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Lecture#1BUSINESSCYCLESThereismoreorlessapatternofexpansion(recovery)andcontraction(recession)ineconomicactivityaroundthepathoftrendgrowth.Atcyclicalpeak-economicactivityishighrelativetotrend.Atcyclicaltrough??Overtimewhatcausesthetrendlinetochange?MoreresourcesFactorsnotfullyemployedallthetime.Whatisinflation?Whyworryaboutinflationinsteadofunempmt.?65 Lecture#2MARKETSWhatarethey??Whatmakesagoodmarket??Canwenamesome“bad”markets??FINANCIALMARKETS&INSTITUTIONSI.FinancialmarketsexisttoaidinthemostefficientallocationofcapitalII.FinancialInstitutionsfacilitatethisallocationofcapital.65 Theplayersinthemarketarehouseholds,businessesandgovernments.Howtheyplayandwhatmotivatesthemtoplayiscriticaltothewellbeingofeconomies.TYPESOFMARKETSPrimary–NewfundraisingSecondary–TradingTherearespecializedmarketsforfundraisingandtrading.Themostimportantoftheseare:MoneyMarkets–Maturities<1yr.CapitalMarkets–Maturities>1yr.65 Lecture#3FLOWOFFUNDSWhoaretheplayers?HouseholdsBusinessesGovernmentsRestoftheWorldAllactatonepointintimeoranotherasborrowersandproviders.FundsarrivedirectlyorindirectlyWhatistheroleofFinancialIntermediaries?TolowertransactioncostsTolowerriskToprovidebettermarketinformation65 Intermediariesalsoincurrisks………I/RriskFXriskCreditordefaultriskWhataboutForeignMkts&Intermediaries?ProvideforborrowingorinvestingabroadImportantsourceofdiversification65 Lecture#4Whatisaninterestrate?Compensationforlendingorgivingupone’sabilitiytospendtoday.Canbeameasuringguidelinegoverningcorportateinvesting.Whydowecareaboutinterestrates?Theyinfluencetheallocationofcapital.Theyimpacttheeconomyanddecisionmaking.Howdowelookatinterestratesandtime?ConceptofPresentValuePresentvalueallowsyoutoplaceavalueonfuturefunds.Whatmight$10todaybeworth10yearsfromnow?65 ThePresentValuecalculationconvertscashflowsreceivedinthefuturetoavalueassumingreceipttoday(thePRESENT).Howmuchis$3000receivedintwoyearsworthtodayiftheinterestrateis4%?Howmuchis$2000nextyearand$3000theyearafterworthtodayiftheinterestrateis5%?65 WheredoyouheartheconceptofPresentValueappliedquiteoften?U.S.SavingsBondsWinningthelotteryBacktoourfirstexample:PVof$3000receivedin2years@4%=Ifthei/ris2%....isPVhigherorlower?Ifthei/ris6%....isPVhigherorlower?Why????65 Lecture#5WHATDETERMINESTHELEVELOFI/RATANYGIVENPOINTINTIME?Thesupplyanddemandofloanablefunds.SameconceptasthesupplyanddemandofgoodsandservicesyoustudiedinEconomics.Sothereisasupplyanddemandcurvehereaswell.SUPPLYHouseholdsBusinessesGovernmentsForeigninvestorsDEMANDHouseholdsBusinessesGovernmentsForeign65 Whatmightthesupplyanddemandcurvelooklike?Whatmightcausethecurvestoshift?SUPPLY:I/RWealthRiskNeartermspendingneedsMonetaryExpansionEconomicConditionsDEMAND:CurrentutilityEconomicconditionsRestrictivenessofnonpriceconditions.65 Lecture#6Whatarethefactorsthatcanaffectthei/rforanindividualsecurity?Beginwiththe“realinterestrate“Directcorrelationbetweeninflation&i/r..U.S.Treasuriesbecomethebenchmark..Whatfactorsinfluencenominali/r?DefaultriskLiquidityriskCovenants-puts/callsTermtoMaturity65 UbiasedExpectationsTheoryLiquidityPremiumTheoryMarketSegmentationTheory65 Lecture#7Whatdoestheyieldcurvetellus?Whatexactlyarebonds?Debtinstruments–Secured/UnsecuredCouponorZeroPV=FaceValue=ParPV>FaceValue=PremiumPV1yearCharacteristicsofmoneymarketinstruments:Large–usually$1mil.+LowdefaultriskMaturityof1yearorlessCorporatesandgovernmentsusuallysellmoneymarketinstrumentstomeetshorttermneeds.65 TREASURYBILLSDefaultriskfreeBenchmarkforothersecuritiespricingRefinancingdebt/govt.deficit/taxtimingSoldatauctionweeklyShortestmaturityis13weeks.SoldatadiscountSupposeyoubuya26weekT-billfor$9500whosefacevalueis$10,000.Whatisthediscountyield?i=10000-9500/10000x360/182=9.89%65 FEDERALFUNDSPrimarilyovernightloansbetweenbanks.Oneoftheusesoftheirexcessreserves.FEDsetsthelendingrate.Forallpracticalpurposesarejustlendingcashbetweentwobanks.REPURCHASEAGREEMENTS(REPOS)Actualsaleofsecuritiesbetweentwopartieswithagreementtorepurchaseatsetdateandprice.Iscollaterizedmostoftenwithgovt.securities.Normally1-14daysbutcango90.MoresecurethanFedFundssohasloweryield…oftenasmuchas25basispoints.65 Lecture#11COMMERCIALPAPER(CP)Anunsecuredpromissorynoteissuedbycorporations.Corporateswithgoodcreditcanoftenborrowcheaperinthecpmkt.thanfromtheirbanks.(seechartonpage135)…comparingcpratestoprimerate.Normallyheldtomaturity….upto270days.LowerratedcorporatescanissuecpbackedbyLOC’sorbanklinesofcredit.Expensivebyeffective….betterthanissuinglongtermifimprovingcredit.Purchasersgetinternalapprovalonacreditandreturnagainagain.CpusuallysoldthrudealerslikeGoldmanSachs…agreetorepurchaseineventofdefault.65 RatesarequotedonadiscountbasisNEGOTIABLECD’sBankissuedpromissorynotes.Specificmaturityandrate.Tradeinsecondarymarketatnegotiatedprice.Normalmaturitiesare14-360days.Unsecuredissuancesoyieldishigher.BANKERSACCEPTANCESAdraftforpaymentbackingaLOCissuedagainstimportedgoods.ImportergetsLOCguaranteeingpaymenttoexporter.BAallowsthemtodrawdownmoneybeforedelivery.Importerthenreimbursesthebank.ThereisasecondarymarketforBA’s.65 MONEYMARKETPARTICIPANTSIssuerInvestorT-billsTreasuryFed/Banks/CorFedFundsBanksBanksReposFed/BanksFed/Banks/CorCpBanks/CorpsCorps/FI’sNeg.CDBanksFI’s/CorpsBA’sBanksBanks/CorpsWherearetheresecondarymarkets?Whereareyieldsthehighest/lowest?WhoaretheimportantFI’s?65 Summary–Moneymarketsareimportantto:TheFed–forcontrollingthemoneysupply.Banks–tomeetreserverequirementandasaplacetouseexcessreserves.Broker-Dealers–KeepthemarketmovingCorporations-sourceofshorttermfundingandasaplacetoinvestshorttermcash.OtherFI’s–Aplacetomaintainliquidity.65 INTERNATIONALMONEYMARKETSForeignersaremajorinvestorsinTreasuriesDiversificationanddefaultfreeKeepdepositsinforeigncountriestofacilitateexhangeinto$.LIBORismajorlendingrate.Nowmajorratemeasurementforalltypesofloans,notjustforeign.BorrowingisusuallyquotedasaspreadoverLIBOR…mightbe350,30or3…dependingontheriskassociatedwiththeborrower.65 Lecture#12THEBONDMARKETBondsarecapitalmarketinstrumentswithmaturitiesofgreaterthanoneyear.Typicallyfixedincome….offeringinterestasettimeperiodsandthereturnofprincipalatmaturity.Abondwithacouponof8%wouldnormallypayinteresteverysixmonths,4%atatime.Treasurynotes>1<10yearsTreasurybonds>10<31yearsTheycompriseabout26%oftotalbondmarketsecurities.Bothpaysemi-annualinterestandaresoldatauction..butaresoldatparunlikeT-bills.TreasuryalsoissuesinflationadjustedbondscalledTIPS.65 TheyalsosellSTRIPSwhereeachcouponpaymentissoldseparately.ThesecondarymarketinTreasuryissuesishuge.Ifabondissoldbetweencouponpaymentsthesellermustpaythebuyertheaccruedinterest..ordiscountthepricetoaccountforit.MUNICIPALBONDSDebtinstrumentsissuedbystateandlocalgovernments.About17%ofallbondso/s.Interestnottaxedbyfedsorstateinvestorlivesinforbondsissuedinthatstate.Taxexemptionlowerscostofbondsissuanceforthegovernmentsbecauseinvestorstakealoweryield.Generalobligation–backedbytaxingpowerRevenuebonds–backedbyrevenueofaproject.Generaltaxreceiptscannotbeusedtopayoffarevenuebond…thusisriskier.65 Industrialdevelopmentbonds–normallyforjobcreation.Howaremunicipalbondssold?Underwritten/bestefforts/negotiatedbasisSecondarymarketverythin.CORPORATEBONDSCompriseabout57%ofo/sbonds.Normallyissuedtofundlongtermobligations.Ratingagencycommentsarecriticaltoprice.Debentures–nocollateralSubordinateddebentures–juniorinstatusConvertiblebonds–debtthatconvertstoequityatsomepointintimeifcertainthingsoccur.CallablebondsSinkingfundsMoody’s/S&P/Fitch65 Whoarebuyersofthevarioustypesofbonds?Whichbondslikelycarrythehighestandlowestyields?INTERNATIONALBONDMARKETSEurobonds–Soldoutsidethecountryofthecurrencyinwhichtheyareissued.CouldbedollardenominatedbondssoldinJapan.Foreignbonds–Bondsissuedoutsidethehomecountrybutdenominatedinthehostcountrycurrency…SamuraibondsaredollardenominatedbondsissuedbyJapaneseborrowersintheU.S.Bradybonds–bondssubstitutedinarestructuringofalessdevelopedcountry’sdebt.Longertermandlowerrates.BackedbytheU.S.TreasurySovereignbonds–specificcountryissued.65 Lecture#13MORTGAGESLoanstopurchaserealpropertysuchasahome,landorbuilding.75%ofmortgagesareforsinglefamilydwellings.Characteristicsofamortgage:Size,term,i/r,collateralQualifications–fairlystandard,incometovalueratio(canyoumakethepayments)Downpayment–reducesdefaultriskConventionalvs.Insured.Maturity–15/30yr…..balloonpaymentI/R–Fixedvs.ARMGreenspanARMquotes.AmortizationscheduleRefinancingdependinguponratecycle.65 OriginatewithFI’smostofwhomdonotcontinuetocarrythemontheirbalancesheet.Soldoffinsecondarymarketthrusecuritization.AllowsFItoenhancetheirliquidityandreducei/randcreditrisk.Whatissecuritizationandhowdoesitwork?Whysecuritize?Mortgagemarketverycyclical.Govt.subsidiesarekeytorolehousingplaysintherobustnessoftheeconomy.Homebuildingmaysufferasratesgoup…65 Lecture#14STOCKMARKETSWhatisstockanyway?Equity/ownershipHowdoesonemakeareturnfromstockownership?Common/PreferredDividendsLimitedliabilityofownershipIPO’s/SeasonedofferingsPrimaryvs.secondarymarkets.65 SEC/Registration/RedHerring/ShelfregistrationTheMarkets:NYSE/NASDAQ/AMEXHowdoestradingoccuroneachmarket?Indices:DOW/S&P500/Wilshire5000WhatcausespricestochangeontheMarket?Efficientmarkettheory/Randomwalk65 Lecture#15FOREIGNEXCHANGEGlobaltraderequiresthatweexchangecurrencies.Theforeignexchangerateistheratioofonecurrencytoanother.Howyenequalonedollar?Initiallyhadfixedcurrencyrates.AndGold!!Eventuallyfloating.NowtheEuro!!Canusespotorforwardmarketstomakeexchangeratemorepredictable.Whatcausesexchangeratedifferentialsbetweencountries?65 Economicflowsbetweencountriesaremeasuredbythebalanceofpayments.CurrentAccount:MerchandisetradebalanceServicesectorUnilateraltransfersCapitalAccount:DirectinvestmentPortfolioinvestment65 Lecture#16DERIVATIVESFinancialinstrumentstailoredtochangewhererisklies.Swaps,caps,floors,etc.areexamplesofthese.Mostdealwiththei/rorcreditmarkets.Spotcontracts-discussedinFXcontext.Isagivenpricetoday….aguarantee.Wheninvestingusingspotcontractsyouareinvestinglookingforappreciation.Forwardsarecontractstobuysomethingatagivenpriceinthefutureatapricedeterminedtoday.Hedgingfuturepricechangebylockingintoday.Example:Airlinesbuyingfuelfortheirfleets.Lockinginamortgageratecouldinvolveaforwardcontract.65 Futurescontractsarelikeforwardbuyaretradedonaformalexchange.Nodefaultriskversustotalwithforwards.Futuresarerevaluedeveryday.Futuresaregenerallyin3areas:i/rcurrencyindexCanholdcontractstomaturityortrade….mostliquidatebeforematurity.Ifholdtomaturityyoutakepossessionoftheunderlyingasset.Soineachofthesemarketsyouarebettingonchange.Optionsareacontractgivingyoutherightbutnottheobligationtobuyorsellsomethingwithinaspecificperiodoftime.Calloptionsgiveyoutherighttobuy(callawayfromtheseller)..asecurityatapredeterminedprice.Thisistheexerciseorstrikeprice.Sellinganoption…youwriteacalloption.65 Putoption…YoucanbuystockoptionsonmanyofthemajorcompaniesintheworldontheNYSEorNASD.Cheapwaytoinvest..Whathappenedtomarketsafter9-11?Whatwouldhavehappenedtoyouroptions?Youcanpurchaseindicesmadeupofthemajorstocks….Dow/S&P500,etc.Youcanusethesetohedge(asaderivative)otherstocksyouown.SWAPS–themostusedderivative…greatfun!!Twopartiesagreetoswapcashflowssometimeinthefuturebaseduponsomeunderlyingasset.Terrifictoolforcompaniestomanagei/rrisk,currencyriskandcreditrisk.Soldbondlastyear-$100mil.10yr–7%coupon.NowIthinkratesaregoingtotrenddown.WhatcanIdoaboutitnow?65 Nothingchangeswiththeunderlyingassets…onlythecashflowstiedtothem.Currencyswaps–eveningoutexposureSwapmarkets–CounterpartyriskCaps(ceilings)–limittheupsideexposure.Floors–protectthebottomCollars–giveupalittletoestablisharangeofrisk.65 .Lecture#17COMMERCIALBANKSServeasprincipalchannelforgovernmentmonetarypolicy.Loansareassets/Depositsareliabilities.Howthendobanksmakeaprofitwhentheirchiefassetsandliabilitiesarejustpiecesofpaper??ASSETS:Loans–Apromisetorepay–Approx.60%ofassets.Loanstowhom?Business–25%oftotalRevolvinglinesofcreditSeasonal(inventory)FloorplansFixed–collateralizedRealEstate–46%oftotalCommercialandresidential65 Mortgages/equitylinesofcreditConsumercredit–16%InternationalInvestmentsBiggestproblems:DefaultFixedratelendingMismatchofmaturitiesKeystosuccessfulassetmanagement:LendtogoodcustomersInvestinlowrisksecuritiesDiversifyTHEREISAFINELINEBETWEENPROFITABILITYANDSAFETY.65 LIABILITIESWhyaredepositsliabilities?Depositsrepresentaout2/3oftotalbankfunding.Generallychecking,savingsandCD’s.Theremainderoffundingcomesfromdirectbondissuance,discountwindowandfedfundsborrowings.Liabilitycharacteristics:ShortertermandmoreliquidthanassetsTransitoryMajorproblems:MaturitymismatchesI/Rrisk65 BANKEQUITYRegulatorsmandateaminimumlevelofequity(capital)toassets..Todaythisnumberisabout9%.Sobanksarereallyhighlylevered.Capitalisprimarilycommonstockandretainedearnings.Italsoincludesreservesforlosses.Servesasacushionagainstadropinassets.Whathappenswhenliabilitiesexceedassets?JapanbankingcrisisWhathappensinarecessiontobankbusiness?Banksfrequentlyhavelotsofbusinessofftheirbalancesheets.Swaps,derivativecontracts,someloancommitments,foreignexchangecontracts,etc.Whywouldtheydothis?65 Commercialbankcompanieshavebeengrowingbecauseofthechangeinthelawallowingbranching.Thishasbroughtonmajormerger/acquisitionactivity.Moreincomecomingfromnon-interest/feebasedbusiness.Commercialbanking–InternationalU.S.banksgoingabroad:LessregulationNewbusinessFollowtheircustomersRisksarehigher–AsarereturnsCreditPoliticalCurrencyBankingaroundtheWorldJapan-China-EuroTheRegulators65 Lecture#18THRIFTSHistoricallysmallinstitutionsservingspecializedneedsoflocalgroups.Savingsassoc.(formerlyS&L’s)…populationhasdeclinedby75%overlast20years.Nowabout1200.Traditionallymadelongtermfixedratemortgagestoindividualsfundedbyshorttermdeposits.Problemsofthe1970’s/RegulationQDisintermediationGarn-St.GermainActof1982/NOW-MMDAOilcollapse/Regulatorsfailed/NewregulatorsAssets:Mortgagesandmortg.Backedsec.73%Comm.Loans–3%Whathappensinaneconomicdownturn?65 Thriftliabilities:Over60%issmalldeposits.Fed.HomeLoanBankborrowings=22%Equity(capital)=8.2%Whathappensinaneconomicdownturn?SAVINGSBANKSEssentiallyS&LorSavingsAssoc.intheNE.Lessthan400exist.BalancesheetssimilartoSavingsAssoc.exceptthataremorehighlycapitalized.CREDITUNIONSEvolvedfromemployerownedinstitutions.Arenownonprofitsownedbytheirdepositors.Customersmusthaveacommonbond.Consumerloansmakeup37%ofassetswithmortgagesat29%.PortfolioismoreliquidandhaslowerdefaultriskthanthatofbanksandSA’s.65 CreditUnionLiabilities:Memberdeposits=89%Primarilysavings,CD’s,andNOWaccts.Equity(capital)isinexcessof9%ShouldbeabletoofferbetterratestocustomersandmakeahigherROAbecauseoftaxstatus.REGULATIONOFTHRIFTS;OfficeofThriftSupervision(partofTreasury)FDICprovidesinsuranceStateassoc.areregulatedbystates.Natl.CreditUnionAdmin.BoardchartersandInsurescreditunions.Willtheseinstitutionsexist10yearsfromnow?65 Lecture#19INSURANCECOMPANIESLifeinsurance–allowsindividualtoprotectthemselvesandtheirbenefactorsagainstthelossofincomefromdeath.Insurespoolrisks–why/Whathappensiftheyarewrong?Typesoflifeinsurance:OrdinarylifeTermlifeWholelifeEndowmentlifeVariablelifeUniversallifeGrouplifeCreditlifeAnnuities65 GIC’sAccidentandHealthWhatdothebalancesheetsofInsurerslooklike?Premiumsareassets–longlivedInvestments?PoliciesareliabilitiesRegulationisatstatelevel.Businessgettingmorecompetitivewithbrokerages,banksentering.Property&Casualty:FireHomeownersCommercialAutoLiabilityPremiumsareassets/claimsareliabilitiesHowdothesecompanieseverlosemoney?65 Lecture#20SECURITIESFIRMS&INVESTMENTBANKINGSecuritiesfirms…..Investmentbanks…..Activities:InvestingInvestmentbankingMarketmakingTradingCashmanagementM&AOthers:Research……thescandals…tyingarrgmts.SEC/Spitzer65 Lecture#21FINANCECOMPANIESLenderstoconsumers,businesses,mortgages.HowaretheydifferentfromBanks?1.SalesFinanceInstitutions2.PersonalCredit3.BusinessCreditAssetmakeup/LiabilitiesSubprime???Howdotheyfundtheirbusiness?Howmuchequitycapitaldotheyemploy?Whydotheyevenexist?65 Lecture#22MUTUALFUNDS&HEDGEFUNDSFinancialinstrumentsthatpoolfunds.Variousfundshavedifferentobjectives:Growth,international,bond,etc.ProspectusesHowdoyoumakemoneyinamutualfund?Howdomutualfundcompaniesmakemoney?401-kgrowthRegulation65 Lecture#23PENSIONFUNDSSavingsplansthroughwhichparticipantsaccumulatetaxdeferredsavingsforretirement.DefinedbenefitplanDefinedcontributionplanPrivateplans:401-kIRAKeoghPublicplansState&localFederal65 Lecture#24REGULATIONOFDEPOSITORYINSTITUTIONSCrucial–ConfidenceinFI’skeyfordomesticandInternationalbusiness.Safety&SoundnessMonetaryPolicyCreditAllocationConsumerProtectionInvestorProtectionEntry&CharteringReg.ofProduct&GeographicExpansionPriortocrashGlass–StegallSection20Glass–StegallrepealGeog.Expansion-Unit/restrictedbranching/interstatebranchingFDICFSLIC65 Whydidproblemsofthe1980’sarise?BalanceSheetRegulations:FocusonleverageCapitaltoassetsratiosbecometriggers:>5%allthewayto<2%OnbalancesheetversusincludingoffbalancesheetWhatishistoryofforeignbanks?SocialSecurityproblems/solutions65 Lecture#25FINANCIALINSTITUTIONRISKSCredit–Badinvestments/BadloansFirmspecificriskSystemicriskLiquidity–Highwithdrawals/“run”InterestRate–MismatchingMarket–TradingOffBalanceSheet-drawdowns/derivativesFX–Sovereign–Technology–OperationalInsolvency65 Lecture#26MANAGINGCREDITRISKHavehadboutsofbadcredit…..1980’s–thrifts/realestate1990’s–junkbonds/creditcards2000–telecom’s/tech/sovereigndebtWhatisthebestwayforaFItolessenitsriskofextendingbadcredit?Realestatelending:AbilitytopayCollateralAbilitytopay:Howlonghaveyoulivedsomewhere/JobCredithistoryOtherobligationsCalculateratios65 Creditscoringalsoused.Comparesyoursituationtootherslikeyou.Ifyoulooklikethosewhohavedefaultedthenassumptionisyouwillalso.Collateral:Perfectsecurityinterest/lienDefaultandtheyforeclose.Non-mortgageconsumerloansjustbasedonabilitytopay.Smallbusinesslendinglooksatcashflowofthebusiness.Mid-marketfocusesmoreonthebusinessitself….cashflow/customerbook/cyclicalityIntheend,howpredictableisthecashflow/Creditanalysisofthesmallerfirmsiscritical.The5C’s….Character/Capacity/Collateral/Conditions/CapitalHaircutsRatios65 Largeborrowers:ToughersellfortheFI.Moreoptions.Informationisbetter.Onceyouhavedecidedtomaketheloanhowdoyoudecidewhattochargeforit?Inotherwords,howdoyoumakemoneyatthisgame?RAROCHowmuchisarelationshipworth?65 Lecture#27MANAGINGLIQUIDITYRISKIWANTMYMONEYNOW!!!Canpurchaseliquidityorusestoredliquidity.RunsandpanicsFDICFedDiscountWindowLifeInsuranceCo.liquidityriskPropertyandCasultyliquidityriskMutualFundsliquidityrisk65 Lecture#28INTERESTRATE&INSOLVENCYRISKMeasuringtheRisk…..RateSensitiveAssetsandLiabilitiesTheRepricingGapTheDurationModelWhatisCapitalandhowisitValued??65 Lecture#29MANAGINGDERIVATIVERISKSReviewContracts:Spot/Forwards/FuturesHedgingwithContractsAccountingRules/BankRegulationsOptions/Swaps65 Lecture#30LOANSALESANDSECURITIZATIONWhatareLoanSales?Whydidtheycometobe?Participations/AssignmentsWhatistheMarket?WhoarethePlayers?WhatdrivestheMarket?HowisLoanSecuritizationdifferentfromLoanSales?65