1 Capital Markets To help to finance Companies 1.Annual Working Capital increases = $ 150 Billion 2.Annual Capital Expenditures “CAPEX” = $ 900 Billion = $ 1,050 Billion Source of funds: 1.Annual Earnings = ($ 800 Billion) GAP $ 250 Billion 2.Annual Debt issued ($ 300 Billion) ( $ 50 Billion) 3.Equity- this represents repurchases of Equity

2 Assets & Investing The Assets Fixed Income Bonds Real Estate Equity Shares Units Derivatives Options Futures The Process Asset Allocation Equity/Fixed 60/40 80/20 120/20 ? Security Selection Security Analysis Risk Return Trade-off

3 Projected 10 year cumulative real return stock return 8%; bond return 4.5% inflation 3% 80% stock / 20% bond52% 70% stock / 30% bond47% 60% stock / 40% bond42% 50% stock / 50% bond38% 40% stock / 60% bond33% 30% stock / 70% bond29% 20% stock / 80% bond24% Stock are riskier than Bonds

4 Prices and Coupon Rates Return Risk Risk and expected Return

5 Financial Instruments Money Market  Certificates of Deposit  U.S. Treasury Bills  Money Market Funds Bond Market  U.S Treasury Notes, Bills, and Bonds  U.K. Gilts and Consols  Municipal Bonds  Corporate Bonds Equity Market  Common Stock  Preferred Stock Derivative Market  Options  Futures Other  Swaps  Pass-throughs

6 Intermediation and Innovation Banks  Commercial Banks  Investment Banks Funds  Mutual  Hedge  Pension  Private Equity  Foreign Exchange  Commodity Securitization  GNMA  CMOs, CDOs Bundling (Un)  STRIPS Engineering  Custom-tailored Risk/Return  Synthetics – derivative hedges – mimic something

7 Fixed Securities & Rates Fixed  CDs – bank time-deposits  Paper – unsecured, trade-able company debt  Acceptances – bank promises  Eurodollars - $ denominated foreign bonds  Repos, Reverse Repos – of treasury debt  Treasuries – bills, notes, bonds Rates  Prime  Fed Funds  LIBOR  TED Spread : the 3-month Treasury less LIBOR

8 Originally calculated as the difference between interest rates on 3-month T-bills and 3-month Eurodollar contracts w/ identical expiration. Acronym is derived from the “T” for “Treasuries" and the ticker symbol for Eurodollars, which is “ED”. Today, the TED spread is calculated as the difference between interest rates on 3-month T-bills and 3-month LIBOR (London Interbank Offered Rate). TED Spread

9 Denominated in basis points (bps). Historically 10 to 50 bps – average 30 bps A rising TED spread indicates shrinking liquidity –an indicator of perceived credit risk: T-bills are considered risk-free LIBOR reflects the credit risk of lending banks. Widening TED spread is a sign that lenders believe default risk on interbank (counterparty) loans is increasing. ] ] TED Spread

10 Historically 20 to 30 bps 2007Average150 – 200 bps September 2008> 300 bps; and on October 8 th 465 bps

11 Pick the Federal Reserve Bank Chairmen? Click Glenn Hubbard for the parody a c de b

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13 Problem with the Fed balance sheet? Not it’s size. But the quality of the assets. The largest piece of the pie is pass-thru-securities (pass thrus from sub-prime mortgages) CDO’s. No one knows the real value of this balance sheet. Did the Fed break the law? (Fed reserve act) by taking less than Federal government backed securities?

14 What’s the problem with the Fed balance sheet? Not it’s size. But the quality of the assets. The largest piece of the pie is pass-thru-securities (pass thrus from sub-prime mortgages) CDO’s. No one knows the real value of this balance sheet. Did the Fed break the law? (Fed reserve act) by taking less than Federal government backed securities?

15 Inflation? Deflation? The problem is losing dollar strength. Most people get this wrong. The effects are similar: prices go up, but the cause is subtly different. The weakening dollar due to the extreme moves by the Fed undermine Americans buying power.

16 Characteristics Pricing Yields Sensitivity to Time, i.e. maturity Sensitivity to interest rates Bonds

17 Bond Characteristics Debt Security – related to borrowing Also called a Fixed Income security Covenants or Indenture define the contract (this can be complex) 2 types of Payments: interest & principal Interest payments are the Coupon Principal payment is the Face

18 Bond Basics Fixed Income Securities: Fixed Income Securities: A security such as a bond that pays a specified cash flow over a specific period. Fixed Claim High Priority on cash flows Tax Deductible Fixed Maturity No Management Control Residual Claim Lowest Priority on cash flows Not Tax Deductible Infinite life Management Control BondsCommon StockHybrids (Combinations of debt and equity) Fixed Income Securities vs. Common Stock

19 Bond Basics The bond indenture usually lists:  Amount of Issue, Date of Issue, Maturity  Denomination (Par value) Face  Annual Coupon, Dates of Coupon Payments  Security  Sinking Funds  Call Provisions  Covenants Features that may change over time:  Rating  Yield-to-Maturity  Market price The indenture is a written agreement between the corporate debt issuer and the lender.

20 Economics 175 Types of Bonds (Fixed Income Instruments) Convertibles (into Equity) Callable Bond (buy-back by Issuer) – shorten the term Putable Bond (sell-back by Owner) – extend the term Floating-rate & Inverse Floaters Asset-backed (like CMOs) Zeros – no Coupons Strips – no Face Senior versus Subordinated

21 Treasury Bonds, Bills, & Notes Notes – up to 10 year term Bonds – to 30 years Face (denomination) of $1,000; quotes in $100’s Coupon (rate) paid semi-annually Prices quoted in points (of face) + 1 / 32 No default / credit risk

22 Bond Pricing As with all Financial Assets The price is a Present Value of the expected cash flows discounted at the appropriate (relative to risk) discount (interest) rate.

23 Coupon Payments Relative to other types of securities, bonds produce cash flows that an analyst can predict with a high degree of precision.  Fixed rate  Variable rate  Zero coupons  Consols – consolidated annuities - perpetuities introduced in 1751.

24 Annual percentage yield (APY) The effective, or true, annual rate of return. The APY is the rate actually earned or paid in one year, taking into account the affect of compounding. The APY is calculated by taking 1+r … the periodic rate and raising it to the number of periods in a year. For example, a 1% per month rate has an APY of 12.68% (1.01^12).

25 Bond Pricing DCF Technique P B =Price of the bond C t = interest or coupon payments T = number of periods to maturity r = semi-annual discount rate or the semi-annual yield to maturity

26 Bond Pricing Example (annual coupon paid SA). Solving for Price: 10-yr, 8% Coupon Bond, Face = $1,000 in a 6% risk-adjusted market. C t = 40 (SA), F = 1000, T = 20 periods, r = 3% (SA) P B = $1, t=1 + 20= P B 40 ) ( 1+.03) t ( ) 20

27 Insert Figure 4-6 here. Three Bonds in a 10 percent world …

28 Bond Pricing Zero Coupon Bonds Consols – Zero Face Bonds

29 Bond Yields Yield to Maturity: Yield to Maturity: The discount rate that makes the present value of a bond’s payments equal to its price.  Internal rate of return from holding bond till maturity.  Example 3 year bond with interest payment of $100, principal of $1,000 and current price of $900  Assume coupon proceeds are reinvested at the YTM.

30 Bond Pricing Example (annual coupon paid SA) in a 6 percent world. Solving for Price: 10-yr, 8% Coupon Bond, Face = $1,000 C t = 40 (SA), P = 1000, T = 20 periods, r = 3% (SA) P B = $1, t=1 + 20= P B 40 ) ( 1+.03) t ( ) 20

31 Approximate Yield to Maturity Approximating YTM Using the earlier example Avg. Income = 80 + ( )/10 = Avg. Price = ( )/2 = Approx. YTM = 65.10/ = Actual YTM = 6.00% Bond Yields

32 Prices and Yields (required rates of return) have an inverse relationship  When yields get very high the value of the bond will be very low  When yields approach zero, the value of the bond approaches the sum of the cash flows Bond Yields

33 Prices and Coupon Rates Price Yield Bond Yields

34 Yield Curve A plot of interest rates against time to maturity. maturity yield

35 3 mo6 mo1 yr3 yr5 yr10 yr30 yr 08/02/ /03/ /04/ /05/ /06/ /09/ Daily Treasury Yield Curve Rates

36 Daily Treasury Yield Curve Rates Date3 Mo6 Mo1 Yr3 Yr5 Yr10 Yr30 Yr 07/02/ /03/ /05/ /06/

37 Bond Yields Current or Annual Yield: Current or Annual Yield: Annual coupon divided by bond price.  Different from YTM! Accrued Interest  Interest is earned for each day that a bond is held, although interest payments are generally made twice a year only.  A bond buyer must pay the accrued interest to the seller of the bond. dirty price = bond price + accrued interest clean price = bond price  By convention, accrued interest is calculated using a 360-day year.

38 Bond Pricing: Accrued Interest Example  Consider a bond that is paying a six percent annual coupon rate in semiannual payments with a yield to maturity of 10 percent and two years and ten months until its maturity. What is the quoted price or clean price? What is the dirty price?

39 Bond Pricing: Accrued Interest What is the quoted price or clean price? Step One: Calculate the present value of a bond that has 2.5 years until it matures and pays semiannual interest coupons. Step Two: The $30 coupon is added to $ The sum is $ Step Three: The value $ is discounted back 4 months to the purchase date.

40 Bond Pricing: Accrued Interest What is the dirty price? Calculate the accrued interest for two months. There are 180 days between semiannual coupon payments and 30 days in a month. Therefore 60/180 is the fraction of the coupon payment earned by the seller. In other words the accrued interest is $10 and the dirty price is $

41 Bond Risks Price Risks  Default risk  Interest rate risk Convenience Risks  Call risk  Reinvestment rate risk  Marketability risk

42 Default Risk The income stream from bonds is not riskless unless the investor can be sure the issuer will not default on the obligation. Rating companies  Moody’s Investor Service  Standard & Poor’s  Duff and Phelps  Fitch

43 Default Risk Rating Categories  Investment Grade Bonds  Speculative Grade Bonds S&PMoody’s Very High QualityAAA, AAAaa, Aa High QualityA, BBBA, Baa SpeculativeBB, BBa, B Very PoorCCC, CC, C, DCaa, Ca, C, D

44 Forward Rates term years r at year One-year rate one year from now One-year rate two years from now