LECTURE 1: MARKETS, FIRMS AND INVESTORS

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.

Types of Financial Assets: Lending and Borrowing Funds

LENDING AND BORROWING

New (physical) investment projects - have to be financed. Transfer of existing physical assets to more productive uses: ( e.g. 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

Financial system: moves funds between borrowers and lenders.

Allows some to spend before they have earned the income and others to defer spending (i.e. save) - intertemporal re-allocation of cash flows.

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

Figure 1: Brokers and dealers

Individual Investor Market Maker A Broker Market Maker B

Institutional Investor

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

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(e.g. cannot sell buildings) - Floating Rate Notes, FRNs - convertibles - callable bonds

Warrants versus Convertibles

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.

Raising Funds: Shares/Equity

Shares (equities, common stocks) - no maturity - variable payments (= dividends) - last to be paid Issuing Shares - IPO (going to market) -Rights Issue - additional shares to existing equity holders - Script Issue - free shares, no new funds - Equity Warrants

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 MBOs - usually highly leveraged buy-outs LBOs (e.g. buy-out of ?) - 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)

Ownership of Firms

-Sole Proprietor - Partnership - Limited Company or Corporation

The Market for Corporate Control

Market for corporate control: efficient managers replace inefficient incumbent managers Merger activity financed by cash acquisitions or from the shareholders in the target firm receiving shares in the acquiring firm (the new merged firm) Defensive tactics used in a hostile takeover: White Knight get a friendly company to make a bid; Pac Man make a counter-bid for bidder; Poison Pills increase the acquirers costs should the bid be successful (e.g. target shareholders are given bonus cash payments if the bid is successful); Crown Jewels defence target sells off most profitable parts of the business

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

Flow of Funds and Financial Intermediations

Lenders and Borrowers

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).

MARKETS and DEALERS

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)

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

Market Maker (MM)

MM Buys "low" at Bid price B 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

Prices Respond To News

Financial prices (e.g 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: Irrational (Over)-Exuberance - bubbles, crashes, noise traders)

Returns And Risk

SPREADS and YIELDS

Spread is the difference between two prices Bid-Ask Spread: Market maker Buys at the Bid (e.g. $100 ) and sells at the offer or ask (e.g. $102) . Bid-ask spread above = $2 Yield (e.g. 10 % p.a.) on an interest bearing asset (e.g. 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)

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% 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%)

Nominal RISKY Return (e.g. 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.

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;

Inflation risk actual inflation may turn out to be

different from what was initially expected;

Default (credit) risk the company may go bankrupt

which severely reduces any future payment to bond and stockholders;

Liquidity risk the asset might trade in a thin market

implying a large fall in price if it is to be sold quickly.

Forward Rates and the Yield Curve

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 , FRAs -Floating Rate Notes, FRNs -Interest Rate Futures Contracts -Floating rate receipts, in an interest rate swap

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.

Relationship between forward rate and spot rates

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 markets best forecast of what the the one-year rate in one-years time (denoted Er1t+1 ) will be

SELF STUDY Algebra of General Calculation of Forward Rates

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 Curve and the Expectations Hypothesis

Figure 2 :YIELD CURVE

Yield
7 6 4 A 1 2 3 A

Time to maturity

The yield curve is usually upward sloping. WHY?

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

Expectations Hypothesis (EH): Term Structure

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

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 ?

Data On Yields, Prices, Returns and Risk

Measuring Historic Returns

Starting

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

Arithmetic Mean Return

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.

Arithmetic Mean Example

Year Holding Period Return 1 10% 2 30% 3 -20% 4 0% 5 20% RA = (HPR)/n = 40/5 = 8%

Geometric Mean Return

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

Geometric Mean Example

Year Holding Period Return 1 10% 2 30% 3 -20% 4 0% 5 20% Return Relative 1.10 1.30 0.80 1.00 1.20

RG = [(1.10)(1.30)(.80)(1.00)(1.20)]1/5 1 RG = .0654 or 6.54%

Arithmetic vs. Geometric

To ponder which is the superior measure, consider the same example with a $1000 initial investment. How much would be accumulated? Year Holding Period Return Investment Value 1 10% $1,100 2 30% $1,430 3 -20% $1,144 4 0% $1,144 5 20% $1,373

Arithmetic vs. Geometric

How much would be accumulated if you earned the arithmetic mean over the same time period? Value = $1,000 (1.08)5 = $1,469 How much would be accumulated if you earned the geometric mean over the same time period? Value = $1,000 (1.0654)5 = $1,373 Notice that only the geometric mean gives the same return as the underlying series of returns.

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

17.3 6.0 5.7 3.9 3.6

13.4 2.1 1.8 0

33.4 8.7 9.4 3.2 5

(Source Brealey & Myers 7th ed p155-164)

Asset Returns and Volatility (Annual): Data, 1926-97

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

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

(Source Brealey & Myers 7th ed p165)

RISK GRADES: FT 19/10/00 (for Oct 17th)

BONDS Europe Americas Asia 25 32 21 EQUITY 86(135) 94(146) 98(139) FX(rel to USD) 62(Euro) 49 39(Yen)

Global UK

38

107(156) 77 (115)

Note: ( . .) = 52-week high 100 = average volatility of international equity mkts

Figure 3: US Industrial Sectors

8000 7000 6000 5000 4000 3000 2000 1000 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

Entertainment Industry

Oil Industry

Chemical Industry

Financial Industry

Automobile Industry

Figure 4 : US stock market (S&P500 and NASDAQ)

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

Figure 5: Local Currency Stock Indices

16000 14000 12000 10000 8000 6000

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

Figure 6: Asian Crises : Spot FX Rates

120

100

80

$ per Malaysian Ringgit

60

$ per Thai Baht

40

$ per Indonesian Ruphia

20

0 1996-2-5

1996-12-1

1997-9-27

1998-7-24

1999-5-20

2000-3-15

2001-1-9