Understanding Financial Markets: Types of Bonds, Yield to Maturity, and Interest Rate Risk, Sintesi del corso di Finanza Aziendale

Scarica Understanding Financial Markets: Types of Bonds, Yield to Maturity, and Interest Rate Risk e più Sintesi del corso in PDF di Finanza Aziendale solo su Docsity! Financial market is about transferring money and is critical for producing an efficient allocation of capital. The funds are transferred with the help of securities (also called a financial instrument) which are claims on the issuer’s future income or assets. All securities have a price that investors must pay to own that security. Well functioning financial markets are key factors in producing high economic growth because channels funds from person or business without investment opportunities (Lender-Savers) to one who has them (Borrower-Spenders). The segments of Financial Markets are Indirect Finance (borrowing happens via financial intermediaries (banks) by issuing financial instruments) and Direct Finance (borrowing happens directly from lenders by selling financial instruments). Lenders and borrows meet „almost“ directly because a broker or dealer helps the buyer and seller with the actual transaction. 
 (A broker means someone who executes a trade order on behalf of a client, with the money of the client. A dealer (or salesperson) is someone who is buying from a client or selling to a client with his own money. A trader is someone who attempts to profit from the purchase and sale of securities). A firm or an individual can obtain funds in a financial market in two ways: (1) Issue a debt instrument (bonds) which is a contractual agreement with the borrower to pay the bond investor fixed amount of money at regular intervals (interest + principal payments) until the maturity date when a final payment is made. (2) Issue equities (stock/shares) which are claims to share in the net income (income after expenses and taxes) and the assets of a business (claims on the firm’s profits). 
 A stock represents a share of ownership in a corporation and doesn’t have a maturity date, to have the capital back someone has to buy the stock from you. Equities often make periodic payments (dividends) to their holders. The Primary Market is when the issuer raises money by selling securities to initial buyers. The Secondary Market is when those securities previously issued are bought and sold among investors; Investors do this in different ways: —Exchanges: trades conducted in central locations through auctions (asta). —Dealer markets: dealers at different locations buy and sell by posting the prices they would be willing to buy and sell specific securities. Dealer markets gather information in one (electronic) place —Over-the-Counter (OTC) Markets: similar to dealer market but with decentralized dealer networks at different locations. Debt instruments are evaluated against one another based on the amount of each cash flow and the timing of each cash flow. This evaluation results in the yield to maturity and is the most accurate measure of interest rate. The evaluation is called present value analysis and enables us to compare different instruments. Applications of the present value technique: —Zero Coupon Bond: a short-maturity bond (<1 year) that just pays the face value/par value of the bond at expiry and no coupon in between. Investors pay the market price of the bond, which is less than the face value. The difference between the price paid and the amount received when the bond is sold represents the return earned on the investment. 
 —Coupon Bond: bonds that pay a fixed interest payment (coupon rate x face value of the bond) at a specified frequency (e.g. semi- annual, quarterly, etc.) until maturity when the face value of the bond is paid, together with the last coupon payment. —Consol Bond: bonds which have no maturity, exist in perpetuity. The investor receives a fixed coupon payments of C forever: (Where P is the price of the perpetuity, C is the coupon payment and i is the yield to maturity). The price of a bond and yield to maturity (YTM) are negatively related. If the interest rate i increases, the price of the bond decreases. When a bond is at par (price=face value) the yield to maturity equals the coupon rate. The yield to maturity is greater than the coupon rate when the price is below par value. How well an investor does by holding a bond or any other security over a particular time period is accurately measured by the rate of return. 
 For any security, the rate of return is defined as the payments to the owner plus the change in its value, expressed as a fraction of its purchase price: Interest-rate risk (interest do change over time) The interest rate and the rate of return on an investment are two different concepts. The rate of return measures how well we do on our investment over a certain holding period. If the interest rate changes over the maturity of the bond, this will affect the return on the investment. Return is calculated using: This formula can be decomposed into two parts: Return = Current Yield + Capital Gain Yield —The Current yield is the coupon payment over the purchase price (Coupons/Price paid for the bond). —The Capital gain yield is the rate of capital gain or the change in the bond’s price relative to the initial purchase price(Price at which the bond is sold — Price paid for the bond/ Price paid for the bond). If it takes a negative value, we may refer to it as a Capital loss yield. —Only bond whose return = yield is the one with maturity = holding period. —For bonds with maturity > holding period, as rates increase, price falls, implying capital loss. —Longer is maturity, greater is price change associated with interest rate change. 
 —Longer is maturity, more return changes with change in interest rate. —Bond with high initial interest rate can still have negative return if i ↑. Prices and returns are more volatile (fluctuate more) for long-term bonds because they have higher interest-rate risk. No interest-rate risk for any bond whose maturity equals holding period. 
 Duration (effective maturity): is the average lifetime of a debt security’s stream of payments. When the maturity of a bond lengthens the duration rises as well, when interest rates rise the duration of a coupon bond fall, the higher the coupon rate on the bond the shorter the duration of the bond. The money market is where the securities are sold, they are short term with high liquidity (mature in as little as 1 day to as long as 1 year) and are close to being money.
 Money markets defined: usually sold in large denominations (1mill), low default risk, so investors do not fear losing their investment, mature in one year or less from their issue date, although most mature in less than 120 days, highly liquid (easy to buy/sell the instruments on the secondary market). Money market is needed because the banking industry should handle the needs for short-term. —Investors in money market provides a place for warehousing surplus funds for short periods of time —Borrowers from money market provides a low-cost source of temporary funds. Money market instruments: Short-term government bonds (treasury bills/ T-bills) and Commercial paper. 1) SHORT-TERM GOVERNMENT BONDS Government bonds with short maturities (up to 12 months). Zero-coupon bonds. The government pays the face (par) value at expiry. The investor pays a price lower than the face value to buy a short term government bond. The investor’s return (yield) comes from the increase in the value of the security between the time it was purchased and the time it matures. 
 —The yield is called “discount rate” and is calculated as: 2) COMMERCIAL PAPER Unsecured short-term debt instrument issued by a corporation of top credit quality with the purpose of financing of accounts payable and inventories and meeting short-term liabilities. Investors are other corporations, financial institutions, wealthy individuals, and “money market funds”. 
 Maturity shorter than one year, usually issued at a discount from face value (like T-bills) in large denominations, usually traded on secondary markets. Commercial paper is used as a cheaper alternative to bank loans. Money market instruments carry low risk for three reasons: —High credit standing of the main actors (governments, big well- known corporations). —Short maturities (c.f. lectures 2 & 3). —The market is extremely deep (many buyers and sellers) and liquid.
 Bonds with maturity up to one year are part of the money market and are the treasury bills and the commercial paper. Bonds and Stocks with maturity longer than one year are part of the capital market and instead are the government bonds and the corporate bonds. —Primary issuers of bonds: governments, G. agencies and municipalities, Financial institutions, Non-financial firms. —Largest investors in the bond market: banks, institutional investors (insurance companies, pension funds, mutual funds, hedge funds), individual investors (retail or household investors). Bonds are securities that represent a debt owed by the issuer to the investor, generally with periodic interest payments: —The par, face, or maturity value of the bond (same thing) is the amount that the issuer must pay at maturity. —The coupon interest rate is the rate of interest that the issuer must pay, and this periodic interest payment is often called the coupon payment. 1) GOVERNMENT BONDS Government bonds typically have very low interest rates because they have low or no default risk. Investors in some government bonds truly believe that the government will pay the coupon payments and the face value at maturity: Germany, United States, Switzerland, Sweden. In countries where there is uncertainty as whether the government will actually pay coupon payments and the maturity value, interest rates are higher to compensate investors for their fear they might not be paid: Italy, Greece, Spain. The term spread is used to denote the difference in yield that the Italian government has to offer to investors to convince them to invest in Italian government bonds compared to the yield that the German government has to offer to their investors. Government bonds with medium and long term maturity are typically referred to as Treasury notes (maturity between 1 and 10 years) and Treasury bonds (maturity between 10 and 30 years). 2) CORPORATE BONDS Corporate bonds are issued by companies to meet financing needs. The terms of the bond are specified in the bond indenture (the contract between the issuer and the bondholder): —Face/par value of the bond: money to be repaid at maturity —Coupon rate: Determines the interest payment. —Coupon frequency: Specifies when interest payments are due (usually semiannually). —Maturity date (usually 5-30 years). —Seniority (refers to the order of repayment in the event of the bankruptcy of the issuer. Senior debt must be repaid before subordinated debt is repaid) —Any additional feature (callability ((or redeemable): can be repurchased by the issuing firm before the maturity date), convertibility (can be exchanged for shares of the firm’s common stock. The conversion can take place only at certain times during the bond’s life and is normally at the discretion of the bondholder) and covenants (a set of agreements aimed at protecting bondholders from an increased riskiness of the issuer after issuing the bond: —Negative covenants: forbid the issuer from taking certain actions (paying out the firms capital as dividends or taking on even more debt). Sets minimum levels of earnings (operating income) that the issuer has to maintain. —Positive covenants: force the issuer to undertake actions (have proper insurance, auditing of financial statements, etc.)). Issuance of corporate bonds can take place in one of two ways: 1) Private placement: bonds will be sold directly to institutional investors. Simple and fast process. Bonds typically held to maturity so no secondary market 2) Public placement: process is subject to formal registration and legal checks done by the government and specialized investment banks (underwriters) so it takes longer and is more complex. Bonds can then be bought and sold on the secondary market. Bonds are sold to any interested investor.