11/9/2001 LECTURE : MARKETS,FIRMS AND INVESTORS Copyright K. Cuthbertson and, D. Nitzsche K....

11/9/2001

LECTURE :MARKETS,FIRMS AND INVESTORS

Copyright K. Cuthbertson and, D. Nitzsche

K. Cuthbertson

Types of Financial Assets:Lending

and Borrowing Funds

Copyright K. Cuthbertson, D. Nitzsche

“New (physical) investment projects - have to be financed.

Transfer of existing physical assets to more productive uses: ( eg. ‘Low’ stock price is a signal for another firm, to raise funds for a takeover by more efficient managers - ‘the market for corporate control’)

Market prices/returns reflect the ‘scarcity’ of funds and the financial system is supposed to allocate “funds” to the most productive/ profitable ‘physical investments’ - competition for funds.

LENDING AND BORROWING


Financial system:

moves “funds” between borrowers and lenders.

Allows some to “spend” before they have earned the “income” and others to defer “spending” (ie. Save)

- “intertemporal re-allocation” of cash flows.

LENDING AND BORROWING


TYPES OF FINANCIAL ASSET(MARKETS)

Financial assets differ in maturity frequency of expected payments uncertainty of cash flow or final price

Shareholders own the firm and control managers via voting rights over the composition of Board of Directors.

Debt holders (=bonds holders +bank loans) do not ‘own’ the firm - but debt holders do have influence on the managers - can put the firm into liquidation


Money market assets (maturity < 1 year)

1) bank deposits/loans, in Eurodollars/Yen etc. - OTC(non- marketable)

2) Commercial Bills, Certificates of Deposit CDs, - (also sold in secondary market)

3) Have a known return (=yield/interest rate), if held to maturity

Raising/Lending Funds: Short-term


Raising/Lending Funds: Bonds

Government Bonds:

T-bonds/Notes (UK = gilts), - long term- usually ‘fixed interest’ ($ coupon) payments- plain vanilla or ‘straight’ bonds

Corporate bonds,( including ‘preference shares’)- entitled to cash payments before equity holders

-restrictive covenants(eg. cannot sell buildings)

- Floating Rate Notes, FRNs- convertibles- callable bonds


Shares (equities, common stocks)

- no maturity- variable payments (= dividends)- last to be paid

Issuing Shares

- IPO (‘going to market’ - e.g. LastMinute.com )- Rights Issue - additional shares to existing equity holders- Script Issue - ‘free shares’, no new funds, - Equity Warrants

Raising Funds: Shares/Equity


Junk/High-yield/ low-grade / BONDS - I.e. below BBB rated- subordinated debt (last in interest payment and ‘debt-

queue’)

- used for management buy-outs MBO’s - usually highly leveraged buy-outs LBO’s (e.g. buy-out of RJR Nabisco)

- used for hostile takeovers (acquirer retains all voting rights in the new company)

- often have equity kickers attached therefore often issued by ‘young’ fast growing firms (media, cable TV)

Raising Funds: Mezzanine Finance


OTHER MARKETS

Foreign Exchange:

Spot market for foreign currencies = trade finance + speculators

All of the above are known as “cash” or “spot” markets (ie. for immediate delivery of the “asset”)

Derivatives Markets

- forwards \ futures (delivery in the future)- options (delivery is “optional” )- swaps ( eg swap USD payments for FRF payments) - used in ‘financial engineering’ / ‘structured finance’


Flow of Funds


Primary Lenders :

Personal Sector and

Primary Borrowers :

Companies and Government

Lenders and Borrowers


Government

If taxes are insufficient to cover expenditure

• Budget Deficit = G - T ( ‘PSBR’ in the UK )

Financed by: a) printing money b) issuing debt

- issuing more debt can raise interest rates and may ultimately lead to debt crises (eg. Latin American debt crises 1980s, Russian bond defaults July 98)

- EMU deprives you of “printing money” or setting your own interest rate but it does not stop you issuing your own bonds (denominated in Euros).


MARKETS and DEALERS


Types Of Transaction

Cash Account :pay “up front”

Margin Account (pay a proportion, borrow the rest)

Going “long” (=buy),Going “short” (=sell what you own).

Short Sales

Repurchase Agreement (Repo)


Trading

Arbitrageurs: Keep price = “fundamental value”

Hedgers: offset risks that they currently face Speculators: take "open" positions to make profit

Note: Speculators provide funds for hedgers


Market Maker (MM)

MM BMM Buys "low" at Bid price

MM MM sells "high" at offer price

“Touch” = difference between highest bid and lowest offer price

SEAQ : best bid and ask/offer prices displayed as the "yellow strip price”


Financial “prices” (eg stock/bond) prices respond to changing views about the future

“Markets”, - look forward ! (The past is only relevant in that it may help to predict the future).

Hence even if everyone acts “rationally”, we expect (Stock) market prices to be volatile as they immediately “embody” changing views about all future prospects for companies (This is referred to as “news”, that is “new information”)

But are markets “excessively volatile” ? (Greenspan/Shiller, “Irrational (Over)-Exuberance” - bubbles, crashes, noise traders)

Prices Respond To ‘News’


Returns And Risk


SPREADS and YIELDS

Spread is the difference between two “prices”

Bid-Ask Spread: Market maker Buys at the “Bid” (eg $100 ) and sells at the “offer” or “ask” (eg. $102) . Bid-ask spread above = $2

Yield (eg. 10 % p.a.) on an interest bearing asset (eg. T-Bill, T-Bond, Eurodollar deposit )~ measure of the “return” on your investment when you hold the asset to maturity

Spread on interest rates = Long rate(10yr) - short rate(3m)Copyright K. Cuthbertson, D. Nitzsche

Prices and Returns:

HPR = Capital Gain + Running(Dividend) Yield

Shares P1 = 100 P2 = 110 D2 = 5

HPR = 10% + 5% = 15%

Bonds P1 = 100 P2 = 110 Coupon = 2HPY = 10% + 2% = 12%

Holding Period Return ( Yield):

Is the “return” when the asset is sold prior to maturity


Nominal v Real Returns (yields): Risk free asset

Risk Free(safe) Asset = T-Bills or Bank deposit

Fisher Equation:

Nominal risk free return,r = real return + expected inflation

Real return : reward for ‘waiting’ (3% p.a.) = increase in number of Harrods Hampers you can buy ….at the end of the year.

(e.g. current 1-year spot rate = 5.5%, implies expected inflation over the coming year = 2.5%)

Indexed bonds earn a known real returnCopyright K. Cuthbertson, D. Nitzsche

Nominal “Risky” Return = risk free rate + risk premium = r + rp

where:rp = risk premium =‘market risk’ + liquidity risk + default risk

We can measure the historic (or ex-post) risk premiume.g. Av. Return = 12% p.a. Av. r = 4% p.a.

Then ex-post (equity) risk premium = 8% p.a.

Nominal “RISKY” Return (eg. On EQUITIES)


Forward Rates and the

Yield Curve


Uses of Forward Rates

Uses of Forward Rates

Today, you can “lock in” an interest rate which will apply between two periods in the future (e.g. between end of year-1 and end of year-2, denoted f12 )

Also used in Pricing

Forward Agreements replaced by:

Forward Rate Agreements , FRA’s

-Floating Rate Notes, FRN’s

-Interest Rate Futures Contracts

-Floating rate receipts, in an interest rate swap


Two period investment horizon - riskless investments.

Choices

1) Invest your $1 for 2-years at r2 (‘spot rate’)

1) Receipts at t=2 are $1 ( 1 + r2 )2

2) Invest $1 for 1-year at r1 and today purchase an FRA to invest between t=1 and t=2 at a quoted rate f12

2) Receipts at t=2 are $1( 1 + r1 ) (1 + f12 )

These transactions are riskless hence investors will switch their funds (between 1-year, 2-year and the FRA ) until the 3 interest rates are such that the amounts received at t=2, are equal.

Relationship between forward rate and spot rates



Equating 1 and 2

$1( 1 + r2 )2 = $1( 1 + r1 ) (1 + f12 ) Therefore ( 1 + f12 ) = ( 1 + r2 )2 / ( 1 + r1 )

Or, approximately (Let r1 = 9% p.a. and r2 = 10% pa )

f12 = 2 . r2 - r1 = 2 (10) - 9 = 11%

1) Correct forward rate is derived from current spot rates (yield curve)

2) f12 is the rate a bank should quote

3) Also it can be shown that f12 is the market’s best forecast of what the “the one-year rate in one-years time” (denoted Er1t+1 ) will be

Relationship between forward rate and spot rates

SELF STUDYAlgebra of General Calculation of Forward Rates

Calculate other forward rates from today’s spot rates is pretty ‘intuitive’ since the superscripts and subscripts ‘add up’ to the same amount on each side of the equals sign

( 1 + r03 )3 = ( 1 + r02 )2 . (1 + f23 )1

( 1 + r03 )3 = ( 1 + r01 )1 . (1 + f13 )2

In general (there is no need to memorise this!)

fm,n = [ n / (n -m) ] rn - [ m / (n -m) ] rm

e.g. f1,3 = [ 3 / 2 ] r3 - [ 1 / 2 ] r1


Yield Curveand the

Expectations Hypothesis


Yield

6

4

1 2 Time to maturity

A

A

3

7

The yield curve is usually upward sloping. WHY?

Figure 5 :YIELD CURVE


THE YIELD CURVE

Why are long rates of interest often higher than short rates of interest ?

- can long rates be lower than short rates ? Yes !

- Expectations Hypothesis

If we know the shape of the yield curve (ie. All the spot rates) then we can calculate forward rates for all maturities


Expectations Hypothesis (EH): Term Structure

Arbitrage: assuming risk neutrality

$1.( 1+ r2 ) 2 = $1. (1+r1) . [ 1 + Er12 ]

Approx. r2 = ( 1 / 2 ) . [ r1 + Er12 ]

EH implies

1.Long-rate r2 is weighted average of current (r1) and

expected future (one-period) short rates Er12


Upward Sloping Yield Curve

Rising yield curve implies that short rates are expected to be higher in the future and this is probably because inflation is expected to rise in future years

Inflation Prediction from the yield curveObserve the current yield curve

r2 = 6%, r1 = 5%, then f12 = 7.0%

If real rate = 3%, then ( from Fisher effect)

Expected annual inflation in 1-years time

= 7 - 3 = 4%

= Bank of England inflation forecast ?Copyright K. Cuthbertson, D. Nitzsche

Data On Yields, Prices,

Returns and Risk


Asset Returns and Volatility (Annual): Data, 1926-97

Arith. Mean S.DStocks (S&P500), Rm 13 20.3Small Stocks(bottom 5th on NYSE) 18 34

L.T Corp Bonds 6.1 8.7L.T. Gov bonds 5.6 9.2US T-bills, r 3.8 3.2Inflation 3.6 5

Notes:1) dividends/coupons reinvested. 2) The geometric mean return would be less than the arithmetic mean return 3) arithmetic mean return is larger the shorter the horizon chosen(eg. 1-year versus 2-year returns etc, - this is because returns are ‘mean reverting’ (or have negative autocorrelation) over longer horizons,( ie. they are not statistically independent) - see elementary stats book. (Source Brealey & Myers 6th ed p156-164)


Av. Real return on S&P = 9.4 % ( = 13 - 3.6)

Av. Excess return on S&P = Rm - r = 9% (approx)

- often referred to as the ‘market risk premium’

“Excess return per unit of risk” = (Rm - r)/ = 0.45 (= 9/20)- often referred to as the ‘Sharpe ratio’

Survivorship bias in just using US data? .Reduce ‘US market risk premium by 1.5% ?

Asset Returns and Volatility (Annual): Data, 1926-97


Volatility of S&P500 (Annual) US Data, 1930-97

S.D1930’s 41.6

1940 17.51950 14.11960 13.1

1970 17.11980 19.41990-97 14.3

(Source Brealey & Myers 6th ed p156-164)


RISK GRADES: FT 19/10/00 (for Oct 17th)

BONDS EQUITY FX(rel to USD)

Europe 25 86(135) 62(Euro)

Americas 32 94(146) 49

Asia 21 98(139) 39(Yen)

Global 38 107(156) ….

UK 77 (115)

Note: ( . .) = 52-week high

100 = average volatility of international equity mkts


Summary Statistics :(Jan. 95 to Sept. 00)

S&P500 NasdaqMean 1.76% 3.41%Std. dev. 3.94% 7.56%

Correlation : 0.6382(monthly data)

Figure 1.6 : US stock market (S&P500 and NASDAQ)

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03/01/95 03/01/96 03/01/97 03/01/98 03/01/99 03/01/00 03/01/01

Nasdaq

S&P500

S&P500


Figure 1.5: US Industrial Sectors

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23/12/88 07/05/90 19/09/91 31/01/93 15/06/94 28/10/95 11/03/97 24/07/98 06/12/99 19/04/01

Entertainment Industry

Oil Industry

Financial Industry

Chemical Industry

Automobile Industry


Figure 1.7: ‘Local Currency’ Stock Indices

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27/02/88 27/01/90 28/12/91 27/11/93 28/10/95 27/09/97 28/08/99 28/07/01

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FTSE


Figure 1.8: Asian Crises : Spot FX Rates

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05/02/96 01/12/96 27/09/97 24/07/98 20/05/99 15/03/00 09/01/01

$ per Malaysian Ringgit

$ per Indonesian Ruphia$ per Thai Baht


Slides End Here


11/9/2001 LECTURE : MARKETS,FIRMS AND INVESTORS Copyright K. Cuthbertson and, D. Nitzsche K....

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