capital markets 3504

8/4/2019 Capital Markets 3504

http://slidepdf.com/reader/full/capital-markets-3504 1/43

Introduction to CapitalIntroduction to Capital

MarketsMarketsB, K & M Chapter 2B, K & M Chapter 2

End of chapter problems: 1End of chapter problems: 1--1313, Project 1, Project 1



The Capital Markets OverviewThe Capital Markets Overview

Value of Outstanding debt in 2007:Value of Outstanding debt in 2007:

Treasury Securities:Treasury Securities: § $4.6 Trillion§ $4.6 Trillion Bills § 21%Bills § 21%

Notes Notes §§ 62%62%

Bonds § 17%Bonds § 17%

GovGov--sponsored enterprise § $2.7 Trillionsponsored enterprise § $2.7 Trillion

(Freddie Mac), (Fannie Mae), (Sallie Mae), etc(Freddie Mac), (Fannie Mae), (Sallie Mae), etc

U.S. Corporate Bond Market:U.S. Corporate Bond Market: §§ $3.1 Trillion$3.1 Trillion

Tax exempt bonds:Tax exempt bonds: §§ $ 2.1 Trillion$ 2.1 Trillion

Mortgage Backed Securities (includes GSEs):Mortgage Backed Securities (includes GSEs): §§ $3.8 Trillion$3.8 Trillion

Value of U.S. Equities in 2007:Value of U.S. Equities in 2007: §§ $15.4 Trillion, (30% of World)$15.4 Trillion, (30% of World)

Residential Real Estate in 2007: § $20.4 TrillionResidential Real Estate in 2007: § $20.4 Trillion

US GDP in 2007: § $14 Trillion (25% of world total)US GDP in 2007: § $14 Trillion (25% of world total)

US Population in 2007: 300 million (<5% of world total)US Population in 2007: 300 million (<5% of world total)



The Money Market: December 2007The Money Market: December 2007



The Money MarketThe Money Market

The U.S. Government is the largest single issuer of debt in theworld

Treasury Bills

Issued by Federal Government at a discount (zero coupon)

Maturities of 91 days and 182 days. Offered each Monday, sold

at auction

Very liquid secondary market for T-Bills (for large investors)

Interest exempt from state and local taxes

Quoted in WSJ in terms of its bank discount yield, which

differs from its effective annual rate of return



TT--Bills (cont.)Bills (cont.)

Effective Annual Yield (rate of return) on a pure discount

bond is defined as r:

)( /!

T

P

FV r

Where:

FV is the future value of the bond ($10,000)

P is the current transaction price of the bond ($9,600)

T is the time to maturity in years, days to maturity over

365 (assume 182)



TT--Bills (cont.)Bills (cont.)

EXAMPLE:EXAMPLE:

!!r



Spread between 3 month CDs and T-Bills



Commercial PaperCommercial Paper

Unsecured notes issued by large (credit worthy)

corporations

³Disintermediation´ Since the late 1980¶s there

have been a few years in which the size of commercial paper market exceeded that of the T-Bill

market

Over 1000 corporations issuing CP in the U.S.

Maturities of 30 to 270 days

Issued in multiples of $100,000



Commercial Paper (cont.)Commercial Paper (cont.)

Rates typically exceeded T-Bills by .5% to 4%

(taxed by all levels of government)

Defaults are rare (fewer than 10 since 1971). LOC

paper is CP issued with a letter of credit (credit

enhancement), with a bank or insurance company

guaranteeing payment in the event of a default

Implication: Purchasing a guarantee and raising

funds in the CP market is cheaper for many

companies than borrowing directly from a bank!



EurodollarsEurodollars

Dollar denominated deposits at foreign banks or

foreign branches of American banks

Of course, no deposit insurance



Federal FundsFederal Funds

Fed funds are bank deposits at a bank¶s district Fed

for the purpose of meeting reserve requirements

Banks with ³excess´ reserves at the Fed loan to

those with a shortfall

An alternative is for a bank to do a ³repo´



Bankers AcceptancesBankers Acceptances

An order to a bank by a bank customer to pay sum at a

future date

When the bank has endorsed the order as ³accepted´ itassumes responsibility for the ultimate payment to the

holder (at this point may be traded in the secondary

market)

Sold at a discount from face value

Used widely in the finance of foreign trade



London Interbank Offered Rate (LIBOR)London Interbank Offered Rate (LIBOR)

The rate at which large banks in London are willing to

lend money among themselves

Premier short-term rate in the European money market



The Fixed Income CapitalThe Fixed Income Capital

MarketMarket



Treasury Notes and BondsTreasury Notes and Bonds

Notes have maturities of 1 to 10 years

Bonds have maturities of 10 to 30 years, may be callable

in the last 5 years

Auctioned at (or near) par value with twice yearly interest

payments

Yield to maturity in the WSJ is calculated with a simple

interest method (sometimes called bond equivalent yieldor annual percentage rate (APR))



Treasury Notes and Bonds (cont.)Treasury Notes and Bonds (cont.)

What is reported yield to maturity on a 10-yr T-Bond with a9% coupon and selling at 100:10 (100 10 32)?

What is its effective rate of return? Solve for the r (discount

rate) that equates the price of the bond to the discounted cash

flows. The final payment is the repayment of principal.

This calculation gives the YTM or effective return in terms of

the 6-month interest rate r. The annualized yield reported in the

WSJ is not (1+r)2 ±1, but rather 2r. (bond equivalent yield)

2

2

1 )1(

1

)1(

.1.1

r r t

t

!§

!



Inflation Adjusted Treasury BondsInflation Adjusted Treasury Bonds

Introduced in the 1990s

Face value is inflation adjusted (although the

principal adjustments are taxable events)



Federal Agency DebtFederal Agency Debt

1) Government National Mortgage Association (Ginnie

Mae)

2) Federal National Mortgage Association (Fannie Mae)

3) Federal Home Loan Mortgage Corporation (Freddie

Mac)

4) Also some farm credit agencies (make seasonal loans to

farm coops, make mortgage loans on farm properties,and provide short-term financing for agricultural

production and marketing)



Federal Agency Debt (cont.)Federal Agency Debt (cont.)

Ginnie Mae guarantees securities issued by pooling privately originated

mortgage, and selling claims to the cash flows as the loans are paid off.As a federal agency, its guarantee carries the full faith and credit of the

U.S. government

a) Mortgages are issued by approved lenders such as commercial

banks and mortgage brokers, with underwriting standards

established by Ginnie Mae

b) The mortgage originator may continue to service the loan,

collecting interest and principal payments, ³passing´ these

along to the mortgage purchaser

c) The security guaranteed by Ginnie Mae is called a mortgage- backed security (MBS), and is sold with a minimum

denomination of $25,000




Freddie Mac and Fannie Mae provide liquidity to the

mortgage market by purchasing mortgages, and then issuing

MBS¶s creating a secondary market

Although referred to as ³Agencies,´the governmentguarantee is only implicit

MBS¶s have attracted to the mortgage market investors

who were not previously active participants. They have

increased liquidity, and made mortgage markets lessdependent on local credit availability

Spreads over Treasury rates were typically small (until

2007-2009)




A major risk to pass-throughs is the call feature available

to mortgage holders who might want to refinance if interest

rates fall ± ³Extension´ and ³Contraction´ risk

Some institutional investors may be primarily concerned

with extension risk, while others may be more concerned

with contraction risk

Collateralized Mortgage Obligations (CMOs) meet this

need



Collateralized Mortgage Obligations (CMOs)Collateralized Mortgage Obligations (CMOs)

A CMO is a security backed by a pool of pass-throughs

that is structured so there are several classes of

bondholders (tranches) with varying stated maturities

Prepayment risk is not eliminated but rather

redistributed among the tranches



CMOs (cont.)CMOs (cont.)

Examples:

- Sequential pay CMOs:

- tranches are retired sequentially

- Interest only (IO) and principal only (PO) strips:

-The PO strip is sold at a discount from par value. The yield depends onthe speed with which prepayments are made (the faster the prepayments

the higher the yield)

-The IO has no par value. The investor receives interest on the amount of

principal still outstanding. Note that prepayments here reduce principal

and hence interest payments. If prepayments are too fast, the investor may not recover the amount paid for the IO!

Issuers of CMOs are both agencies and investment banks (private label

CMOs)



CMOs (cont.)CMOs (cont.)

MortgageMortgage--Backed SecuritiesBacked Securities

Outstanding, 1979Outstanding, 1979--20072007Issuance Volume of Collateralized Mortgage Obligations, 1982-1993

a

Year Number of

Deals

Dollar Value

(in millions)

Number of

Tranches

Average Number of

Tranches per Deal

1982 1 50$ 2 2.0

1983 8 4,748 53 6.6

1984 18 9,903 143 7.91985 59 16,515 434 7.4

1986 89 49,838 951 10.7

1987 94 58,875 1,020 10.9

1988 156 77,066 1,796 11.5

1989 236 95,209 2,608 11.1

1990 280 112,993 3,802 13.6

1991 440 200,810 7,077 16.11992 504 260,410 9,688 19.2

1993 441 271,180 10,597 24.0aIncludes agency and nonagency CMO/REMICs.

Source : Wall Street Analytics, Inc.



Municipal BondsMunicipal Bonds

Issued by state and local governments

Exempt from federal taxes (on interest only) if issued to build

roads, schools, hospitals or to finance deficits

Lower interest because of tax status

The rate a taxable must pay to match the after-tax yield on a

municipal is:

At what tax bracket are investors indifferent between taxableand tax exempt bonds?

)( t

m

!

t m

!1



Tax-exempt debt



Ratio of yields is variable!



Municipal Bonds (cont.)Municipal Bonds (cont.)

In class problem: If taxables yield 8% and similar

municipals yield 6%, which investment should be chosen byan investor in the 28% tax bracket who pays an average tax

rate of 22%?



Corporate BondsCorporate Bonds

Unsecured: backed by earning power of corporation

Secured: backed by specific assets

Callable by issuer after 5 years (utilities) or 10 years

(industrial corporations) at some premium (1 years

interest)

Call feature is an option whose value depends on time toexpiration, strike price, volatility, etc.



Corporate Bonds (cont.)Corporate Bonds (cont.)

A convertible bond contains an option to convert to a

specified number of shares of common stock prior to

maturity

Junk bonds are not rated as investment grade by one of

the rating agencies:

e BB (S&P), e Ba (Moody's)

Taxable (interest and capital gains)

Maturities up to 30 years



EquitiesEquities



Common StockCommon Stock

Residual claim

Limited Liability

Note: For most stocks, the individual investor is no

longer the marginal investor

Direct Individual Ownership of US Equities

47.9% in 1980

21.5% in 2007



Preferred StockPreferred Stock

Hybrid security

Fixed dividend

Dividend payments are not tax-deductible expensesfor the firm (but corporations may exclude 70% of

dividends received from domestic corporations from

taxable income)

May be callable (redeemable) and convertible



Agency Costs and Corporate ControlAgency Costs and Corporate Control

(Important areas in corporate finance)(Important areas in corporate finance)

In theory, shareholders control management, but in

practice, management can hurt shareholders by

incompetence, serving their own interests, and controlling

the board of directors

In theory, proxy fights prevent this, but they are

expensive and 75% lose

The best protection may be through the threat of takeovers

Is Private Equity a Solution?



Market IndexesMarket Indexes

When constructing or using indexes, the problems of

sampling, weighting and averaging must be faced



SamplingSampling

Larger samples are more difficult to handle

(without a computer) but are more representative

Older indexes tend to be based on fewer stocks



WeightingWeighting

Weighting by relative market values is appropriate for

indicating changes in the aggregate value of stocks in

the index

Using equal weights is appropriate for indicating

movement in the price of a typical stock

DJIA weights are proportional to prices!?



AveragingAveraging

Most indexes use arithmetic averages although value line

computes a geometric average

Example:

STOCK RETURN

A 10%B -5%

C 20%

Equally weighted arithmetic average:[.10 + (-.05) + .20] 3 = 8.33%

Equally weighted geometric average:

[(1+.10)(1+(-.05))(1+.20)] 1 3 = 1.0784 or 7.84%



AveragingAveraging

A general mathematical property is that the geometric

average is less than the arithmetic average

The arithmetic average here corresponds to the return

from purchasing the above portfolio with equal weights

There is no portfolio strategy that results in a rate of

return equal to that of a geometric index



Dow Jones Industrial Average (DJIA)Dow Jones Industrial Average (DJIA)

The arithmetic average of the price of 30 large NYSE

stocks (~ 20% of NYSE value)

Represents the return (not including dividends) from a

strategy of holding one share of each stock

A stock split reduces the importance of the split stock in the

index



S&P 500S&P 500

A market value weighted index of 500 large company

stocks

Represents the return (not including dividends) from

the strategy of holding a portfolio of the 500 firms in

proportion to their market values



Other IndexesOther Indexes

Wilshire 5000 (5000 NYSE, AMEX, and OTC

stocks)

NASDAQ Comp (2000 NASDAQ stocks)



CorrelationsCorrelations

Correlation Coefficients between Different U.S. Stock Market IndicatorsCorrelation Coefficients between Different U.S. Stock Market Indicators

(Monthly Returns form 1975(Monthly Returns form 1975--1988)1988)

DJIADJIA S&P400S&P400 S&P500S&P500 NYSE NYSE AMEXAMEX OTCI NDOTCI ND OTCCOMPOTCCOMP CRSPEQWCRSPEQW CRSPVWCRSPVW

DJIADJIA 1.0001.000

S&P400S&P400 0.9580.958 1.0001.000

S&P500S&P500 0.9530.953 0.9770.977 1.0001.000

NYSE NYSE 0.8890.889 0.9090.909 0.9110.911 1.0001.000

AMEXAMEX 0.6750.675 0.7380.738 0.7360.736 0.7360.736 1.0001.000OTCI NDOTCI ND 0.7350.735 0.7700.770 0.7530.753 0.7370.737 0.7620.762 1.0001.000

OTCCOMPOTCCOMP 0.7680.768 0.7820.782 0.7850.785 0.7840.784 0.7820.782 0.8810.881 1.0001.000

CRSPEQCRSPEQ 0.9370.937 0.9450.945 0.9450.945 0.9400.940 0.8440.844 0.7430.743 0.8010.801 1.0001.000

CRSPVWCRSPVW 0.9440.944 0.9490.949 0.9590.959 0.9560.956 0.8530.853 0.7650.765 0.8130.813 0.9220.922 1.0001.000

DJIA = Dow Jones Industrial AverageDJIA = Dow Jones Industrial Average

S&P400 = Standard & Poor¶s 400 Industrial Stock IndexS&P400 = Standard & Poor¶s 400 Industrial Stock Index

S&P500 = Standard & Poor¶s 500 Stock Composite IndexS&P500 = Standard & Poor¶s 500 Stock Composite Index

NYSE = New York Stock Exchange Index NYSE = New York Stock Exchange IndexAMEX = American Stock Exchange AverageAMEX = American Stock Exchange Average

OTCI ND = Over OTCI ND = Over--thethe--Counter IndexCounter Index

OTCCOMP = OTC Composite Stocks AverageOTCCOMP = OTC Composite Stocks Average

CRSPEQW = Center for Research on Securities Prices (CRSP) EquallyCRSPEQW = Center for Research on Securities Prices (CRSP) Equally--Weighted Stocks IndexWeighted Stocks Index

CRSPVW = Center for Research on Securities Prices (CRSP)ValueCRSPVW = Center for Research on Securities Prices (CRSP)Value--Weighted Stocks IndexWeighted Stocks Index

capital markets 3504

Documents