Fireside Chat #1 Notes
Agent: acting on someone else's behalf
Principal: acting on your own behalf
o Buy low & Sell High
o Deals in markets like:
• Financial, Debt, Stock, Derivatives
• Physical (natural gas, crude oil, etc)
Finance in General
Market Agent: the author is selling research to others to use
o Research & Analysis
Market Principal: consuming/buying research to form investment decisions they're
making
o Hedge Fund
o Mutual Fund
o Anything dealing with buy low, sell high
Corporation Agent
o Management Consultant
Corporation Principal
o Respect to financial *finish sentence*
o Venture Capital
Owns part of company in hopes to sell it
o Private Equity
Buy private companies in hopes to sell
Business Line of Investment Bank & Broker/Dealer Structure
Market Agent: transacting in financial markets on behalf of clients
o Prime Brokerage
Companies you can go to & be able to transact in markets as a retail
investor
o Block Trading
o Institutional Sales
o Research
Corporation Agent
o Investment banking (operations of company, deals w/ financing)
• provide advice to people on how to finance business
Market Principal
o Prop Trading
Corporation Principal
o Merchant Banking: Investment banking firm purchasing entire business & runs it
Ch 1: Why study Financial Markets
Helpful for economy
o
Channel funds from savers (people with capital) to investors (people who need
capital for usages), promoting economic efficiency
• Opportunity costs
•
Time is scarce (exogenous)
•
Cost is higher for the person that's better
•
What else you could do with your money? Question relating this
to Finance
o Market efficiency affects: personal wealth business & welfare
• Is it improving lives or not?
• There has to be benefits
Exogenous: given or assumption or input
-
Endogenous: something happening through a process or outcome
Available capital is a limiting principal
•
There is only so much available to use
•
This endogenously causes interest rates
Debt Markets
Allow governments, corporations, individuals to borrow from savers who want a return
o Investor can be used for both sides, company raises capital & invests, so they can
get revenue
Borrowers issue debt offering interest & principal
Interest rates (Endogenous}
Cost of borrowing or a debt
o Driven by supplier & their need for a return
Figure 1.1 (Interest Rates on Selected Bonds Graph}
Corporate bonds have a higher interest rate & yield compared to U.S government bonds
Time Series: over time how are things moving
Cross-section: at a given time what's the difference between 2 variables
Term Spread: short term vs long term difference
Longer the term, higher the yield
The Stock Market
Sell it to raise capital
Initially sold by companies to raise money, then traded among investors
Ch 2: Overview of Financial System
Why they Exist
Positive Analysis: The world is the way it is and lets understand why it exists
Normative Analysis: management consultant
Financial Markets Funds Transferees
Lender- Savers (Suppliers)
- Borrower-Spenders (Consumers)
o
o
o
o
Households
Businesses
Governments
Foreigners
•-•-------•
Businesses
Government
Households
Foreigners
Structure & Classifications of Financial Markets
1. Asset Type
a. Debt Markets
i. Short term
ii. Long term
iii. Intermediate term (maturity in between)
b. Equity Markets
i. Residual claimant: who gets what's left over; proven to be successful
model
ii. Ownership claim in in the firm
2. Primary {IPO} V Secondary (trading w each other}
a. Primary: new securities
i. Investment banks underwriting offerings
b. Secondary: previously issued; brokers, dealers, broker-dealers
i. Exchanges or Over the Counter
ii. Performance indicators of management
1. Equity IPO or Seasoned IPO
111. Compensation
3. Maturity (how far out until you get paid back)
a. Money market (short term): less than a year
b. Capital market (long term} : more than 1 year plus equities
Development of International Financial Markets
Why?
0
0
0
0
New Technology in Foreign Exchanges
Ex: Electric vehicles
Increase risk of lawsuit in U.S
Possible avoid in foreign country
Sarbanes-Oxley increased cost of being a U.S listed public company
Disclosure, relates to helping decrease in lawsuits
Foreign Competition
Allowing opportunity
Function of Financial Intermediaries: indirect
1ntermediaries
o
o
o
Finds savers & obtains funds, then makes loans/ investments with borrowers
• Why do they exist?
Primary means from intermediation
Needed due to frictions
• Transactions costs
•
•
0
Checks/ Online Bill Pay/ Cards
Paying Convenience Yield
o Earning interest on checking/saving, with ability to pay
instantly
• Risk Aversion/sharing
• Asset Transformation: process of making risky assts into safer
assets for investors or shifting to risk to investors that are more
willing/able to take them
o Offer suppliers of capital liquid accounts
o Liquidity: have access money to the$$, right now
o Maturity:
• Asymmetric Info: one person has more info than the other that's lacking
crucial info, impacting decision making
• Adverse Selection (Hidden Type)
o Problematic & nonoptimal
o Prior to transaction occurring
o Potential borrowers most likely to produce adverse
outcome are most likely to seek loan
• Morale Hazard (Hidden Action)
o After transaction occurs
o Borrower has incentives to engage in undesirable activities
making default more likely
Only if they're insured
o Conflict of Interest/ Principle Agent Problem
Ex: Will drive vehicle safer if you bought the car
compared to if your dad bought it
Help individuals & businesses diversify portfolio
• Buying range of assets
• Pooling them
• Selling rights to the pool to individuals
Types of Financial Intermediaries
Depository Institutions (Banks):accept deposits & make loans, they includes
Commercial Banks: raise funds primarily by issuing checkable, savings, time
0
deposits used to make loans (commercial, consumer, & mortgage)
• Largest financial intermediary with most diversified asset portfolio
Thrifts:
S&L's, mutual savings bank, credit unions
0
Issue deposits as shares & owned collectively
Investment Banks: act as dealers & advise companies on securities to issue, underwrite
security offerings, offer M&A assistance
o
Mostly about issuance
Finance Companies (Shadow Bank): sell commercial paper (short term debt) & issue
bonds & stock to raise funds to lend to consumers to buy durable goods
o Non depository institution
o Non-regulated
Mutual Funds: acquire funds by selling shares to individual investors (many held in
retirement accounts) & use proceeds to purchase large, diversified portfolios
o Multiple people's money piled together
o Regulated
o Money Market Mutual Fund: buy highly liquid short term money market
instrument; look like cash but aren't cash
• Short term treasuries
• Repo
o Money Market Account exist because banks are insured up to 400K, if you have
more & still want liquidity services for very large companies
• Uninsured
Hedge Fund: require large investments {100K or more) with long holding periods,
subject to fewer regulations
o Invest across almost all asset classes
o Strategies
o Cannot access money to obtain it
Insurance & Pensions
Insurance: charge premiums & use cash to invest in securities w/ actuaries who try to
predict pay outs
o If things go wrong, we expect a payout afterwards
Pension & Gov Retirement Funds: hosted by corporations & governments
Collect employee & employer contributions to invest in various securities
0
o Provide retirement income via deferred annuities
• Private Sector: Not as common
• Public Sector: Very prevalent
Economies of Scale & Conflicts of Interest
Provide multiple services may increase efficiency but also lead to Conflict of Interest
o Economies of Scope connected to Morale Hazard & Conflict of Interest and are
introduced to financial institutions
Regulation of Financial Markets
Investor Protection: ensure individual investors & investing institutions are adequately
protected so they're willing to invest
o Info
Prosecution: go after those who are misleading or inaccurate
0
o
-
Can investors lose money?
• Savings Account: No, it's Insured
• Mutual Fund: Yes, it's insured
Stability: Prevent problems in finance by causing problems in other markets (other
Broker
Dealer
Trader
Real Estate Agent
Car Dealers
Makes Bets
Never
actually own any stock
Have inventory
Proprietary Trade (Prop)
- Make money based on
- Trades their own
selling to someone
firm's money
Have inventory
- Make money based on
bets
companies & individuals)
o Ensure the Soundness of Financial Intermediaries (prevent runs & fire sales)
Ch 3: What do Interest Rates Mean & What's their
role in Valuation
PV Intro
o
Different Debt Instruments (Fixed Income/Cash Flows)
• Payments to the holder
• Person who needs capital gets$$$, sell a bond, someone else will hold
•
asset/debt (as holder they receive payments)
Evaluated based on amount & timing of each cash flow
•
Leads to its yield to maturity/interest rate
PV
o
o
Represents a series of cash flows or single cash flow
Based on idea that a dollar in future is less valuable than it is today
• WHY?? Opportunity Cost of Capital
PV Applications: Debt will either be a bond (direct) or loan (indirect)
o
Simple Loan
• Principal: funds the lender provides to borrower
• Maturity Date: date the loan must be repaid
• Loan Term: time from initiation to maturity
• Interest Payment: cash amount borrower must pay lender for the use of
the loan principal (borrow-> lender)
•
o
PV of Future 1$= 1$/(1
+ i)n
Fixed Payment Loan
• Principal & interest repaid in several payments (often monthly, equal
dollar amounts over loan term)
iii>
• Installment loans like auto loans & home mortgages
LV=...!!_+ FP
FP
+...
FP
(l+i)
o
(l+i)"2
(1+i)"3
(l+i)"n
Coupon Bond (lenders are bond investors like insurance companies,
pension/hedge funds); lending to governments
• Models corporate bond & defined by coupon rate
• Written in to figure out the cash payments
o
Discount Bond (lenders are bond investors like insurance companies, pension or
hedge funds); lending to governments
Amortize: at the end of the loan it's paid off; part payment goes to interest, part goes to
principal
Yield to Maturity: interest rate that equates todays value w/ present value of all future
payments
o Bonds: PV= FV/ (l+i)
Distinction between Real & Nominal interest Rates
o Real (What we care about)
• Equals the nominal rate - inflation or CPI
• Reflects the true cost of borrowing
• Ex Ante: Treasury Inflation Protected Securities aka TIPS (adjusted for
expected level of inflation or CPI)
• Ex Post: real rate based on consumer price index (observation of inflation
level)
o Nominal (What we see)
• Equals the real rate + inflation
Why you would have negative rates
o Deflationary environment
o Flight to Safety
• Terrified of losing A LOT of money
o Convenience Yield
• Something about asset people are willing lose in order to hold
Distinction between Interest Rates & Returns
o Rate of Return= CI Pt+ (Pt+1- Pt)/Pt
= Current Yield +Capital Gain Yield
= What you pay + What you got
Maturity & Volatility of Bond Returns
o Prices & returns more volatile for long term bonds because they have higher rate
risk
o No rate risk for any bond whose maturity equals holding period
Reinvestment Risk
o Occurs if investor holds a series of short bonds over long holding period
o i @ which reinvest uncertain
Gain from i increase, lose when i decreases
0
Duration (Cash Flow Weighted Maturity)
o
Often confused with maturity
o Cash flow is happening as bond goes along; an understanding of when you' re
o
o
getting cash flow
• Which years are the most important? PV evaluating the years
Weighting the years by how their contributing to the PV
• If interest rates go up, duration will go down because when rates goes up
later cash flows will be worth less, small (earlier) cash flows contribute
more to PV than larger cash flows
• Higher the coupon rate, shorter the duration of the bond
Matters to bond traders because
• Set of cash flows in a portfolio, gives relationship
• Interest rate risk
• Capital gain percentage
• Bond return
%Change in price= -duration* (change in interest/(1+i)
Ch 4: Why Do interest Rates Change?
Determinants of Asset Demand
-
Asset is property that stores value; when deciding to buy/hold, individuals consider
• Personal Characteristics
• Wealth: all assets owned by individual
•
•
Age
• Risk Tolerance: depends on person
Asset Characteristics (Both relative: how does it compare to other assets
& absolute: what is that asset going to do for me)
• Expected Return: return expected over next period, change in
wealth
• Risk: degree of uncertainty associated w/ the expected return;
how uncertain you are about what returns you expect to happen
• Liquidity: ease & speed with which the asset can be turned into
cash; could dry up, all of sudden you can't turn it into cash
Variable (All else Equal)
Change in Variable
Change in Quantity Demanded
(Ceteris Paribus)
Wealth
Increase
Increase
Expected Return relative to other
Increase
Increase
Risk relative to other assets
Increase
Decrease
Liquidity relative to other assets
Increase
Increase
assets
-
The Demand Curve for a Bond
Return entirely determined by its price & is the bond's yield to maturity
Rates & prices inversely related
Summary of Forces that Increase Bond Supply
Expected Profitability of Investment Opportunity: times are good, there's more supply
of bonds; in recession, lower supply of bonds
Expected Inflation: An increase in expected causes supply of bonds because people who
would supply a bond will be more willing to do it
Government Activities: Spending more than their taking in; higher gov deficits increase
the supply, conversely surpluses decrease the supply of bonds
-
Shifts in Demand Curve
Shifts outward (to the right); meaning demand has increased
o Increase in wealth
o Expected Return
o Expected Interest Rate
• If increases, demand decreases (graph will shift inward, to the left)
o Expected Inflation
o Riskiness of bonds relative to other assets
o Liquidity of bonds relative to other assets
Shift in Supply Curve
Shifts outward, meaning supply has increased
o Profitability of Investment Opportunities
o Expected Inflation
• Very good for borrowers, since payments are fixed in nominal terms
o Government Deficit
**If prices drop, interest rates are going to rise **
/
Ch. 5: How Do Risk & Term Structure Affect Interest Rates?
-
Risk Structure of Interest Rates:
O Affected by: Risk of Default, Liquidity, & Income Tax Consideration
-
Term Structure of Interest Rates:
Default Risk Factor
-
Issuer of bond us unable/unwilling to make interest payments when promised; bonds w
this should always have + risk premium
O Risk Premium: additional interest people must earn in order to be willing to hold
a risky bond
0
Default-free bonds: no default risk
•
Ex: U.S Treasury Bonds because fed gov can increase taxes to pay off their
obligations
Liquidity Risk Factor
can be converted to cash cheaply; asset is more desirable, the more liquid it is
0
Corp Bonds: Price decrease, interest increases, Demand shifts left
0 Treasury Bond Market: relatively more liquid, demand increases, prices increase,
interest decreases
Corporate Bonds: Junk Bonds
0
Debt rated below BBB
0
Often, trusts & insurance companies aren't permitted to invest in junk debt
0 Are they bad investments?
•
Is the risk premium high enough to compensate you for the risk your
taking?
Indenture: Contract specifying the bond terms
Restrictive Covenants: mitigates conflicts w/ shareholder interests; rules lender puts on
borrower
0
Ex: may restrict new debt you can issue, pay dividends
Call Provision (prepayment option): as a borrower, they can call the bond; they have the ability
to pay earlier
0 Higher yield required
O Reinvestment Risk
Convertible Bonds: some debt can be converted from debt to equity
0 WHY?
O Option for investor (either have no value or positive value)
~h 7: Why do Financial Institutions Exist?
Asymmetric Info
takes on multiple forms & Is complicated
o Adverse Selection:
\
• One party In transaction has better Info than the (Iother party
• Before transaction occurs
• Potential borrower more likely to produce adverse outcome a,re more
likely to seek loan & be selected
·
o Moral Hazard: Conflict of Interest
• Hidden action or Temptation to exploit
• After the fact/after the transaction has o·ccurred .;,.
• Whether or not borrower will follow through, they'IJ act in .ttiei~ own oest
interest
.
··· ·
• As the principal you don't know how to tell ~hethe·r you're getting a
good deal or not
.: · ... '.
· · .
• If incentives are aligned, there's no problem/w~ aon't care
·.~
Solving Adverse Selection
. . 11. ··
Solving Moral Hazard
.
How Moral Hazard affects choice between debt & Equity contracts , ..: . ,
The Principal-Agent Problem: result of separation of ownership by .
stockholders(principals) from control by managers (agents) '.~j'\~
o mangers will act in own rather than stockholders' interest ·
Ways to help solve problem
o Monitoring
.
• Clocking In/Out, seeing when they're actually there
o Government Regulation to lnctease Information
o Financial Intermediation (Venture Capital)
· o Debt(loans) instead of Equity
• You get your portion, but you're guaranteed your portion
• Aligns incentives
Moral Hazard in Debt Markets
,
- Too much debt may create Incentive to take on very risky projects or pass on good
projects
. ·
'il:< ..
. . ····\
Debt overhang: problems that are created by lots of already Issued debt (a lot of debt & :· ·
its above your head)
·
·
"· ,"
o Won't Undertake a + NPV Project
• Possibility of losing $$$
o Cut Corners to make Interest payments .
• Debt Is collaterallzed with your physical assets
• Struggling to stay afloat
o Special Dividend?
Asset Substitutions (Go for broke/underwater)
Conflicts of Interest
a
...