Introduction to Capital Markets

B, K & M Chapter 2
End of chapter problems: 1-13, Project 1 1-13,

The Capital Markets Overview

Value of Outstanding debt in 2007: Treasury Securities: $4.6 Trillion
Bills 21% Notes 62% Bonds 17%

GovGov-sponsored enterprise $2.7 Trillion

(Freddie Mac), (Fannie Mae), (Sallie Mae), etc

U.S. Corporate Bond Market: $3.1 Trillion Tax exempt bonds:

$ 2.1 Trillion

Mortgage Backed Securities (includes GSEs): $3.8 Trillion Value of U.S. Equities in 2007: $15.4 Trillion, (30% of World)
Residential Real Estate in 2007: $20.4 Trillion

US GDP in 2007: $14 Trillion (25% of world total) US Population in 2007: 300 million (<5% of world total)

The Money Market: December 2007

The Money Market

The U.S. Government is the largest single issuer of debt in the world Treasury Bills

 Issued by Federal Government at a discount (zero coupon)

 Maturities of 91 days and 182 days. Offered each Monday, sold at auction  Very liquid secondary market for T-Bills (for large investors)  Interest exempt from state and local taxes  Quoted in WSJ in terms of its bank discount yield, which differs from its effective annual rate of return

T-Bills (cont.)
Effective Annual Yield (rate of return) on a pure discount bond is defined as r:

FV r!( ) P
Where:

/T

FV is the future value of the bond ($10,000) P is the current transaction price of the bond ($9,600) T is the time to maturity in years, days to maturity over 365 (assume 182)

T-Bills (cont.)
EXAMPLE:

r!

 !

Spread between 3 month CD s and T-Bills

Commercial Paper
 Unsecured notes issued by large (credit worthy) corporations  Disintermediation Since the late 1980s there have been a few years in which the size of commercial paper market exceeded that of the T-Bill market  Over 1000 corporations issuing CP in the U.S.  Maturities of 30 to 270 days  Issued in multiples of $100,000

Commercial Paper (cont.)

 Rates typically exceeded T-Bills by .5% to 4% (taxed by all levels of government)  Defaults are rare (fewer than 10 since 1971). LOC paper is CP issued with a letter of credit (credit enhancement), with a bank or insurance company guaranteeing payment in the event of a default  Implication: Purchasing a guarantee and raising funds in the CP market is cheaper for many companies than borrowing directly from a bank!

Eurodollars
 Dollar denominated deposits at foreign banks or foreign branches of American banks

Of course, no deposit insurance

Federal Funds
 Fed funds are bank deposits at a banks district Fed for the purpose of meeting reserve requirements

 Banks with excess reserves at the Fed loan to those with a shortfall

 An alternative is for a bank to do a repo

Bankers Acceptances
 An order to a bank by a bank customer to pay sum at a future date  When the bank has endorsed the order as accepted it assumes responsibility for the ultimate payment to the holder (at this point may be traded in the secondary market)  Sold at a discount from face value  Used widely in the finance of foreign trade

London Interbank Offered Rate (LIBOR)

 The rate at which large banks in London are willing to lend money among themselves

 Premier short-term rate in the European money market

The Fixed Income Capital Market

Treasury Notes and Bonds

 Notes have maturities of 1 to 10 years  Bonds have maturities of 10 to 30 years, may be callable in the last 5 years  Auctioned at (or near) par value with twice yearly interest payments  Yield to maturity in the WSJ is calculated with a simple interest method (sometimes called bond equivalent yield or annual percentage rate (APR))

Treasury Notes and Bonds (cont.)

 What is reported yield to maturity on a 10-yr T-Bond with a 9% coupon and selling at 100:10 (100 10 32)?  What is its effective rate of return? Solve for the r (discount rate) that equates the price of the bond to the discounted cash flows. The final payment is the repayment of principal.
1 .  1 . 1! t (1  r ) (1  r ) 2 t !1
2

 This calculation gives the YTM or effective return in terms of the 6-month interest rate r. The annualized yield reported in the WSJ is not (1+r)2 1, but rather 2r. (bond equivalent yield)

Inflation Adjusted Treasury Bonds

 Introduced in the 1990s

 Face value is inflation adjusted (although the principal adjustments are taxable events)

Federal Agency Debt

1) Government National Mortgage Association (Ginnie Mae) 2) Federal National Mortgage Association (Fannie Mae) 3) Federal Home Loan Mortgage Corporation (Freddie Mac) 4) Also some farm credit agencies (make seasonal loans to farm coops, make mortgage loans on farm properties, and provide short-term financing for agricultural production and marketing)

Federal Agency Debt (cont.)



Ginnie Mae guarantees securities issued by pooling privately originated mortgage, and selling claims to the cash flows as the loans are paid off. As a federal agency, its guarantee carries the full faith and credit of the U.S. government a) Mortgages are issued by approved lenders such as commercial banks and mortgage brokers, with underwriting standards established by Ginnie Mae b) The mortgage originator may continue to service the loan, collecting interest and principal payments, passing these along to the mortgage purchaser c) The security guaranteed by Ginnie Mae is called a mortgagebacked security (MBS), and is sold with a minimum denomination of $25,000

Federal Agency Debt (cont.)

 Freddie Mac and Fannie Mae provide liquidity to the mortgage market by purchasing mortgages, and then issuing MBSs creating a secondary market  Although referred to as Agencies,the government guarantee is only implicit  MBSs have attracted to the mortgage market investors who were not previously active participants. They have increased liquidity, and made mortgage markets less dependent on local credit availability  Spreads over Treasury rates were typically small (until 2007-2009)

Federal Agency Debt (cont.)

 A major risk to pass-throughs is the call feature available to mortgage holders who might want to refinance if interest rates fall Extension and Contraction risk

 Some institutional investors may be primarily concerned with extension risk, while others may be more concerned with contraction risk

 Collateralized Mortgage Obligations (CMOs) meet this need

Collateralized Mortgage Obligations (CMOs)

 A CMO is a security backed by a pool of pass-throughs that is structured so there are several classes of bondholders (tranches) with varying stated maturities

 Prepayment risk is not eliminated but rather redistributed among the tranches

CMOs (cont.)
Examples:

- Sequential pay CMOs: - tranches are retired sequentially - Interest only (IO) and principal only (PO) strips: -The PO strip is sold at a discount from par value. The yield depends on the speed with which prepayments are made (the faster the prepayments the higher the yield) -The IO has no par value. The investor receives interest on the amount of principal still outstanding. Note that prepayments here reduce principal and hence interest payments. If prepayments are too fast, the investor may not recover the amount paid for the IO!
 Issuers of CMOs are both agencies and investment banks (private label CMOs)

CMOs (cont.)
MortgageMortgage-Backed Securities Outstanding, 1979-2007 1979Issuance Volume of Collateralized Mortgage Obligations, 1982-1993a Year 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993
a

Number of Dollar Value Number of Average Number of Deals (in millions) Tranches Tranches per Deal 1 $ 50 2 2.0 8 4,748 53 6.6 18 9,903 143 7.9 59 16,515 434 7.4 89 49,838 951 10.7 94 58,875 1,020 10.9 156 77,066 1,796 11.5 236 95,209 2,608 11.1 280 112,993 3,802 13.6 440 200,810 7,077 16.1 504 260,410 9,688 19.2 441 271,180 10,597 24.0

Includes agency and nonagency CMO/REMICs.

Source : Wall Street Analytics, Inc.

Municipal Bonds
 Issued by state and local governments  Exempt from federal taxes (on interest only) if issued to build roads, schools, hospitals or to finance deficits  Lower interest because of tax status The rate a taxable must pay to match the after-tax yield on a municipal is: ! m (  t)  At what tax bracket are investors indifferent between taxable and tax exempt bonds?

t !1

Tax-exempt debt

Ratio of yields is variable!

Municipal Bonds (cont.)

In class problem: If taxables yield 8% and similar municipals yield 6%, which investment should be chosen by an investor in the 28% tax bracket who pays an average tax rate of 22%?

Corporate Bonds

 Unsecured: backed by earning power of corporation  Secured: backed by specific assets  Callable by issuer after 5 years (utilities) or 10 years (industrial corporations) at some premium (1 years interest)  Call feature is an option whose value depends on time to expiration, strike price, volatility, etc.

Corporate Bonds (cont.)

 A convertible bond contains an option to convert to a specified number of shares of common stock prior to maturity  Junk bonds are not rated as investment grade by one of the rating agencies:

e BB (S&P), e Ba (Moody's)
 Taxable (interest and capital gains)  Maturities up to 30 years

Equities

Common Stock
 Residual claim  Limited Liability Note: For most stocks, the individual investor is no longer the marginal investor Direct Individual Ownership of US Equities 47.9% in 1980 21.5% in 2007

Preferred Stock
 Hybrid security  Fixed dividend  Dividend payments are not tax-deductible expenses for the firm (but corporations may exclude 70% of dividends received from domestic corporations from taxable income)  May be callable (redeemable) and convertible

Agency Costs and Corporate Control

(Important areas in corporate finance)

 In theory, shareholders control management, but in practice, management can hurt shareholders by incompetence, serving their own interests, and controlling the board of directors  In theory, proxy fights prevent this, but they are expensive and 75% lose The best protection may be through the threat of takeovers Is Private Equity a Solution?

Market Indexes

When constructing or using indexes, the problems of sampling, weighting and averaging must be faced

Sampling

 Larger samples are more difficult to handle (without a computer) but are more representative

 Older indexes tend to be based on fewer stocks

Weighting
 Weighting by relative market values is appropriate for indicating changes in the aggregate value of stocks in the index

 Using equal weights is appropriate for indicating movement in the price of a typical stock

DJIA weights are proportional to prices!?

Averaging
 Most indexes use arithmetic averages although value line computes a geometric average  Example:

STOCK A B C

RETURN 10% -5% 20%

Equally weighted arithmetic average: [.10 + (-.05) + .20] 3 = 8.33% Equally weighted geometric average: [(1+.10)(1+(-.05))(1+.20)] 1 3 = 1.0784 or 7.84%

Averaging
 A general mathematical property is that the geometric average is less than the arithmetic average

 The arithmetic average here corresponds to the return from purchasing the above portfolio with equal weights

 There is no portfolio strategy that results in a rate of return equal to that of a geometric index

Dow Jones Industrial Average (DJIA)

 The arithmetic average of the price of 30 large NYSE stocks (~ 20% of NYSE value)

 Represents the return (not including dividends) from a strategy of holding one share of each stock

 A stock split reduces the importance of the split stock in the index

S&P 500
 A market value weighted index of 500 large company stocks

 Represents the return (not including dividends) from the strategy of holding a portfolio of the 500 firms in proportion to their market values

Other Indexes
Wilshire 5000 (5000 NYSE, AMEX, and OTC stocks)

 NASDAQ Comp (2000 NASDAQ stocks)

Correlations
Correlation Coefficients between Different U.S. Stock Market Indicators (Monthly Returns form 1975-1988) 1975DJIA S&P400 S&P500 NYSE AMEX OTCIND OTCCOMP CRSPEQW CRSPVW

DJIA S&P400 S&P500 NYSE AMEX OTCIND OTCCOMP CRSPEQ

0.958 0.953 0.889 0.675 0.735 0.768 0.937

1.000 1.000 0.977 0.909 0.738 0.770 0.782 0.945

1.000 0.911 0.736 0.753 0.785 0.945

1.000 0.736 0.737 0.784 0.940

1.000 0.762 0.782 0.844

1.000 0.881 0.743

1.000 0.801

1.000 1.000

CRSPVW 0.944 0.949 0.959 0.956 0.853 0.765 0.813 0.922 DJIA = Dow Jones Industrial Average S&P400 = Standard & Poors 400 Industrial Stock Index S&P500 = Standard & Poors 500 Stock Composite Index NYSE = New York Stock Exchange Index AMEX = American Stock Exchange Average OTCIND = Over-the-Counter Index Over-theOTCCOMP = OTC Composite Stocks Average CRSPEQW = Center for Research on Securities Prices (CRSP) Equally-Weighted Stocks Index EquallyCRSPVW = Center for Research on Securities Prices (CRSP) Value-Weighted Stocks Index Value-