financial markets by huanli li. part one introduction

Financial Markets

By Huanli Li

Part One

Introduction

Chapter 1

Why Study Financial Markets and Institutions?

Chapter Preview

The evening news features a segment about interest rates, the Fed Chairman Ben Bernanke, and liquidity in credit markets.

What does all this mean? Do I care about interest rates? What is “the Fed?” Will this impact my firm’s ability to get a bank loan?

Chapter Preview

These are good questions. Of course, the answer to these questions can be found in this book. In fact, this books touches on a variety of topics, including the Fed, stocks markets, bond markets, and banks. We will begin to appreciate many exciting issues related to these topics during the course of this term

Chapter Preview

To start, we preview subjects of interest to anyone who is a part of a productive society. We motivate how financial markets and institutions have significant impact on important questions about our financial well-being. Topics include:

Why Study Financial Markets?

Why Study Financial Institutions?

Applied Managerial Perspective

How Will We Study Financial Markets and Institutions


Financial markets, such as bond and stock markets, are crucial in our economy.

1. These markets channel funds from savers to investors, thereby promoting economic efficiency.

2. Market activity affects personal wealth, the behavior of business firms, and economy as a whole


Well functioning financial markets, such as the bond market, stock market, and foreign exchange market, are key factors in producing high economic growth.

We will briefly examine each of these markets, key statistics, and how we will examine them throughout this course.

Why Study Financial Markets? Debt Markets & Interest Rates

Debt markets, or bond markets, allow governments, corporations, and individuals to borrow to finance activities.

In this market, borrowers issue a security, called a bond, that promises the timely payment of interest and principal over some specific time horizon.

The interest rate is the cost of borrowing.


There are many different types of market interest rates, including mortgage rates, car loan rates, credit card rates, etc.

The level of these rates are important. For example, mortgage rates in the early part of 1983 exceeded 13%. Financing a house was quite expensive at this time.


Because interest rates are important to individuals and business, understanding the history of interest rates is beneficial.

The next slide shows historical interest rates in various sectors of the bond market: Long-Term U.S. Government rates, Short-Term U.S. Government rates, and corporate rates.

We will study these further in several chapters, examining the types and characteristics of bonds, as well as theories on how rates are determined.

Bond Market and Interest Rates

Complete list of interest rateshttp://www.federalreserve.gov/releases


For the moment, we will turn to other topics, but revisit these topics.

In chapters 2, 9, 10, and 12, we will examine the role of debt markets in the economy.

In chapters 3 through 5, we will examine the characteristics of interest rates.

Why Study Financial Markets? The Stock Market

The stock market is the market where common stock (or just stock), representing ownership in a company, are traded.

Companies initially sell stock (in the primary market) to raise money. But after that, the stock is traded among investors (secondary market).

Of all the active markets, the stock market receives the most attention from the media, probably because it is the place where people get rich (and poor) quickly.


The next slide shows the level of the Dow Jones Industrial Average over the last 55 years. Note how volatile stock prices have been, especially over the last five years.

In future chapters, we will examine the role of the stock market, as well as how prices react to information in the marketplace.

Stock Market


Companies, not just individuals, also watch the market. Although corporations don’t typically “invest” in the market, they often seek additional funding in equity markets after going public. The success of these seasoned-equity offerings (SEOs) is very dependent on the current price of the company’s stock.

Why Study Financial Markets? The Foreign Exchange Market

The foreign exchange market is where international currencies trade and exchange rates are set.

Although most people know little about this market, it has a daily volume around $1 trillion!

View historical financial data and forecasts athttp://www.forecasts.org/data/index.htm


The next slide shows how the U.S. dollar has fluctuated in price against a basket of foreign currencies.

These fluctuations matter!

In recent years, consumers have found that vacationing in Europe is expensive, due to a weakening dollar relative to the Euro.

When the dollar strengthens, foreign purchase of domestic goods falls, and US manufacturers experience a decreased demand for their goods.

Foreign Exchange Market


In future chapters, we will examine how exchange rates are determined in both the short- and long-run.


We will also spend considerable time discussing financial institutions—the corporations, organizations, and networks that operate the so-called “marketplaces.” These institutions play a crucial role in improving the efficiency of the economy. We will look at:

1. Central Banks and the Conduct of Monetary Policy The role of the Fed and foreign counterparts

2. Structure of the Financial System Helps get funds from savers to investors


3. Banks and Other Financial Institutions Includes the role of insurance companies, mutual funds,

pension funds, etc.

4. Financial Innovation Focusing on the improvements in technology and its

impact on how financial products are delivered

5. Managing Risk in Financial Institutions Focusing on risk management in the

financial institution.

Applied Managerial Perspective

Financial institutions are among the largest employers in the U.S. and often pay high salaries.

Knowing how financial institutions are managed may help you better deal with them.

How We Study Financial Markets and Institutions

Basic Analytic Framework1. Simplified models are constructed, explained,

and then manipulated to illustrate various phenomena.

2. “Practicing Manager” cases are used to tie theoretical and empirical aspects.


Basic Analytic Framework3. Actual articles from the Wall Street Journal

reinforcing the concepts from the book, and explanations of articles, helping you develop critical skills to identify key concepts from the day’s news.


Other features1. Case studies

2. Applications and Numerical Examples

3. Special Interest Boxes

4. Hundred of analytical end-of-chapter problems

5. Predicting the Future problems

Chapter Summary

Why Study Financial Markets?: the three primary markets (bond, stock, and foreign exchange) were briefly introduced.

Why Study Financial Institutions?: the market, institutions, and key changes affecting these were outlined.

Chapter Summary (cont.)

Applied Managerial Perspective: the book will often present material to better understand how actual managers use the information in daily operations.

How We Will Study Financial Markets and Institutions: we outlines the three key components: analytical framework, features, and web exercises.

Chapter 2

Overview of the Financial System

Chapter Preview

Suppose you want to start a business manufacturing a household cleaning robot, but you have no funds.

At the same time, Walter has money he wishes to invest for his retirement.

If the two of you could get together, perhaps both of your needs can be met. But how does that happen?

Chapter Preview

As simple as this example is, it highlights the importance of financial markets and financial intermediaries in our economy.

We need to acquire an understanding of their general structure and operation before we can appreciate their role in our economy.

Chapter Preview

In this chapter, we examine the role of the financial system in an advanced economy. We study the effects of financial markets and institutions on the economy, and look at their general structure and operations. Topics include: Function of Financial Markets Structure of Financial Markets Internationalization of Financial Markets Function of Financial Intermediaries Financial Intermediaries Regulation of the Financial System

Function of Financial Markets

Channels funds from person or business without investment opportunities (i.e., “Lender-Savers”) to one who has them (i.e., “Borrower-Spenders”)

Improves economic efficiency

Financial Markets Funds Transferees

Lender-Savers

1. Households

2. Business firms

3. Government

4. Foreigners

Borrower-Spenders

1. Business firms

2. Government

3. Households

4. Foreigners

Segments of Financial Markets

1. Direct Finance• Borrowers borrow directly from lenders in financial

markets by selling financial instruments which are claims on the borrower’s future income or assets

2. Indirect Finance• Borrowers borrow indirectly from lenders via financial

intermediaries (established to source both loanable funds and loan opportunities) by issuing financial instruments which are claims on the borrower’s future income or assets

Function of Financial Markets

Importance of Financial Markets

This is important. For example, if you save $1,000, but there are no financial markets, then you can earn no return on this – might as well put the money under your mattress.

However, if a carpenter could use that money to buy a new saw (increasing her productivity), then she’d be willing to pay you some interest for the use of the funds.

Importance of Financial Markets

Financial markets are critical for producing an efficient allocation of capital, allowing funds to move from people who lack productive investment opportunities to people who have them.

Financial markets also improve the well-being of consumers, allowing them to time their purchases better.

Structure of Financial Markets

It helps to define financial markets along a variety of dimensions (not necessarily mutually exclusive). For starters, …


1. Debt Markets Short-Term (maturity < 1 year) Long-Term (maturity > 10 year) Intermediate term (maturity in-between) Represented $41 trillion at the end of 2007.

2. Equity Markets Pay dividends, in theory forever Represents an ownership claim in the firm Total value of all U.S. equity was $18 trillion at the end

of 2005.


1. Primary Market New security issues sold to initial buyers Typically involves an investment bank who underwrites

the offering

2. Secondary Market Securities previously issued are bought

and sold Examples include the NYSE and Nasdaq Involves both brokers and dealers (do you know the

difference?)


Even though firms don’t get any money, per se, from the secondary market, it serves two important functions:

• Provide liquidity, making it easy to buy and sell the securities of the companies

• Establish a price for the securities


We can further classify secondary markets as follows:

1. Exchanges Trades conducted in central locations

(e.g., New York Stock Exchange, CBT)

2. Over-the-Counter Markets Dealers at different locations buy and sell Best example is the market for Treasury securities

NYSE home pagehttp://www.nyse.com

Classifications of Financial Markets

We can also further classify markets by the maturity of the securities:1. Money Market: Short-Term (maturity < 1 year)

2. Capital Market : Long-Term (maturity > 1 year) plus equities

Internationalization of Financial Markets

The internationalization of markets is an important trend. The U.S. no longer dominates the world stage.

International Bond Market Foreign bonds

Denominated in a foreign currency Targeted at a foreign market

Eurobonds Denominated in one currency, but sold in a different

market now larger than U.S. corporate bond market) Over 80% of new bonds are Eurobonds.


Eurocurrency Market Foreign currency deposited outside of home country Eurodollars are U.S. dollars deposited, say, London. Gives U.S. borrows an alternative source for dollars.

World Stock Markets U.S. stock markets are no longer always the largest—at

one point, Japan's was larger


As the next slide shows, the number of international stock market indexes is quite large. For many of us, the level of the Dow or the S&P 500 is known. How about the Nikkei 225? Or the FTSE 100? Do you know what countries these represent?

Global perspectiveRelative Decline of U.S. Capital Markets

The U.S. has lost its dominance in many industries: auto and consumer electronics to name a few.

A similar trend appears at work for U.S. financial markets, as London and Hong Kong compete. Indeed, many U.S. firms use these markets over the U.S.

Global perspectiveRelative Decline of U.S. Capital Markets

Why?

1. New technology in foreign exchanges

2. 9-11 made U.S. regulations tighter

3. Greater risk of lawsuit in the U.S.

4. Sarbanes-Oxley has increased the cost of being a U.S.-listed public company

Function of FinancialIntermediaries: Indirect Finance

We now turn our attention to the top part of Figure 2.1 – indirect finance.

Function of FinancialIntermediaries : Indirect Finance

Instead of savers lending/investing directly with borrowers, a financial intermediary (such as a bank) plays as the middleman:

the intermediary obtains funds from savers the intermediary then makes

loans/investments with borrowers


This process, called financial intermediation, is actually the primary means of moving funds from lenders to borrowers.

More important source of finance than securities markets (such as stocks)

Needed because of transactions costs, risk sharing, and asymmetric information


Transactions Costs

1. Financial intermediaries make profits by reducing transactions costs

2. Reduce transactions costs by developing expertise and taking advantage of economies of scale


• A financial intermediary’s low transaction costs mean that it can provide its customers with liquidity services, services that make it easier for customers to conduct transactions

1. Banks provide depositors with checking accounts that enable them to pay their bills easily

2. Depositors can earn interest on checking and savings accounts and yet still convert them into goods and services whenever necessary

Global Perspective

• Studies show that firms in the U.S., Canada, the U.K., and other developed nations usually obtain funds from financial intermediaries, not directly from capital markets.

• In Germany and Japan, financing from financial intermediaries exceeds capital market financing 10-fold.

• However, the relative use of bonds versus equity does differ by country.


Another benefit made possible by the FI’s low transaction costs is that they can help reduce the exposure of investors to risk, through a process known as risk sharing FIs create and sell assets with lesser risk to one

party in order to buy assets with greater risk from another party

This process is referred to as asset transformation, because in a sense risky assets are turned into safer assets for investors


Financial intermediaries also help by providing the means for individuals and businesses to diversify their asset holdings.

Low transaction costs allow them to buy a range of assets, pool them, and then sell rights to the diversified pool to individuals.


Another reason FIs exist is to reduce the impact of asymmetric information.

One party lacks crucial information about another party, impacting decision-making.

We usually discuss this problem along two fronts: adverse selection and moral hazard.


Adverse Selection

1. Before transaction occurs

2. Potential borrowers most likely to produce adverse outcome are ones most likely to seek a loan

3. Similar problems occur with insurance where unhealthy people want their known medical problems covered

Asymmetric Information: Adverse Selection and Moral Hazard

Moral Hazard1. After transaction occurs

2. Hazard that borrower has incentives to engage in undesirable (immoral) activities making it more likely that won't pay loan back

3. Again, with insurance, people may engage in risky activities only after being insured

4. Another view is a conflict of interest

Asymmetric Information: Adverse Selection and Moral Hazard

Financial intermediaries reduce adverse selection and moral hazard problems, enabling them to make profits. How they do this is the covered in many of the chapters to come.

Types of Financial Intermediaries


Depository Institutions (Banks): accept deposits and make loans. These include commercial banks and thrifts.

Commercial banks (7,500 currently) Raise funds primarily by issuing checkable, savings, and

time deposits which are used to make commercial, consumer and mortgage loans

Collectively, these banks comprise the largest financial intermediary and have the most diversified asset portfolios


Thrifts: S&Ls, Mutual Savings Banks (1,500) and Credit Unions (8,900) Raise funds primarily by issuing savings, time, and

checkable deposits which are most often used to make mortgage and consumer loans, with commercial loans also becoming more prevalent at S&Ls and Mutual Savings Banks

Mutual savings banks and credit unions issue deposits as shares and are owned collectively by their depositors, most of which at credit unions belong to a particular group, e.g., a company’s workers

Contractual Savings Institutions (CSIs)

All CSIs acquire funds from clients at periodic intervals on a contractual basis and have fairly predictable future payout requirements. Life Insurance Companies receive funds from policy

premiums, can invest in less liquid corporate securities and mortgages, since actual benefit pay outs are close to those predicted by actuarial analysis

Fire and Casualty Insurance Companies receive funds from policy premiums, must invest most in liquid government and corporate securities, since loss events are harder to predict

Contractual Savings Institutions (CSIs)

All CSIs acquire funds from clients at periodic intervals on a contractual basis and have fairly predictable future payout requirements. Pension and Government Retirement Funds hosted by

corporations and state and local governments acquire funds through employee and employer payroll contributions, invest in corporate securities, and provide retirement income via annuities


Finance Companies sell commercial paper (a short-term debt instrument) and issue bonds and stocks to raise funds to lend to consumers to buy durable goods, and to small businesses for operations

Mutual Funds acquire funds by selling shares to individual investors (many of whose shares are held in retirement accounts) and use the proceeds to purchase large, diversified portfolios of stocks and bonds


Money Market Mutual Funds acquire funds by selling checkable deposit-like shares to individual investors and use the proceeds to purchase highly liquid and safe short-term money market instruments

Investment Banks advise companies on securities to issue, underwriting security offerings, offer M&A assistance, and act as dealers in security markets.

Regulatory Agencies

Regulation of Financial Markets

Main Reasons for Regulation

1. Increase Information to Investors

2. Ensure the Soundness of Financial Intermediaries

SEC home pagehttp://www.sec.gov

Regulation Reason: Increase Investor Information

• Asymmetric information in financial markets means that investors may be subject to adverse selection and moral hazard problems that may hinder the efficient operation of financial markets and may also keep investors away from financial markets

• The Securities and Exchange Commission (SEC) requires corporations issuing securities to disclose certain information about their sales, assets, and earnings to the public and restricts trading by the largest stockholders (known as insiders) in the corporation

SEC home pagehttp://www.sec.gov

Regulation Reason: Increase Investor Information

• Such government regulation can reduce adverse selection and moral hazard problems in financial markets and increase their efficiency by increasing the amount of information available to investors. Indeed, the SEC has been particularly active recently in pursuing illegal insider trading.

Regulation Reason: Ensure Soundness of Financial Intermediaries

Providers of funds to financial intermediaries may not be able to assess whether the institutions holding their funds are sound or not.

If they have doubts about the overall health of financial intermediaries, they may want to pull their funds out of both sound and unsound institutions, with the possible outcome of a financial panic.

Such panics produces large losses for the public and causes serious damage to the economy.

Regulation Reason: Ensure Soundness of Financial Intermediaries (cont.)

To protect the public and the economy from financial panics, the government has implemented six types of regulations: Restrictions on Entry Disclosure Restrictions on Assets and Activities Deposit Insurance Limits on Competition Restrictions on Interest Rates

Regulation: Restriction on Entry

Restrictions on Entry Regulators have created very tight regulations as to who is

allowed to set up a financial intermediary

Individuals or groups that want to establish a financial intermediary, such as a bank or an insurance company, must obtain a charter from the state or the federal government

Only if they are upstanding citizens with impeccable credentials and a large amount of initial funds will they be given a charter.

Regulation: Disclosure

Disclosure Requirements

There are stringent reporting requirements for financial intermediaries Their bookkeeping must follow certain strict principles, Their books are subject to periodic inspection, They must make certain information available to

the public.

Regulation: Restriction on Assets and Activities

There are restrictions on what financial intermediaries are allowed to do and what assets they can hold

Before you put your funds into a bank or some other such institution, you would want to know that your funds are safe and that the bank or other financial intermediary will be able to meet its obligations to you

Regulation: Restriction on Assets and Activities

One way of doing this is to restrict the financial intermediary from engaging in certain risky activities

Another way is to restrict financial intermediaries from holding certain risky assets, or at least from holding a greater quantity of these risky assets than is prudent

Regulation: Deposit Insurance

The government can insure people depositors to a financial intermediary from any financial loss if the financial intermediary should fail

The Federal Deposit Insurance Corporation (FDIC) insures each depositor at a commercial bank or mutual savings bank up to a loss of $100,000 per account ($250,000 for IRAs)

Regulation: Deposit Insurance

Similar government agencies exist for other depository institutions: The National Credit Union Share Insurance Fund

(NCUSIF) provides insurance for credit unions

Regulation: Past Limits on Competition

Although the evidence that unbridled competition among financial intermediaries promotes failures that will harm the public is extremely weak, it has not stopped the state and federal governments from imposing many restrictive regulations

In the past, banks were not allowed to open up branches in other states, and in some states banks were restricted from opening additional locations

Regulation: Past Restrictions on Interest Rates

Competition has also been inhibited by regulations that impose restrictions on interest rates that can be paid on deposits

These regulations were instituted because of the widespread belief that unrestricted interest-rate competition helped encourage bank failures during the Great Depression

Later evidence does not seem to support this view, and restrictions on interest rates have been abolished

Regulation Reason: Improve Monetary Control

Because banks play a very important role in determining the supply of money (which in turn affects many aspects of the economy), much regulation of these financial intermediaries is intended to improve control over the money supply

One such regulation is reserve requirements, which make it obligatory for all depository institutions to keep a certain fraction of their deposits in accounts with the Federal Reserve System (the Fed), the central bank in the United States

Reserve requirements help the Fed exercise more precise control over the money supply

Financial Regulation Abroad

Those countries with similar economic systems also implement financial regulation consistent with the U.S. model: Japan, Canada, and Western Europe Financial reporting for corporations is required Financial intermediaries are heavily regulated

However, U.S. banks are more regulated along dimensions of branching and services than their foreign counterparts.

Chapter Summary

Function of Financial Markets: We examined the flow of funds through the financial system and the role of intermediaries in this process.

Structure of Financial Markets: We examined market structure from several perspectives, including types of instruments, purpose, organization, and time horizon.


Internationalization of Financial Markets: We briefly examined how debt and equity markets have expanded in the international setting.

Function of Financial Intermediaries: We examined the roles of intermediaries in reducing transaction costs, sharing risk, and reducing information problems.


Financial Intermediaries: We outlined the numerous types of financial intermediaries to be further examined in later chapters.

Regulation of the Financial System: We outlined some of the agencies charged with the oversight of various institutions and markets.

Part Two

Fundamentals of Financial Markets

Chapter 3

What Do Interest Rates Mean and What Is

Their Role in Valuation?

Chapter Preview

Interest rates are among the most closely watched variables in the economy. It is imperative that what exactly is meant by the phrase interest rates is understood. In this chapter, we will see that a concept known as yield to maturity (YTM) is the most accurate measure of interest rates.

Chapter Preview

Any description of interest rates entails an understanding certain vernacular and definitions, most of which will not only pertain directly to interest rates but will also be vital to understanding many other foundational concepts presented later in the text.

Chapter Preview So, in this chapter, we will develop a better

understanding of interest rates. We examine the terminology and calculation of various rates, and we show the importance of these rates in our lives and the general economy. Topics include:

Measuring Interest Rates

The Distinction Between Real and Nominal Interest Rates

The Distinction Between Interest Rates and Returns

Present Value Introduction

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 commonsense notion that a dollar of cash flow paid to you one year from now is less valuable to you than a dollar paid to you today. This notion is true because you could invest the dollar in a savings account that earns interest and have more than a dollar in one year.

The term present value (PV) can be extended to mean the PV of a single cash flow or the sum of a sequence or group of cash flows.

Present Value Applications

There are four basic types of credit instruments which incorporate present value concepts:

1. Simple Loan

2. Fixed Payment Loan

3. Coupon Bond

4. Discount Bond

Present Value Concept: Simple Loan Terms

Loan Principal: the amount of funds the lender provides to the borrower.

Maturity Date: the date the loan must be repaid; the Loan Term is from initiation to maturity date.

Interest Payment: the cash amount that the borrower must pay the lender for the use of the loan principal.

Simple Interest Rate: the interest payment divided by the loan principal; the percentage of principal that must be paid as interest to the lender. Convention is to express on an annual basis, irrespective of the loan term.

Simple loan of $100

Year: 0 1 2 3 n

$100 $110 $121 $133 100(1+i)n

PV of future $1 =$1

1+ i n

Present Value Concept: Simple Loan

Present Value Concept: Simple Loan (cont.)

The previous example reinforces the concept that $100 today is preferable to $100 a year from now since today’s $100 could be lent out (or deposited) at 10% interest to be worth $110 one year from now, or $121 in two years or $133 in three years.

Yield to Maturity: Loans

Yield to maturity = interest rate that equates today's value with present value of all future payments

1. Simple Loan Interest Rate (i = 10%)

$100 $110 1 i

i $110 $100

$100

$10

$100.10 10%

Present Value of Cash Flows: Example

Present Value Concept: Fixed-Payment Loan Terms

Simple Loans require payment of one amount which equals the loan principal plus the interest.

Fixed-Payment Loans are loans where the loan principal and interest are repaid in several payments, often monthly, in equal dollar amounts over the loan term.

Present Value Concept: Fixed-Payment Loan Terms

Installment Loans, such as auto loans and home mortgages are frequently of the fixed-payment type.

Yield to Maturity: Loans

2. Fixed Payment Loan (i = 12%)

$1000 $126

1 i

$126

1 i 2 $126

1 i 3 ... $126

1 i 25

LV FP

1 i

FP

1 i 2 FP

1 i 3 ... FP

1 i n

Yield to Maturity: Bonds

3. Coupon Bond (Coupon rate = 10% = C/F)

P $100

1 i

$100

1 i 2 $100

1 i 3 ... $100

1 i 10 $1000

1 i 10

P C

1 i

C

1 i 2 C

1 i 3 ... C

1 i n F

1 i n

Consol: Fixed coupon payments of $C forever

P C

ii

C

P

Yield to Maturity: Bonds

4. One-Year Discount Bond (P = $900, F = $1000)

$900 $1000

1 i

i $1000 $900

$900.111 11.1%

i F P

P

Relationship Between Price and Yield to Maturity

Three interesting facts in Table 3-11. When bond is at par, yield equals coupon rate2. Price and yield are negatively related3. Yield greater than coupon rate when bond price

is below par value

Relationship Between Price and Yield to Maturity It’s also straight-forward to show that the value of a

bond (price) and yield to maturity (YTM) are negatively related. If i increases, the PV of any given cash flow is lower; hence, the price of the bond must be lower.

Current Yield

Current yield (CY) is just an approximation for YTM – easier to calculate. However, we should be aware of its properties:

1. If a bond’s price is near par and has a long maturity, then CY is a good approximation.

2. A change in the current yield always signals change in same direction as yield to maturity

ic C

P

idb (F - P)

F

360

(number of days to maturity)

idb $1000 - $900

$1000

360

365.099 9.9%

Two Characteristics1. Understates yield to maturity; longer the maturity,

greater is understatement

2. Change in discount yield always signals change in same direction as yield to maturity

Yield on a Discount Basis

One-Year Bill (P = $900, F = $1000)

Bond Page of the Newspaper

Global perspective

In November 1998, rates on Japanese 6-month government bonds were negative! Investors were willing to pay more than they would receive in the future.

Best explanation is that investors found the convenience of the bills worth something – more convenient than cash. But that can only go so far – the rate was only slightly negative.

Distinction Between Real and Nominal Interest Rates

Real interest rate1. Interest rate that is adjusted for expected

changes in the price level

ir i e

2. Real interest rate more accurately reflects true cost of borrowing

3. When the real rate is low, there are greater incentives to borrow and less to lend

Distinction Between Real and Nominal Interest Rates

Real interest rate

ir i e

We usually refer to this rate as the ex ante real rate of interest because it is adjusted for the expected level of inflation. After the fact, we can calculate the ex post real rate based on the observed level of inflation.

Distinction Between Real and Nominal Interest Rates (cont.)

If i = 5% and πe = 0% then

ir 5% 0% 5%

ir 10% 20% 10%

• If i = 10% and πe = 20% then

U.S. Real and Nominal Interest Rates

Sample of current rates and indexeshttp://www.martincapital.com/charts.htm

Distinction Between Interest Rates

and Returns

Rate of Return: we can decompose returns into two pieces:

giP

PPc

t

tt

1CReturn

tc P

Ci where = current yield, and

t

tt

P

PP 1g = capital gains.

Key Facts about the Relationship Between Rates and Returns

Sample of current coupon rates and yields on government bondshttp://www.bloomberg.com/markets/iyc.html

Maturity and the Volatility of Bond Returns

Key findings from Table 3-2

1. Only bond whose return = yield is one with maturity = holding period

2. For bonds with maturity > holding period, i P implying capital loss

3. Longer is maturity, greater is price change associated

with interest rate change

Maturity and the Volatility of Bond Returns (cont.)

Key findings from Table 3-2 (continued)

4. Longer is maturity, more return changes with change in interest rate

5. Bond with high initial interest rate can still have negative return if i

Maturity and the Volatility of Bond Returns (cont.)

Conclusion from Table 3-2 analysis

1. Prices and returns more volatile for long-term bonds because have higher interest-rate risk

2. No interest-rate risk for any bond whose maturity equals holding period

Reinvestment Risk

1. Occurs if hold series of short bonds over long holding period

2. i at which reinvest uncertain

3. Gain from i , lose when i

Calculating Durationi =10%, 10-Year 10% Coupon Bond

126

Calculating Durationi = 20%, 10-Year 10% Coupon Bond

DUR tCPt

1 i tt 1

n

CPt

1 i tt 1

n

Formula for Duration

Key facts about duration1. All else equal, when the maturity of a bond

lengthens, the duration rises as well

2. All else equal, when interest rates rise, the duration of a coupon bond fall

Formula for Duration

1. The higher is the coupon rate on the bond, the shorter is the duration of the bond

2. Duration is additive: the duration of a portfolio of securities is the weighted-average of the durations of the individual securities, with the weights equaling the proportion of the portfolio invested in each

%P DURi

1 i

%P 6.76 0.01

1 0.10

%P 0.0615 6.15%

Duration and Interest-Rate Risk

i 10% to 11%: Table 3-4, 10% coupon bond

Duration and Interest-Rate Risk (cont.)

i 10% to 11%: 20% coupon bond, DUR = 5.72 years

%P 5.72 0.01

1 0.10

%P 0.0520 5.20%

The greater is the duration of a security, the greater is the percentage change in the market value of the security for a given change in interest rates

Therefore, the greater is the duration of a security, the greater is its interest-rate risk

Duration and Interest-Rate Risk (cont.)

Chapter Summary

Measuring Interest Rates: We examined several techniques for measuring the interest rate required on debt instruments.

The Distinction Between Real and Nominal Interest Rates: We examined the meaning of interest in the context of price inflation.


The Distinction Between Interest Rates and Returns: We examined what each means and how they should be viewed for asset valuation.

Chapter 4

Why Do Interest Rates Change?

Chapter Preview

In the early 1950s, short-term Treasury bills were yielding about 1%. By 1981, the yields rose to 15% and higher. But then dropped back to 1% by 2003.

What causes these changes?

Chapter Preview

In this chapter, we examine the forces the move interest rates and the theories behind those movements. Topics include: Determining Asset Demand Supply and Demand in the Bond Market Changes in Equilibrium Interest Rates

Determinants of Asset Demand

An asset is a piece of property that is a store of value. Facing the question of whether to buy and hold an asset or whether to buy one asset rather than another, an individual must consider the following factors:

1. Wealth, the total resources owned by the individual, including all assets

2. Expected return (the return expected over the next period) on one asset relative to alternative assets

3. Risk (the degree of uncertainty associated with the return) on one asset relative to alternative assets

4. Liquidity (the ease and speed with which an asset can be turned into cash) relative to alternative assets

EXAMPLE 1: Expected Return

What is the expected return on an Exxon-Mobil bond if the return is 12% two-thirds of the time and 8% one-third of the time?

Solution

The expected return is 10.68%.

Re = p1R1 + p2R2

where

p1 = probability of occurrence of return 1 = 2/3 = .67

R1 = return in state 1 = 12% = 0.12

p2 = probability of occurrence return 2 = 1/3 = .33

R2 = return in state 2 = 8% = 0.08

Thus

Re = (.67)(0.12) + (.33)(0.08) = 0.1068 = 10.68%

EXAMPLE 2: Standard Deviation (a)

Consider the following two companies and their forecasted returns for the upcoming year:

F ly-by-Night F eet-on-the-G roundP robability 50% 100%R eturn 15% 10%P robability 50%R eturn 5%

O utcome 1

O utcome 2

EXAMPLE 2: Standard Deviation (b)

What is the standard deviation of the returns on the Fly-by-Night Airlines stock and Feet-on-the-Ground Bus Company, with the return outcomes and probabilities described above? Of these two stocks, which is riskier?

EXAMPLE 2: Standard Deviation (c)

Solution Fly-by-Night Airlines has a standard deviation of returns of 5%.

EXAMPLE 2: Standard Deviation (d)

Feet-on-the-Ground Bus Company has a standard deviation of returns of 0%.

EXAMPLE 2: Standard Deviation (e)

Fly-by-Night Airlines has a standard deviation of returns of 5%; Feet-on-the-Ground Bus Company has a standard deviation of returns of 0%

Clearly, Fly-by-Night Airlines is a riskier stock because its standard deviation of returns of 5% is higher than the zero 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 preferrer or risk lover. We assume people are risk-averse, especially in their financial decisions

Determinants of Asset Demand (2) The quantity demanded of an asset differs by factor.

1. Wealth: Holding everything else constant, an increase in wealth raises the quantity demanded of an asset

2. Expected return: An increase in an asset’s expected return relative to that of an alternative asset, holding everything else unchanged, raises the quantity demanded of the asset

3. Risk: Holding everything else constant, if an asset’s risk rises relative to that of alternative assets, its quantity demanded will fall

4. Liquidity: The more liquid an asset is relative to alternative assets, holding everything else unchanged, the more desirable

it is, and the greater will be the quantity demanded

Determinants of Asset Demand (3)

Supply & Demand in the Bond Market

We now turn our attention to the mechanics of interest rates. That is, we are going to examine how interest rates are determined – from a demand and supply perspective. Keep in mind that these forces act differently in different bond markets. That is, current supply/demand conditions in the corporate bond market are not necessarily the same as, say, in the mortgage market. However, because rates tend to move together, we will proceed as if there is one interest rate for the entire economy.

The Demand Curve

Let’s start with the demand curve.

Let’s consider a one-year discount bond with a face value of $1,000. In this case, the return on this bond is entirely determined by its price. The return is, then, the bond’s yield to maturity.

Point B: if the bond was selling for $900.

i Re F P

P

P $950

i $1000 $950

$950.053 5.3%

Bd 100

P $900

i $1000 $900

$900.111 11.1%

Bd 200

Derivation of Demand Curve

Point A: if the bond was selling for $950.


How do we know the demand (Bd) at point A is 100 and at point B is 200?

Well, we are just making-up those numbers. But we are applying basic economics – more people will want (demand) the bonds if the expected return is higher.


To continue …

Point C: P = $850 i = 17.6% Bd = 300

Point D: P = $800 i = 25.0% Bd = 400

Point E: P = $750 i = 33.0% Bd = 500

Demand Curve is Bd in Figure 1 which connects points A, B, C, D, E. Has usual downward slope

Supply and Demand for Bonds

Derivation of Supply Curve

In the last figure, we snuck the supply curve in – the line connecting points F, G, C, H, and I. The derivation follows the same idea as the demand curve.

Derivation of Supply Curve

Point F: P = $750 i = 33.0% Bs = 100 Point G: P = $800 i = 25.0% Bs = 200 Point C: P = $850 i = 17.6% Bs = 300 Point H: P = $900 i = 11.1% Bs = 400 Point I: P = $950 i = 5.3% Bs = 500 Supply Curve is Bs that connects points F, G,

C, H, I, and has upward slope


How do we know the supply (Bs) at point P is 100 and at point G is 200?

Again, like the demand curve, we are just making-up those numbers. But we are applying basic economics – more people will offer (supply) the bonds if the expected return is lower.

Market Equilibrium

The equilibrium follows what we know from supply-demand analysis:

1. Occurs when Bd = Bs, at P* = 850, i* = 17.6%

2. When P = $950, i = 5.3%, Bs > Bd (excess supply): P to P*, i to i*

3. When P = $750, i = 33.0, Bd > Bs (excess demand): P to P*, i to i*

Market Conditions

Market equilibrium occurs when the amount that people are willing to buy (demand) equals the amount that people are willing to sell (supply) at a given price

Excess supply occurs when the amount that people are willing to sell (supply) is greater than the amount people are willing to buy (demand) at a given price

Excess demand occurs when the amount that people are willing to buy (demand) is greater than the amount that people are willing to sell (supply) at a given price

Supply & Demand Analysis

Notice in Figure 1 that we use two different verticle axes – one with price, which is high-to-low starting from the top, and one with interest rates, which is low-to-high starting from the top.

This just illustrates what we already know: bond prices and interest rates are inversely related.

Also note that this analysis is an asset market approach based on the stock of bonds. Another way to do this is to examine the flows. However, the flows approach is tricky, especially with inflation in the mix. So we will focus on the stock approach.

Changes in Equilibrium Interest Rates

We now turn our attention to changes in interest rate. We focus on actual shifts in the curves. Remember: movements along the curve will be due to price changes alone.

First, we examine shifts in the demand for bonds. Then we will turn to the supply side.

Factors That Shift Demand Curve

How Factors Shift the Demand Curve

1. Wealth/saving Economy , wealth Bd , Bd shifts out to right

OR

Economy , wealth Bd , Bd shifts out to right


2. Expected Returns on bonds i in future, Re for long-term bonds Bd shifts out to right

OR πe , relative Re Bd shifts out to right


2. …and Expected Returns on other assets ER on other asset (stock) Re for long-term bonds Bd shifts out to left

These are closely tied to expected interest rate and expected inflation from Table 4.2


3. Risk Risk of bonds , Bd Bd shifts out to rightOR Risk of other assets , Bd Bd shifts out to right


4. Liquidity Liquidity of bonds , Bd Bd shifts out to rightOR Liquidity of other assets , Bd Bd shifts out to right

Shifts in the Demand Curve

Summary of Shifts in the Demand for Bonds

1. Wealth: in a business cycle expansion with growing wealth, the demand for bonds rises, conversely, in a recession, when income and wealth are falling, the demand for bonds falls

2. Expected returns: higher expected interest rates in the future decrease the demand for long-term bonds, conversely, lower expected interest rates in the future increase the demand for long-term bonds

Summary of Shifts in the Demand for Bonds (2)

3. Risk: an increase in the riskiness of bonds causes the demand for bonds to fall, conversely, an increase in the riskiness of alternative assets (like stocks) causes the demand for bonds to rise

4. Liquidity: increased liquidity of the bond market results in an increased demand for bonds, conversely, increased liquidity of alternative asset markets (like the stock market) lowers the demand for bonds

Factors That Shift Supply CurveWe now turn to the supply curve. We summarize the effects in this table:

Shifts in the Supply Curve

1. Profitability of Investment Opportunities

Business cycle expansion, investment opportunities , Bs , Bs shifts out to right


2. Expected Inflation πe , Bs Bs shifts out

to right

3. Government Activities

– Deficits , Bs – Bs shifts out to right

Summary of Shifts in the Supply of Bonds

1. Expected Profitability of Investment Opportunities: in a business cycle expansion, the supply of bonds increases, conversely, in a recession, when there are far fewer expected profitable investment opportunities, the supply of bonds falls

2. Expected Inflation: an increase in expected inflation causes the supply of bonds to increase

3. Government Activities: higher government deficits increase the supply of bonds, conversely, government surpluses decrease the supply of bonds

Case: Fisher Effect

We’ve done the hard work. Now we turn to some special cases. The first is the Fisher Effect. Recall that rates are composed of several components: a real rate, an inflation premium, and various risk premiums.

What if there is only a change in expected inflation?

Changes in πe: The Fisher Effect

If πe 1. Relative Re ,

Bd shifts in to left

2. Bs , Bs shifts out to right

3. P , i

Evidence on the Fisher Effect in the United States

Summary of the Fisher Effect

1. If expected inflation rises from 5% to 10%, the expected return on bonds relative to real assets falls and, as a result, the demand for bonds falls

2. The rise in expected inflation also means that the real cost of borrowing has declined, causing the quantity of bonds supplied to increase

3. When the demand for bonds falls and the quantity of bonds supplied increases, the equilibrium bond price falls

4. Since the bond price is negatively related to the interest rate, this means that the interest rate will rise

Case: Business Cycle Expansion

Another good thing to examine is an expansionary business cycle. Here, the amount of goods and services for the country is increasing, so national income is increasing.

What is the expected effect on interest rates?

Business Cycle Expansion

1. Wealth , Bd , Bd shifts out to right

2. Investment , Bs , Bs shifts right

3. If Bs shifts more than Bd then P , i

Evidence on Business Cycles and Interest Rates

Case: Low Japanese Interest Rates

In November 1998, Japanese interest rates on six-month Treasury bills turned slightly negative. How can we explain that within the framework discussed so far?

It’s a little tricky, but we can do it!


1. Negative inflation lead to Bd • Bd shifts out to right

2. Negative inflation lead to in real rates• Bs shifts out to left

Net effect was an increase in bond prices (falling interest rates).


3. Business cycle contraction lead to in interest rates

• Bs shifts out to left• Bd shifts out to left

But the shift in Bd is less significant than the shift in Bs, so the net effect was also an increase in bond prices.

Case: WSJ “Credit Markets”

Everyday, the Wall Street Journal reports on developments in the bond market in its “Credit Markets” column.

Let’s look at an example and how to interpret what it says.

WSJ article


What is this article telling us? Strength in a sector helped lower T-bond

prices (increase rates). That follows what we learned!

A stronger economy shifts both curves to the right, but the supply curve by more, so prices will fall.


Article also points out that yields on gov’t bonds in Germany and Japan are rising. Money will move from the U.S. Treasury market to these markets, shifting the demand curve to the left (falling prices).

The strong economy also suggests a lower chance of future Fed rate cuts, further shifting the demand curve to the left.

The Practicing Manager

We now turn to a more practical side to all this. Many firms have economists or hire consultants to forecast interest rates. Although this can be difficult to get right, it is important to understand what to do with a given interest rate forecast.

Profiting from Interest-Rate Forecasts

Methods for forecasting1. Supply and demand for bonds: use Flow of

Funds Accounts and judgment

2. Econometric Models: large in scale, use interlocking equations that assume past financial relationships will hold in the future

Profiting from Interest-Rate Forecasts (cont.)

Make decisions about assets to hold1. Forecast i , buy long bonds

2. Forecast i , buy short bonds

Make decisions about how to borrow1. Forecast i , borrow short

2. Forecast i , borrow long

Chapter Summary

Determining Asset Demand: We examined the forces that affect the demand and supply of assets.

Supply and Demand in the Bond Market: We examine those forces in the context of bonds, and examined the impact on interest rates.


Changes in Equilibrium Interest Rates: We further examined the dynamics of changes in supply and demand in the bond market, and the corresponding effect on bond prices and interest rates.

Chapter 5

How Do The Risk and Term Structure Affect Interest Rates

Chapter Preview

In the last chapter, we examined interest rates, but made a big assumption – there is only one economy-wide interest rate. Of course, that isn’t really the case.

In this chapter, we will examine the different rates that we observe for financial products.

Chapter Preview

We will fist examine bonds that offer similar payment streams but differ in price. The price differences are due to the risk structure of interest rates. We will examine in detail what this risk structure looks like and ways to examine it.

Chapter Preview

Next, we will look at the different rates required on bonds with different maturities. That is, we typically observe higher rates on longer-term bonds. This is known as the term structure of interest rates. To study this, we usually look at Treasury bonds to minimize the impact of other risk factors.

Chapter Preview

So, in sum, we will examine how the individual risk of a bond affects its required rate. We also explore how the general level of interest rates varies with the maturity of the debt instruments. Topics include:

Risk Structure of Interest Rates

Term Structure of Interest Rates

Risk Structure of Interest Rates

To start this discussion, we first examine the yields for several categories of long-term bonds over the last 85 years.

You should note several aspects regarding these rates, related to different bond categories and how this has changed through time.

Risk Structure of Long Bonds in the U.S.

Risk Structure of Long Bonds in the U.S.

The figure show two important features of the interest-rate behavior of bonds.

Rates on different bond categories change from one year to the next.

Spreads on different bond categories change from one year to the next.

Factors Affecting Risk Structure of Interest Rates

To further examine these features, we will look at three specific risk factors.

Default Risk

Liquidity

Income Tax Considerations

Default Risk Factor One attribute of a bond that influences its interest

rate is its risk of default, which occurs when the issuer of the bond is unable or unwilling to make interest payments when promised.

U.S. Treasury bonds have usually been considered to have no default risk because the federal government can always increase taxes to pay off its obligations (or just print money). Bonds like these with no default risk are called default-free bonds.

Default Risk Factor (cont.) The spread between the interest rates on bonds

with default risk and default-free bonds, called the risk premium, indicates how much additional interest people must earn in order to be willing to hold that risky bond.

A bond with default risk will always have a positive risk premium, and an increase in its default risk will raise the risk premium.

Increase in Default Risk on Corporate Bonds

Analysis of Figure 5.2: Increase in Default on Corporate Bonds

Corporate Bond Market1. Re on corporate bonds , Dc , Dc shifts left2. Risk of corporate bonds , Dc , Dc shifts left3. Pc , ic

Treasury Bond Market4. Relative Re on Treasury bonds , DT , DT shifts right5. Relative risk of Treasury bonds , DT , DT shifts right6. PT , iT

Outcome Risk premium, ic - iT, rises

Default Risk Factor (cont.) Default risk is an important component of the size of

the risk premium. Because of this, bond investors would like to know

as much as possible about the default probability of a bond.

One way to do this is to use the measures provided by credit-rating agencies: Moody’s and S&P are examples.

Bond Ratings

Case: Enron and the Baa-Aaa spread

Enron filed for bankruptcy in December 2001, amidst an accounting scandal.

Because of the questions raised about the quality of auditors, the demand for lower-credit bonds fell, and a “flight- to-quality” followed (demand for T-securities increased.

Result: Baa-Aaa spread increased from 84 bps to 128 bps.

Liquidity Factor

Another attribute of a bond that influences its interest rate is its liquidity; a liquid asset is one that can be quickly and cheaply converted into cash if the need arises. The more liquid an asset is, the more desirable it is (higher demand), holding everything else constant.

Let’s examine what happens if a corporate bond becomes less liquid (Figure 1 again).

Decrease in Liquidity of Corporate Bonds

Figure 5.2 Response to a Decrease in the Liquidity of Corporate Bonds

Analysis of Figure 5.1: Corporate Bond Becomes Less Liquid

Corporate Bond Market1. Liquidity of corporate bonds , Dc , Dc shifts left

2. Pc , ic Treasury Bond Market

1. Relatively more liquid Treasury bonds, DT , DT shifts right

2. PT , iT Outcome

Risk premium, ic - iT, rises Risk premium reflects not only corporate bonds' default risk but

also lower liquidity

Liquidity Factor (cont.)

The differences between interest rates on corporate bonds and Treasury bonds (that is, the risk premiums) reflect not only the corporate bond’s default risk but its liquidity too. This is why a risk premium is sometimes called a risk and liquidity premium.

Income Taxes Factor

An odd feature of Figure 1 is that municipal bonds tend to have a lower rate the Treasuries. Why?

Munis certainly can default. Orange County (California) is a recent example from the early 1990s.

Munis are not as liquid a Treasuries.

Income Taxes Factor

However, interest payments on municipal bonds are exempt from federal income taxes, a factor that has the same effect on the demand for municipal bonds as an increase in their expected return.

Treasury bonds are exempt from state and local income taxes, while interest payments from corporate bonds are fully taxable.

Income Taxes Factor

For example, suppose you are in the 35% tax bracket. From a 10%-coupon Treasury bond, you only net $65 of the coupon payment because of taxes

However, from an 8%-coupon muni, you net the full $80. For the higher return, you are willing to hold a riskier muni (to a point).

Tax Advantages of Municipal Bonds

Analysis of Figure 5.3: Tax Advantages of Municipal Bonds

Municipal Bond Market1. Tax exemption raises relative Re on municipal bonds,

Dm , Dm shifts right2. Pm

Treasury Bond Market1. Relative Re on Treasury bonds , DT , DT shifts left2. PT

Outcomeim < iT

Case: Bush Tax Cut and Interest Rates

The 2001 tax cut called for a reduction in the top tax bracket, from 39% to 35% over a 10-year period.

This reduces the advantage of municipal debt over T-securities since the interest on T-securities is now taxed at a lower rate.

Term Structure of Interest Rates

Now that we understand risk, liquidity, and taxes, we turn to another important influence on interest rates – maturity.

Bonds with different maturities tend to have different required rates, all else equal.

The WSJ: Following the News

For example, the WSJ publishes a plot of the yield curve (rates at different maturities) for Treasury securities.

The picture on the following slide is a typical example, from May 14, 2007.

What is the 3-month rate? The two-year rate?

Reading the Wall St. Journal

Dynamic yield curve that can show the curve at any time in historyhttp://stockcharts.com/charts/YieldCurve.html

Term Structure Facts to Be Explained

Besides explaining the shape of the yield curve, a good theory must explain why:

Interest rates for different maturities move together. We see this on the next slide.

Interest Rates on Different Maturity Bonds Move Together

Term Structure Facts to Be Explained

Besides explaining the shape of the yield curve, a good theory must explain why:

Interest rates for different maturities move together.

Yield curves tend to have steep upward slope when short rates are low and downward slope when short rates are high.

Yield curve is typically upward sloping.

Three Theories of Term Structure

1. Expectations Theory Pure Expectations Theory explains 1 and 2,

but not 3

2. Market Segmentation Theory Market Segmentation Theory explains 3, but not 1 and 2

3. Liquidity Premium Theory Solution: Combine features of both Pure Expectations

Theory and Market Segmentation Theory to get Liquidity Premium Theory and explain all facts

Expectations Theory

Key Assumption: Bonds of different maturities are perfect substitutes

Implication: Re on bonds of different maturities are equal

Expectations Theory

To illustrate what this means, consider two alternative investment strategies for a two-year time horizon.

1. Buy $1 of one-year bond, and when it matures, buy another one-year bond with your money.

2. Buy $1 of two-year bond and hold it.

Expectations Theory

The important point of this theory is that if the Expectations Theory is correct, your expected wealth is the same (a the start) for both strategies. Of course, your actual wealth may differ, if rates change unexpectedly after a year.

We show the details of this in the next few slides.

(1 it)(1 i

t1e ) 11 i

t i

t1e i

t(i

t1e ) 1

Expectations Theory

Expected return from strategy 1

Since it(iet+1) is also extremely small, expected return is approximately

it + iet+1

(1 i2t

)(1 i2t

) 11 2(i2t

) (i2t

)2 1

Since (i2t)2 is extremely small, expected return is approximately 2(i2t)

Expectations Theory

Expected return from strategy 2

i2t it it1

e

2

Expectations Theory

From implication above expected returns of two strategies are equal

Therefore

2 i2t it it1e

Solving for i2t

(1)

Expectations Theory

To help see this, here’s a picture that describes the same information:

int it it1 it2 ... it n 1

n

More generally for n-period bond…

Don’t let this seem complicated. Equation 2 simply states that the interest rate on a long-term bond equals the average of short rates expected to occur over life of the long-term bond.

(2)

More generally for n-period bond…

Numerical example One-year interest rate over the next five years

are expected to be 5%, 6%, 7%, 8%, and 9%

Interest rate on two-year bond today:(5% + 6%)/2 = 5.5%

Interest rate for five-year bond today:(5% + 6% + 7% + 8% + 9%)/5 = 7%

Interest rate for one- to five-year bonds today:5%, 5.5%, 6%, 6.5% and 7%

Expectations Theory and Term Structure Facts

Explains why yield curve has different slopes1. When short rates are expected to rise in future, average

of future short rates = int is above today's short rate; therefore yield curve is upward sloping.

2. When short rates expected to stay same in future, average of future short rates same as today's, and yield curve is flat.

3. Only when short rates expected to fall will yield curve be downward sloping.


Pure expectations theory explains fact 1—that short and long rates move together

1. Short rate rises are persistent

2. If it today, iet+1, iet+2 etc. average of future rates int

3. Therefore: it int (i.e., short and long rates move together)


Explains fact 2—that yield curves tend to have steep slope when short rates are low and downward slope when short rates are high

1. When short rates are low, they are expected to rise to normal level, and long rate = average of future short rates will be well above today's short rate; yield curve will have steep upward slope.

2. When short rates are high, they will be expected to fall in future, and long rate will be below current short rate; yield curve will have downward slope.


Doesn't explain fact 3—that yield curve usually has upward slope Short rates are as likely to fall in future as rise, so

average of expected future short rates will not usually be higher than current short rate: therefore, yield curve will not usually slope upward.

Market Segmentation Theory Key Assumption: Bonds of different maturities are not

substitutes at all

Implication: Markets are completely segmented;interest rate at each maturity aredetermined separately

Market Segmentation Theory

Explains fact 3—that yield curve is usually upward sloping People typically prefer short holding periods and thus have

higher demand for short-term bonds, which have higher prices and lower interest rates than long bonds

Does not explain fact 1or fact 2 because its assumes long-term and short-term rates are determined independently.

Liquidity Premium Theory

Key Assumption: Bonds of different maturities are substitutes, but are not perfect substitutes

Implication: Modifies Pure Expectations Theory with features of Market Segmentation Theory


Investors prefer short-term rather than long-term bonds. This implies that investors must be paid positive liquidity premium, int, to hold long term bonds.

int

it it1e it 2

e ... it n 1 e

nnt


Results in following modification of Expectations Theory, where lnt is the liquidity premium.

(3)

We can also see this graphically…

Numerical Example

1. One-year interest rate over the next five years: 5%, 6%, 7%, 8%, and 9%

2. Investors' preferences for holding short-term bonds so liquidity premium for one- to five-year bonds: 0%, 0.25%, 0.5%, 0.75%, and 1.0%

Numerical Example

Interest rate on the two-year bond:0.25% + (5% + 6%)/2 = 5.75%

Interest rate on the five-year bond:1.0% + (5% + 6% + 7% + 8% + 9%)/5 = 8%

Interest rates on one to five-year bonds:5%, 5.75%, 6.5%, 7.25%, and 8%

Comparing with those for the pure expectations theory, liquidity premium theory produces yield curves more steeply upward sloped

Liquidity Premium Theory: Term Structure Facts

Explains All 3 Facts Explains fact 3—that usual upward sloped yield

curve by liquidity premium for long-term bonds

Explains fact 1 and fact 2 using same explanations as pure expectations theory because it has average of future short rates as determinant of long rate

247

Market Predictions of Future Short Rates

Evidence on the Term Structure

Initial research (early 1980s) found little useful information in the yield curve for predicting future interest rates.

Recently, more discriminating tests show that the yield curve has a lot of information about very short-term and long-term rates, but says little about medium-term rates.

Case: Interpreting Yield Curves

The picture on the next slide illustrates several yield curves that we have observed for U.S. Treasury securities in recent years.

What do they tell us about the public’s expectations of future rates?

Case: Interpreting Yield Curves, 1980–2008


The steep downward curve in 1981 suggested that short-term rates were expected to decline in the near future. This played-out, with rates dropping by 300 bps in 3 months.

The upward curve in 1985 suggested a rate increase in the near future.


The slightly upward slopes in the remaining years can be explained by liquidity premiums. Short-term rates were stable, with longer-term rates including a liquidity premium (explaining the upward slope).

Mini-case: The Yield Curve as a Forecasting Tool

The yield curve does have information about future interest rates, and so it should also help forecast inflation and real output production. Rising (falling) rates are associated with

economic booms (recessions) [chapter 4]. Rates are composed of both real rates and

inflation expectations [chapter 3].

The Practicing Manager: Forecasting Interest Rates with the Term Structure

Pure Expectations Theory: Invest in 1-period bonds or in two-period bond

1 it 1 it1e 1 1 i2t 1 i2t 1

Solve for forward rate, iet+1

it1e

1 i2t 2

1 it 1 (4)

Numerical example: i1t = 5%, i2t = 5.5%

it1e

1 0.055 2

1 0.05 1 0.06 6%

Forecasting Interest Rates with the Term Structure

Compare 3-year bond versus 3 one-year bonds

Using iet+1 derived in (4), solve for iet+2

1 it 1 it 1e 1 it2

e 1 1 i3t 1 i3t 1 i3t 1

it2e

1 i3t 3

1 i2t 2 1


Generalize to:

Liquidity Premium Theory: int - = same as pure expectations theory; replace int by int - in (5) to get adjusted forward-rate forecast

itne

1 in1t n 1

1 int n 1 (5)

itn

e 1 in1t n 1t n1

1 int nt n 1 (6)


Numerical Example

2t = 0.25%, 1t=0, i1t=5%, i2t = 5.75%

Example: 1-year loan next year T-bond + 1%, 2t = .4%, i1t = 6%, i2t = 7%

Loan rate must be > 8.2%

it1e

1 0.0575 0.0025 2

1 0.05 1 0.06 6%

it1e

1 0.07 0.004 2

1 0.06 1 0.072 7.2%

Chapter Summary

Risk Structure of Interest Rates: We examine the key components of risk in debt: default, liquidity, and taxes.

Term Structure of Interest Rates: We examined the various shapes the yield curve can take, theories to explain this, and predictions of future interest rates based on the theories.

Part 3

Financial Markets

Chapter 6

The Money Markets

Chapter Preview

Topics include: The Money Markets Defined

The Purpose of Money Markets

Who Participates in Money Markets?

Money Market Instruments

Comparing Money Market Securities

The Money Markets Defined

Money Markets Defined

1. Money market securities are usually sold in large denominations ($1,000,000 or more) 交易的数额巨大 --------wholesale markets

2. They have low default risk 违约风险低

3. They mature （到期） in one year or less from their issue date （初始发行日）

The Money Markets Defined: Cost Advantages

Reserve requirements (Required Deposit Reserve) create additional expense for banks that money markets do not have

Regulations on the level of interest banks could offer depositors lead to a significant growth in money markets

The Purpose of Money Markets

Investors in Money Market: Provides a place for warehousing surplus funds for short periods of time (cash- opportunity cost)

Borrowers: money market provide low-cost source of temporary funds

Who Participates in the Money Markets?

Money Market Instruments

We will examine each of these in the following slides:

Treasury Bills

Federal Funds

Repurchase Agreements

Negotiable Certificates of Deposit

Money Market Instruments (cont.)

Commercial Paper

Banker’s Acceptance

Eurodollars

Money Market Instruments: Treasury Bills

T-bills have 28-day maturities through 12- month maturities.

Discounting: When an investor pays less for the security than it will be worth when it matures

Discount rate

Yield rate

Money Market Instruments: Treasury Bills Discounting Example

You pay $996.37 for a 28-day T-bill. It is worth $1,000 at maturity. What is its discount rate?

(1)n

xF

PFi discount

536

%665.428

536

000,1

73.996000,1

xi discount

Money Market Instruments: Treasury Bills Discounting Example

You pay $996.37 for a 28-day T-bill. It is worth $1,000 at maturity. What is its annualized yield?

iyt F P

P

365

n(1)

%76.428

536

37.996

73.996000,1

xi yt

Money Market Instruments: Treasury Bill Auctions

T-bills are auctioned （拍卖） by

competitive bids （竞价招标）

noncompetitive bids （非竞价招标）

Money Market Instruments: Treasury Bill Auctions Example

The Treasury auctioned $2.5 billion par value 91-day T-bills, the following bids were received:

Bidder Bid Amount Bid Price 1 $500 million $0.9940 2 $750 million $0.9901 3 $1.5 billion $0.9925 4 $500 million $0.9936 5 $600 million $0.9939

The Treasury also received in competitive bids. Who will receive T-bills, what quantity, and at what price?

Money Market Instruments: Treasury Bill Auctions Example

The Treasury accepts the following bids:

Bidder Bid Amount Bid Price

1 $500 million $0.9940

5 $500 million $0.9939

4 $650 million $0.9936

Money Market Instruments: Fed Funds

Short-term funds transferred (loaned or borrowed) between financial institutions, usually for a period of one day.

Used by banks to meet short-term needs to meet reserve requirements:

主要目的就是为准备金短缺的银行提供可立即拆入的资金．

Federal Funds Interest Rates

How to set ?

Fed sell securities: higher iFed buy securities: lower i

Money Market Instruments: Repurchase Agreements

These work similar to the market for fed funds, but nonbanks can participate.

A firm sells Treasury securities, but agrees to buy them back at a certain date (usually 3–14 days later) for a certain price.

Money Market Instruments: Repurchase Agreements

This set-up makes a repo agreements essentially a short-term collateralized( 抵押） loan.

This is one market the Fed may use to conduct its monetary policy, whereby the Fed purchases/sells Treasury securities in the repo market.

Money Market Instruments: Negotiable Certificates of Deposit

A bank-issued security that documents a deposit and specifies the interest rate and the maturity date

Denominations range from $100,000 to $10 million

Money Market Instruments: Commercial Paper

Unsecured promissory notes, issued by corporations, that mature in no more than 270 days.

The use of commercial paper increased significantly in the early 1980s because of the rising cost of bank loans.


The next slide shows actual commercial paper rates and the prime rates 1990 through 2007.

Although the two track closely in terms of movements, notice that difference between the two remains roughly 200 basis points.


The next slide shows actual commercial paper volume by year from 1990 through 2006.

Notice that the volume has only begun to fall during the recent economic recession in the economy. Even so, the annual market is still quite large, at well over $1 trillion outstanding.

Money Market Instruments: Commercial Paper Volume

Money Market Instruments: Banker’s Acceptances

An order to pay a specified amount to the bearer on a given date if specified conditions have been met, usually delivery of promised goods.

These are often used when buyers / sellers of expensive goods live in different countries.

Money Market Instruments: Banker’s Acceptances Advantages

1. Exporter paid immediately

2. Exporter shielded from foreign exchange risk

3. Exporter does not have to assess the financial security of the importer

4. Importer’s bank guarantees payment

5. Crucial to international trade

Money Market Instruments: Banker’s Acceptances

As seen, banker’s acceptances avoid the need to establish the credit-worthiness of a customer living abroad.

There is also an active secondary market for banker’s acceptances until they mature. The terms of note indicate that the bearer, whoever that is, will be paid upon maturity.

Money Market Instruments: Eurodollars

Eurodollars represent Dollar denominated deposits held in foreign banks.

The market is essential since many foreign contracts call for payment is U.S. dollars due to the stability of the dollar, relative to other currencies.

Money Market Instruments: Eurodollars

The Eurodollar market has continued to grow rapidly because depositors receive a higher rate of return on a dollar deposit in the Eurodollar market than in the domestic market.

Multinational banks are not subject to the same regulations restricting U.S. banks and because they are willing to accept narrower spreads between the interest paid on deposits and the interest earned on loans.

Money Market Instruments: Eurodollars Rates

London interbank bid rate (LIBID) The rate paid by banks buying funds

London interbank offer rate (LIBOR) The rate offered for sale of the funds

　


The next slide shows a comparison of various money market rates from 1990 through 2007.

Notice that no real pattern is present among the rates, indicating that investor preferences to the features on the instruments fluctuates.

Comparing Money Market Securities : A comparison of rates


The next slide summarizes the types of securities, issuers, buyers, maturity, and secondary market characteristics.

Comparing Money Market Securities: Money Market Securities and Their Depth

Chapter Summary

The Money Markets Defined Short-term instruments Most have a low default probability

The Purpose of Money Markets Used to “warehouse” funds Returns are low because of low risk and

high liquidity


Who Participates in Money Markets? U.S. Treasury Commercial banks Businesses Individuals (through mutual funds)

Money Market Instruments Include T-bills, fed funds, etc.

Comparing Money Market Securities Issuers range from the US government to banks

to large corporations Mature in as little as 1 day to as long as 1 year The secondary market liquidity

varies substantially


Chapter 7

The Bond Market

Chapter Preview

In this chapter, we focus on longer-term securities: bonds. Bonds are like money market instruments, but they have maturities that exceed one year. These include Treasury bonds, corporate bonds, mortgages, and the like.

Chapter Preview

Topics include: Purpose of the Capital Market

Capital Market Participants

Capital Market Trading

Types of Bonds

Treasury Notes and Bonds

Municipal Bonds

Chapter Preview (cont.)

Corporate Bonds

Financial Guarantees for Bonds

Current Yield Calculation

Finding the Value of Coupon Bonds

Investing in Bonds

Purpose of the Capital Market

Original maturity is greater than one year, typically for long-term financing or investments

Best known capital market securities: Stocks and bonds

Capital Market Participants

Primary issuers of securities: Federal and local governments: debt issuers Corporations: equity and debt issuers

Largest purchasers of securities: You and me

? Capital Structure

Capital Market Trading

1. Primary market for initial sale (IPO)

2. Secondary market Over-the-counter Organized exchanges (i.e., NYSE)

Types of Bonds

Bonds are securities that represent debt owed by the issuer to the investor, and typically have specified payments on specific dates.

Types of bonds we will examine include long-term government bonds (T-bonds), municipal bonds, and corporate bonds.

Types of Bonds: Sample Corporate Bond


The U.S. Treasury issues notes and bonds to finance its operations.

The following table summarizes the maturity differences among the various Treasury securities.

Treasury Bond Interest Rates

No default risk since the Treasury can print money to payoff the debt

Very low interest rates, often considered the risk-free rate (although inflation risk is still present)


The next two figures show historical rates on Treasury bills, bonds, and the inflation rate.

Treasury Bond Interest Rates: Bills vs. Bonds

Treasury Bonds: Recent Innovation

Treasury Inflation-Indexed Securities: the principal amount is tied to the current rate of inflation to protect investor purchasing power

Treasury STRIPS: the coupon and principal payments are “stripped” from a T-Bond and sold as individual zero-coupon bonds.

Treasury Bonds: Agency Debt

Although not technically Treasury securities, agency bonds are issued by government-sponsored entities, such as GNMA, FNMA, and FHLMC.

The debt has an “implicit” guarantee that the U.S. government will not let the debt default.

Municipal Bonds

Issued by local, county, and state governments

Used to finance public interest projects

Tax-free municipal interest rate = taxable interest rate (1 marginal tax rate)

Municipal Bonds: Example

Suppose the rate on a corporate bond is 9% and the rate on a municipal bond is 6.75%. Which should you choose?

Answer: Find the marginal tax rate:

6.75% = 9% x (1 – MTR), or MTR = 25%

If you are in a marginal tax rate above 25%, the municipal bond offers a higher after-tax cash flow.

Municipal Bonds

Two types General obligation bonds Revenue bonds

NOT default-free (e.g., Orange County California)

Defaults in 1990 amounted to $1.4 billion in this market

Municipal Bonds

The next slide shows the volume of general obligation bonds and revue bonds issued from 1984 through 2006.

Note that general obligation bonds represent a higher percentage in the latter part of the sample.

Municipal Bonds: Comparing Revenue and General Obligation Bonds

Corporate Bonds

Typically have a face value of $1,000, although some have a face value of $5,000 or $10,000

Pay interest semi-annually

Corporate Bonds

Cannot be redeemed anytime the issuer wishes, unless a specific clause states this (call option).

Degree of risk varies with each bond, even from the same issuer. Following suite, the required interest rate varies with level of risk.

Corporate Bonds

The next slide shows the interest rate on various bonds from 1973-2007.

The degree of risk ranges from low-risk (AAA) to higher risk (BBB). Any bonds rated below BBB are considered sub-investment grade debt.

Corporate Bonds: Interest Rates

Corporate Bonds: Characteristics of Corporate Bonds

Registered Bonds Replaced “bearer” bonds IRS can track interest income this way

Restrictive Covenants

Mitigates conflicts with shareholder interests

May limit dividends, new debt, ratios, etc.

Usually includes a cross-default clause


Call Provisions Higher yield Sinking fund Interest of the stockholders Alternative opportunities

Conversion Some debt may be converted to equity

Similar to a stock option, but usually more limited


Secured Bonds Mortgage bonds Equipment trust certificates

Unsecured Bonds Debentures Subordinated debentures Variable-rate bonds

Junk Bonds Debt that is rated below BBB Often, trusts and insurance companies are not

permitted to invest in junk debt Michael Milken developed this market in the mid-

1980s, although he was convicted of insider trading


Corporate Bonds: Debt Ratings

The next slide explains in further details the rating scale for corporate debt. The rating scale is for Moody’s. Both Standard and Poor’s and Fitch have similar debt rating scales.

Corporate Bonds: Debt Ratings

Financial Guarantees for Bonds

Some debt issuers purchase financial guarantees to lower the risk of their debt.

The guarantee provides for timely payment of interest and principal, and are usually backed by large insurance companies.

Bond Yield Calculations

Bond yields are quoted using a variety of conventions, depending on both the type of issue and the market.

We will examine the current yield calculation that is commonly used for long-term debt.

Bond Current Yield Calculation

What is the current yield for a bond with a face value of $1,000, a current price of $921.01, and a coupon rate of 10.95%?

Answer:

ic = C / P = $109.50 / $921.01 = 11.89%

Note: C ( coupon) = 10.95% x $1,000 = $109.50


Bond pricing is, in theory, no different than pricing any set of known cash flows. Once the cash flows have been identified, they should be discounted to time zero at an appropriate discount rate.

The table on the next slide outlines some of the terminology unique to debt, which may be necessary to understand to determine the cash flows.


Let’s use a simple example to illustrate the bond pricing idea.

What is the price of two-year, 10% coupon bond (semi-annual coupon payments) with a face value of $1,000 and a required rate of 12%?


Solution:

1. Identify the cash flows:• $50 is received every six months in interest• $1000 is received in two years as principal repayment

2. Find the present value of the cash flows (calculator solution):N = 4, FV = 1000, PMT = 50, I = 6

Computer the PV. PV = 965.35

Investing in Bonds

Bonds are the most popular alternative to stocks for long-term investing.

Even though the bonds of a corporation are less risky than its equity, investors still have risk: price risk and interest rate risk, which were covered in chapter 3

Investing in Bonds

The next slide shows the amount of bonds and stock issued from 1983 to 2006.

Note how much larger the market for new debt is. Even in the late 1990s, which were boom years for new equity issuances, new debt issuances still outpaced equity by over 5:1.

Investing in Bonds

Chapter Summary

Purpose of the Capital Market: provide financing for long-term capital assets

Capital Market Participants: governments and corporations issue bond, and we buy them

Capital Market Trading: primary and secondary markets exist for most securities of governments and corporations


Types of Bonds: includes Treasury, municipal, and corporate bonds

Treasury Notes and Bonds: issued and backed by the full faith and credit of the U.S. Federal government

Municipal Bonds: issued by state and local governments, tax-exempt, defaultable.


Corporate Bonds: issued by corporations and have a wide range of features and risk

Financial Guarantees for Bonds: bond “insurance” should the issuer default

Bond Current Yield Calculation: how to calculation the current yield for a bond


Finding the Value of Coupon Bonds: determining the cash flows and discounting back to the present at an appropriate discount rate

Investing in Bonds: most popular alternative to investing in the stock market for long-term investments

Chapter 8

The Stock Market

Chapter Preview

In August of 2004, Google went public, auctioning its shares in an unusual IPO format. The shares originally sold for $85 / share, and closed at over $100 on the first day. In November of 2007, shares are trading on Nasdaq at over $650 / share.

Chapter Preview

The stock market receives considerable attention from investors. As Google illustrates, great fortunes can be made! But also lost.

This is the focus of chapter 11 – a look at the equity side of investing.

Chapter Preview

We examine the markets where stocks trade, and then review the underlying theories for stock valuation. We learn that stock valuations is quite difficult. Topics include: Investing in Stocks Computing the Price of Common Stock How the Market Sets Security Prices Errors in Valuation


Stock Market Indexes

Buying Foreign Stocks

Regulation of the Stock Market

Investing in Stocks

1. Represents ownership in a firm

2. Earn a return in two ways Price of the stock rises

over time Dividends are paid to the

stockholder

3. Stockholders have claim on all assets

4. Right to vote for directors and on certain issues

5. Two types Common stock

Right to vote Receive dividends

Preferred stock Receive a fixed

dividend Do not usually vote

348

Investing in Stocks: Sample Corporate Stock Certificate

Investing in Stocks: How Stocks are Sold

Organized exchanges NYSE is best known, with daily volume around 2

billion shares. “Organized” used to imply a specific trading

location. But computer systems (ECNs) have replaced this idea.

Others include the ASE (US), and Nikkei, LSE, DAX (international)

Listing requirements exclude small firms

Investing in Stocks: How Stocks are Sold

Over-the-counter markets Best example is NASDAQ Dealers stand ready to make a market Today, about 3,300 different securities are listed on

NASDAQ. Important market for thinly-traded securities – securities

that don’t trade very often. Without a dealer ready to make a market, the equity would be difficult to trade.

Investing in Stocks: Organized vs. OTC

Organized exchanges (e.g., NYSE) Auction markets with floor specialists 25% of trades are filled directly by specialist Remaining trades are filled through SuperDOT

Over-the-counter markets (e.g., NASDAQ) Multiple market makers set bid and ask prices Multiple dealers for any given security

Investing in Stocks: ECNs

ECNs (electronic communication networks) allow brokers and traders to trade without the need of the middleman. They provide: Transparency: everyone can see

unfilled orders

Cost reduction: smaller spreads

Faster execution

After-hours trading

Investing in Stocks: ECNs

However, ECNs are not without their drawbacks:

Don’t work as well with thinly-traded stocks

Many ECNs competing for volume, which can be confusing

Major exchanges are fighting ECNs, with an uncertain outcome

Investing in Stocks: ETFs

Exchange Traded Funds are a recent innovation to help keep transaction costs down while offering diversification.

Represent a basket of securities Traded on a major exchange Index to a specific portfolio (eg., the S&P 500), so

management fees are low (although commissions still apply)

Exact content of basket is known, so valuation is certain

Computing the Price of Common Stock

Valuing common stock is, in theory, no different from valuing debt securities: determine the future cash flows and discount them to the present at an appropriate discount rate.

We will review four different methods for valuing stock, each with its advantages and drawbacks.

Computing the Price of Common Stock: The One-Period Valuation Model

Simplest model, just taking using the expected dividend and price over the next year.

Price = )1()1(

11

ee k

P

k

Div

71.53)12.01(

60

)12.01(

16.0

Computing the Price of Common Stock: The One-Period Valuation Model

What is the price for a stock with an expected dividend and price next year of $0.16 and $60, respectively? Use a 12% discount rate

Answer:

Price =

Computing the Price of Common Stock: The Generalized Dividend Valuation Model

Most general model, but the infinite sum may not converge.

Price =

Rather than worry about computational problems, we use a simpler version, known as the Gordon growth model.

1 )1(tt

e

t

k

Div

Computing the Price of Common Stock: The Gordon Growth Model

Same as the previous model, but it assumes that dividend grow at a constant rate, g. That is,

Div(t+1) = Divt x (1 + g)

Price = )()1(

1

1 gk

D

k

Div

ett

e

t

Computing the Price of Common Stock: The Gordon Growth Model

The model is useful, with the following assumptions:

Dividends do, indeed, grow at a constant rate forever

The growth rate of dividends, g, is less than the required return on the equity, ke.

Computing the Price of Common Stock: The Generalized Dividend Valuation Model

The price earnings ratio (PE) is a widely watched measure of much the market is willing to pay for $1.00 of earnings from the firms.

Price = EE

P

Computing the Price of Common Stock: The Price Earnings Valuation Method

If the industry PE ratio for a firm is 16, what is the current stock price for a firm with earnings for $1.13 / share?

Answer:

Price = 16 x $1.13 = $18.08

How the Market Sets Security Prices

Generally speaking, prices are set in competitive markets as the price set by the buyer willing to pay the most for an item.

The buyer willing to pay the most for an asset is usually the buyer who can make the best use of the asset.

Superior information can play an important role.

How the Market Sets Security Prices

Consider the following three valuations for a stock with certain dividends but different perceived risk:

Bud, who perceives the lowest risk, is willing to pay the most and will determine the “market” price.

Errors in Valuations

Although the pricing models are useful, market participants frequently encounter problems in using them. Any of these can have a significant impact on price in the Gordon model.

Problems with Estimating Growth

Problems with Estimating Risk

Problems with Forecasting Dividends

Case: 9/11, Enron and the Market

Both 9/11 and the Enron scandal were events in 2001.

Both should lower “g” in the Gordon Growth model – driving down prices.

Also impacts ke – higher uncertainty increases this value, again lowering prices.

We did observe in both cases that prices in the market fell. And subsequently rebounded as confidence in US markets returned.


Stock market indexes are frequently used to monitor the behavior of a groups of stocks.

Major indexes include the Dow Jones Industrial Average, the S&P 500, and the NASDAQ composite.

The securities that make up the (current) DJIA are included on the next slide.

Stock Market Indexes: the Dow Jones Industrial Average


The next two slides show the Dow Jones Industrial Average from 1980–2007.

As can be seen, $1.00 invested in the DJIA back in 1980, when the DJIA was around 800, would have grown to about $12.50 in 2004, when the Dow reached 10,000. This represented an annual growth rate around 10.6%.

Stock Market Indexes, DJIA

Historical stocks charts are found at http://stockcharts.com/charts/historical/

Stock Market Indexes, DJIA (cont.)

Historical stocks charts are found at http://stockcharts.com/charts/historical/

Buying Foreign Stocks

Buying foreign stocks is useful from a diversification perspective. However, the purchase may be complicated if the shares are not traded in the U.S.

American depository receipts (ADRs) allow foreign firms to trade on U.S. exchanges, facilitating their purchase. U.S. banks buy foreign shares and issue receipts against the shares in U.S. markets.

Regulation of the Stock Market

The primary mission of the SEC is “…to protect investors and maintain the integrity of the securities markets.”

The SEC brings around 500 actions against individuals and firms each year toward this effort. This is accomplished through the joint efforts of four divisions.

Regulation of the Stock Market: Divisions of the SEC

Division of Corporate Finance: responsible for collecting, reviewing, and making available all of the documents corporations and individuals are required to file

Division of Market Regulation: establishes and maintains rules for orderly and efficient markets.

Regulation of the Stock Market: Divisions of the SEC

Division of Investment Management: oversees and regulates the investment management industry

Division of Enforcement: investigates violations of the rules and regulations established by the other divisions.

Chapter Summary

Investing in Stocks: we developed an understanding the structure of the various trading systems, including exchanges and OTC markets

Computing the Price of Common Stock: various techniques for valuing dividends and earnings were presented


How the Market Sets Security Prices: the basic idea that prices are set by the “highest bidder” was reviewed

Errors in Valuation: difficulties in determining dividends, growth rates, and/or required returns can have a significant impact in the pricing models


Stock Market Indexes: a way to track changes in valuation for a broad group of stocks

Buying Foreign Stocks: potential benefits for diversifications, simplified by the use of ADRs.

Regulation of the Stock Market: the primary function of the Securities and Exchange Commission

Chapter 9

The Mortgage Markets

Chapter Preview

Part of the American Dream is to own your own home. But the average price of a home is well over $140,000 (and quite a bit higher is some areas, like California). For most of us, home ownership would be impossible without borrowing most of the cost of a home.

Chapter Preview In this chapter, we identify characteristics of typical

residential mortgages and the usual term and types of mortgages available. We then review who provides and services the loans, along with the growth in the secondary mortgage market. Topics include: What Are Mortgages? Characteristics of Residential Mortgages Types of Mortgage Loans Mortgage-Lending Institutions


Loan Servicing

Secondary Mortgage Market

Securitization of Mortgages

The Impact of Securitized Mortgages on the Mortgage Market

What Are Mortgages?

A long-term loan secured by real estate

An amortized loan whereby a fixed payment pays both principal and interest each month

What Are Mortgages?

The next slide shows the total amount of mortgage debt outstanding in the U.S. during 2006. It further delineates by type of property.

The table shows roughly $13 trillion outstanding. How does this compare to the value of all the stock on the NYSE?

What Are Mortgages?Mortgage Loan Borrowers

What Are Mortgages? History

Mortgages were used in the 1880s, but massive defaults in the agricultural recession of 1890 made long-term mortgages difficult to attain.

Until post-WWII, most mortgage loans were short-term balloon loans with maturities of five years or less.

What Are Mortgages? History

Balloon loans, however, caused problems during the depression. Typically, the lender renews the loan. But, with so many Americans out of work, lenders could not continue to extend credit.

As a part of the depression recovery program, the federal government assisted in creating the standard 30-year mortgage we know today.

Characteristics of the Residential Mortgage

Mortgages can be roughly classified along the following three dimensions:

Mortgage Interest Rates

Loan Terms

Mortgage Loan Amortization

A variety of fun mortgage calculatorshttp://interest.com/calculators/index.shtml

Characteristics of the Residential Mortgage: Mortgage Interest Rates

The stated rate on a mortgage loan is determined by three rates: Market Rates: general rates on

Treasury bonds Term: longer-term mortgages have

higher rates Discount Points: a lower rates negotiated for cash

upfront



The next slide shows the relationship between mortgage rates and long-term treasury rates. As can be seen, mortgage rates are typically higher than Treasury rates, but the spread (difference) between the two varies considerably.

Current mortgage interest rateshttp://www.interest.com/



Characteristics of the Residential Mortgage: Mortgage Interest Rates & Points

A difficult decision when getting a mortgage is whether to pay points (cash) upfront in exchange for a lower interest rate on the mortgage. Suppose you had to choose between a 12% 30-year mortgage or an 11.5% mortgage with 2 discount points. Which should you choose? Assume you wished to borrow $100,000.


First, examine the 12% mortgage. Using a financial calculator, the required payments is:

n = 360, i = 1.0, PV = 100,000,

Calculate the PMT. PMT = $1,028.61


Now, examine the 11.5% mortgage. Using a financial calculator, the required payments is:

n = 360, i = 11.5/12, PV = 100,000,

Calculate the PMT. PMT = $990.29


So, paying the points will save you $38.32 each month. However, you have to pay $2,000 upfront.

You can see that the decision depends on how long you want to live in the house, keeping the same mortgage.


If you only want to live there 12 months, clearly the $2,000 upfront cost is not worth the monthly savings.

Let’s see how to determine the answer.


You need to determine when the present value of the savings ($38.32) equals the $2,000 upfront. Using a financial calculator, this is:

i = 1, PV = -2,000, PMT = 38.32

Calculate n. n = 74 months, or about 6.2 years.


So, if you think you will stay in the house and not refinance for at least 6.2 years, paying the $2,000 for the lower payment is a sound financial decision.

Otherwise, you should accept the 12% loan.


The next table further illustrates this point, showing the effective rate on the 11.5% mortgage if the mortgage is paid in full at various points.

Note that right around year 6, the effective annual rate on the 11.5% mortgage is about the same as effective annual rate on the 12% mortgage (12.68%).

Characteristics of the Residential Mortgage: Effective Rate of Interest

Characteristics of the Residential Mortgage: Loan Terms

Mortgage loan contracts contain many legal terms that need to be understood. Most protect the lender from financial loss.

Collateral: usually the real estate being finance

Down payment: a portion of the purchase price paid by the borrower


Mortgage loan contracts contain many legal terms that need to be understood. Most protect the lender from financial loss.

PMI: insurance against default by the borrower

Qualifications: includes credit history, employment history, etc., to determine the borrowers ability to repay the mortgage as specified in the contact


Lenders will also order a credit report from one of the credit reporting agencies.

The score reported is called the FICO. The range is 300 to 850, with 660 to 720

being average. Payment history, debt, and even credit card

applications can affect your credit score.

Characteristics of the Residential Mortgage: Loan Amortization

Mortgage loans are amortized loans. This means that a fixed, level payment will pay interest due plus a portion of the principal each month. It is designed so that the balance on the mortgage will be zero when the last payment is made.

The next table shows a typical amortization table for a 30-year mortgage at 8.5%.

Characteristics of the Residential Mortgage: Loan Amortization Schedule

Types of Mortgage Loans

Insured vs. Conventional Mortgages: if the down payment is less than 20%, insurance is usually required

Fixed-Rate Mortgages: the interest rate is fixed for the life of the mortgage

Adjustable-Rate Mortgages: the interest rate can fluctuate within certain parameters


Other Types Graduated-Payment Mortgages (GPMs) Growing Equity Mortgages (GEMs) Shared-Appreciation Mortgages (SAMs) Equity Participation Mortgages Second Mortgages Reverse Annuity Mortgages (RAMs)

The following table lists additional characteristics on all the loans.

Mortgage-Lending Institutions

Originally, thrift institutions were the primary originator of mortgages in the U.S. and, therefore, the primary holder of mortgage loans.

As the next figure illustrates, this is not the case anymore.

Mortgage-Lending Institutions

Loan Servicing

Most mortgages are immediately sold to another investor by the originator. This frees cash to originate another loan and generate additional fee income.

Still, someone has to collect the monthly payments and keep records. This is knows as loan servicing, and servicers usually keep a portion of the payments received to cover their costs.

Loan Servicing

In all, there are three distinct elements in mortgage loans:

The originator packages the loan for an investor

The investor holds the loan

The servicing agent handles the paperwork

Secondary Mortgage Market

The secondary mortgage market was originally established by the federal government after WWII when it created Fannie Mae to buy mortgages from thrifts.

The market experienced tremendous growth in the early to mid-1980, and has continued to remain a strong market in the U.S.


The securitization of mortgages developed because of problems dealing with single mortgages: risk of either default or prepayment and servicing. Pools of mortgages eliminated part of this problem through diversification.


The mortgage-backed security (MBS) was created. Pools including hundreds of mortgages were gathered, and the rights to the cash flows generated by the mortgages were sold as separate securities.

At first, simple pass-through securities were designed.

Securitization of Mortgages: The Mortgage Pass-Through

Definition: A security that has the borrower’s mortgage payments pass through the trustee before being disbursed to the investors

This design did eliminate some risk, but investors still faced prepayment risk.

Securitization of Mortgages: CMOs

Definition: A CMO is a structured MBS where investor pools have different rights to different sets of cash flows.

This design structured the prepayment risk. Some classes had little, while other had a lot.

The Impact of Securitization on the Mortgage Market

As the next figure shows, the value of mortgages held in pools is reaching $6.4 trillion near the end of 2006.

The securities compete for funds along with all other bond market participants.

Mortgage Pools


Benefits1. Reduces the problems caused by regional lending

institution’s sensitivity to local economic fluctuations

2. Borrowers have access to a national capital market

3. Investors have low-risk and long-term investments in mortgages without having to service the loan


However, this is not without its costs. Because of securitization, mortgage rates have become more national in nature, and this has lead to increased volatility in mortgage rates.

The Subprime Mortgage Market

In 2000, only 2% of mortgages were subprime. This climbed to 17% by 2006.

The average FICO score was 624 for subprime borrowers. Prime mortgage borrowers were 742.

Mortgage products became more complicated, and income requirements for these mortgages became very lax.

The Subprime Mortgage Market

Subprime mortgages have become quite controversial. Although predatory advertising and “bait and switch” tactics were all-too-common, home ownership did increase because of subprime lending.

Chapter Summary

What Are Mortgages? Loans made for the purchase on real property, and usually collateralized by the purchased property.

Characteristics of Residential Mortgages: includes the length of the mortgage, the terms, and the rate charges for the loan


Types of Mortgage Loans: includes conventional, insured, fixed and variable rate, and a variety of other designs.

Mortgage-Lending Institutions: the primarily originator and holder of mortgages is no longer thrift institutions as other attempt to generate fees


Loan Servicing: the fees generated by collecting, distributing, and recording payments

Secondary Mortgage Market: the active market for mortgages after the mortgage has been originated


Securitization of Mortgages: growing in popularity, causing mortgages to complete with both Treasury and corporate debt

The Impact of Securitized Mortgages on the Mortgage Market: although many benefits can be noted, increased rate volatility is also a side-effect

Chapter 10

The ForeignExchange

Market

Lecture one

Chapter Preview

In the mid-1980s, American businesses became less competitive relative to their foreign counterparts. By the 2000s, though, competitiveness increased. Why?

Part of the answer can be found in exchange rates. In the 1980s, the dollar was strong, and US goods were expensive to foreign buyers.

Chapter Preview

By the 1990s and 2000s, the dollar weakened, so American goods became cheaper and American businesses became more competitive.

Chapter Preview

In this chapter, we develop a modern view of exchange rate determination that explains recent behavior in the foreign exchange market. Topics include: Foreign Exchange Market

Exchange Rates in the Long Run

Exchange Rates in the Short Run

Explaining Changes in Exchange Rates


Most countries of the world have their own currencies: the U.S dollar., the euro in Europe, the Brazilian real, and the Chinese yuan, just to name a few.

The trading of currencies and banks deposits is what makes up the foreign exchange market.

What are Foreign Exchange Rates?

Two kinds of exchange rate transactions make up the foreign exchange market:

Spot transactions involve the near-immediate exchange of bank deposits, completed at the spot rate.

Forward transactions involve exchanges at some future date, completed at the forward rate.


The next slide shows exchange rates for four currencies from 1990-2006.

Note the difference in rate fluctuations during the period. Which appears most volatile? The least?

Why Are Exchange Rates Important?

When the currency of your country appreciates relative to another country, your country's goods prices abroad and foreign goods prices in your country.

1. Makes domestic businesses less competitive

2. Benefits domestic consumers (you)

Why Are Exchange Rates Important?

For example, in 1999, the euro was valued at $1.18. On April 26, 2006, it was valued at $1.36.

Euro appreciated 15% (1.36-1.18) / 1.18 Dollar depreciated 13% (0.75-0.85) / 0.85

Note: 0.75 = 1 / 1.36, and 0.85 = 1 / 1.18

We can see exchange rates in the WSJ.

Foreign Exchange Market: Exchange Rates

Current foreign exchange rateshttp://www.federalreserve.gov/releases/H10/hist

How is Foreign Exchange Traded?

FX traded in over-the-counter market1. Most trades involve buying and selling bank

deposits denominated in different currencies.2. Trades in the foreign exchange market involve

transactions in excess of $1 million.3. Typical consumers buy foreign currencies from

retail dealers, such as American Express.• FX volume exceeds $3 trillion per day.

Exchange Rates in the Long Run

Exchange rates are determined in markets by the interaction of supply and demand.

An important concept that drives the forces of supply and demand is the Law of One Price.

Exchange Rates in the Long Run: Law of One Price

The Law of One Price states that the price of an identical good will be the same throughout the world, regardless of which country produces it.

Example: American steel costs $100 per ton, while Japanese steel costs 10,000 yen per ton.

If E = 50 yen/$ then price are:

American Steel Japanese Steel

In U.S. $100 $200

In Japan 5000 yen 10,000 yen

Exchange Rates in the Long Run: Law of One Price

Law of one price E = 100 yen/$

If E = 100 yen/$ then price are:

American Steel Japanese Steel

In U.S. $100 $100

In Japan 10,000 yen 10,000 yen

Exchange Rates in the Long Run: Theory of Purchasing Power Parity (PPP)

The theory of PPP states that exchange rates between two currencies will adjust to reflect changes in price levels.

PPP Domestic price level 10%, domestic currency 10%

Application of law of one price to price levels

Works in long run, not short run

Exchange Rates in the Long Run: Theory of Purchasing Power Parity (PPP)

Problems with PPP1. All goods are not identical in both countries

(i.e., Toyota versus Chevy)

2. Many goods and services are not traded (e.g., haircuts, land, etc.)

Exchange Rates in the Long Run: PPP

Exchange Rates in the Long Run: Factors Affecting Exchange Rates in Long Run

Basic Principle: If a factor increases demand for domestic goods relative to foreign goods, the exchange rate

The four major factors are relative price levels, tariffs and quotas, preferences for domestic v. foreign goods, and productivity.


Relative price levels: a rise in relative price levels cause a country’s currency to depreciate.

Tariffs and quotas: increasing trade barriers causes a country’s currency to appreciate.


Preferences for domestic v. foreign goods: increased demand for a country’s good causes its currency to appreciate; increased demand for imports causes the domestic currency to depreciate.

Productivity: if a country is more productive relative to another, its currency appreciates.


The following table summarizes these relationships. By convention, we are quoting, for example, the exchange rate, E, as units of foreign currency / 1 US dollar.

Exchange Rates in the Short Run

In the short run, it is key to recognize that an exchange rate is nothing more than the price of domestic bank deposits in terms of foreign bank deposits.

Because of this, we will rely on the tools developed in Chapter 4 for the determinants of asset demand.

Exchange Rates in the Short Run: Expected Returns on Domestic and Foreign Assets

We will illustrate this with a simple example

François the Foreigner can deposit excess euros locally, or he can convert them to U.S. dollars and deposit them in a U.S. bank. The difference in expected returns depends on two things: local interest rates and expected future exchange rates.


Al the American has a similar problem. He can deposit excess dollars locally, or he can convert them to euros and deposit them in a foreign bank. The difference in expected returns depends on two things: local interest rates and expected future exchange rates.

Re for François Re for Al

$ Deposits iD Et1

e Et Et

iD

F Deposits iF iD Et1

e Et Et

Relative Re iD iF Et1

e Et Et

iD iF Et1

e Et Et

Exchange Rates in the Short Run: Expected Returns and Interest Parity


What this shows is simple. As the relative expected return on dollar assets increases (decreases), both François and Al respond by holding more (fewer) dollar assets and fewer (more) foreign assets.

This leads us to our formal title for what is going on here: Interest Parity

iD iF Et1

e Et

EtExample: if iD = 6% (US interest rate) and iF = 3% (foreign currency interest rate), what is the expected appreciation of the foreign currency?


Interest Parity Condition $ and F deposits perfect substitutes

(2)

%3%3%61

t

tet

E

EE

Several things to recognize about the interest rate parity condition:•Expected returns are the same in both dollars and foreign assets•Equilibrium condition for the foreign exchange market

Next, we will develop supply/demand curves to explain how the exchange rate is determined.



To determine the equilibrium condition, we must first determine the expected return in terms of dollars on foreign deposits, RF.

Next, we must determine the expected return in terms of dollars on dollar deposits, RD.

Deriving the Demand Curve

The demand curve connects these points and is downward sloping because when Et is higher, expected appreciation of the dollar is higher.

Assume iF = 5%, Eet+1 = 1 euro/$

Point

A: Et = 1.05 (1.00 – 1.05)/1.05 = -4.8%

B: Et = 1.00 (1.00 – 1.00)/1.00 = 0.0%

C: Et+1 = 0.95 (1.00 – 0.95)/0.95 = 5.2%

Deriving the Supply Curve

Deriving the Supply Curve

There isn’t really anything to derive. We will take the quantity of bank deposits, bonds, and equities as fixed with respect to exchange rates.

Exchange Rates in the Short Run: Equilibrium

Equilibrium Supply = Demand at E* If Et > E*, Demand < Supply, buy $, Et If Et < E*, Demand > Supply, sell $, Et

The following figure illustrates this.

Exchange Rates in the Short Run: Equilibrium

Explaining Changes in Exchange Rates

To understand how exchange rates shift in time, we need to understand the factors that shift expected returns for domestic and foreign deposits.

We will examine these separately, as well as changes in the money supply and exchange rate overshooting.

Explaining Changes in Exchange Rates: Increase in iD

1. Demand curve shifts right when iD : because

people want to hold more dollars

2. This causes domestic currency to appreciate.

Explaining Changes in Exchange Rates: Increase in iF

1. Demand curve shifts left when iF : because

people want to hold fewer dollars

2. This causes domestic currency to depreciate.

etE 1

Explaining Changes in Exchange Rates: Increase in Expected Future FX Rates

1. Demand curve shifts left when : because

people want to hold more dollars

2. This causes domestic currency to appreciate.

Explaining Changes in Exchanges Rates

Similar to determinants of exchange rates in the long-run, the following changes increase the demand for foreign goods (shifting the demand curve to the right), increasing Expected fall in relative U.S. price levels Expected increase in relative U.S. trade barriers Expected lower U.S. import demand Expected higher foreign demand for U.S. exports Expected higher relative U.S. productivity

These are summarized in the following slides.

etE 1

468

Explaining Changes in Exchanges Rates

Explaining Changes in Exchanges Rates (cont.)

Applications

Our analysis allows us to take a look at the response of exchange rates to a variety of macro-economic factors. For example, we can use this framework to examine (1) the impact of changes in interest rates, and (2) the impact of money growth.

Application: Interest Rate Changes

Changes in domestic interest rates are often cited in the press as affecting exchange rates.

We must carefully examine the source of the change to make such a statement. Interest rates change because either (a) the real rate or (b) the expected inflation is changing. The effect of each differs.


When the domestic real interest rate increases, the domestic currency appreciates. We have already seen this situation in Figure 4 (slide 37).

When the domestic expected inflation increases, the domestic currency reacts in the opposite direction – it depreciates. This is shown on the next slide.

Explaining Changes in Exchange Rates: Response to i Because πe


Changes in domestic money supply are a bit more complicated. We summarize the results on the next slide. However, you may want to read the text on this section to fully digest the effects.

Explaining Changes in Exchange Rates: Changes in the Money Supply

1. Ms , P , Eet+1 , shifting

demand curve from D1 to D2.

2. In long run, iD returns to old level, and demand shifts from D2 to D3

(exchange rate overshooting)

Exchange rate volatility

Exchange rate overshooting is important because it helps explain why foreign exchange rates are so volatile.

Another explanation deals with changes in the expected appreciation of exchange rates. As anything changes our expectations (price levels, productivity, inflation, etc.), exchange rates will change immediately.

Applications

Our analysis also allows us to take a look at the weak dollar in the 1980s, and (partially) explain why it became stronger in the 1990s and 2000s. We present a summary in Figure 9, on the next slide.

Daily foreign exchange ratehttp://quotes.ino.com/exchanges/?e=FOREX

The Dollar and Interest Rates1. Value of $ and real

rates rise and fall together, as theory predicts

2. No association between $ and nominal rates: $ falls in late 1970s as nominal rate rises

Case: The Euro’s First Nine Years

The euro debuted in 1999 at $1.18 / euro. It declined to $0.83 by October 2000, but has recovered, trading at $1.35 by the end of 2007.

Initially, the European countries had relatively weaker economies, but that has reversed in recent years, weakening the dollar relative to the euro.

Reading the WSJ

The figure on the next slide shows the “Currency Trading” column from the Wall Street Journal on July 11, 2007.

Some highlights include: Warnings from Home Depot and other sectors

that the economy is weakening – signaling possible Fed rate cuts (did that happen?)

Dollar returns expected to be lower in the future – dollar expected to depreciate

The Practicing Manger: Profiting from FX Forecasts

Forecasters look at factors discussed here FX forecasts affect financial institutions

managers' decisions If forecast yen appreciate, yen depreciate,

Sell franc assets, buy euro assets Make more euros loans, less yen loans FX traders sell yen, buy euros

Chapter 10

The ForeignExchange

Market

Lecture two

13.2 Foreign Exchange Instruments1.Currency Forward

2.Currency Future

3.Currency Option

4.Currency Swap

Derivative Instruments

13.2.1 Currency Forward

1) Background Foreign exchange rates fluctuate constantly Fluctuations expose parties dealing in foreign

exchange to risk Examples:

Exporter expecting to receive foreign currency in the future

Importer obliged to make payment in a foreign currency

Parties would like to hedge the risk

A currency forward contract is an agreement between a firm and a commercial bank to exchange a specified amount of a currency at a specified exchange rate (called the forward rate) on a specified date in the future.

Forward contracts are often valued at $1 million or more, and are not normally used by consumers or small firms.

2)Definition

3)Forward dealings in foreign currency: exporter An exporter exports goods worth USD 10 million

to USA Receipt of USD expected after 1 months Current exchange rate: $100 = ￥ 697.22 Decline in the value of USD is anticipated Exporter enters into a forward contract to sell

USD after 1 months at $100 = ￥ 692.22 After 1 months:

If $100 = ￥ 687.22– gain of 0.5 million If $100 = ￥ 692.22– no profit, no loss If $100 = ￥ 697.22– opportunity loss (loses opportunity

to gain 0.5million)

4)Forward dealings in foreign currency: importer

An importer has imported goods worth Euro 1,000,000 from Europe

Payment to be made after 3 months Current exchange rate: 1 Euro= 1.5443 USD Increase in the value of Euro is anticipated Importer enters into a forward contract to buy Euro after 3

months at 1 Euro= 1.5493 USD After 3 months:

If 1 Euro= 1.5543 USD– gain 5000 USD If 1 Euro= 1.5493 USD– no profit, no loss If 1 Euro= 1.5443 USD - opportunity loss (loses opportunity

to gain 5000 USD)

5)Currency forwards: merits and demerits

Merit: Helps in hedging risk

Demerits: Does not provide opportunity for making profit There is illiquidity There is default risk (credit risk) (the party at

disadvantage may default)

13.2.2Currency Future

1)Definition

A Currency Future Contract is similar to an currency forward contract in that it specifies that foreign currency must be delivered by one party to another on a stated future date.

However, it overcome some of the liquidity and default problem of forward markets.

2)Success of Futures Over Forwards

1. Standardized contracts that can be traded (quantities delivered and delivery dates)

2. Margin Requirement:avoids default risk

3. Marked to market every day: organised exchange

4. Don't have to deliver

4)Hedging with currency futures

Importer buys the required currency futures contract

Thus “locks in” a price for the purchase of foreign currency

Hedges (avoids) risk due to exchange rate fluctuations

Exporter sells the expected currency futures contract

“locks in” a price for the sale Hedges risk due to exchange rate fluctuations

Hedging FX Risk

Example: A manufacturer expects to be paid 10 million euros in two months for the sale of equipment in Europe. Currently, 1 euro = $1, and the manufacturer would like to lock-in that exchange rate.

Hedging FX Risk

The manufacturer can use the FX futures market to accomplish this:

1. The manufacturer sells 10 million euros of futures contracts. Assuming that 1 contract is for $125,000 in euros, the manufacturer takes as short position in 40 contracts.

2. The exchange will require the manufacturer to deposit cash into a margin account. For example, the exchange may require $2,000 per contract, or $80,000.

Hedging FX Risk

3. As the exchange rate fluctuates during the two months, the value of the margin account will fluctuate. If the value in the margin account falls too low, additional funds may be required. This is how the market is marked to market. If additional funds are not deposited when required, the position will be closed by the exchange.

Hedging FX Risk

4. Assume that actual exchange rate is 1 euro = $0.96 at the end of the two months. The manufacturer receives the 10 million euros and exchanges them in the spot market for $9,600,000.

5. The manufacturer also closes the margin account, which has $480,000 in it—$400,000 for the changes in exchange rates plus the original $80,000 required by the exchange 。

6. In the end, the manufacturer has the $10,000,000 desired from the sale.

Delivery date Customized Standardized

Participants Banks, brokers Banks, brokers,

Clearing Handled by Handled byoperation individual banks exchange

& brokers. clearinghouse.Daily settlementsto market prices.

5)Comparison of the Forward & Futures Markets

Forward Markets Futures MarketsContract size Customized Standardized

Regulation Self-regulating CommodityFutures Trading

Commission,National Futures

Association.

Liquidation Mostly settled by Mostly settled byactual delivery. offset.

Transaction Bank’s bid/ask NegotiatedCosts spread. brokerage fees.

Comparison of the Forward & Futures Markets

Forward Markets Futures Markets

Marketplace Worldwide Central exchangetelephone floor with worldwidenetwork communications.

13.2.3:Option Definition

1)Definition Currency options provide the right to

purchase or sell currencies at specified prices. They are classified as calls or puts.

Standardized options are traded on exchanges through brokers.

Customized options offered by brokerage firms and commercial banks are traded in the over-the-counter market.

2)Types of options Call option 看涨期权

Right to buy a currency Useful in an appreciating market

Put option 看跌期权 Right to sell a currency Useful in a depreciating market

Call and put option may be of two types European option: 欧式期权 can be exercised only on expiry date American option: 美式期权 can be exercised any time upto expiry date

3)Parties to option contracts

Purchaser ( trader) Has right to exercise (may exercise or may not

exercise) Seller ( dealer or speculator)

Has obligation to perform (when purchaser exercises the right)

4)Options terminology

Premium: 期权费price paid for buying an option

Exercise price: 执行价格(also known as strike price) price at

which option can be exercised

Option Contract

售出方：银行Option seller

购买方：企业Option owner

合约

出口商出口收汇出口商出口收汇

11

月月 22月月 33月月

获得获得 PremiumPremium

放弃灵活权放弃灵活权支付 Premium

获得选择权

5)Uses of option

Hedging Speculation

Hedging through purchase of options

Importer buys a call option To buy a currency in future when it is

appreciating Exporter buys a put option

To sell a currency in future when it is depreciating

5)Contingency Graphs for Currency Options

+$.02

+$.04

– $.02

– $.04

0$1.46 $1.50 $1.54

Net Profit per Unit

Future Spot Rate

For Buyer of £ Call Option

Strike price = $1.50Premium = $ .02

+$.02

+$.04

– $.02

– $.04

0$1.46 $1.50 $1.54

Net Profit per Unit

Future Spot Rate

For Seller of £ Call Option


Contingency Graphs for Currency Options

+$.02

+$.04

– $.02

– $.04

0$1.46 $1.50 $1.54

Net Profit per Unit

Future Spot Rate

For Seller of £ Put Option


+$.02

+$.04

– $.02

– $.04

0$1.46 $1.50 $1.54

Net Profit per Unit

Future Spot Rate

For Buyer of £ Put Option


13.2.4:Currency Swaps

Contract to exchange two streams of future

cash flows in different currencies

Used to convert debt denominated in one

currency into debt in another currency

Part Four

Financial Institutions

Chapter 11

Commercial Banking Industry: Structure and Competition

Chapter Preview

In the U.S., about 7,500 commercial banks serving the businesses and consumer’s needs. This puts the U.S. in a class by itself. In most other developed nations, only a handful of banks dominate the landscape.

But is this better?

Chapter Preview

Indeed there are many questions we can ask. Why did the U.S. banking system develop this way? Does this mean there is more competition? We try to answer these questions in this chapter.

Chapter Preview

We begin by examining the historical development of the banking system, both in the U.S. and abroad. We then examine the role of financial innovation and its impact on competition. Topics include:

Historical Development of the Banking System

Financial Innovation and the Decline of Traditional Banking

Bank Consolidation and Nationwide Banking


Separation of Banking and Other Financial Service Industries

International Banking

Historical Development of the Banking Industry

The modern commercial banking industry began when the Bank of North America was chartered in Philadelphia in 1782.

The next slide provides a timeline of important dates in the history of U.S. banking prior to WWII.


There are also some major events post-1933 In 1999, Glass-Steagall was repealed.

Commercial banks, which previously had to sell off investment banking arms, now engaged again in securities activities.


The history had one other significant outcome: Multiple Regulatory Agencies

1. Federal Reserve

2. FDIC

3. Office of the Comptroller of the Currency

4. State Banking Authorities


The U.S. Treasury has proposed legislation to centralize the regulation of depository institutions under one independent agency, but it hasn’t survived the scrutiny of Congress.

Financial Innovation

Innovation is result of search for profits. A change in the financial environment will stimulate a search for new products and ideas that are likely to increase the bottom line.

There are generally three types of changes we can examine: Response to Changes in Demand Conditions Response to Changes in Supply Conditions Avoidance of Regulation


Response to Changes in Demand Conditions Major change is huge increase in interest-rate risk starting

in 1960s Adjustable-Rate Mortgages are an example of the reply to

interest-rate volatility Banks also started using derivates to hedge risk, and

intermediaries (like the CBOT) started developing extensive interest rate products.

To see an example of the CBOTs products, visit http://www.cbot.com/cbot/pub/page/0,3181,830,00.html


Response to Changes in Supply Conditions

Major change is improvement in computer technology

1. Increases ability to collect information

2. Lowers transactions costs

3. This lead to many innovations on the supply side

Financial Innovation: Bank Credit and Debit Cards

Many store credit cards existed long before WWII.

Improved technology in the late 1960s reduced transaction costs making nationwide credit card programs profitable.

The success of credit cards led to the development of debit cards for direct access to checkable funds.

Financial Innovation: Electronic Banking

Automatic Teller Machines (ATMs) were the first innovation on this front. Today, over 250,000 ATMs service the U.S. alone.

Automated Banking Machines combine ATMs, the internet, and telephone technology to provide “complete” service.

Virtual banks now exist where access is only possible via the internet. The next slide highlights this.

E-Finance: Will “Clicks” dominate“Bricks” in Banking?

Will virtual banks on the internet become the primary form for bank business, eliminating the need for physical bank branches? Here’s some evidence: Internet-only banks have experienced low

revenue growth Depositors appear reluctant to “trust” the security

of their funds in I-banks

E-Finance: Will “Clicks” dominate“Bricks” in Banking?

I-bank customers seem concerned that their transactions are truly secure and private

Empirical evidence shows that long-term savings products are purchased more often face-to-fact

Technology glitches are still present

Financial Innovation: Electronic Payments

The development of computer systems and the internet has made electronic payments of bills a cost-effective method over paper checks or money.

The U.S. is still far behind some European countries in the use of this technology.

E-Finance: Why are Scandanaviansso far ahead of Americans with E-money

The U.S. writes close to 100 billion checks, and most noncash transactions involve paper. In Europe, however, two-thirds of noncash transactions are electronic. Why the difference? Europeans have been using giro payments for decades

(banks / post office transfers funds for bills) Scandinavians are much bigger users of mobile

technology and the Internet. Why? America’s continued use of paper is costly. Can

that ever be changed?

Financial Innovation: E-Money

Electronic money, or stored cash, only exists in electronic form. It is accessed via a stored-value card or a smart card.

E-cash refers to an account on the internet used to make purchases.

E-Finance: Are We Headedtoward a Cashless Society?

Predictions of a cashless society go back decades. Business Week predicted e-payments would “revolutionize … money itself (but reverse itself later). But several things work against this: Equipment to accept e-money not in all locations Security and privacy concerns

Financial Innovation: Junk Bonds

Prior to 1980, debt was never issued that had a junk rating. The only junk debt was bonds that had fallen in credit rating.

Michael Milken of Drexel Burnham assisted firms in issuing original-issue junk debt, and almost single-handedly created the market.

Financial Innovation: Commercial Paper Market

Commercial paper refers to unsecured debt issued by corporations with a short original maturity.

Currently, over $2.2 billion is outstanding in the market (end of 2006).

The development of money market mutual funds assisted in the growth in this area.

Financial Innovation: Securitization

Securitization refers to the transformation of illiquid assets into marketable capital market instruments.

Today, almost any type of private debt can be securitized. This includes home mortgages, credit card debt, student loans, car loans, etc.

Financial Innovation: Avoidance of Existing Regulations

Regulations Behind Financial Innovation

1. Reserve requirements Tax on deposits = I rD

2. Deposit-rate ceilings (Reg Q)As i , loophole mine to escape reserve requirement

tax and deposit-rate ceilings

Financial Innovation: Avoidance of Existing Regulations

Money Market Mutual Funds: allowed investors similar access to their funds as a bank savings accounts, but offered higher rates, especially in the late 1970s.

Sweep Accounts: Funds are “swept” out of checking accounts nightly and invested at overnight rates. Since they are no longer checkable deposits, reserve requirement taxes are avoided.

Treasury STRIPS

Treasury STRIPS were developed in the early 1980s to help investors avoid reinvestment risk associated with coupon bonds. Because of the change in the risk structure, investment banks were able to profit from the separation of interest into “bonds”. How?

Treasury STRIPS

Take a simple 10-year, 10% coupon bond with a face value of $1,000,000, and is selling at par. The first $50,000 interest payment in six months is worth $47,673. But because investors found it less risky, they are willing to accept a yield lower than 10%. The difference is “profit” for the investment bank.

Financial Innovation and the Decline in Traditional Banking

The traditional role of transforming short-term deposits into long-term loans has been greatly affected by financial innovation. As the next slide shows, the importance of commercial banks as a source of funds to nonfinancial borrowers has shrunk dramatically.


Decline in Cost Advantages in Acquiring Funds (Liabilities)

π i then disintermediation because

1. Deposit rate ceilings and regulation Q

2. Money market mutual funds

• Checkable deposits fell from 60% of bank liabilities to only 10% today.


Decline in Income Advantages on Uses of Funds (Assets)

1. Easier to use securities markets to raise funds: commercial paper, junk bonds, securitization

2. Finance companies more important because easier for them to raise funds

Banks' Response

Loss of cost advantages in raising funds and income advantages in making loans causes reduction in profitability in traditional banking

1. Expand lending into riskier areas (e.g., real estate)

2. Expand into off-balance sheet activities

• Creates problems for U.S. regulatory system

Similar problems for banking industry in other countries

Decline in Traditional Banking in Other Industrialized Countries

Forces similar to those in the U.S. have led to a similar decline in other industrialized countries.

For example, Australian banks have lost business to international securities markets

In many countries, as securities markets develop, banks also face competition from the new products offered

Structure of the U.S. Commercial Banking Industry

Around 7,500 commercial banks currently exist in the U.S.

The tables on the next two slides shows various statistics for these banks as well as the ten largest U.S. banks.

Structure of the Commercial Banking Industry

FDIC statistics on bankinghttp://www.fdic.gov/bank/statistical/index.html

Ten Largest U.S. Banks

World’s 100 largest bankshttp://interactive.wsj.com/public/resources/documents/wb00-100-fpublic-2000-09-25.htm

Branching Regulations

Branching Restrictions (McFadden Act of 1927): Very Anti-competitive

Response to Branching Restrictions

1. Bank Holding Companies Allowed purchases of banks outside state BHCs allowed wider scope of activities by Fed BHCs dominant form of corporate structure for banks

2. Automated Teller Machines Not considered to be branch of bank, so networks allowed


As the next slide shows, the number of commercial banks in the U.S. was very stable from 1934 through the mid-1980s. After that, the number of commercial banks began to fall dramatically.

549Quarterly banking profilehttp://www2.fdic.gov/qbp/qbpSelect.asp?menuItem=QBP

Bank Consolidation and Number of Banks


Bank Consolidation: Why? 1. Loophole mining reduced effectiveness of branching

restrictions2. Development of super-regional banks

Economies of scale1. Increased with the web and computer technology2. Scope economies also present in using data for pricing,

new products, etc.3. Has lead to the birth of large, complex banking

organizations (LCBOs)

E-Finance: Information Technologyand Bank Consolidation

Information technology is particularly relevant for the credit card industry. Today, over 60% of the credit card debt is help by the five biggest banks (only 40% in 1995).

Custody for securities has risen, from 40% as a percent of assets in 1990 to 90% today.

Smaller banks just contract with larger banks, further leading to consolidation.


Riegle-Neal Act of 19941. Allows full interstate branching2. Promotes further consolidation

Future of Industry Structure Will become more like other countries, but not

quite: Several thousand, not several hundred Only half of small banks will remain, and large

banks are expected to double in number


Are Bank Consolidation and Nationwide Banking a Good Thing? Cons

1. Fear of decline of small banks and small business lending

2. Rush to consolidation may increase risk taking

Pros1. Community banks will survive2. Increase competition and efficiency3. Increased diversification of bank loan portfolios:

lessens likelihood of failures


Glass-Steagall allowed commercial banks to sell on-the-run government securities, but prohibited underwriting and brokerage services. It also prohibited real estate and insurance business. But it did protect commercial banks by not allowing other financial intermediaries to offer commercial banking activities.


Erosion of Glass-Steagall Fed, OCC, FDIC are allowing banks to engage in

underwriting activities, under the Section 20 loophole in the act

Gramm-Leach-Bliley Act of 1999 Legislation to eliminate Glass-Steagall States retain insurance regulation, while SEC oversees

securities activities OCC regulates subsidiaries that underwrite securities Fed still oversees bank holding companies


Implications for Financial Consolidation

1. G-L-B will speed-up consolidation

2. Expect mergers between banks and other financial service providers to become more common, and mega-mergers are likely on the way

3. U.S. banks likely to become larger and more complex organizations

Separation of Banking and Other Financial Service Industries Separation in Other Countries

1. Universal banking: Germany

• No separation of banking and underwriting, insurance, real estate, etc.

2. British-style universal banking

• Underwriting ok, but more legal separation of subs, no equity stakes in firms, insurance uncommon

3. Japan

• Allowed to hold equity in firms, but BHCs are illegal. Leaning toward the British system


There are currently 100 American bank branches abroad, with over $1.3 trillion in assets. In 1960, there were only 8 branches with less than $4 billion in assets. Why the rapid growth?1. Rapid growth of international trade2. Banks abroad can pursue activities not allowed in

home country3. Tap into Eurodollar market


The Eurodollar market represents U.S. dollars deposited in banks outside the U.S. Many companies want these dollars: The dollar is widely used in international trade Dollars held outside the U.S. are not subject to

U.S. regulations London is the center for Eurodollars To capture the profits from Eurodollar

transactions, U.S. banks opened abroad


U.S. Banking Overseas. Most foreign branches are in Latin America, the Far East, the Caribbean, and London, for either trade reasons or regulatory avoidance.

Another structure is the Edge Act Corporation, a sub engaged in international banking.


U.S. banks can also own controlling interests in foreign banks and finance companies, governed by Regulation K.

International Banking Facilities were approved by the Fed in 1981 to accept time deposits of foreign investors. They are not subject to reserve requirements, but generally cannot conduct business with American business or people. They also receive favorable local tax treatment.


Foreign Banks in U.S. are very successful. They currently hold more than 11% of total U.S. bank assets and do a large portion of U.S. bank lending – nearly 16% for lending to U.S. corporations.


Foreign Banks in U.S. are setup as: an agency office of a foreign bank

Fewer regulations a sub of a U.S. bank

Same regs as a U.S. bank a branch of a foreign bank

May form Edge Act corps. and IBFs.


1. Regulations (as of 1978 International Banking Act) Same as for U.S. domestic banks, except

banks grandfathered in

2. Impact World financial markets more integrated Encouraged bank consolidation abroad Importance of foreign banks in international

banking

Ten Largest Banks in the World

Chapter Summary

Historical Development of the Banking System: the historical development of the U.S. banking system was reviewed, and the resulting agencies (OCC, Fed, SEC, etc.) discussed

Financial Innovation and the Decline of Traditional Banking: changes in both demand and supply forces, and the response of the banking industry was examined


Bank Consolidation and Nationwide Banking: the forces leading bank consolidation and national banks, and the implications for the future, were outlined

Separation of Banking and Other Financial Service Industries: the rise and fall of separate banks was discussed, and the implications for the future were examined


International Banking: the branching of U.S. banks out of the U.S. as well as foreign banks operating in the U.S. were reviewed

Chapter 12

Savings Associations and Credit Unions

Chapter Preview

Consumer banking was almost non-existent in the early 1800s. Commercial banks were common, but their business was primarily restricted to commercial loans and services. But, in the late 1800s, a new type of institution opened – the savings and loan association. This is the topic of chapter 19.

Chapter Preview

We examine the role of savings and loan associations, mutual savings banks, and credit union, collectively known as thrift institutions. We begin with their history and move into the nature of the industry today. Topics include: Mutual Savings Banks

Savings and Loan Associations

Savings and Loans in Trouble: The Thrift Crisis

Political Economy of the Savings and Loan Crisis


Savings and Loan Bailout: Financial Institution Reform, Recovery, and Enforcement Act of 1989

The Savings and Loans Industry Today

Credit Unions

Mutual Savings Banks

Depositors are the owners of the firm

Stock in the bank is not sold or issued, but rather depositors own a share of the bank in proportion to their deposits

Generally have fewer liabilities than other banks because deposits are ownership, not a liability

Principal-agent problem still present, but managers tent to be more risk-averse


Created by Congress in 1816 to promote home ownership

About 12,000 S&Ls in operation by the 1920s

Regulation was at the state level


The Great Depression led to the failure of thousands of thrift institutions and the loss of $200 million in personal savings

The Federal Home Loan Bank Act of 1932 created the Federal Home Loan Bank Board

In 1934, the FSLIC was created to insure depositors


S&Ls were successful, low-risk businesses for many years following the changes.

The next slide shows the distribution of S&L assets in 2006. Note that most of the assets are still held as mortgages, true to their original intent.

Savings and Loan Associations vs. Mutual Savings Banks

Mutual savings banks are concentrated in the northeast, whereas S&Ls are found throughout the country.

Mutual savings banks insure their deposits with the state or the FDIC. S&Ls may not.

Mutual savings banks are not as heavily invested in mortgages and have more flexibility in their investing practices.


By 1979, inflation was running at 13.3%, but Reg Q restricted interest on deposits to only 5.5%.

Further, money market accounts offered depositors market interest rates on their short-term funds.


Financial deregulation and the permissive 1980s led to several problems: Managers lacked expertise in new product lines

Rapid growth in lending, particularly real estate

Regulators could not keep pace with the growth

The moral hazard problem led to excessive risk-taking

1981–1982 were particularly bad year for some areas, such as the Texas real estate market


Rather than close insolvent S&Ls, regulators adopted the policy of regulatory forbearance, essentially sidestepping their responsibility using temporary Band-Aids.

This policy led to further risk-taking, as insolvent S&Ls had nothing to lose by extreme risk-taking.


To further the problems, insolvent S&Ls offered higher rates to their depositors to attract new funding.

This meant that healthy S&Ls had to compete with insolvent S&Ls going for broke. Needless to say, this caused further problems for the industry.


Competitive Equality in Banking Act of 1987 Allowed the FSLIC to borrow $10.8 billion to cover

depositors’ losses (not nearly enough) Directed the FHLBB to continue regulatory forbearance

Losses in the S&L industry approached $20 billion in 1989 alone. The collapse of the real estate market in the late 1980s only worsened the problem.


The relationship between voter-taxpayers and the regulators and the politicians creates a particular type of moral hazard problem—the principal-agent problem. This idea can explain part of the problem during the S&L Crisis.


Regulators and politicians are ultimately agents for voter-taxpayers.

To act on taxpayers’ behalf, regulators seek to minimize the cost of deposit insurance: Restrict S&Ls from holding assets that are

too risky Require higher bank capital Close insolvent S&Ls


However, regulators have an incentive to “hide” the problem and hope that the situation corrects itself.

Regulators are also funded through Congressional appropriations, which means that politicians may be able to influence the actions of regulators.


Further, both Congress and the president passes legislation in the early 1980s that promoted risk-taking and required additional oversight.

Yet, in years following, Congress refused to fund regulators at a necessary level to monitor S&L activities.

Charles Keating and the LincolnS&L Scandal

Charles Keating acquired Lincoln S&L in 1984. Regulators allowed this, despite his being accused of fraud by the SEC.

Used the S&L to fund his construction firm with loans. Quickly changed Lincoln’s investing, using futures, junk bonds, and land tracks in Arizona.

Charles Keating and the LincolnS&L Scandal

Regulators eventually recommended seizure in 1986, but he fought in vigorously, spending millions in lawyer fees.

He also made campaign contributions to prominent senators – including John McCain. His tactics worked! By 1987, no examiner went near Lincoln – that is, until it failed in 1989.


The Bush administration proposed FIRREA to provide adequate funding to close insolvent S&Ls.

Its major provisions included: The Office of Thrift Supervision assumed

regulatory responsibility, replacing the FHLBB The FDIC assumed replaced the FSLIC The RTC was established to sell assets of failed

S&Ls


The bailout cost taxpayers in the neighborhood of $150 billion.

The bailout continued to cost depositors as FDIC insurance rates rose.

FIRREA essentially re-regulated the thrift industry and made it easier for regulators to remove thrift managers.

The Savings and Loan Industry Today

Despite the problems of the 1980s, the S&L industry did survive.

The next two slides show the totals assets and the number of S&Ls in the U.S.

594



Consistent with the last two slides, as the number of S&Ls has fallen, the average assets held by the average S&L has increased steadily throughout the last twenty years.

The next slide shows this graphically.


The next three slides show the following: Consolidated balance sheet for the S&L industry The net income for S&Ls from 1984-2006 Average ROE for S&Ls from 1993-2006

Many economists believe that S&Ls will disappear based on these findings. However, this does not appear to be a rapid trend. We may again see deregulation before all is said and done.

Credit Unions

Idea developed in Germany where a group pooled assets to use a collateral for a loan

The loan proceeds were then loaned to members of the group.

Default was rare since all the group members knew each other.

Credit Unions: Types of Organization

Mutual Ownership Owned by depositors

Common Bond Membership Defined field of

membership

Nonprofit, Tax-Exempt Status Lower service fee

Regulation and Insurance

Central Credit Unions Help with members’

credit needs Invest excess funds Hold clearing balances Provide educational

services

Credit Union Size

Trade Associations

National Credit Union Administrationhttp://www.ncua.gov

Credit Unions

Credit Unions: Types of Accounts

Regular Share Accounts Savings accounts Receive no interest Do receive dividends

Share Certificates Compatible to CDs

Share Draft Accounts Pay interest Write drafts against account

Credit Unions: Share Distribution

Credit Unions: Type of Loans

Credit Unions: Advantages and Disadvantages

Advantages Employer support Tax advantage Strong trade associations

Disadvantages Common bond requirement

Credit Unions: Memberships

Credit Unions: Assets

Chapter Summary

Mutual Savings Banks: the role of this form of thrift institution represents the first style of saving organization was reviewed

Savings and Loan Associations: since the Federal Home Loan Bank Act of 1932, this form of savings institution was very successful until the late 1980s


Savings and Loans in Trouble: The Thrift Crisis: the reasons behind the crisis, including interest rate volatility, arcane regulations, and increased risk-taking were discussed

Political Economy of the Savings and Loan Crisis: adding the problem, moral hazard on the part of regulators and politicians added to this costly failure of the S&L industry


Savings and Loan Bailout: Financial Institution Reform, Recovery, and Enforcement Act of 1989: this sweeping reform called for significant changes in the oversight and insurance of the S&L industry

The Savings and Loans Industry Today: empirical evidence shows that this industry is shrinking in some respects, possibly suggesting its eventual demise


Credit Unions: the history, form, and role of credit unions was reviewed

Chapter 13

The Mutual Fund Industry

Chapter Preview

Suppose you wanted to start savings for retirement, but you can only afford to invest $100 / month. How do you develop a diversified portfolio? Mutual funds are one potential answer. Mutual funds pool funds under a professional manager who then chooses the securities to invest in.

Chapter Preview

We study why mutual funds have become so popular, the various types of mutual funds, their regulation, and scandals in the mutual fund industry. Topics include: The Growth of Mutual Funds

Mutual Fund Structure

Investment Objective Classes

Fee Structure of Investment Funds


Regulation of Mutual Funds

Hedge Funds

Conflicts of Interest in the Mutual Fund Industry

Mutual Funds

Mutual funds pool the resources of many small investors by selling them shares and using the proceeds to buy securities.

The Growth of Mutual Funds

At the beginning of 2007, nearly 16% of assets held by intermediaries were held by mutual funds.

25% of the retirement market and almost 50% of all U.S. households hold stock via mutual funds.

Assets held by mutual funds have grown by over 17.5% per year for the last 20 years, reaching over $10 trillion by 2007.


The first mutual fund similar to the funds of today was introduced in Boston in 1824.

The stock market crash of 1929 set the mutual fund industry back because small investors avoid stocks and distrusted mutual funds.

The Investment Company Act of 1940 reinvigorated the industry by requiring better disclosure of fees, etc.


There are five principal benefits of mutual funds:

1. Liquidity intermediation: investors can quickly convert investments into cash while still allowing the fund to invest for the long term.

2. Denomination intermediation: investors can participate in equity and debt offerings that, individually, require more capital than they possess.

3. Diversification: investors immediately realize the benefits of diversification even for small investments.


There are five principal benefits of mutual funds:

4. Cost advantages: the mutual fund can negotiate lower transaction fees than would be available to the individual investor.

5. Managerial expertise: many investors prefer to rely on professional money managers to select their investments.


Ownership in mutual funds has changed dramatically over the last 20 years

In 1980, only 5.7% of households held mutual fund shares

In the beginning of 2007, that number was 48% Mutual funds account for $4.1 trillion of the retirement

market (estimated at $16.4 trillion)

The next four slides show the time series of these trends.

The Growth of Mutual Funds (cont.)


Investment companies usually offer a number of different types of mutual funds.

Investors can often move investments among these funds without penalty.

The complexes often issue consolidated statements.

Mutual fund fact bookhttp://www.ici.org/aboutfunds/factbook_toc.html


Closed-End Fund: a fixed number of nonredeemable shares are sold through an initial offering and are then traded in the OTC market. Price for the shares is determined by supply and demand forces.

Open-End Fund: investors may buy or redeem shares at any point, where the price is determined by the net asset value of the fund.

631

Stocks $35,000,000Bonds $15,000,000Cash $3,000,000

Total value of assets $53,000,000Liabilities -$800,000

Net worth $52,200,000Outstanding shares 15 million

NAV = $52,200,000/15,000,000 = $3.48

Calculating a Mutual Fund’s Net Asset Value

Net Asset Value (NAV) Definition: Total value of the mutual fund’s stocks,

bonds, cash, and other assets minus any liabilities such as accrued fees, divided by the number of shares outstanding

Mutual Fund Structure: the Organization

The shareholders, or owners, of the mutual fund are the investors.

The board of directors oversees the fund’s activities, hires the investment advisor, an underwriter, etc., to manage the day to day operations of the fund.

633



In theory, the board can fire the fund manager and hire anyone they choose. For instance, the board for the Fidelity Magellan Fund can fire Fidelity. Of course, if the board hires a non-Fidelity management team, the fund will probably lose its name, and possibly its reputation along with it.


There are four primary classes of mutual funds available to investors:

1. Stock (equity) funds

2. Bond funds

3. Hybrid funds

4. Money market funds

• The next slide shows the distribution of assets among these different classes.


Stock Funds Other than investing in common equity, the stated

objective of any particular fund can vary dramatically. Capital Appreciation Funds seek rapid increase in share

price, not being concerned about dividends. Total Return Funds seek a balance of current income and

capital appreciation. World Equity Funds invest primarily in foreign firms. Other types in Value, Growth, a particular

industry, etc.


Bond Funds Strategic Income Funds invest primarily in U.S. corporate

bonds, seeking a high level of current income.

Government Bond Funds invest in U.S. Treasury, as well as state and local government bonds.

Others include World Bond Funds, etc.

The next figure shows the distribution of assets among the bond fund classifications.


Hybrid Funds

Combine stocks and bonds into a single fund.

Account for about 6% of all mutual fund accounts.


Money Market Mutual Funds

Open-end funds that invest only in money market securities.

Offer check-writing privileges.

Net assets have grown dramatically, as seen in the next slide.


Money Market Mutual Funds

Although money market mutual funds offer higher returns than bank deposits, the funds are not federally insured.

The next slide shows the distribution of assets in MMMF, which are relatively safe assets.


Index Funds A special class of mutual funds that do fit into

any of the categories discussed so far. The fund contains the stock of the index it is

mimicking. For example, an S&P 500 index fund would hold the equities comprising the S&P 500.

Offers benefits of traditional mutual funds without the fees of the professional money manager.


Load funds (class A shares) charge an upfront fee for buying the shares. No-load funds do not charge this fee.

Deferred load (class B shares) funds charge a fee when the shares are redeemed.

If the particular fund charges no front or back end fees, it is referred to as class C shares.


Other fees charges by mutual funds include: contingent deferred sales charge: a back end fee that may

disappear altogether after a specific period. redemption fee: another name for a back end load exchange fee: a fee (usually low) for transferring money

between funds in the same family. account maintenance fee: charges if the account balance

is too low. 12b-1 fee: fee to pay marketing, advertising,

and commissions.


Mutual funds are regulated by four primary laws: Securities Act of 1933: specifies

disclosure requirements

Securities Exchange Act of 1934: details antifraud rules

Investment Company Act of 1940: requires registration and minimal operating standards

Investment Advisors Act of 1940: regulates fund advisors


Mutual funds are the only companies in the U.S. that are required by law to have independent directors, as follows (2001 SEC rules) Independent directors must constitute a majority of

the board

Independent directors select and nominate other independent directors

Legal counsel to the independent directors must also be independent

Hedge Funds

A special type of mutual fund that received considerable attention following the collapse of Long Term Capital Management.

Different from typical mutual funds, as follows: High minimum investment, averaging around $1 million Long-term commitment of funds is required High fees: typically 1% of assets plus 20% of profits Highly levered Little current regulation

651

Hedge Funds Hedge funds are often trying to take advantage of unusual spreads

between security prices

The LTCM Debacle

Long Term Capital Management was a hedge fund run by John Meriwether (the former head of bond trading at Salomon Brothers), and its board included Nobel Laureates Myron Scholes and Robert C. Merton. It recorded returns in excess of 30% for the first several years.

The LTCM Debacle

However, it took bets that went the wrong way. Its collapse was eminent, and regulators decided they had to develop a bailout. LTCM had over $80 billion in equity positions and over $1 trillion in derivative positions. Its failure could have been devastating for the U.S. economy.

The LTCM Debacle

Hedge funds have continued to fail since LTCM. Amaranth Advisors loss $6 billion in one week in natural gas futures. Other funds have similar losses. Indeed, hedge fund investing is a potentially high risk game for well-heeled investors (gamblers?)

Hedge Funds

The SEC passed regulation in 2006 requiring hedge fund advisors to register with the SEC. The SEC became concerned about fraud, and hedge funds became available to the average investor via “retailization”.


Investor confidence in the stability and integrity of the mutual fund industry is critical.

However, the usual problems of asymmetric information and the principal-agent problem arose, leading to abuses on the part of fund management.


Mutual Fund Abuses

Late trading: allowing trades after 4:00 pm to trade at today’s 4:00 NAV instead of tomorrow’s price. This is illegal under SEC regulations.

Market timing: taking advantage of time zone differences for determination of NAV. This is not illegal under SEC rulings.


Government Response to Abuses

Require more independent directors

Hardening the 4:00 valuation rule: this addresses the late trading problem, but not market timing.

Increased and enforces redemption fees: fees to discourage market timing by additional fees for short-term redemptions.

Increased transparency: hits operating practices, directors, investment managers, compensation arrangements with brokers, etc.

Chapter Summary

The Growth of Mutual Funds: mutual funds growth has been dramatic, increasing from under $300 billion in 1980 to over $10 trillion in 2004.

Mutual Fund Structure: the organization structure, including ownership, the board, and operations of the fund were reviewed.


Investment Objective Classes: along with delineating equity and debt funds, we also reviewed classes on funds within each major category.

Fee Structure of Investment Funds: the various fees charged by funds were defined and reviewed.


Regulation of Mutual Funds: the various acts and laws that govern mutual funds were listed.

Hedge Funds: the purpose, definition, and differences between traditional mutual funds and hedge funds was discussed.


Conflicts of Interest in the Mutual Fund Industry: recent abuses and governmental responses to those abuses was outlined.

The End

financial markets by huanli li. part one introduction

Documents

bond markets

functioning financial

credit markets

stock markets

stocks markets

ratesdebt markets

role of debt markets

study financial institutions