Capital markets, Part II Prepared by Pamela Peterson Drake, Ph.D., CFA I. Overview ..................................................................................................................................... 1 II. Direct investing ........................................................................................................................... 1 A. Money market securities ........................................................................................................... 3 B. Capital market securities .......................................................................................................... 5 C. Derivatives .............................................................................................................................. 9 III. Indirect investing ....................................................................................................................... 10 A. Investment companies ........................................................................................................... 10 B. Hedge funds .......................................................................................................................... 15 IV. Further reading ......................................................................................................................... 17 V. Index ........................................................................................................................................ 17 I. Overview An investor may invest directly in securities or indirectly. Direct investing involves the purchase of a security. In this case, the investor controls the purchase and sale of each security in their portfolio. Indirect investing involves investing in vehicles that owned securities, such as mutual funds, closed- end funds, or exchange-traded funds. In this case, the investor does not control the composition of the fund’s investment; the investor only controls whether to buy or sell the shares of the fund. II. Direct investing We’ll introduce you to alternative investment vehicles in this module, but we will reinforce this descriptive material throughout the course as we examine current events in the markets. We can classify most direct securities into the following types: 1. Money market securities e.g., Treasury bills, commercial paper 2. Capital market securities e.g., Municipal bonds, corporate bonds, stocks 3. Derivatives e.g., Options, futures We provide a summary of the prevalence of the money and capital markets securities in Exhibit 1. As you can see in this exhibit, the mortgage and other asset backed securities made up approximately 24% of the market in 1995, whereas these securities make up over 31% of the market in 2005. During the same period, the prevalence of U.S. government issued securities declined from 29% to 16%. Capital Markets II 1 Exhibit 1 Prevalence of debt securities in the U.S., 1995-2005, by type Part A Total amounts outstanding $30,000 $25,000 $20,000 Billions of $15,000 dollars $10,000 $5,000 $0 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 U.S. Treasury securities Federal agency debt Municipal Mortgage-backed securities Asset-backed securities Money market instruments Corporate debt Part B Percentage of amounts outstanding 100% 80% Proportion 60% of securities 40% issued 20% 0% 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 U.S. Treasury securities Federal agency debt Municipal Mortgage-backed securities Asset-backed securities Money market instruments Corporate debt Source: 2007 Statistical Abstract of the United States, U.S. Census Bureau The yields on the different securities reflect the maturity, risk, and other features of the security: . Securities with more risk will have higher expected returns. In periods of economic slowdowns, the spread between the yields of securities with different default risks widens. In most economic environments, the yield curve is upward sloping; hence, longer-maturity securities have higher yields. In periods preceding a slow down, the yield curve may be flat or slope downward. Securities with more seniority over other securities of the same issuer have lower expected rates of return. You can see some of these characteristics on yields in Exhibit 2. You will notice that the spread between the yields on these instruments widens during recessionary environments. Capital Markets II 2 Exhibit 2 Yields on different securities, 1998-2008 Corporate AAA Corporate BBB 10% Federal funds rate 90-day U.S. Treasury 6-month Certificates of deposit 30-year conventional mortgage 9% 8% 7% 6% Annualized yield 5% 4% 3% 2% 1% 0% 01 06 99 00 02 04 05 07 00 05 00 05 98 98 99 03 03 04 08 08 01 06 98 03 08 02 07 - - - - - - - - - - - - - - - - - - - - - - - - - - - Jul Jul Apr Oct Apr Oct Jan Jun Jan Jun Jan Jun Feb Mar Feb Mar Nov Dec Nov Dec Nov Sep Aug Sep Aug May May Month Source of data: FRED II, Federal Reserve Bank of St. Louis The yield curve A. Money market securities Money market securities are short-term, highly- The yield curve is the relation between maturity and yield. The normal yield curve is one in which the liquid, low-risk debt of governments, banks, or securities with longer maturities are associated with corporations. These include: higher yields. U.S. Treasury bills (T-Bills) Yield . Negotiable certificates of deposit (CDs) . Commercial paper . Eurodollar deposits . Repurchase agreements Maturity . Bankers’ acceptances However, inverted yield curves do occur, such that i) U. S. Treasury bills shorter-term securities have higher yields. A U. S. Treasury bill, or T-bill, is a short-term Yield obligation of the U.S. government. Many securities and lending arrangements use the rate on U.S. Treasury bills as a reference rate -- that is, a benchmark for quoting and analyzing rates.1 For Maturity example, if the rate on the U.S. T-Bill is 3.5% and the rate on a specific certificate of deposit (CD) is The inverted yield curve is often a pre-cursor of a 4.2%, we say that there is a spread of 70 basis recessionary economic period. points (bp). The spread is simply the difference 1 Another common reference rate is the London InterBank Offer Rate (LIBOR). Capital Markets II 3 between the rate on the CD and the rate on the T-Bill, quoted in terms of basis points, where one basis point (bp) is 1% of 1% (or in other words, there are 100 bp in a 1% yield). There are two different methods that are commonly used in quoting T-Bill rates, the discount yield basis and the investment yield basis. T-Bills are sold at a discount and do not pay interest, so what you earn on the T-Bill is the difference between what you paid and what you get at maturity. The discount yield basis is the conventional method for quoting T-Bill rates, but this method tends to understate the true yield: Face- Purchase value price 360 Discount =x yield Face value Maturity of bill in days The investment yield basis is useful in comparing T-bill yields with those of other short-term securities: Face- Purchase value price 365 Investment=x yield Purchase price Maturity of bill in days The two primary differences between these yields are that: Example: Yields on Treasuries Problem 1. the denominator in the first term is different (face value for are discount Consider a 182-day Treasury bill that has a price of $9,835 per basis, purchase price for the $10,000 face value. investment yield), and 1. What is the discount yield? 2. the number of days used for 2. What is the investment yield? annualization (360 for the discount yield, 365 for the investment yield). Answer $10,000-$9,835 360 Discount=x Does it make a difference? It is important yield 1. $10,000 182 to be precise in all communications Discount=0.0165 x 1.97802 = 0.032637 or 3.2637% regarding pricing and yields, so it is yield important to understand the difference $10,000-$9,835 365 between these two methods of stating Investment=x yield yields. If you would like to compare the 2. $9,835 182 discount basis and investment yields, Investment=0.01678 x 2.0055 = 0.033646 or 3.3646% check out the recent rates for U.S. T-Bills yield at the Bureau of Public Debt web site, http://wwws.publicdebt.treas.gov/AI/OFBil ls. ii) Negotiated certificates of deposit A certificate of deposit (CD) is issued by a financial institution, indicating that a specified amount of funds have been deposited with the financial institution. A negotiated certificate of deposit (NCD) is a large-denominated certificate of deposit at a bank, which has a specific maturity date. The NCD is a highly liquid security, but the depositor or investor cannot cash it in before its maturity. Though the minimum amount of the NCD is $100,000, NCDs are typically $1 million or more. iii) Commercial paper Commercial paper notes have denominations (face values) starting at $25,000 each, although most have denominations of $100,000 or larger. Commercial paper is unsecured, so the lender (the party buying the commercial paper) is counting on the borrower being able to pay the face amount of the note Capital Markets II 4 at maturity. Nevertheless, almost all commercial paper is backed by a line of credit from a bank. If commercial paper is backed and the borrower is unable to pay the lender at maturity, the bank stands ready (for a fee) to lend the borrower funds to pay off the maturing paper. Most commercial paper issued in the U.S. has a maturity from 3 to 270 days. Though these maturities are relatively short, some firms tend to use commercial paper for financing over longer periods of time by rolling