Theory of Financial Markets

Finance

Field dedicated to determining current value of something based off its prospective future receipt (what is something worth? is core question)

Three Questions of Finance

1. How to determine price of things that give owners money in the future?

2. What’s the present value of future amounts of money?

3. Do current prices accurately measure their current value (answer to 1 and 2 the same?)

Asset

Something with current or future value; can be physical (house, car) or financial (stock, bond)

Securities

Tradable financial asset (“secured interest” in future income); assets with secured claim of ownership and financial contracts with assets are securities

Default

Failure to pay what one owes by deadline

Default-Free

Security that always pays on time (common stocks not default free since future payments not known in advance)

When is fixed income default free?

When debt is sovereign and issued by government that can print own money (this is not risk-free due to depreciating value of money)

Risk-Free

Related to uncertainty; future payments are certain in their outcome

Are Risk-Free investments always good?

No, some involve losing money with certainty

One-Day/Overnight Repo Rate

Sets the risk free rate in academic papers

Arbitrage

Buy at one price, sell at higher price (usually in different market); no risk is assumed

No-Arbitrage assumption

States that arbitrage is impossible according to the efficient market hypothesis (i.e. prices based on incorporation of all available information); assets with zero variance must earn risk-free rate

Fair Game

An investment that produces an expected value equal to its cost

Risk Aversion

Assumption that investors prefer investments with low risk vs high risk if average outcome is the same.

What does Risk Aversion tell us?

• Risky assets only preferred if average expected return is greater than riskless assets

• Not always true that risky returns > riskless returns (can even be negative like insurance)

Net Worth (Equity)

In terms of a balance sheet, sum of assets minus sum of liabilities

Market Value

Financial worth assigned to company by investors in the present (different from equity)

Public Equity

Used by analysts to describe stock market’s valuation of net worth of a company; price per share times number of shares outstanding of the company

Income Statements

Describe differences in accounting between balance sheets

Equity Markets

Where securities (equity securities) that represent ownership in a company are traded (stock market, for example)

Private Equity vs. Public Equity

• Knowledge of Previous Owner: Public = not known, Private = can’t be bought without knowledge of owner

• Means of transaction: Public = anonymously through brokers, Private = done directly through buyer/seller

• Regulation: Public = government regulation to protect interests of shareholders, Private = not as much regulation, so protections come w/ sophisticated investors performing transactions

Sophisticated Investor

Type of investor with enough net worth to partake in certain transactions (usually private equity); more net worth = more sophistication

Initial Public Offering (IPO)

First time a company sells stock to public; further stock issuances are called add-on offerings; company neither gains nor losses money after post issuance trading

Captial Gains/Losses

Appreciation or Depreciation of stock holding as prices change ( Pt - P(t-1) )

Cost Basis

Difference between current share price and price paid by investor

Dividend

Payments received by owners of stock (typically quarterly, but can also be monthly or annually)

Percentage Return from Stocks formula

(Pt - P(t-1) + Div(t, t-1)) / P(t-1)

Dividend Irrelevance Theory

Developed by Modigliani and Miller in the 60s: States that in a world without taxes, paying dividends has no effect on a firm’s value or indication that it’s being run efficiently

Dividend Reinvestment

Using dividend payments from stock to buy more of it

Given taxes, why do dividend payments make stocks less attractive?

Capital gains have more favorable tax conditions to dividends, so firms can perform stock buybacks (sell shares back to company) and lower share count results in increased share prices and lower long-term capital gains tax. Dividends, on the other hand, are taxed immediately at a higher rate.

Why are dividends still paid?

Provide surety of company’s profitability; discontinuing dividends could have negative effects on share price

Debt (Fixed Income)

Money owed to a creditor; In finance, can be thought of as a series of fixed payments

Principal

Amount of money initially borrowed

Principal Ammortization

Money paid periodically in addition to interest payments to pay off principal

Balloon Payment

Final payment a debtor makes at loan’s maturity, equals principal minus sum of principal amortization payments

Bankruptcy

Process that triggers when a borrower defaults (cannot meet obligations of lender) where debt can become equity; Lender assumes ownership of collateral assets and company stock is rendered worthless

Chapter 7 Bankruptcy

Company assets are liquidated and net proceeds given to lenders

Chapter 11 Bankruptcy

Company balance sheet reorganized to resume operations as a financially healthier company; equity transferred from company owners to debtholders

Workout

Proceeding in which debtors and creditors make arrangements on unpayable debts, such as forgiving them in exchange for restrictions on company/equity owners

Distressed Debt Investing

Purchasing debt of financially distressed companies with intention of achieving gains through assuming ownership stake or when value of debt subsequently recovers

Winners and Losers in Bankruptcy

Pre-Bankruptcy Equity Owners: Losers

Debtholders: Depends on newly acquired asset value related to company debt outstanding and status among creditors

Creditor Ranking System

How losses of bankrupt company are borne after original equity owner stake is exhausted; reflects risk and compensation each creditor received before default (First to suffer: Junior unsecured, senior unsecured, junior secured, senior secured); scaled from first to suffer losses and highest paid before default

Secured and Unsecured Debtholders

Debtholders who do or do not have collateral pledged to them by borrower to be given in time of default

Junior and Senior Debtholders

Senior supercedes Junior debtholder due to claims of residual assets of the company (outlined in governing documents)

Capital Stack

Summarizes priority of claims on assets of each stakeholder

Debt vs Equity

Debt = fixed income obligation, returns limited by terms of instrument, Equity = Uncertain residual returns, losses limited to price of acquisition with no upper bound on gains

Attributes of T-Bills

Maturity is 1 year or less, no interest payments (only final on maturity, maturity date used as name), notational amount is $1 million (auction at $97 = 970k cost); note that T-Bill year is 360 days

Discount Rate (Bill)

Annualized return investor earns as percentage of bill price; find by divide 360 by remaining days, find absolute amount of discount (maturity amount minus price paid), calculate raw percentage discount (part 2 divided by notational amount) and multiply first operation by third; NOT THE SAME AS RETURN RATE

How to find Bill Price

Given days remaining and discount rate: calculate raw percentage discount (days remaining / 360 times discount rate), calculate absolute amount of discount (notational amount times part 1), subtract part 2 from notational amount

Types of Bills

Short-Term (4, 6, and 8 week): Issued very frequently for quick cash flow management

Benchmark (13, 17 week): 3 month bill is proxy for risk free rate

Strategic (26, 52 week): Used to manage institutional liquidity and term structure anchoring

Why are billed quoted in discounts?

During early days of Bank of England, King would borrow from the back and quote loans in the form of discounts

Calculate Yield of Bill

• 360 day yield to 365 day: Multiply 360-day yield by 365/360

• x day to 365 day: Multiply x day yield by 365/x

• Note: Yield is always higher than discount rate

Discount Security

Security that makes no interest payments, only a single debt repayment upon maturity (like T-Bills)

Attributes of T-Notes and T-Bonds

Notes:

• Maturity greater than one year, but no greater than than ten

• 2/5 year notes most popular

Bonds:

• Maturity greater than ten years

• 30 year bond only current issue

Both:

• Coupon securities: Pay coupons (interest payments) at periodic intervals throughout life of security (twice a year)

• Naming: (Coupon Interest Rate)’s of (Maturity Month and Year)

• Notational Principal: 100k

• Pricing: In 32nds; 95.16 is 95 & 16/32nds or 95.5 or 95,500

Par value

For T-note and bond trades: Trading at price of 100

Accrued Interest

When notes/bonds sold between investors, buyer pays quoted price plus portion of next coupon; calculate by dividing days elapsed between last coupon payment (91) and span between coupon payments (182) and multiply by coupon (7k) to get accrued interest (3.5k)

Traded Flat

When a bond/note trades without accrued interest

Treasury Auctions

Means by which UST issues bills; take place on Monday/Tuesday and announced 1 week in advance; Conducted by FRS since they own the wire system for settlement

Yield-to-Maturity

Return received from note/bond if bought at market price and held to maturity; equal to discount rate when market price is 100

Price is inversely related to yield

If price > 100, yield-to-maturity of a note is below discount rate, if less, than greater

Duration

Measures how sensitive price of a debt instrument is to changes in interest rates; generally, a longer duration entails more interest rate (duration) risk

Macaulay Duration

where PVi is present value of each cash flow, V is total present value of all expected future cash flows, and ti is time until receipt of each cash flow; expressed as the weighed (by present values of maturities) average number of years to receive full cash flows; longer time = greater risk of loss associated with lower interest rates

Can also be calulcated using (Change in Security Price / Price) / Yield = Negative (-) Macaulay Duration

What question does Macaulay Duration answer

How long (on average) will it take for an investor to receive the cash flows promised by a bond?

Interest rate risk

Risk associated with how sensitive a debt instrument is to interest rate changes (also called duration risk)

Modified Duration

Where ytm = yield to maturity and n = compounding frequency per year; answers question of how much will be gained or lost as a result of interest rate changes; expressed as percentage change in the price of the bond for a one percent change in ytm

Key Rate Duration

Modified duration for specific security

Money Market

Market for default and default-free securities with no greater than 2 years of maturity; global mechanism for short-term wholesale funding w/ most liquid instruments of greatly certain cashflows

Federal Funds rate

Interest rate for loans made between commercial banks; Influenced by Federal Reserve through the repo market; calculation is similar to repo rate calculation; targeted by Fed over past decades to guide monetary conditions

Attributes of Federal Funds Loans

Unsecured (and thus defaultable) cash referred to as reserves

Reserves

Money that is not loaned out by commercial bank; certain amount required by law (required reserves), but banks can hold more (excess reserves); Excess Reserves can be positive (surplus) or negative (deficeit)

Repo

Short for repurchase agreement; a form of loan in which is collateralized with US Treasury securities (cash usually less than UST value); UST sold to lender and agreement to buy back at fixed price; done to avoid large capital requirements that would arise with traditional loans

Reverse Repo

When borrowing party sends UST securities to lending party as collateral for repo

Repo Margin / Haircut

Difference in value between cash and UST in Repo; protection against market risk along with daily revalue of collateral (borrower must post additional margin is price drops)

Who uses the repo market?

• Commercial Banks: Overnight repos used as substitute for federal funds; borrows at the lower of the two rates (overnight repo rate or overnight FF rate) and lends at higher

• Financial Institutions: Park cash temporarily to make money and withdrawal when expenses arise

• Broker-Dealers: Obtain UST securities to fulfill previous transactions and use UST securities to raise cash

Stock Lending Market

Market (not part of the money market) where securities are sold by lenders who don’t own them

Short Sale

Process of selling a security that one does not own; short seller borrows security with cash collateral to get it to buyer by time of purchase, then returned to owner in one day or more (term security loan).

How does the Federal Reserve Influence the Money Market?

Through its actions in the repo market: Open Market Operations, Quantitative Easing/Tightening

Open Market Operations

Consist of Open Market Purchases (Fed buys UST securities from commercial banks) and Sales (Fed sells UST securities to commercial banks), which intends to alter the balance sheet of the commercial banking system; can be short (repos) or long term (quantitative easing)

Consequences of OMP and OMS

OMP: Cash deposited into banking system (asset), with similar increase in checking account balance (liability); Excess reserves increase

OMS: Cash removed from banking system, same decrease in checking account; excess reserves decrease

Fed Targets Excess Reserves

Policy revolves around ER, since changes in ER effect willingness and incentive to lend; Occurs through easing (OMP) and tightening (OMS)

Consequences of Easing and Tightening

Easing: Lower cost of borrowing ER, reduces FF rate, increase loan demand, increase business activity

Tightening: Increase cost of borrowing ER, increase FF rate, dampen loan demand, decrease business activity

Quantitative Easing

Long-term easing as seen during 2008, when Fed purchased tons of debt securities and increased ER to 2.5 trillion; led to Fed no longer being able to use traditional policy

Why didn’t lending increase when ER increased in 2009?

Increased regulation, harsher loan qualification policies, lower asset values, and lower business activity (decreased demand)

Fed tightening in 2015

First tightening attempt since 2009: Offered to be counterparty of repos at 0.25% to set floor for repo rate, later increased to 0.5% (ten-year note, mortgage rate, and other important rate declined, so not entirely successful)

Default and Default Free Securities in the Money Market

Default Free: UST securities, Repos (is collateral is UST and maturity < 3 years)

Defaultable: Federal Funds (often treated as default-free since FDIC will settle with counterparties to prevent banks from failing), Commercial Paper (unsecured short-term debt instruments given out by corporations, corps can fail), Commercial Deposits (short-term debt instruments issued by banks used to manage term liabilites, cannot be sold/bought after purchase unless they’re Jumbo CDs)

Yields of MM securities

CP > CD > UST (gap between CP and CD is greater than gap between CD and UST)

Money Market Funds

Mutual Funds made up of Money Market Securities (Ex.: Reserve Fund lost money in 2009 and resulted in new regulations governing such funds)

Corporate Notes and Bonds

Securities issued by corporations (Notes: Maturity between 1 and 10-12 years; Bonds: > 10-12 years) used to borrow money and avoid tedious bank restrictions associated with regular loans

Brief History of Corporate Loans

Only a few highly elite corporations issued corporate bonds before the 1980s, as they were the only ones who could finance themselves; high-quality with little default risk

Credit Rating

Rating of corporate bonds based on company’s financials and bond provisions (i.e. covenants governing corp’s ability to issue additional debt) declared at issuance. Can be upgraded or downgraded as time goes on (change in price)

Junk Bond

Corporate bond with an exceedingly low bond rating; most institutions unload when bond reaches this status by law; never issued as such until 1970s, always downgraded

Michael Milken

Financier that pioneered the high yield bond market in the 1970s and 80s, being the first to build portfolios of junk bonds and helped bring companies to market through issuing them. Ran into controversy when using HYB to fund corporate takeovers and made management fear for their jobs

Result of Milken’s Career

Management of US companies restructured to be more efficient and financially optimized, as well as new measures being taken to protect against takeover (Poison Pills, Golden Parachutes, Greenmail, Voting-Rights Plans, Acquisitions/White Nights, Election Staggering); thousands more companies now issue corporate bonds

Poison Pills

When additional share rights are granted to current holders in the event a large portionf of shares fall under control of acquirer

Golden Parachutes

Allotment of large severance packages to executive management in case of takeover

Greenmail

Corporation buys back shares from acquirer at premium to market value

Voting Rights Plans

Increase requirements for company decisions: super majority required when acquirer gains controls of significant share portions

Acquisitions / White Nights

Hastily undergoing an acquisition to complicate the process of takeover and increae size of acquisition target

Staggering of Elections

Require acquirer to win several board elections over the course of many years to replace enough members to gain control

Debt Stack

Priority of claims that informs order of obligation fulfillment in bankruptcy; top of stack gets paid first and assumes greater control of company