Equity Investments & FI Flashcards
Infinite period dividend discount model
Dividend discount model assumptions
- Dividends are correct metric for valuation purposes
- Dividend growth rate is perpetual and never changes
- Required rate of return is constant over time
- Dividend growth rate < required rate of return
Gordon model alternatives
- Use a more robust DDM that allows for varying growth patterns
- Use a cash flow measure instead of dividends
- Use another approach, such as a multiplier method
Two stage DDM
PE ratio link to Gordon Growth
EV/EBITDA
- EBITDA used as proxy for operating cash flow (excludes depreciation and amortisation)
- EBITDA is a source of funds to pay interest, dividends and taxes
- EBITDA is calculated prior to payment to any of the company’s financial stakeholders; using it to estimate enterprise value is therefore appropriate
Leverage factor
Margin call price
Global depositary receipts
Issued outside a company’s home country and outside the US.
Not subject to foreign ownership and capital flow restriction
Traded in London and mostly in the USD
American depository receipts (ADRs)
US dollar denominated security
Enables foreign companies to raise capital from US investors
Level I/II Non-Domestic
- Unlisted
- Develop and broaden US investor base with existing shares
- Not raising capital on US market
- Form F6
- Listed
- Same as above but has listing fees
Level III non-domestic securities
- Develop and broaden US investor base with existing shares/new shares
- Forms F-1/ F-6
- Actually raising capital
Rule 144A
Access qualified instituional investors. Raise capitals through private placements to QIBs. No SEC registration. Low listing fees, no reporting. Can be done through private placements
Porter’s 5 forces
- Threat of substitute products
- Bargaining power of customers
- Bargaining power of suppliers
- Threat of new entrants
- Intensity of rivalry
Excess/deficiency bonds
Inverse effect
Bond price is inversely related to the market discount rate
Convexity effect
% price change is greater when market discount rates go down, than when they go up
Coupon effect
Lower coupons more volatile than higher coupons
Maturity effect
Longer dated more volatile than shorter dated bonds
Discount rate basis
Add-on rate basis
Forward rate on bonds
1y1y = “the 1 year into 1 year rate” = one year rate starting in one year time
Spot rates are geometric averages of forward rates. YTM’s are a weighted average of spot rates
G-spread
YT bond - YTM government benchmark (interpolated)
I-Spread
YTM bond - interest swap rate benchmark (interpolated)
Z-Spread
Zero volatility spread for measuring spreads off the spot rate curve, spread over each of the spot rates in a given benchmark term structure
Option Adjusted Spread (OAS)
Measuring spreads summary
Macaulay Duration
Modified Duration
Approximate percentage change in full price
Provides a linear estimate of the percentage price change
Duration Gap
Duration Gap = Macaulay duration - investment horizon
If duration gap is negative reinvestment risk dominates price risk
If duration gap is positive price risk dominates coupon reinvestment risk
Duration gap (first order)
Approximate mdofied Duration
Price-yield relationship straight bonds
Longer maturity, lower coupon means higher duration and convexity
Effective duration
Point value of a basis point
Aproximate Modified Convexity
Convexity price adjustment
Price-yield relationship for callable bonds
Price-yield relationship for putable bonds
Effective convexity
Bond indenture/Trust deeds
Legal contract that describes the form of the bond, the obligations of the issuer and the rights of the bond holders.
Credit enhancements
- Internal enhancements - over collateralization, excess spread(held in reserve accounts), subordination
- External enhancements - Bank guarantee or a surety bond issued by an insurance company reimburse investors for losses incurred & letter of credit from a financial institution
Foreign bonds
Bonds issued by entities that are incorporated in another country in the national bond market of another country in that country’s currency
Eurobond
Issued outside the jurisdiction of any one country and trade in a currency different from the countries in which they trade
Bond tax considerations
Capital gain treated differently than income. Original issue discount bond may have a portion of the the discount subject to income tax. Some jurisdictions have a tax provision for bonds bought at a premium where the premium can be used to offset taxable income.
Amortizing bond
Fully amortised bond entire principle paid over life of bond.
Partially amortized bond – pays interest and principal over the life of the bond but principal is still outstanding on maturity
Sinking fund provisions
Issuer sets aside funds over course of maturity
Could be set aside in a segregated cash reserve or a specific provision to retire a specific portion (e.g. 4%) of principal ever year
Lowers credit risk
Conversion value (parity value)
Current share price x Conversion ratio
Conversion Premium
Convertible bond price - Conversion value
Phases of bond issuance
- Funding determination
- Select the underwriter commonly handled by a syndicator
- Underwriter prepares prospectus (offering circular) and issuer chooses trustees to oversee master agreement
- Gauging demand with roadshow, grew market represents a forward market for bonds about to be issued to help determine the final offer price
- The offering day follows the pricing day, when the underwriting agreement is signed, and added to the final terms of the bond
- On closing day, the bonds are delivered to investors, represented by a global note usually held by the paying agent
Shelf registration
Issuer prepares a single offering circular (master prospectus) that describes a range of future bond issuances
Subject to less scrutiny than standard offerings. Available for issuers, with sufficient clout.
Each document proceded by announcement document.
Public offerings auctions (FI)
- Competitive bids require the bidder to specify an acceptable yield, and if the auction determines a lower yield, the bidder is not offfered anything
- Non-competitive bids require bidder t accept the yield determined by the auction, and thus they will always receive the securities
Bond settlement (secondary market)
- Government bonds typically settle T+1
- Corporate bonds typically settle T+3
- Money market trades can settle T+0 (cash)
T bill
Less than 1 year = T-blll (money market)
T note
At least 1 year, up to 10 years (capital market)
T bond
More than 10 years (capital market)
On-the-run
Sovereign debt which is usually recently issued
Commercial paper ratings
Commercial paper
- Short term unsecured promissory note, can fund working capital requirements, largest issuers are financial institutions
- Can be used to pay the holders of maturing commercial paper (rolling over the paper), can create rollover risk, can obtain back up lines of credit to protect against risk
- Investors are regularly able to assess issuer’s financial condition and so default rates are very low
- Yields are higher than sovereign bonds of the same maturity
US Commercial paper vs Eurocommercial paper
Corporate short-term notes
Up to five years
Corporate medium term notes
More than five years, up to 12 years
Corporate longer-term bonds
Longer than 12 years
Settlement of corporate notes
Primary market settlement takes several days, but secondary market settlement is generally T+3
Retail deposits
Primary source of funding, demand deposits provide highest level of liquidity, typically zero interest.
Savings accounts, pay interest, but less liquid than demand deposits.
Money market accounts
Central bank funds
Reserve funds provide a liquidity buffer for depositors. Central bank may act as lender of last resort. Reserve funds may earn interest, and banks may be required to hold a minimum level of funds. Rate on central bank funds are determined by the market but influenced by central bank open market operations.
Interbank funds
Unsecured loan and deposit market between banks, with terms ranging from overnight to one year. The rate on funds can be quoted fixed or relative to a reference rate. Banks require line of credit with each other to obtain unsecured funds (confidence can dry up)
Large-denomination negotiable Certificates of Deposit
Specific amount on deposit for a fixed term and fixed rate payable on maturity. May represent a deposit that can be traded or not traded. NEgotiable come in two forms’ large or small). Only large denomination CDs are relevant as a wholesale funding source. CD market available domestically and internationally (Eurobond)
Repo
Sale of a security with a simultaneous agreement to buy back the same security from the original buyer at a set price on an agreed date, difference between the prices represents the interest on a collateralized loan. Can theoretically be used for infinite leverage (buy security with funds, use this security as a collateral for more funds etc.)
Reverse repos conversely can be used to borrow securities to cover a short position
Repo detail
Terms can be one day (overnight repor) or more (term repo). High demand collateral is referred to as ‘on special’.
Both parties are exposed to counterparty default risk, credit risk is bilateral, but is usually structured to acknowledge the greater credit risk of the cash borrower, amount of funds borrowed is less than the market value of the collateral and the difference is called the repo margin.
Trustee or trustee agent (ABS)
- Entity with trust powers that safeguard the securitized assets
- Hold funds fue to the bondholders until they are paid
- Provide periodic remittance reports to bondholders
Maturity of mortgages
- US typically 15-30 years
- Europe typically 20-40 years
Payment compositon mortgages
Prepayments
- Allowing prepayments creates uncertainty in the timing and amount of cash flows - known as prepayment risk
Rights of the lender in a foreclosure
- Recourse loan: lender has a claim against the borrower for the shortfall from the loan amount and proceeds from the property sale
- Non-recourse loan - lender has no such claim and can only look to the sale of the property to recover the outstanding balance
Mortgage Pass - Through Security
- Cash flow = Interest + Scheduled principal + Prepayments
- Reduced by servicing fees
Confirming and non-conforming loans
- Conforming loan - meets specified criterion to be included in the loan pool of an agency
- Size of loan
- Loan documentation required
- Maximum loan-to-value ratio
- Requirement for insurance
- Non-conforming loans used as collateral for mortgage pass-through securities are privately issued
Single monthly mortality rate
Extension risk
Interest rates increase, prepayments will decrease. RMBS price declines as interest rates are higher. Income received is typically limited to the interest payment and scheduled principal payment
Contraction risk
If interest rates decrease, prepayments will increase. Risks to the RMBS investor include: reinvestment rate risk, negative convexity puts ceiling on price
Collateralised Mortgage Obligations (CMO)
- Securities whee the cash flow of mortgage-related products are redistributed to various tranches
- Prepayment risk (extension and contraction) is redistributed among tranches through structuring, they have different levels of prepayment risk. Broadens the appea of mortgage backed securities to institutional investors
- In contrast mortgage pass-through secutiries the collateral for a CMO is a pool of mortgage pass-through securities not a pool of mortgages.
Planned amortization class (PAC) tranches
- Amortization based on a sinking fund schedule within a range of prepayment speeds hence creating greater predictability of cash flows for the pac holder
- The greater predictability of cash flows comes at the expense of support tranches or companion
- Most CMO PAC structures have more than one PAC tranche
Support tranches
- If prepayments are slow support tranches do not receive principal until the PAC tranches receive their scheduled principal
- If prepayments are fast support tranches absorb the principal in excess of scheduled principal
Floating rate tranches
- Fixed-rate tranches can be split into floating and inverse-floating tranches
- Floaters pay more when rates go up, converse for inverse-floaters
Commercial mortgage-backed securities
Backed by a pool of commercial loans on income-producing property such as multifamily properties, hotels
Common for loans to be non-recourse. Lender must therefore review each property individually using measures commonly used in credit risk
Loan-to-value
Debt-to-service coverage ratio = Annual net operating income / Debt service
CDO
Generic term to describe a security backed by a diversified pool of one or more debt obligations
- CBO: backed by corporate and emerging market bonds
- CLO: backed by leveraged bank loans
- Synthetic CDO: backed by a portfolio of credit default swaps
CDO transaction
CDO cash flows
Cash flows = interest from collateral assets + maturing of collateral assets + sale of collateral assets
Loss to equity tranches will occur if the returs from the collateral does not exceed the cost of paying off the senor and mezzanine tranches. The maximum loss will represent their entire investment
Credit Engancement in securitisation
Allows for loss absortion
- First to excess spread (excess revenue generated by difference between coupon and underlying collateral)
- Then to overcollaterilisation (FaceV of loans > ParV)
- Then from the bottom tranch upwards
RMBS WAL vs WAM
Weighted average maturity ignores amortisation of the principle. Weighted average life is the weighted average time taken to make a principle repayment
Sequential Pay CMO (High Tranch)
High Contraction risk
Low Extension risk
Sequential CMO (low tranche)
Low contraction risk
High extension risk
Redemption regimes (Covered Bond)
Exist to align covered bond’s cash flows as closely as possible to original maturity schedule should bond’s financial sponsor default
Hard-bullet covered bonds
If payments are not made as schedules a bond default is triggered and bond payments are accelerated
Soft-bullet covered bonds
Delay the default and accelerated payments until a new final maturity date which is usually up to a year after the original maturity date
Conditional pass-through covered bonds
Convert to pass-through securities after the original maturity date if all bond payments not made
Covered bond definition
Similar to ABS but offer bondholders dual recourse to both issuing financial institution and underlying pool of assets
Underlying assets kept on financial institutions balance sheet not transferred to remote SPE
Normally only one bond class
Covered sponsors must replace any prepaid or non-performing assets
Value of security market index made of
Actual or estimated value of constituent securities
Fundamental Weighting
Weighting of each security = Fundamental size measure / Sum of fundamental size measure
Leads to value tilt
Challenges with Fixed Income Indices
Number of different types more than with equities
Much greater index turnover due to maturing FI securities
Primary dealer (market makers) - index providers have to obtain prices from dealers or estimate from similar securities
More difficult to replicate
Commodity indexes
Use futures contracts on one or more commodities
Each index has different weighting mechanism
Changes reflect: risk-free interest rate, change in futures prices, roll yield
REIT
- Indexes Represent market for real estate securities and real estate market in general
- REIT Highly illiquid market, infrequent transactions and pricing information
- Types: Appraisal, repeaat sales, and REIT indexes
- Can be based on public or private unds which invest in real estate
- REIT indexes based on publicaly traded REITS with continuous market prices
Who sells CDS
Insurance companies, IBs, hedge funds
Brokers
Agents who fill orders for their clients
Help clients by reducing cost of finding couterparty
Exchanges
Provide places where traders can meet to arrange trades, becoming more similar to dealers
Alternative Trading Systems vs Exchanges
Function like exchanges but do not exercise regulatory authority over subscribers
Dark pools do not display client orders so help protect traders from market moving against them (pre-trade untransparent)
Dealers
Fill client orders by trading with them
Provide liquidity
May include hedge funds, IBs, prop trading assets
Primary dealers buy/sell government debt
Replication
Buying risk in one form and selling it in another e.g. equity positions and call options
Initial margin requirement
Portion of security price that must be paid to broker by trader (equity potion)
Trader’s equity = margin requirement x initial value of short position
Execution Instruction
How to fill order
Validity Instruction
When the order may be filled
Clearing Instruction
How to arrange final settlement trade
Market Order
Instructs broker or exchange to obtain best price immediately
No price criteria given
Can be expensive to execute as execution price uncertain, but allocation risk low
Limit order
Specifies highest buying price or lowest selling price acceptable
Price risk lowered, but execution risk higher
Examples of validity instructions
- Day order: order expires if unfilled at close
- Good-till-canelled: cancellaiton date specified by trader
- Immediate or cancel: canelled if cannot be filled in whole or in part (fill or kill)
- Good-on-close: Often market orders. Can only be filled at close of trading
- Stop order, may not be filled until stop condition satisfied. Contribute to momentum
- Buy stop execution delayed until trade occers at or above stop price
- Sel stop order: execution delayed until trade occurs at or below stop price
Continuous trading market
Trades can be arranged and executed whenever market is open
Generally used when market is liquid
May start/end trading session with a call market
Call market
Trades can only be arranged when market is called
Highly illiquid between trading sessions
Use single price auctions to match buyers to sellers (single trade price to maximize total volume of trades)
Quote driven market
Electronic exchange which prices are determined from bid and ask quotations made by market makers
Also known as a price-driven market. Dealers fill orders from their own inventory or by matchning them with other orders
Order driven markets
Use rules to match, buy and sell orders
Submitted by customers or dealers
Rank orders based on price (price priority)
Secondary precedence rules include unhidden vs hidden, time enetered
Uniform pricing rules
Commonly used by call markets
All trades executed at same price
Discriminatory pricing rule
Used by continuous markets
Standing order (order that arrives first) determines trade price
Derivative pricing rule
Used by crossing networks
Crossing networks matches buyers and sellers who are willing to trade at prices obtained from other markets
Market Information
- Pre-trade transparent market publishes trade prices and sezes soon after trades occur
- Buy-side traders prefer transparency
- Dealers prefer opaque market - information advantage
- Opaque markets - wider bid/ask spread, higher transaction costs
Positive convexity
Prices go up faster as yields fall, for a given interest rate change % price increase would be greater than % price decrease
