Cap market notes

Week 1 Ch. 1 Overview of The Modern Financial

System
Week 2 Ch. 2 Financial intermediaries
Indirect Finance
- Transaction costs Intermediaries overcome high fixed cost by economies
of scale
- Asymmetric information
o Adverse selection (Pre-transaction)
o Moral hazard (Post-transaction)
o Market for lemons (Quality uncertainty)
- Resolving adverse selection
o Purchase of information Credit ratings
o Government regulation
- Free-rider problem (people replicate portfolio of investors)
o Financial intermediation specialises in managing private information
and limits free-rider problem as portfolio cannot be replicated
o Develops expertise
Direct Finance
- Large well-known companies with high credit rating
Collateral and covenants
- Collateral increases cost to borrower
- Covenants reduces moral hazard by restriction behaviour post transaction
Commercial banks
- Main type of financial institution
- Principle activity include receiving deposits and making loans
Asset vs. liability management
- Asset management (OLD) passive strategy only lending out same
amount as deposits
- Liability management (NEW) Active strategy, sources of funds to meet
future loan demand
- BOTH are balance sheet activity methods (income is the net interest
margin)
SOURCES of funds for banks
- Account, call or demand, term deposits
- Negotiable certificates of deposit
- Bill acceptance liabilities
- Debt liabilities
- Foreign currency liabilities
- Loan capital and shareholders equity
USES of funds for banks
- Personal and housing finance
- Commercial lending
- Government lending
- Other bank assets

Week 3 Interest rate determination

Term structure of interest rates
- Different interest rates on similar risk securities with different maturity
- Normal, inverse or humped yield curve
Expectation theory
- Yield is determined by current and future short-term interest rates
- Long term interest rates equal to average of current short-term rate and
expected future short-term rate. (INDIFFERENCE between long or short
bond otherwise arbitrage!)
- ASSUMPTIONS OF EXPECTATION THEORY
o Homogenous expectation about future short term interest rates
o No transaction costs,
o No restriction of market movement towards equilibrium
o Maximizing expected return (regardless of term to maturity)
- LIMITATIONS TO THEORY
o Assumes same return for one-year or a five-year bond, not always
true
o General yield curves are upward sloping, implying interest to
increase to infinity
o Long term bond are in reality more volatile
General model for calculating future spot rates

m+t 1
t

( 1+ im+t )
f tm=
m
( 1+im )

m = number of periods until forward rate begins

t = length of time the forward rate applies
- Can do a similar model for less than 1 year
Liquidity Premium Theory
- Investors prefer short-term securities (greater liquidity)
- Investors demand premium if to go to longer term securities
- The increase in interest rates might be masked by the liquidity premium
Segmented Markets Theory
- Investors seeks to minimise exposure to fluctuations in price and yields
- Match cash flows and maturities of assets to liabilities
- Relative demand for different maturity ranges
- IGNORES ARBITRAGE!!
Bootstrapping
- The process of creating zero coupon bonds to do arbitrage on coupon
bonds
- Zero coupon and coupon bonds should be equal, if not ARBITRAGE!
- Value Coupon by Theoretical Spot Rate Curve and zero coupon by YTM
- Stripping YTM < TSC, buy coupon bond and issue similar zero coupon
bonds
- Reconstitute YTM > TSC, buy zero coupon and issue similar coupon
bond

Week 4 Short term debt market

Discount Securities
- Issued with a face value payable at maturity, sold at a lower price to give
return to buyer
- Valuation based on simple interest
Holding period yield
- Yield from the total time the investment is held
Short term debt facilities
Trade credit
- Opportunity costs
o May be beneficial to pay early if credit terms are favourable
Bank overdraft
- Day to day working capital needs
- Variable interest and fees for total available limit
Commercial bills (bill of exchange)
- Drawer The issuer of the bill, liability to pay face value to acceptor
- Acceptor Hold primary liability to pay face value of bill the final bill
holder at maturity
- Payee To whom the proceeds from initial sales goes to typically the
drawer
- Discounter Investor who buys the bill
- Endorser a discounter that has rediscounted the bill to a new discounter
- TYPES OF COMMERCIAL BILLS
o Bank-accepted bills Bank is the acceptor
o Bank-endorsed bill Bank has previously been a holder of the bill
(an endorser)
o Non-bank bills No bank is involved as acceptor or endorser
Promissory notes (commercial paper)
- Discount security issued by a corporation without acceptor or endorser
- Unsecured I owe You
- Underwriting of P-note, a bank facilitates sale to investor, but is NOT the
original discounter as with commercial bills
Certificates of deposit
- Discount security issued by a bank
Repurchase agreements
- Sale and buy back agreement for a security
- EXAMPLE THE RBA sells or buys bond to decrease/increase liquidity

Week 5 Long Term Debt Markets

Long term debt options
- Term loans
- Mortgage finance
- Debentures
- Leasing
Debenture vs. Unsecured note
- Debenture
o Is secured by either a fixed or floating charge of borrowers assets
o Fixed have priority over floating and both have priority over
unsecured notes
- Unsecured notes
o No underlying security attached, only residual claim on assets
Rank of Seniority
1. Fixed charge debenture
2. Floating charge debenture
3. Unsecured note holders
4. Subordinated debt holders
Types of Bond issuance
1. Public issue
2. Family issue
3. Private placement
Securitisation and types of securitised loans
- Mortgage backed securities (MBS)
- Collateralised mortgage obligations (CMO)
Prepayment risk
- Contraction risk Prepayment occurring faster
- Extension risk Prepayment occurring slower than expected
Public Securities Association [PSA] prepayment model

Topic 6 Equity
Equity rights (Right to profits in business, but no guaranteed income
stream)
- Asset rights
- Dividend rights
- Voting rights
- Pre-emptive rights
Advantages Corporation
Firms
can
list
on
stock
exchanges
- Separation of ownership and
control
- Continuity of business (change
in ownership)
- Access to large funding base

Disadvantages Corporation
- Agency problems & costs

Stock exchange
- Infrastructure to trade claims over corporations
- Facilitates the creation of securities (primary market) and transfer in
secondary market
Valuation of stocks
ZERO GROWTH P0 = D / K
GROWTH

P 0=

D 0 (1+ g )
Kg

Topic 7 Measurement of Risk

Topic 8 Derivative Markets
Topic 9 Options Market
Topic 10 Swaps