Lecture 1, an overview.pdf

7/27/2019 Lecture 1, an overview.pdf

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LECTURE 1: MARKETS, FIRMS AND

INVESTORSLearning Objectives

To present some of the terminology used across many different

financial instruments and markets To discuss the main f inancial instruments

To analyse the main forms of ownership and how corporatecontrol is exercised

To examine the role played by arbitrageurs, speculators andhedgers in the trading process

To examine the main financial f lows

To distinguish between nominal and real rates of interest byintroducing Fisher equation

To analyse the main sources of risk and risk premium

To presebt data on yields, prices, returns and risk.


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Types of Financial Assets:Lending

andBorrowing Funds


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New (physical) investment projects - have to befinanced.

Transfer of existing physical assets to moreproductive uses: ( e.g. Low stock price is a signalfor another firm, to raise funds for a takeover by

more efficient managers - the market for corporatecontrol)

Market prices/returns reflect the scarcity of fundsand the financial system is supposed to allocate funds to the most productive/ profitablephysical investments - competition for funds.

LENDING AND BORROWING


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Financial system:

moves funds between borrowers and lenders.

Allows some to spend before they haveearned the income and others to deferspending (i.e. save)

- intertemporal re-allocation of cash flows.

LENDING AND BORROWING


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TYPES OF FINANCIAL ASSET(MARKETS)

Financial assets differ inmaturityfrequency 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 ofDirectors.

Debt holders (=bonds holders +bank loans) do notown the firm- but debt holders do have influence on the managers- can put the firm into liquidation


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Figure 1: Brokers and dealers

MarketMaker A

MarketMaker B

Individual

Investor

Broker

Institutional

Investor


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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


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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)- entit led to cash payments before equityholders

-restrictive covenants(e.g. cannot sellbuildings)- Floating Rate Notes, FRNs- convertibles- callable bonds


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Warrants versus Convertibles

Both are ways of issuing debt finance which also gives theholder the option of obtaining an equity stake in the firm at

a later date. Most convertibles are issued publicly while warrants are

often issued through private placements.

Most warrants are detachable and some warrants areissued without initially being attached to bonds at all (e.g.executive stock options).

Warrants are exercised for cash, while convertibles usuallyinvolve an exchange of bonds for equity. Warrants andconvertibles therefore give rise to different cash flows and

changes in debt-to-equity ratios for the company.


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Shares (equities, common stocks)

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

Issuing Shares

- IPO (going to market)

-Rights Issue - additional shares to existing equityholders- Script Issue - free shares, no new funds- Equity Warrants

Raising Funds: Shares/Equity


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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 MBOs- usually highly leveraged buy-outs LBOs

(e.g. buy-out of ?)

- 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


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Ownership ofFirmsFirms

-Sole Proprietor

- Partnership

- Limited Company or Corporation


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Market for corporate control: efficient managers replace inefficient incumbent managersMerger activity financed by cash acquisitions or fromthe shareholders in the target firm receiving shares in the

acquiring firm (the new merged firm)

Defensive tactics used in a hostile takeover:

White Knight get a friendly company to make a bid; Pac Man make a counter-bid for bidder; Poison Pills increase the acquirers costs should the bid

be successful (e.g. target shareholders are given bonus cashpayments if the bid is successful); Crown Jewels defence target sells off most profitableparts of the business

The Market for Corporate Control


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OTHER MARKETS

Foreign Exchange:

Spot market for foreign currencies= trade finance + speculators

All of the above are known as cash or spot markets(i.e. for immediate delivery of the asset)

Derivatives Markets

- forwards \ futures (delivery in the future)- options (delivery is optional )- swaps ( e.g. swap USD payments for FRF payments)- used in financial engineering / structured finance


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Flow of Funds andFinancial Intermediations


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Primary Lenders :

Personal (household) Sector and

Primary Borrowers :

Companies and Government

Lenders and Borrowers


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Financial intermediaries and capital marketschannel funds from surplus to deficit units Low transaction, search and information costs

Risk spreading => portfolio diversification andspecialisation

Asset TransformationBorrow short and lend long, hedge mismatch offixed and floating interest rates by using swaps,futures and options

Portfolio Diversification

Pooling funds of individuals to purchase a diversifiedportfolio of assets, e.g. MM mutual funds, etc.

Financial Intermediaries


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Government

If taxes are insufficient to cover expenditure

Budget Deficit = G - T ( PSBR in the UK )

Financed by: a) printing moneyb) issuing debt

- issuing more debt can raise interest rates and mayultimately lead to debt crises (e.g. Latin American debtcrises 1980s, Russian bond defaults July 98)

- EMU deprives you of printing money or settingyour own interest rate but it does not stop you issuing

your own bonds (denominated in Euros).


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MARKETS and DEALERS

Types Of Transaction


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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)

f O


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Trading: Types of Order

Market order

Limit order

Stop order

Stop limit order

Fill-or-kill order

Open order (good-till-cancelled)

T di T f T d


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Trading: Types of Trader

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)


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Market Maker (MM)

MM BMM Buys " low" at Bid price

MMMM sells "high" at offer price

Touch = difference between highest bid

and lowest offer price

SEAQ : best bid and ask/offer pricesdisplayed as the "yellow strip price

Prices Respond To News


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Financial prices (e.g stock/bond) prices respond to changingviews about the future

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

Hence even if everyone acts rationally, we expect (Stock)

market prices to be volatile as they immediately embodychanging views about all future prospects for companies(This is referred to as news, that is new information)

But are markets excessively volatile ?(Greenspan: Irrational (Over)-Exuberance

- bubbles, crashes, noise traders)

Prices Respond To News


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Returns And Risk

SPREADS and YIELDS


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SPREADS and YIELDS

Spread is the difference between two prices

Bid-Ask Spread:Market maker Buys at the Bid (e.g. $100 ) andsells at the offer or ask (e.g. $102) .

Bid-ask spread above = $2

Yield (e.g. 10 % p.a.) on an interest bearing asset(e.g. 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) - shortrate (3m)

Prices and Returns:


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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

N i l R l R t ( i ld ) Ri k f t


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Nominal v Real Returns (yields): Risk free asset

Risk Free (safe) Asset = T-Bills or BankdepositFisher Equation:

Nominal risk free return = real return + expected inflationr = rr +

Real return : reward for waiting (3% p.a.)

= increase in number of goods you can buy .at the endof the year.

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

Nominal RISKY Return (e.g. On EQUITIES)


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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.

T f Ri k th t i i t Ri k P i


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Types of Risks that give rise to Risk Premium

Market risk the selling price in 3 months timeis uncertain, as may be the dividend payment;

Inflation risk actual inflation may turn out to bedifferent from what was initially expected;

Default (credit) risk the company may go bankruptwhich severely reduces any future payment to bond and

stockholders;

Liquidity risk the asset might trade in a thin market

implying a large fall in price if it is to be sold quickly.


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Forward Rates and the Yield

Curve

Uses of Forward Rates


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Uses of Forward RatesToday, you can lock in an interest rate which will apply between

two periods in the future (e.g. between end of year-1 and endof year-2, denoted f12 )

Also used in Pricing

Forward Agreements replaced by:

Forward Rate Agreements , FRAs

-Floating Rate Notes, FRNs

-Interest Rate Futures Contracts

-Floating rate receipts, in an interest rate swap

Relationship between forward rate and spot


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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 investbetween 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.

rates

Relationship between forward rate and spot rates


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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 markets best forecast of what thethe one-year rate in one-years time (denoted Er1t+1 ) will be

SELF STUDYAl b f G l C l l ti f F d R t


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Algebra of General Calculation of Forward Rates

Calculate other forward rates from todays spot rates ispretty intuitive since the superscripts and subscriptsadd 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 ] r 1


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Yield Curveand the

Expectations Hypothesis

Figure 2 :YIELD CURVE


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Yield

6

4

1 2Time to

maturity

A

A

3

7

The yield curve is usually upward sloping. WHY?

g

THE YIELD CURVE


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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 spotrates) then we can calculate forward rates for all

maturities

Expectations Hypothesis (EH): Term Structure


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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


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Rising yield curve implies that short rates are expected tobe higher in the future and this is probably becauseinflation 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 ?


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Data On

Yields, Prices,Returns and Risk


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Measuring Historic Returns

Starting with annualized Holding Period

Returns, we often want to calculate somemeasure of the average return over time onan investment.

Two commonly used measures of average:Arithmetic Mean

Geometric Mean


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Arithmetic Mean Return

The arithmetic mean is the simple average of a

series of returns. Calculated by summing all of the returns in the series

and dividing by the number of values.

RA = (HPR)/n Oddly enough, earning the arithmetic mean return for

n years is not generally equivalent to the actual

amount of money earned by the investment over all ntime periods.


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Arithmetic Mean Example

Year Holding Period Return

1 10%

2 30%

3 -20%

4 0%

5 20%

RA = (HPR)/n = 40/5 = 8%


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Geometric Mean Return

The geometric mean is the one return that, if earned

in each of the n years of an investments life, givesthe same total dollar result as the actual investment.

It is calculated as the nth root of the product of all of

the n return relatives of the investment.RG = [(Return Relatives)]

1/n 1


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Geometric Mean Example

Year Holding Period Return Return Relative

1 10% 1.102 30% 1.30

3 -20% 0.80

4 0% 1.005 20% 1.20

RG = [(1.10)(1.30)(.80)(1.00)(1.20)]1/5 1

RG = .0654 or 6.54%


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Arithmetic vs. Geometric

To ponder which is the superior measure, consider the

same example with a $1000 initial investment. Howmuch would be accumulated?

Year Holding Period Return Investment Value

1 10% $1,1002 30% $1,430

3 -20% $1,144

4 0% $1,1445 20% $1,373


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Arithmetic vs. Geometric

How much would be accumulated if you earned the

arithmetic mean over the same time period?Value = $1,000 (1.08)5 = $1,469

How much would be accumulated if you earned the

geometric mean over the same time period?Value = $1,000 (1.0654)5 = $1,373

Notice that only the geometric mean gives the same

return as the underlying series of returns.

Asset Returns and Volatility (Annual): Data, 1926-2000


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Arith. Mean Average S.Drisk premium

Common stocks 13.0 9.1 20.2

(S&P500), RmSmall-firm common stocks

(bottom 5th on NYSE) 17.3 13.4 33.4

Corp. bonds 6.0 2.1 8.7Gov. bonds 5.7 1.8 9.4

US T-bills, r 3.9 0 3.2

Inflation 3.6 5

(Source Brealey & Myers 7th ed p155-164)

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


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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

Volatility of S&P500 (Annual) US Data, 1926-2000


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Period S.D1926-30 21.71931-40 37.8

1941-50 14.01951-60 12.11961-70 13.01971-80 15.81981-90 16.5

1991-2000 13.4

(Source Brealey & Myers 7th ed p165)

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


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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

Figure 3: US Industrial Sectors


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0

1000

2000

3000

4000

5000

6000

7000

8000

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 4 : US stock market (S&P500 and NASDAQ)


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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)

0

100

200

300

400

500

600

700

800

900

1000

0 3/01/95 03/01/96 03/01/97 03/01/98 03/01/99 03/01/00 03/01/01

Nasdaq

S&P500

S&P500

Figure 5: Local Currency Stock Indices


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0

2000

4000

6000

8000

10000

12000

14000

16000

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

Hang Seng

Nikkei

S&P

Dax

FTSE

Figure 6: Asian Crises : Spot FX Rates


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0

20

40

60

80

100

120

1996-2-5 1996-12-1 1997-9-27 1998-7-24 1999-5-20 2000-3-15 2001-1-9

$ per Malaysian Ringgit

$ per Indonesian Ruphia

$ per Thai Baht

Lecture 1, an overview.pdf

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