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Introduction to Capital Markets

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B, K & M Chapter 2

End of chapter problems: 2,7,9,12,13,15

- Value of Outstanding debt in 2005:
- Treasury Securities: ≈ $4.3 Trillion Bills ≈ 21%
- Notes ≈ 62%
- Bonds ≈ 17%
- Gov-sponsored enterprise ≈ $2.6 Trillion
- (Freddie Mac), (Fannie Mae), (Sallie Mae), etc
- U.S. Corporate Bond Mkt: ≈ $3.0 Trillion
- Muni’s: ≈ $ 1.9 Trillion
- Mortgage Backed Securities: ≈ $3.5 Trillion

- Value of U.S. Equities in 2005: ≈ $20.0 Trillion,
- Residential Real Estate: ≈ $20.1 Trillion
- US GDP in 2005: ≈ $12.8 Trillion

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
- Minimum denomination of $10,000
- 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

Effective Annual Yield (rate of return) on a pure discount bond is defined as r:

Where:

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)

EXAMPLE:

- Unsecured notes issued by large (credit worthy) corporations
- “Disintermediation” Since the late 1980’s 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

- 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!

- Dollar denominated deposits at foreign banks or foreign branches of American banks
- Of course, no deposit insurance

- Fed funds are bank deposits at a bank’s 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”

- 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

COMPUTATION OF BANK DISCOUNT (FULL DISCOUNT)

- Although Treasury bills (T-bills), Commercial Paper (CPs), and Bankers Acceptances (BAs) are widely quoted & traded on a rate basis often called “yield,” they are actually quoted & calculated on a bank discount basis. The computation of the discount is based on the actual number of days to maturity, 360 days per year, according to the following formula:
- Full Discount Maturity = (Discount Basis/360) x Days to Maturity
- Dollar Price = $100 – Full Discount

- The rate at which large banks in London are willing to lend money among themselves
- Premier short-term rate in the European money market

- 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))

- 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.
- 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)

- Introduced in the 1990s
- Face value is inflation adjusted (although the principal adjustments are taxable events)

Government National Mortgage Association (Ginnie Mae)

Federal National Mortgage Association (Fannie Mae)

Federal Home Loan Mortgage Corporation (Freddie Mac)

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)

- 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
- Mortgages are issued by approved lenders such as commercial banks and mortgage brokers, with underwriting standards established by Ginnie Mae
- The mortgage originator may continue to service the loan, collecting interest and principal payments, “passing” these along to the mortgage purchaser
- The security guaranteed by Ginnie Mae is called a mortgage-backed security (MBS), and is sold with a minimum denomination of $25,000

- Freddie Mac and Fannie Mae provide liquidity to the mortgage market by purchasing mortgages, and then issuing MBS’s creating a secondary market
- Although referred to as “Agencies”,the government guarantee is only implicit
- MBS’s 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!)

- A major risk to pass-through 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

- 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

- 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)

Mortgage-Backed Securities Outstanding, 1979-2005

- 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:
- At what tax bracket are investors indifferent between taxable and tax exempt bonds?

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%?

- 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.

- 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:
- BB (S&P), Ba (Moody's)

- Residual claim
- Limited Liability
- Note: For most stocks, the individual investor is no longer the marginal investor

- 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

(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?

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

- Larger samples are more difficult to handle (without a computer) but are more representative
- Older indexes tend to be based on fewer stocks

- 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!?

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

A 10%

B -5%

C 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%

- A general 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

- 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

- 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

- Wilshire 5000 (5000 NYSE, AMEX, and OTC stocks)
- NASDAQ Comp (2000 NASDAQ stocks)

Correlation Coefficients between Different U.S. Stock Market Indicators

(Monthly Returns form 1975-1988)

DJIAS&P400S&P500NYSEAMEXOTCINDOTCCOMPCRSPEQWCRSPVW

DJIA 1.000

S&P4000.958 1.000

S&P5000.953 0.9771.000

NYSE0.889 0.9090.9111.000

AMEX0.675 0.7380.7360.7361.000

OTCIND0.735 0.7700.7530.7370.7621.000

OTCCOMP0.768 0.7820.7850.7840.7820.8811.000

CRSPEQ0.937 0.9450.9450.9400.8440.7430.8011.000

CRSPVW0.944 0.9490.9590.9560.8530.7650.8130.9221.000

DJIA = Dow Jones Industrial Average

S&P400 = Standard & Poor’s 400 Industrial Stock Index

S&P500 = Standard & Poor’s 500 Stock Composite Index

NYSE = New York Stock Exchange Index

AMEX = American Stock Exchange Average

OTCIND = Over-the-Counter Index

OTCCOMP = OTC Composite Stocks Average

CRSPEQW = Center for Research on Securities Prices (CRSP) Equally-Weighted Stocks Index

CRSPVW = Center for Research on Securities Prices (CRSP) Value-Weighted Stocks Index

- Three most well-known groups are those of Merril Lynch, Lehman Brothers, and Salomon Smith Barney
- Most are computed monthly
- Include interest and capital gains
- Somewhat imprecise because of infrequent trading

What Every CFO Should Know About Scientific Progress in Financial Economics:What Is Known and What Remains to be ResolvedRoll, Richard, "What Every CFO Should Know About Progress in Financial Economics,"Financial Management, Summer 1994, 69-75.

- Option Valuation: Valuation of Simple and Complex Options is considered THE most important topic a CFO should understand!
- Many capital budgeting projects have option components (e.g. callable or convertible corporate debt, etc)
- Roll argues “option theory ought to be the first thing taught in finance, even before discounting arithmetic.”

- Asset securitization (e.g. CMOs, mortgage pass-throughs, credit card receivables, automobile loans, etc) as an application of complex option valuation (i.e. prepayment contingent current and expected future refinancing rate, value of the securitized asset, etc)
- An Interest Rate “Process”: using a factor model (single- or multi-factor) of the time series of spot interest rates
- A Prepayment Model: with many explanatory variables (e.g. geographic, maturity, duration, individual’s characteristics, etc) empirically fit prepayments on large aggregates of mortgages, but provide little explanatory power for individual pools of mortgages
- Numerical Integration or Monte Carlo Simulation: combines the interest rate process and the prepayment model.

- Methods for Hedging: After Option Valuation, Methods for Hedging is the second tool that should be in the CFO’s kit!
- Although financial economists do not yet fully understand risk and return, there are techniques available to reduce risk by employing derivatives
- Foreign Exchange (currency) risk can be hedged using currency hedges (forex) to lock in an exchange rate
- Commodity price risk can be hedged using commodity futures or futures options

- Interest rate risk (basis risk) can be hedged by measuring duration gap an using derivatives (cap/floors/collars, interest rate swaps, etc)
- Credit (default) risk can now be hedged using new types of credit derivatives

- Certain Economic Parity Conditions: The third most important CFO tool that may perhaps avoids the cost of unnecessary hedging!
- Interest Rate Parity is the condition that exists when the interest rate differential between two currencies is approximately (within transactions costs bounds) equal to the forward premium or discount (the difference between the spot exchange rate and the forward exchange rate) between the same two currencies: F is the forward rate, E is the $ to purchase a pound, and r is the risk-free rate.

- Interest Rate Parity:
- - Assumes both currency contracts have equivalent default risk and the same time horizon
- Any departure from interest rate parity is assumed to be due to non-comparability between contracts

- Efficient Market Theory: This is the fourth concept learned by every CFO!
- Market Inefficiency does not refer to market “anomalies” that have potential explanations based on mis-estimation of risks or costs (e.g. small-firm effect, closed-end fund discounts, etc)
- Market Inefficiency refers instead to intertemporal (across time) pricing anomalies exploitable by a defined trading rule (e.g. the January effect, day-of-the-week effect, etc)

- Most of these types of Market Inefficiencies do not provide excess returns compared to a buy-and-hold strategy when transaction costs are included
- Many of these Market Inefficiencies may have provided excess profits prior to their announcement in the academic press, but now the market arbitrages away any excess return – competition will eventually assure that trading rules just cover costs

- “Hawk and Dove Strategies”: In the competition for ‘undervalued’ assets, the ‘hawk’ investor conducts security analysis while the ‘dove’ investor expends no resources on information generation – if everyone is a ‘hawk’, the benefits will be less than the costs, but if everyone is a ‘dove’, the benefits of analysis will be tremendous (Grossman-Stiglitz Paradox)
- Although most persons suffer from numerous irrationalities, there is probably enough rationality within each of us that, when averaged over countless individuals (law of large numbers or portfolio diversification effect) produce a result that appears to be rational and efficient

- Normative Portfolio Theory: Every CFO should grasp how individual assets can be combined to obtain a portfolio that differs from the average of its constituent parts!
- Every CFO should know that the asymptotic volatility (measure of risk) of a portfolio is the average covariance; that mean/variance efficient combinations are not necessarily equal- or value-weighted; that they have particular common properties (such as being positively correlated)

- Model of Risk & Return: This is perhaps the most important unresolved problem because it influences so may other problems!
- Without a risk/return model that enables us to quantify the required rate of return for an investment project, it cannot be valued

- The single greatest risk/return innovation was the CAPM (Capital Asset Pricing Model
- Provided insight that priced risk is non-diversifiable – it cannot be eliminated trough portfolio averaging
- Recent research indicates that , the single risk factor in the CAPM, explains virtually none of the observed cross-sectional variance in average returns, while market capitalization and market-to-book value ratio variables do

- Arbitrage Pricing Theory (APT) shares CAPM’s belief that only non-diversifiable risk is priced, but offers a multi-factor model (compared to CAPM’s single-factor). Factor analysis indicates that there are for factors that are ‘priced’ for a cross-section of stocks. Unfortunately, factor analysis fails to identify WHAT these factors are!

- Dividend Policies: Why are dividends paid? Most dividends are double-taxed! An alternative to paying dividends is a corporate share repurchase program where each individual shareholder elects to tender shares
- Under-Pricing of IPOs: Why are IPOs systematically under-priced (i.e. why is there generally a large price ‘run-up’ after IPO shares are initially issued?)