Professional Documents
Culture Documents
Learning Objectives To present some of the terminology used across many different financial instruments and markets To discuss the main financial instruments To analyse the main forms of ownership and how corporate control is exercised To examine the role played by arbitrageurs, speculators and hedgers in the trading process To examine the main financial flows To distinguish between nominal and real rates of interest by introducing Fisher equation To analyse the main sources of risk and risk premium To presebt data on yields, prices, returns and risk.
Allows some to spend before they have earned the income and others to defer spending (i.e. save) - intertemporal re-allocation of cash flows.
Institutional Investor
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
Both are ways of issuing debt finance which also gives the holder the option of obtaining an equity stake in the firm at a later date. Most convertibles are issued publicly while warrants are often issued through private placements. Most warrants are detachable and some warrants are issued without initially being attached to bonds at all (e.g. executive stock options). Warrants are exercised for cash, while convertibles usually involve an exchange of bonds for equity. Warrants and convertibles therefore give rise to different cash flows and changes in debt-to-equity ratios for the company.
Ownership of Firms
OTHER MARKETS
Foreign Exchange: Spot market for foreign currencies = trade finance + speculators All of the above are known as cash or spot markets (i.e. for immediate delivery of the asset) Derivatives Markets - forwards \ futures (delivery in the future) - options (delivery is optional ) - swaps ( e.g. swap USD payments for FRF payments) - used in financial engineering / structured finance
Primary Lenders :
Personal (household) Sector and
Primary Borrowers :
Companies and Government
Financial Intermediaries Financial intermediaries and capital markets channel funds from surplus to deficit units Low transaction, search and information costs
Risk spreading => portfolio diversification and specialisation
Asset Transformation
Borrow short and lend long, hedge mismatch of fixed and floating interest rates by using swaps, futures and options
Portfolio Diversification
Pooling funds of individuals to purchase a diversified portfolio of assets, e.g. MM mutual funds, etc.
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 (e.g. 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).
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).
Trading: Types of Order Market order Limit order Stop order Stop limit order Fill-or-kill order Open order (good-till-cancelled)
Trading: Types of Trader 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
SEAQ : best bid and ask/offer prices displayed as the "yellow strip price
HPR = 10% + 5% = 15% Bonds P1 = 100 P2 = 110 HPY = 10% + 2% = 12% 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 = real return + expected inflation r = rr +
Real return : reward for waiting (3% p.a.) = increase in number of goods 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%)
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.
Types of Risks that give rise to Risk Premium Market risk the selling price in 3 months time
is uncertain, as may be the dividend payment;
Also used in Pricing Forward Agreements replaced by: Forward Rate Agreements , FRAs -Floating Rate Notes, FRNs -Interest Rate Futures Contracts -Floating rate receipts, in an interest rate swap
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.
Calculate other forward rates from todays 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
Yield
7 6 4 A 1 2 3 A
Time to maturity
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
Arbitrage: assuming risk neutrality $1.( 1+ r2 ) 2 = $1. (1+r1) . [ Approx. r2 = ( 1 / 2 ) . [ r1 + Er12 ] 1 + Er12 ]
EH implies 1.Long-rate r2 is weighted average of current (r1) and expected future (one-period) short rates Er12
with annualized Holding Period Returns, we often want to calculate some measure of the average return over time on an investment. Two commonly used measures of average: Arithmetic Mean Geometric Mean
The arithmetic mean is the simple average of a series of returns. Calculated by summing all of the returns in the series and dividing by the number of values. RA = (HPR)/n Oddly enough, earning the arithmetic mean return for n years is not generally equivalent to the actual amount of money earned by the investment over all n time periods.
The geometric mean is the one return that, if earned in each of the n years of an investments life, gives the same total dollar result as the actual investment. It is calculated as the nth root of the product of all of the n return relatives of the investment. RG = [(Return Relatives)]1/n 1
Asset Returns and Volatility (Annual): Data, 1926-2000 Arith. Mean Common stocks (S&P500), Rm Small-firm common stocks (bottom 5th on NYSE) Corp. bonds Gov. bonds US T-bills, r Inflation Average S.D risk premium 13.0 9.1 20.2
= 9.4 %
( = 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
Volatility of S&P500 (Annual) US Data, 1926-2000 Period 1926-30 1931-40 1941-50 1951-60 1961-70 1971-80 1981-90 1991-2000 S.D 21.7 37.8 14.0 12.1 13.0 15.8 16.5 13.4
Global UK
38
107(156) 77 (115)
Entertainment Industry
Oil Industry
Chemical Industry
Financial Industry
Automobile Industry
1000 900 800 700 600 500 400 300 200 100 0 03/01/95 03/01/96 03/01/97 03/01/98 03/01/99 03/01/00 03/01/01
Nasdaq
Summary Statistics :
(Jan. 95 to Sept. 00) S&P500 Mean 1.76% Std. dev. 3.94% Correlation : 0.6382 (monthly data) Nasdaq 3.41% 7.56%
S&P500
S&P500
Hang Seng
S&P FTSE
4000 2000 0 27/02/88 27/01/90 28/12/91 27/11/93 28/10/95 27/09/97 28/08/99 28/07/01
Dax
Nikkei
100
80
60
20
0 1996-2-5
1996-12-1
1997-9-27
1998-7-24
1999-5-20
2000-3-15
2001-1-9