FIN 4140 Financial Markets & Institutions

FIN 4140Financial Markets & Institutions Lecture 3-6

Valuation of Securities in Financial Markets • The valuation of a security is measured as the present value of its expected cash flows, discounted at a rate that reflects the uncertainty or risk. Since the cash flows and the uncertainty surrounding the cash flows for each security are unique, the value of each security is unique. Info on Economic Conditions Decide whether to take a position in security Assessment of firm’s expected cash flows Valuation of security Info on Industry condition Firm specific info -info provided by firms -info provided by other sources Mohammad KamrulArefin, MSc. in Quantitative Finance, University of Glasgow

Efficient Market • Efficient market hypothesis states that financial market process all relevant information about securities quickly and efficiently, that is, the security price usually reflects all the information available to investors concerning the value of the security. • According to this hypothesis, as new information about a security becomes available, the price of the security quickly adjusts so that at any time, the security price equals the market consensus estimate of the value of the security. If this were so, there would be neither underpriced nor overpriced securities. Mohammad KamrulArefin, MSc. in Quantitative Finance, University of Glasgow

Impact of Asymmetric information • Much of the information used to value securities issued by firms is provided by the managers of these firms. A firm’s managers possess information about its financial condition that is not necessarily available to investors. This situation is referred to as asymmetric information. • The gap between the information known by managers and the information available to investors can be reduced if managers frequently disclose financial data and information to the public. • Investors or financial experts opinion about a stock commonly rely on financial statements provided by the managers and firms that have publicly traded stock are required to disclose financial information. • However, an asymmetric information problem may still exist if some of the information provided by the firm’s managers can not be trusted. Mohammad KamrulArefin, MSc. in Quantitative Finance, University of Glasgow

Role of Financial Institutions in Financial Market • Perfect Market: In a perfect financial market, all information about any securities for sale in primary and secondary markets (including the credit worthiness of the security issuer) would be continuously and freely available to investors interested in purchasing securities and investors planning to sell securities. • Furthermore, all securities for sale could be broken down or unbundled into any size desired by investors, and security transaction costs would be non-existent and under these conditions financial intermediaries would not be necessary. Mohammad KamrulArefin, MSc. in Quantitative Finance, University of Glasgow

Role of Financial Institutions in Financial Market • Imperfect Market: Financial markets are generally imperfect, where securities buyers and sellers do not have full access to information and can not always break down securities to the precise size they desire. • Financial institutions are needed to resolve the problems caused by market imperfections. They received requests from surplus and deficit units on what securities are to be purchased or sold and they use this information to match up buyers and sellers of securities. • Because the amount of a specific security to be sold does not always equal the amount desired by investors, financial institutions sometimes unbundle the securities by spreading across several investors until the entire amount is sold. • Without financial institutions, the information and transactions costs of financial market transactions would be excessive. Mohammad KamrulArefin, MSc. in Quantitative Finance, University of Glasgow

Role of Depository Institutions • A major type of financial intermediary is the depository institution, which accepts deposits from surplus units and provides credit to deficit units through loans and purchases of securities. Depository institutions are popular financial institutions for the following reasons: • They offer deposit accounts that can accommodate the amount and liquidity characteristics desired by most surplus units. • They repackage funds received from deposits to provide loans of the size and maturity desired by deficit units. • They accept the risk on loans provided. • They have more expertise than individual surplus units in evaluating the credit-worthiness of deficit units. • They diversify their loans among numerous deficit units and therefore can absorb defaulted loans better than individual surplus units could. Mohammad KamrulArefin, MSc. in Quantitative Finance, University of Glasgow

Depository Institutions • Commercial Banks: Commercial banks are the most dominant depository institution. They serve surplus units by offering a wide variety of deposit accounts, and they transfer deposited funds to deficit units by proving loans or purchasing debt security of different maturity. • Savings Institutions: Saving institutions, which are sometimes referred to as thrift institutions, include saving and loan association (S&Ls) and savings banks. • Like commercial banks S&Ls offer deposit accounts to surplus units and then channel this deposits to deficit units. However S&Ls have concentrated on residential mortgage loans whereas commercial banks have concentrated on commercial loans. • Savings banks are similar to S&Ls except they have more diversified uses of funds. However this difference has narrowed over time. Mohammad KamrulArefin, MSc. in Quantitative Finance, University of Glasgow

Depository Institutions • Credit Unions: Credit unions differ from commercial banks and savings institutions in that they are non-profit and restrict their business to the credit union members, who share a common bond (such as common employer or union). Because of the common bond characteristics, credit unions tend to be much smaller than other depository institutions. They use most of their funds to provide loans to their members. Mohammad KamrulArefin, MSc. in Quantitative Finance, University of Glasgow

Role of non-depository Institutions • Non-depository financial institutions generate funds from sources other than deposits but also play a major role in financial intermediation. • Finance Companies: Most finance companies obtain funds by issuing securities, then lend the funds to individuals and small businesses. • Mutual Funds: Mutual funds sell shares to surplus units and use the funds received to purchase a portfolio of securities. Some mutual funds concentrate their investment on capital market securities like stocks and bonds while others, known as money market mutual funds, concentrate on money market securities. • By purchasing shares of mutual funds, small savers are able to invest in a diversified portfolio of securities with a relatively small amount of funds. • Securities Firms: Securities firms may provide single or all of the following variety of functions in financial markets: • 1) Broker 2) Underwriter 3) Dealer Mohammad KamrulArefin, MSc. in Quantitative Finance, University of Glasgow

Role of non-depository Institutions • Broker: Brokers charge a fee for securities transactions between two parties • Underwriter or investment banker: Some securities firms place newly issued securities in the primary market for corporations and government agencies • When securities firms underwrite newly issued securities, they may sell the securities at a guaranteed price or at the best price for a client. • Another investment banking activity offered by securities firms is advisory services on mergers and other forms of corporate restructuring. • Securities firms may not only help a firm plan its restructuring but also execute the change in the firm’s capital structure by placing the securities issued by the firm. • Dealer: Securities firms often act as dealers, making a market in specific securities by adjusting their inventory of securities. A dealer’ income is influenced by the performance of the security portfolio maintained. Mohammad KamrulArefin, MSc. in Quantitative Finance, University of Glasgow

Role of non-depository Institutions • Insurance Companies: Insurance companies provide insurance policies to individuals and firms that reduce the financial burden associated with death, illness, and damage to property. They charge premiums in exchange for the insurance that they provide and invest the funds in stocks or bonds issued by corporations or in bonds issued by the government. • Pension Funds: Many corporations and government agencies offer pension plans to their employees. The employees, their employers or both periodically contribute funds to the plan. Pension funds provide an efficient way for individuals to save for their retirement. • The pension funds manage the money until the individuals withdraw the funds from their retirement accounts. They invest the fund in stocks or bonds issued by corporations or bonds issued by government. • See exhibit 1.4 & 1.5 Mohammad KamrulArefin, MSc. in Quantitative Finance, University of Glasgow

Determination of Interest Rates • Interest rate movements have a direct influence on the market values of debt securities, such as money market securities, bonds, mortgages and have an indirect influence on equity security values. • Thus managers of financial institutions attempt to anticipate interest rate movements so that they can capitalize on favorable movements and reduce their institutions’ exposure to unfavorable movement. • Loanable Funds Theory: This theory suggests that the market interest rate is determined by the factors that control the supply of and demand for loanable funds. • This theory is especially useful for explaining movements in the general level of interest rates for a particular country. • The common sectors that demand loanable funds are households, businesses, and governments. • Household and government are the largest supplier of loanable funds in the market. Mohammad KamrulArefin, MSc. in Quantitative Finance, University of Glasgow

Household Demand for Loanable Funds • Households commonly demand loanable funds to finance housing expenditures, purchase of automobiles, household items etc. Households would demand a greater quantity of loanable funds at lower interest rate, considering all other factors constant. Thus there is an inverse relationship between the interest rate and the quantity of loanable funds demanded. • However various events can cause household borrowing preferences to change and thereby shift in the demand schedule. For example, if tax rates on household income are expected to significantly decrease in the future, household might believe that they can more easily afford future loan repayments and thus be willing to borrow more funds. For any interest rate, the quantity of loanable funds demanded by households would be greater as a result of the tax law adjustment. This represents an outward shift in the demand schedule. Mohammad KamrulArefin, MSc. in Quantitative Finance, University of Glasgow

Business Demand for Loanable Funds • Businesses demand loanable funds to invest in long term (fixed) and short term assets. The quantity of funds demanded by businesses depends on the number of business projects to be implemented. • Projects with a positive NPV are accepted because the present value of all cash flows outweighs the required return from the project. • The required return to implement a given project will be lower if interest rates are lower because the cost of borrowing funds to support the project will be lower. • Consequently, more projects will have positive NPVs, and businesses will need a greater amount of financing. This implies that business will demand a greater quantity of loanable funds when interest rates are lower. • The business demand for loanable funds schedule can shift in reaction to any events that affect business borrowing preferences. If economic conditions become more favorable, the expected cash flows from various projects will increase. Thus more projects will have positive NPV causing in increased demand for loanable funds and an outward shift in the demand curve. Mohammad KamrulArefin, MSc. in Quantitative Finance, University of Glasgow

Government Demand for Loanable Funds • Whenever a government’s planned expenditures can not be completed covered by its incoming revenues from taxes and other sources, it demands loanable funds. Municipal govt (state and local) issue municipal bonds while the federal govt issue treasury securities to obtain funds. These securities represent govt debt. • Federal govt expenditure and tax policies are generally thought to be independent of interest rates. Thus federal govt demand for funds is said to be interest in-elastic or insensitive to interest rates. • In contrast, municipal govt sometimes postpone proposed expenditures if the cost of financing is too high, implying that their demand for loanable funds are somewhat sensitive to interest rates. • If new bills are passed that cause a net increase of $20 billion in the deficit, the federal govt demand for loanable funds will increase by that amount and push the demand curve outward. Mohammad KamrulArefin, MSc. in Quantitative Finance, University of Glasgow

Foreign Demand for Loanable Funds • A foreign country’s demand for US funds is influenced by the differential between its interest rates and US rates (along with other factors). Other things being equal, a larger quantity of US funds will be demanded by foreign governments and corporations if their domestic interest rates are high relative to US rates. • Therefore, for a given set of foreign interest rates, the quantity of US loanable funds demanded by foreign governments or firms will be inversely related to US interest rates. • If foreign interest rates rise, foreign firms and governments will likely increase their demand for US funds causing an outward shift in the demand curve. Mohammad KamrulArefin, MSc. in Quantitative Finance, University of Glasgow

Aggregate Demand for Loanable Funds • The aggregate demand for loanable funds is the sum of the quantities demanded by the separate sectors at any given interest rates. Because most of these sectors are likely to demand a larger quantity of funds at lower interest rates (other things being equal), the aggregate demand for loanable funds is inversely related to interest rates at any point in time. Supply of Loanable Funds • The term supply of loanable funds is commonly used to refer to funds provided to financial markets by savers. The household sector is the largest supplier, but loanable funds are also supplied by some government units that temporarily generate more tax revenues than they spend or by some businesses whose cash inflows exceed outflows. • Households as a group, however, represent a net supplier of loanable funds, whereas governments and businesses are net demanders of loanable funds. Mohammad KamrulArefin, MSc. in Quantitative Finance, University of Glasgow

Supply of Loanable Funds • Suppliers of loanable funds are willing to supply more funds if the interest rate (reward for supplying funds) is higher, other things being equal. A supply of loanable funds exists at even a very low interest rate because some households choose to postpone consumption until later years, even when the reward for saving is very low. • The supply of loanable funds is also influenced by the monetary policy implemented by the Central Bank. The Central Bank (e.g. Bangladesh Bank) controls the amount of reserves held by depository institutions and can influence the amount of savings that can be converted into loanable funds. • The aggregate supply schedule of loanable funds is somewhat interest-inelastic or insensitive to interest rates with steep slope. • The supply curve can shift in or out in response to various conditions. For example if the tax rate on interest income is reduced, the supply curve will shift outward, as households save more funds at each possible interest rate level. Mohammad KamrulArefin, MSc. in Quantitative Finance, University of Glasgow

Economic Forces That Affect Interest Rates • Impact of economic growth on interest rates: As a result of more optimistic economic projections, most businesses increase their planned expenditures for expansion, which translates into additional borrowing. The aggregate demand schedule will shift outward. The supply of loanable funds schedule may also shift, but it is more difficult to know how it will shift. • It is possible that the increased expansion by businesses will lead to more income for construction crews and others who serve the expansion. In this case, the quantity of savings, and therefore of loanable funds supplied at any possible interest rate, could increase, causing an outward shift in the supply schedule. Yet, there is no assurance that the volume of savings will actually increase. Even if a shift occurs, it will likely be of a smaller magnitude than the shift in the demand schedule, resulting in an increase in the equilibrium interest rate. • Just as economic growth puts upward pressure on interest rates, an economic slow down or recession puts downward pressure on the equilibrium interest rate. Mohammad KamrulArefin, MSc. in Quantitative Finance, University of Glasgow

Economic Forces That Affect Interest Rates • Impact of inflation on interest rates: Inflation can affect interest rate through affecting demand and supply of loanable funds. During a situation, when inflation rate is expected to increase, households that supply funds may reduce savings at any interest rate level, so that they can make more purchases now before prices rise. This shift in behavior is reflected by an inward shift in the supply curve of loanable funds. • In addition, households and businesses may be willing to borrow more funds at any interest rate level so that they can purchase products now before prices increase. This is reflected by an outward shift in the demand curve for loanable funds. The new equilibrium interest rate is higher because of the shifts in saving and borrowing behavior. Mohammad KamrulArefin, MSc. in Quantitative Finance, University of Glasgow

Economic Forces That Affect Interest Rates • Fisher Effect: Irving Fisher proposed that nominal interest payments compensate savers in two ways. First, they compensate savers’ reduced purchasing power. Second they provide an additional premium to savers for forgoing present consumption. Savers are willing to forgo current consumption only if they receive a premium on their savings above the anticipated rate of inflation, as shown in the following formula: • I = E (Inf) + IR • Here, I = Nominal rate of interest • E (Inf) = Expected inflation rate • IR= Real interest rate • This relationship between interest rate and expected inflation is often referred to as the Fisher Effect. The difference between the nominal interest rate and expected inflation rate is the real return (real interest rate) to a saver after adjusting for the reduced purchasing power over the time period of concern. Mohammad KamrulArefin, MSc. in Quantitative Finance, University of Glasgow

Economic Forces That Affect Interest Rates • There is a positive (though not perfect) relationship between nominal interest rate and inflation rates over time. • When the inflation rate is higher than anticipated, the real interest rate is relatively low. Borrowers benefit because they were able to borrow at a lower nominal interest rate than would have been offered if inflation had been accurately forecasted. When inflation rate is lower than anticipated, the real interest rate is relatively high and borrowers are adversely affected. Mohammad KamrulArefin, MSc. in Quantitative Finance, University of Glasgow

Economic Forces That Affect Interest Rates • Impact of money supply on interest rates: The central bank can offset the supply of loanable funds by increasing or reducing the total amount of deposits held at commercial banks or other depository institutions. When central bank increases money supply, it increases the supply of loanable fund, which places downward pressure on interest rates. • However, if central bank’s action affect inflationary expectations, this will also increase the demand for loanable funds, which could offset the effect of the increase in the supply of funds. • If central bank reduces money supply, it reduces the supply of loanable funds, which places upward pressure on interest rates. Mohammad KamrulArefin, MSc. in Quantitative Finance, University of Glasgow

Economic Forces That Affect Interest Rates • Impact of budget deficit on interest rates: A higher government deficit increases the quantity of loanable funds demanded at any prevailing interest rate, causing an outward shift in the demand schedule. Assuming no offsetting increase in the supply schedule, interest rates will rise. • Given a certain amount of loanable funds supplied to the market, excessive government demand for this funds tends to crowd out the private demand (by consumers or businesses) for funds. The govt may be willing to pay whatever is necessary to borrow these funds, but private sector may not. This impact is known as the crowding-out effect. Thus interest rate will increase due to excessive demand for loanable funds. • However, there is counter-argument that the supply schedule might shift outward if govt creates more job by spending more funds. If this were to occur, the deficit might not necessarily put upward pressure on interest rates. Research shown that higher deficit place upward pressure on interest rates. Mohammad KamrulArefin, MSc. in Quantitative Finance, University of Glasgow

Economic Forces That Affect Interest Rates • Impact of foreign flow of funds on interest rates: Investors from other countries commonly invest in savings accounts or debt securities in countries where interest rates are high and where the currency is no expected to weaken. Mohammad KamrulArefin, MSc. in Quantitative Finance, University of Glasgow

Chapter 3: Structure of Interest Rates Mohammad KamrulArefin, MSc. in Quantitative Finance, University of Glasgow

Characteristics of Debt Securities That Cause Their Yields to Vary • Debt securities offer different yields because they exhibit different characteristics that influence the yield to be offered. In general, securities with unfavorable characteristics will offer higher yields to entice investors. The yields on debt securities are affected by the following characteristics: • Credit (default) Risk • Liquidity • Tax Status • Term to Maturity • Special Provisions Mohammad KamrulArefin, MSc. in Quantitative Finance, University of Glasgow

Characteristics of Debt Securities That Cause Their Yields to Vary • Credit (default) Risk: Because most securities are subject to the risk of default (non-payment), investors must consider the credit-worthiness of the security issuer. • Although investors always have the option of purchasing risk-free treasury securities, they may prefer some other securities if the yield compensates them for the risk. • Securities with a higher degree of risk would have to offer higher rate of return. Credit risk is especially relevant for longer term securities that expose creditors to the possibility of default for a longer time. • Small investors can benefit from bond ratings provided by rating agencies who assess the creditworthiness of corporations that issue bonds. These ratings are based on a financial assessment of the issuing corporation and the higher the rating, the lower the perceived credit risk. Mohammad KamrulArefin, MSc. in Quantitative Finance, University of Glasgow

Characteristics of Debt Securities That Cause Their Yields to Vary • Liquidity: Investors prefer securities that are liquid, meaning that they could be easily converted to cash without a loss in value. • Thus if all other characteristics are equal, securities with lower liquidity will have to offer a higher yield to be preferred. Securities with a short term maturity or an active secondary market have higher liquidity. • Investors who will not need funds until the securities mature can tolerate lower liquidity. Other investors, however, are willing to accept a lower return in exchange for a high degree of liquidity. Mohammad KamrulArefin, MSc. in Quantitative Finance, University of Glasgow

Characteristics of Debt Securities That Cause Their Yields to Vary • Tax status: Investors are more concerned with after tax income than before tax income earned on securities. If all other characteristics are similar, taxable securities will have to offer a higher before tax yield to investors than tax exempt securities to be preferred. • The extra compensation required on such taxable securities depends on the tax rates of individual and institutional investors. Investors in high tax brackets benefit most from tax exempt securities. • When assessing the expected yields of various securities with similar risk and maturity, it is common to convert them into an after tax form, as follows: • Yat = Ybt (1- T) • Here, Yat = after tax yield • Ybt= before tax yield • T= Investors marginal tax rate Mohammad KamrulArefin, MSc. in Quantitative Finance, University of Glasgow

Characteristics of Debt Securities That Cause Their Yields to Vary • Special Provisions: If a security offers any special provision to investors, its yield may be influenced. One type of provision, called a call feature, allows the issuer of the bonds to buy the bonds back before maturity at a specified price. • Because a call feature could force investors to sell their bonds sooner than they would like, investors may require extra compensation to purchase the bonds. • Another special provision of bonds that can affect the yield is a convertibility clause, which allows investors to convert the bond into a specified number of common stock shares. If the market price of the bonds declines, investors who want to dispose of the bonds have an alternative to selling them in the market. For this reason, investors will accept a lower yield on securities that contain the convertibility feature, other things being equal. • Term to Maturity: Maturity differs among securities and is another reason that security yield differ. The term structure of interest rates defines the relationship between maturity and annualized yield, holding other factors such as risk constant. Mohammad KamrulArefin, MSc. in Quantitative Finance, University of Glasgow

The Term Structure of Interest Rates • Yield to Maturity (YTM): Yield to Maturity is defined as the interest rate that makes the present value of future cash flows from the bond equals to its market price. In other words it is the internal rate of return to the bond. • Yield Curve: Yield curve is a plot of yield to maturity as a function of time to maturity. The yield curve is also called the term structure of interest rates and it helps us extract the appropriate rates that should be used to discount cash flows at different maturities. There are various relationship between yield and their maturity. Most common patterns: • Upward sloping • Downward sloping (inverted) • Flat • Hump-shaped (rising and then falling) Mohammad KamrulArefin, MSc. in Quantitative Finance, University of Glasgow

The Term Structure of Interest Rates • Interest rate uncertainty and forward rates: Suppose you buy a 2-year zero coupon bond and hold it till maturity. Alternatively another investor buys a 1 year zero coupon bond and roll it over at the end of the first year for another year (i.e. buy another 1 year zero). If interest rates are known with certainty then these two strategies should yield the same return. • In case we deal with uncertain interest rates and investors are risk-neutral (care only about expected returns), then the previous relationship can be written as • However, investors are risk averse, so to get rid of uncertainty and establish a link between current and future rates, we use forward rates. Mohammad KamrulArefin, MSc. in Quantitative Finance, University of Glasgow

The Term Structure of Interest Rates • Now suppose you buy a 2-year zero coupon bond and hold it till maturity. Alternatively another investor buys a 1 year zero coupon bond and agrees today the rate at which he will roll over his investment at the end of the first year for another year (i.e. the forward rate). These two strategies should yield the same return because by locking the rate today (the forward rate), there is no uncertainty. • In case we deal with uncertain interest rates and investors are risk-neutral (care only about expected returns), then the previous relationship can be written as • However, the interest rate that will actually prevail in the future will not necessarily be equal to the corresponding forward rate extracted today. Mohammad KamrulArefin, MSc. in Quantitative Finance, University of Glasgow

The Term Structure of Interest Rates • Pure Expectations Theory: This theory explains that spot rates are determined by expectations of what rates will be in the future. • Suppose for an upward sloping yield curve with rates increasing for longer maturities, the 2 year rate is greater than the 1 year rate. This is so because the market believes that the 1 year rate will most likely go up next year (because most people believe inflation will rise and thus to maintain the same real rate of interest, the nominal rate must increase). This majority belief that the interest rate will rise translates into a market expectation. An expectation is only an average guess. • According to this theory, the forward rate equals the today’s market consensus expectation of future spot rate. Mohammad KamrulArefin, MSc. in Quantitative Finance, University of Glasgow

The Term Structure of Interest Rates • An upward sloping yield curve is an indication that the interest rates are expected to increase with maturity. • A flat yield curve is an indication that the interest rates are expected to remain same. • A downward sloping yield curve is an indication that the interest rates are expected to fall with maturity. Mohammad KamrulArefin, MSc. in Quantitative Finance, University of Glasgow

The Term Structure of Interest Rates • Liquidity Preference Theory: This theory assumes that investors require a higher expected return (premium) to induce them to hold bonds with maturities different from their investment horizons. • If the investor has a short term horizon, then he needs premium to hold a long term bond (upward sloping curve, ceteris paribus), because he would be exposed to interest rate risk. • If the investor has a long term horizon, then he needs a premium to hold a short term bond –downward sloping ( because he runs the risk of re-investing his capital at an uncertain rate) • Advocates of the liquidity preference theory of the term structure believe that short term investors dominate the market so that the forward rate will generally exceed the expected future spot rate or short rate. Mohammad KamrulArefin, MSc. in Quantitative Finance, University of Glasgow

The Term Structure of Interest Rates • Segmented Markets Theory: According to this theory, investors and issuers of debt seem to have a strong preference for debt of certain maturity and may be indifferent to yield differentials among maturities. • Therefore, if investors are sufficiently risk averse, they will operate only in their desired maturity spectrum. • What determines the yield at each maturity is solely the supply and demand for funds at this specific maturity. • As a result, examining flows of funds into these market segments can help predict changes in the yield curve. Mohammad KamrulArefin, MSc. in Quantitative Finance, University of Glasgow

FIN 4140 Financial Markets & Institutions