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Fin.354 lecture notes

Lecture #1

             BUSINESS CYCLES

There is more or less a pattern of expansion
(recovery) and contraction (recess...
Lecture #2


What are they ??

What makes a good market ??

Can we name some “bad” markets ??
The players in the market are households,
businesses and governments. How they play and
what motivates them to play is cri...
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Fin.354 lecture notes

  1. 1. Lecture #1 BUSINESS CYCLES There is more or less a pattern of expansion (recovery) and contraction (recession) in economic activity around the path of trend growth. At cyclical peak- economic activity is high relative to trend. At cyclical trough ?? Over time what causes the trend line to change ? More resources Factors not fully employed all the time. What is inflation ? Why worry about inflation instead of unempmt.? 1
  2. 2. Lecture #2 MARKETS What are they ?? What makes a good market ?? Can we name some “bad” markets ?? FINANCIAL MARKETS & INSTITUTIONS I. Financial markets exist to aid in the most efficient allocation of capital II. Financial Institutions facilitate this allocation of capital. 2
  3. 3. The players in the market are households, businesses and governments. How they play and what motivates them to play is critical to the well being of economies. TYPES OF MARKETS Primary – New fund raising Secondary – Trading There are specialized markets for fund raising and trading. The most important of these are: Money Markets – Maturities < 1 yr. Capital Markets – Maturities > 1 yr. 3
  4. 4. Lecture #3 FLOW OF FUNDS Who are the players? Households Businesses Governments Rest of the World All act at one point in time or another as borrowers and providers. Funds arrive directly or indirectly What is the role of Financial Intermediaries ? To lower transaction costs To lower risk To provide better market information 4
  5. 5. Intermediaries also incur risks……… I/R risk FX risk Credit or default risk What about Foreign Mkts & Intermediaries ? Provide for borrowing or investing abroad Important source of diversification Lecture #4 5
  6. 6. What is an interest rate ? Compensation for lending or giving up one’s abilitiy to spend today. Can be a measuring guideline governing corportate investing. Why do we care about interest rates ? They influence the allocation of capital. They impact the economy and decision making. How do we look at interest rates and time ? Concept of Present Value Present value allows you to place a value on future funds. What might $10 today be worth 10 years from now ? 6
  7. 7. The Present Value calculation converts cash flows received in the future to a value assuming receipt today (the PRESENT ). How much is $3000 received in two years worth today if the interest rate is 4% ? How much is $2000 next year and $3000 the year after worth today if the interest rate is 5%? 7
  8. 8. Where do you hear the concept of Present Value applied quite often ? U.S. Savings Bonds Winning the lottery Back to our first example : PV of $3000 received in 2 years @ 4% = If the i/r is 2%....is PV higher or lower ? If the i/r is 6%.... is PV higher or lower ? Why ???? Lecture #5 8
  9. 9. WHAT DETERMINES THE LEVEL OF I/R AT ANY GIVEN POINT IN TIME ? The supply and demand of loanable funds. Same concept as the supply and demand of goods and services you studied in Economics. So there is a supply and demand curve here as well. SUPPLY Households Businesses Governments Foreign investors DEMAND Households Businesses Governments Foreign What might the supply and demand curve look like ? 9
  10. 10. What might cause the curves to shift ? SUPPLY: I/R Wealth Risk Near term spending needs Monetary Expansion Economic Conditions DEMAND: Current utility Economic conditions Restrictiveness of nonprice conditions. Lecture #6 What are the factors that can affect the i/r for an individual security ? 10
  11. 11. Begin with the “real interest rate “ Direct correlation between inflation & i/r.. U.S. Treasuries become the benchmark.. What factors influence nominal i/r ? Default risk Liquidity risk Covenants- puts/calls Term to Maturity Ubiased Expectations Theory 11
  12. 12. Liquidity Premium Theory Market Segmentation Theory Lecture #7 What does the yield curve tell us ? 12
  13. 13. What exactly are bonds ? Debt instruments – Secured/Unsecured Coupon or Zero PV = Face Value = Par PV> Face Value= Premium PV < Face Value = Discount These reflect the price of bonds. How does that relate to Yield…. 13
  14. 14. Price and yield are inversely related. Why ? Duration – measure of the weighted average time to maturity. That is, it takes into account the timing of payments. Any received before maturity will result in a shorter duration that the maturity date….. Higher interest rates shorten duration. Why ? Lecture #8 THE FEDERAL RESERVE SYSTEM 14
  15. 15. Objectives: Moderate long-term i/r Maintain high level of employment Stable prices Economic growth It’s duties: Conduct monetary policy Supervise/regulate depository institutions Maintain stability of financial system Provide payments services for governments Also check clearing & wire transfers Independent of Executive Branch Oversight by Congress Chairman/Vice Chair appointed by President 15
  16. 16. 12 Regional Banks 7 Member Board of Governors 5 of Regional Bank Presidents + Board of Governors comprise the Federal Open Market Committee (FOMC) The objectives shown above are their job…. What is important is how they do it…. Lecture #9 MONETARY POLICY What is it and how does it affect us ? 16
  17. 17. In essence it is an attempt to influence the amount of reserves that remain in the banking system….which in turn affects i/r and the availability of credit…which ultimately affects the levels of employment, output, and prices and inflation. In other words the money supply. MONETARY POLICY TOOLS Open Market Operations Discount Rate Reserve Requirements The FOMC impacts the economy thru its practice of buying and selling government securities in the open market. In so doing they are either adding money (expanding) to the existing supply or taking it out (contracting). Discount rate – Rate Fed. Charges bank to borrow from it….In reality is only used as a signal to the market as to which way the Fed wants to see rates go. The discount rate was 17
  18. 18. lowered 11 time in 2001 in an attempt to stimulate the economy. Bank reserves: Required – currently 10% Excess How do these tools help expand the money supply ? How do these tools help contract the money supply ? Definitions of the money supply Base 18
  19. 19. M1 M2 The FED selects a target and uses Monetary Policy to get to that target. Most popular targets: Money Supply Interest Rate Lecture #10 MONEY MARKETS Short term debt instruments < 1 year 19
  20. 20. Active secondary market/ very liquid Capital markets > 1 year Characteristics of money market instruments: Large – usually $1 mil. + Low default risk Maturity of 1 year or less Corporates and governments usually sell money market instruments to meet short term needs. TREASURY BILLS Default risk free 20
  21. 21. Benchmark for other securities pricing Refinancing debt/govt. deficit/tax timing Sold at auction weekly Shortest maturity is 13 weeks. Sold at a discount Suppose you buy a 26 week T-bill for $9500 whose face value is $10,000. What is the discount yield ? i = 10000-9500/10000 x 360/182 = 9.89% FEDERAL FUNDS Primarily overnight loans between banks. One of the uses of their excess reserves. 21
  22. 22. FED sets the lending rate. For all practical purposes are just lending cash between two banks. REPURCHASE AGREEMENTS (REPOS) Actual sale of securities between two parties with agreement to repurchase at set date and price. Is collaterized most often with govt. securities. Normally 1-14 days but can go 90. More secure than Fed Funds so has lower yield…often as much as 25 basis points. Lecture #11 COMMERCIAL PAPER (CP) An unsecured promissory note issued by corporations. 22
  23. 23. Corporates with good credit can often borrow cheaper in the cp mkt. than from their banks. (see chart on page 135)…comparing cp rates to prime rate. Normally held to maturity….up to 270 days. Lower rated corporates can issue cp backed by LOC’s or bank lines of credit. Expensive by effective….better than issuing long term if improving credit. Purchasers get internal approval on a credit and return again again. Cp usually sold thru dealers like Goldman Sachs…agree to repurchase in event of default. Rates are quoted on a discount basis NEGOTIABLE CD’s 23
  24. 24. Bank issued promissory notes. Specific maturity and rate. Trade in secondary market at negotiated price. Normal maturities are 14-360 days. Unsecured issuance so yield is higher. BANKERS ACCEPTANCES A draft for payment backing a LOC issued against imported goods. Importer gets LOC guaranteeing payment to exporter. BA allows them to draw down money before delivery. Importer then reimburses the bank. There is a secondary market for BA’s. MONEY MARKET PARTICIPANTS 24
  25. 25. Issuer Investor T-bills Treasury Fed/Banks/Cor Fed Funds Banks Banks Repos Fed/Banks Fed/Banks/Cor Cp Banks/Corps Corps/FI’s Neg. CD Banks FI’s/Corps BA’s Banks Banks/Corps Where are there secondary markets ? Where are yields the highest/lowest ? Who are the important FI’s ? Summary – Money markets are important to: 25
  26. 26. The Fed – for controlling the money supply. Banks – to meet reserve requirement and as a place to use excess reserves. Broker-Dealers – Keep the market moving Corporations - source of short term funding and as a place to invest short term cash. Other FI’s – A place to maintain liquidity. INTERNATIONAL MONEY MARKETS 26
  27. 27. Foreigners are major investors in Treasuries Diversification and default free Keep deposits in foreign countries to facilitate exhange into $. LIBOR is major lending rate. Now major rate measurement for all types of loans, not just foreign. Borrowing is usually quoted as a spread over LIBOR…might be 350, 30 or 3…depending on the risk associated with the borrower. Lecture #12 THE BOND MARKET 27
  28. 28. Bonds are capital market instruments with maturities of greater than one year. Typically fixed income ….offering interest a set time periods and the return of principal at maturity. A bond with a coupon of 8% would normally pay interest every six months, 4% at a time. Treasury notes >1<10 years Treasury bonds >10 <31 years They comprise about 26% of total bond market securities. Both pay semi-annual interest and are sold at auction..but are sold at par unlike T-bills. Treasury also issues inflation adjusted bonds called TIPS. They also sell STRIPS where each coupon payment is sold separately. The secondary market in Treasury issues is huge. If a bond is sold between coupon payments the seller must pay the buyer the 28
  29. 29. accrued interest..or discount the price to account for it. MUNICIPAL BONDS Debt instruments issued by state and local governments. About 17% of all bonds o/s. Interest not taxed by feds or state investor lives in for bonds issued in that state. Tax exemption lowers cost of bonds issuance for the governments because investors take a lower yield. General obligation – backed by taxing power Revenue bonds – backed by revenue of a project. General tax receipts cannot be used to pay off a revenue bond…thus is riskier. Industrial development bonds – normally for job creation. How are municipal bonds sold ? Underwritten/best efforts/negotiated basis 29
  30. 30. Secondary market very thin. CORPORATE BONDS Comprise about 57% of o/s bonds. Normally issued to fund long term obligations. Rating agency comments are critical to price. Debentures – no collateral Subordinated debentures – junior in status Convertible bonds – debt that converts to equity at some point in time if certain things occur. Callable bonds Sinking funds Moody’s/S & P / Fitch Who are buyers of the various types of bonds? Which bonds likely carry the highest and lowest yields ? 30
  31. 31. INTERNATIONAL BOND MARKETS Eurobonds – Sold outside the country of the currency in which they are issued. Could be dollar denominated bonds sold in Japan. Foreign bonds – Bonds issued outside the home country but denominated in the host country currency…Samurai bonds are dollar denominated bonds issued by Japanese borrowers in the U.S. Brady bonds – bonds substituted in a restructuring of a less developed country’s debt. Longer term and lower rates. Backed by the U.S. Treasury Sovereign bonds – specific country issued . Lecture #13 MORTGAGES Loans to purchase real property such as a home, land or building. 31
  32. 32. 75% of mortgages are for single family dwellings. Characteristics of a mortgage: Size, term, i/r, collateral Qualifications – fairly standard, income to value ratio (can you make the payments) Down payment – reduces default risk Conventional vs. Insured. Maturity – 15/30 yr….. balloon payment I/R – Fixed vs. ARM Greenspan ARM quotes. Amortization schedule Refinancing depending upon rate cycle. Originate with FI’s most of whom do not continue to carry them on their balance sheet. 32
  33. 33. Sold off in secondary market thru securitization. Allows FI to enhance their liquidity and reduce i/r and credit risk. What is securitization and how does it work? Why securitize ? Mortgage market very cyclical. Govt. subsidies are key to role housing plays in the robustness of the economy. Home building may suffer as rates go up… Lecture #14 STOCK MARKETS What is stock anyway ? 33
  34. 34. Equity/ownership How does one make a return from stock ownership ? Common/Preferred Dividends Limited liability of ownership IPO’s /Seasoned offerings Primary vs. secondary markets. SEC/Registration/Red Herring/Shelf registration The Markets: NYSE/NASDAQ/AMEX How does trading occur on each market ? 34
  35. 35. Indices: DOW / S & P 500 / Wilshire 5000 What causes prices to change on the Market ? Efficient market theory / Random walk Lecture #15 FOREIGN EXCHANGE Global trade requires that we exchange currencies. 35
  36. 36. The foreign exchange rate is the ratio of one currency to another. How yen equal one dollar ? Initially had fixed currency rates. And Gold !! Eventually floating. Now the Euro !! Can use spot or forward markets to make exchange rate more predictable. What causes exchange rate differentials between countries ? Economic flows between countries are measured by the balance of payments. Current Account: Merchandise trade balance Service sector Unilateral transfers 36
  37. 37. Capital Account : Direct investment Portfolio investment Lecture #16 DERIVATIVES Financial instruments tailored to change where risk lies. 37
  38. 38. Swaps, caps, floors, etc. are examples of these. Most deal with the i/r or credit markets. Spot contracts - discussed in FX context. Is a given price today….a guarantee. When investing using spot contracts you are investing looking for appreciation. Forwards are contracts to buy something at a given price in the future at a price determined today. Hedging future price change by locking in today. Example: Airlines buying fuel for their fleets. Locking in a mortgage rate could involve a forward contract. Futures contracts are like forward buy are traded on a formal exchange. No default risk versus total with forwards. Futures are revalued every day. Futures are generally in 3 areas: i/r currency index 38
  39. 39. Can hold contracts to maturity or trade….most liquidate before maturity.If hold to maturity you take possession of the underlying asset. So in each of these markets you are betting on change. Options are a contract giving you the right but not the obligation to buy or sell something within a specific period of time. Call options give you the right to buy (call away from the seller)..a security at a predetermined price. This is the exercise or strike price. Selling an option…you write a call option. Put option… You can buy stock options on many of the major companies in the world on the NYSE or NASD. Cheap way to invest.. What happened to markets after 9-11 ? What would have happened to your options ? 39
  40. 40. You can purchase indices made up of the major stocks….Dow/ S & P 500, etc. You can use these to hedge (as a derivative) other stocks you own. SWAPS – the most used derivative…great fun !! Two parties agree to swap cash flows some time in the future based upon some underlying asset. Terrific tool for companies to manage i/r risk, currency risk and credit risk. Sold bond last year - $100 mil. 10yr – 7% coupon. Now I think rates are going to trend down. What can I do about it now ? Nothing changes with the underlying assets…only the cash flows tied to them. Currency swaps – evening out exposure Swap markets – Counterparty risk 40
  41. 41. Caps (ceilings) – limit the upside exposure. Floors – protect the bottom Collars – give up a little to establish a range of risk. .Lecture #17 COMMERCIAL BANKS Serve as principal channel for government monetary policy. 41
  42. 42. Loans are assets/Deposits are liabilities. How then do banks make a profit when their chief assets and liabilities are just pieces of paper ?? ASSETS: Loans – A promise to repay – Approx. 60% of assets. Loans to whom ? Business – 25% of total Revolving lines of credit Seasonal (inventory) Floor plans Fixed – collateralized Real Estate – 46% of total Commercial and residential Mortgages/equity lines of credit Consumer credit – 16% International Investments 42
  43. 43. Biggest problems: Default Fixed rate lending Mismatch of maturities Keys to successful asset management: Lend to good customers Invest in low risk securities Diversify THERE IS A FINE LINE BETWEEN PROFITABILITY AND SAFETY. LIABILITIES Why are deposits liabilities ? Deposits represent aout 2/3 of total bank funding. 43
  44. 44. Generally checking, savings and CD’s. The remainder of funding comes from direct bond issuance, discount window and fed funds borrowings. Liability characteristics: Shorter term and more liquid than assets Transitory Major problems: Maturity mismatches I/R risk BANK EQUITY Regulators mandate a minimum level of equity(capital) to assets.. Today this number is about 9%. So banks are really highly levered. Capital is primarily common stock and retained earnings. It also includes reserves for losses. 44
  45. 45. Serves as a cushion against a drop in assets. What happens when liabilities exceed assets ? Japan banking crisis What happens in a recession to bank business ? Banks frequently have lots of business off their balance sheets. Swaps, derivative contracts, some loan commitments, foreign exchange contracts, etc. Why would they do this ? Commercial bank companies have been growing because of the change in the law allowing branching. This has brought on major merger/acquisition activity. More income coming from non-interest/fee based business. 45
  46. 46. Commercial banking – International U.S. banks going abroad: Less regulation New business Follow their customers Risks are higher – As are returns Credit Political Currency Banking around the World Japan-China-Euro The Regulators Lecture #18 THRIFTS Historically small institutions serving specialized needs of local groups. 46
  47. 47. Savings assoc. (formerly S & L’s)…population has declined by 75% over last 20 years. Now about 1200. Traditionally made long term fixed rate mortgages to individuals funded by short term deposits. Problems of the 1970’s / Regulation Q Disintermediation Garn-St. Germain Act of 1982 / NOW-MMDA Oil collapse / Regulators failed / New regulators Assets: Mortgages and mortg. Backed sec. 73% Comm. Loans – 3% What happens in an economic downturn ? Thrift liabilities: Over 60% is small deposits. Fed. Home Loan Bank borrowings = 22% Equity (capital) = 8.2 % What happens in an economic downturn ? 47
  48. 48. SAVINGS BANKS Essentially S & L or Savings Assoc. in the NE. Less than 400 exist. Balance sheets similar to Savings Assoc. except that are more highly capitalized. CREDIT UNIONS Evolved from employer owned institutions. Are now nonprofits owned by their depositors. Customers must have a common bond. Consumer loans make up 37% of assets with mortgages at 29%. Portfolio is more liquid and has lower default risk than that of banks and SA’s. Credit Union Liabilities: Member deposits = 89% Primarily savings, CD’s, and NOW accts. Equity (capital) is in excess of 9% 48
  49. 49. Should be able to offer better rates to customers and make a higher ROA because of tax status. REGULATION OF THRIFTS; Office of Thrift Supervision (part of Treasury) FDIC provides insurance State assoc. are regulated by states. Natl. Credit Union Admin. Board charters and Insures credit unions. Will these institutions exist 10 years from now ? Lecture #19 INSURANCE COMPANIES 49
  50. 50. Life insurance – allows individual to protect themselves and their benefactors against the loss of income from death. Insures pool risks – why / What happens if they are wrong ? Types of life insurance: Ordinary life Term life Whole life Endowment life Variable life Universal life Group life Credit life Annuities GIC’s Accident and Health What do the balance sheets of Insurers look like ? 50
  51. 51. Premiums are assets – long lived Investments ? Policies are liabilities Regulation is at state level. Business getting more competitive with brokerages, banks entering. Property & Casualty: Fire Homeowners Commercial Auto Liability Premiums are assets / claims are liabilities How do these companies ever lose money ? Lecture#20 SECURITIES FIRMS & INVESTMENT BANKING Securities firms….. 51
  52. 52. Investment banks….. Activities: Investing Investment banking Market making Trading Cash management M&A Others: Research……the scandals…tying arrgmts. SEC / Spitzer Lecture #21 FINANCE COMPANIES Lenders to consumers, businesses, mortgages. How are they different from Banks ? 52
  53. 53. 1. Sales Finance Institutions 2. Personal Credit 3. Business Credit Asset makeup / Liabilities Subprime ??? How do they fund their business ? How much equity capital do they employ ? Why do they even exist ? Lecture #22 MUTUAL FUNDS & HEDGE FUNDS Financial instruments that pool funds. Various funds have different objectives: Growth, international, bond, etc. 53
  54. 54. Prospectuses How do you make money in a mutual fund ? How do mutual fund companies make money ? 401-k growth Regulation Lecture #23 PENSION FUNDS Savings plans through which participants accumulate tax deferred savings for retirement. Defined benefit plan Defined contribution plan 54
  55. 55. Private plans: 401-k IRA Keogh Public plans State & local Federal Lecture #24 REGULATION OF DEPOSITORY INSTITUTIONS Crucial – Confidence in FI’s key for domestic and International business. Safety & Soundness Monetary Policy 55
  56. 56. Credit Allocation Consumer Protection Investor Protection Entry & Chartering Reg. of Product & Geographic Expansion Prior to crash Glass – Stegall Section 20 Glass – Stegall repeal Geog. Expansion- Unit/restricted branching/interstate branching FDIC FSLIC Why did problems of the 1980’s arise ? Balance Sheet Regulations: Focus on leverage Capital to assets ratios become triggers: >5% all the way to <2% On balance sheet versus including off balance sheet 56
  57. 57. What is history of foreign banks ? Social Security problems / solutions Lecture #25 FINANCIAL INSTITUTION RISKS Credit – Bad investments/ Bad loans Firm specific risk Systemic risk Liquidity – High withdrawals/ “run” 57
  58. 58. Interest Rate – Mismatching Market – Trading Off Balance Sheet - draw downs/derivatives FX – Sovereign – Technology – Operational Insolvency Lecture #26 MANAGING CREDIT RISK Have had bouts of bad credit ….. 1980’s – thrifts/real estate 1990’s – junk bonds/credit cards 2000 – telecom’s/tech/sovereign debt 58
  59. 59. What is the best way for a FI to lessen its risk of extending bad credit ? Real estate lending: Ability to pay Collateral Ability to pay: How long have you lived somewhere / Job Credit history Other obligations Calculate ratios Credit scoring also used. Compares your situation to others like you. If you look like those who have defaulted then assumption is you will also. Collateral : Perfect security interest/lien Default and they foreclose. Non-mortgage consumer loans just based on ability to pay. 59
  60. 60. Small business lending looks at cash flow of the business. Mid-market focuses more on the business itself….cash flow/customer book/cyclicality In the end, how predictable is the cash flow / Credit analysis of the smaller firms is critical. The 5 C’s…. Character/Capacity/Collateral/Conditions/ Capital Haircuts Ratios Large borrowers: Tougher sell for the FI. More options. Information is better. Once you have decided to make the loan how do you decide what to charge for it ? In other words, how do you make money at this game ? RAROC 60
  61. 61. How much is a relationship worth ? Lecture# 27 MANAGING LIQUIDITY RISK I WANT MY MONEY NOW !!! Can purchase liquidity or use stored liquidity. Runs and panics 61
  62. 62. FDIC Fed Discount Window Life Insurance Co. liquidity risk Property and Casulty liquidity risk Mutual Funds liquidity risk Lecture #28 INTEREST RATE & INSOLVENCY RISK Measuring the Risk….. Rate Sensitive Assets and Liabilities 62
  63. 63. The Repricing Gap The Duration Model What is Capital and how is it Valued ?? Lecture #29 MANAGING DERIVATIVE RISKS Review Contracts: Spot / Forwards / Futures Hedging with Contracts 63
  64. 64. Accounting Rules / Bank Regulations Options / Swaps Lecture #30 LOAN SALES AND SECURITIZATION What are Loan Sales ? Why did they come to be ? Participations / Assignments 64
  65. 65. What is the Market ? Who are the Players ? What drives the Market ? How is Loan Securitization different from Loan Sales ? 65