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Project • Financial Development facilitates economic grow. Discuss. • What do you think are the causes of the global financial crisis? What lessons can be learnt from the crisis? • Financial system in general and the banks, in particular must be heavily regulated. Discuss taking into account the current global financial crisis. • The JSE is the largest stock exchange in Africa and one of the biggest in the world. Describe the evolution of this institution from when it was established up until now. Include the following in your description its size in terms of market capitalization, number of listed firms, etc. Also explain the ownership structure of JSE. 1 • BESA is South Africa’s bond exchange. Describe the evolution of this institution from when it was established up until now. Include the following in your description its size, ownership structure, etc. • As discussed in class there are four main term structure theories of interest rates. Explain in detail the main postulations of each. Which one do you think is appropriate for an economy like South Africa? • Enumerate the different financial instruments trade in South Africa. Give a detailed explanation of the risks associated with each. Given your risk tolerance level which one would you go for? 2 • Explain the principal-agent problem between shareholders and the management of a firm. Get 10 financial statements from 10 listed firms and do a critical assessment on whether the firms have managed to put in place mechanisms to correct or reduce the principal agent problem. • The banking sector in South Africa is not competitive. Discuss. How do customers benefit from a competitive sector. • The South African monetary policy must be revamped? Discuss. 3 Bonds • Def: A bond is an instrument in which the issuer (borrower) promises to repay the lender/investor the amount borrowed plus interest over some specified period of time. • Bond Features • The borrower issues a bond to the lender for some amount of cash. The arrangement obligates the issuer to make specific payments to the bondholder on specific dates. • A typical bond obligates the issuer to make semi- annual payments of interest to the bondholder for the life of the bond. When the bond matures, the issuer repays the debt by paying the bondholder the bond’s par value. 4 Bond Features • The term to maturity of a bond is the number of years during which the issuer has promised to meet the conditions of the obligation. • The maturity of a bond refers to the day the debt will cease to exist and the day the issuer will redeem the bond by paying back the principal. • The principal value of a bond is the amount the issuer agrees to repay the bondholder at the maturity date. • Example: A 30 year bond with interest of 8% and a par value of R1000 entitles the bondholder an annual cash flow of R80 (8% of 1000) for 30 years. At the end of 30 years the issuer also pays the R1000 par value to the bond holder. • • Examples of bonds:- Treasury bonds and notes, corporate bonds, etc. 5 Bond Categories • Depending on their duration and interest payments bonds can be categorized into four basic types: - • Zero-coupon bonds- these promise a single future payment. They make no coupon (interest) payment. In this case investors receive par value at maturity date but receive no interest payments. • Fixed payments bonds – e.g. Mortgages. • Coupon bonds – these make periodic interest payments and repay the principal at maturity. • Consols – these make periodic interest payments forever never repaying the principal that was borrowed. 6 Bond Pricing • To value a security, we discount its expected cash flow by an appropriate discount rate. The cash flows from a bond consist of coupon payments until the maturity date plus the final payments of the par value. • Bond value = Present Value (PV) of coupons + PV of par value • The value of a bond can be written as: T Coupon ParValue • Bond Value = (1 r ) t (1 r )T t 1 • Where T is the term to maturity and r is the interest rate. 7 Pricing Different Types of Bonds • Zero-coupon bonds - • Example: Consider a zero coupon bond with a face value of R100 sold at $96. The difference of R4 is a discount and is the interest payment to the lender. So the value of a zero-coupon bond is just the value of the payment discounted with an appropriate discount rate: 100 Price of R100 face value zero coupon bond (1 i) T • Where i is the interest rate in decimal form and T is term to maturity. 8 • Fixed Payment (FP) bonds - These are loans that promise to pay a fixed number of equal payments regularly. The borrower pays off the principal along with the interest over the life of the loan. • The value of such a bond today is the present value of all payments. • Value of a FP loan = T 1 i FP FP FP FP ..... 1 i 1 i 2 1 i T i 1 t 9 • Coupon bonds - The issuer of a coupon bond promises to make a series of periodic interest payments plus a principal payment at maturity. • Price of Coupon bond = • Coupon Coupon Coupon FaceValue ........ • 1 i 1 i 2 1 i T 1 i T = T (1 r ) Coupon ParValue t 1 t (1 r ) T 10 • Consols or Perpetuities - This type of a bond offers periodic payments ad infinitum. The borrower only pays the interest and never repays the principal. • Price of a consol = Yearly coupon payments i 11 Bond Yields • The yield on a bond should reflect the coupon interest that will be earned plus any capital gain/loss that will be realized from holding the bond to maturity. • For example, if a 4-year bond with a coupon rate of 5% and a par value of R1000 is selling for R900.64, the yield should reflect the coupon interest of R50 (5% of R1000) every year plus the capital gain of R99.36 (1000-900.64) when the bond is redeemed at maturity. • There are two important types of yields – the current yield and the yield to maturity. 12 • Current yield of a bond - measures the cash income provided by the bond as a percentage of bond price. It measures the proceeds the bondholder receives for making the loan. It is the yearly interest payments divided by the price. Yearly coupon payment • Current Yield = Price of the bond paid • From the formula it can be seen that the current yield measures that part of the return from buying the bond that arises solely from the coupon payments. 13 Yield to Maturity (YTM) • Yield to maturity (YTM) – this is the yield bondholders receive if they hold the bond to maturity when the final payment is made. • More formally the YTM is the interest rate that makes the present value of the cash flow of a bond equal to the market price. The YTM, y, is found by solving the following equation for y: C C C M P ......... 1 y 1 1 y 2 1 y 1 y T T 14 Holding period returns • YTM can be different to holding period return because holders can sell bonds before maturity. The price of the bond can also change between the time of purchase and the time of sale. • Holding period return = Yearly coupon payment Change in price of bond Price paid Price of bond 15 The Bond Market • Bond prices are determined in the market for bonds by supply and demand for bonds. To simplify things we shall look at a stock of bonds existing at a given time period. • Bond Supply Curve • It shows the relationship between the price and quantity of bonds people are willing to sell, ceteris paribus. • The curve is upward slopping. If the price of a bond increases, a holder of the bond would sell it as the investor tries to take advantage of the capital gains. For firms seeking to raise funds the higher the price of bonds the more the funds they can generate if they issue the bonds. 16 Factors that shift the bond supply curve • Change in government borrowing – an increase in government borrowing needs can increase the quantity of outstanding bonds if it finances its deficit for example using bonds. • Changes in general business conditions – As the economy goes through different phases of the business cycle the different economic’ needs for funds also change. For example, during expansion business conditions are good and investment opportunities abound, thus prompting firms to increase borrowing. One option is to borrow by issuing bonds, shifting the bond supply to the right. 17 Bond Demand Curve • The bond demand curve shows the relation between price and quantity of bonds investors demand, ceteris paribus. It is downward sloping i.e, as price falls the reward for holding bonds rises, so demand goes up. • Suppose you are holding a bond with a face value of R1000 with an interest rate of 10%. Now suppose in the bond market the bond is selling at R900. Would you buy more of this bond? Yes because you get interest equal to R100 and an additional capital gain equal to 100 (1000-900). 18 Factors that shift the bond demand curve • Wealth – as wealth increases individuals increase their investments in stocks, real estates and bonds etc. • Expected inflation – a fall in expected inflation shifts the demand curve to the right. • Expected returns and expected interest rates – if the return on bonds rises relative to other alternatives the demand for bonds will rise. For example if there is a shock that adversely affect the stock market then investors can start demanding more bonds as alternative investments. • Risk to alternatives - if a bond becomes less risky relative to alternative investments the demand for the bond shifts to the right. • Liquidity relative to alternatives – other things being equal the more liquid the bond the higher the demand for it. 19 Risks Faced by Bondholders • Default risk – this is the chance that the issuer of the bond may fail to make promised payments. There is no guarantee that the bond issuer will make the promised payments. • Inflation risk – since inflation is a fact of life an investor cannot be sure of what the real value of his/her payments will be. • Interest rate risk – If the interest rate changes between the times the bond is purchased and the time it is sold the investor can suffer a capital loss. 20 Default Risk and Bond Pricing • We stated that the income stream from bonds is not riskless because the issuer of the bond can default on his or her obligation. The actual payments on bonds are uncertain; they depend to some degree on the ultimate financial status of the issuer or firm. • Bond default risk/credit risk is measured by a number of rating agencies such as Moody’s Investors Services and Standard and Poor’s Corporation. These firms provide quality ratings of firms. The firm’s bonds are assigned some grades that reflect the safety of the bonds. 21 Quality Standard and Poor's Moody's Very High quality AAA or AA Aaa High quality A and BBB A and Baa Speculative BB and B Ba and B Very Poor CCC and D Caa and C 22 Determinants of bond safety • Coverage ratio – ratios of company earnings to fixed assets, e.g. EBIT over interest. Low or falling coverage ratios signal possible cash flow difficulties. • Leverage ratio – debt to equity ratio. A too high leverage ratio indicates excessive indebtedness, signaling the possibility that the firm will be unable to satisfy the obligations on its bonds. • Liquidity ratio – two common liquidity ratios are – current ratio (current asset over current liabilities) and quick ratio (current assets less ST over CL). These ratios measure the firm’s ability to pay bills coming due with cash currently being generated. • Profitability ratio – this is an indicator of a firm’s financial strength. An example of profitability ratio is return on assets (EBIT over TA). • Cash flow to debt ratio - ratio of cash flow to outstanding debt. 23 Bond Indentures or Protective Covenants • Subordination of further debt - One of the factors affecting bond safety is total outstanding debt of the issuer. More debt issued after you have already lent to the firm can reduce the quality of your debt. To prevent firms from harming bondholders in this manner, subordination clauses that restrict the amount of additional borrowing can be included in the debt contract. • Dividend restrictions - Dividend restrictions can limit the amount of dividends the firm can pay. These limitations protect the bondholders because they force the firm to retain assets of the firm rather than paying them to shareholders. • Collateral - Some bonds are issued with specific collateral behind. In this case they are called secured bonds. 24 Bond Indentures or Protective Covenants • Sinking Funds - Bonds call for the payment of par value at the end of the bond’s life. This payment constitutes a large cash commitment on the part of the issuer. In order to ensure that this commitment does not result in a cash crisis the firm can be required to establish a sinking fund to spread the burden over several years. 25 The Term Structure of Interest Rates • The "term structure" of interest rates refers to the relationship between the fixed amount of interest paid on a financial security (e.g. government or corporate bond) and the amount of time before the bond reaches its maturity date. • The theory is based on the observation that in general the interest rate on a loans depends on the length of time that the bond is held. • When interest rates of bonds are plotted against their terms, this is called the "yield curve". • Usually, longer term interest rates are higher than shorter term interest rates. This is called a "normal yield curve" and is thought to reflect the higher risk premium that investors demand for longer term bonds. 26 Yield Curve Shapes Yield Yield 0 0 Maturity Maturity 27 Yield Curve Shapes Yield Yield 0 0 Maturity Maturity 28 • Economists and financial academics have developed theories to explain the shape of the yield curve. The four main theories are: – The Expectations Hypothesis Theory – The Liquidity Premium Theory – The Preferred Habitat Theory – The Market Segmentation Theory 29 The Expectations Hypothesis Theory • The expectations hypothesis assumes no uncertainty about the future. • It assumes that a risk-free interest rate can be computed assuming no uncertainty about the future. • According to the expectations hypothesis we know the yield on bonds available today as well as the yields on bonds available in the future. • So for a surplus unit in the market who has excess cash which he wants to use in two years’ time there are two options of purchasing bonds. 30 • He can purchase a 2-year bond or he can purchase a 1-year bond today and a second 1-year bond when the first 1-year bond matures. The investor will be indifferent between holding the 2-year bond and holding a series of two 1-year bonds. • Consider an investor with a 2-year horizon. He has two strategies: • Strategy A • Invest in a 2-year bond and hold the bond to maturity. Let us call the interest rate associated with this investment i2t. • Investing a dollar in this bond will yield the following two years later: 1 i 2t 1 i 2t • Strategy B • Invest in two 1-year bonds; one today and a second one when the first one matures. Let i1t be the interest rate on the 1-year bond purchased today. • Let i te1 be the interest on the1-year bond purchased one year from now. 31 • So $1 invested using this strategy will in two years’ time yield: 1 i 1 i 1t e it 1 32 • According to the expectations hypothesis investors will be indifferent between these two strategies: i.e.; 1 i2t 1 i2t (1 i1t )(1 i e 1t 1 ) i1t e i t 1 i 2t 2 • Thus the two year interest rate is the average of the current and the future expected 1-year interest rates. 33 • For a comparison between a 3-year bond and three 1-year bonds we get: i1t i1t 1 e i1t 2 e i3t 3 34 • Generalizing the above we get: i1t i i e e ......... i e int 1t 1 1t 2 1t n 1 n • According to the expectations hypothesis when interest rates are expected to rise in the future, long term interest rates will be higher than short term interest rates, i.e. the yield curve slopes up. 35 The Liquidity Premium Theory • The liquidity premium theory asserts that investors usually prefer short-term fixed securities over long- term securities. • Because investors do not like to tie up capital in long-term securities, since those funds may be needed before the maturity date. Investors prefer their funds to be liquid rather than tied up. • It assumes investors must be offered a higher expected return to hold a bond with a horizon different from their preferred horizon. 36 • Generally there is a shortage of long-term investors as compared to short-term investors so that an incentive is required to attract more investors into the long-term debt markets. • One weakness of the expectations hypothesis is that it ignores risk. • Bondholders face inflation and interest-rate risk. The longer the term of the bond the higher the inflation and interest rate risk. 37 • Inflation risk • Bondholders care about the real return of their investment not just the nominal dollar value of the interest payments. • Computing the real return from the nominal requires a forecast of future inflation (expected inflation). • Forecasting a longer period is more difficult and less accurate than forecasting a shorter period. • Hence real returns ten years into the future are more risky than real returns two months into the future. • Therefore the further we look into the future the greater the uncertainty about inflation. Thus a bond’s inflation risk increases with its time to maturity. 38 • Interest rate risk • This arises from a mis-match between the investor’s investment horizon and a bond’s time to maturity. • If a bondholder plans to sell a bond prior to maturity changes in interest rate, which causes the bond price to change, generate gains or losses. • The longer the term of the bond the greater the price changes for a given change in interest rates and the larger the potential capital losses. The interest rate risk also increases with the term to maturity. • So both inflation and interest rate risks are positively related to the term to maturity of a bond. For any investor to be willing to tolerate more risk the return must increase to compensate him/her. 39 • The liquidity premium theory adds risk premium to the expectation hypothesis general equation, yielding: i1t i1t 1 i1t 2 e e .........i1t n1 e int rp n n • Since risk increases with maturity and rpn increases with n; the yield on a long-term bond includes a larger risk than the yield on a short-term bond. 40 • Another explanation of the liquidity premium theory which argues that long-term rates should always be higher than short-term rates is that investors prefer to preserve their liquidity and invest for short-term periods. • Borrowers, on the other hand, usually prefer to borrow for long periods of time. This results in a mis-match between the requirements of borrowers and depositors. • In order to solve this problem the banks then offer higher interest to depositors if they make deposits for longer periods (while charging higher rates to investors who borrow for long terms). • This means short term interest rates would be lower than long term interest rates. 41 The Market Segmentation Theory • The market segmentation theory argues that the market for bonds is segmented by maturity dates. • It holds that long-term and short-term bonds are traded in segmented markets, each of which finds its own equilibrium independently. • The group of investors competing for long-term bonds is different from the group competing for short-term bonds. • Hence there need not be any relation between prices (defined by the interest rates) of short and long term bonds. • • So all points on the yield curve are independent, each is determined by the forces of supply and demand in its own market. 42 • The short-term interest rate is determined by demand and supply in the short-term bond market; the long-term interest is determined by demand and supply in the long-term market. • The activities of long-term borrowers and lenders determine rates on long-term while short-term traders similarly set short-term rates independently of long-term expectations. • The market segmentation theory assumes that neither investors nor borrowers are willing to shift from one maturity sector to another to take advantage of the opportunities arising between expectations and forwards rates. • For the segmentation theory the shape of the yield curve is determined by the supply and demand for securities within each maturity sector. 43 The Preferred Habitat Theory • The preferred habitat theory states that investors have distinct investment horizons and require a meaningful premium to buy bonds with maturities outside their "preferred" maturity, or preferred habitat. • Risk-averse investors prefer to match the life of their assets and the life of their liabilities. This is referred to as their preferred habitat. • They can only adjust to other habitats if they are offered an extra return (incentive) to leave their habitats. • If this theory is correct, premiums will exist for maturities where there is insufficient demand. • These premiums are necessary to induce investors to leave their preferred habitat. 44 • For example, if there is a large number of firms issuing long- term debt relative to the number of investors interested in the long-term debt, supply exceeds the demand for the loans. In order to attract more investors to buy the bonds the firms must increase the interest rates on the long-term bonds. i.e., the firms must offer a premium on the long-term debt. • If many firms and institutions wish to issue short-term debt and there are few investors who wish to invest short-term, a premium will have to be offered on short-term debt. • Proponents of this theory believe that short-term investors are more prevalent in the fixed-income market and therefore, longer-term rates tend to be higher than short-term rates. • But short-term rates can be higher than long-term rates occasionally. 45 Conclusion • Each of the above explanations or theories embodies an element of truth. • The whole truth is probably some combination of them all. 46

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posted: | 2/6/2010 |

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