Capital Markets 3504
Transcript of Capital Markets 3504
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Introduction to CapitalIntroduction to Capital
MarketsMarketsB, K & M Chapter 2B, K & M Chapter 2
End of chapter problems: 1End of chapter problems: 1--1313, Project 1, Project 1
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The Capital Markets OverviewThe Capital Markets Overview
Value of Outstanding debt in 2007:Value of Outstanding debt in 2007:
Treasury Securities:Treasury Securities: § $4.6 Trillion§ $4.6 Trillion Bills § 21%Bills § 21%
Notes Notes §§ 62%62%
Bonds § 17%Bonds § 17%
GovGov--sponsored enterprise § $2.7 Trillionsponsored enterprise § $2.7 Trillion
(Freddie Mac), (Fannie Mae), (Sallie Mae), etc(Freddie Mac), (Fannie Mae), (Sallie Mae), etc
U.S. Corporate Bond Market:U.S. Corporate Bond Market: §§ $3.1 Trillion$3.1 Trillion
Tax exempt bonds:Tax exempt bonds: §§ $ 2.1 Trillion$ 2.1 Trillion
Mortgage Backed Securities (includes GSEs):Mortgage Backed Securities (includes GSEs): §§ $3.8 Trillion$3.8 Trillion
Value of U.S. Equities in 2007:Value of U.S. Equities in 2007: §§ $15.4 Trillion, (30% of World)$15.4 Trillion, (30% of World)
Residential Real Estate in 2007: § $20.4 TrillionResidential Real Estate in 2007: § $20.4 Trillion
US GDP in 2007: § $14 Trillion (25% of world total)US GDP in 2007: § $14 Trillion (25% of world total)
US Population in 2007: 300 million (<5% of world total)US Population in 2007: 300 million (<5% of world total)
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The Money Market: December 2007The Money Market: December 2007
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The Money MarketThe Money Market
The U.S. Government is the largest single issuer of debt in theworld
Treasury Bills
Issued by Federal Government at a discount (zero coupon)
Maturities of 91 days and 182 days. Offered each Monday, sold
at auction
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
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TT--Bills (cont.)Bills (cont.)
Effective Annual Yield (rate of return) on a pure discount
bond is defined as r:
)( /!
T
P
FV 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)
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TT--Bills (cont.)Bills (cont.)
EXAMPLE:EXAMPLE:
!!r
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Spread between 3 month CDs and T-Bills
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Commercial PaperCommercial Paper
Unsecured notes issued by large (credit worthy)
corporations
³Disintermediation´ 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
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Commercial Paper (cont.)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!
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EurodollarsEurodollars
Dollar denominated deposits at foreign banks or
foreign branches of American banks
Of course, no deposit insurance
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Federal FundsFederal Funds
Fed funds are bank deposits at a bank¶s district Fed
for the purpose of meeting reserve requirements
Banks with ³excess´ reserves at the Fed loan to
those with a shortfall
An alternative is for a bank to do a ³repo´
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Bankers AcceptancesBankers 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 ³accepted´ itassumes 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
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London Interbank Offered Rate (LIBOR)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
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The Fixed Income CapitalThe Fixed Income Capital
MarketMarket
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Treasury Notes and BondsTreasury 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 yieldor annual percentage rate (APR))
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Treasury Notes and Bonds (cont.)Treasury Notes and Bonds (cont.)
What is reported yield to maturity on a 10-yr T-Bond with a9% 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)
2
2
1 )1(
1
)1(
.1.1
r r t
t
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!
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Inflation Adjusted Treasury BondsInflation Adjusted Treasury Bonds
Introduced in the 1990s
Face value is inflation adjusted (although the
principal adjustments are taxable events)
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Federal Agency DebtFederal Agency Debt
1) Government National Mortgage Association (Ginnie
Mae)
2) Federal National Mortgage Association (Fannie Mae)
3) Federal Home Loan Mortgage Corporation (Freddie
Mac)
4) 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)
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Federal Agency Debt (cont.)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
a) Mortgages are issued by approved lenders such as commercial
banks and mortgage brokers, with underwriting standards
established by Ginnie Mae
b) The mortgage originator may continue to service the loan,
collecting interest and principal payments, ³passing´ these
along to the mortgage purchaser
c) The security guaranteed by Ginnie Mae is called a mortgage- backed security (MBS), and is sold with a minimum
denomination of $25,000
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Federal Agency Debt (cont.)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 ³Agencies,´the governmentguarantee 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 lessdependent on local credit availability
Spreads over Treasury rates were typically small (until
2007-2009)
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Federal Agency Debt (cont.)Federal Agency Debt (cont.)
A major risk to pass-throughs is the call feature available
to mortgage holders who might want to refinance if interest
rates fall ± ³Extension´ and ³Contraction´ 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
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Collateralized Mortgage Obligations (CMOs)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
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CMOs (cont.)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 onthe 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)
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CMOs (cont.)CMOs (cont.)
MortgageMortgage--Backed SecuritiesBacked Securities
Outstanding, 1979Outstanding, 1979--20072007Issuance Volume of Collateralized Mortgage Obligations, 1982-1993
a
Year Number of
Deals
Dollar Value
(in millions)
Number of
Tranches
Average Number of
Tranches per Deal
1982 1 50$ 2 2.0
1983 8 4,748 53 6.6
1984 18 9,903 143 7.91985 59 16,515 434 7.4
1986 89 49,838 951 10.7
1987 94 58,875 1,020 10.9
1988 156 77,066 1,796 11.5
1989 236 95,209 2,608 11.1
1990 280 112,993 3,802 13.6
1991 440 200,810 7,077 16.11992 504 260,410 9,688 19.2
1993 441 271,180 10,597 24.0aIncludes agency and nonagency CMO/REMICs.
Source : Wall Street Analytics, Inc.
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Municipal BondsMunicipal 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 taxableand tax exempt bonds?
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t m
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Tax-exempt debt
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Ratio of yields is variable!
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Municipal Bonds (cont.)Municipal Bonds (cont.)
In class problem: If taxables yield 8% and similar
municipals yield 6%, which investment should be chosen byan investor in the 28% tax bracket who pays an average tax
rate of 22%?
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Corporate BondsCorporate 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 toexpiration, strike price, volatility, etc.
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Corporate Bonds (cont.)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:
e BB (S&P), e Ba (Moody's)
Taxable (interest and capital gains)
Maturities up to 30 years
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EquitiesEquities
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Common StockCommon Stock
Residual claim
Limited Liability
Note: For most stocks, the individual investor is no
longer the marginal investor
Direct Individual Ownership of US Equities
47.9% in 1980
21.5% in 2007
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Preferred StockPreferred Stock
Hybrid security
Fixed dividend
Dividend payments are not tax-deductible expensesfor the firm (but corporations may exclude 70% of
dividends received from domestic corporations from
taxable income)
May be callable (redeemable) and convertible
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Agency Costs and Corporate ControlAgency Costs and Corporate Control
(Important areas in corporate finance)(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?
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Market IndexesMarket Indexes
When constructing or using indexes, the problems of
sampling, weighting and averaging must be faced
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SamplingSampling
Larger samples are more difficult to handle
(without a computer) but are more representative
Older indexes tend to be based on fewer stocks
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WeightingWeighting
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!?
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AveragingAveraging
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%
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AveragingAveraging
A general mathematical 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
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Dow Jones Industrial Average (DJIA)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
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S&P 500S&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
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Other IndexesOther Indexes
Wilshire 5000 (5000 NYSE, AMEX, and OTC
stocks)
NASDAQ Comp (2000 NASDAQ stocks)
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CorrelationsCorrelations
Correlation Coefficients between Different U.S. Stock Market IndicatorsCorrelation Coefficients between Different U.S. Stock Market Indicators
(Monthly Returns form 1975(Monthly Returns form 1975--1988)1988)
DJIADJIA S&P400S&P400 S&P500S&P500 NYSE NYSE AMEXAMEX OTCI NDOTCI ND OTCCOMPOTCCOMP CRSPEQWCRSPEQW CRSPVWCRSPVW
DJIADJIA 1.0001.000
S&P400S&P400 0.9580.958 1.0001.000
S&P500S&P500 0.9530.953 0.9770.977 1.0001.000
NYSE NYSE 0.8890.889 0.9090.909 0.9110.911 1.0001.000
AMEXAMEX 0.6750.675 0.7380.738 0.7360.736 0.7360.736 1.0001.000OTCI NDOTCI ND 0.7350.735 0.7700.770 0.7530.753 0.7370.737 0.7620.762 1.0001.000
OTCCOMPOTCCOMP 0.7680.768 0.7820.782 0.7850.785 0.7840.784 0.7820.782 0.8810.881 1.0001.000
CRSPEQCRSPEQ 0.9370.937 0.9450.945 0.9450.945 0.9400.940 0.8440.844 0.7430.743 0.8010.801 1.0001.000
CRSPVWCRSPVW 0.9440.944 0.9490.949 0.9590.959 0.9560.956 0.8530.853 0.7650.765 0.8130.813 0.9220.922 1.0001.000
DJIA = Dow Jones Industrial AverageDJIA = Dow Jones Industrial Average
S&P400 = Standard & Poor¶s 400 Industrial Stock IndexS&P400 = Standard & Poor¶s 400 Industrial Stock Index
S&P500 = Standard & Poor¶s 500 Stock Composite IndexS&P500 = Standard & Poor¶s 500 Stock Composite Index
NYSE = New York Stock Exchange Index NYSE = New York Stock Exchange IndexAMEX = American Stock Exchange AverageAMEX = American Stock Exchange Average
OTCI ND = Over OTCI ND = Over--thethe--Counter IndexCounter Index
OTCCOMP = OTC Composite Stocks AverageOTCCOMP = OTC Composite Stocks Average
CRSPEQW = Center for Research on Securities Prices (CRSP) EquallyCRSPEQW = Center for Research on Securities Prices (CRSP) Equally--Weighted Stocks IndexWeighted Stocks Index
CRSPVW = Center for Research on Securities Prices (CRSP)ValueCRSPVW = Center for Research on Securities Prices (CRSP)Value--Weighted Stocks IndexWeighted Stocks Index