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Finance 371M
Money and Capital Markets
Lecture #1
BUSINESS CYCLES
There is more or less a pattern of expansion
(recovery) and contraction (recession) in economic
activity around the path of trend growth.
At a cyclical peak- economic activity is high relative
to trend.
Where is it at a cyclical trough ??
Over time what causes the trend line to change ?
More resources or a change in resourceutilizationmore or less usage
Factors not fully employed all the time.
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Lecture #2
MARKETS
What are they ??
What makes a good market ??
What role do secondary markets play ??
TYPES OF MARKETS
PrimaryNew fund raising
SecondaryTradingThere are specialized markets for fund raising and
trading. The most important of these are:
Money MarketsMaturities < 1 yr.Capital MarketsMaturities > 1 yr.
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Lecture #3
FINANCIAL INSTITUTIONS & FLOW OF FUNDS
Where do Corporations and Businesses get the
funds they need to operate?
Stocks, debt,etc.
I. Financial markets exist to aid in the mostefficient allocation of capital
II. Financial Institutions facilitate this allocationof capital.
FLOW OF FUNDS
Who are the players?
HouseholdsBusinessesGovernmentsRest of the World
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All act at one point in time or another as
borrowers and providers.
Funds arrive directly or indirectly
What is the role of Financial Intermediaries ?
To lower transaction costsTo lower riskTo provide better market information
Intermediaries also incur risks
I/R risk
FX riskCredit or default risk
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Lecture #4
LOANABLE FUNDS
What is an interest rate ? (as Huey Long said, am
I buying or selling.)He was right, it does
matter !!!
It can be compensationfor lending or givingup ones ability to spend today.
It can be a costcompensation for receiving a
student loan for example
It can be a measuring guidelinegoverningcorporate investing, i.e., cost of capital.
Why do we care about interest rates?
They influence the allocation of capital.
They impact the economy and public policy
decision making.
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What determines the level of interest rates at any
given point in time ??
The availability and demand for funds is
influenced by a myriad of factors.
There are supply and demand curves for funds
just as there are for oil, autos or natural gas.
Who are the players..the same as in the
flow of funds chart..households, governments,
businesses and foreign participants.
The supplyof funds
is largely influenced by interest ratesafter all
the i/r is the price that one receives for parting
with their money..(compensation)
Changes in wealth impact the availability of
funds flowing from households.
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Other factors such as the near term spending
needs and economic conditions also affect the
supply of money available. Overall confidence inthe economy and markets are key determinants
as well. (RISK !!!!)
Interest rates can impact the demandfor funds
as well. Businesses are very interest rate sensitive.
State and Local governments are interest rate
sensitive.national governments not so much.
Overall confidence in the economy and markets
also have a big impact upon demand for funds.
How would such things as higher taxes impact the
availability of funds?
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Lecture #5
WHAT DETERMINES THE LEVEL OF
INDIVIDUAL INTEREST RATES ?
Begin with the real interest rate.
Recognize that there is a direct correlationbetween inflation and interest rates.
U.S. Treasuries become the benchmark
Build the ladder
Factors that influence the nominal i/r.Default riskLiquidity riskTerm to Maturity
Special Provisions:
CovenantsPuts/Calls
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Theories regarding interest rates:
Unbiased expectationsLiquidity PremiumMarket Segmentation
Bond sensitivity to changes in interest rates
Time to MaturityLevel of Interest Rates
How does this influence investment decisions?
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Lecture #6
RISKS, MORE RISKS, AND DAMN RISKS
Systemic risk is that risk which threatens an entire
market. Lehman and Bear Stearns were examples
of this in 2007 which spurred the regulators to do
some unprecedented things. The fear that onefailure might be a domino bringing down other
players
Very hard to predict..global markets make it
even more difficult to predict.
How will a default of a European Union country
impact stock markets, commodity markets, bond
markets ??? No precedent to look at..
How will the failure of a banking system in Europe
impact worldwide markets? Obviously we didntpredict the wide spread impact of the collapse in
the sub-prime and housing markets??
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Then there are specific risks. These are the risks
associated with a specific assets.how will the
drought affect corn prices ?, how will the potentialof the FED raising interest rates affect the mortgage
market?, how will a slowdown in consumer
spending affect Ipad sales???
What kind of risks are default risk, maturity risk,
liquidity risk in the context of individual interest
rates ?
Moral hazard is a risk fostered by previous actions
which leave a perception that past actions will
repeat themselves. In 2008 thru various actions and
procedures we bailed out our major banks. Moral
hazard refers to the risk that they will be
irresponsible in future actions because of the
perception that we will bail them out again.
Does a driver take more risks because they knowthat they have insurance on their vehicle?
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Moral hazard is often the reason that we end up
with more regulation in the first place. Did your
parents slap restrictions on you after you hadscrewed something up ???
Adverse selection is a special type of risk. It is most
often associated with the insurance industry but
happens in many circumstances.
It essentially deals with the fact that the people
who want to buy insurance are those who are most
likely to need it..Explains part of the reason for the
individual mandate portion of ObamaCare.
Four ways to deal with these type risks
AvoidanceDiversification (hard to do)Hedging Insurance
Each carries a cost
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What other types of risks are common to the
financial markets?
Credit riskLiquidity risk Interest rate riskMarket riskOff Balance sheet riskForeign exchange riskCountry or sovereign riskExogenous riskLater we will talk about each of these in greater
detail and specifically how to hedge each.
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Lecture #7
FEDERAL RESERVEVE AND OTHER CENTRAL
BANKS OF THE WORLD
Federal Reserve Bank of the United States was
established in 1913. Its objectives are:
Moderate long-term interest ratesMaintain high levels of employmentMaintain stable pricesFoster economic growth
Its duties on a day by day basis include:
Conducting monetary policySupervising/regulating depository
institutions.
Maintaining stability of the financial system
Providing payment systems forgovernments & check clearing
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Established to be independent of the Executive
Branch with oversight by Congress. The Chairman
and Vice-Chairman are appointed by the President.
Makeup of the FED:
12 Regional Banks
7 Member Board of Governors run FED daily
5 Regional Presidents + Board of Governors
comprise the Federal Open Market Committee
(FOMC), the main policy implementation arm.
Theories driving todays FED:
Focus on Inflationary Expectations-self fulfillingprophecy.
Spread between Treasuries and TIPS
OBJECTIVES OF THE EUROPEAN CENTRAL BANKMaintain price stability-target is inflation
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Basic daily tasks of the ECB:
Conduct daily foreign exchange operations.Hold and manage official foreign reserves of
euro countries.
Maintain a smooth operating paymentsystem
Issue bank notes.
The European Union and the European Central Bank
are not the same thing. Best to think of the EU as
the political arm and the ECB as the financial arm
with real day to day responsibilities. The Greekproblems as well as those of Spain are really
problems of the EU not the ECB.
MAKEUP OF THE ECB
EXECUTIVE BOARD: (equivalent to Fed. Bd.of Gov.)
President, Vice President + four other Governors all
appointed by member countries. They manage the ECB
on a day by day basis.
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GOVERNING COUNCIL: (equivalent to the FOMC)
Six members of the Executive Board + 15 Governors from
Euro-area National Banks. They meet twice a month and
are the main decision making body of the ECB.
GENERAL COUNCIL:
President and Vice President of the ECB + the
Governors of the 27 Euro area National Banks.
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Lecture #8
MONETARY POLICY
What is it and how does it affect us?
In essence, it is an attempt to influence the
amount of reserves that remain in the banking
system.which in turn affects interest rates and
the availability of credit.which ultimately affectsthe levels of employment, output, prices and
inflation. In other words, the money supply.
THE TOOLS OF MONETARY POLICY
(TRADITIONAL)
1.Open Market Operations2.Discount Rate Changes3.Reserve Requirements
The Federal Open Market Committee (FOMC)
impacts the economy thru its practice of buying and
selling government securities in the open market. In
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so doing they are either adding money (expanding)
to the existing supply or taking it out (contracting).
EXPANSIONARY
FED purchases Treasuries in the Open Market
D demand for Treasuries
Price goes upYield goes down (i/r)Lower i/r creates expansion of economy
CONTRACTIONARY
FED sells Treasuries into the open market
demand for Treasuries goes down
Price of Treasuries goes downYield goes up (i/t)Higher i/r curtails borrowing and expansion
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CHANGES IN THE DISCOUNT RATE
The discount rate is the rate that the FED charges
banks to borrow from itIn reality it is only used
as a signal to the market as to which way the FED
wants to see rates goFor example, the discount
rate was lowered 11 times in 2001 in an attempt to
stimulate the economy.
RESERVE REQUIREMENTS
Banks are required to keep 10% of their deposits on
reserve at the FED. On any given day they may have
more or less than this as their deposits fluctuate.
They then have excess reserves or a reserve deficit.These issues are usually resolved by borrowing or
lending in the Fed Funds market (more about this
later)
If the FED required banks to hold more of their
deposits on reserve it would obviously lower the
amount of money available to lend out, etc.
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Or if they reduced the reserve requirement it would
mean that banks had more to lend out, thus
expanding the money supply.
WHAT IS THE MONEY SUPPLY ?
Base = currencyM1 = currency + demand deposits
M2 = currency + demand deposits + timedeposits.
There are a multitude of economic theories
involving the level of the money supply and the
performance of the economy.
ECB IMPLEMENTATION OF MONETARY POLICY
Handled mainly thru the use of repurchase
agreements with banks and National Banks. The
bidding for the repurchase agreements, which are
short term lending agreements, dictates theinterest rate in the market and influences all other
interest rates charged by the banks.
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Banks are required to maintain certain reserve
levels but these are mainly for liquidity reasons not
to influence interest rates.
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Lecture #9
FINANCIAL BUBBLES & CRISISES
Three stages of Financial Crisises:
Stage One: Initiation of a Financial Crisis
Caused by:
Mismanagement of Financial Liberalization orInnovation-(Eliminating restrictions on financial
institutions or markets or introducing new types
of products.
Stage Two: Banking Crisis
Stage Three: Debt Deflation
(All lead to a decrease in economic activity)
2007-2009 Financial Crisis
Financial innovation in the Mortgage MarketDeterioration of Financial Institution Balance
Sheets.
Global Financial Market contagion.
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Lecture #10
MONEY MARKETS
Money market instruments< 1 yr. maturity
Capital market instruments> 1 yr. maturity
Characteristics of MM instruments:
Large denomination > $1 million
Low default risk
Low transaction costs
Very active secondary market/Very liquid
Many originate from governments and corporate
selling MM instruments to meet their short term
needs.
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TREASURY BILLS
Default risk free (why the downgrade??)
Benchmark for other securities pricing
Refinancing debt/govt.deficit/tax timing
Sold at weekly auction
Traditionally maturities were 13 & 26 weeks but
have been selling as short as 5 day paper recently.
Sold at a discount
FEDERAL FUNDSPrimarily overnight loans between banks, one
of the uses of their excess reserves.
FED sets the lending rate range.
For all practical purposes these are justunsecured loans between two banks.
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REPURCHASE AGREEMENTS (REPOS)
An actual sale of securities between two parties
with agreement to repurchase at set date & price.
Most often collaterized with govt. securities.
Normally 1-14 days but can go as long as 90.
COMMERCIAL PAPER (CP)
An unsecured promissory note issued by a
corporation.
Normally held to maturity by investors.
Maturities range from overnight to 270 days.
Purchasers get internal credit approval on a
credit issuer and return again and again.
Usually sold thru dealers such as GS who agree
to repurchase it if there is a default.
Sold on discount basis.
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Corporates with good credit can often borrow
cheaper in the cp market than from their banks
Lower rated corporate can issue cp backed by
LOC or bank lines of credit. Expensive, but
effective.better than issuing long term.
NEGOTIABLE CDs
Bank issued promissory notes with specific
maturity and rate. Trade in the secondary market
at a negotiated price.
Unsecured.Normal maturity of 14-360 days.
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BANKERS ACCEPTANCES
A draft for payment backing a LOC issued
against imported goods.
Importer gets LOC guaranteeing payment to an
exporter. BA allows them to draw down on the
money before delivery. Importer then reimburses
bank.
There is a secondary market for BAs.
INTERNATIONAL USE OF MONEY MARKETS
Provides diversification for International investorsand issuers. (Flight to quality )
LIBOR is the main lending rate. Borrowing quoted
in spread over LIBORmight be 350, 30 or
5depending upon the risk associated with the
borrower.
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Lecture #11
BONDS AND FIXED INCOME MARKETS
Bonds are capital market instruments with
maturities of greater than one year.
Why do some investors/issuers prefer the money
market to the bond market?
Typically fixed income offering interest at set time
periods and the return of principal at maturity. A
bond with a coupon or yield of 8% would normallypay interest semi-annually at 4% on each
payment date. (Variable rate debt)
Treasury notes >110
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market in Treasury securities. These securities are
issued to finance the national debt.
Interest earned on Treasury securities is exempt
from State income taxes but not Federal. Interest
is paid semi-annually. They are sold at auction like
T-bills but are sold at par.
Are Treasury securities risk free ???
What happens to the value of bonds when
inflation become prevalent ??
In 1996 the Treasury began issuing Treasury
Inflation Protected Securities (TIPS).principal
adjusts based upon changes in inflation.
The market developed and Treasury endorsed the
creation of Treasury strips. The principal payment
at maturity and all interest payments are
separated and sold as individual payments to
investors. A ten year Treasury could be divided
into 21 different payment streams. Investors tend
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to match the inflow of interest to a time that they
will need to make a payment.
MUNICIPAL BONDS
Debt instruments issued by state and local
governments. About 18% of all bonds
outstanding. Interest is not taxed for federal taxpurposes and is exempt in states where it is
issued for state tax purposes.
This tax exemption allows the issuers to pay a
lower nominal interest rate thus lowering taxes
for state and local taxpayers.
Two types of municipal bonds:
General obligation- backed by the taxingpower of the issuer. Generally requires
voter approval. (schools, sewers, etc.)Revenuebacked by the revenue
generated by the funded project. (toll
roads)
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What happens if revenue falls short of that needed
to pay interest and principal?
How do you decide whether to invest in a municipal
bond or a corporate bond? You must make them
equivalent..in other words compensate for the tax
advantage
Assume a muni is paying 5% annually and you are in
the 30% tax bracket. What interest rate would a
corporate bond have to pay to be equivalent?
5%/1-.30 same as 5%/.70= 7.1428%
So if you have a choice between a 5% muni or a
7.10% corporate you would take the muni.
What if you were in the 35% tax bracket ?
5%/1-.35 same as 5%/.65 = 7.69%
So you can see that the higher your tax bracket the
more meaningful the tax exemption is..
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Municipal bonds are usually purchased and held to
maturity. The secondary market is very thin.Mutual
funds are the largest purchasers.
CORPORATE BONDS
Comprise about 54% of outstanding bonds.
Normally issued to fund long term obligations.
Rating agency comments are critical to pricing.
Bond holders are first in line to lay claim to the
assets of the bond issuer. Bonds may be issued as
either secured or unsecured..most are unsecured.
Securedare tied to specific assetsmaybe bondsissued to build a factory.
Bonds are issued with different levels of seniority
meaning different standing in bankruptcy.
Subordinated debentures would be junior in status
to senior debt.junior subordinated debentureswould be even lower in ranking.
Callable bonds
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Sinking funds
Covenants
Convertible bonds.
RATING AGENCIES
Companies such as Moodys, Standard & Poors and
Fitch provide their opinions to the market of the
likelihood of a bond going into default and not
paying interest when due or returning the principal
investment to an investor.
Each of these firms uses a rating scale to
communicate their opinion. They are provided withconfidential information by the firms who are
requesting a rating before issuing debt. These
ratings are very important in helping determine the
interest rate the company will pay. For financial
firms they are important in helping counterpartiesdetermine how much collateral they are going to
require to do business with the issuer.
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Moodys downgraded 12 global banks in June
2012 because of their concerns about their
financial health and cost of doing business goingforward.
Citigroup dropped from A3 to Baa2 as did Bank of
America. Goldman dropped two levels from A1 to
A3 with JP Morgan Chase dropping two levels
from Aa3 to A2. Four years ago Goldman and JP
Morgan were rated AAA.
Since financial firms fund themselves heavily with
short term debt downgrades can increase their cost
of doing business dramatically. Likewise some bond
fund investors are restricted to invest in only highly
rated bonds and might have to sell bonds that are
downgraded thus depressing prices.
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The bond markets have helped develop a cadre of
firms that provide financial guarantees. Meaning
that they will stand in and pay interest and principalshould an issuer default. Of course you pay to
purchase this form of insurance.
Credit default swaps were created in 1995 by JP
Morgan to provide such insurance. They have
exploded in recent years even providing insurance
for foreign nation debt.
INTERNATIONAL BOND MARKETS
Because our financial markets are now global in
nature it has become common for foreign
corporations or governments to issue debt inmarkets other than their own.
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Sovereign bonds are bonds issued by a foreign
country..i.e., Greek bonds !!! Yipes !!! Backed by
the full faith and credit of the countryYipes !!! U.S.Treasury bonds are sovereign debt for example.
Sony sells bonds in most of the major markets in the
world as does General Electric and Proctor and
Gamble. Recognized names will raise funds broadly
to diversify as well as to match revenues and debts
in a given currency.
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Lecture #12
SECURITIZATION & MORTGAGE MARKETS
MORTGAGES
Mortgages are loans to purchase real property
such as a home, land or a building. The represent
a subcategory of the capital markets.
75% of mortgages are for single family dwellings.
Characteristics of a mortgage:
Size-standard/jumboTerm-maturity Interest RateCollateral
Qualifying for a mortgage
Credit history IncomeDown Payment
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Interest rates are the greatest variable and have the
greatest effect upon the number of mortgages that
get done.
Fixed rateAdjustable rate (ARM)Amortization schedule
Refinancing of mortgages is driven by the interestrate cycle.
SECURITIZATION
Allows banks, issuers and investors to diversify risk.
Many different structures that can be done eachtailored to investor risk profiles.
What things could have been done differently in the
2007-2009 period in the area of mortgages to have
moderated the meltdown.
The pendulum always swings too far.
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Lecture #13
EQUITY MARKETS
Equity usually represents an ownership interest in
something..rights in bankruptcy ???
In the capital structure of a company equity is
represented by stock..common or preferred.
Common- typically comes with voting rights.May include a dividend.
Preferred- almost always includes a dividend.Value fluctuating is affected by interest rate
more so than market forces or company
earnings.
How does one make money in the equity markets?
Capital appreciationDividends
Where do dividends come from? Stock buybacks?
When we say that equity ownership comes with
limited liability what do we mean?
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What does the primary market for equity look like?
What do we call it? Discuss IPOs/seasoned
offerings.
Tax rates are a major consideration with stock
ownership..discuss cap. Gains/dividends under
Obama/Romney..double taxation
The major markets for equity trading include the
NYSE and the NASDAQ..differences in the two ???
Indices:
DOWS & P 500WILSHIRE 5000RUSSELLMSCIWhat causes prices to change in the stock market
when it comes to individual equity issues ?Different stock ownership structures..
ADRs.
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Lecture #14
Selling Debt in the Primary Market
Shelf Registration:
Company files registration statement with the
Securities and Exchange Commission (SEC) stating
their intent to sell securities broadly defined in
a certain aggregate amount within the next twoyears.
ABC Corp. announced its intent to sell up to $2
billion in debt or equity securities between now
and October 16, 2014.
Essentially getting pre-clearance from the SEC and
from the rating agencies to come to market when
the Company feels appropriate to do
soopportunistically of course.
No waiting around for approvals. Must keepfinancials updated with the SEC during the two
year period.
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RED HERRING AND FINAL PROSPECTUS:
The red herringpresents to potential buyers of
the offering the specifics of the transaction and
the major risks factors associated with investing.
Provides five years of financials and all
government filings along with descriptions of thebusiness of the issuer and the management.
Essentially it is the marketing document for the
deal.but does not show the interest rate the
issuer will pay.
Thefinal prospectusincludes all of the above plus
the final price of the offering and the interest
payment dates.
INDENTURE:
The final document outlining the specifics of the
offering. Covenants, interest payment dates,
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maturity, optional redemption procedures,
special provisions, trustee, etc. The reference
document that the buyer needs in his files in casesomething bad happens.
THE ACTUAL SALE
BEST EFFORTS UNDERWRITING:
No guaranteed price to the seller
Investment banker sells at whatever they can
get for the bonds. Essentially act as agent.
FIRM COMMITMENT UNDERWRITING:
Investment banker buys the entire issue in a
negotiated transaction after the market closes.
They will attempt to break up the issue and sell itin the primary market the next day. Issuer
receives an agreed to price. Investment banker
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assumes the risk of re-selling the issue. Can
market conditions change overnight ??
PRIVATE PLACEMENT:
Seller normally little known to the market.
Purchasers must be sophisticated buyers.
Purchaser agrees to lock uptime frame.
Non-SEC registered to avoid legal expenses.
May offer under Rule 144A allowing the
purchaser to resell at some date in the future but
only to other sophisticated buyers.
How would you classifiy the liquidity of this
type of issue?
SELLING EQUITY
How is this different from selling debt ?
(Just ask Facebook !!)
Determining correct offering price.Determining size of the offering
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Who gets the proceeds?Profile of the investors
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Lecture #15
DERIVATIVES AND HEDGING
Financial instruments tailored to change where
risk lies.
Swaps, caps, floors are good examples of these.
Most deal with the interest rate or credit markets.
Contracts:
Spot- todayForward-the futureFutures
Contracts can be held to maturity or traded as their
value changes..most are liquidated before maturity.
Options:
CallsPutsSelling calls or puts
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Swaps, caps and floors:
Counterparty risk must be evaluated lest youlose the hedge you wanted in place when
your counterparty fails.
Credit default swaps newest form of hedging
including in the purchase of sovereign debt.
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Lecture #16
FINANCIAL MARKET REGULATION
Two approaches to regulation:
Do no harmDont weaken the bank.
Government Safety Net:
FDICFED as lender of last resortBoth lead to moral hazard.
Stressed diversification in lending.
Legislation such as the Glass-Steagall Act was
passed to limit markets in which banks could
operate.
Later Sarbanes-Oxley and Dodd-Frank were passed
in response to bad actors.FED stress tests and Living Wills
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Lecture #17
CAPITAL RATIOS & TOO BIG TO FAIL
Bank assets are things they own.loans,
investments, etc.
Bank liabilities are things they owe..your
checking account for example.
Shareholders equity is the money invested in the
bank.most often represented by common or
preferred stock. This is also known as the capital
account of the bank. This is where losses go to
die.
C= core capital/ assets
>5% = Good
>4% = Adequate
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Must also consider the risk of the assets.all not
created equal. Also, off balance sheet items are
not measured by the capital adequacy ratio.
Basel accords regulate capital requirements for
global banks. Now requiring banks to bulk up to
avoid future systemic failures.
Adding significant amounts of capital can have a
detrimental effect on the global economy. How
do you decide which is more important??
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Lecture #18
HOW BANKS MAKE MONEY
Serve as the principal conduit for government
monetary policy.
Loans are assets/Deposits are liabilities.
How then do banks make a profit when their chief
assets and liabilities are pieces of paper?
ASSETS:
Loansa promise to repayApprox. 60% ofassets. Loans to whom ???
oBusinesses- 25% of totalRevolving lines of credit
Seasonal (inventory)
Floor plans
oReal Estate-46% of totalCommercial and ResidentalMortgages/Equity lines of credit
oConsumer Credit16% of totaloInternational/Investments remainder.
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Biggest problems:
Default
Fixed rate lending
Mismatch of maturities
Keys to successful asset management:
Lend to good customers
Invest in low risk securities
Diversify
There is a fine line between profitability & safety
LIABILITIES:
Why are deposits liabilities?
Deposits represent about 2/3 of total bank funding.
Generally checking, savings and CDs.
The remainder of funding comes from direct bondissuance, discount window and fed funds
borrowings.
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Liability characteristics:
Shorter term and more liquid than assets
Transitory
Major problems:
Maturity mismatches
I/R risk
BANK EQUITY:
Discussed in the context of regulations. Capital
adequacy a must even if banks dont like it.
Banks frequently have lots of business off their
balance sheets. Swaps, derivative contracts, some
loan commitments, foreign exchange contracts, etc.
Why do they do this?????
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Lecture #19
THE ROLE OF PENSION FUNDS &
MUTUAL FUNDS
Pension plans are essentially savings plans in
which participants can accumulate tax deferred
savings for retirement.
(Largest institutional holders of securitieshold
25% of all equities and 5% of all bonds.in total
hold 20% of all U.S. financial assets)
Two types of corporate plans:
Defined benefitDefined contribution
Private plans are being substituted in many cases:
401-k /403-b IRAKeogh
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Public plans provide for state & local employees as
well as many federal employees.
Times change, employee needs and wants change
and the economy changes. Plans must be flexible
enough to do the same.
Pension challenges:
Workers living longer Individuals entering work force later. Income level may limit ability to save for
retirement.
Underfunding/over promisingLow returnsSocial security
Pension Benefit Guaranty Corporation (PBGC)
insures defined benefit plans.
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MUTUAL FUNDS
These are financial intermediaries which pool funds
for investing.
The pooling of funds provides advantages to
investors which include:
Professional investment managementDiversificationLower cost
Various funds invest based upon stated objectives
such as growth, international, bond, emerging
markets, etc. Began with money market mutual
funds competing with interest bearing accounts at
commercial banks.
Prospectuses
How do you make money in a mutual fund?
How do mutual fund companies make money?
401-k growth spurred the expansion of mutual
funds.
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Value of mutual fund holdings stated in NAV- net
asset value. Value calculated every day when the
market closes.
EXCHANGE TRADED FUNDS (ETFs)
Similar to MF but traded on formal exchange.Priced continuously during the day.
Most often indexed to something.Little or no turnover of stocks so capital gains
are deferred as long as you own the index.
Very low cost.Can buy on margin. Can short. Can buy on dips
during the day.Very focusedspecialized. Can buy currencies,
gold miners, oil exploration, home builders,
Spain, the BRICs, etc.
Some newer funds now offering activemanagement.
Exiting some funds may be a problem becauseof thin trading in the stocks held.
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Lecture #20
PRIVATE EQUITY, HEDGE FUNDS &
VENTURE CAPITAL
Hedge Funds
Pools of money raised from wealthy individuals,
pension funds and endowments. Banks are now
prohibited from investing their own money in
hedge funds. (Dodd-Frank legislation)
Very lightly regulated. Little transparency of
investments. High risk, high reward type
investment strategies. Estimated to be 10,000hedge funds globally today with assets under
management of about $5 trillion.
More often than not they employ high leverage in
their investments.that is use borrowed money
to magnify their potential returns.
Normally follow a stated strategy such as macro,
long/short, arbitrage, distressed debt, etc.
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Unusual fee structurecharge a high
management fee.around 1.5-2% and a
performance fee tied to their profitability..
Normally receiving 25-50% of profits. Very
expensive but if they are successful why do you
care. Some include high water mark meaning
that after a down year they have to get back even
again before they can look at the profit
percentagesThe early theory with hedge fund
managers was that the good ones went out on
their own and were worth the extra fees. But
even Long Term Capital Management which
imploded in 1998 had two Pulitzer Prize winning
economists in their employ..(bet on Russian
debt before default)
There have been some infamous flame-outs
because of bad bets. Generally these involved
investments that were fairly illiquid or were
commodity or currency bets.
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Amaranth Advisors, Marin Capital to name just a
couple failures. John Paulsens bet against the
mortgage markets in 2008 being the big exceptionthat people point to..
Since investors in hedge funds are classified as
accredited investors meaning they have over $1
million in assets why do we care what happens?
Pension money is put at risk. Pension fundtrustees looking for higher returns take higher
risks. Who makes up these losses?
Some bets could have systemic risk. The betsthat Amaranth Advisors made on natural gasfutures in 2006 were done in by a milder than
normal winter and a meek hurricane season.
But they could have affected natural gas
prices across the market.
Good bookThe Hedge Fund Mirage- SimonLack2012 (he estimates 10% of hedge
funds fail each yearcan you avoid picking
the one out of ten that fail ???)
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Why are hedge funds important to financialmarkets in the end ?
Good friend of mine.Steve Mandel has been very
successful as a hedge fund manager.
Has $17 billion under management..has been up an
average of 23% over the last 11 years. Is Chairmanof the Board of Trustees at Dartmouth and is a
Board member for Teach for America.
Was a retail analyst at Goldman and employs a long
only strategyis just a stock pickeris on the Forbes
billionaire list ($1.5 bil)
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PRIVATE EQUITY
Private equity funds are pools of money raised from
wealthy individuals, pension funds, and endowment
funds such as UT. The money raised is usually
invested to buy a controlling interest in existing
firms. Bain Capital which used to be run by Mitt
Romney was an early private equity investor.
Investors expect to profit when the performance of
the firm improves.
In the 1980s these type firms were called leveraged
buyout firms.KKR was very prominent then.
Bought firms with borrowed money then sold offparts of the business and tried to improve the rest.
The exit strategy was to either bring the firm public
again or to sell it to someone else probably in the
same business. Safeway, which owns Randalls and
Tom Thumb in Texas was taken private by KKR in
1986 and brought back public in 2000.
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Lets look at a recent case, that of Hertz, the car
rental firm.
Ford sold Hertz to a consortium of private equity
firms for $14 billion in 2005. Eleven months later
they were taken public with a valuation of $17
billion.Nov. 2006 at $15 per share. In the interim
they had added $12 billion in debt and paid
themselves a $1 billion dividend.
How could you add $3 billion in value in 11 months?
Clear Channel
Washington Mutual
Time is money..Changes in the macroeconomic
environment probably pose the highest risk to
private equity deals. How can you hedge this ???
Orphan funds.when do you finally give up on
the investment??
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VENTURE CAPITAL
Venture capital represents pools of cash raised from
wealthy individuals, university endowments and
pension funds. (UT is a big investor in VC funds)
The money raised is invested in start up
companies such as Google or Facebook in their
infantcy.
Did you see the movie Social Networkthat is
what was going on..
Stages of VC investing:
Infant
Early stageMid stageLate stage
Normal investment cycle is 3-10 yearsvery illiquid.
Investors expect to make 40% on their investment.
High riskhigh reward. Time is money.the longer
it takes to go public the lower the return..
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Take a look at the website for Austin Ventures..
www.austinventures.com
orwww.originpartners.com
http://www.austinventures.com/http://www.austinventures.com/http://www.originpartners.com/http://www.originpartners.com/http://www.originpartners.com/http://www.originpartners.com/http://www.austinventures.com/ -
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Lecture #21
OTHER LENDERS AND INVESTORS
THRIFTS & SAVINGS BANKS:
At one time more prominent than banks.Diminished in importance by poor lending
practices and advent of money market funds.
CREDIT UNIONS:
Originally established as Employer owned.Now non-profits owned by members.Customers have common bond.Tax status is controversial.Lend to members only.
FINANCE COMPANIES:
Many began as captivesSome focus solely on consumersOthers on businessesFactoringFunding thru commercial paper market.
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INSURERS:
Adverse selection and moral hazard big issues.Portfolios structured to the products they sell.Lifewhole life, term, group life, credit life,
accident and health.
Property and CasualtySeverity and frequencyof incidents determine profitability.
NON-BANK INSTITUTIONS ABROAD:
Postal banksMicro lending
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Lecture #22
MANAGING CREDIT AND LIQUIDITY RISK
Have had bouts of bad credit..
1980s-thrifts/real estate
1990s-junk bonds/credit cards
2000-telecoms/tech/sovereign debt
2007-mortgage
2010-sovereign debt
What is the best way of a FI to lessen its risk of
extending bad credit?
Real Estate Lending:
Ability to pay/Collateral
Ability to pay:
How long have you lived somewhere
How long on the job?
Credit history/scoring
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Small business lending looks at the owner and
cash flow of the business.
Mid-market focuses more on the business
itselfcash flow/customer book/cyclicality.
The 5-Cs-
Character/Capacity/Collateral/Conditions/Capital
Haircuts & Ratios
Large Borrowers are tougher sell for FIs.they
have more options but information is better.
RAROC
LIQUIDITY RISK
I WANT MY MONEY NOW !!!!!
Purchase or Stored Liquidity
FED Discount Window
FDIC
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Life Insurance Company liquidity risk
Prop. And Casualty liquidity risk
Mutual Funds liquidity risk
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Lecture #23
MANAGING INTEREST RATE AND
OFF BALANCE SHEET RISK
Measuring the Risk ..
Rate Sensitive Assets(RSA)
Rate Sensitive Liabilities (RSL)
The Repricing Gap
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Lecture #24
LOAN SALES AND SYNDICATION
What are loan sales? Why did they come to be?
Participations / Assignments
What is the market? Who are the Players? What
drives the market?
How are Loan Securitizations different from Loan
Sales?
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