Introduction to Interest Rate Markets

Transcription

1 Introduction to Interest Rate Markets Tanweer Akram, PhD Jan 23, 2018, SANEM, Dhaka, BANGLADESH 0

2 IMPORTANT DISCLAIMER AND DISCLOSURE Disclaimer: The author s institutional affiliation is provided solely for identification purposes. Views expressed are solely those of the author and the standard disclaimer applies. The views are not necessarily those of Thrivent Financial, Thrivent Investment Management, or any affiliates. This is for information purposes only and should not be construed as an offer to buy or sell any investment product or service. Disclosure: Tanweer Akram s employer, Thrivent Financial, invests in a wide range of securities. Asset management services are provided by Thrivent Asset Management, LLC, a wholly owned subsidiary of Thrivent Financial for Lutherans. Compliance Tracking #

3 INTRODUCTION TO INTEREST RATE MARKETS Lecture 1: Introduction to Financial Markets Lecture 2: Introduction to Bonds Lecture 3: Overview of Fixed Income Markets Lecture 4: Introduction to Futures Markets Lecture 5: Introduction to Swaps 2

4 Lecture 1: Introduction to Financial Markets Tanweer Akram, PhD Dec 17, 2017, SANEM, Dhaka, BANGLADESH 3

5 INTRODUCTION TO FINANCIAL MARKETS Overview Bonds Stocks Derivatives The Organization of Financial Markets Margins Transaction Costs 4

6 FINANCIAL MARKETS Basic characteristics and different instruments trade in financial markets Various instruments The organization of financial markets What is a security? A document that confers it owner(s) a financial claim. Fixed income security pays a fixed amount of money to its owner(s). Example: a bond, a saving account, a money market account, a certificate of deposit ( fixed deposit ), and so forth. 5

7 TYPES OF SECURITIES AND CONTRACTS Source: Cvitanic and Zapatero (2004) 6

8 BONDS Bond is a security that gives its owner(s) a claim to payment in the future at a predetermined date, called maturity. Often such payments are sometimes fixed but not always! Two sides of a bond contract: (1) the debtor and (2) the creditor. The debtor is the party that borrows and agrees to meet the obligations, while the creditor is the party that lends and will receive the payments. Bond price is the price at which a bond is traded. The difference between the bond price that the credit pays to the debtor and nominal value (or the face value) of the bond is the interest. The interest as a percentage of total value is called interest rate. 7

9 MONEY IS A TYPE OF BOND What is money? Money is a bond with zero interest rate and zero (immediate) maturity. The counterparty to the party that holds the money is the government (Government of the People s Republic of Bangladesh, the U.S. government, etc). Money is a liability of the government s central bank. 8

10 TYPE OF BONDS Short-term bond: Bonds of maturity less than one year. Long-term bond: Bonds of maturity more than one year. Pure discount bond or zero coupon bond: Only an initial payment is made by the buyer (creditor) and a final payment (nominal value) is paid by the issuer (debtor). Coupons: payments The nominal value or the face value of a bond is called the principal. 9

11 PAR VALUE OF THE BOND If the price at which the bond is trading is exactly equal to its nominal value then the bond is at par. If the bond price > the nominal value, then bond s value is above par. If the bond price < the nominal value, then bond s value is below par. 10

12 DIFFERENT TYPES IN AGENTS IN THE MARKET Households: A household may want to borrow or save. Non-financial corporations: Non-financial corporations may want to borrow to investment in structures, equipment, or intellectual property. They may want to lend or hold financial assets. Financial institutions: Insurance companies, pension funds, mutual funds, pension funds, leasing companies, banks, and so forth. Governments (central, state/provincial, or local) may want to finance public expenses and projects when tax revenues are insufficient to meet government expenditures. Other government may have surplus. Not for profit institutions: NGOs, not for profit universities, charities. Rest of the world: Foreign central banks, foreign corporations, foreign financial institutions. 11

13 REASONS FOR TRADING AND HOLDING BONDS A party may want to borrow. A party may want to lend. A party may want to delay expending, save for retirement, or may want to obtain interest income. A party may want to invest, or advance consumption. Households: A household may want to borrow or save. Non-financial corporations: Invest or save. Financial institutions: Insurance companies, pension funds, mutual funds, pension funds, leasing companies, banks, and so forth. Governments (central, state/provincial, or local) may want to finance public expenses and projects when tax revenues are insufficient to meet government expenditures. 12

14 RISKS OF TRADING BONDS Credit or default risk: If the debtor does not meet the promise of payment then the debtor has defaulted. This is called a credit risk or default risk. Inflation risk: Even if the amount to be repaid is fixed and repaid accordingly, its purchasing power may decline. This is inflation risk. Liquidity risk: The bond may not be liquid. That is, it may not be easily traded. This is known as liquidity risk. The bond older may face a loss if forced to sell the bond prior to its maturity. Other types of risks: market risk, exchange rate risk. 13

15 STOCKS A security that give the owner the right to an ownership share in a firm and a right to a proportional share of its (distributed) profits. Stocks do not expire. However, a firm can incur losses, become bankrupt, and shut down! Most stocks can be traded, some publicly (that is in a stock exchange), and some privately. Stocks can provide either a positive or a negative return. Return of the stock = ([Capital gain]+[dividends])/[purchase Price of the Stock]) Capital gain = Selling price initial price. 14

16 HOW ARE STOCKS DIFFERENT FROM BONDS Stocks are generally more riskier than bonds. Historically U.S. stocks have on average paid a higher return than the interest rate paid by bonds. Stock is a claim to the ownership of a business. It usually confers the right to vote in the company s annual general meeting, and so forth, whereas a bond merely establishes a financial obligation of the borrower to the lender. 15

17 GOING SHORT OR LONG Different investors have divergent views on a company s prospects. An optimistic investor may want to buy a stock, while a pessimistic investor may want to sell a stock. Suppose a pessimistic investor does not own the stock but wants to speculate the price will decline. She can engage in short-selling. She can still bet on her view by borrowing the stock from someone who owns and selling it. If the price of the stock does drop, the short-seller buys the stock at a lower price and return it to the original investor. If the price drops (rises), she makes (loses) money. Short-selling is not just confined to stocks. 16

18 DERIVATIVES Derivatives are financial instruments whose payoffs depends on the value of another financial instrument or variables, such as the price of a stock, the price of a bond, an exchange rate, and so on, called underlying. Example: Alpha will pay Beta $100 if the stock price of Z Fisheries is above $50 in six month, while Beta will pay $10 today to Alpha. Usually in a derivative contract, the profit of one party will be the loss of another party. It is a zero-sum game. 17

19 FUTURES & FORWARDS Futures and forwards are contacts by which one party agrees to buy (sell) the underlying asset in a future, predetermined date at a predetermined price(s). In forward contract, the exchange of money and assets occur only at the final date. Future contracts are more complicated. The date at which exchange takes place is called maturity. The price to be paid at maturity but agreed today is called the futures price or the forward price. The current market price is called the spot price. The party the accepts the obligation to buy take a long position, while the party that accepts the obligation to sell take a short position. 18

20 FORWARD PRICE AND SPOT PRICE: NOTATION F(t) is a forward price agreed upon at the present time t for delivery at maturity time T. S(t) is the spot price at t. At maturity time T, the investor with the short position will have to deliver the good/asset current priced at S(T). The payoff for the short-side of the contact is: F(t)-S(T) The payoff for the long-side of the contract is: S(T)-F(t) The sum of the payoffs is equal to 0, which means that this is a zerosum game. 19

21 MARKING TO MARKET Futures are marked to market. This means that both parties of the contract must keep a cash account whose balance will be updated on a daily basis, depending on the future prices in the market. Marking to market is a way to ensure that both parties of the contract are able to cover their obligations. 20

22 REASONS FOR TRADING FUTURES Hedging Speculating Futures provide embedded leverage 21

23 OPTIONS An option is a security that gives its owner the right to buy or sell another underlying security at or before a future predetermined date for a predetermined price. An owner of an option is not obliged to buy or sell, unlike the case of parties to forward and futures contract. The option that provides its owner the right to buy a security is called a call option. The option that provides its owner the right to sell a security is called a put option. American option: If the option gives the right to buy or sell up to (and including) a given date, it is called an American option. European option: If the option gives the right to buy or sell on a given date only, the option is called an European option. 22

24 MORE DETAIILS ABOUT OPTIONS Exercising an option: buying or selling the underlying security using the option The expiration date or the maturity of option The strike price or the exercise price The decision to exercise an American option prior to its maturity is called an early exercise. 23

25 CALLS & PUTS: BUYER AND WRITER Buyer: the holder or the owner of the option Seller: the writer of the option. 24

26 CALL OPTION PAYOFF Consider a European option with maturity date T, providing the right to buy security S at maturity T for the strike price K. S(t) is the spot price of the underlying security at t. If S(T)>K, the holder will exercise the call option. If S(T)<K, the holder will not exercise the call option. The payoff of the European call option for the buyer is: Max[0,S(T)-K]= [S(T)-K]+ 25

27 CALL OPTION PAYOFF AT EXERCISE TIME Source: Cvitanic and Zapatero (2004) 26

28 PUT OPTION PAYOFF Consider a European put option with maturity date T, providing the right to sell security S at maturity T for the strike price K. S(t) is the spot price of the underlying security at t. If S(T)<K, the holder will exercise the put option. If S(T)>K, the holder will not exercise the put option. The payoff of the European put option for the holder is: Max[0,K-S(T)]= [K-S(T)]+ 27

29 PUT OPTION PAYOFF AT EXERCISE TIME Source: Cvitanic and Zapatero (2004) 28

30 IN THE MONEY AND OUT OF THE MONEY In the case of call when the underlying stock prices is larger than the strike price S(t)>K, the option is in the money. If S(t)<K, the call option is out of the money. When the underlying stock and the strike price are equal, S(t)=K, the call option is at the money. When the call option is in the money, the amount S(t)-K is called the intrinsic value of the option. For a put, it is in the money if the strike price is larger than the stock price, K>S(t), out of the money if K<S(t), and at the money, when K=S(t). When it is in the money, the put s intrinsic value is K-S(t). 29

31 OPTION PRICES Two parties: (1) the holder (buyer) has a right, and (2) the writer (seller) has an obligation. Option price or option premium: what the holder of the option pays to the writer of the option. The pricing of an option will depends on a number of things, including the price of the underlying, the strike price and time left to maturity, and so forth. 30

32 PLAIN VANILLA OPTIONS AND EXOTIC OPTIONs Plain vanilla options Exotic options 31

33 REASONS FOR TRADING OPTIONS Hedging risks Portfolio insurance Implicit leverage 32

34 SWAPS A swap is a contact by which two parties agree to exchange two cash flows with different features. For example, an interest rate swap can be thought of as exchanging interest rates on different type of bonds. Source: Cvitanic and Zapatero (2004) 33

35 DIFERENT TYPE OF SWAPS Interest rate swaps Currency swaps The party that will receive the floating rate buys a swaps, while the party that will pay the floating rate sells the swap. 34

36 ORGANIZATION OF FINANCIAL MARKETS Exchanges: New York Stock Exchange (NYSE), Amex, London Stock Exchange (LSE), Dhaka Stock Exchange (DSE), Chicago Board of Options Exchange (CBOE), Chicago Board of Trade (CBOT), and Chicago Mercantile Exchange (CME). Over the counter (OTC) market: NASDAQ (formerly National Association of Securities Dealers Automated Quotations ) Market maker is the entity that provides liquidity in a given security or a contract. Regulators: Securities and Exchange Commission (SEC), Commodities and Future Trading Commission (CFTC). Market Indices: Standard & Poor s 500 (S&P 500), Dow Jones Industrial Average (DJIA), Russell 3000, Wilshire 6000, and so on. 35

37 MARGINS To guarantee that the investor will be solvent at maturity, margin requirements are imposed Some assets have to deposited as collateral for a given debt, so that these can be used to pay off debt Initial margin Maintenance margin Margin call Buying at margin Covered call and naked call 36

38 TRANSACTION COSTS Bid price: The price at which the dealer is willing to buy a security. Ask price: The price at which the dealer is willing to sell a security. Bid-ask spread: Bid price Ask price 37

39 SUMMARY OF LECUTURE 1 Three types of financial contracts Bonds, stocks, and derivatives. Bonds Zero coupon bonds, a coupon bond, default/credit risk, inflation risk and liquidity risk. Stocks Dividends, capital gain, short-selling, short/long position. Derivatives Future and forward contracts, options, call and put options, European and American options, swaps. Market institutions Exchanges, over the counter market, market indices, transaction costs. 38