Transcript Creation of financial assets

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
“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
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
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
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
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
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
Raising Funds: Mezzanine Finance
Junk/High-yield/ low-grade / BONDS - I.e. below BBB rated
- subordinated debt (last in interest payment and ‘debtqueue’)
- 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
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
Lenders and Borrowers
Primary Lenders :
Personal Sector and
Primary Borrowers :
Companies and Government
Copyright K. Cuthbertson, D. Nitzsche
Government
If taxes are insufficient to cover expenditure
• Budget Deficit = G - T
Financed by:
( ‘PSBR’ in the UK )
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 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
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
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:
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
HPY = 10% + 2% = 12%
Copyright K. Cuthbertson, D. Nitzsche
Coupon = 2
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
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
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
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
Relationship between forward rate and spot rates

Equating 1 and 2
$1( 1 + r2 )2 = $1( 1 + r1 ) (1 + f12 )





Therefore
( 1 + f12 )
= ( 1 + r 2 )2 / ( 1 + r 1 )
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
SELF STUDY
Algebra 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 Curve
and the
Expectations Hypothesis
Copyright K. Cuthbertson, D. Nitzsche
Figure 5 :YIELD CURVE
Yield
7
6
A
4
A
1
2
3
Time to
maturity
The yield curve is usually upward sloping. WHY?
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 curve
Observe 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
Stocks (S&P500), Rm
Small Stocks
(bottom 5th on NYSE)
L.T Corp Bonds
L.T. Gov bonds
US T-bills, r
Inflation
Arith. Mean
13
S.D
20.3
18
34
6.1
5.6
3.8
3.6
8.7
9.2
3.2
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
Asset Returns and Volatility (Annual): Data, 1926-97
Av. Real return on S&P
= 9.4 %
Av. Excess return on S&P = Rm - r = 9%
( = 13 - 3.6)
(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
Volatility of S&P500 (Annual) US Data, 1930-97
1930’s
S.D
41.6
1940
1950
1960
17.5
14.1
13.1
1970
1980
1990-97
17.1
19.4
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
Europe
25
86(135)
62(Euro)
Americas
32
94(146)
49
Asia
21
98(139)
39(Yen)
Global
38
107(156)
….
UK
FX(rel to USD)
77 (115)
Note: ( . .) = 52-week high
100 = average volatility of international equity mkts
Copyright K. Cuthbertson, D. Nitzsche
Figure 1.6 : US stock market (S&P500 and NASDAQ)
1000
900
Summary Statistics :
Nasdaq
800
(Jan. 95 to Sept. 00)
700
600
S&P500
Mean
1.76%
Std. dev. 3.94%
500
400
S&P500
300
Correlation : 0.6382
(monthly data)
200
S&P500
100
0
03/01/95
03/01/96
03/01/97
03/01/98
03/01/99
03/01/00
03/01/01
Copyright K. Cuthbertson, D. Nitzsche
Nasdaq
3.41%
7.56%
Figure 1.5: US Industrial Sectors
8000
7000
6000
5000
Entertainment Industry
4000
3000
Oil Industry
Chemical Industry
2000
1000
Financial Industry
Automobile Industry
0
23/12/88 07/05/90 19/09/91 31/01/93 15/06/94 28/10/95 11/03/97 24/07/98 06/12/99 19/04/01
Copyright K. Cuthbertson, D. Nitzsche
Figure 1.7: ‘Local Currency’ Stock Indices
16000
14000
12000
Hang Seng
10000
8000
S&P
6000
FTSE
4000
Dax
2000
Nikkei
0
27/02/88
27/01/90
28/12/91
27/11/93
28/10/95
Copyright K. Cuthbertson, D. Nitzsche
27/09/97
28/08/99
28/07/01
Figure 1.8: Asian Crises : Spot FX Rates
120
100
$ per Malaysian Ringgit
80
60
$ per Thai Baht
40
$ per Indonesian Ruphia
20
0
05/02/96
01/12/96
27/09/97
24/07/98
20/05/99
Copyright K. Cuthbertson, D. Nitzsche
15/03/00
09/01/01
Slides End Here
Copyright K. Cuthbertson, D. Nitzsche