Portfolio Theory and Financial Markets

Describe forward markets

Forward market however is where foreign exchange is bought and sold for future delivery. It involves a transaction which is constructed today but implemented sometime in the future and therefore the forward rate is the rate at which a future contract for foreign currency can be made.

What are financial markets?

Facilitate the exchange of financial instruments such as stocks,bills,bonds,foreign exchange,futures,options and swaps

Name 6 problems/risks with emerging markets

Poor accounting standards,Governance of companies,Political risks,Foreign Exchange Risk,Controls on Foreign investment, Higher transcation costs

What is a financial security?

Give other names

A legal claim to a future cash flow

Stocks,Bonds,Derivatives,ETFs

What is the difference between debt claims and equity claims?

Debt:

The holder (investor) has a predetermined cash claim via the rate of interest charged with may be fixed or variable

Typically, lower risks

Equity:

The holder is only entitled to a cash payment in the form of dividends once holders of the debt claims have been paid

No guarantee that any cashflow will be paid

Higher risk

Some financial claims are mixture of debt and equity

What is the role of financial intermediaries?

What 5 economic functions does it do?

Assist in the transfer of funds

1. Provision of a payment system

2. Maturity transformation

3. Risk transformation

4. Liquidity provision

5. Reduction of contracting

Describe the difference between primary markets vs secondary markets?

Primary:

Deals with issues of new securities e.g IPO,governmetn bonds local authority bonds and share in new public corporation

Secondary:

Deals with financial securities that have already been issued

List atleast 5 participants in financial markets

Individuals,

Commercial and Investment Banks

Insurance and Pension Funds

Governments

Brokers,

Arbitrageurs,

Hedgers,

Speculators

Describe a bond

Why would a bond be issued?

Security that is issued with a borrowing arrangement and usually obligates the issuer to make payments of interest to the bondholder (investor) for the life of the bond

Bonds are issued by governments,firms and banks to raise money

Are bonds risk free?

Not necessarily e.g Greek Bonds 2010 - 2012 ,collapse of economy

When the YTM is lower than the coupon rate then this means...

This means the bond sells at a premium \= premium bond

if a bond is semi-annual,what happens to the coupon,time periods and yield to maturity?

Half the coupon e.g 8% \= 4% and double the time period e.g 3 years maturity \= 6 years

Half YTM e.g 1+0.08% \= 1.0.04%

Long term bonds are \______ sensitive to \__________ than short term bonds

Long term bonds are MORE sensitive to INTEREST RATES than short term bonds

What are the 10 bond types?

- Straight/Vanilla bonds

- Zero coupon bonds

-Variable/floating rate bonds

- Callable/redeemable

- Puttable bonds

- Perpetual/ Consol Bonds

- Index linked bonds

- Income bonds

- Treasury Bills (or T Bills)

Describe Vanilla Bonds vs Zero Coupon Bonds

Vanilla \=

Pay a fixed coupon at regular intervals for a fixed period to maturity with the return of principal on the maturity date

Zero coupon \=

Pay no coupon,sold at a deep discount to principa; value - reward derives from the principal value on maturity date

Describe Variable bonds

Describe Callable/redeemable bonds

Variable \= variable coupon rate over time

Reedemable/Callable \= issuer has the option to redeem before maturity is reached.

The callable price is defined at the issue date

What are puttable bonds?

Bondholder has the option to force the issuer to repurchase the security at a specific price and dates before maturity - repurchase price define at issue date

What are perputual/consol bonds?

No maturity date and coupons paid indefinitely

What are index linked bonds?

What are income bonds?

Index linked \= coupon payments linked to specific price index e.g CPI

Income \= Only FV is guaranteed to be paid, coupon payments are paid only if the income generated by the firm is sufficient

What is the difference between T Bills and Gilts?

T Bills \= Short term debt instruments with maturity in one year or less from their issue date. Issued by the US Government

Gilts \= Goverment bonds in the UK,India and other countries

do bonds represent a risk free investment?

Government v company bonds, risky governments (Greece) or safe firms.

- Most important risk factor when buying a bond is the interest rate. If inflation is increasing, the government will raise interest rates, which forces bond prices down. If you hold the bond until maturity, the change in price will not matter. But often investors have to sell bonds well before the maturity date because inflation rates have increased since they bought the bond, so it is worth less

What is duration? What does is measure?

Duration calculates the point at which 50% of the cash flows have been returned. Thus it is a weighted average of the net present values of cash flows.

Measures the exposure of the bond's price to fluctuations in interest rates

it enables a comparison of riskiness between bonds with different maturities.

What is modified duration? What is the formula?

The sensitivity of a price of a bond to small changes in its yield,often called the volatility of a bond

- Calculates a bonds exposure to interest risk

Formula \= D/(1+yield)

Describe Default/credit risk and Default Risk premium

Default or credit risk \= the risk that abond issuer may default on its bonds

Default Risk Premium \= the additional yield on a bond that investors require for bearing credit risk

What is the current yield?

The ratio of the annual interest (coupon) payment over the bond over its current market price

What are the 3 limitations of YTM?

1. Assumes bond is held to maturity

2. Discounts each cash flow at the same rate

3. Assume bondholder can reinvest all coupons received at the same rate - whereas in reality coupons will be reinvested at the market rate prevailing at the time they are received

Describe spot rate

-Discounts each cash flow by an appropriate rate to its maturity

- Each spot rate \= the specific zero coupon yield relate to that maturity and bond's risk profile

- More accurate rate of discount than YTM

- Takes into account current spot rates, expectation of future spot rates, expected inflation,liquidity premia and risk premia

Describe expectation theory

Interest rates on a long term bond is equal to the average of the short term interest rates that expected to be occured over the life of the long term bond

- Bond buyers will not hold any bond if expected return is less than another bond with a different maturity

Bonds like this are perfect substitutes

explains:

- why the term structure of interest rates changes at different times

- Explains why interest rates on bonds with different maturities move together over time

- Explains why yield curves tend to slope up when short-term rates are low and slope down when short-term rates are high

Describe Market Segmentation theory

- Bonds of different maturities are not substitutes

- Investors have preferences for bonds of one maturity over another

- The interest rate for each bond with a different maturity is determined by the demand and supply of that bond

- If investors have short desired holding periods and generally prefer bonds with shorter maturities that have less interest-rate risk, then this explains why yield curves usually slope upward

Describe Liquidity Premium Theory

- The interest rate on a long-term bond will equal an average of short-term interest rates expected to occur over the life of the long-term bond plus a liquidity premium that responds to supply and demand conditions for that bond

- Short-term bond bear less interest-rate risk

- Bonds of different maturities are substitutes but not perfect substitutes

Formula for Forward Rate

What the differences between ordinary shares and preferences shares?

Ordinary \= potential of dividends but not guaranteed, voting rights e.g 5% to call a general meeting

Preference \= Fixed rate of dividend,NO voting rights,in case of liquidation - paid after debt holders but before ordinary shareholders