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11/9/2001
LECTURE :MARKETS,FIRMS AND INVESTORS
Copyright K. Cuthbertson and, D. Nitzsche
K. Cuthbertson
Types of Financial Assets:Lending
and Borrowing Funds
Copyright K. Cuthbertson, D. Nitzsche
“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
Copyright K. Cuthbertson, D. Nitzsche
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.
LENDING AND BORROWING
Copyright K. Cuthbertson, D. Nitzsche
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
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: Short-term
Copyright K. Cuthbertson, D. Nitzsche
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
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
Raising Funds: Shares/Equity
Copyright K. Cuthbertson, D. Nitzsche
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)
Raising Funds: Mezzanine Finance
Copyright K. Cuthbertson, D. Nitzsche
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
Flow of Funds
Copyright K. Cuthbertson, D. Nitzsche
Primary Lenders :
Personal Sector and
Primary Borrowers :
Companies and Government
Lenders and Borrowers
Copyright K. Cuthbertson, D. Nitzsche
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
MARKETS and DEALERS
Copyright K. Cuthbertson, D. Nitzsche
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
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
Market Maker (MM)
MM BMM Buys "low" at Bid price
MM 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
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)
Prices Respond To ‘News’
Copyright K. Cuthbertson, D. Nitzsche
Returns And Risk
Copyright K. Cuthbertson, D. Nitzsche
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
Prices and Returns:
HPR = Capital Gain + Running(Dividend) Yield
Shares P1 = 100 P2 = 110 D2 = 5
HPR = 10% + 5% = 15%
Bonds P1 = 100 P2 = 110 Coupon = 2HPY = 10% + 2% = 12%
Holding Period Return ( Yield):
Is the “return” when the asset is sold prior to maturity
Copyright K. Cuthbertson, D. Nitzsche
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 returnCopyright K. Cuthbertson, D. Nitzsche
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 premiume.g. Av. Return = 12% p.a. Av. r = 4% p.a.
Then ex-post (equity) risk premium = 8% p.a.
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
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
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
Copyright K. Cuthbertson, D. Nitzsche
Copyright K. Cuthbertson, D. Nitzsche
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
Relationship between forward rate and spot rates
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
Yield Curveand the
Expectations Hypothesis
Copyright K. Cuthbertson, D. Nitzsche
Yield
6
4
1 2 Time to maturity
A
A
3
7
The yield curve is usually upward sloping. WHY?
Figure 5 :YIELD CURVE
Copyright K. Cuthbertson, D. Nitzsche
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
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
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
Data On Yields, Prices,
Returns and Risk
Copyright K. Cuthbertson, D. Nitzsche
Asset Returns and Volatility (Annual): Data, 1926-97
Arith. Mean S.DStocks (S&P500), Rm 13 20.3Small Stocks(bottom 5th on NYSE) 18 34
L.T Corp Bonds 6.1 8.7L.T. Gov bonds 5.6 9.2US T-bills, r 3.8 3.2Inflation 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
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% ?
Asset Returns and Volatility (Annual): Data, 1926-97
Copyright K. Cuthbertson, D. Nitzsche
Volatility of S&P500 (Annual) US Data, 1930-97
S.D1930’s 41.6
1940 17.51950 14.11960 13.1
1970 17.11980 19.41990-97 14.3
(Source Brealey & Myers 6th ed p156-164)
Copyright K. Cuthbertson, D. Nitzsche
RISK GRADES: FT 19/10/00 (for Oct 17th)
BONDS EQUITY 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
Summary Statistics :(Jan. 95 to Sept. 00)
S&P500 NasdaqMean 1.76% 3.41%Std. dev. 3.94% 7.56%
Correlation : 0.6382(monthly data)
Figure 1.6 : US stock market (S&P500 and NASDAQ)
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03/01/95 03/01/96 03/01/97 03/01/98 03/01/99 03/01/00 03/01/01
Nasdaq
S&P500
S&P500
Copyright K. Cuthbertson, D. Nitzsche
Figure 1.5: US Industrial Sectors
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Entertainment Industry
Oil Industry
Financial Industry
Chemical Industry
Automobile Industry
Copyright K. Cuthbertson, D. Nitzsche
Figure 1.7: ‘Local Currency’ Stock Indices
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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
Nikkei
S&P
Dax
FTSE
Copyright K. Cuthbertson, D. Nitzsche
Figure 1.8: Asian Crises : Spot FX Rates
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05/02/96 01/12/96 27/09/97 24/07/98 20/05/99 15/03/00 09/01/01
$ per Malaysian Ringgit
$ per Indonesian Ruphia$ per Thai Baht
Copyright K. Cuthbertson, D. Nitzsche
Slides End Here
Copyright K. Cuthbertson, D. Nitzsche