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11/9/2001

11/9/2001. LECTURE : MARKETS,FIRMS AND INVESTORS. K. Cuthbertson. Copyright K. Cuthbertson and, D. Nitzsche. Types of Financial Assets: Lending and Borrowing Funds. Copyright K. Cuthbertson, D. Nitzsche. LENDING AND BORROWING.

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11/9/2001

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  1. 11/9/2001 LECTURE :MARKETS,FIRMS AND INVESTORS K. Cuthbertson Copyright K. Cuthbertson and, D. Nitzsche

  2. Types of Financial Assets: Lending and Borrowing Funds Copyright K. Cuthbertson, D. Nitzsche

  3. 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. Copyright K. Cuthbertson, D. Nitzsche

  4. 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. Copyright K. Cuthbertson, D. Nitzsche

  5. 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 Copyright K. Cuthbertson, D. Nitzsche

  6. 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 Copyright K. Cuthbertson, D. Nitzsche

  7. 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 Copyright K. Cuthbertson, D. Nitzsche

  8. 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 Copyright K. Cuthbertson, D. Nitzsche

  9. Raising Funds: Mezzanine Finance Junk/High-yield/ low-grade / BONDS - I.e. below BBB rated - subordinated debt (last in interest payment and ‘debt-queue’) - used for management buy-outs MBO’s - usually highly leveraged buy-outs LBO’s (e.g. buy-out of RJR Nabisco) - used for hostile takeovers (acquirer retains all voting rights in the new company) - often have equity kickers attached therefore often issued by ‘young’ fast growing firms (media, cable TV) Copyright K. Cuthbertson, D. Nitzsche

  10. 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’ Copyright K. Cuthbertson, D. Nitzsche

  11. Flow of Funds Copyright K. Cuthbertson, D. Nitzsche

  12. Lenders and Borrowers Primary Lenders : Personal Sector and Primary Borrowers : Companies and Government Copyright K. Cuthbertson, D. Nitzsche

  13. Government • If taxes are insufficient to cover expenditure • Budget Deficit = G - T ( ‘PSBR’ in the UK ) • Financed by: a) printing money • b) issuing debt • - issuing more debt can raise interest rates and may • ultimately lead to debt crises (eg. Latin American debt • crises 1980s, Russian bond defaults July 98) • - EMU deprives you of “printing money” or setting • your own interest rate but it does not stop you issuing • your own bonds (denominated in Euros). Copyright K. Cuthbertson, D. Nitzsche

  14. MARKETS and DEALERS Copyright K. Cuthbertson, D. Nitzsche

  15. 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) Copyright K. Cuthbertson, D. Nitzsche

  16. 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 Copyright K. Cuthbertson, D. Nitzsche

  17. Market Maker (MM) MM 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” Copyright K. Cuthbertson, D. Nitzsche

  18. 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) Copyright K. Cuthbertson, D. Nitzsche

  19. Returns And Risk Copyright K. Cuthbertson, D. Nitzsche

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

  21. 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 Coupon = 2 HPY = 10% + 2% = 12% Copyright K. Cuthbertson, D. Nitzsche

  22. 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 Copyright K. Cuthbertson, D. Nitzsche

  23. 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. Copyright K. Cuthbertson, D. Nitzsche

  24. Forward Rates and the Yield Curve Copyright K. Cuthbertson, D. Nitzsche

  25. Uses of Forward Rates Uses of Forward Rates Today, you can “lock in” an interest rate which will apply between two periods in the future (e.g. between end of year-1 and end of year-2, denoted f12 ) Also used in Pricing Forward Agreements replaced by: Forward Rate Agreements , FRA’s -Floating Rate Notes, FRN’s -Interest Rate Futures Contracts -Floating rate receipts, in an interest rate swap Copyright K. Cuthbertson, D. Nitzsche

  26. 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. Copyright K. Cuthbertson, D. Nitzsche

  27. Relationship between forward rate and spot rates • Equating 1 and 2 • $1( 1 + r2 )2 = $1( 1 + r1 ) (1 + f12 ) • Therefore • ( 1 + f12 ) = ( 1 + r2 )2 / ( 1 + r1 ) • Or, approximately (Let r1 = 9% p.a. and r2 = 10% pa ) • f12 = 2 . r2 - r1 = 2 (10) - 9 = 11% • 1) Correct forward rate is derived from current spot rates (yield curve) • 2) f12 is the rate a bank should quote • 3) Also it can be shown that f12 is the market’s best forecast of what the “the one-year rate in one-years time” (denoted Er1t+1 ) will be Copyright K. Cuthbertson, D. Nitzsche

  28. SELF STUDYAlgebra of General Calculation of Forward Rates Calculate other forward rates from today’s spot rates is pretty ‘intuitive’ since the superscripts and subscripts ‘add up’ to the same amount on each side of the equals sign ( 1 + r03 )3 = ( 1 + r02 )2 . (1 + f23 )1 ( 1 + r03 )3 = ( 1 + r01 )1 . (1 + f13 )2 In general (there is no need to memorise this!) fm,n = [ n / (n -m) ] rn - [ m / (n -m) ] rm e.g. f1,3 = [ 3 / 2 ] r3 - [ 1 / 2 ] r1 Copyright K. Cuthbertson, D. Nitzsche

  29. Yield Curve and the Expectations Hypothesis Copyright K. Cuthbertson, D. Nitzsche

  30. Figure 5 :YIELD CURVE Yield 7 A 6 4 • A Time to maturity 2 3 1 The yield curve is usually upward sloping. WHY? Copyright K. Cuthbertson, D. Nitzsche

  31. 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 Copyright K. Cuthbertson, D. Nitzsche

  32. Expectations Hypothesis (EH): Term Structure Arbitrage: assuming risk neutrality $1.( 1+ r2 ) 2 = $1. (1+r1) . [ 1 + Er12 ] Approx. r2 = ( 1 / 2 ) . [ r1 + Er12 ] EH implies 1.Long-rate r2 is weighted average of current (r1) and expected future (one-period) short rates Er12 Copyright K. Cuthbertson, D. Nitzsche

  33. Upward Sloping Yield Curve Rising yield curve implies that short rates are expected to be higher in the future and this is probably because inflation is expected to rise in future years Inflation Prediction from the yield curveObserve the current yield curve r2 = 6%, r1 = 5%, then f12 = 7.0% If real rate = 3%, then ( from Fisher effect) Expected annual inflation in 1-years time = 7 - 3 = 4% = Bank of England inflation forecast ? Copyright K. Cuthbertson, D. Nitzsche

  34. Data On Yields, Prices, Returns and Risk Copyright K. Cuthbertson, D. Nitzsche

  35. Asset Returns and Volatility (Annual): Data, 1926-97 Arith. Mean S.D Stocks (S&P500), Rm13 20.3 Small Stocks (bottom 5th on NYSE) 18 34 L.T Corp Bonds 6.1 8.7 L.T. Gov bonds 5.6 9.2 US T-bills, r 3.8 3.2 Inflation 3.6 5 Notes:1) dividends/coupons reinvested. 2) The geometric mean return would be less than the arithmetic mean return 3) arithmetic mean return is larger the shorter the horizon chosen(eg. 1-year versus 2-year returns etc, - this is because returns are ‘mean reverting’ (or have negative autocorrelation) over longer horizons,( ie. they are not statistically independent) - see elementary stats book. (Source Brealey & Myers 6th ed p156-164) Copyright K. Cuthbertson, D. Nitzsche

  36. 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)/ = 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% ? Copyright K. Cuthbertson, D. Nitzsche

  37. Volatility of S&P500 (Annual) US Data, 1930-97 S.D 1930’s 41.6 1940 17.5 1950 14.1 1960 13.1 1970 17.1 1980 19.4 1990-97 14.3 (Source Brealey & Myers 6th ed p156-164) Copyright K. Cuthbertson, D. Nitzsche

  38. RISK GRADES: FT 19/10/00 (for Oct 17th) BONDSEQUITY FX(rel to USD) Europe 25 86(135) 62(Euro) Americas 32 94(146) 49 Asia 21 98(139) 39(Yen) Global 38 107(156) …. UK 77 (115) Note: ( . .) = 52-week high 100 = average volatility of international equity mkts Copyright K. Cuthbertson, D. Nitzsche

  39. Figure 1.6 : US stock market (S&P500 and NASDAQ) Summary Statistics : (Jan. 95 to Sept. 00) S&P500 Nasdaq Mean 1.76% 3.41% Std. dev. 3.94% 7.56% Correlation : 0.6382 (monthly data) Nasdaq S&P500 S&P500 Copyright K. Cuthbertson, D. Nitzsche

  40. Figure 1.5: US Industrial Sectors Entertainment Industry Oil Industry Chemical Industry Financial Industry Automobile Industry Copyright K. Cuthbertson, D. Nitzsche

  41. Figure 1.7: ‘Local Currency’ Stock Indices Hang Seng S&P FTSE Nikkei Dax Copyright K. Cuthbertson, D. Nitzsche

  42. Figure 1.8: Asian Crises : Spot FX Rates $ per Malaysian Ringgit $ per Thai Baht $ per Indonesian Ruphia Copyright K. Cuthbertson, D. Nitzsche

  43. Slides End Here Copyright K. Cuthbertson, D. Nitzsche

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