Finance Lab 8831322338, 9788831322331

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Andrea Cerri, PhD in Management. Since 2016 he has served as Lecturer at the Department of Business Economy at Catholic University, Milan. He also teaches, since 2018, International Financial Markets and Venture capital at IES Aboard foundation, Strategic Analysis at Bicocca University, Milan, and since 2020 he holds the course of Finance Lab at the Bocconi Summer School.

www.bupbooks.com ISBN 978-88-31322-33-1

FINANCE LAB Gimede Gigante Andrea Cerri

FINANCE LAB

Gimede Gigante, PhD in Banking and Finance. Member of the Harvard Business Review advisory council, since 2019 he has served as Academic Director of the Bocconi Summer School. He has held visiting positions at the Finance Department of Columbia Business School and at the Salomon Brothers Center (Stern School of Business, NYU). Winner of the Award for Excellence in Teaching in 2015 and in 2016.

Gigante ∙ Cerri

By addressing the financial markets from a new perspective, this book sets out to take the reader on a journey, explaining the role of financial markets as places where exchanges take place to meet the needs of people, businesses and institutions. The volume is structured in four parts. The first part introduces the functions, structure, and components of the financial system. In the second part, the authors describe the functioning of the markets in terms of risk and return, providing a more in-depth description of the role of intermediaries. In the third part, capital markets are illustrated in various forms, presenting the debt market and the stock market from the accounting to the market/investment point of view. Finally, the last part presents other financial instruments as part of the whole system. This book provides students approaching the financial markets for the first time with a valuable tool that balances clarity and simplicity without losing sight of the real economy.

Foreword by

Maurizio Bernardo

FINANCE LAB Gimede Gigante Andrea Cerri Foreword by

Maurizio Bernardo

Typesetting: Laura Panigara, Cesano Boscone (MI) Cover: Cristina Bernasconi, Milan Copyright © 2021 Bocconi University Press EGEA S.p.A. EGEA S.p.A. Via Salasco, 5 - 20136 Milano Tel. 02/5836.5751 – Fax 02/5836.5753 [email protected] – www.egeaeditore.it

All rights reserved, including but not limited to translation, total or partial adaptation, reproduction, and communication to the public by any means on any media (including microfilms, films, photocopies, electronic or digital media), as well as electronic information storage and retrieval systems. For more information or permission to use material from this text, see the website www.egeaeditore.it Given the characteristics of Internet, the publisher is not responsible for any changes of address and contents of the websites mentioned. First edition: April 2021 ISBN Domestic Edition ISBN International Edition ISBN Digital International Edition ISBN Digital Domestic Edition Print: Logo S.r.l, Borgoricco (Padua)

978-88-99902-79-7 978-88-31322-33-1 978-88-31322-34-8 978-88-238-8147-1

Table of Contents

ForewordIX IntroductionXIII 1  Intro to the Financial World 1.1 Introductory concepts: functions, structure and components of financial system 1.1.1 Two sides of the same coin: lenders and borrowers 1.2 Functions, structure and components of the financial system 1.2.1 Financial markets 1.2.2 Financial intermediaries 1.2.3 Theories of financial intermediation 1.2.4 Classification of financial intermediaries

1 1 3 4 7 13 14 15

2  Interest Rates and Financial Market Risks 2.1 Risk and return 2.1.1 What is expected return? 2.1.2 What is risk? 2.2 Interest rates  2.2.1 The Present Value 2.2.2 Yield to maturity 2.2.3 Interest rates and Returns 2.2.4 The demand curve and equilibrium 2.3 Inflation rates  2.3.1 Nominal interest rates and real interest rates

19 19 20 21 22 23 26 31 32 35 37

3  The Role of Risk in Finance 3.1 Intro to risk 3.2 Market risk 3.2.1 Exchange rate risk 3.2.2 Interest rate risk 3.2.3 Price risk

41 41 42 42 43 43

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3.2.4 3.2.5 3.2.6 3.2.7 3.2.8 3.2.9

Liquidity risk Credit risk Operational risk Systemic risk Reputational risk  Country and sovereign risk

4  The Role of the Financial Intermediaries 4.1 The role of the middleman 4.1.1 Financial intermediaries as firms 4.2 The world of banks 4.2.1 The European universal bank and the American model 4.3 Retail and commercial banks 4.3.1 The balance sheet of banks 4.3.2 The profit & loss statement of banks: how they make money 4.3.3 Basic principles of banking management 4.4 Investment and corporate banks 4.5 The role of investment banks in the capital markets: the IPO process 4.5.1 Reasons for an IPO 4.5.2 Investment bank’s roles in an IPO process 4.6 The role of investment banks in SEOs and other “market operations” 4.7 What’s the future of investment banking in IPOs? 5  Debt Market 5.1 Capital markets: equity capital, liabilities and assets 5.2 The Bond market 5.2.1 Bond instruments: characteristic and types 5.2.2 The role of the financial intermediaries and mechanisms for placing bonds 5.2.3 How to choose a bond: Yield to Maturity and Duration 5.2.4 Calculating the price of the bonds 5.2.5 How to read bond info: the prospectus 5.2.6 How to trade a bond, the book and OTC contributors  5.3 A new era for bonds: Green bonds and SDG bonds 5.3.1 ESG 5.3.2 The first step: Green Bonds 5.3.3 A new frontier: the SDG bonds. The Enel case 5.3.4 SGD-linked bonds: how they work at glance 5.3.5 Rating: a new approach 5.4 The money market 5.4.1 Money market instruments 5.4.2 Money market regulators 

43 43 44 44 45 45

51 51 52 53 54 57 57 70 73 74 80 80 82 85 87

91 91 92 93 101 103 110 114 116 117 120 121 123 127 127 128 128 135

Table of Contents

VII

6  The Stock Market 6.1 What is a stock (share)? 6.1.1 Common stocks vs. preferred stocks 6.1.2 Leverage Debt to Equity 6.1.3 Investors vs. traders 6.2 Equity markets worldwide 6.2.1 The stock markets across the globe 6.2.2 The Globalization of Exchanges – cross-listing 6.2.3 Market capitalisation 6.2.4 Market cap trend: industry leadership turnovers 6.3 2020 Covid-19: a market plunge, an unusually fast recovery and the FAANG role

139 140 142 143 143 145 146 149 150 153

7  Other Instruments and Markets 7.1 The ETFs 7.2 Currencies from all over the world: the foreign exchange market 7.2.1 The Forex market  7.2.2 The exchange rate 7.2.3 Equilibrium exchange rates and foreign exchange risk 7.2.4 What can we do with the currency exchange rates?  7.2.5 The long run (and the PPP theory) and the short run

163 163 166 167 169 170 171 172

8  The Derivative Instruments 8.1 Derivative markets: commodities and financials 8.2 The Forward market 8.2.1 An example of forward trading 8.3 The futures market 8.3.1 What is a future and how does it work? 8.3.2 Stock indexes futures 8.3.3 A future trading example 8.3.4 The WTI crude oil Future and the Covid-19 effect: for the first time in history a negative price 8.4 The options market 8.4.1 An example of option trading 8.5 The swap market 8.5.1 Kinds of swap contracts 8.5.2 An example of swap contract

175 176 180 182 183 185 186 186

157

187 192 196 199 200 203

Bibliography207 The Authors

211

Foreword

This text has a precise goal: to be a helpful tool for students and also for a wider audience to introduce financial markets in an organic way, illustrating their interconnection with the real economy and with market participants. A new perspective: one step back This book approaches the financial markets from a fresh new perspective that takes the reader on a journey, explaining the role of the financial markets as places where exchanges take place to satisfy the needs of people, businesses and institutions. Starting from a macro point of view, the book zooms in to give a detailed analysis of the instruments involved in these exchanges. The balance sheet of firms or institutions provides a snapshot of the extent to which their needs are satisfied; for families we can also draw up a similar accounting sheet. The authors, tapping into their expertise, also describe some elements of accounting and balance sheet analysis in order to help the reader to find a common thread connecting the real economy and the financial markets. Financial markets very often are seen by many different market participants only for what they offer in terms of instruments, opportunities, returns or expenses. But this view is detached from the real economy and does not encompass the needs that the markets satisfy. Financial markets are something more than the sum of several instruments and asset classes, and this book gives a wider view of the role of the markets in the economy. Put another way, a market is not just a playground where you can toy with financial instruments, but a virtual market where needs meet other needs, for the well-being of the economy. What’s interesting As president of AssoFintech and former member of the Italian Parliament, I truly appreciate the effort put into this book and its usefulness at several learning stages. Today the financial community, not only students, needs people who understand the main structure and function of the markets, seen as the whole “cosmos” before addressing specific “clusters” of this world. And only after that can they focus on the small “satellites,” which is what financial instruments are. The innovation that we pursue with AssoFintech is closely linked to knowledge of the whole financial sys-

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tem, in order to give to the financial community a wider view that is not just limited to a single cluster, and to cultivate the people with the potential to introduce new innovations. Serving as President of the Finance Commission for the Italian Chamber of Deputies between 2013 and 2018, I already made every effort to implement the introduction of “financial education” in the Italian system. I saw this as a key element in the new millennium for the growth of the country and of the Italian industrial sector, in cooperation with the banking system. This goal was finally achieved with the approval of Law 17/2017. Within this framework this textbook can be a strategic element to disseminate knowledge of the basics of the financial markets. This systemic dissemination can be achieved, and the challenges of the new millennium confronted, only with a new approach that brings knowledge of the financial markets to everyone, overcoming the old idea that finance and financial markets are something “only for banks and a select few.” Structure The text is divided into four parts. In the first section, Chapter 1, there are some introductory concepts about the functions, structure, and components of the financial system. This section also presents several kinds of financial intermediaries and the roles they play as the middlemen who make the markets work. In the second part, Chapters 2, 3 and 4, the authors introduce how the markets work in terms of the concept of risk and return, giving a deeper description of the role of intermediaries. In the third section, Chapters 5 and 6, the capital markets are described in their various forms, with the presentation of the debt and equity markets, from an accounting to a market/investment point of view. In the fourth section, Chapters 7 and 8, other financial instruments are discussed as part of the whole system, underscoring how they help businesses, institutions and people to satisfy their needs. Audience This book is designed and structured for students who are approaching the financial markets for the first time. It is very useful tool that balances clarity and simplicity, giving them a step by step approach from macrostructure and mechanisms to details of market instruments, without losing touch with the real economy. Moreover, as described above, this book is also for people from professionals to practitioners to those with a variety of backgrounds – anyone who wants to strengthen or simply refresh their knowledge about the financial market, its role and its structure, avoiding an approach that is overly specialized or monothematic. For many people from different cultural and professional backgrounds and roles, this book can help them understand something more about what they do every day,

Foreword

XI

that is, ignore what’s behind what they purchase as an investment or how the system can finance their needs. In the step-by-step approach offered here, they can also learn and understand more about what options they might pass up on, simply due to fear or lack of knowledge, as is often the case for derivative instruments, for example. As far as I am aware, there are few texts available that can help readers who do not already have a strong background in the understanding of the market system as a whole and which, at the same time, delve in-depth into financial instruments, with basic examples that clarify the theory. This book differs from other texts on investments, financial markets and so forth in a number of ways. 1. It recognizes that financial markets are not just a way to make money, and it analyses the market from the perspectives of a number of disciplines. Many investment texts are based solely on financial economics; many others are highly specific about the technicalities of the instruments, very often addressing professionals who want to become experts. The present text does not separate the financial markets into independent and non-correlated clusters. Instead, it starts from a broad perspective that combines accounting, corporate finance, macroeconomy and then refocuses the analysis in detailed chapters only in a second step, once the basics have been already presented. 2. This book uses less mathematics and fewer formulas than many other texts. Although mathematics can provide rigor, it can also be a communicative hurdle that scares many beginners. Some readers find mathematics inaccessible, and can lose sight of the fundamental principles by being distracted by mathematical difficulties. In addition, the book is illustrated, and numerical examples make it easy to understand. 3. This book attempts whenever possible to bring the most recent evolution of the financial markets into the discussion (for example the ESG bond, with a detailed report of the world’s first issuance) so that readers become acquainted with ground breaking ideas in terms of sustainability, topics that are also affecting the financial world and financial instruments. 4. The text recognizes that the financial market is about needs. That is not only for the people at the top, but for everyone in excess or in lack of money who is looking for a smart and efficient solution. 5. The text has an international approach, while many textbooks available today are US-market oriented. There is much more emphasis instead on the fact that nowadays the evolution of financial markets and financial instruments also helps domestic-regional investors to enter markets that would normally not be accessible for them. In addition, international players can improve their balance sheets thanks to the financial markets. In conclusion, I can sincerely say that I hope this book will represent a very useful instrument for a wide audience to approach finance in a more constructive way, helping them to understand the basics behind something that seems quite common but,

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very often, still has a “dark side.” My hope is that, with this approach to teaching about the financial market, with insight from several disciplines, students will enjoy their course, and that many other non-students can use their non-academic way of learning something more about the market. In the end, I hope this book will provide the financial education that everyone needs. Maurizio Bernardo President of Assofintech Italia

Introduction

What does the word “finance” convey to you? The term arouses many feelings in people, both positive and negative. Sometimes it is also associated with a world of fear; sometimes it is interpreted as gambling. Whatever the case, finance as it is most commonly used in the world has a predominantly cynical meaning: the science of making a profit through improper behaviour. This is partly due to the negative events of the past. Simply consider the numerous financial crises, especially in 2008-09, which were related to the infamous sub-prime mortgages and toxic assets like ABS (asset-backed securities).1 But who knows, for example, what “sub-prime”2 refers to? And what is a derivative anyway?3 Our society’s prevalently low level of financial culture means financial markets are demonized. But in reality, finance is much more than this general perception, which brings us to the primary objective of this book: to make closer contact with the financial world. We will do this by addressing some issues that are often taken for granted, and by describing some interesting things that occur in everyday life that we need to pay more attention to. In its broader meaning, finance is first and foremost a science. It has a theoretical framework built by scholars over time, which is in continuous evolution. However, this science is also a profession: who hasn’t seen The Wolf of Wall Street?4 Thousands of individuals choose this path in their working life as an expression of their inclinations and skills. Yet finance is also an art, meaning the financial markets are an art exhibition where people, businesses and institutions satisfy their needs while following the proper guidelines (although to be honest, this is not always true). This book aims to demonstrate how even something as complex as finance and the financial system can represent a positive expression of the capabilities of human beings.

1  ABSs are debt securities whose payments of principal and interest derive from cash flows generated by separate pools of assets. 2  Subprime refers to borrowers or loans who have poor credit ratings. 3  Derivatives are financial instruments that “derive” their value from other underlying assets, as presented in section 6.2. 4  Film directed by Martin Scorsese with Leonardo Di Caprio (2013). Introduced to life in the fast lane through stockbroking, Jordan Belfort takes a hit after a Wall Street crash. His career terminated following Black Monday, the largest one-day stock market drop in history. Thanks to his aggressive pitching style and the high commissions, Jordan makes a fortune. And a style of life.

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Our aim is not just to provide a deep analysis of the financial markets, instruments, rules and mechanism adopted by traders for better results in their work. The ultimate goal of this book is to offer a coherent view of finance to ensure a less distorted and more balanced assessment of its role in everyday life. To achieve this objective, we move step by step from the basic needs of individuals and firms to the general concept of the financial markets, instruments and systems. We will give readers a better understanding of how finance is very closely related to our everyday life and business, as well as the institutions that govern our live. We use this approach precisely to ensure that we consolidate the three aspects of finance we previously mentioned (science, profession and art); our point of reference will be the financial system. In particular, we will explore this system both in general terms, as an essential infrastructure for the economic system, and in specific terms relating to its own structure and functioning. A financial system is the heart of a country’s economy, facilitating its function. Indeed, the financial system is what makes the economy working better. From an institutional point of view, the system can be seen as a complex set of subjects and structures, including intermediaries, markets, financial instruments, regulations and supervisory authorities. The financial system performs several functions from payment collection to fund management, from investment financing to risk management. Because of these many functions, the financial system cannot exist per se. Instead it is closely linked to the economic system and the political-social system. The economic system is the set of institutional sectors5 of the economy which operate on the basis of the range of goods and services. The political-social system, on the other hand, is the set of national and supranational authorities characterized by the pursuit of general interests. So it is easy to see a strong link between these three interdependent systems, which help to ensure adequate governance of the real economy. Within this broader framework, the financial system carries out four main functions: 1. 2. 3. 4.

the transfer of financial resources; the provision of payment methods; risk management and coverage; the transmission of monetary policy initiatives.

The transfer of financial resources coincides with the credit function, ensuring the connection between surplus and deficit units of funds – the central focus of this book. The credit mechanism is fundamentally important as it satisfies the investment needs of people with excess resources by facilitating the transfer of this capital to people in need of additional funding.

5  “Institutional sectors group institutional units which have a similar type of economic behaviour.” (Source: Eurostat.)

Introduction

XV

The function of providing payment methods is closely linked to the need to facilitate trade in goods and services. This too is handled by the financial system, which uses banking intermediaries and a complex support infrastructure: the payment system. Goods and services are mainly paid for through the different currencies used in countries across the globe. The financial system also enables cross-currency trades thanks to the Foreign Exchange Market (FOREX).6 In order to ensure the proper functioning of the payment system, an entity is needed to ensure the issuance and the circulation of money and currencies. In particular, the function of materially issuing currency is attributed to the central banks, while the regulation of trade is carried out through special instruments embedded in the payment system. Risk management and coverage are the natural consequences of the operations conducted by various intermediaries who are forced to take on numerous risks. Examples include failure to repay loans and securities, asymmetric information7 and inevitable price fluctuations. In light of this, a middleman is needed to manage both speculative risks (involving the possibility of losses and gains) and pure risks (losses only). This middleman is exactly what the financial system represents, taking different forms and modalities depending on the risks in question, and playing an essential role for the financial community. Finally, the transmission of monetary policy initiatives arises from the need to have a medium capable of implementing relative interventions throughout the economic system.

6   Forex, the largest money market in the world, is where foreign currencies are traded. We will present it in section 6.3. 7  In financial markets one party often does not know enough about the other party to make accurate decisions. The Lack of information creates problems in the financial system both before and after the transaction is entered into. If the problem occurs before the transaction is called “adverse selection”; if the problem takes place after the transaction the problem is called “moral hazard.”

1  Intro to the Financial World What you will learn in this chapter: • What your personal/family balance sheet (BS) is, and what a firm or bank’s balance sheet looks like; • Why we need an efficient and functional financial system; • What the main functions of a financial system are; • What the key features of financial intermediaries and financial markets are; • Who uses the financial system and what main benefits they gain; • What risks you might face in the financial world.

In this first chapter the aim is to find an initial answer to several questions about financial markets. Before we begin to sail together among the waves of the financial sea, we have to clarify some basic concepts. That’s why our journey into the financial system begins with a brief analysis of the Balance Sheet (BS) structure of the several “players” that we meet along the way. We have to be well-prepared for the unpredictable waters ahead by having total control of our tools. As a result, this is not just an academic book for an accounting course. We try to present some basic concepts in practical way to help you see why finance exists, what we trade in the financial markets and why the financial system is a cornerstone of every society. Once you understand the basic terms, we will take a deep dive into the financial system and its functions. For the purposes of this book, a sort of “sail around the financial world” we could define “financial system” as a set of markets where individuals, business entities and institutions – with too much or too little money – trade “paper versus cash.” These trades, which follow certain rules, under the supervision of markets regulators, satisfy the need to lend or to borrow.

1.1 Introductory concepts: functions, structure and components of financial system In the everyday life, as individuals, family members, entrepreneurs or as a part of a business or institution, it is necessary to satisfy many different needs, from primary goods and services to more complicated ones. To fulfill these needs people may find themselves in a situation with a lack of money, or the opposite, with an excess of money, with no idea how to reinvest this surplus. Now let’s talk about the number one financial accounting tool that helps us have a snapshot of financial balances of an individual or organization: the Balance Sheet (BS). It is clear that BSs are compulsory for business entities and institutions, and have precise, mandatory rules. But sometimes we hear about the family balance sheet or situation, or a personal balance sheet. To get a sense of what a family/indi-

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vidual balance sheet is and how it differs from a business’ BS, let’s look at Tables 1.1 and 1.2. As we can see, for businesses and for some institutions, there is an Equity section in the right column, which represents the book value of the corporation. In this section we find the “capital,” that is, the ownership of the corporation. At “t-zero” the shareholders establish the corporation by injecting a certain amount of money to run the business. Consequently, they receive a sort of “ticket,” or a share, which represents a percentage of ownership in the corporation proportionate to the invested

Table 1.1

An example of a personal/family balance sheet

Assets

Liabilities

House(s)

House mortgage

Car(s)

Leasing contract*

Bike(s)

Student loan

Cash (and bank accounts)

Account overdraft

Financial investments

Debt to mum and dad

Business participation(s)

Bank loan

* accounted accordingly to the local GAAP.

Table 1.2

An example of a business balance sheet

Assets

Equity

Current Assets

Capital

Cash and cash equivalent

Retained earnings

Marketable securities

Other comprehensive Income

Accounts receivables

Liabilities

Inventories

Current Liabilities

Other financial investments

Accounts payable

 

Notes and loans

Noncurrent Assets

Commercial papers

Property, plant and Equipment (net)

 

Long-term securities

Noncurrent Liabilities

Participations

Long-term debt (i.e. bonds)

Intangibles and other assets

Long-term loans

1  Intro to the Financial World

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value in the firm. In order to finance business operations, the firm uses the assets provided with equity, but that won’t be enough. If the firm’s operations produce a positive margin (in the Profit and Loss Statement, Revenues are higher than Expenses, scoring a positive Net Earning) and, more important, if the Operating Cash Flow can produce new cash flows (see Table 1.3), there would be an extra amount of undistributed cash to reinvest in the business (accounted as: positive assets and positive retained earnings). In the same way in the family/individual Profit and Loss (P&L) Statement, if the revenues/cash in-flows from salaries and other sources are higher than expenses/cash out-flows, there will be “savings” that could be reinvested. Table 1.3

The link: from P&L to Cash Flow

P&L Statement

Cash Flow from Operations

Revenues

Profit

– Expenses: – materials

+ Depreciation

– services

+ Amortization

– rents

+ Impairment expense

– amortisation

+/– Change in working capital

– depreciation

+/– Change in provisions

– interests – taxes =

=

Net Earnings (Profit/Loss)

Operating Cash Flow

Clearly, the Cash Flow from Operations is sometimes negative, eroding the availability of cash, and sometimes positive, but the total cash available is not enough for new investments in assets or net working capital. That’s the reason both individuals/families and businesses/institutions try to finance their assets by issuing new liabilities. These can take several forms such as a banker loans, house mortgages, notes and bonds, certificate of deposits and other short-term or long-term liabilities. 1.1.1

Two sides of the same coin: lenders and borrowers

When people, or firms or institutions, are in lack of money, they need to find a source of funding. This new source of funding can come from other people who have excess money. This means there is a borrower and there is a lender. These two parties could set up an agreement that satisfies them both: the lender gives (at the beginning of the

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agreement) some money to the borrower and the borrower will give this amount back to the lender (at the end of the agreement) plus an extra amount, in order to compensate the fact the lender gives up the chance to use that amount of money for a certain amount of time. Here are some frequently asked questions: • Why should someone lend money to someone else? Why wouldn’t they spend their available cash on something for themselves? Do people lend money for free or is there a return on lending? • Who is the counterparty in a borrower-lender relationship? Is this relationship direct or indirect? • Where can lenders and borrowers exchange this stream of cash flow? • What do lenders receive in exchange for their investment? • Is this lending activity free of risk or subject to risk? These questions, which we will investigate in the following chapters, lead to a better understanding of the financial system as one of the pillars of today’s society. Studying the financial system, which is made up of several kinds of markets, will prepare us to sail around the world of finance in two different directions: either trying to find new resources when money is lacking or investing when there is extra money. But in the financial markets, the participants do not only exchange money for capital or liabilities; they can also buy and sell and commodities. So, let’s start this journey by defining some basic terms.

1.2 Functions, structure and components of the financial system What is a market? This is the first question to ask. Before going straight into the financial markets, we want to go back to the Roman Empire. When you need something and you can’t produce it yourself, you could acquire it from a third party. A place where different parties engage in the exchange of their excess goods or services is called a market. In the past, a market was a physical place, but now it can be either physical or virtual. At the dawn of humanity, bartering was used to exchange goods, work, or services. The first known currency in the Western world was created around 600 BC by King Alyattes in Lydia,1 which today is part of Turkey. Trajan’s Market (Latin: Mercatus Traiani) is a large complex of ruins in Rome that is the world’s oldest shopping mall. Here and in other Roman markets customers could purchase what they needed directly from the producer (direct finance) or from a dealer, who was simply a middleman (indirect finance). In fact, in the Roman Empire there was a huge system of markets and trade that allowed inhabitants of every province to acquire goods

1 

See Encyclopaedia Britannica, “Origins of Coins.”

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from other places. Intermediaries made this possible by purchasing products from different areas and delivering them to local dealers. Thanks to this system of linked local markets and importers/exporters, Roman citizens could obtain goods from places such as North Africa, without having any direct contacts with local producers. It is possible to say that the Roman Empire was primarily a market economy. Parts of this economy were very distant from one another, and they were not connected like today’s markets, but they still functioned as part of a comprehensive Mediterranean market.2 Nowadays, financial markets and the financial system are quite similar to the Roman model. On one side there are people, businesses and institutions that lack money; on the other side, there are people, businesses and institutions who have excess money. Both groups need to find the most efficient, safest and cheapest way to make their “exchange.” Motivated by a desire to lend or borrow, they may decide to do so in three different ways: 1. directly with the counterparty; 2. indirectly, via intermediaries (privately); 3. indirectly, via financial markets (publicly). Previous question: Who are the counterparties in borrower-lender relationships? Are these relationships direct or indirect?

“Direct finance” trades are one-to-one between counterparties with no filters. The transaction is tailor-made, but it could be risky and inefficient. Typically, lenders and borrowers decide to use financial intermediaries or one or more organized markets. In these markets, lenders buy liabilities issued by borrowers. Here the newly-issued securities (capital and liabilities) can be exchanged, with the issuer receiving funds directly from the lender. This is called the “primary market.” Another option is trading already-existing shares on the so-called “secondary market.” In this situation no funds are channelled to the issuer; instead lenders simply buy an existing liability from other lenders. Alternatively, borrowers and lenders may decide to make their exchanges via institutions called financial intermediaries. A lender with excess money opens a deposit account at the intermediary (if the intermediary is a bank) or the same bank of the chosen financial intermediary (if the intermediary is not a bank). The intermediary uses this money to offer borrowers a loan or reinvests it by purchasing other assets (liabilities issued by other borrowers). Intermediaries can also make use of markets by issuing securities to finance some of their activities like loans and mortgages or buying shares and bonds as part of their asset portfolio. The two ways are described below in the Figure 1.1.

2  See P. Temin, A Market Economy in the Early Roman Empire, Massachusetts Institute of Technology, Department of Economics, Working Paper 01-08, February 2001.

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Figure 1.1

From savers to spenders, how the market works direct finance

indirect finance Ultimate Lenders (Savers)

indirect finance Financial Intermediaries

Financial Markets

Ultimate Borrowers (Spenders)

ce

nan ct fi

v

t

rke

a ia m

dire

So we can say that the financial system facilitates the flow of funds between lenders and borrowers. A financial system: • channels funds from lenders to borrowers; • creates liquidity and money; • supplies a payment mechanism; • provides financial services such as insurance and pensions; • offers portfolio adjustment facilities.

Following the Roman Empire example, we can explore the other features and roles of the financial markets and system. Let’s take for example a trade to purchase cotton used by the Roman Empire which was produced mainly in Egypt and India.3 How could Roman citizens purchase cotton from India? How could they trust the producer as far as the quality and basic properties of fabric? Moreover, Rome and India were two different worlds with no common currency or language, which led to a lot of informational asymmetries. So from the times of the Roman Empire there was a need for financial intermediaries to help investors (lenders) and borrowers to reduce information asymmetries. In today’s world, dominated by an increasing level of complexity, risk adverse investors probably won’t invest directly with counterparties they don’t know. Instead 3 See E.H. Warmington, The Commerce between the Roman Empire and India, Cambridge, Cambridge University Press, 2014 [1928].

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thanks to the screening activity, positive feedback and assurances offered by a financial intermediary, the investor would consider the same investment less risky. Furthermore, through the financial system there is an opportunity to purchase goods denominated in a different currency and to use innovative systems of payment. Businesses and institutions can issue liabilities outside the borders of their own country, and investors can lend money to counterparties all over the world. After understanding the important roles of the markets and intermediaries in our lives and in the financial world, the questions are: • Which types of financial markets are there? • Who are these middlemen, or financial intermediaries and how can they help us?

1.2.1 Financial markets The financial markets are highly complex systems for exchanging financial instruments in both a physical and virtual way (i.e. remotely exchanging real instruments through a computer, not virtual instruments). There are different types of financial market classifications which vary based on a number of factors. Primarily, depending on the economic nature of the financial instruments in circulation there, financial markets are divided into securities markets and credit markets. In securities markets there is a direct link between surplus and deficit units in which bonds, stocks, options and other kinds of securities are traded. Securities are standardized financial instruments (i.e. their traded quantity and prices are uniform), but in over-the-counter markets non-standardized securities are also traded. In contrast, credit markets are indirect systems that function through financial intermediaries. The exchanges that take place in credit markets are better adapted to the specific needs of the operators; in a sense they are bespoke agreements. A further important classification of financial markets consists in the primary market, in which newly-issued financial instruments are traded, and the secondary market, involving the buying and selling of previously-issued financial instruments which are already in circulation from the original issuance in the primary market. In a primary market, new issues of securities are sold to initial buyers by a corporation or government agency with the help of a bank or some other financial intermediary. This market cluster is usually only for professionals like investment banks who handle these transactions by underwriting securities. In a secondary market, the original firms – the issuers – don’t get any money: the issuers raise funds in the primary market selling the securities, in the secondary markets the holders exchange these securities without interactions with the issuer.4 But this market still serves two essential functions. The first is providing liquidity by making it easy to buy and sell the securities of companies, which also facilitates their issue in the primary market. The second important function is establishing a price for these securities day by day 4 

Except when the issuer in involved in buy backs or trading of treasury shares.

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(the market value of the issuing firms); meanwhile brokers and dealers link buyers and sellers. If the maturity5 of the financial instruments is taken into account, we can identify two different markets: the money market, where short-term debt instruments are traded with average maturities of one year or less; and the capital market, used for medium to long-term financial instruments with a maturity of more than one year (or no maturity, like equity). Finally, the legal framework regulating traded financial instruments draws a distinction between the bond market (debt market), the stock market (equity market) and the derivatives market, where commodities and financial instruments are traded indirectly on four sub-markets: the futures market, the options market, the swap market and the forward market. Concerning the nature of trading, there are two types of platforms. Organized physical markets are represented by a physical location where transactions carried out (like the NYSE6); instead on virtual markets or over-the-counter (OTC) markets (like NASDAQ7) trades are made electronically through remote connection via a network of computers. There are also Alterative Trading Systems (ATSs)8 and Multilateral Trading Facilities (MTFs),9 used among institutional investors, that allow buyers and sellers to deal directly with each other. It is also possible to classify the markets according to the way in which trading takes place. In auction markets, this happens through intermediaries. These markets can take advantage of a call auction mechanism or a continuous auction. As an example, US Treasury bills are issued every Thursday via call auctions with com5 

“In the world of business and finance, maturity stands for the last payment date of either a loan or some other form of financial instrument. It is also known as the maturity date. On this maturity date, both the outstanding principal and any remaining associated interest are owed and expected to be rendered for final payment. If they are not paid on the maturity date, such loans or instruments are considered to be in default” (from ©2014-2020 Herold Financial Dictionary). 6  The New York Stock Exchange (NYSE, nicknamed “The Big Board”) is an American stock exchange located at 11 Wall Street, Lower Manhattan, New York, New York. It is by far the world’s largest stock exchange in terms of market capitalisation. 7   NASDAQ is an acronym for the National Association of Securities Dealers Automated Quotations, founded in 1971 by the National Association of Securities Dealers (NASD), now known as the Financial Industry Regulatory Authority (FINRA). On 8 February 1971, the NASDAQ began operations as the world’s first electronic stock market. It is currently the world’s second largest stock exchange by market capitalisation. 8   An Alternative Trading System (ATS) is a North American term that refers to a trading venue that matches buyers and sellers for transactions. 9   M.G. Cerini, Markets in Financial Instruments Directive - MiFID, Associazione Nazionale Enciclopedia della Banca e della Borsa, Working Paper n. 1, 2011. “Multilateral Trading Facilities (MTFs) is a multilateral facility operated and/or managed by an investment firm or market operator ‘[...] which brings together multiple third-party buying and selling interests in financial instruments [...] in a way that results in a contract in accordance with the provisions of Title II [of Directive 2004/39/EC.].’ In the same way, the Italian Consolidated Law (TUF) states that ‘[…] management of multilateral facilities that allows, in the system and in accordance with non-discretionary rules, the meeting of multiple third-party buying and selling interests in financial instruments, so as to generate contracts (article 1, paragraph 5-octies).”

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petitive and non-competitive bidding. In the Italian Stock Market (MTA10) and the NYSE, a call auction is used during the opening (opening call auction) and closing phases, while during the day trading takes place through a continuous auction. In the following Box 1.1, 1.2 and 1.3 it is described how NYSE, NASDAQ and Treasury Auctions work. Box 1.1 Trading at the NYSE The official opening time for the NYSE is 9:30 a.m. EST, and closing time is 4:00 p.m. EST. Orders to buy and sell securities can be entered as early as 7:30 a.m. The two types of orders that are accepted before the market officially opens are Market on Open (MOO) and Limit on Open (LOO). MOO orders seek to purchase shares at the current market price at the time the market opens. LOO orders seek to purchase a specific number of shares at a specific price when the market opens. If the requested price is not met, the trade does not take place. The first data stream of the new trading day includes a reference price for each security. This price generally matches the previous night’s closing price. The data stream also includes data regarding the current imbalance between buy and sell orders and prices. In the opening auction, for the final ten minutes before the market opens, data is published every 15 seconds. Beginning at 9:28 am, the likely opening price for each security is added to the published data stream. Orders placed between 9:28 a.m. and 9:35 a.m. cannot be canceled. At the end of the trading day, a closing auction takes place, which is somewhat similar to the opening auction. Orders can be placed as early as 7:30 a.m. (the same as the opening auction). Dissemination of trade imbalance information begins at 3:45 p.m. Every five seconds from this time until 3:59:55 p.m., information about trading volume, matching trades, trade imbalances, and pricing is released. At 3:58 p.m., MOC and LOC orders are final and can no longer be canceled. At 4:00 p.m., the market closes for the day. Source: https://www.nyse.com/publicdocs/nyse/markets/nyse/NYSE_Opening_and_Closing_Auctions_ Fact_Sheet.pdf

In dealer markets, like the NASDAQ in the US, prices depend on the quotations from dealers, financial operators who “make” the market by engaging in buying and sell-

10  “MTA (Mercato Telematico Azionario) is the Italian Market where shares, convertible bonds, warrants and option rights are traded. It is dedicated to mid and large-size companies that meet the highest international standards. MTA supports companies in raising domestic and international financing from institutional and professional investors on the one hand, and from retail investors on the other. It has always registered high liquidity performances. Companies are admitted to MTA according to both formal and substantial requirements. Among the formal requirements, a capitalisation of at least 40 million euros and a free float of at least 25% (35% for STAR companies) are required. The substantial requirements also include having a sound and clear strategy, a good competitive advantage, a balanced financial structure, the management autonomy and all of the aspects, which contribute to improving the company’s ability to create value for the investors. The adoption of the so-called Codice di Autodisciplina (Corporate Governance Code) is recommended to all companies listed on MTA on a ‘comply or explain’ basis. STAR companies are requested to comply with specific governance requirements.” See https://www.lseg.com/areas-expertise/our-markets/borsa-italiana/equities-markets/raisingfinance/mta.

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ing financial instruments continuously: this kind of market is also called a “quotedriven market.”11 Box 1.2 Trading on the NASDAQ The NASDAQ is a computerized marketplace; stocks are traded from 9:30 a.m. to 4:00 p.m. EST. Prices for the opening are determined through an auction process, with buyers and sellers placing offers and counteroffers until prices match, resulting in a trade. The objective of the opening cross process12 is to achieve maximum execution by getting the greatest number of shares of a given security to trade at a single price. But the process is not as simple as it sounds. At the NASDAQ, the opening auction uses what’s called the cross process, which gives all investors access to the same information and ensures their orders get the same treatment. This brings fairness and transparency into the marketplace. It also efficiently matches buyers and sellers to ensure liquidity, and market liquidity in turn allows investors to sell quickly if necessary. The opening cross gives investors the confidence that the quoted price fairly reflects supply-anddemand conditions within the first minutes of the trading day. Many retail and even professional traders won’t execute orders too near the open or close of a market, especially with market orders, fearing volatility to either the upside or downside. The opening cross is an attempt to limit such volatility by providing adequate information. In addition, the opening cross consolidates all these requests and makes the resulting data electronically available to market participants. At the NASDAQ, from 4:00 a.m. EST on trading orders can be placed; at 9:25 a.m. EST the market opens/enters quotes for participants with no open interest; at 9:28 a.m. EST the dissemination of imbalance information begins and at 9:30 a.m. EST the Opening Cross takes place. In the afternoon, for the closing auctions, at 3:50 p.m. EST the dissemination of imbalance information begins and at 4:00 p.m. EST the Closing Cross occurs. How does the cross-auction work? The Opening and Closing Cross threshold are greater than $0.50 or 10%. The latter is utilized to calculate a price range for the Cross. To establish a price range, 10% of the NASDAQ Best Bid and Offer (QBBO) Midpoint (with a minimum of $0.50) is added to the NASDAQ Offer and subtracted from the NASDAQ. For example, if the bid/offer is $10.00 x $11.00, then the midpoint equals 10.50 and the threshold value is 10%: 10% x 10.50 =1.05. This value is then added to the offer and subtracted from the bid to obtain the Cross’s threshold range: • Bid: $10.00 – $1.05 = $8.95 • Offer: $11.00 + $1.05 = $12.05 Therefore, in this example the Cross can occur within the price range of $8.95 and $12.05. This means $8.95 is the lowest price and $12.05 is the highest price for the Cross. The threshold range is dynamic; as the NASDAQ Best Bid and Offer (QBBO) changes, so does the threshold price range. Source: http://www.nasdaqtrader.com/Trader.aspx?id=OpenClose

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  Market in which an automated system posts firm stock quotes of the dealers, who place equivalent buy limit orders and sell limit orders. 12  The opening cross is a method that Nasdaq uses to determine the opening price for each stock. This method accumulates data on the buy and sell interest from market participants before the market open. Usually the cross trade is a practice that offsets orders (bid and ask) for the same asset without recording the trade on the exchange and it is not permitted on most major exchanges. Nasdaq makes this information available to all investors, ensuring them the same treatment. This also ensures liquidity.

1  Intro to the Financial World

Box 1.3 How Treasury Auctions Work Marketable securities can be bought, sold, or transferred after they are originally issued. The US Treasury uses an auction process to sell these securities and determine their rate or yield. Annual auction activity: • offers several types of securities with varying maturities; • conducted 322 public auctions in 2019; • issued approximately $11.806 trillion in securities in 2019. To finance the public debt, the US Treasury sells bills, notes, bonds, Floating Rate Notes (FRNs), and Treasury Inflation-Protected Securities (TIPS) to institutional and individual investors through public auctions. Treasury auctions occur regularly and have a set schedule. There are three steps to an auction: announcement of the auction, bidding, and issuance of the purchased securities. Announcement You can find out when Treasury securities will be auctioned by viewing the recent announcements of pending auctions. Once an auction is announced, your institution may submit a bid for the security. You may bid directly through Treasury Direct (except for Cash Management Bills), TAAPS (with an established account), or you can make arrangements to purchase securities through a broker, dealer, or financial institution. The auction announcement details: • • • • • • •

Amount of the security being offered; Auction date; Issue date; Maturity date; Terms and conditions of the offering; Non-competitive and competitive bidding close times; Other pertinent information.

View upcoming auction announcements. Detailed information about US Treasury announcements is available in the Code of Federal Regulations (CFR) at 31 CFR Part 356. Bidding When participating in an auction, there are two bidding options – competitive and non-competitive. • Competitive bidding is limited to 35% of the offering amount for each bidder, and a bidder specifies the rate, yield, or discount margin that is acceptable. • Non-competitive bidding is limited to purchases of $5 million per auction. With a non-competitive bid, a bidder agrees to accept the rate, yield, or discount margin determined at auction. Bidding limits apply cumulatively to all methods that are used for bidding in a single auction. At the close of an auction, Treasury awards all non-competitive bids that comply with the auction rules and then accepts competitive bids in ascending order of their rate, yield, or discount margin (lowest to highest) until the quantity of awarded bids reaches the offering amount. All bidders will receive the same rate, yield, or discount margin at the highest accepted bid. All auctions are open to the public. The following US Treasury services are available: • TreasuryDirect accounts: Individuals and various types of entities including trusts, estates, corporations, partnerships, etc. See Learn More about Entity Accounts for full information on the new registration types. • TAAPS: Institutional Investors.

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Read the relevant  auction regulations  and the  Treasury Securities Offering Announcement Press Release to find out if your institution may participate. Issuance • On issue day, Treasury delivers securities to bidders who were awarded securities in a particular auction. In exchange, Treasury charges the accounts of those bidders for payment of the securities. • Treasury bills are issued at a discount or at par (face amount) and will be paid back its par value at maturity. The purchase price is listed on the auction results press release and is expressed as a price per hundred dollars. • FRNs have quarterly interest payments and are issued with a par, discount, or premium price and a stated spread. In some cases, the purchaser may have to pay accrued interest. • Treasury notes, bonds, and TIPS are issued with a stated interest rate applied to the PAR amount and have semiannual interest payments. For TIPS, the interest payments and the final payment at maturity are based on the inflation-adjusted principal value of the security. In some cases, the purchaser may have to pay accrued interest. Source: https://www.treasurydirect.gov/instit/auctfund/work/work.htm

According to the liquidation system used in the transaction, there are two different markets. The first one is the spot market, where the time between trading and execution is very short and usually limited to the necessary technical time to finalize the deal. The second is the future market, in which the time is much longer; an example here is over-the-counter (OTC), as mentioned before.13 As far as regulation is concerned, a distinction can be made between the regulated markets, subject to an external supervisory authority (SEC14 in the US, FCA15

13  “There are two basic ways to organize financial markets – exchange and over the counter (OTC) – although some recent electronic facilities blur the traditional distinctions . . . Unlike exchanges, OTC markets have never been a ‘place.’ They are less formal, although often well-organized, networks of trading relationships centered around one or more dealers. Dealers act as market makers by quoting prices at which they will sell (ask or offer) or buy (bid) to other dealers and to their clients or customers. That does not mean they quote the same prices to other dealers as they post to customers, and they do not necessarily quote the same prices to all customers. Moreover, dealers in an OTC security can withdraw from market making at any time, which can cause liquidity to dry up, disrupting the ability of market participants to buy or sell. Exchanges are far more liquid because all buy and sell orders as well as execution prices are exposed to one another. Also, some exchanges designate certain participants as dedicated market makers and require them to maintain bid and ask quotes throughout the trading day. In short, OTC markets are less transparent and operate with fewer rules than do exchanges. All of the securities and derivatives involved in the financial turmoil that began with a 2007 breakdown in the U.S. mortgage market were traded in OTC markets.” See https://www.imf.org/external/pubs/ft/fandd/basics/markets.htm. 14   “The U.S. Securities and Exchange Commission (SEC) is an independent federal government regulatory agency created by Congress in 1934. The SEC holds primary responsibility for enforcing the federal laws, proposing securities rules, and regulating the securities industry, which is the nation’s stock and options exchanges, and other activities and organizations, including the electronic securities markets in the United States’ SEC” (June 10, 2013). From What We Do, U.S. Securities and Exchange Commission, retrieved March 24, 2017. Refer also to: https://www.sec.gov/ 15  The Financial Conduct Authority (FCA) regulates the financial services industry in the UK. Its

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in the UK and CONSOB16 in Italy), the self-regulated market, where the rules are established by the intermediaries that make them up (the multilateral trading facility, MTF), and the unregulated markets or OTCs, which are not subject to any regulation (e.g. the CDS markets). Finally, depending on the geographical area in which the markets operate, they are divided into three different levels: 1. Domestic markets, in which financial instruments issuing and trading within the single country; each domestic market is denominated by the currency of the home country. 2. Foreign markets, where financial instruments, generated by foreign issuers, are traded in other countries and denominated by the currency of the trading country. 3. International markets, where financial instruments are traded worldwide. The most developed international market is the foreign exchange market for the trading of currencies. This last representation of the financial markets is also very important because it allows us to understand the trends underlying their evolution over time. In sum, the main trends in financial markets are the transition from public to private ownership, the ongoing evolution from physical to online markets, the development of the regulatory process with the consequence that regulated and self-regulated markets prevail over OTC markets, and the rapid rise in international markets compared to domestic markets. 1.2.2 Financial intermediaries By definition, intermediation means the act of going between two parties. In the financial markets, as we have already seen, transfers of funds take place from those who have excess resources (surplus operators) to those who need them (deficit operators). As we mentioned before the transfer of funds can take place either through direct transfer, without any intermediation between the borrowers and lenders, or indirect transfer through financial intermediaries. As a broad and generic description, we can affirm that: A financial intermediary is an organization (entity/firm) that borrows funds from lenders and makes them available to borrowers on certain terms. Both parties prefer to respect these terms rather than deal directly with one another.

role includes protecting consumers, keeping the industry stable, and promoting healthy competition between financial service providers. Refer also to: https://www.fca.org.uk/ 16  “The Commissione Nazionale per le Società e la Borsa (CONSOB) is the public authority responsible for regulating the Italian financial markets.” Refer to: http://www.consob.it/

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Note that the general principle of “going between” involves more than just bringing the two parties together or introducing them to one another. In fact, delving a little bit deeper into the analysis of what financial intermediaries do, a wide range of services appear to help their customers (lenders and borrowers) with potential problems. Here are some examples: • Liquidity management: the ability to convert an asset into money for a certain value both quickly and at low cost; • Transaction cost reduction: exploiting economies of scale reduces the time and money used in carrying out the exchange of assets, goods or services. Risk sharing like: • Asymmetric information: the ability to provide information that clients might not be able to discover by themselves; • Diversification: the ability to allocate the same amount of resources in many (rather than a few); • Default risk management: the reduction of the risk that a borrower fails to pay interest or to repay the principal at the date originally specified; • Maturity transformation: the conversion of funds lent for a short period into loans of longer maturity; • Risk transformation: the reduction in risk that can be achieved by diversifying lending and by screening of borrowers. 1.2.3 Theories of financial intermediation In order to understand the reasons underlying the existence of financial intermediaries, it is necessary first of all to define the role of both information and transaction costs in the financial markets. In these markets, information asymmetry is defined as the (complete or partial) inability of the person who starts a negotiation to have a sufficient amount of information. Asymmetric information can generate two types of problems: adverse selection and moral hazard. Adverse selection arises before the transaction takes place. The borrowers with the higher default risk become less attractive to be financed, so lenders may decide to hold back funds even to creditworthy borrowers. Hence, asymmetric information could cause a market failure by blocking transactions. On the other hand, a moral hazard arises after the conclusion of the transaction. This occurs when the borrower, after obtaining the funding, takes an action that negatively affects the lender. Moral hazard increases the risk of default. By significantly augmenting the level of information between the parties, financial intermediaries help to reduce both of the problems caused by information asymmetry. So the presence of financial intermediaries can create efficient markets.

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Another important problem that arises in any economic trade is the transaction cost, which is any cost incurred in carrying out a financial transaction in terms of time and money. This can also pose problems for those who receive the funds. Financial intermediaries are able to significantly lower transaction costs due to their experience and because they can leverage economies of scale. Low transaction costs also allow intermediaries to redistribute investment risk by transforming higher risk assets into lower risk assets. In this way, intermediaries help investors diversify their portfolio. 1.2.4 Classification of financial intermediaries Financial intermediaries are one of the most important pillars of the financial system; these institutions enable markets to work and carry out a vital role in the system. But there are significant differences between the products they offer. So financial intermediaries can be distinguished according to the nature of the transactions and the main activity they perform. • Credit intermediaries systematically link surplus and deficit units. • Insurance intermediaries protect investors from the pure risks, who pay a premium for this service, calculated on the basis of statistical variables. • Securities brokers arrange and support transactions involving securities on their customers’ behalf. A widely-used distinction also splits intermediaries into depository institutions, contractual savings institutions and investment intermediaries. Deposit-taking institutions are organizations like retail/commercial banks that usually raise funds by issuing checkable deposits, saving deposits and time deposits. Later, they make commercial, consumer and mortgage loans and purchase (reinvest) in government securities. Mutual saving banks and credit unions also fall into this category. Non-deposit-taking institutions are organizations such as life insurance companies, pension funds and government retirement funds. Investment intermediaries include the above-mentioned intermediaries as well as finance companies, mutual funds, money market mutual funds and hedge funds. We can sum up the sources of funding and the primary assets in terms of use of the acquired funds as illustrated in Table 1.4. Moreover, we can describe savers and borrowers as the “ultimate lenders” and the “ultimate borrowers” as described in Box 1.4.

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Table 1.4

Sources and use of funds for each type of intermediary

Type of intermediary

Source of funds

Uses of funds

Finance Companies

commercial papers, stocks, bonds consumer and business loans

Mutual Funds

shares

stocks, bonds

Money Market Mutual Funds

shares

money market instruments

Hedge Funds

partnership participation

stocks, bonds, loans, foreign currencies and other assets

Box 1.4 Ultimate lenders and ultimate borrowers As the savers described above make their surplus available to borrowers via financial intermediaries, it is sometimes useful to refer to savers and borrowers as ultimate lenders and ultimate borrowers. This enables us to distinguish their behaviour from that of the intermediaries themselves who are also “lending” (to ultimate borrowers) and “borrowing” (from ultimate lenders) and frequently lending and borrowing among themselves. It is ultimate lenders and borrowers that we are concerned with here. • Ultimate lenders: Agents whose excess of income over expenditure creates a financial surplus which they are willing to lend. • Ultimate borrowers: Agents whose excess of expenditure over income creates a financial deficit which they wish to meet by borrowing.

Summary Financial markets are critical for producing an efficient allocation of capital, allowing funds to move from people who lack productive investment opportunities to people in lack of money for their productive activities. Financial markets also improve the well-being of consumers, allowing them to facilitate their purchases in a better and safer way. The markets can be divided and analyzed based on the kind of securities traded on it, and also the “connection” between the participants. Based on this market characteristic there are two markets: primary market and secondary market. 1. Primary Market: – New issues of a security are sold to initial buyers by the corporation or government agency with the help of a bank or a financial intermediary. – This market is usually only for professionals like investment banks, who handle these transactions by underwriting securities.

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2. Secondary Market, even though firms don’t get any money,17 serves two important functions: – Providing liquidity, making it easy to buy and sell the securities of the companies; this also helps players issue securities in the primary market. – Establishing a price for the securities day by day (the firms’ market value). There are brokers and dealers on the secondary market who link buyers and sellers.

Questions 1. 2. 3. 4. 5. 6.

List the main functions of the financial system. List the different types of financial markets. What is the indirect financial circuit? Who are the middlemen or financial intermediaries? What are transaction costs in financial exchanges? Why do financial intermediaries have advantages in supporting transaction costs in financial exchanges? 7. Why are financial exchanges characterized by uncertainty and information asymmetry? 8. What do intermediaries perform an important function regarding information asymmetry problems? 9. Why are there different supervisors and authorities? 10. Describe the main differences between the primary and secondary market.

17  In secondary markets, except in a few cases, the original issuer of the security is not involved in transactions which instead take place between other market players (third parties).

2  Interest Rates and Financial Market Risks What you will learn in this chapter: • The relationship between risk and return; • The different intrinsic kinds of risk in the financial markets; • The price fluctuations that reflect the risk-return correlation.

2.1 Risk and return “Students should understand that every saving and investment product has different risks and returns. Differences include how readily investors can get their money when they need it, how fast their money will grow, and how safe their money will be.”1 Everything in life comes with trade-offs. Do you want to be a professional trader, or a professional athlete, or a famous musician? To achieve any of these goals, you have to devote a lot of time and energy to the profession you choose. Investing is no different. The determinants of asset demand are four: 1. 2. 3. 4.

Wealth; Expected Return; Risk; Liquidity.

Given the wealth of the investors and the liquidity of an asset, most of the time this trade-off is between the expected return and the risk that they are willing to accept. Nowadays many people believe that the best things in life are usually the most expensive, or the rarest, or the riskiest. People, in every context, not only in the financial world, sometimes accept a risk by adopting a conscious strategy of acknowledging the probability and the repercussions it might have, although other times our approach might be to avoid a risk because it has a significant impact. Moreover, an acceptable risk level for one person could be too much for someone else. This is the reason for different risk profiles. People always have these same questions when they come into contact with the financial world and financial markets for the first time: • Why are there investments with rates of return? And why do these rates of return differ?

1  Check Investor.gov, US Securities and Exchange Commission at https://www.investor.gov/additional-resources/information/youth/teachers-classroom-resources/risk-and-return.

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• If we invest in a listed security, why does the return or yield that we can obtain change every day? And how does this return relate to the price of the security? • How good are our investments? In other words, do they generate returns that exceed the cost of funding them? • What do we expect the excess returns to look like on future investments? Before we can understand the relationship between risk and return, we need to solidify our understanding of expected risk and return. 2.1.1

What is expected return?

Following our approach, accentuating the interconnection between corporate (or personal) finance and the financial markets, firstly it is better to describe what the return is for a company that has invested a certain amount of money in a new business. Professor A. Damodaran to some extent answers the previous questions by saying: “A firm that generates higher returns on an investment than it costs it to raise capital for that investment is earning excess returns and will trade at a premium over a firm that does not earn excess returns.” He adds: “A firm that expects to continue generating positive excess returns on new investments in the future will see its value increase as growth increases, whereas a firm that earns returns that do match up to its cost of funding will destroy value as it grows.”2 This is a view from a corporate finance angle. Now shifting focus to a firm or a financial intermediary, we can say the portfolio value would increase when this player is able to raise capital (which implies a cost of funding), and reinvest this capital into some financial asset to get back some future cash flows: when the sum of the present value of these cash flows is more than the initial investment, there is an excess of value that increases the value of the whole portfolio. Questions: What is the present value? Why don’t we just compare the pure cash flows?

Following the previous example from Damodaran, to link corporate finance and financial markets, we could discuss a simple loan as an example of a financial investment. Through this loan, we as lenders will make an investment by providing, say, 100 to a borrower (in other words, the loan principal is 100; the currency doesn’t matter for now). The borrower promises to pay back 110 at a future point in time (the maturity date). We will eventually receive 110, which is the sum of the principal (100) plus an additional amount, the so-called interest, which is equal to 10. This means that we are able to increase the value of our cash by 10% in this given period

2  See A. Damodaran, Return on Capital (ROC), Return on Invested Capital (ROIC) and Return on Equity (ROE): Measurement and Implications, New York University – Stern School of Business, July 2007.

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of time. The interest payment divided by the amount of the loan, the principal investment, is the interest rate. As this is a simple loan, the interest rate is also called a simple interest rate. Interest of 10% is calculated as (Repayment – Principal Investment) and so as Principal Investment (110 – 100) . 100 As we discussed in the previous chapter, in the financial markets we have “two players on the same pitch”: a lender and a borrower. So the 10%, the interest rate of the “trade” between the two parties, can be seen in two different ways. The interest rate is the “cost of funding” paid by the borrower in order to have the initial 100 from the lender. It is also the yield to maturity, or the “return” on the investment, received by the lender as compensation for not having that amount of cash available for a set period of time. Important Note The interest rate is the cost of funding for the borrower that issues a security at a specific price at a point in time. The lender will have a return on the investment that could be equal to the interest rate paid by the borrower if the transaction takes place in the primary market. However, the return could be different if the lender decided to invest that amount of money in the secondary market by purchasing an alreadyexisting security and trading it with another market counterparty without directly financing the borrower. Questions: If I invest 100 and get 121 back, my “return” is 21%. Is this a better investment, since I get a higher return?

Your answer might be “yes” but there is a third variable to consider: time. That’s the reason we need to learn what the present value is, the “factor” for measuring interest rates more accurately. For now, we can consider the return as the expectation of an increase in the value of our investment. 2.1.2 What is risk? Ask this question to some of your friends with different backgrounds and education. They will probably give you various definitions of risk, such as the possibility of harm or loss, or failing to achieve the result they hoped for. But if you ask a person who knows the markets, or a trader or a banker, the answer will be the chance of getting a return that is different from the expected return. Taken together, in finance and financial markets, risk is the extent to which we fall short of the expected or targeted return on our choice of investment. Considering the previous example of loans as they relate to risk, some questions could readily come to mind: • Is 10% fair and proper compensation for the fact that we are losing the chance to use our 100 for the whole contract period? • Is the borrower a trustworthy counterparty? And will the borrower pay us back?

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Finance Lab

At this point, we have to think about the trade-off between risk and return. The return of 10% in terms of interest rate, as absolute interest, could be either a lot or not enough. It depends on the risk level we face by financing the borrower, also with respect to the free-risk rate that is generally accepted in the market. To explain this idea, assume you have two investment options, Borrower A or B, both with an expected interest rate return of 10%. You know that A is a trustworthy counterparty with a perfect record for being punctual on paying back loans, while B has a reputation for not being a reliable borrower. Obviously, you will choose Borrower A to get same return at a lower risk. What’s more, to get a loan, B will have to offer an additional return – a premium – to encourage potential lenders to invest resources despite this borrower’s poor reputation. Generally speaking, when investors want to earn higher returns, they will face a higher level of risk. After this introduction we will discuss in more detail the following questions: 1. 2. 3. 4.

How is return measured? What is present value and why is it important? What is the distinction between interest rates and returns? What is inflation and the real rate? What type of risk do we face in the financial markets?

2.2 Interest rates “The interest percent that a bank or other financial company charges you when you borrow money, or the interest percent it pays you when you keep money in an account.”3 “The percentage amount that you pay for borrowing money, or get for lending money, for a period of time, usually a year.”4 These are just two definitions of “Interest rate” that we can get from a dictionary. We can say that interest rates are among the most closely watched variables in the general economy, and not only in finance: this parameter is used widely and in a number of different contexts. So to clarify, there are actually various definition of interest rate, but for our scope the well-known concept of Yield to Maturity is the most accurate measure. To simplify matters, we can say that the interest rate is the percentage of the principal charged by the lender for the use of the money in question. (The principal is the amount of money borrowed or lent.) As a result, when banks pay you an interest rate on your deposits, they are essentially borrowing that money from you. Anyone can lend money and charge interest, but it’s usually done by banks, corporations or institutions. They use the deposits from savings or checking accounts to fund loans, reinvest in their business or finance public expenses. They

3  4 

See Cambridge Advanced Learner’s Dictionary & Thesaurus © Cambridge University Press. See Cambridge Business English Dictionary © Cambridge University Press.

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23

pay interest rates to encourage people (or other lenders) to make deposits. Banks charge borrowers a slightly higher interest rate than they pay depositors so they can make a profit. At the same time, banks compete with each other for both depositors and borrowers. The resulting competition keeps interest rates from all banks within a narrow range. Like the prices in the markets of Ancient Rome and markets today, interest rates are determined by the interaction of the supply and demand for money in the economy until a point of equilibrium is reached. As interest goes up, demand for borrowing will dwindle because individuals cannot afford or choose not to borrow at the higher rate. The level of interest rates is usually a concern to governments when implementing macroeconomic policy and monetary policy and formulating future expectations about current economic policy. A classic approach to interest rates is Fisher’s Theory,5 which holds that there are three factors that influence rate levels: 1. the marginal rate of time preference; in other words, the willingness to defer spending money now for a future point in time; 2. levels of income; higher income gives the opportunity for saving; 3. rate of interest; higher interest rates push people to save money and spend tomorrow. The interaction of these three factors will help to determine the savings, the circulation of this liquidity in the markets, the available funds for borrowers, and the cost of funding. 2.2.1 The Present Value We have already introduced how to measure the interest rates, or the yield to maturity, in a very simple way. If you lend a certain amount of money for a set period of time, you will be repaid with the principal you invested plus an extra amount as interest. As we mentioned before, this interest is expressed as a percentage: (Disinvestment – Investment) Investment or (Cash In at T final – Cash Out at T initial) Cash Out at T initial

5  I. Fisher, The Theory of Interest, as Determined by Impatience to Spend Income and Opportunity to Invest It, New York, Macmillan, 1930.

24

or

Finance Lab

Interest payment Principal

This happens within a period of time, so time is an important variable. How can we compare the same increase of value (in absolute terms) during two different time periods? Let’s consider the 110 dollars you should be getting in one year. This could be the interest plus the principal repayment on the loan. So you might plan to buy something next year which costs $110 now. But the question is, how much will this item cost a year’s time if we factor in inflation? In other words, how much does it cost today to get a payback of $110 in one year? The cost of $110 one year from now is the number of dollars we would have to set aside today to get $110 next year. To calculate the cost of $110 one year from now, you need to know the market interest rates. An interest rate is the rate of growth in the balance of an account or the amount of a debt. Suppose today you borrow $100 from a friend. In one year, you will pay your friend back $110. The $100 is called the principal and the extra $10 is called the interest payment. The amount of your debt grows to $110 over one year. The interest rate on this loan, as defined above, is 10%. This means that in the market, the value of money under these hypothetical conditions, grows by 10% annually. In general, future value can be calculated as the amount you have today times (1 + i), where i is the interest rate. Initial deposit × (1 + i) = Future Value This means that if we deposit $100 in a bank today at an interest rate i equalling 10%, in one year our bank deposit will total $100 × (1 + 10%) = $110. Assume that you leave this amount of money in that bank deposit for another year. How much would the value of your deposit be at the end of Year 2? The final amount will not increase just by another $10 like the first year, because now the “initial value” is $110. Therefore, by the end of the second year, the bank statement will show $110 × (1 + 10%) = $121. We can say in this case that if we lend out today $100, after two years we will have $100 × (1 + 10%) × (1 + 10%) = $121. That can also be written as $100 × (1 + 10%)2 = $121. Overall, given an interest rate i, lending out an amount of money for a period of n years, our final value will be: FV = investment × (1 + i)n As illustrated in Figure 2.1, we can easily understand by considering the interest rate, having $110 one year from now is exactly the same of having $100 now. We can work backwards from a future amount to define the present one. If we know that $133 is the future value in the third year of a loan, assuming a 10% interest rate, then we can calculate the present value: $133 = $100 (1 + 10%)3

2  Interest Rates and Financial Market Risks

Figure 2.1

25

The time growth value n

$ 100 (1 + 10%) $ 133 $ 121 $ 110 $ 100

time

1

2

3

4

…

n

We can calculate today’s value of an amount we will receive in future by discounting by the same rate, according to this formula: Present Value (PV) =

Future Cash Flow (CF) (1 + i)n

The concept of present value (or present discounted value) is based on the commonsense notion that a dollar today is worth more than a dollar tomorrow. This notion is true because you could invest the dollar in a savings account that earns interest and have more than a dollar in one year. The term Present Value (PV) can be extended to mean the PV of a single cash flow or the sum of a sequence or set of cash flows. The price of any kind of investment that will give us a stream of payments (one or more) at future times can be calculated summing up the present values of the future cash flows. The above used principal keywords are better described in the following Box 2.1. Box 2.1 Keywords • Loan Principal: the amount of funds the lender provides to the borrower. • Maturity Date: the date the loan must be repaid; the Loan Term is from initiation to maturity date. • Interest Payment: the cash amount that the borrower must pay the lender for the use of the loan principal. • Simple Interest Rate i: a percentage calculated as the interest payment divided by the loan principal; the percentage of principal that must be paid as interest to the lender. Conventionally this is expressed on an annual basis, irrespective of the loan term. • FV: Future Value of an investment/deposit you make today, calculated as FV = investment × (1 + i)n • PV: Present Value of one future payment/cash flow today (CF), according to the interest rate, CF . calculated as PV = (1 + i )n

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Finance Lab

Let’s look at another example. Assume a grandmother would like to put some money in a bank account today for her 10-year-old granddaughter to make sure that, at the age of 18, she will have enough money to buy a car. If she wants her granddaughter to be able to purchase a $20,000 car in ten years’ time, and she knows banks offer a 5% interest rate per year on savings accounts during this time, how much should she put into the account now? Using the present value formula, we can discount a future cash flow (the amount of money she can get by liquidating the account, which her granddaughter will use for her car purchase) by the interest rate (5%) seen in the market for the period of time of the deposit (8 years): PV =

$20,000 = $13,536.80 (1 + 0.05)8

Thus, $13,536.80 will be worth $20,000 in 8 years if grandma can earn 5% each year. In other words, the present value of $20,000 in this scenario is $13,536.80. 2.2.2 Yield to maturity In the credit market we basically have four types of instruments that incorporate the present value concepts: 1. 2. 3. 4.

simple loan; fixed-payment loan; coupon bond; discount bond.

For simple loans there is just one payment, as seen in the previous examples; that’s why the calculation is easy. For a discount bond like a money market security (i.e. T-bills), we just have a present value and a face value (which is the future value), so it is quite easy as well. It gets more complicated when there are two or more payments split over a period of time. We need to know the rate applied to a given series of payments that will make them equal to the security’s present value or its market price. Question: What are fixed-payment loans, coupon bonds and discount bonds?

Fixed-payment loans are loans where the principal and interest are repaid in several equal payments, often monthly, over the loan term. Typical examples are instalment loans such as auto loans and home mortgages. Example: a $50,000 loan, that will be repaid in 10 fixed payments of $9,031 as in Figure 2.2.

2  Interest Rates and Financial Market Risks

Figure 2.2

27

Fixed payment loan example

$ 50,000 t

0

1

2

3

4

5

6

7

8

9

$ 9,031 $ 9,031 $ 9,031 $ 9,031 $ 9,031 $ 9,031 $ 9,031 $ 9,031 $ 9,031

Installments

Coupon bonds pay the owners of the bond a fixed interest payment (coupon payments) based on a percentage, i.e. the coupon interest rate, usually every year (or every six months) until the maturity date, when the face value will be repaid. Example: Here is a coupon bond that will pay you back at maturity (t = 5) a face value of $1,000 plus every year a coupon based on the coupon rate of 10%. The purchase price at t = 0, in this example, is $911 (see Figure 2.3). Figure 2.3

Coupon bond example

Purchase Price

$ 911

t

0

Cupons Face Value

1

2

3

4

5

$ 100

$ 100

$ 100

$ 100

$ 100 $ 1,000

Discount bond – also called a Zero-Coupon Bond (ZCB) – is a title of debt sold at a price below its face value (in other words, sold at “discount”) that will pay the investor back the face value, with no coupons. Example: Here is a Zero-Coupon Bond that at maturity (t = 3) will pay you back the face value of $1,000; it would be sold today at the discounted purchase price of $702 (see Figure 2.4).

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Figure 2.4

ZCB example

Purchase Price

t

$ 702 0

Face Value

1

2

3 $ 1,000

The Yield to Maturity (or YTM) is the most accurate measure of return. This is the rate that equates the present value of some future cash flows provided by the instrument to its value today.

The YTM is based on the assumption that an investor purchases the security at the current market price and holds it until the security has matured (i.e. reached its full value), and that all interest and coupon payments are made in a timely fashion. The primary importance of the yield to maturity is that it enables investors to draw comparisons between different alternative securities by computing the expected returns on each investment, which may differ in terms of maturity or payment structure. The YTM is also useful because it allows investors to understand of how changes in market conditions might affect the price of the securities in the secondary markets; for instance, when securities drop in price, yields rise and vice versa. In other words, considering that it is possible to purchase a security in the secondary market at a price that is not the issuance price, the YTM is the internal rate of return (IRR) earned by the investor who holds the bond until maturity, with all payments made as scheduled and reinvested at the same rate. Question: How can we calculate the YTM of a fixed-payment loan or a coupon bond?

For a fixed-payment loan, we have to discount every single future cash flow like a simple loan, by (1 + i)n, according to the point on the timeline where the payment will take place. In the previous example the formula would be: $9,031 $9,031 $9,031 $9,031 $9,031 $9,031 $9,031 + + + + + + + (1 + i)1 (1 + i)2 (1 + i)3 (1 + i)4 (1 + i)5 (1 + i)6 (1 + i)7 $9,031 $9,031 $9,031 + + + (1 + i)8 (1 + i)9 (1 + i)10

$50,000 =

More generally, we could write the previous formula for each fixed-payment loan as follows: Loan value (LV) =

FP FP FP FP + + ±…+ (1 + i)1 (1 + i)2 (1 + i)3 (1 + i)n

2  Interest Rates and Financial Market Risks

29

The YTM i is the discount rate that makes the sum of the present values of each cash flow equal to the loan value. With Excel®,6 or a financial calculator, we can find the value that makes the value of the 10 fixed payments (FP) of $9,031 equal to the loan value (LV) of $10,000, as in Figure 2.5. Figure 2.5

Instalment loan example Yield to maturity “i”

$ 50,000 t

0

Installments (1 + i)

n

PV of each FP

1

2

3

12.50% 4

5

6

7

8

10

9

$ 9,031 $ 9,031 $ 9,031 $ 9,031 $ 9,031 $ 9,031 $ 9,031 $ 9,031 $ 9,031 $ 9,031 1.125

1.266

1.424

1.602

8,028

7,136

6,343

5,638

1.802 5,012

2.027 4,455

2.281 3,960

2.566

2.887

3,520

3,129

3.247 2,781

To calculate the yield to maturity for a coupon bond we use the same strategy. This time we do not always have the same cash flow, because the coupons (C) are the same. But we will receive the face value (FV) back at maturity, which will be discounted like any other cash flow. The YTM is the rate i that makes the sum of the present values of each coupon equal to the current purchase price of the bond. In the previous example the formula would be: Purchase Price (PP) =

$100 $100 $100 $100 $1,000 + + + + + (1 + i)1 (1 + i)2 (1 + i)3 (1 + i)4 (1 + i)5

More generally, we could write the previous formula for each coupon bond as follows: PP =

C C C C VF + + ±…+ + (1 + i)1 (1 + i)2 (1 + i)3 (1 + i)n (1 + i)n

Applying the formula to the previous example we obtain a Yield to Maturity equal to 12.5% (see Figure 2.6). This means that the coupon interest rate is equal to 10% and represents the cost of funding for the issuer, or the borrower. On the contrary, the Yield To Maturity, that is the return from the investment for the lender (if the purchase price for this bond was $911) is 12.5%. The investor, due to several risk factors, is purchasing below par (with a discount on the Face Value).

For a discount bond, the calculation of the Yield to Maturity is like a simple loan. In this case we capitalise an amount that we invest and, depending on the rate the bor6 

Use the function X.IRR in the English version.

30

Finance Lab

Figure 2.6

Coupon bond pricing

Purchase Price

$ 911

t

0

Coupons

Yield to maturity “i”

12.50%

1

2

3

$ 100

$ 100

$ 100

4 $ 100

Face Value (1 + i)

n

PV of each FP

5 $ 100 $ 1,000

1.125

1.266

1.424

1.602

1.802

$ 88.9

$ 79.0

$ 70.2

$ 62.4

$ 610.4

rower guarantees us, we can calculate the amount that we will have back at the end of the period when we disinvest. When we decide to lend money by purchasing a Zero-Coupon Bond, we know that we will be repaid the face value and we look for the best purchase price that reflects the discount rate applied. The YTM is the rate i that makes the sum of the purchase price equal to the face value. In the previous example the formula would be: Purchase Price (PP) = $ 702 =

$1,000 (1 + i)3

Due to the fact that we invest a specific amount (the purchase price), that is just the discounted price of a future cash flow (the face value), we calculate the return (the YTM) as follows. The YTM is the rate i that makes the sum of the present values of each coupon equal to the current purchase price of the bond. When you calculate the YTM pay attention about the factors you use in the computation, and do not fall in a common mistake, as described in the Box 2.2. In the previous example the formula would be: (1 + i)3 =

$1,000 $702

With a basic mathematical transformation, we can write it as: i=

3

$ 1,000 – 1 = 12.5% $ 702

2  Interest Rates and Financial Market Risks

31

Box 2.2 A common mistake Warning – a common mistake: • If you deposit $100 in a savings account and you get a 10% interest rate, by the end of the period you have $110: your principal of $100 plus an extra interest of $10, equal to 10%. • If you purchase a ZCB for $90 and at maturity you are repaid $100, the cash value of the interest is $10, but your return, the YTM, is not 10%. FV – PP . PP That’s why with the Zero-Coupon Bond you “make” $10 just by investing $90. This means that your ($ 1,000– $ 900) = 11.1%. YTM is i = $ 900 The formula is: i =

In the three examples above, even though they are different, the Yield to Maturity that we can get by investing (i.e. lending money to a borrower) would be the same annually. In the market, it is also possible to purchase bonds with a maturity longer than 50 years, sometimes with a “call.”7 These are called Perpetual Bonds due to the fact that they could pay a coupon annually for a very long time. In this case, for investors the maturity date is so far in the future they don’t calculate the Yield to Maturity, but just what is called the Consol. The return on a Perpetual Bond is calculated by dividing the coupon cash flow by the price of the Consol. The different concepts of Interest, Yield to Maturity and Present Value will be useful in the following Chapter IV to analyse in detail the pricing of bonds and other fixed-payment securities. 2.2.3 Interest rates and Returns A very common mistake among students, and even some lenders, is to consider the interest rate, especially the coupon interest rate, as equal to the yield to maturity, supposing that the interest rate paid by the borrower is the return for the lender. The concept of return is extremely important because for any security the rate of return is defined as the payments to the owner plus the change in its value expressed as a fraction of its purchase price. Let’s make this clearer. Assume that you purchase $1,000 face value bond with a coupon interest rate of 10% and this bond pays you $100 in the first year after investment. Suppose you are able, after just one year, to sell the bond in the secondary market for $1,200. You would have a capital gain, that is, the difference between the selling price and the purchase price, that amounts to $200. Moreover, you would get a coupon of $100, which means your total gain is $300 or 30% on an investment of $1,000. 7 

The right for the issuer to pay back, on pre-set dates, the lender at a specific agreed price.

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As you can see, that’s something quite surprising! More generally, we can say that the return on a bond held for a certain period of time, from t to t+1, is calculated as follows: Return =

(C + Pt + 1 – Pt) Pt

Conceptually this expresses how the return can be split into two parts: • the current yield ic which is the coupon payment over the purchase price; • the rate of capital gain g, that is the change in the bond’s price relative to the initial purchase price. Return =

C Pt

+

(Pt + 1 – Pt) Pt

= ic + g

2.2.4 The demand curve and equilibrium As mentioned above, interest rates are determined by supply and demand. So, let’s analyse the mechanics of interest rates together. Interest rates are determined by transactions of interest-bearing securities, and the supply and demand of these securities determine the interest rate. That’s why there is not just one single interest rate in the market but there are several, related to different market characteristics and maturities implicit in the rates. Before going further, let’s ask some questions: why do balance sheets classify debts and investments in two different classes (short-term and long-term)? Would you accept the same rate over a long-term investment as for a short-term investment? The answer is no because with the same interest rate no one will finance long-term borrowers; this means they cannot plan long-term investments and there would be far fewer investment opportunities. But it is a well-known fact that rates in the same class fluctuate every day, and they might change a great deal in the long run. For borrowers like corporations and institutions, this inflation could cause an increase (or decrease) in the cost of funding. Some basic rates are also set by the central banks, and other rates adjust accordingly. Later we will discuss how and why central banks such as the Fed, the ECB and the Bank of England change the rates. In any case, there are very short-term rates, like the so-called “overnights,” and very long-term rates. There are rates for spot or term intra-bank exchanges, and there are rates for short, medium and long-term securities. Keep in mind that these drivers act differently in different markets. For instance, the current supply/demand conditions in the corporate bond market are not necessarily the same in the mortgage market. A simple example can help us to better understand how a rate is determined, in search of “equilibrium.” Let’s consider a Zero-Coupon Bond that will pay us back $1,000 one year from now. Being a discounted bond, the price could vary, determining the YTM. Assuming the price of this ZCB is $970, the demand (B d) at Point A

2  Interest Rates and Financial Market Risks

33

might be 1,000,000; and if the price is $950 the demand could be 2,000,000. Purchasing the ZCB for $970 means we can have a return of 3.09%. Paying just $950 for the same ZCB the return, expressed as YTM, should be 5.26%. Applying basic principles of economics, we could say that the return rate at Point A is 3.09% and at Point B is 5.26%: more people will want (demand) the bond if the expected return is higher, ceteris paribus.8 Following the same principle, we can make additional hypotheses, as summarised in Table 2.1 illustrating the demand curve. Table 2.1

Demand curve constituents

Price

YTM

Quantity (Bd)

Point

$970.00

3.09%

1,000,000

A

$950.00

5.26%

2,000,000

B

$930.00

7.53%

3,000,000

C

$900.00

11.11%

4,000,000

D

$870.00

14.94%

5,000,000

E

The demand curve is Bd in the figure below, which connects points A, B, C, D, and E. For the supply curve we use the same basic principles. If you issue a Zero-Coupon Bond, you look for the cheapest funding solution. A higher price corresponds to a lower interest rates (to be paid to the underwriter) and the issuer will be willing to borrow more through this issuance. For the issuer the best solution would be to issue the ZCB at the price of $1,000 and the repayment will be at the same value, with no cost of funding, like a cost-free loan. Of course, no one lends money for nothing, because if we do not make our money grow, we implicitly lose value due to inflation. We can assume a supply curve as that shown in Table 2.2. Table 2.2

Supply curve constituents

Price

YTM

Quantity (Bd)

Point

$870.00

3.09%

5,000,000

F

$900.00

5.26%

4,000,000

G

$930.00

7.53%

3,000,000

H

$950.00

11.11%

2,000,000

I

$970.00

14.94%

1,000,000

J

8   Ceteris paribus is a Latin phrase that is commonly translated into English as “all else being equal” or more literally “holding other things constant.” In finance it acts as a shorthand indication of the effect of one economic/financial variable on another, provided all other variables remain the same.

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By connecting the points of the demand curve and the points of the supply curve on a chart (Y axis = price of the ZCB; X axis = quantity of ZCB), we can also understand graphically what the point of equilibrium is, as you can see graphically in Figure 2.7. Figure 2.7

Supply and demand curve chart

$ 1,000 $ 980

A

$ 960

J B

I

Price

$ 940 $ 920

Supply C=H

EQUILIBRIUM

Demand

$ 900

D

G

$ 880 $ 860

E

F

1,000,000 2,000,000

3,000,000

4,000,000

5,000,000 6,000,000

Quantity

The Bd has the usual downward slope (a decrease in price means an increase on returns and consequently higher demand), while the Bs has the usual upward slope (an increase in price means a decrease on interest rate paid and consequently a bigger supply). The equilibrium follows what we know from supply – demand analysis. So according to the graph, equilibrium occurs: • when Bd = Bs, at PRICE = $930, with an implicit interest rate of 7.53%; • when the price is higher than $930, Bs > Bd determining an excess of supply; • when the price is lower than $930, Bd > Bs determining an excess of demand. More generally speaking, market equilibrium occurs when the number of people willing to buy (demand) equals the number of people who are willing to sell (supply) at a given price. Excess supply occurs when the number of people willing to sell (supply) is greater than the number of people who are willing to buy (demand) at a given price. Excess demand occurs when the opposite happens: the number of people willing to buy (demand) is greater than the number of people willing to sell (supply) at a given price.

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2.3 Inflation rates The European Central Bank describes inflation as follows: “In a market economy, prices for goods and services can always change. Some prices rise; some prices fall. One speaks of inflation if there is a broad increase in the prices of goods and services, not just of individual items. As a result, you can buy less for €1. Expressed the other way around, a euro is worth less than it was before.” In a very simple way, inflation reduces the purchasing power of each unit of currency and occurs when day-to-day expenses rise. This rise is measured with a large “basket” of goods, because we have a variety of different preferences when we spend our money. The annual rate of inflation is the price of this basket in a given month, compared with its price in the same month one year before. In this way we can determine how the cost of living has grown in 12 months. Here is a simple example: suppose you do your grocery shopping in London, and purchase 50 different items, spending £103. For exactly the same groceries, one year before, you paid just £100. This means that your basket of goods, related to your personal purchases, has increased by 3%. More technically, “Inflation measured by the consumer price index (CPI) is defined as the change in the prices of a basket of goods and services that are typically purchased by specific groups of households. Inflation is measured in terms of the annual growth rate.”9 In order to exemplify the different inflation rates across the world in the new millennium, see the following Figures 2.8, 2.9 and 2.10. The central banks of the world use monetary policy to curb inflation and, on the contrary, to create the positive effect of deflection. In the United States, the Federal Reserve aims for a target inflation rate of 2% year-over-year, because a stable rate with little growth reflects good economy health. It is true that the focus of this book is about financial markets and not macroeconomic aspects or dynamics of inflation. Nonetheless markets and market players such as financial intermediaries, institutions, large businesses, and even private investors and small businesses are very interested in the inflation rate. Inflation can be construed as either a good or a bad thing, depending on who you are. For example, individuals with tangible assets like properties and commodities, may like to see some inflation as that enhances the value of their assets, so they can sell them at higher prices. However, buyers who need to use these assets may not be happy with inflation, as they will have to shell out more money. The worst-case scenario could be to purchase something at the end of a period of strong inflation and then see deflation or a flat inflation curve. Inflation promotes investments, both by businesses in projects and by individuals in stocks of companies, as they expect better returns with respect to inflation. But this does not work if investors hold fixed-income securities. 9

  See https://data.oecd.org/price/inflation-cpi.htm

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Figure 2.8 Inflation (CPI) Total, Annual growth rate (%), Q2 2010 – Q4 2019 Euro area Vs China, Japan, USA Republic of China

Japan

United States

Euro area (19 countries)

6 5 4 3 2 1 0 –1 –2 2011

2012

2013

2014

2015

2016

2017

2018

Source: IMF.

Figure 2.9 IMF Data mapper: Inflation rate, average consumer prices (annual percent change, 2000)

Source: IMF.

2019

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Figure 2.10 IMF Data mapper: Inflation rate, average consumer prices (annual percent change, 2021)

Source: IMF.

Holding liquid cash erodes the value of these cash amounts. Here’s a simple example: with a €2 coin you can buy an ice cream today, but in one year with inflation €2 won’t be enough. Suppose the inflation rate is 1% right now. You have $1,000 to purchase a new computer or to invest in a coupon bond at par value that will mature in one year and give you a 4% annual return. If you invest your $1,000, one year from now you will get your principal ($1,000) and your coupon, which is the interest at 4% of the face value ($40). Finally, you are ready to purchase the computer. How much does it cost right now? Last year’s price times (1 + inflation); this means that the computer will cost $1,010 in one year. So you can gain a return in the market, with the existing nominal rates, but the inflation rate would affect this value. 2.3.1 Nominal interest rates and real interest rates According to the theory, nominal interest rates reflect the financial return an individual gets on a bank deposit. For example, a nominal interest rate of 10% per year means that an individual will receive an additional 10% on the money deposited in the bank. Unlike the nominal interest rate, the real interest rate considers purchasing power in the equation. This is the so-called Fisher Effect (for more details, check Box 2.3). The real interest rate is the amount that mirrors the purchasing power of the borrowed money as it grows over time.

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Box 2.3 What Is the Fisher Effect? The Fisher Effect is an economic theory developed by economist Irving Fisher. The theory describes the relationship between inflation and both real and nominal interest rates. The Fisher Effect states that: the real interest rate equals the nominal interest rate minus the expected inflation rate. Therefore, real interest rates fall as inflation increases, unless nominal rates increase at the same rate as inflation. Fisher’s equation reflects that the real interest rate can be taken by subtracting the expected inflation rate from the nominal interest rate. In this equation, all the provided rates are compounded. The Fisher Effect can be seen each time you deposit your money in a bank account: the interest rate that an investor has on a savings account is the nominal interest rate. For example, if the nominal interest rate on a savings account is 4% and the expected is 3%, then the money in the savings account is really growing at 1%.

Summary The financial world follows the basic rule of “risk and return,” two factors which are directly proportional. When lenders take on a higher risk level for, they will ask for a higher return to compensate for the increase in risk. Borrowers in this case have to face the fact that, all other things being equal, investors would prefer a safer borrower. So high-risk borrowers must increase their cost of funding, raising the return offered to the lenders, in order to attract investors. The determinants of asset demand are the risk level and the expectation of return, along with the liquidity of the asset and of the issuer, which is a sort of extra risk. Finally, wealth in the market, that is the availability of money to be reinvested, is the last determinant. If we want to compare two or more investments, we need to understand the return we can obtain from each one. To make this comparison, we have to use the same timeframe (i.e. yearly) because there are different maturities in the market. The interest rate generated by an asset is not always the return that we can get by investing in that specific instrument. In order to assess the value and the return of an investment, we have to know the price, because this is one of the determinants of the return. The role and the value of time are also key, according to the rule that the value of one dollar today is greater than one dollar tomorrow. Present value is a technique that allow us to compare different investments with different structures and cash flows over time. Specifically, the present value of a payment is the value today of an amount that we will receive at a future time, discounted by a certain rate, related to the kind of asset that generates the cash flow in question. Yield to Maturity (YTM) is the most accurate measure of return, which takes into account the structure of the investment and the value of time. Price is directly related to YTM: market forces can adjust the price of a given asset and the YTM rises or falls. Price is the point of equilibrium that is driven by demand and supply for a specific asset. Due to the fact that in our society and economy prices can fluctuate, rising with inflation, the return from a fixed asset can be adjusted by the inflation rate, giving us the real rate of return.

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Questions 1. What is the risk in a financial investment? 2. How can you get a return from an investment? 3. Is the present value of a cash flow you will receive in two years equal to the same cash flow that you will receive in four years? Which is greater today? 4. When is the coupon rate of a bond equal to the Yield to Maturity of the same bond? 5. Why, if the price drops, does the YTM increase? 6. Why, if inflation increases by 1%, does the real return that you get from a fixed-coupon bond fall?

3  The Role of Risk in Finance What you will learn in this chapter: • Details about the several kinds of risk in financial markets; • The risk is not only directly related to the business but could be indirect; • A real application of what is a sovereign risk.

3.1 Intro to risk Risk refers to uncertain situations in which people have to make decisions. The results of these decisions could either be desirable or undesirable. This situation of uncertainty can also occur in a financial environment, where risk depends on uncertain variables. The availability of adequate information can reduce risk because in this way decisions are made with greater awareness and resources can be allocated more efficiently. Relevant information should be available to actors both when decision-makingand monitoring. During the decision-making process, it is necessary to evaluate the transaction characteristics and assess the other party’s reliability. Later, monitoring is needed to ensure compliance with the terms of the agreement. Through the intervention of financial intermediaries, it is possible to reduce risk by minimising information asymmetry between the lender and borrower. The intermediary who serves as a middleman to facilitate financial transactions also mitigates risk; the end result of this activity is more borrowers and lenders on the market. Financial intermediaries not only offer the advantage of reducing the risks associated with financial activities but also offer risk transformation services. Moreover, investors benefit from risk reduction through diversification of their investment portfolios. Finally, financial intermediaries lessen the risk of individual investments by transforming their maturities. For example, if a bank receives cash flows from a short-term loan it issued, it would be able to finance long-term investments with that money. Risk is one of the reasons why financial intermediaries operate in the financial market. In both economics and finance, the first classification of risk distinguishes between pure risk and financial risk or speculative risk. Pure risk only generates negative risk, which is managed by insurance companies through risk transformation. This type of risk involves some chance of loss and no chance of gain; examples are civil liability, damage to property or persons, natural disasters or unexpected death. On the other hand, financial or speculative risk is related to the transfer of resources over time and produces effects that can be positive or negative. Examples of speculative risks are currency and interest rate risks, credit risk, liquidity risk and business risk.

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It is also possible to make another distinction between systematic and unsystematic risks. Systematic risk occurs independently of the individual company. This type of risk take place in general market situations due to macroeconomic factors. On the contrary, unsystematic risk depends solely on the situation of the individual enterprise. The relationship between risk and return is one of the most important aspects of finance. In the previous chapter, we described how the return on an investment may vary through the investment period, because there are many external factors at play. Who amongst us wouldn’t rather risk a little and gain a lot? Unfortunately, this is not the case in the financial world, and it is only possible to achieve very high returns by accepting higher risk levels. However, not all investors tolerate a high degree of risk; therefore, the choice of the rate of return should be made through a risk appetite analysis. This analysis must take into account both objective aspects (e.g. the ability to generate savings, stability and equity capital, the targets and time horizon) and subjective ones such as previous unfavorable investment experiences, education level and age. Risk exposure associated with an intermediary depends on two factors: the composition of the investment portfolio and the characteristics of the financial instruments. According to the supervisory authority, the most important risks are market risk, liquidity risk, credit risk and operational risk. For this reason, companies hire risk managers who are responsible for managing risks. Their job is to identify and classify risks, measuring them using quantitative methods, monitoring their evolution and managing them in order to ensure a more efficient allocation of resources.

3.2 Market risk Market risk arises from variations in the value of financial assets in a particular financial system, due to a change in a market factor. It may have positive or negative impacts on the price of securities (assets and liabilities) that are not covered by appropriate financial instruments. There are generally three types of market factors that have the ability to create market risk, namely exchange rate risk, interest rate risk and price risk. 3.2.1 Exchange rate risk Exchange rate risk arises from changes in the relative price of one currency in relation to another, i.e. the exchange rate. When the value of the currency falls with respect to the time at which a particular financial instrument was acquired, its value automatically drops too. A simple example is when you purchase a security at a specific euro/dollar exchange rate: if the value of the euro decreases compared to the dollar, the same security will have a lower value than before.

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3.2.2 Interest rate risk Interest rate risk is the probability of the fluctuation in the interest rate of a given financial instrument over time. If the interest rate associated with a security decreases, borrowers will be excited as they will pay less interest to the lender (unless future interest rate variation occurs). 3.2.3 Price risk Price risk instead involves exposure to the risk of a decline in the value of a security, due to changes other than the interest rate or exchange rate. These factors are called exogenous, as they do not relate to the intrinsic nature of the security. Examples of exogenous factors are financial market expectations, which are influenced by a myriad of possible events that might be macroeconomic (such as a new economic policy), political (like a forecast of the election results in a country) or even social (for example scandals or news concerning a large group of people). 3.2.4 Liquidity risk Liquidity risk relates to the marketability of a particular asset before its maturity at a different price from the one stated in the agreement. A financial asset is called liquid asset if it can be quickly converted into cash. Cash on hand is the most liquid financial asset. Every financial intermediary should effectively manage this risk, which could be generated from both external and internal factors. For instance, if the market becomes less efficient than before, this is considered an external impact. However, in the case that an entity fails to maintain an adequate balance between inflows and outflows, an internally liquidity risk factor would arise. The players that are most exposed to this risk are the banks, which have a large percentage of both assets and liabilities that are not easily tradable (non-liquid assets). This is the reason why the central bank sets the minimum amount of capital reserves that must be held by every commercial bank. 3.2.5 Credit risk Credit risk relates to the creditworthiness of the issuer of the security, referring to the chances that a lender may not receive payment of the interest or the expected amount from the borrower on the maturity date. In particular, intermediaries with long-term financial investments are more exposed to credit risk. Therefore, lenders are required to carefully analyse the creditworthiness of their counterparties. Every security is exposed to a risk of not being fully repaid at maturity. The only ex-

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ception by convention is a risk-free financial asset such as sovereign bond, which is assumed to have zero credit risk even though in reality it has a minimum return on investment. Since credit risk is inherent to all financial activities, it is important to measure, price and manage such risk accurately. This is the reason behind the success of credit derivatives, products that can help investors deal with risk-related issues. The most important credit derivative is the credit default swap, a financial instrument that can be seen as an insurance contract providing protection against losses arising from some kind of pre-defined credit event involving a reference entity. The protection buyer makes fixed-periodic payments, while the protection seller collects the premium in exchange for guaranteeing the payment of a notional amount in case of default. CDS (Credit Default Swap) contracts were introduced by J.P. Morgan in 1997 and are traded over-the-counter (OTC). 3.2.6 Operational risk Operational risk is the risk of incurred losses due to inefficient internal operations or external events, which is intrinsic to any business activity. It is often even the result of fraud or other illegal behaviour by employees who have important positions. The Basel II Accord has required banks to take operational risk into account when calculating their capital requirements. In fact, this risk continues to proliferate with the development of information technology. Simply consider the potential damage to the stability of the financial system that could be caused by a computer virus attack on a database, for example. 3.2.7 Systemic risk Systemic risk is about the possibility that the failure or default of a financial intermediary could trigger severe instability over the entire financial system. In recent years, there has been an alarming upsurge in the frequency of crises resulting from a domino effect between banks. The most infamous example of this phenomenon occurred in 2008 after the bankruptcy of Lehman Brothers (a global financial services firm which having held onto large positions in subprime mortgages, sadly declared bankruptcy in a short time). This event was a major contributor to the dramatic slowdown in the international financial market for years. One of the many forms of chain reactions regarding systemic risk is the so-called run counter. This is a typical financial panic situation in which the fear of a shock in the financial markets, to even include a potential crisis (e.g. concerning the stability of a bank) leads economic agents to withdraw their deposits from banks. This could amplify the effects of the situation or even generate new problems.

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3.2.8 Reputational risk Finally, in the world where trust in a financial intermediary is at the heart of all its activities, maintaining a reputation becomes vital for business. Therefore, it is essential to avoid adverse impact on a company’s reputation or involvement in any fraud. 3.2.9 Country and sovereign risk Each country has peculiarities that make it different from any other. These differences, embedded in the inherent structure of every State, relate to government policies, history, and geography as well as the development of domestic financial markets. The literature usually acknowledges that country risk is the result of political, social and economic factors which are normally highly correlated; this risk is also linked to issues that may arise when conducting business in a given country. Political risk refers to political conditions and events that can create a hostile environment for international business, leading to an anticipated loss for investors. We could therefore describe this risk as a country’s willingness to fulfil its obligations, which may not necessarily coincide with its ability to make its payments. This implies that, even if a country has a strong, smoothly-functioning economy, its leadership may decide to create an unfriendly environment which will scare investors away by creating adverse tax and fiscal regulations. Specifically, we can consider these factors as divided into macro- and micro-risks, with the former referring to unexpected changes that affect all companies indistinctly, and the latter indicating variations that affect only selected industries or firms. Additionally, it is fundamental to notice the importance that economic risk plays within this framework. Accounting for such a risk means understanding the variability in the economic environment and thus analysing the levels of output, prices, interest rates, unemployment and all those factors that may affect the outcome of an international transaction.1 Therefore, risk assessment calls for an analysis of the country’s ongoing and future economic performance, meaning factoring in all those economic variables that are commonly used for domestic macroeconomic analysis. However, when it comes to sovereign risk, we have to introduce a more specific, well-defined concept. Indeed, if country risk refers more broadly to any risk that arises from conducting business in a certain country, sovereign risk indicates the risk that a foreign central bank will alter its foreign-exchange regulations, thus significantly reducing or completely nullifying the value of foreign-exchange contracts. More practically, we can also define sovereign risk as the inability of a government to fulfil its debt obligations, therefore triggering a default on its debt. It is possible

1  See E. Clark, Evaluating Country Risks for International Investments: Tools, Techniques and Applications, Hackensack (NJ), World Scientific Publishing, 2018.

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to establish a positive association between sovereign and country risk, implying that by performing an assessment of sovereign risk, in many cases we can use this to estimate the level of country risk. Indeed, sovereign spreads can be used as proxies, or at least as caps, when there is a need to account for country risk, clearly indicating a positive connection between the two: if sovereign risk increases, it means that the government is not implementing those actions that are aimed at meeting its debt obligations, thus signalling a tumultuous political environment, which in turn indicates a higher level of country risk. Therefore, monitoring sovereign risk in a way helps investors to assess the level of country risk. What makes sovereign risk unique is that, being influenced by a multitude of interacting aspects, there is no juridical way for creditors to enforce their claims over sovereign debt.2 The decision on providing payments relies entirely on the decision of the government and on its willingness to pay. As a matter of fact, a sovereign country may benefit from a default as it will be able to allocate the not-repaid capital to more convenient purposes. However, what must never be forgotten is that the consequences of a default are very serious, as they will affect the real economy as a whole, also making access to new credit even more difficult. When assessing these risks, investors used to consider these factors applicable only to developing countries, given that Western economies were considered safe places for investments. However, starting from the 1990s, this line of reasoning changed.3 Indeed, as developed countries started to accumulate debt and run up trade deficits, rating agencies decided to downgrade their ratings. What is more, although these countries are known to have well-established legal, regulatory and institutional frameworks, they are not exempt from political and social turmoil within their own territory. A notable example lies in the EU, where peripheral countries such as Greece, Ireland, Italy, Portugal, Spain (aka GIIPS) were greatly affected by the recent sovereign debt crisis and have since witnessed the creation and rise of radical, populist parties, whose actions are feared by most investors. Country and sovereign risk should not be seen as something strictly related to foreign investors who need to account for this factor when considering investing a part of their wealth in a certain country. Undoubtedly domestic residents as well, including both households and corporations, are affected by their government’s political actions and economic reforms. If a destabilized business environment is created and uncertainty spreads, residents who want to save, invest and plan for their future will suffer. In this context, the “average Joe” will also be affected by heavy-handed bureaucracy, changing regulations and abrupt deviations in the interest rate levels. So it would be a mistake to think that this risk factor is only pertinent to the financial and macroeconomic dimension of a country, or restricted exclusively to foreign investors. Indeed, this broad array of risks that include legal, regulatory and environ2 

M. Frenkel, A. Karmann, and B. Scholtens, Sovereign Risk and Financial Crises, Berlin, Springer, 2004. 3  M.H. Bouchet, C.A. Fishkin, and A. Goguel, Managing Country Risk in an Age of Globalization: A Practical Guide to Overcoming Challenges in a Complex World, Cham, Palgrave Macmillan, 2018.

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mental, should never be ignored as they shape the overall business environment in which local and foreign actors operate. In all, these risk factors are of fundamental importance from both a financial and an economic point of view. However, it appears that this does not represent a primary concern for governments, as politicians are more focused on succeeding in the very short term, aiming for re-election; they are therefore not fully concentrated on the economic consequences of their political actions. Of course, this is detrimental to the entire business sector as well as the everyday citizen who, in the long run, will experience all the drawbacks of political short-sightedness. For a real example of how the country and sovereign risk works over a firm, read some in-depth analysis about the FCA case, in Box 3.1. Box 3.1 The Fiat case: Avoiding the sovereign-corporate nexus Fiat S.p.A., an Italian-incorporated company founded in 1899 in Turin by Giovanni Agnelli, has experienced a history of success, expansion and diversification. Over the years the company has gone on to complete acquisitions as well as demergers, such as in the case of Ferrari and Fiat Industrial. Within this context, the strategic alliance that Fiat formed with Chrysler in 2009 appears noteworthy for the financial community. Sergio Marchionne took control of the Group in June 2004, becoming the CEO: from that moment Fiat S.p.A. experienced a number of turnaround years which allowed the company to improve its overall performance and to conduct deleveraging activities. Among other things, these initiatives boosted the company’s credit rating, which was previously quite low due to the high level of debt. Following the tough years of the global financial crisis, Fiat’s management decided to focus its attention on multiple activities: achieving challenging performance targets thanks to the new 2010 business plan, solving the conglomerate dilemma by demerging Fiat Industrial (2010), and reaching the level of critical mass through an alliance with Chrysler. In that moment the Detroit-based carmaker was greatly affected by the automotive industry crisis of 2008-10: Fiat S.p.A, the US and Canadian government, along with United Auto Workers pension fund, helped Chrysler with huge financial injections. As Chrysler was achieving performance goals, Fiat gradually acquired blocks of shares in the equity of Chrysler, eventually achieving 100% ownership in January 2014. Thanks to a new role of global carmaker following the Chrysler takeover, and considering that the Italian market was a small percentage of Fiat’s overall global revenues, Marchionne decided to implement a strategy aimed at accurately reflecting the new intrinsic nature of the new “two-souls” entity. The merger was carried out by creating a Dutch NewCo subsidiary, which upon completion of the merger process was renamed Fiat Chrysler Automobiles (FCA). After winning shareholder approval in August 2014, the transaction was finalised in October 2014, creating a resulting structure with FCA being a Dutch-incorporated company, with a UK tax domicile, with shares listed both in New York on the NYSE and on the Milan Stock Exchange (MTA); Chrysler remained a 100%-owned subsidiary. The first reason for this strategy is straightforward: being an Italian holding company, listed only on the Milan Stock Exchange with a small investor audience, Fiat was not able to reflect its new global image with increasingly diverse capital market needs. The second reason behind this change, the choice of the Netherlands as the jurisdiction of incorporation, was in light of its neutrality towards the historical jurisdictions of the largest businesses of the group. Another consideration was the fact that the Netherlands provides a governance regime which is attractive to investors in multinational enterprises, along with flexibility in raising capital and in conducting strategic acquisitions.

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Therefore, the transaction was aimed at enhancing the Group’s appeal to international investors and to facilitate the listing and trading of shares on the NYSE. Moreover, considering the historical under-representation of global investors as shareholders, FCA now wanted to direct its attention to American retail and institutional investors as well as international ones. The declared goal was to improve the liquidity of the shares and to provide access to a deeper pool of equity and debt capital; at the same time, the listing on the Milan Exchange could facilitate the involvement of a pan-European investor base. All in all, what appears evident from this transaction is that, although the company’s history started in Italy and the country always represented an important point of reference for Fiat’s business, the Group’s management came to the conclusion that the Italian business environment did not represent a suitable match for a company looking for global scope. Arguments in favour of this position assert that Italian capital markets limit the ability of a company to express its intrinsic value and to gain exposure to a broad and diversified international investor base. Indeed, Fiat’s management was convinced that the Group was suffering from an undervaluation with respect to its peers, given the already-established positive correlation of its stock with the performance of the Milan Stock Exchange. Being listed only in Milan meant being subject to sovereign risk exposure. As a matter of fact, the company’s 2014 Annual Report clearly states that the European sovereign crisis and its consequences have created concerns for the debt burden of many countries. These concerns could have a detrimental impact on the global economic recovery, as well as on the financial condition of European financial institutions. This situation required the adoption of austerity measures that “could continue to adversely affect consumer confidence, purchasing power and spending, which could negatively impact our financial condition and results of operations.”4 The situation shows how the sovereign-corporate nexus in the case of Fiat is strong and requires attention from the company’s management. This implies that a global-oriented company like Fiat, if it wants to fully realise its potential, needs to adopt drastic changes in its structure and presence on capital markets. Therefore, Marchionne’s move proved to be a well-thought strategy, implemented in the right direction to release the company from Italian constraints so as to achieve an increase in value for shareholders and of the Group as a whole. As a matter of fact, the creation of FCA was intended to provide the Group with long-term benefits which included operational improvements as well as more efficient access to capital markets, two objectives of growth and value fundamental for the company’s success.

Summary The chapter focuses on the several kinds of risk, following the introduction of the risk factor in the previous chapter. Investments and issuers’ decisions are driven by the risk profile they are willing to accept in order to increase the potential return or to mitigate the cost of funding, as the Fiat case clearly illustrates. In the following chapter we will analyse the role of financial intermediaries in relation to these risks, and the ability of these professionals to help their customers reduce their risks.

4 

Fiat Chrysler Automobiles N.V., 2014 Annual Report.

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Questions 1. What is a systematic risk? 2. How can risk affect your return from investments? 3. If a firm issues two identical bonds, in two different markets, why one can be traded at a cheaper price than the twin traded in a smaller market? 4. Why, if the rating of a country decreases, a corporate bond issued by a corporation – fiscal resident in that country – could decrease (without other news or factors)? 5. The fact that the issuer of a financial instrument has been involved in some penal proceeding, could affect the value of the issuances of this corporation?

4  The Role of the Financial Intermediaries What you will learn in this chapter: • • • •

Who is the middleman in the financial markets? How are the financial intermediaries helping the market and the market’s participants? The role of the banks in the society and in the financial world; Differences between retail banks and investment banks.

4.1 The role of the middleman In Chapter 1 we introduced the role of financial intermediaries, drawing a parallel with markets in the Roman Empire. In ancient times, in addition to a direct market “from producer to user,” there was a large market of imported goods coming to Rome from all over the Empire and beyond. There were merchants and dealers who could satisfy the needs of different individuals, institutions and businesses. These middlemen, taking on several risks themselves, were able to reduce risk for their clients and suppliers. It goes without saying that in offering a service, and taking some risks, they were betting on a good return; in short, they were doing business, with all the risks and rewards that go with it. The role of financial intermediaries in today’s international and domestic financial markets is quite similar. We can analyse what people, firms, institutions do every day and see quite clearly that the role of financial intermediaries is a necessary one. Questions: what do financial intermediaries do?

A countless number of things! See Figure 4.1 for a few examples. They serve the financial system both in the primary market and in the secondary market. The most important and crucial financial intermediaries are banks, but there are many others like securities brokers and dealers, stock exchanges, financial advisory firms, insurance companies, trusts, venture capital firms, and so on. Because financial intermediation is a business, financial intermediaries are organised as firms, making profits – or at least trying! – by offering services and transforming money into more money. Have you ever thought about how credit card payments work? Have you ever thought, when a bank gives you a loan for a new car, where this money is coming from? From another perspective, have you ever thought about what happens to your money when you deposit your wages into your bank account? Or what happens when you purchase stock from an IPO?

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Figure 4.1

4.1.1

Financial intermediaries’ businesses

Financial intermediaries as firms

Financial institutions are firms, and broadly speaking their behaviour can be analysed in the same way as any other kind of firm. So we can think about them as businesses that “sell” various financial instruments, such as loans on money that people are willing to provide (for a price). Or they sell a service, like intermediation or handling payments, and receive a fee. What’s more, like any other kind of business (except non-profits) we can assume that they are profit maximisers: their profit arises from charging interest to borrowers at a higher rate than what they pay to lenders. Or purchasing and selling currencies with a margin, the so-called “bid-ask spread.” Like any other firm, profits will be maximised at the point where total revenue minus total costs is at its highest, that is where the marginal revenue accruing from an extra unit of output is matched by the marginal cost of producing it. Then they use the rule of the economies of scale, through acquisitions and/or merges, also in order to fulfil regulatory and legal provisions and meet margin requirements. An important – indeed, fundamental – goal, which we will discuss further in the following sections, is stability. Financial intermediaries, especially retail banks, do not only invest the capital provided by shareholders and other creditors who are eager to take risks. They also have a strategic role in the financial system due to the fact that they “store” money; in doing so they must safeguard the finances of families and other risk-adverse depositors. In terms of stability, 2008 represents a milestone with its turmoils and crises. The liquidity management and regulation changed radically after 2008: see in-depth in Box 4.1.

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Box 4.1 Liquidity management for players with a surplus after 2008 There was a time when, for successful corporates, “liquidity” was neither a buzzword nor much of a concern, when borrowing came easily and depositing excess cash was second nature. Nowadays, managing a company’s money may feel more like negotiating a labyrinth where several signposts have been left confusingly pointing in all the wrong direction.1 After the 2008 crisis, and subsequent credit crunch, low interest rates are “the new normal”: treasurers have had to contend with a host of new environmental and regulatory factors, as well as liquidity shortages and volatility. Markets saw something that a student would find difficult to believe; negative interest rate regimes in Europe and Japan. In addition, the turmoil created by the Lehman Brothers crack and defaults of other banks pushed the environment to new invasive developments, especially the implementation of the Basel III global bank regulation. Ultimately, the main aim of Regulators is to protect customers by keeping banks financially safe and solvent. Since the crisis, corporates with a liquidity shortage have experienced tremendous difficulties in finding affordable borrowing; this was due to the risk aversion of very conservative banks and the lack of bank liquidity. After 2008, rates still stayed very low to compensate for the fear of regulation hurdles and capital requirements. The crisis left another important milestone in market history: traditional deposits are no longer a safe place, immune to scenario loss. Bank deposits in fact may actually cost corporates rather than earning interest, due to almost zero – or even negative – interest rates. In fact, in the past banks were able to leverage end-of-day liquidity to maximise returns for clients. After 2008, regulations tightened around banks’ own operational risk and liquidity, altering the way liquidity and deposits are treated. The Markets in Financial Instruments Directive II (MiFID II) has amplified reporting requirements, resulting in further system costs for banks. Basel III has a much greater impact in terms of liquidity availability. The Liquidity Coverage Ratio, for example, requires banks to have enough liquidity to manage a 30-day stress event. This means that banks need to keep varying levels of reserves for different forms of bank deposits and other borrowings. The result is that banks must hold a certain amount of “High-Quality Liquid Assets” (HQLAs) – assets that can be easily converted into cash within the day with no value loss.

4.2 The world of banks As we have described, banks represent a wide variety of institutions, organized as firms, whose principal function is to accept deposits and make loans. In the past, it was possible (and useful) to classify banking firms by the kind of banking business that they did. So we used to speak of “clearing banks,” which contrasted with the old British concept of “merchant banks,” “discount houses” and so on. In the final two decades of the last century a remarkable evolution occurred which, through mergers and the globalisation of banking activity, changed the banking system. The result is that the major retail banking firms now also include divisions specialising in other forms of banking.

1  See Deutsche Bank Global Transaction Banking Report 2016, Liquidity Management – Thriving in a New World.

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Question: What is a retail bank?

Retail banking involves the provision of loan and deposit facilities to individuals or households. This definition also encompasses banks which provide similar services to small and medium-sized firms, which is why they are also called “commercial banks.” Both types of activity include payment services, and so banks operating in both segments of the retail sector are heavily involved in handling payment mechanisms such as bank transfers and credit cards. However, we have already outlined how banks are institutions, operating as firms, that offer several other services such as consultancy and advisory, brokerage and investing services for people or companies with surplus cash. In addition, they help large institutions in funding, and structuring and issuing securities. Question: What is a corporate – investment bank?

Under the heading of wholesale banking we have corporate banks which provide loans and deposit facilities to large corporate clients, plus other hybrid funding solutions. They also offer a broad range of fee-based financial services. In addition, there are investment banks, whose principal activities have little direct contact with conventional banking as do commercial and corporate banks, like loans and deposits. Instead investment banks primarily deal with security markets. We can underline how banks that provide retail banking services may also offer services typical of wholesale banks, but the opposite is not true. In fact, banks which specialise in wholesale banking do not provide retail services. Just think about some European-based banks that offer customers a simple checkable deposit and a credit card, but they also have department specialised in mergers & acquisitions or structured finance: this is a typical example of the so-called “Universal bank.” 4.2.1 The European universal bank and the American model Europe and America (intended as the USA) are, in a globalized world, quite dissimilar. This is especially true in terms of regulation, as a reflection of different backgrounds and the divergent views of key players. The post-2008 crisis has evidenced a very wide gap in terms of returns for shareholders between the American and the European banking system, giving rise to two opposite scenarios. Box 4.2 presents an excerpt from a recent article that appeared online comparing the performance of the US banking index and the Eurostoxx index from 2008 to 2019. We can easily see that the American banking business is growing in terms of value as expressed by financial market prices. At the same time the European sector is in decline. The banking system structure is quite diverse in these two worlds, especially after what happened in the United States in 1933 when the Banking Act (sometimes referred to as the Glass-Steagall Act) separated commercial and investment banking.

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Box 4.2 US and Eurozone stock markets 2008-2019, a comparison The better performance of the US stock market compared to its Eurozone counterpart in recent years is explained principally by the different returns offered to investors by the banking sector. The investor in a portfolio of shares who replicated the US banking index who invested 100 dollars in January 2008, who maintained his investment in that index, and who had reinvested the dividends paid in the same index, in January 2019 would have shared worth approximately 170 dollars. On the other hand, and investor who had replicated the portfolio of shares that make up the Eurostoxx Bank index in January 2008 (reinvesting the dividends aid in the same index), would see his initial investment of 100 euros become, 11 years later, a portfolio worth about 40 euros. In short: in the last 11 years, an investor in the American banking sector has obtained a positive profitability of 70%, whereas an investor in the European banking sector has obtained a negative return of 60%.2

The early 1920s were a golden era for Wall Street and for the building industry: the stock market had gone up by almost 20% in just a year. So the banks, seeing the chance to make easy profits, invested massively in the stock market, especially in speculation related to the building industry. When the market crashed in 1929,3 depositors rushed to withdraw their funds. At the outset of the crises, over 8,000 commercial banks belonged to the Federal Reserve System, but nearly 16,000 did not.4 By March 8, depositors had withdrawn around $1.8 billion in just a month. Others demanded gold in return for their money, because the United States was still on the gold standard. But the demand was so high that the Federal Reserve was running low on its gold deposits. Millions of Americans lost their jobs in the Great Depression. Many (around the 25%) also saw their savings disappear when 4,000 US banks went out of business between 1929 and 1933, leaving depositors with nearly $400 million in losses. US Senator Carter Glass, a Democrat from Virginia, first introduced the legislation bearing his name in January 1932, and the bill was co-sponsored by Democratic Alabama Representative Henry Steagall. By June 16, 1933, President Franklin D. Roosevelt signed the Glass-Steagall Act into law as part of a series of measures adopted during his first 100 days to restore the country’s economy and trust in its banking systems. The main provisions of the Banking Act of 1933 effectively separated commercial banking from investment banking.5 Basically, commercial banks, which took in 2   See O. Marín Lozano, “US Banks Vs European Banks: Why Such a Gap in Returns,” The Corner, 20 March 2019. 3   On October 29, 1929, the infamous Black Tuesday hit Wall Street as investors traded more than 16 million shares on the New York Stock Exchange in a single day. Billions of dollars of capitalization were lost, wiping out thousands of investors. In the aftermath, USA and the rest of the industrialized world spiralled downward into the Great Depression (1929-39), the deepest and longest-lasting economic downturn in the history of the Western industrialized world. 4  See also https://www.federalreservehistory.org/essays/banking_panics_1930_31 5  See https://www.federalreservehistory.org/essays/glass_steagall_act

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deposits and made loans, were no longer allowed to underwrite or deal in securities, while investment banks, which underwrote and dealt in securities, were no longer allowed to have close connections to commercial banks, such as overlapping directorships or common ownership. Following the passage of the act, institutions were given a year to decide whether they would specialize in commercial or investment banking. Only 10% of commercial banks’ total income could stem from securities; however, an exception allowed commercial banks to underwrite government-issued bonds. The separation of commercial and investment banking was not controversial in 1933. There was a broad belief that separation would lead to a healthier financial system. It became more controversial over the years and in 1999 the Gramm-LeachBliley Act repealed the provisions of the Banking Act of 1933 that restricted affiliations between banks and securities firms. The act also gave tighter regulation of national banks to the Federal Reserve System, requiring holding companies and other affiliates of state member banks to make three reports annually to their Federal Reserve Bank and to the Federal Reserve Board. Furthermore, bank holding companies that owned a majority of shares of any Federal Reserve member bank had to register with the Fed and obtain its permit to vote their shares in the selection of directors of any such member-bank subsidiary. Another important provision of the act created the Federal Deposit Insurance Corporation (FDIC), which insures bank deposits with a pool of money collected from banks. The act had a large impact on the Federal Reserve. Notable provisions included the creation of the Federal Open Market Committee (FOMC) under Section 8. However, the 1933 FOMC did not include voting rights for the Federal Reserve Board, which was revised by the Banking Act of 1935 and amended again in 1942 to closely resemble the modern FOMC. In Continental Europe there is no regulatory distinction between investment banks and commercial banks. Therefore, banks of a very large size tend to operate as universal banks, alongside smaller firms specialised as commercial banks or as investment banks. A universal bank participates in many kinds of banking activities: it is both a commercial bank and an investment bank, very often also providing other financial services such as insurance. These banks, with dedicated departments, also offer specialist services such as wealth and asset management, trading, underwriting, researching, merger and acquisition, structured finance and financial advisory. In the United States as well as the United Kingdom, historically there was a distinction drawn between pure investment banks and commercial banks. In the US, as we have seen, this was a result of the Glass–Steagall Act of 1933. However, through the years, the regulatory barrier preventing the combination of investment banks and commercial banks has largely been removed, and a number of universal banks have emerged in both jurisdictions.

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4.3 Retail and commercial banks Banks play an important role in channelling funds from individuals and businesses in excess of liquidity, without opportunities of investment, to finance productive investment opportunities. Retail and commercial banks provide loans to businesses, but also to individuals, for example financing people’s college education, granting mortgages to purchase homes, or issuing loans for cars and other uses. 4.3.1 The balance sheet of banks In section 4.1.1, we described how these organisations are profit oriented. Therefore, balance sheet analysis helps us to understand how the banking business works. The balance sheet, as simplified in Table 4.1 and as detailed in Table 4.2, is simply a list of a bank’s assets and liabilities, following the basic principle that total assets = total liabilities + capital (equity). We can read a bank’s balance sheet as a list of: • sources of bank funds (liabilities); and • the uses to which they are put (assets). In few words we can summarise as follows: banks obtain funds from customers’ deposits and by issuing other liabilities; they then “work” these raw funds and use them to acquire assets such as securities and loans. Conducting a deeper analysis, below we detail – according with the Federal Reserve – an example of a commercial bank’s balance sheet structure. Let’s focus now on the source of funding for a bank, in particular for a retail or commercial bank, by taking an in-depth look in the following sections. A bank acquires funds by issuing (selling) liabilities, such as deposits, which are the most important source of funds the bank has. Those funds are then used to purchase – or produce – income-earning assets. Checkable Deposits are accounts that allow the owner (depositor) to write checks to third parties. There are both non-interest-earning checking accounts and interestearning negotiable orders of withdrawal accounts; a hybrid instrument is also available called a money market deposit account (MMDA).6 Checkable deposits and money market deposit accounts are payable on demand: this means that depositors can withdraw or transfer funds to other banks at any time. So for banks these are liabilities have the negative profile of not being stable, due to the fact that the bank could be asked to reimburse them. On the contrary, thanks to this instability, they have very low costs for banks, while for depositors they are safe and liquid, but offer low interest. 6  MMDAs, introduced in 1982 with features similar to money market mutual funds, are included in the checkable deposits’ category. MMDAs are not subject to reserves requirements.

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Table 4.1

Bank’s balance sheet general structure Balance sheet structure Assets

Fixed assets

Equity Long-term liabilities

Current assets

Table 4.2

Liabilities & Equity

Current liabilities

Detailed bank’s balance sheet example Bank’s balance sheet Assets

Equity (Bank’s capital)

Reserves and cash items

Liabilities

Securities

Checkable deposits

  US Government and agency

  Non transaction deposits

  State and local gov and other

  Small denomination time deposits

Loans

  Large denomination time deposits

  Commercial and industrial

Borrowings

  Real Estate

  Fed Funds

 Consumer

  Discount loans (advances)

 Other

 RePos

Other assets*

Other liabilities incl. trading liabilities

* Includes other owned real estate; premises and fixed assets; investments in unconsolidated subsidiaries; intangible assets (including goodwill); direct and indirect investments in real estate ventures; accounts receivable; derivative contracts (interest rate, foreign exchange rate, other commodity and equity contracts) with a positive fair value, as determined under FASB Interpretation No. 39 (FIN 39); and other assets. Excludes the due-from position with related foreign offices.

Checking Account:7 a type of account that enables customers to make deposits and withdrawals on demand, typically by writing a check or using a debit card. These accounts are sometimes interest-bearing. These deposits are either payable immediately or are issued with an original maturity or required notice period of less than seven days or represent funds for which the depository institution does not reserve the right to require at least seven days written notice of an intended withdrawal. 7 

See Bank of America, Glossary of banking terms.

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A money market deposit account (MMDA) is a high-yield savings account but offers account holders check-writing capability, making it a hybrid account that has the features and benefits of both traditional checking and savings accounts. Like checking accounts, MMDAs let you access your money when you want, except in a few cases. Most accounts allow holders to write checks or withdraw cash. Some offer a debit card to make purchases, but depositors can’t make payments by bank transfer or debit card more than six times per month by law (some banks allow only three payments per month). MMDAs allow depository financial institutions to be more competitive with money market mutual funds. MMDAs are insured by the Federal Deposit Insurance Corp. (FDIC), and they generally earn interest at a higher rate than standard savings accounts. Investing in an MMDA often requires the customer to maintain a higher balance than what is required for a standard savings or checking account. That feature prohibits some customers from opening an MMDA. They could look quite similar to a Certificate of Deposit (CD), but they are quite different because in MMDAs there is no holding period on the money. Non-transaction deposits, the primary source of bank liabilities, are accounts from which the depositor cannot write checks. This feature allows banks to manage their liquidity needs and timing. That is why the interest rates on non-transaction deposits are usually higher than checkable deposits. Banks offer their “suppliers,” the depositors, savings accounts and time deposits, which are also called certificates of deposit (CDs) These deposits have a fixed maturity and a penalty for early withdrawal, helping banks to forecast the outflow of liquidity and thus the necessary management of the “assets’ side timing.”8 Due to these characteristics CDs have a higher cost for banks and offer a better rate for depositors. Time deposits are bank deposits from which withdrawals may be made only after advance notice or at a specified future date. The depositor does not have the right, and in fact is not permitted, to make withdrawals until six days after the date of deposit. If a withdrawal is made in this period, the deposit is subject to an early withdrawal penalty. “Save your money for a set period of time and get a higher interest rate than in an easy access savings account.”9 Savings deposit is a deposit account that generally earns higher interest than a checking account and limits the customer to no more than a limited number of bank

8  Usually banks borrow short and lend long; that’s why they need a stable liability-side in order to match different asset-side maturities. 9  See HSBC Hong Kong.

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transfers and other operations (including check, draft and point-of-sale transactions, if checks or debit cards are allowed on the account) each monthly. Certificate of Deposit10 is a time deposit that is payable at the end of a specified amount of time or term. CDs generally pay a fixed rate of interest and, depending on the market rate environment, can offer a higher interest rate than other types of deposit accounts. Terms can range from 7 days to 10 years. CDs are insured by the FDIC up to applicable limits. If early withdrawal from the CD prior to the end of the term is permitted, a penalty is usually assessed. While saving accounts are available for small depositors, CDs are available in large denominations and are bought by large corporations and other banks. CDs are also negotiable. Under the heading borrowings there are several different, diversified forms of funding for banks. Banks collect liquidity not only from individuals and small businesses in excess of money, but also via the Federal Reserve System and from other banks and large corporations. Banks acquire funds from the Fed in the form of discount loans called advances. According to the Federal Reserve Act, Section 10 B, Letter a), “In General any Federal Reserve bank, under rules and regulations prescribed by the Board of Governors of the Federal Reserve System, may make advances to any member bank on its time or demand notes having maturities of not more than four months and which are secured to the satisfaction of such Federal Reserve bank.” Banks can raise liquidity through Fed funds in Overnight transactions from other banks; the aim here is often to meet the amount of reserves required by the authority of short-term needs of liquidity. The overnight bank funding rate is the measure of unsecured overnight bank funding costs, while a Repo is a secured form of bank funding. It is calculated using federal funds transactions, certain Eurodollar transactions, and certain domestic deposit transactions. Read in Box 4.3, 4.4, 4.5 and 4.6 for a few more detailed description about the overnight bank funding rate, about the Eurodollars, about what is a Repo and about the commercial papers. Other forms of funding for banks are: 1. interbank offshore dollar deposits (from other banks in the Eurodollar market); 2. repurchase agreements (aka “repos”), a collateralized loan structured with the exchange of a long-term security – previously accounted among the borrowers’ assets – for cash, with the agreement for a future buyback; 3. commercial papers and notes issued to large institutions with private placements.

10 

See Bank of America, Glossary of banking terms.

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Box 4.3 What is the overnight bank funding rate?11 The overnight bank funding rate is a measure of wholesale, unsecured, overnight bank funding costs. In the American system it is calculated using federal funds transactions, certain Eurodollar transactions, and certain domestic deposit transactions and selected Money Market Rates. The federal funds market consists of domestic unsecured borrowings in US dollars by depository institutions from other depository institutions and certain other entities, primarily government-sponsored enterprises. The Eurodollar market consists of unsecured US dollar deposits held at banks or bank branches outside of the United States. US-based banks can also take Eurodollar deposits domestically through international banking facilities (IBFs). The overnight bank funding rate (OBFR) is calculated as a volume-weighted median of overnight federal funds transactions, Eurodollar transactions, and the domestic deposits reported as “Selected Deposits.” In the European system the euro short-term rate (€STR) reflects the wholesale euro unsecured overnight borrowing costs of banks located in the euro area. The €STR is published on each TARGET2 business day based on transactions conducted and settled on the previous TARGET2 business day (the reporting date “T”) with a maturity date of T+1 which are deemed to have been executed at arm’s length and thus reflect market rates in an unbiased way.

Box 4.4 What are the Eurodollars? Eurodollars are bank deposit liabilities denominated in US dollars but not subject to US banking regulations. For the most part, banks offering Eurodollar deposits are located outside the United States. However, since late 1981 non-US residents have been able to conduct business free of US banking regulations at International Banking Facilities (IBFs) in the United States. Eurodollar deposits may be owned by individuals, corporations, or governments from anywhere in the world, with the exception that only non-US residents can hold deposits at IBFs. Originally, dollar-denominated deposits not subject to US banking regulations were held almost exclusively in Europe; hence, the name Eurodollars. Most such deposits are still held in Europe, but they also are held at US IBFs and in such places as the Bahamas, Bahrain, Canada, the Cayman Islands, Hong Kong, Japan, the Netherlands Antilles, Panama, and Singapore. Regardless of where they are held, such deposits are referred to as Eurodollars worldwide. Banks in the Eurodollar market compete with banks in the United States to attract dollar-denominated funds. Since the Eurodollar market is relatively free of regulation, banks in the Eurodollar market can operate on narrower margins or spreads between dollar borrowing and lending rates than can banks in the United States. This gives Eurodollar deposits an advantage relative to deposits issued by banks operating under US regulations. In short, the Eurodollar market has grown up largely as a means of avoiding the regulatory costs involved in dollar-denominated financial intermediation.12

11  12 

See https://apps.newyorkfed.org/markets/autorates/obfr See Marvin Goodfriend at Federal Reserve Bank of Richmond, Virginia.

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Box 4.5 What is a Repo? In a general definition a Repo is a short term repurchase agreement, a transaction used to finance the holders of bonds and other debt securities in shortage of liquid money on the very short period. In a standard repo transaction, a dealer finances its ownership of a bond by borrowing money from a customer on an overnight basis and posting the bond as collateral. The dealer borrows less than the market value of the bond, so that the loan from the customer is overcollateralized, protecting the customer against a drop in the value of the bond. This form of funding is use also between banks and other financial institutions. The Fed, for example, uses the Repurchase Agreements to make collateralized loans to primary dealers. In a reverse repo or “RRP,” the Fed borrows money from primary dealers. The typical term of these operations is overnight, but the Fed can conduct these operations with terms out to 65 business days. The Fed uses these two types of transactions to offset temporary swings in bank reserves; a repo temporarily adds reserve balances to the banking system, while reverse repos temporarily drains balances from the system. Repos and reverse repos are conducted with primary dealers via auction. In a repo, dealers bid on borrowing money versus various types of general collateral. In a reverse repo, dealers offer interest rates at which they would lend money to the Fed versus the Fed’s Treasury general collateral, typically Treasury bills.13

Box 4.6 What are commercial papers? Commercial paper is a short-term, unsecured debt instrument with a duration of 1-270 days. Financial institutions and large corporations are the main issuers of commercial paper, because they have high credit ratings. There is trust in the market that they will repay unsecured promissory notes of this nature. Commercial paper is usually sold at a discount to its face value and is a cheaper alternative to other forms of borrowing, like any other money market instrument. The commercial paper market is used by commercial banks, nonbank financial institutions, and nonfinancial corporations to obtain short-term external funding. There are two main types of commercial paper: unsecured and asset backed. Unsecured commercial paper consists of promissory notes issued by financial or nonfinancial institutions with a fixed maturity of 1 to 270 days, unless the paper is issued with the option of an extendable maturity. An unsecured commercial paper is not backed by collateral, which makes the credit rating of the originating institution a key variable in determining the cost of issuance. All commercial paper is traded in the over-the-counter (OTC) market, where money market desks of securities broker-dealers and banks provide underwriting and market-making services. In the United States, commercial paper is cleared and settled by the Depository Trust Company (DTC). Commercial paper provides institutions with direct access to the money market. In traditional bankintermediated financial systems, borrowing institutions obtain loans from commercial banks, which in turn are funded primarily by deposits. Since the early 1980s, however, the US financial system has undergone a major transformation, as an ever-increasing fraction of credit intermediation migrated from banks to financial markets.14 After the 2008 crisis, following Lehman Brothers’ bankruptcy on September 15, 2008, US Federal Reserve launched the Commercial Paper Funding Facility (CPFF) to support the flow of credit to 13 

See https://www.newyorkfed.org/aboutthefed/fedpoint/fed04.html T. Adrian, K. Kimbrough, and D. Marchioni, “The Federal Reserve’s Commercial Paper Funding Facility,” FRBNY Economic Policy Review, May 2011. 14 See

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households and businesses. Commercial paper markets directly finance a wide range of economic activity, supplying credit and funding for auto loans and mortgages as well as liquidity to meet the operational needs of a range of companies. By ensuring the smooth functioning of this market, particularly in times of strain, the Federal Reserve is providing credit that will support families, businesses, and jobs across the economy. Commercial paper is held by many classes of investors. The largest share of ownership is by money market mutual funds, followed by the foreign sector, and then by mutual funds that are not money market mutual funds. Other financial institutions that hold commercial paper include nonfinancial corporations, commercial banks, insurance companies, and pension funds. The creation of the Commercial Paper Funding Facility is closely tied to the operation of money market mutual funds. Money market funds in the United States are regulated by the Securities and Exchange Commission’s (SEC): money market funds are limited to investing mainly in highly rated debt with maturities of less than thirteen months.

Once we understand the liabilities side, and how banks can collect liquidity, it is time to scout the asset side: how banks reinvest the liquidity. On the asset side, we can find reinvested liabilities or “use of funds” that provide interest income which enables banks to make a profit. According to banking regulation, and for safe and conservative bank management activity, not every cent is reinvested. This is necessary because, as we have seen, some deposits may vary every day when people withdrawal or transfer funds. In the American scenario the Fed system asks banks to maintain a certain amount of money and not reinvest it. These funds, called reserves, are held in an account with the Fed. Instead, currencies physically held by banks are called “vault cash.” Across the Euro area, banks are required to hold minimum reserves in their current accounts at their national central bank. A bank’s minimum reserve requirement is set for six-week maintenance periods. The level of reserves is calculated on the basis of the bank’s balance sheet before the start of the maintenance period.15 The annual and quarterly data on minimum reserve requirements refer to averages of the last maintenance period of the year/quarter. As of 10 March 2004, maintenance periods start on the settlement day of the Main Refinancing Operation (aka MRO) following the Governing Council’s assessment of the monetary policy stance. The Federal Reserve Act and the International Banking Act of 1978 impose reserve requirements on all depository institutions and banking corporations that have transaction accounts, nonpersonal time deposits, or Eurocurrency liabilities. US branches and agencies of foreign banks that have such deposits or liabilities are also subject to reserve requirements if they are part of or affiliated with a foreign bank with total, worldwide consolidated assets in excess of $1 billion.16 Regulation D, Reserve Requirements of Depository Institutions, issued by the Federal Reserve Board, defines the institutions that are subject to reserve require15 https://www.ecb.europa.eu/stats/policy_and_exchange_rates/minimum_reserves/html/index. en.html 16  Check the Fed, Reserve Maintenance Manual, 20 November 2019.

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ments; the liabilities that are reservable; and the associated reporting, reserve calculation, and maintenance requirements. A reserve balance requirement17 is the portion of an institution’s reserve requirement that is not satisfied by its vault cash and therefore must be maintained either directly with a Reserve Bank or in a pass-through arrangement. According to the Fed system, “The Reserve Maintenance Manual provides information regarding reserve calculations. As announced by the Fed on March 15, 2020, the Board reduced reserve requirement ratios to zero percent effective March 26, 2020. This action eliminated reserve requirements for all depository institutions.” (See Box 4.7.) Box 4.7 Federal Reserve Actions to Support the Flow of Credit to Households and Businesses18 March 15, 2020 Reserve Requirements For many years, reserve requirements played a central role in the implementation of monetary policy by creating a stable demand for reserves. In January 2019, the FOMC announced its intention to implement monetary policy in an ample reserves regime. Reserve requirements do not play a significant role in this operating framework. In light of the shift to an ample reserve’s regime, the Board has reduced reserve requirement ratios to zero percent effective on March 26, the beginning of the next reserve maintenance period. This action eliminates reserve requirements for thousands of depository institutions and will help to support lending to households and businesses.

Any additional reserves beyond this level are optional and called excess reserves. Banks keep these reserves because they are the most liquid assets; banks can use them to meet their obligations when funds are withdrawn. After the 2008 turmoil subsequent to the Lehman Brother’s default, and the US recession that followed, banks have hugely increased their excess reserves, as shown in Figure 4.2. As described in the following Table 4.3, due to the forecasts of risk from the Covid-19 pandemic, US banks decided to shore up their excess reserves from the second quarter of 2020, with an increase of around +119.9% from January 2020 to May 20, 2020. In the US, consumers also rely on the Federal Deposit Insurance Corporation (FDIC) to insure their bank deposits. As of the third quarter of 2019, the FDIC insured 5,256 institutions, of which 4,587 were commercial banks and the remainder, savings banks. According to the FDCI, the total amount of assets the FDIC insured was $18.5 trillion, and the total amount of loans insured was $10.4 trillion.19

17 

Ibidem. Federal Reserve Actions to Support the Flow of Credit to Households and Businesses, Press release, 15 March 2020 https://www.federalreserve.gov/newsevents/pressreleases/monetary20200315b. htm. 19  See FDIC, Statistics At A Glance, 30 September 2019. 18 Fed,

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Figure 4.2

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Bank’s excess reserves: St. Louis Fed

3,200,000 Millions of Dollars

2,800,000 2,400,000 2,00,000 1,600,000 1,200,000 800,000 400,000 0 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020

Source: Adapted from Federal Reserve Bank, St. Louis.

Table 4.3

Banks excess reserves: details

Source: Author’s computation on Federeal Reserve Bank, St. Louis, downloadable data.

On the other side of the Atlantic, the European Central Bank (ECB) requires credit institutions to hold compulsory deposits on accounts with the National Central Banks (NCBs): these are called “minimum” or “required” reserves. The amount of required reserves to be held by each institution is determined by its reserve base. In order to determine an institution’s reserve requirement, the reserve base is multiplied by the reserve ratio. The ECB applies a uniform positive reserve ratio to most of the balance sheet items included in the reserve base.20 A bank’s minimum reserve requirement is 20 

See also ECB, What are minimum reserve requirements?, 11 August 2016.

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set for a period of six-week, according to the “minimum reserves” Guideline21 or the legal framework related to minimum reserves. The amount of these reserves is calculated on the basis of the bank’s balance sheet before the start of the maintenance period. As of 10 March 2004, maintenance periods start on the settlement day of the main refinancing operation (MRO) following the Governing Council’s assessment of the monetary policy stance. Once they account for the compulsory and extra reserves, banks have to reinvest the liquidity in order to do business and make profits. Analysing the most important asset classes, according to the Fed analysis of banks’ balance sheets, we can find the following items. Cash items in process of collection: checks deposited at a bank; funds from other banks that have not yet been transferred. Suppose that a check written on an account at Bank Alfa is deposited at Bank Beta, but the funds for this check have not yet been received from Bank Alfa. This check will be accounted as “cash in process of collection” because Bank Beta, barring any problems, will receive this amount in a few days. “Cash items in process of collection” includes:22 1. Checks or drafts in process of collection that are drawn on another depository institution (or on a Federal Reserve Bank) and that are payable immediately upon presentation in the United States; 2. Government checks drawn on the Treasurer of the United States or any other government agency that are payable immediately upon presentation and that are in process of collection; 3. Other items in process of collection that are payable immediately upon presentation and that are customarily cleared or collected as cash items by depository institutions in the country where the reporting bank’s office which is clearing or collecting the item is located. In normal daily operations, all banks have items which are charged to demand deposits, but which cannot be processed because of insufficient funds, a lack of information, unknown accounts, etc. Such items include return items, rejects, or unposted debits and may consist of checks, loan payments, or other debit memos. In some banks, these items are singled out and an entry is made reclassifying them to a separate asset account. Other banks include the items in a subsidiary control account in the individual demand deposit ledgers. In that case, the account would have a debit balance that would be credited when the bank returns the checks to their sources. Cash items not in process of collection should be carried in a noncash account and reported as other assets. Deposits at other banks usually deposits from small banks at larger banks (re-

21  22 

ECB/2014/60, as amended (General Documentation Guideline). See the FDIC Risk Management Manual of Examination Policies.

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ferred to as correspondent banking), including services for check collection, foreign exchange transaction, etc. Correspondent banking is a service offered by one bank (the “correspondent bank”) to another (the “respondent bank”). Large international banks typically act as correspondents for thousands of other smaller banks around the world. Respondent banks may be provided with a wide range of services, including cash management (e.g. interest-bearing accounts in a variety of currencies), international wire transfers, cheque clearing, payable-through accounts and foreign exchange services. International banks are often the international channel for small, local banks. Correspondent banking is an activity that has been negatively impacted by derisking in certain regions and sectors. This is of concern to the international community, as correspondent banking is an important means of facilitating cross-border movements of funds, enabling financial institutions to access financial services in different currencies and foreign jurisdictions. This supports international trade, charitable giving, commerce and remittances flows, all of which contributes to promoting financial inclusion.23 Securities are another very important income-earning asset class for banks. Securities can be held-to-maturity, reported at amortized cost; available-for-sale, reported at fair value; held as trading assets, also reported at fair value Equity securities have readily-determinable fair values and are not held for trading. Securities are usually accounted in a bank’s balance sheet, according to the Fed, under “treasury and agency securities” or “other securities.” Treasury securities are liabilities of the US government. Agency securities are liabilities of US government agencies and US government-sponsored enterprises. “Other securities” includes those issued by states and political subdivisions in the United States, asset-backed securities (ABSs), other domestic and foreign debt securities, and investments in mutual funds and other equity securities with readily-determinable fair values. This asset class is quite strategic for retail and commercial bank revenues, because it is a type of cash-generating unit with a very low risk profile. According to a recent analysis, in 2018 the interest income of FDIC-insured commercial banks from investment securities amounted to approximately $87.19 billion, fairly similar to 2009, after an intra-period low of $63.89 billion in 2013. Securities accounted for 21.4% of US banks’ assets by the end of January 2020, which broke down to around 16.8% in treasuries and 4.6% in other securities. Short-term treasuries, held by banks, are considered a sort of secondary reserve because of their high liquidity. The most important asset for commercial and retail banks is the made up of loans which represent 56% of bank assets (check Figure 4.3 for the 2002-20 trend). Commercial real estate (CRE) lending in the United States is an important component of overall business lending, measuring a little less than 14% of GDP as of third quarter 2018. Bank and nonbank lenders compete in the CRE market, with US com-

23 

See FATF Guidance, Correspondent Banking Services, October 2016.

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Figure 4.3

All commercial banks, commercial and industrial loans

Billions of U.S. Dollars

3,200 2,800 2,400 2,00 1,600 1,200 800

2002

2004

2006

2008

2010

2012

2014

2016

2018

2020

Source: Adapted from Federal Reserve Bank, St. Louis.

Figure 4.4

All commercial banks commercial real estate loans

Percent Change at Annual Rate

20 15 10 5 0 –5

–10

Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020

Source: Adapted from Federal Reserve Bank, St. Louis.

mercial banks holding almost 60% of the volume of commercial mortgages.24 See in Figure 4.4 the Real Estate Loan percent changed per annum between Q1-2005 and Q1-2020. Loans are a bank’s income-earning assets, accounting for more than half of bank revenues, and are classified as follows (in % over total assets, as of January 2020): 1. Commercial and industrial loans (1.1%); 2. Real estate loans (25.8%); 24  See D. Glancy, J. Krainer, R. Kurtzman, and J. Nichols, Intermediary Segmentation in the Commercial Real Estate Market, Federal Reserve Board of Governors, September 2019.

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3. Consumer loans (8.9%); 4. Other loans (8.2%). This asset class is not very liquid, because loans are a medium to long-term investment for banks that cannot be called back (except in very rare cases). Loans can be sold but with a sizeable loss of value and to a very limited number of counterparties. Loans have a higher percentage of default risk,25 which is why they can provide a very high return. Mortgage loans are typically classified as either prime or subprime, depending on their credit risk, defined as the risk that the borrower could default on the loan. Interest rates are higher on subprime mortgages, reflecting their higher credit risk. Despite its common usage, the prime/subprime distinction is not clear-cut and there is still some confusion regarding a precise characterization of subprime lending. The so-called “subprimes” are sadly infamous due to their direct link to the 2007-2010 financial crisis: for an in-depth analysis about how this “bubble” exploded, check Box 4.8. Box 4.8 A Fed history: The subprime crisis of 2007-10. How and why the crisis occurred26 The subprime mortgage crisis of 2007-10 stemmed from an earlier expansion of mortgage credit, including to borrowers who previously would have had difficulty getting mortgages, which both contributed to and was facilitated by rapidly rising home prices. Historically, potential homebuyers found it difficult to obtain mortgages if they had below-average credit histories, provided small down payments or sought high-payment loans. Unless protected by government insurance, lenders often denied such mortgage requests. While some high-risk families could obtain small-sized mortgages backed by the Federal Housing Administration (FHA), others, facing limited credit options, rented. In that era, homeownership fluctuated around 65%, mortgage foreclosure rates were low, and home construction and house prices mainly reflected swings in mortgage interest rates and income. In the early and mid-2000s, high-risk mortgages became available from lenders who funded mortgages by repackaging them into pools that were sold to investors. New financial products were used to apportion these risks, with private-label mortgage-backed securities (PMBS) providing most of the funding of subprime mortgages. The less vulnerable of these securities were viewed as having low risk either because they were insured with new financial instruments or because other securities would first absorb any losses on the underlying mortgages.27 This enabled more firsttime homebuyers to obtain mortgages,28 and homeownership rose. The resulting demand bid up house prices, more so in areas where housing was in tight supply. These induced expectations of a continuous price gains, further increasing housing demand and prices29 in a circular movement. Investors purchasing private-label mortgage-backed securities profited at first because rising house prices protected them from losses. When high-risk mortgage 25

  For delinquency rates check https://www.federalreserve.gov/releases/chargeoff/delallsa.htm.   See https://www.federalreservehistory.org/essays/subprime_mortgage_crisis. 27   See D. DiMartino and J. Duca, “The rise and fall of subprime mortgages,” Economic Letter, vol. 2, n. 11, 2007. 28  See J.V. Duca, J. Muellbauer, and A. Murphy, “House Prices and Credit Constraints: Making Sense of the US Experience,” The Economic Journal, vol. 121, 2011. 29  See K.E. Case, R.J. Shiller, and A. Thompson, What Have They Been Thinking? Home Buyer Behavior in Hot and Cold Markets, National Bureau of Economic Research, Working Paper 18400, 2012. 26

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borrowers could not make loan payments, they either sold their homes at a gain and paid off their mortgages or borrowed more against higher market prices. Because such periods of rising home prices and expanded mortgage availability were relatively unprecedented, and new mortgage products’ longer-run sustainability was untested, the riskiness of PMBS may not have been well-understood. On a practical level, risk was “off the radar screen” because many gauges of mortgage loan quality available at the time were based on prime, rather than new, mortgage products. When house prices peaked, mortgage refinancing and selling homes became less viable means of settling mortgage debt and mortgage loss rates began rising for lenders and investors. In April 2007, New Century Financial Corp., a leading subprime mortgage lender, filed for bankruptcy. Shortly thereafter, large numbers of PMBS and PMBS-backed securities were downgraded to high risk, and several subprime lenders closed. Because the bond funding of subprime mortgages collapsed, lenders stopped making subprime and other nonprime risky mortgages. This lowered the demand for housing, leading to sliding house prices that fuelled expectations of still more declines, further reducing the demand for homes. Prices fell so much that it became hard for troubled borrowers to sell their homes to fully pay off their mortgages, even if they had provided a sizable down payment. As a result, two government-sponsored enterprises, Fannie Mae and Freddie Mac, suffered large losses and were seized by the federal government in the summer of 2008. Earlier, in order to meet federally mandated goals to increase homeownership, Fannie Mae and Freddie Mac had issued debt to fund purchases of subprime mortgage-backed securities, which later fell in value. In addition, the two government enterprises suffered losses on failing prime mortgages, which they had earlier bought, insured, and then bundled into prime mortgage-backed securities that were sold to investors. In response to these developments, lenders subsequently made qualifying even more difficult for high-risk and even relatively low-risk mortgage applicants, depressing housing demand further. As foreclosures increased, repossessions multiplied, boosting the number of homes being sold into a weakened housing market. This was compounded by attempts by delinquent borrowers to try to sell their homes to avoid foreclosure, sometimes in “short sales,” in which lenders accept limited losses if homes were sold for less than the mortgage owed. In these ways, the collapse of subprime lending fuelled a downward spiral in house prices that unwound much of the increases seen in the subprime boom. The housing crisis provided a major impetus for the recession of 2007-09 by hurting the overall economy in four major ways. It lowered construction, reduced wealth and thereby consumer spending, decreased the ability of financial firms to lend, and reduced the ability of firms to raise funds from securities markets.30

Commercial banks also make loans to other banks in the so-called “Fed fund market,” as seen in the liabilities section. Lastly, other assets include bank properties, tangible and intangible assets, computer systems, and other equipment. 4.3.2 The profit & loss statement of banks: how they make money Now let’s consider how a firm, whose business consists in the transformation of raw materials, can account for profits on its profit & loss statement: the cost of the raw materials plus the structure’s expenses must be lower than the revenues from the 30  See J. Duca and J. Muellbauer, Tobin LIVES: Integrating evolving credit market architecture into flow of funds based macro-model, ECB Working Paper Series No. 1581, 2013.

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sales of the final product. There is a reason behind the choice of this previous example; it is not a trader of raw materials making profits by purchasing from a dealer and selling to other buyers. In fact, banks and financial intermediaries, according to a broader definition, are not just traders moving resources from someone who has an excess quantity to someone else who is lacking these resources. These financial institutions are able to offer several layers of transformation, offering to customers solutions that can help them get over some hurdles such as the lack of information, the diversification problem and the sizing issue. To make a profit, banks basically harvest “raw” liquidity (input), transform this liquidity into a wide range of issuances and sell them (output) at a price that is higher than the cost of funding plus the operational expenses. What this means is that this liquidity leaves the bank and comes back, after a certain period of time following one or more steps, in a larger quantity. The funding process is usually conducted by offering deposits (a safe place to store cash) to entities in surplus (the major input), and through other issuances of debt, both short- and long-term. Output for banks consists of loans and other forms of lending or “investments” that could guarantee a positive return. All other things being equal, banks try to attract more deposits (or to issue more liabilities) with which to increase the production of loans by offering a higher rate of interest or better services. Let’s introduce a basic example to understand the role of the bank as middleman As shown in Figure 4.5, banking plays the role of middleman between lenders and borrowers, ensuring that the financial system and the economy run smoothly and efficiently. So now we will analyse the profit and loss of the three players involved in the theorical transaction. Figure 4.5

Intermediation: lenders, bank and borrowers

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Lender’s side: Deposit

$ 100

Reimbursement

$ 105

Margin

$

5

Lenders, who are in excess of money, deposits an amount (the capital) in a bank’s time deposit account, with the promise from the bank to get their capital back plus the interest rate, which by their accounting is the net income. Simply put, this is the return on the investment. Borrower’s side: Loan received

$

90

Repayment

$ 110

Cost

$

20

Borrowers, the other pole of this world, are lacking money. They receive a loan from the bank (called the principle) and promise to pay the principle back plus an interest rate: the cost of using someone else’s money (for a certain period of time. Their accounting shows a loss, basically the cost of funding. The interest rate charged to the borrower reflects several factors, such as the credit risk for the bank that the borrower might not be solvent, and the length of time between the issuance of the loan and reimbursement to the bank. Bank’s side: Margin over loans out

$ 20

Cost of funding (i.e. deposits)

$

General expenses

$ 10

Margin

$

5 5

The bank, the middleman who puts the two poles in contact, with one hand collects money from the lender and with the other one lends money to the final borrower. The bank has a cost of funding for “harvesting” money from depositors. This is why, in order to do profitable business, a bank must charge the final borrower a rate that is higher than its cost of funding plus other expenses (cost of the structure, salaries, rent, IT, etc.). The bank’s books show a gain, a positive margin from the intermediation activity, thanks to the return from the lending activity that produces margins which are wider than the cost of funding and expenses. As you can see from this example, when the bank borrowed $100, it “reinvested” just $90 in its lending activity. In the next section we will explore some details about the basic principles of banking management.

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4.3.3 Basic principles of banking management It is helpful to understand some of the simple accounting associated with the process of banking, something that we can already deduce from the previous two sections. Banks make profits by selling liabilities with one set of characteristics and using the proceeds to buy assets with a different set of characteristics. Think beyond debit/credits and try to see that banks engage in asset transformation. An example of this is when a bank takes your savings deposits and uses the funds to issue a mortgage loan. Banks tend to “borrow short and lend long” (in terms of maturity). What does this mean? Time is a variable of return: borrowing short means cutting the cost of funding. Lending long means an increase in risk, but at the same time in the return. Managers want to make sure that the bank is ready to pay when there are deposit outflows, so they must engage in liquidity management in order to meet the bank’s obligation to its depositors. Bank managers must pursue an acceptably low level of risk by acquiring assets that have a low rate of default, and by diversifying asset holdings. All this involves asset management, which represents an attempt to earn the highest possible return on assets while minimizing risk and forecasting liquidity needs. How is this possible? By finding borrowers with a low default risk who are willing to pay high interest rates, or by buying securities with high returns and low risk. Since this situation is quite utopic, the best option available to managers is to invest in a wide range of diversified assets and securities, thereby reducing the risk profile without greatly impacting returns. In order to be profitable, like any other kind of business, banks need to acquire funds at low cost, using a liability management approach. Liability management has been an imperative since the 1960s, when banks began to explore ways in which the liabilities on their balance sheets could provide them with reserves and liquidity. Liability management deals with the source of funds, from deposits to CDs to other debt. But banks cannot simply rely on deposits in a passive way because of the constant “risk” of withdrawals. So, when they see loan opportunities, banks borrow or issue CDs to acquire funds. Funding at low cost involves shorter borrowing, while longer borrowing (such as savings accounts, which are much more stable and much more useful for time management) brings an increase in costs. Large banks or bank groups use their own’s money centre banks’ in key financial centres and manage both sides of the balance sheet with an asset-liability management committee (ALM). Sometimes international banks issue liabilities and borrow in one country where there are cheaper opportunities, and then reinvest in other countries, moving money through their internal system.

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4.4 Investment and corporate banks Financial intermediaries, in US tradition, are known as investment banks and are specialised in underwriting. In the UK, they are called commercial banks, specialised in equity trading. In Europe they are known as Universal Banks, specialised in corporate trading. Nowadays, there is no such distinction. Investment Banks (or just IBs) are: • • • • •

a system of very different businesses; based in consultancy and advisory; close to customers’ financial structure; sized with a medium-big ticket dealing (assistance referred to large deals); focused on an international perspective.

Investment bankers operate behind the scenes which makes their functions less known to the public. Investment banks provide financial services to public authorities, financial institutions and multinational corporations, offering their services in a number of different contexts, which are detailed below. 1. 2. 3. 4. 5. 6. 7.

Capital markets. Corporate finance. Private equity. Structured finance. Risk management. Asset management. Lending.

1. Capital markets: financial services provided to large customers for the issuance process of financial instruments. There are different types of instruments in capital markets, so we need to understand, which one investment banks deal with. We also need to look at the type of service, and where and when it will be offered. As far as where, the answer is the primary or secondary markets. Primary market services: • Originating the deal, and explaining to clients the conditions of the market where the issuance will occur (for example, low return rates could be acceptable by foreign investors in one country because investors are betting on an appreciation of the currency, on the condition that the maturity of the bond is not more than two years (i.e. short term). • Advising/arranging: pricing and recommending certain issues to international investors. Pricing an equity issue is one of the most difficult parts of an issuance. The wrong price target, set too high, could determine very weak demand for the IPO due to the risk that the price will drop, while a low pricing could bring a less

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Figure 4.6

75

Issuance process

cash flow to the issuer, lower than the fair value. Investment banks also help issuers by assisting them with filings for the SEC or other market authorities. • Underwriting: Investment banks buy all the stocks/bonds and resell them in the market, in some cases forming a syndicate with other banks, in order to guarantee the success of the IPO or placement. This service is fundamental for the well-being of the market. Banks take a risk by using their reserves of capital; their returns consist of service fees plus possible capital gains. Generally, primary market activity, which is totally fee based, has no impact on regulatory capital usage, with the exception of underwriting. The “issuance process” can be graphically described as in Figure 4.6. Secondary market services: • Trading (also called brokerage): Investment banks buy and sell securities. The bank stands ready to do so following requests from clients, while not exposing its balance sheet to the transactions. Remuneration for investment banks is, in this case, fee-based. IBs offer services such as: • Market order: instructions to an agent to buy/sell at the current market price; • Limit order: buy orders specify a maximum acceptable price, and sell orders a minimum acceptable price; • Stop loss order/take profit order: below/above a specific level the broker will buy/sell automatically in order to protect the customers from loss or take gains; • Short selling: investors borrow stocks from a brokerage house and sell them today, with the promise of replacing the borrowed stocks by buying them back in the future.

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• Dealing (also called market making): using money from a bank’s own balance sheet to buy securities at the bid price and resell them at the ask price. The IB in this phase is also called “contributor.” Remuneration comes from the bid-ask spread they are able to make in this middleman role, purchasing and then reselling securities. Using a financial dat provider for trading it is easy to notice how, especially for bonds but not only, it’s possible to find, for the security, the price for each regulated markets and also the price made by the IBs acting as contributors. These banks are often larger than the official market platforms, especially in the OTC market. • Other services: Investment banks in the secondary market offers services like the margin credit. This service, aka leverage, refers to loans advanced by the brokerage house to help investors buy securities. IBs also offer other services traditionally conducted by commercial banks. For example, in 1977 Merrill Lynch developed the Cash Management Account, bypassing the 1933 Banking Act. For a more generic description we can say that the secondary market activity is the advisory and support that is given post-issuing. The only secondary market activity which impacts regulatory capital usage is dealing, while pure intermediation, like trading, is fee-based. 2. Corporate finance: financial support provided to clients who want to implement a particular strategy, decided by managers and approved by shareholders’ general meeting. In particular, the strategy could be to grow or to restructure. Growth services include: • Origination: helping the client understand the best available opportunity in terms of markets and targets (cross-border M&A transactions); • Arranging: beginning with evaluating the foreign target, determining a price to offer to target shareholders, negotiating the price of acquisition, identifying synergies; • Financing: lending or issuing; in general payment for an acquisition takes the form of stock and cash; • Restructuring: depends on which part of the company has to be restructured and where the company is when restructuring activities begin. If the asset side of the balance sheet has to be restructured, the company can sell assets or businesses not related to core businesses. Regarding liabilities, in case of a liquidity crises, the problem is that the company cannot repay its outstanding debt in addition to interest. Shareholders will be disappointed but will not demand liquidation of the company. The first thing to discuss with creditors is amending and extending the outstanding debt, so that the company can go back to profitability and pay back its creditors. The next topic is debt equitization, meaning transforming debt into equity. Here the company needs a credible advisor so creditors will have confidence in the restructuring of the company. In this case, the company will not have the stress of interest payments, but only dividends, which can be deferred. On the

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other hand, this is a good deal for creditors because they can expect unlimited potential return from this exchange. Regarding where the company is when restructuring services start, we can distinguish between: • Private workout: the company stays out of court, realizing it will have a liquidity problem in the future, so it will be in default. The investment bank, as an advisor, deals with the management of the company; • Public workout: the company goes to court since it has already declared default, so the judge appoints a trustee manager that runs the company in order to liquidate the firm, selling the remaining valuable assets, for the creditors’ maximization. The investment bank deals with the judge (that embodies the law and operates through the trustee manager). 3. Private equity (PE): investment in the equity of a non-listed company which needs money and is willing to give up part of its equity (meaning influence over governance) to raise it. Equity always represents the ownership of a corporation, but private equity diverges from public equity because of liquidity, pricing and monitoring issues. An investment in equity in a private (non-listed) firm brings investors to face these risks (less liquidity, being the shares not listed in regulated markets, and the different pricing) in exchange for participating in the control of the company, thanks to a limited numbers of equity owners. This is a marriage of convenience, since the final goal of investors is not control (in a very long-term view) but returns in the form of capital gains: the interest of the equity investor is to see the value of the equity appreciate in order to sell it at a higher price within a limited number of years (usually 5 to 7). Investment banks can invest in PE directly (but this is very risky since the investment will absorb too much regulatory capital) or indirectly through a closed-end fund (totally owned or indirectly controlled). Regarding the percentage of equity acquired, we can draw a distinction between: • Venture capital (VC) transactions: involving a minority of shares of a firm at the beginning of its life; • Buyout transactions: the majority of shares of a firm in its maturity stage. The PE/VC usually follows a consolidated scheme, on a timeline that can be graphically illustrated in Figure 4.7. Each investment is conducted between/after the drawdown period till time “N”, starting already at time “N-0.5”, half year before the official kick off, to look for an existing strategy, with an extra time to N+3 for maximising the result (a sale at N could – maybe just due to unfavourable market conditions – reduce the PE/VC profits).

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Figure 4.7

– 1.5 Fundraising

Private Equity investment timeline

0

3 Draw down period

N – 0.5 Getting to time N

N

N+3 Extra time

4. Structured finance: it is quite similar to Corporate Finance, but often it is necessary to build up some ad-hoc structures and vehicles, usually isolating risky assets (that create cash flow) inside a special purpose vehicle (SPV). This transaction is financed by debt and this debt is repaid by the SPV with the cash flows produced by the valuable assets/business. There are different kinds of structured finance: • Securitisation: the structure of the asset can be represented by real estate, a mortgage, or commercial credit. Assets contained in the balance sheet of a company but not related to its core businesses are transferred to an SPV, created with the express intent of acquiring those assets. This entity raises money leveraging on the reputation of investment banks through a syndicated loan or bonds. The debt will be repaid by the cash flows produced by the asset. • Project Finance: the structure of the asset is represented by a large project such as an infrastructure. Debt is raised in order to sustain the construction cost during the construction period. Investors are willing to finance because they will have access to the operation stage when the cash flows will be produced. • Leveraged buyout: this involves the direct acquisition of a target company by the SPV. First, equity and debt are inserted into a SPV mechanism and the overall cash flow will be used to gain the control of the equity of the target. The second step is for the target to raise debt as well; and then the target is merged into the SPV. So overall the assets of the target become the assets of the SPV, and likewise on the liability side the debt of the target is added to the debt of the SPV. There are a number of conditions to be respected, such as a target that produces a huge amount of cash flows; also, after the merger these cash flows would pay back the debt raised by the firm that proposes the LBO and the debt raised by the target company (before the LBO operation). There is a legal separation between the risk of default of the SPV and the target and the firm originator of the deal. As an investment bank, profits are the remuneration from the syndicated loan, playing the key role of lead arranger, and then being the global coordinator. Structured finance deals are very powerful tools for creating revenues for the investment banks, because these transactions can generate many activities like: • issuing securities to finance the SPV; • financing the SPV through corporate lending; • using securities for asset management.

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The three deals, even if they are used for very different purposes, share a very strong potential for leveraging and creating liquidity. At the same time, there is a similarly strong potential for conflicts of interest. This effect can be very dangerous if control is weak and banks are universal (European style). 5. Risk management: The division between financial risk and pure risk (insurance contracts). The focus lies on how to protect the company from financial risk, especially inherent to currency derivatives such as futures and options. Risk management services are based on: • internal risk matching; • insurance services (like insurance contracts); • financial services (like financial derivatives contracts). Internal matching is a typical approach for financial risks, while insurance contracts are more effective for industrial risks (and only partially for financial risks). Financial derivatives are better suited to covering financial risks. Banks can issue and manage financial services, but by law they cannot produce insurance contracts, only deliver them. 6. Asset management: services to allocate, protect and invest either financial assets or non-financial assets (i.e., real estate, fine art, cars, etc.). As regards, financial assets, this activity involves cash management. The technicalities of the asset management industry are based on: • • • • •

asset allocation capabilities; asset-specific knowledge (for real estate, private equity, etc.); taxation and legal expertise (for managing holdings and trusts, tax arbitrage, etc.); solid know-how regarding insurance; country-specific knowledge.

Asset management covers all the activities devoted to managing customers’ wealth (i.e., allocating it, protecting it, and making it grow): these activities are often managed by the same team/division that runs the HNWI asset management. Asset management is quite relevant for Financial Institutions Group (FIG), customers who have huge amounts of money that are directly or indirectly invested by an IB. Examples are pension funds, foundations, insurance companies, etc. Asset management is a fee-based activity, a sort of consultancy, that can be done directly by the bank and/or through vehicles like asset management companies. 7. Lending: a secondary service. It is inconvenient for a bank to lend $1 billion because it would cost too much in terms of capital requirements. Lending involves the use of money by the bank both to finance customers and to sustain the development of many corporate investment banks’ transactions (like cor-

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porate finance and structured finance). Corporate lending has a very complex impact on banking economics because it generates fees (for arranging the deals), interest margins (for relative revenues) and utilises regulatory capital. Corporate lending can be developed through a stand-alone approach or (very often) a syndication strategy. The organisation of investment banks is based on customers, products and markets, the so-called C-P-M model. The business might function as a global player providing all types of products to all types of customers in all markets. Or a bank can be organised as an international player that provides all products to all customers but only in certain markets in certain countries. The last type of investment bank would be a local organisation that provides all products to all customers but one certain market.

4.5 The role of investment banks in the capital markets: the IPO process 4.5.1 Reasons for an IPO The Initial Public Offering, aka IPO, is the company’s first introduction to the public market. The firm will be listed in a regulated market and the ownership, or just a part – the free floating – of the ownership, from that day will be traded and potentially could changes hands every day, or more than one time per day (in the secondary market). The company and its board of directors make the decision “to go public” for a variety of reasons but the main one is to raise capital to further expand the company into new and existing markets: it clear that IPOs are an essential part of corporate funding. Sometimes Private Equity investors use the IPO as the tool that allow them to transform their previous investment in cash, selling to the market what’s no other private investors want to purchase. What Is, technically, an Initial Public Offering (IPO)?

An IPO is the process by which a private company issues its first shares of stock for public sale. This is also known as “going public.” Companies do not begin an IPO upon launch. While successful start-ups may go public eventually, it takes a firm time to establish the necessary business plan and market position. And obviously it is necessary to set the right price, because if the price is too high no one would invest in the project and the IPO will be unsuccessful, while if the price is too cheap, the issuer would not raise the possible maximum amount, losing chances. And before the IPO the company have to meet many of the market’s authority’s qualifications for an IPO.

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Prior to launching an IPO, a company may be held entirely by its founders or by a combination of firm principals and private shareholders. At this point the firm entirely controls its ownership structure. If it has shares, the firm’s principals can restrict those shares to purchasers or investors of their choosing. If we would summarize the reasons behind an IPO, we can list the following options: 1. Give liquidity to existing shareholders. 2. Crystallize an objective valuation. If the company is not listed, there is no market cap that gauges the market value of the company. 3. Obtain a current valuation. If a company is not listed, the only way it can acquire another company is by paying cash. Actually, it is possible for a private company, but the vendor cannot know the value of the shares to be exchanged. (Because the company is not listed, the shares have no market value.) Therefore, the vendor would not accept the deal. Further, even if the vendor/target agreed to the deal, he will be stuck in the position if he decides afterwards to sell the shares, because there is no market where to sell them. 4. Finance growth. This can happen in two ways, either by selling already-existing shares or issuing new ones. Raising capital through share is sometimes the best way to finance growth, since the company should always keep an optimal capital structure to preserve profitability. 5. Gain visibility. An example here is the listing of Luxottica in the US market in order to be considered a domestic player in that country. Afterwards, Luxottica managed to buy an American brand (Ray-Ban), a deal which would not have been feasible or executable if Luxottica was not listed in New York. 6. Align management incentives with shareholders objectives. An often-big percentage of the compensation of partners is in company shares. This means that partner and shareholder wealth is aligned. 7. Leverage and cost of funding/rating. Increasing and fortifying the equity structure, the weight of the debt, in percentage, will be lower and protected by the equity (last claim call). This would help the company to raise cheaper money from the debt market, also thanks to a better rating obtained from the capital enhancement. The final result obtain trough an IPO would bring to the firm a Market leadership because the company has a bigger sustainable market share, a strong management, a solid financial position (while buying shares or lending money in an over-leveraged company is not advisable), a better Corporate Governance, a high level of visibility and disclosure, more liquidity in terms of marketability of the shares (the issue should be big enough in size and needs to have enough free float. If there’s no liquidity, it’s best to stay private) and lastly an interesting (fair market) valuation.

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4.5.2 Investment bank’s roles in an IPO process In addition to underwriting and selling securities, investment bankers have both advisory and financial functions in an Initial Public Offering. A company decides it wants to raise money by going public with an IPO, and an investment bank helps by connecting them with willing investors, promoting the company’s stock, navigating complex legal frameworks, helping determine a price for the stock, and purchasing an agreed-upon number of shares and reselling them, thus taking on risk for how the stock will perform. Most importantly, they determine the best timing of the IPO, because timing of the offering influences profitability and movement of shares. They also take care of selling debt of the companies to investors. Once a company finds a bank (or group of banks) that want to underwrite the IPO, the bank plans the so called “road show,” some corporate events where the company and/or bank executives give presentations to potential large investors like mutual fund managers, hedge fund managers, and others across the country who may want to buy large blocks of shares. While they drum up interest in the company, known as “book building,” underwriters also work to price the IPO, or determine how the stock should be priced when it first hits the market. To do this, they look at examples of comparable companies that have gone public, projecting how the company may perform in the future, and assessing how much funds may be willing to pay to invest. The IBs can have a sort of multiple role: • Global coordinators: oversee the whole process from kick off to closing. • Book-runners: are actively involved in preparing the documentation and are responsible for the entire marketing effort. They also have “control of the order book,” meaning, that after the roadshow that they organize, they gauge the response of the investors, how they like the story etc. The book-runners are the ones which eventually size the offering, give recommendations on the final price and decide on the allocation of the final shares. • Co-lead managers: complement the research coverage and overall marketing effort in the transaction. • Lead manager (in this case Italian): one of the local banks needs to be the bookrunners because of their knowledge of the local market; they have the responsibility for the retail offerings. For this work, the underwriting bank can make tens of millions from an IPO – whether or not the stock performs well. The remuneration for investment banks could be variable and link the different factors and roles into the syndicate. In a broad definition we can say that the offer size is inversely proportional to the percentage of fees (but of course directly proportional to absolute amount). Fees can then be broken down into three parts:

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1. Underwriting commission, fees paid proportionally to the underwriting commitment for taking the risk of having to buy the shares if there is no market; 2. Management commission, fees that go to the Global coordinator as compensation for their oversight and management activity throughout the deal; 3. Selling concession: the players that are eligible to see the numbers are the bookrunners. So, the advantage of this role is being able to see all the orders, and then getting credit for them. All selling concession fees go to bookrunners, but the all the parties get a fixed fee, decided ex-ante, from the joint bookrunners. In addition, there is another form of remunerations, very lucrative, for the IBs: the Greenshoe. The Greenshoe is a stabilisation mechanism regulated under a lending agreement between the Global Coordinator (GC) and the company in the process of listing. To see how this works, let’s assume a base offer of 100m shares. The Global Coordinator places on the market 100m shares +15m of greenshoe. The GC retains the cash received from the sale of that 15% (for 30 days). Then two things can happen: • If the after-market is healthy and shares are performing well, the lending agreement is closed and the GC gives the money that it retained from the sale of greenshoe to the issuing company, which cashes in. • If people start selling shares, the GC buys back up to that 15% of shares (greenshoe), using the previously retained cash and gives those shares back to the company in the process of listing. Since the buyback of that 15% usually happens at a lower price (when things go bad), the difference between the price paid for the buyback and the sales price on the shares beforehand goes either to the GC or the company in the process of listing (depending on the lending agreement). • If the IB has to buy back the shares from the market, then in one sense it is not a problem of money for the bank, because they received more than what they paid; but in another sense it is, because if the bank needs to buy the shares back, then it means that the IPO did not go well because the share price went down. The roadmap for an Equity offering process, with its several options to be considered, can be schematized as in Table 4.4.

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Best for

Precedents

Size

Time

Authorization

Description

Table 4.4

Equity offering process options

Traditional rights issue

Accelerated offering (ABO)

Private placement

Pre-emptive rights given to existing shareholders Subscription price at a discount (determined ex-ante)

Requires avoiding pre-emptive rights on sale of new share in an accelerated bookbuilding to institutional investors Pricing determined ex-post depending on the demand of the book

Issue of new shares or equity-linked securities to a specific investor

Pros: Open to all investors Discount economically neutral More time to do marketing activities

Cons: Much documentation needed It takes time to receive capital

Pros: Fast execution If the shareholder base is concentrated, it should improve price efficiency

Cons: Discount dilutive for shareholders that do not participate Can only raise up to 10% in a short time

–

–

Approval needed after an extraordinary general meeting (EGM) of shareholders Prospectus required (takes more time)

Approval needed after an extraordinary general meeting (EGM) of shareholders No documentation Up to 10% of the total shares outstanding

Needs approval (EGM?) No documentation required if not explicitly specified in the agreement between the parties

2-3 months (very long)

2-3 days (very short)

Flexible timing, depending on how fast the agreement is made

Maximum possible (even possible to double the number of shares)

If 10% then more time is needed for documentation

10% of new shares is the maximum size

Most common type of equity offering in Europe

Multiple precedents in Europe

Less frequent (GS w/ Warren Buffet)

To raise capital for M&A Balance sheet repair (cover expected or realised losses) In case of poor market conditions when marketing activity is needed

Small and mid-cap financing

–

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4.6 The role of investment banks in SEOs and other “market operations” If a company, already listed in a regulated market, after an IPO wants to raise new funding without issuing liabilities, it is possible to sell new shares in the market. A Seasoned Equity Offering (SEO) is implemented by a company already listed in the market to increase its capital, selling new equity into the market. A company may opt for an SEO due to an emergency or for restructuring purposes, or to pursue internal or external growth. The idea is to seduce shareholders by presenting a holistic plan which would improve the company’s financial operations and operational profile. Depending on where it is listed, a corporation can implement different kinds of SEOs: in the US, it can realize a market-oriented SEO (approaching shareholders directly with an Accelerated Book Building transaction) or a private placement (through a bought deal, selling additional shares privately). In Europe, companies going public are obliged to execute a right issue transaction. Bought deal. Investment banks buy shares directly from the issuer, reselling them to institutional investors as quickly as possible. The IB buys the shares because it is convinced it will be able to sell them again in a few days. The profit does not come from fees but instead from the spread between the price paid to the company and the price paid by the market for the shares when they sell. The risk is buying the issue without knowing for certain if there are enough institutional investors willing to pay a higher price. To attract investors and convince the IB to buy the shares, the company must offer a discount to the IB with respect to the market price, which is called the discount to market. Accelerated book building (ABB). This type of transaction is concluded in a few days and targets a small group of institutional investors in order to implement a fast book-building procedure to allocate all the shares sold in the SEO. Profit in this case is generated by gross-spread fees. The difference between this and a normal bookbuilding transaction is the time in which it is carried out (a few days vs months) and the target investors (in this case they are only institutional, since there is no time to work on the prospectus). Again, the concept of discount to market applies. Right Issue. Pre-existing shareholders have the right to be offered the chance to participate in any future increase of capital. This right comes from the Napoleon Code and makes the process very long. So when buying stock, investors buy the right that protects them from a future capital increase: in proportion with the number of shares held by pre-existing shareholders before the issuance, they get the right to buy new shares in order to maintain their participation in the company. The ratio is the number of new shares offered to pre-existing shareholders given a certain number of old shares: this ratio is decided by the underwriter. So another reason of for a negative market reaction can be explained by the fact that the participation in the increase of

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capital is necessary for shareholders if they do not want to be diluted after the issue, if the new capital is bought by new investors. From the launch of the deal in the market, these rights can be traded in the market itself for two weeks (the trading period). The subscription period (the trading period plus one week) is the time when pre-existing shareholders decide whether or not to participate in the increase of capital. If they do not exercise this right, they lose it. So, pre-existing shareholders face a sort of American call option, whose strike price is called the subscription price and whose exercise period is the subscription period. Hopefully, the strike price will be below the expected (theoretical) traded price during the three weeks of execution, which we call TERP (Theoretical Ex Right Price), defined as the average of the value of the old and new shares. Because the day of the execution in the market the old shares split in two different instruments, it is possible to calculate the value of one as the difference between the market price (before the execution) and the TERP. As for the IPO, there is regulated and mandatory timetable for the SEO, as follow: 1. Announcement to the market: The company stands ready to disclose as much as possible as regards the terms and conditions of the transaction – size, rationale behind the SEO and commitment of the underwriter (which the advisor wants to postpone in order to gauge the reaction of the market). 2. Extraordinary General Meeting (EGM): This is called for the approval of the transaction by pre-existing shareholders; to convince them to take part in the SEO, they may be offered a subscription price which is a discount on the TERP. 3. Register for the seasoning offering: Documents are filed with the authorities; the company asks for permission to complete the transaction from the national commission for listed companies (CONSOB in Italy, FCA in UK, SEC in the US). Technically at least two months pass from announcement to approval. The TERP is theoretical because the EGM with shareholders takes place at least two months before the day of execution in the market. During the EGM, an option is offered to pre-existing shareholders, which has to be in the money two months later. An option is ITM if the strike price is below the current market price. This means that during the EGM a discount on the market price at which shares will be traded during the execution of the transaction must be offered. The current market price at the time of the issue must be predicted, which is the TERP. The discounted price is the discount to the TERP. So, shareholders will have in their hands an option that is in the money. If the price of the shares once the issue is made goes below the TERP and the strike price is above the current market price, the option will be out of the money and the issuer will sell no shares to pre-existing shareholders. The number of shares not subscribed by pre-existing shareholders which are bought by the underwriter at the end of the subscription period is called the rump. Offering a high discount implies increasing auctions of the shareholders but sends a bad signal to the market since it would give rise to the suspicion that the proposal has some kind of problem. On the other hand, offering a low discount sends a good signal to the

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market but increases the chances of a future rump. To find a compromise between the two, past data are analysed to come up with an average discount. Therefore, the TERP is theoretical because it is simply a prediction made on the day of the EGM; it is called ex-right because at the time of the execution shares will be traded separately from the value of the right.

4.7 What’s the future of investment banking in IPOs? Investment banks are facing plummeting IPO profits and finding their new place amid stronger regulatory constraints and innovation. Investment banks charge an underwriting fee that traditionally comes in at around 3-7% of the gross proceeds of the IPO but there is no guarantee of success. Today, this system is showing signs of breaking down – or at least shifting in favour of the massive tech companies that have given investment banks their biggest IPOs in recent years. In 2006, before the Lehman Brothers’ default and the Subprime crisis, investment banks were at the top of the finance world. Fast forward through a crisis in the US mortgage market, the ruin of Lehman Brothers and several mammoth hedge funds, and a subsequent global recession – and history has marked a change and today this world is a bit different. Alto thanks to technology and a global world interconnection. At least until the Covid-19 pandemic. The role of IB in IPOs was dominant and providing services to helping companies going public has historically been one of the banks most lucrative transactions for these large financial intermediaries. We can notice a decrease in the P&L statements: in 2017 IBs generated just $7.3 billion in revenue from underwriting IPOs, a reduction of 43% from 2000, the era of the tech IPOs.31 In the past IPOs accounted for around 25% of investment bank revenues, while in recent years that figure has decreased to about 15%.32 In addition, some academics studies have also focused their attention on the trade-off between IB and creation of value in operations like Mergers & Acquisitions and IPOs, analysing how the role of the specialist creates asymmetries that are not a driver of value for the corporations.33 According to some studies and researches, seems that especially during the Internet bubble period of 1999-2000 investment banks allocated some IPOs shares to their affiliated mutual funds, given their informational advantage about the quality of the IPO prior to the offering. An Investment bank could allocate hot IPOs to affiliated funds in an effort to improve fund returns and increase management fee income, which existing literature calls the nepotism hypothesis (Ritter and Zhang, 2007). Moreover, after the markets’ collapse in 2007, more and more companies opted to 31 

Source: Wall Street Journal. Source: Seeking Alpha. 33  See, for example, T. Mooney, Essays on the Role of Investment Banks as IPO Underwriters, Mutual Fund Managers, and Merger Advisors, University of Wisconsin-Milwaukee, 2013. 32 

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delay public offerings and many others in the last decade opted for large Private Equity investments, without going public at all. Especially thanks to the amount of cash available in the market, offered by venture capitalists and sovereign wealth funds, many start-ups are opting to stay private indefinitely, also for a less invasive regulation. Due to several events it is possible to say that the Investment banking sector is seeing its historical profit centres eroded by technology and regulations. Many processes are being automated or commoditized. From IPOs, to M&A, to research and trading, investment banks’ role is shrinking and their specialistic divisions are getting smaller, leaner, and scrambling to keep up with innovations. Recently the powerful tech companies fuelling the world’s biggest IPOs are exerting their influence, using their size and name recognition to extract lower fees from the investment banks. Some other firm are also exploring alternatives to the IPO: a very common and rising option is the Direct Public Offering (DPO) and alternative exchanges, and even in some limited cases the Initial Coin Offerings (ICO). The DPO model is intriguing to private companies because it could save them much of the sizable fee, they might otherwise pay to an investment bank. Even if DPOs cannot replace the IPO model at all for typical companies looking to go public, they remain – in the current market – an attractive option for already well-known firms, like large tech companies. Companies plotting to go public that already have their prestige linked with their success, along with strong consumer reputation, it’s much harder to convince them of the added value from hiring an investment bank to help them go public. Spotify it is the best example of DPO: selling shares directly to the investing public without going through the underwriting process. The company was able to achieve its primary goal for going public in the first place: providing liquidity to its shareholders. In addition it’s possible to notice that on its first day of trading, Spotify’s stock showed a volatility around 12% – much lower than most other large-scale tech IPOs with a price fixed by the IB, and in the following months the trading price increased by around 30%, decreasing then back on par with its initial pricing. Another alternative to the classic IPO is represented by the new technologies, like the idea of selling shares in a company directly to consumers using the blockchain channel. In an Initial Coin Offering (ICO), instead of going public on an exchange or raising equity financing, companies instead issue their own cryptocurrency, avoiding the need for bankers at all. This market is virtual but works with a new system, not just a virtual replacement of the old paper stock certificates: most companies don’t give any equity away in their ICOs either – instead, giving their investors a cryptographic token that could potentially rise in value. In 2017, start-ups raised $5.6 billion from ICOs worldwide. However, interest in ICOs has cooled after a number of fraud allegations and a crackdown by the SEC. The experimentation in the field is likely to continue thanks to the central role of technologies and innovations and DPOs and ICOs are a clear signal of the many

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ways private companies are coming up with new ways to avoid the expensive and invasive IPO process. Suffering this markets’ evolution, seeking a reduction of revenues generated from IPOs assistance, investment banks have “adjusted” their business style, implementing new massive investments in technology in order to lower costs and automate parts of the process. This is helping banks maintain high profit margins for their P&L statement. As a result, following basic supply and demand rules, investment banks are having to chase more deals and reaping lower revenues for doing so. Then, in addition to the evolution of the times, many episodes have infected the reputation, and therefore their revenues, of the IBs in the IPO process. When eToys went public, the underwriter – Goldman Sachs – settled up its listing price at $20. The stock price jumped in the first day of trading more than 4x, but months later the company collapsed. According to eToys, Goldman intentionally mispriced the stock to benefit its many institutional clients and filed suit against Goldman: after more than 10 years in court, Goldman Sachs settled with eToys’ creditors for $7.5 million. When Facebook wanted to go public in 2012, it convinced Morgan Stanley, Goldman Sachs and others to accept a reported fee of just 1.1%. Furthermore, the stock fell 15% in its first few days on the market. Despite this, the Wall Street Journal reported that Morgan Stanley, Goldman Sachs, and the company’s other underwriters made $175 million in fees. Some have even accused the pool of investment banks of mispricing stocks, alleging that the banks deliberately under-price new stocks in order to engineer a “pop” on their first day of trading – benefiting the bank but also the institutional investors that the bank brought into the stock. Google’s IPO (that took place in 2004) was the first time a large technology company had expressed public frustration at the way investment banks cloaked IPOs in secrecy, making it impossible for either issuer or buyer to figure out what was happening behind the curtain. Instead, Google’s management asked the banks to run an open auction – much as eBay conducts a sale – to determine an eventual price. Barry McCarthy’s, Spotify’s CFO and previously Netflix CFO, publicly complaints against traditional IPOs because the process shows an inflexible commission structure and a tendency, from the IB, to dictate how much money a company should raise. He also complaints against the “arcane instrument known as the “greenshoe,” which allows the banks to raise more money than the company wants, gruelling two and three-week roadshows, and – the final indignity – selection of who is permitted to price and buy the shares.”34 As we can notice the world has changed, and the Covid-19 would probably bring another shadow of instability, that will also erode margins for everyone. Young com-

34 

See Michael Moritz, Financial Times, August 2019.

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panies are going to staying private far longer than their predecessors, without risking spending money for unsuccessful expensive IPOs with high risk and low return. The IB world has already adjusted but new changes are necessary for a split with the old very lucrative years for IBs in the world of IPOs.

Summary The chapter focuses on the role of the financial intermediaries serving as a sort of middleman. The financial intermediaries have a strategic role in the financial industry, because allow the markets’ participant to have access to instruments and investment options, or funding options, that they could not have without the intermediation. The intermediaries are also able to reduce the complexity and the several risks that mine the markets for the participants. Banks play a central role in the financial world, being strategic for the well-being of the economy and the well-working of the entire society. Banks can be split in two macro area: retail banks, that offers services for the daytime activities of everyone, and investment banks, specialized in capital markets that support large markets’ participants.

Questions 1. 2. 3. 4. 5.

Why in the US a retail bank cannot act as an investment bank? How could a financial intermediary mitigate the customer’s risk? What is a bank doing for a firm in the capital market? How can a bank make profits? What is an IPO?

5  Debt Market What you will learn in this chapter: • • • • • •

What is a bond; Bond’s characteristics and types; How bonds are issued and sold in the market; Return for investors from a trading point of view; How to price a bond in the market; New kind of bonds linked to sustainability and the environment.

5.1 Capital markets: equity capital, liabilities and assets “Capital markets play a vital role in connecting the providers of capital with users of capital. They channel savings into productive investment and help companies, investors and individuals manage their risk. Capital markets provide a supplementary source of funding to bank lending, and act as a ‘spare tyre’ for the economy.”1 As defined in the previous chapters, capital markets are the set of markets where buyers and sellers engage in trade of a wide range of securities such as bonds, stocks, etc (see Figure 5.1). The buying/selling is undertaken by participants who may be individuals or institutions. Thanks to the capital markets surplus funds can be channelled from savers to entities that have the opportunity to reinvest them, putting them to productive use. This exchange takes place in the primary markets, with trades of new issues of securities. Capital markets also have a secondary market, where already existing or previously issued securities are exchanged. The capital markets are usually divided and governed by specific laws and rules on the basis of the nature of the security traded there, i.e. the stock market and the bond market. However it is important to underline that a borrower can issue different securities at the same time (read as, ‘they sell in the capital markets’) just as a lender, the “investor” could decide to underwrite (in the primary market) or purchase (in the secondary market) different kind of securities, depending on his/her preferences. The issuer receives a certain amount of money, accounted in the asset side of the balance sheet (according to the basics of accounting principles); for the counterparty this amount is recorded as a liability or capital debentures. For commodities, exchanged via derivatives contracts, the relationship between the two parties is quite similar, because the seller underwrites an obligation to sell – at a future date – and the purchaser subscribes an agreement to buy something. The accounting policy for derivative instruments may vary depending on local GAAP,

1 See W. Wright, What Have the Capital Markets Ever Done for Us? And How Could They Do It Better?, Newfinancial.eu, February 2017.

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Figure 5.1

Investors/issuers relationship Government Balance Sheet

Assets

Liabilities Equity

BANK Balance Sheet

Liabilities

Equity Assets

Short Term Treas. Long Term Treas.

Stocks

INVESTOR Balance Sheet Assets

Money Market Bonds Market Equity Market Commodities Currencies

Saving (long term) CDs Bonds

Equity Liabilities

Assets

Liabilities Equity

BUSINESS Balance Sheet Stocks Corporate Bonds Commercial Papers Derivates

and/or according to the nature of the business, and/or if the parties are listed and/or obligated to adhere to some specific regulations or accounting principles. (This is especially applicable for banks and financial institutions, which have specific accounting policies that differ from industrial corporations and nonfinancial institutions.) In this chapter and in the following ones we will focus on the liability side, detailing the medium- and long-term debt instruments traded in the bond market and the short-term liabilities traded in the money market, plus the innovative debt securities.

5.2

The Bond market

What is a bond? To answer this question, we can take two different perspectives.

A bond, for borrowers, is a source of funding, a way to raise money for their capital expenditures without the typical instability and withdrawal risk of a deposit. A bond, for lenders, is a way to get income and stability, with less risk than the equity market. From a more operational perspective, a bond is a fixed-income security sold by governments and corporations to raise money from investors today in exchange for the promised future payment.2 From a more legalistic viewpoint, according to Black’s Law Dictionary (2018), “a bond is a contract by specialty to pay a certain sum of money; being a deed or instrument under seal, by which the maker or obligor promises [...] to pay a designated sum of money to another.”

2

See Berk and DeMarzo, 2014.

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In general, we can say that bonds are seen as stable both for issuers and investors. However, there is a huge bond market that moves billions every day, more than equity. So it’s possible for traders to get very interesting returns. Let’s try to see how these two opposite descriptions can be combined. Secure returns usually mean reduced returns. But sometimes returns on bonds can be safe and surprisingly good, depending on the latest in our back-to-basics series for investors. Before making a deeper more detailed analysis, at a glance we can say that a bond: • is a fixed-income instrument that represents a loan made by an investor to a borrower; • is a contract between the two parties that includes the details of the loan and its future cash flow payments; • can be sold to a third party at a later date in regulated markets that ensure the liquidity of the instrument; • is typically used by businesses, municipalities, states, and sovereign governments to finance projects and operations; • can be denominated in the issuers’ currency or in another currency, in order to have a better liquidity or a lower cost of funding for the issuer; • generally, pays a stated interest rate or is sold at a discount price; • generally, offers lower interest rates if it is higher quality (more likely to be paid on time); • tends to offer lower interest rates if it has a shorter maturity (length of time until full repayment). 5.2.1 Bond instruments: characteristic and types Bonds, like any other financial instrument in the present day, are dematerialized and virtually transferred in the market from one party to another. Years ago, bonds were just a physical “bearer” instrument (i.e., possession is evidence of ownership), as in Figure 5.2: a printed, numbered sheet of paper with all the characteristics written in the original contract signed by the issuer, made up of the bond itself plus the coupons. In order to understand how a bond works, let’s discover more, analysing in detail the coupon bond illustrated in Figure 5.1. The term “coupon” is an old-fashioned term dating back to when borrowers (governments or companies) actually issued bearer bonds on paper. The issuance date on this particular bond is February 1979 [A]. The lender, with excess money and no invest opportunities, lend the US Treasury $1,000, and the Treasury hands you a promise of reimbursement (certificate n° 10656) with coupons attached. Every six months, the investor would tear off the appropriate coupon and take it to the bank. The bank, empowered for this duty, would give the investor his $45 interest payment [B]. This $45 is equal to 9%, the annual coupon interest rate [C], over the face value amount of $1,000 [D], paid every 6 months (in August

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Figure 5.2

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US Treasury paper bond

and February [E]). So the investor receive the annual 9% split in two tranches every year (4.5%). Physical bond coupons were attached to the bearer bond to be torn off (or marked as “collected”) on the date specified. This sample US Treasury bond is structured with coupons to be paid at six-month intervals starting six months from the settlement date until the maturity date (the last coupon is paid in addition to the principal repayment). On the maturity date [F], the investor would bring the bond to the bank and they (the Treasury or an empowered agency) would give you your $1,000 back. But bond issuers don’t create paper bonds anymore; they’re all electronic, but the structure and the term coupon are still the same. “Coupon” simply means a fixed interest payment. This example is based on a $1,000 purchase price (and Face value) bond; in other words, the lender invested $1,000 to “purchase” the bond, but this purchase “price” is not mandatory and fix. The issuance price can be lower (below the par) or higher (above the par) in the primary market and fluctuates every day in the secondary market. In the secondary market the bond is traded every day, but the issuer is not involved anymore; it’s just an exchange between one lender and another new one. Many short-term bonds don’t have coupons at all, as it will be investigated further in the next chapter about the Money market. In this market’s cluster the issuer

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sells a $1,000 Face Value bond at a discounted price, for example $950. The lender will receive the full-face value ($1,000) at maturity, making a gain. If the maturity is in one year, your yield on that bond will be a little over 5%. It is the yield percentage that needs to be calculated, based on the ever-changing market price of the bond. The language of bonds can be a little confusing, and the terms that are important to know will depend on whether you’re buying bonds, when they’re issued and holding them to maturity, or buying and selling them on the secondary market. Box 5.1 comprises a small glossary that could be useful to navigate the wide world of bonds. Box 5.1 Glossary of bond terms Issuer (also called debt holder or creditor): the player who needs money, and borrows funds for a certain time at fixed or variable interest with the obligation to pay them back. Face value: the monetary amount the bond will be worth at maturity; it is also the reference amount the bond issuer uses when calculating interest payments. Usually a bond’s face value is conventionally 1,000 (USD or GBP or EUR, depending on the currency denomination). (For example, say an investor purchases a bond at a premium $1,090 and another investor buys the same bond later when it is trading at a discount for $980. When the bond matures, both investors will receive the $1,000 face value of the bond.) Price: the amount paid by a lender for a bond. The issue price is the price at which the bond issuer originally sells the bonds in the primary market. (Sometimes, but not always, this is equal to the face value, so we say that the bond is issued “at par”). The market price is the amount the bond would currently cost on the secondary market. Several factors play into a bond’s current price, but one of the biggest is how favourable its coupon is compared with other similar bonds. Coupon: the periodic cash flow payment that the borrower receives from the issuer. Coupon rate: the rate of interest the bond issuer pays on the face value of the bond, expressed as a percentage. For the issuer, this is the nominal cost of funding. For example, a 5% annual coupon rate means that bondholders will receive 5% × $1,000 face value = $50 every year. It doesn’t matter if the issuance/market price was higher or lower. Coupon dates: when the bond issuer will make interest payments. Payments can be made in any interval, but the standard is annual (corporate) or semi-annual (government) payments. Maturity date: when the bond will mature, and the bond issuer will pay the bondholder the face value of the bond. Maturity: the “length” of the investment calculated from the day of purchase till the maturity date.

Referring once again to the previous example, we can illustrate the bond’s evolution on a timeline with the relative periodic cash flows (see Figure 5.3). The previous example is an example of a government bond with an eight-year maturity. In the market we have a wide range of bonds that we can classify by issuer, by maturity length and then by several other characteristics as well as risk (read as the probability that the investment will be repaid).

96

Figure 5.3

Finance Lab

Coupon bond structure and discount Issue date Feb. 15, 1979

Coupon interest rate Issuance price

Coupon date 1 Coupon date 2 Aug. 15, 1979

Feb. 15, 1980

$ –45

$ 45

Coupon dates

Maturity date

…

Feb. 15, 1987

9% $ – 1,000

Coupon calculated ad Face Value

(1,000 × 9%)/2 (1,000 × 9%)/2

$ 45 (1,000 × 9%)/2 $ – 1,000

a) Bonds classification by issuer Bonds are usually issued by governments (aka sovereign bonds or, in trader slang, “govies”) or government agencies (also called “quasi-government”). Bond issuers can also be other public entities like municipalities, central banks and their affiliates, or banks and companies both listed and non-listed in regulated markets. Other possible bonds to list include: 1. emerging market bonds: sovereign and corporate bonds issued by developing countries, denominated in major external currencies like the US dollar or the euro, or local currencies (which are often referred to as emerging local market bonds); 2. mortgage-backed securities (MBS): bonds created from the mortgage payments of residential homeowners;3 3. asset-backed securities (ABS): bonds created from car payments, credit card payments or other loans.4 Bonds can have a wide range of different maturities. Businesses issue short-term securities like commercial papers; banks issue Certificates of Deposit, while governments usually issue very short-term bonds like Treasury Bills in the US or Gilts in the UK and BOT or CCT in Italy. For instruments structured like bonds with a maturity of less than 12 months (also called “notes”), we refer to the Money Market (see section 5.3). 3   Mortgage lenders, typically banks and finance companies, sell individual mortgage loans to another entity that bundles those loans into a security that pays an interest rate similar to the mortgage rate being paid by the homeowners. 4  As with mortgage-backed securities, similar loans are bundled together and packaged as a security that is then sold to investors. Special entities are created to administer asset-backed securities, allowing credit card companies and other lenders to move loans off of their balance sheets.

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b) Bond classification by maturity Bonds are usually categorized as short-term (from 1 to 5 years), medium-term (5 to 12 years), and long-term (more than 12 years). There are also bonds called “perpetual,” (usually callable) which have a very long maturity (around 100 years) or none at all. c) Bonds classification by characteristics In terms of characteristics, the most common are the coupon bond and the zero-coupon bond. The coupon bond (government, quasi-government or corporate), is a bond that pays a stream of cash to the investor periodically. This coupon can be fixed or variable, and linked to other indexes or variables, also with a floor or cap on its variability. Coupon bonds can be classified as: • Fixed Rate Bonds, instruments with an interest rate that remains fixed throughout the tenure of the bond. Owing to a constant interest rate, fixed rate bonds are resistant to changes and fluctuations in the market; • Floating Rate Bonds, which have a fluctuating interest rate (coupons) as per the current market reference rate; • Inflation Linked Bonds which, as the name suggests, are linked to inflation rate. Zero-coupon bonds (ZCB) do not have coupon payments; instead they are issued at a discount to their par value that will generate a return once the bondholder is paid the full Face Value when the bond matures. US Treasury bills are zero-coupon bonds issued at a discount and repaid at face value. Coupon Bonds can have other characteristics that give them an additional classification. Convertible bonds are debt instruments with an embedded option that allows bondholders to convert their debt into stock (equity) at some point, depending on certain conditions like the share price. The investors who purchase a convertible bond may think this is a great solution because they can profit from the upside in the stock if the project is successful. They are taking more risk by accepting a lower coupon payment, but the potential reward if the bonds are converted could make that tradeoff acceptable. Callable bonds can be “called” back by the company before they mature. Call dates and prices are pre-defined in the contract. The investors usually compute the yield to maturity on the upcoming call. Assume that a company borrowed $1 million by issuing bonds with a 10% coupon that matures in 10 years. If interest rates decline (or the company’s credit rating improves) in Year 5 when the company could borrow for 8%, it will call or buy the bonds back from the bondholders for the principal amount and reissue new bonds at a lower coupon rate, improving its profit and loss. Warrant bonds have an attached “warrant” that gives the holder the right to purchase for a pre-agreed price and for a certain period of time a number of shares of the same company (or a different one).

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d) Bonds classification by characteristics Bonds are also classified by “quality.” Corporate and government bonds are assigned credit ratings by five agencies recognized by the Securities and Exchange Commission in the US, with Standard & Poor’s, Moody’s Investor Service and Fitch being the three dominant rating agencies worldwide. Other agencies provide similar ratings for bonds in other countries. Bond ratings range from AAA, the highest rating, to C. Bonds with lower ratings carry a higher risk of default and consequently usually pay a higher interest rate. Bonds with good rating are called “investment grade” (IG) while bonds with low ratings are also known as junk bonds. • Standard & Poor’s denotes bonds rated “BBB−” or higher as investment grade. • Moody’s denotes bonds rated “Baa3” or higher as investment grade. • Fitch denotes bonds rated “BBB−” or higher as investment grade. Sometimes we hear about another classification of bonds high-yield. These bonds carry a low credit rating from the credit rating agencies. If the rating is below “BBB−” from S&P and Fitch or below “Baa3” from Moody’s, bonds are considered speculative; as such they will have a higher yield. From a technical point of view, a high-yield or “junk” bond is quite similar. High-yield bonds are typically split into two sub-categories. 1. “Fallen angels” are bonds that were once investment grade but have since been reduced to junk bond status because of the issuing company’s falling credit quality. 2. “Rising stars” are the opposite, in other words, bonds with a rating that has been upgraded because of the issuing company’s improving credit quality. A rising star may still be a junk bond, but it’s on its way to becoming investment quality. These bonds are very interesting for investors, who can take advantage of purchasing a bond with high yield that is growing in price, thanks to its extra return compared to the market average, ensuring capital gains. e) Bonds classification by bearer’s claim ranking Bonds are also classified according a characteristic written in the contract: a debt claim priority for the investor in case of the issuer’s liquidation. • Secured (vs. unsecured) are bonds backed by a pledge of collateral (e.g. in the form of real estate or corporate assets; an example here is a covered bond). • Subordinated (vs. senior) are bonds lower in priority to other types of debt in the capital structure of the issuer. In other words, in case of default, claims on the company’s assets from the holders of these securities get repaid only after holders of debt instruments with higher seniority. This claim priority can be ranked in three macro classes in descending order: senior bonds, subordinate bonds and hybrids. Senior bonds are generally unsecured for IG

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credits (sometimes there are guarantees from subsidiaries, to avoid structural subordination), although a security package is frequently put in place for high yield credits (e.g. pledges on shares or assets). Subordinated bonds are the second liens (which benefit from a second level guarantee or absence of guarantees compared to the other debt). Hybrid bonds, which have some characteristics similar to equity instruments such as deferability of interests or perpetuity, are issued by IG companies to protect their ratings. The typical classification, according to Basel III, reflects (in ascending order) Tier I (core capital) and Tier II (supplementary capital) requirements; banks may employ a third tier of capital (Tier 3), consisting of short-term subordinated debt for the purpose of covering market risks. If a bank faces serious difficulty (to avoid bankruptcy and favor business continuity), its capital will be impacted initially. The next stage is that coupons will not be paid on the AT1. Finally, losses will be taken according to a ranking structure, from the AT1 to the Tier 3, depending on the amount of losses to be allocated.5 This means that a subordinate bond, for capital requirements according to banking regulations, may not pay some coupons, or pay partially, or make a late payment, or pay less than the face value. Among the subordinate class the priority can differ, according to the bond’s characteristics written in the contract: the lower the priority, ceteris paribus, the higher the return offered. Until 2018 a senior bond, except in the case of issuer default, always paid both coupon and face value. The following levels, from the safest to the most dangerous, are Tier 3 for maturity in 5 year, Lower Tier 2 (called also “junior subordinate”), Upper Tier 2, Tier 1 and AT1 (Additional Tier 1, also called Co.Co. bonds). In the European scenario, with different adoption timing across the several countries, the EU Bank Recovery and Resolution Directive – or “bail in” – directive (BRRD)6 has partially modified the scenario. The “old” Tier 3, Upper Tier 2 and Lower Tier 2 are still available in the market but no longer issued, as they have been replaced by a comprehensive Tier 2 class. In Table 5.1 is a comprehensive list of Debt Capital Market solutions.

5 

See Thierry Trigo, Understanding Tier 3 Issued by Banks, BNP Paribas, 23 August 2017. bank recovery and resolution directive (BRRD) 2014/59/EU was adopted in spring 2014 to provide authorities with: 6  The

•  comprehensive and effective arrangements to deal with failing banks at national level; •  cooperation arrangements to tackle cross-border banking failures. The directive requires banks to prepare recovery plans to overcome financial distress. It also grants national authorities powers to ensure an orderly resolution of failing banks with minimal costs for taxpayers. The directive includes rules to set up a national resolution fund that must be established by each EU country. All financial institutions have to contribute to these funds. Contributions are calculated on the basis of the institution’s size and risk profile. The EU’s bank resolution rules ensure that the banks’ shareholders and creditors pay their share of the costs through a “bail-in” mechanism.

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Table 5.1

 

Status

Kinds of Debt Capital Market issuances

Covered bond

Secured by a pool of assets

Senior Preferred Bond

Senior Nonpreferred Bond

Unsecured

Unsecured

Senior to Tier 2 and AT1 – Junior to Senior Preferred

Tier 2 Subordinate Bond

Additional Tier 1 Sub. Bond (AT1)

Assetbacked Securities

Unsecured

Secured by a pool of assets

Senior to AT1 – Subordinated to Senior

Most subordinate class

Typically offbalance sheet transaction as financial institutions is the originator, not the issuer

Yes

No

Unsecured

Subordination

None

Senior to Tier 2 and AT1

Capital instrument

No

No

No

Yes

Default risk

Default of the issuer – Limited recovery from the collateral

Default of the issuer

Default of the issuer

Default of the Default of the issuer issuer

Default of the collateral pool

Maturity

5/7/10 years

3/5/7/10 years

5/7 years

Perpetual, 10 years with with possicall option bility of call after 5 years option

Depend on the average life of the collateral pool

Type of repayment

Bullet (final repayment at maturity)

Bullet

Bullet or Callable

Bullet or Callable

Perpetual or Callable

Amortising

Fixed

Fixed or Floating

Fixed or Floating

Fixed or Fixed and Floating after the call

Fixed or Fixed and Floating after the call

Fixed or Floating

None

In case of resolution of the bank

In case of resolution of the bank

At the point of nonviability of the bank

At the point of non-viability None of the bank

Interest rate

Loss absorption

Source: Mediobanca, revised and adapted by the authors.

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5.2.2 The role of the financial intermediaries and mechanisms for placing bonds When corporations or governments need to raise money, they may sell bonds to the public. Because this is a highly technical and complicated process, the issuing organizations usually hire specialists to do this work for them. When a corporation or government agency is considering issuing bonds it usually contacts an investment banker for advice on the marketplace, the possible issuing price, and other factors. An investment banker is a firm that serves as an intermediary between the organisation issuing the securities and the investors who purchase them. The bond issuer itself does not sell the bonds. In fact, the issuance of a debt instrument reflects the liquidity needs of the borrower, which will size the placement accordingly. The risk is that if the wrong balance is struck between targeting, pricing and other characteristics, the market would not have any appetite for that particular security and the issuer would be unable to satisfy its needs. In order to guarantee the issuer will collect the amount of money needed, in light of the uncertainty surrounding the success of a placement of the bond in the markets, financial intermediaries play a crucial role for debt issuers as underwriters. When investment bankers underwrite the bonds, they assume the risk of buying the newly issued bonds from the corporation or government unit; they then resell the bonds to the public or to dealers who sell them to the public. This eliminates the risk for the issuer, of an unsuccessful placement. The intermediary takes on this risk but earns a profit for doing so, based on the difference between purchase price and selling price. This difference is sometimes called the underwriting spread. Sometimes the financial intermediary markets the newly issued bond but does not underwrite it. The investment banker simply acts as a sales agent under a best effort agreement, promising to do its utmost to market the bonds. The investment banker has the option to buy the bonds and usually purchases only enough bonds to meet buyer demand, receiving a commission on the bonds sold. Corporations and government units realise that financial intermediaries such as investment banks possess the knowledge and expertise, they need to reach investors. Investment bankers often begin assisting the corporation or government agency well before the bonds are actually issued. And the organisation’s relationship with the investment banker may continue after the bonds have been issued, and the investment banker may sit on the corporation’s board of directors. Investment bankers usually have well-developed networks and may identify the brokers and sales forces most able to market a particular bond offering. Sometimes these intermediaries have established networks with investors who may be interested in the offering; they may encourage the investors to contact brokerage houses, specifying what they want in a bond. Investment bankers also may sell newly issued bonds through private placements to large, institutional investors like insurance companies or government unit retirement funds. In some cases, these investment banks purchase

102

Figure 5.4

Finance Lab

Bond issuance process and its timeline

mandate

mkt announcement origination

offering day book building

closing stabilization

bonds as an investment and not for resale for their own portfolios, or because they will act as market maker in the OTC market, which is very often the largest market for bonds. A bond offering, quite like an equity offering, is a complex process over a timeline (as in Figure 5.4) that involves many players, highlighting how crucial financial intermediaries are: an issuer, the investors, and – many times – a syndicate in between led by a book-runner. A fundamental task is the pricing of the securities being offered. But pricing a bond is not as difficult as the equity asset class, thanks to credit ratings, which are opinions about the creditworthiness of a firm (or its debt securities) expressed by independent agencies. In a bond offering process it is quite common to have a syndication, which might seem somewhat similar to a security offering, but it is actually quite different. The most relevant difference is the absence of investors. If the loan is too big to be granted by a single bank, it is necessary to structure a pool of banks (i.e., the syndicate), coordinated by a lead. When a bond is issued that is very large in size, the modus operandi is the same. Therefore, each single bank in the syndicate is lending money to the borrower, whereas in a bond offering the securities are ultimately bought by investors. The syndication process of a bond is driven by a leader, the book-runner, which organises the syndicate, possibly inviting a small additional group of banks, thus forming the managing group. An underwriting team and a selling team are also invited. From the intermediaries’ point of view the fee can be split into i) the management fee, ii) the underwriting fee, and iii) the selling concession. The fee is extracted by discounts on the prices at which bonds are sold to syndicate banks. The origination step starts with the book-runner receiving the mandate by the issuer. The book-runner discusses with the issuer the characteristics and terms of issuance such as the type of bond, the maturity, the coupon, etc. The book-runner, acting as consultant, also prepares a credit opinion on the issue, which is particularly relevant when the bond is not rated by an independent agency. The investment bank, as described above, starts an “intangible” pre-marketing activity, contacting and proposing the bond issuance to potential large investors in order to get a sense of their “feelings” about the issue. For this reason, the bond features are only provisional until the offering day: the role of the intermediaries is to “target” the bond as much as possible, also according to the market situation. Price ranging takes some weeks and could vary according to the market sentiment. Once the announcement to the market is made, there is the kick-off of the bookbuilding process. Note that the prospective issuance is announced as soon as the

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mandate is given to the investment bank. In other words, the market (at least the large investors) is aware of a potential bond issuance since the beginning of the origination phase. However, details about the bond characteristics are yet to be defined in the origination phase and are released just before the book-building starts, like in a Venture Capital dealing process. At the end of the book-building period, a final version containing the definitive terms is produced, and the bond is priced. The pricing of a bond is usually expressed in terms of credit spread, which is the difference between interest rate paid and the risk-free rate with the same maturity. On the offering day the syndicate purchases the bonds from the issuer (but the bond is not yet traded in the market); the issuer will get the funds, less expenses and fees, on the closing day. 5.2.3 How to choose a bond: Yield to Maturity and Duration In the previous section 2.2.2 we introduced the concept of Yield to Maturity, the most accurate measure of return, as the rate that equals the present value of some future cash flows, provided by the financial instrument, at today’s value. Very often, a common mistake made by non-expert investors and students as well, is to take the coupon rate of a bond as the return offered to the investors. First of all, a very important question, analysing the world of bonds through the eyes of whoever wants to invest int this asset class.

Question: How can investors choose the right bond to purchase?

The question is very relevant, but we have to start by saying that investors can have very different views, in terms of time and market outlook, different risk profiles and different expectations. This said, as we saw in the previous bond map, there is a huge variety of bonds with different maturities, risk profiles and, obviously, returns. Clearly, as we have shown in our description of the demand and offer curve, we can multiply returns by increasing the risk, seen as the issuer risk profile of maturity risk as well. With so many variables we need a parameter that we can use to match the options we have in the market, with all other conditions being equal. The yield to maturity, computed on annual basis, is the answer. To explain yield to maturity, an example could be useful. Let’s consider two bonds, A and B, issued by the same issuer, thus with the same default risk, industry risk and country risk. Bond A will pay you back a face value (FV) of $ 1,000 in 2 years plus 2 coupons of $50 at the end of the first and second year, i.e. a 5% coupon interest rate. Bond B will pay you back a face value of $1,000 in 2 years, plus 2 $70-coupons, at the end of the first and of the second year, a 7% coupon interest rate. We might think that a 7% coupon rate is better than a 5% coupon rate. Let’s also consider that Bond A pays a 5% interest rate two times, and Bond B pays a 7% coupon interest rate but just once.

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Which one of two bonds is the best option for our investment? With this information we can’t make a proper valuation because we’re missing a parameter that could change everything. Oftentimes we wrongly assume that face value is equal to the price of the bond, in other words, we invest an amount that will be reimbursed for the same value. But if this were true, it means that we are purchasing a bond at PAR value and the coupon rate is a key variable in our assessment. In this case we will analyse the two options also considering the time horizon related to the maturity of the two bonds, if it is not the same. If the equation is not true, this means that the Purchase Price (read it as the Bond’s market price) is a key variable. Let’s assume, as in Figure 5.5, that the Purchase Price (PP) of Bond A is $935 while the PP of Bond B is $975. Figure 5.5

Example of coupon bonds YTM PP

Coupon 1

Coupon 2

FV

YTM

t

0

1

2

A

$ –935

$ 50

$ 50

$ 1,000

8.67 %

B

$ –975

$ 70

$ 70

$ 1,000

8.40 %

2

Using a financial calculator, or excel (function Internal Rate of Return IRR, depending on the version), we can compute the YTM for an investment of $935 in Bond A or $975 in Bond B: the two rates are quite similar, with the investment in Bond A that pays 27 basis points7 more than Bond B. Applying the formulas presented in Chapter 2, we can also verify that the YTM is the rate that equates the future cash flows to the present price. In Figure 5.6 each cash flow and its Present value is detailed both for Bond A and Bond B. In this example we have shown how the price is a crucial variable, and in the next section we will explain how to calculate the fair price of a bond if we know the other details. This example compares two investments with the same maturity but implicitly we went straight to the yearly-based computation. Now we have to understand why it is necessary to “measure” the return on an annual basis. One simple question: how could we drive a car with speedometer in Kmph on a road with sign7 Basis points, also called bps, are widely used in finance when the gap between two variables or the fluctuation in the percentage of an asset is fairly small. One basis point is equal to 1/100th of 1%, or 0.01%.

5

Debt Market

Figure 5.6

105

Example of coupon bonds YTM and PVs PP

Coupon 1

t

0

1

2

A

$ –935

$ 50

$ 50

$ 1,000

$ 46

$ 42

$ 847

$ 70

$ 70

$ 1,000

$ 65

$ 60

$ 851

PVs ∑ PVi

$ –935

B

$ –975

PVs ∑ PVi

Coupon 2

FV

YTM

2 8.67 %

8.40 %

$ –975

posts and speed limits in mph? It would be quite difficult, because we would have to do a calculation if we wanted to know if we were respecting the speed limit, and to do that we’d have to know the conversion rate. So can we decide if one investment is better or worse than another one if we compute the return on two different time measures (all else being equal)? The answer is no. That is why we need measurements that are comparable. From this example we can recognize that the return from the investment in a bond can be split into two components: the coupons and the capital gain. We can describe the previous example calculation with the formula:

=

+

−

=

+

where: •

=

is the Current Yield, the yield that the investor will get from the coupon −

payments in relation to the investment made, as with a perpetual bond; •

=

is the Capital Gain the investor can get by trading the bond or holding it till maturity, when the bond will be repaid.

Using another little example, suppose we have two investment options in Zero Coupon Bonds C and D (see Figure 5.7). The first one, ZCB C, is sold at the current price of $970 and would pay us back $1,000 after 6 months, while ZCB D is sold at the

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current price of $950 and would pay us back $1,000 after 1 year. Just comparing the two monetary gains, D is better than C, increasing our investment by $50, while C increases our investment by only $30. A gain of $30 over an investment of $970 means a growth rate of 3.09%, while $50 over an investment of $950 means a growth rate of 5.26%. Can we compare these two measures and say that D, being bigger, is better than C? No, because the time horizons of the investment are different. Figure 5.7

Example of zero-coupon bonds YTM (1) PP

FV

t

0

0.5

A

$ –970

$ 1,000

B

$ –950

FV

$ Gain

Growth rate

1

$ 1,000

$ 30

3.90 %

$ 50

5.26 %

With ZCB C after 6 months we will have $1,000 and, reinvesting at the same rate, we can “produce” an additional $31. On a yearly base this means that the YTM of the investment in the ZCB C is 6.30%, better than the annual YTM of the ZCB D, which is just 5.26% (see Figure 5.8). Figure 5.8

Example of zero-coupon bonds YTM (2) PP

FV

FV

$ Gain

Growth rate

t

0

0.5

1

C

$ –970

$ 1,000

$ 1,031

$ 61

6.30 %

D

$ –950

$ 1,000

$ 50

5.26 %

That’s why, once we’ve considered all the other factors and combined our view of investors, in terms of risk aversion, time horizon of the investment, etc. we have a reduced panel of options. At this point we can decide how to invest by computing the YTM (on an annual basis) of the investment options that we have in hand. This also shows us that the coupon interest rate that we can read in the prospectus8 is the nom8 The legal document issued by the issuer that is proposing to offer bonds for sale, with all the bond’s details.

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inal cost of funding for the issuer (gross cost, which doesn’t compute the other expenses for the issuing process). But it is not always the return for the lender (coupon interest rate and yield to maturity converge only when a bond is issued, or purchased in the secondary market, AT PAR). Considering that the YTM of two bonds can be the same, even with a different maturity, we have another instrument that we can use for our assessment called duration. Duration is a measure of a bond’s sensitivity to interest rate changes. The higher the bond’s duration, the greater its sensitivity to the change (also known as volatility) and vice versa. There is more than one way to calculate duration, depending on one’s compounding assumptions, but the Macaulay duration (named after Frederick Macaulay, an economist who developed the concept in 1938) is the most common. The Macaulay Duration is computed as

.

=

1+

+

1+

where: • t = period in which the coupon is received; • C = periodic (usually semi-annual or annual) coupon payment; • y = the periodic yield to maturity or required yield; • n = number of periods; • M = maturity value; • P = market price of bond. The previous formula can be written also as follow, in a more practical way for application and calculation:

.

=

1+

×

where: • f = cash flow number; • CF = cash flow amount; • y = yield to maturity; • k = compounding periods per year; • tf = time in years until the cash flow is received; • PV = present value of all cash flows​. Duration can help investors understand how sensitive a bond is to changes in prevailing interest rates. By multiplying a bond’s duration by the change, the investor can estimate the percentage price change for the bond. The duration is influenced by the time to maturity and coupon rate of the bond. The longer the maturity, the higher the duration, and the greater the interest rate risk. That’s why one bond with a shorter maturity than another would have a lower duration and, therefore, less risk. So if the other con-

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ditions are the same except the coupon rates, the bond with the higher coupon rate will pay back its original costs faster than the bond with a lower coupon. Thus, the higher the coupon rate, the lower the duration, due to the repayment ability of the bond. In the Zero-Coupon Bonds, because there are no coupons, the duration is equal to maturity. In a sense, the duration can be read at the break-even point of the bond investment: at that point the initial investment is virtually repaid (considering the value of time) and in the following part of the timeline the bond produces the return for the investor. Consider a Coupon Bond “A”, issued and sold at PAR value $1,000 with a coupon interest rate of 10% that will pay back the face value of $1,000 at maturity, in 10 years. The Macaulay Duration can be calculated as shown in Figure 5.9. Figure 5.9

Example of Duration calculation (1) y

CF

Year

Cash Flows

0 1 2 3 4 5 6 7 8 9 10

100 100 100 100 100 100 100 100 100 1100

df

CF/df

Discount factor

PV of CF

1.10000 1.21000 1.33100 1.46410 1.61051 1.77156 1.94872 2.14359 2.35795 2.59374 Total ( = PP) :

Duration:

(CF/df) × y PV × n° year

90.91 82.64 75.13 68.30 62.09 56.45 51.32 46.65 42.41 424.10

90.91 165.29 225.49 273.21 310.46 338.68 359.21 373.21 381.69 4,240.987

1,000.00

6,759.02

6.759024

Suppose that another bond, called B, has the same structure as the previous one, but due to some issuer’s credit risk it has a YTM equal to 20%. The price of the bond drops, as the issuer is riskier, but the coupons are the same, since the coupon interest rate is the same. Owing to the fact that the investment is smaller (the purchase price) but the coupons and the maturity remain the same, the Duration becomes smaller, as shown in Figure 5.10. Lastly, we can notice that duration is additive: the duration of a portfolio of securities is the weighted average of the durations of the individual securities, with the weights equalling the proportion of the portfolio invested in each. Suppose that there are two bonds: • Bond A is issued at par, coupon rate 10%, maturity 10 years; • Bond B is issued below par with a YTM of 20%, coupon rate 10%, and a maturity of 10 years.

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Figure 5.10

109

Example of Duration calculation (2) y

Year

0 1 2 3 4 5 6 7 8 9 10

CF Cash Flows

100 100 100 100 100 100 100 100 100 1100

Duration:

df

CF/df

Discount factor

PV of CF

(CF/df) × y PV × n° year

1.20000 1.44000 1.72800 2.07360 2.46832 2.98598 3.58318 4.29982 5.15978 6.19174

83.33 69.44 57.87 48.23 40.19 33.49 27.91 23.26 19.38 177.66

83.33 138.89 173.61 192.90 200.94 200.94 195.36 186.05 174.43 4,240.987

Total ( = PP) :

580.75

3,323.01

5.721903

The portfolio is made up of Bond A: 30% and Bond B: 70%. The weighted duration is computed as shown in Figure 5.11. Figure 5.11

Example of weighted duration calculation

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Sometimes the duration is calculated as modified duration. The modified duration provides a good measurement of a bond’s sensitivity to changes in interest rates. The formula is: . . = 1+ 5.2.4 Calculating the price of the bonds How can I get the right price? The purchase price (the lender’s investment) is the present value of the future cash flows that will be generated by the investment, as described in the contract. The present value (PV) describes how much a future sum of money is worth today. One important note: with a fixed rate bond, the coupons’ cash flow and the redemption price (the FV) doesn’t change once the bond is issued. The only thing that can change is the issuance price (when there is more than one single issuance tranche) or the purchase price (PP) in the secondary market. When you purchase a bond at a price that is equal to the face value (redemption price -RP) we say that you purchase AT PAR. A bond that trades at par has a yield to maturity equal to its coupon. Investors expect a return equal to the coupon for the risk of lending to the bond issuer. Bonds are usually quoted at 100 when trading at par; this mean that you pay the 100% of the face value. Due to interest rate fluctuations and many other factors, in the secondary market financial instruments almost never trade exactly at par. A bond is not likely to trade at par when interest rates that are generally accepted for that kind of security with that risk profile are above or below its coupon rate. Bond yields and bond prices are inversely proportional: • When yields drop due to declining interest rates in the economy, bond prices increase. • When interest rates rise, bond prices decline. The basic reason for this inverse relationship is that an existing yield of a bond must match the yield of a new bond issued in a market with higher or lower prevailing interest rates. To illustrate this, let’s look at another example. Suppose a bond is issued at par value of $1,000 with a coupon rate of 5%. Six months later, due to a slowdown in the economy, interest rates in the markets are lower. The bond will trade ABOVE PAR because of the inverse relationship between yield and price. An investor who purchases a bond trading above par (in the secondary market) receives a coupon interest rate higher than the rate offered by similar bonds issued in that moment, because the coupon rate of the “old” bond was set in a market with higher prevailing interest rates. This drives the price of that bond above par, because the investor purchased something that is no longer in production with characteristics

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that are better than the new releases. If on the other hand market interest rates go up, the bond you’re holding loses value because its coupon is lower than the new issues. So all other conditions equal, this bond will trade at a discount price BELOW PAR. • If you buy UNDER PAR, you will have a Capital Gain (RP – PP = +Δ). • If you buy ABOVE PAR, you will have a Capital Loss (RP – PP = –Δ). The view from the Issuer’s side: If the issuer receives less than the face value for the security, it is issued at a discount; If the issuer receives more than the face value for the security, it is issued at a premium. The coupon rate for bonds or dividend rate for preferred stocks has a material effect on whether new issues of such securities are issued at par, at a discount or at a premium. Until this point, in section 5.2.3 and in Chapter 2, we have investigated the Yield to Maturity as the most accurate measure of return on an investment. We know that we can purchase a bond that is already “priced” by the issuer or by the (secondary) market. Now we have to understand if the market is pricing that bond, for our parameters, accurately. This is more or less what the financial intermediary does when acting as a specialist for the issuer, pricing the release of the bond in the primary market. The price of a bond, given the structure of the coupons and maturity, is influenced by several risk factors such as the ones we have already analysed: the credit (default) risk, the industry and country risk and the bond specifications like secure or unsecured and senior or subordinate. Applying the build-up method used in corporate finance for the valuations, we could split the return as the sum of several components: • the risk-free rate9 existing in that moment in the country of issuance; • a credit risk spread that reflects the safety of the issuer (and its business/industry); • other extra spreads related to the structure and characteristics of the bond. If these components change after the issuance of the bond, the return will automatically adjust with a price fluctuation that will modify the components and g. Suppose that there are two firms that operate in the same industry in the same country, France for instance. Both have a credit rating of, say, BBB+. On the 30 June 2020, Alpha issues, AT PAR, a 6-year, euro-denominated bond with a coupon interest rate of 7% (annual payment). Face value, the minimum size10 for the investment, is €1,000. The coupon interest rate reflects an existing risk-free rate of 2%, a credit default risk equal to 4% and, let’s assume, another 1% because this bond is less liquid than other similar issuances denominated in USD. 9  Usually

the 10-year sovereign bond, considering the fact that a county-default, except few of the most important corporations worldwide, would affect also corporations’ resident in that country. 10  Usually bonds have a minimum size of (EUR or USD) 1,000 for the retail market, 50,000 or 100,000 for the professional market and 200,000 for Institutions (banks).

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Figure 5.12

Example of a coupon bond discount and price calculation (1) date

30/06/2020

cash out – purchase price

30/06/2021 30/06/2022 30/06/2023

30/06/2023

30/06/2024

– 1,000 €

cash in – coupons

70 €

70 €

70 €

70 €

cash in – redemption price

70 € 1,000 €

discount yield

7%

7%

7%

7%

7%

t

1

2

3

4

5

discount factor

1.07

1.1449

1.225043

1.310796

1.4025517

discontuded CFs (PVS

65.42 €

61.14 €

57.14 €

53.40 €

762.90 €

∑ PV i

1,000 €

The discount factor, since this bond is issued AT PAR, equals the coupon interest rate and is actually the Yield to Maturity that the investor would obtain by purchasing this bond and holding it till the maturity date. In Figure 5.12 it’s possible to appreciate how the sum of the present values of each cash flows is equal to € 1,000. After a few days, on the 10 July 2020, Beta will be issuing a 6-year bond, euro denominated like Alpha’s on, with a 7% coupon interest rate, annual payment. On 5 July 2020 a credit rating agency releases a new rating for Beta, from BBB+ to A. The firm looks much safer than before. Bonds issued by firms with an A rating are traded with a risk default spread of 2%. The investment bank that is doing the issuance process for Beta decides not to change the prospectus, already approved by the Autorité des Marchés Financiers (AMF)11 and EuroNext. The only option would be an issuance ABOVE THE PAR. Why? Do you want to sell a bond rated A for €1,000 when few days before, a bond rated BBB+ with the same characteristics was issued at the same price? It would be anti-economic because Beta, thanks to the new rating, sounds safer to the market so it can raise money at a cheaper price than Alpha. If the coupon cannot change, the only variable that can “adjust” the mismatch is the price. The “fair” price can be computed by discounting the future cash flows, which will be paid as written in the prospectus (the bond’s issuance contract), with a discount rate that embodies 11

In English “Financial Markets Regulator” – the stock market regulatory body in France.

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Figure 5.13

113

Example of a coupon bond discount and price calculation (2) date

10/07/2020

cash out – purchase price

10/07/2021

10/07/2022

10/07/2023

10/07/2024

10/07/2025

– 1,087 €

cash in – coupons

70 €

70 €

70 €

70 €

70 € 1,000 €

cash in – redemption price discount yield

5%

5%

5%

5%

5%

t

1

2

3

4

5

discount factor

1.05

1.1025

1.157625

1.2155063

1.2762816

discontuded CFs (PVs)

66.67 €

63.49 €

60.47 €

57.59 €

838.37 €

∑ PV i

1,087 €

the new credit rating of the issuer. The credit rating spread has dropped by 200 bps (2%) thus the discount factor is now 5% (2% free-risk rate, 2% credit risk rate, 1% liquidity risk). The “fair” price, calculating a discount factor of 5%, should be €1,087 as in Figure 5.13. The bond issued by Alpha with the same characteristics, was issued just few days before the Beta bond for €1,000. The latter, issued ABOVE PAR, will give the bearer the same coupon cash flow but with a capital loss, purchasing a €1,087 bond that will pay back just $1,000. The YTM for Beta bond holders will be less than 7%: they will have a lower coupon yield i (70/1,087 while for Alpha it is 70/1,000) and a capital loss (while for Alpha there is no capital loss/gain). Suppose now that the investment bank that acts as a book-runner for Beta can change the prospectus and decide, thanks to the new Beta’s A rating, to issue a bond AT PAR with a 5% coupon interest rate (see Figure 5.14 for the detailed calculation). What do you think will happen, in the secondary market, to the Alpha Bond? The fact that a bond issued by a safer competitor (according to the rating agency valuation) is traded at the same price (or around the same price) doesn’t affect the price of Alpha. Due to a new rating, the two bonds are no longer in the same basket of choice for the investors: they might accept paying €1,000 for a BBB+ bond that offers a YTM of 7% or decide to pay €1,000 for an A-rated bond that offers a 5% YTM.

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Figure 5.14

Example of a coupon bond discount and price calculation (3) date

10/07/2020

cash out – purchase price

10/07/2021 10/07/2022

10/07/2023

10/07/2024 10/07/2025

– 1,000 €

cash in – coupons

50 €

50 €

50 €

50 €

cash in – redemption price

50 € 1,000 €

discount yield

5%

5%

5%

5%

5%

t

1

2

3

4

5

discount factor

1.05

1.1025

1.157625 1.21550625

1.2768156

discontuded CFs (PVs)

47.62 €

45.35 €

∑ PV i

5.2.5

43.19 €

41.14 €

822.70 €

1,000 €

How to read bond info: the prospectus

The prospectus is a comprehensive and detailed guide on how a bond works. It is also called the offering statement and provides the information you need to know about the issuer and the bond before making an investment decision. The prospectus outlines the terms of the agreement between the bond issuer and the bondholder and details the characteristics of the bond such as in the example that follows, a 2025 Note, issued by Tesla in 2017. Schedule III (shown in Figure 5.15) to the prospectus gives a schematic summary as follows: • • • • •

the total amount of the issuance is $ 1.8 billion but the issuer after expenses gets only $1.77 billion; the maturity, when the bond will be repaid, is 15 August 2025; the issuance price is the 100% of the Face Value, thus, the issuance is AT PAR; the coupon interest rate is 5.3%. Being issued AT PAR, the YTM is equal to the coupon interest rate; due to a rating B2/B− of the corporation, and B3/B− of the issuance, the bond pays 320 bps spread over the treasury (free-risk) benchmark;

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Figure 5.15

115

Tesla senior note 2020 prospectus pricing supplement: Schedule III Pricing Supplement, dated August 11, 2017 to the Preliminary Offering Circular, dated August 7, 2017 Tesla, Inc. $1,800,000,000 5.30% Senior Notes due 2025

The information in this pricing term sheet supplements Tesla, Inc.’s preliminary offering circular, dated August 7, 2017 (the “Preliminary Offering Circular”) and supersedes the information in the Preliminary Offering Circular to the extent inconsistent with the information in the Preliminary Offering Circular. In all other respects, this term sheet is qualified in its entirety by reference to the Preliminary Offering Circular. Terms used herein but not defined shall have the respective meanings as set forth in the Preliminary Offering Circular. Tesla, Inc., a Delaware corporation Issuer: Guarantor: SolarCity Corporation, a Delaware corporation Title of Securities: 5.30% Senior Notes due 2025 (the “Notes”) Placement: 144A/Regulation S for life Offering Size: $1,800,000,000 Gross Proceeds: $1,800,000,000 Net Proceeds to Issuer (After Expenses): Approximately $1.77 billion Maturity: August 15, 2025 100% of face amount Issue Price: Coupon: 5.30% Yield to Maturity: 5.30% Spread to Benchmark: Treasury: 320 bps Benchmark Treasury: 2.000% due August 15, 2025 Corporate Rating: B2 (Stable) / B- (Negative) Tranche Rating: B3 / B Trade Date: August 11, 2017 August 18, 2017 (T+5) Settlement Date: Interest Payment Dates: February 15 and August 15 of each year, beginning on February 15, 2018 Record Dates: February 1 and August 1 of each year Make-Whole Redemption: Make-whole redemption at Treasury Rate + 50 basis points prior to August 15, 2020 Optional Redemption: On or after August 15, 2020, at the following redemption prices (expressed as a percentage of principal amount), plus accrued and unpaid interest to, but excluding, the redemption date: Period Beginning August 15, Price 2020 103.9750% 2021 102.6500% 2022 101.3250% 2023 and thereafter 100.0000% Up to 35% at 105.3000% prior to August 15, 2020 EquityClawback: CUSIP Numbers: Rule 144A: 88160R AE1 Regulation S: U8810L AA1 ISIN Numbers: Rule 144A: US88160 RAE18 USU8810L AA18 Regulation S: Use of Proceeds:  The Issuer will use the net proceeds from this offering to further strengthen its balance sheet during a period of rapid scaling with the launch of Model 3, and for general corporate purposes. Pending the use of proceeds as described above, the Issuer intends to invest the proceeds in highly liquid cash equivalents or United States government securities. Listing: None

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• the first trading date is 11 August 2017, while the (semi-annual) coupons are paid on February 15 and August 15 of each year, beginning 15 February 2018; • there is an optional redemption call, that allows the issuer to call the bond back at preordered prices on August 15, from 2020. In Schedule I (shown in Figure 5.16) we can see the role of the financial intermediaries, the team of bookrunners, that underwrite the bond for its total amount before selling it in the market. Figure 5.16

Tesla senior note 2020 the team of bookrunners: Schedule I

Principal Amount of Securities to be Purchaser Purchased Goldman Sachs & Co. LLC $ 450,000,000 342,000,000 Morgan Stanley & Co. LCC Barclays Capital Inc. 201,600,000 Merril Lynch, Pierce, Fenner & Smith Incorporated 201,600,000 201,600,000 Citigroup Global Markets Inc. Deutsche Bank Securities Inc. 201,600,000 RBC Capital Markets, LLC 201,600,000 TOTAL $ 1,800,000,000

5.2.6 How to trade a bond, the book and OTC contributors As seen in the previous section, bonds are purchased by specialists who sell them in the market acting like dealers, sometimes also keeping in their accounts some bonds for a second round of trading, acting as market makers in the OTC market, ensuring the liquidity of the security. The intermediaries (IBs) serve as market makers and through a trading platform can be seen how contributors’ trading volumes (BSz, bid size – Asz, Ask size) are much higher than the regular markets’ volumes. As for any traded security in the secondary market, there are players aiming to purchase (Bid, also called Money) and players aiming to sell (Ask, also called Paper). The bid price is the highest price that a trader is willing to pay to go long. The ask price is the lowest price someone is willing to sell. All players, when bidding or asking, also have to declare the amount that they want to buy or sell a given security. This mechanism, as seen in section 2.2.4, determines the equilibrium price, that is the price where bid and ask, at a given quantity, meet. This is called the “last price” because it is the last equilibrium price, which may go up or down in few seconds. Traders can see a list of bid prices (with the total quantity and number of investors aiming to purchase at that level) and a list of ask prices (with the total quantity and number of investors aiming to sell at that level) in a unique snapshot, called the “order book.” An order book is an electronic register of buy (bid) and sell (ask) orders for specific securities at all price levels. See an example in Table 5.2.

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Table 5.2

117

Example of order book structure

As for the demand curve, there is equilibrium only if supply and demand meet. If the bid increases or the ask decreases, a new trade takes place. In the order panel there are also other options: the traders can ask for a total execution only or not. Just suppose that the two prices (bid and ask) meet but the quantity required and offered do not meet: if the option “total execution only” is not flagged, the trade will take place, if the option is flagged the trade cannot take place.

5.3

A new era for bonds: Green bonds and SDG bonds

We have analysed the world of bonds as the marketplace where demand meets supply, seeking equilibrium in the price. This price is the quote that combines several variables; lenders, all other factors being equal (risk, maturity, etc.), will prefer the investment that guarantees the best return. Very often this has been true, especially in the past (see Figure 5.17). But there is something more. Investors consider a variety of factors when determining the longterm value of a company (and its issuance for funding). Public records, such as annual reports, have always been a traditional source of information, helping investors discern the effects of company-specific issues on valuations. In recent years, thanks to easier access to a vast amount of information, more and more investors have new

Figure 5.17

The history of socially responsible investment

118 Finance Lab

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types of data to glean investment insights and make their assessments. Environmental, social, and governance (ESG) factors are one example of this “new” information which is gaining in public consideration among investors around the world. The new frontier is “responsible investment” which is driven not only by profits (that also includes speculation) but also by other intangible values. This could change the mass of potential investors, helping firms and institutions to raise money across a wider population of investors, also winning the trust of some former market sceptics. What does “investing responsibly” mean? And why are investors looking for “a new way”? Why do issuers have to follow this new trend? As defined by the Principles for Responsible Investment12 (PRI), there are many ways to invest responsibly. The most common approaches, summarised in Table 5.3, are typically a combination of two overarching areas: • considering EGS issues when building a portfolio (also known as ESG incorporation); • improving investees’ ESG performance (active ownership or stewardship). Several forces are driving the growth of responsible investment, three are the most well-known and usually cited: materiality, client demand and regulation. Recently there is growing recognition in the financial industry, and in academic research, that Table 5.3

12

Two common approaches in sustainable and responsible investment

  The PRI is an investor initiative in partnership with UNEP Finance Initiative and UN Global Compact. The PRI is the world’s leading proponent of responsible investment. It works to understand the investment implications of environmental, social and governance (ESG) factors and to support its international network of investor signatories in incorporating these factors into their investment and ownership decisions. The PRI acts in the long-term interests of its signatories, of the financial markets and economies in which they operate and ultimately of the environment and society as a whole. See https://www.unpri.org/about-the-pri.

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ESG factors influence investor returns. Results from many studies indicate that engaging with companies on ESG issues can create value for both investors and companies, by encouraging better ESG risk management and more sustainable business practices. The constant growth in terms of focus for investors on the environmental and social impact of the companies they are invested in is pushing firms to adopt a policy of transparency about how and where their money is invested, also forcing them to pay attention to their reputation in the financial community. A negative market image can exclude or limit the funding activity of certain sectors or prevent companies from tapping the markets’ flow of funds. Lastly, since the mid-1990s, responsible investment regulation has increased significantly. The financial crisis of 2008, albeit not directly related to environmental troubles, has deeply affected the “mood” of the investors and escalated the fear among the investors of unethical behaviours. This has pushed governments and market regulators to make a change, driven also by the idea that the financial sector can play an important role in meeting global challenges such as climate change, water waste, recycling activities, modern slavery and tax avoidance. 5.3.1 ESG What does ESG stands for? ESG stands for Environmental, Social and Governance. The acronym refers to the three key factors when measuring the sustainability and ethical impact of an investment in a business or company. We could add that ESG is a generic term found in capital markets and commonly used by investors to evaluate the behaviour of companies, as well as to determine their future financial performance. ESG is growing in significance amongst both institutional and retail investors. Recently, socially responsible investors have been assessing companies using ESG criteria to screen investments. Environmental Social and Governance factors are a subset of non-financial performance indicators which include ethical, sustainable and corporate government issues such as ensuring there are systems in place to guarantee accountability and managing the corporation’s carbon footprint. The practice of ESG investing is not completely new, even if Green bonds are still young considering their recent debut, and SDG bonds have just come on the scene. But the practice itself began in the 1960s as socially responsible investing, with investors excluding stocks or entire industries from their portfolios based on business activities such as tobacco production or involvement in the South African apartheid regime.13 Today, ethical considerations and alignment with values remain common motivations and not only for many ESG investors; these factors have a wider impact on investors in general. The field is rapidly growing and evolving, as many investors look to incorporate ESG into the investment process alongside traditional financial analysis. 13 

See MSCI.

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5.3.2 The first step: Green Bonds Around a decade ago, a new market opened up: the green bonds market. After a slow start, it has boomed in recent years, helping spur development of other socially conscious debt products. Green bonds are a way for issuers to raise money specifically for environmentally friendly projects, such as renewable energy or clean transport; then they get bragging rights. Fund managers also like these notes as a way of meeting growing investor demand for sustainable options. In 2008, the World Bank launched the Strategic Framework for Development and Climate Change; the goal was to help stimulate and coordinate public and private sector activity to combat climate change. The World Bank itself launched a Green Bonds program, an example of the kind of innovation the institution is trying to encourage within this context.14 The World Bank Environmental & Social Framework sets out the institution’s commitment to sustainable development, designed to support borrowers’ projects. The Framework comprises: • a Vision for Sustainable Development; • the World Bank Environmental and Social Policy for Investment Project Financing, which sets out the mandatory requirements that apply to the World Bank; • the Environmental and Social Standards which lay down the mandatory requirements that apply to borrowers and projects. Strong regulation is necessary because investors face the challenge of judging whether or not a note is truly green: investors are quite sceptical, afraid of misleading issuances. Regulators are working on standards to help guard against greenwashing, or misleading claims about just how good a friend to the environment an issuer is. As we said, the market was once quite cold toward this new kind of bond: in 2013, 5 years after the first issuance, the green bond cluster accounted for a total issuance of only $13 billion. That amount would gradually grow to $86 billion in 2016 and then make a huge leap to $158 billion in 2017, almost doubling in size from the previous year. In 2018, the market experienced slight stagnation, recording issuances for $168 billion. Nevertheless, growth resumed in 2019 hitting $257.7 billion. According to Sean Kidney, CEO at Climate Bonds Initiative (CBI), new forecasts for 2020 are around $350-400 billion and the goal for 2021/22 is to break $1 trillion issuances.15 Another forecast, released by the credit rating agency Moody’s, estimated that total global green bond issuance in 2019 is heading towards $250 billion; that shows how for the third consecutive year issuances rose by more than $100 billion. 2013 was a key turning point year, with a structural change in the green bond market. Before 2012, only supra-national entities such as the World Bank and the European Investment Bank were issuing green bonds. Then, after a French munici-

14  15 

See World Bank – IBRD Funding Program. Forecast by CBI, made before the Covid-19 health emergency.

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pality issued its first green bond in 2013, a new trend of issuances by corporations, financial institutions, municipalities and sovereigns went global. The Green Bond European Investor Survey run by the Climate Bond Initiative in 2019 shows that now development banks represent the major issuer worldwide, followed by financial and non-financial corporates. These three together account for 58% of green bond issuances. Non-financial corporates have the highest potential for growth among top issuers because they’re the preference of European investors; in fact, as 93% of them have already invested in them or are willing to do so in the near future. In 2019, the top issuer in the world was the US-government-sponsored enterprise Fannie Mae with $22.9 billion issuances of agency Green Mortgage Backed Securities (9% of total). In second and third place we find respectively the German state-owned development bank, KFW, with $9 billion and the Dutch State Treasury Agency with its $6.7 billion debut green bond. The United States cemented its leading position with more than $50 billion in issuances in 2019, followed by China and France, with around $30 billion. The “Big 3” accounted for 44% of global issuance in 2019. Despite some reluctant investors, the green bond market is growing globally and experiencing further geographic diversification. Kind of issuances The most common type is the general obligation green bond (also called the GO bond), whose proceeds might be allocated either to specific green projects or to general corporate purposes. Then there are project bonds, issued to fund specific sustainable projects whose cash flow will be used to pay back investors, who is thus directly exposed to project risk. Finally, the last type is a green bond collateralized by a pool of assets. This can be in the form of an Asset Backed Security (ABS), among which the most often utilized is the Mortgage Backed Security (MBS), or covered bond issued by banks. Sectors The proceeds of green bonds issued worldwide went mainly to three sectors: Energy (31% of proceeds), building (30%) and transportation (20%). A consistent part of proceeds (9%) also went to the water sector, notably because of Fannie Mae’s allocation of $4 billion for programs to improve efficiency in water management. The remaining share of the market is made up of waste, land use, industry, information and communication technologies sectors. Investors The heterogeneity of issuers, sectors and countries around the world leads to heterogeneity in the risk profile of green bonds too. This is one of the several aspects that contributed to the growth of the market, as different kinds of investors could theoretically find a green bond matching their demand in terms of risk aversion.

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According to the “Global Bond Treasurer Survey 2020” by Climate Bonds, recent first-time green bond issuers are able to get the deal done in less time. The vast majority of respondents (88%) said that the process of issuing a first green bond required less than a year once the decision had been made. The development of well-established practices around key parts of the green bond concept, for example through the Green Bond Principles has likely benefitted recent issuers (including the green bond framework, management of proceeds and post-issuance transparency). Most green bonds are known for having a low level of risk and the majority of investors are institutional ones. This category includes national development banks, insurance companies and, above all, pension funds. The latter is the investor that best fits the nature of most green bonds, providing a low-risk, steady cash flow related to a sustainable project. Exchanges and markets for green bonds Green bonds can be listed on any exchange with a bond platform, just like vanilla bonds. As of January 2020, 17 stock exchanges across the world offered dedicated green bond sections, providing additional visibility to the green bond label (see Table 5.4). The listing in regulated markets can offer improved access, flexibility and transparency for investors. 5.3.3 A new frontier: the SDG bonds. The Enel case The green bond market has grown at a rapid rate over the last few years. These are several bonds issued by corporations or governments with proceeds earmarked for various kind of investments in sectors such as renewable energy, energy efficiency, clean water, water saving, land restoration, pollution prevention, ecosystem protection and acquisition of land to mitigate climate change impact. Most green bonds, in order to incentivise bondholders, are directly linked to the assets and provide tax exemptions and tax credit. In October 2019, Italian utility company Enel,16 through Enel Finance International N.V., issued the world’s first Sustainable Development Goals (SDG) bond. The 16   Enel is a multinational power company and a leading integrated player in the global power, gas and renewables markets. It is the largest European utility by market capitalization and ordinary EBITDA, and is present in over 30 countries worldwide, producing energy with around 90 GW of managed capacity. Enel distributes electricity through a network of over 2.2 million kilometres, and with around 73 million business and household end users globally, the Group has the largest customer base among its European peers. Enel’s renewables arm Enel Green Power already manages around 46 GW of wind, solar, geothermal and hydropower plants in Europe, the Americas, Africa, Asia and Oceania (source: Enel Corporate website). Enel, listed on Milan Stock exchange, according to charts, had a market cap of around €80 billion as of 31 December 2019, reaching a peak of €94.3 billion before Covid-19 market drop. It is currently (2020) the second largest utility firm worldwide after the US based NextEra (source: Macrotrends).

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Table 5.4

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Green bonds in the stock exchanges around the world

Stock Exchange for Green & Social Bonds

Launch Date

Italian Stock Exchange

mar-17

Japan Exchange Group

gen-18

Vienna Stock Exchange

mar-18

Moscow Exchange

ago-19

Stock Exchange for Green Bond

Launch Date

Oslo Stock Exchange

gen-15

Shanghai Stock Exchange

mar-16

Mexico Stock Exchange

ago-16

Taipei Stock Exchange

mag-17

Johannesburg Stock Exchange

ott-17

Frankfurt Stock Exchange

nov-18

The International Stock Exchange

nov-18

EuroNext

nov-19

Stock Exchange for Green, Social and Sustainability bonds

Launch Date

London Stock Exchange

lug-15

Luxembourg Stock Exchange

set-16

NASDAQ Sustainable Bond Network

dic-19

Stock Exchange for Sustainable bond

Launch Date

Stockholm Stock Exchange

giu-15

NASDAQ Nordic & Baltics

mag-18

Source: Authors’ elaboration from Green Bond Treasurer Survey 2020 – Climate Bonds Initiative.

issuance was called “general purpose SDG-linked bond,” successfully placing $1.5 billion on the US market (for technical details, see Box 5.2). The issue was almost three times oversubscribed, with orders of about $4 billion. This strong demand confirmed the appreciation and confidence of the financial markets in the soundness of sustainable strategy. Obviously with a consequent impact on the economic and financial results for the issuers as Enel. The terms and conditions of this five-year instrument include a key performance indicator (KPI) which Enel commits to achieving for investors by 2021: the increase of its renewable energy installed capacity to at least 55% (from 46% as of H1 2019) of total capacity. By the end of 2021, if the target is achieved, there can be an increase in the coupon (the annual interest payment to bondholders) of 25 basis points. The review is carried out as part of the annual audit.

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This cause a stir in the market: a new era with a new approach to funding policies. Under this new framework, Enel declared explicitly its commitment to achieving the SDGs of the United Nations, thereby linking its cost of debt to SDGs in the areas of affordable and clean energy and climate action. The trade off with the lender is clear: the borrower can raise funds at a cheaper price only if it achieves specific targets relating to a sustainable world. Lender accept this challenge and prefer a lower return for a more ethical approach to the business carried out with their money. This new approach could also attract new investors, eliciting the engagement of finance sceptics, thanks to this more sustainable, innovative less profit-oriented way of raising money (in terms of how the financial resources are used). Enel, which has already issued several green bonds in the past, with this new SDG-linked bond aims to provide much more transparency for investors with regard to the evolution of its entire business model, to address the energy transition goal rather than focusing on specific projects it aims to finance. This kind of issuance leads the way to a new product for the sustainable finance market where other bond issuers can follow and grow the market. In fact, this Enel bond is not a single issuance, but part of a plan, one that soon other issuers could follow. In 2018 Enel launched the 2019-21 Sustainability Plan, which is based on industrial pillars and ESGs. The Group is confirming the fundamental principles of its strategy, with greater change and acceleration in its implementation. The Plan promotes combining different cultures and objectives within the same Group, across mature businesses and upcoming activities, promoting the application of a sustainable business model along the entire value chain, in line with the 17 Sustainable Development Goals. Enel promotes the achievement of these goals, aligning its own strategy with the United Nations goals and measuring and managing its own direct contribution to achieving them. According to the 2019-21 Plan, Enel will make investments for €16.5 billion for the development of renewable energies and network digitalization. The Group also launched “Enel X” – activities for electric mobility and its “Demand response” service. Enel is focused on creating value through business decisions that support the pursuit of the following four SDGs in the 2019-21 plan: • SDG 7 Affordable and clean energy, with over 11.6 GW of additional renewable generation capacity; • SDG 9 Industry, innovation and infrastructure, with over 46.9 million smart meters installed and €5.4 billion of investment in innovation and digitalisation; • SDG 11 Sustainable cities and communities, with retail investment and new electrification-oriented energy services to achieve, among others, 9.9 GW of demand response capacity and 455,000 charging points for electric mobility; • SDG 13 Climate action, with a commitment to reduce carbon dioxide emissions to below 125 g/kWh by 2030 and full decarbonisation by 2050. The company has pledged to achieve, firstly, a 55% renewable generation capacity as a percentage of its total business by the end of 2021, and secondly, to reduce its greenhouse gas emissions to less than 125g/kWh by 2030 (with external verifiers to

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monitor its development). In the event Enel fails to achieve these targets, the coupon on its SDG-bonds will step up by 25bp, making it more expensive for Enel to fund its business activities. After the successful US market placement, Enel tapped into the European market with another SDG-linked bond of €2.5 billion. This new issuance was almost four times oversubscribed, with total orders of about €10 billion. This latest bond added to the renewable generation capacity goal set in the US bond, a target linked to SDG 13 (climate action) to achieve a level of greenhouse gas emissions by 2030 equal to or less than 125 g of CO2 per kWh, foreseeing for both a 25 bps step-up mechanism if targets are not reached. Enel has declared the organization is “fully committed towards this innovative financing tool, expecting to increase the share of sustainable finance sources, such as the SDG-linked bonds, on Enel’s gross debt, from around 22% in 2019 to approx. 43% in 2022 and to around 77% in 2030.”17 Box 5.2 Enel SDG bond’s Technical features extract Issuer: Enel Finance International N.V. ISIN CODE: USN30707AM05 Issue date: 10/09/2019 Maturity: 10.09.2024 Size: $1.5 billion Coupon: 2.650% Issue price: USD 99.879 This bond issue, the first of its kind and intended to meet the Company’s ordinary financing needs, is linked to the Group’s ability to achieve, by December 31, 2021, a percentage of installed renewable generation capacity (on a consolidated basis) equal to or greater than 55% of total consolidated installed capacity. To ensure the transparency of the results, the achievement of that target (as of June 30, 2019, the figure was already equal to 45.9%) will be certified by a specific assurance report issued by the auditor engaged for this purpose. The operation has been structured as a single tranche issue of $1.5 billion paying a rate of 2.650% maturing September 10, 2024. The issue price has been set at 99.879% and the effective yield at maturity is equal to 2.676%. The settlement date for the issue is September 10, 2019.The interest rate will remain unchanged to maturity subject to achievement of the sustainability target indicated above as of December 31, 2021. If that target is not achieved, a step-up mechanism will be applied, increasing the rate by 25 bps starting from the first interest period subsequent to the publication of the assurance report of the auditor. Additional information on the guiding principles of the bond issue and the Group’s sustainability strategy is available to the public on the Enel website, at www.enel.com/investors/fixed-income/ mainprograms/sdg-bond. The operation was supported by a syndicate of banks, with BofA Securities, Inc., BNP Paribas Securities Corp., Citigroup Global Markets Inc., Credit Agricole Securities (USA) Inc., Goldman Sachs & Co. LLC, J.P. Morgan Securities LLC, Morgan Stanley & Co. LLC, Société Générale acting as jointbookrunners. In consideration of its characteristics, the issue was assigned a provisional rating of BBB+ by Standard &Poor’s and A- by Fitch, as well as a definitive rating equal to Baa2 by Moody’s.

17 

See Enel press release, 16 December 2019.

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The success of this new approach to corporate funding linked to sustainable growth was recognized by the International Financing Review (IFR), which named Enel the world’s leading provider of global capital market intelligence, as ESG Issuer of the Year for the IFR Awards 2019. The award was given for Enel’s commitment to a sustainable strategy resulting in the innovation of the sustainable finance market brought about through the world’s first general purpose bonds linked to the achievement of the United Nations SDGs, launched by the Group on the US dollar and euro markets, in September and October 2019 respectively. Furthermore, the Group’s 1.5 billion US dollar SDG-linked five-year bond was named Yankee Bond for 2019. Controversy arose because Enel is not committed to use the proceeds from the SDG bonds directly towards green investments but has bought an option not to deliver on these two renewable goals at a cost of 25bp, which leaves room for “greenwashing” – the practice of conveying to investors that the company is more environmentally friendly than it actually is. In December 2019 the German Federal Government announced its intention to support the development of sustainable financial markets, issuing Green German Government securities, joining its European peers like France and Poland. 5.3.4 SGD-linked bonds: how they work at glance The first key is that, with these instruments, issuers commit to using the actual funds raised with the bond’s issuance to achieve certain SDG objectives. The second key is that the integration of SDGs into the bond market brings the issuer to include a covenant that links the coupon of a bond to the issuer’s achievement of SDG goals. Progress or lack thereof toward the SDGs then results in a decrease or increase in the instrument’s coupon. The essential aim of these bonds can be summed as the objective for the issuer to achieve these goals or risk an increase in the cost of funding. 5.3.5 Rating: a new approach Environmental, social and governance (ESG) are the three main factors used to measure the impact on society and sustainability of a company or organization. With the birth and growth of these new issuances, the old rating methods have become irrelevant which is why many ESG ratings agencies create scores assessing the ESG performance of companies by using their expertise and research methodology. The growth of the green bond market and SDG bond market, and more intense public attention towards sustainability has made the ratings created by these agencies a key reference for academia, financial markets and companies.

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5.4 The money market This chapter is called Debt Markets and in the previous parts sections it addressed the bond market, a classic capital market instrument. Alongside the bond market there is another market for debt called the money market. But in one sense this name is misleading. In both markets, what is offered for sale is debts or claims in exchange for money. In both markets it is money that is being borrowed. What justifies the two different labels is the time to maturity of the debts or, more simply, how long the funds are borrowed. In money markets, funds are borrowed for a short period, i.e. less than one year; in the capital markets, funds are borrowed for long-term use. Since 1944 most of the countries that have domestic money markets or that play a role in the international money market have joined together in the International Monetary Fund, which represents a pooling of part of the foreign exchange reserves and gold of more than 100 member countries. 5.4.1 Money market instruments The term “money market” is a misnomer. Money (meant as currency) is not actually traded in the money markets. The securities in the money market are short-term issuance of debt with high liquidity; therefore, they are almost like money. To sum up, a money market is where securities are traded that can be transform into cash quickly, without facing illiquidity risks. In addition, since these securities have very short maturities, they suffer very little volatility, and their prices are quite stable. If we refer back to the balance sheet structure, and we think about the liability side and the need for banks especially, but for governments and sometimes corporations too, to borrow “short,” these instruments are the perfect solution. They are widely used by banks for matching regulatory capital needs as well. In a general sense we can say that money markets instruments are usually sold in large denominations (transaction size is $1,000,000 or more). What’s more, being issued by large highly rated issuers, they have a low default risk. The maturity for money markets securities is one year or less from their issue date, although most mature in less than 120 days. These instruments are well traded in the secondary market and used by big market players to fill short-term financial needs at a low cost. The biggest issuers are banks and governments through dealing agencies. We have to remember that the secondary market does not raise new funds; it merely redistributes the ownership of previously issued securities. But the fact that lenders can sell their loans cheaply and easily in a secondary market may make them much more willing to lend. An active secondary market increases the supply of lending, while reducing prices. From the investor’s point of view the money market represent a place for warehousing surplus funds for short periods of time: idle cash represents an opportunity cost in terms of lost interest income. So reinvesting operational cash surplus, even with quite a small lender rate, is a better solution.

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Governments use these markets because the timing of cash inflows and outflows are not well synchronized; think about tax inflows and expenses outflows that could have a short-time mismatch. Long term funding would have higher cost of funding, while short-term issuances are cheaper. So broadly speaking we can say that money markets provide a way to solve these cash-timing problems. The money markets are made up of distinctive markets and types of securities, as follows: • • • • • •

the discount (or “traditional”) market; the interbank market; the certificate of deposit (CDs) market; the commercial paper market; the repo market; the eurocurrency markets.

It is important to note that on the money market, instruments are issued with a rate of discount. The discount is not the rate of return for the investor; the instrument has a slightly higher equivalent rate of interest.18 Money market instruments whose rate of return is expressed as a conventional rate of interest are said to be “quoted on a yield basis,” like treasury bills, commercial bills and commercial papers. For certificates of deposit, interbank deposits, money market deposits and repurchase agreements the return is expressed as a rate of discount. a) The discount market In discussing the bond market we have already introduced the zero-coupon bond, instruments of debt sold at a discounted price that will be repaid at 100% of the face value, with an implicit return for the lender. In the money market, very often funds are raised by issuing bills “at a discount” on their eventual redemption or maturity value. These instruments have a very short maturity (a year or less). For this timebased reason, it would be very difficult to pay periodical coupons, which is why they are sold at a discount as ZCB. Transactions that take place in the discount market are normally very large, making it possible for profits to be made from deals involving differentials at discount rates of small fractions of a percentage. The market has no physical location and it is a typical OTC market: deals are made through contact between financial intermediaries. As with any market, prices are fixed on the supply and demand equilibrium theory. Theoretically, bills can be issued by anyone, but in practice they are issued (on the supply side) mainly by large corporations (commercial papers) and govern-

18  Mathematically if you discount by 10% 100 you get 90, if you the capitalize 100 by 10% you will have 99. The investor invests 90 and will see an increase of 10 over 90, which is a bit more than 10%.

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ments (treasury bills). The main buyers (demand side) and holders of bills used to be a highly specialized group of banks known as discount houses. These banks then use these bills very often for reducing the risk and volatility profile of ETF and Funds. The existence of an active discount market means that these assets are highly liquid. In the event of a shortage of primary reserves (cash and deposits at the central bank – see Chapter 4) banks can sell bills, accounted in their assets, very quickly and for a price which is virtually certain. New money market liabilities can also be issued for a very short period of time. Analysing the characteristics and features of money markets instruments, traded at discount, we can state the following: • treasury bills are usually issued with a size between 250,000 and 1 million (EUR, USD or GBP); • money market instruments are a highly liquid form of asset; • money market instruments have a low default risk; • commercial bills have acquired a status similar to treasuries, being issued by very large and solid corporations. How does the discount method work? Remember that these instruments very often have different maturities. So when we compare the returns, we have to pay attention to this variable, and compute the return on a yearly basis. Let’s look at this first example: a 52-week UK Gilt is issued at £98,500 (P, Price), and the redemption price is £100,000 (FV). The investor pays an upfront of £98,500, the discount spread is £1,500. In this kind of calculation very often one year is counted as 360 days, as per convention. The discount rate is calculated as follows:

=

=

−

×

360

100,000 − 98,500 360 × = 1.5% 100,000 360

The return for the investor is calculated, instead, over the price paid (the investment) as follows:

=

=

−

×

360

360 100,000 − 98,500 = 1.523% × 360 98,500

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Now take a second example: a 3-month19 UK Gilt is issued at £99,500 (P, Price), and the redemption price is £100,000 (FV). The investor pays an upfront of £99,500, the discount spread is £500. In this kind of calculation very often one year is counted as 360 days, as per convention. The discount rate is calculated as follows:

=

−

×

360

100,000 − 99,500 4 × = 2% 100,000 1 The return for the investor is calculated, instead, over the price paid (the investment) as follows: − 360 = × =

=

b) The interbank market

100,000 − 99,500 × 4 = 2.0101% 99,500

The interbank market is a wholesale market where banks and other financial institutions trade currencies and lend or borrow money to one another. Like the discount market, this provides individual banks with an outlet for surplus funds and a source of borrowing when their reserves are low. This market is an OTC market, and individual investors cannot participate this market. Loans are normally made for very short periods, from overnight to fourteen days; some lending for three, six months and one year occurs. Loans are unsecured and there is no lender of last resort. The rate of interest paid on interbank loans depends on the system where loans are exchanged. The most common rate, also outside British soil, is the London InterBank Offer Rate or LIBOR. LIBOR is the most important rate also because in the Eurodollar market, when funds are exchanged overseas, London has always been the centre of this world. That is why, for some time, the LIBOR has influenced the overseas lending rates of large US banks, particularly when the spread between US money market base rates and LIBOR rates favour the latter. Also, access to overseas sources of funds has recently made LIBOR an increasingly popular base rate among borrowers of regional and smaller banks.20 Interbank rates are an important point of reference to banks for

19

For the purpose of this book we conventionally use months. Each treasury market has specific rules and definitions. 20  See M. Melvin, S.C. Norrbin, “The Eurocurrency Market,” in International Money and Finance, London, Academic Press, 2013.

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other kinds of transactions because they are the best indication of the cost of raising immediate marginal funds. In fact, very often other rates are set as a spread over the interbank rates. Summing up, then, numerous bank interest rates are tied to LIBOR. In order to highlight the key role of LIBOR, we can think back to 2012. A huge scandal rocked the UK, when Barclays and subsequently other banks such as JP Morgan and Citibank, were investigated by the Financial Conduct Authority, accused of LIBOR Manipulation between 2005 and 2008.21 For the euro area, the benchmark rate is the EURIBOR, while in the US the leading rate id the FED Funds rate. The EURIBOR is the rate at which wholesale funds in euro can be obtained by credit institutions in the EU and EFTA countries in the unsecured money market. EURIBOR is a critical interest rate benchmark authorised under the EU Benchmarks Regulation (BMR); according to the European Commission, EURIBOR is one of most important interest rate benchmarks in the world. For the US, the benchmark rate is the Fed funds rate. The federal funds rate is the main interest rate in the US financial market. It influences other interest rates such as the prime rate, which is the rate banks charge their customers with higher credit ratings. Additionally, the federal funds rate indirectly influences longer-term interest rates such as mortgages, loans, and savings, all of which are very important to consumer wealth and confidence.22 The Federal Open Market Committee (FOMC) meets eight times a year to determine the federal funds target rate. c) Certificates of deposits (CDs) A certificate of deposit (CD) is a contract that states a deposit has been made with a bank for a fixed period of time, at the end of which it will be repaid with interest. This bank-issued security documents a deposit and specifies the interest rate and the maturity date. So in substance, a CD is a receipt for a time deposit. When you cash in or redeem your CD, you receive the money you originally invested plus any interest. Certificates of deposit are considered to be one of the safest savings options. Since a CD is a bearer instrument, whoever holds it at maturity received the principal and interest. There are CDs for the retail markets with a small size and issuance for institutional investors, with denominations range from $100,000 to $10 million. The risk is quite low, and the rates are negotiated between the bank and the customer, very often another bank or a large corporation. An institution is said to “issue” a CD when it accepts a deposit (and enters is as a liability on the P/L). Instead “holding” a CD is when the institution itself makes a deposit (and receives a CD) or buys a certificate in the secondary market (recording it as an asset). Unlike bills, CDs are priced on a yield basis. The rate of interest paid on CDs is often linked to an interbank rate. If EURIBOR is 1.75%, for example, the

21 See M.-C. Frunza, “LIBOR Manipulation,” in Solving Modern Crime in Financial Markets, Waltham, Academic Press, 2016. 22  See Board of Governors of the Federal Reserve System, “Monetary Policy.”

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CD might be paying 2.10% because it is quoted as EURIBOR plus 25 bps due to the features of the issuer and the CD. d) Commercial papers Commercial papers are a form of unsecured short-term promissory notes issued by corporations. In the US, for example, the maturity is no longer than 270 days in order to avoid the need to register the security issue with the SEC. Commercial papers represent an important alternative to bank loans primarily because of the lower cost, and also because direct placement means there are no commissions to pay. The use of commercial papers increased significantly in the early 1980s because of the rising cost of bank loans. The interest rate paid by the issuer reflects the firm’s level of risk. Firms wishing to tap the commercial paper market will usually seek a credit rating from a credit rating agency: a higher rating means that the commercial paper can be issued at a smaller discount, with a cost saving for the corporation. Commercial papers are usually issued on a discount basis. In countries like the UK, where there is a highly developed commercial bill23 market alongside the treasury bills market, the market for commercial paper is relatively small. By contrast, in France and the US, where the commercial bill market is less developed, the commercial paper market is very large. A special type of commercial paper, known as asset-backed commercial paper (ABCP), played a key role in the financial crisis in 2008 as the assets in this case were securitised mortgages. When the poor quality of the underlying assets was exposed, this triggered a run on ABCPs, and since these securities were held by many money market mutual funds (MMMFs), these funds also experienced a run. The government eventually had to step in to prevent the collapse of the MMMF market. e) Repurchase agreements or RePos A repurchase agreement, also called RePo, in a general sense is an agreement to buy any securities from a seller on the condition that they will be repurchased at some specified price and time in the future. In the money market, a firm sells treasury securities or other high rating securities but agrees to buy them back at a certain date for a certain price. This setup makes a Repo agreement essentially a short-term collateralized loan, in which the seller is the equivalent of the borrower and the buyer is the lender the repurchase price is higher than the initial sale price, and the difference in price constitutes the return to the lender. Deals are quoted on a yield basis. The length of any repurchase agreement is likely to be short, from overnight to 14 days, sometimes a matter of months at most. This is why Repos are a form of 23 

The main difference between commercial papers and commercial bills lies in the manner of their creation: a firm borrows via a commercial bill when it agrees to “accept” a bill which is “drawn” by a creditor. The bill originates with the lender. A firm borrows via commercial paper when it issues the paper itself.

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short-term finance. Therefore, logically, they represent an alternative to other money market transactions. These instruments work in a way that is similar to the market for fed funds, but nonbanks can participate. Repos are often used by the Federal Reserve, ECB and other central banks to conduct their monetary policies. Imagine that the ECB agrees to set a repurchase deal with a commercial bank. The bank is in need of money, but it does hold some long-term sovereign bonds as assets issued by some European country. It sells these bonds to the ECB for €10 million, agreeing to repurchase them in fourteen days for €10.003 million. In this case, the cost of funding for the commercial bank can be determined as follows:

10.003 − 10 360 × = 1.543% 10 7 Repo contracts are usually set up using the GMRA model agreement. GMRA is the acronym for the  Global Master Repurchase Agreement.24 It is a model legal agreement designed for parties transacting repos and is published by the International Capital Market Association (ICMA), which is the body representing the cross-border bond and repo markets in Europe. The GMRA is the principal master agreement for cross-border repos globally, as well as for many domestic repo markets. =

f) The EuroDollars and Euro-currency market After World War II the quantity of US dollars outside the United States, especially in Europe, increased significantly, as a result of both the Marshall Plan and imports into the US and payments in US dollars. Because they were held outside the United States, Eurodollars were not subject to regulation by the Federal Reserve Board, including reserve requirements. London rapidly became the centre of the Eurodollar market. The major source of competitive advantage for London was the regulatory environment which combined tight money in the domestic economy with relative freedom in international finance.25 The geopolitical tensions during the cold war and the regulation of US domestic banks in the 1960s and 1970s led many US banks and some oil-producing countries in the Middle East, South America, and even Russia, to search for a home outside the United States for their US dollar deposits. (Crude oil trades are regulated in US dollars worldwide.) In the new millennium, the market is essential since many foreign contracts call for payment in US dollars, for instance the crude oil market, due to the stability of the dollar, relative to other currencies. 24

  See www.icmagroup.org. ICMA has been settled in 2005 from the merge of “International Securities Market Association” (ISMA) and “International Primary Market Association” (IPMA). 25  See Catherine R. Schenk, “The Origins of the Eurodollar Market in London: 1955–1963,” Explorations in Economic History, 35, 221-238, 1998.

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The Eurodollar market has continued to grow rapidly because depositors receive a higher rate of return on a dollar deposited in the Eurodollar market than in the domestic market. In addition, multinational banks are not subject to the same regulations restricting US banks and they are willing to accept narrower spreads between the interest paid on deposits and the interest earned on loans. In any case, London is still the largest depository for US dollars outside the United States.26 Broadly speaking, we can use the term eurocurrency to describe currencies held outside the country of origin. So a eurocurrency instrument is denominated in a currency different from that of the country in which it is traded. These instruments are classified as money market because they involve lending and borrowing exchanges through banks and large institutions. Eurocurrency can be found today all over the world and has no obvious connection whatsoever with Europe or the euro. (Great Britain, in fact, never adopted the euro.) The “euro-” prefix is simply reminiscent of past trading instruments denominated in foreign currencies, beginning with the US dollar being traded in Europe. 5.4.2 Money market regulators In the United States the Federal Reserve System conducts day-to-day operations in the money market on its own initiative in order to assist the smooth working of the nation’s financial machinery and to exert a general influence aimed at fostering economic growth and limiting economic instability. Its transactions include substantial outright purchases or sales of government securities, relatively small purchases and run-offs of bankers’ acceptances, and a considerable volume of loans made for a few days at a time to dealers in government securities or acceptances in the form of repurchase agreements. The New York Fed is authorised by the Federal Open Market Committee (FOMC) to buy and sell treasury securities for the System Open Market Account (SOMA) to the extent necessary to carry out the most recent FOMC directive and ) to conduct repo and reverse repo operations for the System Open Market Account (SOMA) to the extent necessary to carry out the most recent FOMC directive. The New York Fed’s Open Market Trading Desk (the Desk) executes these repo and reverse repo operations in the tri-party repo market. The New York Fed also provides limited transaction services, including purchases and sales of Treasury securities, to its official sector account holders. Primary dealers are trading counterparties of the New York Fed in its implementation of monetary policy. They are also expected to make markets for the New York Fed on behalf of its official accountholders as needed, and to bid on a pro-rata basis in all Treasury auctions at reasonably competitive prices.

26 

See Patrick McGuire, “A Shift in London’s Eurodollar Market,” BIS Quarterly Review, 2004.

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Treasury Bills, the most common money market issuance, can have 4-week, 8-week, 13-week, 26-week, or 52-week maturity. Market quotations are obtained each business day by the Federal Reserve Bank of New York. The Bank Discount rate, the rate at which a Bill is quoted in the secondary market, is based on the par value, the discount amount, and a 360-day year. The US Treasury Department uses an auction process to sell marketable securities and determine their rate, yield, or discount margin. The value of treasury marketable securities fluctuates with changes in interest rates and market demand. You can participate in an auction and purchase bills, notes, bonds and other kind of securities directly from the treasury or through a bank or broker. In 2019 the US Treasury has conducted 322 public auctions, selling securities for approximately $11.806 trillion. The process begins several days before the scheduled auction when the Treasury announces the details of the upcoming issue, including the amount to be auctioned and the maturity date. Auctions have two bidding options: competitive and non-competitive. With a competitive bid, you specify the rate, yield, or discount margin you will accept. With a non-competitive bid, you agree to accept the high rate, yield, or discount margin set at auction. Non-competitive bidding is limited to purchases of $5 million per auction. At the close of an auction, Treasury accepts all non-competitive bids that comply with the auction rules, and then accepts competitive bids in ascending order in terms of their rates, yields, or discount margins (lowest to highest) until the quantity of accepted bids reaches the offering amount. All bidders, non-competitive and competitive, will receive the same rate, yield, or spread as the highest accepted bid. For a detailed numerical example of how auctions work, see the examples in Box 5.3. In the United Kingdom, the Debt Management Office27 (DMO) is an Executive Agency of Her Majesty’s Treasury responsible for debt and cash management for the UK Government, lending to local authorities and managing certain public sector funds. The DMO’s role is to make arrangements for funding and for placing net cash positions, primarily by carrying out market operations in the light of forecasts provided by HM Treasury of daily net cash flows into or out of the National Loans Fund (NLF). The DMO issues treasury bills through regular weekly or ad hoc tenders: it may also issue bills bilaterally upon request from recognised counterparties, subject to certain conditions. All UK treasury bills,28 as defined by the UK Debt Management Office, are “sterling denominated unconditional obligations of the UK Government with recourse to the National Loans Fund and the Consolidated Fund. They are issued from, and are liabilities of, the Debt Management Account. Treasury bills are zero-coupon eligible debt securities. Treasury bills may be issued with a minimum maturity of 1 day and a maximum maturity of 364 days. However, regular weekly tenders are 27 

See dmo.gov.uk. Treasury Bills are issued under the generic terms and conditions of the following: The Treasury Bill Act 1877, The Treasury Bill Regulations 1968 (as amended), and the Treasury Bill Information Memorandum, the current version of which can be found at dmo.gov.uk. 28 

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Box 5.3 Example of US Treasury auctions The US Treasury auctions $2.5 billion of 91-day T-bills. The following bids are received:

Bidder

Bid Amount

Bid Price

1

$ 500 million

$ 0.9940

2

$ 750 million

$ 0.9901

3

$ 1.5 billion

$ 0.9925

4

$

1 billion

$ 0.9936

5

$ 600 million

$ 0.9939

Total

$ 4.35 billion

The Treasury also received $750 million in non-competitive bids. Who will receive T-bills, what quantity, and at what price?

Bidder

Bid Amount

Bid Price

1

$ 500 million

$ 0.9940

5

$ 600 million

$ 0.9939

4

$ 650 million

$ 0.9936

$ 750 million

non comp.

$ 4.35 billion

$ 0.9936

Total

Both the competitive and non-competitive bidders pay the highest yield – based on the price of $ 0.9936.

typically for maturities of 1 month (approximately 28 days), 3 months (approximately 91 days) and 6 months (approximately 182 days). Further issues of treasury bills will carry the same ISIN code and be fungible with any existing bills of the same maturity date.” In Europe the puzzle is a bit different, with the overlapping of a central authority, the European Central Bank, that issues money market instruments as well, and the national central banks that issue money market securities. These institutions also exchange money market instruments with the ECB as borrowers.

Summary The chapter focuses on the debt market as a source of financing for businesses and financial institutions. The chapter analyse the structure of this very large market and the instruments traded in these markets, that could be divide into two main markets: the bond market and the money market. The chapter explain how to read the finan-

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cial information of the contract that is implied into a bond, teach some basic technicalities about the fixed income market, like the computation of the Yield to maturity and the pricing of a bond. In addition, the chapter focuses over new kind of bonds, like the green bonds and the SDG bonds, citing and analysing the first ever SDG bond issued by the electric multiutility firm Enel.

Questions 1. 2. 3. 4.

What is a zero-coupon bond? What is the Yield to maturity and how can be computed? Which kind of info and investor can find in the prospectus of a bond? If an investor purchases a bond in the secondary market, is the issuer receiving new liquidity? 5. How is the calculated return offered to the investors in the SDG bond?

6  The Stock Market

What you will learn in this chapter: • • • • •

What a share in a corporation is; Stock characteristics and function; Who are the equity market participants; The run for the leadership in market capitalizations; What happened to the Equity market in 2020 due to Covid-19.

Capital markets provide funds for long-term use. In Chapter 5 we introduced the capital markets with a broad analysis of the debt markets, specifically consisting of the bond market and money market. But debt it is not the only source of liquidity used by corporations and institutions for financing their assets. The other side of the capital market, and for non-specialists probably the most well-known and discussed in the news, is the stock market. When a company lists its shares on a stock market, it seeks to access capital from a wide pool of investors. The “primary” and necessary source of funding for a corporation is equity. While debt is capital provided by a third party, equity is the capital provided to the firm by the owners of the firm itself. A firm can finance its assets with equity alone but it’s impossible to use only debt.1 Everyday billions of shares (stocks) are traded among investors in regulated “secondary”2 markets all over the world. When a company decides to go public, it issues new shares with an IPO (Initial Public Offering); these shares are listed in regulated markets and traded in the secondary market that establishes the “value” of the corporation every day. This secondary market determines the cost of additional equity capital: the more investors are willing to pay for a company’s shares; the cheaper additional capital will be when the company issues more shares. Another benefit of listing on a public stock exchange is that the presence of a stock market price can be used to align the interests of managers with the interests of shareholders.

1  Governments, acting like the board of a corporation, issue bonds to finance the public debt of the nation (in fact, these are called sovereign bonds), but nations do not issue shares in the market. 2  As already discussed, the primary market is for newly-issued shares and one of the counterparties is the issuer; after the issuance, exchanges take place in the secondary market and the issuer does not collect any other amount.

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6.1 What is a stock (share)? A share, traded as stock, represents a piece of ownership in the capital of a corporation. The owners of equity stock are legal owners of the firm.3 The law requires that the company provide them with specified information in the annual report, which is subject to approval by these same shareholders at the annual general meeting. When a firm is set up, the investors “lend” a certain amount of money (that will be deposited in the firm’s bank account and accounted in the assets of the firm) and receive shares (accounted in the equity section of the balance sheet) that represent their claim on this amount of money, thus, the ownership of the firm. Assume that the firm is set up with 100 shares, each at a nominal value of 1 euro. Assets

Equity

Cash   100

Capital   100

When a firm goes public through an IPO, the company “opens” its equity to new investors who will give a certain amount of money (which will be deposited into the firm’s bank account), and in exchange they will receive new shares. If the issue price of the new shares is higher than the “nominal” value injected by the founder of the corporation, this extra value will be accounted in the equity section as “additional paid-in capital.” Now assume that the same firm goes public and issues 100 new shares, for the price of 1.2 euro each. The underwriter will pay 1.2 euro but will receive one share that gives him or her the same rights as those who originally set up the corporation. This higher amount includes the 0.2 euro accounted as additional paid-in capital, because in the meantime the value of the corporation has increased. Assets Cash

220

Equity Capital Additional paid-in capital

Total Assets

220

Total Equity

200 20 220

The shareholder, as part owner of the firm, has rights and benefits. As we said before, owning a share means having the right to vote in the general meeting and, depending on the number of shares, also the chance to guide the business of the firm by appointing the board of directors. What’s more, shares represent claims over the

3  Individual shareholders have a number of votes coinciding with the size of their shareholding, according to the kind and specifications of the shares.

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firm’s assets, like the right to receive dividends, but these claims are the last to be called and executed, after all the others.4 From an accounting point of view, shareholders’ equity is the difference between the value of the firm’s assets and its liabilities. When a company grows, scoring profits over time, if it doesn’t distribute dividends, there would be an increase of the net working capital and/or cash. If the financial liabilities are the same this stated that there is an increase of the total equity value, that represents the nominal capital value and the nondistributed profit reserves. For this reason, for both listed and non-listed firms, the share value represents the nominal value of the capital injected in the firm (issued capital) plus other components such as the additional paid-in capital, the reserves or the “Other comprehensive income,” the “retained earnings” and (minus) any treasury stocks. When a firm is listed, with each trade the market ‘prices’ the value of the firm, assessing the firm’s assets (and their ability to produce cash flows in the future), implicitly deriving the equity market value. This value is computed as the market value of the assets minus that of the liabilities (which except in very few cases is equal to their book value). The value of the firm that derives from the computation of the firm’s market price times the number of shares could be higher (or lower) than the book value. In this case, from a corporate finance perspective, we can refer to the Market Value Added (MVA). The total equity value of the firm, in a given moment, is made up of the stock price times the number of outstanding shares, which are an integral part of shareholders’ equity. Subsequent to the firm’s establishment, equity value is also the amount of company stock that has been sold to investors and not repurchased by the company. When – and if – the company reports profits or “produces” cash, it could pay out the profits to the owners; these profits are called dividends. Sometimes, on the contrary, the firm might not distribute this income, depending on what the Board decides to do. This net undistributed income is accounted as retained earnings. At this point what should be clear is the substantial difference between bonds and stocks. A bond is a contractual agreement with an intrinsic characteristic: the firm will pay the investors a cash flow stream (granted pertinent subordination clauses). A stock is a kind of financial instrument that may or may not pay dividends depending the firm’s health, corporate policies and the strategic decisions of the board of directors. As we’ve seen, when a firm is established, the equity is not locked and could be opened to new investors. If other investors join the company at a later date, new shares can be issued and the newcomers will have the same rights as any other shareholder, even if they pay more for the shares than the original underwriters. There are also shareholders with different rights: common/ordinary stocks have full voting rights while preferred stocks have no voting rights but, as compensation, they can get a higher dividend or even a fixed dividend, like a bond (but with no maturity date). Sometimes there are different classes of stocks with enhanced (or double) vot-

4  Dividends can be paid, if the board of directors decides to do so, only if all the other obligation of payments have been satisfied.

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ing rights. In other cases, the free-floating shares of a listed firm have limited voting rights, while the non-traded shares, held by the owner-managers of the corporation, have more voting rights per share. Moreover, sometimes firms buy back their outstanding shares in the market for different purposes. These shares are accounted in the total equity as treasury stocks and reduce the total equity value. A company hold its own stock in its treasury for later use. It might purchase and resell the stock at a later date as a form of liquidity control or use it to prevent a hostile takeover. These shares may also serve to satisfy the need for some stock option plans, or to reduce the number of free-floating shares for questions of voting rights at the Assembly of the shareholders (aka Shareholders’ general meeting). In sum, shareholders’ equity is the amount of money a company could return to shareholders if all its assets were converted to cash and all its debts were paid off. 6.1.1

Common stocks vs. preferred stocks

There are two kinds of stock: common stock and preferred stocks. Because a stock is a slice of the ownership of a company, it must imply he right to vote. So common shareholders have the right to vote in the general shareholders’ meeting. There are also a variety classes of common stocks with differences in terms of voting rights. However, for short-term investors like traders, or for investors with a small number of shares (in percentage over the total outstanding shares), they see the right to vote as irrelevant to their investment goals. Preferred stocks instead are a form of equity from a legal and tax point of view, even though they differ from common stocks in several ways. Preferred shares receive a fixed dividend, like a bond; they may offer a higher dividend yield. So the prices of preferred stocks and common stocks differ. (If a firm scores positive income and does not pay dividends, the common stock trades at a price that reflects the value of the undistributed cash.) Preferred shares usually have a claim priority higher than common stocks (but lower than subordinate bonds). Only a small percentage of the capital is issued in the form of preferred stocks. The primary reason for this is that due to tax treatment of the dividends, preferred shares – albeit similar to bonds – are more expensive for the firm. Some shares have the so-called “Dual class share listing”, with more than one class and different voting rights, as shown in Box 6.1. Box 6.1 Multiple classes share, the Google example An example of multiple classes shares is Google, now listed as Alphabet, with ticker GOOG and GOOGL. GOOG stock represents Class C shares, while GOOGL stock represents Class A shares. Class C shares (GOOG) have no voting rights, while Class A shares (GOOGL) have one vote each. Anyone who owned Google stock before the split (2012) got one share of the voting GOOGL stock and one share of the non-voting GOOG stock. The fine print: every time the company sells a share of Class C stock, it also must convert one Class B share into a Class A share.

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It is interesting that since Google split into A and C classes, there hasn’t been much of a price difference between the two classes of Alphabet stock. As of January 4, 2019, GOOG stock was worth $1,065.29 per share, while GOOGL stock was going for a 0.9% premium: $1,075.25. As of July 15, 2020 GOOG was worth $1,515.42 per share and GOOGL was traded at $1,516 per share. Here we should clarify that Google policy is to not pay dividends. As the company declared in its 2017 annual filing with the Securities and Exchange Commission, “we intend to retain any future earnings and do not expect to pay any cash dividends in the foreseeable future.”5 Then there are also Class B shares of Google stock, which do not trade in the public market; these shares are owned by Google insiders and each one gets ten votes. The reason behind this structure is obvious: to help founders Larry Page and Sergey Brin stay in control with no risk of hostile takeovers. Google’s reliance on nonvoting stock to protect their founders’ interests isn’t unprecedented in the technology industry. Facebook, LinkedIn and Yelp all have issued nonvoting stock for the same reason as Google.

6.1.2 Leverage Debt to Equity It is worthwhile to analyse the capital structure of a firm: the proportion of bond (debt) finance to equity finance within a firm (sometimes called the debt to equity ratio (D/E) or gearing or leverage) affects the variability of returns to shareholders. And, according to Modigliani and Miller’s theorem, leverage also affects the risk level of the firm, increasing the cost of debt, which is usually cheaper than the cost of equity. Once profits exceed the level necessary to pay the interest, therefore, the whole of any marginal addition to profit accrues to this small number of shareholders. On the other hand, if profits fall, this entire depletion has to be borne by this small number of shareholders in the form of lower payments. Thus, we can state that the higher the debt to equity ratio, the greater the variability in dividend payments to shareholders. Since the uncertainty of the magnitude of future dividend payments is normally said to be part of the risk of owning shares, companies with high leverage (and their shares) are normally regarded as riskier than those with a low leverage. 6.1.3 Investors vs. traders Generally speaking, we can say that equity owners could have a return from their stock investment in two ways, and there are substantially two different kind of investors. The shareholder is the “owner” of the corporation (or one of several). This gives him/her the right of residual claimant6 and the right to vote on the appointment of 5  P.R.

La Monica, “Google has more than $100 billion in cash. It’s time to pay a dividend,” CNN Business, 5 February 2019. 6  Stockholders have a claim on all assets and income left over after all other claimants have been satisfied. Stock owners are the last to be repaid in voluntary or compulsory liquidations.

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directors and on certain issues, such as approval of the annual financial statement, any amendments to the corporate charter and the decision as to whether new shares can be issued. This is basically the description of shareholders who invest in corporations with a long-term view. These investors are interested in the company’s control or management. So their investment gives them the power to have a certain influence in the general meeting for the board’s appointment, which impacts the managerial decisions of the firm, especially in order to receive the annual dividend payment. These “long-term horizon” investors have a return on their investment that is related to two dimensions: in the short-term, the dividend payments that they would receive every year, in the long-term the delta price between the purchase price of the stock and the sell price, i.e. the capital gain. Vice-versa, traders, who invest with a short-term view, usually hold a number of stocks below the percentage of ownership that obliges them to publicly declare these positions.7 Traders simply want to buy and sell shares in order to earn capital gains over a short period. In other words, traders aim to buy low and to sell after few hours, days, or weeks at a higher price; they have no interest in dividend payments, or even voting rights at the annual general meeting. In general, investors seek larger returns over an extended period through buying and holding. Traders, by contrast, take advantage of both rising and falling markets to enter and exit the market, opening and closing positions over a short timeframe, making smaller, more frequent profits. Very often we hear about short-selling in the equity market. This practice is sometimes limited by market authorities, especially during shocks from panic selling. In any case short-selling allows a trader (who is essentially betting that a share – or the entire market – will fall) to sell a stock and buy it back at a lower price. The aim is to earn capital gains on the fall. The peculiarity about this technique is that market players sell something that they don’t have. In fact, short-selling is possible thanks to a side contract that permits the trader to “rent” a share without actually owning it, on the condition that the share goes back to the owner within a given period of time. So, once the trader gets the share (again, without owning it), he or she sells it on the market with the commitment to buy it back within a set period of time, and later return it to the official owner. The trader, selling the share for, say, £20, and buying it back for £15, will have a gain of £5, minus the expenses for the rental agreement with another counterparty. If within the contractual period the price of the share never falls below £20, the trader will be forced to purchase the share for the market price and will suffer a loss.

7  According to each market regulator, a large percentage of ownership in a firm listed in a public market has to be declared.

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6.2 Equity markets worldwide A few numbers from the equity markets to begin with. Of the world’s stock market capitalisation, the US accounted for 31% at the end of 2010. The second-largest market was Japan, followed by China.8 The total value of all US equity was approximately $15 trillion at the end of 2009, which doubled to $30.1 at the end of 2018 (see Table 6.1 for yearly US equity market value between 1999 and 2020).The total market capitalisation of the US stock market at the end of 2019, calculated as the total market cap of all US-based public companies listed on New York Stock Exchange, Nasdaq Stock Market and OTCQX US Market (Over The Counter market), was $37.69 trillion.9 Six months later, due in part to the effects of the Covid-19 pandemic, the total market capitalisation of the US stock market plummeted to $35.5 million (as of 30 June 2020).By the end of 2020 the US market, leaded by the so-called “techs,” grew up till a record value of more than $50 trillion. During 2019, the total market value of American companies surged by a record 25.2%, overtaken by a 2020 huge record growth of more than 34%. Some investors are afraid of a new bubble, like the internet bubble in 2000, when the market grew thanks to the “explosion” of the so-called dot-com economy. Between 1 January 2010 and 31 December 2020, the market cap of public US corporations skyrocketed by nearly 193%. The world’s most famous index, the Dow Jones Industrial average, which lists the 30 biggest caps in the New York Stock Exchange, reached a $8.3 trillion market capitalisation by the end of December 2019. At that same time, the total market capitalisation of the Chinese stock market was $11.7 trillion; Japan recorded $6.16 trillion. For China this figure is calculated as the sum of all Chinese companies listed in Shanghai and Shenzhen Stock Market plus mainland companies listed in the Hong Kong Stock Exchange (H-shares of Chinese companies). Currently the American market is, and always has been, the largest stock market in the world. But the relative market capitalisations of the different exchanges around the world are constantly fluctuating. At one point in the 1980s, Japan’s stock market become the world’s largest, yet this Japanese dominance was also somewhat artificial due to crossholding10 stocks which inflated the numbers.

8

  To define the Chinese market precisely is quite complex because there is a Stock Exchange in Shanghai and another one in Shenzen, and many Chinese firms are also listed in Hong Kong. 9  Source: Siblis Research Ltd. 10  Cross-holding refers to the practice of one firm owning shares in another firm. If both of these firms are listed on an exchange, and one calculates total market capitalisation by merely multiplying the total number of shares outstanding by the market price per share, the market capitalisation will be overstated because part of the value of the shares is essentially double-counted.

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The market cap of public US corporations, 1999-2020 Date

US Equity Market Value

31/12/2020

50,808,508.70

30/06/2020

35,503,373.10

31/12/2019

37,689,255.80

31/12/2018

30,102,771.20

31/12/2017

31,774,585.40

31/12/2016

27,362,567.70

31/12/2015

25,076,923.70

31/12/2014

26,338,838.90

31/12/2013

24,041,484.60

31/12/2012

18,673,959.20

31/12/2011

15,645,563.90

31/12/2010

17,288,139.60

31/12/2009

15,081,511.90

31/12/2008

11,461,287.60

31/12/2007

19,670,052.90

31/12/2006

19,291,426.60

31/12/2005

16,919,160.80

31/12/2004

16,245,286.60

31/12/2003

14,177,207.60

31/12/2002

11,101,543.00

31/12/2001

13,858,390.20

31/12/2000

15,108,448.00

31/12/1999

17,601,921.00

Source: Authors’ elaboration on Siblis Research Ltd data.

6.2.1 The stock markets across the globe In 2020, stock markets in the United States accounted for over 54% of world’s stocks.11 11  See M. Szmigiera, “Countries with largest stock markets globally 2020,” Statista, 28 February 2020.

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Figure 6.1 Largest stock exchange operators worldwide as of March 2020, by market capitalisation of listed companies

NYSE, United States

25.53

NASDAQ, United States

11.23

Japan Exchange Group Shanghai Stock Exchange, China Hong Kong Exchanges Euronext Europe Shenzhen Stock Exchange, China

5.1 4.67 4.23 3.67 3.28

LSE Group, UK and Italy

2.92 0

5

10

15

20

25

30

Market cap in trillion U.S. dollars

Source: Authors’ elaboration on Statista data.

The New York Stock Exchange (NYSE) and Nasdaq are the largest stock exchange operators worldwide, followed by the Japan Exchange Group and the Shanghai Stock Exchange (see Figure 6.1 for the 2020 market cap per market and Box 6.2 for a few details about the Shanghai Stock Exchange).

Question: What is a stock exchange?

A stock exchange is a marketplace where stockbrokers, traders, buyers, and sellers can trade in equity products. The largest exchanges, such as NYSE, Nasdaq, FTSE, Euronext, and so forth have thousands of listed companies. Once a company is listed in the markets, it must be considered a “public listed company” (PLC). This means that the company has sold all or part of its shares to the financial community, giving the general public the opportunity to invest. The stock exchange is the place where these shares are exchanged among investors and traders. This is usually a secondary market that doesn’t involve the issuer of the shares, but a stock exchange can also be a primary market, when through an IPO a firm sells its share to the general public. The oldest exchange worldwide is the Frankfurt Stock Exchange, founded in the late sixteenth century. The first modern publicly-traded company was the Dutch East India Company, which sold shares to

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the general public to fund expeditions to Asia. Since then, groups of companies have formed exchanges in which brokers and dealers can come together and make transactions in one place. Stock market indices group together companies that trade on a given exchange, showing how they evolve in real time. Traditionally, stock exchanges were physical buildings in each country of operation, but with the shift toward electronic trading many have closed their trading floors and switched to online platforms. However, the institutions themselves are still around, and some of them are bigger than ever with market capitalisations of trillions of dollars. (See section 1.2.1 for the difference between Exchanges and OTC markets.) The Nasdaq is quite unique because it never operated on an open outcry system. Founded by a group of local stockbrokers in 1971, it has always used a computer- and telephone-based system of trading, which made it the first electronic stock exchange. It is the second largest stock exchange overall and has the largest market capitalisation of technology stocks such as Apple (APPL), Microsoft (MSFT), Facebook (FB) and Tesla (TSLA). Box 6.2 Chinese market focus The Shanghai Stock Exchange (SSE) is one of three independent stock exchanges in the People’s Republic of China, the other two being Shenzhen and Hong Kong. The Shanghai Stock Exchange is the fourth largest stock exchange in the world, despite the fact that it was only founded in 1990. The original exchange is very old, dating back to 1866, but it was suspended in 1949 after the Chinese Revolution. Each stock listed on the Shanghai Stock Exchange has A shares that are priced in the local currency, Yuan (CNY), and B shares that are quoted in US dollars. A shares are for domestic investment only, while B shares are available to both domestic and foreign investors. Since the end of 2002, certain foreign investors are allowed to trade in A shares under the Qualified Foreign Institutional Investor (QFII) program, albeit with various restrictions. The Hong Kong Stock Exchange (SEHK) was founded in 1891 by the Association of Stockbrokers in Hong Kong; it was renamed the Hong Kong Stock Exchange in 1914. The physical trading floor of the SEHL was closed in 2017 because of the shift toward electronic trading. Given its close links to China already before the handover, the Hong Kong market also provides indirect access to Chinese equities through H shares and ‘red chips.” An H share is a share of a company incorporated in mainland China but listed on the Hong Kong Stock Exchange. While regulated by Chinese law, H shares are denominated in Hong Kong dollars (HK$) and trade the same as other equities on the Hong Kong exchange. Red chip stocks refer to Chinese companies incorporated outside mainland China and listed in Hong Kong. Their actual business is based in mainland China, and they are controlled, either directly or indirectly, by Chinese organizations, which are, in turn, often controlled by the local, regional, or central government. For non-Chinese investors, H shares and red chips may be the simplest way to invest in China, because Chinese capital controls make investing in stocks listed on the mainland exchanges rather difficult. The Shenzhen Stock Exchange (SZSE) is the third exchange of the People’s Republic of China. Founded in 1987, it wasn’t formally operational until 1990. The SZSE is a self-regulated body, but it is supervised by the China Securities Regulatory Commission (CSRC). The SZSE trades shares in Chinese Yuan. The Shenzhen Stock Exchange is also home to the SME Board established in 2004 for businesses in the manufacturing sector, and the ChiNext Board, which was launched in 2009 to replicate the 0’s focus on technology start-ups.

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6.2.2 The Globalization of Exchanges – cross-listing Many corporations are listed in their “home country” where they are incorporated, and in other markets at the same time, usually in the US Just a few examples: Ferrari is listed on the Milan Stock Exchange and the New York Stock Exchange; British Petroleum in London and New York too; Toyota is listed on the London Stock Exchange, the NYSE and the Tokyo Stock Exchange; Equinor ASA (formerly Statoil, a Norwegian state-owned multinational energy company) is listed in Oslo and on the NYSE. Royal Dutch Shell has a primary listing on the London Stock Exchange and secondary listings on Euronext Amsterdam and on the New York Stock Exchange. This practice is called cross-listing, in other words, the listing of a company’s common shares on a different exchange other than its primary and original stock exchange. Cross-listing has globalized the market simply by extending trading hours to make markets more accessible to foreign traders located in other time zones. To be approved for cross-listing, the company in question must meet the same requirements as any other listed member of the exchange with regard to accounting policies. These requirements include the initial filing and ongoing filings with regulators, a minimum number of shareholders, and minimum capitalisation. With cross-listing there are some benefits for the issuer. First of all, having international exposure gives shares higher liquidity in terms of trading exchanges, reaching a larger pool of buyers and sellers in the market; this also provides liquidity in terms of the ability to raise capital or new money by issuing new shares of stock or corporate bonds too. No less relevant, a double/multiple listing could markedly enhance brand reputation, especially if the local market is not among the most liquid in the world, as is the case for Nokia (Finland) or Equinor (Norway). A company with an international brand tends to be seen as a major player in an industry and can leverage its brand name to boost sales and garner more media attention in the local foreign markets. From a technical point of view, companies who get listed in the US do so via American Depositary Receipts (ADRs). The ADR list is long, with many familiar names such as Alibaba (see Box 6.3) and Baidu Inc. of China, Sanofi of France, Siemens of Germany, Toyota and Honda of Japan, and Royal Dutch Shell of the UK. Box 6.3 An example from the market: Alibaba Although the US has traditionally had tougher listing requirements, there was a notable exception in 2014 with the Hong Kong Stock Exchange (HKG) and what happened to Alibaba. Alibaba Group Holdings Ltd. (BABA), the Chinese e-commerce giant based in Hangzhou, sought listing on the Hong Kong Stock Exchange but faced some difficulties. As a result, Alibaba proceeded with an IPO on the NYSE in 2014, the largest IPO in US history at that time. Nevertheless, the company stated that it preferred to list in Hong Kong and finally, in November of 2019, Alibaba got cross-listed on the Hong Kong Stock Exchange. Alibaba is currently listed in New York (at $215,70 as of June 30, 2020) and Hong Kong (at HK$209,60 as of June 30, 2020).

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6.2.3 Market capitalisation Market capitalisation is the number of shares multiplied by their value in the stock market.12 Market capitalisation, along with annual income, is one of the methods used to evaluate the investment attractiveness of a company. Very often we hear news of a record market cap, or a corporate takeover in the US touted as the largest, by market capitalisation. This classification is currently dominated by tech companies that develop new computer technologies gained the upper hand on the “classic” largest caps such as oil companies and banks. According to Bloomberg, in Table 6.2, Apple has dominated the US chart for the last six years in a row as the largest cap in the American market. Table 6.2 Largest firms in the US by market cap as of fiscal year’s end and 30 June 2020 Company Name

31/12/2019

31/12/2018

31/12/2017

31/12/2016

31/12/2015

31/12/2014

2014

664,153.50

Apple Inc.

1.304.756,25

746.079,13

859.967,80

617.588,49

586.859,34

647.361,04

Microsoft Corp.

1.203.881,80

780.362,31

659.085,70

483.160,31

443.169,41

382.880,52

144,312.80

925.392,59

726.828,20

731.884,41

546.188,24

534.763,62

360.940,07

343,566.30

Amazon.com Inc.

914.680,80

737.467,27

566.023,48

356.313,48

316.831,55

143.693,91

359,376.60

Facebook Inc.

585.783,50

374.130,86

512.792,76

332.724,60

297.757,70

218.221,94

218,221.90

Berkshire Hathaway Inc

555.585,02

502.567,43

489.062,06

401.987,01

325.490,35

370.024,10

371,318.00

JPMorgan Chase & Co.

437.226,01

319.780,30

366.301,48

308.768,40

243.065,01

233.935,87

292,405.40

Visa Inc.

418.483,36

299.355,37

257.324,21

181.084,42

186.817,95

161.506,02

131,862.70

Johnson & Johnson

383.778,28

343.572,91

374.802,39

313.432,49

284.220,49

292.702,93

274,315.40

Walmart Stores Inc

337.386,76

271.319,40

293.090,00

212.418,89

196.276,04

276.807,56

232,471.50

Alphabet Inc. Class A

Source: Authors’ elaboration based on data from Bloomberg, amounts in USD millions. Note that (*) Apple fiscal year end in September, data are taken form Apple’s Q1, while (**) Walmart fiscal year ends in January, date are taken as of 31 January and 30 April 2020 (Q1).

The number one non-tech company was Berkshire Hathaway, the holding company leaded by Warren Buffet with a market cap of $555 billion, followed by Johnson & Johnson, Visa, Walmart and JP Morgan. Apple also led the way in 2018 as the world’s most profitable company, with a net income of $59.4 billion. Saudi Aramco undertook the largest IPO in history in November 2019, raising $25.6 billion, selling shares at 32 riyals each (the Saudi currency), overtaking Microsoft, Amazon

12

  The price can be the spot price by the end of a specific day or the average over a span of time, e.g. the last 3 months. Firms also have shares listed in more than one exchange in different currencies. For these reasons the market caps “classifications” may vary and show non-identical values for the same date.

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and Apple as the world’s most valuable listed company. In fact, Saudi Aramco shares surged after the oil producer’s initial public offering, valuing the company at a record $1.88 trillion in the culmination of a four-year effort by the kingdom to list its crown jewel. Saudi Aramco hit a $2 trillion market cap on second day of trading.13 In a worldwide view, in the first quarter of 2020, the US led this classification. With the exception of Aramco, the other non-American firms are the Chinese Alibaba and Tencent, again two tech firms, and the Swiss-based food giant Nestlé (see Table 6.3). Table 6.3 Largest stock exchange operators worldwide as of June 2020, by market capitalisation of listed companies (in thousand US dollars) Company Name

Market Capitalisation

Saudi Aramco Oil Co. (Saudi Arabia)

1.684,80

Microsoft (United States)

1.359,00

Apple (United States)

1.285,50

Amazon (United States)

1.233,40

Alphabet (United States)

919,3

Facebook (United States)

583,7

Alibaba (China)

545,4

Tencent Holdings (China)

509,7

Berkshire Hathaway (United States)

455,4

Johnson & Johnson (United States)

395,3

Visa (United States)

383,9

Walmart (United States)

344,4

Nestlé (Switzerland)

304,1

Source: Bloomberg and authors’ data computation.

Also notable is the fact that that the Saudi Aramco IPO was quite peculiar. The freefloating amount (the number shares sold to the market) was very limited, especially in comparison with the other heavyweight corporations in the world. As Figure 6.2 shows, Saudi Aramco is one of the biggest listed company in the world but had one of the world’s smallest free floats.

13 

Source: Bloomberg.

152

Figure 6.2

Finance Lab

Free float percentages over the largest market cap companies in the world 2021 Aramco

Apple

Microsoft

$2.30 T MARKET CAP 99.93% FREE FLOAT

$1.84 T 1.76%

$1.83 T 99.93%

Tesla

Facebook

Berkshire Hathaway Inc.

$818 B 80.01%

$759 B 99.28%

$557 B 57.09%

Taiwan semiconductor Co

$479 B 78.81%

Free float

Nestlè

$318 B 99.91%

Sony Corp

$141 B 99.86%

Held by insiders /controlling sahareholder

Note: Values are calculated at close on 14 February 2021. Source: Authors’ elaboration on market public data from Refinitiv data provider.

The market value can overestimate (or underestimate) the intrinsic value of a corporation; the difference between the market value and the book value is measured as Market Value Added. The equity market and its participants evaluate listed firms daily. The value can derive from performances, Profit & Loss statements, analysts forecast or even intangible values such as market appeal. Just think of how many “fans” have purchased Ferraris just for the intangible value of the brand and its reputation for being most famous car maker in the world; they may have no idea of company data such as revenues, EBITDA, cash flow etc. By the same token we can consider the intangible value that has driven the exponential price surge of Amazon after the outbreak of the Covid-19 pandemic. “Thanks” to the lockdown imposed in many countries, the delivery service has shown huge growth. As a result, many people have purchased Amazon stock without any forecasted data in terms of margins, profits, and cash flow generation, just because they think that “that kind of business is growing a lot.”

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The history of the equity markets is replete with “bubbles,” like the “net economy bubbles” of 2000, with trading prices that overestimate real business value. See Box 6.4 for a more in-depth analysis of the “Dot-com bubble”. Box 6.4 The Dot-Com bubble From 1995 to 2000, the Nasdaq index saw an over fivefold growth in value. Many firms operating in internet-related businesses marked unexpected trading prices, and many of the most capitalized firms in the world were players in the internet economy. The “dot-com bubble” is one way of describing the seismic shift in the landscape of the top ten market capitalized firms after 1999. The dot-com bubble of 1999-2000 was fuelled by proliferating investments in internet-based companies and rapid growth in technology equity stocks, with prices pushed up by the hype and not sustainable by the firms’ business results. Some hold the view that the Tax-Payers Relief Act of 1997 primed the market for bullish behaviour by encouraging investments in stocks that paid little or no dividends by investors who were ill-informed on the sector. At its peak, in March 2000, Dell and Cisco placed huge sell orders on stock spawning panic-selling amongst investors. Within weeks the market shrunk by 10% and investment capital for tech start-ups became increasingly scarce. These trends became more entrenched following the 9/11 terroristic attacks and the Enron fraud. As a result, from six tech companies dominating the top ten in market capital share in 1999, by 2004 only two survived in the top ten list (Microsoft and Intel).

Despite the fact that companies might be over- or under-valued by the market, to come up with the real value of a company, we could assess its activity from a fundamental point of view. For example, in its report “Global 2000 – The World’s Largest Public Companies,” Forbes ranks firms by their assets.

6.2.4 Market cap trend: industry leadership turnovers Analysing the market cap evolution in the last two decades, we notice how in some sense this has been circular – “from tech to tech.” This could comfort those who are forecasting a sort of tech bubble that will explode after the unexpectedly fast market recovery following the Covid-19 pandemic. Striking is the fact that Microsoft, a sort of standard setter in the computer world, is still in the top ten of largest companies by market cap worldwide, also thanks to a constant evolution and renovation in its business format. In the late 1980s, Japanese companies dominated the ranks of the biggest global firms thanks to a very strong yen and the Nikkei index reached stratospheric levels. By the end of the 1990s, internet companies climbed into the market with unprecedented hype, creating the conditions for the subsequent dot-com bubble burst (see Table 6.4). The bear14 market that ensued from 2000 to 2002 resulted in the S&P 500 plunging 45%, while the Nasdaq cratered by almost 80% at its lowest. As a result,

14 

In trading slang a bull market is a growing, while a bear market is a falling.

154

Table 6.4

Finance Lab

Largest market cap in 1999

1999 Company

Dot.com Bubble M. Cap

Industry

Country

Microsoft

583

Tech

US

G.E.

504

diversified

US

Cisco

353

Tech

US

Exxon

283

Oil

US

Walmart

283

Consumer

US

Intel

271

Tech

US

NTT

262

Telecom

Japan

Lucent tech

252

Tech

US

Nokia

197

Tech

Finland

British Petroleum

196

Oil

UK

many former heavyweights were transformed into lightweights, worth a fraction of their previous peak values. In 1999 the Finnish Nokia ruled the world of mobile phones, but shortly after disappeared from the market, and in 2013 was acquired by Microsoft. Lucent Technologies dropped off the radar as fast as it had burst into the top ten, surviving a bankruptcy only thanks to the merger with a French firm in 2006. Once the bubble burst, the market collapsed and the top ten was populated by a diverse mix of companies by industry, while the classification was dominated by the US firms, with the Union Jack the only flag other than the Stars and Stripes (see Table 6.5). Microsoft’s market cap was around a half of the pre-bubble value. The Lehman Brothers’ bankruptcy and the subprime crisis shocked the market once again in 2007-08, with the financial crisis having a huge impact on US company valuations. PetroChina became the world’s first trillion-dollar company15 in November 2007 after shares in the business almost tripled in value on its flotation on the Shanghai Stock Exchange. Thanks to heavy demand, the shares raced up from the flotation price of 16.7 renminbi16 to 43.96 renminbi by the end of the trading session, giving the Group a market capitalisation of about $1 trillion (£480 billion). At that price PetroChina accounted for 25% of the entire Shanghai A-list market value. 15   See J. Watts, G. Wearden, “PetroChina makes its debut as world’s first trillion-dollar firm,” The Guardian, 6 November 2007. 16  The renminbi is the official currency of the People’s Republic of China and translates to “people’s money.” Its international code is CNY and the symbol ¥. The yuan is the name of the unit in which renminbi transactions are denominated, but also refers to the currency generally. Thus, a person might pay for a meal using a 20 Yuan banknote and get some Yuan and Jiao (a tenth of a yuan) in change (the Jiao is then divided into 10 fen). This is similar to the pound-sterling, which is the name of the British currency, while the price of a pint of beer in a London pub would simply be stated in pounds.

6  The Stock Market

Table 6.5

155

Largest market cap in 2004

2004

Post-Bubble

Company

M. Cap

Industry

Country US

G.E.

319

diversified

Exxon

283

Oil

US

Microsoft

282

Tech

US

Pfizer

270

Pharma

US

Citi group

240

Financial

US

Walmart

240

Consumer

US

British Petroleum

197

Oil

UK

AIG

189

Insurance

US

Intel

184

Tech

US

Bank of America

168

Financial

US

PetroChina was just one example of the surging Chinese economy, with a massive quotation growth also related to a small debt market and many constraints on Chinese investors who attempted to export money out of China. The Chinese market showed an incredible growth of the Shanghai Index before the 2007 crisis, but even afterward the voice of Chinese big caps was loud. In 2009, there was an equal distribution of Chinese and American companies alongside Royal Dutch Shell (UK/Netherlands) and Petrobras (Brazil) in the top ten (see Table 6.6). The oil industry was the most represented. Table 6.6

Largest market cap in 2009 2009

Company

Financial Crisis M. Cap

Industry

Country

Petro China

367

Oil

China

Exxon

341

Oil

US

ICBC

257

Financial

China

Microsoft

212

Tech

US

China Mobile

201

Telecom

China

Walmart

189

Consumer

US

China Construction Bank

182

Financial

China

Petrobras

165

Oil

Brazil

Johnson & Johnson

157

Consumer

US

Shell

156

Oil

UK/Ned

156

Finance Lab

The crude oil rallies, after a low of $41 per barrel following huge fluctuations in 2007-08, pushed prices to around $100 per barrel from 2010 to 2014, with many benefits for the oil companies. But tech did eventually make a comeback, with the impact of the brand-new mobile device – the iPhone – launched in 2007, which turned Apple into a gold mine. Google followed as the new standard setter in internet search engines, listed in 2004 and after being renamed Alphabet. Apple was the first US company to surpass a market cap of $1 trillion on August 2, 2018. Interesting to note that Apple was only the fifteenth largest in the US in 2008. What’s more, after reaching its peak in 2018 the company dropped in valuation due in part to struggling iPhone sales. But without much impact from new models in the market, especially in the Chinese market, the stock price rose again above $300 per share. Finally, G.E. (General Electric) made its last appearance in the top ten. The company founded by Thomas Edison in 1892 was removed from the Dow Jones in mid2018 after ranking for more than 100 years among the 30 best companies in the US (see Table 6.7). Table 6.7

Largest market cap in 2014

2014 Company Apple

$100 Oil M. Cap

Industry

Country

560

Tech

US

Exxon

432

Oil

US

Alphabet

358

Tech

US

Microsoft

344

Tech

US

Berkshire Hathaway

312

diversified

US

Johnson & Johnson

277

Consumer

US

Shell

269

Oil

UK/NL

G.E.

263

diversified

US

Wells Fargo

261

Financial

US

Roche

256

Pharma

Swiss

The tech completed companies their comeback in 2019, flagging seven top ten rankings, along with huge growth in terms of market capitalisation. Apple and Microsoft topped the hurdle of $1 trillion in the late 2019. However, as of May 2019, the tech sector has suffered a temporary sharp decline, according to Nasdaq’s Market Review. But winds were still blowing, bringing back the tech to their peak in 2019 and early 2020, before the Covid-19 pandemic. Tech companies were originally outperforming other industries and, after a very strong 2018, their growth helped the whole US market to gain an impressive 25% in 2019 (see Table 6.8).

6  The Stock Market

Table 6.8

157

Largest market cap in 2019

2019 (June)

Big Tech Era

Company

M. Cap

Industry

Country

Microsoft

1050

Tech

US

Amazon

943

Tech

US

Apple

920

Tech

US

Alphabet

778

Tech

US

Facebook

546

Tech

US

Berkshire Hathaway

507

diversified

US

Alibaba

435

Tech

China

Tencent

431

Tech

China

Visa

379

Financial

US

Johnson & Johnson

376

Consumer

US

From a geopolitical point of view, a bull market, a strong US dollar (EUR/USD was in a range between 1.08 and 1.11), and premium valuations accorded to US mega-caps have helped US presence dominate while in same period the European market suffered a great deal, unable to recapture 2007 levels. This analysis shows how the market cap can be driven by many factors and how intangible values drive price rises in the market. In the sector of new technologies, the intangible impact of the evolution allows these businesses to attract the attention of investors, who essentially “bet” on a brighter future and a continual evolution.

6.3 2020 Covid-19: a market plunge, an unusually fast recovery and the FAANG role The market Capitalization of the Global Top 100 companies, according to Price Waterhouse Cooper and its yearly report, escalated by 20% ($4,301 billion) from March 2019 to December 2019, before contracting by 15% ($3,905 billion) in three months to March 2020. The key event was the Covid-19 pandemic and the imposed lockdown, which shut down many activities and businesses all across the globe. What is clear from the analysis is that this market drop hit some industrial sectors more than others. All sectors declined, from between 1% and 37%, but Oil & Gas sector was hit hardest by the widespread impact and uncertainties caused by Covid-19. This magnified oil and gas price weaknesses from very low demand related to the stop in airline travel and very limited use of cars. The financial industry also suffered a huge sell off, recording a 23% average slide in this three-month period. Technology companies lost 11% market capitalisation, extinguishing the 24% increase from March to December 2019.

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The lockdown, however, had also rewarded some winners. Companies such as Netflix (a top ten faller in 2019) and Amazon have seen their market capitalisation soar. The reason of this growth lies in a rise in an upward spiral in demand for their services (streaming, online purchases and delivery) due to restrictions imposed by governments all over the world. On the other hand, European firms suffered a 25% capitalisation collapse from December 2019 to March 2020. Again, we have two different speeds between America and Europe (see Table 6.9). Table 6.9 Change in market capitalisation of the Global Top 100 companies (December 2019 to March 2020) Area

$ bn

%

−2,204

−14%

Europe

−956

−25%

China, HK, Taiwan

−355

−11%

Rest of the world

−389

−13%

−3,905

−15%

US

Total

The real winner, and an unexpected outcome of Covid-19, was Tesla. Tesla reported Q4 2019 data that went beyond market expectations; the company’s share price also got a boost from the short position coverage (see Table 6.10). Tesla growth continued during the whole 2020, as shown in the table for June 2020. Some companies were able, after the 2020 nightmare Q1, to regain some market value, while others continued the fall. It’s quite clear that Covid-19 has had a huge impact on the global economy and on the financial markets. But what happened in the first and second quarters of 2020 was a reaction that makes this crisis very different from the previous 2007 and 2000 crisis and market shocks. In Table 6.11 we can analyse the trend of the S&P500, the index of the 500 largest companies in the world, a sort of world business health index. Since the S&P 500 is a broad representation of the market, the movement of the market mirrors the index’s movement. According to this analysis, it’s quite clear that the Covid-19 pandemic has shocked the market with a huge drop in just a month: around 35% of the capitalisation was lost. What differs with the dot-com bubble and the subprime crisis is that at the bottom the other two crises eroded half of the market capitalisation. Yet the most impressive data is the recovery rate. In 2000 the market gained more than 50% from its low point, but over a period of one and a half years, before taking a breath in its run back to the top, being anyhow 25% below the pre-crisis level. In 2010 the market scored +80% over the lows in after around a year, but the market cap was still 22.65% lower than the pre-crisis level. What’s more, the market was still cleansing from the toxic assets and their false values in the trading prices of many banks and financial institutions.

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Table 6.10 The risers and fallers: companies with the largest relative increases and decreases in market capitalisation (December 2019 vs. March 2020 vs June 2020)

TOP FALLERS (Dec. ‘19 to Mar ‘20)

TOP RISERS (Dec. ‘19 to March ‘20)

Data in $bn

market cap

change

market cap

change

market cap

change

31 Dec 2019

Dec to Mar

31 Mar 2020

Mar to Jun

30 Jun 2020

Dec to Jun

Company name Location

Sector

Tesla

United States

Consumer goods

75

28,0%

96

105,2%

197

162,7%

Netflix

United States

Consumer services

142

16,2%

165

18,2%

195

37,3%

Nvidia

United States

Technology

144

11,8%

161

40,4%

226

56,9%

Eli Lilly & Co

United States

Health Care

126

5,6%

133

17,3%

156

23,8%

Novo Nordisk

Denmark

Health Care

139

3,6%

144

3,5%

149

7,2%

Tencent

Mainland China Technology

461

1,7%

469

27,7%

599

29,9%

Amazon

United States

Technology

916

6,0%

971

37,7%

1337

46,0%

Roche

Switzerland

Health Care

279

0,4%

280

7,1%

300

7,5%

Adobe

United States

Technology

160

–4,4%

153

34,0%

205

28,1%

China Mobile

Mainland China Telecommunications

172

–11,6%

152

–9,2%

138

–19,8%

Pepsico

United States

Consumer goods

191

–12,6%

167

9,0%

182

–4,7%

Apple

United States

Technology

1,305

–14,7%

1,113

40,9%

1,568

20,2%

Aramco

Saudi Arabia

Oil & Gas

1,879

–14,7%

1,602

8,7%

1,741

–7,3%

Home Depot

United States

Consumer services

238

–15,5%

201

31,8%

265

11,3%

Tsmc

Taiwan

Technology

287

–18,1%

235

16,6%

274

–4,5%

Samsung

South Korea

Technology

288

–18,8%

234

11,1%

260

–9,7%

Coca–Cola

United States

Consumer goods

237

–19,8%

190

–1,6%

187

–21,1%

Lvmh

France

Consumer goods

235

–20,0%

188

17,0%

220

–6,4%

Walt Disney

United States

Consumer services

261

–33,3%

174

13,8%

198

–24,1%

Jpmorgan Chase United States

Financials

437

–36,6%

277

2,2%

283

–35,2%

Chevron

Financials

228

–40,4%

136

20,6%

164

–28,1%

Royal Dutch Shell United Kingdom Financials

234

–42,3%

135

–10,4%

121

–48,3%

Exxon Mobil

United States

Oil & Gas

295

–45,4%

161

16,1%

187

–36,6%

Wells Fargo

United States

Financials

228

–48,7%

117

–10,3%

105

–53,9%

United States

Source: Authors’ elaboration based on Bloomberg and PwC analysis.

160

Table 6.11

Finance Lab

2000, 2007 and 2020 crisis analysis

Date February 20, 2020

S&P500 points

n° days

period

3,389

March 23, 2020

2,192

32

−35.32%

June 9, 2020

3,193

78

45.68%

October 1, 2007

1,576

March 1, 2009

overall

668

517

−57.61%

April 1, 2010

1,219

396

82.49%

March 1, 2000

1,552

October 1, 2002

768

944

−50.52%

March 1, 2004

1,163

517

51.43%

−5.78%

−22.65%

−25.06%

In contrast, the market reaction that the financial world faced in Q2 2020 was something really new: the market, on the whole, in a few days, 78 days, 2 months and a half, was already close to the pre-crisis level (−5.8%). A widely-held opinion, as we go to press, is that there is “One Key Reason Why The S&P 500 Doesn’t Fully Reflect The Economic Crisis,”17 especially because many economic indicators are breaking records in the most negative sense as a recession engulfs the globe. Analysing the S&P500 and the Nasdaq tech indices, clearly the tech companies are overperforming the market, and their weights in the S&P500 are very relevant. Consider the so-called FAANG,18 an acronym that refers to the stocks of five prominent American technology companies: Facebook (FB), Amazon (AMZN), Apple (AAPL), Netflix (NFLX), and Alphabet (GOOG) (formerly known as Google). Traded on Nasdaq and included in the S&P500, we can note that FAANG make up about 15% of the S&P 500 and, therefore, that their growth can have a sizeable influence on S&P500 results. In addition to being widely-known among consumers, five FAANG stocks are among the largest companies in the world, with a combined market capitalisation of over $4.1 trillion as of Q2 2020. But while the IT sector, led by FAANG, makes up 26% of the S&P 500, the energy sector weighs in at just 3%. So what happens to the tech sector matters eight times more for the S&P 500 than what happens to energy right now. And there are other large investment vehicles which are listed (and as such accounted as total market capitalisation) who have added FAANG stocks to their port17  See S. Moore, “One key reason why the S&P 500 doesn’t fully reflect the economic crisis,” Forbes, 2 May 2020. 18  The term was coined by Jim Cramer, the television host of CNBC’s Mad Money, in 2013, who praised these companies for being “totally dominant in their markets.” Originally, the term FANG was used, with Apple – the second “A” in the acronym – added in 2017.

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folios because of their perceived strength, growth, or momentum. For this reason, CNN Business has defined the S&P500 as the S&P5, saying that “if you’re plowing money into an index fund, you might think you’re doing a good job of diversifying your assets. You’d be wrong. These days, it’s basically the S&P 5.” Consider the previous analysis of the largest caps in 1999, 2004, 2009, 2014 and 2019, and remember that in addition to the high weighting for tech in 1999, financial stocks were also a disproportionately large part of the Index in 2007 (before Lehman Brothers and the subprime crisis). In addition, oil stocks had a high concentration before oil prices plunged after 2014. In light of all this we might think that the weight of tech in the S&P500 could be very risky. The current sector concentration should be sort of a wake-up call for investors to be aware of the potential risk of simply “owning” the market. On the contrary we need to realize that with a few momentary exceptions, these large tech companies are achieving better-than-average revenues and earnings growth in a growth-starved financial world, sustaining their extraordinary market growth with similar business growth.

Summary The chapter focuses on the equity market as a source of financing for businesses and explain the role of shares as instrument of firms’ control. The chapter analyse the different kind of shares from a corporate side view and then the difference between investors, that use the equity market as long-term investment in the business, and traders that want to have just short-term profits. The chapter provide an overview of the stock exchanges, analyse the equity market “numbers” worldwide and a offers a track record of the largest market capitalization, explaining a cyclical trend related to the bubbles and crisis of the market on the last 2 decades. Lastly the chapter compare the massive shock suffered by the market in the first semester of 2020 due to the Covid-19 pandemic, an event that brought an unprecedent market’s shock, with a very fast reaction if compare to the other recent crisis, with a focus over the role in the S&P500 of the so-called FAANG.

Questions 1. 2. 3. 4. 5.

What is a preferred stock? Does a stock always pay dividends like a senior bond? What is the Capital Gain? Is it a stock traded OTC? How is the calculated the market capitalization of a firm?

7  Other Instruments and Markets What you will learn in this chapter: • • • • •

What is an EFT; The growing popularity of the ETFs and their pros and cons; The key role of the currency market in a globalized world; How is an exchange rate determined; The Forex market is the largest market in the world.

The previous chapters offered an in-depth analysis of the capital market, where equity and debts are issued and then traded. In Chapters 2 and 3, the description of financial intermediaries – who they are and what they do – shows how they can reduce the risk impact for investors in terms of pure risk (default risk, counterparty risk, etc.) and risk related to differentiation, liquidity and exchange rates. They can also help many investors access the market where the latter would not otherwise be allowed. The world uses many raw materials and commodities, like crude oil, wheat, soybeans, orange juice, etc. There is always a spot market for these commodities and raw materials, for a just-in-time purchase, like when we do our grocery shopping. But obviously large corporations that use these commodities and materials cannot purchase large quantities of these items in the spot market, where they would face the risk of upturn in the price and also a lack of availability. That’s why already more than a century ago the derivative market was the place to go to buy or sell large quantities of commodities, locking in prices for the forecasted needs and outlooks. In a global market, but even prior to the globalization process, trades take place between countries denominated in different currencies. What’s more governments, institutions and large corporations move money from one corner of the globe to another for various reasons, transforming one currency into another, willing them to purchase and pay – for example – in another country. The foreign exchange markets is the global market where currencies are traded.

7.1 The ETFs Let’s take Mrs. and Mr. Green, a family with an extra $20,000 to invest. Mrs. Green wants to invest in the stock market, and she knows that it would be smart not to invest in a single share (in other words, in a single company), in a single industry, and possibly even in a single country. She knows that with just $20,000 she cannot purchase many different shares and she will not be able to create a portfolio of investments with a wide differentiation, also because each trade will cost her something in commission (fees paid to the brokerage intermediary).

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Mr. Green instead is very keen on one specific industrial sector because he has heard something about possible growth in the near future. He knows a little about the listed companies that operate in this sector and, after a bit of research, he has discovered that some of these firms are listed in Europe, the UK and China. Again, it would be a bit difficult to purchase these stocks and to create a portfolio, also because some are traded in foreign markets and denominated in non-USD currencies. That means he might not be able to purchase them with his ordinary bank account. So, who can the Greens turn to? Financial intermediaries are the middlemen who can solve these problems, creating differentiated portfolios that replicate a benchmark and allow investors to purchase only a portion of this portfolio – a fund – and trade the relative shares in the secondary market like a stock. The Greens, with their ordinary account denominated in dollars, might invest $10,000 for example in an ETF that replicates the MSCI World Index.1 The idea here would be to invest their money as if in a large portfolio, for maximum diversification. Then they would put the remaining $10,000 into another ETF that invests in just one specific industrial sector, to get the desired return from that market. At the same time, they would be reducing the risk of investing in just one or two firms and/ or eliminating the risk of purchasing shares in another currency that could fluctuate. Question: What is an ETF?

ETF is the acronym that stands for Exchange Traded Fund, a basket of securities that (usually) tracks an underlying index. ETFs are available on virtually all asset classes ranging from traditional investments to alternative assets like commodities or currencies. These funds offer many benefits and can be an excellent vehicle for achieving investment goals. What’s more, innovative ETF structures allow investors to short markets, to gain leverage, and to avoid short-term capital gains taxes. ETFs, introduced in the US in the early 1990s and in Europe in the late 1990s, offer public investors an undivided interest in a pool of securities and other assets. In this sense they are similar in many ways to traditional mutual funds, except that shares in an ETF can be bought and sold throughout the day like stocks on an exchange with a large and liquid secondary market. ETFs combine the characteristics of traditional mutual funds, which issue redeemable shares, and of closed-end investment companies, which generally issue shares that trade at negotiated market prices on a national securities exchange and are not redeemable. The SPDR S&P 500 ETF Trust (code: SPY) is the most widely-recognized and oldest US listed ETF and typically tops the rankings for the largest AUM and the largest trading volume. The fund tracks the massively popular US index, the S&P 500.

1  The MSCI World Index is a broad global equity index that represents around 2800 large and midcap equity performance across all 23 developed markets countries. It covers approximately 85% of the free float-adjusted market capitalization in each country.

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Most ETFs are index funds, but some ETFs do have active management. Since 2008 in the US the so-called “actively-managed ETFs” are available in the market for investors. The first active ETF was Bear Stearns Current Yield ETF. The shares of an ETF can be bought and held (sometimes as a core component of a portfolio), or they can be traded frequently as part of an active trading strategy.2 There are several types of ETFs, which can allow investors to invest – for example – indirectly in commodities, where usually an investment with derivatives would be too big in terms of size, into large sized high yield bonds and into foreign markets usually not accessible to non-professionals. The most common ones are: • Market ETFs: designed to track a particular index like the S&P 500; • Bond ETFs: designed to provide exposure to virtually every type of bond available, from the “Govies” from all over the world to domestic corporate, or international bonds and high-yield; • Sector and industry ETFs: designed to provide exposure to a particular industry, such as only energy or oil, real estate, pharmaceuticals or telecommunication; • Commodity ETFs: designed to track the price of a commodity, such as gold, oil, or corn (the ETF could invest in derivatives of shares of firms related to that commodities); • Foreign market ETFs:  designed to track non-domestic markets, especially the non-accessible markets (like the Shanghai Index for non-Chinese investors); • Inverse ETFs: structured to perform inversely from the tracked index: these ETFs make profits from a decline in the underlying market or index; • Actively-managed ETFs: created to outperform an index, unlike most ETFs, which are designed to track an index; • Alternative investment ETFs:  these ETFs have innovative structures, for instance, some allow investors to trade volatility or gain exposure to a particular investment strategy, such as currency carry or covered call writing. Despite having many pros, many investors criticize the ETFs for some cons, especially for what’s called “tracking error.” To explain, generally ETFs track their underlying index fairly well. But on occasion technical issues can create discrepancies and the ETF moves with a bit temporary lag. Or the index could underperform, especially because: EFT share prices can be impacted by movements on the trading market. Recently the ETFs that invest in crude oil, which manage around the 50% of the open interest in the derivative crude oil market, have been accused of being inefficient and unable to replace the crude oil market price. But these allegations do not take into account the fact that the ETFs in crude oil purchase a basket of derivative contracts with different maturities, while the price usually considered by many investors is simply the last price of the next contract to be delivered.

2

See also G.L. Gastineau, The Exchange-Traded Funds Manual, New York, Wiley, 2002.

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7.2 Currencies from all over the world: the foreign exchange market Many aspects of our society have been affected by the globalization process. Economically speaking, two are the main effects: first of all, countries continue to expand their trade in goods and services across the globe; secondly countries continue to reduce their barriers to capital flows. Many economists, beginning with the famous David Ricardo back in the nineteenth century, have studied and theorised that countries gain from trade if each nation specialises in the production of those goods in which it has a comparative advantage. Even if one country is better at producing a given item or items than other countries, it should focus its production on those goods in which it is relatively most efficient. Furthermore, doing so will make all trading partners better off. The huge growth of multinational corporations after World War II boosted international trade. Thanks to the internationalisation of financial markets and the profound changes in how multinationals manage their business risks (especially after the Cold War, in the late 1980s and during the 1990s), these organisations improved their access to foreign capital and enhanced their ability to reduce financing costs. Following this evolutionary process, many developing countries began a financial liberalisation process, relaxing restrictions on foreign ownership of their assets and adopting other measures to develop their capital markets, often in tandem with macroeconomic and trade reforms. In the previous chapters we discussed what shares and bonds are, we described their markets, and we detailed how the cost of funding in different markets could be more expensive or cheaper. It is quite normal nowadays for an American firm to raise money on European soil, issuing capital market instruments denominated in euro, and then to reinvest this money in Asia, with expenses denominated in renminbi, or in South America with expenses, say, in Brazilian reais. In this process of internationalisation of several business activities, the role of the banking system is central: the major banks operate internationally to service their multinational clients, use economic information provided by an international organisation, operate within a regulatory framework set by local governments or international institutions, and deal with investor relations in several countries. The final question of this introduction is: how can an investor, a business, or a bank, purchase shares, bonds, iron, crude oil, grains and pay employees and do many other things in another country with another currency? The internationalisation problem struggles with this hurdle, alongside different cultures, rules and laws: different countries, different currencies. The financial system offers an institutional structure that allows corporations, banks, international investors, as well as tourists, to convert an amount of money in their currency into another amount of money denominated in a foreign currency. This increasing interdependence of countries in the recent past has led to dramatic growth in the proportion of financial transactions that have an international aspect. At the same time, major international imbalances and the volatility of exchange

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rates have led to the development of new financial instruments and the growth of markets in which they are traded. 7.2.1

The Forex market

The foreign exchange market – often abbreviated as “Forex” (or even FX) – is the market where currency exchange rates are determined. The currency market is the largest of all financial markets in the world. The foreign exchange market is open 24 hours a day, split over three time zones. Foreign exchange trading begins each day in Sydney and moves around the world as the business day begins in each financial centre, first to Tokyo, London and then New York. Computer screens around the world continuously show exchange rate prices. Thanks to the bid and ask rule we already described, the value of one currency versus another one can increase or decrease. The US dollar is the currency against which all other currencies are priced. Any exchange rate, AUD/CAD for instance, that does not involve the USD is considered a “cross-rate.” Currency cross rates are not usually quoted outside of a few significant market pairs such as EUR/GBP, EUR/JPY, EUR/CHF and AUD/NZD. These rates have their own quotations and large volumes, and are influenced directly by the market; this being the case, they can be no longer be considered cross-rates. Instead, the rate for the Swedish Krona versus the Singapore dollar must be computed passing through the respective exchange rates with the US dollar. The foreign exchange market is the exchange platform for virtually all of the currencies of the world but, upon closer inspection, this market involves the currencies of the major developed countries. The currencies of developing countries are officially traded as well, but markets are so heavily controlled by governments that often the rates of exchange have little to do with genuine supply and demand. This phenomenon is also due to a lack of volumes traded by the large market participants. (In many small growing countries there is a local currency but it is very common to pay in US dollars or euro.) The foreign exchange market is the generic term for the worldwide institutions that exist to exchange or trade the currencies of different countries. It is loosely organized in two tiers: the retail tier and the wholesale tier. The retail tier is where the small agents buy and sell foreign currencies. The wholesale tier is an informal, geographically dispersed network of about 2,000 banks and currency brokerage firms that deal with each other and with large corporations. Market participants can be split into five groups:3 • the end-users of foreign exchanges: firms, individuals and governments who need foreign currency in order to acquire goods and services from abroad;

3

See also P. Howells, K. Bain, Financial Markets and Institutions, Harlow, Pearson, 2007.

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• the market-makers: large international banks which hold stocks of currencies to allow the market to operate and which make their profits through the spread between buying (bid) and selling (offer) rates of exchange; • speculators: banks, firms and individuals who attempt to profit from outguessing the market; • arbitrageurs: banks that make profits from buying in one market at the same time and selling into another, taking advantage of small inconsistencies that develop between markets; • central banks, which enter the market to attempt to influence the international value of their currency – perhaps to protect a fixed rate of exchange or to influence an allegedly market-determined rate. According to the BIS4 Triennial Central Bank Survey 2019, trading in Forex markets reached a peak $6.6 trillion per day in April 2019, up from $5.1 trillion three years earlier. What happened in the last three-year period is that the FX derivatives trading, especially FX swaps, outpaced spot trading. In April 2019, the major markets were London, with 43% of the daily volume, New York (17%), Singapore (7%), Hong Kong (8%), and Tokyo (6%). Zurich, Frankfurt, Paris, and Amsterdam are small players. The US dollar, as we mentioned above, retained its leadership as the most-traded currency, being on one of the two sides in 88% of all trades. The share of trades with the euro on one side reached 32%. The yen, despite a decrease, remained the third most actively-traded currency (on one side of 17% of all trades). Some people might be surprised that the Chinese currency, the yuan (CNY, also as coin called renminbi) is not on the top of the list, China being the second biggest economy in the world. The reason for this has to do with the fact that the currency has been restricted from trading for a long time. So far in 2019, the CNY has been responsible for 4.3% of the trading on the foreign exchange market, less than the Swiss Franc, the currency of a very small country. The currencies of emerging market economies (EMEs) again gained market share, reaching 25% of overall global turnover. From the survey it is worth noting that the volume of spot trades increased relative to April 2016, but the expansion was less strong compared with the FX derivative instruments: FX swap contracts continued to gain in market share, accounting for 49% of total FX market turnover in April 2019. In terms of market technology, in 1992 Reuters introduced an automated, electronic brokerage system, Reuters Dealing 2000. The Reuters system allows dealers to enter their live prices, which appear on a screen as anonymous live quotations. Traders from around the world can hit a price from their terminals, then Reuters 2000

4 Bank for International Settlements. The BIS Triennial Central Bank Survey is the most comprehensive source of information on the size and structure of global foreign exchange (FX) and over-thecounter (OTC) derivatives markets.

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checks for mutual credit availability between the two counterparties and completes the transaction with ticket writing and confirmations. Since the introduction of Reuters 2000, other competing systems were developed. Very quickly, two competitors appeared: MINEX, developed by Japanese banks and Dow Jones Telerate, and Electronic Brokering Service (EBS), developed by Quotron and a consortium of US and European banks. Electronic trading offers greater transparency compared to the traditional means of dealing described above. Spot foreign exchange markets have been traditionally opaque, leaving room for opportunities for some traders with arbitrage skills, given the difficulty of disseminating information in the absence of centralized exchanges. Traders using an electronic brokerage system can instantly find the best price available in the market. Once introduced, electronic trading platforms gained market share almost overnight. The share of electronic trading leaped from 2% in 1993 to almost 20% in 2001. In the most recent BIS survey in 2019, the share of electronic trading in the spot foreign exchange market was 56%. For certain market segments, such as those involving the major currencies, electronic brokers reportedly covered 90% of the interbank market. Thanks to the higher transparency, the bid-ask spreads for the major currencies have fallen to about two- to three-hundredths of a US cent. Today, electronic FX trading market is very competitive, with many well-established trading venues OTC. The main electronic platforms are EBS, Thompson Reuters and Bloomberg. Big international banks such as Barclays, Citibank, UBS and others use their own single-bank platforms to internalise volumes. Two kinds of exchange rate transactions make up the foreign exchange market: • spot transactions involve the near-immediate exchange of bank deposits, completed at the spot rate; • forward transactions involve exchanges at some future date, completed at the forward rate. 7.2.2 The exchange rate To clarify any doubts, while for a stock there is an absolute price, for a currency this is impossible. There is not a price of the USD or for the EUR, but a rate of one currency versus another. The exchange rate is the mechanism by which world currencies are tied together in the global marketplace, providing the price of one currency in relation to another. For instance, the Euro/US dollar exchange rate (written in the market as EUR/USD) is the price of one dollar expressed in euro. If the exchange rate is EUR/USD=1.10 this means that with 1 euro we can buy 1.10 dollar. Let’s look at a real-life example. Imagine that a cup of Italian coffee in Milan, an espresso, usually costs €1. For an American tourist this espresso, at this rate, costs $1.10. If in a week the rate falls to EUR/USD=1.08, it means that the price of the espresso will be the same at the cash desk, but the expense for the American tourist will be $1.08, a bit cheaper. On the contrary, if in a month the rate increases to EUR/

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USD=1.15, the same cup of espresso will be a bit more expensive for the American in Milan. The exchange rate is just the price of one currency compared to another one, but it is very important in international trades and equilibriums since it directly influences imports, exports, cross-border investments and also tourism (as a business). This rate also has an indirect effect on other economic variables, such as the domestic price level, Pd, and real wages. Going back to the previous example, we can understand how the rate’s fluctuation could have a very invasive impact on several businesses: considering stable production prices, a stronger US dollar will make a vacation in Europe cheaper for an American, while it would be more expensive for a European tourist on the other side of the Atlantic. The same is true for imports and exports. Being cheaper to purchase in Europe, importing European goods into the US will be cheaper too, affecting local producers who will see new overseas substitutes for their productions, determining more competition and a reduction in margins. On the contrary, for example, when the euro increases, in the US foreign imports (from Europe or from counties with prices in euro) become more expensive in dollars. As a result, the domestic price levels rise and real wages sink (through a reduction in purchasing power). Also, the USD-denominated goods and assets are more affordable to foreigners with euro, so they’ll buy more in and from the US These factors drive aggregate demand up, causing an increase in the GDP. 7.2.3 Equilibrium exchange rates and foreign exchange risk Like in any other market, supply and demand determine the price of a currency. At any point in time in a given country, the exchange rate is determined by the interaction of the demand for foreign currency and the corresponding supply of foreign currency. Thus, the exchange rate is an equilibrium price determined by supply and demand considerations. What are the determinants of currency supply and demand in the foreign exchange market? Let’s consider one currency as domestic and one currency as foreign. The supply of foreign currency derives from foreign residents purchasing domestic goods and services (i.e. domestic export), foreign investors purchasing domestic assets, and foreign tourists traveling to the domestic country. These foreign residents need domestic currency to pay for their domestic purchases. Thus, the foreign residents buy the domestic currency with foreign currency in the foreign exchange market. Similarly, the demand for foreign currency derives from domestic residents purchasing foreign goods and services (i.e. domestic imports), domestic investors purchasing foreign assets, and domestic tourists traveling abroad. Over time, the many variables that affect foreign trade, international investments and international tourism will change, forcing exchange rates to adjust to new equilibrium levels. For example, suppose that interest rates in the domestic country rise, ceteris paribus, relative to interest rates in the foreign country. The domestic de-

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mand for foreign bonds will decline, reducing the demand for foreign currency in the foreign exchange rate. The foreign demand for domestic bonds will climb, increasing the supply of foreign currency in the foreign exchange rate. As a result of these movements of the supply and the demand curves in the foreign exchange market, the price of the foreign currency in terms of domestic currency will see a downturn. Risk arises every time actual outcomes differ from expected outcomes. Assets and liabilities are exposed to financial price risk when their actual values differ from expected values. In foreign exchange markets, there is the intrinsic presence of a foreign exchange risk: currency risk. Let’s imagine an investment that is supposed to give investors a 7% yield to maturity, more or less, like a bond issued by the European Central Bank but denominated in TRY (Turkish Lira). But over the period of the investment the TRY drops by 10% against euro, the coupons and the face value are paid in TRY (and converted) so the real return in the domestic currency for the investor is negative. Currency risk occurs when the actual exchange rate is different from the expected exchange rate. The foreign exchange cannot be predicted with perfect accuracy; that’s why the financial market offers instruments of protection like currency swaps. 7.2.4 What can we do with the currency exchange rates? According to the description provided at the beginning of this section, exchange rates have a crucial role in international transactions. So many businesses that use different currencies for their activities need protection. Hedging is a way to transfer part of the foreign exchange risk inherent in all transactions which involve two currencies, such as an export or an import. Put another way, in contrast to speculation, hedging is the activity of covering an open position. A hedger makes a transaction in the foreign exchange market to cover the currency risk of another position. Although many financial intermediaries, or traders, use the FX market to try to turn a profit just by “playing” with the rates, very often with sophisticated mathematic models. Speculation is the activity that leaves a currency position open to the risk of currency movements. Speculators take a position to “speculate” on the direction of exchange rates, without having another “leg,” or the real amount of cash to be paid/ received. A speculator takes on a foreign exchange position on the expectation of a favourable currency rate change. In other words, a speculator does not take any other position to reduce or cover the risk of this open position. The last opportunity offered by the FX market is arbitrage. Forex is a worldwide market, made up of several smaller markets. Arbitrage refers to the process by which banks, financial institutions, large firms or even individuals attempt to make a riskprofit by taking advantage of discrepancies among prices prevailing simultaneously in different markets. The simplest form of arbitrage in the foreign exchange market is spatial arbitrage, which exploits the geographically dispersed nature of the market. For example, a spatial arbitrageur will attempt to buy GBP at 1.61 USD/GBP in London and sell GBP at 1.615 USD/GBP in New York. Triangular arbitrage profits from

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pricing mistakes between three currencies. Cross-rates are determined by triangular arbitrage. Covered interest arbitrage takes advantage of a misalignment of spot and forward rates, and domestic and foreign interest rates. 7.2.5 The long run (and the PPP theory) and the short run Exchange rates are determined in markets by the interaction of supply and demand, in other words, the quantity of one “in-demand” currency versus another one. An important concept that drives the forces of supply and demand is the Law of One Price. The Law of One Price states that the price of an identical good will be the same throughout the world, regardless of which country produces it. The theory of Purchasing Power Parity (PPP) states that the exchange rate between two currencies depends on the purchasing power of each currency in its home country and the exchange rate changes to keep the home purchasing power of the two currencies equal. According to the PPP, if the domestic price level rises by 10%, the domestic currency will eventually fall by 10%. The application of the Law of One Price theory to price levels works in the long run, having a macro-economic effect that cannot be reflected in the short run. As with any theory, there are several problems connected with the proper functioning of the PPP. For example, all goods are not identical in every country. Let’s take a car, for instance. Even the same model will have different specifications for each market, according to environmental rules, driving rules, drivers’ preferences, etc. What’s more, many goods and services are not traded; think about the espresso example from before. And even for something that can be quite similar, like a coffee at Starbucks’s, or a pair of basketball shoes like Nike Air Max, the price is influenced by many other factors, such as the preferences, tastes and styles in different countries. In general, however, we can say that if a factor drives up demand for domestic goods relative to foreign goods, the exchange rate will tick up as well. The four major factors are relative price levels, tariffs and quotas, preferences for domestic vs. foreign goods, and productivity: a rise in relative price levels cause a country’s currency to depreciate; higher trade barriers (tariffs and quotas) causes a country’s currency to appreciate; intensified demand for a country’s goods causes its currency to appreciate while a boost in demand for imports causes the domestic currency to depreciate. Lastly, if a country is more productive relative to another, its currency appreciates. In the short run instead, an exchange rate is the price of domestic bank deposits in terms of foreign bank deposits. The usual approach to supply-demand analysis explains how rates move up and down, reacting to interest rates, the announcement of new monetary policies, or news related to the four previous factors as well. In fact, traders – in their search for profits or protection – try to anticipate in the short run what should happen in the future based on long-run theories. The movement of billions from one currency to another shifts the equilibrium in the markets, driving one currency to appreciate versus others.

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Summary The chapter focuses in the first part on the EFT market, a new tool for market participants that allows many investors to reduce their risk exposure and to improve their portfolio diversification easily and with little capital available for investment. These instruments, similar to open-end funds and traded in the regulated markets, also enable investors to access markets that are inaccessible to non-professionals. In the second part, the focus is on the role of currencies in a global economy, where trades are worldwide, and firms raise capital all over the globe. This underpins the need for currency conversion and hedging, and the Forex market is the answer to these needs. This currency market, the most liquid market in the world, also offers many opportunities to arbitrageurs (albeit fewer than in the past due to the newly-introduced electronic platforms) and speculators who trade in currencies. The chapter goes on to explain how exchange rates are determined, according to the supply and demand rule in the short run, and the macro-economic factors that move the rates in the long run, such as the Law of One Price.

Questions 1. What is an ETF? 2. Why is investing $1,000 in an ETF is less risky than purchasing $1,000 worth of a single stock included in the basket of that same ETF? 3. Is the Forex a money market? 4. Who is an arbitrageur? 5. Why are there always two currencies in exchange rates?

8  The Derivative Instruments What you will learn in this chapter: • • • • • •

Why the name “derivative” for this kind of contract; The derivatives are a very old instrument for trading commodities; Financial derivatives are very young if compared to the derivatives over commodities; The 4 kinds of derivatives instruments: forward, future, option and swap; Who are the market participants and the use of these contracts; Some applied example for each derivative instrument.

In the 1970s the financial markets became riskier with several episodes of high volatility,1 so financial intermediaries worked to find a solution for risk-reduction. Derivative instruments already existed in the market but operating exclusively on commodities. Financial intermediaries adapted the methodology used for agricultural goods and other raw materials to the financial markets. This is how financial derivatives were born, with the aim of having payoffs linked to previously-issued securities in order to be used as risk-reduction tools. Financial derivatives, as had already happened for other commodities, were effective because they enabled financial institutions to hedge, to reduce or almost eliminate risks. Following the dot-com bubble stock market crash in 2001-02, commodity futures emerged as a very popular asset class within investment portfolios for several financial institutions and investors. The potential diversification benefits of investing in commodity markets stimulated rapid growth of commodity indices,2 when previously only real commodity users once traded in these markets. The levels of financial activity measured by open interest in commodity futures surged from around $100 billion at the end of 2003 to $500 billion in July 2008,3 and the total value of commodity index-related instruments purchased by institutional investors soared from about $15 billion to $200 billion during the same period. At the same time, a broad set of commodities across agriculture, energy and metal sectors registered synchronized sequences of large price swings, drawing renewed attention from policymakers 1 Between 11 January 1973 and 6 December 1974, the New York Stock Exchange’s Dow Jones Industrial Average suffered a loss over 45% of its value. In the United Kingdom the London Stock Exchange’s FT 30 lost 73% of its value during the crash. In the same period the Hong Kong Hang Seng Index also fell from 1,800 in early 1973 to close to 300. In the United Kingdom, the crash ended after the rent freeze was lifted on 19 December 1974, allowing a readjustment of property prices; over the following year, stock prices rose by 150%. 2  See K. Tang and W. Xiong, “Index investment and financialization of commodities,” Financial Analysts Journal, 68(6), 54-74, 2010. 3  See H. Hong and M. Yogo, “What does futures market interest tell us about the macroeconomy and asset prices?” Journal of Financial Economics, 105(3), 473-490, 2010.

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and academics to the risk that speculation could cause price distortions in commodity markets which adversely affect the real economy. The first problems emerged in 2007, with the futures markets speculation that caused a bubble in energy prices in 2007-08. The criticism was quickly extended to agricultural commodities in a report by the US Senate and captured attention across the Atlantic in public statements by the British Prime Minister, the French President, the German Finance Minister, and even the Pope. Derivative instruments have been seen as very risky tools in the financial market, especially after the 2008-09 financial crisis, tools which are very often related to speculation, as with the Subprime Mortgage Credit Derivatives. Something quite unique in history happened in November 2014, when in a speech the Pope said that “market priorities,” especially the logic of the “primacy of profit” has “reduced foodstuffs to a commodity like any other, subject to speculation, also of a financial nature.” This logic is hindering the “struggle against hunger and malnutrition.”4 However, this view is very partial and does not reflect the real nature of the derivative instruments. First of all, we need to define what a derivative is: a financial instrument whose value is based upon other financial instruments, such as a stock index, interest rates or commodity indexes.5 From a legal standpoint it is a contract between two parties (who are directly or indirectly linked) regarding the trade of certain assets; the value of this contract derives from an underlying asset or financial instrument.

8.1 Derivative markets: commodities and financials To clarify, equity, fixed-income securities, currencies, and commodities are traded in spot markets (also called cash markets) and their prices are referred to as spot prices. The same assets can also be traded between two parties with a derivative instrument, which are financial instruments that derive their values from the performance of these basic assets. It’s helpful to think of it this way: you can purchase (sell) today some assets at their spot prices, or you can sign an agreement in order to purchase (sell) the same assets at a future time, at an agreed price, with the clause to purchase (sell) only if certain events take place, or simply to exchange the cash flows related to this asset with a counterparty. In order to avoid any doubt, it’s better to clarify that there are basically two types of derivatives: • derivatives on commodities, which have been traded for more than 160 years in regulated markets such as the Chicago Board of Trade (CBoT) and the Chicago Mercantile Exchange (CME); 4  See B. Algieri, “A Journey Through the History of Commodity Derivatives Markets and the Political Economy of (De)Regulation”, ZEF Discussion Papers on Development Policy, No. 268, 2018. 5  See CME glossary.

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• financial derivatives, traded since the mid-1970s, with underlying bonds (especially Govies), equity indexes and other derivatives (derivatives of derivatives, like the options on the futures). Commodities are a diverse asset class comprised of various sectors: energy, grains, industrial (base) metals, livestock, precious metals, and softs (cash crops). Each of these sectors has a number of characteristics that are important in determining the supply and demand for each commodity, including ease of storage, geo-politics, and weather. The life cycle of commodities varies considerably depending on each one’s economic, technical and structural profile (i.e., industry, sector, value chain). For some details about the history of the derivatives and commodities markets, in particular CBoT and CME, see Box 8.1. Box 8.1 A bit of history: the CBoT and the CME6 The Chicago Board of Trade is the oldest operating futures and options exchange in the world, established in 1848 as a trading floor for grain merchants in Chicago. The concept of exchanging forward contracts in a “futures market” may have originated at the CBoT in the 1860s. This investment hub also helped to popularize “open outcry” trading floors; traders met in the octagon-shaped ‘pits’ to literally shout (or gesture) to make offers on stocks or futures contracts in a public setting, helping set markets on the exchange. Open outcry trading was replaced at the CBOT in 1994 by an electronic system of placing orders. After more than 125 years of trading exclusively in agricultural products, financial contracts were added to the Chicago Board of Trade in 1975. Financial futures contracts followed in 1982, and then futures-options contracts in 1997. The Chicago Mercantile Exchange was founded in 1898 as the Chicago Butter and Egg Board before changing its name in 1919. It was the second-largest futures and options exchange in the world and the largest in the United States. The CME launched financial futures and currency contracts in 1969 and the first interest rate futures contracts in 1972. The CME become then a Designated Self-Regulatory Organization (DSRO), and it holds regulatory/ audit authority over its many subsidiary organizations. Popular investments traded at the CME include forex futures, currencies, stock indexes, interest rate futures and agricultural products. The Chicago Mercantile Exchange, sometimes referred to as the Merc, has both public outcry trading floors and an electronic trading platform called GLOBEX, where more than 70% of its transactions take place. Chicago Mercantile Exchange Holdings Inc. (NYSE/Nasdaq: CME) and CBOT Holdings, Inc. (NYSE: BOT) announced in July 2007 that they have completed the merger of their companies, now called CME Group Inc., in that moment the world’s largest and most diverse exchange. CME Group serves the risk management needs of customers around the globe. As an international marketplace, CME Group brings buyers and sellers together on the CME Globex electronic trading platform and on its trading floors. CME Group offers the widest range of benchmark products available across all major asset classes, including futures and options based on interest rates, equity indexes, foreign exchange, agricultural commodities, energy, and alternative investment products such as weather and real estate. CME Group is currently traded on both the New York Stock Exchange and NASDAQ under the symbol CME and it is the second world’s largest derivative exchange.

  For more detail see www.cmegroup.com/company/history/timeline-of-achievements.html.

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As said, derivative instruments directly “derive” their value from changes in the value of a related asset or liability, called underlying. It’s possible to trade “cash” the underlying asset or, on the contrary, to trade it for a derivate contract. This sounds a bit difficult for many finance novices to understand. Arbitrage is the condition that two equivalent assets or derivatives or combinations of assets and derivatives sell for different prices, leading to an opportunity to buy at the low price and sell at the high price, thereby earning a risk-free profit without committing any capital. The combined actions of arbitrageurs bring about a convergence of prices, so we can say that arbitrage leads to the law of one price: transactions that produce equivalent results must sell for equivalent prices.  In any case, the price of the derivative instrument does not always move like the underlying asset or index. Because derivatives may consist of several types of financial assets, change in derivative prices may be not proportional in value to the underlying assets. In addition, these prices are also related to the trading exchanges of the instrument and to the volatility in the market. All this determines a sort of increased “beta”7 correlation, higher than that of the underlying asset. Derivative instruments are divided into four classes: futures and options, traded in regulated markets and in standard sizes, and forwards and swaps, traded over the counter with a tailor-made size. Derivatives can be created as standardised instruments on derivatives exchanges or as customized instruments in the over-the-counter market. The exchange markets, with standard-sized trades, are highly regulated, and provide transparent transactions that are guaranteed against default through the clearing house of the derivatives exchange, thanks to what is called margin maintenance. On the other hand, OTC (overthe-counter) derivatives are customized, flexible, more private and less regulated than exchange-traded derivatives, but are subject to a greater risk of default. A clearing house is an intermediary between buyers and sellers in the regulated markets. It is an agency, or separate corporation of a futures exchange, responsible for settling trading accounts, clearing trades, collecting and maintaining margins, regulating delivery, and reporting trading data. The purpose of a clearing house is to improve the efficiency of the markets and add stability to the financial system. In each trade, a clearing house takes the opposite position of each of the two market players, acting as the middleman on behalf of both parties. Derivatives pricing relies heavily on the principle of storage, meaning the ability to hold or store the underlying asset (especially for commodities). Storage can incur costs but can also generate cash flow production, such as dividends and interest. Futures are standardized contracts that allow the holder of the contract to buy or sell the respective underlying asset at an agreed price on a specific date. The parties involved in a futures contract not only possess the right but also are under the obligation to

7  The beta (β) of an investment security (i.e. a stock) is a measurement of its volatility of returns relative to the entire market. In this context, the beta correlation is used to determine whether the standard deviation of the derivative instrument is higher than that of its underlying.

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carry out or execute the contract as agreed. These contracts – being standardised – have a very liquid secondary market. Forward contracts are similar to futures in purpose, in the sense that the holder of the contract possesses not only the right but is also under the obligation to execute the contract as agreed. However, forward contracts are tailor made and customized on the needs of the two parties, non-standard in size, and as such traded over the counter, which means they are not regulated. As a result, forwards embody a higher counterparty and illiquidity risk. Options are financial derivative contracts that give the buyer the right, but not the obligation, to buy or sell an underlying asset at a specific price (referred to as the strike price) during a specific period of time. On the contrary, the seller (also called the “writer”) has the obligation to satisfy the decision of the buyer (the holder) to exercise the option (or not). American options can be exercised at any time before the expiry of their option period. In contrast, European options can only be exercised on their expiration date. Swaps are derivative contracts that involve two holders, or parties to the contract, who exchange financial obligations. Interest rate swaps (IRS) are the most common swap contracts used by investors. Swaps are not traded on the exchange market but over the counter, because of the need for swap contracts to be customizable to suit the needs and requirements of both parties involved. The swap market is usually limited to financial institutions, governments and large international corporations. As we’ve said, derivatives can be used for different purposes by diverse market participants. For example, large corporations have a real interest in the purchase of commodities, while other market participants look for risk reduction when purchasing stocks (with options) or protection for their investments from price fluctuations. There are also speculative investments with high leverage. As reported on the CME Group website, under the NYMEX WTI crude oil page, “use WTI Crude Oil futures to hedge against adverse oil price moves or speculate on whether WTI oil prices will rise or fall.” Participants in the derivatives market can be broadly categorized into the following four groups: hedgers, speculators, arbitrageurs and margin traders. A hedger is the market participant who wants to reduce the risk of price volatility in exchange markets, i.e., eliminate the risk of future price movements. Derivatives are the most popular instruments in the sphere of hedging, because derivatives offer the chance to take an opposite direction regarding the portfolio of underlying assets already held. Speculation instead is the most common – yet risky – market activity that participants of a financial market take part in. With the purchase of any financial derivative instrument, an investor speculates that the future value of the underlying asset will either significantly increase (the so-called “long” position) or decrease (the “short” position). The motivation for speculation is potentially earning lucrative profits in the future. Arbitrage is a very common profit-making activity in financial markets that comes into effect by taking advantage of or profiting from the price volatility of

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the market. In fact, arbitrageurs make a profit from the price difference arising in an investment of a financial instrument such as a bond, stock, derivative, etc. by not trading the underlying at the spot price, arbitrageurs can anticipate its movement. Lastly in the finance world, margin trading refers to the process whereby individual investors buy more of a given financial instrument than they can afford to. With derivative products, investors are not required to pay the total value of their position up front, but rather to deposit only a fraction of the value of the outstanding position, or the margin, hence the name margin trading. This activity results in a high leverage factor in derivative trades, which means that with a small deposit the trader is able to maintain a large outstanding position. This leverage factor is a sort of multiplier, which allows speculators to buy three to five times the quantity that their capital investment would otherwise have allowed them to purchase in the cash market. This mechanism is also common in trading platforms that use CFDs.8

8.2 The Forward market A forward is a contractual agreement between two parties to engage in a financial transaction at a future (forward) point in time. This agreement can be theoretically written on anything, and the underlying, the size and the date of execution can be customised on the two parties’ needs. This contract obligates one party to buy and another to sell an underlying – a financial instrument (i.e., foreign currency) or a commodity – at a future date for an agreed-upon price. Forward-type contracts are “zero sum” payoff: one party wins, one party loses. The most common kind of forward transaction is linked to a debt instrument, the so-called interest rate forward contract. Interest rate forward contracts, which involve the future sale or purchase of a debt instrument, have several characteristics: 1. 2. 3. 4.

specification of the actual debt instrument that will be delivered at a future date; amount of the debt instrument to be delivered; price (interest rate) on the debt instrument when delivered; date on which delivery will take place.

For someone new to financial derivatives, the fact that there is this mixture of terms like debt, price and interest rate could sound complex. In order to clarify we can say that debt instruments are generally fixed-income securities that pay the holder a re-

8  The contract for differences (CFD) offers to investors an opportunity to profit from price movement without owning the underlying asset, investing just a small amount of liquidity compared to the virtual value of the investment from which they can get the return. It’s a relatively simple security calculated by the asset’s movement between trade entry and exit, computing only the price change without considering the asset’s underlying value.

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turn, the yield to maturity. This is the interest the investor will obtain by purchasing a bond at a given price. Let’s assume that a certain bond is being traded today in the secondary market in London at £105; at this price the interest that investors will get until maturity is, say, 4%. The investors cannot purchase the bond in the spot market now, but they will invest in one year. How much will the price of the bond be in the spot market in one year? It’s hard to predict. If the price is higher, the return (interest) will be thinner; if the price is lower than £105, the interest will be higher. In any case, it is impossible to forecast whether or not the price will be the same. Forward contracts offer the chance to fix at ‘t0’ the interest rate for an investment at ‘t+1’: if a counterparty accepts, the investor will sign a contract – a forward contract – that fixes the purchase of this bond at £ 105 in one year. The spot price of the bond at t+1 might be £108 or £102, but the transaction, for the agreed size, will be executed at £105. In this way investors are guaranteed to get interest from the investment, something impossible to predict now, as they are unable to forecast the exact sport price in one year. Instead with a forward, knowing the purchase price, the rate can be computed. However, investors need to find a counterparty who is willing to sell that specific bond at the agreed price at t+1. The risk here is that, if at t+1 the counterparty does not honour the contract because the spot price is, say, £108, the investor will have to find the bond on the spot market. But being much more expensive, the interest from an investment in that bond will be reduced. The problem is the same for the counterparty: if investors, seeking a price of £102, do not honour the contract, the seller will have to sell on the spot market at £102 instead of £105. Obviously, the injured party can sue the counterparty for damages, but all the market forecasts and strategies would be lost. This example is quite extreme and involves a disreputable action by one of the two players. Instead a common risk is the so-called “default risk”: the counterparty (for whatever reason) – may not be able to honour the contract at the pre-fixed date. In addition, there is also the problem of lack of liquidity,9 or the difficulty of finding another counterparty, because the contract is tailor-made. Forwards are not standard contracts, so when they are traded this takes place on the OTC market. What’s more, there are several pros with this kind of contract: it is a very useful hedging tool for a specific position or portfolio, and it can also be used for speculation. The payoff of the contract is zero: if the price of the underlying asset at t + 1 is identical to that at t0, there is a draw; if instead the price is higher or lower, the loss of one party equals the gain of the other party.

9  Liquidity, applied to assets, refers to the ease with which the asset can be turned into cash; liquidity for market refers to the ease of carrying out financial transactions.

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Figure 8.1

Forward payoff

Profit Long Foward Buyer

Short Gain

Long Loss

Long Gain S1

F O, T

S t (Underlying price in T)

S2 Short Loss

Short Forward Seller Loss

8.2.1 An example of forward trading Let’s think about a forward contract on a commodity, for example wheat. The contract details are as follows: – FUTURE PRICE (F 0,t) – QUANTITY (in bushels) – TERMINATION DATE (t+1)

$4.00 98,000.00 in 3 months

Note that this is a tailor-made contract between the two parties and the size is 98,000 bushels, while there are also standard contracts in the futures market (5,000 bushels per each contract). This contract allows the parties to agree on a size that cannot be structured in the futures market. The risk is that this contract is not as liquid as a future, and there is also counterparty risk. Suppose that Biscuits Inc. is a purchaser taking a long position, because the company will buy the wheat in three months at the pre-fixed price of $4.00 per bushel. The supplier, the farmer, gets a short position, agreeing to sell to Biscuits Inc. the wheat in the same time frame and at the same price. Biscuit Inc. in three months will have a gain if the underlying asset’s SPOT price at t+1 is higher that the agreed FORWARD price. So for example suppose that on the future agreed exercise day (+3 months) the spot price is $5.00 per bushel. Biscuit has agreed to purchase from the supplier at the price of $4.00, while without this contract Biscuit would pay $5.00:

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Biscuit, thanks to the forward agreement, saves $1.00 per bushel so $98,000 overall. The farmer, on the contrary, probably forecasting a lower price in the future, has agreed to sell the wheat for $4.00 per bushel. At the termination date the farmer must sell at $4.00 instead of $5.00, which translates into an income reduction compared to the potential earnings from selling that same wheat in the spot cash market. The same is true if the supplier is not a producer of wheat, but simply a dealer: the loss is still $98,000 because to honour the contract, the supplier must purchase 98,000 bushels of wheat in the spot market at $5.00 and deliver it to Biscuit for the agreed price of $4.00.

8.3 The futures market According to the Annual Report of the Futures Industry Association (FIA),10 the trading activity in the global exchange-traded derivatives markets rose by 13.7% in 2019 to reach a record of 34.47 billion contracts. Futures volume grew 12% to 19.24 billion contracts, while options volume expanded by 16% to 15.23 billion contracts. Exchanges in Asia-Pacific and the Latin American regions grew the most rapidly in 2019. The number of contracts traded on Asia-Pacific exchanges jumped by 29.1% to 14.49 billion contracts, while Latin American exchange volume ballooned by 47.6% to 4.10 billion contracts. In contrast, trading activity in North America and Europe declined in 2019. Volume on North American exchanges dipped 2.8% to 10.27 billion contracts, while volume on European exchanges fell 4.4% to 5.03 billion contracts. It is interesting to note that the National Stock Exchange of India mushroomed by 58% to hit 6 billion contracts traded in 2019, surpassing CME Group and becoming the world’s largest exchange. CME recorder trades for 4.83 billion contracts, the same as the prior year. As a percentage of worldwide trading activity, the Asia-Pacific region had the largest share, with 42% of the global trading volume in 2019. North America came in second with 29.8% of global trading volume, and Europe third with 14.6%.  Derivative contracts, as we’ve already discussed, trades financial and commodities underlying assets. Analysing the CME Group trading volumes, we can note that the S&P500 future is the most liquid contract traded (mini and micro mini), followed by the Eurodollar future, the mini Nasdaq 100 and the WTI crude oil future (see Table 8.1). Analysing the mix, we can see that the traded volume of financial futures is much higher than commodities: as Table 8.2 shows, equity contracts (over indices, not single shares) represents more than 40% of the CME volume, followed by Interest Rates, while the Crude Oil future is the most liquid commodity future.

10 

FIA was founded in 1955 in New York as the Association of Commodity Exchange Firms.

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Futures contracts by volume @CME Group as of 23 July 2020

Product Name

Product Group

Volume

Open Interest

E-mini S&P 500 Futures

Equities

1,705,486.00

2,641,558.00

Micro E-mini S&P 500 Index Futures

Equities

1,188,308.00

116,533.00

Eurodollar Futures

Interest Rate

832,413.00

9,680,374.00

Micro E-mini Nasdaq-100 Index Futures

Equities

828,481.00

31,876.00

Crude Oil Futures

Energy

734,121.00

1,960,622.00

10-Year T-Note Futures

Interest Rate

662,758.00

3,474,435.00

E-mini Nasdaq-100 Futures

Equities

645,012.00

223,911.00

Gold Futures

Metals

513,274.00

608,445.00

Henry Hub Natural Gas Futures

Energy

430,889.00

1,302,199.00

5-Year T-Note Futures

Interest Rate

362,604.00

3,466,672.00

US Treasury Bond Futures

Interest Rate

257,421.00

1,066,642.00

Corn Futures

Agriculture

240,194.00

1,554,713.00

Euro FX Futures

FX

236,325.00

658,140.00

Silver Futures

Metals

193,640.00

185,705.00

E-mini Dow ($5) Futures

Equities

193,321.00

79,820.00

E-mini Russell 2000 Index Futures

Equities

172,030.00

499,916.00

Soybean Futures

Agriculture

166,620.00

842,979.00

Source: Authors’ elaboration on CME group data.

Table 8.2

Futures by class @CME Group as of 23 July 2020

FUTURES

Volume

Agriculture

821,959.00

7.00%

Energy

1,545,711.00

13.30%

Equities

5,030,507.00

43.10%

743,113.00

6.40%

2,598,377.00

22.30%

FX Interest Rate Metals Total

Source: Authors’ elaboration on CME group data.

%

921,439.00

7.90%

11,661,106.00

100.00%

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8.3.1 What is a future and how does it work? A futures contract is a legally binding agreement to buy or sell a standardised asset on a specific date or during a specific month. The fact that futures contracts are standardised and exchange-traded makes these instruments indispensable to commodity producers, consumers, traders and investors. An exchange-traded futures contract specifies the quality, quantity, and physical delivery time and location for the given product. The specifications of the contract are identical for all participants. This characteristic of futures contracts allows the buyer or seller to easily transfer contract ownership to another party by way of a trade. Given that contract specifications are standardised, the only contract variable is price. The price is established by way of bids and offers, also known as quoting, until a match, or trade, occurs.11 For every futures contract there must be a buyer who takes a long position and a seller who takes a short position, but there is no direct contact between the two parties. The reason for this is that although this kind of contract trades on regulated markets, the clearing house associated with the futures exchange will manage the entire process. This means that when a futures contract is bought or sold, the exchange itself becomes the buyer to every seller and the seller to every buyer. This protects the parties involved in the transaction from default risk. Moreover, the exchange guarantees that the contract will be honoured, eliminating counterparty risk. Buyers and sellers must put down an initial deposit, called the margin requirement. This margin generally represents a smaller percentage of the notional value of the contract, typically 3-12% per a futures contract. The initial margin is the amount of money to be deposited, as required by the clearing agent, to open a futures position. This process is indirectly managed by financial intermediaries, like banks or brokers; they may be required to collect additional funds for deposit. The maintenance margin is the minimum amount that must be maintained by the investor at any given time in the margin account. If the funds in this account drop below the “maintenance margin level,” the investor may receive the so-called ‘margin call’ and would be required to add more funds – immediately – to bring the account back up to the initial margin level. If the investor cannot satisfy the margin call request, the position will be reduced depending on the amount of funds remaining in the account, so that this amount satisfies the minimum requirements. The position may be liquidated automatically if it drops below the maintenance margin level. Most futures contracts do not result in delivery of the underlying asset on the expiration date, whereas forward contracts do. (Holding long and short positions means that traders would actually be delivering the bonds to themselves, so contracts are cancelled.) Usually futures are “quarterly contracts,” with expiration in March, June, September and December, while crude oil futures have monthly contracts.

11

  See CME Group, Definition of a Futures Contract.

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8.3.2 Stock indexes futures Many “market players” worry about stock market risk, because stock prices fluctuate. In 1982, stock index futures were developed to meet the need to manage stock market risk. The most widely-traded stock index futures contract in the US is the S&P 500 Index futures contract. Stock index futures are settled with cash delivery, so they have a very high liquidity lever and there is no cornering12 risk. Cash delivery over the S&P 500 futures is $250 times the index and a change of 1 point represents a change of $250 in the contract’s value, while for e-mini and micro mini future these multipliers are smaller. 8.3.3 A future trading example Lets’ think about a future contract on wheat. The contract details are as follows: – FUTURE PRICE (F 0,t) – QUANTITY (in bushels) – TERMINATION DATE

$4.00 5,000 in 3 days

In the futures market, there are long and short positions, because there are market players that want to buy the wheat and producers that want to sell it, but there are also speculators who want to bet on the wheat’s price rising or falling. Each day, before expiration, the long (buy) and short (sell) positions in the traders’ accounts are marked to market (MTM), or adjusted to current rates. Each day the clearing house “adjusts” the maintenance margins, maintaining a safe and liquid market, avoiding counterparty risk. Assume prices in the following days as: day +1: $4.70;  day +2: $4.40;  day +3: $5.00.

What happens to the long and short positions each day? At the end of the first trading day SHORT positions will add an extra margin while LONG positions will receive some money back, being above the minimum margin requirement: the amount is computed as ($4.70 – $4.00) × 5,000 = $3,500 for each contract held, as the settlement for the first day’s price rise of 10 cents. The contract would be rewritten at $4.10.

12  To corner a market means to acquire enough shares of a security, or to hold a significant commodity position to be able to manipulate its price. The term implies that the market has been backed into a corner, and there is nowhere for the market to move to find other sellers and buyers. A company that has cornered the market has a significant competitive advantage compared to others operating in the same market.

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At the end of the second trading day SHORT positions will receive some money back while LONG positions will add an extra margin of ($4.40 – $4.70) × 5,000 = $1,500 for each contract held, as the settlement for the second day’s price declines. The contract would be rewritten at $4.05. At the end of Day 3 of trading, the future price will converge with the SPOT price in the commodities market ($5.00). SHORT positions will have to add margins while LONG positions will receive ($5.00 – $4.40) × 5,000 = $3,000 for each contract held, as the settlement for the third day price rise of 7 cents. The total net payment made by the SHORT position and the total gain for the LONG can be summed up as follows: LONG

SHORT

day 1

$

$ –3,500

day 2

$ – 1,500

$

day 3

$

3,000

$ –3,000

Total

$

5,000

$ –5,000

3,500

1,500

Sometimes financial futures are written on assets because the future contracts are more liquid that the underlying assets, so it’s possible to use the margin leverage to speculate at a higher level. For example, the CboT US Treasury future contracts track deliverable baskets of US treasuries, fixed-income securities issued which are backed by the US government to finance debt. Using a financial future, you can “lock” the price of the underlying asset that you would purchase or sell in a future time ‘t’, fixing now the price while in the spot market you can just purchase now. The main difference with the forward is that, being the future contract standardized and thanks to the role of the clearing house, the market participant can always offset the contact without facing an illiquidity risk. 8.3.4 The WTI crude oil Future and the Covid-19 effect: for the first time in history a negative price Crude oil futures trading exploded in the first quarter of 2020 as price volatility reached record levels, but that was only the latest chapter in a long-term uptrend in the world’s most actively traded commodity futures. During March and April 2020, crude prices were under severe downward pressure. This was underscored by the implosion of NYMEX May 2020 WTI prices to negative values on 20 April 2020, the day before the contract expired. The West Texas Intermediate (WTI) is as an American Oil Benchmark, probably the most well-known and used by the media as a proxy of the crude oil price around the globe. The other world-famous crude oil benchmark is the Brent from the North

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Sea. (For the technical differences between WTI and Brent, see Box 8.2) There are many other oil futures traded on derivatives exchanges around the world, but these two contracts are the most important benchmarks for the industry, with the deepest liquidity and the greatest impact on prices. The significance of a benchmark in the oil market is that it serves as a reference price for buyers and sellers of crude oil. Oil benchmarks are frequently quoted in the media as the price of oil. But this is a bit misleading, because there is a cash price and numerous futures, with different prices. Box 8.2 The differences between WTI and Brent From a technical point of view, the WTI crude oil has a sulphur content of 0.24%, whereas Brent has 0.37%. The lower the sulphur content of oil, the easier it is to refine, making it more attractive. A sulphur content below 0.5% is considered “sweet.” Due to these technical details, WTI is ideal for gasoline, whereas Brent is ideal for diesel. Theoretically, WTI crude should trade at a premium to Brent crude, given the quality, but this is not always the case. WTI is probably the best-known index for non-specialists, but not the most commonly used benchmark globally. That honour goes to Brent, seeing as two-thirds of oil contracts globally use Brent as a benchmark. Both, however, are considered high-quality oils and are therefore the two most important oil benchmarks in the world.

According to FIA,13 in the last decade the trading volume of the futures on WTI light sweet crude has seen growth of almost 200%. In the first quarter of 2008, the volume of the WTI futures traded on the New York Mercantile Exchange was 33.5 million contracts; by the first quarter of 2019, it had nearly tripled to 95 million contracts. It’s impressive that the trading volume of the Brent crude oil futures grew even more rapidly. Brent futures, traded on ICE14 Futures Europe, shot up from 16.7 million contracts in the first quarter of 2008 to 78.5 million in the first quarter of 2019, an upsurge of 370%. But Brent has been more popular lately, with open interest running 10% to 20% higher than WTI since the beginning of 2019. Since the shale boom in the US, which resulted in a production increase of WTI, the price has gone down and usually trades at a discount to Brent. Furthermore, transporting WTI overseas to Brent crude’s market could come at a cost that would make WTI unable to compete with Brent crude in terms of pricing. “The Brent contract has gained popularity for hedging the cost of oil shipped by sea to the rapidly growing economies of Asia-Pacific. Brent is a waterborne crude, it is a basket comprised of five different North Sea crudes (Brent, Forties, Oseberg,   See W. Acworth, “Battle of the benchmarks - Brent vs WTI crude oil futures,” FIA.org, 8 June

13

2020. 14  The Intercontinental Exchange (ICE) is an American company that owns and operates financial and commodity marketplaces and exchanges. It was founded in May 2000 in Atlanta, Georgia. ICE operations include futures exchanges, cash exchanges, central clearing houses, and market services for off-exchange trading. ICE operates futures exchanges in the US, Europe, and Singapore. Its cash exchanges include the New York Stock Exchange (NYSE).

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Ekofisk, and Troll, commonly referred to as BFOET). As a waterborne crude, it can be put on a vessel and shipped anywhere. Because of this, Brent reflects global oil market fundamentals and the global economy. This is reinforced by the fact that approximately 70% of the world’s traded crude is priced relative to Brent, including Dubai, Urals, and West African crudes. Brent can be shipped and stored globally, either on land or in floating storage. As it has much more flexibility than WTI in terms of logistics and storage locations (see below). Brent is less prone to go negative.” 15 A historic drop occurred on Monday 20 April 2020, when the price of West Texas Intermediate crude contracts May 20 plunged by almost 300%, trading at around negative $37 per barrel16 (see the trading chart in Figure 8.2). The unheard of happened: the price of oil produced in the US turned negative for the first time in history. Figure 8.2

WTI Futures for May 2020 Delivery chart

Source: Authors’ elaboration on CME Group data. 16

  Each derivative has its own measure; crude oil uses barrels as the unit of measure.

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The news, which shocked the media, was widely reported on TV news shows and on the front pages of the newspapers. The crash in demand for oil from the major producers that followed the Covid-19 pandemic played a key role in the downward spiral to negative prices. Planes were grounded and few cars were running in cities, causing demand to dry up and creating the huge risk of limited storage capacity. To make matters worse, a price war erupted between oil giants Saudi Arabia and Russia in early March after OPEC and its allies failed to reach an agreement on deeper supply cuts. As supply remained steady while demand hit record-breaking lows, the industry quickly began running out of storage space for stocking all the oil. Some rumours17 alluded to a secret agreement between Russia and Saudi Arabia in April: Saudi Crown Prince Mohammad bin Salman and Russian President Vladimir Putin, with the historic sub-zero-dollar price in the US, were ultimately seeking the slow destruction of America’s shale oil industry. In fact, this new oil source would have taken many more years to rebuild, giving the Russians and the Saudis a large new market to share when the demand came back. The price plunge and consequent negative price on April 20 was driven in part by a sort of storage nightmare and a technicality of the global oil market. At that time, the Oklahoma hub in the town of Cushing, Payne County, that serves as delivery point for the expiring futures of the US benchmark, reached an estimated 60 million barrels stored, versus a maximum capacity of about 90 million. At the rate Cushing was building (an average of 16 million barrels weekly in March 2020), analysts forecasted the hub would hit full capacity by mid-May or June if the lockdown continued. These forecasts were devastating news for investors in WTI futures, who are expected to take physical possession of the oil when the contract expired. As a reminder, futures are derivative instruments with an expiration date. Crude oil has 12 contracts that expire each month, while for many other futures there are just 4 contracts per year. So crude oil bottomed out on April 20 because the oil contract with May delivery was due to expire on Tuesday April 21. Traders were keen to offload those holdings, to avoid having to take delivery of the oil and incur storage costs. On the same day, the prices of the other contracts, from June 2020 through all of 2021, were dropping down, but trading at above $20 per barrel (see the WTI futures contracts’ market price on that day in Figure 8.3). Meanwhile, Brent Crude (the benchmark used by Europe and the rest of the world, which was already trading based on June contracts) was also weaker, down 8.9% at less than $26 a barrel. After this shock the WTI crude oil price bounced back to around $40 per barrel and in the meanwhile many ETFs, trading WTI crude oil, rolled their contracts to longer maturities (see Figure 8.4 for contracts’ price on July 24).

17  See B. Krishnan, “At below-zero USD, U.S. crude is exactly where the Saudis and Russians want it,” investing.com, 21 April 2020.

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Figure 8.3 WTI futures on CME, during the night (US time zone) by April 20 (9 AM CET)

Source: Authors’ elaboration on CME Group data.

Figure 8.4

WTI futures on CME, by July 24

Source: Authors’ elaboration on CME Group data.

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8.4 The options market From the pages of an English dictionary under the word “option,” here are some of the definitions of the noun: “the act or an instance of choosing or deciding,” “the power or liberty to choose” and “an exclusive opportunity, usually for a limited period, to buy something at a future date.” And here’s another definition: “An option is something that you can choose to do in preference to one or more alternatives.” But what exactly is an option in the financial sense of the word? Options are financial contracts, deriving their value from an underlying asset, which give the buyer a right, but not an obligation, to buy or sell an asset (or the underlying financial instrument) on a specific date, at a given price called strike price. The most important difference compared to a forward or a futures contract is that the option, once purchased, gives the owner the right to purchase or sell, but there is no obligation for the investor. An obligation instead belongs to whoever sold the option, because without this obligation for the writer, there market would have the same problems as with forward contracts. An option, in fact, is a standardised contract traded on the regulated exchanges, so it is liquid and regulated as for the futures. With forwards and futures, the investor can take a long or a short position, while for options there are four different possibilities, in other words, four different choices of investment. There are two types of options: • call options; • put options. Investors can buy or sell either type, which means they have four different opportunities. The purchaser of an option is called “the holder,” having a security that embodies the right to exercise the option (or not). The holder pays a “premium” for having this opportunity, an amount of money that is the maximum loss he or she could incur, or a reduction of gain in case of a positive pay off. The seller of an option is called the “writer” of the contract. The writer gets the premium but has the obligation to deliver the underlying asset to the holder of the option if this person decides to exercise that option. Let’s try to get a clearer understanding of why there are four options. Investors might think that the price of the underlying will fall in the future, but instead of purchasing or short selling the underlying, they could use the option contract. For each underlying there are many options that combine two “variables” or factors: the strike price and the exercise date. Let’s imagine that for the same stock you can purchase a call option strike price €22, exercise in May, a call option strike price €22, strike in September, a call option strike price €20, exercise in May. You can do the same with a put option: for the same underlying you can purchase a put option strike price €22, exercise in May, a put option strike price €22 strike in September, a put option strike price €20, exercise in May. Investors buy call options when they believe the price of the underlying asset will go up. But, they can also sell call options if they believe the price will go down.

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On the contrary, investors buy put options when they believe the price of the underlying asset will decrease and sell puts if they believe this price will increase. For an example of how to use options, with a long or with a short strategy, for the same underlying, see more in Box 8.3. Box 8.3 How options work Assume that the spot price at the end of March of share XYZ is €20. Forecasted scenario: growth of the underlying Let’s say Pam is an investor. If she believes that the price of the underlying asset will increase, she could purchase the share and wait. If the price of the share in June was €25, she would report a gain of €5, but if the price was €16 she would incur a loss of €4. So Pam purchases a call option, strike €20, maturity June, paying a premium of €0.5. If the price hits €25 in June, she will exercise the option, having the right to purchase for €20 something with a spot market value of €25, with a gain of €5 less the €0.5 premium that she already paid. Why does the investor pay this premium that reduces the gain? If the spot price in June is €16, she will not exercise, and the loss will be limited to the €0.5 premium. In this way the potential upside is unlimited, reduced by the cost of the option, while the loss is limited to the cost of the premium. If the price falls, the investor will not exercise the option and she will only lose the 50 cent premium. Another option for the investor long in the underlying asset is to sell a put option. Thinking the price will rise, our investor can sell a put option, strike price €22, receiving a premium of €1.75. If her expectations are correct, and the spot price fluctuates above €22, the counterparty (a holder) will not exercise the option and let it expire. That way, the investor will keep the premium of €1.75 in her pocket. Instead, in this case the gain is limited to the premium, and the risk is the potential downside of the price of the underlying. If the price of the share falls to €16, the holder will exercise the option and will sell to the writer (the subject of this example) a share for €20 that has a spot price of €16. The writer is obliged to purchase, suffering a virtual loss of €2.25 (computed as €20 paid minus the market price of €16 minus the €1.75 premium). The risk of potential loss embodied by selling the put options would be higher than purchasing the call option, and it is adjusted by the market with different premium paid (by the purchaser) or received (by the writer) for the same strike. Forecasted scenario: fall of the underlying If our investor believes that the price of the underlying asset will fall in the future, she will short sell the share and wait for the right moment to repurchase the asset for a lower price, with a gain. If the price of the share in June is €15, she will report a gain of €5 (the bank’s commissions and expenses excluded), but if the price is €23 she would suffer a loss of €3. The investor purchases a put option, strike €20, maturity June, paying a premium of let’s say €1. If the price falls to €15 in June, she will exercise the option, having the right to sell for €20 something with a spot market value of just €15, with a gain of €5 less the €1 premium she already paid. Again, why does our investor pay this premium that reduces her (forecasted potential) gain? If the spot price in June is €16, she will not exercise, and the loss will be limited to the premium she paid of €0.5. In this way the potential upside is unlimited, less the premium paid for the option, while the loss is limited to this same premium payment. If the price moves up, the investor will not exercise the option and will lose only the premium of €1. Another choice, if the view of the investor is short about the underlying asset, is to sell a call option. Thinking the price will decrease, the investor can sell a call option, strike price €22, receiving a pre-

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mium of €1.75. If her expectations are correct, and the spot price fluctuates in June below €22, the counterparty (a holder) will not exercise the option and let it expire. This way the investor will keep the premium of €1.75 in her pocket. Instead, in this case the gain is limited to the premium, and the risk is the potential downside of the price of the underlying. If the price of the share rises to €30, the holder will exercise the option and for €20 will purchase from the writer (the subject of this example) a share whose spot price is €30. The writer is obliged to sell something that if she has in the portfolio, she sells with a minus of €8.25 (computed as €30 the market value minus €20 from the sale and €1.75 of the premium received). Or if she doesn’t already have the underlying, she would have to purchase it in the spot market and sell immediately, suffering a loss of €8.75 (computed as €30 paid minus €20 from the sale and minus €1.75 of the premium received).

The difference between buying and selling an option contract, be it a call or a put, is related to the legal profile: the buyer of a call has the right to buy the shares at the strike price on or before the expiration date, and the seller of a call has the obligation to sell the shares, if asked. The buyer of a put has the right to sell the shares at the strike price on or before the expiration date, while the seller of a put has the obligation to buy the shares, if asked. So we can say that the holder has the right to buy/sell the shares, at the strike price, on or before the expiration date. There are two types of option contracts: • American options can be exercised at any time up to the expiration date of the contract; • European options can be exercised only on the expiration date. All optionable stocks as well as ETFs have American-style options, while the major broad-based indices, including the S&P 500, have very actively traded European-style options. European index options stop trading one day earlier, at the close of business on the Thursday preceding the third Friday of the expiration month. The settlement price is the official closing price for the expiration period, establishing which options are in the money and subject to auto-exercise. In the US, all options once had an expiry date of the third Friday of each month. Some other options expire every three months. The so-called “triple witching,” on the third Fridays of March, June, September and December, is when options, index futures and options on index futures expire concurrently. This generates a peak in trading activities and volatility because contracts that are allowed to expire necessitate the purchase or sale of the underlying security or the roll out or the offset of the open positions. Option contracts are written on a number of financial instruments, not only on a single underlying asset. Options on individual stocks are called stock options, which have existed for many years. Options on financial futures (financial futures options or futures options) were developed in 1982 and have become the most widely traded option contracts. Options on futures are an example of a derivative of a derivative instrument. Why are option contracts more likely to be written on financial futures than on underlying assets such as bonds? Due to the mechanism explained above, at the ex-

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piration date the price of futures and the price of the underlying will converge, but often the futures are often more liquid and give the investors more opportunities. Options are often said to be “out of the money” or “in the money.” These two terms refer to the fact that above or below a certain level of the underlying price, the option could generate a gain, after covering the premium paid. How is the price of an option determined? There are mathematical methods to do so; the price also embodies the value of the volatility. In any case, in general we can say that the option premium is the sum of its intrinsic value and the time value. As we’ve already discussed, for the same strike price there can be a different maturity, and the price of the options could vary depending on the fact that in the short term there is less chance of events occurring that could change the price of the underlying. The intrinsic value is much easier to understand: it is the positive difference between the share spot price and the exercise price. The following Figure 8.5 explains graphically how a Call option price changes according to the underlying asset’s spot price. Figure 8.5

Option price structure Option premium = Intrinsic value + Time value Intrinsic value (in-the-money option) = Share price – Exercice Price

Call Option Value

Total Value of option Time price Intrinsic value

Spot price

}

} Out-of-the-money

E

In-the-money

We should point out that options have a large secondary market. Option traders, like the futures traders, buy (or sell) option contracts and offset their position by selling (or buying) the contracts that they have. The price of the option fluctuates in the market according to the price of the underlying asset (the intrinsic value), the time value and the volatility. An option that’s out of the money can become in the money in the future and vice versa. The trader who purchased an option “out of the money” (considered at that time an option with few probability of exercise) can sell the option once it’s “in the money” with a gain over the premium, without waiting for the conversion which calls for

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an extra capital addition. This is the “leverage” of the derivative instruments: a trader with €100,000 can purchase some contracts investing the whole amount in premiums (let’s assume at €10 each), but they must sell the contracts before the conversion because they have no extra liquidity for the purchase of the underlying (assume at €100). With this mechanism they can gain a number of shares 10 times greater than the amount they could have purchased in the spot market. (But this multiplier will also affect potential losses). For a whole comprehensive glossary about the options, see Box 8.4. Box 8.4 Options glossary Calls: the right, but not the obligation, to buy a specific number of shares of the underlying security at a defined price, until the expiration date. Puts: the right, but not the obligation, to sell a specific number of shares of the underlying security at a defined price until the expiration date. Strike price: the price at which option holders can exercise their rights. Exercise: the process in which the buyer of an option takes, or makes, delivery of the underlying contract. Assignment: the process by which the seller of an option is notified that the contract has been exercised. Expiration: the time at which an option can no longer be exercised. In the Money (ITM): a call (put) option whose strike price is below (above) the stock price. At the Money (ATM): an option whose strike price is roughly equal to the stock price. Out of the Money (OTM): a call (put) option whose strike price is above (below) the stock price. American style: an option that can be exercised at any time before expiration. European style: an option that can be exercised only at expiration. (Note: These are mainly index securities.) Intrinsic value: the amount that an option is in the money. Time value: the price of an option less the intrinsic value.

8.4.1 An example of option trading Let’s consider an option on a stock that is trading right now at $125 (spot price SP). The several available option contracts are priced as shown in Table 8.4. Table 8.4

Option’s prices chart

PRICE Exercise price

CALL

PUT

Jun

Sep

Dec

Jun

Sep

Dec

$

105.00

$ 12.00

$ 22.00

$ 31.00

$ 4.00

$ 11.00

$ 15.00

$

115.00

$ 9.00

$ 17.00

$ 22.00

$ 8.00

$ 16.00

$ 20.00

$

125.00

$ 3.00

$ 4.00

$ 5.00

$ 21.00

$ 26.00

$ 30.00

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Remember that for every party that purchases a call (long position over the underlying) or a put option (going short on the underlying) through the exchange market, there is a counterparty that writes (sells) a call or a put option. Let’s say Tom has some shares of a firm in his portfolio but he has a bad feeling about the firm’s quarterly data release due to the market crunch. In fact, he anticipates that the price will fall, so he wants to take a short position in order to hedge his portfolio. Tom has different choices in terms of strike price and exercise date. He believes that he could hedge his portfolio by buying a put option contract, strike price $125, exercise in June, which pays a premium of $21; this would give him the right to sell the shares for $125 each. The contract is structured over an amount of 100 shares, so the premium to be paid is 100 times the quoted price. If our investor holds 200 shares, and wants to protect his existing portfolio, he would purchase two contracts. If he holds 150 shares he must face the problem of having a partial hedging purchasing only one contract (protection 100 over 150 shares) or the problem of having a sort of extra protection (200 over 150), that will be a speculation for the extra coved part (the extra 50 shares) purchasing two contracts. If in June, at the exercise date, the spot price of the underlying asset is: a) SP > 125, the investor will not exercise the option and will lose the premium; b) > 91 SP < 125, the investor will have a virtual limited loss; c) SP < 91 the investor will have a gain because he can purchase below $91, something he has the right to sell for $125 in the spot market (the gain less the premium). Thanks to the option contract Tom can protect his portfolio just by paying a given amount which is the premium. If the market grows, his portfolio value will increase, and he will only be out the cost of the premium paid. On the other hand, if the market falls the drop in value in his stock portfolio he will be compensated by the gain over the option contract, minus the premium paid. The payoff of the various scenarios can be summarised as shown in Table 8.5. Scenario C, being negative, the investor will not exercise the options thus the loss is equal to the premium paid of $21. Table 8.5a

Option payoff in scenario A, B and C  

A

cash flow

B

cash flow

C

cash flow

Put OPT premium

$ 21

$ −21

$ 21

$ −21

$ 21

$ −21

STRIKE price

$ 125

$ 125

$ 125

$ 125

$ 125

$ 125

Spot Price on Exercise date

$ 91

$ −91

$ 105

$ −105

$ 140

$ −140

 

$ 13

 

$ −1

 

$ −21

Total Cash Flow

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Table 8.5b

Option payoff in scenario A, B and C  

A

cash flow

B

cash flow

C

cash flow

Put OPT premium

$ 21

$ 21

$ 21

$ 21

$ 21

$ 21

STRIKE price

$ 125

$ −125

$ 125

$ −125

$ 125

$ −125

Spot Price on Exercise date

$ 140

$ 140

$ 105

$ 105

$ 91

$ 91

 

$ 36

 

$ 1

 

$ −13

Total Cash Flow

As we’ve said, for each purchaser there is an option seller. Let’s analyse what happens in the other side of the market, where the “writer” has the obligation to answer to the holder request of execution (remember that he doesn’t have just a right, as the holder has). If in June, at the Exercise date, the spot price of the underlying asset will be: a) SP > = 125 the writer will have a gain of $21, the 100% of the Premium; b) > 104 SP < 125 the writer will have a gain between $0 and $21; c) SP < 91 the writer will have a loss, potentially up to $91. If the price is $150 instead of $140 in Scenario C, the maximum loss for the investor would in any case be $21, the premium. In addition, due to the fact that the writer will let the option expire, the maximum gain will be $21. Instead if the price falls to $81, the holder will have a gain of $23 and the writer a loss of $23. In the extreme scenario, just before default the holder can, theoretically, have a gain of $104 while the seller can face a maximum loss of $104. The two payoffs are graphically structured in a chart (x: share’s spot price, y: P&L) as shown in Figure 8.6. Figure 8.6

Options’ payoff

P/L

P/L

+$ 21 75 85 95 –$ 21

115 104

Share price 125 135

75 85 95

Share price 104 115 125 135

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8.5 The swap market A swap is a derivative contract in which two transacting agents agree to exchange payment streams (cash flows) arising from some underlying assets held by each party in the future, often at periodical intervals, based on some agreed-upon price or rate. The amounts exchanged on the same date between the two parties can be different; this is the aim of the exchange between the two participants in the contracted transaction. The cash flows can be different amounts because the two underlying assets, which are not exchanged in the transaction, have the same notional amount, but the factor that “sized” the payments is different: one can be fixed and the other variable, or they could be denominated in two different currencies – say, dollars and euros. The two streams of payments are the two legs or sides of the swap. The swap’s contractual terms specify the timing and frequency of payments and the factors that build up the cash flows. Swaps are tailor-made contracts, usually structured between banks, financial institutions and large corporations. Due to their customised structure, swaps are not traded on exchanges, and retail investors do not generally engage in swaps. Rather, swaps are OTC contracts primarily between businesses or financial institutions. Again, swaps are traded OTC, which means there are no exchanges but there are many platforms that offer swap intermediation services, giving the market liquidity and stability by serves as a clearing house in the futures market. Two platforms rule the swap market, acting as a sort of exchange: from many parts ICE maintains its dominance (since trades are OTC, there are different methodologies for calculating trading volumes) in credit while LCH ForexClear leads the foreign exchanges. The ICE Swap Rate™ (formerly known as ISDAFIX) is recognised as the principal global benchmark for swap rates and spreads for IRS. It represents the mid-price for interest rate swaps (the fixed leg) in three major currencies (EUR, GBP and USD) in a tenor range from one to 30 years. The London Produce Clearing House (LPCH) was established in 1888 and offered clearing services for futures contracts in coffee, sugar and other soft commodities. In 1999 SwapClear, a service for clearing interest rate swaps, was launched. Today, SwapClear allows end users to clear options in 21 currencies, with maturities of up to 50 years, and non-IRS instruments such as inflation swaps. In order to have an idea of the volume of the swap market, Table 8.6 shows the volumes traded at LCH (formerly LPCH) in the first part of 2021 (as of 12 March).

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Table 8.6 Currency

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Currencies Swap market, Volume and Notional outstanding totals Daily

Weekly

YTD

Notional Outstanding

USD

$1.416.964.620.113

$9.855.591.527.627

$93.320.236.778.988

$131.768.883.955.428

EUR

€ 624.435.851.293

€ 3.827.712.101.842

€ 43.163.057.341.276

€ 83.687.911.345.477

GBP

£380.497.363.998

£2.051.688.574.474

£36.553.458.149.044

£48.225.953.553.717

JPY

¥2.278.591.160.000

¥28.129.306.771.604

CHF

CHF 13.081.236.000

CHF 105.530.659.060 CHF 1.166.234.945.506

AUD

$56.047.763.056

$730.734.478.447

$6.585.311.981.099

$21.400.202.034.035

CAD

$110.797.946.000

$633.578.808.453

$6.429.463.988.443

$19.530.562.726.345

Other* Show All

$249.678.758.726

$1.554.005.717.217

$13.427.853.559.120

$37.796.346.821.536

$3.109.858.200.672

$20.265.270.351.125

$224.151.875.846.851

$382.451.052.324.169

Total in USD

¥351.474.333.339.944 ¥1.108.519.205.085.010 CHF 3.079.520.378.585

8.5.1 Kinds of swap contracts The most common SWAP is the Interest Rate Swap (IRS) that involves the exchange of one set of payments for another set of interest payments, all denominated in the same currency. Interest rate swaps have become an integral part of the fixed income market. These derivative contracts, which typically swap fixed for floating-rate interest payments, are an essential tool for investors who use them in an effort to hedge, speculate, and manage risk, as happens for the other derivatives and their different applications. The “principal,” the underlying asset, doesn’t change owner, there is just an exchange of cash flows from one party to the other and vice versa. Interest rate swaps are most commonly used by firms and banks that either generate revenues or incur costs linked to a different interest rate. One cash flow is generally fixed, means based on a fix rate over the principal amount, while the other cash flow is variable, means that is based on a benchmark interest rate. The two interest rates can be both variable, based on different index or benchmark. Introduces in 1982, IRS are an important tool for managing interest rate risk. This kind of contract in fact allows the issuer of a liability to switch from paying floating interest on the debt to paying fixed interest or vice versa, with the aim, according to some forecasts, to reduce the cost of funding previously supposed. The most common IRS is the so-called plain vanilla, a contract that specifies: • the interest rate on the payments that are being exchanged; • the type of interest payments (fixed or variable);

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• the amount of notional principal, which is the amount on which the interest is being paid; • the time period over which the exchanges continue to be made. The “vanilla” swaps are usually based on LIBOR, the London Inter Bank Offered Rate, which is the interest rate high-credit quality banks charge one another for short-term financing. LIBOR is the benchmark for floating short-term interest rates and is set daily Each transaction, as written in the contract, applies an amount of basis points, a spread, over the LIBOR, reflecting the credit reputation of the contract. Although there are other types of interest rate swaps, such as those that trade one floating rate for another, vanilla swaps comprise the vast majority of the market. The Interest Rate Swap has become so popular that in the OTC market there are also non official rates denominated as “swap rate”: this rate is the fixed interest rate that the receiver demands in exchange for the uncertainty of having to pay the short-term LIBOR (floating) rate over time. At any given time, the market’s forecast of what LIBOR will be in the future is reflected in the forward LIBOR curve. The “swap spread” instead is the difference between the swap rate and the equivalent local government bond yield for the same maturity.18 Very often there are news, especially during markets’ turmoil, about the “swap curve.” The swap curve is a plot of the swap rates across all available maturities. Because swap rates incorporate a snapshot of the forward expectations for LIBOR, as well as the market’s perception of other factors such as liquidity, supply and demand dynamics, and the credit quality of the banks, the swap curve is a widely used interest rate benchmark. The swap curve is similar in shape to the equivalent sovereign yield curve, but the swaps can be traded a bit higher or a bit lower than the corresponding sovereign yields maturities. The difference between the two curves is the “swap spread.” The other kind of swap is the currency swap, called FX swap, that involves the exchange of a set of payments in one currency for another currency. Currency swaps allow their holders to swap financial flows associated with two different currencies. Consider international firms that works all over the world that can raise (cheaper) money issuing liabilities in one currency, and reinvest in another country with a different currency. American businesses often collect money from the European debt market by issuing euro-denominated bonds, even if they to do business in the US. That means that business revenue and costs are in different currencies: these firms need to make interest payments in euro, whereas their business generates revenues in dollars, so the firms are exposed to fluctuations in the EUR/USD exchange rate. To get protection from the currency fluctuations, they can enter into a EUR/USD currency swap, to hedge against such a risk. If the business generates operative margins for $50 million and has to pay €20 million in in-

18

  See Pimco Investment.

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terest, excluding taxes, the net margin can fluctuate according to the interest rate. If the rate EUR/USD= 1 the margin would be $30 million, but if the rate rises to EUR/USD=1.2 the financial expenses cost the firm $24 million, cutting $4 million profits. In order to protect against such a risk (the dollar depreciating against the euro), the business can use a EUR/USD swap, that allows the American firm to exchange the euro-based payments with another firm or bank, one denominated in euro that has to make payments in dollars and faces the opposite problem. Since the swap is a tailor-made contract, the transaction can only take place if the business and the swap seller have opposing views on whether the EUR/USD exchange rate will appreciate or depreciate. The total payoff is zero: if one party gains the other party loses from the agreement. In the market there are also what are called hybrid swaps, or exotic swaps. Hybrid swaps allow their holders to swap financial flows associated with different debt instruments that are also denominated in two different currencies. For example, a Japanese variable rate mortgage provider that does some business in China can swap a fixed interest rate loan denominated in Japanese Yen for a variable interest rate loan denominated in Chinese renminbi. Swap contracts are also attractive to oil and gas producers because, having no upfront costs (such as a premium in the option markets), there are a relatively large number of counterparties willing to enter into swap transactions, so there is an active trading market that increases the liquidity of these contracts. For these reasons, price swaps are commonly used by producers to protect against falling oil and gas prices. What is an oil swap? These contracts are proliferating a great deal in an era of unpredictable markets because they give the producer predictable revenues and some measure of financial flows. There are several kinds of swaps that help oil and gas producers to hedge price risk. These swaps involve, like a true financial swap, the exchange, in an interval of time for a specified period into the future, of a floating price for a fixed price based on an agreed notional quantity of oil or gas. These price swaps (whether oil or gas) are always financially settled by comparing, on agreed periodic dates, the floating price of the oil or gas (as published by an index agreed by the two parties) to the fixed price agreed on in the swap contract. In an oil price swap (see the example in Box 8.5), if the floating price is greater than the fixed price, then the producer is obligated to make a payment to its swap counterparty equal to the difference between the floating and fixed price multiplied by the notional quantity of oil specified in the contract. The underlying does not change hands. The swap ensures that the net effective price for the producer’s oil or gas production is locked in at the fixed price agreed in the swap contract and guarantees the producer a steady, predictable, and consistent stream of revenue.

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Box 8.5 Illustration of an Oil Swap19 Assume that an oil and gas producer expects to produce 25,000 barrels of oil in February, and has contractually committed to sell this production at spot prices. But this producer wants to hedge 100% of this amount at a fixed price of $50 per barrel. The producer wants to lock its revenues in at $1.25 million ($50 per barrel × 25,000 barrels = $1.25 mln) Under the oil price swap hedge: • The producer must make a payment to its counterparty equal to the floating indexed price of oil, as specified in the contract (multiplied by the notional quantity of oil specified in the contract). • In exchange the swap counterparty will make a payment equal to the fixed price of oil multiplied by the notional quantity of oil specified in the contract. If the (floating) index price of oil rises to $65.00 per barrel at the time specified for valuation in the swap contract, the producer owes its swap counterparty $375,000: the difference between the spot price ($65 per barrel) minus the fixed price as per contract ($50 per barrel), times the notional quantity (25,000 barrels). Assuming that the producer’s contract to sell its production in February is tied to the same index, then the producer is entitled to receive the spot price of $65.00 multiplied by the 25,000 barrels to be sold for a total $1.625 million. As a result, the producer receives a net $50.00 per barrel price or a total of $1.25 million ($1.625 million – $375,000). If the (floating) index price of oil falls to $40.00 per barrel at the time specified for valuation in the swap contract, the swap counterparty owes the producer $250,000 under the hedge contract: the product of the fixed price ($50.00) minus the spot price ($40.00) multiplied by the notional quantity (25,000 barrels). That payment, combined with the amount the producer receives from the purchaser for its oil production (assuming that the physical contract price for that period is determined on the same index), results in the producer receiving its targeted $50.00 per barrel. The hedge swap payment costs an extra $250,000 in cash flow for the purchaser that supplements the producer’s sale of oil at the spot price ($40.00 per barrel × 25,000 barrels = $1 million). This provides the producer with $1.25 million in revenue during the month of February ($1 million + $250,000 = $1.25 million). The swap sterilizes the ups and downs of the oil market and guarantees the cash flows for the two parties engaging the contract.

8.5.2 An example of swap contract In an IRS contract, the parties exchange cash flows based on a notional principal amount. (This amount, represented by the underlying asset, is not actually exchanged.) The purpose in doing so is to hedge against interest rate risk or to speculate. Assume that a firm, say ABC Co., has just issued a 5-year maturity bond, face value $1 million, structured with a variable annual interest rate, defined as the London Interbank Offered Rate (LIBOR) plus a spread of 130 basis points (bps). The LIBOR, at the bond’s issuance date, is rated around 1.7%, a low rate for its historical range, therefore ABC management is anxious about a possible future interest rate rise. 19 See D. Nossa, J.S. Lotay and P.E. Vrana, Hedging Oil and Gas Production: Issues and Considerations, Thomson Reuters Practical Law Finance, 2016.

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Another firm, XYZ Inc., previously issued another bond on the market of same size, with a fixed interest rate of 6%. XYZ Inc. forecasts a LIBOR decrease, which is why the XYZ management is worried about a very high cost of funding. The two firms, with a different view of market rates, are able to meet their needs and engage in a swap contract, as numerically described in Box 8.6. XYZ is willing to pay ABC an annual rate of LIBOR​plus 130 bps on a notional principal of $1 milBox 8.6 SWAP scenarios First scenario: LIBOR rises by 0.75% per year • ABC pays XYZ $300,000 = $1,000,000 × 5 (years) × 0.06 (6% fixed rate); • ABC receives $225,000 in return as calculated in the following table (the same as ABC’s interest payments to bond holders); • ABC’s net loss on the swap amounts to $75,000 = $300,000 – $225,000. SWAP terms

HP: LIBOR increases by 0.75% yearly

Notional

$

year

1

LIBOR (t1)

1.70%

increase/decrease Total variable component

1,000,000.000

 

2

3

4

5

0

0.75%

0.75%

0.75%

0.75%

1.70%

2.45%

3.20%

3.95%

4.70%

spread component

1.30%

1.30%

1.30%

1.30%

1.30%

Tot interest rate (variable)

3.00%

3.75%

4.50%

5.25%

6.00%

Tot cash flow to ABC

$ 30,000

$ 37,500

$ 45,000

$ 52,500

$ 60,000

TOT

$ 225,000

Second scenario: LIBOR rises by 2% per year This scenario drives ABC’s total interest payments, according to the variable bond’s specs, to $350,000. According to Swap terms, XYZ pays the same amount to ABC as calculated in the following table (having agreed on a variable rate swap), while ABC pays XYZ $300,000 in return (the 6% fixed rate for 5 years over $1 million). ABC’s net gain on the swap contract is $50,000, allowing ABC to reduce its cost of funding. SWAP terms

HP: LIBOR increases by 2.00% yearly

Notional

$

year

1

LIBOR (t1)

1.70%

increase/decrease

1,000,000.000 2

3

4

5

0

2.00%

2.00%

2.00%

2.00%

Total variable component

1.70%

3.70%

5.70%

7.70%

9.70%

spread component

1.30%

1.30%

1.30%

1.30%

1.30%

Tot interest rate (variable)

3.00%

5.00%

7.00%

9.00%

11.00%

Tot cash flow to ABC

$ 30,000

$ 50,000

$ 70,000

$ 90,000

$ 110,000

TOT

$ 350,000

8  The Derivative Instruments

205

lion for 5 years. In other words, XYZ will fund ABC’s interest payments on its latest bond issue, and at the beginning of the contract the rate to be paid is the 3% (the LIBOR 1.7% + the spread of 1.3%). In exchange, ABC pays XYZ a fixed annual rate of 6% on a notional value of $1 million for five years. As the swap payoff is zero: • ABC benefits from the swap if rates rise significantly over the next five years; • XYZ benefits if the LIBOR rate falls, remains flat or rises only gradually.

Summary The chapter analyses the world of the derivate instruments, and its complexity. The dissertation clarifies how the derivatives are a very old financial instrument used by large corporation for their purchases of commodities, while the financial derivatives, used as tool for portfolio protection and/or speculation were introduced in the 1970s and 1980s of the last centuries. The chapter present a brief introduction of the market’s structure and volumes and enlighten the technicalities of instruments that derives their prices/values from an underlying asset, that often – as for the commodities – is the final goal for the purchaser. The main body of the chapter explains also the difference between the instruments traded OTC and the instruments traded in the exchanges and explains the role of the clearing house as middleman that basically guarantees liquidity and eliminates the counterparty risk. Subsequently the chapter analyses the four different kind of derivative instruments, giving for each contract a more detailed description of the instruments and an example of application to a real situation. In addition, for the future contract, there is a focus about the event that shocked the market in 2020: the negative price of the WTI crude oil.

Questions 1. Why do the large firms purchase commodities with derivative contracts and not in the spot market? 2. What is the underlying? 3. What is the “strike price”? 4. Why does a financial institution engage a swap contract after the issuance of a bond? 5. Can you trade buy and sell a short position over the underlying asset?

Bibliography

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Useful websites LSEG, MTA (Mercato Telematico Azionario): https://www.lseg.com/areas-expertise/ our-markets/borsa-italiana/equities-markets/raising-finance/mta. R. Dodd, Markets: Exchange or Over-the-Counter, IMF.org: https://www.imf.org/external/ pubs/ft/fandd/basics/markets.htm. OECD, Inflation (CPI): https://data.oecd.org/price/inflation-cpi.htm. G. Richardson, Banking Panics of 1930-31, Federal Reserve Bank of Richmond: https://www. federalreservehistory.org/essays/banking_panics_1930_31. J. Maues, Banking Act of 1933 (Glass-Steagall), Federal Reserve Bank of St. Louis: https:// www.federalreservehistory.org/essays/glass_steagall_act. Federal Reserve Bank of New York, Overnight Bank Funding Rate Data: https://apps.newyorkfed.org/markets/autorates/obfr. Federal Reserve Bank of New York, Repurchase and Reverse Repurchase Transactions: https://www.newyorkfed.org/aboutthefed/fedpoint/fed04.html. ECB, Minimum reserves and liquidity: https://www.ecb.europa.eu/stats/policy_and_exchange_rates/minimum_reserves/html/index.en.html.

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The Authors

Gimede Gigante, PhD in Banking and Finance. Harvard Business Review advisory board council member, since 2019 he has served as Academic Director of the Bocconi Summer School. Deputy Director of the Master of Science in Finance, he is also Deputy Director of the Bachelor’s Degree Program in Economics and Finance at Bocconi University where he holds the academic position of Lecturer in the Finance Department. He holds the ITP qualification (International Teachers’ Program) from SDA Bocconi. He has held visiting positions at the Finance Department of Columbia Business School, and at the Salomon Brothers Center (Stern School of Business, NYU). Certified Public Accountant and professional auditor, his main areas of research are international finance, financial markets, corporate finance, investment banking and private equity. He has published a variety of papers on banking areas and acts as a consultant to several financial and non-financial institutions. Winner of the Award for Excellence in Teaching in 2015 and in 2016. From 2021, he is board member of Assofintech. Andrea Cerri, PhD in Management. Since 2016 he has served as Lecturer at the Department of Business Economy at Catholic University, Milan. He also teaches, since 2018, International Financial Markets and Venture capital at IES Aboard foundation, Strategic Analysis at Bicocca University in Milan and since 2020 he holds the course of Finance Lab at the Bocconi Summer School. On the professional side he is a Certified Public Accountant and professional auditor, serving as consultant for firms and in forensic field, with expertise in the areas of accounting, business administration, corporate finance, investment and private equity. As a professional he has supported several firms in M&A, valuations and restructuring/ turnaround process, and he has been a member of the O.d.V. of BS24 Business School.

Acknowledgements The authors would like to thank Mahsa Bohlooli Zamani for her help with all the graphics of the book.

Andrea Cerri, PhD in Management. Since 2016 he has served as Lecturer at the Department of Business Economy at Catholic University, Milan. He also teaches, since 2018, International Financial Markets and Venture capital at IES Aboard foundation, Strategic Analysis at Bicocca University, Milan, and since 2020 he holds the course of Finance Lab at the Bocconi Summer School.

www.bupbooks.com ISBN 978-88-31322-33-1

FINANCE LAB Gimede Gigante Andrea Cerri

FINANCE LAB

Gimede Gigante, PhD in Banking and Finance. Member of the Harvard Business Review advisory council, since 2019 he has served as Academic Director of the Bocconi Summer School. He has held visiting positions at the Finance Department of Columbia Business School and at the Salomon Brothers Center (Stern School of Business, NYU). Winner of the Award for Excellence in Teaching in 2015 and in 2016.

Gigante ∙ Cerri

By addressing the financial markets from a new perspective, this book sets out to take the reader on a journey, explaining the role of financial markets as places where exchanges take place to meet the needs of people, businesses and institutions. The volume is structured in four parts. The first part introduces the functions, structure, and components of the financial system. In the second part, the authors describe the functioning of the markets in terms of risk and return, providing a more in-depth description of the role of intermediaries. In the third part, capital markets are illustrated in various forms, presenting the debt market and the stock market from the accounting to the market/investment point of view. Finally, the last part presents other financial instruments as part of the whole system. This book provides students approaching the financial markets for the first time with a valuable tool that balances clarity and simplicity without losing sight of the real economy.

Foreword by

Maurizio Bernardo