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									Financial Markets
         By Huanli Li
Part One
 Introduction
             Chapter 1
Why Study Financial Markets
           and Institutions?
Chapter Preview
  The evening news features a segment about
  interest rates, the Fed Chairman Ben Bernanke,
  and liquidity in credit markets.
  What does all this mean? Do I care about interest
  rates? What is ―the Fed?‖ Will this impact my
  firm’s ability to get a bank loan?
Chapter Preview
  These are good questions. Of course, the
  answer to these questions can be found in
  this book. In fact, this books touches on a
  variety of topics, including the Fed, stocks
  markets, bond markets, and banks. We will
  begin to appreciate many exciting issues
  related to these topics during the course of
  this term
Chapter Preview
 To start, we preview subjects of interest to anyone
 who is a part of a productive society. We motivate
 how financial markets and institutions have
 significant impact on important questions about our
 financial well-being. Topics include:
    Why Study Financial Markets?
    Why Study Financial Institutions?
    Applied Managerial Perspective
    How Will We Study Financial Markets and Institutions
Why Study Financial Markets?
Financial markets, such as bond and stock
   markets, are crucial in our economy.
1.   These markets channel funds from savers to
     investors, thereby promoting economic
     efficiency.
2.   Market activity affects personal wealth, the
     behavior of business firms, and economy as
     a whole
Why Study Financial Markets?
   Well functioning financial markets, such as
    the bond market, stock market, and foreign
    exchange market, are key factors in
    producing high economic growth.
   We will briefly examine each of these
    markets, key statistics, and how we will
    examine them throughout this course.
Why Study Financial Markets?
Debt Markets & Interest Rates
   Debt markets, or bond markets, allow
    governments, corporations, and individuals to
    borrow to finance activities.
   In this market, borrowers issue a security,
    called a bond, that promises the timely
    payment of interest and principal over some
    specific time horizon.
   The interest rate is the cost of borrowing.
Why Study Financial Markets?
Debt Markets & Interest Rates
   There are many different types of market
    interest rates, including mortgage rates, car
    loan rates, credit card rates, etc.
   The level of these rates are important. For
    example, mortgage rates in the early part of
    1983 exceeded 13%. Financing a house was
    quite expensive at this time.
Why Study Financial Markets?
Debt Markets & Interest Rates
   Because interest rates are important to individuals
    and business, understanding the history of interest
    rates is beneficial.
   The next slide shows historical interest rates in
    various sectors of the bond market: Long-Term U.S.
    Government rates, Short-Term U.S. Government
    rates, and corporate rates.
   We will study these further in several chapters,
    examining the types and characteristics of bonds, as
    well as theories on how rates are determined.
Bond Market and Interest
Rates




                Complete list of interest rates
                http://www.federalreserve.gov/releases
Why Study Financial Markets?
Debt Markets & Interest Rates
   For the moment, we will turn to other topics,
    but revisit these topics.
   In chapters 2, 9, 10, and 12, we will examine
    the role of debt markets in the economy.
   In chapters 3 through 5, we will examine the
    characteristics of interest rates.
Why Study Financial Markets?
The Stock Market
   The stock market is the market where common
    stock (or just stock), representing ownership in a
    company, are traded.
   Companies initially sell stock (in the primary market)
    to raise money. But after that, the stock is traded
    among investors (secondary market).
   Of all the active markets, the stock market receives
    the most attention from the media, probably
    because it is the place where people get rich (and
    poor) quickly.
Why Study Financial Markets?
The Stock Market
   The next slide shows the level of the Dow
    Jones Industrial Average over the last 55
    years. Note how volatile stock prices have
    been, especially over the last five years.
   In future chapters, we will examine the role of
    the stock market, as well as how prices react
    to information in the marketplace.
Stock
Market
Why Study Financial Markets?
The Stock Market
   Companies, not just individuals, also watch
    the market. Although corporations don’t
    typically ―invest‖ in the market, they often
    seek additional funding in equity markets
    after going public. The success of these
    seasoned-equity offerings (SEOs) is very
    dependent on the current price of the
    company’s stock.
Why Study Financial Markets?
The Foreign Exchange Market
   The foreign exchange market is where
    international currencies trade and exchange
    rates are set.
   Although most people know little about this
    market, it has a daily volume around
    $1 trillion!



                         View historical financial data and forecasts at
                         http://www.forecasts.org/data/index.htm
Why Study Financial Markets?
The Stock Market
   The next slide shows how the U.S. dollar has
    fluctuated in price against a basket of foreign
    currencies.
   These fluctuations matter!
       In recent years, consumers have found that vacationing in
        Europe is expensive, due to a weakening dollar relative to
        the Euro.
       When the dollar strengthens, foreign purchase of domestic
        goods falls, and US manufacturers experience a
        decreased demand for their goods.
Foreign Exchange Market
Why Study Financial Markets?
The Stock Market
   In future chapters, we will examine how
    exchange rates are determined in both the
    short- and long-run.
Why Study Financial
Institutions?
     We will also spend considerable time discussing financial
     institutions—the corporations, organizations, and networks that
     operate the so-called ―marketplaces.‖ These institutions play a
     crucial role in improving the efficiency of the economy. We will
     look at:

1.   Central Banks and the Conduct of
     Monetary Policy
      The role of the Fed and foreign counterparts

2.   Structure of the Financial System
       Helps get funds from savers to investors
Why Study Financial
Institutions?
3.   Banks and Other Financial Institutions
        Includes the role of insurance companies, mutual funds,
         pension funds, etc.

4.   Financial Innovation
        Focusing on the improvements in technology and its
         impact on how financial products are delivered

5.   Managing Risk in Financial Institutions
        Focusing on risk management in the
         financial institution.
Applied Managerial
Perspective
   Financial institutions are among the largest
    employers in the U.S. and often pay
    high salaries.
   Knowing how financial institutions are
    managed may help you better deal
    with them.
How We Study Financial Markets
and Institutions
   Basic Analytic Framework
    1.   Simplified models are constructed, explained,
         and then manipulated to illustrate various
         phenomena.

    2.   ―Practicing Manager‖ cases are used to tie
         theoretical and empirical aspects.
How We Study Financial Markets
and Institutions
   Basic Analytic Framework
    3.   Actual articles from the Wall Street Journal
         reinforcing the concepts from the book, and
         explanations of articles, helping you develop
         critical skills to identify key concepts from the
         day’s news.
How We Study Financial Markets
and Institutions
   Other features
    1.   Case studies
    2.   Applications and Numerical Examples
    3.   Special Interest Boxes
    4.   Hundred of analytical end-of-chapter problems
    5.   Predicting the Future problems
Chapter Summary
   Why Study Financial Markets?: the three
    primary markets (bond, stock, and foreign
    exchange) were briefly introduced.
   Why Study Financial Institutions?: the market,
    institutions, and key changes affecting these
    were outlined.
Chapter Summary (cont.)
   Applied Managerial Perspective: the book will
    often present material to better understand
    how actual managers use the information in
    daily operations.
   How We Will Study Financial Markets and
    Institutions: we outlines the three key
    components: analytical framework, features,
    and web exercises.
                 Chapter 2
Overview of the Financial System
Chapter Preview
   Suppose you want to start a business
    manufacturing a household cleaning robot,
    but you have no funds.
   At the same time, Walter has money he
    wishes to invest for his retirement.
   If the two of you could get together, perhaps
    both of your needs can be met. But how
    does that happen?
Chapter Preview
   As simple as this example is, it highlights the
    importance of financial markets and financial
    intermediaries in our economy.
   We need to acquire an understanding of their
    general structure and operation before we
    can appreciate their role in our economy.
Chapter Preview
   In this chapter, we examine the role of the financial
    system in an advanced economy. We study the
    effects of financial markets and institutions on the
    economy, and look at their general structure and
    operations. Topics include:
       Function of Financial Markets
       Structure of Financial Markets
       Internationalization of Financial Markets
       Function of Financial Intermediaries
       Financial Intermediaries
       Regulation of the Financial System
Function of Financial Markets
   Channels funds from person or business
    without investment opportunities (i.e.,
    ―Lender-Savers‖) to one who has them (i.e.,
    ―Borrower-Spenders‖)

   Improves economic efficiency
Financial Markets Funds
Transferees
Lender-Savers       Borrower-Spenders
1. Households       1. Business firms

2. Business firms   2. Government

3. Government       3. Households

4. Foreigners       4. Foreigners
Segments of Financial Markets
1.   Direct Finance
     •   Borrowers borrow directly from lenders in financial
         markets by selling financial instruments which are claims
         on the borrower’s future income or assets

2.   Indirect Finance
     •   Borrowers borrow indirectly from lenders via financial
         intermediaries (established to source both loanable funds
         and loan opportunities) by issuing financial instruments
         which are claims on the borrower’s future income or
         assets
Function of Financial Markets
Importance of Financial
Markets
   This is important. For example, if you save
    $1,000, but there are no financial markets,
    then you can earn no return on this – might
    as well put the money under your mattress.
   However, if a carpenter could use that money
    to buy a new saw (increasing her
    productivity), then she’d be willing to pay you
    some interest for the use of the funds.
Importance of Financial
Markets
   Financial markets are critical for producing an
    efficient allocation of capital, allowing funds to
    move from people who lack productive
    investment opportunities to people who have
    them.
   Financial markets also improve the well-being
    of consumers, allowing them to time their
    purchases better.
Structure of Financial Markets
 It helps to define financial markets along a
 variety of dimensions (not necessarily
 mutually exclusive). For starters, …
Structure of Financial Markets
1.   Debt Markets
        Short-Term (maturity < 1 year)
        Long-Term (maturity > 10 year)
        Intermediate term (maturity in-between)
        Represented $41 trillion at the end of 2007.
2.   Equity Markets
        Pay dividends, in theory forever
        Represents an ownership claim in the firm
        Total value of all U.S. equity was $18 trillion at the end
         of 2005.
Structure of Financial Markets
1.   Primary Market
         New security issues sold to initial buyers
         Typically involves an investment bank who underwrites
          the offering

2.   Secondary Market
         Securities previously issued are bought
          and sold
         Examples include the NYSE and Nasdaq
         Involves both brokers and dealers (do you know the
          difference?)
Structure of Financial Markets
    Even though firms don’t get any money, per
    se, from the secondary market, it serves two
    important functions:

•   Provide liquidity, making it easy to buy and
    sell the securities of the companies

•   Establish a price for the securities
Structure of Financial Markets
     We can further classify secondary markets as
     follows:
1.   Exchanges
        Trades conducted in central locations
         (e.g., New York Stock Exchange, CBT)

2.   Over-the-Counter Markets
        Dealers at different locations buy and sell
        Best example is the market for Treasury securities



                                NYSE home page
                                http://www.nyse.com
Classifications of Financial
Markets
  We can also further classify markets by the
  maturity of the securities:
  1.   Money Market: Short-Term (maturity < 1 year)
  2.   Capital Market : Long-Term (maturity > 1 year)
       plus equities
Internationalization of Financial
Markets
    The internationalization of markets is an important
    trend. The U.S. no longer dominates the world
    stage.
   International Bond Market
       Foreign bonds
          Denominated in a foreign currency
          Targeted at a foreign market
       Eurobonds
          Denominated in one currency, but sold in a different
           market
          now larger than U.S. corporate bond market)
          Over 80% of new bonds are Eurobonds.
Internationalization of Financial
Markets
   Eurocurrency Market
       Foreign currency deposited outside of home country
       Eurodollars are U.S. dollars deposited, say, London.
       Gives U.S. borrows an alternative source for dollars.

   World Stock Markets
       U.S. stock markets are no longer always the largest—at
        one point, Japan's was larger
Internationalization of Financial
Markets
 As the next slide shows, the number of
 international stock market indexes is quite
 large. For many of us, the level of the Dow or
 the S&P 500 is known. How about the Nikkei
 225? Or the FTSE 100? Do you know what
 countries these represent?
Internationalization of Financial
Markets
Global perspective
Relative Decline of U.S. Capital Markets

   The U.S. has lost its dominance in many
    industries: auto and consumer electronics to
    name a few.

   A similar trend appears at work for U.S.
    financial markets, as London and Hong Kong
    compete. Indeed, many U.S. firms use these
    markets over the U.S.
Global perspective
Relative Decline of U.S. Capital Markets

     Why?
1.   New technology in foreign exchanges
2.   9-11 made U.S. regulations tighter
3.   Greater risk of lawsuit in the U.S.
4.   Sarbanes-Oxley has increased the cost of
     being a U.S.-listed public company
Function of Financial
Intermediaries: Indirect Finance
   We now turn our attention to the top part of Figure
   2.1 – indirect finance.
Function of Financial
Intermediaries : Indirect Finance
    Instead of savers lending/investing directly
    with borrowers, a financial intermediary
    (such as a bank) plays as the middleman:
   the intermediary obtains funds from savers
   the intermediary then makes
    loans/investments with borrowers
Function of Financial
Intermediaries : Indirect Finance
   This process, called financial intermediation,
    is actually the primary means of moving
    funds from lenders to borrowers.
   More important source of finance than
    securities markets (such as stocks)
   Needed because of transactions costs, risk
    sharing, and asymmetric information
Function of Financial
Intermediaries : Indirect Finance
   Transactions Costs
    1.   Financial intermediaries make profits by
         reducing transactions costs
    2.   Reduce transactions costs by developing
         expertise and taking advantage of economies
         of scale
Function of Financial
Intermediaries : Indirect Finance
•   A financial intermediary’s low transaction costs
    mean that it can provide its customers with
    liquidity services, services that make it easier for
    customers to conduct transactions
    1.   Banks provide depositors with checking accounts that
         enable them to pay their bills easily
    2.   Depositors can earn interest on checking and savings
         accounts and yet still convert them into goods and
         services whenever necessary
Global Perspective
•   Studies show that firms in the U.S., Canada, the
    U.K., and other developed nations usually obtain
    funds from financial intermediaries, not directly
    from capital markets.
•   In Germany and Japan, financing from financial
    intermediaries exceeds capital market financing
    10-fold.
•   However, the relative use of bonds versus equity
    does differ by country.
Function of Financial
Intermediaries : Indirect Finance
   Another benefit made possible by the FI’s low
    transaction costs is that they can help reduce the
    exposure of investors to risk, through a process
    known as risk sharing
       FIs create and sell assets with lesser risk to one
        party in order to buy assets with greater risk from another
        party
       This process is referred to as asset transformation,
        because in a sense risky assets are turned into safer
        assets for investors
Function of Financial
Intermediaries : Indirect
Finance
   Financial intermediaries also help by
    providing the means for individuals and
    businesses to diversify their asset holdings.
   Low transaction costs allow them to buy a
    range of assets, pool them, and then sell
    rights to the diversified pool to individuals.
Function of Financial
Intermediaries : Indirect
Finance
   Another reason FIs exist is to reduce the
    impact of asymmetric information.
   One party lacks crucial information about
    another party, impacting decision-making.
   We usually discuss this problem along two
    fronts: adverse selection and moral hazard.
Function of Financial
Intermediaries : Indirect
Finance
   Adverse Selection
    1.   Before transaction occurs
    2.   Potential borrowers most likely to produce
         adverse outcome are ones most likely to seek a
         loan
    3.   Similar problems occur with insurance where
         unhealthy people want their known medical
         problems covered
Asymmetric Information:
Adverse Selection and Moral
Hazard
   Moral Hazard
    1.   After transaction occurs
    2.   Hazard that borrower has incentives to engage
         in undesirable (immoral) activities making it
         more likely that won't pay loan back
    3.   Again, with insurance, people may engage in
         risky activities only after being insured
    4.   Another view is a conflict of interest
Asymmetric Information:
Adverse Selection and Moral
Hazard
   Financial intermediaries reduce adverse
    selection and moral hazard problems,
    enabling them to make profits. How they do
    this is the covered in many of the chapters to
    come.
Types of Financial
Intermediaries
Types of Financial
Intermediaries
Types of Financial
Intermediaries
   Depository Institutions (Banks): accept deposits and
    make loans. These include commercial banks and
    thrifts.
   Commercial banks (7,500 currently)
       Raise funds primarily by issuing checkable, savings, and
        time deposits which are used to make commercial,
        consumer and mortgage loans
       Collectively, these banks comprise the largest financial
        intermediary and have the most diversified asset portfolios
Types of Financial
Intermediaries
   Thrifts: S&Ls, Mutual Savings Banks (1,500) and
    Credit Unions (8,900)
       Raise funds primarily by issuing savings, time, and
        checkable deposits which are most often used to make
        mortgage and consumer loans, with commercial loans also
        becoming more prevalent at S&Ls and Mutual Savings
        Banks
       Mutual savings banks and credit unions issue deposits as
        shares and are owned collectively by their depositors,
        most of which at credit unions belong to a particular group,
        e.g., a company’s workers
Contractual Savings
Institutions (CSIs)
   All CSIs acquire funds from clients at periodic
    intervals on a contractual basis and have fairly
    predictable future payout requirements.
       Life Insurance Companies receive funds from policy
        premiums, can invest in less liquid corporate securities
        and mortgages, since actual benefit pay outs are close to
        those predicted by actuarial analysis
       Fire and Casualty Insurance Companies receive funds
        from policy premiums, must invest most in liquid
        government and corporate securities, since loss events
        are harder to predict
Contractual Savings
Institutions (CSIs)
   All CSIs acquire funds from clients at periodic
    intervals on a contractual basis and have fairly
    predictable future payout requirements.
       Pension and Government Retirement Funds hosted by
        corporations and state and local governments acquire
        funds through employee and employer payroll
        contributions, invest in corporate securities, and provide
        retirement income via annuities
Types of Financial
Intermediaries
   Finance Companies sell commercial paper (a
    short-term debt instrument) and issue bonds and
    stocks to raise funds to lend to consumers to buy
    durable goods, and to small businesses for
    operations
   Mutual Funds acquire funds by selling shares to
    individual investors (many of whose shares are held
    in retirement accounts) and use the proceeds to
    purchase large, diversified portfolios of stocks and
    bonds
Types of Financial
Intermediaries
   Money Market Mutual Funds acquire funds by
    selling checkable deposit-like shares to individual
    investors and use the proceeds to purchase highly
    liquid and safe short-term money market
    instruments
   Investment Banks advise companies on securities
    to issue, underwriting security offerings, offer M&A
    assistance, and act as dealers in security markets.
Regulatory Agencies
Regulation of Financial
Markets
   Main Reasons for Regulation
     1.   Increase Information to Investors
     2.   Ensure the Soundness of Financial
          Intermediaries
Regulation Reason:
Increase Investor Information
•   Asymmetric information in financial markets means that investors
    may be subject to adverse selection and moral hazard problems
    that may hinder the efficient operation of financial markets and
    may also keep investors away from financial markets
•   The Securities and Exchange Commission (SEC) requires
    corporations issuing securities to disclose certain information
    about their sales, assets, and earnings to the public and restricts
    trading by the largest stockholders (known as insiders) in the
    corporation




                                     SEC home page
                                     http://www.sec.gov
Regulation Reason:
Increase Investor Information
•   Such government regulation can reduce adverse selection and
    moral hazard problems in financial markets and increase their
    efficiency by increasing the amount of information available to
    investors. Indeed, the SEC has been particularly active recently
    in pursuing illegal insider trading.




                                   SEC home page
                                   http://www.sec.gov
Regulation Reason: Ensure Soundness
of Financial Intermediaries

   Providers of funds to financial intermediaries may
    not be able to assess whether the institutions
    holding their funds are sound or not.
   If they have doubts about the overall health of
    financial intermediaries, they may want to pull their
    funds out of both sound and unsound institutions,
    with the possible outcome of a financial panic.
   Such panics produces large losses for the public
    and causes serious damage to the economy.
Regulation Reason: Ensure Soundness
of Financial Intermediaries (cont.)

   To protect the public and the economy from financial
    panics, the government has implemented six types
    of regulations:
       Restrictions on Entry
       Disclosure
       Restrictions on Assets and Activities
       Deposit Insurance
       Limits on Competition
       Restrictions on Interest Rates
Regulation: Restriction on
Entry
   Restrictions on Entry
       Regulators have created very tight regulations as to who is
        allowed to set up a financial intermediary
       Individuals or groups that want to establish a
        financial intermediary, such as a bank or an insurance
        company, must obtain a charter from the state or the
        federal government
       Only if they are upstanding citizens with impeccable
        credentials and a large amount of initial funds will they be
        given a charter.
Regulation: Disclosure
   Disclosure Requirements
   There are stringent reporting requirements for
    financial intermediaries
       Their bookkeeping must follow certain strict principles,
       Their books are subject to periodic inspection,
       They must make certain information available to
        the public.
Regulation: Restriction on Assets
and Activities
   There are restrictions on what financial
    intermediaries are allowed to do and what assets
    they can hold
   Before you put your funds into a bank or some other
    such institution, you would want to know that your
    funds are safe and that the bank or other financial
    intermediary will be able to meet its obligations to
    you
Regulation: Restriction on Assets
and Activities
     One way of doing this is to restrict the financial
      intermediary from engaging in certain risky
      activities
     Another way is to restrict financial intermediaries
      from holding certain risky assets, or at least from
      holding a greater quantity of these risky assets
      than is prudent
Regulation: Deposit Insurance
   The government can insure people depositors to a
    financial intermediary from any financial loss if the
    financial intermediary should fail
   The Federal Deposit Insurance Corporation (FDIC)
    insures each depositor at a commercial bank or
    mutual savings bank up to a loss of $100,000 per
    account ($250,000 for IRAs)
Regulation: Deposit Insurance
   Similar government agencies exist for other
    depository institutions:
       The National Credit Union Share Insurance Fund (NCUSIF)
        provides insurance for credit unions
Regulation: Past Limits
on Competition
   Although the evidence that unbridled competition
    among financial intermediaries promotes failures
    that will harm the public is extremely weak, it has not
    stopped the state and federal governments from
    imposing many restrictive regulations
   In the past, banks were not allowed to open up
    branches in other states, and in some states banks
    were restricted from opening
    additional locations
Regulation: Past Restrictions
on Interest Rates
   Competition has also been inhibited by regulations
    that impose restrictions on interest rates that can be
    paid on deposits
   These regulations were instituted because of the
    widespread belief that unrestricted interest-rate
    competition helped encourage bank failures during
    the Great Depression
   Later evidence does not seem to support this view,
    and restrictions on interest rates have
    been abolished
Regulation Reason: Improve
Monetary Control
   Because banks play a very important role in determining the
    supply of money (which in turn affects many aspects of the
    economy), much regulation of these financial intermediaries is
    intended to improve control over the money supply
   One such regulation is reserve requirements, which make it
    obligatory for all depository institutions to keep a certain fraction
    of their deposits in accounts with the Federal Reserve System
    (the Fed), the central bank in the United States
   Reserve requirements help the Fed exercise more precise
    control over the money supply
Financial Regulation Abroad
   Those countries with similar economic systems also
    implement financial regulation consistent with the
    U.S. model: Japan, Canada, and Western Europe
       Financial reporting for corporations is required
       Financial intermediaries are heavily regulated

   However, U.S. banks are more regulated along
    dimensions of branching and services than their
    foreign counterparts.
Chapter Summary
   Function of Financial Markets: We examined
    the flow of funds through the financial system
    and the role of intermediaries in this process.
   Structure of Financial Markets: We examined
    market structure from several perspectives,
    including types of instruments, purpose,
    organization, and time horizon.
Chapter Summary (cont.)
   Internationalization of Financial Markets: We
    briefly examined how debt and equity
    markets have expanded in the
    international setting.
   Function of Financial Intermediaries: We
    examined the roles of intermediaries in
    reducing transaction costs, sharing risk, and
    reducing information problems.
Chapter Summary (cont.)
   Financial Intermediaries: We outlined the
    numerous types of financial intermediaries to
    be further examined in later chapters.
   Regulation of the Financial System: We
    outlined some of the agencies charged with
    the oversight of various institutions
    and markets.
     Part Two
      Fundamentals
of Financial Markets
             Chapter 3
What Do Interest Rates Mean
                 and What Is
                   Their Role
                in Valuation?
Chapter Preview
   Interest rates are among the most closely
    watched variables in the economy. It is
    imperative that what exactly is meant by the
    phrase interest rates is understood.
    In this chapter, we will see that a concept
    known as yield to maturity (YTM) is the most
    accurate measure of interest rates.
Chapter Preview
   Any description of interest rates entails an
    understanding certain vernacular and
    definitions, most of which will not only pertain
    directly to interest rates but will also be vital
    to understanding many other foundational
    concepts presented later in the text.
Chapter Preview
   So, in this chapter, we will develop a better
    understanding of interest rates. We examine the
    terminology and calculation of various rates, and we
    show the importance of these rates in our lives and
    the general economy. Topics include:
       Measuring Interest Rates
       The Distinction Between Real and Nominal
        Interest Rates
       The Distinction Between Interest Rates and Returns
Present Value Introduction
   Different debt instruments have very different
    streams of cash payments to the holder (known as
    cash flows), with very different timing.
   All else being equal, debt instruments are evaluated
    against one another based on the amount of each
    cash flow and the timing of each cash flow.
   This evaluation, where the analysis of the amount
    and timing of a debt instrument’s cash flows lead to
    its yield to maturity or interest rate, is called present
    value analysis.
Present Value
   The concept of present value (or present
    discounted value) is based on the commonsense
    notion that a dollar of cash flow paid to you one year
    from now is less valuable to you than a dollar paid to
    you today. This notion is true because you could
    invest the dollar in a savings account that earns
    interest and have more than a dollar in one year.
   The term present value (PV) can be extended to
    mean the PV of a single cash flow or the sum of a
    sequence or group of cash flows.
Present Value Applications
   There are four basic types of credit
    instruments which incorporate present value
    concepts:
    1.   Simple Loan
    2.   Fixed Payment Loan
    3.   Coupon Bond
    4.   Discount Bond
Present Value Concept:
Simple Loan Terms
   Loan Principal: the amount of funds the lender provides to the
    borrower.
   Maturity Date: the date the loan must be repaid; the Loan Term is
    from initiation to maturity date.
   Interest Payment: the cash amount that the borrower must pay
    the lender for the use of the loan principal.
   Simple Interest Rate: the interest payment divided by the loan
    principal; the percentage of principal that must be paid as interest
    to the lender. Convention is to express on an annual basis,
    irrespective of the loan term.
Present Value Concept: Simple
Loan

      Simple loan of $100
      Year: 0        1        2      3        n
          $100   $110       $121   $133   100(1+i)n


                         $1
      PV of future $1=
                       1+ i n
Present Value Concept:
Simple Loan (cont.)
   The previous example reinforces the concept
    that $100 today is preferable to $100 a year
    from now since today’s $100 could be lent
    out (or deposited) at 10% interest to be worth
    $110 one year from now, or $121 in two
    years or $133 in
    three years.
Yield to Maturity: Loans
    Yield to maturity = interest rate that equates today's
     value with present value of all
     future payments
1.   Simple Loan Interest Rate (i = 10%)

       $100  $110 1  i  
          $110 $100 $10
       i                  .10  10%
             $100     $100
Present Value of Cash Flows:
Example
Present Value Concept:
Fixed-Payment Loan Terms
   Simple Loans require payment of one amount
    which equals the loan principal plus the
    interest.
   Fixed-Payment Loans are loans where the
    loan principal and interest are repaid in
    several payments, often monthly, in equal
    dollar amounts over the loan term.
Present Value Concept:
Fixed-Payment Loan Terms
   Installment Loans, such as auto loans and
    home mortgages are frequently of the fixed-
    payment type.
Yield to Maturity: Loans
2.   Fixed Payment Loan (i = 12%)

             $126     $126      $126          $126
     $1000                2      3  ...
             1 i  1  i 1 i          1 i 25

            FP       FP        FP             FP
     LV                  2      3  ...
          1  i  1  i  1 i          1 i n
Yield to Maturity: Bonds
3.   Coupon Bond (Coupon rate = 10% = C/F)
        $100     $100      $100          $100       $1000
     P               2      3  ...        10 
        1 i  1  i 1 i          1 i  1  i 10
          C        C       C              C        F
     P               2      3  ...        n 
        1 i  1  i 1 i          1 i  1  i n

     Consol: Fixed coupon payments of $C forever
        C               C
     P              i
        i               P
Yield to Maturity: Bonds
4.   One-Year Discount Bond (P = $900, F = $1000)

            $1000
     $900          
            1  i
        $1000  $900
     i               .111  11.1%
           $900
        FP
     i
         P
Relationship Between Price
and Yield to Maturity




   Three interesting facts in Table 3-1
    1.   When bond is at par, yield equals coupon rate
    2.   Price and yield are negatively related
    3.   Yield greater than coupon rate when bond price
         is below par value
Relationship Between Price
and Yield to Maturity
   It’s also straight-forward to show that the value of a
    bond (price) and yield to maturity (YTM) are
    negatively related. If i increases, the PV of any given
    cash flow is lower; hence, the price of the bond must
    be lower.
Current Yield
          C
     ic 
          P
   Current yield (CY) is just an approximation for YTM
    – easier to calculate. However, we should be aware
    of its properties:
     1. If a bond’s price is near par and has a long
         maturity, then CY is a good approximation.
     2. A change in the current yield always signals
         change in same direction as yield to maturity
Yield on a Discount Basis
                (F - P)              360
          idb          
                  F       (number of days to maturity)
   One-Year Bill (P = $900, F = $1000)
           $1000- $900 360
     idb                   .099  9.9%
              $1000     365
   Two Characteristics
     1.    Understates yield to maturity; longer the maturity,
           greater is understatement
     2.    Change in discount yield always signals change in same
           direction as yield to maturity
Bond Page of the Newspaper
Global perspective
   In November 1998, rates on Japanese 6-
    month government bonds were negative!
    Investors were willing to pay more than they
    would receive in the future.
   Best explanation is that investors found the
    convenience of the bills worth something –
    more convenient than cash. But that can
    only go so far – the rate was only slightly
    negative.
Distinction Between Real
and Nominal Interest Rates
   Real interest rate
     1.   Interest rate that is adjusted for expected
          changes in the price level

            ir  i     e


    2. Real interest rate more accurately reflects
       true cost of borrowing
    3. When the real rate is low, there are greater
       incentives to borrow and less to lend
Distinction Between Real
and Nominal Interest Rates
 Real interest rate

          ir  i     e


  We usually refer to this rate as the ex ante real
  rate of interest because it is adjusted for the
  expected level of inflation. After the fact, we
  can calculate the ex post real rate based on the
  observed level of inflation.
Distinction Between Real
and Nominal Interest Rates (cont.)
   If i = 5% and πe = 0% then

     ir  5% 0% 5%
• If i = 10% and πe = 20% then

    ir  10% 20% 10%
U.S. Real and Nominal Interest
Rates




                  Sample of current rates and indexes
                  http://www.martincapital.com/charts.htm
Distinction Between Interest Rates
and Returns
   Rate of Return: we can decompose returns
    into two pieces:
                 C  Pt 1  Pt
        Return                  ic  g
                      Pt
                        C
             where ic     = current yield, and
                        Pt
                      Pt 1  Pt
                   g              = capital gains.
                           Pt
Key Facts about the Relationship
Between Rates and Returns




                  Sample of current coupon rates
                  and yields on government bonds
                  http://www.bloomberg.com/markets/iyc.html
Maturity and the Volatility
of Bond Returns
   Key findings from Table 3-2
     1.   Only bond whose return = yield is one with
          maturity = holding period
     2.   For bonds with maturity > holding period, i  P 
          implying capital loss
     3.   Longer is maturity, greater is price change associated
          with interest rate change
Maturity and the Volatility
of Bond Returns (cont.)
   Key findings from Table 3-2 (continued)
    4.   Longer is maturity, more return changes with change
         in interest rate
    5.   Bond with high initial interest rate can still have
         negative return if i 
Maturity and the Volatility
of Bond Returns (cont.)
   Conclusion from Table 3-2 analysis
    1.   Prices and returns more volatile for long-term
         bonds because have higher interest-rate risk
    2.   No interest-rate risk for any bond whose
         maturity equals holding period
Reinvestment Risk
1.   Occurs if hold series of short bonds over
     long holding period
2.   i at which reinvest uncertain
3.   Gain from i , lose when i 
Calculating Duration
i =10%, 10-Year 10% Coupon Bond
Calculating Duration
i = 20%, 10-Year 10% Coupon
Bond




                              126
Formula for Duration
                     n                 n
                      CP                   CP
         DUR   t      t
                                       1  it
                                             t

               t 1   i
                          t
                     1                t 1


   Key facts about duration
    1.   All else equal, when the maturity of a bond
         lengthens, the duration rises as well
    2.   All else equal, when interest rates rise, the
         duration of a coupon bond fall
Formula for Duration
1.   The higher is the coupon rate on the bond,
     the shorter is the duration of the bond
2.   Duration is additive: the duration of a
     portfolio of securities is the weighted-
     average of the durations of the individual
     securities, with the weights equaling the
     proportion of the portfolio invested in each
Duration and Interest-Rate
Risk
                         i
           %P  DUR 
                        1 i
   i  10% to 11%:
       Table 3-4, 10% coupon bond

                            0.01
            %P  6.76 
                          1  0.10
            %P  0.0615 6.15%
Duration and
Interest-Rate Risk (cont.)
   i  10% to 11%:
       20% coupon bond, DUR = 5.72 years

                           0.01
           %P  5.72 
                         1  0.10
           %P  0.0520 5.20%
Duration and
Interest-Rate Risk (cont.)

   The greater is the duration of a security, the
    greater is the percentage change in the
    market value of the security for a given
    change in interest rates

   Therefore, the greater is the duration of a
    security, the greater is its interest-rate risk
Chapter Summary
   Measuring Interest Rates: We examined
    several techniques for measuring the interest
    rate required on debt instruments.

   The Distinction Between Real and Nominal
    Interest Rates: We examined the meaning of
    interest in the context of price inflation.
Chapter Summary (cont.)
   The Distinction Between Interest Rates and
    Returns: We examined what each means and
    how they should be viewed for asset
    valuation.
               Chapter 4
Why Do Interest Rates Change?
Chapter Preview

 In the early 1950s, short-term Treasury bills
 were yielding about 1%. By 1981, the yields
 rose to 15% and higher. But then dropped
 back to 1% by 2003.


 What causes these changes?
Chapter Preview

 In this chapter, we examine the forces the
 move interest rates and the theories behind
 those movements. Topics include:
    Determining Asset Demand
    Supply and Demand in the Bond Market
    Changes in Equilibrium Interest Rates
Determinants of Asset Demand

   An asset is a piece of property that is a store of value. Facing the
    question of whether to buy and hold an asset or whether to buy
    one asset rather than another, an individual must consider the
    following factors:
     1.   Wealth, the total resources owned by the individual, including
          all assets
     2.   Expected return (the return expected over the next period) on
          one asset relative to alternative assets
     3.   Risk (the degree of uncertainty associated with the return) on
          one asset relative to alternative assets
     4.   Liquidity (the ease and speed with which an asset can be
          turned into cash) relative to alternative assets
EXAMPLE 1: Expected Return
What is the expected return on an Exxon-Mobil bond if the return
is 12% two-thirds of the time and 8% one-third of the time?
Solution
The expected return is 10.68%.
                                             Re = p1R1 + p2R2
where
p1 = probability of occurrence of return 1   = 2/3   =    .67
R1 = return in state 1                       = 12% =     0.12
p2 = probability of occurrence return 2      = 1/3   =    .33
R2 = return in state 2                       = 8%    =   0.08
Thus
Re = (.67)(0.12) + (.33)(0.08) = 0.1068 = 10.68%
EXAMPLE 2: Standard
Deviation (a)
   Consider the following two companies and
   their forecasted returns for the upcoming year:


                          F ly-by-Night F eet-on-the-G round
           P robability        50%             100%
O utcome 1
           R eturn             15%              10%
           P robability        50%
O utcome 2
           R eturn              5%
EXAMPLE 2: Standard
Deviation (b)
   What is the standard deviation of the returns
    on the Fly-by-Night Airlines stock and Feet-
    on-the-Ground Bus Company, with the return
    outcomes and probabilities described above?
    Of these two stocks, which is riskier?
EXAMPLE 2: Standard
Deviation (c)
   Solution
      Fly-by-Night Airlines has a standard deviation of returns of 5%.
EXAMPLE 2: Standard
Deviation (d)
   Feet-on-the-Ground Bus Company has a standard
    deviation of returns of 0%.
EXAMPLE 2: Standard
Deviation (e)
   Fly-by-Night Airlines has a standard deviation of returns of 5%;
    Feet-on-the-Ground Bus Company has a standard deviation of
    returns of 0%
   Clearly, Fly-by-Night Airlines is a riskier stock because its
    standard deviation of returns of 5% is higher than the zero
    standard deviation of returns for Feet-on-the-Ground Bus
    Company, which has a certain return
   A risk-averse person prefers stock in the Feet-on-the-Ground (the
    sure thing) to Fly-by-Night stock (the riskier asset), even though
    the stocks have the same expected return, 10%. By contrast, a
    person who prefers risk is a risk preferrer or risk lover. We assume
    people are risk-averse, especially in their financial decisions
Determinants of Asset Demand
(2)
   The quantity demanded of an asset differs by factor.
    1.   Wealth: Holding everything else constant, an increase in
         wealth raises the quantity demanded of an asset
    2.   Expected return: An increase in an asset’s expected return
         relative to that of an alternative asset, holding everything else
         unchanged, raises the quantity demanded of the asset
    3.   Risk: Holding everything else constant, if an asset’s risk rises
         relative to that of alternative assets, its quantity demanded
         will fall
    4.   Liquidity: The more liquid an asset is relative to alternative
         assets, holding everything else unchanged, the more desirable
         it is, and the greater will be the quantity demanded
Determinants of Asset Demand
(3)
Supply & Demand in the Bond
Market
 We now turn our attention to the mechanics of interest
 rates. That is, we are going to examine how interest rates
 are determined – from a demand and supply perspective.
 Keep in mind that these forces act differently in different
 bond markets. That is, current supply/demand conditions
 in the corporate bond market are not necessarily the
 same as, say, in the mortgage market. However, because
 rates tend to move together, we will proceed as if there is
 one interest rate for the entire economy.
The Demand Curve

Let’s start with the demand curve.


Let’s consider a one-year discount bond with a face value
of $1,000. In this case, the return on this bond is entirely
determined by its price. The return is, then, the bond’s
yield to maturity.
Derivation of Demand Curve
                 F  P 
   iR    e

                      P
Point A: if the bond was selling for $950.
      P  $950
           $1000 $950 
      i                     .053  5.3%
               $950
      Bd  100

Point B: if the bond was selling for $900.
      P  $900
           $1000 $900 
      i                     .111  11.1%
               $900
      Bd  200
Derivation of Demand Curve


How do we know the demand (Bd) at point A is 100 and at point
B is 200?

Well, we are just making-up those numbers. But we are applying
basic economics – more people will want (demand) the bonds if
the expected return is higher.
Derivation of Demand Curve

    To continue …
   Point C: P = $850 i = 17.6% Bd = 300
   Point D: P = $800 i = 25.0% Bd = 400
   Point E: P = $750 i = 33.0% Bd = 500
   Demand Curve is Bd in Figure 1 which
    connects points A, B, C, D, E.
       Has usual downward slope
Supply and Demand for Bonds
Derivation of Supply Curve
In the last figure, we snuck the supply curve in –
the line connecting points F, G, C, H, and I. The
derivation follows the same idea as the demand
curve.
Derivation of Supply Curve

   Point F: P = $750 i = 33.0% Bs = 100
   Point G: P = $800 i = 25.0% Bs = 200
   Point C: P = $850 i = 17.6% Bs = 300
   Point H: P = $900 i = 11.1% Bs = 400
   Point I: P = $950 i = 5.3% Bs = 500
   Supply Curve is Bs that connects points F, G,
    C, H, I, and has upward slope
Derivation of Demand Curve


How do we know the supply (Bs) at point P is 100 and at point G
is 200?

Again, like the demand curve, we are just making-up those
numbers. But we are applying basic economics – more people
will offer (supply) the bonds if the expected return is lower.
Market Equilibrium

     The equilibrium follows what we know from supply-
     demand analysis:

1.   Occurs when Bd = Bs, at P* = 850, i* = 17.6%

2.   When P = $950, i = 5.3%, Bs > Bd
     (excess supply): P  to P*, i  to i*

3.   When P = $750, i = 33.0, Bd > Bs
     (excess demand): P  to P*, i  to i*
Market Conditions

Market equilibrium occurs when the amount that people are willing
to buy (demand) equals the amount that people are willing to sell
(supply) at a given price
Excess supply occurs when the amount that people are willing to
sell (supply) is greater than the amount people are willing to buy
(demand) at a given price
Excess demand occurs when the amount that people are willing to
buy (demand) is greater than the amount that people are willing to
sell (supply) at a given price
Supply & Demand Analysis

Notice in Figure 1 that we use two different verticle axes – one with
price, which is high-to-low starting from the top, and one with
interest rates, which is low-to-high starting from the top.
This just illustrates what we already know: bond prices and interest
rates are inversely related.
Also note that this analysis is an asset market approach based on
the stock of bonds. Another way to do this is to examine the flows.
However, the flows approach is tricky, especially with inflation in the
mix. So we will focus on the stock approach.
Changes in Equilibrium Interest
Rates

 We now turn our attention to changes in interest rate.
 We focus on actual shifts in the curves. Remember:
 movements along the curve will be due to price
 changes alone.

 First, we examine shifts in the demand for bonds.
 Then we will turn to the supply side.
Factors
That Shift
Demand
Curve
How Factors Shift the Demand
Curve

1.   Wealth/saving
         Economy , wealth 
         Bd , Bd shifts out to right

     OR

         Economy , wealth 
         Bd , Bd shifts out to right
How Factors Shift the Demand
Curve

2. Expected Returns on bonds
      i  in future, Re for long-term bonds 
      Bd shifts out to right
  OR
      πe , relative Re 
      Bd shifts out to right
How Factors Shift the Demand
Curve
2.       …and Expected Returns on other assets
          ER on other asset (stock) 
          Re for long-term bonds 
          Bd shifts out to left


         These are closely tied to expected interest
         rate and expected inflation from Table 4.2
How Factors Shift the Demand
Curve
3.   Risk
         Risk of bonds , Bd 
         Bd shifts out to right
     OR
         Risk of other assets , Bd 
         Bd shifts out to right
How Factors Shift the Demand
Curve
4. Liquidity
      Liquidity of bonds , Bd 
      Bd shifts out to right
  OR
      Liquidity of other assets , Bd 
      Bd shifts out to right
Shifts in the Demand Curve
Summary of Shifts
in the Demand for Bonds
1.   Wealth: in a business cycle expansion with
     growing wealth, the demand for bonds rises,
     conversely, in a recession, when income and
     wealth are falling, the demand for bonds falls
2.   Expected returns: higher expected interest rates
     in the future decrease the demand for long-term
     bonds, conversely, lower expected interest rates in
     the future increase the demand for long-term
     bonds
Summary of Shifts
in the Demand for Bonds (2)
3.   Risk: an increase in the riskiness of bonds causes
     the demand for bonds to fall, conversely, an
     increase in the riskiness of alternative assets (like
     stocks) causes the demand for bonds
     to rise
4.   Liquidity: increased liquidity of the bond market
     results in an increased demand for bonds,
     conversely, increased liquidity of alternative asset
     markets (like the stock market) lowers the demand
     for bonds
Factors That Shift Supply
Curve
We now turn to the
supply curve.
We summarize the
effects in this table:
Shifts in the Supply Curve

1.    Profitability of Investment
      Opportunities
       Business cycle expansion,
       investment opportunities , Bs ,
       Bs shifts out to right
Shifts in the Supply Curve

2.    Expected Inflation
       πe , Bs 
       Bs shifts out
        to right


3. Government Activities
   – Deficits , Bs 
   – Bs shifts out to right
Shifts in the Supply Curve
Summary of Shifts
in the Supply of Bonds
1.   Expected Profitability of Investment Opportunities: in a
     business cycle expansion, the supply of bonds increases,
     conversely, in a recession, when there are far fewer expected
     profitable investment opportunities, the supply of bonds falls
2.   Expected Inflation: an increase in expected inflation causes
     the supply of bonds to increase
3.   Government Activities: higher government deficits increase
     the supply of bonds, conversely, government surpluses
     decrease the supply of bonds
Case: Fisher Effect

 We’ve done the hard work. Now we turn to
 some special cases. The first is the Fisher
 Effect. Recall that rates are composed of
 several components: a real rate, an inflation
 premium, and various risk premiums.
 What if there is only a change in expected
 inflation?
Changes in πe: The Fisher
Effect
   If πe 
      1. Relative Re ,
         Bd shifts
         in to left
      2. Bs , Bs shifts
         out to right
      3. P , i 
Evidence on the Fisher Effect
in the United States
Summary of the Fisher Effect

1.   If expected inflation rises from 5% to 10%, the expected return
     on bonds relative to real assets falls and, as a result, the
     demand for bonds falls
2.   The rise in expected inflation also means that the real cost of
     borrowing has declined, causing the quantity of bonds supplied
     to increase
3.   When the demand for bonds falls and the quantity of bonds
     supplied increases, the equilibrium bond
     price falls
4.   Since the bond price is negatively related to the interest rate,
     this means that the interest rate will rise
Case: Business Cycle
Expansion
 Another good thing to examine is an
 expansionary business cycle. Here, the
 amount of goods and services for the country
 is increasing, so national income is
 increasing.

 What is the expected effect on interest rates?
 Business Cycle Expansion

1.   Wealth , Bd , Bd
     shifts out to right
2.   Investment , Bs ,
     Bs shifts right
3.   If Bs shifts
     more than Bd
     then P , i 
Evidence on Business Cycles
and Interest Rates
Case: Low Japanese Interest
Rates
 In November 1998, Japanese interest rates
 on six-month Treasury bills turned slightly
 negative. How can we explain that within the
 framework discussed so far?

 It’s a little tricky, but we can do it!
Case: Low Japanese Interest
Rates
1.       Negative inflation lead to Bd 
     •     Bd shifts out to right
2.       Negative inflation lead to  in real rates
     •     Bs shifts out to left

           Net effect was an increase in bond prices (falling
           interest rates).
Case: Low Japanese Interest
Rates
3.       Business cycle contraction lead to  in
         interest rates
     •     Bs shifts out to left
     •     Bd shifts out to left

           But the shift in Bd is less significant than the shift
           in Bs, so the net effect was also an increase in
           bond prices.
Case: WSJ “Credit Markets”

 Everyday, the Wall Street Journal reports on
 developments in the bond market in its
 ―Credit Markets‖ column.

 Let’s look at an example and how to interpret
 what it says.
WSJ article
Case: WSJ “Credit Markets”

    What is this article telling us?
   Strength in a sector helped lower T-bond
    prices (increase rates). That follows what we
    learned!
   A stronger economy shifts both curves to the
    right, but the supply curve by more, so prices
    will fall.
Case: WSJ “Credit Markets”

   Article also points out that yields on gov’t
    bonds in Germany and Japan are rising.
    Money will move from the U.S. Treasury
    market to these markets, shifting the demand
    curve to the left (falling prices).
   The strong economy also suggests a lower
    chance of future Fed rate cuts, further shifting
    the demand curve to the left.
The Practicing Manager

 We now turn to a more practical side to all
 this. Many firms have economists or hire
 consultants to forecast interest rates.
 Although this can be difficult to get right, it is
 important to understand what to do with a
 given interest rate forecast.
Profiting from Interest-Rate
Forecasts

   Methods for forecasting
    1. Supply and demand for bonds: use Flow of
       Funds Accounts and judgment

    2. Econometric Models: large in scale, use
       interlocking equations that assume past
       financial relationships will hold in the future
Profiting from Interest-Rate
Forecasts (cont.)

   Make decisions about assets to hold
    1.   Forecast i , buy long bonds
    2.   Forecast i , buy short bonds


   Make decisions about how to borrow
    1.   Forecast i , borrow short
    2.   Forecast i , borrow long
Chapter Summary

   Determining Asset Demand: We examined
    the forces that affect the demand and supply
    of assets.
   Supply and Demand in the Bond Market: We
    examine those forces in the context of bonds,
    and examined the impact on interest rates.
Chapter Summary (cont.)

   Changes in Equilibrium Interest Rates: We
    further examined the dynamics of changes in
    supply and demand in the bond market, and
    the corresponding effect on bond prices and
    interest rates.
              Chapter 5
  How Do The Risk and Term
Structure Affect Interest Rates
Chapter Preview
 In the last chapter, we examined interest
 rates, but made a big assumption – there is
 only one economy-wide interest rate. Of
 course, that isn’t really the case.
 In this chapter, we will examine the different
 rates that we observe for financial products.
Chapter Preview
 We will fist examine bonds that offer similar
 payment streams but differ in price. The
 price differences are due to the risk
 structure of interest rates. We will examine
 in detail what this risk structure looks like and
 ways to examine it.
Chapter Preview
 Next, we will look at the different rates
 required on bonds with different maturities.
 That is, we typically observe higher rates on
 longer-term bonds. This is known as the
 term structure of interest rates. To study
 this, we usually look at Treasury bonds to
 minimize the impact of other risk factors.
Chapter Preview
   So, in sum, we will examine how the
    individual risk of a bond affects its required
    rate. We also explore how the general level
    of interest rates varies with the maturity of the
    debt instruments. Topics include:
       Risk Structure of Interest Rates
       Term Structure of Interest Rates
Risk Structure of Interest
Rates
   To start this discussion, we first examine the
    yields for several categories of long-term
    bonds over the last 85 years.
   You should note several aspects regarding
    these rates, related to different bond
    categories and how this has changed through
    time.
Risk Structure
of Long Bonds in the U.S.
Risk Structure
of Long Bonds in the U.S.
    The figure show two important features of
    the interest-rate behavior of bonds.

   Rates on different bond categories change
    from one year to the next.

   Spreads on different bond categories
    change from one year to the next.
Factors Affecting Risk Structure
of Interest Rates
    To further examine these features, we will
    look at three specific risk factors.

   Default Risk

   Liquidity

   Income Tax Considerations
Default Risk Factor
   One attribute of a bond that influences its interest
    rate is its risk of default, which occurs when the
    issuer of the bond is unable or unwilling to make
    interest payments when promised.
   U.S. Treasury bonds have usually been considered
    to have no default risk because the federal
    government can always increase taxes to pay off its
    obligations (or just print money). Bonds like these
    with no default risk are called default-free bonds.
Default Risk Factor (cont.)
   The spread between the interest rates on bonds
    with default risk and default-free bonds, called the
    risk premium, indicates how much additional
    interest people must earn in order to be willing to
    hold that risky bond.
   A bond with default risk will always have a positive
    risk premium, and an increase in its default risk will
    raise the risk premium.
Increase in Default Risk
on Corporate Bonds
Analysis of Figure 5.2: Increase in
Default on Corporate Bonds
   Corporate Bond Market
    1.   Re on corporate bonds , Dc , Dc shifts left
    2.   Risk of corporate bonds , Dc , Dc shifts left
    3.   Pc , ic 
   Treasury Bond Market
    4.   Relative Re on Treasury bonds , DT , DT shifts right
    5.   Relative risk of Treasury bonds , DT , DT shifts right
    6.   PT , iT 
   Outcome
        Risk premium, ic - iT, rises
Default Risk Factor (cont.)
   Default risk is an important component of the size of
    the risk premium.
   Because of this, bond investors would like to know
    as much as possible about the default probability of
    a bond.
   One way to do this is to use the measures provided
    by credit-rating agencies: Moody’s and S&P are
    examples.
Bond Ratings
Case: Enron and the Baa-Aaa
spread
   Enron filed for bankruptcy in December
    2001, amidst an accounting scandal.
   Because of the questions raised about
    the quality of auditors, the demand for
    lower-credit bonds fell, and a ―flight- to-
    quality‖ followed (demand for T-securities
    increased.
   Result: Baa-Aaa spread increased from
    84 bps to 128 bps.
Liquidity Factor
   Another attribute of a bond that influences its
    interest rate is its liquidity; a liquid asset is
    one that can be quickly and cheaply
    converted into cash if the need arises. The
    more liquid an asset is, the more desirable it
    is (higher demand), holding everything else
    constant.
   Let’s examine what happens if a corporate
    bond becomes less liquid (Figure 1 again).
Decrease in Liquidity
of Corporate Bonds




   Figure 5.2 Response to a Decrease in the Liquidity of Corporate Bonds
Analysis of Figure 5.1: Corporate
Bond Becomes Less Liquid
   Corporate Bond Market
     1.  Liquidity of corporate bonds , Dc , Dc shifts left
     2.  Pc , ic 
   Treasury Bond Market
     1.  Relatively more liquid Treasury bonds, DT , DT shifts right
     2.  PT , iT 
   Outcome
        Risk premium, ic - iT, rises
   Risk premium reflects not only corporate bonds' default risk but
    also lower liquidity
Liquidity Factor (cont.)
   The differences between interest rates on
    corporate bonds and Treasury bonds (that is,
    the risk premiums) reflect not only the
    corporate bond’s default risk but its liquidity
    too. This is why a risk premium is sometimes
    called a risk and liquidity premium.
Income Taxes Factor
   An odd feature of Figure 1 is that municipal
    bonds tend to have a lower rate the
    Treasuries. Why?
   Munis certainly can default. Orange County
    (California) is a recent example from the early
    1990s.
   Munis are not as liquid a Treasuries.
Income Taxes Factor
   However, interest payments on municipal
    bonds are exempt from federal income taxes,
    a factor that has the same effect on the
    demand for municipal bonds as an increase
    in their expected return.
   Treasury bonds are exempt from state and
    local income taxes, while interest payments
    from corporate bonds are fully taxable.
Income Taxes Factor
   For example, suppose you are in the 35% tax
    bracket. From a 10%-coupon Treasury bond,
    you only net $65 of the coupon payment
    because of taxes
   However, from an 8%-coupon muni, you net
    the full $80. For the higher return, you are
    willing to hold a riskier muni (to a point).
Tax Advantages of Municipal
Bonds
Analysis of Figure 5.3:
Tax Advantages of Municipal
Bonds
   Municipal Bond Market
     1.   Tax exemption raises relative Re on municipal bonds,
          Dm , Dm shifts right
     2.   Pm 
   Treasury Bond Market
     1.   Relative Re on Treasury bonds , DT , DT shifts left
     2.   PT 
   Outcome
     im < iT
Case: Bush Tax Cut and Interest
Rates
   The 2001 tax cut called for a reduction in
    the top tax bracket, from 39% to 35% over a
    10-year period.
   This reduces the advantage of municipal
    debt over T-securities since the interest on
    T-securities is now taxed at a lower rate.
Term Structure of Interest
Rates
 Now that we understand risk, liquidity, and
 taxes, we turn to another important influence
 on interest rates – maturity.
 Bonds with different maturities tend to have
 different required rates, all else equal.
The WSJ: Following the News
 For example, the WSJ publishes a plot of the
 yield curve (rates at different maturities) for
 Treasury securities.
 The picture on the following slide is a typical
 example, from May 14, 2007.


 What is the 3-month rate? The two-year rate?
Reading the Wall St. Journal




                Dynamic yield curve that can show the curve
                at any time in history
                http://stockcharts.com/charts/YieldCurve.html
Term Structure Facts to Be
Explained
    Besides explaining the shape of the yield
    curve, a good theory must explain why:
   Interest rates for different maturities
    move together. We see this on the next slide.
Interest Rates on Different
Maturity Bonds Move Together
Term Structure Facts to Be
Explained
    Besides explaining the shape of the yield
    curve, a good theory must explain why:
   Interest rates for different maturities
    move together.
   Yield curves tend to have steep upward slope
    when short rates are low and downward slope
    when short rates are high.
   Yield curve is typically upward sloping.
Three Theories of Term
Structure

1.   Expectations Theory
        Pure Expectations Theory explains 1 and 2,
         but not 3
2.   Market Segmentation Theory
        Market Segmentation Theory explains 3, but not 1 and 2
3.   Liquidity Premium Theory
        Solution: Combine features of both Pure Expectations
         Theory and Market Segmentation Theory to get Liquidity
         Premium Theory and explain all facts
Expectations Theory
   Key Assumption: Bonds of different
    maturities are perfect substitutes
   Implication:     Re on bonds of different
    maturities are equal
Expectations Theory
 To illustrate what this means, consider two
 alternative investment strategies for a two-
 year time horizon.
  1.   Buy $1 of one-year bond, and when it
       matures, buy another one-year bond with your
       money.
  2.   Buy $1 of two-year bond and hold it.
Expectations Theory
 The important point of this theory is that if the
 Expectations Theory is correct, your
 expected wealth is the same (a the start) for
 both strategies. Of course, your actual
 wealth may differ, if rates change
 unexpectedly after a year.
 We show the details of this in the next few
 slides.
Expectations Theory
   Expected return from strategy 1


    (1 it )(1 i ) 1  1 it  i
                     e
                    t 1
                                  e
                                 t 1
                                         it (i ) 1
                                             e
                                            t 1


Since it(iet+1) is also extremely small,
expected return is approximately
       it + iet+1
Expectations Theory
   Expected return from strategy 2

      (1 i2t )(1 i2t ) 1  1 2(i2t )  (i2t )2 1

Since (i2t)2 is extremely small, expected return is approximately
                 2(i2t)
Expectations Theory
   From implication above expected returns of two
    strategies are equal
   Therefore

      2i2t   it  i    e
                         t 1

Solving for i2t

            it  ite1
      i2t                                           (1)
                2
Expectations Theory
   To help see this, here’s a picture that
    describes the same information:
More generally for n-period
bond…
                 it  it 1  it  2  ... it  n1
         int                                            (2)
                                  n
   Don’t let this seem complicated. Equation 2
    simply states that the interest rate on a long-
    term bond equals the average of short rates
    expected to occur over life of the long-term
    bond.
More generally for n-period
bond…
   Numerical example
       One-year interest rate over the next five years
        are expected to be 5%, 6%, 7%, 8%, and 9%
   Interest rate on two-year bond today:
       (5% + 6%)/2 = 5.5%
   Interest rate for five-year bond today:
       (5% + 6% + 7% + 8% + 9%)/5 = 7%
   Interest rate for one- to five-year bonds today:
       5%, 5.5%, 6%, 6.5% and 7%
Expectations Theory
and Term Structure Facts
   Explains why yield curve has different slopes
     1.   When short rates are expected to rise in future, average
          of future short rates = int is above today's short rate;
          therefore yield curve is upward sloping.
     2.   When short rates expected to stay same in future,
          average of future short rates same as today's, and yield
          curve is flat.
     3.   Only when short rates expected to fall will yield curve be
          downward sloping.
Expectations Theory
and Term Structure Facts

   Pure expectations theory explains fact 1—that
    short and long rates move together
    1.   Short rate rises are persistent
    2.   If it  today, iet+1, iet+2 etc.  
         average of future rates   int 
    3.   Therefore: it   int 
         (i.e., short and long rates move together)
Expectations Theory
and Term Structure Facts
   Explains fact 2—that yield curves tend to have
    steep slope when short rates are low and downward
    slope when short rates are high
    1.   When short rates are low, they are expected to rise to
         normal level, and long rate = average of future short
         rates will be well above today's short rate; yield curve
         will have steep upward slope.
    2.   When short rates are high, they will be expected to fall
         in future, and long rate will be below current short rate;
         yield curve will have downward slope.
Expectations Theory
and Term Structure Facts
   Doesn't explain fact 3—that yield curve
    usually has upward slope
       Short rates are as likely to fall in future as rise, so
        average of expected future short rates will not
        usually be higher than current short rate:
        therefore, yield curve will not usually
        slope upward.
Market Segmentation Theory
   Key Assumption:      Bonds of different maturities are not
    substitutes at all

   Implication:         Markets are completely segmented;
                         interest rate at each maturity are
                         determined separately
Market Segmentation Theory
   Explains fact 3—that yield curve is usually upward
    sloping
       People typically prefer short holding periods and thus have
        higher demand for short-term bonds, which have higher
        prices and lower interest rates than long bonds

   Does not explain fact 1or fact 2 because its
    assumes long-term and short-term rates are
    determined independently.
Liquidity Premium Theory
   Key Assumption:   Bonds of different maturities
                      are substitutes, but are not
                      perfect substitutes
   Implication:      Modifies Pure Expectations
                      Theory with features of Market
                      Segmentation Theory
Liquidity Premium Theory
   Investors prefer short-term rather than long-term
    bonds. This implies that investors must be paid
    positive liquidity premium, int, to hold long term
    bonds.
Liquidity Premium Theory
   Results in following modification of Expectations
    Theory, where lnt is the liquidity premium.


            it  ie
                 t 1   i
                         e
                         t2    ... ie
                                      t   n1
    int                                              nt   (3)
                             n
   We can also see this graphically…
Liquidity Premium Theory
Numerical Example
1.   One-year interest rate over the next five
     years: 5%, 6%, 7%, 8%, and 9%
2.   Investors' preferences for holding short-term
     bonds so liquidity premium for one- to five-
     year bonds: 0%, 0.25%, 0.5%, 0.75%, and
     1.0%
Numerical Example
   Interest rate on the two-year bond:
        0.25% + (5% + 6%)/2 = 5.75%
   Interest rate on the five-year bond:
        1.0% + (5% + 6% + 7% + 8% + 9%)/5 = 8%
    Interest rates on one to five-year bonds:
        5%, 5.75%, 6.5%, 7.25%, and 8%
   Comparing with those for the pure expectations
    theory, liquidity premium theory produces yield
    curves more steeply upward sloped
Liquidity Premium Theory:
Term Structure Facts
   Explains All 3 Facts
       Explains fact 3—that usual upward sloped yield
        curve by liquidity premium for
        long-term bonds
       Explains fact 1 and fact 2 using same
        explanations as pure expectations theory
        because it has average of future short rates as
        determinant of long rate
Market
Predictions
of Future
Short Rates




              247
Evidence on the Term
Structure
   Initial research (early 1980s) found little
    useful information in the yield curve for
    predicting future interest rates.
   Recently, more discriminating tests show that
    the yield curve has a lot of information about
    very short-term and long-term rates, but says
    little about medium-term rates.
Case: Interpreting Yield
Curves
   The picture on the next slide illustrates
    several yield curves that we have observed
    for U.S. Treasury securities in recent years.
   What do they tell us about the public’s
    expectations of future rates?
Case: Interpreting Yield Curves,
1980–2008
Case: Interpreting Yield
Curves
   The steep downward curve in 1981
    suggested that short-term rates were
    expected to decline in the near future. This
    played-out, with rates dropping by 300 bps in
    3 months.
   The upward curve in 1985 suggested a rate
    increase in the near future.
Case: Interpreting Yield
Curves
   The slightly upward slopes in the remaining
    years can be explained by liquidity premiums.
    Short-term rates were stable, with longer-
    term rates including a liquidity premium
    (explaining the upward slope).
Mini-case: The Yield Curve as a
Forecasting Tool
   The yield curve does have information about
    future interest rates, and so it should also
    help forecast inflation and real output
    production.
       Rising (falling) rates are associated with
        economic booms (recessions) [chapter 4].
       Rates are composed of both real rates and
        inflation expectations [chapter 3].
The Practicing Manager: Forecasting
Interest Rates with the Term Structure
   Pure Expectations Theory: Invest in 1-period bonds
    or in two-period bond 

               1  it 1  ite1  1  1 i2t 1  i2t   1
Solve for forward rate, iet+1

                                       1  i2t 
                                                  2
                              e
                             it 1                   1            (4)
                                         1  it
Numerical example: i1t = 5%, i2t = 5.5%
                           1  0.0552
                 ite1                      1  0.06  6%
                            1  0.05
Forecasting Interest Rates
with the Term Structure
   Compare 3-year bond versus 3 one-year bonds

    1  it 1  ite1 1  ite2  1  1  i3t 1 i3t 1  i3t   1

Using iet+1 derived in (4), solve for iet+2

                            e        1  i3t 
                                             3

                           i                  2 1
                            t 2
                                     1 i2t 
Forecasting Interest Rates
with the Term Structure
   Generalize to:
                     e        1 in1t  n 1

                     i                          1         (5)
                                1  int 
                     t n                 n


Liquidity Premium Theory: int -    = same as pure
expectations theory; replace int by int - in (5)
to get adjusted forward-rate forecast


               e       1 in1t  n 1t        n1

              i                                       1   (6)
                         1 int  nt 
              t n                       n
Forecasting Interest Rates
with the Term Structure
   Numerical Example
    2t = 0.25%, 1t=0, i1t=5%, i2t = 5.75%

                  1  0.0575  0.0025 2
          ite1                           1  0.06  6%
                         1  0.05 
Example: 1-year loan next year
   T-bond + 1%, 2t = .4%, i1t = 6%, i2t = 7%
                  1  0.07  0.004 2
          ite1                        1  0.072  7.2%
                       1  0.06 
Loan rate must be > 8.2%
Chapter Summary
   Risk Structure of Interest Rates: We examine
    the key components of risk in debt: default,
    liquidity, and taxes.
   Term Structure of Interest Rates: We
    examined the various shapes the yield curve
    can take, theories to explain this, and
    predictions of future interest rates based on
    the theories.
       Part 3
Financial Markets
   Chapter 6
The Money Markets
Chapter Preview
       Topics include:
       The Money Markets Defined
       The Purpose of Money Markets
       Who Participates in Money Markets?
       Money Market Instruments
       Comparing Money Market Securities
The Money Markets Defined
   Money Markets Defined
    1.   Money market securities are usually sold in large
         denominations ($1,000,000 or more)交易的数额
         巨大--------wholesale markets
    2.   They have low default risk 违约风险低
    3.   They mature(到期) in one year or less from
         their issue date (初始发行日)
The Money Markets Defined:
Cost Advantages
   Reserve requirements (Required Deposit
    Reserve) create additional expense for banks
    that money markets do not have
   Regulations on the level of interest banks
    could offer depositors lead to a significant
    growth in money markets
The Purpose of Money Markets
   Investors in Money Market: Provides a place
    for warehousing surplus funds for short
    periods of time (cash- opportunity cost)
   Borrowers: money market provide low-cost
    source of temporary funds
Who Participates
in the Money Markets?
Money Market Instruments
   We will examine each of these in the
    following slides:
       Treasury Bills
       Federal Funds
       Repurchase Agreements
       Negotiable Certificates of Deposit
Money Market Instruments
(cont.)


       Commercial Paper
       Banker’s Acceptance
       Eurodollars
Money Market Instruments:
Treasury Bills
   T-bills have 28-day maturities through 12-
    month maturities.
   Discounting: When an investor pays less
    for the security than it will be worth when it
    matures
                             Discount rate
                               Yield rate
Money Market Instruments:
Treasury Bills Discounting
Example
   You pay $996.37 for a 28-day T-bill. It is worth
    $1,000 at maturity. What is its discount rate?

                          F  P 365
           i discount         x                       (1)
                            F    n

                      1,000  996 .73 36 5
       i discount                   x      4.665 %
                          1,000        28
Money Market Instruments:
Treasury Bills Discounting
Example
   You pay $996.37 for a 28-day T-bill. It is worth
    $1,000 at maturity. What is its annualized yield?

                             F  P 365
                      iy t                        (1)
                               P    n


               1,000  996.73 365
      i yt                  x     4.76%
                   996.37      28
Money Market Instruments:
Treasury Bill Auctions
   T-bills are auctioned(拍卖)by
    competitive bids(竞价招标)
   noncompetitive bids(非竞价招标)
Money Market Instruments:
Treasury Bill Auctions Example
 The Treasury auctioned $2.5 billion par value 91-day T-bills, the
 following bids were received:

     Bidder   Bid Amount      Bid Price
       1       $500 million    $0.9940
       2       $750 million    $0.9901
       3       $1.5 billion    $0.9925
       4       $500 million    $0.9936
       5       $600 million    $0.9939

 The Treasury also received in competitive bids. Who will receive
 T-bills, what quantity, and at what price?
Money Market Instruments:
Treasury Bill Auctions Example
 The Treasury accepts the following bids:

    Bidder Bid Amount     Bid Price
      1 $500 million $0.9940
      5 $500 million $0.9939
      4 $650 million       $0.9936
Money Market Instruments:
Fed Funds
   Short-term funds transferred (loaned or
    borrowed) between financial institutions,
    usually for a period of one day.
   Used by banks to meet short-term needs to
    meet reserve requirements:
   主要目的就是为准备金短缺的银行提供可立即
    拆入的资金.
Federal Funds Interest Rates
How to set ?



Fed sell securities:
higher i
Fed buy securities:    lower
i
Money Market Instruments:
Repurchase Agreements
   These work similar to the market for fed
    funds, but nonbanks can participate.
   A firm sells Treasury securities, but agrees to
    buy them back at a certain date (usually 3–14
    days later) for a certain price.
Money Market Instruments:
Repurchase Agreements
   This set-up makes a repo agreements
    essentially a short-term collateralized(抵押)
    loan.
   This is one market the Fed may use to
    conduct its monetary policy, whereby the Fed
    purchases/sells Treasury securities in the
    repo market.
Money Market Instruments:
Negotiable Certificates of Deposit
   A bank-issued security that documents a
    deposit and specifies the interest rate and the
    maturity date
   Denominations range from $100,000
    to $10 million
Money Market Instruments:
Commercial Paper
   Unsecured promissory notes, issued by
    corporations, that mature in no more than
    270 days.
   The use of commercial paper increased
    significantly in the early 1980s because of the
    rising cost of bank loans.
Money Market Instruments:
Commercial Paper
  The next slide shows actual commercial
  paper rates and the prime rates 1990
  through 2007.
  Although the two track closely in terms of
  movements, notice that difference between
  the two remains roughly 200 basis points.
Money Market Instruments:
Commercial Paper
  The next slide shows actual commercial
  paper volume by year from 1990
  through 2006.
  Notice that the volume has only begun to fall
  during the recent economic recession in the
  economy. Even so, the annual market is
  still quite large, at well over $1 trillion
  outstanding.
Money Market Instruments:
Commercial Paper Volume
Money Market Instruments:
Banker’s Acceptances
   An order to pay a specified amount
    to the bearer on a given date if specified
    conditions have been met, usually delivery
    of promised goods.
   These are often used when buyers / sellers of
    expensive goods live in different countries.
Money Market Instruments:
Banker’s Acceptances
Advantages
1.   Exporter paid immediately
2.   Exporter shielded from foreign
     exchange risk
3.   Exporter does not have to assess the
     financial security of the importer
4.   Importer’s bank guarantees payment
5.   Crucial to international trade
Money Market Instruments:
Banker’s Acceptances
   As seen, banker’s acceptances avoid the
    need to establish the credit-worthiness of a
    customer living abroad.
   There is also an active secondary market for
    banker’s acceptances until they mature. The
    terms of note indicate that the bearer,
    whoever that is, will be paid upon maturity.
Money Market Instruments:
Eurodollars
   Eurodollars represent Dollar denominated
    deposits held in foreign banks.
   The market is essential since many foreign
    contracts call for payment is U.S. dollars due
    to the stability of the dollar, relative to other
    currencies.
Money Market Instruments:
Eurodollars
   The Eurodollar market has continued to grow rapidly
    because depositors receive a higher rate of return
    on a dollar deposit in the Eurodollar market than in
    the domestic market.
   Multinational banks are not subject to the same
    regulations restricting U.S. banks and because they
    are willing to accept narrower spreads between the
    interest paid on deposits and the interest earned on
    loans.
Money Market Instruments:
Eurodollars Rates
   London interbank bid rate (LIBID)
       The rate paid by banks buying funds

   London interbank offer rate (LIBOR)
       The rate offered for sale of the funds


Comparing Money Market
Securities
   The next slide shows a comparison of various
    money market rates from 1990 through 2007.
   Notice that no real pattern is present among
    the rates, indicating that investor preferences
    to the features on the instruments fluctuates.
Comparing Money Market
Securities : A comparison of rates
Comparing Money Market
Securities
   The next slide summarizes the types of
    securities, issuers, buyers, maturity, and
    secondary market characteristics.
Comparing Money Market Securities:
Money Market Securities and Their
Depth
Chapter Summary
   The Money Markets Defined
       Short-term instruments
       Most have a low default probability
   The Purpose of Money Markets
       Used to ―warehouse‖ funds
       Returns are low because of low risk and
        high liquidity
Chapter Summary (cont.)
   Who Participates in Money Markets?
       U.S. Treasury
       Commercial banks
       Businesses
       Individuals (through mutual funds)

   Money Market Instruments
       Include T-bills, fed funds, etc.
Chapter Summary (cont.)

   Comparing Money Market Securities
       Issuers range from the US government to banks
        to large corporations
       Mature in as little as 1 day to as long as 1 year
       The secondary market liquidity
        varies substantially
 Chapter 7
The Bond Market
Chapter Preview
   In this chapter, we focus on longer-term
    securities: bonds. Bonds are like money
    market instruments, but they have maturities
    that exceed one year. These include
    Treasury bonds, corporate bonds, mortgages,
    and the like.
Chapter Preview
       Topics include:
       Purpose of the Capital Market
       Capital Market Participants
       Capital Market Trading
       Types of Bonds
       Treasury Notes and Bonds
       Municipal Bonds
Chapter Preview (cont.)
    Corporate Bonds
    Financial Guarantees for Bonds
    Current Yield Calculation
    Finding the Value of Coupon Bonds
    Investing in Bonds
Purpose of the Capital Market
   Original maturity is greater than
    one year, typically for long-term financing or
    investments
   Best known capital market securities:
       Stocks and bonds
Capital Market Participants
   Primary issuers of securities:
       Federal and local governments: debt issuers
       Corporations: equity and debt issuers

   Largest purchasers of securities:
       You and me


                                ? Capital Structure
Capital Market Trading
1.   Primary market for initial sale (IPO)
2.   Secondary market
         Over-the-counter
         Organized exchanges (i.e., NYSE)
Types of Bonds
   Bonds are securities that represent debt
    owed by the issuer to the investor, and
    typically have specified payments on specific
    dates.
   Types of bonds we will examine include long-
    term government bonds (T-bonds), municipal
    bonds, and corporate bonds.
Types of Bonds:
Sample Corporate Bond
Treasury Notes and Bonds
   The U.S. Treasury issues notes and bonds to
    finance its operations.
   The following table summarizes the maturity
    differences among the various Treasury
    securities.
Treasury Notes and Bonds
Treasury Bond Interest Rates
   No default risk since the Treasury can print
    money to payoff the debt
   Very low interest rates, often considered the
    risk-free rate (although inflation risk is still
    present)
Treasury Bond Interest Rates
   The next two figures show historical
    rates on Treasury bills, bonds, and the
    inflation rate.
Treasury Bond Interest Rates
Treasury Bond Interest Rates:
Bills vs. Bonds
Treasury Bonds:
Recent Innovation
   Treasury Inflation-Indexed Securities:
    the principal amount is tied to the current rate
    of inflation to protect investor purchasing
    power
   Treasury STRIPS: the coupon and principal
    payments are ―stripped‖ from a T-Bond and
    sold as individual zero-coupon bonds.
Treasury Bonds: Agency Debt
   Although not technically Treasury securities,
    agency bonds are issued by government-
    sponsored entities, such as GNMA, FNMA,
    and FHLMC.
   The debt has an ―implicit‖ guarantee that the
    U.S. government will not let the
    debt default.
Municipal Bonds
   Issued by local, county, and
    state governments

   Used to finance public interest projects

   Tax-free municipal interest rate =
    taxable interest rate  (1  marginal
    tax rate)
Municipal Bonds: Example
 Suppose the rate on a corporate bond is 9% and
 the rate on a municipal bond is 6.75%. Which
 should you choose?

 Answer: Find the marginal tax rate:
    6.75% = 9% x (1 – MTR), or MTR = 25%

 If you are in a marginal tax rate above 25%,
 the municipal bond offers a higher after-tax
 cash flow.
Municipal Bonds
   Two types
       General obligation bonds
       Revenue bonds

   NOT default-free (e.g., Orange
    County California)
       Defaults in 1990 amounted to $1.4 billion in this
        market
Municipal Bonds
 The next slide shows the volume of general
 obligation bonds and revue bonds issued
 from 1984 through 2006.

 Note that general obligation bonds represent
 a higher percentage in the latter part of the
 sample.
Municipal Bonds: Comparing Revenue
and General Obligation Bonds
Corporate Bonds
   Typically have a face value of $1,000,
    although some have a face value of $5,000
    or $10,000

   Pay interest semi-annually
Corporate Bonds
   Cannot be redeemed anytime the issuer
    wishes, unless a specific clause states this
    (call option).

   Degree of risk varies with each bond, even
    from the same issuer. Following suite, the
    required interest rate varies with level
    of risk.
Corporate Bonds
   The next slide shows the interest rate on
    various bonds from 1973-2007.

   The degree of risk ranges from low-risk (AAA)
    to higher risk (BBB). Any bonds rated below
    BBB are considered sub-investment grade
    debt.
Corporate Bonds: Interest
Rates
Corporate Bonds:
Characteristics of Corporate
Bonds
   Registered Bonds
       Replaced ―bearer‖ bonds
       IRS can track interest income this way

   Restrictive Covenants
       Mitigates conflicts with shareholder interests
       May limit dividends, new debt, ratios, etc.
       Usually includes a cross-default clause
Corporate Bonds:
Characteristics of Corporate
Bonds
   Call Provisions
       Higher yield
       Sinking fund
       Interest of the stockholders
       Alternative opportunities

   Conversion
       Some debt may be converted to equity
       Similar to a stock option, but usually more limited
Corporate Bonds:
Characteristics of Corporate
Bonds
   Secured Bonds
       Mortgage bonds
       Equipment trust certificates

   Unsecured Bonds
       Debentures
       Subordinated debentures
       Variable-rate bonds
Corporate Bonds:
Characteristics of Corporate
Bonds
   Junk Bonds
       Debt that is rated below BBB
       Often, trusts and insurance companies are not
        permitted to invest in junk debt
       Michael Milken developed this market in the mid-
        1980s, although he was convicted of insider
        trading
Corporate Bonds: Debt
Ratings
 The next slide explains in further details the
 rating scale for corporate debt. The rating
 scale is for Moody’s. Both Standard and
 Poor’s and Fitch have similar debt
 rating scales.
Corporate
Bonds:
Debt
Ratings
Financial Guarantees for
Bonds
   Some debt issuers purchase financial
    guarantees to lower the risk of their debt.

   The guarantee provides for timely payment of
    interest and principal, and are usually backed
    by large insurance companies.
Bond Yield Calculations
   Bond yields are quoted using a variety of
    conventions, depending on both the type of
    issue and the market.

   We will examine the current yield calculation
    that is commonly used for long-term debt.
Bond Current Yield Calculation
 What is the current yield for a bond with a face value
 of $1,000, a current price of $921.01, and a coupon
 rate of 10.95%?

 Answer:
 ic = C / P = $109.50 / $921.01 = 11.89%

 Note: C ( coupon) = 10.95% x $1,000 = $109.50
Finding the Value of Coupon
Bonds
 Bond pricing is, in theory, no different than
 pricing any set of known cash flows. Once
 the cash flows have been identified, they
 should be discounted to time zero at an
 appropriate discount rate.
 The table on the next slide outlines some of
 the terminology unique to debt, which may be
 necessary to understand to determine the
 cash flows.
Finding the Value of Coupon
Bonds
Finding the Value of Coupon
Bonds
 Let’s use a simple example to illustrate the
 bond pricing idea.
 What is the price of two-year, 10% coupon
 bond (semi-annual coupon payments) with a
 face value of $1,000 and a required rate of
 12%?
Finding the Value of Coupon
Bonds
Solution:
1.       Identify the cash flows:
     •     $50 is received every six months in interest
     •     $1000 is received in two years as principal repayment

2.       Find the present value of the cash flows (calculator
         solution):
     N = 4, FV = 1000, PMT = 50, I = 6
     Computer the PV. PV = 965.35
Investing in Bonds
   Bonds are the most popular alternative to
    stocks for long-term investing.
   Even though the bonds of a corporation are
    less risky than its equity, investors still have
    risk: price risk and interest rate risk, which
    were covered in chapter 3
Investing in Bonds
 The next slide shows the amount of bonds
 and stock issued from 1983 to 2006.
 Note how much larger the market for new
 debt is. Even in the late 1990s, which were
 boom years for new equity issuances, new
 debt issuances still outpaced equity by
 over 5:1.
Investing in Bonds
Chapter Summary
   Purpose of the Capital Market: provide
    financing for long-term capital assets
   Capital Market Participants: governments and
    corporations issue bond, and we
    buy them
   Capital Market Trading: primary and
    secondary markets exist for most securities
    of governments and corporations
Chapter Summary (cont.)
   Types of Bonds: includes Treasury, municipal,
    and corporate bonds
   Treasury Notes and Bonds: issued and
    backed by the full faith and credit of the U.S.
    Federal government
   Municipal Bonds: issued by state and local
    governments, tax-exempt, defaultable.
Chapter Summary (cont.)
   Corporate Bonds: issued by corporations and
    have a wide range of features and risk
   Financial Guarantees for Bonds: bond
    ―insurance‖ should the issuer default
   Bond Current Yield Calculation: how to
    calculation the current yield for a bond
Chapter Summary (cont.)
   Finding the Value of Coupon Bonds:
    determining the cash flows and discounting
    back to the present at an appropriate
    discount rate
   Investing in Bonds: most popular alternative
    to investing in the stock market for long-term
    investments
 Chapter 8
The Stock Market
Chapter Preview
 In August of 2004, Google went public,
 auctioning its shares in an unusual IPO
 format. The shares originally sold for $85 /
 share, and closed at over $100 on the first
 day. In November of 2007, shares are trading
 on Nasdaq at over $650 / share.
Chapter Preview
   The stock market receives considerable
    attention from investors. As Google
    illustrates, great fortunes can be made! But
    also lost.
   This is the focus of chapter 11 – a look at the
    equity side of investing.
Chapter Preview
   We examine the markets where stocks trade,
    and then review the underlying theories for
    stock valuation. We learn
    that stock valuations is quite difficult. Topics
    include:
       Investing in Stocks
       Computing the Price of Common Stock
       How the Market Sets Security Prices
       Errors in Valuation
Chapter Preview (cont.)
    Stock Market Indexes
    Buying Foreign Stocks
    Regulation of the Stock Market
 Investing in Stocks
1.   Represents ownership            4.   Right to vote for
     in a firm                            directors and on
2.   Earn a return in                     certain issues
     two ways                        5.   Two types
        Price of the stock rises            Common stock
         over time                             Right to vote
        Dividends are paid to the             Receive dividends
         stockholder                         Preferred stock
3.   Stockholders have claim                   Receive a fixed
     on all assets                               dividend
                                               Do not usually vote
Investing in Stocks:
Sample Corporate Stock
Certificate




                         348
Investing in Stocks:
How Stocks are Sold
   Organized exchanges
       NYSE is best known, with daily volume around 2
        billion shares.
       ―Organized‖ used to imply a specific trading
        location. But computer systems (ECNs) have
        replaced this idea.
       Others include the ASE (US), and Nikkei, LSE,
        DAX (international)
       Listing requirements exclude small firms
Investing in Stocks:
How Stocks are Sold
   Over-the-counter markets
       Best example is NASDAQ
       Dealers stand ready to make a market
       Today, about 3,300 different securities are listed on
        NASDAQ.
       Important market for thinly-traded securities – securities
        that don’t trade very often. Without a dealer ready to make
        a market, the equity would be difficult to trade.
Investing in Stocks:
Organized vs. OTC
   Organized exchanges (e.g., NYSE)
       Auction markets with floor specialists
       25% of trades are filled directly by specialist
       Remaining trades are filled through SuperDOT

   Over-the-counter markets (e.g., NASDAQ)
       Multiple market makers set bid and ask prices
       Multiple dealers for any given security
Investing in Stocks: ECNs
 ECNs (electronic communication networks)
 allow brokers and traders to trade without the
 need of the middleman. They provide:
    Transparency: everyone can see
     unfilled orders
    Cost reduction: smaller spreads
    Faster execution
    After-hours trading
Investing in Stocks: ECNs
 However, ECNs are not without
 their drawbacks:
    Don’t work as well with thinly-traded stocks
    Many ECNs competing for volume, which can be
     confusing
    Major exchanges are fighting ECNs, with an
     uncertain outcome
Investing in Stocks: ETFs
    Exchange Traded Funds are a recent innovation to
    help keep transaction costs down while offering
    diversification.
   Represent a basket of securities
   Traded on a major exchange
   Index to a specific portfolio (eg., the S&P 500), so
    management fees are low (although commissions
    still apply)
   Exact content of basket is known, so valuation is
    certain
Computing the Price
of Common Stock
 Valuing common stock is, in theory, no
 different from valuing debt securities:
 determine the future cash flows and discount
 them to the present at an appropriate
 discount rate.

 We will review four different methods for
 valuing stock, each with its advantages
 and drawbacks.
Computing the Price of Common Stock:
The One-Period Valuation Model

   Simplest model, just taking using the
    expected dividend and price over the
    next year.
                Div1       P
   Price =                1
              (1  ke ) (1  ke )
Computing the Price of Common Stock:
The One-Period Valuation Model

 What is the price for a stock with an expected
 dividend and price next year of $0.16 and
 $60, respectively? Use a 12% discount rate
 Answer:
    Price =
                 0.16         60
                                      53 .71
              (1  0.12 ) (1  0.12 )
Computing the Price of Common Stock:
The Generalized Dividend Valuation
Model

   Most general model, but the infinite sum may
    not converge.
                 
                   Divt
   Price = 
            t 1 (1  ke ) t
   Rather than worry about computational
    problems, we use a simpler version, known
    as the Gordon growth model.
Computing the Price of Common Stock:
The Gordon Growth Model

   Same as the previous model, but it assumes that
    dividend grow at a constant rate, g. That is,

              Div(t+1) = Divt x (1 + g)


              
                   Div t       D1
   Price =
               (1  k )t  (k  g )
              t 1    e       e
Computing the Price of Common Stock:
The Gordon Growth Model

    The model is useful, with the
    following assumptions:

   Dividends do, indeed, grow at a constant rate
    forever

   The growth rate of dividends, g, is less than
    the required return on the equity, ke.
Computing the Price of Common Stock:
The Generalized Dividend Valuation
Model

   The price earnings ratio (PE) is a widely
    watched measure of much the market is
    willing to pay for $1.00 of earnings from
    the firms.

   Price = P  E
            E
Computing the Price of Common Stock:
The Price Earnings Valuation Method

 If the industry PE ratio for a firm is 16, what is
 the current stock price for a firm with earnings
 for $1.13 / share?

 Answer:

    Price = 16 x $1.13 = $18.08
How the Market Sets Security
Prices
   Generally speaking, prices are set in
    competitive markets as the price set by the
    buyer willing to pay the most for an item.
   The buyer willing to pay the most for an asset
    is usually the buyer who can make the best
    use of the asset.
   Superior information can play an
    important role.
How the Market Sets Security
Prices
   Consider the following three valuations for a stock
    with certain dividends but different perceived risk:




   Bud, who perceives the lowest risk, is willing
    to pay the most and will determine the
    ―market‖ price.
Errors in Valuations
    Although the pricing models are useful,
    market participants frequently encounter
    problems in using them. Any of these can
    have a significant impact on price in the
    Gordon model.
   Problems with Estimating Growth
   Problems with Estimating Risk
   Problems with Forecasting Dividends
Case: 9/11, Enron and the
Market
   Both 9/11 and the Enron scandal were events in
    2001.
   Both should lower ―g‖ in the Gordon Growth model –
    driving down prices.
   Also impacts ke – higher uncertainty increases this
    value, again lowering prices.
   We did observe in both cases that prices in the
    market fell. And subsequently rebounded as
    confidence in US markets returned.
Stock Market Indexes
   Stock market indexes are frequently used to
    monitor the behavior of a groups
    of stocks.
   Major indexes include the Dow Jones
    Industrial Average, the S&P 500, and the
    NASDAQ composite.
   The securities that make up the (current)
    DJIA are included on the next slide.
Stock Market Indexes:
the Dow Jones Industrial Average
Stock Market Indexes
   The next two slides show the Dow Jones
    Industrial Average from 1980–2007.

   As can be seen, $1.00 invested in the DJIA
    back in 1980, when the DJIA was around 800,
    would have grown to about $12.50 in 2004,
    when the Dow reached 10,000. This
    represented an annual growth rate
    around 10.6%.
Stock Market Indexes, DJIA




                Historical stocks charts are found at
                http://stockcharts.com/charts/historical/
Stock Market Indexes, DJIA
(cont.)




                Historical stocks charts are found at
                http://stockcharts.com/charts/historical/
Buying Foreign Stocks
   Buying foreign stocks is useful from a
    diversification perspective. However, the
    purchase may be complicated if the shares
    are not traded in the U.S.
   American depository receipts (ADRs) allow
    foreign firms to trade on U.S. exchanges,
    facilitating their purchase. U.S. banks buy
    foreign shares and issue receipts against the
    shares in U.S. markets.
Regulation of the Stock Market
   The primary mission of the SEC is ―…to
    protect investors and maintain the integrity of
    the securities markets.‖
   The SEC brings around 500 actions against
    individuals and firms each year toward this
    effort. This is accomplished through the joint
    efforts of four divisions.
Regulation of the Stock Market:
Divisions of the SEC
   Division of Corporate Finance: responsible
    for collecting, reviewing, and making
    available all of the documents corporations
    and individuals are required to file
   Division of Market Regulation: establishes
    and maintains rules for orderly and
    efficient markets.
Regulation of the Stock Market:
Divisions of the SEC
   Division of Investment Management:
    oversees and regulates the investment
    management industry
   Division of Enforcement: investigates
    violations of the rules and regulations
    established by the other divisions.
Chapter Summary
   Investing in Stocks: we developed an
    understanding the structure of the various
    trading systems, including exchanges and
    OTC markets
   Computing the Price of Common Stock:
    various techniques for valuing dividends and
    earnings were presented
Chapter Summary (cont.)
   How the Market Sets Security Prices: the
    basic idea that prices are set by the ―highest
    bidder‖ was reviewed
   Errors in Valuation: difficulties in determining
    dividends, growth rates, and/or required
    returns can have a significant impact in the
    pricing models
Chapter Summary (cont.)
   Stock Market Indexes: a way to track
    changes in valuation for a broad group
    of stocks
   Buying Foreign Stocks: potential benefits for
    diversifications, simplified by the use
    of ADRs.
   Regulation of the Stock Market:
    the primary function of the Securities
    and Exchange Commission
      Chapter 9
The Mortgage Markets
Chapter Preview
 Part of the American Dream is to own your
 own home. But the average price of a home
 is well over $140,000 (and quite a bit higher
 is some areas, like California). For most of
 us, home ownership would be impossible
 without borrowing most of the cost of a home.
Chapter Preview
   In this chapter, we identify characteristics of typical
    residential mortgages and the usual term and types
    of mortgages available. We then review who
    provides and services the loans, along with the
    growth in the secondary mortgage market. Topics
    include:
       What Are Mortgages?
       Characteristics of Residential Mortgages
       Types of Mortgage Loans
       Mortgage-Lending Institutions
Chapter Preview (cont.)
    Loan Servicing
    Secondary Mortgage Market
    Securitization of Mortgages
    The Impact of Securitized Mortgages on the
     Mortgage Market
What Are Mortgages?
   A long-term loan secured by real estate

   An amortized loan whereby a fixed payment
    pays both principal and interest each month
What Are Mortgages?
   The next slide shows the total amount of
    mortgage debt outstanding in the U.S. during
    2006. It further delineates by type
    of property.
   The table shows roughly $13 trillion
    outstanding. How does this compare to the
    value of all the stock on the NYSE?
What Are Mortgages?
Mortgage Loan Borrowers
What Are Mortgages? History
   Mortgages were used in the 1880s, but
    massive defaults in the agricultural recession
    of 1890 made long-term mortgages difficult to
    attain.
   Until post-WWII, most mortgage loans were
    short-term balloon loans with maturities of
    five years or less.
What Are Mortgages? History
   Balloon loans, however, caused problems
    during the depression. Typically, the lender
    renews the loan. But, with so many
    Americans out of work, lenders could not
    continue to extend credit.
   As a part of the depression recovery program,
    the federal government assisted in creating
    the standard 30-year mortgage we know
    today.
Characteristics of
the Residential Mortgage
   Mortgages can be roughly classified along
    the following three dimensions:
       Mortgage Interest Rates
       Loan Terms
       Mortgage Loan Amortization
Characteristics of the Residential
Mortgage: Mortgage Interest Rates
   The stated rate on a mortgage loan is
    determined by three rates:
       Market Rates: general rates on
        Treasury bonds
       Term: longer-term mortgages have
        higher rates
       Discount Points: a lower rates negotiated for cash
        upfront


                              A variety of fun mortgage calculators
                              http://interest.com/calculators/index.shtml
Characteristics of the Residential
Mortgage: Mortgage Interest Rates
   The next slide shows the relationship
    between mortgage rates and long-term
    treasury rates. As can be seen, mortgage
    rates are typically higher than Treasury rates,
    but the spread (difference) between the two
    varies considerably.




                          A variety of fun mortgage calculators
                          http://interest.com/calculators/index.shtml
Characteristics of the Residential
Mortgage: Mortgage Interest Rates




                  Current mortgage interest rates
                  http://www.interest.com/
Characteristics of the Residential Mortgage:
Mortgage Interest Rates & Points

   A difficult decision when getting a mortgage is
    whether to pay points (cash) upfront in exchange for
    a lower interest rate on the mortgage. Suppose you
    had to choose between a 12% 30-year mortgage or
    an 11.5% mortgage with 2 discount points. Which
    should you choose? Assume you wished to borrow
    $100,000.




                             A variety of fun mortgage calculators
                             http://interest.com/calculators/index.shtml
Characteristics of the Residential Mortgage:
Mortgage Interest Rates & Points

  First, examine the 12% mortgage.
  Using a financial calculator, the required
  payments is:

  n = 360, i = 1.0, PV = 100,000,

  Calculate the PMT. PMT = $1,028.61
Characteristics of the Residential Mortgage:
Mortgage Interest Rates & Points

  Now, examine the 11.5% mortgage. Using
  a financial calculator, the required payments
  is:

  n = 360, i = 11.5/12, PV = 100,000,

  Calculate the PMT. PMT = $990.29
Characteristics of the Residential Mortgage:
Mortgage Interest Rates & Points

   So, paying the points will save you $38.32
    each month. However, you have to pay
    $2,000 upfront.

   You can see that the decision depends on how long
    you want to live in the house, keeping the same
    mortgage.
Characteristics of the Residential Mortgage:
Mortgage Interest Rates & Points

   If you only want to live there 12 months,
    clearly the $2,000 upfront cost is not worth
    the monthly savings.

   Let’s see how to determine the answer.
Characteristics of the Residential Mortgage:
Mortgage Interest Rates & Points

  You need to determine when the present
  value of the savings ($38.32) equals the
  $2,000 upfront. Using a financial calculator,
  this is:

  i = 1, PV = -2,000, PMT = 38.32

  Calculate n. n = 74 months, or about
  6.2 years.
Characteristics of the Residential Mortgage:
Mortgage Interest Rates & Points

  So, if you think you will stay in the house and
  not refinance for at least 6.2 years, paying
  the $2,000 for the lower payment is a sound
  financial decision.

  Otherwise, you should accept the
  12% loan.
Characteristics of the Residential Mortgage:
Mortgage Interest Rates & Points

  The next table further illustrates this point,
  showing the effective rate on the 11.5%
  mortgage if the mortgage is paid in full at
  various points.
  Note that right around year 6, the effective
  annual rate on the 11.5% mortgage is about
  the same as effective annual rate on the 12%
  mortgage (12.68%).
Characteristics of the Residential
Mortgage: Effective Rate of
Interest
Characteristics of the Residential
Mortgage: Loan Terms
    Mortgage loan contracts contain many legal
    terms that need to be understood. Most
    protect the lender from financial loss.
   Collateral: usually the real estate
    being finance
   Down payment: a portion of the purchase
    price paid by the borrower
Characteristics of the Residential
Mortgage: Loan Terms
    Mortgage loan contracts contain many legal
    terms that need to be understood. Most
    protect the lender from financial loss.
   PMI: insurance against default by
    the borrower
   Qualifications: includes credit history,
    employment history, etc., to determine the
    borrowers ability to repay the mortgage as
    specified in the contact
Characteristics of the Residential
Mortgage: Loan Terms
    Lenders will also order a credit report from
    one of the credit reporting agencies.
   The score reported is called the FICO.
   The range is 300 to 850, with 660 to 720
    being average.
   Payment history, debt, and even credit card
    applications can affect your credit score.
Characteristics of the Residential
Mortgage: Loan Amortization
 Mortgage loans are amortized loans. This
 means that a fixed, level payment will pay
 interest due plus a portion of the principal
 each month. It is designed so that the
 balance on the mortgage will be zero when
 the last payment is made.
 The next table shows a typical amortization
 table for a 30-year mortgage at 8.5%.
Characteristics of the Residential
Mortgage: Loan Amortization Schedule
Types of Mortgage Loans
   Insured vs. Conventional Mortgages: if the
    down payment is less than 20%, insurance is
    usually required
   Fixed-Rate Mortgages: the interest rate is
    fixed for the life of the mortgage
   Adjustable-Rate Mortgages: the interest rate
    can fluctuate within certain parameters
Types of Mortgage Loans
   Other Types
       Graduated-Payment Mortgages (GPMs)
       Growing Equity Mortgages (GEMs)
       Shared-Appreciation Mortgages (SAMs)
       Equity Participation Mortgages
       Second Mortgages
       Reverse Annuity Mortgages (RAMs)

   The following table lists additional
    characteristics on all the loans.
Types of Mortgage Loans
Mortgage-Lending Institutions
   Originally, thrift institutions were the primary
    originator of mortgages in the U.S. and,
    therefore, the primary holder of mortgage
    loans.
   As the next figure illustrates, this is not the
    case anymore.
Mortgage-Lending Institutions
Loan Servicing
   Most mortgages are immediately sold to
    another investor by the originator. This frees
    cash to originate another loan and generate
    additional fee income.
   Still, someone has to collect the monthly
    payments and keep records. This is knows
    as loan servicing, and servicers usually keep
    a portion of the payments received to cover
    their costs.
Loan Servicing
    In all, there are three distinct elements in
    mortgage loans:
   The originator packages the loan for
    an investor
   The investor holds the loan
   The servicing agent handles the paperwork
Secondary Mortgage Market
   The secondary mortgage market was
    originally established by the federal
    government after WWII when it created
    Fannie Mae to buy mortgages from thrifts.
   The market experienced tremendous growth
    in the early to mid-1980, and has continued
    to remain a strong market in
    the U.S.
Securitization of Mortgages
 The securitization of mortgages developed
 because of problems dealing with single
 mortgages: risk of either default or
 prepayment and servicing. Pools of
 mortgages eliminated part of this problem
 through diversification.
Securitization of Mortgages
 The mortgage-backed security (MBS) was
 created. Pools including hundreds of
 mortgages were gathered, and the rights to
 the cash flows generated by the mortgages
 were sold as separate securities.
 At first, simple pass-through securities
 were designed.
Securitization of Mortgages:
The Mortgage Pass-Through
   Definition: A security that has the borrower’s
    mortgage payments pass through the trustee
    before being disbursed to the investors
   This design did eliminate some risk, but
    investors still faced prepayment risk.
Securitization of Mortgages:
CMOs
   Definition: A CMO is a structured MBS where
    investor pools have different rights to different
    sets of cash flows.
   This design structured the prepayment risk.
    Some classes had little, while other had
    a lot.
The Impact of Securitization on
the Mortgage Market
   As the next figure shows, the value of
    mortgages held in pools is reaching $6.4
    trillion near the end of 2006.
   The securities compete for funds along with
    all other bond market participants.
Mortgage
Pools
The Impact of Securitization
on the Mortgage Market
   Benefits
     1.   Reduces the problems caused by regional lending
          institution’s sensitivity to local economic fluctuations
     2.   Borrowers have access to a national capital market
     3.   Investors have low-risk and long-term investments in
          mortgages without having to service the loan
The Impact of Securitization
on the Mortgage Market
 However, this is not without its costs.
 Because of securitization, mortgage rates
 have become more national in nature, and
 this has lead to increased volatility in
 mortgage rates.
The Subprime Mortgage
Market
   In 2000, only 2% of mortgages were
    subprime. This climbed to 17% by 2006.
   The average FICO score was 624 for
    subprime borrowers. Prime mortgage
    borrowers were 742.
   Mortgage products became more
    complicated, and income requirements for
    these mortgages became very lax.
The Subprime Mortgage
Market
   Subprime mortgages have become quite
    controversial. Although predatory advertising
    and ―bait and switch‖ tactics were all-too-
    common, home ownership did increase
    because of subprime lending.
Chapter Summary
   What Are Mortgages? Loans made for the
    purchase on real property, and usually
    collateralized by the purchased property.
   Characteristics of Residential Mortgages:
    includes the length of the mortgage, the
    terms, and the rate charges for the loan
Chapter Summary (cont.)
   Types of Mortgage Loans: includes
    conventional, insured, fixed and variable rate,
    and a variety of other designs.
   Mortgage-Lending Institutions: the primarily
    originator and holder of mortgages is no
    longer thrift institutions as other attempt to
    generate fees
Chapter Summary (cont.)
   Loan Servicing: the fees generated by
    collecting, distributing, and recording
    payments
   Secondary Mortgage Market: the active
    market for mortgages after the mortgage has
    been originated
Chapter Summary (cont.)
   Securitization of Mortgages: growing in
    popularity, causing mortgages to complete
    with both Treasury and corporate debt
   The Impact of Securitized Mortgages on the
    Mortgage Market: although many benefits
    can be noted, increased rate volatility is also
    a side-effect
Chapter 10
   The Foreign
     Exchange
        Market
   Lecture one
Chapter Preview
   In the mid-1980s, American businesses
    became less competitive relative to their
    foreign counterparts. By the 2000s, though,
    competitiveness increased. Why?
   Part of the answer can be found in exchange
    rates. In the 1980s, the dollar was strong,
    and US goods were expensive to foreign
    buyers.
Chapter Preview
   By the 1990s and 2000s, the dollar
    weakened, so American goods became
    cheaper and American businesses became
    more competitive.
Chapter Preview
   In this chapter, we develop a modern view of
    exchange rate determination that explains
    recent behavior in the foreign exchange
    market. Topics include:
       Foreign Exchange Market
       Exchange Rates in the Long Run
       Exchange Rates in the Short Run
       Explaining Changes in Exchange Rates
Foreign Exchange Market
   Most countries of the world have their own
    currencies: the U.S dollar., the euro in
    Europe, the Brazilian real, and the Chinese
    yuan, just to name a few.
   The trading of currencies and banks deposits
    is what makes up the foreign exchange
    market.
What are Foreign Exchange Rates?
 Two kinds of exchange rate transactions
 make up the foreign exchange market:
    Spot transactions involve the near-immediate
     exchange of bank deposits, completed at the
     spot rate.
    Forward transactions involve exchanges at
     some future date, completed at the forward rate.
Foreign Exchange Market
   The next slide shows exchange rates for four
    currencies from 1990-2006.
   Note the difference in rate fluctuations during
    the period. Which appears most volatile?
    The least?
Why Are Exchange Rates
Important?
   When the currency of your country
    appreciates relative to another country, your
    country's goods prices  abroad and foreign
    goods prices  in your country.
     1.   Makes domestic businesses less competitive
     2.   Benefits domestic consumers (you)
Why Are Exchange Rates
Important?
   For example, in 1999, the euro was valued at
    $1.18. On April 26, 2006, it was valued at
    $1.36.
        Euro appreciated 15% (1.36-1.18) / 1.18
        Dollar depreciated 13% (0.75-0.85) / 0.85
            Note: 0.75 = 1 / 1.36, and 0.85 = 1 / 1.18


     We can see exchange rates in the WSJ.
 Foreign
 Exchange
 Market:
 Exchange
 Rates




Current foreign exchange rates
http://www.federalreserve.gov/releases/H10/hist
How is Foreign Exchange Traded?
   FX traded in over-the-counter market
     1.   Most trades involve buying and selling bank
          deposits denominated in different currencies.
     2.   Trades in the foreign exchange market involve
          transactions in excess of $1 million.
     3.   Typical consumers buy foreign currencies from
          retail dealers, such as American Express.
•   FX volume exceeds $3 trillion per day.
Exchange Rates in the Long
Run
   Exchange rates are determined in markets by
    the interaction of supply and demand.
   An important concept that drives the
    forces of supply and demand is the Law
    of One Price.
Exchange Rates in the Long Run:
Law of One Price
   The Law of One Price states that the price of
    an identical good will be the same throughout
    the world, regardless of which country
    produces it.
   Example: American steel costs $100 per ton,
    while Japanese steel costs 10,000 yen per
    ton.
Exchange Rates in the Long Run:
Law of One Price
         If E = 50 yen/$ then price are:
                     American Steel    Japanese Steel
         In U.S.     $100              $200
         In Japan    5000 yen          10,000 yen

         If E = 100 yen/$ then price are:
                     American Steel    Japanese Steel
         In U.S.     $100              $100
         In Japan    10,000 yen        10,000 yen

   Law of one price  E = 100 yen/$
Exchange Rates in the Long Run:
Theory of Purchasing Power Parity (PPP)

   The theory of PPP states that exchange rates
    between two currencies will adjust to reflect
    changes in price levels.
   PPP  Domestic price level  10%, domestic
    currency  10%
       Application of law of one price to price levels
       Works in long run, not short run
Exchange Rates in the Long Run:
Theory of Purchasing Power Parity (PPP)

   Problems with PPP
     1.   All goods are not identical in both countries
          (i.e., Toyota versus Chevy)
     2.   Many goods and services are not traded (e.g.,
          haircuts, land, etc.)
Exchange Rates in the Long Run:
PPP
Exchange Rates in the Long Run:
Factors Affecting Exchange Rates in
Long Run

   Basic Principle: If a factor increases demand
    for domestic goods relative to foreign goods,
    the exchange rate 
   The four major factors are relative price
    levels, tariffs and quotas, preferences for
    domestic v. foreign goods, and productivity.
Exchange Rates in the Long Run:
Factors Affecting Exchange Rates in
Long Run

   Relative price levels: a rise in relative
    price levels cause a country’s currency
    to depreciate.
   Tariffs and quotas: increasing trade barriers
    causes a country’s currency to appreciate.
Exchange Rates in the Long Run:
Factors Affecting Exchange Rates in
Long Run

   Preferences for domestic v. foreign goods:
    increased demand for a country’s good
    causes its currency to appreciate; increased
    demand for imports causes the domestic
    currency to depreciate.
   Productivity: if a country is more productive
    relative to another, its currency appreciates.
Exchange Rates in the Long Run:
Factors Affecting Exchange Rates in
Long Run

   The following table summarizes these
    relationships. By convention, we are quoting,
    for example, the exchange rate, E, as units of
    foreign currency / 1 US dollar.
Exchange Rates in the Long Run:
Factors Affecting Exchange Rates in
Long Run
Exchange Rates in the Short
Run
   In the short run, it is key to recognize that an
    exchange rate is nothing more than the price
    of domestic bank deposits in terms of foreign
    bank deposits.
   Because of this, we will rely on the tools
    developed in Chapter 4 for the determinants
    of asset demand.
Exchange Rates in the Short Run:
Expected Returns on Domestic and
Foreign Assets

   We will illustrate this with a simple example
   François the Foreigner can deposit excess
    euros locally, or he can convert them to U.S.
    dollars and deposit them in a U.S. bank. The
    difference in expected returns depends on
    two things: local interest rates and expected
    future exchange rates.
Exchange Rates in the Short Run:
Expected Returns on Domestic and
Foreign Assets

   Al the American has a similar problem. He
    can deposit excess dollars locally, or he can
    convert them to euros and deposit them in a
    foreign bank. The difference in expected
    returns depends on two things: local interest
    rates and expected future exchange rates.
Exchange Rates in the Short Run:
Expected Returns and Interest
Parity

                 Re for François                                Re for Al
                         D     E   e
                                   t 1    Et 
$ Deposits           i                                                  iD
                                        Et

                                    F
                                                            i   D
                                                                    
                                                                      E  e
                                                                         t 1     Et 
F Deposits                        i
                                                                              Et

             e   D
                 i i        F
                                 
                                   E   e
                                        t 1    Et    D
                                                        i i        F
                                                                        
                                                                          E    e
                                                                                t 1    Et 
Relative R
                                             Et                                    Et
Exchange Rates in the Short Run:
Expected Returns on Domestic and
Foreign Assets

   What this shows is simple. As the relative
    expected return on dollar assets increases
    (decreases), both François and Al respond by
    holding more (fewer) dollar assets and fewer
    (more) foreign assets.
   This leads us to our formal title for what is
    going on here: Interest Parity
Exchange Rates in the Short Run:
Expected Returns and Interest
Parity
   Interest Parity Condition
       $ and F deposits perfect substitutes
                               Ete1  Et
                     iD  iF                   (2)
                                   Et
    Example: if iD = 6% (US interest rate) and iF = 3%
    (foreign currency interest rate), what is the expected
    appreciation of the foreign currency?
               Ete1  Et
                           6%  3%  3%
                   Et
Exchange Rates in the Short Run:
Expected Returns and Interest
Parity
  Several things to recognize about the
  interest rate parity condition:
  •Expected returns are the same in both dollars
  and foreign assets
  •Equilibrium condition for the foreign exchange
  market

  Next, we will develop supply/demand curves to
  explain how the exchange rate is determined.
Exchange Rates in the Short Run:
Expected Returns and Interest
Parity
   To determine the equilibrium condition, we
    must first determine the expected return in
    terms of dollars on foreign deposits, RF.
   Next, we must determine the expected return
    in terms of dollars on dollar
    deposits, RD.
Deriving the Demand Curve
Assume iF = 5%, Eet+1 = 1 euro/$
Point
A: Et = 1.05      (1.00 – 1.05)/1.05 = -4.8%
B: Et = 1.00      (1.00 – 1.00)/1.00 = 0.0%
C: Et+1 = 0.95    (1.00 – 0.95)/0.95 = 5.2%

   The demand curve connects these points and is
    downward sloping because when Et is higher,
    expected appreciation of the dollar is higher.
Deriving the Supply Curve

   Deriving the Supply Curve
       There isn’t really anything to derive. We
        will take the quantity of bank deposits,
        bonds, and equities as fixed with respect to
        exchange rates.
Exchange Rates in the Short Run:
Equilibrium

   Equilibrium
       Supply = Demand at E*
       If Et > E*, Demand < Supply, buy $, Et 
       If Et < E*, Demand > Supply, sell $, Et 

   The following figure illustrates this.
Exchange Rates in the Short Run:
Equilibrium
Explaining Changes
in Exchange Rates
   To understand how exchange rates shift in
    time, we need to understand the factors that
    shift expected returns for domestic and
    foreign deposits.
   We will examine these separately, as well as
    changes in the money supply and exchange
    rate overshooting.
 Explaining Changes in Exchange
 Rates: Increase in iD
1.   Demand curve shifts
     right when
       iD : because
         people want to
         hold more dollars
2.   This causes
     domestic currency to
     appreciate.
 Explaining Changes in Exchange
 Rates: Increase in iF
1.   Demand curve shifts
     left when
       iF : because
          people want to
          hold fewer dollars
2.   This causes
     domestic currency to
     depreciate.
 Explaining Changes in Exchange Rates:
 Increase in Expected Future FX Rates
1.   Demand curve shifts
     left when
     
         E te1 : because
         people want to
         hold more dollars
2.   This causes domestic
     currency to
     appreciate.
    Explaining Changes in Exchanges
    Rates
   Similar to determinants of exchange rates in the long-run, the
    following changes increase the demand for foreign goods
    (shifting the demand curve to the right), increasing           E te1
     Expected fall in relative U.S. price levels

     Expected increase in relative U.S. trade barriers

     Expected lower U.S. import demand

     Expected higher foreign demand for U.S. exports

     Expected higher relative U.S. productivity

   These are summarized in the following slides.
Explaining Changes in Exchanges
Rates




                                  468
Explaining Changes
in Exchanges Rates (cont.)
Applications
  Our analysis allows us to take a look at the
  response of exchange rates to a variety of macro-
  economic factors. For example, we can use this
  framework to examine (1) the impact of changes in
  interest rates, and (2) the impact of money growth.
Application: Interest Rate
Changes
   Changes in domestic interest rates are often
    cited in the press as affecting exchange rates.
   We must carefully examine the source of the
    change to make such a statement. Interest
    rates change because either (a) the real rate
    or (b) the expected inflation is changing. The
    effect of each differs.
Application: Interest Rate
Changes
   When the domestic real interest rate
    increases, the domestic currency appreciates.
    We have already seen this situation in Figure
    4 (slide 37).
   When the domestic expected inflation
    increases, the domestic currency reacts in
    the opposite direction – it depreciates. This
    is shown on the next slide.
Explaining Changes in Exchange
Rates: Response to i  Because πe

Application: Interest Rate
Changes
   Changes in domestic money supply are a bit
    more complicated. We summarize the
    results on the next slide. However, you may
    want to read the text on this section to fully
    digest the effects.
 Explaining Changes in Exchange
 Rates: Changes in the Money
 Supply
1.   Ms , P , Eet+1 ,
     shifting demand curve
     from D1 to D2.
2.   In long run, iD returns to
     old level, and demand
     shifts from D2 to D3
     (exchange rate
     overshooting)
Exchange rate volatility
   Exchange rate overshooting is important
    because it helps explain why foreign
    exchange rates are so volatile.
   Another explanation deals with changes in
    the expected appreciation of exchange rates.
    As anything changes our expectations (price
    levels, productivity, inflation, etc.), exchange
    rates will change immediately.
Applications
  Our analysis also allows us to take a look at the
  weak dollar in the 1980s, and (partially) explain
  why it became stronger in the 1990s and 2000s.
  We present a summary in Figure 9, on the next
  slide.
    The Dollar and Interest Rates
  1.   Value of $ and real
       rates rise and fall
       together, as
       theory predicts
  2.   No association
       between $ and
       nominal rates:
       $ falls in late
       1970s as nominal
       rate rises




Daily foreign exchange rate
http://quotes.ino.com/exchanges/
?e=FOREX
Case: The Euro’s First Nine
Years
   The euro debuted in 1999 at $1.18 / euro. It
    declined to $0.83 by October 2000, but has
    recovered, trading at $1.35 by the end of
    2007.
   Initially, the European countries had relatively
    weaker economies, but that has reversed in
    recent years, weakening the dollar relative to
    the euro.
Reading the WSJ
   The figure on the next slide shows the
    ―Currency Trading‖ column from the Wall
    Street Journal on July 11, 2007.
   Some highlights include:
       Warnings from Home Depot and other sectors
        that the economy is weakening – signaling
        possible Fed rate cuts (did that happen?)
       Dollar returns expected to be lower in the future –
        dollar expected to depreciate
The Practicing Manger:
Profiting from FX Forecasts
   Forecasters look at factors discussed here
   FX forecasts affect financial institutions
    managers' decisions
   If forecast yen appreciate, yen depreciate,
       Sell franc assets, buy euro assets
       Make more euros loans, less yen loans
       FX traders sell yen, buy euros
Chapter 10
   The Foreign
     Exchange
        Market
   Lecture two
13.2 Foreign Exchange Instruments
1.Currency Forward
2.Currency Future            Derivative
3.Currency Option            Instruments
4.Currency Swap
13.2.1 Currency Forward
1)       Background
        Foreign exchange rates fluctuate constantly
        Fluctuations expose parties dealing in foreign
         exchange to risk
        Examples:
         Exporter expecting to receive foreign currency in the
          future
         Importer obliged to make payment in a foreign currency
        Parties would like to hedge the risk
2)Definition

    A currency forward contract is an
     agreement between a firm and a
     commercial bank to exchange a specified
     amount of a currency at a specified
     exchange rate (called the forward rate) on
     a specified date in the future.
    Forward contracts are often valued at $1
     million or more, and are not normally used
     by consumers or small firms.
3)Forward dealings in foreign
currency: exporter
   An exporter exports goods worth USD 10 million
    to USA
   Receipt of USD expected after 1 months
   Current exchange rate: $100 = ¥697.22
   Decline in the value of USD is anticipated
   Exporter enters into a forward contract to sell
    USD after 1 months at $100 = ¥692.22
   After 1 months:
       If $100 = ¥687.22– gain of 0.5 million
       If $100 = ¥692.22– no profit, no loss
       If $100 = ¥697.22– opportunity loss (loses opportunity
        to gain 0.5million)
4)Forward dealings in foreign
currency: importer
     An importer has imported goods worth Euro 1,000,000 from
      Europe
     Payment to be made after 3 months
     Current exchange rate: 1 Euro= 1.5443 USD
     Increase in the value of Euro is anticipated
     Importer enters into a forward contract to buy Euro after 3
      months at 1 Euro= 1.5493 USD
     After 3 months:
       If 1 Euro= 1.5543 USD– gain 5000 USD
       If 1 Euro= 1.5493 USD– no profit, no loss
       If 1 Euro= 1.5443 USD - opportunity loss (loses opportunity
         to gain 5000 USD)
5)Currency forwards: merits
and demerits
   Merit:
       Helps in hedging risk
   Demerits:
       Does not provide opportunity for making profit
       There is illiquidity
       There is default risk (credit risk) (the party at
        disadvantage may default)
13.2.2Currency Future

 1)Definition
 A Currency Future Contract is similar to an
 currency forward contract in that it specifies
 that foreign currency must be delivered by one
 party to another on a stated future date.
 However, it overcome some of the liquidity
 and default problem of forward markets.
2)Success of Futures Over Forwards
 1.    Standardized contracts that can be traded
      (quantities delivered and delivery dates)
 2.   Margin Requirement:avoids default risk
 3.   Marked to market every day: organised
      exchange
 4.   Don't have to deliver
 4)Hedging with currency
futures
   Importer buys the required currency futures
    contract
   Thus “locks in” a price for the purchase of foreign
    currency
   Hedges (avoids) risk due to exchange rate
    fluctuations
   Exporter sells the expected currency futures
    contract
   “locks in” a price for the sale
   Hedges risk due to exchange rate fluctuations
Hedging FX Risk
   Example: A manufacturer expects to be paid
    10 million euros in two months for the sale of
    equipment in Europe. Currently, 1 euro = $1,
    and the manufacturer would like to lock-in
    that exchange rate.
Hedging FX Risk
   The manufacturer can use the FX futures market to
    accomplish this:
    1.   The manufacturer sells 10 million euros of futures
         contracts. Assuming that 1 contract is for $125,000 in
         euros, the manufacturer takes as short position in 40
         contracts.
    2.   The exchange will require the manufacturer to deposit
         cash into a margin account. For example, the
         exchange may require $2,000 per contract, or $80,000.
Hedging FX Risk
  3.   As the exchange rate fluctuates during the two
       months, the value of the margin account will
       fluctuate. If the value in the margin account
       falls too low, additional funds may be required.
       This is how the market is marked to market. If
       additional funds are not deposited when
       required, the position will be closed by the
       exchange.
Hedging FX Risk
  4.   Assume that actual exchange rate is 1 euro = $0.96 at
       the end of the two months. The manufacturer receives
       the 10 million euros and exchanges them in the spot
       market for $9,600,000.
  5.   The manufacturer also closes the margin account,
       which has $480,000 in it—$400,000 for the changes in
       exchange rates plus the original $80,000 required by
       the exchange。
  6.   In the end, the manufacturer has the $10,000,000
       desired from the sale.
5)Comparison of the Forward & Futures
Markets
              Forward Markets Futures Markets
 Contract size Customized      Standardized

 Delivery date     Customized         Standardized

 Participants    Banks, brokers     Banks, brokers,

 Clearing          Handled by          Handled by
 operation       individual banks       exchange
                    & brokers.       clearinghouse.
                                    Daily settlements
                                    to market prices.
Comparison of the Forward & Futures
Markets
               Forward Markets      Futures Markets
 Marketplace      Worldwide          Central exchange
                  telephone        floor with worldwide
                   network           communications.

 Regulation     Self-regulating       Commodity
                                    Futures Trading
                                     Commission,
                                    National Futures
                                      Association.
 Liquidation   Mostly settled by    Mostly settled by
               actual delivery.          offset.
 Transaction    Bank’s bid/ask         Negotiated
  Costs            spread.           brokerage fees.
13.2.3:Option Definition
   1)Definition
    Currency options provide the right to
    purchase or sell currencies at specified prices.
    They are classified as calls or puts.
   Standardized options are traded on
    exchanges through brokers.
   Customized options offered by brokerage
    firms and commercial banks are traded in the
    over-the-counter market.
2)Types of options
   Call option 看涨期权
       Right to buy a currency
       Useful in an appreciating market
   Put option 看跌期权
       Right to sell a currency
       Useful in a depreciating market
   Call and put option may be of two types
       European option: 欧式期权
       can be exercised only on expiry date
       American option: 美式期权
       can be exercised any time upto expiry date
3)Parties to option contracts
   Purchaser ( trader)
       Has right to exercise (may exercise or may not
        exercise)
   Seller ( dealer or speculator)
       Has obligation to perform (when purchaser
        exercises the right)
4)Options terminology
 Premium: 期权费
 price paid for buying an option




 Exercise price: 执行价格
 (also known as strike price) price at
  which option can be exercised
Option Contract

售出方:银行                 购买方:企业
                  合约
Option seller          Option owner
                  1    出口商出口收汇
                  月
获得Premium         2    支付Premium
放弃灵活权             月
                       获得选择权
                  3
                  月
5)Uses of option
   Hedging
   Speculation
Hedging through purchase of
options
   Importer buys a call option
       To buy a currency in future when it is
        appreciating
   Exporter buys a put option
       To sell a currency in future when it is
        depreciating
5)Contingency Graphs for Currency
Options
      For Buyer of £ Call Option            For Seller of £ Call Option
         Strike price = $1.50                  Strike price = $1.50
         Premium      = $ .02                  Premium      = $ .02
 Net Profit                            Net Profit
 per Unit                              per Unit
  +$.04                                 +$.04
                                                                    Future
  +$.02                                 +$.02                        Spot
                                                                     Rate
        0                                     0
              $1.46   $1.50   $1.54                 $1.46   $1.50   $1.54
  –   $.02                    Future    –   $.02
                               Spot
  –   $.04                     Rate     –   $.04
Contingency Graphs for Currency
Options
      For Buyer of £ Put Option             For Seller of £ Put Option
         Strike price = $1.50                  Strike price = $1.50
         Premium      = $ .03                  Premium      = $ .03
 Net Profit                            Net Profit
 per Unit                              per Unit
  +$.04                                 +$.04
                              Future
  +$.02                        Spot     +$.02
                               Rate
        0                                     0
              $1.46   $1.50   $1.54                 $1.46   $1.50   $1.54
  –   $.02                              –   $.02                    Future
                                                                     Spot
  –   $.04                              –   $.04                     Rate
13.2.4:Currency Swaps

   Contract to exchange two streams of future
    cash flows in different currencies

   Used to convert debt denominated in one
    currency into debt in another currency
        Part Four
Financial Institutions
           Chapter 11
Commercial Banking Industry:
   Structure and Competition
Chapter Preview
 In the U.S., about 7,500 commercial banks
 serving the businesses and consumer’s
 needs. This puts the U.S. in a class by itself.
 In most other developed nations, only a
 handful of banks dominate the landscape.
 But is this better?
Chapter Preview
 Indeed there are many questions we can ask.
 Why did the U.S. banking system develop
 this way? Does this mean there is more
 competition? We try to answer these
 questions in this chapter.
Chapter Preview
   We begin by examining the historical development
    of the banking system, both in the U.S. and abroad.
    We then examine the role of financial innovation and
    its impact on competition. Topics include:
       Historical Development of the Banking System
       Financial Innovation and the Decline of Traditional
        Banking
       Bank Consolidation and Nationwide Banking
Chapter Preview (cont.)
    Separation of Banking and Other Financial
     Service Industries

    International Banking
Historical Development
of the Banking Industry
   The modern commercial banking industry
    began when the Bank of North America was
    chartered in Philadelphia in 1782.
   The next slide provides a timeline of
    important dates in the history of U.S. banking
    prior to WWII.
Historical Development
of the Banking Industry
Historical Development
of the Banking Industry
   There are also some major events post-1933
       In 1999, Glass-Steagall was repealed.
        Commercial banks, which previously had to sell
        off investment banking arms, now engaged again
        in securities activities.
Historical Development
of the Banking Industry
   The history had one other significant
    outcome: Multiple Regulatory Agencies
    1.   Federal Reserve
    2.   FDIC
    3.   Office of the Comptroller of the Currency
    4.   State Banking Authorities
Historical Development
of the Banking Industry
   The U.S. Treasury has proposed legislation
    to centralize the regulation of depository
    institutions under one independent agency,
    but it hasn’t survived the scrutiny of
    Congress.
Financial Innovation
   Innovation is result of search for profits. A change
    in the financial environment will stimulate a search
    for new products and ideas that are likely to
    increase the bottom line.
   There are generally three types of changes we can
    examine:
       Response to Changes in Demand Conditions
       Response to Changes in Supply Conditions
       Avoidance of Regulation
  Financial Innovation
     Response to Changes in Demand Conditions
           Major change is huge increase in interest-rate risk starting
            in 1960s
           Adjustable-Rate Mortgages are an example of the reply to
            interest-rate volatility
           Banks also started using derivates to hedge risk, and
            intermediaries (like the CBOT) started developing
            extensive interest rate products.


To see an example of the CBOTs products, visit http://www.cbot.com/cbot/pub/page/0,3181,830,00.html
Financial Innovation
   Response to Changes in Supply Conditions
       Major change is improvement in
        computer technology
         1.   Increases ability to collect information
         2.   Lowers transactions costs
         3.   This lead to many innovations on the supply side
Financial Innovation:
Bank Credit and Debit Cards
   Many store credit cards existed long
    before WWII.
   Improved technology in the late 1960s
    reduced transaction costs making nationwide
    credit card programs profitable.
   The success of credit cards led to the
    development of debit cards for direct access
    to checkable funds.
Financial Innovation:
Electronic Banking
   Automatic Teller Machines (ATMs) were the
    first innovation on this front. Today, over
    250,000 ATMs service the U.S. alone.
   Automated Banking Machines combine ATMs,
    the internet, and telephone technology to
    provide ―complete‖ service.
   Virtual banks now exist where access is only
    possible via the internet. The next slide
    highlights this.
E-Finance: Will “Clicks” dominate
“Bricks” in Banking?
   Will virtual banks on the internet become the
    primary form for bank business, eliminating
    the need for physical bank branches? Here’s
    some evidence:
       Internet-only banks have experienced low
        revenue growth
       Depositors appear reluctant to ―trust‖ the security
        of their funds in I-banks
E-Finance: Will “Clicks” dominate
“Bricks” in Banking?


     I-bank customers seem concerned that their
      transactions are truly secure and private
     Empirical evidence shows that long-term savings
      products are purchased more often face-to-fact
     Technology glitches are still present
Financial Innovation:
Electronic Payments
   The development of computer systems and
    the internet has made electronic payments of
    bills a cost-effective method over paper
    checks or money.
   The U.S. is still far behind some European
    countries in the use of this technology.
Scandanavians
so far ahead of Americans with E-
money
   The U.S. writes close to 100 billion checks, and
    most noncash transactions involve paper. In
    Europe, however, two-thirds of noncash transactions
    are electronic. Why the difference?
       Europeans have been using giro payments for decades
        (banks / post office transfers funds for bills)
       Scandinavians are much bigger users of mobile
        technology and the Internet. Why?
   America’s continued use of paper is costly. Can that
    ever be changed?
Financial Innovation: E-Money
   Electronic money, or stored cash, only exists
    in electronic form. It is accessed via a
    stored-value card or a smart card.
   E-cash refers to an account on the internet
    used to make purchases.
E-Finance: Are We Headed
toward a Cashless Society?
   Predictions of a cashless society go back
    decades. Business Week predicted e-
    payments would ―revolutionize … money
    itself (but reverse itself later). But several
    things work against this:
       Equipment to accept e-money not in all locations
       Security and privacy concerns
Financial Innovation: Junk Bonds
   Prior to 1980, debt was never issued that had
    a junk rating. The only junk debt was bonds
    that had fallen in credit rating.
   Michael Milken of Drexel Burnham assisted
    firms in issuing original-issue junk debt, and
    almost single-handedly created the market.
Financial Innovation:
Commercial Paper Market
   Commercial paper refers to unsecured debt
    issued by corporations with a short
    original maturity.
   Currently, over $2.2 billion is outstanding in
    the market (end of 2006).
   The development of money market mutual
    funds assisted in the growth in this area.
Financial Innovation:
Securitization
   Securitization refers to the transformation of
    illiquid assets into marketable capital market
    instruments.
   Today, almost any type of private debt can be
    securitized. This includes home mortgages,
    credit card debt, student loans, car loans, etc.
Financial Innovation: Avoidance
of Existing Regulations
   Regulations Behind Financial Innovation
    1.   Reserve requirements
             Tax on deposits = I  rD

    2.   Deposit-rate ceilings (Reg Q)
             As i , loophole mine to escape reserve requirement
              tax and deposit-rate ceilings
Financial Innovation: Avoidance
of Existing Regulations
   Money Market Mutual Funds: allowed
    investors similar access to their funds as a
    bank savings accounts, but offered higher
    rates, especially in the late 1970s.
   Sweep Accounts: Funds are ―swept‖ out of
    checking accounts nightly and invested at
    overnight rates. Since they are no longer
    checkable deposits, reserve requirement
    taxes are avoided.
Treasury STRIPS
   Treasury STRIPS were developed in the
    early 1980s to help investors avoid
    reinvestment risk associated with coupon
    bonds. Because of the change in the risk
    structure, investment banks were able to
    profit from the separation of interest into
    ―bonds‖. How?
Treasury STRIPS
   Take a simple 10-year, 10% coupon bond
    with a face value of $1,000,000, and is selling
    at par. The first $50,000 interest payment in
    six months is worth $47,673. But because
    investors found it less risky, they are willing to
    accept a yield lower than 10%. The
    difference is ―profit‖ for the investment bank.
Financial Innovation and the
Decline in Traditional Banking
   The traditional role of transforming short-term
    deposits into long-term loans has been
    greatly affected by financial innovation. As
    the next slide shows, the importance of
    commercial banks as a source of funds to
    nonfinancial borrowers has shrunk
    dramatically.
Financial Innovation and the
Decline in Traditional Banking
Financial Innovation and the
Decline in Traditional Banking
   Decline in Cost Advantages in Acquiring
    Funds (Liabilities)
       π  i  then disintermediation because
         1.   Deposit rate ceilings and regulation Q
         2.   Money market mutual funds

•   Checkable deposits fell from 60% of bank
    liabilities to only 10% today.
Financial Innovation and the
Decline in Traditional Banking
   Decline in Income Advantages on Uses of
    Funds (Assets)
    1.   Easier to use securities markets to raise funds:
         commercial paper, junk bonds, securitization
    2.   Finance companies more important because
         easier for them to raise funds
Banks' Response
   Loss of cost advantages in raising funds and income
    advantages in making loans causes reduction in
    profitability in traditional banking
    1.   Expand lending into riskier areas (e.g., real estate)
    2.   Expand into off-balance sheet activities
•   Creates problems for U.S. regulatory system
   Similar problems for banking industry in
    other countries
Decline in Traditional Banking in
Other Industrialized Countries
   Forces similar to those in the U.S. have
    led to a similar decline in other industrialized
    countries.
   For example, Australian banks have lost
    business to international securities markets
   In many countries, as securities markets
    develop, banks also face competition from
    the new products offered
Structure of the U.S. Commercial
Banking Industry
   Around 7,500 commercial banks currently
    exist in the U.S.
   The tables on the next two slides shows
    various statistics for these banks as well as
    the ten largest U.S. banks.
Structure of the Commercial
Banking Industry




                  FDIC statistics on banking
                  http://www.fdic.gov/bank/statistical/index.html
Ten Largest U.S. Banks




               World’s 100 largest banks
               http://interactive.wsj.com/public/resources/docu
               ments/wb00-100-fpublic-2000-09-25.htm
Branching Regulations
   Branching Restrictions (McFadden Act of 1927):
    Very Anti-competitive
   Response to Branching Restrictions
    1.   Bank Holding Companies
           Allowed purchases of banks outside state

           BHCs allowed wider scope of activities by Fed

           BHCs dominant form of corporate structure for banks

    2.   Automated Teller Machines
           Not considered to be branch of bank, so networks allowed
Bank Consolidation
and Nationwide Banking
 As the next slide shows, the number of
 commercial banks in the U.S. was very
 stable from 1934 through the mid-1980s.
 After that, the number of commercial banks
 began to fall dramatically.
  Bank Consolidation
  and Number of Banks




Quarterly banking profile                             549

http://www2.fdic.gov/qbp/qbpSelect.asp?menuItem=QBP
Bank Consolidation
and Nationwide Banking
   Bank Consolidation: Why?
     1.   Loophole mining reduced effectiveness of branching
          restrictions
     2.   Development of super-regional banks
   Economies of scale
     1.   Increased with the web and computer technology
     2.   Scope economies also present in using data for pricing,
          new products, etc.
     3.   Has lead to the birth of large, complex banking
          organizations (LCBOs)
E-Finance: Information
Technology
and Bank Consolidation
   Information technology is particularly relevant
    for the credit card industry. Today, over 60%
    of the credit card debt is help by the five
    biggest banks (only 40% in 1995).
   Custody for securities has risen, from 40% as
    a percent of assets in 1990 to 90% today.
   Smaller banks just contract with larger banks,
    further leading to consolidation.
Bank Consolidation
and Nationwide Banking
   Riegle-Neal Act of 1994
     1.   Allows full interstate branching
     2.   Promotes further consolidation
   Future of Industry Structure
         Will become more like other countries, but not
          quite:
             Several thousand, not several hundred
             Only half of small banks will remain, and large
              banks are expected to double in number
Bank Consolidation
and Nationwide Banking
   Are Bank Consolidation and Nationwide Banking a
    Good Thing?
       Cons
         1. Fear of decline of small banks and small business
            lending
         2. Rush to consolidation may increase risk taking

       Pros
         1. Community banks will survive
         2. Increase competition and efficiency
         3. Increased diversification of bank loan portfolios:
            lessens likelihood of failures
Separation of Banking and Other
Financial Service Industries
  Glass-Steagall allowed commercial banks to
  sell on-the-run government securities, but
  prohibited underwriting and brokerage
  services. It also prohibited real estate and
  insurance business. But it did protect
  commercial banks by not allowing other
  financial intermediaries to offer commercial
  banking activities.
Separation of Banking and Other
Financial Service Industries
   Erosion of Glass-Steagall
       Fed, OCC, FDIC are allowing banks to engage in
        underwriting activities, under the Section 20 loophole in
        the act

   Gramm-Leach-Bliley Act of 1999
       Legislation to eliminate Glass-Steagall
       States retain insurance regulation, while SEC oversees
        securities activities
       OCC regulates subsidiaries that underwrite securities
       Fed still oversees bank holding companies
Separation of Banking and Other
Financial Service Industries
   Implications for Financial Consolidation
    1.   G-L-B will speed-up consolidation
    2.   Expect mergers between banks and other
         financial service providers to become
         more common, and mega-mergers are likely on
         the way
    3.   U.S. banks likely to become larger and more
         complex organizations
Separation of Banking and Other
Financial Service Industries
   Separation in Other Countries
    1.   Universal banking: Germany
          •   No separation of banking and underwriting, insurance,
              real estate, etc.
    2.   British-style universal banking
          •   Underwriting ok, but more legal separation of subs, no
              equity stakes in firms, insurance uncommon
    3.   Japan
          •   Allowed to hold equity in firms, but BHCs are illegal.
              Leaning toward the British system
International Banking
   There are currently 100 American bank branches
    abroad, with over $1.3 trillion in assets. In 1960,
    there were only 8 branches with less than $4 billion
    in assets. Why the rapid growth?
     1. Rapid growth of international trade
     2. Banks abroad can pursue activities not allowed in
        home country
     3. Tap into Eurodollar market
International Banking
   The Eurodollar market represents U.S. dollars
    deposited in banks outside the U.S. Many
    companies want these dollars:
      The dollar is widely used in international trade
      Dollars held outside the U.S. are not subject to
       U.S. regulations
   London is the center for Eurodollars
   To capture the profits from Eurodollar
    transactions, U.S. banks opened abroad
International Banking
   U.S. Banking Overseas. Most foreign branches are
    in Latin America, the Far East, the Caribbean, and
    London, for either trade reasons or regulatory
    avoidance.
   Another structure is the Edge Act Corporation, a sub
    engaged in international banking.
International Banking
   U.S. banks can also own controlling interests in
    foreign banks and finance companies, governed by
    Regulation K.
   International Banking Facilities were approved by
    the Fed in 1981 to accept time deposits of foreign
    investors. They are not subject to reserve
    requirements, but generally cannot conduct
    business with American business or people. They
    also receive favorable local tax treatment.
International Banking
   Foreign Banks in U.S. are very successful.
    They currently hold more than 11% of total
    U.S. bank assets and do a large portion of
    U.S. bank lending – nearly 16% for lending
    to U.S. corporations.
International Banking
   Foreign Banks in U.S. are setup as:
       an agency office of a foreign bank
           Fewer regulations
       a sub of a U.S. bank
           Same regs as a U.S. bank
       a branch of a foreign bank
           May form Edge Act corps. and IBFs.
International Banking
1.   Regulations (as of 1978 International
     Banking Act)
        Same as for U.S. domestic banks, except
         banks grandfathered in
2.   Impact
        World financial markets more integrated
        Encouraged bank consolidation abroad
        Importance of foreign banks in international
         banking
Ten Largest Banks in the
World
Chapter Summary
   Historical Development of the Banking System: the
    historical development of the U.S. banking system
    was reviewed, and the resulting agencies (OCC,
    Fed, SEC, etc.) discussed
   Financial Innovation and the Decline of Traditional
    Banking: changes in both demand and supply forces,
    and the response of the banking industry was
    examined
Chapter Summary (cont.)
   Bank Consolidation and Nationwide Banking:
    the forces leading bank consolidation and
    national banks, and the implications for the
    future, were outlined
   Separation of Banking and Other Financial
    Service Industries: the rise and fall of
    separate banks was discussed, and the
    implications for the future were examined
Chapter Summary (cont.)
   International Banking: the branching of U.S.
    banks out of the U.S. as well as foreign
    banks operating in the U.S. were reviewed
  Chapter 12
Savings Associations
  and Credit Unions
Chapter Preview
 Consumer banking was almost non-existent
 in the early 1800s. Commercial banks were
 common, but their business was primarily
 restricted to commercial loans and services.
 But, in the late 1800s, a new type of
 institution opened – the savings and loan
 association. This is the topic of chapter 19.
Chapter Preview
   We examine the role of savings and loan
    associations, mutual savings banks, and credit
    union, collectively known as thrift institutions. We
    begin with their history and move into the nature of
    the industry today. Topics include:
       Mutual Savings Banks
       Savings and Loan Associations
       Savings and Loans in Trouble: The Thrift Crisis
       Political Economy of the Savings and Loan Crisis
Chapter Preview (cont.)
    Savings and Loan Bailout: Financial Institution
     Reform, Recovery, and Enforcement Act
     of 1989
    The Savings and Loans Industry Today
    Credit Unions
Mutual Savings Banks
   Depositors are the owners of the firm
   Stock in the bank is not sold or issued, but rather
    depositors own a share of the bank in proportion to
    their deposits
   Generally have fewer liabilities than other banks
    because deposits are ownership, not a liability
   Principal-agent problem still present, but managers
    tent to be more risk-averse
Savings and Loan
Associations
   Created by Congress in 1816 to promote
    home ownership
   About 12,000 S&Ls in operation by
    the 1920s
   Regulation was at the state level
Savings and Loan
Associations
   The Great Depression led to the failure of
    thousands of thrift institutions and the loss of
    $200 million in personal savings
   The Federal Home Loan Bank Act of 1932
       created the Federal Home Loan Bank Board

   In 1934, the FSLIC was created to
    insure depositors
Savings and Loan
Associations
   S&Ls were successful, low-risk businesses
    for many years following the changes.
   The next slide shows the distribution of S&L
    assets in 2006. Note that most of the assets
    are still held as mortgages, true to their
    original intent.
Savings and Loan
Associations
Savings and Loan Associations
vs. Mutual Savings Banks
   Mutual savings banks are concentrated in the
    northeast, whereas S&Ls are found
    throughout the country.
   Mutual savings banks insure their deposits
    with the state or the FDIC. S&Ls may not.
   Mutual savings banks are not as heavily
    invested in mortgages and have more
    flexibility in their investing practices.
Savings and Loans in Trouble:
The Thrift Crisis
   By 1979, inflation was running at 13.3%, but
    Reg Q restricted interest on deposits to only
    5.5%.
   Further, money market accounts offered
    depositors market interest rates on their
    short-term funds.
Savings and Loans in Trouble:
The Thrift Crisis
   Financial deregulation and the permissive 1980s led
    to several problems:
       Managers lacked expertise in new product lines
       Rapid growth in lending, particularly real estate
       Regulators could not keep pace with the growth
       The moral hazard problem led to excessive risk-taking
       1981–1982 were particularly bad year for some areas,
        such as the Texas real estate market
Savings and Loans in Trouble:
The Thrift Crisis
   Rather than close insolvent S&Ls, regulators
    adopted the policy of
    regulatory forbearance, essentially
    sidestepping their responsibility using
    temporary Band-Aids.
   This policy led to further risk-taking, as
    insolvent S&Ls had nothing to lose by
    extreme risk-taking.
Savings and Loans in Trouble:
The Thrift Crisis
   To further the problems, insolvent S&Ls
    offered higher rates to their depositors to
    attract new funding.
   This meant that healthy S&Ls had to compete
    with insolvent S&Ls going for broke.
    Needless to say, this caused further
    problems for the industry.
Savings and Loans in Trouble:
The Thrift Crisis
   Competitive Equality in Banking Act of 1987
       Allowed the FSLIC to borrow $10.8 billion to cover
        depositors’ losses (not nearly enough)
       Directed the FHLBB to continue regulatory forbearance

   Losses in the S&L industry approached $20 billion in
    1989 alone. The collapse of the real estate market
    in the late 1980s only worsened the problem.
Political Economy of the Savings
and Loan Crisis
 The relationship between voter-taxpayers
 and the regulators and the politicians creates
 a particular type of moral hazard problem—
 the principal-agent problem. This idea can
 explain part of the problem during the S&L
 Crisis.
Political Economy of the Savings
and Loan Crisis
   Regulators and politicians are ultimately
    agents for voter-taxpayers.
   To act on taxpayers’ behalf,
    regulators seek to minimize the cost
    of deposit insurance:
       Restrict S&Ls from holding assets that are
        too risky
       Require higher bank capital
       Close insolvent S&Ls
Political Economy of the Savings
and Loan Crisis
   However, regulators have an incentive to
    ―hide‖ the problem and hope that the situation
    corrects itself.
   Regulators are also funded through
    Congressional appropriations, which means
    that politicians may be able to influence the
    actions of regulators.
Political Economy of the Savings
and Loan Crisis
   Further, both Congress and the president
    passes legislation in the early 1980s that
    promoted risk-taking and required additional
    oversight.
   Yet, in years following, Congress refused to
    fund regulators at a necessary level to
    monitor S&L activities.
Charles Keating and the Lincoln
S&L Scandal
   Charles Keating acquired Lincoln S&L in
    1984. Regulators allowed this, despite his
    being accused of fraud by the SEC.
   Used the S&L to fund his construction firm
    with loans. Quickly changed Lincoln’s
    investing, using futures, junk bonds, and land
    tracks in Arizona.
Charles Keating and the Lincoln
S&L Scandal
   Regulators eventually recommended seizure
    in 1986, but he fought in vigorously, spending
    millions in lawyer fees.
   He also made campaign contributions to
    prominent senators – including John McCain.
    His tactics worked! By 1987, no examiner
    went near Lincoln – that is, until it failed in
    1989.
Savings and Loan Bailout: Financial
Institution Reform, Recovery, and
Enforcement Act of 1989

   The Bush administration proposed FIRREA
    to provide adequate funding to close
    insolvent S&Ls.
   Its major provisions included:
       The Office of Thrift Supervision assumed
        regulatory responsibility, replacing the FHLBB
       The FDIC assumed replaced the FSLIC
       The RTC was established to sell assets of failed
        S&Ls
Savings and Loan Bailout: Financial
Institution Reform, Recovery, and
Enforcement Act of 1989

   The bailout cost taxpayers in the
    neighborhood of $150 billion.
   The bailout continued to cost depositors as
    FDIC insurance rates rose.
   FIRREA essentially re-regulated the thrift
    industry and made it easier for regulators to
    remove thrift managers.
The Savings and Loan
Industry Today
   Despite the problems of the 1980s, the S&L
    industry did survive.
   The next two slides show the totals assets
    and the number of S&Ls in the U.S.
The Savings and Loan
Industry Today
The Savings and Loan
Industry Today




                       594
The Savings and Loan
Industry Today
   Consistent with the last two slides, as the
    number of S&Ls has fallen, the average
    assets held by the average S&L has
    increased steadily throughout the last twenty
    years.
   The next slide shows this graphically.
The Savings and Loan
Industry Today
The Savings and Loan
Industry Today
   The next three slides show the following:
       Consolidated balance sheet for the S&L industry
       The net income for S&Ls from 1984-2006
       Average ROE for S&Ls from 1993-2006

   Many economists believe that S&Ls will disappear
    based on these findings. However, this does not
    appear to be a rapid trend. We may again see
    deregulation before all is said
    and done.
The Savings and Loan
Industry Today
The Savings and Loan
Industry Today
 The Savings and Loan
Industry Today
Credit Unions
   Idea developed in Germany where a group
    pooled assets to use a collateral for a loan
   The loan proceeds were then loaned to
    members of the group.
   Default was rare since all the group members
    knew each other.
Credit Unions: Types of
Organization
   Mutual Ownership               Central Credit Unions
       Owned by depositors              Help with members’
                                          credit needs
   Common Bond Membership
                                         Invest excess funds
       Defined field of
                                         Hold clearing balances
        membership
                                         Provide educational
   Nonprofit, Tax-Exempt                 services
    Status
                                   Credit Union Size
       Lower service fee
                                   Trade Associations
   Regulation and Insurance



                               National Credit Union Administration
                               http://www.ncua.gov
Credit Unions
Credit Unions
Credit Unions: Types of
Accounts
   Regular Share Accounts
       Savings accounts
       Receive no interest
       Do receive dividends
   Share Certificates
       Compatible to CDs
   Share Draft Accounts
       Pay interest
       Write drafts against account
Credit Unions: Share
Distribution
Credit Unions: Type of Loans
Credit Unions:
Advantages and Disadvantages
   Advantages
       Employer support
       Tax advantage
       Strong trade associations

   Disadvantages
       Common bond requirement
Credit Unions: Memberships
Credit Unions: Assets
Chapter Summary
   Mutual Savings Banks: the role of this form of
    thrift institution represents the first style of
    saving organization was reviewed
   Savings and Loan Associations: since the
    Federal Home Loan Bank Act of 1932, this
    form of savings institution was very
    successful until the late 1980s
Chapter Summary (cont.)
   Savings and Loans in Trouble: The Thrift Crisis: the
    reasons behind the crisis, including interest rate
    volatility, arcane regulations, and increased risk-
    taking were discussed
   Political Economy of the Savings and Loan Crisis:
    adding the problem, moral hazard on the part of
    regulators and politicians added to this costly failure
    of the S&L industry
Chapter Summary (cont.)
   Savings and Loan Bailout: Financial
    Institution Reform, Recovery, and
    Enforcement Act of 1989: this sweeping
    reform called for significant changes in the
    oversight and insurance of the S&L industry
   The Savings and Loans Industry Today:
    empirical evidence shows that this industry is
    shrinking in some respects, possibly
    suggesting its eventual demise
Chapter Summary (cont.)
   Credit Unions: the history, form, and role of
    credit unions was reviewed
Chapter 13
    The Mutual
  Fund Industry
Chapter Preview
 Suppose you wanted to start savings for
 retirement, but you can only afford to invest
 $100 / month. How do you develop a
 diversified portfolio? Mutual funds are one
 potential answer. Mutual funds pool funds
 under a professional manager who then
 chooses the securities to invest in.
Chapter Preview
   We study why mutual funds have become so
    popular, the various types of mutual funds,
    their regulation, and scandals in the mutual
    fund industry. Topics include:
       The Growth of Mutual Funds
       Mutual Fund Structure
       Investment Objective Classes
       Fee Structure of Investment Funds
Chapter Preview (cont.)
    Regulation of Mutual Funds
    Hedge Funds
    Conflicts of Interest in the Mutual
     Fund Industry
Mutual Funds
   Mutual funds pool the resources of many
    small investors by selling them shares and
    using the proceeds to buy securities.
The Growth of Mutual Funds
   At the beginning of 2007, nearly 16% of
    assets held by intermediaries were held by
    mutual funds.
   25% of the retirement market and almost
    50% of all U.S. households hold stock via
    mutual funds.
   Assets held by mutual funds have grown by
    over 17.5% per year for the last 20 years,
    reaching over $10 trillion by 2007.
The Growth of Mutual Funds
   The first mutual fund similar to the funds of
    today was introduced in Boston in 1824.
   The stock market crash of 1929 set the
    mutual fund industry back because small
    investors avoid stocks and distrusted mutual
    funds.
   The Investment Company Act of 1940
    reinvigorated the industry by requiring better
    disclosure of fees, etc.
The Growth of Mutual Funds
   There are five principal benefits of mutual funds:
    1.   Liquidity intermediation: investors can quickly convert
         investments into cash while still allowing the fund to
         invest for the long term.
    2.   Denomination intermediation: investors can participate in
         equity and debt offerings that, individually, require more
         capital than they possess.
    3.   Diversification: investors immediately realize the benefits
         of diversification even for small investments.
The Growth of Mutual Funds
   There are five principal benefits of
    mutual funds:
    4.   Cost advantages: the mutual fund can negotiate
         lower transaction fees than would be available
         to the individual investor.
    5.   Managerial expertise: many investors prefer to
         rely on professional money managers to select
         their investments.
The Growth of Mutual Funds
   Ownership in mutual funds has changed
    dramatically over the last 20 years
       In 1980, only 5.7% of households held mutual
        fund shares
       In the beginning of 2007, that number was 48%
       Mutual funds account for $4.1 trillion of the retirement
        market (estimated at $16.4 trillion)

   The next four slides show the time series of these
    trends.
The Growth of Mutual Funds
The Growth of Mutual Funds (cont.)
The Growth of Mutual Funds
The Growth of Mutual Funds
Mutual Fund Structure
   Investment companies usually offer a number
    of different types of mutual funds.
   Investors can often move investments among
    these funds without penalty.
   The complexes often issue
    consolidated statements.



                        Mutual fund fact book
                        http://www.ici.org/aboutfunds/factbook_toc.html
Mutual Fund Structure
   Closed-End Fund: a fixed number of
    nonredeemable shares are sold through an
    initial offering and are then traded in the OTC
    market. Price for the shares is determined by
    supply and demand forces.
   Open-End Fund: investors may buy or
    redeem shares at any point, where the price
    is determined by the net asset value of the
    fund.
Calculating a Mutual Fund’s
Net Asset Value
   Net Asset Value (NAV)
   Definition: Total value of the mutual fund’s stocks,
    bonds, cash, and other assets minus any liabilities
    such as accrued fees, divided by the number of
    shares outstanding

               Stocks                       $35,000,000
               Bonds                        $15,000,000
               Cash                          $3,000,000
                  Total value of assets     $53,000,000
               Liabilities                    -$800,000
                  Net worth                 $52,200,000
               Outstanding shares             15 million
               NAV = $52,200,000/15,000,000 = $3.48        631
Mutual Fund Structure:
the Organization
   The shareholders, or owners, of the mutual
    fund are the investors.
   The board of directors oversees the fund’s
    activities, hires the investment advisor, an
    underwriter, etc., to manage the day to day
    operations of the fund.
Mutual Fund Structure:
the Organization




                         633
Mutual Fund Structure:
the Organization
   In theory, the board can fire the fund manager and
    hire anyone they choose. For instance, the board
    for the Fidelity Magellan Fund can fire Fidelity. Of
    course, if the board hires a non-Fidelity
    management team, the fund will probably lose its
    name, and possibly its reputation along with it.
Investment Objective Classes
   There are four primary classes of mutual
    funds available to investors:
    1.   Stock (equity) funds
    2.   Bond funds
    3.   Hybrid funds
    4.   Money market funds

•   The next slide shows the distribution of
    assets among these different classes.
Investment Objective Classes
Investment Objective Classes
   Stock Funds
       Other than investing in common equity, the stated
        objective of any particular fund can vary dramatically.
       Capital Appreciation Funds seek rapid increase in share
        price, not being concerned about dividends.
       Total Return Funds seek a balance of current income
        and capital appreciation.
       World Equity Funds invest primarily in foreign firms.
       Other types in Value, Growth, a particular
        industry, etc.
Investment Objective Classes
   Bond Funds
       Strategic Income Funds invest primarily in U.S. corporate
        bonds, seeking a high level of
        current income.
       Government Bond Funds invest in U.S. Treasury, as well
        as state and local government bonds.
       Others include World Bond Funds, etc.

   The next figure shows the distribution of assets
    among the bond fund classifications.
Investment Objective Classes
Investment Objective Classes
   Hybrid Funds
       Combine stocks and bonds into a single fund.
       Account for about 6% of all mutual
        fund accounts.
Investment Objective Classes
   Money Market Mutual Funds
       Open-end funds that invest only in money
        market securities.
       Offer check-writing privileges.
       Net assets have grown dramatically, as seen in
        the next slide.
Investmen
t Objective
Classes
Investment Objective Classes
   Money Market Mutual Funds
       Although money market mutual funds offer
        higher returns than bank deposits, the funds are
        not federally insured.
       The next slide shows the distribution of assets in
        MMMF, which are relatively safe assets.
Investment Objective Classes
Investment Objective Classes
   Index Funds
       A special class of mutual funds that do fit into
        any of the categories discussed so far.
       The fund contains the stock of the index it is
        mimicking. For example, an S&P 500 index
        fund would hold the equities comprising the S&P
        500.
       Offers benefits of traditional mutual funds
        without the fees of the professional
        money manager.
Fee Structure of Investment Funds
   Load funds (class A shares) charge an upfront fee
    for buying the shares. No-load funds do not charge
    this fee.
   Deferred load (class B shares) funds charge a fee
    when the shares are redeemed.
   If the particular fund charges no front or back end
    fees, it is referred to as class C shares.
Fee Structure of Investment Funds
   Other fees charges by mutual funds include:
       contingent deferred sales charge: a back end fee that may
        disappear altogether after a specific period.
       redemption fee: another name for a back end load
       exchange fee: a fee (usually low) for transferring money
        between funds in the same family.
       account maintenance fee: charges if the account balance
        is too low.
       12b-1 fee: fee to pay marketing, advertising,
        and commissions.
Regulation of Mutual Funds
   Mutual funds are regulated by four primary laws:
       Securities Act of 1933: specifies
        disclosure requirements
       Securities Exchange Act of 1934: details
        antifraud rules
       Investment Company Act of 1940: requires registration
        and minimal operating standards
       Investment Advisors Act of 1940: regulates
        fund advisors
Regulation of Mutual Funds
   Mutual funds are the only companies in the U.S. that
    are required by law to have independent directors,
    as follows (2001 SEC rules)
       Independent directors must constitute a majority of
        the board
       Independent directors select and nominate other
        independent directors
       Legal counsel to the independent directors must also be
        independent
Hedge Funds
   A special type of mutual fund that received
    considerable attention following the collapse of Long
    Term Capital Management.
   Different from typical mutual funds, as follows:
       High minimum investment, averaging around $1 million
       Long-term commitment of funds is required
       High fees: typically 1% of assets plus 20% of profits
       Highly levered
       Little current regulation
Hedge Funds
   Hedge funds are often trying to take advantage of unusual spreads
    between security prices




                                                                        651
The LTCM Debacle
 Long Term Capital Management was a
 hedge fund run by John Meriwether (the
 former head of bond trading at Salomon
 Brothers), and its board included Nobel
 Laureates Myron Scholes and Robert C.
 Merton. It recorded returns in excess of 30%
 for the first several years.
The LTCM Debacle
 However, it took bets that went the wrong
 way. Its collapse was eminent, and
 regulators decided they had to develop a
 bailout. LTCM had over $80 billion in equity
 positions and over $1 trillion in derivative
 positions. Its failure could have been
 devastating for the U.S. economy.
The LTCM Debacle
 Hedge funds have continued to fail since
 LTCM. Amaranth Advisors loss $6 billion in
 one week in natural gas futures. Other funds
 have similar losses. Indeed, hedge fund
 investing is a potentially high risk game for
 well-heeled investors (gamblers?)
Hedge Funds
   The SEC passed regulation in 2006 requiring
    hedge fund advisors to register with the SEC.
    The SEC became concerned about fraud,
    and hedge funds became available to the
    average investor via ―retailization‖.
Conflicts of Interest
in the Mutual Fund Industry
   Investor confidence in the stability and
    integrity of the mutual fund industry
    is critical.
   However, the usual problems of asymmetric
    information and the principal-agent problem
    arose, leading to abuses on the part of fund
    management.
Conflicts of Interest
in the Mutual Fund Industry
   Mutual Fund Abuses
       Late trading: allowing trades after 4:00 pm to
        trade at today’s 4:00 NAV instead of tomorrow’s
        price. This is illegal under
        SEC regulations.
       Market timing: taking advantage of time zone
        differences for determination of NAV. This is not
        illegal under SEC rulings.
Conflicts of Interest
in the Mutual Fund Industry
   Government Response to Abuses
       Require more independent directors
       Hardening the 4:00 valuation rule: this addresses the late
        trading problem, but not market timing.
       Increased and enforces redemption fees: fees to
        discourage market timing by additional fees for short-term
        redemptions.
       Increased transparency: hits operating practices, directors,
        investment managers, compensation arrangements with
        brokers, etc.
Chapter Summary
   The Growth of Mutual Funds: mutual funds
    growth has been dramatic, increasing from
    under $300 billion in 1980 to over $10 trillion
    in 2004.
   Mutual Fund Structure: the organization
    structure, including ownership, the board, and
    operations of the fund were reviewed.
Chapter Summary (cont.)
   Investment Objective Classes: along with
    delineating equity and debt funds, we also
    reviewed classes on funds within each major
    category.
   Fee Structure of Investment Funds: the
    various fees charged by funds were defined
    and reviewed.
Chapter Summary (cont.)
   Regulation of Mutual Funds: the various acts
    and laws that govern mutual funds were
    listed.
   Hedge Funds: the purpose, definition, and
    differences between traditional mutual funds
    and hedge funds was discussed.
Chapter Summary (cont.)
   Conflicts of Interest in the Mutual Fund
    Industry: recent abuses and governmental
    responses to those abuses was outlined.
The End

								
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