Master of Business Administration Money and Capital Markets Module MBAZ510 Author: Kennell Madzirerusa Master of Science Finance and Investment (NUST) Bachelor of Commerce (Honours) in Banking (NUST) Institute of Bankers (Diploma) Content Reviewer: Roy Robson Jubenkanda MSc Strategic Management (Derby, UK) MSc in International Economics, Banking and Finance (Cardiff, UK) BSc (Hons.) Economics (UZ) Diploma in Business Adminstration (Solusi University) Certificate in Distance Education (UNISA) Certificate in Higher Education Management (Witts. University, SA) Editor: Kudzanayi Ruvharo MSc in Statistics (UZ) BSc Special Honours in Statistics (UZ) BSc Mathematics and Statistics (Gweru Teachers’ College) Published by: The Zimbabwe Open University P.O. Box MP1119 Mount Pleasant Harare, ZIMBABWE The Zimbabwe Open University is a distance teaching and open learning institution. Year: 2012 Cover design: T. Ndhlovu Layout : S. Mushore Printed by: ZOU Press ISBN: 978-1-77938-639-7 Typeset in Times New Roman, 12 point on auto leading © Zimbabwe Open University. All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without the prior permission of the Zimbabwe Open University. To the student The demand for skills and knowledge and the requirement to adjust and change with changing technology, places on us a need to learn continually throughout life. As all people need an education of one form or another, it has been found that conventional education institutions cannot cope with the demand for education of this magnitude. It has, however, been discovered that distance education and open learning, now also exploiting e-learning technology, itself an offshoot of ecommerce, has become the most effective way of transmitting these appropriate skills and knowledge required for national and international development. Since attainment of independence in 1980, the Zimbabwe Government has spearheaded the development of distance education and open learning at tertiary level, resulting in the establishment of the Zimbabwe Open University (ZOU) on 1 March, 1999. ZOU is the first, leading, and currently the only university in Zimbabwe entirely dedicated to teaching by distance education and open learning. We are determined to maintain our leading position by both satisfying our clients and maintaining high academic standards. To achieve the leading position, we have adopted the course team approach to producing the varied learning materials that will holistically shape you, the learner to be an all-round performer in the field of your own choice. Our course teams comprise academics, technologists and administrators of varied backgrounds, training, skills, experiences and personal interests. The combination of all these qualities inevitably facilitates the production of learning materials that teach successfully any student, anywhere and far removed from the tutor in space and time. We emphasize that our learning materials should enable you to solve both work-related problems and other life challenges. To avoid stereotyping and professional narrowness, our teams of learning materials producers come from different universities in and outside Zimbabwe, and from Commerce and Industry. This openness enables ZOU to produce materials that have a long shelf life and are sufficiently comprehensive to cater for the needs of all of you, our learners in different walks of life. You, the learner, have a large number of optional courses to choose from so that the knowledge and skills developed suit the career path that you choose. Thus, we strive to tailor-make the learning materials so that they can suit your personal and professional needs. In developing the ZOU learning materials, we are guided by the desire to provide you, the learner, with all the knowledge and skill that will make you a better performer all round, be this at certificate, diploma, undergraduate or postgraduate level. We aim for products that will settle comfortably in the global village and competing successfully with anyone. Our target is, therefore, to satisfy your quest for knowledge and skills through distance education and open learning Any course or programme launched by ZOU is conceived from the cross-pollination of ideas from consumers of the product, chief among whom are you, the students and your employers. We consult you and listen to your critical analysis of the concepts and how they are presented. We also consult other academics from universities the world over and other international bodies whose reputation in distance education and open learning is of a very high calibre. We carry out pilot studies of the course outlines, the content and the programme component. We are only too glad to subject our learning materials to academic and professional criticism with the hope of improving them all the time. We are determined to continue improving by changing the learning materials to suit the idiosyncratic needs of our learners, their employers, research, economic circumstances, technological development, changing times and geographic location, in order to maintain our leading position. We aim at giving you an education that will work for you at any time anywhere and in varying circumstances and that your performance should be second to none. As a progressive university that is forward looking and determined to be a successful part of the twenty-first century, ZOU has started to introduce e-learning materials that will enable you, our students, to access any source of information, anywhere in the world through internet and to communicate, converse, discuss and collaborate synchronously and asynchronously, with peers and tutors whom you may never meet in life. It is our intention to bring the computer, email, internet chatrooms, whiteboards and other modern methods of delivering learning to all the doorsteps of our learners, wherever they may be. For all these developments and for the latest information on what is taking place at ZOU, visit the ZOU website at www.zou.ac.zw Having worked as best we can to prepare your learning path, hopefully like John the Baptist prepared for the coming of Jesus Christ, it is my hope as your Vice Chancellor that all of you, will experience unimpeded success in your educational endeavours. We, on our part, shall continually strive to improve the learning materials through evaluation, transformation of delivery methodologies, adjustments and sometimes complete overhauls of both the materials and organizational structures and culture that are central to providing you with the high quality education that you deserve. Note that your needs, the learner ‘s needs, occupy a central position within ZOU’s core activities. Best wishes and success in your studies. _____________________ Prof. Primrose Kurasha Vice Chancellor The Six Hour Tutorial Session At The Zimbabwe Open University A s you embark on your studies with the Zimbabwe Open University (ZOU) by open and distance learning, we need to advise you so that you can make the best use of the learning materials, your time and the tutors who are based at your regional office. The most important point that you need to note is that in distance education and open learning, there are no lectures like those found in conventional universities. Instead, you have learning packages that may comprise written modules, tapes, CDs, DVDs and other referral materials for extra reading. All these including radio, television, telephone, fax and email can be used to deliver learning to you. As such, at the ZOU, we do not expect the tutor to lecture you when you meet him/her. We believe that that task is accomplished by the learning package that you receive at registration. What then is the purpose of the six hour tutorial for each course on offer? At the ZOU, as at any other distance and open learning university, you the student are at the centre of learning. After you receive the learning package, you study the tutorial letter and other guiding documents before using the learning materials. During the study, it is obvious that you will come across concepts/ideas that may not be that easy to understand or that are not so clearly explained. You may also come across issues that you do not agree with, that actually conflict with the practice that you are familiar with. In your discussion groups, your friends can bring ideas that are totally different from yours and arguments may begin. You may also find that an idea is not clearly explained and you remain with more questions than answers. You need someone to help you in such matters. This is where the six hour tutorial comes in. For it to work, you need to know that: · There is insufficient time for the tutor to lecture you · Any ideas that you discuss in the tutorial, originate from your experience as you work on the materials. All the issues raised above are a good source of topics (as they pertain to your learning) for discussion during the tutorial · The answers come from you while the tutor’s task is to confirm, spur further discussion, clarify, explain, give additional information, guide the discussion and help you put together full answers for each question that you bring · You must prepare for the tutorial by bringing all the questions and answers that you have found out on the topics to the discussion · For the tutor to help you effectively, give him/her the topics beforehand so that in cases where information has to be gathered, there is sufficient time to do so. If the questions can get to the tutor at least two weeks before the tutorial, that will create enough time for thorough preparation. In the tutorial, you are expected and required to take part all the time through contributing in every way possible. You can give your views, even if they are wrong, (many students may hold the same wrong views and the discussion will help correct The Six Hour Tutorial Session At The Zimbabwe Open University the errors), they still help you learn the correct thing as much as the correct ideas. You also need to be open-minded, frank, inquisitive and should leave no stone unturned as you analyze ideas and seek clarification on any issues. It has been found that those who take part in tutorials actively, do better in assignments and examinations because their ideas are streamlined. Taking part properly means that you prepare for the tutorial beforehand by putting together relevant questions and their possible answers and those areas that cause you confusion. Only in cases where the information being discussed is not found in the learning package can the tutor provide extra learning materials, but this should not be the dominant feature of the six hour tutorial. As stated, it should be rare because the information needed for the course is found in the learning package together with the sources to which you are referred. Fully-fledged lectures can, therefore, be misleading as the tutor may dwell on matters irrelevant to the ZOU course. Distance education, by its nature, keeps the tutor and student separate. By introducing the six hour tutorial, ZOU hopes to help you come in touch with the physical being, who marks your assignments, assesses them, guides you on preparing for writing examinations and assignments and who runs your general academic affairs. This helps you to settle down in your course having been advised on how to go about your learning. Personal human contact is, therefore, upheld by the ZOU. The six hour tutorials should be so structured that the tasks for each session are very clear. Work for each session, as much as possible, follows the structure given below. Session I (Two Hours) Session I should be held at the beginning of the semester. The main aim of this session is to guide you, the student, on how you are going to approach the course. During the session, you will be given the overview of the course, how to tackle the assignments, how to organize the logistics of the course and formation of study groups that you will belong to. It is also during this session that you will be advised on how to use your learning materials effectively. The Six Hour Tutorial Session At The Zimbabwe Open University Session II (Two Hours) This session comes in the middle of the semester to respond to the challenges, queries, experiences, uncertainties, and ideas that you are facing as you go through the course. In this session, difficult areas in the module are explained through the combined effort of the students and the tutor. It should also give direction and feedback where you have not done well in the first assignment as well as reinforce those areas where performance in the first assignment is good. Session III (Two Hours) The final session, Session III, comes towards the end of the semester. In this session, you polish up any areas that you still need clarification on. Your tutor gives you feedback on the assignments so that you can use the experience for preparation for the end of semester examination. Note that in all the three sessions, you identify the areas that your tutor should give help. You also take a very important part in finding answers to the problems posed. You are the most important part of the solutions to your learning challenges. Conclusion In conclusion, we should be very clear that six hours is too little for lectures and it is not necessary, in view of the provision of fully selfcontained learning materials in the package, to turn the little time into lectures. We, therefore, urge you not only to attend the six hour tutorials for this course, but also to prepare yourself to contribute in the best way possible so that you can maximally benefit from it. We also urge you to avoid forcing the tutor to lecture you. BEST WISHES IN YOUR STUDIES. ZOU Contents Course Overview __________________________________________________________ 1 Unit One: Functions and Roles of the Financial System in the Global Economy 1.0 _______ Introduction ___________________________________________________ 3 1.1 _______ Objectives _____________________________________________________ 4 1.2 _______ The Financial System ___________________________________________ 4 _________ 1.2.1 Functions of the financial system ____________________________ 4 1.3 _______ Flows within the Global Economic System _________________________ 4 _________ Activity 1.1 _____________________________________________________ 5 1.4 _______ The Role of Markets in the Global Economic System ______________ 6 1.5 _______ Types of Market _______________________________________________ 6 1.6 _______ Financial Assets ________________________________________________ 7 _________ 1.6.1 Characteristics of financial assets ___________________________ 7 _________ 1.6.2 Different kinds of financial assets ___________________________ 8 _________ 1.6.3 How financial assets are created ____________________________ 8 1.7 _______ Financial Assets and the Financial System _________________________ 8 _________ Activity 1.2 _____________________________________________________ 9 1.8 _______ The Evolution of Financial Transactions __________________________ 9 1.9 _______ Disintermediation of Funds ____________________________________ 12 _________ Activity 1.3 ____________________________________________________ 13 1.10 ______ Financial Markets and the Financial System ______________________ 14 _________ Activity 1.4 ____________________________________________________ 14 1.11 ______ The Global Financial System ___________________________________ 14 1.12 ______ Functions of the Global Financial System ________________________ 15 _________ Activity 1.5 ____________________________________________________ 15 1.13 ______ Factors Tying all Financial Markets Together _____________________ 16 1.14 ______ The Dynamic Financial System __________________________________ 16 1.15 ______ Bank-dominated versus Security-dominated Financial Systems _____ 17 _________ Activity 1.6 ____________________________________________________ 17 1.16 ______ Summary _____________________________________________________ 17 _________ R ef erences ___________________________________________________ 18 Unit Two: The Roles of Financial Markets and Financial Institutions 2.0 _______ Introduction __________________________________________________ 19 2.1 _______ Objectives ____________________________________________________ 20 2.2 _______ What is a Financial Market? ____________________________________ 20 2.3 _______ The Role of Financial Markets and Institutions ___________________ 20 2.4 _______ Types of Financial Markets ____________________________________ 21 _________ 2.4.1 Money versus capital markets ______________________________ 21 _________ 2.4.2 Primary versus secondary markets __________________________ 21 _________ Activity 2.1 ____________________________________________________ 22 2.5 _______ How Financial Markets Facilitate Corporate Finance ______________ 22 2.6 _______ How Financial Markets Facilitate Investment _____________________ 23 _________ Activity 2.2 ____________________________________________________ 23 2.7 _______ Securities Traded in Financial Markets __________________________ 23 _________ 2.7.1 Money market securities __________________________________ 24 _________ 2.7.2 Capital market securities __________________________________ 24 _________ 2.7.3 Derivative securities ______________________________________ 24 2.8 _______ Valuation of Securities in Financial Markets _____________________ 24 2.9 _______ Market Efficiency _____________________________________________ 25 _________ Activity 2.3 ____________________________________________________ 25 2.10 ______ Global Financial Markets _______________________________________ 25 2.11 ______ International Corporate Governance Relating to Financial Markets _ 26 2.12 ______ Global Integration _____________________________________________ 26 2.13 ______ Role of the Foreign Exchange Market ____________________________ 26 _________ Activity 2.4 ____________________________________________________ 27 2.14 ______ Role of Financial Institutions ___________________________________ 27 2.15 ______ Role of Depository Institutions _________________________________ 28 2.16 ______ Role of Non-depository Financial Institutions ____________________ 28 _________ 2.16.1 Finance companies ______________________________________ 28 _________ 2.16.2 Mutual funds ___________________________________________ 28 _________ 2.16.3 Securities firms _________________________________________ 29 _________ 2.16.4 Insurance companies ____________________________________ 29 _________ 2.16.5 Pension funds __________________________________________ 29 2.17 ______ Comparison of Roles among Financial Institutions ________________ 30 _________ Activity 2.5 ____________________________________________________ 32 2.18 ______ Summary ____________________________________________________ 32 _________ R ef erences ___________________________________________________ 33 Unit Three: Money Markets 3.0 _______ Introduction __________________________________________________ 35 3.1 _______ Objectives ____________________________________________________ 36 3.2 _______ Money Markets _______________________________________________ 36 _________ 3.2.1 Why do we need money markets? __________________________ 36 _________ Activity 3.1 ____________________________________________________ 37 _________ 3.2.2 Functions of money markets _______________________________ 37 3.3 _______ Money Market Securities _______________________________________ 38 _________ Activity 3.2 ____________________________________________________ 39 3.4 _______ Securities Quoted on a Yield Basis ______________________________ 39 _________ 3.4.1 Money market deposits ___________________________________ 39 _________ 3.4.2 Certificates of deposit ____________________________________ 40 3.5 _______ Securities Quoted on a Discount Basis __________________________ 40 _________ Activity 3.3 ____________________________________________________ 40 _________ 3.5.1 Treasury bills (T-bills) ____________________________________ 41 _________ Activity 3.4 ____________________________________________________ 46 _________ 3.5.2 Commercial paper ________________________________________ 46 _________ Activity 3.5 ____________________________________________________ 49 _________ 3.5.3 Negotiable certificates of deposit (NCDs) ___________________ 49 _________ 3.5.4 Repurchase agreements (repo) _____________________________ 50 _________ 3.5.5 Bankers’ Acceptances (BA) ________________________________ 51 _________ Activity 3.6 ____________________________________________________ 53 3.6 _______ Summary _____________________________________________________ 53 _________ R ef erences ___________________________________________________ 54 Unit Four: Bond Markets 4.0 _______ Introduction __________________________________________________ 55 4.1 _______ Objectives ____________________________________________________ 56 4.2 _______ Purpose of Capital Markets ____________________________________ 56 4.3 _______ Capital Market Participants ____________________________________ 56 _________ Activity 4.1 ____________________________________________________ 57 4.4 _______ Background on Bonds _________________________________________ 57 _________ 4.4.1 Why issue bonds? ________________________________________ 57 _________ Activity 4.2 ____________________________________________________ 59 _________ 4.4.2 Issuers of bonds _________________________________________ 59 4.5 _______ Main Features of Bonds _______________________________________ 60 _________ 4.5.1 Indenture and covenants __________________________________ 60 _________ 4.5.2 Maturity _________________________________________________ 60 _________ 4.5.3 Par value ________________________________________________ 61 _________ 4.5.4 Current yield ____________________________________________ 61 _________ 4.5.5 Yield to maturity _________________________________________ 61 _________ 4.5.6 Duration ________________________________________________ 62 _________ 4.5.7 Coupon rate _____________________________________________ 62 _________ Activity 4.3 ____________________________________________________ 64 4.6 _______ Provisions for Paying off Bonds ________________________________ 65 _________ 4.6.1 Call and refunding provision ______________________________ 65 _________ 4.6.2 Prepayments _____________________________________________ 66 _________ 4.6.3 Sinking fund provision ____________________________________ 66 _________ 4.6.4 Conversion privilege ______________________________________ 66 _________ 4.6.5 Put provision ____________________________________________ 66 4.7 _______ Types of Bonds ______________________________________________ 67 _________ 4.7.1 Secured bonds ___________________________________________ 67 _________ 4.7.2 Unsecured bonds _________________________________________ 67 _________ 4.7.3 Junk bonds ______________________________________________ 67 _________ 4.7.4 Callable bonds ___________________________________________ 68 _________ 4.7.5 Non-refundable bonds ____________________________________ 68 _________ 4.7.6 Putable bonds ___________________________________________ 68 _________ 4.7.7 Perpetual debentures _____________________________________ 68 _________ 4.7.8 Zero-coupon bonds _______________________________________ 69 _________ 4.7.9 Convertible bonds ________________________________________ 69 _________ 4.7.10 Adjustable bonds ________________________________________ 69 _________ 4.7.11 Structured securities _____________________________________ 69 4.8 _______ Corporate Bond Risks _________________________________________ 70 4.9 _______ International Bond Markets ____________________________________ 71 4.10 ______ Importance of International Bond Markets ______________________ 71 _________ Activity 4.4 ____________________________________________________ 72 4.11 ______ Summary _____________________________________________________ 72 _________ R ef erences ___________________________________________________ 74 Unit Five: Bond Valuation 5.0 _______ Introduction __________________________________________________ 75 5.1 _______ Objectives ____________________________________________________ 76 5.2 _______ Bond Valuation Process _______________________________________ 76 _________ 5.2.1 Impact of the discount rate on bond valuation _______________ 77 _________ Activity 5.1 ____________________________________________________ 78 _________ 5.2.2 Impact of the timing of payments on bond valuation __________ 78 _________ 5.2.3 Valuation of bonds with semiannual payments _______________ 78 _________ 5.2.4 Relationships between coupon rates, required return ___________ _________ and bond price ________________________________________________ 79 _________ Activity 5.2 ____________________________________________________ 81 5.3 _______ Explaining Bond Price Movements ______________________________ 81 _________ 5.3.1 Factors that affect the risk-free rate _________________________ 82 _________ 5.3.2 Factors that affect the credit risk premium ___________________ 83 _________ Activity 5.3 ____________________________________________________ 84 _________ 5.3.3 Sensitivity of bond prices to interest rate movements _________ 84 _________ Activity 5.4 ____________________________________________________ 88 _________ Activity 5.5 ____________________________________________________ 92 5.4 _______ Summary _____________________________________________________ 93 _________ R ef erences ___________________________________________________ 94 Unit Six: Risks Associated with Investing in Bonds 6.0 _______ Introduction __________________________________________________ 95 6.1 _______ Objectives ____________________________________________________ 96 6.2 _______ Interest Rate Risk _____________________________________________ 96 _________ 6.2.1 Reason for the inverse relationship between changes in interest _ _________ rates and bond price __________________________________________ 97 _________ Activity 6.1 ____________________________________________________ 97 _________ 6.2.2 Bond features that affect interest rate risk ___________________ 98 _________ Activity 6.2 ___________________________________________________ 100 6.3 _______ Yield Curve Risk _____________________________________________ 100 6.4 _______ Call and Prepayment Risk _____________________________________ 100 6.5 _______ Reinvestment Risk ____________________________________________ 101 6.6 _______ Credit Risk __________________________________________________ 102 _________ 6.6.1 Default risk _____________________________________________ 102 _________ 6.6.2 Credit spread risk _______________________________________ 102 _________ 6.6.3 Downgrade risk _________________________________________ 103 _________ Activity 6.3 ___________________________________________________ 104 6.7 _______ Liquidity Risk ________________________________________________ 104 6.8 _______ Currency Risk (Exchange Rate Risk) ____________________________ 105 6.9 _______ Inflation or Purchasing Power Risk ____________________________ 105 6.10 ______ Volatility Risk ________________________________________________ 105 6.11 ______ Event Risk ___________________________________________________ 106 6.12 ______ Sovereign Risk _______________________________________________ 107 _________ Activity 6.4 ___________________________________________________ 107 6.13 ______ Summary ____________________________________________________ 108 _________ R ef erences __________________________________________________ 109 Unit Seven: Equity Markets 7.0 _______ Introduction _________________________________________________ 111 7.1 _______ Objectives ___________________________________________________ 112 7.2 _______ Private Equity ________________________________________________ 112 _________ 7.2.1 Motivations for private equity _____________________________ 112 _________ 7.2.2 Venture capital funds ____________________________________ 112 7.3 _______ Public Equity ________________________________________________ 113 7.4 _______ Equity Markets _______________________________________________ 113 7.5 _______ Participation in Stock Markets _________________________________ 114 _________ 7.5.1 How investor decision affect stock prices ___________________ 114 _________ 7.5.2 Investor reliance on information __________________________ 114 _________ Activity 7.1 ___________________________________________________ 114 7.6 _______ Initial Public Offerings (IPO) _________________________________ 115 _________ 7.6.1 Process of going public __________________________________ 115 _________ 7.6.2 Abuses in the IPO market ________________________________ 115 7.7 _______ Secondary Stock Offerings ____________________________________ 116 7.8 _______ Stock Repurchases ___________________________________________ 117 _________ Activity 7.2 ___________________________________________________ 117 7.9 _______ Stock Exchanges ______________________________________________ 118 _________ 7.9.1 Organised exchanges ____________________________________ 118 _________ 7.9.2 Over-the-counter market (OTC) ___________________________ 118 _________ 7.9.3 Organised versus over-the-counter trading _________________ 118 7.10 ______ Globalisation of Stock Markets ________________________________ 119 7.11 ______ Emerging Stock Markets _______________________________________ 119 _________ Activity 7.3 ___________________________________________________ 120 7.12 ______ Summary ____________________________________________________ 120 _________ R ef erences __________________________________________________ 121 Unit Eight: Stock Valuation and Risk 8.0 _______ Introduction _________________________________________________ 123 8.1 _______ Objectives ___________________________________________________ 124 8.2 _______ Stock Valuation Methods ______________________________________ 124 _________ 8.2.1 Price-earnings method ___________________________________ 124 _________ 8.2.2 Dividend Discount Method _______________________________ 125 _________ Activity 8.1 ___________________________________________________ 127 _________ 8.2.3 Adjusting the dividend discount method ____________________ 127 _________ 8.2.4 Free cash flow method ___________________________________ 129 8.3 _______ Required Rate of Return on Stocks _____________________________ 129 _________ 8.3.1 Capital Asset Pricing Model (CAPM) ______________________ 129 _________ 8.3.2 Arbitrage Pricing Theory (APT) ___________________________ 130 _________ Activity 8.2 ___________________________________________________ 131 8.4 _______ Factors that Affect Stock Prices ________________________________ 131 _________ 8.4.1 Economic factors ________________________________________ 131 _________ 8.4.2 Market-related factors ___________________________________ 132 _________ 8.4.3 Firm-specific factors _____________________________________ 132 _________ Activity 8.3 ___________________________________________________ 134 8.5 _______ Stock Market Efficiency _______________________________________ 134 _________ 8.5.1 Weak-form efficiency ____________________________________ 134 _________ 8.5.2 Semi-strong form efficiency _______________________________ 134 _________ 8.5.3 Strong-form efficiency ___________________________________ 135 _________ Activity 8.4 ___________________________________________________ 135 8.6 _______ Summary ____________________________________________________ 135 _________ R ef erences __________________________________________________ 136 Unit Nine: Mortgage Markets 9.0 _______ Introduction _________________________________________________ 137 9.1 _______ Objectives ___________________________________________________ 138 9.2 _______ Background on Mortgages _____________________________________ 138 9.3 _______ How Mortgage Markets Facilitate the Flow of Funds _____________ 138 _________ Activity 9.1 ___________________________________________________ 139 9.4 _______ Criteria used to Measure Creditworthiness ______________________ 139 _________ 9.4.1 Level of equity invested by the borrower ___________________ 139 _________ 9.4.2 Borrower’s income level _________________________________ 139 _________ 9.4.3 Borrower’s credit history _________________________________ 139 9.5 _______ Classifications of Mortgages __________________________________ 140 _________ 9.5.1 Prime versus subprime mortgages _________________________ 140 ___________ 9.5.2 Insured versus conventional mortgages ___________________________ 1 4 0 ___________ Activity 9.2 ________________________________________________________ 1 4 0 9.6 _______ Types of Residential Mortgage _________________________________ 140 _________ 9.6.1 Fixed-rate mortgages _____________________________________ 141 _________ 9.6.2 Adjustable-rate mortgages ________________________________ 141 _________ Activity 9.3 ___________________________________________________ 141 _________ 9.6.3 Graduated-payment mortgages ____________________________ 142 _________ 9.6.4 Growing-equity mortgages ________________________________ 142 _________ 9.6.5 Second mortgages _______________________________________ 142 _________ 9.6.6 Shared-appreciation mortgages ____________________________ 142 _________ 9.6.7 Equity participation mortgages ____________________________ 143 _________ 9.6.8 Reverse annuity mortgages (RAM) _________________________ 143 _________ 9.6.9 Balloon payment mortgages _______________________________ 143 _________ Activity 9.4 ___________________________________________________ 144 9.7 _______ Mortgage Loan Amortization __________________________________ 144 _________ Activity 9.5 ___________________________________________________ 147 9.8 _______ Valuation and Risk of Mortgages _______________________________ 147 9.9 _______ Risks from Investing in Mortgages ______________________________ 148 _________ 9.9.1 Credit risk ______________________________________________ 148 _________ 9.9.2 Interest rate risk ________________________________________ 148 _________ 9.9.3 Prepayment risk _________________________________________ 148 _________ Activity 9.6 ___________________________________________________ 149 9.10 ______ Mortgage-backed Securities ____________________________________ 149 9.11 ______ The Securitisation Process ____________________________________ 149 9.12 ______ Risk of Mortgage-backed Securities _____________________________ 150 _________ 9.12.1 Credit risk of MBS _____________________________________ 150 _________ 9.12.2 Interest rate risk of MBS ________________________________ 150 _________ 9.12.3 Prepayment risk of MBS ________________________________ 150 _________ Activity 9.7 ___________________________________________________ 151 9.13 ______ Summary ____________________________________________________ 151 _________ R ef erences __________________________________________________ 152 Unit Ten: Foreign Exchange Markets 10.0 ______ Introduction _________________________________________________ 153 10.1 ______ Objectives ___________________________________________________ 154 10.2 ______ Foreign Exchange Markets ____________________________________ 154 10.3 ______ Functions of Foreign Exchange Markets _________________________ 155 10.4 ______ Types of Foreign Exchange Market ____________________________ 155 _________ 10.4.1 The spot market ________________________________________ 155 _________ 10.4.2 The futures market _____________________________________ 155 10.5 ______ Foreign Exchange Market Participants __________________________ 155 _________ Activity 10.1 __________________________________________________ 157 10.6 ______ Foreign Exchange Rates _______________________________________ 157 _________ 10.6.1 Exchange rate quotations ________________________________ 157 _________ 10.6.2 Why are exchange rates important? ______________________ 158 _________ 10.6.3 How is foreign exchange traded? _________________________ 158 _________ Activity 10.2 __________________________________________________ 158 10.7 ______ Types of Exchange Rate Regimes _______________________________ 159 _________ 10.7.1 Fixed (pegged) exchange rate system ______________________ 159 _________ 10.7.2 Floating exchange rates _________________________________ 159 _________ Activity 10.3 __________________________________________________ 160 10.8 ______ Factors Affecting Exchange Rates _______________________________ 161 _________ 10.8.1 Relative price levels _____________________________________ 161 _________ 10.8.2 Tariffs and quotas ______________________________________ 161 _________ 10.8.3 Preferences for domestic versus foreign goods _____________ 161 _________ 10.8.4 Productivity ____________________________________________ 162 _________ 10.8.5 Differential inflation rates _______________________________ 162 _________ 10.8.6 Differential interest rates ________________________________ 162 _________ 10.8.7 Central bank intervention _______________________________ 162 _________ Activity 10.4 __________________________________________________ 163 10.9 ______ Forecasting Exchange Rates ___________________________________ 163 _________ 10.9.1 Technical forecasting ___________________________________ 163 _________ 10.9.2 Fundamental forecasting ________________________________ 163 _________ 10.9.3 Market-based forecasting ________________________________ 164 _________ 10.9.4 Mixed forecasting ______________________________________ 164 _________ Activity 10.5 __________________________________________________ 165 10.10 _____ Forms of Exposure to Exchange Rate Risk _______________________ 165 _________ 10.10.1 Transaction exposure __________________________________ 165 _________ 10.10.2 Translation exposure __________________________________ 165 _________ 10.10.3 Economic exposure ____________________________________ 166 10.11 _____ Exchange Rate Risk Management Techniques ____________________ 166 _________ 10.11.1 Forward contracts _____________________________________ 166 _________ 10.11.2 Currency futures contracts _____________________________ 167 _________ 10.11.3 Currency swaps _______________________________________ 167 _________ 10.11.4 Forward rate agreements _______________________________ 168 _________ 10.11.5 Currency options contract ______________________________ 168 _________ Activity 10.6 __________________________________________________ 169 10.12 _____ Summary ____________________________________________________ 169 _________ R ef erences __________________________________________________ 170 Unit Eleven: The International Financial System 11.0 ______ Introduction _________________________________________________ 171 11.1 ______ Objectives ___________________________________________________ 172 11.2 ______ Intervention in the Foreign Exchange Market ____________________ 172 _________ 11.2.1 Unsterilised intervention ________________________________ 172 _________ 11.2.2 Sterilised intervention __________________________________ 173 _________ 11.2.3 Depreciation of the domestic currency ____________________ 174 _________ 11.2.4 Appreciation of the domestic currency ____________________ 174 _________ Activity 11.1 __________________________________________________ 175 11.3 ______ Balance of Payments _________________________________________ 175 _________ 11.3.1 Current account ________________________________________ 175 _________ 11.3.2 Capital account _________________________________________ 175 11.4 ______ Exchange Rate Regimes in the International Financial System ______ 176 _________ 11.4.1 Intervention in the foreign exchange market under a __________ _________ fixed exchange rate regime ____________________________________ 176 _________ 11.4.2 Shortcomings of fixed exchange rate systems ______________ 179 _________ Activity 11.2 __________________________________________________ 179 11.5 ______ Currency Board System _______________________________________ 179 11.6 ______ Do llarisation ________________________________________________ 180 11.7 ______ Managed Floating Exchange Rates ______________________________ 180 11.8 ______ Capital Controls _____________________________________________ 181 _________ 11.8.1 Controls on capital outflows _____________________________ 181 _________ 11.8.2 Controls on capital inflows ______________________________ 181 _________ Activity 11.3 __________________________________________________ 182 11.9 ______ Summary ____________________________________________________ 183 _________ R ef erences __________________________________________________ 184 Overview Module Overview T his module is written for investment managers and other corporate decision makers who wish to sharpen their skills in undertaking financial decisions. The module introduces you to the main functions of financial markets in an economy. Financial markets have the basic function of facilitating the movement of funds from those with surplus funds to those who are short of funds. Well functioning financial markets are critical to economic prosperity of nations while malfunctioning financial markets can contribute to misallocation of resources, which ultimately stifle economic growth. The synopsis of the broad areas covered by this course is given below: Zimbabwe Open University Unit One introduces you to the functions and roles of the financial system and explains the importance of financial intermediation and disintermediation within the global financial system. In Unit Two we discuss the roles of financial markets and financial institutions. In Unit Three we describe the key features of money markets and 1 Money and Capital Markets 2 Module MBAZ510 demonstrate the valuation process of a variety of money market securities. Unit Four introduces you to bond markets and discusses the main purpose of bond markets in an economy. Unit Five delves into bond valuation and outlines the factors that affect bond prices. Unit Six covers the various risks investors face when investing in bonds. In Unit Seven we discuss the importance of equity markets in an economy and describe the globalisation of equity markets. In Unit Eight we explain the various methods of valuing stocks and outline the various factors that affect stock prices. In Unit Nine we describe the functions of mortgage markets and analyses the valuation and risk of mortgages. In Unit Ten we look at the operations of foreign exchange markets and discuss the various factors that affect exchange rates. Unit Eleven is about the various interventionist measures taken by central banks around the world for purpose of creating a stable international financial system. Zimbabwe Open University Unit One Functions and Roles of the Financial System in the Global Economy 1.0 Introduction T he success of any economy depends greatly on the smooth functioning of the financial system. The financial system helps in the efficient allocation of financial resources between surplus units and deficit units within the economy. In this unit, we introduce you to the components, functions and nature of the financial system. Further, we examine its linkage with the global economy. Money and Capital Markets Module MBAZ510 1.1 Objectives By the end of this unit, you should be able to: define what a financial system is describe the functions of the financial systems in the global economy explain how the financial system assists in generating new jobs, building our savings to meet tomorrow’s financial needs and boosting the people’s standard of living explain the channels through which funds flow between lenders and borrowers within the global system discuss the nature and characteristics of financial assets explain how financial assets are created and destroyed by decision-makers within the financial system analyse the importance of financial intermediation and disintermediation within the global economy evaluate the factors tying together all financial markets 1.2 The Financial System Madura, J. (2010) defines a financial system as a collection of financial markets, institutions, laws, regulations, and techniques through which bonds, stocks, and other securities are traded, interest rates are determined, and financial services are produced and delivered around the world. 1.2.1 Functions of the financial system The primary task of the financial system is to allocate scarce financial resources from surplus units to deficit units. This in turn facilitates the exchange of goods and services in any economy. Further, the financial system allows investors to secure funds to purchase industrial machinery and equipment meant to boost industrial production. 1.3 Flows within the Global Economic System Rose and Marguis (2006) suggest that the basic function of the economic system is to allocate scarce resources such as land, labour, management skill, 4 Zimbabwe Open University Unit 1 Functions and Roles of the Financial System in the Global Economy and capital, to produce the goods and services needed by society. The global economy generates a flow of goods and services in return for a flow of payments. Figure 1.1 below illustrates the circular flow of income, payments and production in the global economic system. Figure 1.1: Circular flow of Income, Payments, and Production in the Global Economy Source: Peter S .Rose and Milton H. Marguis (2006): Money and Capital Markets The flow of productive services from the consuming units is compensated with a flow of income from the producing units. The consuming units in turn use this income to purchase goods and services from the producing units and payment of taxes to government. This circular flow of income, payments and production is interdependent and never ending, and what drives the economic system. Activity 1.1 is your understanding of a financial system? ? 1.2. What Explain the primary task of financial markets. 3. Zimbabwe Open University Discuss how the circular flow of income concept work in real life? 5 Money and Capital Markets Module MBAZ510 1.4 The Role of Markets in the Global Economic System Most economies around the world rely principally upon markets to carry out the complex task of allocating scarce resources. The marketplace determines what goods and services will be produced and in what quantities through the price mechanism. Markets also distribute income by rewarding superior producers with increased profits, higher wages, and other economic benefits. 1.5 Types of Market There are essentially three types of market within the global economic system. These are: factor markets that allocate factors of production (land, labour, entrepreneurship, and capital) and distribute income (wages, rent) to the owners of productive resources consuming units that use most of their income from factor markets to purchase goods and services in the product markets financial markets that channel savings to those individuals and institutions needing more funds for spending than are provided by their current incomes Figure 1.2 below illustrates the interconnectedness of these broad types of market within the global economic system 6 Zimbabwe Open University Unit 1 Functions and Roles of the Financial System in the Global Economy Figure 1.2 Types of Market: Source: Peter S .Rose and Milton H. Marguis (2006) Money and Capital Markets 1.6 Financial Assets Madura, J. (2010) defines financial assets as claims against the income or wealth of a business firm, household, or unit of government, represented usually by a certificate, receipt, computer record file, or other legal document, and usually created by or related to the lending of money. Financial assets are attractive financial instruments because these promise future returns to their owners and serve as a store of value (purchasing power). 1.6.1 Characteristics of financial assets The following are some of the characteristics of financial assets: Zimbabwe Open University financial assets do not depreciate like physical goods, and their physical condition or form is usually not relevant in determining their market value these instruments have little or no value as a commodity and their cost of transportation and storage is low 7 Money and Capital Markets Module MBAZ510 financial assets are fungible, that is, they can easily be changed in form and substituted for other assets 1.6.2 Different kinds of financial assets The different kinds of financial assets include equities, debt securities and derivatives. Equities represent ownership shares in a business firm and are claims against the firm’s profits and against proceeds from the sale of its assets. Common stock and preferred stock are examples of equities. Debt securities entitle their holders to a priority claim over the holders of equities to the assets and income of an economic unit. They can be negotiable or nonnegotiable. Examples include bonds, notes, accounts payable, and savings deposits. Derivatives are a form of financial instruments whose value is derived from the price of the underlying asset. Examples include futures contracts, options, and swaps. 1.6.3 How financial assets are created Deficit units normally create financial assets by issuing financial liabilities (debt) or stock (equities) to surplus units in order to finance their operations. This is referred to as external financing as the financial resources are sourced from outside the firm. 1.7 Financial Assets and the Financial System The financial system provides the essential channel necessary for the creation and exchange of financial assets between savers and borrowers so that real assets can be acquired. Rose and Marguis (2006) argue that the act of borrowing or of issuing new stock simultaneously gives rise to the creation of an equal volume of financial assets. All financial assets are recorded as a liability or claim on some other economic unit’s balance sheet. The equation is written as: Volume of financial assets created for lenders = Volume of liabilities issued by borrowers 8 Zimbabwe Open University Unit 1 Functions and Roles of the Financial System in the Global Economy For the balance sheet of any economic unit, the following holds: Total assets = total liabilities + net worth Total assets represent real and financial assets. For the whole economy and financial system, the following equation holds: Total financial assets = total liabilities So, for the economy as a whole, the following holds: Total real assets = total net worth Given the above, society increases its wealth only by saving and increasing the quantity of its real assets. These assets enable the economy to produce more goods and services in the future. Activity 1.2 types of market exist in the global economy? ? 1.2. What Describe the characteristics of financial markets. 3. 4. 5. Explain clearly the different kind of assets listed in section 1.6.2. Describe how financial assets are created in the financial system. Discuss the relationship between financial assets and the financial system. 1.8 The Evolution of Financial Transactions Financial systems change constantly in response to shifting demands from the public, the development of new technology, and changes in laws and regulations. The transfer of funds from savers to borrowers can be accomplished in at least three different ways as shown in Figures 1.3, 1.4 and 1.5 below. Zimbabwe Open University 9 Money and Capital Markets Module MBAZ510 Figure 1.3: Direct finance Source: Peter S .Rose and Milton H. Marguis (2006) Money and Capital Markets In direct financing, intermediaries are not involved in the transference of funds from surplus business units (lenders) to deficit business units (borrowers). The borrowers directly issue primary securities to lenders for cash. These securities represent direct claims against borrowers. Although this form of financing is simple, it is difficult to match lenders and borrowers with complementary needs. In addition, lenders are faced with default risk and may therefore demand high premium for their money thereby making this type of financing relatively expensive. 10 Zimbabwe Open University Unit 1 Functions and Roles of the Financial System in the Global Economy Figure 1.4: Semi-direct finance Source: Peter S .Rose and Milton H. Marguis (2006): Money and Capital Markets Semi-direct financing involves direct lending with the aid of market makers who assist in the sale of direct claims against borrowers. These market makers include security brokers, dealers and investment bankers. The involvement of market makers reduces search and matching costs. However, this type of financing is still risky and matching of borrowers and lenders is still required. Zimbabwe Open University 11 Money and Capital Markets Module MBAZ510 Figure 1.5: Indirect financing Source: Peter S .Rose and Milton H. Marguis (2006: Money and Capital Markets In this type of financing, financial intermediaries such as banks, insurance companies, credit unions, mutual funds, pension funds, finance companies play a critical role of matching lenders and borrowers and transform the primary securities into secondary securities. This financial intermediation of funds makes this type of financing attractive to both lenders and borrowers as it is relatively less risky and cheaper. 1.9 Disintermediation of Funds Rose and Marguis (2006) define financial disintermediation as the withdrawal of funds from a financial intermediary by the ultimate lenders (surplus business units) and the lending of those funds directly to the ultimate borrowers (deficit business units). It involves the shifting of funds from indirect finance to direct and semi-direct finance. This is clearly illustrated in Figure 1.6 below: 12 Zimbabwe Open University Unit 1 Functions and Roles of the Financial System in the Global Economy Figure 1.6: Financial disintermediation Source: Peter S .Rose and Milton H. Marguis (2006): Money and Capital Markets Listed below are some of the new forms of financial disintermediation which have appeared in recent years: Activity 1.3 Initiation by financial intermediaries: Some banks are selling off some of their loans because of difficulties in raising capital. Initiation by borrowing customers: Some borrowing customers learned how to raise funds directly from the open market, taking advantage of technological advancement. financial intermediation and financial ? 1.2. Define disintermediation. The transfer of funds from savers to borrowers can be 3. Zimbabwe Open University accomplished in at least three different ways. Discuss these three forms of financing. Explain the motivations for financial intermediation. What are theeconomic implications associated with this type of financing? 13 Money and Capital Markets Module MBAZ510 1.10Financial Markets and the Financial System Financial markets and the financial system are critical channels for savings and investment in any economy. The three main forms of savings in any economy are represented by the following: Households’ current income less tax payments less consumption expenditures Businesses’ retained earnings Governments’ current revenues less expenditures The nature of investment in any economy takes any of the following: Households purchasing of homes Businesses’ expenditures on capital goods and inventories Governments building/maintaining public facilities The financial markets enable the exchange of current income for future income and the transformation of savings into investment so that production, employment, and income can grow, and living standards can improve. The suppliers of funds to the financial system expect not only to recover their original funds but also to earn additional income as a reward for waiting and assuming risk. Activity 1.4 between savings and investment. Explain how ? 1.2. Distinguish the two are critical to economic growth. Describe how savings and investment are created in any 3. economy. Discuss how financial markets facilitate savings and investment in any economy. 1.11 The Global Financial System Marc Levinson (2006) describes the global financial system as the financial system consisting of institutions and regulators that act on the international level as opposed to those that act on a national or regional level. The main players are the global institutions such as the International Monetary Fund, Bank for International Settlements, central banks and other private institutions. 14 Zimbabwe Open University Unit 1 Functions and Roles of the Financial System in the Global Economy 1.12 Functions of the Global Financial System The following are some of the functions performed by the global financial system: Savings function: The global system of financial markets and institutions provides a conduit for the public’s savings. Wealth function: The financial instruments sold in the money and capital markets provide an excellent way to store wealth. Liquidity function: Financial markets provide liquidity for savers who hold financial instruments but are in need of money. Credit function: Global financial markets furnish credit to finance consumption and investment spending. Payments function: The global financial system provides a mechanism for making payments for goods and services, in the form of currency, checking accounts, debit cards, credit cards, digital cash, etc. Risk protection function: The financial markets offer protection against life, health, property, and income risks, by permitting individuals and institutions to engage in both risk-sharing and risk reduction. Policy function: The financial markets are a channel through which governments may attempt to stabilise the economy and avoid inflation. The financial services that are most widely sought by the public include: Activity 1.5 Payments services Advisory services Insurance services Credit services Hedging services Agency services the global financial system. ? 1.2.3. Define List the key players in the global financial system. Discuss the functions performed by the global financial 4. Zimbabwe Open University markets. Outline the key financial services widely sought by the public. 15 Money and Capital Markets Module MBAZ510 1.13Factors Tying all Financial Markets Together Rose and Marguis (2006) observed that the following are some of the factors that help to weld financial markets together: Credit, the common commodity: The shifting of borrowers among markets helps to weld the financial system together and to balance the costs of credit in the different markets. Speculation and arbitrage: Speculators who gamble on their market forecasts and arbitrageurs who watch for profitable arbitrage opportunities help to level out prices and maintain price consistency among the markets. Perfect and efficient markets: Financial markets are closely tied to one another due to their near perfection and efficiency. Financial markets in the real world: In the real world however, market imperfection and information asymmetry exist. 1.14The Dynamic Financial System The global financial system is rapidly changing. In particular, the trend towards the global integration of financial systems has been aided by the gradual deregulation of financial institutions and services as well as the increasing harmonisation of their regulations together with rapid technological advancement. The results have been increasingly intense competition, many new financial services, increased risk, and a wave of mergers among financial institutions. 1.15 Bank-dominated versus Security-dominated Financial Systems Less-developed financial systems are often bank-dominated financial systems, in which banks and other similar institutions dominate in supplying credit and attracting savings. The more mature systems today are becoming security-dominated financial systems, in which traditional intermediaries play lesser roles and growing numbers of borrowers sell securities to the public to raise the funds they need. 16 Zimbabwe Open University Unit 1 Functions and Roles of the Financial System in the Global Economy Activity 1.6 in detail the main factors that tie all financial ? 1. Describe markets together. 2. 3. Discuss the factors that have led to the globalization of financial markets, and the consequences thereof. Distinguish between bank-dominated and securitydominated financial systems. Which one is more preferable to the other? Explain your answer. 1.16Summary A financial system is a collection of financial markets, institutions, laws, regulations and techniques through which securities are traded. The primary task of the financial system is to allocate scarce financial resources from surplus units to deficit units. It facilitates the circular flow of income, payments and production of goods and services in any economy. All economies around the world rely on financial markets to carry out the complex task of allocating scarce financial resources. Ultimately, financial markets provide the essential channel for the creation and exchange of financial assets between savers and borrowers. Through financial intermediation, financial markets are critical channels for savings and investment in any economy. The interconnectedness of financial markets has led to the emergence of the global financial system, which consists of institutions and regulators that act on an international level. The dynamism of the financial system continues to be caused by rapid technological advancement, changing consumer tastes, stiff competition among other factors. Zimbabwe Open University 17 Money and Capital Markets Module MBAZ510 References Levinson, M. (2006). Guide to Financial Markets. 4th Edition. London: Profile Books Limited. Madura, J. (2010). Financial Markets and Institutions. 9th Edition. Florida: South- Western College. Mishkin, F.S. & Eakins, S.G. (2006). Financial Markets and Institutions. 5th Edition. New York: Pearson Addison Wesley. Rose, P.S. and Marguis, M.H. (2006). Money and Capital Markets. New York: McGraw-Hill Professional. 18 Zimbabwe Open University Unit Two The Roles of Financial Markets and Financial Institutions 2.0 Introduction I n this unit, we are going to look at the different types of financial market, type of securities traded within financial markets and the different players within the financial markets. Money and Capital Markets Module MBAZ510 2.1 Objectives By the end of this unit, you should be able to: describe the types of financial market that facilitate the flow of funds explain the type of securities traded within financial markets discuss the role of financial institutions within financial markets identify the type of financial institutions that facilitate transactions in financial markets 2.2 What is a Financial Market? Madura, J. (2010) defines a financial market as a market in which financial assets such as stocks and bonds can be purchased or sold. Funds are transferred in financial markets when one party purchases financial assets previously held by another party. Financial markets facilitate the flow of funds and thereby allow financing and investing by households, firms and government agencies. 2.3 The Role of Financial Markets and Institutions Frank J. Fabozzi (2008) asserts that financial markets transfer funds from those who have excess funds to those who need funds. Households and businesses that supply funds to financial markets earn a return on their investment, which return is necessary to ensure that funds are supplied to the financial markets. If funds are not supplied, the financial markets would not be able to play their intermediation role. Those participants who receive more money than they spend are referred to as surplus units (investors). They provide their net savings to the financial markets. Those participants who spend more money than they receive are referred to as deficit units (or borrowers). They access funds from financial markets so that they can spend more money than they receive. Many deficit units such as firms and government agencies access funds from financial markets through issuing securities. Securities represent a claim on 20 Zimbabwe Open University Unit 2 The Roles of Financial Markets and Financial Institutions the issuer. Debt securities represent debt (also called credit, or borrowed funds) incurred by the issuer. Deficit units issue the securities to surplus units and pay interest to the surplus units on a periodic basis. Debt securities have a maturity date, when the surplus units can redeem them, receiving the principal from the issuer. Equity securities (also called stocks) represent equity or ownership in the issuer. Some businesses issue equity securities as an alternative way of raising funds. Issuing securities enables corporations and government agencies to obtain money from surplus units and thus to spend more money than they receive from normal operations. 2.4 Types of Financial Markets There are many different types of financial markets, and each market can be distinguished by the maturity structure and trading structure of its securities. Each financial market is created to satisfy particular preferences of market participants. For example, some participants may want to invest funds for a short-term period, whereas others want to invest for a long-term period. Some participants are willing to tolerate a high level of risk when investing, whereas others need to avoid risk. Some participants that need funds prefer to borrow, whereas others prefer to issue stock. 2.4.1 Money versus capital markets The financial markets that facilitate the transfer of debt securities are commonly classified by the maturity of the securities. Those financial markets that facilitate the flow of short-term funds (with maturities of one year or less) are known as money markets, while those that facilitate the flow of long-term funds are known as capital markets. 2.4.2 Primary versus secondary markets Money market securities are debt securities that have a maturity of one year or less. They have a relatively high degree of liquidity, due to their short-term maturities, and because they typically have an active secondary market. Whether referring to money market securities or capital market securities, it is necessary to distinguish between transactions in the primary market and transactions in the secondary market. Primary markets facilitate the issuance of new securities. Secondary markets facilitate the trading of existing securities, which allows for a change in the ownership of the securities. Primary market transactions Zimbabwe Open University 21 Money and Capital Markets Module MBAZ510 provide funds to the initial issuer of securities while secondary market transactions do not. The issuance of new corporate stock is a primary market transaction, while the sale of existing corporate stock holdings by one investor to another is a secondary market transaction. An important characteristic of securities that are traded in secondary markets is liquidity, which is the degree to which securities can easily be liquidated (sold) without a loss of value. Some securities have an active secondary market, meaning that there are many willing buyers and sellers of the security at a given point in time. Investors prefer liquid securities so that they can easily sell the securities whenever they want (without a loss in value). If a security is illiquid, investors may not be able to find a willing buyer for it in the secondary market and may have to sell the security at a large discount just to attract a buyer. Activity 2.1 types of financial market are in existence around the ? 1. What globe? 2. 3. 4. 5. 6. Discuss possible ways firms and governments raise funds to finance their operations. What is the importance of financial markets in any economy? Distinguish between money markets and capital markets. Distinguish between primary and secondary markets. Describe the activities that take place in each type of market. Describe the characteristics of a security that makes it attractive to investors. 2.5 How Financial Markets Facilitate Corporate Finance The financial markets attract funds from investors and channel them to corporations. They serve as the means by which corporations finance their existing operations and their growth. The money markets enable corporations to borrow funds on a short-term basis so that they can support their working 22 Zimbabwe Open University Unit 2 The Roles of Financial Markets and Financial Institutions capital requirements. The capital markets enable corporations to obtain longterm funds to support corporate expansions. Figure 2.1 illustrates this process. Investors (Including financial institutions) $ Invested Securities Financial markets and institutions $ Invested Securities Corporations $ Invested Corporate financing of existing operations and expansions Figure 2.1: How financial markets facilitate corporate finance and investment management Madura Jeff (2010): Financial Markets and Institutions, 9th Edition 2.6 How Financial Markets Facilitate Investment Figure 2.1 above further illustrates how financial markets facilitate investment activities in any economy. Investment management involves decisions by investors regarding how to invest their funds. The financial markets offer investors a wide variety of investment opportunities. A major part of investment management is deciding which securities to purchase. When investing in stock, investors assess the financial management of various firms. They look for firms that are currently undervalued and have the potential to improve. The market price of the stock serves as a measure of how well each publicly traded firm is being managed by its managers. Activity 2.2 how financial markets channel funds to ? 1. Explain corporations. 2. 3. Describe how financial markets provide funds to investors. How do dealers on the market judge the health of a firm? 2.7 Securities Traded in Financial Markets Madura, J. (2010) and Fabozzi, F. J. (2008) postulate that each type of security tends to have specific return and risk characteristics. The term risk is Zimbabwe Open University 23 Money and Capital Markets Module MBAZ510 used here to represent the uncertainty surrounding the expected return. The more uncertain the expected return, the greater the risk is. Investors differ with respect to the risk they are willing to incur, the amount of liquidity they desire, and their tax status, making some types of securities more desirable to some investors than to others. Normally, investors attempt to balance the objective of high return with their particular preference for low risk and adequate liquidity. Some investors are much more willing than others to invest in risky securities, as long as the potential return is sufficiently high. Securities can be classified as money market securities, capital market securities and derivative securities. 2.7.1 Money market securities Money market securities are debt securities that have a maturity of one year or less. They generally have a relatively high degree of liquidity. They tend to have a low expected return but also a low degree of risk. Common types of money market securities include Treasury Bills, Commercial Paper, Negotiable Certificates of Deposit and Banker’s Acceptances. 2.7.2 Capital market securities Securities with a maturity of more than one year are called capital market securities. These are commonly issued to finance the purchase of capital assets, such as buildings, equipment or machinery. Three common types of capital market securities are bonds, mortgages, and stocks. 2.7.3 Derivative securities These are a certain type of financial instruments whose value is derived from the market value of the underlying assets. Examples include options, swaps, forward contracts and futures contracts. 2.8 Valuation of Securities in Financial Markets Each type of security generates a unique stream of expected cash flows to investors. Further, each security has a unique level of uncertainty surrounding the expected cash flows that it will provide to investors and therefore surrounding its return. The valuation of a security is measured as the present value of its expected cash flows, discounted at a rate that reflects the uncertainty. 24 Zimbabwe Open University Unit 2 The Roles of Financial Markets and Financial Institutions Since the cash flows and the uncertainty surrounding the cash flows for each security are unique, the value of each security is unique. 2.9 Market Efficiency Because securities have market-determined prices, their favourable or unfavourable characteristics as perceived by the market are reflected in their prices. When security prices fully reflect all available information, the markets for these securities are referred to as efficient. In an efficient market, securities are rationally priced. If a security is clearly undervalued based on public information, some investors will capitalise on the discrepancy by purchasing the security. This strong demand for the security will push the security’s price higher until the discrepancy no longer exists. The investors’ actions to capitalise on discrepancies typically ensure that securities are properly priced, based on the information that is available. Activity 2.3 does the term “risk” mean with reference to financial ? 1. What securities? 2. 3. 4. 5. What differentiate investors with respect to risk? Distinguish between the three common types of securities. How are securities valued? What distinguish efficient markets? 2.10Global Financial Markets Financial markets are continuously evolving throughout the world to improve the transfer of funds from surplus units to deficit units. The financial markets are much more developed in some countries than in others. Further, they also vary in terms of the volumes of funds that are transferred from surplus units to deficit units and the types of funding that are available. Some countries have had financial markets for a long time, but other countries have converted to market-oriented economies and established financial markets relatively recently. Capital flows are often restricted through lack of depth and vibrancy in the less developed capital markets. Zimbabwe Open University 25 Money and Capital Markets Module MBAZ510 2.11 International Corporate Governance Relating to Financial Markets Since financial markets channel funds from surplus units to deficit units, they can function only if surplus units are willing to provide funds to the markets. If there is a lack of information about the securities traded in the market, or a lack of safeguards to ensure that investors are treated fairly, surplus units will not participate. Consequently, the financial markets will not be liquid. Financial markets have evolved slowly in some developing countries for several reasons. First, the issuers of debt securities do not provide much financial information to indicate how they intend to repay the investors who would buy the securities. Second, regulatory agencies provide very little enforcement to ensure that the financial information provided by the issuers is correct. Third, businesses that do not repay the investors are rarely prosecuted. Fourth, courts in these countries do not provide an efficient system of recourse that investors can rely upon in litigation cases to recover owed funds. 2.12Global Integration Many financial markets are globally integrated, allowing participants to move funds out of one country’s markets and into another’s. Foreign investors serve as key surplus units in our domestic economy by purchasing money and capital market securities issued in our financial markets. With these more integrated financial markets, the performance of our local financial markets are greatly affected by movements in other financial markets and by any macroeconomic development in foreign countries. 2.13Role of the Foreign Exchange Market International financial transactions normally require the exchange of currencies. The foreign exchange market facilitates the exchange of currencies. Many commercial banks and other financial institutions serve as intermediaries in the foreign exchange market by matching up participants who want to exchange one currency for another. Some of these financial institutions also serve as dealers by taking positions in currencies to accommodate foreign exchange requests (Mishkin, F.S. & Eakins, S.G. (2006). Like securities, most currencies have a market-determined price (exchange 26 Zimbabwe Open University Unit 2 The Roles of Financial Markets and Financial Institutions rate) that changes in response to supply and demand conditions. If there is a sudden shift in the aggregate demand for a given currency by corporations, government agencies and individuals, or a shift in the aggregate supply of that currency for sale, the price will change. Currency appreciation and currency depreciation affect the performance of financial markets. Activity 2.4 how corporate governance issues affect the ? 1. Discuss development of financial markets. 2. Explain how the performance of local financial markets can be positively or negatively affected by external factors. 2.14Role of Financial Institutions Frank J. Fabozzi (2008) argues that if financial markets were perfect, all information about any security for sale in primary markets including the creditworthiness of the security issuer would be continuously and freely available to investors. In addition, all information identifying investors interested in purchasing securities as well as investors planning to sell securities would be freely available. Further, all securities for sale could be broken down or unbundled into any size desired by investors, and security transaction costs would not be necessary. In practice, financial markets are imperfect to the extent that security buyers and sellers do not have full access to relevant information. Individuals who have funds available normally do not have a means of identifying creditworthy borrowers to whom they could lend their funds. In addition, they do not have the expertise to assess the creditworthiness of potential borrowers. Financial institutions are needed to resolve the problems caused by market imperfections. They accept funds from surplus units and channel the funds to deficit units. Without financial institutions, the information and costs of financial market transactions would be excessive. Financial institutions can be classified as depository and non-depository institutions. Zimbabwe Open University 27 Money and Capital Markets Module MBAZ510 2.15Role of Depository Institutions Depository institutions accept deposits from surplus units and provide credit to deficit units through loans and purchases of securities. They are popular financial institutions for the following reasons: they offer deposit accounts that can accommodate the amount and liquidity characteristics desired by most surplus units; they repackage funds received from deposits to provide loans of the size and maturity desired by deficit units; they accept the risk on loans provided; they have more expertise than individual surplus units in evaluating the creditworthiness of deficit units; and they diversify their loans among numerous deficit units and therefore can absorb defaulted loans better individual than surplus units could. 2.16 Role of Non-depository Financial Institutions Non-depository institutions generate funds from sources other than deposits but also play a major role in financial intermediation. These institutions are briefly described below: 2.16.1 Finance companies Most finance companies obtain funds by issuing securities, then lend the funds to individuals and small businesses. The functions of finance companies and depository institutions overlap. 2.16.2 Mutual funds These sell shares to surplus units and use the funds received to purchase a portfolio of securities. They are the dominant non-depository financial institutions when measured in total assets. Some mutual funds concentrate their investment in capital market securities, such as stocks or bonds. Others, known as money market mutual funds, concentrate in money market securities. Typically, mutual funds purchase securities in minimum denominations that are larger than the savings of an individual surplus unit. By purchasing shares of mutual funds and money market mutual funds, small savers are able to invest in diversified portfolio of securities with a relatively small amount of funds. 28 Zimbabwe Open University Unit 2 The Roles of Financial Markets and Financial Institutions 2.16.3 Securities firms These provide a variety of functions in financial markets. Some securities use their information resources to act as brokers, executing securities transactions between two parties. In addition to brokerage services, securities firms also provide investment banking services. Some securities firms place newly issued securities for corporations and government agencies. This task differs from traditional brokerage activities because it involves the primary market. When securities firms underwrite newly issued securities, they may sell the securities for a client at a guaranteed price, or they may simply sell the securities at the best price they can get for their client. Furthermore, securities firms often act as dealers, making a market in specific securities by adjusting their inventory of securities. They also offer advisory services on mergers and other forms of corporate restructuring. 2.16.4 Insurance companies These provide individuals and firms with insurance policies that reduce the financial burden associated with death, illness, and damage to property. They charge premiums in exchange for the insurance that they provide. They invest the funds that they receive in the form of premiums until the funds are needed to cover insurance claims. They commonly invest the funds in stocks or bonds issued by government. In this way, they finance the needs of deficit units and thus serve as important financial intermediaries. 2.16.5 Pension funds Many corporations and government agencies offer pension plans to their employees. The employees, their employers, or both periodically contribute funds to the plan. Pension funds provide an efficient way for individuals to save for their retirement. The pension funds manage the money until the individual withdraw the funds from their retirement accounts. The money that is contributed to individual retirement accounts is commonly invested by the pension funds in stocks or bonds issued by corporations or bonds issued by government agencies. In this way, pension funds finance the needs of deficit units and thus serve as important financial intermediaries. Zimbabwe Open University 29 Money and Capital Markets Module MBAZ510 2.17Comparison of Roles among Financial Institutions The role of financial institutions in facilitating the flow of funds from individual surplus units (investors) to deficit units is illustrated in Figure 2.1. Surplus units are shown on the left side while deficit units are shown on the right side. Three different flows of funds from surplus units to deficit units are in the diagram. One set of flows represents deposits from surplus units that are transformed by depository institutions into loans for deficit units. A second set of flows represents purchases of securities (commercial papers) issued by finance companies that are transformed into finance company loans for deficit units. A third set of flows reflects the purchases of shares issued by mutual funds, which are used by the mutual funds to purchase debt and equity securities of deficit units. The deficit units also receive funding from insurance companies and pension funds as shown in the diagram. 30 Zimbabwe Open University Unit 2 The Roles of Financial Markets and Financial Institutions Deposits Surplus Units Purchase Depository Institutions Finance Companies Securities Purchase Shares Policy Holders Employers and Employees Mutual Funds Premiums Insurance Companies Employee Pension Funds Deficit Units (Firms, Government Agencies, Individuals) Contributions Figure 2.2 Comparison of roles among financial institutions Source: Jeff Madura (2010) Financial Markets and Institutions, 9th Edition Zimbabwe Open University 31 Money and Capital Markets Module MBAZ510 Activity 2.5 between perfect and imperfect markets. Explain ? 1. Distinguish why the existence of imperfect markets creates a need for 2. 3. 4. financial intermediaries. Compare the main sources and uses of funds for finance companies, insurance companies and pension funds. Explain the general difference between depository and nondepository institution sources of funds. Explain how financial intermediation contributes to the smooth operations of financial markets. 2.18 Summary Financial markets facilitate the transfer of funds from surplus units to deficit units. Because funding needs vary among deficit units, various financial markets have been established. The primary market allows for the issuance of new securities, while the secondary market allows for the sale of existing securities. Money markets have developed in response to market players who need short-term funds, stable returns and low risky investments. Capital markets carter for those savers and investors who prefer long-term funds, high returns in return for high risk involved. The theory of efficient and perfect market does not hold, therefore, financial institutions play a critical role of solving the problem of imperfect financial markets. These institutions are ordinarily grouped into depository and non-depository institutions and these facilitate the financing of deficit units. 32 Zimbabwe Open University Unit 2 The Roles of Financial Markets and Financial Institutions References Chisholm, A. M. (2009). Introduction to International Capital Markets. 2nd Edition. London: John Wiley & Sons. Choudhry, M. (2001). The Bond and Money Markets. London: ButterHeinemann. Choudhry, M. et al. (2010). Capital Market Instruments: Analysis and Valuation. 3rd Edition. London: Palgrave Macmillan. Fabozzi, F. J. (2008). Handbook of Finance, Volume 1. New York: John Wiley & Sons. Howells, P and Bain, K. (2007): Financial Markets and Institutions. 5th Edition. London: Prentice Hall. Levinson, M. (2006): Guide to Financial Market: 4th Edition. London: Profile Books Limited. Madura, J. (2010): Financial Markets and Institutions. 9th Edition. Florida: SouthWestern College. Mishkin, F.S. & Eakins, S.G. (2006): Financial Markets and Institutions. 5th Edition. New-York: Pearson Addison Wesley. Zimbabwe Open University 33 Blank page Unit Three Money Markets 3.0 Introduction M oney market securities are short-term instruments with an original maturity of less than one year. These securities trade in the money markets. They include treasury bills, commercial paper, repurchase agreements, bankers’ acceptances and negotiable certificates of deposits. Many participants in the money markets both buy and sell money market securities. In this unit, we are going to look at the functions of money markets and the various instruments traded in the money markets. Money and Capital Markets Module MBAZ510 3.1 Objectives By the end of this unit, you should be able to: describe the features of the most popular money market securities explain how money markets are used by institutional investors explain the valuation of money market securities 3.2 Money Markets Mishkin & Eakins (2006) argue that the term “money market” is actually a misnomer because money (currency) is not traded in the markets. However, the securities that are traded on the money market are short-term and highly liquid and close to being money, hence the term, “money market”. 3.2.1 Why do we need money markets? Mishkin & Eakins (2006) argue that, in theory, money markets are not necessary because the banking industry exists primarily to provide short-term loans to borrowers and to accept short-term deposits from savers. Banks have therefore an efficiency advantage in gathering information, an advantage that should eliminate the need for the money markets. Thanks to continuing relationships with customers, banks should be able to offer loans more cheaply than diversified markets, which must evaluate each borrower every time a new security is offered. Furthermore, short-term securities offered for sale in the money markets are neither as liquid nor as safe as deposits placed in banks. This line of argument further states that banking industry exists primarily to mediate the asymmetric information problem between saver-lenders and borrower-spenders, and banks can earn profit by capturing economies of scale while providing this service. However, the banking industry is subject to more regulations and governmental costs than are the money markets. In situations where the asymmetric information problem is not severe, the money markets have a distinct cost advantage over banks in providing short-term funds. 36 Zimbabwe Open University Unit 3 Money Markets Activity 3.1 ? Critically analyse the proposition that money markets are not necessary in cases where an efficient banking industry exists. 3.2.2 Functions of money markets A well developed secondary market for money market instruments makes the money market an ideal place for firms or financial institutions to warehouse surplus funds until the time they are needed. Money markets are used to facilitate the transfer of short-term funds from individuals, corporations, or governments with excess funds to those with deficit funds. Even investors who focus on long-term securities tend to hold some money market securities. Money markets enable financial participants to maintain liquidity. Market issuers include sovereign governments, which issue treasury bills, corporations issuing commercial paper, and banks issuing bills of exchange and certificates of deposit. Investors are attracted to the market because the instruments are highly liquid and carry relatively low credit risk. Investors in the money market include banks, local authorities, corporations, money market investment funds and individuals. However, the money market is essentially a wholesale market and the denominations of individual instruments are relatively large. The means by which money markets facilitate the flow of funds are illustrated in Figure 3.1 below. Governments issue treasury bills and use the proceeds to finance their budget deficits. Corporations issue money market securities and use the proceeds to support their existing operations or to expand their operations. Financial institutions issue money market securities and bundle the proceeds to make loans to households and corporations. Thus the funds are channeled to support household purchases, such as cars and homes, and to support corporate investments in buildings and machinery. Governments and some corporations commonly pay off their debts from maturing money market securities with the proceeds from issuing new money market securities. In this way, they are able to finance expenditures for long periods of time even though money market securities have short-term maturities. Overall, money markets allow households, governments and corporations to increase their expenditures, thus the markets finance economic growth. Zimbabwe Open University 37 Money and Capital Markets Module MBAZ510 Government Agencies Spending on Government Programs Corporations Spending to support Existing Business Operations or Expansions Buy T-Bills $ Households, Corporations, and Government Agencies That Have Short-term Funds Available Buy money market securities Loans Financial Intermediaries $ Buy money market securities Households Spending on cars homes, credit cards etc. Figure 3.1 How Money Markets Facilitate the Flow of Funds Source: Madura, J. (2010): Financial Markets and Institutions, 9th Edition 3.3 Money Market Securities Money market securities have at least five basic characteristics in common, and these are listed below: they are usually sold in large denominations they have low default risk they mature in one year or less from their original issue date they are relatively liquid their market values are relatively stable Money market transactions do not take place in any one particular location or building. Instead, traders usually arrange purchases and sales between participants over the phone and complete them electronically. 38 Zimbabwe Open University Money Markets Unit 3 Because of this characteristic, money market securities usually have an active secondary market. This means that after the security has been sold initially, it is relatively easy to find buyers who will purchase it in the future. An active secondary market makes money market securities very flexible instruments to use to fill short term financial needs. The cash instruments traded in the money market include the following: Treasury bills Time Deposit Certificate of Deposit Commercial Paper Bankers’Acceptance Negotiable Certificates of Deposits The instruments above fall into one of two main classes of money market securities: those quoted on a yield basis and those quoted on a discount basis. These two terms are discussed in section 3.4 below. Activity 3.2 how governments and firms use money markets ? 1. Explain to finance capital projects of a long-term nature. 2. “The success of money markets depends on how strong and active the secondary market is”. Discuss. 3.4 Securities Quoted on a Yield Basis The following are some of the securities which are quoted on a yield-basis: 3.4.1 Money market deposits These are fixed-interest term deposits of up to one year with banks and securities houses. They are also known as time deposits or clean deposits. They are not negotiable so cannot be liquidated before maturity. The interest rate on the deposit is fixed for the term and related to the inter-bank rate of the same term. Interest and capital are paid on maturity. The effective rate on a money market deposit is the annual equivalent interest rate for an instrument with a maturity of less than one year. Zimbabwe Open University 39 Money and Capital Markets Module MBAZ510 3.4.2 Certificates of deposit Certificates of Deposits (CDs) are receipts from banks for deposits that have been placed with them. The deposits themselves carry a fixed rate of interest related to the inter-bank rate and have a fixed term to maturity, so cannot be withdrawn before maturity. However, the certificates themselves can be traded in a secondary market, that is, they are negotiable. CDs are therefore very similar to negotiable money market deposits, although their yields are below the equivalent deposit rates because of the added benefit of liquidity. Banks, merchant banks and building societies issue CDs to raise funds to finance their business activities. On issue a CD is sold for face value, so the settlement proceeds of a CD on issue always equal its nominal value. The interest is paid, together with the face amount, on maturity. The interest rate is sometimes called the coupon, but unless the CD is held to maturity this will not equal the yield, which is of course the current rate available in the market and varies over time. 3.5 Securities Quoted on a Discount Basis The remaining money market instruments are all quoted on a discount basis, and so are known as ‘discount’ instruments. This means that they are issued on a discount to face value, and are redeemed on maturity at face value. Treasury bills, bills of exchange, bankers’ acceptances and commercial paper are examples of money market securities that are quoted on this basis: that is, they are sold on the basis of a discount to par. The difference between the price paid at the time of purchase and the redemption value (par) is the interest earned by the holder of the paper. Explicit interest is not paid on discount instruments. Rather, interest is reflected implicitly in the difference between the discounted issue price and the par value received at maturity. Activity 3.3 ? 40 Explain the differences between securities quoted on a yield basis and those quoted on a discount basis. Zimbabwe Open University Unit 3 Money Markets 3.5.1 Treasury bills (T-bills) These are short-term debt securities issued by governments through their central banks to borrow money from the money market to finance government operations. Treasury bills have 91-day, 182-day, 270-day or 360-day maturities. Treasury bills are attractive to investors because they are backed by the government and therefore are virtually free of credit (default) risk. Another attractive feature of T-bills is their liquidity, which is due to their short maturity and strong secondary market. Depository institutions commonly invest in Tbills so that they can retain a portion of their funds in assets that can easily be liquidated if they suddenly need to accommodate deposit withdrawals. Other financial institutions also invest in T-bills in the event that they need cash because cash outflows exceed cash inflows. Pricing Treasury bills T-bills do not pay interest but are priced at a discount from their par value. The price that an investor will pay for a T-bill with a particular maturity is dependent on the investor’s required rate of return on that T-bill. That price is determined as the present value of the future cash flows to be received. Since the T-bill does not generate interest payments, the value of a T-bill is the present value of the par value. Thus, investors are willing to pay a price for a one year T-bill that ensures that the amount they receive a year later will generate their desired return. Example 3.1 A T-bill with $10 million face value issued for 91 days will be redeemed on maturity at $10 million. If the three-month yield at the time of issue is 5.25%, the price of the bill at issue is: 10m P = 1 + 0.0525 × 91 365 = $9,870,800.69 Interest rate on discount instruments is quoted as a discount rate rather than a yield. This is the amount of discount expressed as an annualized percentage of the face value, and not as a percentage of the original amount paid. By definition, the discount rate is always lower than the corresponding yield. If the discount rate on a bill is d, then the amount of discount is given by: Zimbabwe Open University 41 Money and Capital Markets Module MBAZ510 d value = M × d × n B Where M = face value d = discount rate n = maturity period B = base year Example 3.2 A T-bill with $10 million face value is issued for 91 days at a discount rate of 30%. Calculate the discount value. Solution d value = M × d × n B d value = 10,000,000 × 30% × 91 365 = $747,945.21 The price P paid for the bill is the face value minus the discount amount, given by: N sm d 365 P = 100 × 1 − 100 If we know the yield on the bill then we can calculate its price at issue by using the simple present value formula, as shown in: 42 Zimbabwe Open University Unit 3 Money Markets P= M N sm 1 + r 365 Example 3.4 A 91-day $100 Treasury bill is issued with a yield of 4.75%. What is its issue price? Solution P= 100 91 1 + 0.0475 365 = $98.83 The discount rate d for T-bills is calculated using the following formula: d = (1 − P ) × B n The relationship between discount rate and true yield is given by: d= r= Zimbabwe Open University r n 1 + r × B d n 1 − d × B 43 Money and Capital Markets Module MBAZ510 Example 3.5 A T-bill with a remaining maturity of 39 days is quoted at a discount of 4.95%. What is the equivalent yield? Solution r= = d n 1 − d × B 0.0495 39 1 − 0.0495 × 365 = 4.976% Estimating the yield As explained earlier, T-bills do not offer coupon payments but are sold at a discount from par value. Their yield is influenced by the difference between the selling price and the purchase price. If an investor purchases a newly issued T-bill and holds it until maturity, the return is based on the difference between the par value and the purchase price. If the T-bill is sold prior to maturity, the return is based on the difference between the price for which the bill was sold in the secondary market and the purchase price. The annualized yield from investing in a T-bill (YT) can be determined as: YT = SP − PP 365 × PP n Where SP = Selling Price PP = Purchase Price n = number of days of the investment (holding period) Example 3.6 An investor purchases a T-bill with a six-month (182-day) maturity and $10,000 par value for $9,600. If this T-bill is held to maturity, its yield is: 44 Zimbabwe Open University Unit 3 Money Markets YT = $10,000 − $9,600 365 × = 8.36% $9,600 182 If the T-bill is sold prior to maturity, the selling price and therefore the yield are dependent on market conditions at the time of the sale. Suppose the investor plans to sell the T-bill after 120 days and forecasts a selling price of $9,820 at that time. The expected annualized yield based on this forecast is: YT = $9,820 − $9,600 365 × = 6.97% $9,600 120 Estimating the T-bill discount Some business periodicals quote the T-bill discount along with the T-bill yield. The T-bill discount represents the percent discount of the purchase price from par value for newly issued T-bills and is computed as: T-bill discount = Par − PP 360 × Par n A 360-day year is used to compute the T-bill discount. Using the information from the previous example, the T-bill discount is: T-bill discount = $10,000 − $9,600 360 × = 7.91% $10,000 182 For a newly issued T-bill that is held to maturity, the T-bill yield will always be higher than the discount. The difference occurs because the purchase price is the denominator of the yield equation, while the par value is the denominator of the T-bill discount equation, and the par value will always exceed the purchase price of a newly issued T-bill. In addition, the yield formula uses a 365-day year versus a 360-day year for the discount computation. Zimbabwe Open University 45 Money and Capital Markets Module MBAZ510 Activity 3.4 an investor purchased a six-month T-bill with a ? 1. Assume $10,000 par value for $9,000 and sold it 90 days later for $9,100. What is the yield? Newly issued three-month T-bills with a par value of $10,000 sold for $9,700. Compute the T-bill discount. 3. You paid $98,000 for a $100,000 T-bill maturing in 120 days. If you hold it until maturity, what is the T-bill yield? What is the T-bill discount? 4. A money market security that has a par value of $10,000 sells for $8,816.60. Given that the security has a maturity of two years, what is the investor’s required rate of return? 5. (a) Determine how the annualized yield of a T-bill would be affected if the purchase price is lower. Explain the logic of this relationship. (b) Determine how the annualized yield of a T-bill would be affected if the selling price is lower. Explain the logic of this relationship. (c) Determine how the annualized yield of a T-bill would be affected if the number of days is shorter, holding the purchase price and selling price constant. Explain the logic of this relationship. 2. 3.5.2 Commercial paper Commercial paper securities (CP) are unsecured promissory notes, issued by corporations that mature in no more than 270 days. Because these securities are unsecured, only the largest and most creditworthy corporations issue commercial papers. The interest rate the corporation is charged reflects the firm’s level of risk. Companies’ short-term capital and working capital requirements are usually sourced directly from banks, in the form of bank loans. CP is an alternative short-term funding instrument, which is available to firms that have a sufficiently strong credit rating. The issuer of the note promises to pay its holder a specified amount on a specified maturity date. CP normally has a zero coupon and trades at a discount to its face value. The discount represents interest to the investor in the period to maturity. CP is typically issued in bearer form, although some issues are in registered form. 46 Zimbabwe Open University Unit 3 Money Markets Originally the CP market was restricted to borrowers with high credit rating, and although lower-rated borrowers do now issue CP, sometimes by obtaining credit enhancements or setting up collateral arrangements, issuance in the market is still dominated by highly rated companies. The majority of issues are very short-term, from 30 to 90 days to maturity. It is extremely rare to observe paper with a maturity of more than 270 days or nine months. This is because of regulatory requirements. Although there is a secondary market in CP, very little trading activity takes place since investors generally hold CP until maturity. This is to be expected because investors purchase CP that matches their specific maturity requirements. When an investor wishes to sell paper, it can be sold back to the dealer, or when the issuer has placed the paper directly in the market (and not via an investment bank), it can be sold back to the issuer. Commercial paper programmes The issuers of CP are often divided into two categories of company, financial institutions and non-financial companies. The majority of CP issues are by financial companies. Financial companies include not only banks but the financing arms of firms. Most of the issuers have strong credit ratings, but lower-rated borrowers have tapped the market, often after arranging credit support from a higherrated company, such as a letter of credit from a bank, or by arranging collateral for the issue in the form of high-quality assets such as Treasury bonds. CP issued with credit support is known as credit-supported commercial paper, while paper backed with assets is known as asset-backed commercial paper. Although banks charge a fee for issuing letters of credit, borrowers are often happy to arrange for this, since by so doing they are able to tap the CP market. The yield paid on an issue of CP will be lower than a commercial bank loan. Issuers often roll over their funding and use funds from a new issue of CP to redeem a maturing issue. There is a risk that an issuer might be unable to roll over the paper where there is a lack of investor interest in the new issue. To provide protection against this risk, issuers often arrange a stand-by line of credit from a bank, normally for all of the CP programmes, to draw against in the event that it cannot place a new issue. Methods of issuance There are two methods by which CP is issued, known as direct-issued or Zimbabwe Open University 47 Money and Capital Markets Module MBAZ510 direct paper and dealer-issued or dealer paper. Direct paper is sold by the issuing firm directly to investors, and no agent bank or securities house is involved. It is common for financial companies to issue CP directly to their customers, often because they have continuous programmes and constantly roll over their paper. It is therefore cost-effective for them to have their own sales arm and sell their CP direct. The treasury arms of certain non-financial companies also issue direct paper. Dealer paper is paper that is sold using a banking or securities house intermediary. Commercial paper yields Commercial paper is a discount instrument. Thus CP is sold at a discount to its maturity value, and the difference between this maturity value and the purchase price is the interest earned by the investor. The CP day-count base is 365 days. The paper is quoted on a discount yield basis, in the same manner as Treasury bills. The yield on CP follows that of other money market instruments and is a function of the short-dated yield curve. The yield on CP is higher than the T-bill rate; this is because of the credit risk that the investor is exposed to when holding CP, for tax reasons (in certain jurisdictions interest earned on T-bills is exempt from income tax) and because of the lower level of liquidity available in the CP market. CP also pays a higher yield than certificates of deposit (CD), because of the lower liquidity of the CP market. Example 3.7 A 60-day CP note has a nominal value of $100,000. It is issued at a discount of 7.5% per annum. The discount is calculated as: Dis = $100,000(0.075 × 60) = $1,232.88 365 The issue price for the CP is therefore $98,768, that is, ($100,000 - $1,232). The money market yield on this note at the time of issue is: 365 × 0.075 × 100% = 7.954% 365 − (0.075 × 60) 48 Zimbabwe Open University Unit 3 Money Markets Another way to calculate this yield is to measure the capital gain (the discount) as a percentage of the CP’s cost, and convert this from a 60-day yield to a one-year (365-day) yield, as shown below: Example 3.8 ABC plc wishes to issue CP with face value of $100,000 with 90 days to maturity. The investment bank managing the issue advises that the discount rate should be 9.5%. What should the issue price be, and what is the money market yield for investors? Dis = 100,000(0.095 × 90) = 2,342 365 The issue price will be 100,000 – 2,342 = $97,658. The yield to investors will be: 2,342 365 × × 100% = 9.725% 97,658 90 Activity 3.5 an investor purchased 6-month commercial paper ? 1. Assume with a face value of $1 million for $940,000. What is the 2. 3. 4. yield? The price of 182-day commercial paper is $7,840. If the annualized yield is 4.04%, what will the paper pay at maturity? The price of $8000 face value commercial paper is $7930. If the annualized yield is 4%, when will the paper mature? Explain why commercial papers are usually unsecured. 3.5.3 Negotiable certificates of deposit (NCDs) These certificates are issued by large commercial banks and other depository institutions as a short-term source of funds. Negotiable Certificates of Deposits Zimbabwe Open University 49 Money and Capital Markets Module MBAZ510 are typically too large for individual investors. These are sometimes purchased by money market funds that have pooled individual investors’ funds. Thus money market funds allow individuals to be indirect investors in NCDs, creating a more active NCD market. NCDs must offer a premium above the T-bill yield to compensate for less liquidity and safety. The premiums are generally higher during recessionary periods. The premiums also reflect the market’s perception about the safety of the financial institution. Yield NCDs provide a return in the form of interest along with the difference between the price at which the NCD is redeemed (or sold in the secondary market) and the purchase price. Given that an institution issues an NCD at par value, the annualized yield that it will pay is the annualized interest rate on the NCD. If investors purchase this NCD and hold it until maturity, their annualized yield is the interest rate. However, the annualized yield can differ from the annualized interest rate for investors who either purchase or sell the NCD in the secondary market instead of holding it from inception until maturity. Example 3.9 An investor purchased an NCD a year ago in the secondary market for $970,000. He redeems it today upon maturity and receives $1,000,000. He also receives interest of $40,000. His annualized yield (YNCD) on this investment is calculated as follows: Y NCD = = SP − PP + INTEREST PP $1,000,000 − $970,000 + $40,000 $970,000 = 7.22% 3.5.4 Repurchase agreements (repo) With a repurchase agreement (repo), one party sells securities to another with an agreement to repurchase the securities at a specified date and price. In 50 Zimbabwe Open University Unit 3 Money Markets essence, the repo transaction represents a loan backed by the securities. If the borrower defaults on the loan, the lender has claim to the securities. A reverse repo refers to the purchase of securities by one party with an agreement to sell them. Thus, a repo and a reverse repo can refer to the same transaction but from different perspectives. Estimating the yield The repo rate is determined by the difference between the initial selling price of the securities and the agreed-on repurchase price, annualized with a 360day year. Example 3.10 An investor initially purchases securities at a price (PP) of $9,852,217, with an agreement to sell them back at a price (SP) of $10,000,000 at the end of a 60-day period. The yield (or repo rate) on this repurchase agreement is: Repo rate = = 1. SP − PP 365 × PP n $10,000,000 − $9,852,217 365 × $9,852,217 60 = 9.12% 3.5.5 Bankers’ Acceptances (BA) A banker’s acceptance is an order to pay a specified amount of money to the bearer on a given date. They are used to finance goods that have not yet been transferred from the seller to the buyer. A banker’s acceptance indicates that a bank accepts responsibility for a future payment. These are commonly used for international trade transactions. An exporter that is sending goods to an importer whose credit rating is not known will often prefer that a bank act as a guarantor. The bank therefore facilitates the transaction by stamping ACCEPTED on a draft, which obligates payment at a specified point in time. In turn, the importer will pay the bank what is owed to the exporter along with a fee to the bank for guaranteeing the payment. Zimbabwe Open University 51 Money and Capital Markets Module MBAZ510 The following are the steps for using bankers’ acceptances: i. ii. iii. iv. v. The importer requests its bank to send an irrevocable letter of credit to the exporter The exporter receives the letter, ships the goods, and is paid by presenting to its bank the letter along with the proof that the merchandise was shipped The exporter’s bank creates a time draft based on the letter of credit and sends it along with the proof of shipment to the importer’s bank The importer’s bank stamps the time draft “accepted” and sends the bankers’ acceptance back to the exporter’s bank so that the exporter’s bank can sell it on the secondary market and collect payment The importer deposits funds at its bank sufficient to cover the banker’s acceptance when it matures Exporters can hold a banker’s acceptance until the date at which payment is to be made, but they frequently sell the acceptance before then at a discount to obtain cash immediately. The investor who purchases the acceptance then receives the payment guaranteed by the bank in the future. The investor’s return on a banker’s acceptance, like that on commercial paper, is derived from the difference between the discounted price paid for the acceptance and the amount to be received in the future. Maturities on banker’s acceptances often range from 30 to 270 days. Because there is a possibility that a bank will default on payment, investors are exposed to a slight degree of credit risk. Thus, they deserve a return above the T-bill yield as compensation. Because acceptances are often discounted and sold by the exporting firm prior to maturity, an active secondary market exists. Dealers match up companies that wish to sell acceptances with other companies that wish to purchase them. A dealer’s bid price is less than its ask price, which creates the spread, or the dealer’s reward for doing business. Importance of banker’s acceptances The following are some of the advantages of banker’s acceptance: i. ii. iii. 52 The exporter is paid immediately. This is important when delivery times are long after shipment The exporter is shielded from foreign exchange rate risk because the local bank pays in domestic currency The exporter does not have to assess the creditworthiness of the importer because the importer’s bank guarantees payment Zimbabwe Open University Unit 3 Money Markets Activity 3.6 is the difference between money market instruments ? 1. What quoted ‘on a discount basis’’ and ‘on a yield basis? 2. 3. 4. a. b. c. d. 5. Suppose that one-month treasury bills and one-month CDs are both quoted as having a rate of return of 5%. Which gives the higher return to an investor? John purchased an NCD a year ago in the secondary market for $980,000. The NCD matures today at a price of $1 million, and John receives $45,000 in interest. What is John’s return on the NCD? CBZ Bank arranged a repurchase agreement in which it purchased securities for $4.9 million and will sell the securities back for $5 million in 40 days. What is the yield or repo rate to CBZ Bank? Explain how each of the following would use bankers’ acceptances: Exporting firm Importing firm Commercial bank Investors Based on what you know about repurchase agreements, would you expect them to have a lower or higher annualized yield than commercial paper? Explain. 3.6 Summary The main money market securities are treasury bills, commercial paper, bankers’ acceptances, repurchase agreements, negotiable certificates of deposits. These securities vary according to the issuer. Consequently, their perceived degree of credit risk can vary. Therefore, the quoted yields at any given point in time vary among money market securities. Financial institutions manage their liquidity by participating in money markets. They may issue money market securities when they experience cash shortages and need to boost liquidity. They can also sell holdings of money market securities to obtain cash. The value of a money market security represents the present value of future cash flows generated by that security. Zimbabwe Open University 53 Money and Capital Markets Module MBAZ510 References Chisholm, A. M. (2009). Introduction to International Capital Market. 2nd Edition. London: John Wiley and Sons. Choudhry, M. (2001). The Bond and Money Markets. London: ButterHeinemann. Choudhry, M. et al (2010). Capital Market Instruments: Analysis and Valuation. 3rd Edition. London: Palgrave Macmillan. Fabozzi, F. J. (2008): Handbook of Finance, Volume 1. New York: John Wiley & Sons. Howells, P and Bain, K. (2007). Financial Markets and Institutions. 5th Edition. London: Prentice Hall. Levinson, M. (2006): Guide to Financial Markets. 4th Edition. London: Profile Books Limited. Madura, J. (2010). Financial Markets and Institutions: 9th Edition. Florida: SouthWestern College. Mishkin, F.S. and Eakins, S.G. (2006). Financial Markets and Institutions. 5th Edition. New York: Pearson Addison Wesley. 54 Zimbabwe Open University Unit Four Bond Markets 4.0 Introduction I n the previous unit, we discussed short-term securities that are traded in money markets. In this unit, we will talk about one of the several securities that are traded in the capital market. Capital markets are markets for securities with an original maturity that is greater than one year. These securities include bonds, mortgages and stocks. Money and Capital Markets Module MBAZ510 4.1 Objectives By the end of this unit, you should be able to: describe the main purpose of capital markets identify the key participants in the bond markets explain why firms issue bonds discuss the various categories of bonds describe the basic features of a bond analyse the provisions for redeeming bonds explain how bond markets have become globally integrated 4.2 Purpose of Capital Markets Firms and individuals use the capital markets for long-term investments. The primary reason that firms and individuals choose to borrow long-term is to reduce the risk that interest rates will rise before they pay off their debt. Firms that issue capital market securities and investors who buy them have very different motivations from those who operate in the money markets. Firms and individuals use the money markets primarily to warehouse funds for shortterm periods of time until a more important need or a more productive use for the funds arises. 4.3 Capital Market Participants The primary issuers of capital market securities are central and local governments and corporations. Central governments issue long-term bonds to fund national debts, while local government agencies also issue bonds to finance capital projects. Corporations issue both bonds and stock. One of the most difficult decisions a firm faces can be whether it should finance its growth with debt or equity. The distribution of a firm’s capital between debt and equity is its capital structure. Firms may enter the capital markets because they do not have sufficient capital to fund their investment opportunities. Alternatively, firms may choose to enter the capital markets because they want to preserve their capital to protect 56 Zimbabwe Open University Unit 4 Bond Markets against unexpected needs. In either case, the availability of efficiently functioning capital markets is crucial to the continued health of the business sector. Activity 4.1 ? 1. 2. 3. 4. What would you say is the purpose of capital markets? Who are the participants on the capital markets? What is capital structure? “Firms that issue capital market securities and investors who buy them have very different motivations from those who operate in the money markets”. Explain these different motivations. 4.4 Background on Bonds Moorad Choudhry (2001) states that the word “bond” means contract, agreement, or guarantee. All these terms are applicable to the securities known as bonds. An investor who purchases a bond is lending money to the issuer, and the bond represents the issuer’s contractual promise to pay interest and repay principal according to specified terms. Bonds were a natural outgrowth of the loans that early bankers provided to finance wars starting in the Middle Ages. As governments’ financial appetites grew, bankers found it increasingly difficult to come up with as much money as their clients wanted to borrow. Bonds offered a way for governments to borrow from many individuals rather than just a handful of bankers, and they made it easier for lenders to reduce their risks by selling the bonds to others if they thought the borrower might not repay. Bonds are debt securities which entitle the owner to receive interest payments during the life of the bond and repayment of principal, without having ownership or managerial control of the issuer. 4.4.1 Why issue bonds? Bonds are never an issuer’s only source of credit. All businesses and government entities that choose to sell bonds have already borrowed from banks, and many have received financing from customers, suppliers or Zimbabwe Open University 57 Money and Capital Markets Module MBAZ510 specialised finance companies. The principal reason for issuing bonds is to diversify sources of funding. The amount any bank will lend to a single borrower is limited. By tapping the vastly larger base of bond market investors, the issuer can raise far more money without exhausting its traditional credit lines with direct lenders. Bonds also help issuers carry out specific financial-management strategies. These include the following: 58 Minimising financing costs: Leverage, the use of borrowed money, enables profit-making businesses to expand and earn more profit than they could from equity funds. Firms generally prefer bonds to other forms of leverage, such as bank loans, because the cost is lower and the funds can be repaid over a longer period. A bond issue may or may not increase the issuer’s leverage, depending upon whether the bonds increase the total amount of borrowing or merely replace other forms of borrowing. Matching revenue and expenses: Many capital investments, such as a toll bridge or a copper smelter, take years to complete but are then expected to produce revenue over a lengthy period. Bonds offer a way of linking the repayment of borrowings for such projects to anticipated revenue. Promoting inter-generational equity: Governments often undertake projects, such as building roads or buying park land, that create longlasting benefits. Bonds offer a means of requiring future taxpayers to pay for the benefits they enjoy, rather than putting the burden on current taxpayers. Controlling risk: The obligation to repay a bond can be tied to a specific project or a particular government agency. This can insulate the parent corporation or government from responsibility if the bond payments are not made as required. Avoiding short-term financial constraints: Governments and firms may turn to the bond markets to avoid painful steps, such as tax increases, redundancies or wage reductions that might otherwise be necessary owing to a lack of cash. Zimbabwe Open University Unit 4 Bond Markets Activity 4.2 ? 1. 2. Why do firms generally prefer bonds to other forms of credit? Discuss how bonds help firms carryout their specific financial management strategies. 4.4.2 Issuers of bonds The following are the basic types of entities that issue bonds. National governments Bonds backed by the full faith and credit of national governments are called sovereign bonds. These are generally considered the most secure type of bond. A national government has strong incentives to pay on time in order to retain access to credit markets, and it has extraordinary powers, including the ability to print money and to take control of foreign currency reserves, that can be employed to make payments. Lower levels of governments Bonds issued by a government at the sub-national level, such as municipality, are called semi-sovereigns. Semi-sovereign bonds are generally riskier than sovereigns because government agencies such as municipalities have no power to print money or to take control of foreign exchange. Government agencies and investment banks An asset-backed security is a type of bond on which the required payments are made out of the income generated by specific assets, such as mortgage loans or future sales. Some asset-backed securities are initiated by government agencies, others by private-sector entities. These sort of securities are assembled by an investment bank, and often do not represent the obligations of a particular issuer. Corporations Corporate bonds are issued by a business enterprise, whether owned by private investors or by a government. Most corporate bonds have a face value of $1,000 and pay interest semiannually. The degree of risk varies widely among issues because the risk of default depends on the company’s health, Zimbabwe Open University 59 Money and Capital Markets Module MBAZ510 which can be affected by a number of variables. 4.5 Main Features of Bonds The following characteristics are associated with corporate bonds: 4.5.1 Indenture and covenants The promises of the issuer and the rights of the bondholders are set forth in great detail in a bond’s indenture. Bondholders would have great difficulty in determining from time to time whether the issuer was keeping all the promises made in the indenture. This problem is resolved for the most part by bringing in a trustee as a third party to the bond or debt contract. The indenture identifies the trustee as a representative of the interests of the bondholders. As part of the indenture, there are affirmative covenants and negative covenants. Affirmative covenants set forth activities that the borrower promises to do. The most common affirmative covenants are (1) to pay interest and principal on a timely basis, (2) to pay all taxes and other claims when due, (3) to maintain all properties used and useful in the borrower’s business in good condition and working order, and (4) to submit periodic reports to a trustee stating that the borrower is in compliance with the loan agreement. Negative covenants set forth certain limitations and restrictions on the borrower’s activities. The more common restrictive covenants are those that impose limitations on the borrower’s ability to incur additional debt unless certain tests are satisfied. 4.5.2 Maturity The term to maturity of a bond is the number of years the debt is outstanding or the number of years remaining prior to final principal payment. The maturity date of a bond refers to the date that the debt will cease to exist, at which time the issuer will redeem the bond by paying the outstanding balance. The maturity date of a bond is always identified when describing a bond. For example, a description of a bond might state ‘‘due 12/1/2020.’’ There are three reasons why the term to maturity of a bond is important: Reason 1: Term to maturity indicates the time period over which the bondholder can expect to receive interest payments and the number of years before the principal will be paid in full. 60 Zimbabwe Open University Unit 4 Bond Markets Reason 2: The yield offered on a bond depends on the term to maturity. The relationship between the yield on a bond and maturity is called the yield curve. Reason 3: The price of a bond will fluctuate over its life as interest rates in the market change. The price volatility of a bond is a function of its maturity (among other variables). More specifically, by holding all other factors constant, the longer the maturity of a bond, the greater the price volatility resulting from a change in interest rates. 4.5.3 Par value The par value of a bond is the amount that the issuer agrees to repay the bondholder at or by the maturity date. This amount is also referred to as the principal value, face value, redemption value, and maturity value. Note that a bond may trade below or above its par value. When a bond trades below its par value, it is said to be trading at a discount. When a bond trades above its par value, it is said to be trading at a premium. 4.5.4 Current yield Current yield is the effective interest rate for a bond at its current market price. This is calculated by a simple formula: Annual dollar coupon interest Current price If the price has fallen since the bond was issued, the current yield will be greater than the coupon; if the price has risen, the yield will be less than the coupon. 4.5.5 Yield to maturity This is the annual rate the bondholder will receive if the bond is held to maturity. Unlike current yield, yield to maturity includes the value of any capital gain or loss the bondholder will incur when the bond is redeemed. This is the most widely used figure for comparing returns on different bonds. Zimbabwe Open University 61 Money and Capital Markets Module MBAZ510 4.5.6 Duration Duration is a number expressing how quickly the investor will receive half of the total payment due over the bond’s remaining life, with an adjustment for the fact that payments in the distant future are worth less than payments due soon. This complicated concept can be grasped by looking at two extremes. A zero-coupon bond offers payments only at maturity, so its duration is precisely equal to its term. A hypothetical ten-year bond yielding 100% annually lets the owner collect a great deal of money in the early years of ownership, so its duration is much shorter than its term. Most bonds fall in between. If two bonds have identical terms, the one with the higher yield will have the shorter duration, because the holder is receiving more money sooner. 4.5.7 Coupon rate The coupon rate, also called the nominal rate, is the interest rate that the issuer agrees to pay each year. The annual amount of the interest payment made to bondholders during the term of the bond is called the coupon. The coupon is determined by multiplying the coupon rate by the par value of the bond. That is, Coupon = coupon rate × par value The coupon rate also affects the bond’s price sensitivity to changes in market interest rates. Holding other factors constant, the higher the coupon rate, the less the price will change in response to a change in market interest rates. Zero coupon bonds Not all bonds make periodic coupon payments. Bonds that are not contracted to make periodic coupon payments are called zero-coupon bonds. The holder of a zero-coupon bond realises interest by buying the bond substantially below its par value (i.e., buying the bond at a discount). Interest is then paid at the maturity date, with the interest being the difference between the par value and the price paid for the bond. So, for example, if an investor purchases a zerocoupon bond for $70, the interest is $30. This is the difference between the par value ($100) and the price paid ($70). Step-up notes There are securities that have a coupon rate that increases over time. These securities are called step-up notes because the coupon rate ‘‘steps up’’ over time. For example, a 5-year step-up note might have a coupon rate that is 5% 62 Zimbabwe Open University Unit 4 Bond Markets for the first two years and 6% for the last three years. Or, the step-up note could call for a 5% coupon rate for the first two years, 5.5% for the third and fourth years, and 6% for the fifth year. When there is only one change (or step up), as in the first example, the issue is referred to as a single step-up note. When there is more than one change, as in the second example, the issue is referred to as a multiple step-up note. Deferred coupon bonds There are bonds whose interest payments are deferred for a specified number of years. That is, there are no interest payments for the deferred period. At the end of the deferred period, the issuer makes periodic interest payments until the bond matures. The interest payments that are made after the deferred period are higher than the interest payments that would have been made if the issuer had paid interest from the time the bond was issued. The higher interest payments after the deferred period are to compensate the bondholder for the lack of interest payments during the deferred period. These bonds are called deferred coupon bonds. Floating-rate securities The coupon rate on a bond need not be fixed over the bond’s life. Floatingrate securities, sometimes called variable-rate securities, have coupon payments that reset periodically according to some reference rate. The typical formula (called the coupon formula) on certain determination dates when the coupon rate is reset is as follows: Coupon rate = reference rate + quoted margin The quoted margin is the additional amount that the issuer agrees to pay above the reference rate. For example, suppose that the reference rate is the 1month London inter-bank offered rate (LIBOR). Suppose that the quoted margin is 100 basis points. Then the coupon formula is: Coupon rate = 1-month LIBOR + 100 basis points So, if 1-month LIBOR on the coupon reset date is 5%, the coupon rate is reset for that period at 6% (5% plus 100 basis points). Accrued interest Bond issuers do not disburse coupon interest payments every day. Typically, coupon interest is paid every six months. In some countries, interest is paid annually. For mortgage-backed and asset-backed securities, interest is usually Zimbabwe Open University 63 Money and Capital Markets Module MBAZ510 paid monthly. The coupon payment is made to the bondholder of record. Thus, if an investor sells a bond between coupon payments and the buyer holds it until the next coupon payment, then the entire coupon interest earned for the period will be paid to the buyer of the bond since the buyer will be the holder of record. The seller of the bond gives up the interest from the time of the last coupon payment to the time until the bond is sold. The amount of interest over this period that will be received by the buyer even though it was earned by the seller is called accrued interest. The bond buyer must pay the bond seller the accrued interest. The amount that the buyer pays the seller is the agreed upon price for the bond plus accrued interest. This amount is called the full price. (Some market participants refer to this as the dirty price.) The agreed upon bond price without accrued interest is simply referred to as the price. (Some refer to it as the clean price.) A bond in which the buyer must pay the seller accrued interest is said to be trading cum-coupon (‘‘with coupon’’). If the buyer forgoes the next coupon payment, the bond is said to be trading ex-coupon (‘‘without coupon’’). There are exceptions to the rule that the bond buyer must pay the bond seller accrued interest. The most important exception is when the issuer has not fulfilled its promise to make the periodic interest payments. In this case, the issuer is said to be in default. In such instances, the bond is sold without accrued interest and is said to be traded flat. Activity 4.3 ? 64 1. 2. 3. 4. 5. a. b. Describe the characteristics associated with corporate bonds. What is a coupon rate? How does the coupon rate influence the bond price? Distinguish between current yield and yield to maturity. Explain the following terms: dirty price clean price Zimbabwe Open University Unit 4 Bond Markets 4.6 Provisions for Paying off Bonds The issuer of a bond agrees to pay the principal by the stated maturity date. The issuer can agree to pay the entire amount borrowed in one lump sum payment at the maturity date. That is, the issuer is not required to make any principal repayments prior to the maturity date. Such bonds are said to have a bullet maturity. Fixed income securities backed by pools of loans (mortgage-backed securities and asset-backed securities) often have a schedule of partial principal payments. Such fixed income securities are said to be amortizing securities. For many loans, the payments are structured so that when the last loan payment is made, the entire amount owed is fully paid. Another example of an amortizing feature is a bond that has a sinking fund provision. This provision for repayment of a bond may be designed to pay all of an issue by the maturity date, or it may be arranged to repay only a part of the total by the maturity date. An issue may have a call provision granting the issuer an option to retire all or part of the issue prior to the stated maturity date. Some issues specify that the issuer must retire a predetermined amount of the issue periodically. Various types of call provisions are discussed in sections 4.6.1 to 4.6.5. 4.6.1 Call and refunding provision An issuer generally wants the right to retire a bond issue prior to the stated maturity date. The issuer recognizes that at some time in the future interest rates may fall sufficiently below the issue’s coupon rate so that redeeming the issue and replacing it with another lower coupon rate issue would be economically beneficial. This right is a disadvantage to the bondholder since proceeds received must be reinvested in the lower interest rate issue. As a result, an issuer who wants to include this right as part of a bond offering must compensate the bondholder when the issue is sold by offering a higher coupon rate, or equivalently, accepting a lower price than if the right is not included. The right of the issuer to retire the issue prior to the stated maturity date is referred to as a call provision. If an issuer exercises this right, the issuer is said to ‘‘call the bond.’’ The price which the issuer must pay to retire the issue is referred to as the call price or redemption price. When a bond is issued, typically the issuer may not call the bond for a number of years. That is, the issue is said to have a deferred call. The date at which the bond may first be called is referred to as the first call date. Zimbabwe Open University 65 Money and Capital Markets Module MBAZ510 4.6.2 Prepayments For amortizing securities that are backed by loans that have a schedule of principal payments, individual borrowers typically have the option to pay off all or part of their loan prior to a scheduled principal payment date. Any principal payment prior to a scheduled principal payment date is called a prepayment. The right of borrowers to prepay principal is called a prepayment option. Basically, the prepayment option is the same as a call option. However, unlike a call option, there is not a call price that depends on when the borrower pays off the issue. Typically, the price at which a loan is prepaid is par value. 4.6.3 Sinking fund provision An indenture may require the issuer to retire a specified portion of the issue each year. This is referred to as a sinking fund requirement. The alleged purpose of the sinking fund provision is to reduce credit risk. This kind of provision for debt payment may be designed to retire all of a bond issue by the maturity date, or it may be designed to pay only a portion of the total indebtedness by the end of the term. If only a portion is paid, the remaining principal is called a balloon maturity. 4.6.4 Conversion privilege A convertible bond is an issue that grants the bondholder the right to convert the bond for a specified number of shares of common stock. Such a feature allows the bondholder to take advantage of favorable movements in the price of the issuer’s common stock. An exchangeable bond allows the bondholder to exchange the issue for a specified number of shares of common stock of a corporation different from the issuer of the bond. 4.6.5 Put provision An issue with a put provision included in the indenture grants the bondholder the right to sell the issue back to the issuer at a specified price on designated dates. The specified price is called the put price. Typically, a bond is putable at par if it is issued at or close to par value. For a zero-coupon bond, the put price is below par. The advantage of a put provision to the bondholder is that if, after the issuance date, market rates rise above the issue’s coupon rate, the bondholder can force the issuer to redeem the bond at the put price and then reinvest the put bond proceeds at the prevailing higher rate. 66 Zimbabwe Open University Unit 4 Bond Markets 4.7 Types of Bonds Bonds are not as standardised as stocks. An increasing variety of bonds is available in the marketplace. In some cases, an issuer agrees to design a bond with the specific characteristics required by a particular institutional investor. Such a bond is then privately placed and is not traded in the bond markets. Bonds that are issued in the public markets generally fit into one or more of the following categories. 4.7.1 Secured bonds Secured bonds are ones with collateral attached. Mortgage bonds are used to finance a specific project. For example, a building may be the collateral for bonds issued for its construction. In the event that the firm fails to make payments as promised, mortgage bondholders have the right to liquidate the property in order to be paid. These bonds are less risky comparable to unsecured bonds. As a result, they will have a lower interest rate. 4.7.2 Unsecured bonds Debentures are long-term unsecured bonds that are backed only by the general creditworthiness of the issuer. No specific collateral is pledged to repay the debt. In the event of default, the bondholders must go to court to seize assets. Collateral that has been pledged to other debtors is not available to the holders of debentures. Debentures have lower priority than secured bonds if the firm defaults. As a result, they will have a higher interest rate than otherwise comparable to secured bonds. Subordinated debentures are similar to debentures except that they have a lower priority claim. This means that in the event of a default, subordinated debenture holders are paid only after non-subordinated bondholders have been paid in full. As a result, subordinated debenture holders are at greater risk of loss. 4.7.3 Junk bonds One of the most important bond-market developments in recent years is the issuance of debt by entities with weak credit ratings. Such bonds are called high-yield debt or below-investment-grade debt. They are better known to the public as junk bonds. Some bonds that carry investment-grade ratings when they are issued may in Zimbabwe Open University 67 Money and Capital Markets Module MBAZ510 future trade as high-yield bonds because the issuer’s financial condition has deteriorated. These are known as fallen angels. When the condition of the issuer of a below-investment-grade bond improves significantly, the bond may gain an investment-grade rating. In this case, traders refer to it as a rising star. 4.7.4 Callable bonds The issuer may reserve the right to call the bonds at particular dates. A call obliges the owner to sell the bonds to the issuer for a price, specified when the bond was issued, that usually exceeds the current market price. The difference between the call price and the current market price is the call premium. A bond that is callable is worth less than an identical bond that is non-callable, to compensate the investor for the risk that it will not receive all of the anticipated interest payments. Borrowers prefer to have this provision attached to their bonds as it enables them to refinance debt at cheaper levels when market interest rates have fallen significantly below the level they were at the time of the bond issue. A call provision is a negative feature for investors, as bonds are only paid off if their price has risen above par. Although a call feature indicates an issuer’s interest in paying off the bond, because they are not attractive for investors, callable bonds pay a higher yield than non-callable bonds of the same credit quality and maturity. 4.7.5 Non-refundable bonds These may be called only if the issuer is able to generate the funds internally, from sales or taxes. This prohibits an issuer from selling new bonds at a lower interest rate and using the proceeds to call bonds that bear a higher interest rate. 4.7.6 Putable bonds Putable bonds give the investor the right to sell the bonds back to the issuer at par value on designated dates. This benefits the investor if interest rates rise, so a putable bond is worth more than an identical bond that is not putable. 4.7.7 Perpetual debentures Also known as irredeemable debentures, perpetual debentures are bonds that will last forever unless the holder agrees to sell them back to the issuer. 68 Zimbabwe Open University Unit 4 Bond Markets 4.7.8 Zero-coupon bonds Zero-coupon bonds do not pay periodic interest. Instead, they are issued at less than par value and are redeemed at par value, with the difference serving as an interest payment. Zeros are designed to eliminate reinvestment risk, the loss an investor suffers if future income or principal payments from a bond must be invested at lower rates than those available today. The owner of a zero-coupon bond has no payments to reinvest until the bond matures, and therefore has greater certainty about the return on the investment. 4.7.9 Convertible bonds Under specified conditions and strictly at the bondholder’s option, convertible bonds may be exchanged for another security, usually the issuer’s common shares. The prospectus for a convertible issue specifies the conversion ratio, the number of shares for which each bond may be exchanged. A convertible bond has a conversion value, which is simply the price of the common shares for which it may be traded. The buyer must usually pay a premium over conversion value, to reflect the fact that the bond pays interest until and unless it is converted. Convertibles often come with hard call protection, which prohibits the issuer from calling the bonds before the conversion date. 4.7.10 Adjustable bonds There are many varieties of adjustable bonds. The interest rate on a floatingrate bond can change frequently, usually depending on short-term interest rates. The rate on a variable-rate bond may be changed only once a year, and is usually related to long-term interest rates. A step-up note will have an increase in the interest rate no more than once a year, according to a formula specified in the prospectus. Inflation-indexed bonds seek to protect against the main risk of bond investing: the likelihood that inflation will erode the value of both interest payments and principal. Capital-indexed bonds apply an inflation adjustment to interest payments as well as to principal. Interest-indexed bonds adjust interest payments for inflation, but the value of the principal itself is not adjusted for inflation. Indexed zero-coupon bonds pay an inflationadjusted principal upon redemption. 4.7.11 Structured securities Bonds that have options attached to them are called structured securities. Callable, putable and convertible bonds are simple examples of structured securities. Zimbabwe Open University 69 Money and Capital Markets Module MBAZ510 Another traditional example is a warrant bond, a bond which comes with a warrant entitling the holder to buy a different bond under certain conditions at some future date. Many structured securities are far more complex, featuring interest rates that can vary only within given limits and can change at an exponential rate or can even cease to be payable altogether in certain circumstances. The prices of such instruments can be difficult to calculate and depend heavily on the value attached to the option features. 4.8 Corporate Bond Risks Corporate bonds hold additional risks for investors when compared with sovereign bonds. Issuers frequently take steps to reduce the risk bondholders must bear in order to sell them at lower interest rate. There are three common ways of doing this: 70 Covenants are legally binding promises made at the time a bond is issued. A simple covenant might limit the amount of additional debt that the issuer may sell in future, or might require it to keep a certain level of cash at all times. Covenants are meant to protect bondholders not only against default, but also against the possibility that management’s future actions will lead ratings agencies to downgrade the bonds, which would reduce the price in the secondary market. Bond insurance is frequently sought by issuers with unimpressive credit ratings. A bond insurer is a private firm that has obtained a top rating from the main ratings agencies. An issuer pays it a premium to guarantee bondholders that specific bonds will be serviced on time. With such a guarantee, the issuer is able to sell its bonds at a lower interest rate. Sinking funds ensure that the issuer arranges to retire some of its debt, on a prearranged schedule, prior to maturity. The issuer can do this either by purchasing the required amount of its bonds in the market at specified times, or by setting aside money in a fund overseen by a trustee, to ensure that there is adequate cash on hand to redeem the bonds at maturity. Zimbabwe Open University Unit 4 Bond Markets 4.9 International Bond Markets The bond markets have long since ceased to be domestic markets. As restrictions on the cross-border flow of capital have been reduced or eliminated, investors have increasingly been able to buy bonds regardless of the national origin of the issuer and the currency of issue. The issuance of bonds outside the issuer’s home country can occur in two different ways: Foreign bonds are issued outside the issuer’s home country and are denominated in the currency of the country where they are issued. Eurobonds are denominated in neither the currency of the issuer’s home country nor that of the country of issue, and are generally subject to less regulation. Thus a sterling-denominated bond offered in London by a Japanese firm would be considered a foreign bond, and the same security offered in London but denominated in dollars or Swiss francs would be called a eurobond. 4.10 Importance of International Bond Markets Why would an issuer choose an international issue rather than a domestic one? First, it may wish to match its borrowing to the income that is intended to pay for that borrowing. A Zimbabwean firm intending to build an electrical generation plant in UK, for example, might borrow in British Pounds rather than in euros because the electricity will be priced and sold in pounds. Second, the greater liquidity of the main bond markets, particularly in developed economies, means that borrowers from other countries can often obtain lower interest rates than at home, even after taking currency risk into account. This is particularly true for issuers from countries where financial markets are underdeveloped and investors’ willingness to purchase localcurrency bonds is limited. Third, an international issue is often undertaken to establish the issuer’s reputation among international investors, to ease the way for future borrowings or share offerings. Zimbabwe Open University 71 Money and Capital Markets Module MBAZ510 Activity 4.4 ? 1. 2. 3. 4. 5. 6. 7. 8. What is a bond indenture? What is the function of a trustee, as related to the bond indenture? Explain the use of a sinking fund provision. How can it reduce the investors’ risk? What are protective covenants? Why are they needed? Explain the use of call provisions on bonds. How can a call provision affect the price of a bond? What are the advantages and disadvantages to a firm that issues low or zero coupon bonds? Are variable-rate bonds attractive to investors who expect interest rates to decrease? Explain. Would a firm that needs to borrow funds consider using variable-rate bonds if it expects that interest rates will decrease? Explain. Explain why convertible bonds are usually issued by firms at a higher price than other bonds? Consider the following two bond issues: Bond A: 5% 15-year bond Bond B: 5% 30-year bond Neither bond has an embedded option. Both bonds are trading in the market at the same yield. Which bond will fluctuate more in price when interest rates change? Why? 4.11 Summary The three major users of bond markets are governments, firms and individuals. Bond markets are used mainly for long-term investments. Governments issue bonds mainly to finance their national debts while firms issue bonds to finance their capital projects. These entities use bonds as additional sources of funds and enable them to diversify their sources of funds. Bonds are not as standardised as stocks. There is an increasing variety of bonds in the marketplace, and these include; secured bonds, unsecured bonds, junk bonds, callable bonds, non-refundable bonds, convertible bonds, perpetual bonds, zero-coupon bonds, adjustable bonds and many others. The main characteristics associated with bonds include indenture and covenants, coupon 72 Zimbabwe Open University Unit 4 Bond Markets rates, maturity, duration, current yields, par value. Corporate bonds carry additional risk compared to sovereign bonds. Corporate bond issuers take steps such as covenants, bond insurance and sinking fund provisions to reduce the attendant risks. In response to the advent of globalisation, bond markets have since assumed an international outlook. This facility now enables multinational corporations to issue bonds in global markets. Zimbabwe Open University 73 Money and Capital Markets Module MBAZ510 References Choudhry, M. et al (2010). Capital Market Instruments: Analysis and Valuation. 3rd Edition. London: Palgrave Macmillan. Frank J. Fabozzi (2007). Fixed Income Analysis. 2nd Edition. John Wiley & Sons. Levinson, M. (2006). Guide to Financial Markets. 4th Edition. London: Profile Books Limited. Madura, J. (2010). Financial Markets and Institutions. 9th Edition. Florida: SouthWestern College. Mishkin, F.S. and Eakins, S.G. (2006). Financial Markets and Institutions. 5th Edition. New York: Pearson Addison Wesley. 74 Zimbabwe Open University Unit Five Bond Valuation 5.0 Introduction T he values of bonds can change substantially over time. Hence, financial institutions that consider buying or selling bonds closely monitor their values. In this unit, we will discuss the bond valuation process and the factors that influence bond prices. Money and Capital Markets Module MBAZ510 5.1 Objectives By the end of this unit, you should be able to: explain how bonds are priced identify the factors that affect bond prices discuss the sensitivity of bond prices to interest rates is dependent on particular bond characteristics 5.2 Bond Valuation Process Bond valuation is conceptually similar to the valuation of capital budgeting projects, businesses, or even real estate as reflected in the formula given below. The appropriate price reflects the present value of the cash flows to be generated by the bond in the form of periodic interest (coupon) payments and the principal payment to be provided at maturity. According to Madura (2010) and Mishkin & Eakins (2006), the current price of a bond should be the present value (PV) of its remaining cash flows as shown below: PV of bond = Where C C C + Par + + ...... + 1 2 (1 + k ) (1 + k ) (1 + k ) n C = coupon payment provided in each period Par = par value or face value K = required rate of return per period used to discount the bond n = number of periods to maturity Example 5.1 Consider a bond that has a par value of $1,000 which pays $100 at the end of each year in coupon payments, and has three years remaining until maturity. Assume that the prevailing annualized yield on other bonds with similar characteristics is 12%. In this case, the appropriate price of the bond can be determined as follows. The future cash flows to investors who would purchase this bond are $100 in year 1, $100 in year 2, and $1,100 (computed as $100 in coupon payments plus $1,000 par value) in year 3. The appropriate market price of the bond is its present value: 76 Zimbabwe Open University Unit 5 Bond Valuation PV of bond = $100 $100 $1,100 + + 1 2 (1.12) (1.12) (1.12) 3 = $89.29+$79.72+$782.96 = $951.97 5.2.1 Impact of the discount rate on bond valuation The discount rate selected to compute the present value is critical to accurate valuation. The appropriate discount rate for valuing any asset is the yield that could be earned on alternative investments with similar risk and maturity. Figure 5.1 below shows the impact of a discount rate on bond valuation. Figure 5.1 Relationship between discount rate and present value of $10,000 payment to be received in 10 years. Source: Frederic S. Mishkin & Stanley G. Eakins (2006): Financial Markets and Institutions, 5th Edition; Pearson Addison Wesley Investors usually require higher returns on riskier securities. They therefore use higher discount rates to discount the future cash flows of these securities. Consequently, a high-risk security will have a lower value than a low risk security even though both securities have the same expected cash flows. Zimbabwe Open University 77 Money and Capital Markets Module MBAZ510 Activity 5.1 should one closely monitor the values of bonds? ? 1.2. Why When should investors use higher discount rates? 3. What is the relationship between magnitude risk and expected return? 5.2.2 Impact of the timing of payments on bond valuation The market price of a bond is also affected by the timing of the payments made to bondholders. Funds received sooner can be reinvested to earn additional returns. A dollar to be received soon has a higher present value than one to be received later. 5.2.3 Valuation of bonds with semiannual payments In reality, most bonds have semiannual payments. The present value of such bonds can be computed as follows. First, the annualized coupon should be split in half because two payments are made per year. Second, the annual discount rate should be divided by 2 to reflect two-six month periods per year. Third, the number of periods should be doubled to reflect two times the number of annual periods. Incorporating these adjustments, the present value is determined as follows: PV of bond with semiannual payments = C/2 C/2 C / 2 + Par + + ... + 1 2 [1 + (k / 2)]2 n [1 + (k / 2)] [1 + (k / 2)] Where C/2 = the semiannual coupon payment k/2= the periodic discount rate used to discount the bond 2n = in the denominator exponent to reflect the doubling of periods Example 5.2 As an example of the valuation of a bond with semiannual payments, consider a bond with $1,000 par value, a 10 percent coupon rate paid semiannually, and three years to maturity. Assuming a 12 percent required return, the present value is computed as follows: 78 Zimbabwe Open University Unit 5 Bond Valuation PV of bond 50 50 50 50 50 50 + 1,000 + + + + + 1 2 3 4 5 (1.06) (1.06) (1.06) (1.06) (1.06) (1.06) 6 = = $950.82 5.2.4 Relationships between coupon rates, required return and bond price Bonds that sell at a price below their par value are called discount bonds. The larger the investor’s required rate of return relative to the coupon rate, the larger the discount of a bond with a particular par value. Example 5.3 Consider a zero-coupon bond with 3 years remaining to maturity and $1,000 par value. Assume the investor’s required rate of return on the bond is 13%. The appropriate price of this bond can be determined by the present value of its future cash flows: PV of bond= $0 $0 $1,000 + + 1 2 (1.13) (1.13) (1.13) 3 = $693.05 The very low price of this bond is necessary to generate a 13% annualized return to investors. If the bond offered coupon payments, the price would have been higher because those coupon payments would provide part of the return required by investors. Example 5.4 Consider another bond with a similar par value and maturity that offers a 13% coupon rate. The appropriate price of the bond would now be: Zimbabwe Open University 79 Money and Capital Markets Module MBAZ510 PV of bond= $130 $130 $1,130 + + 1 2 (1.13) (1.13) (1.13)3 = $1,000 Notice that the price of this bond is exactly equal to its par value. This is because the entire compensation required by investors is provided by the coupon payments. This type of bond is called a par value bond, where the coupon rate is the same with the required rate of return. Example 5.5 Finally, consider a bond with a similar par value and term to maturity and coupon rate that offers a coupon rate of 15%, which is above the investor’s required rate of return. The appropriate price of this bond as determined by its present value is: $150 $150 $1,150 PV of bond = (1.13)1 + (1.13) 2 + (1.13) 3 = $1,047.22 The price of this bond exceeds its par value because the coupon payments are large enough to offset the high price paid for the bond and still provide a 13% annualized return. The above examples show the following relationships: a) b) c) 80 If the coupon rate of a bond is below the investor’s required rate of return, the price of the bond should be below the par value. This type of bond is called a discount bond. If the coupon rate equals the investors’ required rate of return, the price of the bond should be the same as the par value. This type of bond is called a par value bond. If the coupon rate of a bond is above the investors’ required rate of return, the price of the bond should be above the par value. This is an example of a premium bond. Zimbabwe Open University Unit 5 Bond Valuation Activity 5.2 how bond price is affected by the timing of the coupon ? 1. Explain payments. 2. Discuss the relationship between coupon rates, required rates of return and bond prices. 3. Explain the following terms: · discount bonds · par value bonds · premium bonds 5.3 Explaining Bond Price Movements The price of a bond should reflect the present value of future cash flows based on a required rate of return. Since the required rate of return on a bond is primarily determined by the prevailing risk-free (R f ), which is the yield on a treasury bond with the same maturity, and the credit risk premium (RP) on the bond, the general price movements of bonds can be modeled as: ∆Pb = f (∆R f , ∆RP ) Where ∆Pb = a percentage change in the price of a bond ∆R f = a percentage change in the prevailing risk-free return ∆RP = a percentage change in the credit risk premium Notice how the bond price is affected by a change in the risk-free rate or the risk premium. An increase in the risk-free rate on bonds results in a higher required rate of return on bonds and therefore causes bond prices to decrease. Thus, bonds are exposed to interest rate risk or the risk that their market value will decline in response to a rise in interest rates. An increase in the credit (default) risk premium also results in a higher required rate of return on bonds and therefore causes bond prices to decrease. The following are some of the factors that affect the risk-free rate or default risk premiums and consequently affect bond prices: Zimbabwe Open University 81 Money and Capital Markets Module MBAZ510 5.3.1 Factors that affect the risk-free rate The long-term risk free rate is driven by inflationary expectations (INF), economic growth (ECON), the money supply (MS), and the budget deficit (DEF). This is expressed as follows: ∆ R f = f ( ∆ INF , ∆ ECON , ∆ MS , ∆ DEF ) + + -/+ + Where ∆INF = a change in inflationary expectations ∆ECON = a change in economic growth ∆MS = a change in money supply ∆DEF = a change budget deficit The general relationships are summarized below: Impact of inflationary expectations If the level of inflation is expected to increase, there will be upward pressure on interest rates and therefore, on required rate of return on bonds. Conversely, a reduction in the expected level of inflation results in downward pressure on interest rates, and therefore on the required rate of return on bonds. Impact of economic growth Strong economic growth tends to place upward pressure on interest rates, while weak economic conditions place downward pressure on rates. Any signals about future economic conditions will affect expectations about future interest rate movements and cause bond markets to react immediately. For example, any economic announcements that signal stronger than expected economic growth tend to reduce bond prices. Investors anticipate that interest rates will rise, thereby causing a decline in bond prices. Therefore, they sell bonds, which places immediate downward pressure on bond prices. Conversely, any economic announcements that signal a weaker than expected economy tend to increase bond prices, because investors anticipate that interest rates will decrease, causing bond prices to rise. Therefore, investors buy bonds, which places immediate upward pressure on bond prices. This explains why sudden news of a possible economic recession can cause the bond market to rally. 82 Zimbabwe Open University Unit 5 Bond Valuation Impact of money supply growth Increased money supply results in an increased supply of loanable funds. If demand for loanable funds is not affected, the increased money supply should place downward pressure on interest rates, causing bond portfolio managers to expect an increase in bond prices and thus to purchase bonds based on such expectations. Impact of budget deficit An increase in the annual budget deficit over the previous year results in a higher level of borrowing by Governments, which can place upward pressure on the risk-free interest rate. Increased borrowing by government can result in a higher required return on government bonds. An increase in borrowing by governments can indirectly affect the required rate of return and therefore the yield on all types of bonds. 5.3.2 Factors that affect the credit risk premium According to Frank J. Fabozzi (2007), the credit risk premium tends to be larger for corporate or municipal bonds than for money market securities issued by a given corporation because the probability of a corporation experiencing financial distress is higher for a bond with a longer term to maturity. Strong economic growth tends to improve a firm’s cash flows and reduce the probability that the firm will default on its debt payments. Conversely, weak economic conditions tend to reduce a firm’s cash flows and increase the probability that it will default on its bonds. The credit risk premium is relatively low when economic growth is strong. When the economy is weak, however, the credit risk premium is higher, as investors will provide credit in such periods only if they are compensated for the high degree of credit risk. The price of a bond can also be affected by factors specific to the issuer of the bond, such as a change in its capital structure. If a firm that issues bonds subsequently obtains additional loans, it may be less capable of making its coupon payments, and its credit risk increases. Consequently, investors would now require a higher rate of return if they were to purchase those bonds in the secondary market, which would cause the market value (price) of the bonds to decrease. If the bond market is efficient, this would suggest that bond prices fully reflect all available public information. Thus, any new information about a firm that changes its perceived ability to repay its bonds could have an immediate effect on the price of the bonds. Zimbabwe Open University 83 Money and Capital Markets Module MBAZ510 Activity 5.3 the impact of a decline in interest rates on: ? 1.i. Explain an investor’s required rate of return ii. the present value of existing bonds iii. the prices of existing bonds 2. Why is the relationship between interest rates and bond prices important to financial institutions? 3. How would a financial institution with a large bond portfolio be affected by falling interest rates? Would it be affected more than a financial institution with a greater concentration of bonds (and fewer short-term securities)? Explain. 4. If the coupon rate of a bond is above its required rate of return, would its price be above or below its par value? Explain. 5. Is the price of a long-term bond more or less sensitive to a change in interest rates than the price of a short-term security? Explain. 5.3.3 Sensitivity of bond prices to interest rate movements The sensitivity of the price of a bond to interest rate movements is dependent on the characteristics of the bond. Investors can measure the sensitivity of the price of their bonds to interest rate movements, which will indicate the potential damage to their bond holdings in response to an increase in interest rates. Two common methods for assessing the sensitivity of bonds to a change in the required rate of return on bonds are (1) bond price elasticity and (2) duration. Bond price elasticity The sensitivity of bond prices (P) to changes in the required rate of return (k) is commonly measured by the bond price elasticity (Pe), which is estimated as: Pe = Percent change in P Percent change in k 84 Zimbabwe Open University Unit 5 Bond Valuation Table 5.1 below compares the price sensitivity of 10-year bonds with $1,000 par value and four different coupon rates: 0%, 5%, 10% and 15%. Initially, the required rate of return (k) on the bonds is assumed to be 10%. The price of each bond is therefore the present value of its future cash flows, discounted at 10%. The initial price of each bond is shown in column 2. The top panel shows the effect of a decline in interest rates that reduces the investors’ required return to 8%. The prices of the bonds based on an 8% required return are shown in column 3. The percentage change in the price of each bond resulting from the interest rate movements is shown in column 4. The bottom panel shows the effect of an increase in interest rates that increases the investors’ required return to 12%. The price elasticity for each bond is estimated in Table 5.1 according to the assumed change in the required rate of return. Note that the price sensitivity of any particular bond is greater for declining interest rates than for rising interest rates. The bond price elasticity is negative in all cases, reflecting the inverse relationship between interest rate movements and bond price movements. Zimbabwe Open University 85 Money and Capital Markets Module MBAZ510 Table 5.1: Sensitivity of 10 year bonds with different coupon rates to interest rate changes EFFECTS OF A DECLINE IN THE REQUIRED RATE OF RETURN (1) (2) (3) (4)=[(3)-(2)]/(2) (5) (6)=(4)/(5) BONDS WITH COUPON RATE OF: INITIAL PRICE OF BONDS WHEN k=10 % PRICE OF BONDS WHEN PERCENTAGE CHANGE IN BOND PRICE PERCENTAGE CHANGE IN k BOND PRICE ELASTICITY 0% $386 $463 +19.9% -20.0% -0.995 5 693 799 +15.3 -20.0 -0.765 10 1000 1134 +13.4 -20.0 -0.670 15 1307 1470 +12.5 -20.0 -0.625 e (P ) k=8% EFFECTS OF AN INCREASE IN THE REQUIRED RATE OF RETURN (1) (2) (3) (4)=[(3)-(2)]/(2) (5) (6)=(4)/(5) BONDS WITH COUPON RATE OF: INITIAL PRICE OF BONDS WHEN k=10 % PRICE OF BONDS WHEN PERCENTAGE CHANGE IN BOND PRICE PERCENTAGE CHANGE IN k BOND PRICE ELASTICITY 0% $386 $322 -16.6 +20.0% -0.830 5 693 605 -12.7 +20.0 -0.635 10 1000 887 -11.3 +20.0 -0.565 15 1307 1170 -10.5 +20.0 -0.525 (Pe ) k=12% Source: Jeff Madura (2010), Financial Markets and Institutions, 9th Edition; Joe Sabatino Publishers 86 Zimbabwe Open University Unit 5 Bond Valuation Influence of coupon rate on bond price sensitivity A zero-coupon bond, which pays all of its proceeds to the investor at maturity, is most sensitive to changes in the required rate of return because the adjusted discount rate is applied to one lump sum in the distant future. Conversely, the price of a bond that pays all of its yield in the form of coupon payment is less sensitive to changes in the required rate of return because the adjusted discount rate is applied to some payments that occur in the near future. The adjustment in the present value of such payments in the near future due to a change in the required rate of return is not as pronounced as an adjustment in the present value of payments in the distant future. Influence of maturity on bond price sensitivity As interest rates (and therefore required rates of return) decrease, long-term bond prices (as measured by their present value) increase by a greater degree than short-term bond prices because the long-term bonds will continue to offer the same coupon rate over a longer period of time than short-term bonds. Of course, if interest rates increase, prices of the long-term bonds will decline by a greater degree. Duration An alternative measure of bond price sensitivity is the bond’s duration, which is a measurement of the life of the bond on a present value basis. The longer a bond’s duration, the greater its sensitivity to interest rate changes. A commonly used measure of a bond’s duration (DUR) is: n C t (t ) ∑ (1 + k ) DUR = t =n1 Ct ∑ (1 + k ) t =1 t t Where Ct = coupon or principal payment generated by the bond t k = time at which the payments are provided = bond’s yield to maturity, which reflects the required rate of return by investors The numerator of the duration formula represents the present value of future payments, weighted by the time interval until the payments occur. The longer the intervals until payments are made, the larger the numerator, and the larger the duration. The denominator of the duration formula represents the discounted future cash flows resulting from the bond, which is the present value of the bond. Zimbabwe Open University 87 Money and Capital Markets Module MBAZ510 Example 5.6 The duration of a bond with $1,000 par value and a 7% coupon rate, three years remaining to maturity, and a 9% yield to maturity is: $70 $70( 2) $1,070(3) + + 1 (1.09) (1.09) 2 (1.09) 3 DUR = $70 $70 $1,070 + + 1 2 (1.09) (1.09) (1.09) 3 = 2.80 years By comparison, the duration of a zero-coupon bond with a similar par value and yield to maturity is: $1,000(3) (1.09) 3 DUR = $1,000 (1.09) 3 = 3 years The duration of a zero-coupon bond is always equal to the bond’s term to maturity. The duration of any coupon bond is always less than the bond’s term to maturity because some of the payments occur at intervals prior to maturity. Activity 5.4 explain the two common methods of assessing the ? 1. Briefly sensitivity of bonds to a change in the required rate of return on bonds. 2. Review how the bond price elasticity is measured. 3. Briefly explain why the duration of any coupon bond is always less than the bond’s term to maturity. 88 Zimbabwe Open University Unit 5 Bond Valuation Duration of a portfolio Bond portfolio managers commonly attempt to immunise their portfolio, that is, insulate it from the effects of interest rate movements. A first step in this process is to determine the sensitivity of their portfolio to interest rate movements. Once the duration of each individual bond is measured, the bond portfolio’s duration (DURp) can be estimated as: m DURp = ∑ w j DUR j j =1 Where m = number of bonds in the portfolio wj = bond j’s market value as a percentage of the portfolio market value DURj = bond j’s duration In other words, the duration of a bond portfolio is the weighted average of bond durations, weighted according to relative market value. Financial institutions concerned with interest rate risk may compare their asset duration to their liability duration. A positive difference means that the market value of the institution’s assets is more rate sensitive than the market value of its liabilities. Thus, during a period of rising interest rates, the market value of the assets would be reduced by a greater degree than that of the liabilities. The institution’s real net worth (market value of net) would therefore decrease. Modified duration The duration measurement of a bond or a bond portfolio can be modified to estimate the impact of a change in the prevailing bond yield on bond prices. The modified duration (DUR*) is estimated as: DUR* = DUR (1 + k ) where k represents the prevailing yield on bonds. The modified duration can be used to estimate the percentage change in the price of the bond in response to a 1 percentage point change in bond yields. For example, assume that bond X has a duration of 8, while bond Y has a duration of 12. Assuming that the prevailing bond yield is 10 percent, the modified duration is estimated for each bond: Zimbabwe Open University 89 Money and Capital Markets Module MBAZ510 Bond X DUR* = Bond Y 8 (1 + 0.10) = 7.27 DUR* = 12 (1 + 0.10) = 10.9 Given the inverse relationship between the change in bond yields and the response in bond prices, the estimate of modified duration should be applied such that the bond price moves in the opposite direction from the change in bond yields. According to the modified duration estimates, a 1 percentage point increase in bond yield (from 10% to 11%) would lead to a 7.27% decline in the price of bond X and a 10.9% decline in the price of bond Y. A 0.5 percentage point increase in yield (from 10% to 10.5%) would lead to a 3.635% decline in the price of bond X (computed as 7.27 x 0.5) and a 5.45% decline in the price of bond Y (computed as 10.9 x 0.5). The percentage increase in bond prices in response to a decrease in bond yields is estimated in the same manner. The percentage change in the price of a bond in response to a change in yield can be expressed more directly with a simple equation: %∆P = - DUR*× ∆y Where %∆P = percentage change in the bond’s price ∆y = change in yield The equation above simply expresses the relationship discussed in the preceding paragraphs mathematically. For example, the percentage change in price for bond X for an increase in yield of 0.2 percentage point would be: %∆P = - 7.27 × 0.002 = - 1.45% Thus, if interest rates rise by 0.2%, the price of bond X will drop 1.45%. Similarly, if interest rates decrease by 0.2%, the price of bond X will increase by 1.45% according to the modified duration estimate. 90 Zimbabwe Open University Unit 5 Bond Valuation Estimation errors from using modified duration If investors rely strictly on modified duration to estimate the percentage change in the price of a bond, they will tend to overestimate the price decline associated with an increase in rates and underestimate the price increase associated with a decrease in rates. Bond convexity A more complete formula to estimate the percentage change in price in response to a change in yield will incorporate the property of convexity as well as modified duration. The estimated modified duration suggests a linear relationship in the response of the bond price to a change in bond yields. This is shown by the straight line in Figure 5.3 below. For a given 1 percentage point in bond yields from the initially assumed bond yield of 10%, the modified duration predicts a specific change in bond price. However, the actual response of the bond’s price to a change in bond yields is convex and is represented by the curve in Figure 5.3. Notice that if the bond yield (horizontal axis) changes slightly from the initial level of 10%, the difference between the expected bond price adjustment according to the modified duration estimate (the straight line in Figure 5.3) and the bond’s actual price adjustment (the convex curve) is small. Bond Price Curves (actual) relationship between bond yield and bond prices relationship Linear between bond yields and prices based on the modified-duration estimate: slope reflects a specific percent change in bond price for every 1.0 percentage point change in yield Figure 5.3: Relationship between Bond Yields and Prices Source: Frederic S. Mishkin & Stanley G. Eakins (2006): Financial Markets and Institutions, 5th Edition; Pearson Addison Wesley Zimbabwe Open University 91 Money and Capital Markets Module MBAZ510 For relatively large changes in the bond yield, however, the bond price adjustment as estimated by modified duration is less accurate. The larger the change in the bond yield, the larger the error from estimating the change in bond price in response to the change in yield. Since a change in the price of the bond in response to a change in yield is positively related to the maturity of the bond, convexity is also more pronounced for bonds with a long maturity. The prices of low- or zero-coupon bonds are more sensitive to changes in yields. Similarly, bond convexity is more pronounced for bonds with low (or no) coupon rates. Activity 5.5 ? 1. 2. 3. 4. a. b. c. 5. 6. 7. 8. 92 Explain the concept of bond price elasticity. Determine how the bond elasticity would be affected if the bond price changed by a larger amount, holding the change in the required rate of return constant. An analyst recently suggested that there will be a major economic expansion, which will favorably affect the prices of high-rated fixed rate bonds, because the credit risk of bonds will decline as corporations improve their performance. Assuming that the economic expansion occurs, do you agree with the analyst’s conclusion? Explain. Assume the following information for an existing bond that provides annual coupon payments: Par value = $1 000 Coupon rate = 11% Maturity = 4 years Required rate of return by investors = 11% What is the present value of the bond? If the required rate of return by investors were 14% instead of 11%, what would be the present value of the bond? If the required rate of return by investors were 9%, what would be the present value of the bond? Assume that you require a 14% return on a zero-coupon bond with a par value of $1 000 and 6 years to maturity. What is the price you should be willing to pay for this bond? Determine how the duration of a bond would be affected if the coupons are extended over additional time periods. A bond has a duration of 5 years and a yield to maturity of 9%. If the yield to maturity changes to 10%, what should be the percentage price change of the bond? Describe how bond convexity affects the theoretical linear price-yield relationship of bonds. What are the implications of bond convexity for estimating changes in bond prices? Zimbabwe Open University Unit 5 Bond Valuation 5.4 Summary The value of a bond is the present value of future cash flows generated by that security, using a discount rate that reflects the investor’s required rate of return. The discounted value of bond payments declines when a higher discount rate is applied. Bond prices are affected by the factors that influence interest rate movements, including economic growth, money supply, changes in credit risk and so on. Two methods commonly used in measuring the sensitivity of bond portfolios to interest rate movements are bond price elasticity and duration. Zimbabwe Open University 93 Money and Capital Markets Module MBAZ510 References Chisholm, A. M. (2009). Introduction to International Capital Markets. 2nd Edition. London: John Wiley and Sons. Choudhry, M. et al (2010). Capital Market Instruments: Analysis and Valuation. 3rd Edition. London: Palgrave Macmillan. Frank J. Fabozzi (2007). Fixed Income Analysis. 2nd Edition. John Wiley and Sons. Levinson, M. (2006). Guide to Financial Markets. 4th Edition. London: Profile Books Limited. Madura, J. (2010). Financial Markets and Institutions. 9th Edition Florida: South- Western College. Mishkin, F.S. & Eakins, S.G. (2006). Financial Markets and Institution. 5th Edition New York: Pearson Addison Wesley. 94 Zimbabwe Open University Unit Six Risks Associated with Investing in Bonds 6.0 Introduction A rmed with an understanding of the basic features of bonds, we now turn to the risks associated with investing in bonds. These risks include interest rate risk, call and prepayment risk, yield curve risk, reinvestment risk, credit risk, liquidity risk, exchange-rate risk, volatility risk, inflation or purchasing power risk, event risk and sovereign risk. These risks are discussed in this unit. Money and Capital Markets Module MBAZ510 6.1 Objectives By the end of this unit, you should be able to: discuss the various risks associated with investing in bonds explain why there is an inverse relationship between a change in interest rates and bond prices identify the relationships among a bond’s coupon rate, yield required by the market, and price relative to par value (that is, discount, premium, or par value) explain the relationship among the price of a callable bond, the price of an option-free bond, and the price of the embedded call option outline the factors that affect the reinvestment risk of a security; give the disadvantages of a callable and prepayable security to an investor explain why prepayable amortizing securities expose investors to greater reinvestment risk than non-amortizing securities describe the types of credit risk: default risk, credit spread risk, and downgrade risk discuss the various forms of event risk describe the components of sovereign risk 6.2 Interest Rate Risk The price of a typical bond will change in the opposite direction to the change in interest rates or yields. That is, when interest rates rise, the bond price will fall; when interest rates fall, the bond price will rise. For example, consider a 6%, 20-year bond. If the yield investors require to buy this bond is 6%, the price of this bond would be $100. However, if the required yield increased to 6.5%, the price of this bond would decline to $94.4479. Thus, for a 50 basis point increase in yield, the bond price declines by 5.55%. If, instead, the yield declines from 6% to 5.5%, the bond price will rise by 6.02% to $106.0195. Since the price of a bond fluctuates with market interest rates, the risk that an investor faces is that the price of a bond held in a portfolio will decline if market interest rates rise. This risk is referred to as interest rate risk and is the major risk faced by investors in the bond market. 96 Zimbabwe Open University Unit 6 Risks Associated with Investing in Bonds 6.2.1 Reason for the inverse relationship between changes in interest rates and bond price The reason for this inverse relationship between bond price change and the change in interest rates (or change in market yields) is as follows. Suppose investor X purchases a hypothetical 6% coupon 20-year bond at a price equal to par (100). The yield for this bond is 6%. Suppose that immediately after the purchase of this bond two things happen. First, market interest rates rise to 6.50%, so that if a bond issuer wishes to sell a bond priced at par, it will require a 6.50% coupon rate to attract investors to purchase the bond. Second, suppose investor X wants to sell the bond with a 6% coupon rate. In attempting to sell the bond, investor X would not find an investor who would be willing to pay par value for a bond with a coupon rate of 6%. The reason is that any investor who wanted to purchase this bond could obtain a similar 20-year bond with a coupon rate 50 basis points higher, 6.5%. What can the investor do? The investor cannot force the issuer to change the coupon rate to 6.5%, neither can the investor force the issuer to shorten the maturity of the bond to a point where a new investor might be willing to accept a 6% coupon rate. The only thing that the investor can do is adjust the price of the bond to a new price where a buyer would realize a yield of 6.5%. This means that the price would have to be adjusted down to a price below par. It turns out the new price must be $94.4479. While we assumed in our illustration an initial price of par value, the principle holds for any purchase price. Regardless of the price that an investor pays for a bond, an instantaneous increase in market interest rates will result in a decline in bond price. Suppose that instead of a rise in market interest rates to 6.5%, interest rates decline to 5.5%. Investors would be more than happy to purchase the 6% coupon 20-year bond at par. However, investor X realizes that the market is only offering investors the opportunity to buy a similar bond at par with a coupon rate of 5.5%. Consequently, investor X will increase the price of the bond until it offers a yield of 5.5%. That price turns out to be $106.0195. Activity 6.1 the various risks associated with investing in ? 1. Explain bonds. 2. Zimbabwe Open University Explain why there is an inverse relationship between changes in interest rates and bond prices. 97 Money and Capital Markets Module MBAZ510 6.2.2 Bond features that affect interest rate risk Bond price sensitivity to change in market interest rates (that is, a bond’s interest rate risk) depends on various features of the issue, such as maturity, coupon rate, and embedded options. The impact of maturity Holding all other factors constant, the longer the bond’s maturity the greater the bond price sensitivity to change in interest rates. For example, we know that for a 6% 20-year bond selling to yield 6%, a rise in the yield required by investors to 6.5% will cause the bond price to decline from $100 to $94.4479, a 5.55% price decline. Similarly for a 6% 5-year bond selling to yield 6%, the price is 100. A rise in the yield required by investors from 6% to 6.5% would decrease the price to $97.8944. The decline in the bond price is only 2.11%. The impact of coupon rate Holding all other factors constant, the lower the coupon rate the greater the bond price sensitivity to change in interest rates. For example, consider a 9% 20-year bond selling to yield 6%. The price of this bond would be $134.6722. If the yield required by investors increases by 50 basis points to 6.5%, the price of this bond would fall by 5.13% to $127.7605. This decline is less than the 5.55% decline for the 6% 20-year bond selling to yield 6% discussed above. An implication is that zero-coupon bonds have greater price sensitivity to interest rate changes than same-maturity bonds bearing a coupon rate and trading at the same yield. The impact of embedded options The value of a bond with embedded options will change depending on how the value of the embedded options changes when interest rates change. As interest rates decline, the price of a callable bond may not increase as much as an otherwise option-free bond (that is, a bond with no embedded options). To understand why, let us decompose the price of a callable bond into two components, as shown below: price of callable bond = price of option-free bond minus price of embedded call option 98 Zimbabwe Open University Unit 6 Risks Associated with Investing in Bonds The reason for subtracting the price of the embedded call option from the price of the option-free bond is that the call option is a benefit to the issuer and a disadvantage to the bondholder. This reduces the price of a callable bond relative to an option-free bond. Now, when interest rates decline, the price of an option-free bond increases. However, the price of the embedded call option in a callable bond also increases because the call option becomes more valuable to the issuer. So, when interest rates decline both price components increase in value, but the change in the price of the callable bond depends on the relative price change between the two components. Typically, a decline in interest rates will result in an increase in the price of the callable bond but not by as much as the price-change of an otherwise comparable option-free bond. Similarly, when interest rates rise, the price of a callable bond will not fall as much as an otherwise option-free bond. The reason is that the price of the embedded call option declines. So, when interest rates rise, the price of the option-free bond declines but this is partially offset by the decrease in the price of the embedded call option component. The impact of the yield level Because of credit risk (discussed later), different bonds trade at different yields, even if they have the same coupon rate, maturity, and embedded options. How then, holding other factors constant, does the level of interest rates affect bond price sensitivity to changes in interest rates? As it turns out, the higher a bond yield, the lower the price sensitivity. To see this, we compare a 6% 20-year bond initially selling at a yield of 6%, and a 6% 20-year bond initially selling at a yield of 10%. The former is initially at a price of $100, and the latter $65.68. Now, if the yield for both bonds increases by 100 basis points, the first bond trades down by 10.68 points (10.68%) to a price of $89.32. The second bond will trade down to a price of 59.88, for a price decline of only 5.80 points (or 8.83%). Thus, we see that the bond that trades at a lower yield is more volatile in both percentage price change and absolute price change, as long as the other bond characteristics are the same. An implication of this is that, for a given change in interest rates, price sensitivity is lower when the level of interest rates in the market is high, and price sensitivity is higher when the level of interest rates is low. Zimbabwe Open University 99 Money and Capital Markets Module MBAZ510 Activity 6.2 the bond features that affect interest rate risk. ? 1.2. Identify Describe the relationship between bond price and bond 3. 4. a. b. maturity. What impact does coupon rate have on bond price? Explain the relationship between bond prices and: embedded options the yield level 6.3 Yield Curve Risk We know that if interest rates or yields in the market change, the price of a bond will change. One of the factors that will affect how sensitive bond price is to changes in yield is the bond’s maturity. A portfolio of bonds is a collection of bond issues typically with different maturities. So, when interest rates change, the price of each bond issue in the portfolio will change and the portfolio’s value will change. There is not one interest rate or yield in the economy. There is a structure of interest rates. One important structure is the relationship between yield and maturity. The graphical depiction of this relationship is called the yield curve. When interest rates change, they typically do not change by an equal number of basis points for all maturities. The point here is that portfolios have different exposures to how the yield curve shifts. This risk exposure is called yield curve risk. The implication is that any measure of interest rate risk that assumes that the interest rates changes by an equal number of basis points for all maturities (referred to as a ‘‘parallel yield curve shift’’) is only an approximation. 6.4 Call and Prepayment Risk A bond may include a provision that allows the issuer to retire, or call, all or part of the issue before the maturity date. From the investor’s perspective, there are three disadvantages to call provisions: 100 The cash flow pattern of a callable bond is not known with certainty because it is not known when the bond will be called. Zimbabwe Open University Unit 6 Risks Associated with Investing in Bonds Because the issuer is likely to call the bonds when interest rates have declined below the bond’s coupon rate, the investor is exposed to reinvestment risk, i.e., the investor will have to reinvest the proceeds when the bond is called at interest rates lower than the bond’s coupon rate. The price appreciation potential of the bond will be reduced relative to an otherwise comparable option-free bond. (This is called price compression.) Because of these three disadvantages faced by the investor, a callable bond is said to expose the investor to call risk. The same disadvantages apply to mortgage-backed and asset-backed securities where the borrower can prepay principal prior to scheduled principal payment dates. This risk is referred to as prepayment risk. 6.5 Reinvestment Risk Jabozzi (2007) defines reinvestment risk as the risk that the proceeds received from the payment of interest and principal (i.e., scheduled payments, called proceeds, and principal prepayments) that are available for reinvestment must be reinvested at a lower interest rate than the security that generated the proceeds. We already saw how reinvestment risk is present when an investor purchases a callable or principal prepayable bond. When the issuer calls a bond, it is typically done to lower the issuer’s interest expense because interest rates have declined after the bond is issued. The investor faces the problem of having to reinvest the called bond proceeds received from the issuer in a lower interest rate environment. When dealing with amortizing securities (that is, securities that repay principal periodically), reinvestment risk is even greater. Typically, amortizing securities pay interest and principal monthly and permit the borrower to prepay principal prior to schedule payment dates. Now the investor is more concerned with reinvestment risk due to principal prepayments usually resulting from a decline in interest rates, just as in the case of a callable bond. However, since payments are monthly, the investor has to make sure that the interest and principal can be reinvested at no less than the computed yield every month as opposed to semiannually. With an understanding of reinvestment risk, we can now appreciate why zerocoupon bonds may be attractive to certain investors. Because there are no coupon payments to reinvest, there is no reinvestment risk. That is, zeroZimbabwe Open University 101 Money and Capital Markets Module MBAZ510 coupon bonds eliminate reinvestment risk. Elimination of reinvestment risk is important to some investors. That is, the plus side of the risk equation. The minus side is that, the lower the coupon rate the greater the interest rate risk for two bonds with the same maturity. Thus, zero-coupon bonds of a given maturity expose investors to the greatest interest rate risk. 6.6 Credit Risk An investor who lends funds by purchasing a bond issue is exposed to credit risk. There are three types of credit risk: a) b) c) default risk credit spread risk downgrade risk 6.6.1 Default risk Default risk is defined as the risk that the issuer will fail to satisfy the terms of the obligation with respect to the timely payment of interest and principal. Studies have examined the probability of issuers defaulting. The percentage of a population of bonds that is expected to default is called the default rate. If a default occurs, this does not mean the investor loses the entire amount invested. An investor can expect to recover a certain percentage of the investment. This is called the recovery rate. Given the default rate and the recovery rate, the estimated expected loss due to a default can be computed. 6.6.2 Credit spread risk Even in the absence of default, an investor is concerned that the market value of a bond will decline and/or the price performance of a bond will be worse than that of other bonds. To understand this, recall that the price of a bond changes in the opposite direction to the change in the yield required by the market. Thus, if yields in the economy increase, the price of a bond declines, and vice versa. The yield on a bond is made up of two components: (1) the yield on a similar default-free bond issue and (2) a premium above the yield on a default-free bond issue necessary to compensate for the risks associated with the bond. The risk premium is referred to as a yield spread. The part of the risk premium or yield spread attributable to default risk is called the credit spread. 102 Zimbabwe Open University Unit 6 Risks Associated with Investing in Bonds The price performance of a non-Treasury bond issue and the return over some time period will depend on how the credit spread changes. If the credit spread increases, investors say that the spread has ‘‘widened’’ and the market price of the bond issue will decline. The risk that an issuer’s debt obligation will decline due to an increase in the credit spread is called credit spread risk. 6.6.3 Downgrade risk While portfolio managers seek to allocate funds among different sectors of the bond market to capitalize on anticipated changes in credit spreads, an analyst investigating the credit quality of an individual issue is concerned with the prospects of the credit spread increasing for that particular issue. But how does the analyst assess whether he or she believes the market will change the credit spread associated with an individual issue? One tool investors use to gauge the default risk of an issue is the credit ratings assigned to issues by rating companies, popularly referred to as rating agencies. According to Jabozzi (2007), a credit rating is an indicator of the potential default risk associated with a particular bond issue or issuer. It represents in a simplistic way the credit rating agency’s assessment of an issuer’s ability to meet the payment of principal and interest in accordance with the terms of the indenture. Bonds rated triple A (AAA or Aaa) are prime grade; double A (AA or Aa) are of high quality grade; single A issues are called upper medium grade, and triple B are lower medium grade. Lower-rated bonds are said to have speculative grade elements or to be distinctly speculative grade. Bond issues that are assigned a rating in the top four categories (that is, AAA, AA, A, and BBB) are referred to as investment-grade bonds. Issues that carry a rating below the top four categories are referred to as non-investmentgrade bonds or speculative bonds, or more popularly as high yield bonds or junk bonds. Once a credit rating is assigned to a debt obligation, a rating agency monitors the credit quality of the issuer and can reassign a different credit rating. An improvement in the credit quality of an issue or issuer is rewarded with a better credit rating, referred to as an upgrade; deterioration in the credit rating of an issue or issuer is penalised by the assignment of an inferior credit rating, referred to as a downgrade. An unanticipated downgrading of an issue or issuer increases the credit spread and results in a decline in the price of the Zimbabwe Open University 103 Money and Capital Markets Module MBAZ510 issue or the issuer’s bonds. This risk is referred to as downgrade risk and is closely related to credit spread risk. Activity 6.3 the two major forms of reinvestment risk for those ? 1. Explain investing in callable bonds. 2. 3. 4. 5. Discuss the three major disadvantages of call provisions with reference to bonds. Explain the three types of credit risk. Investors are exposed to credit risk when they purchase a bond. However, even if an issuer does not default on its obligation prior to its maturity date, there is still a concern about how credit risk can adversely impact the performance of a bond. Explain. A Zimbabwean portfolio manager is considering investing in Japanese government bonds denominated in yen. What are the major risks associated with this investment? 6.7 Liquidity Risk When an investor wants to sell a bond prior to the maturity date, he or she is concerned with whether or not the bid price from broker/dealers is close to the indicated value of the issue. For example, if recent trades in the market for a particular issue have been between $90 and $90.5 and market conditions have not changed, an investor would expect to sell the bond somewhere in the $90 to $90.5 range. According to Choudhry and Pienaar (2010), liquidity risk is the risk that the investor will have to sell a bond below its indicated value, where the indication is revealed by a recent transaction. The primary measure of liquidity is the size of the spread between the bid price (the price at which a dealer is willing to buy a security) and the ask price (the price at which a dealer is willing to sell a security). The wider the bid-ask spread, the greater the liquidity risk. 104 Zimbabwe Open University Unit 6 Risks Associated with Investing in Bonds 6.8 Currency Risk (Exchange Rate Risk) A bond whose payments are not in the domestic currency of the portfolio manager has unknown cash flows in his or her domestic currency. The cash flows in the manager’s domestic currency are dependent on the exchange rate at the time the payments are received from the issuer. For example, suppose a portfolio manager’s domestic currency is the U.S. dollar and that manager purchases a bond whose payments are in Japanese yen. If the yen depreciates relative to the U.S. dollar at the time a payment is made, then fewer U.S. dollars can be exchanged. The risk of receiving less of the domestic currency when investing in a bond issue that makes payments in a currency other than the manager’s domestic currency is called exchange rate risk or currency risk. 6.9 Inflation or Purchasing Power Risk Inflation risk or purchasing power risk arises from the decline in the value of a security’s cash flows due to inflation, which is measured in terms of purchasing power. For example, if an investor purchases a bond with a coupon rate of 5%, but the inflation rate is 3%, the purchasing power of the investor has not increased by 5%. Instead, the investor’s purchasing power has increased by only about 2%. For all but inflation protection bonds, an investor is exposed to inflation risk because the interest rate the issuer promises to make is fixed for the life of the issue. 6.10 Volatility Risk In the previous discussion of the impact of embedded options on the interest rate risk of a bond, it was said that a change in the factors that affect the value of the embedded options will affect how the bond price will change. Earlier, we looked at how a change in the level of interest rates will affect the price of a bond with an embedded option. But there are other factors that will affect the price of an embedded option. A major factor affecting the value of an option is ‘‘expected volatility.’’ In the case of an option on common stock, expected volatility refers to ‘‘expected price volatility.’’ The relationship is as follows: the greater the expected price volatility, the greater the value of the option. The same relationship holds for options on bonds. However, instead of expected price volatility, for bonds it Zimbabwe Open University 105 Money and Capital Markets Module MBAZ510 is the ‘‘expected yield volatility.’’ The greater the expected yield volatility, the greater the value (price) of an option. Now let us tie this into the pricing of a callable bond. We repeat the formula for the components of a callable bond below: Price of callable bond = Price of option-free bond minus Price of embedded call option If expected yield volatility increases, holding all other factors constant, the price of the embedded call option will increase. As a result, the price of a callable bond will decrease (because the former is subtracted from the price of the option-free bond). To see how a change in expected yield volatility affects the price of a putable bond, we can write the price of a putable bond as follows: Price of putable bond = Price of option-free bond + Price of embedded put option A decrease in expected yield volatility reduces the price of the embedded put option and therefore will decrease the price of a putable bond. Thus, the volatility risk of a putable bond is that expected yield volatility will decrease. The risk that the price of a bond with an embedded option will decline when expected yield volatility changes is called volatility risk. 6.11 Event Risk Occasionally the ability of an issuer to make interest and principal payments changes dramatically and unexpectedly because of factors including the following: a natural disaster (such as an earthquake or hurricane) or an industrial accident that impairs an issuer’s ability to meet its obligations a takeover or corporate restructuring that impairs an issuer’s ability to meet its obligations a regulatory change that impairs an issuer’s ability to meet its obligations (regulatory risk) These factors are commonly referred to as event risk. 106 Zimbabwe Open University Unit 6 Risks Associated with Investing in Bonds 6.12Sovereign Risk When an investor acquires a bond issued by a foreign entity the investor faces sovereign risk. This is the risk that, as a result of actions of the foreign government, there may be either a default or an adverse price change even in the absence of a default. This is analogous to the forms of credit risk described in the previous section - credit risk spread and downgrade risk. That is, even if a foreign government does not default, actions by a foreign government can increase the credit risk spread sought by investors or increase the likelihood of a downgrade. Both of these will have an adverse impact on the bond price. Sovereign risk consists of two parts. First is the unwillingness of a foreign government to pay. A foreign government may simply repudiate its debt. The second is the inability to pay due to unfavorable economic conditions in the country. Historically, most foreign government defaults have been due to a government’s inability to pay rather than unwillingness to pay. Activity 6.4 why a callable bond’s price would be expected ? 1. Explain to decline less than an otherwise comparable option-free 2. 3. 4. Zimbabwe Open University bond when interest rates rise? Explain how certain types of event risk can result in downgrade risk. Comment on the following statement: ‘‘Sovereign risk is the risk that a foreign government defaults on its obligation.’’ A portfolio manager is considering the purchase of a new type of bond. The bond is extremely complex in terms of its embedded options. Currently, there is only one dealer making a market in this type of bond. In addition, the manager plans to finance the purchase of this bond by using the bond as collateral. The bond matures in five years and the manager plans to hold the bond for five years. Because the manager plans to hold the bond to its maturity, he has indicated that he is not concerned with liquidity risk. Explain why you agree or disagree with the manager’s view that he is not concerned with liquidity risk. 107 Money and Capital Markets Module MBAZ510 Smith and Jane Brody are assistant portfolio ? 5. John managers. The senior portfolio manager has asked them · · · a) b) to consider the acquisition of one of two option-free bond issues with the following characteristics: Issue 1 has a lower coupon rate than Issue 2 Issue 1 has a shorter maturity than Issue 2 Both issues have the same credit rating. Smith and Brody are discussing the interest rate risk of the two issues. Smith argues that Issue 1 has greater interest rate risk than Issue 2 because of its lower coupon rate. Brody counters by arguing that Issue 2 has greater interest rate risk because it has a longer maturity than Issue 1. Which assistant portfolio manager is correct with respect of their selection to the issue with the greater interest rate risk? Explain your answer. Suppose that you are the senior portfolio manager. How would you suggest that Smith and Brody determine which issue has the greater interest rate risk? 6.13 Summary Bonds are debt securities associated with a multitude of risks, which include interest rate risk, credit risk, volatility risk, prepayment risk, event risk, sovereign risk, currency risk, reinvestment risk, liquidity risk, among others. The price of a bond changes inversely with a change in market interest rates. Interest rate risk refers to the adverse price movement of a bond as a result of a change in market interest rates; for the bond investor typically it is the risk that interest rates will increase. A bond’s interest rate risk depends on the features of the bond: maturity, coupon rate, yield, and embedded options. All other factors constant, the longer the bond’s maturity, the greater is the bond price sensitivity to changes in interest rates. 108 Zimbabwe Open University Unit 6 Risks Associated with Investing in Bonds References Chisholm, A. M. (2009). Introduction to International Capital Markets. 2nd Edition. London: John Wiley and Sons. Choudhry, M. et al (2010). Capital Market Instruments: Analysis and Valuation. 3rd Edition. London: Palgrave Macmillan. Frank J. Fabozzi (2007). Fixed Income Analysis. 2nd Edition.John Wiley and Sons. Levinson, M. (2006). Guide to Financial Markets. 4th Edition. London: Profile Books Limited. Madura, J. (2010). Financial Markets and Institutions. 9th Edition. Florida: South-Western College. Mishkin, F.S. & Eakins, S.G. (2006). Financial Markets and Institution. 5th Edition. New York: Pearson Addison Wesley. Zimbabwe Open University 109 Blank page Unit Seven Equity Markets 7.0 Introduction E quity markets facilitate the flow of funds from individuals or institutional investors to corporations. Thus, they enable corporations to finance their investments in new or expanded business ventures. They also facilitate the flow of funds between investors. In this unit, we are going to describe stock offerings and explain how participants in the stock market monitor firms that have publicly traded stock. Money and Capital Markets 7.1 Objectives Module MBAZ510 By the end of this unit, you should be able to: explain how stock markets facilitate secondary market trading describe investor participation in the stock markets outline the process of initial public offerings discuss the process of secondary offerings describe the globalisation of stock markets 7.2 Private Equity When a firm is created, its founders typically invest their own money in the business. The founders may also invite some family or friends to invest equity in the business. This is referred to as private equity, as the business is privately held, and the owners cannot sell their shares to the public. 7.2.1 Motivations for private equity A public offering of stock may be feasible only if the firm has a large shareholder-base to support an active secondary market. With an inactive secondary market, the shares would be illiquid. Investors will be forced to sell their shares at a discount from the fundamental value. In addition, there are many fixed costs associated with going public, which might be prohibitive for a firm that is raising only a small amount of funds. 7.2.2 Venture capital funds Private firms that need huge equity investments but are not yet in a position to go public may obtain funding from venture capitalists. Venture capitalists receive money from wealthy investors who are willing to maintain the investment for a long-term period, such as 5 or 10 years. These investors are not allowed to withdraw their money before a specified deadline. The venture capital market brings together the private businesses that need equity funding and the venture capitalists that can provide funding. One way of doing this is through venture capital conferences where each business briefly makes its pitch as to why it will be very successful if it receives equity funding. Alternatively, businesses may submit proposals to venture capitalists. 112 Zimbabwe Open University Unit 7 Equity Markets Terms of a venture capital deal Once a venture capitalist has identified a viable business, it negotiates the terms of its investment, including the amount being invested. It will set out clear requirements that the firm must meet such as providing detailed periodic reports. It may also insist on seconding its members on the board of directors of that firm to monitor business operations. Exit strategy Once the business gets well established within the agreed time frame, the venture capitalists have to exit the business and look for new businesses. One common exit strategy is to sell its equity stake to the public after the business engages in a public stock offering. Alternatively, the investors may cash out if the company is acquired by another firm. Thus, venture capitalists serve as a bridge for financing the business until the business either goes public or is acquired. 7.3 Public Equity When a firm goes public, it issues stock in the primary market in exchange for cash. Going public has two effects on the firm. First, it changes the firm’s ownership structure by increasing the number of owners. Second, it changes the firm’s capital structure by increasing the equity investment in the firm, which allows the firm to either pay off some its debt or expand its operations. 7.4 Equity Markets The stock markets are like other financial markets in that they link surplus units with deficit units. Firms issue new stock so that they will have sufficient funds to expand their operations. The massive growth in the stock market has enabled many firms to expand to a much greater degree and has allowed investors to share in the profitability of firms. In addition to the primary market, which facilitates new financing for firms, there is also a secondary market that allows investors to sell the stock they previously purchased to other investors who want to buy the stock. Thus, the secondary market creates liquidity for investors who invest in stocks. Investors also receive periodic dividends from the firms in which they invest. Zimbabwe Open University 113 Money and Capital Markets Module MBAZ510 7.5 Participation in Stock Markets Investors are normally in two groups, that is, individual and institutional investors. Institutional investors hold large amounts of stock as they have huge financial resources. Their collective sales or purchases usually significantly affect stock market prices. 7.5.1 How investor decision affect stock prices Investors make decisions to buy a stock when its market price is below their valuation, which means they believe the stock is undervalued. They may sell their holdings of a stock when the market price is above their valuation. Thus, stock valuation drives their investment decisions. Investors commonly disagree on how to value stock. Some investors may believe a stock is undervalued while others believe it is overvalued. This difference in opinion allows for market trading, as this ensures that there will be buyers and sellers of the same stock at a given point in time. The law of supply and demand for shares determines the ultimate market prices of shares. However, stock transactions between investors in the secondary market do not affect the capital structure of the issuer, but merely transfer shares from one investor to another. 7.5.2 Investor reliance on information Investors respond to the release of new information that affects their opinion about a firm’s future performance. Generally, favorable news about the firm’s performance will make investors believe that the firm’s stock is undervalued at its prevailing price. The demand for shares of that stock will increase, placing upward pressure on the price. Unfavorable news will have the opposite effect. Activity 7.1 ? 1. 2. 3. 4. 5. 114 What purpose do equity markets serve? Explain what is meant by private equity. Under what circumstances is a public offering of stock feasible? Why would people or firms prefer to go for private equity? Explain how investor decisions affect stock prices. Zimbabwe Open University Unit 7 Equity Markets 7.6 Initial Public Offerings (IPO) This is a first-time offering of shares by a specific firm to the public. An IPO is commonly used not only to obtain new funding but also to offer some founders and venture capitalists a way to cash out their investment. 7.6.1 Process of going public Firms that engage in an IPO are not well known to investors, and must therefore provide detailed information about their operations and financial condition. Securities firms are normally hired to serve as lead underwriters for the IPO. The lead underwriter is involved in the development of the prospectus and the pricing and placement of the shares. Developing a prospectus The lead underwriter develops a detailed prospectus that provides information about the firm which includes financial statements and a discussion of the risks involved. It is intended to provide potential investors with the information they need to decide whether or not to invest in the firm. Once the prospectus is developed, the issuing firm and the lead underwriter extensively engage on promotional activities. Institutional investors are the main target of these promotional programs because they usually buy large blocks of shares at the time of the IPO. Pricing The lead underwriter determines the so-called offer price at which the shares will be offered at the time of the IPO. The price that investors are willing to pay per share is influenced by prevailing market and industry conditions. During the road show, the lead underwriter solicits indications of interest in the IPO by institutional investors as to the number of shares that they demand at various possible offer prices. This process is referred to as book-building. As a result of the bookuilding process for setting an offer price, many institutional investors pay a lower price than they would have been willing to pay for the shares. In other cases, an auction process is used for IPOs, and investors pay whatever they bid for the shares. The top bidder’s order is accommodated first, followed by the next highest bidder, and so on, until all shares are issued. 7.6.2 Abuses in the IPO market The following are some of the common abuses in the IPO Market: Zimbabwe Open University 115 Money and Capital Markets Module MBAZ510 Spinning This occurs when the underwriter allocates shares from IPO to corporate executives who may be considering an IPO or other business that will require the help of a securities firm. The underwriter hopes that the executives will remember the favor and hire the securities firm in the future. Laddering When there is substantial demand for an IPO, some brokers engage in laddering; that is, they encourage investors to place first-day bids for the shares that are above the offer price. This helps to build upward price momentum. Some investors may be willing to participate to ensure that the broker will reserve some shares of the next hot IPO for them. Excessive commissions Some brokers charge excessive commissions when demand is high for an IPO. Investors are willing to pay the price because they could normally recover the cost from the return on the first day. Since the underwriter set an offer price significantly below the market price that would occur by the end of the first day of trading, investors are willing to accommodate the brokers. The gain to the brokers is a loss to the issuing firm, however, because its proceeds were less than they would have been if the offer price had been set higher. 7.7 Secondary Stock Offerings A secondary offering is a new stock offering by a specific firm whose stock is already publicly traded. Firms engage in secondary stock offerings to raise more equity so that they can more easily expand their operations. Many secondary offerings cause the market price of the shares to decline on the day of the offering, which reflects the new price at which the increased supply of shares in the market is equal to the demand for the shares. Because of the potential for a decline in the equilibrium price of all its shares, a firm considering a secondary stock offering generally monitors stock market movements. It prefers to issue new stock when the market price of its outstanding shares is relatively high and the general outlook for the firm is favorable. Under these conditions, it can issue new shares at a relatively high price, which will generate more funds for a given amount of shares issued. 116 Zimbabwe Open University Unit 7 Equity Markets 7.8 Stock Repurchases The notion of asymmetric information means that a firm’s managers have information about the firm’s future prospects that is not known by the firm’s investors. When firms believe that their stock is undervalued, they can use the firm’s excess cash to purchase a portion of its shares in the market at a relatively low price based on their valuation of what the shares are really worth. Firms tend to repurchase some of their shares when share prices are at very low levels. Just as firms may issue new shares, they may also undertake to acquire their own shares from willing sellers, a process known as a repurchase or a buyback. A repurchase may be undertaken for several reasons: a) b) c) d) e) a firm may wish to repurchase all of its own shares and become a privately owned corporation a partial share repurchase is often used to boost a sagging share price, particularly because it signals to the market that the company’s own managers, who presumably know its prospects best, consider the shares undervalued a repurchase gives the firm a way to return excess capital to shareholders. Many countries give favourable tax treatment to gains from the sale of securities, known as capital gains. In such a case, taxable shareholders will benefit if capital is returned via a share repurchase rather than through a dividend some firms repurchase shares for the purpose of using them in employee compensation programmes some repurchase offers are aimed at investors who own only a small number of shares in order to reduce the expense of dealing with small shareholders Activity 7.2 the key steps involved in the IPO. ? 1.2. Describe Describe the common abuses in the IPO market. 3. 4. Zimbabwe Open University Explain the process of secondary stock offering. Why do firms engage in stock repurchases? 117 Money and Capital Markets Module MBAZ510 7.9 Stock Exchanges Stock exchanges are usually in two forms, namely organized exchanges and over-the-counter exchanges. 7.9.1 Organised exchanges Organised exchanges have a trading floor where floor traders buy and sell securities for their clients. These brokers can match orders of buyers and sellers. In addition, these traders can buy and sell stock for their own account and thereby create more liquidity for the stock. In other words, each trader can act as both a seller and a buyer. The trading that takes place on the floor of an exchange resembles an auction. 7.9.2 Over-the-counter market (OTC) This market is not organized in the sense of having a building where trading takes place. Unlike the organized exchanges, the OTC market does not have a trading floor. Instead, the buy and sell orders are completed through a telecommunications network. Because there is no trading floor, it is not necessary to buy a seat to trade on this exchange. Stocks not listed on the organised exchanges are traded in the OTC market. Like the organised exchanges, the OTC markets also facilitate secondary market transactions. 7.9.3 Organised versus over-the-counter trading Whereas organised exchanges have specialists who facilitate trading, overthe-counter markets have market makers. Rather than trading stocks in an auction format, they trade on an electronic network where bid and ask prices are set by the market makers. Stock exchanges provide a more organised way to trade shares. They are generally superior to the OTC market for several reasons. First, they bring many investors together, offering greater liquidity and thus making it possible to obtain better prices. Second, the exchange is able to obtain and publish the prices at which trades have occurred or are being offered, giving investors an important source of information not available on the OTC market. Third, the exchanges have rules and procedures to ensure that parties live up to their commitments. 118 Zimbabwe Open University Unit 7 Equity Markets 7.10Globalisation of Stock Markets Stock markets are becoming globalised in the sense that barriers between countries have been removed or reduced. Firms in need of funds can tap foreign markets, and investors can purchase foreign stocks. This strategy may represent an effort by a firm to enhance its global image. Listing stock on a foreign stock exchange not only enhances the stock’s liquidity but may also increase the firm’s perceived financial standing. Furthermore, it can also protect a firm against hostile takeovers because it disperses ownership and makes it more difficult for other firms to gain a controlling interest. Listing on a foreign stock exchange entails some costs, such as expenses for converting financial data in an annual report into a foreign currency and making financial statements compatible with the accounting standards used in that country. In general, more investors are attracted to stock markets in countries that provide voting rights and legal protection for shareholders, strictly enforce the laws, do not tolerate corruption, and impose stringent accounting requirements. These conditions encourage investors to have more confidence in the stock market and allow for greater pricing efficiency. In addition, companies are attracted to the stock market when there are many investors, because they can easily raise funds in the market under these conditions. 7.11 Emerging Stock Markets Stock markets in developing economies are relatively new and small and may not be as efficient as those in developed economies. Hence, some stocks may be undervalued, a possibility that has attracted investors to these markets. Furthermore, insider trading is more prevalent in these emerging stock markets because rules against it are not enforced. Although international stocks can generate high returns, they may also exhibit high risk. Some of the emerging stock markets are often referred to as casinos because of the wild gyrations in prices that sometimes occur. Large price swings are common because the small number of shares allows large trades to jolt the equilibrium price. In addition, valid financial information about firms is sometimes lacking, causing investors to trade according to rumors. Trading patterns based on continual rumors are more volatile than trading patterns based on factual data. Zimbabwe Open University 119 Money and Capital Markets Module MBAZ510 Activity 7.3 is the danger of issuing too much stock? What is ? 1. What the role of the securities firm that serves as the underwriter, 2. 3. 4. 5. 6. and how can it ensure that the firm does not issue too much stock? Discuss the concept of asymmetrical information. Explain why it may motivate firms to repurchase some of their stock. Explain why the stock price of a firm may rise when the firm announces that it is repurchasing its shares. Compare and contrast organised exchanges and overthe-counter exchange markets. Explain the pros and cons of globalised foreign stock markets. Explain the potential benefits and dangers of investing in emerging stock markets. 7.12Summary Equity represents the interests of shareholders in a firm. This equity can either be private or public. The issuance of shares and purchases of these shares are done in equity markets. The initial issuance of shares is done in primary equity markets while trading in existing shares is done in secondary equity markets. These equity markets provide an essential facility for the optimal allocation of capital and resources for firms. Investors with excess financial resources are enabled, through the stock exchange, to buy shares from issuing firms, which in turn use those funds to expand their business operations. Stock markets serve to encourage savers to invest their savings and thereby contribute to long-term capital formation in an economy. Like any other financial markets, stock exchange markets have assumed a global outlook. These global stock exchange markets now make it easy for firms to diversify their sources of funds into foreign markets. Of late, emerging stock markets have proved to be attractive to foreign investors owing to the arbitrage opportunities associated within these markets. 120 Zimbabwe Open University Unit 7 Equity Markets References Chisholm, A. M. (2009). Introduction to International Capital Markets. 2nd Edition. London: John Wiley and Sons. Choudhry, M. et al (2010). Capital Market Instruments: Analysis and Valuation. 3rd Edition. London: Palgrave Macmillan. Frank J. Fabozzi (2007). Fixed Income Analysis. 2nd Edition. John Wiley and Sons. Levinson, M. (2006). Guide to Financial Markets. 4th Edition. London: Profile Books Limited. Madura, J. (2010). Financial Markets and Institutions. 9th Edition. Florida: South-Western College. Mishkin, F.S. & Eakins, S.G. (2006). Financial Markets and Institution. 5th Edition. New York: Pearson Addison Wesley. Zimbabwe Open University 121 Blank page Unit Eight Stock Valuation and Risk 8.0 Introduction T here are many different methods of valuing stocks. Fundamental analysis relies on fundamental financial characteristics (such as earnings) of the firm and its corresponding industry that are expected to influence stock values. Technical analysis relies on stock price trends to determine stock values. The focus of this unit is on fundamental analysis. Fundamental analysis commonly uses the price-earnings method, the dividend model, or the free cash flow model to value stocks. Money and Capital Markets Module MBAZ510 8.1 Objectives By the end of this unit, you should be able to: explain methods of valuing stocks describe the required rate of return on stocks identify the factors that affect stock prices measure the various risks associated with stocks discuss the concept of stock market efficiency 8.2 Stock Valuation Methods Investors conduct valuations of stocks when making their investment decisions. They consider investing in undervalued stocks and selling their holdings of stocks that they consider to be overvalued. There are many different methods of valuing stocks. Fundamental analysis relies on fundamental financial characteristics (such as earnings) of the firm and its corresponding industry that are expected to influence stock values. Technical analysis relies on stock price trends to determine stock values. 8.2.1 Price-earnings method A relatively simple method of valuing a stock is to apply the mean priceearnings (PE) ratio of all publicly traded competitors in the respective industry to the firm’s expected earnings for the next year. Example 8.1 Consider a firm that is expected to generate earnings of $3 per share next year. If the mean ratio of share price to expected earnings of competitors in the same industry is 15, then the valuation of the firm’s shares is: Valuation per share = (Expected earnings of firm per share) x (Mean Industry PE ratio = $3 x 15 = $45 The logic of this method is that future earnings are an important determinant of a firm’s value. Although earnings beyond the next year are also relevant, this 124 Zimbabwe Open University Unit 8 Stock Valuation and Risk method implicitly assumes that the growth in earnings in future years will be similar to that of the industry. Reasons for different valuations The price-earning method has several variations, which can result in different valuations. For example, investors may use different forecasts for the firm’s earnings or the mean industry earnings over the next year. The previous years’ earnings are often used as a base for forecasting future earnings, but the recent year’s earnings do not always provide an accurate forecast of the future. A second reason for different valuations when using the PE method is that investors disagree on the proper measure of earnings. Some investors prefer to use operating earnings or exclude some usually high expenses that result from one time events. A third reason is that investors may disagree on which firms represent the industry norm. Some investors use a narrow industry composite composed of firms that are very similar (in terms of size, lines of business etc) to the firm being valued; others prefer a broad industry composite. Consequently, even if investors agree on the firm’s forecasted earnings, they may still derive different values for that firm as a result of applying different PE ratios. 8.2.2 Dividend Discount Method This method states that the price of a stock should reflect the present value of the stock’s future dividends, or: ∞ Price = Dt ∑ (1 + k ) t =1 Where t t = period Dt = dividend in period t K = discount rate The model can account for uncertainty by allowing Dt to be revised in response to revised expectations about a firm’s cash flows, or by allowing k to be revised in response to changes in the required rate of return by investors. Zimbabwe Open University 125 Money and Capital Markets Module MBAZ510 Example 8.2 Consider a stock that is expected to pay a dividend of $7 per share per year forever. This constant dividend represents a perpetuity, or an annuity that lasts for ever. The present value of the cash flows (dividend payments) to investors in this example is the present value of a perpetuity. Assuming that the required rate of return (k) on the stock of concern is 14%, the present value of the future dividend is: PV of stock = = D k $7 0.14 = $50 per share Unfortunately, the valuation of most stocks is not this simple because their dividends are not expected to remain constant forever. If the dividend is expected to grow at a constant rate, however, the stock can be valued by applying the constant-growth dividend discount model: PV of stock = D1 (k − g ) Where D1 = the expected dividend per share to be paid over the next year k = the required rate of return by investors g = the rate at which the dividend is expected to grow Example 8.3 If a stock is expected to provide a dividend of $7 per share next year, the dividend is expected to increase by 4% per year, and the required rate of return is 14%, the stock can be valued as: PV of stock = = 126 $7 (0.14 − 0.04) $70 per share Zimbabwe Open University Unit 8 Stock Valuation and Risk Limitations of the dividend discount model The dividend discount model may result in an inaccurate valuation of a firm if errors are made in determining the dividend to be paid over the next year, or the growth rate, or the required rate of return by investors. The limitations of this method are more pronounced when valuing firms that retain most of their earnings, rather than distributing them as dividends, because the model relies on the dividend as the base for applying the growth rate. Activity 8.1 computing the price of a stock with the dividend ? 1. When discount model, how would the price be affected if the 2. required rate of return is increased? Explain the logic of this relationship. When computing the price of a stock using the constantgrowth discount model, how would the price be affected if the growth rate is reduced? Explain the logic of this relationship. 8.2.3 Adjusting the dividend discount method The dividend discount model can be adapted to assess the value of any firm, even those that retain most or all of their earnings. From the investor’s perspective, the value of the stock is: the present value of the future dividends to be received over the investment horizon the present value of the forecasted price at which the stock will be sold at the end of the investment horizon To forecast the price at which the stock can be sold, investors must estimate the firm’s earnings per share (after removing any nonrecurring effects) in the year that they plan to sell the stock. This estimate is derived by applying an annual growth-rate to the prevailing annual earnings per share. Then, the estimate can be used to derive the expected price per share at which the stock can be sold. Zimbabwe Open University 127 Money and Capital Markets Module MBAZ510 Example 8.4 Assume that a firm currently has earnings of $12 per share. Future earnings can be forecasted by applying the expected annual growth rate to the firm’s existing earnings (E): Forecasted earnings in n years = E(1+G)n Where G = the expected growth rate of earnings n = the number of years until the stock is to be sold If investors expect that the earnings per share will grow by 2% per year and expect to sell the firm’s stock in three years, the earnings per share in the three years are forecasted to be: Earnings in three years = $12 x (1+0.02)3 = $12 x 1.0612 = $12.73 The forecasted earnings per share can be multiplied by the PE ratio of the firm’s industry to forecast the future stock price. If the mean PE ratio of all other firms in the same industry is 6, the stock price in three years can be forecasted as follows: Stock price in 3 years = (Earnings in 3 years) x (PE ratio of industry) = $12.73 x 6 = $76.38 This forecasted stock price can be used along with expected dividends and the investor’s required rate of return to value the stock today. If the firm is expected to pay a dividend of $4 per share over the next 3 years, and if the investors’ required rate of return is 14%, the present value of expected cash flows to be received by the investor is: $4 $4 $4 $76.38 PV= (1.14)1 + (1.14) 2 + (1.14) 3 + (1.14)3 = $3.51 + $3.08 + $2.70 + $51.55 = $60.84 128 Zimbabwe Open University Unit 8 Stock Valuation and Risk Limitations of the adjusted dividend discount model This model may result in an inaccurate valuation if errors are made in deriving the present value of dividends over the investment horizon or the present value of the forecasted price at which the stock can be sold at the end of the investment horizon. Since the required rate of return affects both of these factors, the use of an improper required rate of return will lead to inaccurate valuations. 8.2.4 Free cash flow method For firms that do not pay dividends, a more suitable valuation may be the free cash flow model, which is based on the present value of future cash flows. The first step is to estimate the free cash flows that will result from operations. Second, subtract existing liabilities to determine the value of the firm. Third, divide the value of the firm by the number of shares to derive a value per share. Limitations of the model The limitation of this model is the difficulty of obtaining an accurate estimate of free cash flow per period. One possibility is to start with forecasted earnings and then add a forecast of the firm’s noncash expenses and capital investment and working capital investment required to support the growth in the forecasted earnings. Obtaining accurate earnings forecasts can be difficult, however. Even if earnings can be forecasted accurately, the flexibility of accounting rules can cause major errors in estimating free cash flow based on earnings. 8.3 Required Rate of Return on Stocks Valuation of firms based on discounted cash flows requires the use of a required rate of return by investors who invest in that stock. This required rate of return reflects the risk-free interest rate plus a risk premium. Two commonly used models for deriving the required rate of return are the capital asset pricing model and the arbitrage pricing model. 8.3.1 Capital Asset Pricing Model (CAPM) This model is used to estimate the required rate of return for any firm with publicly traded stock. The model is based on the premise that the only important risk of a firm is systematic risk, or the risk that results from exposure to general Zimbabwe Open University 129 Money and Capital Markets Module MBAZ510 stock market movements. CAPM is not concerned with unsystematic risk, which is specific to an individual firm, because investors can avoid that risk by holding diversified portfolios. The CAPM suggests that the return of an asset (Rj) is influenced by the prevailing risk-free rate (Rf), the market return (Rm), and the covariance between Rj and Rm as follows: R j = Rf + âj(Rm – Rf) Where the beta, âj = COV(Rj, Rm)/VAR(Rm). Example 8.5 Consider a firm that has a beta of 1.2, the prevailing risk-free rate is 6% and the market risk premium is 7%. The required rate of return on the firm is: Rj = 6% + 1.2(7%) = 14.4% The firm’s required rate of return is 14.4%, so its estimated future cash flows would be discounted using a discount rate of 14.4% to derive the firm’s present value. 8.3.2 Arbitrage Pricing Theory (APT) This model differs from the CAPM in that it suggests that a stock’s price can be influenced by a set of factors in addition to the market. The factors may possibly reflect economic growth, inflation, and other variables that could systematically influence asset prices. The following model is based on the arbitrage pricing theory: m E(R) = âo + ∑β F t =1 i i Where E(R) = expected return of asset âo 130 = a constant Fi ..Fm = values of factors 1 to m âi sensitivity of the asset return to particular factor = Zimbabwe Open University Unit 8 Stock Valuation and Risk The model suggests that in equilibrium, expected returns on assets are linearly related to the covariance between asset returns and the factors. This is distinctly different from the CAPM, where expected returns are linearly related to the covariance between asset returns and the market. Activity 8.2 using the CAPM, how would the required rate of ? 1. When return on a stock be affected if: a. b. c. 2. the risk-free rate is lower? the market return is lower? the beta is higher? Clearly outline the distinction between the CAPM and APT models. 8.4 Factors that Affect Stock Prices Stock prices are mostly driven by three types of factors: economic factors, market-related factors and firm-specific factors. 8.4.1 Economic factors A firm’s value should reflect the present value of its future cash flows. Investors consider various economic factors that affect a firm’s cash flows when valuing a firm to determine whether its stock is over-or-undervalued. Impact of economic growth An increase in economic growth is expected to increase the demand for products and services produced by firms and therefore increase a firm’s cash flows and valuation. Participants in the stock markets monitor economic indicators such as employment, gross domestic product, retail sales, and personal income because these indicators may signal information about economic growth and therefore affect cash flows. In general, unexpected favorable information about the economy tends to cause a favorable revision of a firm’s expected cash flows and therefore places upward pressure on the firm’s value. Impact of interest rates One of the most prominent economic forces driving stock market prices is Zimbabwe Open University 131 Money and Capital Markets Module MBAZ510 the risk-free interest rate. Investors should consider purchasing a risky asset only if they expect to be compensated with a risk premium for the risk incurred. High interest rates should raise the required rate of return and therefore reduce the present value of future cash flows generated by a stock. However, interest rates commonly rise in response to an increase in economic growth, so stock prices may rise in response to an increase in expected cash flows even if investors’ required rate of return rises. Conversely, lower interest rates should boost the present value of cash flows and therefore boost stock prices. However, lower interest rates commonly occur in response to weak economic conditions, which tend to reduce expected cash flows of firms. Overall, the effect of interest rates should be considered along with economic growth and other factors to offer a more complete explanation of stock price movements. Impact of exchange rates Exchange rate movements affect stock prices. Foreign investors prefer to purchase our domestic firms’ shares when the local currency is weak and sell them when it is strong. Foreign demand for local shares may be higher when the local currency is expected to strengthen, other things being equal. A multinational corporation’s consolidated reported earnings will be affected by exchange rate fluctuation even if the company’s cash flows are not affected. 8.4.2 Market-related factors Market-related factors also drive stock prices. A key market-related factor is the investor sentiment, which represents the general mood of investors in the stock market. Since stock valuations reflect expectations, in some periods the stock market performance is not highly correlated with existing economic conditions. For example, even though the economy is weak, stock prices may rise if most investors expect that the economy will improve in the near future. That is, there is a positive sentiment because of optimistic expectations. The reverse is true in the case of negative sentiments. For example, investors might have a negative outlook on the economy even though the economy may be strong. 8.4.3 Firm-specific factors A firm’s stock is affected not only by macroeconomic and market conditions but also by firm-specific conditions. Some firms are more exposed to conditions within their own industry than to general economic conditions, so participants monitor industry sales forecasts, entry into the industry by new competitors 132 Zimbabwe Open University Unit 8 Stock Valuation and Risk and price movements of the industry’s products. Stock market participants may focus on announcements by specific firms that signal information about a firm’s sales growth, earnings, or other characteristics that may cause a revision in the expected cash flows to be generated by that firm. Change in dividend policy An increase in dividends may reflect the firm’s expectation that it can more easily afford to pay dividends. A decrease in dividends may reflect the firm’s expectation that it will not have sufficient cash flow. Earnings surprises Recent earnings are used to forecast future earnings and therefore to forecast a firm’s future cash flows. When a firm’s announced earnings are higher than expected, some investors raise their estimates of the firm’s future cash flows and therefore revalue its stock upward. Conversely, an announcement of lower than expected earnings can cause investors to reduce their valuation of a firm’s future cash flows and its stock. Acquisitions and divestitures The expected acquisition of a firm typically results in an increased demand for the target’s stock and therefore raises the stock price. Investors recognise that the target’s stock price will be bid up once the acquiring firm attempts to acquire the target’s stock. Divestitures tend to be regarded as a favourable signal about a firm if the divested assets are not related to the firm’s core business. The typical interpretation by the market in this case is that the firm intends to focus on its core business. Expectations Investors do not necessarily wait for a firm to announce a new policy before they revalue the firm’s stock. Instead, they attempt to anticipate new policies so that they can make their move in the market before other investors. In this way, they may be able to pay a lower price for a specific stock or sell the stock at a higher price. For example, they may use the firm’s financial reports or recent statements by the firm’s executives to speculate on whether the firm will adjust its dividend policy. The disadvantage of trading based on incomplete information is that the investors may not properly anticipate the firm’s future policies. Zimbabwe Open University 133 Money and Capital Markets Module MBAZ510 Activity 8.3 the three broad categories of factors that affect ? 1. Identify stock prices? 2. Explain how each of these factors influences stock prices. 8.5 Stock Market Efficiency If stock markets are efficient, the prices of stocks at any point in time should fully reflect all available information. As investors attempt to capitalise on new information that is not already accounted for, stock prices should adjust immediately. Investors commonly overreact or under react to information. This does not mean markets are inefficient unless the reaction is biased. In this case, investors who recognize the bias will be able to earn abnormally high risk-adjusted returns. The degree to which markets are efficient (that markets are perfect in that they fully reflect all relevant information, and that all assets are priced fairly) is divided into three forms. The three forms of market efficiency are classified based upon the type of information from which an individual could or could not derive abnormal profits. The three forms are weak-form efficiency, semistrong form efficiency, and strong-form efficiency. 8.5.1 Weak-form efficiency Weak-form efficiency suggests that security prices reflect all trade-related information, such as historical security price movements and volume of securities trades. Thus, investors will not be able to earn abnormal returns on a trading strategy that is based solely on past price movements. 8.5.2 Semi-strong form efficiency Semi-strong form efficiency suggests that security prices fully reflect all public information. The difference between public information and market-related information is that public information also includes announcements by firms, economic news or events, and political news or events. Thus, if semi-strong form efficiency holds, weak-form efficiency must hold as well. It is possible, however, for weak-form efficiency to hold, while semi-strong form efficiency does not. In this case, investors could earn abnormal returns by using the relevant information that was not immediately accounted for by the market. 134 Zimbabwe Open University Unit 8 Stock Valuation and Risk 8.5.3 Strong-form efficiency This suggests that security prices fully reflect all information, public or private, from any and all sources. This implies that not even insider trading information would be useful. Inside information gives insiders such as employees or board members an unfair advantage over other investors. Insiders who are aware of favorable news about the firm that is not yet disclosed to the public may consider purchasing shares or advising their friends to purchase the firm’s shares. Though such acts are illegal, they still happen and can create market inefficiencies. Activity 8.4 the concept of market efficiency. ? 1.2. Explain Discuss the feasible existence of the three forms of stock market efficiency in your country’s stock exchange. 8.6 Summary Stocks are commonly valued using the price-earnings (PE) method, the dividend discount model, or the free cash flow model. The PE method applies the industry PE ratio to the firm’s earnings to derive its value. The dividend discount model estimates the value as the present value of expected future dividends. The free cash flow model is based on the present value of future cash flows. Stock prices are affected by those factors that affect future cash flows or the required rate of return by investors. Stock market efficiency implies that stock prices reflect all available information and there are three forms of market efficiency, namely, weak-form efficiency, semi-strong form efficiency and strong-form efficiency. Zimbabwe Open University 135 Money and Capital Markets Module MBAZ510 References Chisholm, A. M. (2009). Introduction to International Capital Markets. 2nd Edition. London: John Wiley and Sons. Choudhry, M. et al (2010). Capital Market Instruments: Analysis and Valuation. 3rd Edition. London: Palgrave Macmillan. Frank J. Fabozzi (2007). Fixed Income Analysis. 2nd Edition. John Wiley and Sons. Levinson, M. (2006). Guide to Financial Markets. 4th Edition. London: Profile Books Limited. Madura, J. (2010). Financial Markets and Institutions. 9th Edition. Florida: South-Western College. Mishkin, F.S. and Eakins, S.G. (2006). Financial Markets and Institution. 5th Edition. New York: Pearson Addison Wesley. 136 Zimbabwe Open University Unit Nine Mortgage Markets 9.0 Introduction I n this unit, we discuss mortgage markets where borrowers; individuals, and businesses, can obtain long-term collateralized loans. The mortgage markets form a subcategory of the capital markets because mortgages involve longterm funds. However, the mortgage markets differ from the stock and bond markets in that the usual borrowers in the capital markets are government entities and businesses, whereas the usual borrowers in the mortgage markets are individuals. Further, mortgage loans are made for varying amounts and maturities, depending on the borrowers’ needs, features that cause problems for developing a secondary market. Money and Capital Markets Module MBAZ510 9.1 Objectives By the end of this unit, you should be able to: provide a background on mortgages describe the functions of mortgage markets discuss the common types of residential mortgages analyse the valuation and risk of mortgages explain mortgage-backed securities 9.2 Background on Mortgages Mishkin & Eakins (2006) define a mortgage as a form of debt created to finance investment in real estate. The debt is secured by the property, so if the property owner does not meet the payment obligations, the creditor can seize the property. Financial institutions such as building societies serve as intermediaries by originating mortgages. They consider mortgage applications and assess the creditworthiness of the applicants. The mortgage represents the difference between the down payment and the value to be paid for the property. The mortgage contract specifies the mortgage rate, the maturity, and the collateral that is backing the loan. 9.3 How Mortgage Markets Facilitate the Flow of Funds Financial intermediaries originate mortgages and finance purchases of residential properties. The financial intermediaries that originate mortgages obtain their funding from household deposits. They also obtain funds by selling some of the mortgages that they originate directly to institutional investors in the secondary market. Overall, mortgage markets allow households and firms to increase the purchases of residential property, commercial property and consequently, financing economic growth. 138 Zimbabwe Open University Unit 9 Mortgage Markets Activity 9.1 between mortgage markets and other capital ? 1. Distinguish markets. 2. Explain how mortgage markets facilitate the flow of funds in any economy. 9.4 Criteria used to Measure Creditworthiness When mortgage originators consider mortgage applications, they review information that reflects the prospective borrower’s ability to repay the loan. The following are three important criteria that are used to measure a borrower’s repayment ability: 9.4.1 Level of equity invested by the borrower The down payment represents the equity invested by the borrower. The lower the level of equity invested, the higher the probability that the borrower will default. One proxy for this factor is the loan-to-value ratio, which indicates the proportion of the property’s value that is financed with debt. When borrowers make relatively small down payments, the loan-to-value ratio is higher, and borrowers have less to lose in the event that they stop making their mortgage payments. 9.4.2 Borrower’s income level Borrowers who have a lower level of income relative to the periodic loan payments are more likely to default on their mortgages. Income determines the amount of funds that borrowers have available per month to make mortgage payments. Income levels change over time, however, so it is difficult for mortgage lenders to anticipate whether prospective borrowers will continue to earn their monthly income over the life of the mortgage, especially given the high frequency of layoffs. 9.4.3 Borrower’s credit history Other conditions being similar, borrowers with a history of credit problems are more likely to default on their loans than those without credit problems. Zimbabwe Open University 139 Money and Capital Markets Module MBAZ510 9.5 Classifications of Mortgages Mortgages can be classified in various ways, but two important classifications are prime versus subprime mortgages and insured versus conventional mortgages. 9.5.1 Prime versus subprime mortgages Mortgages can be classified according to whether the borrower meets the traditional lending standards. Borrowers who obtain prime mortgages satisfy the traditional lending standards. Subprime mortgages are offered to borrowers who do not qualify for prime loans because they have relatively lower income or high existing debt, or can make only a small down payment. Subprime mortgages usually attract higher interest rates to compensate for the risk of default. 9.5.2 Insured versus conventional mortgages Mortgages are classified as either insured or conventional. Insured mortgages are originated by mortgage lenders but are guaranteed by government agencies. The government agency guarantees to pay off the mortgage loan if the borrower defaults. Conventional mortgages are not government insured but can be privately insured. The insurance premium paid for such private insurance is often passed on to borrowers, thus making them relatively more expensive. Activity 9.2 the criteria used to assess the creditworthiness ? 1. Describe of potential borrowers. 2. 3. Differentiate between prime and subprime mortgages. Explain why conventional mortgages are relatively expensive when compared to insured mortgages. 9.6 Types of Residential Mortgage Various types of residential mortgages are available to home owners, including the following: 140 Zimbabwe Open University Unit 9 Mortgage Markets Fixed-rate mortgages Adjustable-rate mortgages Graduated-payment mortgages Growing-equity mortgages Second mortgages Share-appreciation mortgages 9.6.1 Fixed-rate mortgages A fixed-rate mortgage locks in the borrower’s interest rate over the life of the mortgage. The periodic interest payment received by the mortgage lender is constant regardless of how market rates change over time. Mortgage lenders who hold portfolios of fixed-rate mortgages are exposed to interest rate risk because they commonly use funds obtained from short-term deposits to make long-term mortgage loans. If interest rates change over time, the mortgage lenders’ cost of obtaining funds will increase. The return on the fixed-rate mortgage loans will be unaffected, however, causing its profit margin to decrease. Borrowers with fixed-rate mortgages do not suffer from the effects of rising interest rates, but they also fail to benefit from declining rates. Although they can attempt to refinance (obtain a new mortgage to replace the existing mortgage) at the lower prevailing market interest rate, they will incur transaction costs such as closing costs and origination fees. 9.6.2 Adjustable-rate mortgages These allow the mortgage interest rate to adjust to market conditions. Some adjustable-rate mortgages contain a clause that allows mortgage holders to switch to a fixed rate within a specified period, such as one to five years after the mortgage is originated. The fixed rate is typically higher than the adjustable rate at any given point in time when a mortgage is originated. Activity 9.3 ? Zimbabwe Open University Compare and contrast fixed-rate mortgages and adjustablerate mortgages. 141 Money and Capital Markets Module MBAZ510 9.6.3 Graduated-payment mortgages These allow the borrower to initially make small payments on the mortgage; the payments increase on a graduated basis over the first 5 to 10 years and then level off. These types of mortgages are tailored for borrowers who anticipate higher income and thus the ability to make larger monthly mortgage payments as time passes. In a sense, they are delaying part of their mortgage payment. 9.6.4 Growing-equity mortgages These are similar to graduated-payment mortgages in that the monthly payments are initially low and increase over time. However, they differ in that the payments never level off but continue to increase throughout the life of the loan. 9.6.5 Second mortgages Second mortgages are loans that are secured by the same real estate that is used to secure the first mortgage. The second mortgage is junior to the original loan. This means that should a default occur, the second mortgage holder will be paid only after the original loan has been paid off, if sufficient funds remain. The purpose of second mortgages is to give borrowers a way to use the equity they have in their homes as security for another loan. An alternative to the second mortgage would be to refinance the home at a higher loan amount than is currently owed. The cost of obtaining a second mortgage is often much lower than refinancing. Interest rates on second mortgages are higher because their priority claim against the property in the event of default is behind that of the first mortgage. The higher interest rate reflects greater compensation as a result of the higher risk incurred by the provider of the second mortgage. 9.6.6 Shared-appreciation mortgages When interest rates are high, the monthly payments on mortgage loans are also high. That prevents many borrowers from qualifying for loans. To help borrowers qualify and to keep loan volume high, lenders created the sharedappreciation mortgages. A shared-appreciation mortgage allows a home purchaser to obtain a mortgage at a below-market interest rate. In return, the lender providing the attractive loan rate will share in the appreciation of the home. The precise percentage of 142 Zimbabwe Open University Unit 9 Mortgage Markets appreciation allocated to the lender is negotiated at the origination of the mortgage. 9.6.7 Equity participation mortgages In a shared-appreciation mortgage, the lender shares in the appreciation of the property. In an equity participation mortgage, an outside investor rather than the lender shares in the appreciation of the property. This investor will either provide a portion of the purchase price of the property or supplement the monthly payments. In return, the investor receives a portion of any appreciation in the property. As with the shared-appreciation mortgages, the borrower benefits being able to qualify for a larger loan than without such help. 9.6.8 Reverse annuity mortgages (RAM) The reverse annuity mortgage is an innovation method for retired people to live on the equity they have in their homes. The contract for a RAM has the bank advancing funds on a monthly schedule. This increasing-balance loan is secured by the real estate. The borrower does not make any payments against the loan. When the borrower dies, the borrower’s estate sells the property to retire the debt. The advantage of the RAM is that it allows retired people to use the equity in their homes without the necessity of selling it. 9.6.9 Balloon payment mortgages A balloon-payment mortgage requires only interest payments for a three- to five year period. At the end of this period, the borrower must pay the full amount of the principal (the balloon payment). Because no principal payments are made until maturity, the monthly payments are lower. Realistically, though, most borrowers have not saved enough funds to pay of the mortgage in three to five years, the balloon payment in effect forces them to request a new mortgage. Therefore, they are subject to the risk that mortgage rates will be higher at the time they refinance the mortgage. Zimbabwe Open University 143 Money and Capital Markets Module MBAZ510 Activity 9.4 the various types of residential mortgage available ? Describe to homeowners. 9.7 Mortgage Loan Amortization Mortgage loan borrowers agree to pay a monthly amount of principal and interest that will fully amortize the loan by its maturity. “Fully amortize” means that the payments will pay off the outstanding indebtedness by the time the loan matures. During the early years of the loan, the lender applies most of the payments to the interest on the loan and a small amount to the outstanding principal balance. Many borrowers are surprised to find that after years of making payments, their loan balance has not dropped appreciably. Example 9.1 Consider a 30-year (360-month) $100,000 mortgage at an annual interest rate of 8%. Insurance and taxes are ignored in this example. The amortization schedule for this mortgage is shown below: 144 Zimbabwe Open University Unit 9 Mortgage Markets Table 9.1: Amortization Schedule for a 30-year $100,000 Mortgage at 8% Payment Payment of Payment of Total Remaining 1 $666.66 $67.10 $733.76 $99,932.90 2 $666.21 $67.55 $733.76 $99,865.35 ………………………………………………………………………………………………. 100 $604.22 $129.54 $733.76 $90,504.68 101 $603.36 $130.40 $733.76 $90,374.28 ………………………………………………………………………………………………. 200 $482.01 $251.75 $733.76 $72,051.18 201 $480.34 $253.42 $733.76 $71,797.76 ………………………………………………………………………………………………. 300 $244.52 $489.24 $733.76 $36,188.12 301 $241.25 $492.51 $733.76 $35,695.61 ………………………………………………………………………………………………. 359 $9.68 $724.08 $733.76 $728.91 360 $4.85 $728.91 $733.76 $0.00 A breakdown of the monthly payments into principal versus interest is shown above. Note that a larger proportion of interest is paid in the earlier years and a larger portion of principal in the later years. Example 9.2 A 30-year mortgage at 8% requires monthly payments of approximately $734. The same mortgage for 15 years would require monthly payments of $956. Total payments for the 30-year loan would be $264,155 versus $172,017 for the 15-year mortgage. Total payments are lower on mortgages with shorter lives, due to the more rapid amortization and lower cumulative interest. In addition, mortgages with shorter maturities are subject to less interest rate risk than longer-term ones. Zimbabwe Open University 145 Money and Capital Markets Module MBAZ510 Example 9.3 You obtain a 30-year loan at 8% on the $95,000 you need to finance your new condo. The price of the condo is $100,000 minus a $5,000 down payment. Calculate the fixed monthly payment. To compute fixed-amount loan payments, you must equate the present value of the stream of payments you will pay to the amount of the loan. In equation form: Loan amount = P(PVIFAi,n) Where: Loan amount = amount loaned by the bank = $95,000 i = interest rate on the loan = 0.08 n = term of the loan = 30 Thus, $95,000 = Pann(PVIFA8%,30) $95,000= Pann(11.2578) Pann = $95,000 11.2578 Pann = $8,439 Pann = $8,439 12months = $703 per month 146 Zimbabwe Open University Unit 9 Mortgage Markets Activity 9.5 the required monthly payment on an $80,000 ? 1. Compute 30-year fixed-rate mortgage with a nominal interest rate 2. 3. of 5.80%. How much of the payment goes toward principal and interest during the first year? Compute the face value of a 30-year fixed-rate mortgage with a monthly payment of $1,100, assuming a nominal interest rate of 9%. If the mortgage requires 5% down, what is the maximum house price? Consider a 30-year fixed-rate mortgage for $100,000 at a nominal rate of 9%. If the borrower pays an additional $100 with each payment, how fast will the mortgage be paid off? 9.8 Valuation and Risk of Mortgages Since mortgages are commonly sold in the secondary market, they are continually valued by investors. The market price (PM) of a mortgage should equal the present value of its future cash flows: n PM = C + Prin ∑ (1+ k) t t =1 Where C = the interest payment Prin = the principal payment made each period k = the required rate of return by investors Similar to bonds, the market value of a mortgage is the present value of the future cash flows to be received by the investor. Unlike bonds, however, the periodic cash flows commonly include a payment of principal along with an interest payment. Zimbabwe Open University 147 Money and Capital Markets Module MBAZ510 9.9 Risks from Investing in Mortgages Given the uncertainty of the factors that influence mortgage prices, future mortgage prices and returns are uncertain. The uncertainty that financial institutions face from investing in mortgages is due to credit risk, interest rate risk, and prepayment risk. 9.9.1 Credit risk Credit risk (default risk) represents the size and likelihood of a loss that investors will experience if borrowers make late payments or even default. Whether investors sell their mortgages prior to maturity or hold them until maturity, they are exposed to credit risk. The probability that a borrower will default is influenced both by economic conditions and by the characteristics specific to the borrower that lenders use to assess a borrower’s creditworthiness. 9.9.2 Interest rate risk The values of mortgages tend to decline in response to an increase in interest rates. Mortgages are long term but are commonly financed by some financial institutions with short-term deposits. Such mortgages can also generate high returns when interest rates fall, but the potential gains are limited because borrowers tend to refinance (obtain new mortgages at the lower interest rate and repay their mortgages) when interest rates decline. Investors holding fixedrate mortgages to maturity may not experience some loss due to a change in interest rates, but may still incur opportunity costs of what the investors might have earned if they had invested in other securities. Mortgage lenders can limit their exposure to interest rate risk by selling mortgages shortly after originating them. They can also limit their exposure by maintaining adjustable-rate residential mortgages. Alternatively, they could invest in fixed-rate mortgages that have a short time remaining until maturity. 9.9.3 Prepayment risk It is the risk that a borrower may prepay the mortgage in response to a decline in interest rates. In this case, the investor receives a payment to retire the mortgage and has to reinvest at the prevailing lower interest rates. Thus, the interest rate on the new investment will be lower than the rate that would have been received on the retired mortgages. Prepayment risk is high in environment of declining interest rates. Lenders can insulate themselves against prepayment 148 Zimbabwe Open University Unit 9 Mortgage Markets risk by selling mortgages shortly after originating them or invest in adjustablerate mortgages. Activity 9.6 the major risks associated with investing in ? 1. Outline mortgages. 2. 3. Explain why the values of mortgages tend to decline in response to increasing interest rates. Explain the various ways used to manage these risks. 9.10Mortgage-backed Securities As an alternative to selling their mortgages outright, financial institutions can engage in securitisation, or the pooling and repackaging of loans into securities called mortgage-backed securities (MBS; or pass-through securities). These securities are then sold to investors, who become the owners of the loans represented by those securities. Although securitisation has enhanced the secondary market for mortgages, it also contributed to the credit crisis that occurred in 2008 in the USA and UK and other western economies. 9.11 The Securitisation Process When mortgages are securitised, a financial institution such as a securities firm combine individual mortgages together into packages in tranches based on their risk level. Securitisation allows the institution to sell smaller mortgage loans that could not be easily sold in the secondary market on an individual basis. These repackaged mortgages become more attractive to the large institutional investors. The issuer of the MBS assigns a trustee to hold the mortgages as collateral for the buyers of the securities. After the securities are sold, the financial institution that issued the MBS receives interest and principal payments on the mortgages and transfers (passes through) the payments to the investors that purchased the securities. The MBS are assigned risk ratings by credit rating agencies and investors use these ratings in making their decisions whether to invest in these securities. The mortgages in a highly rated (low risk) tranche are expected to generate Zimbabwe Open University 149 Money and Capital Markets Module MBAZ510 more favourable payments. The tranches containing subprime mortgages are assigned a lower credit rating (high risk). 9.12Risk of Mortgage-backed Securities Some institutional investors are willing to purchase MBS representing risky mortgages because they expect to earn a higher return. Like mortgages, MBS are subject to credit risk, interest rate risk and prepayment risk. 9.12.1 Credit risk of MBS If homeowners are unable to make their payments on some mortgages that were packaged to create MBS, this reduces the total payments that will be received by the institutional investors that purchased the securities. Investors in MBS can suffer major losses if there are many defaults on the underlying mortgages represented by the MBS. 9.12.2 Interest rate risk of MBS The interest and principal payments to owners of MBS can vary over time. For example, if a higher-than-normal proportion of the mortgages backing the securities are prepaid in a specific period, the payments received by the financial institutions will be passed through to the security owners. 9.12.3 Prepayment risk of MBS The primary source of prepayment risk associated with a mortgage pool results from a borrower’s right to prepay a mortgage in part or in full without penalty, which alters the expected life of mortgages depending upon market rates. 150 Zimbabwe Open University Unit 9 Mortgage Markets Activity 9.7 mortgage loans once had balloon payments; now ? 1. Most most current mortgage loans fully amortize. What is the 2. 3. 4. 5. difference between a balloon loan and an amortizing loan? Mortgage lenders with fixed-rate mortgages should benefit when interest rates decline, yet research has shown that this favorable impact is dampened. By what? Explain why some financial institutions prefer selling the mortgages they originate. Compare the secondary market activity for mortgages to the activity for other capital market instruments (such as stocks and bonds). Explain how a mortgage company’s degree of exposure to interest rate risk differs from that of other financial institutions. 9.13Summary Mortgages are long-term loans secured by real estate. Both individuals and businesses obtain mortgage loans to finance real estate purchases. A variety of mortgages are available to meet the needs of most borrowers. These are fixed-rate mortgages, adjustable-rate mortgages, graduated-payment mortgages, shared-appreciation mortgages, second mortgages and many others. The valuation of a mortgage is the present value of its expected future cash flows, discounted at a discount rate that reflects the uncertainty surrounding the cash flows. The major risks associated with mortgages include credit risk, interest rate risk and prepayment risk. Zimbabwe Open University 151 Money and Capital Markets Module MBAZ510 References Chisholm, A. M. (2009). Introduction to International Capital Markets. 2nd Edition. London: John Wiley and Sons. Choudhry, M. et al (2010). Capital Market Instruments: Analysis and Valuation. 3rd Edition. London: Palgrave Macmillan. Frank J. Fabozzi (2007). Fixed Income Analysis. 2nd Edition. John Wiley and Sons. Levinson, M. (2006). Guide to Financial Markets. 4th Edition. London: Profile Books Limited. Madura, J. (2010). Financial Markets and Institutions. 9th Edition. Florida: South-Western College. Mishkin, F.S. and Eakins, S.G. (2006). Financial Markets and Institution. 5th Edition. New York: Pearson Addison Wesley. 152 Zimbabwe Open University Unit Ten Foreign Exchange Markets 10.0Introduction T he price of one currency in terms of another is called the exchange rate. Determining the relative values of different currencies is the role of foreign exchange markets. The foreign exchange markets underpin all other financial markets. They directly influence each country’s foreign-trade patterns, determine the flow of international investment and affect domestic interest and inflation rates. In this unit, we will discuss the functions of foreign exchange markets and the factors determining exchange rates. Money and Capital Markets Module MBAZ510 10.1Objectives By the end of this unit, you should be able to: explain the functions of foreign exchange markets identify the key participants in the foreign exchange market analyse the roles of key participants in the foreign exchange market describe how various factors affect exchange rates demonstrate how to forecast exchange rates discuss exchange rate risk management techniques 10.2Foreign Exchange Markets Madura (2010) contends that the foreign exchange market is by far the largest market in the world. Even though major currencies are traded like commodities, the foreign exchange market is distinguished from both the commodity or equity markets by having no fixed base. The foreign exchange market exists through communications and information systems consisting of telephones, the internet or other means of instant communications. It is not located in a building, nor is it limited by fixed trading hours, but is truly a 24-hour global trading system. It knows no barriers and trading activity in general moves with the sun from one major financial center to the next; so that around the clock a foreign exchange market is active somewhere in the world. Because of this decentralisation, the total size of the foreign exchange market can only be guessed at. The foreign exchange market is an over-the-counter market where buyers and sellers conduct business. It is a global network of buyers and sellers of currencies with a foreign exchange transaction being a contract to exchange one currency for another currency at an agreed rate on an agreed date. Today, what began as a way of facilitating trade across country borders has grown into one of the most liquid, hectic, and volatile financial markets in the world— where banks (and many hedge funds) are the major players and have the potential of generating huge profits, or losses. 154 Zimbabwe Open University Unit 10 Foreign Exchange Markets 10.3Functions of Foreign Exchange Markets The foreign-exchange markets underpin all other financial markets. They directly influence each country’s foreign-trade patterns, determine the flow of international investment and affect domestic interest and inflation rates. They operate in every corner of the world, in every single currency. Collectively, they form the largest financial market. 10.4Types of Foreign Exchange Market The foreign-exchange markets comprise two main different types, which function separately yet are closely interlinked. 10.4.1 The spot market Currencies for immediate delivery are traded on the spot market. A tourist’s purchase of foreign currency is a spot-market transaction, as is a firm’s decision immediately to convert the receipts from an export sale into its home currency. Large spot transactions among financial institutions, currency dealers and large firms are arranged mainly on the telephone, although electronic broking services have gained considerable importance. The actual exchange of the two currencies is handled through the banking system and generally occurs two days after the trade is agreed, although some trades are settled more quickly. Small spot transactions often occur face to face, as when a currency dealer converts individuals’ local currency into foreign currency. 10.4.2 The futures market The futures markets allow participants to lock in an exchange rate at certain future dates by purchasing or selling a futures contract. For example, a Zimbabwean firm expecting to receive ZAR10 million might purchase Rand futures contracts. This would effectively guarantee that the rands the firm receives can be converted into Zimbabwean dollars at an agreed rate, protecting the firm from the risk that the South African rands will lose value against the dollar before it receives the payment. 10.5Foreign Exchange Market Participants According to Mishkins & Eakins (2006), to “make a market” means to be Zimbabwe Open University 155 Money and Capital Markets Module MBAZ510 willing and ready to buy and sell currencies. Market makers are those market participants that both buy and sell currencies. According to market practice, a market maker, dealer, or trader will generally quote a two-way price to another market maker. (The terms dealer and trader are used interchangeably when referring to market makers.) For market makers, reciprocity is standard practice. They constantly make prices to one another, and market makers are primarily banks. Price takers are those market participants seeking to either buy (bid) or sell (offer) currencies and are usually corporations, fund managers, or speculators. For price takers, there is no reciprocity inasmuch as they won’t quote a price to other market participants. The major participants in the market play a number of roles depending on their need for foreign exchange and the purpose of their activities: 156 International money center banks are market makers and deal with other market participants. Regional banks deal with market makers to meet their own foreign exchange needs and those of their clients. Central banks are in the market to handle foreign exchange transactions for their governments, for certain state-owned entities, and for other central banks. They also pay or receive currencies not usually held in reserves and stabilize markets through intervention. Investment banks, like money center banks, can be market makers and deal with other market participants. Corporations are generally price takers and usually enter into foreign exchange transactions for a specific purpose, such as to convert trade or capital flows or to hedge currency positions. Brokers are the intermediaries or middlemen in the market, and as such do not take positions on their own behalf. They act as a mechanism for matching deals between market makers. Brokers provide market makers with a bid and/or offer quote left with them by other market makers. Brokers are bound by confidentiality not to reveal the name of one client to another until after the deal is done. Investors are usually managers of large investment funds and are a major force in moving exchange rates today. They may engage in the market for hedging, investment, and/or speculation. Regulatory authorities, while not actually participants in the market, impact the market from time to time. This sector includes government and international bodies. Most of the market is self-regulated, with guidelines of conduct being established by groups such as the Bank for International Settlement (BIS) and the IMF. National governments can Zimbabwe Open University Unit 10 Foreign Exchange Markets and do impose controls on foreign exchange by legislation or market intervention through the central banks. Activity 10.1 do you differentiate the foreign exchange market ? 1. How from other markets? 2. 3. 4. Who are the key participants in the foreign exchange markets? Explain the functions of the foreign exchange markets. Distinguish between the spot and futures market with reference to foreign exchange transactions. 10.6Foreign Exchange Rates There are two kinds of exchange rate transactions. The predominant ones, called spot transactions, involve the immediate (two-day) exchange of bank deposits. Forward transactions involve the exchange of bank deposits at some specified future date. The spot exchange rate is the exchange rate for the spot transaction, and forward exchange rate is the exchange rate for the forward transaction. If the forward rate is above the spot rate, it contains a premium. If the forward rate is below the spot rate, it contains a negative premium (also called a discount). 10.6.1 Exchange rate quotations The direct exchange rate specifies the value of a currency in local currency terms. For example, the U.S dollar may have a value of ZW$150.00, expressed as USD/ZWD=150, while the Malawian Kwacha may have a value of ZW$0.005, expressed as KWA/ZWD=0.005. The indirect exchange rate specifies the number of units of a foreign currency equal to a unit of the local currency. For example, using the same figures above, ZWD/USD=0.00667 and ZWD/KWA=200. Note that the indirect exchange rate is the reciprocal of the direct exchange rate. A cross-exchange rate is the exchange rate between two foreign currencies. It reflects the amount of one foreign currency per unit of another foreign currency. Zimbabwe Open University 157 Money and Capital Markets Module MBAZ510 10.6.2 Why are exchange rates important? Exchange rates are important because they affect the relative price of domestic and foreign goods. The dollar price of French goods to an American is determined by the interaction of two factors: the price of French goods in euros and the euro/dollar exchange rate. When a country’s currency appreciates (rises in value relative to other currencies), the country’s goods abroad become more expensive and foreign goods in that country become cheaper (holding domestic prices constant in the two countries). Conversely, when a country’s currency depreciates, its goods abroad become cheaper and foreign goods in that country become more expensive. Appreciation of a currency can make it harder for domestic manufacturers to sell their goods abroad and can increase competition at home from foreign goods because they cost less. 10.6.3 How is foreign exchange traded? You cannot go to a centralised location to watch exchange rates being determined. Currencies are not traded on exchanges such as Stock Exchanges. Instead, the foreign exchange market is organised as an over-the-counter market in which several hundred dealers (mostly banks) stand ready to buy and sell deposits denominated in foreign currencies. These dealers are in constant telephone and computer contact, the market is very competitive, and it functions no differently from a centralised market. Activity 10.2 what a foreign exchange rate is. ? 1.2. Define Explain why foreign exchange rates are important in any 3. 4. a. b. c. 158 economy. Distinguish between spot and forward exchange rates. Define the following: direct exchange rate indirect exchange rate cross exchange rate Zimbabwe Open University Unit 10 Foreign Exchange Markets 10.7Types of Exchange Rate Regimes There are two types of exchange rate regimes: the fixed (pegged) exchange rate system and the floating exchange rate system. 10.7.1 Fixed (pegged) exchange rate system This is when a country ties or pegs the value of its currency to a stable foreign currency. Under this regime, governments use foreign exchange controls (such as restrictions on the exchange of the currency) as a form of indirect intervention to maintain the exchange rate of their currency. However, such countries have no complete control over their local interest rates because their interest rates must be aligned with the interest rates of the currency to which their currencies are pegged. Advantages of fixed exchange rate regime Fixed rates of exchange enforce a discipline on domestic economic policies. Fixed exchange rates lead to reduced uncertainty regarding goods prices and lower risk premiums on interest rates. This, in turn, leads to better investment decisions abroad. Disadvantages of fixed exchange rate regime With fixed exchange rates, there is the problem of the rate at which it is fixed. As with any other form of government intervention, incorrect decisions regarding the exchange rate impose heavy costs on the economy. Fixed exchange rate systems are asymmetrical in the sense that they force action on deficit countries, which are likely to respond with barriers to trade, interfering with comparative advantage as the basis for trade, lowering efficiency of resource use and lowering rates of economic growth. 10.7.2 Floating exchange rates A system with no boundaries in which exchange rates are market determined but are still subject to government intervention is called a dirty float. This can be distinguished from a freely floating system, in which the foreign exchange market would be totally free from government intervention. Advantages of floating exchange rate regime These are as follows: Zimbabwe Open University 159 Money and Capital Markets Module MBAZ510 These allow continuous adjustment to change in the relative real strengths of economies. These allow countries to retain control over their own monetary policy. Hence, a floating exchange rate system reduces the number of policy targets governments are attempting to achieve and improves the balance between targets and instruments. With floating rates, the country is insulated against external shocks of all kinds. There will be less need for a country to hold international reserves. Floating rates will tend towards long-run equilibrium and be relatively stable. Speculation is assumed to be stabilising. Disadvantages of floating exchange rate regime The disadvantages are: Changes in exchange rates are not a good way to overcome balance of payments problems. Floating rate systems have an inflationary bias because there is an asymmetrical effect between countries with depreciating and appreciating currencies. Speculation may be destabilising. Thus, floating exchange rate systems are likely to be unstable and produce a great deal of uncertainty for traders. If falling exchange rates do not work to solve balance of payments problems quickly, reserves will still be needed in a floating system. The market exchange rate will be determined by the whole balance of payments (capital and current accounts) but this may not be in the longterm interest of the economy. Floating exchange rates allow manipulation of exchange rates in a country’s own interests and this leads to competitive devaluations and attempts to export unemployment to other countries. Activity 10.3 the strengths and weaknesses of the: ? Discuss a. fixed exchange rate system b. 160 floating exchange rate system Zimbabwe Open University Unit 10 Foreign Exchange Markets 10.8Factors Affecting Exchange Rates There are various factors that affect or determine exchange rates in an economy. Anything that increases the demand for domestic goods relative to foreign goods tends to appreciate the domestic currency because domestic goods will continue to sell well even when the value of the domestic currency is higher. Similarly, anything that increases the demand for foreign goods relative to domestic goods tends to depreciate the domestic currency because domestic goods will continue to sell well only if the value of the domestic currency is lower. Some of the factors are discussed below. 10.8.1 Relative price levels When prices of domestic goods rise, (holding prices of foreign goods constant), the demand for domestic goods falls and the domestic currency tends to depreciate so that domestic goods can still sell well. By contrast, if prices of foreign goods rise so that the relative prices of domestic goods fall, the demand for domestic goods increases, and the domestic currency tends to appreciate because domestic goods will continue to sell well even with a higher value of the domestic currency. In the long run, a rise in a country’s price level (relative to the foreign price level) causes its currency to depreciate, and a fall in the country’s relative price level causes its currency to appreciate. 10.8.2 Tariffs and quotas Barriers to free trade such as tariffs (taxes on imported goods) and quotas (restrictions on the quantity of foreign goods that can be imported) can affect the exchange rate. Suppose a country imposes a tariff or a quota on foreign goods. These trade barriers increase the demand for domestic goods, and the domestic currency tends to appreciate because domestic goods will still sell well even with a higher value of the domestic currency. Increasing trade barriers causes a country’s currency to appreciate in the long run. 10.8.3 Preferences for domestic versus foreign goods Increased demand for a country’s exports causes its currency to appreciate in the long run; conversely, increased demand for imports causes the domestic currency to depreciate. If the South Africans develop an appetite for Zimbabwean goods, the increased demand for our domestic goods (exports) tends to appreciate our domestic currency because our domestic goods will Zimbabwe Open University 161 Money and Capital Markets Module MBAZ510 continue to sell well even at a higher value. Likewise, if Zimbabweans decide that they prefer South African goods to domestic goods, the increased demand for imports tends to depreciate the domestic currency. 10.8.4 Productivity If one country becomes more productive than other countries, businesses in that country can lower the prices of domestic goods relative to foreign goods and still earn a profit. As a result, the demand for domestic goods rises, and the domestic currency tends to appreciate. If, however, its productivity lags behind that of other countries, its goods become relatively more expensive, and the currency tends to depreciate. In the long run, as a country becomes more productive relative to other countries, its currency appreciates. 10.8.5 Differential inflation rates A well-known theory about the relationship between inflation and exchange rates, Purchasing Power Parity (PPP), suggests that the exchange rate will, on average, change by a percentage that reflects the inflation differential between two countries. 10.8.6 Differential interest rates Interest rate movements affect exchange rates by influencing the capital flows between countries. An increase in domestic interest rates relative to foreign interest rates may attract foreign investors, especially if the higher interest rates do not reflect an increase in inflationary expectations. Increased demand for domestic interest-bearing securities will result in increased demand for the domestic currency thereby causing its appreciation. In the reverse situation, opposite forces occur, resulting in upward pressure on the foreign currency and downward pressure on the value of the domestic currency. 10.8.7 Central bank intervention A country’s government can intervene in the foreign exchange market to affect a currency’s value. Direct intervention occurs when a country’s central bank sells or buys some of its currency reserves to defend the value of its currency. Central bank intervention may significantly affect the foreign exchange markets in two ways. First, it may slow the momentum of adverse exchange rate movements. Second, foreign exchange market participants may reassess their foreign exchange strategies if they believe the central bank will continue to intervene. ? 162 Zimbabwe Open University Unit 10 Foreign Exchange Markets Activity 10.4 the key factors that determine exchange rates in any ? Discuss economy. 10.9Forecasting Exchange Rates Market participants who use foreign exchange derivatives tend to take positions based on their expectations of future exchange rates. Speculators may take positions in foreign exchange derivatives to benefit from the expectation that certain currencies will strengthen. Thus, the initial task is to develop a forecast of specific exchange rates. Most forecasting techniques can be classified as one of the following: Technical forecasting Fundamental forecasting Market-based forecasting Mixed forecasting 10.9.1 Technical forecasting Technical forecasting involves the use of historical exchange rate data to predict future values. For example, the fact that a given currency has increased in value over four consecutive days may provide an indication of how the currency will move tomorrow. Technical forecasting of exchange rates is similar to technical forecasting of stock prices. If the pattern of currency values over time appears random, then technical forecasting is not appropriate. Unless historical trends in exchange rate movements can be identified, examination of past movements will not be useful for indicating future movements. 10.9.2 Fundamental forecasting Fundamental forecasting is based on fundamental relationships between economic variables and exchange rates. Given current values of these variables along with their historical impact on currency’s value, corporations can develop exchange rate projections. For example, high inflation in a given country can lead to depreciation in its currency. Of course, all other factors that may influence exchange rates should also be considered. Zimbabwe Open University 163 Money and Capital Markets Module MBAZ510 10.9.3 Market-based forecasting Market-based forecasting, the process of developing forecasts from market indicators, is usually based on either the spot rate of the forward rate. Use of the spot rate Assume that the British Pound is expected to appreciate against the American dollar in the very near future. This will encourage speculators to buy the pound with dollars today in anticipation of its appreciation, and those purchases could force the pound’s value up immediately. Conversely, if the pound is expected to depreciate against the dollar, speculators will sell off pounds now, hoping to purchase them back at a lower price after they decline in value. Such action could force the pound to depreciate immediately. Thus, the current value of the pound should reflect the expectation of the pound’s value in the very near future. Corporations can use the spot rate to forecast, since it represents the market’s expectation of the spot rate in the near future. Use of the forward rate The forward rate can serve as a forecast of the future spot rate, because speculators would take positions if there was a large discrepancy between the forward rate and expectations of the future spot rate. For instance, suppose, the 30-day forward rate of the British pound is $1.40 and the general expectation of speculators is that the future spot rate of the pound will be $1.45 in 30 days. Given the future spot rate of $1.45 against the prevailing forward rate of $1.40, speculators will buy pounds 30 days forward at $1.40 and then sell them when received in 30 days at the spot rate existing then. If their forecast is correct, they earn $0.05 per pound. If a large number of speculators implement this strategy, the substantial forward purchases of pounds will cause the forward rate to increase until this speculative demand stops. Once the forward rate equals the future spot rate, this speculative transaction stops as there if no profit to be gained. 10.9.4 Mixed forecasting Because no single forecasting technique has been found to be consistently superior to the others, some multinational corporations use a combination of forecasting techniques. Various forecasts for a particular currency value are developed using several forecasting techniques. Each of the techniques used is assigned a weight so that the weights total 100 percent. The techniques thought to be more reliable are assigned higher weights. The actual forecast of the currency by the multinational corporation will be a weighted average of the various forecasts developed. 164 Zimbabwe Open University Unit 10 Foreign Exchange Markets Activity 10.5 do you think it is important to forecast foreign ? 1. Why exchange rates? 2. Describe the four main techniques used in forecasting exchange rates. 10.10 Forms of Exposure to Exchange Rate Risk By way of explanation, foreign exchange exposure is the risk of financial impact due to changes in foreign exchange rates and, in general, there are three types of foreign exchange exposures: transaction exposure, translation exposure and economic exposure. 10.10.1 Transaction exposure Transactions exposures principally impact a company’s profit and loss and cash flow and result from transacting business in a currency or currencies different from the company’s home currency. For example, consider the position of a British exporting company selling in the U.S. market and entering into a contract to supply goods over the next year. Payment is to be made in dollars within a stated period after the delivery of the goods. The British company bases its sterling prices on its current production costs in the UK, but to convert these into dollar prices must assume an exchange rate for sterling against the dollar. The company is said to be long in dollars (it has net assets in dollars in the form of the future payments to be received in dollars). The risk facing a company long in a foreign currency is that the foreign currency will weaken between the signing of the contract and the settlement of the account. A company that owes money in a foreign currency is said to be short in that currency (it has net liabilities in the foreign currency). The risk it faces is that the value of the foreign currency will rise before it pays its debts. Market participants who are either long or short in a foreign currency have an open position in the market. 10.10.2 Translation exposure Translation exposure covers the case of a parent company with subsidiaries in other countries, where there is a need to produce a financial statement showing the position of the whole group of companies. If the accounts of the Zimbabwe Open University 165 Money and Capital Markets Module MBAZ510 subsidiaries involve foreign currency-denominated assets and liabilities (on balance sheets or in income statements), the translation of these into the group statement may involve foreign exchange exposure. 10.10.3 Economic exposure Economic exposure, like transaction exposure, relates to cash flows but is concerned with the impact on the present value of future cash flows of all changes associated with the depreciation or appreciation of a currency. As an example, consider more closely the British exporter selling its goods in the US. Remember that the risk the firm faces is that the value of the US dollar will fall. Suppose, however, that there is inflation in the US and thus that the firm is able to sell its product for an increasing number of dollars. Suppose further that the fall in the value of the dollar that occurs is just equal to the difference in the rate of inflation in the two countries (relative purchasing power parity holds). In this case, the firm will be no worse off overall. There would be transaction exposure because a fixed quantity of dollars would at a given time exchange for fewer pounds. However, there would be no economic exposure because the firm would have benefited from the difference in inflation rates that had caused the dollar to fall in value. Thus, one way of comparing the two types of exposure is to say that transaction exposure arises from changes in nominal exchange rates while economic exposure derives from changes in real exchange rates (when purchasing power parity does not hold). 10.11 Exchange Rate Risk Management Techniques A variety of techniques have been developed to help firms counter foreign exchange risk (to allow companies to cover themselves against risk, or to move from an open to a closed position in the market). These may be divided into internal techniques, which relate to the accounting systems and the payment and invoicing procedures used by companies, and external techniques, which concern the development of new instruments and markets. This unit concentrates on the market techniques here. They include the use of forward exchange markets, the use of derivatives markets such as those in financial futures and options, swap deals and short-term borrowing in a foreign currency. 10.11.1 Forward contracts Forward contracts are a common hedging product and are used by importers, exporters, investors, and borrowers. They are valuable to those with existing 166 Zimbabwe Open University Unit 10 Foreign Exchange Markets assets or liabilities in foreign currencies and to those who want to lock in a specific foreign exchange rate in the future. For example, corporations that must receive or pay foreign currencies in the future because of their normal business activities usually prefer to transfer the risk that the values of these currencies will change during the intervening period. They can use the bank forward market to establish today, the exchange rate between two currencies for a value date in the future. Generally, when corporations contract to pay to or receive from a bank foreign currency in the future, no money is exchanged until the settlement on the value date. While forwards may be used to hedge payables and receivables, corporations will also hedge other assets and liabilities on a company’s balance sheet. The value dates of forward contracts are often constructed to match up with the expected dates of receipts for a foreign payment, or payment of a foreign currency obligation. A forward contract can be tailored to meet a client’s specific needs in terms of delivery dates and amount. In addition to transacting with clients, banks actively trade forward currency commitments among themselves, as well. In essence, forwards provide certainty in the uncertain world of currency movements by locking in a specific rate, and as the forward markets are quite liquid, the bid/offer spreads are relatively low for the major currencies. 10.11.2 Currency futures contracts Currency futures contract is an alternative to the forward contract, which is a standardised contract that specifies an amount of a particular currency to be exchanged on a specified date and at a specified exchange rate. A firm can purchase a futures contract to hedge payables in a foreign currency by locking in the price at which it could purchase that specific currency at a particular point in time. To hedge receivables denominated in a foreign currency, it could sell futures, thereby locking in the price at which it could sell that currency. A futures contract represents a standard number of units. Currency futures contracts also have specific maturity (or settlement) dates from which the firm must choose. They differ from forward contracts in that they are standardised, whereas forward contracts can specify whatever amount and maturity date the firm desires. Forward contracts have this flexibility because they are negotiated with commercial banks rather than on a trading floor. 10.11.3 Currency swaps A currency swap is an agreement that allows one currency to be periodically swapped for another at specified exchange rates. It essentially represents a Zimbabwe Open University 167 Money and Capital Markets Module MBAZ510 series of forward contracts. Banking institutions facilitate currency swaps by serving as the intermediary that links two parties with opposite needs. Alternatively, banks may be willing to take the position counter to that desired by a particular party. In such a case, they expose themselves to exchange rate risk unless the position they have assumed will offset existing exposure. 10.11.4 Forward rate agreements Forward rate agreements allow two parties to exchange interest-payment obligations, and if the obligations are in different currencies there is an exchange-rate component to the agreement. 10.11.5 Currency options contract Another instrument used for hedging is the currency options. Its primary advantage over forward and futures contract is that it provides a right rather than an obligation to purchase or sell a particular currency at a specified price within a given period. A currency call option provides the right to purchase a particular currency at a specified price (called the exercise price) within a specified period. This type of option can be used to hedge future cash payments denominated in a foreign currency. If the spot rate remains below the exercise price, the option will not be exercised, because the firm could purchase the foreign currency at a lower cost in the spot market. A fee or premium must be paid for options, however, so there is a cost to hedging with options, even if the options are not exercised. A put option provides the right to sell a particular currency at a specified price (exercise price) within a specified period. If the spot rate remains above the exercise price, the option will not be exercised, because the firm could sell the foreign currency at a higher price in the spot market. Conversely, if the spot rate is below the exercise price at the time the foreign currency is received, the firm can exercise its put option. 168 Zimbabwe Open University Unit 10 Foreign Exchange Markets Activity 10.6 is always worse off when its currency is weak ? 1. “A(fallscountry in value).” Is this statement true, or untrue? Explain 2. 3. 4. 5. 6. 7. your answer. If the European price level rises by 5% relative to the price level in the United Sates, what does the theory of purchasing power parity predict will happen to the value of the euro in terms of dollars? If the demand for a country’s exports falls at the same time that tariffs on imports are raised, will the country’s currency tend to appreciate or depreciate in the long run? Assume that a certain country has a very strong economy, putting upward pressure on both inflation and interest rates. Explain how these conditions could put pressure on the value of its domestic currency, and determine whether the domestic currency will rise or fall. Under what circumstances might speculators perform the role normally played by arbitrageurs in foreign exchange markets – that of removing inconsistencies among prices? (Note: consider the relationship between forward and future spot rates of exchange.) Consider the relative advantages and disadvantages of using forward contracts, futures contracts and options as means of speculation. Discuss the three main forms of exchange rate exposures and explain the various risk management techniques used to manage the same. 10.12 Summary The foreign exchange market is by far the largest of all financial markets. It has no fixed base but exists through communications and information systems consisting of telephones, internet and other means of instant communications. The rapid growth in international trade between countries contributed to the growth of the foreign exchange market. The market forces of supply and demand for currencies determine movements in exchange rates, ultimately determining the values of currencies. Participants in the foreign exchange market are exposed to transaction exposure, translation exposure and economic exposure. Forward contracts, currency swaps and forward rate agreement are some of the hedging instruments against these exposures. Zimbabwe Open University 169 Money and Capital Markets Module MBAZ510 References Chisholm, A. M. (2009). Introduction to International Capital Markets. 2nd Edition. London: John Wiley and Sons. Choudhry, M. et al (2010). Capital Market Instruments: Analysis and Valuation. 3rd Edition London: Palgrave Macmillan. Frank J. Fabozzi (2007). Fixed Income Analysis. 2nd Edition. John Wiley and Sons. Levinson, M. (2006). Guide to Financial Markets. 4th Edition. London: Profile Books Limited. Madura, J. (2010). Financial Markets and Institutions. 9th Edition. Florida: South-Western College. Mishkin, F.S. and Eakins, S.G. (2006). Financial Markets and Institution. 5th Edition. New York: Pearson Addison Wesley. 170 Zimbabwe Open University Unit Eleven The International Financial System 11.0 Introduction T he international financial system now plays a more prominent role in economic events around the world. In this unit, we are going to discuss the different types of intervention in the foreign exchange markets, the concept of dollarisation and currency board system. In addition, we will explain the balance-of-payment surpluses and deficits and how these affect economic performance of countries. Money and Capital Markets Module MBAZ510 11.1 Objectives By the end of this unit, you should be able to: explain the different types of intervention in the foreign exchange markets discuss the concept of dollarisation and the currency board system describe how the fixed and managed exchange rate systems work explain how the balance-of-payment surpluses and deficits affect the economic performance of countries analyse the pros and cons of capital controls on economic performance 11.2 Intervention in the Foreign Exchange Market Foreign exchange markets, like other financial markets, are not free of government intervention. Central banks regularly engage in international financial transactions called foreign exchange interventions in order to influence exchange rates. 11.2.1 Unsterilised intervention This is the intervention in which a central bank allows the purchase or sale of domestic currency to have an effect on the monetary base and hence on the money supply. A central bank’s purchase of domestic currency and corresponding sale of foreign assets in the foreign exchange market leads to an equal decline in its international reserves and the monetary base. 172 Zimbabwe Open University Unit 11 The International Financial System Table 11.1: Simultaneous purchase of domestic currency and sale of foreign assets (unsterilised intervention) Central Bank System Assets Liabilities Foreign assets Currency in circulation -$1billion International reserves -$1 billion International reserves are holdings of assets denominated in foreign currency. Monetary base is made up of currency in circulation plus reserves. The central bank’s purchase of domestic currency has the effect of reducing its international reserves and currency in circulation. A central bank’s sale of domestic currency to purchase foreign assets in the foreign exchange market results in an equal increase in its international reserves and the monetary base. 11.2.2 Sterilised intervention A foreign exchange intervention with an offsetting open market operation that leaves the monetary base unchanged is called a sterilised foreign exchange intervention. This is when the central bank does not want the purchase or sale of domestic currency to affect the monetary base and the money supply in the economy. All it has to do is to counter the effect of the foreign exchange intervention by conducting an offsetting open market operation in the government bond market. For example, a central bank’s purchase (sale) of domestic currency and corresponding sale (purchase) of foreign assets in the foreign exchange market leads to an equal decline (increase) in its international reserves and the monetary base. This can be countered by the open market purchase (sale) of the domestic government bonds, which would increase (decrease) the monetary base by the same amount. The net effect is that the monetary base would remain unchanged. Zimbabwe Open University 173 Money and Capital Markets Module MBAZ510 Table 11.2: Sterilised intervention Central Bank System Assets Liabilities Foreign assets Monetary base international reserves -$1 billion currency in circulation + reserves 0 Government bonds +$1 billion 11.2.3 Depreciation of the domestic currency An unsterilised intervention in which domestic currency is sold to purchase foreign assets leads to a gain in international reserves, an increase in the money supply, and a depreciation of the domestic currency. The increase in the money supply reduces the interest rate on domestic currency deposits relative to foreign deposits. The decrease in the expected return on domestic deposits relative to foreign deposits will mean that people will want to buy more foreign deposits, and the exchange rate will decline. This, of course, holds under the assumption that foreign and domestic deposits are perfect substitutes that is, equally desirable. 11.2.4 Appreciation of the domestic currency An unsterilised intervention in which domestic currency is purchased by selling foreign assets leads to a drop in international reserves, a decrease in the money supply, and an appreciation of the domestic currency. The decrease in the money supply raises the interest rate on domestic currency deposits relative to foreign deposits. The increase in the expected return on domestic deposits relative to foreign deposits will mean that people will want to buy more domestic deposits, and the exchange rate will rise. This, of course, holds under the assumption that foreign and domestic deposits are perfect substitutes that is, equally desirable. 174 Zimbabwe Open University Unit 11 The International Financial System Activity 11.1 do central banks regularly intervene in foreign ? 1. Why exchange markets? 2. 3. 4. Explain the different types of intervention in the foreign exchange markets. What are international reserves? Describe actions and activities that can lead to an appreciation or depreciation of currencies. 11.3 Balance of Payments Because international financial transactions such as foreign exchange interventions have considerable effect on the economy, it is worth knowing how these transactions are measured. This is done using the balance of payments, a bookkeeping system for recording all receipts and payments that have a direct bearing on the movement of funds between nations that result from private and government transactions. The two important items in the balance of payments are the current and capital accounts. 11.3.1 Current account This shows international transactions that involve currently produced goods and services. The most important item in this account is the trade balance, the difference between merchandise exports and imports (i.e. the net receipts from trade. When merchandise imports are greater than exports, we have a trade deficit. If exports are greater than imports, we have a trade surplus. 11.3.2 Capital account This is another important item in the balance of payments. These are the net receipts from capital transactions. Flows of capital into a country are registered as receipts, whereas outflows are registered as payments. A positive capital account means that, on net, capital is flowing into a country. Because the balance of payments must balance, the net change in government international reserves that a government (as represented by its central bank) uses to finance international transactions equals the current account plus the capital account. That is, Zimbabwe Open University 175 Money and Capital Markets Module MBAZ510 Current account + capital account = net change in government international reserves This equation shows why the current account receives so much attention from economists and the media. It tells us whether the country (private sector and government combined) is increasing its claims on foreign wealth or whether foreigners are increasing their claims on a country’s domestic wealth. The account tells us that a negative current account balance (i.e. a deficit) must be matched either by a positive capital account (net capital inflow) or a negative net change in international reserves, both of which involve an increase in claims of foreigners on a country’s wealth. 11.4 Exchange Rate Regimes in the International Financial System Exchange rate regimes in the international financial system are of two basic types: fixed and floating. In a fixed exchange rate regime, the values of currencies are kept pegged relative to one currency (called the anchor currency) so that exchange rates are fixed. In a floating exchange rate regime, the values of currencies are allowed to fluctuate against one another. However, countries often attempt to influence their exchange rates by buying and selling currencies, so in this case the regime is referred to as a managed float regime (or a dirty float). 11.4.1 Intervention in the foreign exchange market under a fixed exchange rate regime Figure 11.1 below describes a situation in which the domestic currency is fixed relative to an anchor currency and is initially overvalued. The schedule for the expected return on foreign deposits RF1 intersects the schedule for the expected return on domestic deposits RD1 at exchange rate E1, which is lower than the par (fixed) value of the exchange rate E par. To keep the exchange rate at E par, the central bank must intervene in the foreign exchange market to purchase domestic currency by selling foreign assets, and this action, like an open market sale, means that the monetary base and the money supply decline. Because the exchange rate will continue to be fixed at E par, the expected future exchange rate remains unchanged, and so the schedule for the expected return on foreign deposits remains at RF1. However, the purchase of domestic currency, which leads to a fall in the money supply, also causes the interest rate on domestic deposits iD to rise. This increase in turn shifts the expected 176 Zimbabwe Open University Unit 11 The International Financial System return on domestic deposits RD to the right. The central bank will continue purchasing domestic currency and selling foreign assets until the RD curve reaches RD2 and the equilibrium exchange rate is E par at point 2. In conclusion, when the domestic currency is overvalued, the central bank must purchase domestic currency to keep the exchange rate fixed, but as a result it loses international reserves. RD2 Exchange Rate, Et (foreign currency/ domestic currency) RD1 RF1 E par …………………………………………………… 2 E 1 . ……………………………….. RD2 iD1 1 iD2 Expected Return (in domestic currency terms) Figure 11.1 Intervention in the case of an overvalued exchange rate Source: Jeff Madura (2010), Financial Markets and Institutions, 9th Edition; Joe Sabatino Publishers Figure 11.2 below describes a situation in which the domestic currency is fixed relative to an anchor currency and is initially undervalued. It shows how a central bank intervention keeps the exchange rate fixed at E par when the Zimbabwe Open University 177 Money and Capital Markets Module MBAZ510 exchange rate is initially undervalued, that is, when RF1 and the initial RD1 intersect at exchange rate E1, which is above Epar. Here the central bank must sell domestic currency and purchase foreign assets, and this works like an open market purchase to raise the money supply and to lower the interest rate on domestic deposits iD. The central bank keeps selling domestic currency and lowers iD until RD shifts all the way to RD2, where the equilibrium exchange rate is at E par – point 2 in figure 11.2. Exchange Rate, Et (foreign currency/ domestic currency) E1 E par RD2 RD1 ……………………………………………… RF1 1 …………………………… 2 iD2 iD1 Figure 11.2 Intervention in the case of an undervalued exchange rate Source: Jeff Madura (2010), Financial Markets and Institutions, 9 th Edition; Joe Sabatino Publishers When the domestic currency is undervalued, the central bank must sell domestic currency to keep the exchange rate fixed, but as a result it gains international reserves. If a country’s currency has an overvalued exchange rate, its central bank’s attempts to keep the currency from depreciating will result in a loss of 178 Zimbabwe Open University Unit 11 The International Financial System international reserves. If the country’s central bank eventually runs out of international reserves, it cannot keep its currency from depreciating, and the devaluation must occur, meaning that the par exchange rate is reset as a lower level. If, by contrast, a country’s currency has an undervalued exchange rate, its central bank’s intervention to keep its currency from appreciating leads to a gain of international reserves. Because the central bank might not want to acquire these international reserves, it might want to reset the par value of its exchange rate at a higher level (a revaluation). 11.4.2 Shortcomings of fixed exchange rate systems Fixed exchange rate systems can lead to foreign exchange crises involving a speculative attack on a currency; i.e. massive sales of a weak currency or purchases of a strong currency to cause a sharp change in the exchange rate. Activity 11.2 do you understand by the term “balance of ? 1. What payments”? 2. 3. Explain the two components constituting the balance of payments of any country. Describe the conditions under which a devaluation or revaluation is possible in any economy. 11.5 Currency Board System A currency board system is one in which the domestic currency has 100% backing in foreign reserves and in which the note-issuing authority, whether the central bank or the government, adopts a fixed exchange rate against a particular foreign currency and then stands ready to exchange domestic currency for foreign currency at that rate whenever the public requests it. A currency board is just a variant of a fixed exchange rate regime in which the commitment to the fixed exchange rate is especially strong because the conduct of monetary policy is in effect put on autopilot and is completely taken out of the hands of the central bank and the government. The central bank no longer Zimbabwe Open University 179 Money and Capital Markets Module MBAZ510 has the ability to print money and thereby cause inflation. In addition, the central bank losses its lender of last resort function. 11.6 Dollarisation Dollarisation involves the adoption of another country’s currency, and it is a more extreme version of fixed exchange rate than is a currency board. A currency board can be abandoned, allowing a change in the value of the currency, but a change of value is impossible with dollarisation. A dollar bill is always worth one dollar whether it is held in the U.S. or outside of it. Dollarisation, like a currency board, prevents a central bank from creating inflation. Another key advantage is that it completely avoids the possibility of a speculative attack on the domestic currency (because there is none) that is still a danger even under a currency board arrangement. However, like a currency board, dollarisation does not allow a country to pursue its own monetary policy or have a lender of last resort. One additional disadvantage of dollarisation not characteristic of a currency board is that; because a country adopting dollarisation no longer has its own currency, it loses the revenue that a government receives by issuing money, which is called seigniorage. Because governments (or the central banks) do not have to pay interest on their currency, they earn revenue (seigniorage) by using this currency to purchase income-earning assets such as bonds. If an emerging-market country dollarises and gives up its currency, it needs to make up this loss of revenue somewhere, which is not always easy for a poor country. 11.7 Managed Floating Exchange Rates Although exchange rates are currently allowed to change daily in response to market forces, central banks have not been willing to give up their option of intervening in the foreign exchange market. Preventing large changes in exchange rates makes it easier for firms and individuals purchasing or selling goods abroad to plan into the future. Furthermore, countries with surpluses in their balance of payments frequently do not want to see their currencies appreciate because it makes their goods more expensive abroad and foreign goods cheaper in their country. Because an appreciation might hurt sales for domestic businesses and increase unemployment, surplus countries have often sold their currency in the foreign exchange market and acquired international reserves. 180 Zimbabwe Open University Unit 11 The International Financial System Countries with balance-of-payments deficits do not want to see their currency lose value because it makes foreign goods more expensive for domestic consumers and can stimulate inflation. To keep the value of the domestic currency high, deficit countries have often bought their own currency in the foreign exchange market and given up international reserves. The current international financial system is a hybrid of a fixed and a flexible exchange rate system. Rates fluctuate in response to market forces but are not determined solely by them. Furthermore, many countries continue to keep the value of their currency fixed against other currencies. 11.8 Capital Controls Capital controls have been an important element in the currency crises that rocked the world from time immemorial. Politicians and economists have advocated that capital mobility in emerging market countries should be restricted with capital controls in order to avoid financial instability. Are capital controls a good idea? 11.8.1 Controls on capital outflows Capital outflows can promote financial instability in emerging market countries because when domestic residents and foreigners pull their capital out of a country, the resulting capital outflow forces a country to devalue its currency. Empirical evidence indicates that controls on capital outflows are seldom effective during a crisis because the private sector finds ingenious ways to evade them and has little difficulty moving funds out of the country. Furthermore, capital flight may even increase after controls are put into place because confidence in the government is weakened. Controls on capital outflows often lead to corruption, as government officials get paid off to look the other way when domestic residents are trying to move funds abroad. Controls on capital outflows may lull governments into thinking they do not have to take the steps to reform their financial systems to deal with the crisis, with the result that opportunities are lost to improve the functioning of the economy. 11.8.2 Controls on capital inflows Although most economists find the arguments against controls on capital outflows persuasive, controls on capital inflows receive more support. Supporters argue that if speculative capital cannot come in, then it cannot go Zimbabwe Open University 181 Money and Capital Markets Module MBAZ510 out suddenly and create a crisis. Capital inflows can lead to a lending boom and excessive risk taking on the part of banks, which then helps trigger a financial crisis. Controls on capital inflows have the undesirable feature that they may block from entering a country funds that would be used for productive investment opportunities. Although such controls may limit the fuel supplied to lending booms through capital flows, over time they produce substantial distortions and misallocation of resources as households and businesses try to get around them. These controls can lead to corruption. Capital controls cannot be effective in today’s environment, in which trade is open and where there are many financial instruments that make it easier to get around these controls. On the other hand, there is a strong case for improving bank regulation and supervision so that capital inflows are less likely to produce a lending boom and encourage excessive risk taking by banking institutions. For example, restricting banks in how fast their borrowing could grow might have the impact of substantially limiting capital inflows. Supervisory controls of this type, focusing on the sources of financial fragility rather than the symptoms, can enhance the efficiency of the financial system rather than hampering it. Activity 11.3 a central bank buys its domestic currency in the foreign ? 1. Ifexchange market but conducts an offsetting open market 2. 3. 4. 182 operation to sterilise the intervention, what will be the impact on international reserves, the money supply, and the exchange rate? If the central bank buys its domestic currency in the foreign exchange market but does not sterilise the intervention, what will be the impact on international reserves, the money supply, and the exchange rate? If a country’s par exchange rate was undervalued during the Bretton-Woods fixed exchange rate regime, what kind of intervention would that country’s central bank be forced to undertake, and what effect would it have on its international reserves and the money supply? How can a large balance-of-payments surplus contribute to the country’s inflation rate? Zimbabwe Open University Unit 11 The International Financial System a country wants to keep its exchange rate from ? 5. “Ifchanging, it must give up some control over its money 6. 7. 8. 9. 10. 11. 12. supply”. Is this statement true, false, or uncertain? Explain your answer. Why can balance-of-payments deficits force some countries to implement a contractionary monetary policy? How can persistent balance-of-payments deficits stimulate world recession? Are capital controls on capital outflows a good idea? Explain. Discuss the pros and cons of capital controls on capital inflows. Define the concept “dollarisation”, and discuss its pros and cons. Discuss the pros and cons of a currency board and contrast it from dollarisation. If the balance in the current account increases by $2 billion while the capital account is off $3.5 billion, what is the impact on governmental international reserves? 11.9 Summary The economies of the rest of the world have become interlinked and interdependent. The international financial system now plays a more prominent role in economic events around the world. In this unit, we discussed how fixed and managed exchange rate systems work and how they can provide substantial profit opportunities for financial institutions. Central banks regularly engage in international transactions known as foreign exchange interventions in order to influence exchange rates. These foreign exchange interventions have considerable effect on the economy. The international financial system comprises two types of exchange rate regime, namely, the fixed exchange rate system and the floating exchange rate system. A currency board is an extension of a fixed exchange rate in which a domestic currency has 100% backing in foreign reserves. Dollarisation is an extreme version of a fixed exchange rate regime, in which a country’s local currency is abandoned in place of a stable foreign currency. Zimbabwe Open University 183 Money and Capital Markets Module MBAZ510 References Chisholm, A. M. (2009). Introduction to International Capital Markets. 2nd Edition London: John Wiley and Sons. Choudhry, M. et al (2010). Capital Market Instruments: Analysis and Valuation. 3rd Edition London: Palgrave Macmillan. Frank J. Fabozzi (2007). Fixed Income Analysis. 2nd Edition John Wiley and Sons. Levinson, M. (2006). Guide to Financial Markets. 4th Edition London: Profile Books Limited. Madura, J. (2010). Financial Markets and Institutions. 9th Edition Florida: South-Western College. Mishkin, F.S. and Eakins, S.G. (2006). Financial Markets and Institution. 5th Edition New York: Pearson Addison Wesley. 184 Zimbabwe Open University Blank page