Finance 3301: Money and Capital Markets - Midterm 2
Finance 3301: Money and Capital Markets - Midterm 2 FINA 3301
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This 12 page Study Guide was uploaded by Layan Notetaker on Wednesday March 23, 2016. The Study Guide belongs to FINA 3301 at George Washington University taught by Hwang in Spring 2016. Since its upload, it has received 132 views. For similar materials see Finance Money and Capital markets in Finance at George Washington University.
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Study Guide – Midterm 2 Lecture 6: Bond Markets Treasury Notes & Bonds o Issued by the U.S. Treasury to finance national debt and other government expenditures o Are default risk free; meaning they are backed by the full faith and credit of the U.S. government o Have low return; because of low default risk low interest rates (yields to maturity) o Because of their long maturity, they experience wider price fluctuations than money market securities when interest rates change – Interest rate risk o Older issued Tbonds & Tnotes trade less frequently than those newly issued – Liquidity risk Treasury Bond Quote: Maturity | Coupon | Bid | Ask | Chg. | Asked Yield o If coupon rate is 4.5 paid semiannually coupon payment is $2.25 each 6mo o Coupons paid same day as bond maturity date & 6mo anniversary o On maturity, coupon payment and face value are paid o Bid is the closing price per the par value that the dealer is willing to pay the seller would receive this price from selling to the dealer o Ask is the closing price per the par value that the dealer requires selling the bond the buyer would pay this to the dealer o Chg. Is the change from the prior closing ask price o Asked Yield is the promised compound yield rate if purchase was made at asked price Bond Valuation (clean price) – buy the bond right after the last coupon payment/ in the time when your next coupon payment will take place 6 months away , Where: = ; =FV; = a ; = # ; = # ; = () Bond Valuation (dirty price) – buy from middle or somewhere in the 6mo o When the bond is sold on dates different from coupon dates, the buyer pays “accrued interest” o The full (dirty) price of Tbonds and Tnotes is the sum of the clean price and the accrued interest InflationIndexed Notes and Bonds (TIPS) – give you protection against inflation; by adjusting the FV of the bond on a regular basis o Treasury InflationIndexed Securities: The principal amount is tied to the current rate of inflation to protect investor purchasing power Principal (FV) adjusts for inflation based on the CPI (consumer price index) Fixed coupon rate is determined by auction process Minimum denomination is $1,000 Separate Trading of Registered Interest and Principal Securities (STRIPS) o Also known as Treasury zero bonds or Treasury zerocoupon bonds o Created by financial institutions and government securities brokers and dealers, from Tnotes & Tbonds o Have the periodic interest payments separated from each other and from the principal payments One set of securities reflects interest payments One set of securities reflects principal payments o Used to immunize against interest rate risk Municipal Bonds o Securities issued by state and local governments to fund imbalances between expenditures and receipts, and to finance longterm capital outlays o These are attractive to household investors because interest is exempt from federal and most local income taxes o Types include: General obligation (GO): backed by the full faith and credit of the issuing municipality Revenue bonds: sold to finance specific revenue generating projects Municipal Bonds: Tax Benefits o By calculating the after tax return for corporate bonds a comparison of municipal returns and fully taxable corporate bonds can be made: ; Where, = aftertax rate of return on a taxable corporate bond = beforetax rate of return on a taxable bond = marginal total income tax rate of the bond holder o Alternately, convert municipal interest rates to tax equivalent rates of return: Corporate Bonds o Longterm bonds issued by corporations o A bond indenture is the legal contract that specifies the rights and obligations of the issuer and the holders o Bearer vs. registered bonds o Term vs. serial bonds o Mortgage bonds are secured debt issues (has collateral – a debenture bond doesn’t) o Highly risky bonds (no collateral) o Pay interest semiannually o Degree of risk varies with each bond, even from the same issuer. The required interest rate varies with level of risk. The Bond Indenture o Collateral Mortgage bonds real assets pledged Equipment trust certificates specific, titled, or identifiable equipment. – Collateral bonds secured by financial assets. Debentures unsecured bonds. o Claim on assets Senior debt first priority to general assets. Subordinated debt asset claim ranking of unsecured debentures below senior or specific general creditors. o Provisions; issuer has some freedom/ they exercise whenever it is good for them Sinking fund provision; requirement for issuer saying that there is a certain amount of bond that issuer has to purchase in the market; no matter what happens to market IR, they have to buy back in the secondary market of the bonds Call provision; the right of the issuer to buy back the bonds o Convertible Bonds; exercise option whenever they think it is good for them; demand for bond higher, price is higher, and so the yield is lower Bonds that can be converted into common stock o Restrictive Covenants Mitigates conflicts with shareholder interests May limit dividends, new debt, ratios, etc. Usually includes a crossdefault clause Lecture 7: Mortgage Markets Mortgages – longterm debt & the collateral – the house o Mortgages are backed by a specific piece of real property. If the borrower defaults on a mortgage, the lender can take the ownership of the property. o Mortgage loans are made for varied amounts no standard denomination. o Mortgages are private loan contracts themselves, not public securities. However, there are active secondary markets for mortgages through securitization, which creates mortgagebacked securities. Amortization: paying off principal bit-by-bit (not in the same amount; it keeps increasing) o In a FRM (fixed-rate mortgage) contract, there is no FV, and CF=PMT FRMs: Payments and Balance o Three ways of calculating balance of mortgage: 1. Accumulated monthly payments Loan amount + Accumulated interest payments 2. PV of the remaining payments in the future 3. FV after the paidout payment in the past Balloon Mortgages o For a balloon mortgage with i and FV balance at the end of the term T, the monthly payment of a balloon mortgage is calculated by Adjustable Rate Mortgages (ARMs) o Interest rate will be periodically adjusted by a market interest rate o Interest rate = index rate + margin o Interest rate changes periodically with market interest rates, and the interest rate risk is not shared by borrowers as well o Lender point of view an ARM contract is good in terms of interest rate risk (lower) however there is higher probability of the borrower to default! Refinancing o Very prevalent – when existing mortgage has higher interest rate than the current rate o Borrow as much as you currently owe to the first lender Take out new mortgage and use proceed to pay off existing mortgage Prepayment o Paying off a loan earlier than the maturity date o A main risk factor for lenders o In order to refinance, the contract should allow a pay off of the loan before maturity date o Most loan contracts do not allow borrowers to pay off early; Corporate Bonds & Commercial Mortgages Risk in Mortgage Lending: Borrowers o For borrowers of FRM Mortgages are safe No interest rate risk Option to prepay But those benefits are not free o For borrowers of ARM Mortgages are risky Interest rate risk There is a reward for taking risk in terms of higher interest rates ARMs are cheaper than FRMs at least at the beginning Risk in Mortgage Lending: Lenders o Prepayment The borrower recalls the loan A majority of prepayment is due to refinancing Also happens if the house is sold (due on sales) o Defaults The borrower fails to make payments & ultimately this leads to foreclosure Foreclosure o Foreclosure is the ultimate recourse for the lender in mortgage defaults. o It will terminate all claims of ownership by the borrower and all liens inferior to the foreclosing loan. o It is a long and complicated legal process, which can take up to two years (and possibly longer). Lenders have incentives to avoid foreclosure if they can. o The property will be auctioned off at the county courthouse in a public sale to the highest bidder. Hedging Default Risks o By asking for a large down payment. The larger the down payment, the safer the mortgage o Private mortgage insurance (PMI) is generally required when LTV>80% o Federally insured mortgages: Federal Housing Administration (FHA) Veterans Administration (VA) o Conventional mortgages are those which are not federally insured o Conforming mortgages are conventional mortgages eligible for sale to Fannie Mae & Freddie Mac; who either hold these mortgages in their portfolios or package the loans into mortgagebacked securities (MBS) that may be sold. Lecture 8: Stock Markets Common Stock o = Fundamental ownership claim o Owners have a lower claim compared to preferred stock owners Dividends Residual Claims: common stockholders have the lowest priority claim in the event of bankruptcy o Voting rights: common stockholders control the firm’s activities indirectly Election of the board of directors Authorization to issue new shares Approval of amendments to the corporate charter Adoption of bylaws Preferred Stocks o Hybrid securities with characteristics of both bonds and common stock o Dividends are generally fixed and are paid quarterly o Generally no voting rights unless dividend payments are missed o Preferred share types: Nonparticipating versus participating Cumulative versus noncumulative Perpetual vs. nonperpetual IPO: Primary Markets for Equity o A first time offering of shares by a firm to the public. o Costly process and only for offerings of at least $50 million o Firms at IPO are required to provide detailed info about their operations & financial conditions in order to gain investors. o A lead underwriter helps the IPO in developing a prospectus and also pricing and placement of the shares IPO: Prospectus o Filed with SEC. o Provides detailed information about the firm and includes financial statements and a discussion of the risk involved. o Once SEC approves, it will be sent to potential investors, many of who are institutional investors, and so they are provided with the information they need for investment decisions. o Red herring: a preliminary version of the formal prospectus sent to potential investors. IPO: Road Shows o Firm’s management and the lead underwriter meet with potential investors o They travel to different cities and make presentations to the potential investors, mainly target the institutional investors who can purchase a large block of shares. o Online road shows become more popular. IPO: Allocation o Two types of underwriting: Best efforts underwriting: underwriters act as distribution agents Firm commitment underwriting: underwriters act as principals Gross proceeds – net proceeds = underwriter’s spread o A syndicate is a group of investment banks working in concert to issue stock; the lead underwriter is the originating house. Each underwriter in the syndicate contacts and sell the shares to institutional investors. Seasoned (secondary) Offering o The sale of additional securities by a firm whose securities are already publicly traded o Preemptive rights Given to the existingstockholders the ability to maintain their proportional ownership The existing stockowners buy at a price slightly lower than the market value of the existing shares. o Shelf registration allows firms to offer multiple issues of stock over a twoyear period with only one registration statement Secondary Stock Market o Markets in which issued stocks are traded among investors o U.S. stock markets include: NYSE/Euronext Exchange – purchased by ICE in 2013 NASDAQ Bats/Direct Edge (former ECNs) o Choice of market listings NYSE: extensive listing requirements (e.g., firm market value & trading volume) NASDAQ: cheaper requirements that can be met by smaller firms with less active trading o Electronic communication networks (ECNs) Extendedhours trading occurs BATS (better alternative trading system) has now become an exchange o Online trading via the internet is becoming increasingly popular with both individual & professional investors o Search Investors have to find the best trading partners Brokers: find compatible trading partners and negotiate acceptable prices for their clients & charge commission for their services Dealers: buy and sell their own inventory @ their quoted prices & earn their revenues by bidask spread o Auction markets Provide centralized procedures for exposures of purchase and sell orders to all the market participants simultaneously Over the Counter (OTC) o Trading of small companies’ stocks with low liquidity o Primarily dealer markets A network of brokers and dealers Customers contact their brokers who solicit quotes from dealer to find the best transaction prices. o Main OTC markets for stocks OTC bulletin board & Pink OTC markets o Main Regulator: FINRA (Financial Industry Regulatory Authority) NASDAQ o The world’s first electronic market and has no physical trading floor Provides continuous trading for the most active stocks traded overthecounter Primarily a dealer market where many, often more than 20, dealers act as market makers A small order execution system (SOES) provides automatic order execution for orders of less than or equal to 1,000 shares The NASD maintains an electronic “OTC bulletin board” and “pink sheets” for small firms that are not part of the NASDAQ NYSE o Has a specialist system that acts as broker and dealer at the same time. A single dealer for each stock Historically every trade had to go through the specialist but now it is a hybrid of floor trading, Super DOT and NYSE Direct + o Currently a part of the ICE, which owns NYSE Euronext. Stock Market Indexes o The composite value of a group of secondary markettraded stocks o Two types: Priceweighted index: The Dow Jones Industrial Average (DJIA) – composed of 30 companies – is the most widely known stock market index Valueweighted index NYSE Composite S&P 500 NASDAQ Composite Wilshire 5000 Lecture 9: Commercial Banks Commercial banks o Largest group of financial institutions in terms of total assets Major assets are loans Major liabilities are federally insured deposits—thus, they are considered depository institutions o Perform services essential to U.S. financial markets Play a key role in the transmission of monetary policy Provide payment services Provide intermediation in terms of maturity, risk, liquidity and denomination o Banks are regulated to protect against disruptions to the services they perform OffBalanceSheet Activities o Commercial banks engage in many feerelated activities that are conducted off the balance sheet Guarantees such as letters of credit Future commitments to lend Derivative transactions (e.g., futures, forwards, options, and swaps) o Offbalancesheet assets: move onto the asset side of the balance sheet or income is realized on the income statement o Offbalancesheet liabilities: move onto the liability side of the balance sheet or an expense is realized on the income statement Commercial Banks o The ReigleNeal Act of 1994 allowed nationwide branch networks to evolve 14,483 banks with some 60,000 branches in 1984 7,350 banks with some 83,000 branches in 2007 o The Financial Services Modernization Act of 1999 Gave commercial banks the full authority to enter the investment banking and insurance business Regulators o FDIC insures the deposits of commercial banks o U.S. has a dual banking system—banks can be either nationally or statechartered The Office of the Comptroller of the Currency (OCC) charters and regulates national banks State agencies charter and regulate state banks o The Federal Reserve System (FRS) has regulatory power over nationally chartered banks and their holding companies and state banks that opt in to the Federal Reserve System Holding company parent company that owns a controlling interest in a subsidiary bank or other FI Lecture 10: Bank Credit Risk Management Importance of Credit Risk Management o Larger banks are generally more likely to accept riskier loans than smaller banks o Larger banks are also exposed to more counterparty risk offthebalancesheet than smaller banks o Managerial efficiency and credit risk management strategies directly affect the return and risk of the loan portfolio o At the extreme, credit risk can lead to insolvency as large loan losses can wipe out a commercial bank’s equity capital Lending Standards o Analysis of the 6C’s pertaining to the borrower: [[Character, collateral, capacity], capital, conditions], and compliance Character personal traits & attitudes about debt payment commitment Collateral pledged assets Capacity borrower’s success at running a business cash flows Capital financial condition of the borrow net worth Conditions economic conditions Compliance compliance with laws & regulations (Community Reinvestment Act, the Environmental Superfund Act, lender liability, etc.) Managing Credit Risk o For CBs, different methods are used in managing credit risks: Individual borrowers, small firms, midsized firms, and large firms Real estate loans, personal loans, and C&I loans o CBs use: Scoring System, Financial Statements, and Ratio Analysis approaches Credit Scoring: FICO o Developed by Fair Isaac Inc. & widely used in residential mortgages & consumer loans o Factors considered when determining FICO score: Payment History (35%); Amounts Owed (30%); Length of Credit History (15%); Type of Credit in Use (10%); New Credit (10%) o Score ranges from 300 – 850 Bad (350620); Fair (620660); Good (660750); Excellent (750850) Credit Scoring: Large Businesses o Altman’s Zscore (Z=1.2X + 11 X + 3.2 + 0.3X + 1.04 ) 5 If Z < 1.81 high risk firm If 1.81 ≤ Z ≤ 2.99 intermediate risk firm If Z > 2.99 low risk firm o Problems with Zscore Weights are less likely to stay constant over time The 5 ratios used in the model may not be enough Other quantifiable factors, such as reputation of borrowers or the borrower lender relationship, exist Economic condition Accounting variables are infrequently updated Financial Analysis o Traditionall y, banks analyze financial statements of potential borrowers Very typical in loans to corporations and business Less typical in residential mortgage loans and consumer loans. o Purposes Evaluating financial conditions and creditworthiness of potential borrowers Monitoring the financial behavior of borrowers after credit has been extended. o Comparison Historical Trends Comparison with other companies Financial Analysis: Cash Flow Analysis o Banks make sure if the (potential) borrowers have enough cash flows (=cash receipts – cash disbursement) compared to loan payments o Cash flows are not the same as net income! o Cash Flows (not) the same as net income – they are from: Operating activities Investment activities Financing activities Ratio Analysis o Ratios are conveniently used to summarize information in financial statements o Similar companies can be compared using a ratio analysis Real Estate Lending o Real estate loans Mortgage loan applications are among the most standard of all credit applications Decisions to approve or disapprove a mortgage application depend on: The applicant’s ability and willingness to make timely interest and principal payments The value of the borrower’s collateral Consumer Loans/ Small Business Loans o Techniques are very similar to that of mortgage lending; however, nonmortgage consumer loans focus on the ability to repay rather than on the property o Smallbusiness loan decisions often combine computerbased financial analysis of borrower financial statements with behavioral analysis of the business owner Commercial and Industrial (C&I) Loans: MidMarket Firms o Generally a profitable market for creditgranting commercial banks o Midmarket corporations typically: Have sales revenues from $5million to $100million per year Have a recognizable corporate structure Do not have ready access to deep and liquid capital markets o Commercial loans can be for as short as a few weeks to as long as 8 years or more Shortterm: finance working capital needs Longterm: finance fixed asset purchases Commercial and Industrial (C&I) Loans: Large Firms o Fees and spreads are smaller compared to small & mid, but transactions are often large enough to make them worthwhile o CB’s relationships with large clients often center around broker, dealer, and advisor activities with lending playing a lesser role o Large corporations often use: Loan commitments Performance guarantees Term loans o Account officers often rely on rating agencies and market analysts to aid in their credit analysis along with sophisticated models such as Altman’s Zscore or KMV models. Calculating the Return on a Loan o The return on assets (ROA) approach uses the contractually promised gross return on a loan, k, per dollar lent Where, f = loan origination fee; b = compensating balance requirement; RR = reserve requirement ratio; BR = base lending rate; m = credit risk premium on loan Lecture 11: Interest Rate Risk Management Interest Rate Risk o When interest rates change, bank’s cash flows and asset values are effected in different ways o Financial Institutions use two main methods to measure interest rate exposure 1) The repricing model – examines the impact of interest rate changes in net interest income (NII) – it is also known as the funding gap model or maturity gap model 2) The duration model – examines the impact of interest rate changes on the overall market value of a financial institution and thus ultimately on net worth The Repricing Model o The repricing gap is the difference between those assets & liabilities whose interest rates will be re priced or changed over some future period The change in net interest income for any given bucket I (ΔNII) is meisured as: ΔNII = iGAP )ΔR = (iSA – RiL)ΔR i i i Where: GAP = ihe dollar size of the gap between the book value of ratesensitive assets and rate sensitive liabilities in maturity bucket i ΔRi = the change in the level of interest rates impacting assets and liabilities in the ith maturity bucket The Repricing Model: Spread Effect o Rate changes on rate sensitive assets (RSAs) generally differ from those on rate sensitive liabilities (RSLs) o Suppose interest rates rise: If the spread increases, interest income increases by more than interest expense, resulting in NII to rise If the spread decreases, interest income increases by less than interest expense, resulting in NII to fall o The spread effect is the effect that a change in the spread between rates on RSAs and RSLs has on net interest income as interest rates change ∆ = (i × ∆ i RSA ) – ( × i RSL) = (( – ) × ∆ ) + ( × (∆ − ∆ )) i i RSA i RSA RSL o Spread = ∆ ∆ RSA RSL o If positive pricing gap + positive spread effect + rising interest rate NII will increase o If positive pricing gap + negative spread effect + rising interest rate NII will increase then decrease The Duration Gap Model o Duration measures the interest rate sensitivity of an asset or liability’s value to small changes in interest rates o The duration gap is a measure of overall interest rate risk exposure for an FI o The change in market value of equity of an FI given a change in interest rates is determined from the basic balance sheet equation A = L + E ∆A = ∆L + ∆E ∆R ∆E = (D kA ) x ALx 1+R , Where k is L/A = a measure of the FI’s leverage o The effect of interest rate changes on the market value of equity or net worth of an FI breads down to 3 effects: 1) The leverage adjusted duration gap = D A D (mL sured in years; reflects duration mismatch on FI’s balance sheet; the larger the gap the more exposed the FI is to interest rate risk) 2) The size of the FI 3) The size of the interest rate shock o Difficulties emerge when applying the duration model to realworld FI balance sheets Duration matching (immunization) can be costly as restructuring the balance sheet is time consuming, costly, and generally not desirable Immunization is a dynamic problem Duration of assets and liabilities change as they approach maturity The rate at which the duration of assets and liabilities change may not be the same Duration is not accurate for large interest rate changes unless convexity is modeled into the measure Convexity is the degree of curvature of the priceyield curve around some interest rate level
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