Lecture 1: Financial Markets

Financial Markets textbook definition: “Markets through which entities with

surplus (excess) financial funds transfer those surplus funds to entities who
have a shortage (shortfall) of available funds.
Types of financial markets:
 Stock markets (azioni);
 Bond markets (obbligazioni);
 Mortgage markets (ipoteca): securing the deposit with your home;
 Treasury security (buoni del tesoro);
 Commercial paper market (promesse di pagamento/contratti).
Federal Funds Rate: the short term (generally overnight) interest rate in the
U.S. interbank market for lending/borrowing “excess” bank reserves.
Federal Funds rate is the interest rate at which one commercial bank will lend
excess of reserves to another commercial bank.
Federal Funds rate (target) is regarded as a key (benchmark) short interest rate
in the U.S. because Federal Reserve sets this rate so as to implement monetary
policy.
Effective federal funds rate: This is the actual rate at which banks are lending
excess reserves to one another, it generally parallel the target, but when it
does not it too provides us with important signals as to conditions in financial
markets.
Federal Reserve Discount Rate: Interest rate the Federal Reserve will
charge member banks and other depository institutions to borrow short term
(overnight) reserves.
Administratively set by the Federal Reserve Historically called the Discount
Rate, now called the Primary Credit Rate.
This market is important as it represents a “safety” net for financial institutions.
The Fed affect the federal funds rate through open market operation, the
buying and selling of government securities.
Buying government securities increases bank excess reserves. An increase in
the supply of bank reserves (everything else equal) will put downward pressure
on the Federal funds rate. Selling government securities reduces bank excess
reserves. A decrease in the supply of bank reserves (everything else equal) will
put upward pressure on the Federal funds rate.
Key ECB (European Central Bank) interest rates for the euro area:
 The interest rate on the main refinancing operations (MRO), which
provide the bulk of liquidity to the banking system.
 The rate on the deposit facility, which banks may use to make overnight
deposits with the Euro system.
 The rate on the marginal lending facility, which offers overnight credit to
banks from the Euro system.
Policy rates are set (or influenced) by central bank and thus it carries important
signals for the market. It tells us what the central bank thinks about the
economy and the direction of the economy. These signals will affect how the
market sets its interest rates.
Bottom line: Other money market rates are probably influenced by the direction
and level of the Policy Rates.
Measures of Economic Activity:
1. Economic output (Business Activity):
o GDP (changes in real GDP).
2. Business Cycles:
o Traditional recession definition: 2 consecutive quarters decline in
real GDP.
o Current definition: incorporates more analysis.
3. Price levels:
o Inflation (Consumer and producer prices).
Differences in cross country government bond interest rates reflect:
  Relative differences in economic growth (where countries are in their
business cycles).
 Relative differences in rates of inflation (generally the higher the rate of
inflation, the higher the interest rate).
 Relative differences in the “accommodative” stance of each country’s
central bank (generally the more accommodative, the lower interest
rate).
 Relative differences in the market’s assessment about the risk associate
with a sovereign borrower.
 Impact of flight to safe havens as markets become risk adverse
(movement into “safer” countries during regional and global uncertainty
will drive down yields).
One quick way to observe and measure these differences is through “spreads”
to major country bond rates.
In comparing government bonds cross country, the 2 most common
comparison rates are either yields to maturity on 10-year U.S. Treasuries (T-
Bonds) and 10-year German Treasuries (Bunds). We assume both of this are
“default-free”.
Given that the spreads are relative to the two major default free sovereign
borrowers (Germany and the U.S.), perhaps we can use these spreads as a
market measure of risk of default (certainly the case of Italy, Spain, Portugal
and Greece).
On the other hand, spreads may simply represent differences in inflation rates
(Japan and U.K.), economic activity, or central bank accommodation.
Differences between the Bund and T-Bill probably reflect differences in global
market demand stemming from regional and global safe haven effects.
Any price changes indicate economic activity, if there is no activity the price
stays the same.

Lecture 2: Types of markets

Primary market: raising funds.
The financial market in which new issues of a security, such as a bond or a
stock, are sold to initial buyers by a corporation or a government.
Investments banks: financial institution that assists in the initial sale of
securities in primary markets, they do this by “underwriting securities”
guaranteeing a price for a corporation’s securities and then selling them to the
public.
Secondary market: trading of financial assets between people who are not
the original borrower (es: bond markets).
The financial market in which securities that have been previously issued can
be resold. The New York Stock Exchange (NYSE) and National Association of
Securities Dealers Automated Quotation System (NASDAQ) are examples for
secondary markets.
Functions of financial markets:
 Provide the means for entities to protect their financial/commercial
position (assurance purpose).
 Mechanism for generating a return on surplus financial funds (investing).
 Allocates limited financial resources among competing users (this
improves economic efficiency and result in the highest economic grow).
 Provides financial signals to market participants:
Stock prices and interest rates can tell us something about the market
assets of companies, financial institutions and overall financial markets.
Exchange rates and government interest rate spreads can tell us something
about the market’s assessment of countries or regions.
Money markets: the financial markets for short-term debt instruments
(those with original maturity of one year or less). Shorter term securities
have smaller fluctuations in prices than long-term securities, making them
safer to invest as well as highly liquid.
Corporations and banks use the money market to earn interest on surplus
working capital and to finance working capital shortages. Institutions, such
as money market mutual funds, specialize in acquiring these assets.
Money market instruments include U.S Treasury bills, Commercial paper,
bank certificate of deposit, and bankers’ acceptance.
Capital markets: The financial market for longer-term debt (generally those
with maturities greater than one year) and equity (common stock).
Long term securities are often held by financial intermediaries such as
insurance companies and pension funds, which have less uncertainty about the
amount of funds they will need in the future (they are also less liquid).
Capital market instruments include Common Stock, U.S Treasury bonds,
corporate bonds, and Mortgages.
Indirect Finance: Funds that flow through financial intermediaries, such as
depository institutions, insurance companies and mutual funds. These
institutions work as a channel of indirect financing by pooling saver funds then
invest (or lending) those funds through to businesses and others that need
them.
Direct Finance: Funds that flow directly lenders to borrowers with the
assistance of institutions that provide brokerage services (research and advice,
retirement planning, tax tips, execution of trades). These institutions work as a
channel of direct financing, in which businesses and governments can raise
funds directly from lenders in financial markets (IPOs).
Why are the financial intermediaries important in financial markets?
 Transaction cost: Refers to the time and money spent in carrying out
financial transactions. Financial intermediaries can substantially reduce
transaction costs because they have developed expertise in lowering
them, and because their large size allows them to take advantage of
economies of scale.
 Risk sharing: Financial intermediaries sell assets with risk
characteristics that people are comfortable with and then use the funds
to purchase other assets that may have far more risk. This process of risk
sharing is called asset transformation, i.e., risky assets are turned into
safer assets for investors. Another way of risk sharing provided was
through diversification; financial intermediaries invest in a collection of
assets whose return do not always move together, with the result that
overall risk is lower than for individual assets.
 Asymmetric information (i.e., one party has more or better
information): Financial intermediaries are usually better at credit risk
screening than individuals, therefore reducing losses due to wrong
investment decision making. They have developed expertise in
monitoring the parties they lend to, thus reducing losses due to moral
hazard. Moral hazard: The tendency to take on more risk because of the
perception that one is protected from the consequences of doing so.
Classification of financial assets:
 Financial assets which represent a claim on the issuer’s future income
and/or assets:
o Bonds: Debt instruments with a contractual agreement (indenture
specifies interest payment, maturity date, etc.).
o Common Stocks: Instruments representing an ownership position in
a corporation (note this does not represent a “legal” claim such as
a bond.
  Instruments which are neither debt nor equity based and thus belong in
their own category. (i.e., Foreign Exchange)
 Cash instruments: financial assets whose value is determined directly by
financial markets. (i.e., Stock and bonds).
 Derivative instruments: financial assets which derive their value from
some other (underlying) financial instrument (i.e., called the underlying
asset) or variable. Futures, forwards, options (puts and calls).
A market is well functioning when:
1. Transparency: Condition whereby all participants will have access to
reliable and important information at the same time.
2. Adequate Regulation: Financial markets need to have regulation which
ensures a level and fair playing field and appropriate behaviour.
3. Competition: Markets need to be structured and regulated so as to offer
easy access and exit. Competition applies to both domestic and foreign
entities. Goal: To ensure best prices and services for end users.
4. Market Structure which Allows for Innovation: To provide needed
new services and new product development. Allowing financial service
providers to respond to needs of end users.
Effects of Changes in interest rates:
 Affect the cost of borrowing (end users and intermediaries).
 Influence the returns (and profit margins) to interest sensitive financial
institutions (e.g., banks) and the borrowings/investments of non-financial
sectors (household and companies).
 Affect asset prices (bonds, stocks, foreign exchange).
 Impact on the M&A market (leveraging activities).
 Impact on mortgage markets.
Effects of Changes in stock prices:
 Affect the Economy’s perception of wealth (influence spending decisions).
 Affect the IPO market and M&A market (P/E multiples).
Effects of Changes in exchange rates:
 Affect the competitive position of global firms, exporters and importers.
 Affect the returns to global investment funds (mutual funds, pension
funds).
Beating the market = consistently earning a positive excess return.
The excess return on an investment is the return in excess of that earned by
other investments that have the same risk.
Market efficiency can be obtained if:
 Investors use their information in a rational manner.
 There are independent deviations from rationality.
 Arbitrageurs exist.
A Weak-form Efficient Market is one in which past prices and volume figures are
of no use in beating the market.
 A Semi-strong-form Efficient Market is one in which publicly available
information is of no use in beating the market.
A Strong-form Efficient Market is one in which information of any kind, public or
private, is of no use in beating the market.
No matter how often a particular stock price path has related to subsequent
stock price changes in the past, there is no assurance that this relationship will
occur again in the future.
Stock prices change when traders buy and sell shares based on their view of
the future prospects for the stock. But, the future prospects for the stock are
influenced by unexpected news announcements.
Prices could adjust to unexpected news in three basic ways:
1. Efficient Market Reaction: The price instantaneously adjusts to the new
information.
2. Delayed Reaction: The price partially adjusts to the new information.
3. Overreaction and Correction: The price over-adjusts to the new
information, but eventually falls to the appropriate price
Informed trader: an investor decides to buy or sell a stock based on publicly
available information and analysis.
Insider traders: investor who has non-public information, for being legal they
need to respect the reporting rules made by the SEC.
Short-term stock price and market movements appear to be difficult to predict
with any accuracy.
The market reacts quickly and sharply to new information, and various studies
find little or no evidence that such reactions can be profitably exploited.
Markets anomalies:
 The day-of-the-week effect (tendency for Monday to have a negative
average return),
 The January effect (tendency for small-capitalization stocks to have large
returns in January).
Bubble: occurs when market prices soar far in excess of what normal and
rational analysis would suggest.
Investment bubbles eventually pop.
When a bubble does pop, investors find themselves holding assets with
plummeting values.
A bubble can form over weeks, months, or even years.
Crash: significant and sudden drop in market values.
Crashes are generally associated with a bubble.
Crashes are sudden, generally lasting less than a week but the financial
aftermath of a crash can last for years.
Exchange: specific location when individuals meet and exchange money with
specific rules.
Over the counter (OTC): transaction without agreements (vado al mercato e
compro delle mele).
Mostly financial exchange is made OTC.
Money market = for short term debt
Capital markets = longer term debt, bond (the longest is 50 years) and equity
(no final dates) market
Cash instrument: their values depend by financial markets.
Derivate instruments are more complicated because they depend by multiple
factors, they are usually exchanging OTC so they are less regulated (es: ETF).

Lecture 3: Financial Institutions

Financial system is complex in both structure and function throughout the
world.

Includes many different types of institutions: banks, insurance companies,

mutual funds, stock and bond markets, and so on.

Stocks are not the most important source of external financing for businesses.
Issuing marketable debt and equity securities is not the primary way in which
businesses finance their operations.
Indirect finance, which involves the activities of financial intermediaries, is
many times more important than direct finance, in which businesses raise
funds directly from lenders in financial markets.
Financial intermediaries, particularly banks, are the most important source of
external funds used to finance businesses.
The financial system is among the most heavily regulated sectors of economy.
Only large, well-established corporations have easy access to securities
markets to finance their activities.
Collateral is a prevalent feature of debt contracts for both households and
businesses.
Debt contracts are typically extremely complicated legal documents that place
substantial restrictions on the behaviours of the borrowers.
Transaction costs influence financial structure, financial intermediaries
reduce transaction costs, allow small savers and borrowers from the
existence of financial markets.
If you have only a small amount available, you can make only a restricted
number of investments because a large number of small transactions would
result in very high transaction costs.
Bundle the funds of many investors together, reduce in transaction costs per
dollar of investment as the size of transactions increases, reduces transaction
costs for each individual investor.
Economies of scale possible because the total cost of carrying out a transaction
in financial markets increases only a little as the size of the transaction grows.
Funds are large enough to buy a widely diversified portfolio of securities,
reducing risk.
Financial intermediaries can also beat asymmetric information:
1. Adverse selection: Occurs when one party in a transaction has better
information than the other party (before transaction occurs).
2. Moral hazard: Occurs when one party has an incentive to behave
differently once an agreement is made between parties, after transaction
occurs.
Agency theory: the analysis of how asymmetric information problems affect
behaviour.
Conflicts of interest are a type of moral hazard that occurs when a person or
institution has multiple interests, and serving one interest is detrimental to the
other.
Asymmetric information creates barriers between savers and firms with
productive investment opportunities.
A financial crisis occurs when information flows in financial markets experience
a particularly large disruption. Financial markets may stop functioning
completely.
Financial crises are major disruptions in financial markets characterized by
sharp declines in asset prices and firm failures.
Financial crisis can begin in several ways:
 Credit Boom and Bust
 Asset-Price Boom and bust
 Increase in Uncertainty
The seeds of a financial crisis can begin with mismanagement of financial
liberalization or innovation like elimination of restrictions or introduction of
new types of loans or other financial products.
Either can lead to a credit boom, where risk management is lacking.
Government safety nets weaken incentives for risk management.
Depositors ignore bank risk-taking.
Eventually, loan losses accrue, and asset values fall, leading to a reduction in
capital. Financial institutions cut back in lending (process called
deleveraging).
Bank funding falls as well.
As FIs (financial institutions) cut back on lending, no one is left to evaluate
firms. The financial system losses its primary institution to address adverse
selection and moral hazard.
Economic spending contracts as loans become scarce.

A financial crisis can also begin with an asset- price boom and bust (i.e.:
bolle immobiliari):
A pricing bubble starts, where asset values exceed their fundamental values.
When the bubble bursts and prices fall, corporate net worth falls as well.
Moral hazard increases as firms have little to lose.
FIs also see a fall in their assets, leading again to deleveraging
A financial crisis can also begin with an increase in uncertainty: Periods of
high uncertainty can lead to crises, such as stock market crashes or the failure
of a major financial institution. Examples include: 1857, when the Ohio Life
Insurance & Trust Company failed 2008, when AIG, Bear Sterns, and Lehman
Bros. failed.
With information hard to come by, moral hazard and adverse selection
problems increase, reducing lending and economic activity.
Deteriorating balance sheets lead financial institutions into insolvency. If severe
enough, these factors can lead to a bank panic.
Panics occur when depositors are unsure which banks are insolvent, causing all
depositors to withdraw all funds immediately.
As cash balances fall, FIs must sell assets quickly, further deteriorating their
balance sheet.
Adverse selection and moral hazard become severe it takes years for a full
recovery.
If the crisis also leads to a sharp decline in prices, debt deflation can occur,
where asset prices fall, but debt levels do not adjust, increasing debt burdens.
This leads to an increase in adverse selection and moral hazard, which is
followed by decreased lending Economic activity remains depressed for a long
time.

Lecture 4: Understanding Interest Rates and

Risks in the Bond Markets.
Interest rate definition depends on whether you see it from the borrower’s or
saver’s perspective.
Borrowing: the cost of borrowing or the price (%) paid for the “rental” of
funds.
Saving: the return from investing funds or the price (%) paid to delay
consumption.
Both concepts are expressed as a percentage per year (Percent per annum;
“p.a.”).
True regardless of maturity of instrument of the financial liability or financial
asset.
Savings and Borrowing Rates move together.
Basis Point: A unit that is equal to 1/100th of 1% and is used to denote the
changes in interest rates or differences in interest rates between various debt
instruments.
The relationship between interest rate changes (or differentials) and basis
points can be summarized as follows: 1% change (or difference) = 100 basis
points.
Example 1: If Bond A’s yield increases from 5% to 6.5%, then Bond A’s yield
increased150 basis points.
Example 2: If Bond B’s yield falls from 7.00% to 6.93%, then Bond B’s yield
decreased 7 basis points.
Example 3: If Bond C has a yield of 6% and Bond D a yield of 2%, then Bond C
is 400 basis points more than Bond D.
There are four important ways of measuring (and reporting) interest rates on
financial instruments. These are:
 Coupon yield: The “promised” annual percent return on a coupon
instrument.
 Current Yield: Bond’s annual coupon payment divided by its current
market price.
 Yield to Maturity: The interest rate that equates the future payments to
be received from a financial instrument (coupons plus maturity value)
with its market price today (i.e., to its present value).
 Discount Yield and Investment Yield: These are yields on short term
(one year or less) debt instruments that have no coupon payments and
are selling at a discount of their par values. These interest rates are the
“implied” returns from buying a debt instrument at a price below its par
value.
Par Value: The amount that the bond holder will receive when the bond
matures (also called face value and maturity value). In the U.S. all bonds have
a par value of $1,000.
Coupon Payment: This is the (dollar) amount of interest to be paid to the
bond holder. Usually expressed on an annual basis (even if the bond pays
interest semi-annually).
Market Price: This is the current market price for an outstanding bond.
Premium bond: Market price above its par value.
Discount bond: Market price below its par value.
Interest rates can be used for cross-country assessments or changes in
individual country assessments over time.
The 2 most common benchmark rates are yields to maturity on 10-year
Government U.S. Treasuries and German Bunds. We assume both of these are
“default-free.”
We can compare other sovereigns to these (and to one another) to assess:
 Credit ratings risk.
  Inflation risk.
 The market’s overall assessment of country risk.
Coupon yield is the annual interest rate which was promised by the issuer
when a bond was first sold.
Coupon information is found in the bond’s indenture (legal contract). Indenture
will state the coupon payment (as a percent of the bond’s par value) and the
schedule of payments (semi-annual or annual). The coupon yield on a bond will
not change during the lifespan of the bond.
Current Yield is measured by dividing a bond’s annual coupon payment by its
current market price. This provides us with a measure of the “current” interest
yield obtained at the bond’s current market price (i.e., cost associated with
investing in a particular bond).
Current yield = annual coupon payment / market price
Yield to Maturity (YTM) is a financial concept used to estimate the total
return an investor can expect to earn if they hold a bond until it matures.
Yield to maturity is the interest rate which will discount the incomes (i.e.,
cash-flows) of a bond to produce a present value which is equal to the bond’s
current market price (or produce a net present value = 0).

Discount yields and investment yields are calculated for U.S. T-bills and
other short term money market instruments (e.g., commercial paper and
bankers’ acceptances) where there are no stated coupons (the assets are
quoted at a discount of their maturity value).
The discount yield relates the return to the instrument’s par value (or face or
maturity).
The discount yield is sometimes called the bank discount rate or the discount
rate.
The investment yield relates the return to the instrument’s current market
price.
The investment yield is sometimes called the coupon equivalent yield, the bond
equivalent rate, the effective yield or the interest yield.
Investment yield = [(PV - MP)/MP] * [365 or 366/M]
The investment yield relates the return to the instrument’s current market price
(MP.
The investment yield is generally calculated so that we can compare the return
on T-bills to “coupon” investment options.
The investment yield formula will tend to “over-state” yields relative to those
computed by the discount method, because the market price (in the
investment yield formula) is (likely to be) lower than the par value ($1,000).
However, if the market price is very close to the par value, the yields will be
very close to one another.
Think of the yield to maturity as the “required return on an investment.”
Since the required return changes over time, we can expect these changes to
produce inverse changes in the prices on outstanding (seasoned) bonds.
Why will the required return change over time?
 Changes in inflation (inflationary expectations).
 Changes in the economy’s credit conditions resulting from change in
business activity.
 Changes in central bank policies.
 Changes in the assumptions about credit risk and announced changes in
credit risk ratings associated with the issuer of the bond (i.e., risk of
default).
 Contagion effects.
 Safe haven effects (market uncertainty).
For a given interest rate change, the longer the term to maturity, the greater
the bond’s price change.
When the market interest rate (i.e., the required rate) rises above the coupon
rate on a bond, the price of the bond falls (i.e., it sells at a discount of par).
When the market interest rate (i.e., the required rate) falls below the coupon
rate on a bond, the price of the bond rises (i.e., it sells at a premium of par).
There is an inverse relationship between market interest rates and
bond prices (on outstanding or seasoned bonds).
The price of a bond will always equal par if the market interest rate equals the
coupon rate.
The greater the term to maturity, the greater the change in price (on
outstanding bonds) for a given change in market interest rates.
Interest Rate (or Price) Risk on a Bond: The risk associated with a reduction
in the market price of a bond, resulting from a rise in market interest rates.

This risk is present because of the “inverse” relationship between market

interest rates and bond prices. The longer the maturity of the fixed income
security, the greater the risk and hence the greater the impact on the overall
return.

Return = coupon + change in market price

Reinvestment risk occurs because of the need to “roll over” securities at

maturity, i.e., reinvesting the par value into a new security.

Problem for bond holder: The interest rate you can obtain at roll over is
unknown while you are holding these outstanding securities.

If market interest rates fall you will then re-invest at a lower interest rate then
the rate you had on the maturing bond.

Potential reinvestment risk is greater when holding shorter term fixed income
securities.

With longer term bonds, you have locked in a known return over the long term.

Inflation Risk: Risk the future “unanticipated” inflation will erode the real
value of future payments. You Can reduce this risk through inflation protected
instruments (TIPs in the U.S.) Default Risk: Risk that the issuer of the bond
will encounter financial difficulties which will render coupon and principal
payments difficult (or impossible). Can “insure” against default with credit
default swaps.

The fact that two bonds have the same term to maturity does not necessarily
mean that they carry the same interest rate risk (i.e., potential for a given
change in price).

Duration is an estimate of the average lifetime of a security’s stream of

payments.

The lower the coupon rate (maturity equal), the longer the duration.

The longer the term to maturity (coupon equal), the longer duration.
Zero-coupon bonds, which have only one cash flow, have durations equal to
their maturity. Duration is a measure of risk because it has a direct relationship
with price volatility.

The longer the duration of a bond, the greater the interest rate (price) risk and
the shorter the duration of a bond, the less the interest rate risk.

For those who wish to minimize interest rate risk, they should consider bonds
with high coupon payments and shorter maturities (also stay away from zero
coupon bonds).

For those who wish to maximize the potential for price changes, they should
consider bonds with low coupon payments and longer maturities (including
zero coupon bonds).

Real interest rate: This is the market (or nominal) interest rate that is
adjusted for expected changes in the price level (i.e., inflation):

When the real rate is low (or negative), there should be a greater incentive to
borrow and less incentive to lend (or invest).

When the real rate is high, there should be less incentive to borrow and more
incentive to lend (or invest).

The real interest rate (on the fed funds rate) is also assumed to be a better
measure of the stance of monetary policy than just the market interest rate.

If the real rate is negative, or very low, monetary policy is very accommodative
and borrowing will be encouraged.

If the real rate high, monetary policy is very tight and borrowing will be
discouraged.

A neutral monetary policy occurs when the real rate is zero.

Lecture 5: The Term Structure of Interest Rates.

Duration is an estimate of the average lifetime of a security’s stream of
payments.

The lower the coupon rate (maturity equal), the longer the duration.

The longer the term to maturity (coupon equal), the longer duration.

Zero-coupon bonds, which have only one cash flow, have durations equal to
their maturity. Duration is a measure of risk because it has a direct relationship
with price volatility.
The longer the duration of a bond, the greater the interest rate (price) risk and
the shorter the duration of a bond, the less the interest rate risk.

t = time period in which the coupon or principal payment occurs

Ct = interest or principal payment that occurs in period t

i = yield to maturity on the bond

Duration: the time it takes for the bond's cash flows (coupon payments and
principal repayment) to be received.

Term to maturity: the length of time remaining until the bond's principal
amount (face value) is due to be repaid to the bondholder.

Duration of a bond with coupons is always less than its term to maturity
because duration gives weight to these interim payments.

There is an inverse relation between duration and coupon.

There is a positive relation between term to maturity and duration, but duration
increases at a decreasing rate with maturity.

Th ere is an
inverse
relation
between YTM
and duration.

Sinking funds
and call
provisions
can have a
dramatic effect on a bond’s duration.

An adjusted measure of duration can be used to approximate the price

volatility of a bond:
Bond price movements will vary proportionally with modified duration for small
changes in yields.

An estimate of the percentage change in bond prices equals the change in

yield time modified duration.

Longest-duration security provides the maximum price variation.

If you expect a decline in interest rates, increase the average duration of your
bond portfolio to experience maximum price volatility, if you expect an
increase in interest rates, reduce the average duration to minimize your price
decline.

The duration of your portfolio is the marketvalue-weighted average of the

duration of the individual bonds in the portfolio.

Immunization: Attempt to generate a specified rate of return regardless of

what happens to market rates during an investment horizon.

Immunization is a process intended to eliminate interest risk; it is achieved if

the ending wealth of a bond portfolio is the same regardless of whether interest
rates change.

There are three basic shapes that yield curves can take.

 Ascending Yield Curves (“Upward Sloping; Positive”) : Long term interest

rates higher than short interest term.
 Descending Yield Curves (“Downward Sloping; Inverted; Negative”) :
Short term interest rates higher than long term interest rates.

 Relatively) Flat Yield Curves: Long term and short-term rates

essentially the same.
Since we need to make sure that observed differences in market interest rates

only from Government securities (we assume that these securities carry no risk
are not being affected by credit risk (i.e., default risk), we generally use data

of default).

How Do We Actually Construct a Yield Curve? What Interest Rate Should We

Use?

Interest rate possibilities include:

x Coupon yield = coupon payment/par value

x Current yield = coupon payment/market price of bond.
 Yield to maturity = internal rate of return on a bond’s cash flow.

Yield to Maturity as it is the best representation of interest rate conditions at a

point in time, because it takes into account the time value of money.

If you don’t have yield to maturity data, use the current yield as this is a better
approximation of the yield to maturity than is the coupon yield.

Never use the coupon yield.

There are three generally accepted theories or explanations of the yield curve,
these are:

 (Pure) Expectations Theory

Assumption: Financial market’s expectations regarding future interest rates will

shape the current yield curve.

Model assumes that financial markets are efficient.

The existence of widely disseminated information allows market participants to

form expectations about future interest rates (referred to as forward interest
rates).

The Expectations Theory assumes that the current long term spot (forward)
interest rate is comprised of 2 components: current short term interest rate and
expected, or forward, interest rate.
The shape and slope of the yield curve reflects the markets’ expectations about
future interest rates.

Upward Sloping (Ascending, Positive) Yield Curves: future (forward) interest

rates are expected to increase below existing spot rates.

Downward Sloping (Descending, Inverted, Negative) Yield Curves: interest

rates are expected to decrease below existing spot rates.

Flat Yield Curves: interest rates are expected to remain the same as existing
spot rates.

 Liquidity Premium Theory

Assumptions of Liquidity Premium Theory: Long term securities carry a greater

risk and therefore investors require greater returns to invest for longer periods
of time. i.e. (Price risk, Risk of default, Inflation risk).

Liquidity Premium is added by market participants to longer term bonds.

It is actually a premium for giving up the liquidity associated with shorter term
issues.

The Liquidity Premium needs to modify the pure expectations theory formula to
take into account a liquidity premium, or:
Where, Ln is the liquidity premium for holding a bond of n maturity.

 Market Segmentations Theory

Assumptions of the Market Segmentations Theory: Each maturity segment of

the yield curve (short term through long term) has its interest rate determined
by the supply of and the demand for debt instruments within that maturity
segment.

These schedules are independent of one another.

According to the market segmentations theory, the shape of the yield curve is
determined by shifts in the demand for and supply of debt instruments along
various segments of the maturity range.

Changes in this curve reflect changes in demand and supply as borrowers and
lenders move away from their typical preferences.

Lecture 6: The Money Markets.

The term “money market” is a misnomer. Money (currency) is not actually
traded in the money markets.

The securities in the money market are short term with high liquidity; therefore,
they are close to being money.

Money Markets Defined:

1. Usually sold in large denominations ($1,000,000 or more).

2. Low default risk.
3. Mature in one year or less from their issue date, although most
mature in less than 120 days.
Investors in Money Market provides a place for warehousing surplus funds for
short periods of time.

Borrowers from money market provide low-cost source of temporary funds.

Usually better than banks, the cost structure of banks limits their
competitiveness to situations where their informational advantages outweigh
their regulatory costs.

Corporations and U.S. government use these markets because the timing of
cash inflows and outflows are not well synchronized.

Money markets provide a way to solve these cash-timing problems.

Money Market Instruments:

 Treasury Bills

T-bills have 28-day maturities through 12- month maturities.

Discounting: When an investor pays less for the security than it will be worth
when it matures, and the increase in price provides a return. This is common to
short-term securities because they often mature before the issuer can mail out
interest checks.

T-bills are auctioned to the dealers every Thursday.

Each week the Treasury announces how many and what kind of Treasury bills it
will offer for sale.

The Treasury accepts the bids offering the highest price.

The Treasury accepts competitive bids in ascending order of yield until the
accepted bids reach the offering amount.

Each accepted bid is then awarded at the highest yield paid to any accepted
bid.

As an alternative to the competitive bidding procedure, the Treasury also

permits noncompetitive bidding.
Noncompetitive bids include only the amount of securities the investor wants.

The Treasury accepts all noncompetitive bids.

The price is set as the highest yield paid to any accepted competitive bid.

 Federal Funds

Short-term funds transferred (loaned or borrowed) between financial

institutions, usually for a period of one day.

Used by banks to meet short-term needs to meet reserve requirements.

 Repurchase (repo) Agreements

These work like the market for fed funds, but nonbanks can participate.

A firm sells Treasury securities but agrees to buy them back at a certain date
(usually 3–14 days later) for a certain price.

This set-up makes a repo agreement essentially a short-term collateralized

loan.

This is one market the Fed may use to conduct its monetary policy, whereby
the Fed purchases/sells Treasury securities in the repo market.

 Negotiable Certificates of Deposit (CD)

A bank-issued security that documents a deposit and specifies the interest rate
and the maturity date.

Denominations range from $100,000 to $10 million.

Market for T-bills and the market for CDs are very similar.

 Commercial Paper

Unsecured promissory notes, issued by corporations, that mature in no more

than 270 days. The use of commercial paper increased significantly in the early
1980s because of the rising cost of bank loans.

Commercial paper volume fell significantly during the recent economic

recession but annual market is still large.

 Banker’s Acceptances Advantages

An order to pay a specified amount to the bearer on a given date if specified

conditions have been met, usually delivery of promised goods.

These are often used when buyers / sellers of expensive goods live in different
countries.

Exporter paid immediately and is shielded from foreign exchange risk

Exporter does not have to assess the financial security of the importer.
Importer’s bank guarantees payment. Crucial to international trade

As seen, banker’s acceptances avoid the need to establish the creditworthiness

of a customer living abroad.

There is also an active secondary market for banker’s acceptances until they
mature.

The terms of note indicate that the bearer, whoever that is, will be paid upon
maturity.

 Eurodollars

Eurodollars represent Dollar denominated deposits held in foreign banks.

The market is essential since many foreign contracts call for payment is U.S.
dollars due to the stability of the dollar, relative to other currencies.

The Eurodollar market is one of the most important financial markets, but oddly
enough, it was fathered by the Soviet Union.

In the 1950s, the USSR had accumulated large dollar deposits, but all were in
US banks. They feared the US might seize them, but still wanted dollars. So,
the USSR transferred the dollars to European banks, creating the Eurodollar
market.

The Eurodollar market has continued to grow rapidly because depositors

receive a higher rate of return on a dollar deposit in the Eurodollar market than
in the domestic market.

Multinational banks are not subject to the same regulations restricting U.S.
banks and because they are willing to accept narrower spreads between the
interest paid on deposits and the interest earned on loans.

Euro Interbank Bid Rate (EURIBID) = The rate paid by banks buying funds.

Euro Interbank Offered Rate (EURIBOR) = The rate offered for sale of the
funds.

Time deposits with fixed maturities = Largest short-term security in the world.

Euribor is the average interbank interest rate at which European banks are
prepared to lend to one another.

When Euribor is being mentioned it is often referred to as THE Euribor, like

there’s only 1 Euribor interest rate. This is not correct, since there are in fact 5
different Euribor rates, all with different maturities.
Lecture 7: The Bond Market.
Bonds are like money market instruments, but they have maturities that
exceed one year. These include Treasury bonds, corporate bonds, mortgages,
and the like.

Bonds are securities that represent debt owed by the issuer to the investor,
and typically have specified payments on specific dates.

Types of bonds we will examine include long-term government bonds (T-bonds),

municipal bonds, and corporate bonds.

The U.S. Treasury issues notes and bonds to finance its operations.

Treasury bill = less than 1 year

Treasury note = 1 to 10 years

Treasury bond = 10 to 30 years

No default risk since the Treasury can print money to pay off the debt.

Very low interest rates often considered the risk-free rate (although inflation
risk is still present).

Treasury Inflation-Indexed Securities: the principal amount is tied to the

current rate of inflation to protect investor purchasing power.

Treasury STRIPS: the coupon and principal payments are “stripped” from a T-
Bond and sold as individual zero-coupon bonds.

Municipal Bonds:

Issued by local, county, and state governments. NOT default-free

Used to finance public interest projects.

There are two types:

- General obligation bonds

- Revenue bond

Corporate Bonds:

Typically have a face value of $1,000, although some have a face value of
$5,000 or $10,000.

Pay interest semi-annually. The interest rate varies with level of risk.

Cannot be redeemed anytime the issuer wishes, unless a specific clause states
this (call option).

Degree of risk varies with each bond, even from the same issuer.

The degree of risk ranges from low risk (AAA) to higher risk (BBB).
Any bonds rated below BBB are considered sub investment grade debt.

Secured Bonds: Mortgage bonds & Equipment trust certificates.

Unsecured Bonds: Debentures & Subordinated debentures & Variable-rate

bonds.
Junk Bonds: Debt that is rated below BBB.

Often, trusts and insurance companies are not permitted to invest in junk debt.
Some debt issuers purchase financial guarantees to lower the risk of their
debt.

The guarantee provides for timely payment of interest and principal and are
usually backed by large insurance companies. Not all guarantees actually make
sense.

Bond yields are quoted using a variety of conventions, depending on both the
type of issue and the market.

Bond pricing is, in theory, no different than pricing any set of known cash flows.
Once the cash flows have been identified, they should be discounted to time
zero at an appropriate discount rate.

Coupon interest rate: The stated annual interest rate on the bond. It is
usually fixed for the life of the bond.

Current yield: The coupon interest payment divided by the current market
price of the bond.

Face amount: The maturity value of the bond. The holder of the bond will
receive the face amount from the issuer when the bond matures. Face amount
is synonymous with par value.

Indenture: The contract that accompanies a bond and specifies the terms of
the loan agreement. It includes management restrictions, called covenants.

Market rate: The interest rate currently in effect in the market for securities of
like risk and maturity. The market rate is used to value bonds.

Maturity: The number of years or periods until the bond matures and the
holder is paid the face amount.

Par value: The same as face amount.

Yield to maturity: The yield an investor will earn if the bond is purchased at
the current market price and held until maturity.

Bonds are the most popular alternative to stocks for long-term investing.

Even though the bonds of a corporation are less risky than its equity, investors
still have risk!
Lecture 8: The Stock Market
IPO = initial public offering

Investing in Stocks represents ownership in a firm.

Earn a return in two ways:

1. Price of the stock rises over time.

2. Dividends are paid to the stockholder.

Stockholders have claim on all assets and the right to vote for directors and on
certain issues Two types:

 Common stock
o Right to vote
o Receive dividends
 Preferred stock
o Receive a fixed dividend
o Do not usually vote

Stocks are Sold:

- Organized exchanges (there are requirement both for firms

and investors, investors meet investors)
- Over-the-counter markets (more flexible, market makers set
bid and ask prices)

ECNs (electronic communication networks) allow brokers and traders to trade

without the need of the middleman.

They provide:

 Transparency: everyone can see unfilled orders

 Cost reduction: smaller spreads
 Faster execution
 After-hours trading

But

 Don’t work as well with thinly-traded stocks

 Many ECNs competing for volume, which can be confusing
 Major exchanges are fighting ECNs, with an uncertain outcome

Exchange Traded Funds (ETF) are a recent innovation to help keep

transaction costs down while offering diversification.
 • Represent a basket of securities
• Traded on a major exchange
• Index to a specific portfolio (e.g., the S&P 500), so management fees are
low (although commissions still apply)
• Exact content of basket is known, so valuation is certain

Valuing common stock is, in theory, no different from valuing debt

securities: determine the cash flows and discount them to the present.

1. The One Period Valuation Model , simplest model, just taking using the
expected dividend and price over the next year.

2. The Generalized Dividend Valuation Model, most general model, but

the infinite sum may not converge.

3. The Gordon Growth Model same as the previous model, but it assumes
that dividend grow at a constant rate.

The model is useful, with the following assumptions:

Dividends do, indeed, grow at a constant rate forever.
The growth rate of dividends, g, is less than the required return on the
equity, ke.
4. The Price Earnings (PE) Valuation Method is a widely watched measure
of much the market is willing to pay for $1.00 of earnings from the
firms, it is useful to compare the firm with the others already listed
from the same market.

Prices are set in competitive markets as the price set by the buyer willing to
pay the most for an item.

The buyer willing to pay the most for an asset is usually the buyer who can
make the best use of the asset.

Who perceives the lowest risk, is willing to pay the most and will determine the
market price.
Market participants frequently encounter problems in using them: Problems
with Estimating Growth, Problems with Estimating Risk, Problems with
Forecasting Dividends.

Security valuation is not an exact science! Considering different growth rates,

required rates, etc., is important in determining if a stock is a good value as an
investment.

Stock market indexes are frequently used to monitor the behaviour of a groups
of stocks (i.e. tech, multinationals.

Major indexes include the Dow Jones Industrial Average, the S&P 500, and the
NASDAQ (smaller firm stocks) composite.

Buying foreign stocks is useful from a diversification perspective. However, the

purchase may be complicated if the shares are not traded in the U.S.

American depository receipts (ADRs) allow foreign firms to trade on U.S.

exchanges, facilitating their purchase. U.S. banks buy foreign shares and issue
receipts against the shares in U.S. markets.

The primary mission of the SEC is “…to protect investors and maintain the
integrity of the securities markets” through actions against individuals and
firms.

Divisions of the SEC:

1. Division of Corporate Finance: responsible for collecting, reviewing, and

making available all the documents’ corporations and individuals are
required to file.
2. Division of Market Regulation: establishes and maintains rules for orderly
and efficient markets.
3. Division of Investment Management: oversees and regulates the
investment management industry.
4. Division of Enforcement investigates violations of the rules and
regulations established by the other divisions, heavy consequences.

Lecture 9: The Foreign Exchange (FX) Market

Two kinds of exchange rate transactions make up the foreign exchange market:

 Spot transactions involve the near-immediate exchange of bank deposits,

completed at the spot rate. (On spot = sul posto)
 Forward transactions involve exchanges at some future date, completed
at the forward rate.
FX traded in over-the-counter market

Most trades involve buying and selling bank deposits denominated in different
currencies. Trades in the foreign exchange market involve transactions more
than $1 million.

Typical consumers buy foreign currencies from retail dealers, such as American
Express.

When the currency of your country appreciates relative to another country,

your country's goods prices  abroad and foreign goods prices  in your country.

1. Makes domestic exporters less competitive

2. Makes domestic importers more competitive
3. Benefits domestic consumers (you)

Exchange rates are determined in markets by the interaction of supply and

demand.

An important concept that drives the forces of supply and demand is the Law of
One Price.

The Law of One Price states that the price of an identical good will be
the same throughout the world, regardless of which country produces
it.

Example: American steel costs $100 per ton, while Japanese steel costs 10,000
yen per ton.

Law of one price  E = 100 yen/$

The theory of Purchasing Power Parity (PPP) states that exchange rates
between two currencies will adjust to reflect changes in price levels.
PPP  Domestic price level  10%, domestic currency  10%

Works in long run, not short run (useful information for plane in which currency
save your money).

Problems with PPP:

 All goods are not identical in both countries.

 Many goods and services are not traded (e.g., haircuts, land, etc.) .
 Transportation costs and tariffs.

Se concordo di pagare il mio debito in un’altra valuta può essere più

vantaggioso nel lungo termine.

If a factor increases demand for domestic goods relative to foreign

goods, the exchange rate  .

The four major factors are:

1. Relative price levels

2. Tariffs and quotas
3. Preferences for domestic rather foreign goods
4. Productivity (i.e. as a company where I will open a factory).

Relative price levels: a rise in relative price levels cause a country’s currency to
depreciate. Tariffs and quotas: increasing trade barriers causes a country’s
currency to appreciate.

Preferences for domestic rather foreign goods: increased demand for a

country’s good causes its currency to appreciate; increased demand for
imports causes the domestic currency to depreciate.
Productivity: if a country is more productive relative to another, its currency
appreciates.

In the short run, it is key to recognize that an exchange rate is nothing more
than the price of domestic bank deposits in terms of foreign bank deposits.

The difference in expected returns depends on two things: local interest rates
and expected future exchange rates.

Interest Parity Condition:

Several things to recognize about the interest rate parity condition: •Expected
returns are the same in both dollars and foreign assets •Equilibrium condition
for the foreign exchange market.

The demand curve connects these points and is downward sloping because
when Et is higher, expected appreciation of the dollar is higher.

Equilibrium:

 Supply = Demand at E*
 If Et > E*, Demand < Supply, buy $, Et 
 If Et < E*, Demand > Supply, sell $, Et 
Increase in id:

1. Demand curve
shifts right
when id :
because
people want to
hold more
dollars
2. This causes
domestic
currency to
appreciate.
Increase in if:

1. Demand curve shifts left when if : because people want to hold fewer
dollars
2. This causes domestic currency to depreciate.
Changes in domestic interest rates are often cited in the press as affecting
exchange rates. We must carefully examine the source of the change to make
such a statement.

Interest rates change because either the real rate or the expected inflation is
changing. The effect of each differs.
When the domestic real interest rate increases, the domestic currency
appreciates.

When the domestic expected inflation increases, the domestic currency reacts
in the opposite direction – it depreciates.
Exchange rate overshooting is important because it helps explain why foreign
exchange rates are so volatile.

Another explanation deals with changes in the expected appreciation of

exchange rates. As anything changes our expectations (price levels,
productivity, inflation, etc.), exchange rates will change immediately.

Value of $ and real rates rise and fall together.

FX forecasts affect financial institutions managers' decisions.

If forecast euro appreciate, yen depreciate:

 Sell yen assets, buy euro assets.

 Make more euros loans, less yen loans.
 FX traders sell yen, buy euros.
Nella realtà le compagnie decidono di vendere e comprare assets non
necessariamente per i tassi controllando giornalmente le variazioni ma in modo
più naturale in base ai loro impegni.