Lecture 1:
Debt and Equity Markets
Mark Hendricks
University of Chicago
September 2012
Money Markets
Debt Capital Markets
Equity Capital Markets
Outline
Money Markets
Debt Capital Markets
Equity Capital Markets
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Money markets and capital markets
Two important distinctions between assets are their liquidity and
risk.
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Money markets. A subclass of the fixed-income market.
These are very short-term debt securities which are highly
marketable.
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Capital markets. Riskier securities and longer-term
securities. A wide range of securities are included in this
category. Stocks, long-term bonds, derivatives, and more.
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Treasury bills
U.S. Treasury bills (T-bills) are the most liquid of money market
securities.
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T-bills do not make interest payments, but rather just pay
face value at maturity.
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Maturities are for 4, 13, 26, and 52 weeks.
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Face values are as low as $100, though they typically are
larger, ($10,000.)
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T-bills are exempt from state and local taxes.
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T-bill dealers
T-bills are bought by auction or in secondary markets.
Hendricks,
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Primary dealers buy most new issues at auction and sell them
all over the world.
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The New York Fed publishes a list of these dealers, along with
a “Weekly Release of Primary Dealer Transactions”.
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Include Citigroup, Deutsche Bank, Morgan Stanley, Nomura,
UBS.
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T-bill yields
T-bill prices are quoted in terms of yields.
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Let P denote the price of a T-bill with face value of $100.
The yield is defined as the constant, Y which satisfies
P=
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Hendricks,
100
1+Y
As a standard, quoted T-bill yields are annualized with
simple compounding.
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T-bill yield example
Suppose that a T-bill matures in 90 days, at which point it pays
$100. Suppose that the current price is $99.
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Using the formula on the previous slide, we find the yield is
Y = .0101 = 1.01%.
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Yields are typically annualized, and for T-bills they are
traditionally annualized using simple compounding.
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The Bond-equivalent yield, (also known as the investment
yield,) would then be
1.01% ×
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365
= 4.10%.
90
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T-bill quoting conventions
Aside from the bond-equivalent yield, another simplified quoting
convention is the discount yield.
Hendricks,
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The Discount yield uses simplified compounding as does the
bond-equivalent yield (BEY).
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Unlike the BEY, the discount yield simplifies by assuming 360
days in a year.
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Furthermore, the discount yield uses the face-value, rather
than the market price, as the base of the calculation.
100 − 99
360
discount yield =
×
= .04 = 4%.
100
90
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No compelling reason to use now, but traditional.
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Yield-to-Maturity
Quoted yields are unsatisfactory for the reasons detailed above. A
more useful yield is as follows.
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Let P denote the price of a T-bill which matures in N years
and has face value of $100.
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Yield-to-Maturity (YTM) is defined as the constant which
satisfies
PN =
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100
(1 + YTM)N
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Yield versus return
A yield is just a convenient way to quote prices.
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In general, YTM is not the same as the return on the security.
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YTM is the average annualized return on the investment only
if the investment is held until maturity.
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Discount of bond-equivalent yields would have other
differences from a return, due to their approximations in
calculation.
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Data: Warning!
When you are using data on Treasuries, be sure of which yield is
being quoted.
Hendricks,
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YTM is more often discussed, and is more natural.
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But raw data will often be quoted with bond-equivalent-yields
or discount-yields.
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However it is quoted, can convert back to prices and go from
there.
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Data: T-bill quotes
Maturity
Bid
Asked
Chg
Asked
yield
9/8/2011
0.025
0.005
0.0100
0.0050
9/15/2011
0.010
-0.010
0.0000
0.0000
9/22/2011
0.015
-0.005
0.0000
0.0000
9/29/2011
0.025
-0.005
0.0000
0.0000
10/6/2011
0.010
-0.010
0.0000
0.0000
10/13/2011
0.010
0.005
0.0000
0.0050
10/20/2011
0.030
0.010
0.0200
0.0100
Figure: U.S. Treasury bill quotes on Sep. 2, 2011. Yield-to-maturity
quoted.
Source: Wall Street Journal.
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Certificates of deposit
A certificates of deposit (CD) is a time deposit where the bank
pays back principal and interest at the end of a fixed term.
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A CD is considered a savings account, and are thus FDIC
insured.
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Deposits can not be withdrawn on demand.
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A large enough CD, (say $100,000,) is typically transferable,
so there is a market for these.
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Most traded CD’s have a very short maturity, (3 months or
less.)
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Commercial paper
Commercial paper is short-term, unsecured debt issued by firms.
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This is an important source of funding for nonfinancial firms.
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The paper typically matures in one to two months. It must be
less than 270 days in order to avoid SEC registration and
regulation.
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The paper is typically issued in $100,000 denominations.
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While the paper is unsecured, its short maturity makes it
relatively safe.
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LIBOR
The London Interbank Offered Rate (LIBOR) serves as a reference
short-term interest rate for the money market.
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This is a rate at which large banks in London will lend and
borrow to each other.
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The rate is quoted for several currencies, with the
dollar-denominated LIBOR frequently used in U.S. markets.
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Eurodollars
A Eurodollar is a dollar deposited in a bank outside the U.S. It is
widely used in interest-rate futures.
Hendricks,
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The Eurodollar rate is the interest earned on these
dollar-denominated deposits held by banks outside the U.S,
(in many countries besides Europe.)
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The Federal Reserve reports of the Eurodollar rate tend to
match the LIBOR rate.
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The Fed publishes the Eurodollar rate on release H.15.
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Federal Funds
The Fed Funds rate is the rate at which one bank lends overnight
Federal Reserve deposits to another.
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This rate is a key measure of monetary policy, and is used
widely in discussing short-term interest rates.
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The Federal Reserve requires that banks maintain reserve
deposits at a Federal Reserve bank.
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To meet the reserve requirement, banks with excess reserves
lend to banks with a shortage at the Fed Funds rate.
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In practice, the Fed Funds rate is not just used by big banks
to cover shortages, but actually as a funding source.
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Data: Fed Funds Rate
Figure: Source: St. Louis Fed.
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Data: Fed Funds Rate, last 5 years
Figure: Source: St. Louis Fed.
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Repo
A repurchase agreement (repo) is a contract where a dealer sells
securities to another party with a deal to buy them back at a later
date at a predetermined price.
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Repo is a common form of short-term borrowing.
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The difference between the selling price and the re-purchase
price is the interest paid. This effective interest rate is the
repo rate.
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The difference between the value of the collateral and the sell
price is the haircut on the repo.
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The repo is, in essence, a collateralized loan.
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Repo risk
Repo is considered very safe as the security transacted serves as
collateral against default by either party.
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The most common repo is overnight. Longer term repos are
referred to as term repo.
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Notably, the repo security is not subject to bankruptcy
procedures. Either party can truly “walk away” if anything
happens.
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Reverse repo
A reverse repo is the other side of the repo deal.
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Namely, the lender of funds, (borrower of the collateral,) is
engaging in a reverse repo.
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A party may engage in a reverse repo in order to take a short
position in the underlying collateral. ie. A dealer can do a
reverse repo and immediately sell the collateral. When the
repo term is up, the dealer then buys back the collateral.
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Repo example
Example: Suppose an asset has a market value of $100 and a bank
sells it for $80 with an agreement to repurchase it for $88.
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The repo rate is 10%.
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The haircut is 20%.
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88−80
80
100−80
100
.
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Data: Money markets
$ Billion
Savings deposits
Treasury bills
Commercial paper
Repurchase agreements
Small-denomination time deposits (*)
Large-denomination time deposits (*)
$4,612
2,004
1,280
1,245
1,175
2,152
Table: Money market securities - amounts outstanding in 2009.
(*) Small denominations are less than $100,000.
Source: Bodie, Kane, and Marcus. (2010)
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Money market funds
Money market funds provide small investors with access to money
market securities.
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Money market mutual funds aim to keep net asset value
(NAV), or share value constant at $1. The interest rate paid
out fluctuates with the return of the assets in the fund.
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Money market mutual funds have become an important
funding source for money market instruments.
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At the end of 2011 QI, the amount outstanding was $2,679
billion.
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Risk of money market funds
Money market funds have been very successful in maintaining NAV
at $1.
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Furthermore, money market funds have restrictions to
enhance safety.
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Average maturity of securities had to be less than 90 days. In
response to crisis, moved to 60.
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Enhanced rules on allocations, ratings of investments, etc.
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Money market funds in the crisis
If the share value of the market fund falls below $1, it is said to
“break the buck.”
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Given the safe assets held by the fund, this is a very unlikely
event. Until 2008, it had only happened once.
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When Lehman failed, its commercial paper was worthless.
This caused a fund to break the buck and another to liquidate
due to redemptions.
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The U.S. Treasury intervened and offered insurance like FDIC.
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At the end of 2008, the balance in money market funds was at
$3,757. The volume has declined about 33% from its
pre-crisis high. (Source: Flow of Funds. Board of Governors.)
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Data: Warning!
Financial models often use a risk-free rate. This is often taken as
a T-bill rate? Is this accurate?
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T-bills are used to fulfill a variety of regulatory requirements,
and they are given preferential regulatory treatment.
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T-bills are given favorable tax treatment. (State and
municipal taxes do not apply.)
These facts cause extra demand for T-bills, driving the rates
(artificially?) lower.
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Outline
Money Markets
Debt Capital Markets
Equity Capital Markets
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Asset Classes
Capital markets include a wide variety of securities.
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Fixed Income
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Money market
Bonds
Equities
We discuss bonds and equities below. We will also discuss
derivatives markets.
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Bond market
The bond market is comprised of longer-term debt securities/loans
than those in the money market.
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Bonds are referred to as the fixed income capital markets.
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Fixed income is a misleading term.
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As we saw with the fixed income money markets, many of the
security cashflows are not actually fixed.
The term “bonds” is often used somewhat generally, referring to a
range of longer maturity debt securities.
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Importance of debt markets
The size of debt markets has exploded.
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No indication that it will slow given increasing government
debt worldwide.
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Fixed income has been prominent in the two most important
recent financial events:
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Hendricks,
The recent financial crisis revolved around mortgages debt.
The current Euro crisis is about sovereign debt.
The recent crisis has put focus on the role of financial
institutions, which are huge players in these markets.
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Treasury notes and bonds
The U.S. government borrows funds largely by issuing bills, notes
and bonds.
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T-notes have maturities from 2 years up to 10 years.
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T-bonds have maturities of 20 or 30 years.
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Both T-notes and T-bonds pay a semiannual coupon.
Recall that T-bills have maturity up to one year, and they do not
pay a coupon.
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Yield on coupon-paying securities
T-notes and T-bonds pay coupons, so the formula connecting yield
and price is more complex.
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Let N denote the number of years until maturity.
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Let C denote the annual coupon amount, paid twice per year.
(2 × N) coupons total.
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Let F denote the face value paid at maturity.
The price of the maturity-N security, (denoted PN ,) and the
yield-to-maturity, (denoted Y ,) of the security are related as
PN =
2×N
X
i/2
i=1
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C /2
(1 + YTM)
+
F
(1 + YTM)N
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T-note and T-bond quoting conventions
Keep in mind that the coupon rate (C /F ) is not the same as the
return or even the yield.
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If the price equals the face value, the bond is selling at par.
(This implies the YTM equals the coupon rate.)
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Price below the face value (yield above the coupon rate) is
referred to as selling below par.
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Data: Treasury quotes
Maturity
Coupon
Bid
Asked
Chg
Asked yield
9/30/2011
9/30/2011
6/30/2016
2/15/2020
5/15/2020
5/15/2039
8/15/2041
1.000
4.500
1.500
8.500
3.500
4.250
3.750
100.0313
100.2578
103.1797
154.3281
114.4375
117.7188
108.1875
100.1016
100.3281
103.2188
154.3594
114.5000
117.7969
108.2656
-0.0078
-0.0547
0.1328
1.0625
1.1719
3.9219
3.8594
-0.524
-0.471
0.817
1.591
1.698
3.268
3.313
Table: U.S. Treasury quotes on Sep. 2, 2011.
Source: Wall Street Journal.
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T-note rate
The ten-year T-note rate is perhaps the benchmark rate in U.S.
capital markets.
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Hendricks,
As of September 7, 2012, the ten-year T-note rate was 1.67%.
(Source: U.S. Dept. of the Treasury.)
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Data: T-note (10yr) rate
Figure: Source: St. Louis Fed.
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TIPS
Since 1997, the U.S. government also issues inflation-protected
bonds.
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Treasury Inflation Protected Securities TIPS have face values
which are scaled by a measure of inflation.
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TIPS also pay a semiannual coupon.
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Both notes and bonds are issued.
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Data: TIPS note (10yr) rate
Figure: Source: St. Louis Fed.
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Data: Treasury securities outstanding
TIPS
$693,464 T‐bills
$1,491,239 T‐bonds
$1,003,417 T‐notes
$6,313,529 Figure: Treasury securities outstanding ($ millions). Publicly held.
Source: Monthly Statement of the Public Debt. Aug. 2011.
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Data: Maturity structure of treasuries
4%
5%
33%
20%
Within 1 year
1 to 5 years
5 to 10 years
10 to 20 years
20 years and over
38%
Figure: Maturity structure of publicly held treasuries.
Source: Economic Report of the President. Feb 2011.
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Owners of U.S. Treasuries
60
50
Individuals
Mutual Funds
Banks
Insurance/Pensions
Fed
State and Local Gov
Foreign
Percent %
40
30
20
10
0
1996
1998
2000
2002
2004
2006
2008
2010
Figure: Treasury owners. Source: SIFMA
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Municipal bonds
Municipal bonds are issued by state and local governments.
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Interest income is exempt from federal income taxes, as well
as state and local taxes in the issuing state.
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Capital gains taxes still apply.
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Due to the Federal income tax savings, municipal bonds are
particularly attractive to those with high marginal tax rates.
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International bonds
Traditionally, the main international debt instrument has been
foreign bonds. These are bonds issued by a foreign country, but
denominated in the currency of the market in which they are
issued. (ie. Sony issues a dollar-denominated bond in the U.S.)
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More recently, Eurobonds have become popular. These
bonds are denominated in a currency other than that of the
country in which they are sold.
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Example: Suppose that a firm issues a bond in Japan with the
bond denominated in U.S. dollars.
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The name “Eurobond” is perhaps unfortunate. It need not
have anything to do with Europe or the Euro.
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Corporate bonds
Corporate bonds are often structured similarly to T-bonds: they
tend to pay a semiannual coupon and return face value at maturity.
Firms may deduct the interest payments from their taxes.
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Some corporate bonds are secured, meaning that they are
backed by collateral.
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Unsecured corporate bonds are sometimes referred to as
debentures in financial reporting.
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Subordinated debentures have a lower priority than other debt
in case of bankruptcy.
Corporate bonds are often issued with options attached that allow
for early calling of the bond or conversion to equity.
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Corporate financing
The size of the corporate bond market is significantly smaller than
the size of the stock market.
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However, the volume of new corporate bonds issued each year
is much larger than new stock issues.
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Thus, the corporate bond market may not be the most
important for asset pricing, but it is pivotal for corporate
finance and is a key measure of financial health in the
economy.
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Data: Firm financing
Figure: Sources of external funds for nonfinancial firms, 1970-2000.
Source: Mishkin (2010)
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Mortgages
Mortgages are loans to households and firms in order to buy land,
real estate, or other structures.
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The primary mortgage lenders in the U.S. have been savings
and loan associations and mutual savings banks, though
recently, commercial banks have increased their role.
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The federal government is very active in this market.
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Three agencies, (commonly referred to as Fannie Mae, Freddie
Mac, and Ginnie Mae,) buy a large amount of mortgages.
This is to provide liquidity in the market and achieve certain
government objectives regarding home ownership.
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Federal agency debt
Several government agencies issue their own securities.
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Agency debt securities are backed by specific revenue
streams; it is not explicitly insured by the Federal government.
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Most of these are involved with funding U.S. mortgages. ie.
Fannie Mae, Freddie Mac, and Ginnie Mae.
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Implicitly, agency debt is fully backed by the U.S. government.
In 2008, the Federal government assumed responsibility for
the bonds of the above agencies.
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MBS
A mortgage-backed security (MBS) is a claim on a pool of
mortgages or a claim backed by such a pool.
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The originator of the mortgage, (the lender,) usually services
the loans: they pass the principal and interest on to the
mortgage purchaser, (and on to the MBS investors.) Thus,
many MBS are referred to as pass-throughs.
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Besides MBS, many other loans are pooled into securities.
These asset-backed securities (ABS) are backed by
credit-card, auto, and student loans.
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MBS allows for widespread investing in mortgages.
We will discuss securitization and MBS in some detail later.
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U.S. Debt
10000
9000
8000
Municipal
Treasury
Mortgage Related
Corporate Debt
Federal Agency
Money Markets
Asset Backed
7000
Billions $
6000
5000
4000
3000
2000
1000
0
1985
1990
1995
2000
2005
2010
Figure: Growth in U.S. Debt. Source: SIFMA
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Outline
Money Markets
Debt Capital Markets
Equity Capital Markets
Hendricks,
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Stocks
Stocks are equity claims on the net income and assets of a
corporation. The two defining features of a stock is that it is a
residual claim with limited liability.
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Stockholders have a junior claim on the assets and income of
the firm. Namely, they receive whatever is left over after all
other claimants (suppliers, tax collectors, creditors, etc.) have
been paid. The firm can pay out the residual as dividends or
reinvest it in the firm which increases the value of the shares.
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Limited liability means that shareholders are not accountable
for a firm’s obligations. Losses are limited to the original
investment. (Compare this to unincorporated businesses
where owners are personally liable.)
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Equity Capital Markets
Market size and ownership
Of all types of capital market securities, stocks have the most
market value.
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However, annual new issues are much smaller than that of
corporate bonds. Annual new issues are less than 1% of the
market value of equities.
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About half of stocks are held by individuals. The other half
are held by pension funds, mutual funds, and insurance
companies.
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Data: Capital markets
Amount outstanding
($ billions, end of year)
Security type
1980
1990
2000
2010
Corporate stocks
Corporate bonds
Residential mortg.
Commercial and farm mortg.
U.S. government (*)
U.S. government agency
State and local gov’t
1,601
366
1,106
352
407
193
310
4,146
1,008
2,886
829
1,653
435
870
17,627
2,230
5,463
1,214
2,184
1,616
1,192
22,962
4,560
11,371
2,449
6,710
7,598
2,450
Table:
(*) marketable, long-term
Sources: Federal Reserve Flow of Funds Accounts (2011).
Mishkin (2009).
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Types of stock
There are two types of stock.
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Common stock is a simple equity claim. It may or may not
have voting rights.
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Preferred stock is a hybrid of equity and debt. Like debt, it
has no voting rights. The next slide discusses some specifics.
If no specification is made, “stock” typically refers to common
stock, a pure equity claim.
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Preferred stock
Consider some ways preferred is like debt and also equity.
1. It has a stated dividend rate, which is similar to a coupon rate
on a bond.
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Unlike a bond, the dividend does not have to be paid.
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However, common stockholders cannot be paid dividends until
preferred dividends are paid. In fact, usually the cumulative
preferred dividend must be paid first.
2. Though preferred dividends are similar to debt interest, they
are not tax-deductible to the firm.
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However, corporations may deduct 70% of dividends received
from domestic corporations.
Thus, other firms are motivated to hold shares of preferred
stock, driving their price up.
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International stocks
American Depository Receipts (ADR’s) are certificates traded in
U.S. markets which represent foreign stocks.
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ADR’s are used to make it easier for foreign firms to register
securities in the U.S.
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Most foreign stocks traded in U.S. markets use ADRs.
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Sometimes, these are called American Depository Shares, or
ADS.
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DJIA
Stock indexes are widely quoted as a measure of overall market
performance. The Dow Jones Industrial Average (DJIA) is the
most oft-cited in the news.
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The DJIA is an average of 30 large, high quality U.S. stocks.
It has been computed since 1896.
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The stocks in the index change over time, to maintain a
reflection of the overall market.
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The DJIA used to be computed simply as the average price of
the 30 stocks. However, the formula keeps the DJIA constant
anytime one of the stocks splits, pays a large dividend, or is
switched.
On September 7, 2012, the DJIA was at 13,306.64.
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Data: DJIA
Figure: Source: St. Louis Fed.
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Stock indexes
Other stock indices are also widely quoted.
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S&P 500 goes beyond the DJIA in that it includes 500 firms.
Also, it uses a market-weighted average. That is, each of the
500 firms receives weighting in the index proportional to its
market value of outstanding equity.
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NYSE. A market-value-weighted composite index of all
NYSE-listed stocks. NYSE also produce subindexes for
specific industries.
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NASDAQ. An index of more than 3,000 firms traded on the
NASDAQ market.
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International indexes
In recent years, international equity markets have grown larger and
more globally accessible. Some of the most oft-quoted
international indexes are
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Nikkei (Japan)
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FTSE (United Kingdom)
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DAX (Germany)
Morgan Stanley Capital International (MSCI) publishes a
variety of international indexes for different countries and regions
of the world.
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Index funds
Investors may want to hold a portfolio which mimics an index as a
proxy for investing in the market.
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Many mutual funds are designed to track indexes like the S&P
500. They provide a return equal to the index performance
without the impractical costs of trying to hold many stocks.
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Similarly, investors can buy exchange-traded funds (ETF’s).
A share in an ETF can be bought and sold like a share in a
stock, but it represents a portfolio of stocks held by the fund.
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References
Hendricks,
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Bank of International Settlements. BIS Quarterly Review.
June 2011. www.bis.org
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Bodie, Kane, and Marcus. Investments. 2011.
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Federal Reserve Statistical Release. Federal Reserve Flow of
Funds Accounts; First Quarter 2011. June 9, 2011.
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Hull, John. Options, Futures, and Other Derivatives. 2012.
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Mishkin, Frederic. Money, Banking, and Financial Markets.
2010.
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U.S. Dept. of the Treasury. Monthly Statement of the Public
Debt. August 31, 2011. www.treasurydirect.gov
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Veronesi, Pietro. Fixed Income Securities. 2010.
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