Investment by Charles P Jones Chapter No. 2

Investment: Analysis and Management

By Charles P. Jones

Chapter 2-Investment Alternatives

Q 2-1: What is meant by indirect investing?

Indirect investing refers to the buying and selling of securities issued by investment companies that hold the portfolio of securities that are traded in financial markets. By investing in securities of investment companies, the investors are relieved from making decisions about the portfolio. Investors who purchase shares of a particular portfolio managed by an investment company are purchasing an ownership interest in that portfolio of securities and are entitled to a pro rata share of dividends, interest and capital gains generated by the portfolio. Shareholders of the investment company must also pay a pro rata share of the company’s expenses and management fee, which will be deducted from the portfolio’s earnings  as it flows back to the shareholders.

Q 2-2: What does it mean for Treasury bills to be sold at discount?

Treasury bills are short term, highly liquid and risk-free money market security, which are offered at a price less than its face value. Here is no interest payment made to the security holder till the maturity of the security. At the time of maturity the holder of the security receives the face value of the bill. The rate of return on the security (interest rate) is the underlying spread between discounted purchase price and the maturity value (face value).

Q 2-3: Distinguish between a negotiable certificate of deposit and the certificate of deposit in the section “non-marketable securities?

A certificate of deposit is a security issued in exchange of a deposit. A negotiable certificate of deposit is a marketable security that can be sold in the open market on the other hand a non-negotiable certificate of deposit cannot be sold in the market. The holder of such a security has to wait till maturity for principal.

Q 2-4: Name four issuers of bonds. Which do you think is the most risky as a general proposition?

The four issuers of bonds are

Federal government

Federal agencies

Municipal government

corporations

The bonds issued by corporations are considered to be the most risky since the probability of a default by a corporation is greater than any of the other three issuers. The securities issued by federal government in the denomination of local currency are free from default risk since the federal government can print notes to avoid a default on payment. The federal agency and municipal government securities are backed by the federal government and in case the agency or the municipal government defaults, the federal government will bail them out by providing them with additional funds. The corporations may default on interest payments and therefore are considered the most risky as a general proposition.

Q 2-5: From an issuer standpoint, what is the distinction between Fannie Mae and Ginnie Mae?

Fannie Mae (Federal National Mortgage Association) was created as a federally sponsored credit agency. Ginnie Mae (Government National Mortgage Association) is a government agency. The securities of government agency are guaranteed by government while those of the federally sponsored credit agencies are not.

Q 2-6: Name and explain the difference between two types of municipal securities?

The two types of municipal securities are general obligation bonds and revenue bonds. General obligation bonds are backed by the full faith and credit of the issuer. The funds raised by these bonds may not produce revenues and the issuer taxes the residents to pay for the bond interest and principal. On the other hand, revenue bonds are repaid from the revenues generated by the project, for which these securities were issued. Since the interest payments on the revenue bonds are linked to the cash flows generated by the project that the municipal government has funded through issuance of bonds, the revenue bonds are considered to be more risky than the general obligation bonds.

Q 2-7: What does it mean to say that investors in Ginnie Mae face the risk of early redemption?

Ginnie Mae (Government National Mortgage Association) purchases mortgages from the bank and thrift institutions and issues securities against the assets bought. Although, by securitization, the default risk of these securities is minimized, they pose uncertainty to the investors as they can receive varying amounts of monthly payments depending on how quickly the owners of the assets pay of their mortgages. Due to this fact, while the stated maturity can be as long as 40 years, the average life of the security is much shorter and many such securities experience early redemption as the mortgages are paid off before maturity of the mortgage.

 

Q 2-8: What are the advantages and disadvantages of Treasury bonds?

The government issues treasury bonds for a long maturity ranging from 10 to 30 years. These bonds carry very low risk as the bonds are issued by the government and the return on these bonds is also very low as compared to bonds of other issuers. These bonds generally experience a liquid market. Where the liquidity and the low risk of the security can be viewed as advantages of the bond, low return and usually long maturity can be considered as disadvantages. Owing to the longer maturity, these securities are more sensitive to interest rate changes. The newer types of Treasury bonds have more advantages as they provide investors protection against inflation and deflation. These bonds guarantee face value if the consumer prices drop—a guard against deflation. Taxes are paid according to inflation adjustments, although the actual cash is not received till maturity—a guard against inflation.

Q 2-9: Is there any relationship between a saving bond and a US Treasury bond?

A saving bond is a non-traded debt of the US government, is non-marketable, non-transferable and non-negotiable. These bonds cannot be used for collateral. When saving bonds are held for at least five years, the investor receive higher of the market-based rate or a guaranteed minimum rate. The market-based rate is calculated as 85 percent of the average return on treasury securities with five years maturity. Hence, the rate of saving bond is tied to the rate offered by Treasury securities.

Q 2-10: Why is preferred stock referred to as ‘hybrid’ security?

Preferred stock is an equity security with an intermediate claim (between the bondholders and the common stockholders) on a firm’s assets and earnings. Preferred stock is considered a hybrid security because it carries the features of both equity and fixed-income instruments. As an equity security, preferred stock usually has an indefinite life and pays dividends, although some of the preferred stocks may have a maturity of 50 years.  The dividend is fixed in amount and known in advance, providing a stream of income very similar to that of a bond.

Q 2-11: Why is the common stockholder referred to as a residual claimant?

The common stockholders are referred to as residual claimants as they are entitled to the remaining income after the fixed income claimants (including the preferred stockholders) are paid in full. In case of liquidation also, the stockholders would be considered as the residual claimants, i.e. they would be paid if the claims of the bondholders and preferred stockholders are paid off.

Q 2-12: Do all common stocks pay dividends? Who decides?

Dividends are payments regularly made by corporations to their stockholders. They are decided upon and declared by the board of directors  and can range from zero to 100 percent of present and past net earnings. The common stockholder has no specific promises to receive any cash from the corporation since the stock never matures and dividends are not mandatory to be paid.

Q 2-13: What is meant by the term derivative security?

Securities that derive their value in whole or in part by having a claim on some underlying security are known as derivative securities. Options and future contracts are popular derivative securities.

Q 2-14: What is meant by the term securitization?

Securitization refers to the transformation of illiquid, risky loans into more liquid, less risky securities by backing them up with assets.

Q 2-15: Give at least two examples of asset-backed securities?

Asset-backed securities are those securities which have been converted into more liquid and less risky assets through the process of securitization. Pass-through securities and collateralized mortgage obligations are two examples of asset-backed securities, which differ in maturity, yields and face value.

Q 2-16: Why should we expect six-month Treasury bill rates to be less than six months CD rates of six month commercial paper rates?

The Treasury Department is the issuer of treasury bills, while banks and other financial institutions issue CDs and commercial papers. The US government has no risk of default, whereas banks and other financial institutions may default. Since the Treasury bill is a risk-free security, the return offered on it would be lesser than any other security that carries some risk, no matter how little.

Q 2-17: Why is the call provision on a bond generally a disadvantage to a bondholder?

The call provision gives the issuer the right to call in the bonds, thereby depriving the investors of that particular fixed-income security. Exercising the call provision usually takes place when market rates drop sufficiently below the coupon rate on the bonds. Exercising call provision helps the bond issuer to save money, by avoiding payments on a rate higher than the market interest rates. Costs are incurred to call the bonds, such as call premium and administrative expense. However, issuer expects to sell new bonds at a lower interest rate, thereby replacing existing higher interest cost bonds with new, lower interest cost bonds. However, some investors who purchase the bond at a price above the face value may suffer losses when the bond is unexpectedly called in and paid off.

Q 2-18: Is a typical investor more likely to hold zero-coupon in a taxable account or a non-taxable account? Why?

A typical investor would prefer to hold zero-coupon bonds in a non-taxable account since the actual return of a security in a taxable account is expected to be lesser than that of a non-taxable account. Zero coupon securities make no coupon payments and the bond holder gets the benefit only at the time of maturity when the implied interest is paid; however, the bondholder is taxed every year

Q 2-19: What are the potential advantages and disadvantages of DANs (Direct Access Notes) to investors compared to the conventional bonds?

To make bonds more accessible to individual investors, high credit quality forms have started issuing direct access notes.  These notes eliminate some of the traditional details associated with conventional bonds by issuing them at par value, which means no premium, discount or accrued interest. Coupons are usually fixed on these notes and maturities range from nine months to 30 years. The company issuing the bonds typically “posts” the maturities and rates that it is offering for one week, allowing the investors to shop around. Some companies act as the wholesalers of these bonds to their extensive network of brokerage firms, from which the investors would buy the bond. The brokerage firm buys the notes from the wholesaler at a discount and pays the broker’s commission.

One potential disadvantage of these notes is that they are best suited for buy-and-hold investor. A seller has no assurance of a good secondary market for the bonds, and therefore there is no assurance of the price that may be received by selling these notes in the secondary markets.

Q 2-20: What is an ADR? What advantages do they offer to investors?

American Depository Receipts (ADRs) represent indirect ownership of a specified number of foreign company shares. These shares are held on deposit in a bank, in the issuing company’s home country, while the US banks, known as depositories, issue the ADRs. In effect, ADRs are tradable receipts issued by depositories that have physical possession of the foreign securities through their correspondent banks or custodian abroad . The bank holding the securities collect the dividends, pays any applicable foreign withholding taxes, converts the remaining funds into dollars and pays the amount to the ADR holders. Holders can choose to convert their ADRs into specified number of foreign shares represented by paying a fee. This simplifies the process of investing in companies outside US for investors.

Q 2-21: Of what value to investors are stock dividends and splits?

Stock dividend and stock splits attract considerable investor’s attention. With a stock split the book value and the par value of the equity are changed. On practical basis, there is a little difference between a stock split and a stock dividend. The real question before the investor is that although the number of shares owned has increased, but has anything of real value been received or not? Other things being equal, these additional shares do not represent additional value because proportional has not changed. Regardless of the above mentioned fact, there is ample evidence that the stock price receives a boost following a split. The company, which announces a split, seems confident about its future prospects, which boosts the confidence of the investor.

Q 2-22: What are the advantages and disadvantages of being a holder of a common stock of IBM as opposed to being a bondholder?

As a bondholder of IBM, the investor would not find it hard to forecast the returns as despite being a corporate bond, its ranking as investment grade security suggests that the bond carries a little default risk. However, the returns on the common stocks of IBM would be higher than that of bonds. Still there is no certainty that the stream of dividends would remain stable. The risk involved in common shares may be greater, but so is the return. The shareholders also participate in the growth of the company’s profits. As the profits will grow so would the dividend earned by the shareholders. However, the bondholders do not get any such benefit with the growth of the company.

Q 2-28: Assume that a company in whose stock you are interested will pay regular quarterly dividend soon. Looking in the Wall Street Journal, you see a dividend figure of $3.20 listed for this stock. The board of directors has received dividend payable on September 1, with a holder of record date of August 15. When must you buy the stock to receive this dividend, and how much will you receive if you buy 150 shares?

To receive a declared divided, an investor must be holder of record on the specific date a company closes its stock transfer book and compiles the list of stockholders to be paid. The brokerage industry has established a procedure according to which the right to dividend remains with the stock until four days before the holder of record date. On fourth day , the right to dividend leaves the stock. To be entitled to the dividend the stock needs to be bought before August 12. If 150 stocks were to be bought a dividend of $3.20 per share would provide the investor with 150 X 3.20 = $480

Problems

2-1: Assuming an investor is in the 15 percent tax bracket, what taxable equivalent yield on must be  earned on a security to equal a municipal bond yield of 9.5 percent?

The taxable equivalent yield can be calculated using the following formula.

TEY = Tax-exempt municipal yield/ 1­ – Marginal tax rate

TEY = 0.095/ (1 – 0.15) = 0.095/0.85 = 0.111764 or 11.1764 percent

Q 2-2: Assume an investor is in the 36 percent tax bracket. Other things being equal, after taxes are paid, would this investor prefer a corporate bond paying 12.4 percent or a municipal bond paying 8 percent?

We can compare the two bonds by finding the taxable equivalent yield of the municipal bond

TEY = Tax-exempt municipal yield/ 1­ – Marginal tax rate

TEY = 0.08/ (1 – 0.36) = 0.08/0.64 = 0.125 or 12.5 percent

Comparing the rates of the two bonds, a municipal bond offering 8 percent is a better choice.

Q 2-3: Assume an investor is in 31 percent federal tax bracket and faces a 7 percent marginal tax rate. What is the combined TEY for a municipal bond paying six percent?

To calculate the TEY in such cases, first determine the effective state rate

Effective state rate = marginal state tax rate X (1 – federal marginal rate)

Effective state rate = 0.07 X (1 – 0.31) = 0.0483 = 4.83 percent

Then calculate the combined tax rate

Combined tax rate = effective state rate + federal rate

Combined tax rate = 0.0483 + 0.31 = 0.3583 or 35.83 percent

Taxable equivalent yield (TEY) = Tax-exempt municipal yield/ (1 – marginal tax rate)

Taxable equivalent yield (TEY) = 0.06/ (1 – 0.3583) = 0.06/0.6417 = 0.0935 or 9.35 percent

CHAPTER 2: FINANCIAL INSTITUTIONS, FINANCIAL INTERMEDIARIES, AND ASSET MANAGEMENT FIRMS

Foundation of Financial Markets and Institutions

Frank J. Fabozzi

Franco Modigliani

Frank J. Jones

Micheal G. Ferri

CHAPTER 2

FINANCIAL INSTITUTIONS,

FINANCIAL INTERMEDIARIES,

AND ASSET MANAGEMENT FIRMS

FINANCIAL INSTITUTIONS

Financial institutions perform several important services:

1.      Transforming financial assets acquired through the market and constituting them into a different, and more widely preferable, type of asset, which becomes their liability. This is the function performed by financial intermediaries.

2.      Exchange financial assets for their customers, typically a function of brokers and dealers.

3.      Exchange financial assets for their own account.

4.      Create financial assets for their customers and sell them to other market participants—the underwriter this role.

5.      Give investment advice to others and manage portfolios of customers.

6.      Managing the portfolio of other market participants.

Financial intermediaries including depository institutions, which acquire the bulk of their funds by offering their liabilities to the public mostly in the form of deposits, insurance companies, pension funds, and finance companies.

ROLE OF FINANCIAL INTERMEDIARIES

Intermediaries obtain funds from customers and invest these funds. Such a role is called direct investment. Customers who give their funds to the intermediaries and who thereby hold claims on these institutions are making indirect investments. A commercial bank accepts deposits and uses the proceeds to lend funds. Financial intermediaries, such as investment companies, play a basic role of transforming financial assets which are less desirable for a large part of the public into other financial assets which are broadly preferred by the public. By doing so they provide at least one of the following four economic functions: (1) providing maturity intermediation, (2) reducing risk via diversification, (3) reducing costs of contracting and information process, (4) providing a payment mechanism.

Maturity Intermediation

The customer (depositor) often wants only a short-term claim, which the intermediary can turn into a claim on long-term assets. In other words, the intermediary is willing and able to handle the liquidity risk more readily than the customer. This is called maturity intermediation.

Risk Reduction Via Diversification

By pooling funds from many customers the financial intermediary can better achieve diversification of its portfolio than its customers.

Reduced Costs of Contracting and Information Processing

Financial institutions provide expert analysis, better data access, and loan enforcement. Costs of writing loan contracts are referred to as contracting costs. Also there are information processing costs. They also benefit from economies of scale.

Providing a Payments Mechanism

Financial depositories provide a payment mechanism, e.g. checking accounts, credit cards, certainty debt cards, and electronic transfers of funds.

OVERVIEW OF ASSET/LIABILITY MANAGEMENT FOR FINANCIAL INSTITUTIONS

All intermediaries face asset/liability management problems. The nature of the liabilities dictates the investment strategy a financial institution will pursue.

Nature of Liabilities

The liabilities of a financial institution mean the amount and time of the cash outlays that must be made to satisfy the contractual terms of the obligations issued. These liabilities can be categorized into four types.

Type I Liabilities: Both amounts of cash outflows and timing are known, e.g., fixed-rate certificates of deposit and guaranteed investment contracts. The former are among liabilities of financial depositories. Life insurance companies offer the latter.

Type II Liabilities: Cash outflows are known, but timing is not, e.g. life insurance policies.

Type III Liabilities: Cash outflows are not known, but timing is known, e.g. floating-rate certificates of deposit.

Type IV Liabilities: Neither cash outflows nor timing are known, e.g., auto or home insurance policies.

Liquidity Concerns

Due to different degrees of certainty about timing and outlay, some institutions must have deposits more cash on hand or accessible in order to satisfy their obligations, e.g. the offering of demand means customers can obtain whatever amount of their funds whenever they wishplays . The greater the concern over liquidity, the fewer less-liquid investments an intermediary can hold.

CONCERNS OF REGULATORS

The risks of a financial institution are: credit, settlement, market, liquidity, operational, and legal.

Credit risk is the risk that the obligor of a financial instrument held by a financial institution will fail to fulfill its obligation. Settlement risk is the risk that when there is a settlement of a trade or obligation, the transfer fails to take place. Counterparty risk is the risk that a counterparty fails to satisfy its obligation.

Liquidity risk in the context of settlement risk means that the counterparty can eventually meet its obligations, but not at the due date. Liquidity risk has two forms. Market liquidity risk is the risk that a financial institution is unable to transact in a financial instrument at a price near its market value. Funding liquidity risk is the risk that the financial institution will be unable to obtain funding to obtain cash flow necessary to satisfy its obligations.

Market risk is the risk of a financial institution’s economic well being that results from an adverse movement in the market price of the asset it owns or the level or the volatility of market prices. There are measures that can be used to gauge this risk. One such measure endorsed by bank regulators is value-at-risk.

Operational risk is the risk of loss resulting from inadequate or failed internal processes, people and systems, or from external events. The definition of operational risk includes legal risk. This is the risk of loss resulting from failure to comply with laws as well as prudent ethical standards and contractual obligations. Sources of operation risk include: employees, business process, relationships, technology, and external factors.

ASSET MANAGEMENT FIRMS

Asset management firms manage the funds of individuals, businesses, endowments and foundations, and state and local governments. Types of funds managed by asset management firms include regulated investment companies, insurance company funds, pension funds, and hedge funds. Asset management firms are ranked based on assets under management. These firms receive compensation primarily from management fees charged based on the market value of the assets managed for clients. Also, they are increasingly adopting performance-based management fees for other types of accounts.

Hedge Funds

There is not a single definition of hedge fund. There are several characteristics.

1.      The word “hedge” is misleading. Many funds do not hedge risk at all, but engage in highly risk, leveraged transactions.

2.      Hedge funds use a wide range of trading strategies and techniques to earn a superior return. These strategies include: leverage, short selling, arbitrage, and risk control.

3.      Hedge funds operate in all of the financial markets: cash markets for stocks, bonds, and currencies and the derivatives markets.

4.      The management fee structure for hedge funds is a combination of a fixed fee based on the market value of assets managed plus a share of the positive return.

5.      Investors are interested in the absolute return generated by the asset manager, not the relative return. Absolute return is simply the return realized. Relative return is the difference between the absolute return and the return on some benchmark or index.

Types of hedge funds: There are various ways to categorize the different types of hedge funds.

1.   A market directional hedge fund is one in which the asset manager retains some exposure to systemic risk.

2.   A corporate restructuring hedge fund is one in which the asset manager positions the portfolio to capitalize on the anticipated impact of a significant corporate event. These funds include: (1) hedge funds that invest in the securities of a corporation that is either in bankruptcy or is highly likely in the opinion of the asset manager to be forced into bankruptcy; (2) hedge funds that focus on merger arbitrage, (3) hedge funds that seek to capitalize on other types of broader sets of events impacting a corporation.

3.   A convergence trading hedge fund uses a strategy to take advantage of misalignment of prices or yields, an arbitrage strategy. Technically, arbitrage means riskless profit. Some strategies used by hedge funds do not really involve no risk, but instead low risk strategies of price misalignments.

4.   An opportunistic hedge fund is one that has a broad mandate to invest in any area that it sees opportunities for abnormal returns. These include fund of funds, and global macro hedge funds that invest opportunistically on macroeconomic considerations in any world market.

Concerns with hedge funds in financial markets: There is concern that the risk of a severe financial crisis due to the activities and investment strategies of hedge funds, most notably the use of excess leverage. The best known example is the collapse of Long-Term Capital Management in September 1998. Most recently, in June 2007, there was the collapse of two hedge funds sponsored by Bear Stearns. Obviously, subsequent market develops in 2008 relate to the concern with hedge fund activities in financial markets.

ANSWERS TO QUESTIONS FOR CHAPTER 2

(Questions are in bold print followed by answers.)

1. Why is the holding of a claim on a financial intermediary by an investor considered an indirect investment in another entity?

An individual’s account at a financial intermediary is a direct claim on that intermediary. In turn, the intermediary pools individual accounts and lends to a firm. As a result, the intermediary has a direct contractual claim on that firm for the expected cash flows. Since the individual’s funds have in essence been passed through the intermediary to the firm, the individual has an indirect claim on the firm. Two separate contracts exist. Should the individual lend to the firm without the help of an intermediary, he then has a direct claim.

2. The Insightful Management Company sells financial advice to investors. This is the only service provided by the company. Is this company a financial intermediary? Explain your answer.

Strictly speaking, the Insightful Management Company is not a financial intermediary, because it lacks the function of deposit taking and creating liabilities.

3. Explain how a financial intermediary reduces the cost of contracting and information processing.

Financial intermediaries can reduce the cost of contracting by its professional staff because investing funds is their normal business. The use of such expertise and economies of scale in contracting about financial assets benefits both the intermediary as well as the borrower of funds. Risk can be reduced through diversification and taking advantage of fund expertise.

4. “All financial intermediaries provide the same economic functions. Therefore, the same investment strategy should be used in the management of all financial intermediaries.” Indicate whether or not you agree or disagree with this statement.

Disagree. Although each financial intermediary more or less provides the same economic functions, each has a different asset-liability management problem. Therefore, same investment strategy will not work.

5. A bank issues an obligation to depositors in which it agrees to pay 8% guaranteed for one year. With the funds it obtains, the bank can invest in a wide range of financial assets. What is the risk if the bank uses the funds to invest in common stock?

Practically, it is not a valid statement as banks are not allowed to hold stocks. The bank has a funding risk. On the liability side, amount of cash outlay and timing are known with certainty (Type I). However, on the asset side, both factors are unknown. Thus, there is liquidity risk and price risk.

6. Look at Table 2-1 again. Match the types of liabilities to these four assets that an individual might have:

a.      car insurance policy

b.      variable-rate certificate of deposit

c.       fixed-rate certificate of deposit

d.      a life insurance policy that allows the holder’s beneficiary to receive $100,000 when the holder dies; however, if the death is accidental, the beneficiary will receive $150,000

a.       Car insurance: neither the time nor the amount of payoffs are certain, which is Type IV liability

b.      Variable rate certificates of deposit: times of payments are certain, the amounts are not, which is Type II liability.

c.       Fixed-rate certificate of deposit: both times of payments and cash outflows are known, which is Type I liability.

d.      Life insurance policy: time of payout is not known, but the amount is certain, which is Type III liability.

7. Each year, millions of American investors pour billions of dollars into investment companies, which use those dollars to buy the common stock of other companies. What do the investment companies offer investors who prefer to invest in the investment companies rather than buying the common stock of these other companies directly?

In investing funds with the investment companies, investors are reducing their risk via diversification and the cost of contracting and information. These companies also provide liquidity to the investor.

8. In March 1996, the Committee on Payment and Settlement Systems of the Bank for International Settlements published a report entitled “Settlement Risk in Foreign Exchange Transactions” that offers a practical approach that banks can employ when dealing with settlement risk. What is meant by settlement risk?

Counterparty risk is that risk that a counterparty to a transaction cannot fulfill its obligation. It is related to settlement risk in that counterparty party risk bears on the question of whether settlement can take place or not.  

9. The following appeared in the Federal Reserve Bank of San Francisco’s Economic Letter, January 25, 2002:

Financial institutions are in the business of risk management and reallocation, and they have developed sophisticated risk management systems to carry out these tasks. The basic components of a risk management system are identifying and defining the risks the firm is exposed to, assessing their magnitude, mitigating them using a variety of procedures, and setting aside capital for potential losses. Over the past twenty years or so, financial institutions have been using economic modeling in earnest to assist them in these tasks. For example, the development of empirical models of financial volatility led to increased modeling of market risk, which is the risk arising from the fluctuations of financial asset prices. In the area of credit risk, models have recently been developed for large-scale credit risk management purposes.

   Yet, not all of the risks faced by financial institutions can be so easily categorized and modeled. For example, the risks of electrical failures or employee fraud do not lend themselves as readily to modeling.

What type of risk is the above quotation referring to?

Operational risk is the risk of loss resulting from inadequate or failed internal processes, people and systems, or from external events.  

10. What is the source of income for an asset management firm?

The sources of income are a fee based on assets under management, and sometimes a performance fee based on returns that meet certain benchmarks or targets.

11. What is meant by a performance-based management fee and what is the basis for determining performance in such an arrangement?

Performance based management fees are typically seen in hedge funds. Increasingly, they are also used by managers of asset management firms. These fees are fees based on performance that meet specified criteria.

12. a. Why is the term hedge to describe “hedge funds” misleading?

b. Where is the term hedge fund described in the U.S. securities laws?

a.       Hedge denotes hedging risk. Many hedge funds, however, do not use hedge as a strategy, and these funds take significant risk in their attempt to achieve abnormal returns.

b.      The term is not described in US securities laws, and hedge funds are not regulated by the SEC.

13. How does the management structure of an asset manager of a hedge fund differ from that of an asset manager of a mutual fund?

Asset management firms are compensated by a fee on asset under management. Hedge funds are compensated by a combination of assets under management and a performance fees. Clearly, investment strategies of these firms will be different since hedge funds seek to generate abnormal returns.

14. Some hedge funds will refer to their strategies as “arbitrage strategies.” Why would this be misleading?

Arbitrage means riskless profit. These opportunities are few and fleeting. Hedge funds take great risk. The arbitrage typically taken is where there is a disparity between the risk and the return, such as pricing disparities across markets.

15. What is meant by a convergence traded hedge fund?

A convergence trading hedge fund uses a strategy to take advantage of misalignment of prices or yields.

16. What was the major recommendation regarding hedge funds of the President’s Working Group on Financial Markets?

The major recommendation was that commercial banks and investment banks that lend to hedge funds improve their credit risk management practices.

CHAPTER 1: INTRODUCTION

Foundation of Financial Markets and Institutions

Frank J. Fabozzi

Franco Modigliani

Frank J. Jones

Micheal G. Ferri

CHAPTER 1

INTRODUCTION

FINANCIAL ASSETS

An asset is any possession that has value in an exchange.  It can be tangible or intangible, the latter being a financial asset.  Specifically, a financial asset is a claim to a future benefit.  For example, in the case of an automobile loan the borrower issues a note to the lender, who now holds a claim to future cash flows. 

Debt versus Equity Instruments

A debt instrument is a contractual claim, paying fixed dollar amounts. An equity instrument (or residual claim) obligates the issuer to pay the holder an amount based on earnings after holders of debt instruments are paid. Some securities combine both debt and equity features, such as preferred stock or convertible debt.

Price of a Financial Asset and Risk

The price (or value) of any financial asset is equal to the present value of expected cash flows.  The return on an asset is the amount paid to the investor relative to the price paid by him.  Related to return is the degree of risk, namely the certainty of expected cash flows.  The degree of risk ranges from very low -- as in the case of payments on U.S. Treasury securities -- to very high in the cases of some equities and low-rated bonds.  Uncertainty or risk takes several forms: (1) purchasing power risk (or inflation risk); (2) credit or default risk; (3) foreign exchange risk.

Financial Assets versus Tangible Assets

Both types of assets are expected to generate cash flows to their owners.  They are also linked in the sense that tangible assets are financed by the issuance of some type of financial claim, e.g. mortgages finance commercial buildings.  The use of the offices generates income that helps pay off the loan.

Role of Financial Assets

The principal economic functions of financial assets are: (1) to transfer funds from persons who have surplus funds to those who need funds to invest in tangible assets (e.g. mortgage funds lending to homebuyers); (2) transfer funds in such a way as to redistribute the unavoidable risk associated with the cash flow generated by tangible assets among those seeking and those providing the funds (seekers of funds ask others to share the risks in their undertakings).

FINANCIAL MARKETS

Financial markets where financial assets are exchanged.  Delivery of the actual asset may occur immediately (spot or cash market) or in the future (future or forward market).

Role of Financial Markets

Financial markets provide the following functions.

1.  Price discovery process.  Price is determined by supply and demand, the interaction of buyers and sellers.  The returns provide signals for funds allocations among investments;

2.  Liquidity.  Well-developed markets provide an opportunity to convert a financial asset into cash at close to real value of the asset;

3.  Reduced transactions costs. In the price discovery process, searching for counter parties and information costs (assessing merits of an investment or the likelihood of expected cash flows) are costly. An informationally efficient market exists when prices reflect all information known by market participants.

Classification of Financial Markets

There are various ways to classify financial markets.

Maturity of claim. Money market for financial instruments a year or less to maturity.  Capital market for securities longer than a year.

Seasoning of claim. Primary market is for new or first issue market.  Secondary market involves sales of previously marketed claims.

Time of delivery. While prices are set immediately, the actual delivery of the financial asset may be now (spot or cash market) or later (futures or forward market).

Organizational structure. Auction market involving brokers acting for clients in organized exchanges, over-the-counter markets (OTC) wherein trades are made through dealers who buy for and sell from their own inventory.  In intermediated markets, financial institutions sell their own securities issues to customers and invest the proceeds.

Market Participants

Participants run the full range, from households, non-financial business firms, financial institutions, and public regulators.

GLOBALIZATION OF FINANCIAL MARKETS

The existence of foreign financial markets permits raising and investing funds outside of the domestic market.  There is a trend toward integration of financial markets throughout much of the world.  The factors that have led to integration are:

1.  Deregulation or liberalization of markets to encourage competition;

2.  Technological advances permit more information flows and rapid execution of orders;

3.  Increased participation of financial institutions in global markets relative to individuals.  Such firms are more willing and able to transfer funds to diversify their portfolios and to take advantage of possible mis-pricing in markets.

Classification of Global Financial Markets

Financial markets can be classified as either internal or external.

Internal:  securities issued in the domestic or foreign markets.  Foreigners can issue securities in other country markets, subject to national regulations, e.g., Japanese firms can issue dollar-denominated securities in the United States, but they must follow U.S. regulations, which apply to nationals and foreigners alike.

External:  securities issued outside jurisdiction of any country, e.g., offshore or Eurodollar offerings can be dollar-denominated.  They thereby fall outside of foreign rules, which are designed to deal with domestic financial concerns. The external market is sometimes called the offshore market or Euromarket.

Motivation for Foreign and Eurodollar Markets

Some funds needs cannot be met in small country markets, e.g. giant firm Philips cannot raise all the funds it needs if it is restricted to the Dutch capital market.  Also, many underdeveloped nations simply do not have a sizeable capital market to meet their funds needs.

Lower funding costs when imperfections exist among capital markets, e.g. Eurodollar loans are often less expensive since institutions holding such funds are not hampered by regulations as would be the case in the U.S. market.

DERIVATIVE MARKETS

A derivative instrument is a financial asset whose value derives from the value of some other asset, index, or interest rate. A futures transaction is a contract that exchanges an asset or commodity at a fixed price in the future. In an option, owner has right but not the obligation to buy (call option) or sell (put option) an asset at a specified price. In a swap, parties exchange one form of cashflow for another, typically a fixed cashflow for a variable one.

Role of Derivative Instruments

Derivatives have several uses: (1) hedging interest rate risk and foreign exchange risk; (2)  lower transactions costs than on cash market; (3) faster transactions than on the cash market; (4) greater liquidity than on the cash market.

ROLE OF THE GOVERNMENT IN FINANCIAL MARKETS

Justification for Regulation

The government plays a significant role in the financial markets. It regulates the financial markets. One justification for regulation is market failure, when the market’s pricing mechanism is incapable of maintaining all the requirements of a competitive, efficient market. Regulation has several purposes: (1) to prevent issuers of securities from defrauding investors; (2) to promote competition and fairness in trading; (3) to promote the stability of financial institutions; (4) to restrict the activities of foreign concerns in domestic markets and institutions; (5) to control the level of economic activity.

Disclosure regulation is the form of regulation that requires issuers of securities to make public a large amount of financial information to investors. This addresses the problem of asymmetric information and the problem of agency.

Financial activity regulation consists of rules on trading financial assets.

Regulation of financial institutions is that form of governmental monitoring that restricts these institutions’ activities in the vital areas of lending, borrowing and funding.

Regulation of foreign participants is that form of governmental activity that limits the roles foreign forms can have in domestic markets and their ownership or control of financial institutions. Authorities use banking and monetary regulation to try to control changes in a country’s money supply.

Regulation in the United States

Regulation in the United States is largely due to the stock market crash of 1929 and the Great Depression of the 1930s.

ANSWERS TO QUESTIONS FOR CHAPTER 1

(Questions are in bold print followed by answers.)

1. What is the difference between a financial asset and a tangible asset?

A tangible asset is one whose value depends upon certain physical properties, e.g. land, capital equipment and machines.  A financial asset, which is an intangible asset, represents a legal claim to some future benefits or cash flows.  The value of a financial asset is not related to the physical form in which the claim is recorded.

2. What is the difference between the claim of a debtholder of General Motors and an equityholder of General Motors?

The claim of the debt holder is established by contract, which specifies the amount and timing of periodic payments in the form of interest as well as term to maturity of the principal.  The debt holder stands as a creditor and in case of default, he has a prior claim on firm assets over the equity-holder.

The equity holder has a residual claim to assets and income.  He can receive funds only after other claimants are satisfied.  Income is in terms of dividends, the amount and timing of which are not certain.

3. What is the basic principle in determining the price of a financial asset?

The price of any financial asset is the present value of the expected cash flows or a stream of payments over time. Thus, the basic variables in determining the price are: expected cash flows, discount rate and the timing of these cash flows.

4. Why is it difficult to determine the cash flow of a financial asset?

The estimation and determination of cash flows is difficult because of several reasons.  These include accounting measures, possibility of default of the issuer, and embedded options in the security.  Interest payments can also change over time.  There is uncertainty as to the amount and the timing of these payments.

5. Why are the characteristics of an issuer important in determining the price of a financial asset?

The characteristics of the issuer are important because these determine the riskiness or uncertainty of the expected cash flows.  These characteristics, which determine the issuer’s creditworthiness or default risk, have an impact on the required rate of return for that particular financial asset.

6. What are the two principal roles of financial assets?

The first role of financial assets is to transfer funds from surplus spending units (i.e. persons or institutions with funds to invest) to deficit spending units (i.e. persons or firms needing funds to invest in tangible assets).

The second role is to redistribute risk among persons or institutions seeking and providing funds.  Funds providers share the risks of expected cash flows generated by tangible assets.

7.  In September 1990, a study by the U.S. Congress, Office of Technology Assessment, entitled “Electronic Bulls & Bears: U.S. Securities Markets and Information Technology,” included this statement:

Securities markets have five basic functions in a capitalistic economy:

a.      They make it possible for corporations and governmental units to raise capital.

b.      They help to allocate capital toward productive uses.

c.       They provide an opportunity for people to increase their savings by investing in them.

d.      They reveal investors’ judgments about the potential earning capacity of corporations, thus giving guidance to corporate managers.

e.       They generate employment and income.

For each of the functions cited above, explain how financial markets (or securities markets, in the parlance of this Congressional study) perform each function.

The five economic functions of a financial market are: (1) transferring funds from those who have surplus funds to invest to those who need funds to invest in tangible assets, (2) transferring funds in such a way that redistributes the unavoidable risk associated with the cash flow generated by tangible assets, (3) determining the price of financial assets (price discovery), (4) providing a mechanism for an investor to sell a financial asset (to provide liquidity), and (5) reducing the cost of transactions.

The five economic functions stated in the Congressional Study can be classified according to the above five functions:

1.      “they make it possible for corporations and governmental units to raise capital” --functions 1 and 2;

2.      “they help to allocate capital toward productive uses” -- function 3;

3.      “they provide an opportunity for people to increase their savings by investing in them” -- functions 1 and 5;

4.      “they reveal investors’ judgments about the potential earning capacity of corporations, thus giving guidance to corporate managers” --function 3;

5.      “they generate employment and income” -- follows from functions 1 and 2 allowing those who need funds to use these funds to create employment and income opportunities.

8. Explain the difference between each of the following:

a.      money market and capital market

b.      primary market and secondary market

c.       domestic market and foreign market

d.      national market and Euromarket

a.       The money market is a financial market of short-term instruments having a maturity of one year or less.  The capital markets contain debt and equity instruments with more than one year to maturity;

b.      The primary market deals with newly issued financial claims, whereas the secondary market deals with the trading of season issues (ones previously issued in the primary market);

c.       The domestic market is the national market wherein domestic firms issue securities and where such issued securities are traded.  Foreign markets are where securities of firms not domiciled in the country are issued and traded;

d.      In a national market securities are traded in only one country and are subject to the rules of that country.  In the Euromarket, securities are issued outside of the jurisdiction of any single country.  For example, Eurodollars are dollar-denominated financial instruments issued outside the United States.

9. Indicate whether each of the following instruments trades in the money market or the capital market:

a.      General Motors Acceptance Corporation issues a financial instrument with four months to maturity.

b.      The U.S. Treasury issues a security with 10 years to maturity.

c.       Microsoft Corporation issues common stock.

d.      The State of Alaska issues a financial instrument with eight months to maturity.

a.       GMAC issue trades in the money market.

b.      U.S. security trades in the capital market.

c.       Microsoft stock trades in the capital market.

d.      State of Alaska security trades in the money market.

10. A U.S. investor who purchases the bonds issued by the government of France made the following comment: “Assuming that the French government does not default, I know what the cash flow of the bond will be.” Explain why you agree or disagree with this statement.

One would tend to disagree with this statement.  Even though there is no default risk with French bonds issued by the government, some other risks include price risk and foreign exchange risk.

11. A U.S. investor who purchases the bonds issued by the U.S. government made the following statement: “By buying this debt instrument I am not exposed to default risk or purchasing power risk.” Explain why you agree or disagree with this statement.

This is not true.  There is no default (credit) risk of U.S. government securities.  However, it is not free of purchasing power or inflation risk.  There is also price risk, which is related to maturity of any bond.

12. In January 1992, Atlantic Richfield Corporation, a U.S.-based corporation, issued $250 million of bonds in the United States. From the perspective of the U.S. financial market, indicate whether this issue is classified as being issued in the domestic market, the foreign market, or the offshore market.

The corporate bonds issued by Atlantic Corporation are in the domestic market, but the investors can also be from foreign markets.

13. In January 1992, the Korea Development Bank issued $500 million of bonds in the United States. From the perspective of the U.S. financial market, indicate whether this issue is classified as being issued in the domestic market, the foreign market, or the offshore market.

This issue can be classified as a domestic issue.

14.       14. Give three reasons for the trend toward greater integration of financial markets throughout the world.

There are several reasons.  These include:

a.       Deregulation and/or liberalization of financial markets to permit greater participants from other countries;

b.      Technological innovations to provide globally-available information and to speed transactions;

c.       Institutionalization -- financial institutions are better able to diversify portfolio and exploit mis-pricings than are individuals.

15. What is meant by the “institutionalization” of capital markets?

The term “institutionalization” refers to the dominance of large institutional investors such as pension funds, investment companies, banks, insurance companies, etc. in the money and capital markets.

16.a. What are the two basic types of derivative instruments?

b. “Derivative markets are nothing more than legalized gambling casinos and serve no economic function.” Comment on this statement.

a.       The two basic types of derivative instruments are futures and options contracts.  They are called derivatives because their values are derived from the values of their underlying stocks or bonds.

b.      The statement implies that derivative instruments can be used only for speculative purposes.  Actually, derivatives serve an important economic function by permitting hedging, which involves shifting risks on those individuals and institutions (speculators) that are willing to bear them.

17. What is the economic rationale for the widespread use of disclosure regulation?

The economic rationale is that disclosure mitigates the potential for fraud by the issuer. Typically, there information asymmetry between the issuer (management) and the investors, and disclosure regulation mitigates the harm to investors that could result from this informational disadvantage. As a result, there is confidence in the market and the pricing mechanism of the market.

18. What is meant by market failure?

Market failure occurs when the market cannot produce its goods or services efficiently. In the context of financial market failure, it occurs when the pricing mechanism fails and thus the supply and demand equilibrium is disrupted. This results in failure to price securities efficiently and reduced liquidity.

19. What is the major long-term regulatory reform that the U.S. Department of the Treasury has proposed?

The long-term proposal is to replace the prevailing complex array of regulators with a regulatory system based on functions. Specifically, there would be three regulators: (1) market stability regulator, (2) prudential regulator, (3) business conduct regulator.

20. Why does increased volatility in financial markets with respect to the price of financial assets, interest rates, and exchange rates foster financial innovation?

Increased volatility of the prices of financial assets has fostered innovation as investors and institutions seek ways to mitigate financial risk. Among other things, these innovations include the advancement of the modern derivatives markets.