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FIN 310 Study Guides and Formulas

by: Gabby Greenberg

FIN 310 Study Guides and Formulas FIN 310

Marketplace > Colorado State University > Finance > FIN 310 > FIN 310 Study Guides and Formulas
Gabby Greenberg
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With these study guides, you will have all the material necessary for each exam. By learning these and doing the iclicker questions found at the bottom of each doc, plus back of the book questions ...
Financial Markets and Institutions
Frank Smith
FIN310, FrankSmith
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Date Created: 08/07/16
Fin 310 Exam 1 Systemic risk  The spread of financial problems, among financial institutions and across financial markets, that could cause a collapse in the financial system. Surplus/deficit units  Surplus Units – o Participants who receive more money than they spend, such as investors.  Deficit Units – o Participants who spend more money than they receive, such as borrowers. Types of markets  Primary Markets – o Facilitate the issuance of new securities, IPOs  Secondary Markets – o Facilitate the trading of existing securities, which allows for a change in the ownership of the securities  Money Markets – o The trading of short-term loans between banks and other financial institutions happens on the money market o On commercial paper and negotiable CSs, they interest rates only slightly higher than T-bill rates to compensate for lower liquidity and higher default risk.  Capital Market – o Raising capital by dealing in shares, bonds, and other long-term investments. o Municipal bonds have the lowest before-tax yield, but their after-tax yields are typically higher than Treasury Bonds. o Treasury Bonds have the lowest yield because of their low default risk and high liquidity. Efficient markets  A market is efficient when prices properly reflect all information – if prices are far higher than they should be and people are making substantially larger amounts than they should, that means there could be insider trading and inefficiency in the market Mutual funds  Sell shares to surplus units and use the funds received to purchase a portfolio of securities  Diversifies risk, professionally managed Equilibrium interest rate  Combining aggregate demand and aggregate supply curves allows the comparison of total amount of demand verse supply.  At equilibrium interest rate i, the supply of loanable funds is equal to the demand for loanable funds. o At interest rates above i, there is a surplus of funds o At interest rates below I, there is a shortage of loanable funds Factors that affect interest rates  Economic growth – o Puts upward pressure on interest rates by shifting demand for loanable funds upwards.  Inflation – o Puts upward pressure on interest rates by shifting supply of funds inward and demand for funds outward  Budget Deficit – o With an increase in the deficit, there is a decrease in the money supply and vise-versa o Crowding-out Effect –  Given a certain amount of loanable funds supplied to the market, excessive government demand for funds tends to “crowd out” the private demand for funds.  Foreign Flow of Funds – o Interest rate for a certain currency is determined by the demand for funds in the currency and the supply of funds available in that currency.  Economic Conditions – o Primary forces behind the change in the supply of savings provided by households and a change in the demand for funds by households, business, or government. o Demand for funds in the US is indirectly affected by US monetary and fiscal policies because these policies influence economic growth and inflation, which affect business demand for funds. Interest elasticity  Governments demand for loanable funds when planned expenditures are not covered by income revenues is said to be inelastic. o The government has planned spending so they are going to do what they need to do no matter what the interest rates may be o Inelasticity - insensitive to interest rates. Not going to change when the interest rates change. Expenditures and tax policies are independent of the level of interest rates. Nominal vs. Real Rates  Nominal Interest Rate – o The quoted interest rate. The rate that you are paying o Nominal = Real + Expected Inflation  Real Interest Rate – o Real = Nominal - Expected Inflation Fisher effect/equation  i = E(INF) + iR  i = nominal or quoted rate of interest  E(INF) = expected inflation rate  iR = Real interest rate Risk/Return relationship  The higher the risk on an investment, the higher the anticipated yield/return should be.  In order to entice buyers for high risk securities, they must have high interest rates (Yield to Maturity) to produce a higher return in the end Credit crisis – why happened, impact on firms and rates, fed actions  Credit risk, or default risk is the chance of a borrower not being able to complete payment on a loan. During the credit crisis, many people began unable to pay their mortgages and began defaulting (and in turn, mortgage backed securities began to fail) which systematically led to an economic meltdown. Derivatives, role of and risk  Derive their value from something else – underlying security  Intend to work as a form of insurance so you get paid if your investment failed but during the credit crisis they all went belly up and no one had any money or level of equity to pay anyone back. Default risk  The risk of being unable to pay required payments  Investors must consider the creditworthiness of the security issuer  All else equal, securities with a higher degree of default risk must offer higher yields Credit ratings  Rating Agencies – o Rating agencies charge the issuers of debt securities a fee for assessing default risk  Accuracy of Credit Ratings – o The Ratings issued by the agencies are useful indicators of default risk but they are opinions, not guarantees.  Investment-grade securities – o AAA, AA, A, BBB, BB  Junk bonds – o Anything below investment grade o Much higher rate of return due to the high amount of risk it will not be completed M1, M2, M3  M1 o Currency held by the public and checking deposits at depository institutions  Demand deposits, NOW accounts, and automatic transfer balances o Most liquid of the three. Money directly in circulation or available for withdrawal  M2 o M1+ saving accounts, small time deposits, money market accounts  M3 o M2 + large deposits and other large, long-term deposits Characteristics that effect yield and how  Credit (Default) Risk o Investors must consider the creditworthiness of the security issuer o All else equal, securities with a higher degree of default risk must offer higher yeilds  Liquidity o The lower a security’s liquidity, the higher the yield preferred by an investor. o Debt securities with a short-term maturity or an active secondary market have greater liquidity.  Tax Status o Investors are more concerned with after-tax income. o Taxable securities must offer a higher before-tax yield. o High-tax bracket investors benefit more from tax-exempt securities because their tax savings from avoiding taxes is greater. o Corporate bonds offer a higher before-tax yield, since they are taxable by the federal government. o Municipal bonds may have a higher tax yield for investors subject to a high tax rate. o Computing the Equivalent Before-Tax Yield”  AT Yield = BT Yield (1-T)  After-Tax Yield = Before-Tax Yield (1-T)  Term to Maturity o Maturity dates will differ between debt securities o The term structure of interest rates defines the relationship between term to maturity and the annualized yield DLTM  Characteristics that effect yield  Default Liquidity Tax Maturity Theories that describe the yield curve  Default risk liquidity, tax rates, maturity  All bonds trade at a higher volume when they have a longer maturity, people are more interested when maturity rate is short Pure Expectations Theory –  Term structure reflected in the shape of the yield curve is determined solely by the expectations of interest rates. o Impact of expected:  Increase – upward sloping yield curve  Decrease – downward sloping yield curve  Forward Rates/Expected Rates o The forward rate is the expected interest rate at a future point in time (1+¿ t+1F 1 i 2 o 1+t ) = (+i 1) 2 o t = known annual interest rate of a two year security at time t i o t1 = known annual interest rate of one year security a time t (1+¿ t+1 1 o ¿ = one plues one-year interest rate that is anticipated as of time t + 1  If there was an expected increase in interest rates the demand for short-term securities would increase, placing upward (downward) pressure on their prices (yields). The demand for long-term securities would decrease, placing downward (upward) pressure on their prices (yields). If the yield curve was originally upward sloped, it would now have a steeper slope as a result of the expectation. If it was originally downward sloped, it would now be more horizontal (less steep), or may have even become upward sloping.  Assume there is a sudden expectation of lower interest rates in the future. What would be the effect on the shape of the yield curve? o The demand for short-term securities would decrease, placing downward (upward) pressure on their prices (yields). The demand for long-term securities would increase, placing upward (downward) pressure on their prices (yields). If the yield curve was originally upward sloped, it would now be more horizontal (less steep). If it was downward sloped, it would now be more steep. Liquidity Premium Theory –  If investors believe that securities with larger maturities are less liquid, they will require a premium when investing in such securities to compensate. This theory can be combined with the other theories to explain the shape of a yield curve.  Investors prefer short-term liquid securities but will be willing to invest in long-term securities if compensated with a premium for lower liquidity  Estimating Forward Rates based on Liquidity Premium (1+¿ r )+LP t+1 1 2 o (1+t 2)= 1+i ¿ ( 1) o L P 2 is the liquidity premium on the 2 year security Segmented Markets Theory –  People divide themselves into a time of maturity they prefer and don’t come out of that  If a downward-sloping yield curve is mainly attributed to segmented markets theory, what does that suggest about the demand for and supply of funds in the short-term and long-term maturity markets? o A downward-sloped yield curve suggests that the demand for short- term funds is high relative to the supply of short-term funds, causing a high yield. In addition, the demand for long-term funds is low relative to the supply of long-term funds, causing a low yield.  Investors choose securities with maturities that satisfy their forecasted cash needs. o Limitations – some borrowers and savers have the flexibility to choose among various maturities Preferred Habitat Theory –  The preferred maturity an investor usually invests in, but if you offer them enough money they will go to another segment  Although investors and borrowers may normally concentrate on a particular maturity market, certain events may cause them to wander from their “natural” or preferred market.  The preferred habitat theory suggests that while investors and borrowers may prefer a natural maturity, they may wander from that maturity under conditions where they can benefit from selecting a different maturity. Yield Curve  When demand is higher for short-term than long-term maturities, there is a downward sloping curve  Supply curve of loanable funds indicates the quantity of funds that would be supplies *at that time) at various possible interest rates.  The yield differential is the difference between the yield offered on a security and the yield on the risk-free rate. o Differentials on Money Market Securities:  Market forces cause the yields on all securities to move in the same direction.  The yield curve’s shape is affected by the demand and supply conditions for securities in various maturity markets. Expectations of interest rates, the desire for liquidity, and the desire by investors or borrowers for a specific maturity will influence the demand and supply conditions.  The yield curve can be used to determine the market’s expectations of future interest rates. Market participants can compare their own expectations to the market’s expectations in order to determine their borrowing or investing decisions How the Fed is organized and how/why they control the money supply  The central bank of the US is the Fed. They conduct national monetary policy in attempt to achieve full employment and price stability (low or zero inflation) o 12 Federal Reserve banks.  New York Fed is considered the most important.  Commercial banks purchase stock in their Federal Reserve district bank to become members.  The stock pays a maximum dividend of 6% annually.  Each Fed district bank has 9 directors  All national banks are required to be members of the Fed. o Board of Governors  7 members appointed by the President of the United States and serves a nonrenewable 14-year term.  Federal Reserve Chairman has a 4-year renewable term.  Vice Chairman for Supervision o Federal Open Market Committee (FOMC)  7 members of the Board of Governors plus presidents of five Fed district banks (New York plus 4 others as determined on a rotating basis).  Meets 8 times per year, sets target for the money supply growth level and the interest rate level, and implements monetary policy.  The main goals of the FOMC are to promote high employment, economic growth, and price stability. o Advisory committees advise the board o The board oversees operation of the district banks o Federal Trading Desk – Open Market Desk  If a change in monetary policy is appropriate, the FOMC decision is forwarded to the trading desk at the NY Fed through a policy directive.  The Fed facilitates operations within the banking system by clearing checks, replacing old currency, and providing loads (through the discount window) to depository institutions in need of funds.  The Fed can increase money supply by purchasing securities in the secondary market. Reserve Requirement Ratio  The proportion of bank deposit accounts that must be held as required reserves of funds held in reserve. This has historically been set between 8 and 12 percent of transaction accounts.  By reducing the reserve requirement, the Board increases the proportion of a bank’s deposits that can be lent out. The lower the reserve requirement, the greater the lending capacity of depository institution meaning an increase in the money supply  Impact on Money Growth: Leakage occur when households hold cash or banks hold excess reserves. In these cases, the money does not multiply as expect. Different tools available to the Fed  Monetary Policy o The Fed reduces (increases) the money supply, and it reduces (increases) the supply of loanable funds, putting upward (downward) pressure on interest rates. o The Fed’s monetary policy can affect the supply of loanable funds available in financial markets and therefore may affect interest rates. It may also affect inflation (with a lag) and therefore affect the demand for loanable funds by influencing inflationary expectations. o Active –  Active monetary policy reflects actions taken by the Fed to adjust money supply in order to affect economic conditions o Passive –  A passive monetary policy means that the Fed does not attempt to adjust money supply in order to improve economic conditions  Fiscal Policy o Determines the budget deficit and therefore determines federal government demand for funds  Open Market Operations o Dynamic operations are implemented to increase or decrease the level of funds o Defensive operations offset the impact of other conditions that affect the level of funds. Buy/selling of the Fed  Fed purchasing securities – o To lower the federal funds rate, traders purchase Treasury securities from securities dealers. The dealers’ bank account balances increase causing an increase in the supply of funds.  Fed sale of securities – o To increase the federal funds rate, traders sell government securities to government securities dealers. As the dealers pay for the securities, their bank balances decrease leading to a decrease in the supply of funds.  Fed trading of repurchase agreements – o Purchases Treasury securities from government securities dealers with an agreement to sell back the securities at a specific date in the near future Operation Twist  An attempt to lower long-term interest rates. Sold short-term T-bills and bought long-term T-bills which pressured long-term bond yields to go down Impact of foreign investment/central banks and currency  Each country has its own central bank that controls the money supply and monetary policy  Central banks of other industrialized countries use open market operation and reserve requirement adjustments as monetary policy tools.  The Fed must consider economic conditions in other countries when assessing the US economy.  Impact of the Euro on Monetary Policy – o Any changes in the money supply affect all European countries that use the euro. o Prevents participating countries from solving local economic problems using their own unique economic policies. Beige book  Pre-meeting Economic Report – o A consolidated report of regional economic conditions in each district. o Given to the FOCM before their meetings so they are aware of the conditions before making decisions on monetary policy implementations Interest rate movements and impact on firms cost of capital and projects  Monetary policy affects interest rates and has a strong influence on the cost of borrowing by households.  It also affects the cost of borrowing by businesses and thereby influences how much money businesses are willing to borrow to support and expand their operations.  During the credit crisis, the Fed lowered interest rates, so the cost of borrowing was far lower, yet institutions and corporations did not take this lending availability because the expected cash flows were too low due to the recession and consumers having no interest in spending money. How fiscal policy and fed policy are linked  Government borrowing could place upward pressure on interest rates. If the fed wants to keep interest rates low in order to stimulate the economy, it may loose monetary policy  Flow of funds, interest rates, inflation, changes lending habits  Simulative can increase economic growth and reduce unemployment but increase inflation  Restrictive keeps inflationary pressure low but can cause higher unemployment Stimulative vs. Restrictive Policies  Stimulative – o Increases economic growth and reduces unemployment by lowering interest rates and stimulating the economy o Criticism: interest rates are so low that banks can’t lend or make money off loans, investors can’t make returns  Restrictive – o Puts downward pressure on inflation to stabilize prices o Criticism: increases interest rates and unemployment rates. Lags  Tend to rise or fall a few months after business-cycle expansion and contractions.  Consumer and Producer Price Indexes – o There is a lag time of about one month after the period being measured due to the time required to compile price information for the indexes.  The recognition lag represents the time from when a problem exists until it is recognized by the Fed. It occurs because the economic statistics that are monitored to detect problems are only reported periodically.  The implementation lag occurs when the Fed recognizes a problem but does not implement a policy to solve the problem until later. The dual mandates and why they are a problem  The "dual mandate" of the Federal Reserve was established by the Federal Reserve Act of 1977. This act stipulates that the goals of the Federal Reserve are to maintain price stability and maximum employment. In this way, Congress technically decides what the goals of the Federal Reserve should be. That said, it is left to the Federal Reserve to decide what the relative priorities on price stability and maximum employment should be. Fin 310 – Exam 2 Study Guide – Spring 2016 Background on Bonds  Long-term debt securities issued by government agencies or corporations.  The issuer is obligated to pay interest (or coupon) payments periodically (such as annual or semiannual) and the par value (principal) at maturity.  Bonds are often classified according to the type of issuer: Treasury Bonds –  Issued to finance federal government expenditures. o How they are bought and sold –  Treasury Bond Auctions –  Normally held in the middle of each quarter.  Financial institutions submit bids for their own accounts or for their clients.  Bids are either: o Competitive –  Specify a price and a dollar amount of securities to be purchased o Noncompetitive –  Specify only a dollar amount of securities to be purchased.  Trading Treasury Bonds –  Bond dealers serve as intermediaries in the secondary market by matching up buyers and sellers of Treasury bonds.  Dealers profit from the spread between the bid and ask prices.  Treasury bonds are registered at the New York Stock Exchange, but the secondary market trading occurs over the counter.  Online – Investors can also buy/trade bonds through the Treasury Direct Program and get online quotes o Maturity –  10 years or more. o Liquidity –  Not typically as liquid as bills so require a more active secondary market o Pricing –  Minimum denomination is $100.  Interest is taxed by the federal government as ordinary income, but it is exempt from any state and local taxes. o Yield –  Semiannual payments from Treasury  Stripped Treasury Bonds – huge market* o Cash flows of bonds are commonly transformed (stripped) by securities firms to create principal only and interest only bonds. o Stripped Treasury securities are commonly called STRIPS (Separate Trading of Registered Interest and Principal of Securities). o STRIPS are not issued by the Treasury but instead are created and sold by carious financial institutions. o Came to be for a need for different cash flows at a different point in time. o STRIP away payment and becomes its own zero coupon bond. o There is a huge need for different payments in different parts of time so they can strip them apart and are not issued by the treasury. o Not coming from federal government – comes from financial intermediaries and sold to financial institutions. Inflation-indexed (will be on exam) – o Provides returns tied to the inflation rate. o A function of PPI – principal value is increased by the amount of the US inflation rate. o Inflation rate can change because underlying value and if the CPI is negative then the underlying value of the bond will decrease. o Commonly referred to as TIPS (Treasury Inflation-Protected Securities) o The principal value is increased by the amount of the US Inflation rate. o Saving Bonds –  Can roll them over into other bonds.  Can be purchased for as low as $25.  Don’t have to pay capital gains if you roll it into a different bond.  Issued by the Treasury, but they can be purchased from many financial institutions.  Interest income on savings bonds is not subject to state and local taxes but is subject to federal taxes. Treasury Notes –  Finance federal government expenditures o Maturity –  Less than 10 years. o Pricing –  Minimum denomination is $100.  Interest is taxed by the federal government as ordinary income, but it is exempt from any state and local taxes.  Semiannual payments from Treasury o Structured Notes –  The amount of interest and principal to be paid is based on specified market conditions. o Exchange-Traded Notes –  Debt instruments in which the issuer promises to pay a return based on the performance of a specific debt index.  Typically mature in 10-30 years and are not secured by assets. o Auction-Rate Securities –  A way for borrowers (municipalities and student loan organizations) to borrow for long-term periods while relying on a series of short-term investments by investors.  Every 7-36 days, the securities can be auctioned off to other investors, and the issuer pays interest based on the new reset rate to the winning bidders. Federal Agency Bonds –  Issued by the federal agencies such as the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Association (Freddie Mac) who use the proceeds to purchase mortgages in the secondary market. Municipal Bonds – General obligation bonds – o Supported by the municipal government’s ability to tax. o Best out there because they are supported by the government’s ability to tax. o These do not go under as often. Revenue Bonds – o Supported by revenues of the project for which the bonds were issued. o Vast majority are something frank would invest in – toll roads and bridges. o You will either get a higher return or your par value but it is very reliable. Weary of parks and such that get rented out How they are bought and sold – o Issued by state and local governments. o Tend to have a lot lower volume. o Most municipal bonds have a call provision. Trading and Quotations – o There are more than 1 million different municipal bonds outstanding and more than 50,000 different issuers. o Many municipal bonds have inactive secondary markets. o Electronic trading of municipal bonds has become very popular. Variable rate – o Floating interest that is based on a benchmark interest rate. Tax Advantages – o Usually exempt from federal taxes. o Interest income within a particular state is normally exempt from income taxes in that state. Credit Risk – o Based on the ability of the issuer to repay the debt. o Some municipal bonds are insured to protect against default. Pricing – o Minimum denomination is usually $5,000. o Semiannual interest payments. Yield – o The municipal bond must pay a risk premium to compensate for the possibility of default risks. o The municipal bond must pay a slight premium to compensate for being less liquid than Treasury bonds with the same yield. o The income earned from a municipal bond is exempt from federal taxes allowing municipal bonds to offer a lower yield than Treasury bonds. Corporate Bonds –  How they are bought and sold –  Long-term debt securities issued by corporations that promise the owner coupon payments (interest) on a semiannual basis.  Dealers broker bonds between buyers and sellers.  Offerings – o Public Offering –  Underwriters try to place newly issued bonds with institutional investors. o Private Placement –  Small firms that borrow small amounts of funds (such as $30 million) may consider private placements rather than public offerings.  The institutional investors that purchase a private placement include insurance companies, pension funds, and bond mutual funds. o Electronic bond networks –  Match institutional investors, that wish to sell some bond holdings or purchase additional bonds in the over-the-counter bond market at a lower transactional cost. o Orders through Brokers –  Money Order –  The transaction will occur at the prevailing market price.  Limit Order –  The transaction will occur only if the price reaches the specified limit.  Maturity –  10-30 years  Credit Risk –  Corporations hire rating agencies to have their bonds rated.  Higher rated bonds have a higher price (lower yield) because they are perceived to have a lower credit risk.  Liquidity –  Bonds issued by large, well known firms are liquid.  Bonds issued by smaller, lesser known firms are less liquid.  Pricing –  Minimum denomination is $1,000.  Interest paid by the corporation to investors is tax deductible to the corporation.  Interest income earned on corporate bonds represents ordinary income to the bondholders and is therefore subject to federal taxes and to state taxes.  Yield –  Subject to the risk of default  Yield paid contains a risk premium  Junk Bonds –  Corporate bonds perceived as very high risk.  Primary investors – mutual funds, life insurance companies, pension funds  Offer a high yield compared to Treasury yields  Can be issued as: Bearer Bonds – o An unregistered, negotiable bond on which interest and principal are payable to the holder, regardless of whom it was originally issued to. o The coupons are attached to the bond, and each coupon represents a single interest payment. o The holder submits a coupon, usually semi-annually, to the issuer or paying agent to receive payment. o Bearer bonds are being phased out in favor of registered bonds. Registered Bonds – o A bond issued with the name of the owner printed on the face of the certificate. It can be transferred to another individual only with the owner's endorsement.  Bonds are issued in the primary market through a telecommunications network.  Commercial banks, saving institutions, and finance companies commonly issue bonds in order to raise capital to support their operations. Investors –  Commercial Banks  Saving institutions  Bond mutual funds  Insurance companies  Pension funds Yields –  Issuer’s perspective – o Commonly measured by yield to maturity. o Annual discount rate that equates the future coupon and principal payments to the initial proceeds received from the bond offering.  Investor’s perspective – o Holding period return is used by bond investors who do not hold the bond until maturity. o Yield consists of two components –  Set of coupon payments  Difference between the par value that the issuer must pay to investors at maturity and the price it received when selling the bonds. Sinking Fund Provision –  Requirement that the firm retire a certain amount of the bond issue each year.  Usually work through a third party to avoid subjectivity.  Considered to help the bond holder.  Concern/down side is if the firm sinks your bond – putting it into other things and telling you that you won’t get your interest payments anymore.  If they are not callable and the interest rate decreases, they want to sink it Protective Covenants –  Restrictions placed on the issuing firm that are designed to protect bondholders from being exposed to increasing risk during the investment period. Call Provision –  They can call back your bond and there is a no buy time when you buy it before they can be called. normally requires a price above par value when bonds are called.  The difference between the bond’s call price and par value is the call premium. If market interest rates decline, the firm may sell a new issue of bonds with a lower interest rate and use the proceeds to retire the previous issue by calling the old bonds. Bond Collateral –  Collateralized buy, bonds can be classified according to whether they are secured by collateral and by the nature of that collateral. Low and zero-coupon bonds –  Issued at a deep discount from par value, are purchased mainly for tax-exempt investment accounts. (zero coupon payments) Variable rate bonds –  Long-term debt securities with a coupon rate that is periodically adjusted. Convertibility –  Allows investors to exchange the bond for a stated number of shares of the firm’s common stock.  Ability to convert to common stock, sometimes the best performing due to the equity opportunity.  Offers low interest rate and has a conversion rate or ratio and that tells you how much you can convert. Up to the bond holder usually. Using Bonds to Finance a Leveraged Buyout –  The proceeds from debt are used to buy the outstanding shares of stock, so that the firm is owned by a small number of owners. Using Bonds to Revise the Capital Structure –  Debt is normally perceived to be a cheaper source of capital than equity as long as the corporation can meet its debt payments.  In some cases, corporations issue bonds and then use the proceeds to repurchase some of their existing stock. This is a debt-for-equity swap. Bond Valuation Process o The price of a bond is the present value of the cash flows that will be generated by the bond, namely periodic interest or coupon payments and the principal at maturity. o Current Price of a Bond: o PV= c/(1+k)^1 + c/(1+k)^2 …. + c+par/(1+k)^n  C = Coupon Payment each period  K = required rate of return  N = number of periods to maturity Impact of Discount Rate – o Higher risk securities have higher discount rates (higher YTM). o The appropriate discount rate for valuing any asset is the yield that could be earned on alternative investments with similar risk and maturities. o Timing of Payments – o Timing affects the market price of a bond. o Funds received sooner can be reinvested to earn additional funds. Discount bonds – o Bonds selling below par o If coupon rate is below required rate, the price of the bond is below par o PV < 1000 Par Bonds – o Bonds selling at Par o If coupon rate equals the required rate, the price of the bond is equal to par value. o PV = 1000 Premium Bonds – o Bonds selling above par o If the coupon rate is above the required rate, the price of the bond is above par. o PV > 1000 Bond Price Movements o Bond price elasticity – o Some are more sensitive than others. o Percentage change in Bond prices (pb) /Percentage change in rate of return (k) Coupon Rate on Bond Price Sensitivity – o Zero coupon is most sensitive to changes because you only get one payment at the end. o The price of a bond that pays all of its yields in the form of coupon payments is less sensitive to changes in the required rate of return. Maturity on Bond Price Sensitivity – o As interest rates decrease, long-term bond prices increase by a greater degree than short-term bond prices. Implications for Financial Institutions – o Any factors that lead to higher interest rates tend to reduce the market values of financial institutions assets and therefore reduce their valuations. o Any factor that lead to lower interest rates tend to increase the market values of financial institution assets and therefore increase their valuations. Duration – o A measurement of the life of the bond on a present value basis. o The longer a bond’s duration, the greater its sensitivity to interest rate change. o Duration of a Portfolio –  The weighted average of bond durations weighted accordingly to relative market value. o Modified Duration –  Can be used to estimate the percentage change in the bond’s price in response to a 1 percent point change in the bond yield.  Estimating Errors – o Rely strictly on modified duration to estimate the percentage change in the price of a bond may lead to overestimating the price decline when rates rise and understating the price increase when rates fall. o Criticism: linear model to estimate a curved price – convexity is more likely when change is greater. Convex (actual) relationship between linear and curved line.  Bond Convexity –  The actual response of the bond’s price to a change in bond yields is convex.  Convexity is more pronounced for bonds with long maturities  Convexity is more pronounced for bonds with low (or no) coupons. Investing strategies – o Matching strategy –  Involves estimating future cash outflows and then developing a bond portfolio that can generate sufficient coupon or principal payments to cover those outflows. o Laddered strategy –  Funds are evenly allocated to bonds in each of several different maturity classes. o Barbell strategy –  Funds are allocated to bonds with a short term maturity as well as to bonds with a long term to maturity. o Interest rate strategy –  Funds are allocated in a manner that capitalizes on interest rate forecasts. Influence of Foreign Interest Rate Movements –  As the risk-free interest rate of a currency changes, the required rate of return by investors in that country change as well. Influence of Credit Risk –  An increase in risk causes a higher required rate of return on the bond and therefore lowers its present value, whereas a reduction in risk causes a lower required rate of return on the bond and increases its present value. Influence of Exchange Rate Fluctuations –  Changes in the value of the foreign currency denominating a bond affect the US Dollar cash flows generated from the bond and the return to US investors who invested in it.  Bonds issued by foreign governments are attractive to investors because of the government’s ability to meet debt obligations. International Bond Diversification –  May diversify foreign bond holdings among countries to reduce their exposure to different types of risk o Reduction of interest rate risk, credit risk, exchange risk. o International integration of Credit Risk –  When one country experiences weak economic conditions, its consumers in other countries are also affected. Money Market  Money market securities are debt securities with a maturity of one year or less.  Issued in the primary market through a telecommunications network by the Treasury, corporations, and financial intermediaries that wish to obtain short-term financing.  Commonly purchased by households, corporations, and governments that have funds available for a short term period.  Can be sold in the secondary market and are liquid.  Financial institutions purchase money market securities in order to earn a return while maintaining adequate liquidity.  Financial institutions that purchase money market securities are acting as creditors to the initial issuers of the securities.  Money Market Securities can be used to enhance liquidity in two ways: o Newly issued securities generate cash o Purchased money market securities will generate cash upon liquidation.  During periods of heightened uncertainty, investors shift from risky money market securities to Treasury securities in a flight to quality. Interest Rate Risk – o If short-term interest rates increase, the required rate of return will increase and the prices of securities will decrease. Inverse relationship between interest and price of money market securities. o An increase in interest rates is not as harmful to a money market security as it is to a longer term bond. o Can use a sensitivity analysis to determine how the value of money market securities may change in response to a change in interest rates. Globalization of Money Markets – o Flow of funds between countries has increased as a result of tax differences among countries, speculation on exchange rate movements, and a reduction in government barriers that were previously imposed on foreign investment in securities. Types of money market securities: o Treasury Bills (T-bills)  How they are bought and sold –  Issued when the US government needs to borrow funds.  Treasury Bill Auction – o Bids can be submitted online – competitive or not competitive  T-bills with 4-week, 13-week, and 26-week maturities are issued on a weekly basis.  Investors –  Depository institutions retain a portion of their funds in assets that can be easily liquidated to accommodate withdrawals.  Other financial institutions invest in T-bills in case cash outflows exceed inflows.  Corporations invest in T-bills to cover unanticipated expenses.  Maturity –  One year or less.  Credit Risk –  Backed by the federal government, so basically no default risk.  Liquidity –  Highly liquid due to short maturities and strong secondary market.  Pricing –  Sold at discount so gain is difference between paid and par (Paid Amount – Par Value).  Minimum par value is $1,000 and multiples of $1000.  Price depends on the investor’s required rate of return.  Value of a T-bill is the present value of the par value.  Par value is face value = Face Value / (1 + annualized return)  EX: If investors require a 4 percent annualized return on a one-year treasury bill with a $10,000 par value, the price that they are willing to pay is: o P=$10,000 / (1+.04) so 10,000/1.04 o P= $9,615.38  Yield –  Yield curve highly correlated with the T-bill rate  (SP-PP)/PP x (365/n) o (selling price – purchase price) / purchase price * (365/n)  Estimating Discount –  (Par – PP)/PP x (365/n) o Commercial Paper  How they are bought and sold –  Short term debt instrument issued by well-known, credit worthy firms and typically unsecured.  Maturity –  Maturities average between 20-45 days but can be as short as 1 day or as long as 270 days.  Credit Risk –  Issued by corporations susceptible to failure.  Affected by issuer’s financial position and cash flow.  During the credit crisis, institutional investors were less willing to invest in commercial paper because of concerns that other firms might default. As a result, many firms were no longer able to rely on the commercial paper market for short-term funding. o The Fed began to purchase commercial paper issued by highly rated firms to increase liquidity in the commercial paper market.  Pricing –  Does not pay interest and is priced at a discount from par value – a lot of money market instruments sell at discount and mature at par value.  Minimum denomination of commercial paper is usually $100,000   Placement –  Firms place commercial paper directly with investors or rely on commercial paper dealers to sell their commercial paper.  Backing –  Some backed by assets of the issuer and offers lower yield than unsecured commercial paper.  Typically maintain a backup lines of credit.  Yield –  Yield is higher (than yield on T-bills with same maturity) because of credit risk and less liquidity. o Negotiable certificates of deposit –  How they are bought and sold –  Issued by large commercial banks and other depository institutions as a short-term source of funds.  Maturity –  Maturities on NCDs normally range from two weeks to one year.  Liquidity –  Some liquidity due to secondary market for NCD’s existing.  Pricing –  Minimum denomination of $100,000.  Placement –  Some issuers place their NCDs directly.  Some use a correspondent institution that specializes in placing NCDs.  Yield –  Offer a premium above the T-bill yield in order to compensate for less liquidity and safety.  Provide a return in the form of interest along with the difference between the price at which the NCD is redeemed *or sold in the secondary market) and the purchase price. o (Selling Price – Purchase Price + Interest) / Purchase Price o Repurchase agreements –  How they are bought and sold –  One party sells securities to another with an agreement to repurchase the security at a specific date and price.  A reverse repo is the purchase of securities by one party with an agreement to sell.  A repurchase agreement (repo) is a loan backed by the securities.  Investors –  Financial Institutions often participate in repos.  Maturity –  The most common maturities are from 1-15 days and for one, three, and six months.  Pricing –  Repo market is about $4.5 trillion.  Transaction amount is usually $10 million or more.   Placement –  Negotiated through telecommunications network.  Dealers and repo brokers act as financial intermediaries to create repos for firms with deficient or excess funds, receiving a commission for their services.  Yield –  (SP – PP) / PP x (360/n)  Credit Crisis –  Many financial institutions that relied on the market for funding were not able to obtain funds.  Investors became more concerned about the securities that were posted as collateral. o Federal funds –  How they are bought and sold –  Enables depository institutions to lend or borrow short-term funds from each other at the federal fund rate  The Federal Reserve adjusts the amount of funds in depository institutions in order to influence the federal funds.  Federal Fund Rate is usually slightly higher than the T-bill rate at any given time.  The volume of interbank loans on commercial bank balance sheets over time is an indication of the importance of lending between depository institutions.  Investors –  Commercial banks are the most active participants. o Banker’s acceptances –  Indicates that a bank accepts responsibility for a future payment.  Commonly used for international trade transactions.  Exporters can hold a banker’s acceptance until the date at which payment is to be made, but they frequently sell the acceptance before then at a discount to obtain cash immediately.  Because acceptances are often discounted and sold by the exporting firm prior to maturity, an active secondary market exists.  Market Price of Money market Security (Pm) o Par/(1+k)^n o K = required rate of return by investors  A change in price can be modeled as: o ∆ Pm= f (∆k ) and ∆k= f (∆Rf ,∆RP)  Rf = Risk-free interest rate  RP = risk premium Mortgages  A form of debt to finance a real estate investment Maturity – o Most have 30 years, but 15 year maturities are also available. Contract specifies – o Rate o Maturity o Collateral  Originators charge an origination fee when providing the mortgage. o The originators are paying the funding from household deposit and sell some of the mortgages that they originated directly to institutional investors. How Mortgage Markets Facilitate the Flow of Funds – o Mortgages originators obtain their funding from household deposits and sell some of the mortgages that they originated directly to institutional investors in the secondary market.  These funds are then used to finance more purchases of homes, condos, and commercial property. o Mortgage markets allow households and corporations to increase their purchase of homes, condos, and commercial property and finance economic growth. o Institutional use –  Mortgage companies, savings institutions, and commercial banks originate mortgages.  Mortgage companies tend to sell their mortgages in the secondary market, although they may continue to process payments for the mortgages that they originated.  Common purchasers of mortgages in the secondary market are savings institutions, commercial banks, insurance companies, pension funds, and some types of mutual funds.  Measuring Creditworthiness – o Level of Equity Invested by borrower –  The lower level of equity invested, the higher the probability that the borrower will default.  One proxy for this factor is the loan-to-value ratio, which indicates the proportion of the property’s value that is financed with debt. o Borrower’s Income Level –  Borrowers who have a lower level of income relative to the periodic loan payments are more likely to default on their mortgages. o Borrower’s Credit History –  Borrowers with a history of credit problems are more likely to default on their loans.  Classification of Mortgages – o Prime vs. Subprime mortgages –  Prime –  Borrower meets traditional lending standards  Subprime –  Borrower does not qualify for prime loan. o Relatively lower income o High exiting debt o Can only make a small down payment o Insured vs. Conventional Mortgages  Insured –  Loan is insured by FHA or VA  Conventional –  Loan is not insured by FHA or VA, but can be privately insured  Types of Residential Mortgages – o Fixed-rate Mortgages –  Locks in borrower’s interest rate over the life of the mortgage.  Financial institutions that hold fixed-rate mortgages are exposed to interest rate risk because it commonly uses funds obtained from short-term customer deposits to make tong-term mortgages.  Borrowers with fixed-rate mortgages do not suffer from rising rates, but they do not benefit from declining rates.  Amortizing Fixed-Rate – EXHIBIT 9.3***  An amortization schedule shows the monthly payments broken down into principal and interest.  Payment Calculation Example: o 30 years, 100,000 mortgage, at an 8 percent annualized rate –  N = 30*12 i=8/12 Pv= -100,000 FV= 0 (you have paid it off) so PMT= $733.76 o Adjustable-rate Mortgages (ARMs) –  Allows the mortgage interest rate to adjust to market conditions.  Contract will specify a precise formula for this adjustment.  Some ARMs contain a clause that allow the borrower to switch to a fixed rate within a specific period.  You can get lower interest rate loans with an adjustable rate.  Normally it helps because when interest rates go up they can charge you more for interest but once it reaches your cap the bank is stuck with it.  From a Financial Institution’s Perspective –  Because the interest rate moves with prevailing interest rates, financial institutions can stabilize their profit margin.  If market interest rates move outside given boundaries, the profit margin on ARMs could be affected. o Graduated Payment Mortgages (GPM) –  Allows borrowers to make small payments initially. The payments increase on a graduated basis over the first 5-10 years then levels off. o Growing-equity Mortgages –  Monthly payments are initially low and increase over time. The payments never level off but continue to increase throughout the life of the loan. o Second Mortgages –  A second mortgage can be used in conjunction with the primary or first mortgage. o Shared-appreciation Mortgages –  Allows a home purchaser to obtain a mortgage at a below-market interest rate. In return, the lender will share in the price appreciation of the home. o Balloon Payment Mortgages –  Requires only interest payments for a three to five-year period. At the end of the period, the borrower must pay the full amount of the principal (the balloon payment).  Risk from investing in Mortgages – o Credit Risk –  The risk that the borrower will make a late payment or will default o Interest Rate Risk –  The risk that value of mortgages will fall when interest rates rise. o Prepayment Risk –  The risk that the borrower will prepay the mortgage when interest rates fall. Securitization – o Clumping mortgages into packages and selling them to investors who become the owners of the loans represented by those securities. o Process –  Financial institution (security firm or commercial bank) combine individual mortgages together into packages.  The issuer of the mortgage backed security assigns a trustee to hold the mortgages as collateral for the investors who purchase the security.  After the securities are sold, the financial institution that issued the mortgage backed security receives interest and principal payments on the mortgages and then transfers (passes through) the payments to investors that purchased the securities.  Types of Mortgage Backed Securities (MBS) – o GNMA (Ginnie Mae) –  Government National Mortgage Association – corporation wholly owned by the federal government.  Guarantees timely payment of principal and interest to investors who purchase securities backed by FHA and VA mortgages. o Private Label Pass-Through Securities –  Backed by conventional rather than FHA or VA mortgages.  Insured through private insurance companies. o FNMA (Fannie Mae) –  Federal National Mortgage Association – developed a more liquid secondary


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