Financial Markets

11/9/2001
LECTURE : MARKETS,FIRMS AND INVESTORS K. Cuthbertson
Copyright K. Cuthbertson and, D. Nitzsche
TOPICS
Types Of Financial Asset:Lending And Borrowing Funds Flow of Funds Markets And Dealers Returns And Risk Forward Rates and the Yield Curve Data on Yields, Prices, Returns and Risk
Copyright K. Cuthbertson, D. Nitzsche
READING
Investments:Spot and Derivative Markets, K.Cuthbertson and D.Nitzsche
Chapter 1: Markets, Firms and Investors Chapter 2 The Business Environment
RATIONALE OF SLIDES
TO GIVE AN OUTLINE OF KEY TOPICS WHICH CAN THEN BE FOLLOWED UP IN CUTHBERTSON AND NITZSCHE
EVERY SLIDE IS NOT DISCUSSED LINE BY LINE IN THE LECTURES
TO PROVIDE SELF ASSESSMENT SLIDES WITH QUESTIONS OR NEW MATERIAL, TO FOLLOW UP OUTSIDE THE LECTURES
RATIONALE OF SLIDES
DO SEMINAR SHEETS (BEFORE CLASSES) AND MUST DO BACKGROUND READING (CUTHBERTSON/NITZSCHE)
ALL OF THE SYLLABUS IS EXAMINABLE
REVISE YOUR BASIC STATISTICAL CONCEPTS, NOW ! (E.G. mean, standard deviation, correlation, covariance, elementary probability, expected value, regression + s-errors + t-tests, decision trees.)
THERE IS A LOT TO DO, BUT MUCH USEFUL VALUE ADDED
Types of Financial Assets: Lending and Borrowing Funds
LENDING AND BORROWING
New (physical) investment projects - have to be financed. Transfer of existing physical assets to more productive uses: ( eg. Low stock price is a signal for another firm, to raise funds for a takeover by more efficient managers - the market for corporate control) Market prices/returns reflect the scarcity of funds and the financial system is supposed to allocate funds to the most productive/ profitable physical investments competition for funds.
LENDING AND BORROWING

Financial system: moves funds between borrowers and lenders. Allows some to spend before they have earned the income and others to defer spending (ie. Save) - intertemporal re-allocation of cash flows.
TYPES OF FINANCIAL ASSET(MARKETS)
Financial assets differ in maturity frequency of expected payments uncertainty of cash flow or final price Shareholders own the firm and control managers via voting rights over the composition of Board of Directors. Debt holders (=bonds holders +bank loans) do not own the firm - but debt holders do have influence on the managers - can put the firm into liquidation
Money marker vs. capital market

The
capital market is a source of intermediate-term to long-term financing in the form of equity or debt securities with maturities of more than one year. Money market fixed income securities The capital market is a source of intermediate-term to long-term financing in the form of equity or debt securities with maturities of more than one year Money market characteristics: liquidity, discount pricing to their face value, safety.
Raising/Lending Funds: Short-term

Money market assets (maturity < 1 year) 1) bank deposits/loans, in Eurodollars/Yen etc. - OTC(non- marketable) 2) Commercial Bills, Certificates of Deposit CDs, - (also sold in secondary market) 3) Have a known return (=yield/interest rate), if held to maturity
Raising/Lending Funds: Bonds

Government Bonds:
T-bonds/Notes (UK = gilts), - long term - usually fixed interest ($ coupon) payments - plain vanilla or straight bonds Corporate bonds,( including preference shares) - entitled to cash payments before equity holders -restrictive covenants(eg. cannot sell buildings) - Floating Rate Notes, FRNs - convertibles - callable bonds
Raising Funds: Shares/Equity

Shares (equities, common stocks) - no maturity - variable payments (= dividends) - last to be paid Issuing Shares - IPO (going to market - e.g. LastMinute.com ) - Rights Issue - additional shares to existing equity holders - Script Issue - free shares, no new funds, - Equity Warrants
Equity warrants
Warrants
are like stock rights in that they offer the option to buy common stock in the future, at a specific subscription price. Many warrants have no expiry dates. The subscription price for a rights offering is usually less than the stock's market price. Warrant subscription prices, on the other hand, are always higher than the current market price for the newly issued stock. Warrants are also traded on the open market.
Raising Funds: Mezzanine Finance

Junk/High-yield/ low-grade / BONDS i.e. < BBB ratesubordinated debt (last in interest payment and debt-queue) - used for management buy-outs MBOs - usually highly leveraged buy-outs LBOs (e.g. buy-out of RJR Nabisco) - used for hostile takeovers (acquirer retains all voting rights in the new company) - often have equity kickers attached therefore often issued by young fast growing firms (media, cable TV)
Management Buyout - MBO

When
the managers and/or executives of a company purchase controlling interest in a company from existing shareholders. The management will buy out all the outstanding shareholders and then take the company private because it feels it has the expertise to grow the business better if it controls the ownership. Quite often, management will team up with a venture capitalist to acquire the business because it's a complicated process that requires significant capital.
What Does Leveraged Buyout - LBO Mean?

-> The acquisition of another company using a significant amount of borrowed money (bonds or loans) to meet the cost of acquisition. -> Often, the assets of the company being acquired are used as collateral for the loans in addition to the assets of the acquiring company-> a company's success can be used against it as collateral by the hostile company (ironic, predatory tactic) ->The purpose of leveraged buyouts is to allow companies to make large acquisitions without having to commit a lot of capital. -> In an LBO, there is usually a ratio of 90% debt to 10% equity. Because of this high debt/equity ratio, the bonds usually are not investment grade and are referred to as junk bonds.
Kickers
Kickers
are essentially features that are added to "get the deal done", as they are exclusively for the benefit of lenders and used to add to their expected return on investment (ROI). A company that adds a kicker (for example, a rights offering) to a bond issue is only doing so because it will help get the entire issue into the hands of investors. The kicker may or may not actually be usable; often a certain breakpoint must be reached (such as a stock price above a certain level) before the kicker has any real value.
Mezzanine financing
A
hybrid of debt and equity financing that is is typically used to finance the expansion of existing companies Mezzanine financing is basically debt capital that gives the lender the rights to convert to an ownership or equity interest in the company if the loan is not paid back in time and in full It is generally subordinated to debt provided by senior lenders such as banks and venture capital companies
OTHER MARKETS
Foreign Exchange: Spot market for foreign currencies = trade finance + speculators All of the above are known as cash or spot markets (ie. for immediate delivery of the asset) Derivatives Markets - forwards \ futures (delivery in the future) - options (delivery is optional ) - swaps ( eg swap USD payments for FRF payments) - used in financial engineering / structured finance
Flow of Funds
Lenders and Borrowers Primary Lenders :

Personal Sector and
Primary Borrowers :
Companies and Government
Government
If taxes are insufficient to cover expenditure Budget Deficit = G - T Financed by: ( PSBR in the UK ) a) printing money b) issuing debt
- issuing more debt can raise interest rates and may ultimately lead to debt crises (eg. Latin American debt crises 1980s, Russian bond defaults July 98) - EMU deprives you of printing money or setting your own interest rate but it does not stop you issuing your own bonds (denominated in Euros).
MARKETS and DEALERS
Types Of Transaction Cash Account :pay up front Margin Account (pay a proportion, borrow the rest) Going long (=buy), Going short (=sell what you own). Short Sales Repurchase Agreement (Repo)
Trading Arbitrageurs: Keep price = fundamental value Hedgers: offset risks that they currently face Speculators: take "open" positions to make profit Note: Speculators provide funds for hedgers
Market Maker (MM)

MM B Buys "low" at Bid price MM sells "high" at offer price
Touch = difference between highest bid and lowest offer price
SEAQ : best bid and ask/offer prices displayed as the "yellow strip price
Prices Respond To News

Financial prices (eg stock/bond) prices respond to changing views about the future
Markets, - look forward ! (The past is only relevant in that it may help to predict the future).
Hence even if everyone acts rationally, we expect (Stock) market prices to be volatile as they immediately embody changing views about all future prospects for companies (This is referred to as news, that is new information)
But are markets excessively volatile ? (Greenspan/Shiller, Irrational (Over)-Exuberance - bubbles, crashes, noise traders)
Returns And Risk
SPREADS and YIELDS

Spread is the difference between two prices Bid-Ask Spread: Market maker Buys at the Bid (eg $100 ) and sells at the offer or ask (eg. $102) . Bid-ask spread above = $2
Yield (eg. 10 % p.a.) on an interest bearing asset (eg. T-Bill, T-Bond, Eurodollar deposit ) ~ measure of the return on your investment when you hold the asset to maturity
Spread on interest rates = Long rate(10yr) - short rate(3m)

Prices and Returns:

Holding Period Return ( Yield):
Is the return when the asset is sold prior to maturity
HPR = Capital Gain + Running(Dividend) Yield
Shares
P1 = 100
P2 = 110
D2 = 5
HPR = 10% + 5% = 15%
Bonds P1 = 100 P2 = 110 HPY = 10% + 2% = 12%

Coupon = 2
Nominal v Real Returns (yields): Risk free asset Risk Free(safe) Asset = T-Bills or Bank deposit
Fisher Equation:
Nominal risk free return,r = real return + expected inflation
Real return : reward for waiting (3% p.a.) = increase in number of Harrods Hampers you can buy .at the end of the year. (e.g. current 1-year spot rate = 5.5%, implies expected inflation over the coming year = 2.5%) Indexed bonds earn a known real return
Nominal RISKY Return (eg. On EQUITIES)

Nominal Risky Return = risk free rate + risk premium = r + rp where: rp = risk premium =market risk + liquidity risk + default risk
We can measure the historic (or ex-post) risk premium e.g. Av. Return = 12% p.a. Av. r = 4% p.a. Then ex-post (equity) risk premium = 8% p.a.
Forward Rates and the Yield Curve
Uses of Forward Rates

Uses of Forward Rates Today, you can lock in an interest rate which will apply between two periods in the future (e.g. between end of year-1 and end of year-2, denoted f12 )
Also used in Pricing Forward Agreements replaced by: Forward Rate Agreements , FRAs -Floating Rate Notes, FRNs -Interest Rate Futures Contracts -Floating rate receipts, in an interest rate swap
Relationship between forward rate and spot rates

Two period investment horizon - riskless investments. Choices 1) Invest your $1 for 2-years at r2 (spot rate) 1) Receipts at t=2 are $1 ( 1 + r2 )2 2) Invest $1 for 1-year at r1 and today purchase an FRA to invest between t=1 and t=2 at a quoted rate f12 2) Receipts at t=2 are $1( 1 + r1 ) (1 + f12 )
These transactions are riskless hence investors will switch their funds (between 1-year, 2-year and the FRA ) until the 3 interest rates are such that the amounts received at t=2, are equal.
Relationship between forward rate and spot rates

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

Or, approximately (Let r1 = 9% p.a. and r2 = 10% pa ) f12 = 2 . r2 - r1 = 2 (10) - 9 = 11%
1) Correct forward rate is derived from current spot rates (yield curve) 2) f12 is the rate a bank should quote 3) Also it can be shown that f12 is the markets best forecast of what the the one-year rate in one-years time (denoted Er1t+1 ) will be
SELF STUDY Algebra of General Calculation of Forward Rates
Calculate other forward rates from todays spot rates is pretty intuitive since the superscripts and subscripts add up to the same amount on each side of the equals sign ( 1 + r03 )3 = ( 1 + r02 )2 . (1 + f23 )1 ( 1 + r03 )3 = ( 1 + r01 )1 . (1 + f13 )2 In general (there is no need to memorise this!) fm,n = [ n / (n -m) ] rn - [ m / (n -m) ] rm e.g. f1,3 = [ 3 / 2 ] r3 - [ 1 / 2 ] r1
Yield Curve and the Expectations Hypothesis
Figure 5 :YIELD CURVE
Yield
7 6 4 A 1 2 3 A
Time to maturity
The yield curve is usually upward sloping. WHY?

THE YIELD CURVE
Why are long rates of interest often higher than short rates of interest ? - can long rates be lower than short rates ? Yes ! - Expectations Hypothesis If we know the shape of the yield curve (ie. All the spot rates) then we can calculate forward rates for all maturities
Expectations Hypothesis (EH): Term Structure
Arbitrage: assuming risk neutrality $1.( 1+ r2 ) 2 = $1. (1+r1) . [ Approx. r2 = ( 1 / 2 ) . [ r1 + Er12 ] 1 + Er12 ]
EH implies 1.Long-rate r2 is weighted average of current (r1) and expected future (one-period) short rates Er12
Upward Sloping Yield Curve

Rising yield curve implies that short rates are expected to be higher in the future and this is probably because inflation is expected to rise in future years Inflation Prediction from the yield curve Observe the current yield curve r2 = 6%, r1 = 5%, then f12 = 7.0% If real rate = 3%, then ( from Fisher effect) Expected annual inflation in 1-years time = 7 - 3 = 4% = Bank of England inflation forecast ?
Data On Yields, Prices, Returns and Risk
Asset Returns and Volatility (Annual): Data, 1926-97 Arith. Mean 13 18 6.1 5.6 3.8 3.6 S.D 20.3 34 8.7 9.2 3.2 5
Stocks (S&P500), Rm Small Stocks (bottom 5th on NYSE) L.T Corp Bonds L.T. Gov bonds US T-bills, r Inflation
Notes:1) dividends/coupons reinvested. 2) The geometric mean return would be less than the arithmetic mean return 3) arithmetic mean return is larger the shorter the horizon chosen(eg. 1-year versus 2-year returns etc, - this is because returns are mean reverting (or have negative autocorrelation) over longer horizons,( ie. they are not statistically independent) - see elementary stats book. (Source Brealey & Myers 6th ed p156-164)
Asset Returns and Volatility (Annual): Data, 1926-97
Av. Real return on S&P
= 9.4 %
( = 13 - 3.6)
Av. Excess return on S&P = Rm - r = 9%
(approx)
- often referred to as the market risk premium
Excess return per unit of risk = (Rm - r)/W = 0.45 (= 9/20) - often referred to as the Sharpe ratio
Survivorship bias in just using US data? . Reduce US market risk premium by 1.5% ?
Volatility of S&P500 (Annual) US Data, 1930-97 S.D 41.6 17.5 14.1 13.1 17.1 19.4 14.3
1930s 1940 1950 1960 1970 1980 1990-97
(Source Brealey & Myers 6th ed p156-164)
RISK GRADES: FT 19/10/00 (for Oct 17th)
BONDS Europe Americas Asia 25 32 21
EQUITY 86(135) 94(146) 98(139)
FX(rel to USD) 62(Euro) 49 39(Yen)
Global UK
38
107(156) 77 (115)
Note: ( . .) = 52-week high 100 = average volatility of international equity mkts

Figure 1.6 : US stock market (S&P500 and NASDAQ)
1000 900 800 700 600 500 400 300 200 100 0 03/01/95 03/01/96 03/01/97 03/01/98 03/01/99 03/01/00 03/01/01
Nasdaq
Summary Statistics :
(Jan. 95 to Sept. 00) S&P500 Mean 1.76% Std. dev. 3.94% Correlation : 0.6382 (monthly data) Nasdaq 3.41% 7.56%
S&P500
S&P500
Figure 1.5: US Industrial Sectors

8000 7000 6000 5000 4000 3000 2000 1000 0 23/12/88 07/05/90 19/09/91 31/01/93 15/06/94 28/10/95 11/03/97 24/07/98 06/12/99 19/04/01
Entertainment Industry
Oil Industry
Chemical Industry
Financial Industry
Automobile Industry
Figure 1.7: Local Currency Stock Indices

16000 14000 12000 10000 8000 6000 4000 2000 0 27/02/88 27/01/90 28/12/91 27/11/93 28/10/95 27/09/97 28/08/99 28/07/01
Hang Seng
S&P FTSE Dax Nikkei
Figure 1.8: Asian Crises : Spot FX Rates
120
100
80
$ per Malaysian Ringgit
60
$ per Thai Baht

40
$ per Indonesian Ruphia
20
0 05/02/96 01/12/96 27/09/97 24/07/98 20/05/99 15/03/00 09/01/01
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11/9/2001

LECTURE : MARKETS,FIRMS AND INVESTORS K. Cuthbertson

Copyright K. Cuthbertson and, D. Nitzsche

Chapter 1: Markets, Firms and Investors Chapter 2 The Business Environment

Copyright K. Cuthbertson, D. Nitzsche

EVERY SLIDE IS NOT DISCUSSED LINE BY LINE IN THE LECTURES

Copyright K. Cuthbertson, D. Nitzsche

DO SEMINAR SHEETS (BEFORE CLASSES) AND MUST DO BACKGROUND READING (CUTHBERTSON/NITZSCHE)

ALL OF THE SYLLABUS IS EXAMINABLE

THERE IS A LOT TO DO, BUT MUCH USEFUL VALUE ADDED

Copyright K. Cuthbertson, D. Nitzsche

Types of Financial Assets: Lending and Borrowing Funds

Copyright K. Cuthbertson, D. Nitzsche

LENDING AND BORROWING

LENDING AND BORROWING

Copyright K. Cuthbertson, D. Nitzsche

TYPES OF FINANCIAL ASSET(MARKETS)

Money marker vs. capital market

Raising/Lending Funds: Short-term

Copyright K. Cuthbertson, D. Nitzsche

Raising/Lending Funds: Bonds

Raising Funds: Shares/Equity

Copyright K. Cuthbertson, D. Nitzsche

Raising Funds: Mezzanine Finance

Copyright K. Cuthbertson, D. Nitzsche

Management Buyout - MBO

What Does Leveraged Buyout - LBO Mean?

Copyright K. Cuthbertson, D. Nitzsche

Lenders and Borrowers Primary Lenders :

Copyright K. Cuthbertson, D. Nitzsche

MARKETS and DEALERS

Copyright K. Cuthbertson, D. Nitzsche

Market Maker (MM)

Touch = difference between highest bid and lowest offer price

Copyright K. Cuthbertson, D. Nitzsche

Prices Respond To News

Returns And Risk

Copyright K. Cuthbertson, D. Nitzsche

SPREADS and YIELDS

Spread on interest rates = Long rate(10yr) - short rate(3m)

Prices and Returns:

Is the return when the asset is sold prior to maturity

HPR = Capital Gain + Running(Dividend) Yield

HPR = 10% + 5% = 15%

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

Nominal RISKY Return (eg. On EQUITIES)

Copyright K. Cuthbertson, D. Nitzsche

Forward Rates and the Yield Curve

Copyright K. Cuthbertson, D. Nitzsche

Uses of Forward Rates

Relationship between forward rate and spot rates

Copyright K. Cuthbertson, D. Nitzsche

Relationship between forward rate and spot rates

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

Or, approximately (Let r1 = 9% p.a. and r2 = 10% pa ) f12 = 2 . r2 - r1 = 2 (10) - 9 = 11%

SELF STUDY Algebra of General Calculation of Forward Rates

Yield Curve and the Expectations Hypothesis

Copyright K. Cuthbertson, D. Nitzsche

Figure 5 :YIELD CURVE

The yield curve is usually upward sloping. WHY?

THE YIELD CURVE

Copyright K. Cuthbertson, D. Nitzsche

Expectations Hypothesis (EH): Term Structure