level of risk: bonds with lower risk and a higher rating (AAA being the highest) have lower interest rates than more risky bonds (BBB). The spread between the differently rated bonds varies over time. The spread between AAA and BBB rated bonds has historically averaged a little over 1%. A bond's interest rate also depends on its features and characteristics. CHARACTERISTICS OF CORPORATE BONDS: At one time bonds were sold with attached coupons that the owner of the bond clipped and mailed to the firm to receive interest payments = BEARER BONDS, because payments were made to whoever had physical possession of the bonds. They have now been largely replaced by registered bonds, which do not have coupons. Instead, the owner must register with the firm to receive interest payments. The firms are required to report to the IRS - The Internal Revenue Service, the name of the person who receives interest income. Despite the fact that bearer bonds with attached coupons have been phased out, the interest paid on bonds is still called the “coupon interest payment," and that interest payment divided by a bond's par value is the coupon interest rate. Restrictive Covenants > A corporation's financial managers are hired, fired, and compensated at the direction of the board of directors, which represents the corporation's stockholders. This arrangement implies that the managers will be more interested in protecting stockholders than in protecting bondholders. Managers might not use the funds provided by the bonds as the bondholders might prefer. Since bondholders cannot look to managers for protection when the firm gets into trouble, they must impose rules and restrictions on managers designed to protect the bondholders’ interests = RESTRICTIVE COVENANTS. They usually limit the amount of dividends the firm can pay (to conserve cash for interest payments to bondholders) and the ability of the firm to issue additional debt. Other financial policies, such as the firm's involvement in mergers, may also be restricted. Restrictive covenants are included in the bond indenture. Typically, the interest rate is lower the more restrictions are placed on management through these covenants because the bonds will be considered safer by investors. Call Provisions > Most corporate indentures 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 waiting period between the time the bond is initially issued and the time when it can be called. The price bondholders are paid for the bond is usually set at the bond's par price or slightly higher (usually by one year's interest cost). If interest rates fall, the price of the bond will rise. If rates fall enough, the price will rise above the call price, and the firm will call the bond. Because call provisions put a limit on the amount that bondholders can earn from the appreciation of a bond's price, investors do not like call provisions. A second reason that issuers of bonds include call provisions is to make it possible for them to buy back their bonds according to the terms of the sinking fund = it is a requirement in the bond indenture that the firm pay off a portion of the bond issue each year. This provision is attractive to bondholders because it reduces the probability of default when the issue matures. Because a sinking fund provision makes the issue more attractive, the firm can reduce the bond's interest rate. A third reason firms usually issue only callable bonds is that firms may have to retire a bond issue if the covenants of the issue restrict the firm from some activity that it feels is in the best interest of stockholders. Finally, a firm may choose to call bonds if it wishes to alter its capital structure. A maturing firm with excess cash flow may wish to reduce its debt load if few attractive investment opportunities are available. Because bondholders do not generally like call provisions, callable bonds must have a higher yield than comparable noncallable bonds. Despite the higher cost, firms still typically issue callable bonds because of the flexibility this feature provides the firm. Conversion > Some bonds can be converted into shares of common stock. This feature permits bondholders to share in the firm’s good fortunes if the stock price rises. Most convertible bonds will state that the bond can be converted into a certain number of common shares at the discretion of the bondholder. The conversion ratio will be such that the price of the stock must rise substantially before conversion is likely to occur. Issuing convertible bonds is one way firms avoid sending a negative signal to the market. It is very similar to buying just a bond but receiving both a bond anda stock option. The price of the bond will reflect the value of this option and so will be higher than the price of comparable nonconvertible bonds. The higher price received for the bond by the firm implies a lower interest rate. TYPES OF CORPORATE BONDS: They are usually distinguished by the type of collateral that secures the bond and by the order in which the bond is paid off if the firm defaults. Secured Bonds + they are ones with collateral attached. Mortgage bonds are used to finance a specific project. In the event that the firm fails to make payments as promised, mortgage bondholders have the right to liquidate the property in order to be paid. Because these bonds have specific property pledged Financially weaker security issuers frequently purchase financial guarantees to lower the risk of their bonds. A financial guarantee ensures that the lender (bond purchaser) will be paid both principal and interest in the event the issuer defaults. Large, well-known insurance companies write what are actually insurance policies to back bond issues. With such a financial guarantee, bond buyers no longer have to be concerned with the financial health of the bond issuer. Instead, they are interested only in the strength of the insurer. Essentially, the credit rating of the insurer is substituted for the credit rating of the issuer. The resulting reduction in risk lowers the interest rate demanded by bond buyers. Of course, issuers must pay a fee to the insurance company for the guarantee. Financial guarantees make sense only when the cost of the insurance is less than the interest savings that result. In 1995 J.P. Morgan introduced a new way to ensure bonds called the credit default swap - CDS. In its simplest form a CDS provides insurance against default in the principal and interest payments of a credit instrument. OVERSIGHT OF THE BOND MARKETS: Stocks typically sell in public markets where bid and ask prices are readily available and transparent. By contrast, bonds typically trade over the counter, where transaction details can be hidden from the public. To open this market to scrutiny, in 2002 the Securities and Trade Commission created a trade reporting and compliance engine - TRACE. lt has two significant missions: 1. Rules that say which bond transactions must be publicly reported. 2. The establishment of a trading platform that makes transaction data readily available to the public. lt is under the Financial Industry Regulatory Authority - FINRA. All companies that trade securities are required to be members of FINRA. FINRA was formerly the National Association of Securities Dealers - NASD. In 2007 it was created to consolidate the regulatory and oversight functions of NASD with those of the New York Stock Exchange. The most common violations of rules that result in fines or charges relate to anti-money laundering, the distribution of securities, quality of markets, reporting and recordkeeping, sales practices, and supervision. CURRENT YIELD CALCULATION: If you buy a bond and hold it until it matures, you will earn the yield to maturity. The current yield is an approximation of the yield to maturity on coupon bonds that is often reported because it is easily calculated. It is defined as the yearly coupon payment divided by the price of the security, ic = C/P. ic = current yield P = price of the coupon bond C = yearly coupon payment When a coupon bond has a long term to maturity (say, 20 years or more), it is very much like a perpetuity, which pays coupon payments forever. However, as the time to maturity of the coupon bond shortens, it behaves less and less like a perpetuity and so the approximation afforded by the current yield becomes worse and worse. The bond price equals the par value of the bond, the yield to maturity is equal to the coupon rate (the coupon payment divided by the par value of the bond). Because the current yield equals the coupon payment divided by the bond price, the current yield is also equal to the coupon rate when the bond price is at par. When the bond price is at par, the current yield equals the yield to maturity = it means that the nearer the bond price is to the bond’s par value, the better the current yield will approximate the yield to maturity. The current yield is negatively related to the price of the bond. The current yield and the yield to maturity always move together; a rise in the current yield always signals that the yield to maturity has also risen. Example: What is the current yield for a bond that has a par value of $1.000 and a coupon interest rate of 10,95%? The current market price for the bond is $921,01. C = yearly payment = 0,1095 * $1.000 = $ 109,50 P = price of the bond = $921,01 ic = C/P = 109,50/921,01 = 0,1189 = 11,89% + The current yield is 11,89%. The current yield better approximates the yield to maturity when the bond's price is nearer to the bond’s par value and the maturity of the bond is longer. It becomes a worse approximation when the bond'’s price is further from the bond’s par value and the bond's maturity is shorter. Regardless of whether the current yield is a good approximation of the yield to maturity, a change in the current yield always signals a change in the same direction of the yield to maturity. FINDING THE VALUE OF COUPON BONDS: The current price is the present value of all future cash flows and must be such that the seller is indifferent between continuing to receive the cash flow stream provided by the asset and receiving the offer price. Steps to find the value of a security: 1. Identify the cash flows that result from owning the security. 2. Determine the discount rate required to compensate the investor for holding the security. 3. Find the present value of the cash flows estimated in step 1 using the discount rate determined in step 2. FINDING THE PRICE OF SEMI-ANNUAL BONDS: A bond usually pays interest semi-annually in an amount equal to the coupon interest rate times the face amount (or par value) of the bond. When the bond matures, the holder will also receive a lump sum payment equal to the face amount. The issuing corporation will usually set the coupon rate close to the rate available on other similar outstanding bonds at the time the bond is offered for sale. Unless the bond has an adjustable rate, the coupon interest payment remains unchanged throughout the life of the bond. The first step in finding the value of the bond is to identify the cash flows the holder of the bond will receive. The value of the bond is the present value of these cash flows. The cash flows consist of the interest payments and the final lump sum repayment. In the second step these cash flows are discounted back to the present using an interest rate that represents the yield currently available on other bonds of like risk and maturity. Most bonds pay interest semi-annually. To adjust the cash flows for semi- annual payments, divide the coupon payment by 2, since only half of the annual payment is paid each six months. Similarly, to find the interest rate effective during one-half of the year, the market interest