Financial Markets and Institutions Week 3 Slide

8/11/2019 Financial Markets and Institutions Week 3 Slide

1/47

1

Week Three

Mathematics of Finance Revisited

Short, medium and long-term debt Structure of the money markets.

Interest bearing securities

Discount securities. Securitisation

Viney Chapters 8, 9 and 10


2/47


3/47

3

Introductory concepts

Financial market calculations operate according to aset of market conventions

Example: interest rates are quoted per annum andto 2 decimal places

Example : coupon payments on fixed interestsecurities are usually 6-monthly. Australian

Government bonds always pay interest and matureon the 15thof the month.

Example : British empire countries use 365 days in ayear. USA/Euro countries use 360 days


4/47

4

Students Please Note

If you are not longer familiar with these

concepts review the examples in the text. It is assumed that you can manage these

calculations.


5/47

5

Introductory concepts - continued

Nominal interest rate: the annual simple

percentage rate of return taking no accountof compounding.

Effective interest rate: the annual percentagecumulative rate of return after including

compounding effects You are expected to know how to calculate

these!


6/47

6



7/477


Securities with maturity less than one year

are quoted on a per annum basis adjustedfor the number of days to maturity

Example: a 90-day bill with 9% pa. nominal

rate has a per period rate of:

0.09 x 90/365 = 0.0222 (or 2.22%)


8/478

Discount securities

Definition: a security sold at a price below its facevalue. There are no other cash flows.

The profit to the investor is the difference betweenthe face value (F) and the price (P). It is known asthe discount.

eg: an investor buys a bank bill with face value$100,000 for $98,000. The discount is F-P = $2000.This is also the expected return.


9/479

Holding period yield (HPY)

HPY is the yield on securities sold in the secondarymarket prior to maturity

Short-term money market securities (e.g. T-notes)may be sold prior because Intended short-term management of surplus cash held by

investor

The investors cash flow position has unexpectedly changedand cash is needed

A better rate of return can be earned in an alternativeinvestment


10/4710

Holding period yield (HPY) (cont.)

The yield to maturity is the yield obtained by

holding the security to maturity The HPY is likely to be different from the

yield to maturity


11/47

11

Holding period yield (HPY) (cont.)

The HPY will be

Greater than the yield to maturity when themarket yield declines from the yield at purchasei.e. interest rates have declined and the price ofthe security increases

Less than the yield to maturity when the marketyield increases from the yield at purchase i.e.interest rates have increased and the price of thesecurity decreases


12/47

12

Short-Term Debt cont

Commercial Bills

A bill of exchange is a discount security issuedwith a face value payable at a future date

A commercial bill is a bill of exchange issued toraise funds for general business purposes

A bank-accepted bill is a bill issued by acorporation that incorporates the name of a bankas acceptor


13/47

13


Calculating priceyield known

A company decides to fund it short-term inventoryneeds by issuing a 30-day bank-accepted bill with aface value of $500,000.

Having approached two prospective discounters, thecompany has been quoted yields of 9.52 per centper annum and 9.48 per cent per annum.

Which quote should the company accept, and whatamount will the company raise?


14/47

14

134.23$496

365

30*0948.1

1*000,500

or

118.04$496

365

30*0952.1

1*000,500



15/47

15


Calculations cont In the previous example a company issued a 30-day bank-

accepted bill with a face value of $500,000.

The bill was discounted at a yield of 9.48 per cent per annum,representing a price of $496,134.23.

After seven days the discounter sells the bill in the short-term

money market for $497,057.36. Assume the bill is not traded again in the market, calculate the

yield to the original discounter and to the holder at maturity.


16/47

16

Calculating yield (cont.)

Yield to original discounter:

Yield to holder at maturity:

9.70%7

50036

134.23496

134.23)496057.36(497

9.39%23

50036

057.36497

057.36)497000.00(500



17/47

17

Long-Term Debt

Repayment may be Interest only during term of loan and principal

repayment on maturity Amortized loan (credit foncier loan)

periodic loan installments consisting of interest dueand reduction of principal

Deferred repayment loan loan installments commence after a specified period

related to project cash flows, and the debt is amortizedover the remaining term of the loan


18/47

18

Long-Term Debt cont

Calculations: Fixed Interest Securities

Price of a fixed interest bond at coupon date The price of a fixed interest security is the sum of

the present value of the face value and thepresent value of the coupon stream

niAi

n

iCP )1(])1(1[

(Example also in Viney 8.10)


19/47

19

Long-Term Debt cont

Calculations: Fixed Interest Securities (cont.)

Price of a fixed interest bond at coupon date(cont.) Current corporate bond yields in the market are 8 per cent per

annum.

An existing corporate bond with a face value of $100,000, paying10 per cent per annum with half-yearly coupons, and exactly sixyears to maturity, would be sold at a price of:


20/47

20

Calculations: Fixed Interest

Securities (cont.)

a

b

9385.07$10

925.37$46459.70$62Price

925.37$46

]0.04

120.04)(11$5000[coupons

plus459.70$62

120.04)000(1$100valueface

PV

PV


21/47

21

On The Calculator

Make sure payments are set to 1 per year

N = 6 * 2 = 12 I/Yr = 8/2 = 4

PMT10%x100,000/2 = 5,000

FV = 100,000 PV = 109,385.07

Why is the PV negative?


22/47

22

Relationship Between Price and

Yield

The relationship between price and yield is

inverse Thus as the yield of the security rises, the

price falls

As the yield of the security falls, the price

rises


23/47

23


Yield cont

An example;

Calculate the price of the following security(assume $1,000 face value)

90 day bank bill at a yield of 4.5%

recalculate at a yield of 4.25%

180 day bank bill at a yield of 4.50% Recalculate at a yield of 4.25%


24/47

24


Yield cont

Now calculate the percentage change in

price of both the securities Which has had the bigger change?

Why?


25/47

25

Term/Yield 90 Days 180 Days

4.50% $989.03 $978.29

4.25% $989.63 $979.47

Per Cent Change 0.061% 0.121%

Relationship Between Price

and Yield cont


26/47

26

Relationship Between Price and Yield

on Bonds

Another example;

Calculate the price of the following security(assume $1,000 face value)

Coupon 6.5%. Maturity 5 years. Current yield4.5%

recalculate at a yield of 4.25% Coupon 6.5%. Maturity 10 years. Current yield

4.5%

recalculate at a yield of 4.25%


27/47

27

Relationship Between Price and Yield

on Bonds cont

Calculate the percentage change in price forboth

Which has had the bigger change?


28/47

28

Term/Yield 5 years 10 years

4.50% $1088.66 $1159.64

4.25% $1100.40 $1181.75

Per Cent Change 1.0747% 1.915%


Yield on Bonds cont


29/47

29

Tender vs Tap System

Tender

Issuer announces the amount and terms underwhich they wish to issue new securities

Interested parties have a set time by which theymust state how much and at what price they areprepared to buy the new securities.

Highest bidder application is filled. Allocationcontinues to bidders in order of price until allnew issue is allocated.


30/47

30

Tender System cont

Objective of bidder

To obtain all new securities required withoutpaying too much

To ensure that the price paid is so low that anallocation is not received

Objective of issuer To receive as high a price as possible


31/47

31

Tender System cont.

Advantages

Receive all funds required at a market price Disadvantages

No control over price paid (unless a reserve priceis set or the issue is underwritten)


32/47

32

Tap System

Tap System

Issuer announces the amount, terms and priceatwhich they will issue new securities

Interested parties have a set time by which theymay make application for the securities

All allocations are filled as long as the window isstill open and that there are securities to beissued.


33/47

33

Tap System cont

Advantages

Seller sets the price of the security

Disadvantages

If the set price and terms are not attractive theissuer may not receive all the funds required.


34/47

34

Securitization

Securitized bonds: a packaging of smallincome-generating assets into a large fixedinterest (asset-backed) security

Example: housing loans


35/47

35

Securitization - continued

How securitization works


36/47

36


Enhancement: increases marketability improving onthe risk of a security and increasing its credit rating

Involves various steps, for example Primary Mortgage Insurance

Pool Insurance

Maturity refinance

Cash flow guarantees

But will reduce return due to cost of guarantees

See Viney p 417- 420 for more information


37/47

37


Why securitize?

- better risk management

- diversify funding base

- balance sheet management

- product diversification


38/47

What Role has Securitisation

Played in the Current GFC?

38


39/47

39

In Conclusion

In this lecture we have

Reviewed the pricing of securities

Discussed the important relationship betweenprice and yield

The process by which fixed income securities arefirst issued

The process and rationale for securitization.


40/47

40

Next Week - Week Four

Interest Rate Markets continued

Market participants and reasons for trading Price behaviour

The impact of maturity date

The risk and term structures of interest rates

Trading strategies and rate forecasting

Viney Chapter 13


41/47

Assignment

Gives a practical insight into the mechanicsand operations of the

Foreign exchange

Equity and

Interest rate markets

By trading futures contracts in each market.

41


42/47

Futures Contracts

Foreign exchange as traded on the CME.

Each contract has a face value of AUD100,000

ASX S&P 200 SPI as traded on the ASX

Each contract has a face value of $25 * points

Interest rates (bonds and bank bills) as

traded on the ASX Bank bill face value $1m

Bond face value $100,000

42


43/47

Limits

Closing position not to exceed 50 contractsat any time.

Limit of 1 trade per week.

Limit of 1 zero position

43


44/47

Short Selling

How can I sell something I dont own?

44


45/47

Reporting

Stage 1

Weekly iJournal in MyECU blog.

Team mates to comment on your blog

This should be the start of your final writtenreport.

Stage 2 Weekly in class discussion by sector

One person to write up notes in blog in MyECU

45


46/47

Stage 3

Final report

Part 1Report to the Board of Directors (28/35) Cover letter

Executive summary

Theory

Weekly discussion based on your blogs

Part 2Assessment of your assignment (3.5/35)

Part 3Reflection (3.5/35)

46


47/47

Questions

Financial Markets and Institutions Week 3 Slide

Documents