FINC 203 Tutorials Term Test Presented by The

FINC 203 Tutorials Term Test Presented by The Investment Society

Overview • Introduction of Financial System • Interest Rates • Money Market • Bond Market • Equity Market • Derivatives Market • Foreign Exchange Market

Key Points to Take Away • How to “Question Spot” • Remembering relevant formulas and methods • Know when & how to apply these formulas and methods • Basic tips for the test/exam situation

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Introduction to the Financial Markets

Flow of funds • The system moves money from lender-savers to borrowerspenders. • Suppliers of funds- Lender Savers • Eg households, businesses, state and local governments • Surplus spending units (SSUs) • Demanders of funds- Borrower – Spenders • Eg Businesses and Commonwealth government • Deficit spending units (DSUs)

Direct Financing • The DSUs and SSUs deal ‘directly’ with one another- there is no middleman. DSUs sell securities, such as shares or bonds, to SSUs in exchange for money • Without using the market- • If a company needs financing, they can contact an investor directly who may be interested in buy the securities that the company sells in order to get funding. • Using the Market- • To raise funds, companies can issue their own securities in the financial market. Typically requires help from experts to organise, issue and sell the securities in the market.

Indirect Financing • Requires financial intermediaries to purchase direct claims from DSUs and transform them into indirect claims by selling to SSUs. • Has a middleman such as a broker who brings buyers and sellers of funds together. • Benefits to financial intermediation • • • Denomination divisibility Currency transformation Maturity flexibility Credit risk diversification Liquidity

Primary and Secondary Markets • Primary Markets- • Market for the sale of new securities by corporates • Includes IPOs- first offering of stock to the general public. • Secondary Markets- • Market in which previously issued securities are trading among investors. • Key Terms- • Marketability- the ease with which a security can be sold and converted to cash • Liquidity- the ability to convert an asset into cash quickly • Brokers- Market specialists who bring buyers and sellers together for a sale to take place • Dealers- ‘make markets’ for securities and bear risk.

Organised and OTC Markets • Organised Markets (Exchanges) • Provide a platform and facilities for members to buy and sell securities or other assets under a specific set of rules and regulations eg NZX. • Over-the-counter (OTC) Markets • Securities not listed on an exchange are bought and sold in OTC markets. • Has no central location • Trade through an OTC dealer by visiting/ calling them or using an electronic trading system linked to the dealer. • Usually has securities of relatively smaller and unknown companies compared to organised markets.

Key Risks Faced by Financial Institutions • Credit risk/ default risk • The possibility that the borrower will fail to make either interest or principal payments in the amount and at the time promised. • Interest rate risk • The risk of fluctuations in a security’s price of reinvestment income caused by changes in market interest rates. • Political risk • The risk of fluctuation in the value of a financial institution resulting from the actions of domestic or foreign governments.

Key Risks Faced by Financial Institutions (cont) • Liquidity risk • The risk that a financial institution will be unable to generate sufficient cash inflow to meet required cash outflows. • Foreign Exchange risk • The fluctuation in the earnings or value of a financial institution that arises from changes in exchange rates. • Operational risk • Complexity and scale of large businesses create a risk of loss due to the failure or inadequacy of internal systems, people and processes that should ensure the effective and efficient operation of a financial institution.

Efficient Capital Markets Fully reflect the knowledge and expectations of all investors at a particular point in time. Overall efficiency depends on • Operational efficiency- focusses on bringing buyers and seller together at the lowest possible cost. • Informational efficiency- market prices reflect all relevant information about securities at a particular point in time. • Efficient Market hypothesis- • Strong form efficiency- the idea that all information about a security is reflected in its price. • Semi-strong form efficiency- holds that all public information available to investors is reflected in security prices. • Weak-form efficiency- holds that all information contained in past prices of a security is reflected in current prices.

Interest Rates

Time value of money • The concept that a dollar is worth more today than it is tomorrow because people would rather consume goods sooner rather than later. • This is because the dollar represents purchasing power which may be rented out to others and earn a return, if the owner does not need it immediately for consumption. • If you have a dollar today, you can invest it and earn interest on that dollar making it more valuable tomorrow.

Interest Rates • The rental price of money- usually expressed as an annual percentage of the nominal amount of money borrowed. • Determinants of real rate of interest • The real interest rate is determined by supply and demand. Any economic factor that causes a shift in desired lending or borrowing with cause a change in the equilibrium rate of interest. • The level of interest rates tends to rise in times of economic expansion and fall during periods of economic contraction.

Fisher Equation • where i= nominal interest rate, r= real interest rate and change in Pe = inflation rate. NOTE- THIS IS AN APPROXIMATION OF INTEREST RATES - NOT AN EXACT CALCULATION

Simple Interest • Simple interest is calculated on the principal sum borrowed. • The future value of a single sum calculated using simple interest where FS is the sum which must be repaid. • The present value of a single sum calculated using simple interest is given in the equation: P = FS/ (1+in)

Compound Interest • Interest calculated on the actual amount outstanding each period. • The future value of a single sum with compound interest is calculated using: Where k is the compounding rate. • The present value of a single sum with compound interest is calculated using: PV = FVn/ (1+k)^n

Bonds • A contractual obligation of a borrower to make cash payments to a lender for a fixed number of years. Upon maturity, the lender is paid the face value of the security. • The price of a bond is the present value of the bond’s cashflows. • Terms of the bond contract • Consists of 2 cashflows- coupon (interest payments) and principal • Bond pricing formula

Bonds (cont) • Bonds can be sold at par, premium or discount. • Bonds sold at par- bond that is selling at a price equal to its face value- usually $1000. • Bonds sold at a premium- bond whose market value is above its par or face value. A bond sells at a premium when the market rate of interest is less than the bond’s fixed coupon rate. • Bonds sold at a discount- bond that sells below its par or face value. A bond sells at a discount when the market rate of interest is above the bond’s fixed coupon rate.

Bond Yields • Yield to maturity • The yield to maturity is the yield promised to the bondholder if the bond is held to maturity and all coupons are reinvested at the promised yield. • Realised yield • The actual return earned on a bond given the cashflows actually received by the investor and assuming reinvestment at the coupon rate is called the realised yield. • Expected yield • The predicted or forecast yield based on an expected sale price.

Bond Theorems Tell us about the relationship between bond prices and interest rate changes. • As the market rate of interest declines (rises), bond prices increase (fall). • The longer the term to maturity, the greater the sensitivity of a bond’s price to changes in interest rates. • The lower a bond’s coupon rate, the greater the sensitivity of the bond’s price to changes in interest rates.

Interest rate risk • Two types of interest rate: • Price risk- arises from the inverse relationship between bond prices and interest rates. • Reinvestment risk- associated with the reinvestment of the proceeds of a short-term bond at an uncertain future interest rate. • These two offset each other to some extent; when yields increase, bond prices fall but the rate at which coupons are reinvested increases.

Duration • Duration: • The effective maturity, a measure of interest rate risk that considers both the coupon rate and maturity of the bond. • The greater the bond’s sensitivity to interest changes, the higher the interest rate risk, the higher the duration.

Term Structure of Interest Rates • The term to maturity • The length of time until the principal amount borrowed becomes payable. • The relationship between yield and term to maturity is call the Term Structure of Interest Rates and is geometrically plotted as a yield curve. • Yield curve • Defined as the graph of the relationship between interest rates on particular securities and their terms to maturity.

Theories of the Term Structure • The Expectation Theory • Suggests that the shape of the yield curve is determined by investors’ expectations of future interest rates. For example, an upward sloping yield curve implies that investors expect interest rates to increase the future. • Because investors can trade in securities with different maturities, an equilibrium return across the spectrum of maturities emerges to ensure there is no free lunch.

Theories of the Term Structure (cont) • The Expectation Theory (cont) • The relationship between LT and ST interest rates can be stated as follows: • Implied forward rates • The one year forward rate is the rate on a one-year security originating one year from now. A forward rate can be computed using:

Theories of the Term Structure (cont) • The Market Segmentation Theory • States that most investors have set preferences regarding the length of maturities that they will invest in and will not trade outside of these preferences. • Preferred-habitat Theory • States that if an investor chooses to invest outside their term of preference, they must compensated for taking on that additional risk. – This relaxes the market segmentation theory and says that if there is sufficient reward, investors will trade outside of their preferences. • Liquidity Premium Theory • Liquidity premium is defined as the additional interest paid by borrowers who issue illiquid securities to obtain long-term funds. • The interest premium compensates lenders who acquire a security that cannot be resold easily or quickly at par value. There is not enough evidence saying that one theory is correct. Market participants tend to favour the preferred habitat theory, while economists favour the expectations theory.

Money Market

Money Markets • Collection of markets each trading a different short term financial instrument. • Characteristics of money market instruments • • • Low default risk Short maturity High marketability / liquidity Traded in large denominations Low transaction costs

Money Market Securities- One Name Paper • A short term debt with no endorsement other than the signature of the issuer. • Treasury Notes- issued to finance the operations of the government • T- notes are issued by the Treasury and bids are submitted by large investors. The bid with the lowest yield is accepted first. • Pricing t-notes • Repurchase Agreement (repo)- An agreement involving the sale of a security with the condition that the seller will buy it back at a predetermined price. The securities involved are treasury securities and semi-government bonds. • The rate charged on a repo is negotiated between the parties. • Negotiable certificates of deposit (CD) • A bank term deposit that is negotiable • Designed by banks to attract large corporate deposits two

Money Market Securities (cont) • Commercial Paper • The name for promissory notes issued by large corporations. • Firms of high credit rating issue commercial paper as an alternative to borrowing from a bank • Can be through under-written or non-underwritten offer. • Asset backed commercial paper • ST securities backed by financial assets including mortgages, receivables and LT securities.

Money Market Securities • Bank accepted bills aka two(three)-name paper • A BAB is a time draft drawn on and accepted by a commercial bank. The bank promises to pay the holder of the bill its face value at maturity. • Traded in large denominations • Mature in 90, 120 or 180 days • Once bills are accepted, they may be sold and traded on secondary market (very common)

Capital Market

Capital Market • Used by firms and individuals for long term investments. • Major issuers (borrowers) • Households (mortgages) • Business (bonds and stocks) • Government (bonds) • Major investor (lender) • Households- either directly or indirectly through financial intermediaries.

Capital Market – Bond Market • Debt instruments where the interest paid to investors is fixed for the life of the contract are called Fixed income securities. • Government securities • Treasury bonds • Attractive investments because of their low credit risk. • Treasury indexed bonds- (TIBs) • Bonds that adjust for inflation • Since the principal and interest payments of TIBs are adjusted for changes in price levels, the interest rates provides a direct measure of inflation.

Capital Market – Bond Market • Government securities (cont) • State Government bonds (municipal bonds) • Their trading price is lower than that for an otherwise identical treasury securities. • The Local Government Funding Agency (LFGA) acts as a central borrowing • Not explicitly guaranteed by federal government • A joint guarantee is built into the LGFA (joint liability) • Types of municipal bonds: • General obligation bonds- backed by issuer’s full faith and credit, no security • Revenue bonds- backed by the cashflow of particular revenue generating project

Capital Market – Bond Market • Corporate Bonds • Secured bonds • Holders have the right to liquidate the collateral property in order to get paid. • Lower interest rates. • Unsecured bonds • Have no specified security attached as collateral in the case of default • Lower priority therefore higher interest rate • Senior debt • Gives the bondholder first priority to the firm’s assets in the event of default. • Subordinated debt • Bondholders claim to the company’s assets rank behind senior debt.

Capital Market – Bond Market • Corporate Bond Indentures • Restrictive covenant • Rules/ restrictions on firm managers designed to protect bondholder’s interests. • Sinking fund provision • Firm pays off a portion of the bond issue each year. • Call provision • Issuer has the right to buy back the bond from the holder at a specific price before maturity. • Higher interest rates because of Call Interest Premium • Convertible bonds • Hybrid security- has components of both debt and equity • Can be converted into common shares at the discretion of the bond holder.

Capital Market – Bond Market • Bond Valuation • • PV of the bond= PV of each coupon pmt + PV of principal payment If the bond sells at par, coupon rate= market interest rate. If the bond sells at premium, coupon rate > market interest rate. If the bond sells at discount, coupon rate < market interest rate. • Effective annual yield

Capital Market – Equity Market • Secondary markets efficiency • Efficient when the current market prices of securities traded reflect all available information relevant to the security. • Direct search market • Buyers and sellers seek out each other directly • Brokered market • Brokers bring buyers and sellers together in order to earn a fee called commission. • Dealer market • Dealers earn their profits from the spread on the securities they trade. The difference between their bid and ask price. • Auction • Buyers and sellers confront each other directly and bargain over price.

Capital Market – Equity Market • Common Shares • Represent the basic ownership claim in a company • Owners of common shares are not guaranteed any dividend payments and have the lowest priority claim on the company’s assets in the event of insolvency • Preferred Shares • Have components of debt and equity. • Have no maturity so viewed as perpetuities. • No voting rights • Preferred shareholders received a fixed dividend regardless of the company’s earnings and, if the company is liquidated, they receive a pay out.

Capital Market – Equity Market • Valuing common shares • General dividend valuation model • Valuing preference shares • The key issue is whether they have an effective maturity. p=par value, d= div, m= pmts per year

Derivative Market

Derivatives • A derivative security is a financial instrument whose value is derived from some underlying security. Includes • Forwards • Futures • Options • Swaps

Derivatives- Forward Markets • A forward contract guarantees the delivery of an amount of goods on a specific day in the future. • Involves two parties agreeing today on a price (the forward price) at which the purchases will buy a specific amount of an asset from the seller on a fixed future date. • Buyer of forward contract is said to have a long position. • Seller of forward contract is said to have a short position. • The forward price for an asset is that price that makes the forward contract have a zero net present value.

Derivatives- Futures Markets • A futures contract is similar to a forward but • Are traded on an exchange • Are standardised • Parties to a futures contract hold contracts with the exchange, rather than each other. • Futures positions are marked to the market each day. • Futures exchange is a place in which buyers and sellers can exchange futures contracts.

Derivatives- Futures Markets • Two types of participants in futures and forward markets: • Hedgers • Individuals or firms that engage in financial-market transactions to reduce price risk. • Speculators • Those who assume price risk in the expectation of earning a high return • Futures can be used to manage the risks associated with changing interest rates and asset prices as futures prices move inversely with interest rates and directly with asset prices. • Can stock index futures to reduce the systematic risk of their portfolios. • Can guarantee the costs of funds by selling bond futures. If interest rates rise, the bond futures price falls. The profit from the short position will offset the increase in the borrowing costs. • Futures can be used to reduce the firm’s losses if prices move adversely, but can also reduce profits.

Derivatives- Option Markets • An option gives the holder the right but not the obligation to buy or sell an asset at a pre-determined price. • The price is called the exercise or strike price. • The option buyer pays the option seller a price (called the premium) for the right. • Two types of options: • Call option- gives the holder the right to buy the underlying asset. • Put option- gives the holder the right to sell the underlying asset.

Derivatives- Swap Markets • Swaps involve the exchange of payment obligations on two underlying financial liabilities where principal amounts are the same but the payment patterns are different. • A swap only involves a net transfer of funds. • Ie if one party owes the other 6% on a notional principle of $1 m and the second owes the first party 5%, the first party only pays the second $10, 000 per year. The $1 m principal never changes hands. • Reasons to enter a swap: • To hedge interest rate risk by exchanging fixed rate payments for floating rate payments, and • To take advantage of credit risk differentials.

Derivatives- Swap Markets • Swap dealers • Because the obligations of various parties are not perfectly matched in practice, swap dealers serve as counterparties to both sides of the swap. • Dealers operate a book of swaps, which they try to keep as closely matched as possible so as to minimise market risk. • Credit default swap • A CDS is a financial swap agreement where the seller of the CDS will compensate the buyer in the event of a debt default or other credit event. That is, the seller of the CDS insures the buyer against some reference asset defaulting. • Interest rate swaps are forward contracts where one stream of future interest payments is exchanged for another based on a specified principal amount.

Final Tips/ Tricks • Read the question and answer what is asked! • Make sure to define terms you use- these are quick and easy marks to pick up • Watch out for time- work quickly and make sure you’re spending an appropriate amount of time on each question • Do some practice questions! These will be a good indication of what will be tested • Make sure you also practice the numerical questions, there will most likely be at least one of these in the test!

Thanks for coming and good luck! Our slides will be up on our website/ Facebook page later today!