The Capital Markets Prof. Ian Giddy - NYUpages.stern.nyu.edu/~igiddy/ing-barings/capitalmarkets.pdf · The Capital Markets Prof. Ian Giddy ... uParticipants in the Money Market uThe

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The Capital Markets

Prof. Ian GiddyNew York University

New York University/ING Barings

Copyright ©1999 Ian H. Giddy Capital Markets 2

The Money and Capital Markets

l The playersl Stocks and bonds: the instruments and

marketsl The economy and the marketl Constructing a portfoliol Picking stocks

The Portfolio ProjectThe Portfolio Project



The Project

l Part I: Construct a well balanced portfolio for a client

l Part II: Analyze a company to add to the portfolio


Finance Theory...

l Time Is Moneyl Same Thing, Same Pricel Risk Is Rewarded



Applied Finance Theory...

Price

Value

versus


Buy, Sell or Hold?

l How and where do I trade?l What should I buy? When? Why?l How can I estimate the value of a bond?

A stock? An IPO? An option or other derivative?

l How should I combine investments?l When is it time to sell?



Stock and Bond Issues

Stocks & BondsStocks & Bonds

Secondary MarketSecondary Market

Primary MarketPrimary Market


Primary Market for Equities

Initial Public Offering (IPO)

Subsequent Offering

Private Equity Placement

Stock Buyback?

Management Buyout?




Investment Banking Arrangements

l Underwritten vs. “Best Efforts”

uUnderwritten: firm commitment on proceeds to the issuing firm

uBest Efforts: no firm commitment

l Negotiated vs. Competitive Bid

uNegotiated: issuing firm negotiates terms with investment banker

uCompetitive bid: issuer structures the offering and secures bids



Secondary Market Trading

Secondary Market for Equities

Initial Public Offering (IPO)

Subsequent Offering

Private Equity Placement


Institutional Investors and Money Managers

Institutional Investors Money Managers

Mutual Funds

Insurance Companies

Pension Funds

Hedge funds, Central banks, etc.

Stocksand

bonds

Money managersMoney managers



Mutual Funds

Open-End Closed-End

Stocksand

bonds

Variablenumber

of shares

n Not traded on an exchange

n Price = NAV (less fees)

Stocksand

bonds

Variablenumber

of shares

n Traded on a stock exchange

n Price may not = NAV


Active vs. Passive Management

Active Managementl Finding undervalued securitiesl Timing the marketPassive Managementl No attempt to find undervalued

securitiesl No attempt to timel Holding an efficient portfolio



Instruments and Markets

What Investments?What Investments?

Treasury Bills?(risk-free)

Treasury Bills?(risk-free)

Stocks and Bonds?(risky)

Stocks and Bonds?(risky)


Risky Investments?

Return

Risk



Capital Allocation Possibilities:Treasuries or an Equity Fund?

Expected Return

Risk

THE EQUITY FUNDReturn 17%Risk 27%

THE EQUITY FUNDReturn 17%Risk 27%

THE US TREASURY BONDReturn 7%Risk Zero

THE US TREASURY BONDReturn 7%Risk Zero


Capital Allocation Possibilities:Treasuries or an Equity Fund?

rf=7%

E(rP)=17%

σ = 27%

10%

P

Expected Return

Risk

7%

THE EQUITY FUND



We Can Buy Some T-bills and Some of the Risky Fund

SLOPE=0.37

E(R)

Risk (Standard Deviation)

17%

14%

18.9% 27%

ONE PORTFOLIO:30% Bills, 70% FundE(R)=.3X7+.7X17=14%SD=.7X27=18.9%

rf=7%


Financial Institutions and Markets

l The Money MarketuThe operation of the Money Market

uParticipants in the Money Market

uThe Eurocurrency Market

l The Capital MarketuDomestic bonds, Eurobonds

uEquities

l Foreign Exchange


How do Securities Trade?


Key Securities

l Money market instruments - Short-term debt instruments, like deposits and bills

l Bonds - used by businesses and governments to raise money

l Common Stock - Units of ownership, interest, or equity

l Preferred Stock, Convertibles - A form of ownership with features of both debt and common stock


How do Securities Trade?

Efficient Inefficient

Unregulated Regulated


Foreign Exchange:How Much Does a Dollar Buy? Cost?

An over-the-counter marketAn over-the-counter market

SpotSpotForwardForwardForwardForwardForwards

Futures, Options

ForwardsFutures, Options



Organized Securities Exchanges are organizations that act as markets for previously issued securities

l They are secondary markets - for stocks traded after they have been issued in the public market

l Trading is accomplished through an auction process

l Once placed, an order to buy or sell is usually executed in a matter of minutes

l Examples: NYSE, American, London, Tokyo

Major Securities Markets


World Stock Exchanges

0

1,000,000

2,000,000

3,000,000

4,000,000

5,000,000

6,000,000

7,000,000

8,000,000

9,000,000

US

$ m

illio

ns

New

Yor

k

Toky

o

Lond

on

Ger

man

y

Par

is

Hon

gkon

g

Toro

nto

Sw

itzer

land

Am

ster

dam

Taiw

an

Aus

tralia

Kua

la L

umpu

r

Kor

ea

Sin

gapo

re

Phi

lippi

nes

Thai

land

Market Value of Shares of Domestic Listed Companies, June 1997



l Create a continuous, liquid market in which demanders of funds can obtain needed financing

l Design and enforce rules of conduct so that trading is fair

l Create an efficient market that allocates funds to their most productive uses

l A key to the efficient allocation of funds is the rate of return on an investment

The Role of Securities Exchanges


Let’s Play the Game

Costs of tradingl Commission: fee paid to broker

for making the transactionl Spread: cost of trading with

dealeruBid: price dealer will buy from youuAsk: price dealer will sell to youuSpread: ask - bid

l Combination: on some trades both are paid



Costs of Trading

l Commission: fee paid to broker for making the transaction

l Spread: cost of trading with dealeruBid: price dealer will buy from youuAsk: price dealer will sell to youuSpread: ask - bid

l Combination: on some trades both are paid


Types of Orders

Instructions to the brokers on how to complete the order

l Marketl Limitl Stop loss



Margin Trading

l Using only a portion of the proceeds for an investment

l Borrow remaining componentl Margin arrangements differ for stocks

and futures


Stock Margin Trading

l Maximum margin is currently 50%; you can borrow up to 50% of the stock value

l Set by the Fedl Maintenance margin: minimum amount

equity in trading can be before additional funds must be put into the account

l Margin call: notification from broker you must put up additional funds



Margin Trading - Initial Conditions

X Corp $7050% Initial Margin40% Maintenance Margin1000 Shares PurchasedInitial PositionStock $70,000 Borrowed $35,000

Equity 35,000


Margin Trading - Maintenance Margin

Stock price falls to $60 per shareNew PositionStock $60,000 Borrowed $35,000

Equity 25,000Margin% = $25,000/$60,000 = 41.67%



Margin Trading - Margin Call

How far can the stock price fall before a margin call?

(1000P - $35,000)* / 1000P = 40%

P = $58.33* 1000P - Amt Borrowed = Equity


Short Sales

Purpose: to profit from a decline in the price of a stock or security

Mechanicsl Borrow stock through a dealer

l Sell it and deposit proceeds and margin in an account

l Closing out the position: buy the stock and return to the party from which is was borrowed



Short Sale - Initial Conditions

Z Corp 100 Shares

50% Initial Margin

30% Maintenance Margin

$100 Initial Price

Sale Proceeds $10,000

Margin & Equity 5,000

Stock Owed 10,000


Short Sale - Maintenance Margin

Stock Price Rises to $110

Sale Proceeds $10,000Initial Margin 5,000Stock Owed 11,000Net Equity 4,000Margin % (4000/11000) 36%



Short Sale - Margin Call

How much can the stock price rise before a margin call?

($15,000* - 100P) / (100P) = 30%P = $115.38

* Initial margin plus sale proceeds



GovernmentsGovernments

TreasuriesTreasuries Agencies, Mortgage-backed

Securities

Agencies, Mortgage-backed

Securities




GovernmentsGovernments

TreasuriesTreasuries Agencies, Mortgage-backed

Securities

Agencies, Mortgage-backed

Securities


Benchmark Bonds



Corporate Bonds: Spread over Benchmark


US Bond Markets

Governments53%

Corporates16%

Mortgage-Backed

29%

Asset-Backed2%




Corporate BondsCorporate Bonds

DomesticDomestic InternationalInternational


International Capital Marketsl The Eurobond Market is the market for bonds issued

outside the country of the currencyl The Foreign Bond Market is one in which a foreign

corporation or government issues bonds in a domestic market in the local currency

l An International Equity Market has emerged that allows corporations to sell large blocks of shares simultaneously to investors in several different countries

Major Securities Markets



International Bond Markets are Linked

l Issuers and investors compare terms in the domestic and Eurobond markets, which are linked across currencies via currency swaps

BONDMARKETSWITHINCOUNTRYOFCURRENCY

BONDMARKETSOUTSIDECOUNTRYOFCURRENCY

CurrencySwaps

Long-datedForwardExchange

Domestic US

- Gov't- Corporate

ForeignBonds

"Yankee"

DomesticJapanese

- Gov't- Corporate

ForeignBonds

"Samurai"

EurodollarBond Market

EuroyenBond Market


Interest Rate Swap

The typical interest-rate swap is an exchange of a fixed for a floating interest rate for a period of time.

Effectively, it involves paying the difference between a fixed rate and a floating rate likeLibor:

GEGE ChaseChase

8% Fixed

3-mo Libor,floating



Derivatives

l Derivatives are, by definition, derived from cash instruments, like bonds, stocks, currencies or commodities

l Example: foreign exchange

SPOT FOREXCONTRACTS

lFX Forwards, futures, swaps

lCurrency options

lKnock-ins, PERLS


The Chicago Mercantile Exchange



Risk-Free Asset

Bonds Real Estate

ConEd Viacom Chase Siemens

Security Selection

Stocks Commodities FX

Asset Allocation

Risky Assets

Capital Allocation

Managing a Portfolio


Long-Term Returns on Investments

4

8

8

4

5

4

12

0 2 4 6 8 10 12 14

Stocks total return

Bonds total return

Bills total return

Consumer prices

Stocks capital gains

Stocks after inflation

Dividends and reinvestment

Stocks, Bonds, Bills and Inflation



The Economy and the Markets

l How much should I pay for a bond?l Interest rates and inflationl Growth and employmentl How much should I pay for a stock?l Corporate profits and equity values


Emerging Equity Markets



Corporate Profits Drives Stock Prices

Corporate profits

0.0

500.0

1,000.0

1,500.0

2,000.0

2,500.0

3,000.0

3,500.0

4,000.0

1959

1961

1963

1965

1967

1969

1971

1973

1975

1977

1979

1981

1983

1985

1987

1989

1991

1993

1995

Year

$ b

illio

ns

(199

2 d

olla

rs)


Performance Benchmarking:Buy Kellogg?














Conclusion: Benchmarks are needed because performance is

relative

Conclusion: Benchmarks are needed because performance is

relative


How Can We Know About a Company?

l Financial statementsl Web resourcesl Forecasting and comparative

Example:n J&J company reportn Pharma industry report



Ian H. Giddy

Ian GiddyNYU Stern School of Business

Tel 212-998-0332; Fax 212-995-4233

[email protected]

http://giddy.org

Documents

The Capital Markets Prof. Ian Giddy - NYUpages.stern.nyu.edu/~igiddy/ing-barings/capitalmarkets.pdf · The Capital Markets Prof. Ian Giddy ... uParticipants in the Money Market uThe