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Financial Markets and Products (Financial Market Players (Banks (major…
Financial Markets and Products
Financial Market Players
Banks
types of banks
Investment banks
assist in raising capital for customers
advising on corporate finance matters
Commerical banks
make loans
take deposit
major risks faced by banks
credit risk
market risk
operational risk
economic capital vs. regulatory capital
regulatory capital
the amount determined by bank regulators
tier 1 capital: equity
tier 2 capital: subordinated long-term debt
economic capital
the amount of capital that a bank believes is adequate based on its own risk models
deposit insurance and moral hazard
moral hazard
the observed phenomenon that insured parties take greater risks than they would normally take if they were not insured
investment banking financing agreements
private placement
securities are sold directly to qualified investors with substantial wealth and investment knowledge
the investment bank earns fee income from arranging a private placement
没有流通性，不可以公开招募投资人，不能放到市场和Internet上卖
public offering
securities are sold to investing public at large
two methods of assisting with a public offering
firm commitment
investment bank agrees to purchase the entire issue at a price that is negotiated between the issuer and bank
bank earns income by selling the issue to the public at a spread above the price it paid the issuer
best efforts
if only part of the issue can be sold, the bank is not obligated to buy the unsold whole issue
the bank earns fee income for its services
initial public offerings (IPO)
investment bank can assist in determining an IPO price by analyzing the value of the issuer
an IPO price may also be discovered through a Dutch auction
begins with a price greater than what any bidder will pay
price is reduced until a bidder agrees to pay it
each bidder may specify how many units they will purchase when accepting a price
the price continue to be reduced until bidders have accepted all the shares
the price at which the last of the shares can be sold becomes the price paid by all successful bidders
potential conflicts of interest
the urgency of selling shares vs the independence and objectivity of analysts
material nonpublic information
banking book vs. trading book
banking book
loans made, which are the primary assets of a commercial bank
includes the principal amount to be repaid and accrued interest on the loan
for a nonperforming loan, the accrued interest is not included
nonperforming loan: payments are more than 90 days overdue
trading book
assets and liabilities related to a bank's trading activities
trading book items are marked to market daily
the originate-to-distribute model
making loans and selling them to other parties
benefit
increases liquidity in the sectors of the lending market where it is used
for banks originate the loans, this frees up capital which they can meet regulatory requirements or make new loans
drawback
led banks to loosen lending standards
Insurance Companies and Pension Plans
categories of insurance companies
life insurance
term life insurance: coverage for fixed periods
whole life insurance: coverage upon death
most commonly, premiums and the amount of coverage are fixed
property and casualty (P&C) insurance
property insurance
covers property losses
casualty (liability) insurance
covers third-party liability for injuries sustained while on a policyholder's premises or caused by the policyholder's use of a vehicle, for example
subject to long-tail risk
health insurance
covers medical services that are not covered under a publicly funded health care system
risks facing insurance companies
insufficient funds to satisfy policyholders' claims
poor return on investments
liquidity risk of investments
credit risk
operational risk
mortality tables
Age, Probability of Death Within 1 Year, Survival Probability, Life Expectancy
calculation of breakeven premium
P&C insurance ratios
loss ratio: the percentage of payouts versus premiums generated for a given year
expense ratio: the percentage of expenses versus premiums generated
combined ratio: the sum of the loss ratio and the expense ratio
combined ratio after dividends: combined ratio plus the payment of dividends to policyholders
operating ratio: the combined ratio (after dividends) less investment income
moral hazard and adverse selection
moral hazard: the risk to the insurance company that having insurance will lead the policyholder to act more recklessly than if the policyholder did not have insurance
methods to mitigate against moral hazard
deductibles
coinsurance provisions
policy limits
adverse selection: the situation where an insurer is unable to differentiate between a good risk and a bad risk
methods to mitigate against adverse selection
greater initial due diligence
ongoing due diligence
mortality risk vs longevity risk
hedging mortality and longevity risks
reinsurance contracts
natural hedging between mortality and longevity risks
longevity derivatives
capital requirements for insurance companies
guaranty system for insurance companies
pension funds
defined benefit plans
employee benefit known
employer contribution unknown
defined contribution plans
employer contribution known
employee benefit unknown
Mutual Funds and Hedge Funds
types of mutual funds
mutual funds are pooled investment vehicles that offer instant diversification for their investors
open-end mutual funds
number of shares goes up as new investors arrive and goes down as investors withdraw assets
four types
money market funds: short-term interest bearing instruments
equity funds: invest solely in stocks
bond funds: invest only in fixed-income instruments
hybrid funds: blend stock and bond ownership into the same bond
transaction happens after market closes; price base on the fund's net asset value (NAV= (assets-liabilities of the funds)/shares outstanding)
Taxes are passed on to investors (pay proportional based on ownership)
fees
management fee: operational costs
advertising surcharge
sales charge (loads)
front-end load
back-end load
poor price visibility
closed-end mutual funds
tend to invest in niche areas like specific emerging markets
the number of shares remain statistic
investors cannot redeem their shares from the fund company. must find another investor to buy their shares
price may not be NAV
exchange-traded funds (ETFs)
typically trade at NAV
must disclose their holdings twice each day
lower management fees
net asset value
(fund assets-fund liabilities)/(total shares outstanding)
hedge funds vs mutual funds
both offer
professional management
instant diversification
the ability to commingle funds with other investors
mutual funds are marketed to all investors, where hedge funds are restricted to only wealthy and sophisticated investors
hedge funds do not need to provide
the redemption of shares at any time the investor chooses
a daily calculated NAV
the full disclosure of their investment policies and strategies
hedge funds are permitted to use leverage while mutual funds are not
hedge funds are permitted to use both long and short investment strategies
lock-up period: the investor is not able to withdraws his funds
hedge fund expected returns and fee structures
incentive fees
2 plus 20%: flat 2% of all assets + additional 20% of all profits
hurdle rate (最低资本回报率): 投资者要求的最低资本投资率，只有达到这个最低的标准，投资者才愿意投资。若一项投资的回报率高于最低资本回报率，这个投资就是值得的，若低于最低资本回报率，这个项目就应放弃（会导致投资者亏损)
high-water market clause: previous losses must first be recouped and hurdle rate surpassed before incentive fees once again apply
clawback clause: enable investors to retain a portion of previously paid incentive fees in an escrow account to offset investment losses
hedge fund strategies
long/short equity
find mispriced securities
market neutral funds
factor neutral funds
dedicated short：先卖空并不持有的证券然后以更低的价格买回来获利
distressed securities
invest in distressed bond (CCC rating)
merger arbitrage
cash deals
stock deals
convertible arbitrage
fixed income arbitrage： 从相似固定收益证券的错误定价中获取收益
emerging market
global macro： 依靠自上而下的全球视野对世界经济、大宗商品、货币、政权等走势进行预测
managed futures： 通过使用保证金进行交易，依据技术分析或者个人判断进行买卖，交易频繁但是在止赢或者止损上严格遵守操作纪律
hedge fund performance and measurement bias
measurement bias
backfill bias: 在原index的基础上增加表现好的hedge funds and their historical performance. This will boost the historical performance of the index, even though the fund is not in the index previously
Financial Products
Introduction (Options, Futures, and Other Derivatives)
OTC market
advantages
terms are not set by any exchange
participants have flexibility to negotiate
in the event of a misunderstanding, calls are recorded
disadvantages
more credit risk
Basics of derivative securities
option contract
call option
Payoff: CT=max(0, ST-X)
C0: call premium
profit = CT-C0
put option
Payoff: PT=max(0, X-ST)
P0: put premium
profit= PT-P0
forward contract
payoff = ST-K
futures contract
Hedging Strategies
Speculative Strategies
leverage
Arbitrage Opportunities
Risk from Derivatives
Common Terms Related to Derivatives
derivative
market maker
spot contract
forward contract
futures contract
call option
put option
American option
European option
long position
short position
strike price
expiration
bid price
offer price = asking price
bid-ask spread
hedgers
speculators
arbitrageurs
Mechanics of Futures Markets
open interest: the total number of long positions in a given futures contract
trading futures contracts
characteristics specified in a futures contract
quality of the underlying asset
contract size
delivery location
delivery time
price quotations and tick size
daily price limits
limit down
limit up
position limits
the maximum number of contracts that a speculator may hold (do not apply to hedgers)
futures/spot convergence
basis = spot price - futures price
as the maturity date nears, the basis converges toward zero
at expiration, the spot price must equal the futures price
operation of margin
margin
initial margin
maintenance margin
margin call
variation margin
clearinghouses in futures transactions
act as the buyer to every seller and the seller to every buyer
OTC markets
high credit risk
collateralization
recently passed legislation requires that some OTC transactions use clearinghouses
margin
normal and inverted futures market
settlement price: an average of the prices of the trades during the last period of trading, called the closing period, which is set by the exchange
increasing settlement prices over time: normal market
decreasing settlement prices over time: inverted market
the delivery process
four ways to terminate a futures contract
delivery
notice of intention to delivery
location for delivery
terms of delivery
details of exactly what is to be delivered
cash-settlement contract
make a reverse, or offsetting, trade in the futures market
exchange for physicals
find a trader with an opposite position to your own and deliver the goods and settle up between yourselves, off the floor of the exchange
types of orders
market orders
discretionary order
limit order
limit buy order
limit sell order
stop-loss order
stop loss sell order
stop-loss buy order
stop-limit orders
market-if-touched orders (MIT)
time-of-day order
good-till-cancel (GTC) orders
fill-or-kill orders
regulatory, accounting, and tax frameworks
Regulation
Commodity Futures Trading Commission (CFTC)
National Futures Association (NFA)
Securities and Exchange Commission (SEC)
Federal Reserve Board
U.S. Treasury Department
Accounting
Taxes
futures contracts are considered closed out at the end of each year
60/40 rule
Hedging Strategies Using Futures
Hedging with Futures
short hedge
long hedge
Advantages and Disadvantages of Hedging
less uncertainty regarding future profitability
can lead to less profitability
Basis Risk
Basis = spot price of asset being hedged - futures price of contract used in hedge
Def: the change in basis over the hedge horizon
Three sources of basis risk
interruption in the convergence of the futures and spot prices
changes in the cost of carry
imperfect matching between the cash asset and the hedge asset
maturity or duration mismatch
liquidity mismatch
credit risk mismatch
The Optimal Hedge Ratio
HR = rho_s,f *sigs/sigf=beta_s,f
effectiveness of hedge
measures the variance that is reduced by implementing the optimal hedge
R^2 = rho^2
Hedging with Stock Index Futures
number of contracts = beta_portfolio *(portfolio value/value of futures contract)
Tailing the Hedge
multiply the hedge ratio by the daily spot price to futures price ratio
Adjusting the Portfolio Beta
number of contracts = (desired beta - current beta)* portfolio value / asset value
Rolling a Hedge Forward
as a maturity date approaches, the hedger must close out the existing position and replace it with another contract with a later maturity
rollover (basis) risk
when rolling a hedge forward, hedgers are not only exposed to the basis risk of the original hedge, they are also exposed to the basis risk of a new position each time the hedge is rolled forward
Interest Rates
Treasury rates
the rates that correspond to government borrowing in its own currency. risk-free rates
LIBOR
London Interbank Offered Rate
the rate at which large international banks fund their activities
Repo rates
repurchase agreement rate