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Transcript
Guy Hargreaves ACE-102 Recap of yesterday The concepts of market liquidity and product fungibility The major instruments traded in global financial markets Broad trends that have led to today’s financial instruments 2 Today’s goals Describe the term structure of interest rates Understand risk based pricing theory Understand generic bond and discount instrument valuation models Understand FX and forward rate pricing Understand the concepts of market efficiency and arbitrage 4 Interest rates Interest rates are a fundamental input into conditions in any given economy The level of interest rates provide an incentive in the decision on whether to consume or save For each currency we find a “term structure” of interest rates – the “yield curve” To develop yield curves, markets take “risk free” interest rates and add appropriate “risk premia” 5 The risk free yield curve Many theories on the drivers behind risk free yield curve level and shape Firstly the issuer must be risk free! Major components of risk from Money Market and Fixed Income instruments: Interest rate risk Default risk Liquidity risk Duration / convexity risk Tax / other event risk 6 The risk free yield curve Issuer Government Agency Corporate IG Corporate HY Interest rate risk Similar Similar Similar Similar Default risk “zero” Near zero Moderate High Liquidity risk Low Low Moderate High Duration risk Similar Similar Similar Similar Tax/event risk Low Low Lowish Lowish + => Clearly the best “risk free” yield curve it the government curve – noting that nothing is really risk free! 7 US Treasury yield curve Long end Short end • Short end rates formed from announced setting of Fed Funds overnight cash rate and expectations on its 1-2 year path • Long end rates formed from Inflation Expectations, inflation linked bond yields (real rates) and the expected path of inflation expectations 8 Measuring inflation expectations TIPS rates • Treasury Inflation Protected Securities (TIPS) - real rate yield curve showing long term inflation expectations of ~ 1.5-2% • Inflation expectations ~ (Nominal Rates – Real Rates) 9 Fed watching and the CPI Setting the risk free rate in an economy is critical Too tight (high rates) and economic activity might contract Too loose (low rates) and the economy might overheat Fed watching is a national sport! Janet Yellen, current Fed chief, is very influential in setting the path of Fed Funds cash rates => short rates The Consumer Price Index (CPI), amongst other indicators, is critical to setting longer term inflation expectations Real rates are quite stable – changing inflation expectations can play havoc with bond prices 10 Now we have a risk free yield curve All other interest rate based financial instruments can priced as a margin to risk free Risky bonds Derivatives and other contracts Any cash flow imaginable! Issuer Government Agency Corporate IG Corporate HY Interest rate risk Similar Similar Similar Similar Default risk “zero” Near zero Moderate High Liquidity risk Low Low Moderate High Duration risk Similar Similar Similar Similar Tax/event risk Low Low Lowish Lowish + 11 Current USD yield curves 4.50 4.00 3.50 3.00 US Treasury Bonds Yield 2.50 Corporate Bonds AAA 2.00 Corporate Bonds AA Corporate Bonds A 1.50 1.00 0.50 0.00 3 Month 6 Month 2 Year 3 Year 5 Year 10 Year 30 Year • How does the market conclude “A” rated corporate bonds should yield ~ 2.0% more than risk free UST in 5-years? • “A” rating default probability => compensation for expected loss + some compensation for unexpected losses 12 Recall our ratings table Standard & Poor’s Moody’s Fitch Default Risk profile AAA Aaa AAA Investment Grade: extremely strong AA+ | AA | AA- Aa1 | Aa2 | Aa3 AA+ | AA | AA- Investment Grade: very strong A+ | A | A- A1 | A2 | A3 A+ | A | A- Investment Grade: strong BBB+ | BBB | BBB- Baa1 | Baa2 | Baa3 BBB+ | BBB | BBB- Investment Grade: adequate BB+ | BB | BB- Ba1 | Ba2 | Ba3 BB+ | BB | BB- High Yield : less vulnerable B+ | B | B- B1 | B2 | B3 B+ | B | B- High Yield : more vulnerable CCC Caa1 | Caa2 | Caa3 CCC High Yield : vulnerable CC Ca CC High Yield : highly vulnerable C C C High Yield : highly vulnerable + SD Selective default D D Default NR NR Not rated Credit ratings are a critical component of the efficient operation of the fixed income market 13 Credit spread pricing Some science, plenty of art! Assuming our A rated corporates had a probability of defaulting over 5 years of 2% and if they defaulted we would lose 60% 0f our investment (40% recovery) This could account for 1.2% of the 2.0% credit margin The balance 0.8% could account for liquidity and event risk pricing Rating Probability of default (PD) over 5-years Loss Given Default (LGD) Expected Loss (PD * LGD) A ~ 2% 60% 1.20% 14 Pricing in the Money Market We now have a “Yield to Maturity” (YTM) curve for an issuer – what do we do with that? Money market instruments are mostly “discount” securities Say a corporate issues Commercial Paper (CP) which repays $100 in 90 days Investors will lend the issuer (buy the CP) $X today to receive $100 in 90 days How do we calculate X? 15 Discount valuation Simple interest formula $PV = $FV (1 + YTM * t) Where: $PV is the purchase price of the discount instrument $FV is the repayment amount of the discount instrument YTM is the yield an investor requires for investing t is the term of the instrument in years (watch the daycount) 16 Discount valuation So in this case let’s assume $FV is $100 YTM is 0.25% based on a 365 day daycount t is 90 days $PV = $100 (1 + 0.25% * 90 / 365) = $99.938 17 What happens if yields rise? Say investors now demand a higher YTM to account for higher short term interest rate expectations $FV is still $100 YTM is 0.50% based on a 365 day daycount t is 90 days $PV = $100 (1 + 0.50% * 90 / 365) = $99.877 (versus $99.938 18 Yield versus price Discount instrument prices fall when yields rise Does this make sense? If investors demand higher yields this implies they need to be compensated for higher expected and unexpected risks Issuers of discount instruments can not change repayment Investors need to buy those instruments at lower prices to generate their higher required returns What are the implications for “traders” of these instruments? 19 Pricing in the Bond Market Bond pricing is a much more complicated process than discount pricing Bonds can pay quarterly, semi annual or annual coupons To calculate a price today multiple coupons need to be discounted using an appropriate YTM Many assumptions go into bond pricing models but ultimately the markets tend to simplify models and apply agreed conventions 20 Typical bond cashflows Apple issues a 3-year fixed rate bond to investors paying 1.0% semi annual coupon Bond principal is $100m with a “bullet repayment” Cashflows are: Apple pays $0.5m coupons every 6 months Apple repays $100m + $0.5m coupon on maturity date Apple receives $100m on issue date 21 Theoretical bond pricing model Where: C = coupons payable i = YTM N = number of annual coupons M = principal repayment P = market price 22 Foreign exchange pricing “Spot” FX markets need no special pricing models Pricing of cash is simply the principal or notional amount of cash one holds An FX transaction is just the exchange of cash in one currency for cash in another Settlement periods are normally very short T, T+1 or T+2 Market pricing in FX markets is function of pure supply and demand 23 Foreign exchange pricing Many factors influence supply and demand in FX markets including: Relative interest rates in each currency Expectations of the direction of interest rates in each currency Trade and capital flows into and out of each currency/country International commodity prices 24 Foreign exchange pricing For example the Canadian economy is a significant exporter of crude oil 25 Foreign exchange pricing The Australian economy is large exporter of iron ore 26 Forward FX pricing The forward FX market is very deep and liquid Importers and exporters enter into FX transactions where settlement is not spot but some time in the future eg 3 months Used to hedge known or expected future FX flows Pricing is straight forward – use discount methodology pricing each currency leg against interest rates in each currency 27 Forward FX pricing Assume an Australian iron ore exporter expects to receive US$10m in 90 days from the sale of iron ore Spot AUD/USD rate = 0.80 90 day AUD interest rate = 3.00% (365 daycount) 90 day USD interest rate = 0.30% (360 daycount) Discount USD10m for 90 days 2. Convert discounted USD amount to AUD at spot FX 3. “Future Value” the resulting AUD amount for 90 days 4. Calculate forward FX rate 1. 28 Forward FX pricing Discount USD10m for 90 days US$ = US$10,000,000 (1 + 0.30% * 90 / 360) = US$9,992,505.62 29 Forward FX pricing Convert discounted USD amount to AUD at spot FX AU$ = US$9,992,505.62 0.80 = AU$12,490,632.03 30 Forward FX pricing “Future Value” the resulting AUD amount for 90 days FV(AU$) = AU$12,490,632.03 * (1 + 3.00% * 90 / 365) = AU$12,583,028.48 31 Forward FX pricing Calculate forward FX rate 90 day AUD/USD Forward FX rate = US10,000,000.00 AU$12,583,028.48 = 0.7947 Quoted as 53 “Forward points” “Arbitrage free” pricing 32 Financial Arbitrage Arbitrage is the act of profiting by taking two equal but opposing positions in the “same product” at the same time Find a buyer at $10 at the same time find a seller at $9 Buy at $9 and sell at $10 to realise $1 profit Assume no market risk in doing so Financial instruments are priced in markets to be “arbitrage free” 33 Financial Arbitrage Many activities in markets today are called arbitrage but are not in fact arbitrage eg “Merger Arbitrage” – in a M&A transaction usually the share price of the acquirer falls whereas the share price of the target rises Buy the target, sell the acquirer Not risk free Most arbitrage requires asymmetric information to exist => potential abuse eg 2007-9 GFC 34 Market efficiency Global market pricing is much more efficient than it was say three decades ago Professional arbitrageurs act to remove pricing discrepancies on a 24/7/365 basis Players consistently on the wrong side of arbitrage lose money and leave the business “Algo” traders and “HFTs” troll the markets 35 Market efficiency While arbitrage in markets is now low, market prices move daily in reaction to updated information that impacts on risk premia Efficient markets hypothesis: the application of rational expectations to financial markets so that the equilibrium price of a security is always equal to its fundamental value Most applicable to corporate securities – bonds/shares Many players believe share prices are driven more by “Random Walk” 36