fin.371 lecture notes 2014

8/12/2019 Fin.371 Lecture Notes 2014

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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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fin.371 lecture notes 2014

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