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FINANCE 102
March 05
2020
UW FARMSAMarket Research Team
AG
EN
DA
March 05, 2020
1
2
3
4
Macroeconomics & Portfolio Management
Public Equity & Private Equity
Bonds & Structured Credit
Intermission: Finance at RBC
5
6
FOREX
Forward, Future, Swap, and Option
Different Investment Funds
MACROECONOMICS
Stages of the Business Cycle
Business Cycle: describes the rise and fall in production output of goods in an economy.
● Peak
● Recession
● Trough
● Recovery
● Expansion
Sector Performance
● Aggressive stocks do
well in early stages
● Defensive stocks do
better in late stages
Sector: An area of the economy in which businesses share the same or a related product or service.
Macro Factors
Macroeconomic Factors: factors that currently affect or in the future may affect business. Examples - Interest Rates, Inflation, Unemployment
Macro Factors
Example Indicators: Manufacturing Data (ISM), Non-Farm Payrolls, Consumer Price Index (CPI)
Macro Factors
PORTFOLIO
MANAGEMENT
Asset Allocation
Asset Mix: proportion of each asset class held in a portfolio relative to the overall portfolio value
• Allocation of principle to equities, fixed
income, commodities, exotics, cash (mm)
• Strategy of diversification to minimize risk
• Eliminate diversifiable risk, remaining risk
is taken on in order to capture return
Sample Allocation
Equities Fixed Income Cash
Asset Performance
Key Considerations
2
43
1Time Horizon- Time to Maturity- Timing of Cash Flows- Liquidity Requirements
Risk Tolerance- Investment Objective- Risk/Return Trade Off- Income Stability
Rebalancing- Frequency (Cost of Spread)- Cross Asset Synergy- Portfolio Strategy- Review Methodology
Investor Profile- Degree of Financial
Literacy/Interest- Ability to Monitor- Sector/Market Exposure
PUBLIC EQUITY
Public Equity
Public Equity: is an asset class where individuals or organizations can buy ownership and shares of a public company through the public market
- Public Equity is a liquid asset
- Over 630,000 companies traded around the world
- New York Stock Exchange is the largest stock market in the world- Equity Market Capitalization of over 19
trillion US Dollars
Technical Analysis
Technical Analysis: Uses historical price movement to identify trends and make predictions of price action in the future
- Core Principle of Technical Analysis- Market Prices Reflect all relevant information
impacting the market
- Technical Indicators- heuristic or mathematical calculations based on
the price, volume or open interest of a security
Efficient MarketHypothesis:Shares traded at their fair value price and all information is represented in the price
Technical Indicators
Technical Indicators:- Moving Average- Bollinger Bands- Relative Strength Index (RSI)
Moving Average Indicator: Lagging indicator that helps smooth out price action from price fluctuations
Moving Average
Golden Cross:- Short term moving average
crosses above the long term moving average
- Creates a buy signal, predicting future growth
Moving Average
Death Cross:- Short term moving average
crosses below the long term moving average
- Creates a sell signal, predicting future losses
Fundamental Analysis
Fundamental Analysis: Is a process used to evaluate the value of a company using the metrics of the past, other businesses, and sectors.
Inefficient Markets Hypothesis: States that shares do not trade at their fair value, but rather can be underpriced or overpriced
Intrinsic Value
Discounted Cash Flows
- FV is Future Cash Flows
- i is Discount rate
Comparative Analysis
Company Name Price Per Share
($)
Market Cap
(B)
Earnings per
share
Price to
Earnings (x)
P/E to Growth
(x)
Procter and
Gamble Co.
$123 $305.57 $1.78 69.52 3.54
McCormick Inc. $153 $20.345 $5.24 29.20 1.73
Clorox Co. $173 $21.747 $6.35 27.36 4.91
Sector Average 25.33 2.28
Comparative Analysis of Consumer Staples Companies shares
Comparative Analysis: Is a process used to evaluate the value of a company using the metrics of the past, other businesses, and sectors.
PRIVATE EQUITY &
VENTURE CAPITAL
What is Private Equity and Venture Capital?
• Alternative investments targeting companies in private markets
Private Equity (PE)
• Primarily invests in mature companies or growth equity
• Can specialize into certain sectors or be sector agnostic
• Larger deals
• Acquires controlling stakes
Venture Capital (VC)
• Invests in start-ups and growing companies with limited capital
• Most prominent in Tech, Biotech, and Cleantech industries
• Smaller deals
• Acquires minority stakes
Growth as an asset class
Why has the asset class grown?
• Liability-Driven Investors beset by low Fixed Income returns
• Avoids the scrutiny of public markets
• Historically higher returns than public equities
How do firms earn returns?
“Good private equity investors create a lot more economic value
than they destroy”— Bill Ackman, CEO Pershing Square Capital
Private Equity
• Uses leverage to acquire companies
• Improve firms operationally
• Sell firms for a higher multiple
Venture Capital
• Growth of company size and valuation
• Cash flow from equity investment allows
for capital expenditures
• Sell equity stake when company is larger
3 ways to generate value
1. Multiple expansion
2. Operational improvement
3. Deal structure
BONDS
What is a Bond?
• A debt financing instrument
• A form of I.O.U
• Legal Agreement
• Features:
• Par value
• Maturity Date
• Coupon Rate
• Payment Frequency
How to Price a Bond?
C1 C2 C3
Price?
t=1 t=2 t=3
……
t=N
CN+Par ValueVanilla Coupon Bond
Interest Risk (y)
• Inverse relation between interest rate
and bond price
• Positive relation between interest rate
and bond yield
Scenarios Bond Price Bond Yield
Interest Rate Increases
Decreases Increases
Interest Rate Decreases
Increases Decreases
Major Players
Major Issuers (Borrower)
• Governments (Federal, Provincial,
Municipal)
• Infrastructure Establishment
• Government Financing
• Corporations
• Capital expenditures
• The use of leverage
• Hedging (Derivatives)
Major Holders (Lenders)
• Central bank
• Monetary policy
• Mutual Funds
• Insurance Companies
• Investment banks
• Pension Plans
• Households are not major players
Credit Risk
• Credit rating
• Investment grade vs High-yield
• Government bonds considered risk free (Treasury bill)
• Credit ratings are assigned by rating agencies
• S&P (AAA, AA+,…)
• Moody’s Investors Service (Aaa, Aa1, …)
Treasury Bill/Notes/Bond (US)
Points of Comparison
Treasury Bill Treasury Notes Treasury Bond
Maturity
Zero Coupon Bond
• A bond with only one cashflow
• Provides insight to the interest rate over the years
Price?
t=N
Par Value
Zero Coupon Bond
Spot Rate
Yield Curve
0
1
2
3
4
5
6
7
8
9
0 1 2 3 4 5
Sp
ot
Rate
Time to Maturity
Yield Curve (Spot Rate)
Yield Curve
STRUCTURED CREDIT
What is Structured Credit?
• Financial assets such as loans and mortgages are packaged into interest-
bearing securities backed by those assets and issued to investors
Asset-backed securities (ABS)
Mortgage-backed securities (MBS)
• Residential mortgage-backed securities (RMBS)
• Commercial mortgage-backed securities (CMBS)
Non-Real Estate
• Debt-related consumer products (Auto-loans, consumer credit)
• Corporate contracts (Equipment leases, aircraft leases, shipping)
Collateralized debt obligations (CDOs)
• Tranches of debt from ABS separated by credit rating
Structured Credit Products
Senior, AAA, 3%Mezz., BBB, 5%Junior, B, 7%
Investing in Structured Credit
• Given low correlation with other Fixed Income securities, ABS can be a robust
diversification and yield-enhancing tool for institutional portfolios
What happened in the Financial Crisis?
“I am not responsible for the financial crisis, I
hate to tell you” — Jamie Dimon, CEO JP. Morgan
1. Strong housing market
• Home prices increasing in the United States
• Increase in high-risk subprime mortgage lending
2. Growth of the MBS and CDO market
• Credit rating agencies lacked due diligence (S&P, Moody’s)
• Credit ratings did not reflect the risk profile of underlying loans in debt tranches
3. Mortgage defaults skyrocket and the housing bubble bursts
• People could no longer afford their mortgages and MBS cash flows dried up
• Homes, or the collateral on the MBS and CDOs no longer held previous value
• Everyone lost money….. except Michael Burry
Since the Financial Crisis
• While ABS have again risen in popularity, RMBS and Subprime Mortgage growth
continues to be muted – the stigma remains
FINANCE AT RBC
Opportunities at RBC
• RBC Capital Markets• Investment Banking and Debt Capital Markets (DCM)• Sales and Trading• Global Research• Corporate Banking• Derivatives Solutions
• RBC Wealth Management• RBC Global Asset Management (GAM)• RBC Dominion Securities
• RBC Economics
Highlights of the firm
• Largest bank in Canada by market capitalization
• RBC Capital Markets• Top Canadian investment bank in Canada and the United States• Highest S&T volume across Canadian banks in most products
• RBC Wealth Management• Top 15 wealth manager globally by AUM
• For a co-op student• High access to internal networking• Truly diverse and inclusive workplace
FOREX
What is Forex?
Forex: is a marketplace where various national currencies are traded, also known as the Foreign Exchange Market
• World’s most traded market per day
○ 5.1 Trillion vs 257 Billion USD/day for equities
• 24 Hours a day, 5 days a Week
• Most liquid, accessible worldwide
• Decentralized, over-the-counter
How to Trade Forex
Day-To-Day Speculation
Selling your currency at hand to buy another currency through a
financial institution
FX Spot Derivative, is a contract between two parties to buy one currency against selling
another
Major Currency Pairs:
EUR/USD USD/JPYGBP/USD USD/CHFUSD/CAD AUD/USD
EUR/GBP
Currency Pairs
Currency Pair: Quotation of two currencies, with the value of one currency being quoted against the other
1 pip = 0.0001 = 0.01%
Forex and Economics
Effects of Macroeconomic Changes on Value of Currencies
Factor Response in
Increase
Response in Decrease
Interest Rate ↑ ↓
Inflation ↓ ↑
Unemployment Rate ↓ ↑
Manufacturing ↑ ↓
Gross Domestic Product
(GDP)
↑ ↓
Forex Speculation Strategies
Hedging to Minimize Risk Triangular Arbitrage
Hedging: Strategy to minimize risk of loss from an unexpected market event
In forex, the two most common strategies consist of:- Obtaining a spot contract in
opposite directionEx: If buying EUR/USD, also sell it
- Obtaining forex options
Definition: Rare exchange rate mismatching between three foreign currency pairs.
1.5000
100.0070.00 ¥105,000
FUTURES AND
FORWARDS
Futures vs. Forwards
Both involve an agreement to trade an asset at a later date with the price already predetermined.
Characteristics Futures Forwards
Execution On an exchange Over-the-counter
Maturity > 1 1
Affected by Market? Yes No
Commodities
Commodities Trading
● Commodities can be bought and sold directly in the spot market.
● Commodities can be traded using derivatives contracts, ie. Futures and Options
● Certain market conditions provide optimal opportunities to invest in certain commodity sectors
A good that is interchangeable with another good of the same type.
Commodities
Categories
ex. Crude oil, Natural Gas
Energy Metals Livestock Agriculture
ex. Gold, Silver, Copper
ex. Live Cattle, Eggs, Pork Belly
ex. Soybean, Sugar, Coffee
Futures vs. Forwards
Futures and forwards intuitively are hedging tools.
Producer Hedge Consumer HedgeNew Market Price
($)Price Equation ($) Net Price ($)
25 25 - 5
2020 20
17 17 + 3
New Market Price ($)
Price Equation ($) Net Price ($)
30 30 - 10
2020 20
10 10 + 10
Ex: Assume a futures contract needs to be locked in at $20 in 1 year
Commodities Current Example
Ex. Coffee
SWAPS
What is a swap?
• Exchange of one financial feature for the other between two parties
• Over-the-counter contract
• Cash flows based on notional principal amount
• Two legs of cash flows
Benchmark Interest Rate
Fixed Rate: fixed interest rate for
discounting on a set of cash flows
Floating Rate: interest rate based
on a benchmark + x bps
Benchmark Rate
• Risk free rate is too stable to
represent market condition
• Historically: LIBOR (phase out
by the end of 2021)
• Substitutes:
• Canada: CORRA
• US: SOFR
• Europe: ESTR
• UK: SONIA
Interest Rate Swap (IRS)
Party Fixed Floating
Y 5.0% CORRA + 10bps
X 6.5% CORRA + 100bps
Interest Rate Swap: an customized
contract that allow two parties to
exchange fixed/floating rates
Analysis
• Party Y:
• Want to have floating rate
• Absolute advantage on both
• Comparative advantage on fixed
• Party X:
• Want to have fixed rate
• Comparative advantage on floating
• Potential Saving: 60 bps
Interest Rate Swap (IRS)
Party Initial IRS Result Saving
Y 5.0% Pay CORRA + 100 bps CORRA – 20 bps 30 bps
X CORRA + 100bps Pay 6.2% 6.2% 30 bps
Financial intermediaries might take spread from this saving
Direct Selection
Party Direct Selection
Y CORRA + 10 bps
X 6.5%
Specialize and use IRS
Split the potential saving
equally: 30 bps each
Cross Currency Swaps
• Exchange denominated in different currencies.
• Principal : Exchange in beginning = Exchange in end.
• Interest : Fixed rate, floating rate or both.
• Take place between countries
Uses of Cross Currency Swaps
• Purchase less expensive debt
• Hegde against exchange rate fluctuations
• Against Financial Crisis
• US Federal Reserve vs European Central Banks
OPTIONS
Options
Key Features
● Put/Call
● American/European
● Strike price
● Underlying Asset
● Expiration Date
● Premium/Discount
Call/Put Premium
Payoff
K
Payoff
K
Profit/Loss
K
P
Profit/Loss
K
P
Nothing is free
Buy/Write
Call Option Put Option
Buy (Long)
Purchase a call option
Purchase a put option
Write (Short)
Sell a call option
Sell a put option
Reversed
Payoff
/Profit
Charts
K
K K
K
PayoffProfit
Volatility of an Option Investment
• Option premium is usually much less than the
price of the underlying asset
• The return is much more volatile than its
underlying asset
• consider an investment of $1000
• Stock: 200 shares
• Call: 1000 calls
Payoff
K=10
P=1
A: S=2 B: S=20
15
-3
Scenario Stock Price
StockProfit
Option Profit
StockReturn %
OptionReturn %
A 2 -600 -1000 -60% -100%
B 20 3000 10000 +300% +1000%
Option Strategies: Covered Call
Covered Call
• Long a stock, write a call
• Limited profit but quick
premium revenue
• Given start with a stock
portfolio
Profit/Loss
K
P
Long a Stock
Write a Call
Covered Call
Option Strategies: Protective Put
Protective Put
• Long a stock, long a put
• Limited loss
• Resembles a long on call option
• Given start with a stock portfolio
Profit/Loss
K
P
Long a Stock
Long a Put
Protective Put
Option Strategies: Straddle and Strangle
Profit/Loss
K
Profit/Loss
K1 K2
Straddle
• Long a call and put at the
same strike price
• Profit on volatility
• Expensive premium cost
Strangle
• Long a call at a higher
strike price and put at a
lower strike price
• Cheaper but need larger
price volatility
Long a Call at K
Long a Put at K
Straddle
Long a Call at K2
Long a Put at K1Strangle
Greeks
change in underlying priceGreeks are the sensitivities of an option’s price to given factors, ie. underlying price, risk-free rate, volatility, etc.
Delta ∆ Vega 𝜈 Theta 𝜃 Gamma 𝛤 Rho 𝜌Greeks
Sensitive Factors
underlying asset’s price
underlying asset’s volatility
time to maturity Change in Delta Risk-free rate
Mutual Funds
• Carrier made up of a pool of money collected from various investors
• Open-end fund
• Closed-end fund
• Net Asset Value per share = Price of Fund share
Advantages
• Diversified
• Low investment requirements
• Expert management
Disadvantages
• High fees/expense
• Over-diversification
• Dilution
ETF
A Similar Concept to Mutual Funds
Common Types of ETFs
• INDEX
• Commodity
• Inverse
• Industries
• Foreign Markets
• Actively Managed
Why Choose an ETF Over a Mutual Fund?
Let’s talk differences!
HEDGE FUNDS
Hedge Fund Definition
1. Alternative investments, only accessible by accredited investors
2. Large variety of asset exposure, management strategies (regulation)
3. Fee structure (2 and 20), rather than flat expense ratio
4. Restriction on redemptions (lockup period, notice period)
Universe of StrategiesEv
ent
Dri
ven • Merger
Arbitrage• Distressed +
Restructuring• Activist
Shareholder• Special
Situations (mergers, acquisitions, bankruptcy)
Rel
ativ
e V
alu
e • Fixed-Income Convertible Arbitrage
• Fixed-Income Asset Backed
• Fixed Income General
• Volatility• Multi-Strategy
Mac
ro S
trat
egie
s • Macro Trends• Long-short
positions• Profit from
view on overall market direction
Equ
ity
Hed
ge • Market Neutral• Fundamental Growth
• Fundamental Value
• Quantitative Directional
• Short Bias• Sector Specific
THANK YOU FOR
LISTENING