Introduction to Capital Markets B, K & M Chapter 2 End of chapter problems: 2,7,9,12,13,15
The Capital Markets Overview • 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 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 • 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
T-Bills (cont.) 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)
T-Bills (cont.) EXAMPLE:
Commercial Paper • 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
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 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”
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
Bank Discount Method Computations 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
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
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. • 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 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)
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 • 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
Federal Agency Debt (cont.) • 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!)
Federal Agency Debt (cont.) • 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
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.) Mortgage-Backed Securities Outstanding, 1979-2005
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: • At what tax bracket are investors indifferent between taxable and tax exempt bonds?
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: • BB (S&P), Ba (Moody's) • Taxable (interest and capital gains) • Maturities up to 30 years
Common Stock • Residual claim • Limited Liability • Note: For most stocks, the individual investor is no longer the marginal investor
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 RETURN 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%
Averaging • 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
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)
Correlation Coefficients between Different U.S. Stock Market Indicators (Monthly Returns form 1975-1988) DJIA S&P400 S&P500 NYSE AMEX OTCIND OTCCOMP CRSPEQW CRSPVW DJIA 1.000 S&P400 0.958 1.000 S&P500 0.953 0.977 1.000 NYSE 0.889 0.909 0.911 1.000 AMEX 0.675 0.738 0.736 0.736 1.000 OTCIND 0.735 0.770 0.753 0.737 0.762 1.000 OTCCOMP 0.768 0.782 0.785 0.784 0.782 0.881 1.000 CRSPEQ 0.937 0.945 0.945 0.940 0.844 0.743 0.801 1.000 CRSPVW 0.944 0.949 0.959 0.956 0.853 0.765 0.813 0.922 1.000 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 Correlations
Bond Market Indexes • 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.
Five Topics in Financial Economics That Have Been Scientifically Settled • 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.”
Five Topics in Financial Economics That Have Been Scientifically Settled (cont.) • 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.
Five Topics in Financial Economics That Have Been Scientifically Settled (cont.) • 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