Introduction to Financial Markets Financial Markets Education
Financial Markets Education Financial Markets Education provides instruction on all aspects of banking and finance for UBS employees and for our top clients. Europe
United States
APAC
Joe Troccolo
Joe Bonin
Onn Chan
London +44 20 7568 0735
[email protected]
Stamford +1 203 719 6507
[email protected]
Singapore +65 6836 5708
[email protected]
Walter Braegger
Kai-Hing Lum
London +44 20 7568 8938
[email protected]
Tokyo +81 352 08 6494
[email protected]
Spencer Morris London +44 20 7568 8938
[email protected]
1
This class ♦ Introduction ♦ Issuers & Investors ♦ Equities and Indexes ♦ Fixed Income Markets ♦ Foreign Exchange Markets ♦ All About UBS
2
Markets ♦ Market: an institution joining buyers and sellers [need not be “a” location] ♦ Who are the buyers and sellers? ♦ Financial markets are mechanisms for the flow of – money – risk
3
Markets: the buyer, the seller & the price ♦ How much would you pay for this ticket?
♦ What is its fair value?
4
Value and price – the official definition ♦ Fair market value. Fair market value is the price that [property] would sell for on the open market. It is the price that would be agreed on between a willing buyer and a willing seller, with neither being required to act, and both having reasonable knowledge of the relevant facts.
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A market price
6
A stock market, then
“Sshh!”
“Buy! Sell! Buy! Sell!” 7
And now (the information processor)
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Who are the players? ♦ Who are the players in the financial markets?
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And what do they do? ♦ Why do they need to be involved in the financial markets?
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Financial Markets – a model Liabilities Individuals
Mortgages and personal loans
Corporates
Governments
Debt and equity issuance
Commercial loans
Risk transformation products
Securities & money markets
Banks
-cash, CP, bonds, equities -primary and secondary markets -disintermediation of banks -origination and distribution -brokers and dealers
-commercial and retail banks -deposit-taking institutions -(inc. building societies in UK)
Deposits
‘Hedging’ Markets -foreign exchange -interest rates derivatives -equity derivatives
Risk transformation products
Debt and equity purchases
Asset Managers -pension funds -insurance companies -mutual funds / unit trusts (CIVs)
Assets Individuals
Corporates
Governments
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What is a Bank? ♦ Retail banking - cheque drawing account ♦ Private banking - for wealthier clientele ♦ Commercial banking - business accounts ♦ Investment banking – Raising capital/Issuing securities – Brokerage/execution – Advisory services
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Products: Banking Finance ♦ Loans – term loans – revolving facilities
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Products: Money and securities Markets ♦ Cash ♦ Treasury Bills ♦ Commercial paper ♦ Government Bonds ♦ Corporate Bonds ♦ Ordinary shares ♦ Preference shares ♦ Convertible Bonds and other ‘Equity-linked’ ♦ Structured Products
14
‘Hedging’ markets ♦ Foreign Exchange – spot – forward – options – exotics
♦ Interest rates – FRAs, futures and swaps – interest rate options – bond forwards, futures and options
♦ Equities – equity swaps – stock options – index swaps – index options
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Financial markets: Who are the players? ♦ Companies
♦ Investment funds
♦ Governments ♦ Municipals
♦ Brokers
♦ Hedge funds managers’
♦ Agencies
♦ Dealers
♦ Pension funds
♦ Supranationals
♦ Market-makers
♦ Private Equity funds & “sponsors”
‘Fund
♦ Insurance companies
♦ Financial Institutions
♦ Commercial banks ♦ Central banks (increasingly) ♦ Regulators ♦ Exchanges ♦ Central banks
♦ Private banks ♦ Charities ♦ Individuals (through Private Banking)
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Issuers & Investors Financial Markets Education
Introduction ♦ Issuers
♦ Investors
♦ Those who want to raise capital are the issuers
♦ They are “lending” or investing
♦ They “issue”
♦ They buy – Money market instruments
– Loans
– Bonds, share etc DIRECTLY and
– Bonds
– Through funds – pools of money
– Preferred Stock – Equity – Convertible Bonds
♦ They are concerned with
♦ They are concerned with – Return – Preservation of capital – Risks
– Amount
– Market
– Maturity for loans and bonds
– Credit
– Cost – Market value
– Fraud
– Share price – Credit rating – Investor base 1
Issuers - Companies
What do companies do?
Bond holder
Debt capital
Share holder
Share capital
Assets
Profits
3
Corporate clients - Shareholder value Shareholder Value
Shareholder Value
– measures business activities by the value they add to the owners of the company – framework for analysing our own activities and those of our clients
Return on Capital
Cost of
Capital
– other business drivers serve to achieve this one
“ “
“We raise capital to make concentrate and sell it at an operating profit then we pay the cost of capital.Share-holders pocket the difference”
”
Roberto Goizueta, former Chairman & CEO, Coca-Cola Company
“... any investment project and its concomitant financing plan must pass only the following test: Will the project, as financed, raise the market value of the firm’s shares? If so, it is worth undertaking; if not, its return is less than the marginal cost of capital to the firm.” Merton Miller and Franco Modigliani 1958
”
Corporate activity & shareholder value Improve operating performance – – – –
Measure and Reduce cost of capital
Sales growth Operating performance Investment decisions Sensible Management
Buying companies or divisions Selling companies or divisions
– – – –
Capital structure Tax structure Dividend policy Financial management
Debt
Raising, repaying or refinancing debt
Equity
Raising or buying back equity
Assets
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Example - M & A
6
Example - Selling a Company
7
From Debt to Equity Typical “single A” corporate capital structure
Equity
Debt Loans
Bonds
Preference shares
Senior debt
Source: UBS DCMG
8
Debt equity Spectrum ♦ In a bankruptcy, holders of subordinated debt are repaid after the senior bank lenders
Secured Debt Unsecured Debt
Hybrid
Cost
Seniority
Subordinated Debt
Preferred Shares Common Shares
♦ Holders of subordinated debt rank above equity investors ♦ Equity investors only have a residual claim
9
Disney Bonds
10
Disney Bond
11
High-Yield Ford Bond
12
Ford Bond
13
Why do people issue equity? Funding M&A / major expansion
Need cash to pay down debt Selling stakes in companies they own (privatisation) Giving a subsidiary autonomy Exit from a financial or strategic investment 14
Initial Public Offering (IPO)
15
Initial Public Offering (IPO)
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Equity issuance
IPO
Equity-linked
Follow-on (Marketed)
Block / Accelerated trades
17
Tesco - Case Study
Case Study - TESCO ♦ Largest retailer in the UK ♦ More than 30% market share UK
Source: Reuter’s 26/07/2006 19
TESCO
20
TESCO Strategy
21
UK Business
22
Market Rewards Performance
23
TESCO Shares are a Popular Investment
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Lend £ to TESCO?
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Debt Financing O n B a la n c e S h e e t D e b t M a t u r it ie s T h is in f o r m a t io n w a s c o r r e c t a s a t 2 6 t h F e b r u a r y 2 0 0 5
800
700
600
Millions (£)
500
400
300
200
100
eb F
eb
-3
-3
2
0
8 F
F
eb
-2 F
eb
-2 eb F
-2
6
4
2 -2 eb F
F
eb
-2
-1 F
eb
-1 eb
0
8
6
4 F
F
eb
eb
-1
-1
2
0 F
F
eb
-1
-0 eb F
F
eb
-0
8
6
0
Y e a r to F e b ru a ry D e b t M a tu r i n g i n Y e a r
C ash
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TESCO’s Credit Rating
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Investors - Funds
The theory behind WHAT THE THEORY SAYS
WHAT THE ASSET MANAGER ADDS
♦ Capital asset pricing theory
♦ What is the market
♦ The optimal portfolio is part risk free asset and part market portfolio
♦ Who creates the market portfolio
♦ The proportions depend on how risk averse you are
♦ Should incorporate superior information ♦ Harvesting the asset premium is good ♦ Adding superior market information is better ♦ The two words: Beta & Alpha ♦ The quant adds: Tracking Error
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What is Equity Risk?
30
Diversification – How to earn an asset premium ♦ The higher the number of different stocks in the portfolio, the more companyspecific risks are eliminated
Risk
Market- AND company-specific risk of the portfolio Companyspecific risk Market Risk Number of Stocks Owned 31
The FTSE 100 Index
32
Diversification
Diversification works better in quiet times
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SECTION 4
The Fund Industry
You are an investor ♦ With 100m to invest ♦ What will you buy?
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Some Possibilities ♦ Deposit the money with the Government ♦ Deposit the money with a bank ♦ Buy Government bonds ♦ Buy commercial paper ♦ Buy corporate bonds ♦ Lend money to one company ♦ Buy equities ♦ Buy private equity ♦ Build your own wind turbine in Scotland ♦ Buy 100m lottery tickets
36
Some Fund types ♦ Money-market funds
♦ Pension Funds
♦ Government bond funds
♦ Life funds
♦ Corporate bond funds
♦ Hedge funds
♦ High yield bond funds ♦ Emerging market bond funds ♦ Index tracking equity funds ♦ Small-cap equity funds ♦ Equity ‘growth’ funds ♦ Private equity funds
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Spoilt for Choice
38
Many Alternatives
39
Funds ♦ Collect assets together – economies of scale ♦ Have performance objectives – Benchmarks or Absolute – Risk – Return
♦ Are sold to various clients – Retail funds – to individuals – Institutional funds - to pension funds, endowments – Hedge Funds – typically to institutions and HNW individuals
40
Investment Funds ♦ Open ended collective investments ♦ Investors participate by buying shares in the funds ♦ US - Mutual Funds ♦ UK – OEICs & Unit Trusts – subject to the same regulation – OEIC is more flexible and simplified alternative – OEIC has 'Umbrella' fund structure – many 'sub-funds' with different investment objectives. – Easier to move between different OEICs in the same management group
41
Investment Funds ♦ Traditional Funds are organised around styles: – sectors – growth – value – large, small, mid cap
♦ Traditional funds have: – benchmarks – economies of scale
♦ Traditional Funds – try to minimise fees and costs to stay competitive
♦ Are easily accessible and mostly open to new investors
42
Case Study: UBS (Lux) Equity Fund ♦ Investment objective – Achieve high growth and adequate earnings – Due considerations to capital security and liquidity of assets – Minimum investment in equities: 70%
♦ Fund type:open-end investment fund ♦ Domicile of fund:Luxembourg – Portfolio management:UBS Asset Management – Management Company:UBS Equity Fund Management Company S.A. – Custodian bank:UBS (Luxembourg)S.A.
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Example UBS (Lux) Equity Fund - Legal ♦ Entire assets of each subfund are undivided property of all investors in subfund – Equal rights in proportion of units hold
♦ Fund assets are separate from the assets of the Management Company. ♦ Assets of subfund can only be used to offset liabilities of subfund ♦ Assets are managed by the Management Company in the interest and for the account of the unitholders.
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UBS (Lux) Equity Fund – EURO STOXX 50 ♦ Benchmark: STOXX 50 ♦ Fund weightings not necessarily identical with benchmark
♦ Fund’s assets (Dec 04) – EUR 1,270,360,000
♦ Weightings determined by – Strategic orientation – Market position – Quality of Management – Soundness of earnings – Growth potential – Shareholder value potential
♦ Dividends reinvested ♦ All-in fee: 1.2% p.a.
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UBS (Lux) Equity Fund - the structure ♦ Management Company – management of the Fund – issue and redeem of units
♦ Portfolio management
♦ Administrative agent – UBS Fund Services (Luxembourg) S.A., Luxembourg – general administrative duties
– UBS AG, UBS Global Asset Management
– calculation of the net asset value per unit
– Portfolio Advice
– Fund’s accounts
♦ Custodian Bank and main paying agent – holds all the liquid assets and securities – performs all customary banking duties – routine administrative work in connection with the Fund’s assets
– Reporting
♦ Sales agencies – UBS (Luxembourg) S.A and other sales agencies in various countries
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The Structure UBS (LUX) EQUITY Fund Subfund
Service
Subfund
Subfund
Service
Subfund Subfund Subfund Subfund
Money
Service
Fund Manager Money
Custodian Bank
Administrative Agent
Portfolio Management
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Performance Measures – the numbers
48
Performance Measures – the pictures
49
Mutual Funds & Banks – the services ♦ research – equity research – quantitative research – credit research – strategy – economic research
♦ advice – portfolio advice – execution advice – risk management advice
♦ market-making & execution ♦ financing – especially leveraged funds services
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How do we make money? ♦ How we make money – Commissions on trades – Income from trading volumes (bid / offer) – Fees for operational services – Fees for advice
♦ Broker review process: – Institutional investors measure the services that are provided – research – execution – added services – voting process to assign commissions – fund managers / traders / research analysts have votes – commissions allocated accordingly
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Hedge Funds
Why hedge funds are in vogue …
Source: UBS AIS Report (J. Johansen, July 2004) 53
European hedge fund industry ♦ 298 hedge fund managers domiciled in Europe (Dec’ 03) ♦ Managing around US$125 billion – around 15% of the global assets under management of US$817 billion.
♦ Growth rate of the European hedge fund industry between 1995 and 2002 was around 50% (but from a very low base) ♦ United Kingdom is the dominant location – Market share of around 73% based on assets under management – Market share of around 62% based on number of managers.
♦ Strategies related to equities are dominant – European long/short equity had a market share of 36% based on managers and 30% based on assets under management.
♦ The median manager in Europe has a 1.5% management fee and a 20% performance fee. ♦ Europe’s market share in fund of funds land is around 40%
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Hedge funds and traditional funds ♦ Traditional Funds are organised around styles:
♦ Hedge Funds are organised around strategies:
– sectors
– convertible arbitrage
– growth
– equity long/short
– value
– equity market neutral
– large, small, mid cap
– event driven – relative value – global macro
♦ Traditional funds have:
♦ Hedge Funds
– benchmarks
– try to achieve absolute not relative returns
– economies of scale
– have dis-economies of scale
♦ Hedge Funds ♦ Traditional Funds – try to minimise fees and costs to stay competitive
♦ Are easily accessible and mostly open to new investors
– charge aggressive fees - although their ability to do this may diminish
♦ Hard to get information – close quickly
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Long Google / short Yahoo ♦ Google has just gone public
♦ Systematic versus company specific risk
♦ You like Google and you think that Google should do better than Yahoo
Market Exposure
Leverage 0
♦ Buying Google shares? – You are exposed to the overall market performance
♦ Why not just buy the difference between Google & Yahoo ♦ Buy Google & Sell Yahoo
3
0% 1
2
75%
25% 25% 50%
♦ Returns will be correlated to the market only because of the “non-hedged” exposure ♦ Likely to under-perform in strong bull markets
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Long / Short Equity Historical Returns 94 – 04 Market Exposure 0% 75%
25% 25% 50%
Long Short
Source: CSFB/Tremont Advisers
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Comparison to traditional strategies Traditional Fund Return Characteristics
♦ Relative to benchmark
♦ Absolute, positive returns ♦
(exploit investment opportunity) Return volatility dictated by manager’s approach to risk
♦ Market risk ♦ Credit risk
♦ ♦ ♦ ♦
Liquidity risk Mark to market risk Change of strategy risk Human risk
Transparency
♦ High
♦ Low
Regulation
♦ High
♦ Low
Performance Driver
♦ Market performance ♦ Asset allocation decision
♦ Sustainable investment skills ♦ Sound risk management
Fee Structure
♦ Management Fee < 1%
♦ Management Fee (1-2%) ♦ Incentive Fee (10-25%)
♦ Risk Attributes
(capture asset class premium) Return volatility tracks market volatility
Hedge Fund
58
Hedge Fund industry – Not only equity
8%
6%
3%
8%
8%
3 8%
10% 19 %
Lon g / Short Equity
Eve n t Drive n
G loba l Ma cro
Con ve rtible A rbitra g e
Equity Ma rk e t Ne utra l
Fixe d In com e A rbiutra g e
Ma n a g e d Future s
Othe rs
Composition in 2002
Source: TASS Research 59
Case Study: Man Multi-Strategy Fund
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What do they do and why?
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Investment Allocation
62
Performance
63
Banks & Hedge Funds - Prime Brokerage ♦ All services an in-house trader would receive including: – stock loan – financing – leverage – clearing – balance sheet / position management – reporting
♦ Funds select Prime Brokerage based on following priorities – service and responsiveness – securities lending capabilities – financing / leverage – systems / product sophistication – cross margining
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Equity Financing - Short Selling Example ♦ Suppose a hedge fund sells short to the market 10,000 shares of IBM at US$85 ♦ To cover, he borrows from AFund
Trade date
Security Borrowing & Lending Collateral
Hedge Fund
AFund 10,000 IBM
Short sale
10,000 IBM
US$850,000
Market 65
Closing Trade ♦ Suppose we close the position 1 week later. ♦ The new IBM price is US$84.50
Security Borrowing & Lending
1 week later
Collateral
Hedge Fund
AFund 10,000 IBM + Fee
Close short
10,000 IBM
US$845,000
Market 66
Equity & Equity Indices Financial Markets Education
Types of Products Same Issuer as Underlying Shares
Third Party Issuer
♦ Shares
♦ Investment Funds
♦ Depository Receipt
♦ Indexes
♦ Preferred Shares
♦ Futures / Forwards
♦ Convertible Bonds
♦ Equity (Asset) Swaps
♦ Warrants
♦ Exchange Traded Funds ♦ Options ♦ Exchangeables ♦ Equity-Linked Notes
1
Shares ♦ Trading: Exchange (or Listed) vs. OTC ♦ Voting Rights – May have multiple votes, one vote, no votes
♦ May pay dividends, may not pay dividends – Many stocks generate this sort of income – Amount often not strongly correlated with earnings
♦ May be on the whole enterprise or part ♦ May have ownership restrictions – Registered vs Bearer – Foreign Ownership – Qualified Ownership
Div Div Div Div Div Div Div Div Div Div
– Short Sales Price 2
Share Characteristics ♦ Assets have costs and benefits associated with them. ♦ Assets have risk associated with them ♦ Characteristics of an asset – Price (Market Value) – Income (Dividend, Coupon) – Non-financial benefits (voting rights) – Risk (Price Risk)
Price
Voting Rights
Dividend Benefits
Economic Exposure
Price Risk
3
Being long and being short Trader starts with no position, and:
♦ Has a position which:
♦ Has a position which:
♦ makes money when share price goes up
♦ loses money when share price goes up
♦ loses money when share price goes down
♦ makes money when share price goes down
0
LONG share price
Value of position
♦ Sells 1000 shares
Value of position
♦ Buys 1000 shares
0
SHORT share price
4
Being long and being short – financing position Trader starts with no position, and: ♦ Buys 1000 shares
♦ Sells 1000 shares
♦ Trader needs to
♦ Trader needs to
– borrow money
– borrow shares
– (and could lend the shares out)
– (and could lend the money out)
♦ Will receive dividends
♦ Will pay dividends
5
Tesco benefits – Dividend History
Source: Bloomberg 6
TESCO - description
7
Preferred Shares ♦ Fixed dividend (like a coupon), usually no voting rights ♦ May have a redemption date and price ♦ Hybrid of shares and bonds ♦ Rank above common shares, but below all other forms of debt, therefore yield is better than straight debt ♦ If cumulative, then any dividend arrearage must be settled before common shares can earn a dividend ♦ Trade like bonds; prices usually don’t move with stock ♦ Terms vary, may be listed on different exchange from the common shares; usually thinly traded
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Stock Exchange ♦ Organisation that provides a marketplace to trade stocks ♦ Sets rules to ensure that market operates efficiently and fairly ♦ Only the exchange members can directly trade on the exchange ♦ General public needs to place the order with an exchange member ♦ To be accepted for trading on an exchange a security has to meet certain listing requirements ♦ To be listed on the NYSE a company must have – issued at least a million shares of stock worth $100 million – earned more than $10 million over the last three years
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NYSE: We Are There
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London Stock Exchange listing requirements ♦ Three-year record of accounts ♦ Independent revenue earning business ♦ The directors and senior management must have collectively appropriate expertise and experience ♦ Directors must be free of conflict between duties to the company and private interests and other duties. ♦ If there is a 30% or more shareholder, the company must be capable of operating and making independent decisions ♦ Sufficient working capital for at least the next 12 months ♦ Minimum 25% in public hands
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Exchange Clearing Mechanism Client A wants to buy
Exchange Member (Bank A)
Exchange matches orders
Exchange Member (Bank B)
Client B wants to sell
♦ standardised (price is the only variable) ♦ liquid (easy to close position and hedge) ♦ transparent ♦ no Credit Risk (clearing)
13
Over The Counter (OTC) Bank A Client needs a specific product
– Client negotiates the price and the other characteristics of a product with a bank directly – Might involve brokers
Bank B
♦ tailor made ♦ often no secondary market (more difficult to close position) ♦ no transparency ♦ credit risk
14
Depositary Receipt ♦ Relate to single equities ♦ Depositary Receipts (‘DRs’) are re-packaged equities ♦ DRs convert foreign equities into products which are readily available to investors in terms of trading and settlement. ♦ Approximate linear exposure to the underlying equity. ♦ DRs are legally transferable products
15
US Invests in Europe Through ADRs
Source: Bank of New York
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BASF ADR
Source: Bank of New York
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TESCO: A Good Investment Anywhere!
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SECTION 3
World Indices
Indexes ♦ Was the market up or down yesterday? ♦ Reflect the value of a “basket” of stocks ♦ Calculation – capitalisation weighted, price weighted – usually not dividend adjusted
♦ Can you buy a “cash” FTSE 100 instrument? ♦ Index Types: sector, wide market, global ♦ Related Investments – Futures, Forwards, Options, Equity Linked Notes, Tracking Baskets, . . .
20
World Equity Indices
21
P/E of World Equity Indices
22
They all seem to be similar but … ♦ Nikkei 225 – Index for the Tokyo stock market – 225 Stocks in Index
– Price-weighted index – Price change of a small company has same effect as a price change of a large company – Index includes many old-line manufacturing firms, which are less important for the economy than they used to be. Name % Weight – Record high of 38,915 (Dec 29 1989)
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
Advantest Corp TDK Corp Kyocera Corp Fanuc Ltd Tokyo Electron Ltd Honda Motor Co Ltd Canon Inc KDDI Corp Takeda Pharmaceutical Co Ltd Softbank Corp CSK Corp Trend Micro Inc Shin-Etsu Chemical Co Ltd Toyota Motor Corp Secom Co Ltd
in the Index 3.156 2.72 2.72 2.522 2.182 2.006 1.962 1.915 1.794 1.79 1.713 1.71 1.497 1.486 1.486 23
Dow Jones industrial average ♦ Most widely recognised index ♦ Started with 12 stocks in 1896 (GE only survivor) ♦ Price-weighted index
♦ Does not truly represent US market – Only 30 companies – Price weighted
♦ ETF that tracks DJ: Dow Diamonds
– Stocks with high prices have bigger weighting
♦ 30 largest publicly traded companies in US – Low diversification
♦ Only industrial companies (no transport and utility stocks) ♦ Included Microsoft and Intel in 1999
Name
% Weight Last Price in the Index United Technologies Corp 7.004 100.02 International Business Machines Corp 6.573 93.86 Caterpillar Inc 6.311 90.12 3M Co 5.888 84.08 American International Group Inc 4.674 66.74 Johnson & Johnson 4.581 65.42 Altria Group Inc 4.476 63.91 American Express Co 3.974 56.75 Exxon Mobil Corp 3.73 53.27 Procter & Gamble Co 3.702 52.87
24
S&P500 Index ♦ 500 leading US companies from different sectors ♦ Diverse index
♦ Tracked by many funds – Most liquid ETF: S&P SPDRs – Known as Spyder (Spider)
♦ 70% of total market cap of all US stocks ♦ Capitalisation weighted ♦ Only large cap stock in Index ♦ Only profitable stocks in index ♦ Started in 1923 with 233 stocks
Name 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
General Electric Co Exxon Mobil Corp Microsoft Corp Citigroup Inc Wal-Mart Stores Inc Johnson & Johnson Bank of America Corp Pfizer Inc American International Group Inc International Business Machines Corp Intel Corp Procter & Gamble Co JPMorgan Chase & Co Altria Group Inc Cisco Systems Inc
% Weight in the Index 3.461 3.101 2.589 2.317 2.01 1.752 1.701 1.621 1.569 1.41 1.291 1.21 1.205 1.184 1.077
25
Nasdaq ♦ National Association of Securities Dealers Automated Quotations ♦ World largest electronic stock market ♦ Created in 1971 to provide better market for OTC stocks ♦ Stocks listed stocks on NYSE – Larger, older – More established – Floor traded
♦ Stocks listed on Nasdaq tend to be – Smaller, newer – Often technology – More volatile – Electronically traded
26
Nasdaq Indices ♦ Nasdaq Composite Index – 4,000 stocks traded on Nasdaq (about every stock traded on the exchange)
♦ Nasdaq 100 Index – 100 largest stock in Nasdaq
– Market Cap weighted
– Modified market weightings to prevent largest caps from being too dominant
– About 65% technology
– No stock more than 24% of index
– Top 10 stocks about 30% of Index
– Top 10 stocks about 40% of index
– Often cited in Financial press
– Heavily weighted towards technology
– Not that actively traded
– Very volatile
– ETF: Fidelity Nasdaq Composite Index Fund
– Very actively traded – ETF: Nasdaq 100 Trust
– Symbol QQQ
27
Nasdaq Index Composition ♦ Nasdaq Composite
Name
Name 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
% Weight in the Index Microsoft Corp 9.247 Intel Corp 4.615 Cisco Systems Inc 3.85 Dell Inc 3.335 Amgen Inc 2.561 Oracle Corp 2.258 Qualcomm Inc 1.947 eBay Inc 1.666 Yahoo! Inc 1.541 Comcast Corp 1.385 Nextel Communications Inc 1.026 Apple Computer Inc 1.005 Applied Materials Inc 0.898 Comcast Corp 0.856 Fifth Third Bancorp 0.85 Costco Wholesale Corp 0.71 Starbucks Corp 0.698 Biogen Idec Inc 0.696 Electronic Arts Inc 0.641 Amazon.Com Inc 0.559
♦ Nasdaq 100
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
Microsoft Corp Qualcomm Inc Intel Corp Apple Computer Inc Cisco Systems Inc Nextel Communications Inc eBay Inc Dell Inc Amgen Inc Comcast Corp Starbucks Corp Oracle Corp Yahoo! Inc Biogen Idec Inc Electronic Arts Inc Genzyme Corp Maxim Integrated Products Inc IAC/InterActiveCorp Symantec Corp Bed Bath & Beyond Inc
% Weight in the Index 7.797 5.696 3.971 3.456 3.394 3.229 3.016 3.002 2.92 2.392 2.37 2.306 1.879 1.857 1.588 1.43 1.415 1.364 1.363 1.299
28
Nasdaq Composite versus Nasdaq 100 - Volatility
29
Nasdaq Composite versus Nasdaq 100 - Level
30
DAX & CAC40 ♦ Deutscher Aktien Index – DAX
♦ CAC40
– Performance based Index
– Tracks stocks on Paris Bourse – 40 largest & most liquid stocks
– Dividends etc. reinvested – Benchmark for Shares traded on the Frankfurt stock Exchange – 30 stocks in Index (largest and most liquid) – Capitalisation weighted
– Float-weighted index
– Only public outstanding shares are counted – Started in 1987 with a base of 1000
– Started in 1984 (base 1000) Name 1 2 3 4 5 6 7 8 9 10
Siemens AG E.ON AG Deutsche Telekom AG Deutsche Bank AG Allianz AG DaimlerChrysler AG BASF AG SAP AG RWE AG Bayer AG
% Weight in the Index 11.214 10.363 9.271 7.766 6.933 6.448 6.235 5.112 4.349 3.872
Name 1 2 3 4 5 6 7 8 9 10
Total SA Sanofi-Aventis BNP Paribas France Telecom SA Societe Generale AXA SA Vivendi Universal SA Carrefour SA Suez SA L'Oreal SA
% Weight in the Index 13.734 9.617 7.02 5.387 5.141 4.277 3.962 3.509 3.099 2.919
31
DJ STOXX 50 ♦ Dow Jones STOXX indices – Index family that represents the price development of European shares – market capitalization of the free float of the company – calculated as price & performance indices. – The shares on which the indices are based are converted into euros or dollars
♦ Dow Jones STOXX 50 – Capitalisation weighted index of 50 European blue chips stocks
♦ Dow Jones Euro STOXX 50 – Capitalisation weighted index of 50 European blue chips stocks in the euro area
32
DJ STOXX 50 ♦ DJ STOXX 50 Name
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
% Weight in the Index BP PLC 6.629 HSBC Holdings PLC 5.541 Vodafone Group PLC 5.077 GlaxoSmithKline PLC 3.944 Total SA 3.927 Royal Dutch Petroleum Co 3.761 Novartis AG 3.636 Nestle SA 3.226 Royal Bank of Scotland Group Plc 3.168 Shell Transport & Trading Co PLC 2.617 UBS AG 2.608 Telefonica SA 2.417 Banco Santander Central Hispano SA 2.244 Nokia OYJ 2.194 Barclays PLC 2.174 Roche Holding AG 2.17 Siemens AG 2.007 HBOS PLC 1.902 E.ON AG 1.881 ENI SpA 1.877
♦ DJ Euro STOXX 50 Name 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
Total SA Royal Dutch Petroleum Co Telefonica SA Banco Santander Central Hispano SA Sanofi-Aventis Nokia OYJ Siemens AG E.ON AG ENI SpA BNP Paribas Banco Bilbao Vizcaya Argentaria SA ING Groep NV Deutsche Telekom AG Deutsche Bank AG ABN AMRO Holding NV France Telecom SA Societe Generale Allianz AG DaimlerChrysler AG Unilever NV
% Weight in the Index 6.365 6.097 3.918 3.633 3.593 3.562 3.253 3.05 3.041 2.959 2.829 2.762 2.729 2.284 2.266 2.203 2.186 2.041 1.897 1.88
33
How do you “buy” an index ? ♦ Tracking baskets ♦ Funds ♦ ETFs ♦ Index linked Notes ♦ Futures ♦ Options ...
Shares Price discovery Exchange traded Expiry (Settlem ent) Short Sale Dividend
Continuous YES NO YES YES
Investm ent . Fund OEIC Once a day NO NO NO YES
ETF Continuous YES NO YES YES
Index linked Note Continuous Some YES (Cash) NO NO
Futures Continuous YES YES (Cash) YES NO
34
Equity Portfolios ♦ Index Tracking Mutual Funds – “track” publicly traded market index – High degree of correlation or exact replication – Low management fees (under 20 bp per year)
♦ Exchange Traded Funds – Portfolio of shares – Buyer of the fund is the beneficial owner of the shares – Trade continuously during the day – For many investors they are tax advantaged since they do not distribute capital gains – Replicate or track an index – Market Index – Sector Index – Country Index (priced in home currency) – Style Index
35
Exchange Traded Funds (ETFs) ♦ Like Open-Ended Mutual Funds, but trade intra-day ♦ Combines advantages of index funds with advantages of listed shares ♦ Liquidity is “big” – (QQQs have traded over $5.3 billion in a day)
♦ Buy / sell any time during trading day ♦ Can be sold short ♦ Sector ETFs on the rise
36
SPDRs
37
Why? ♦ Entire index in one security ♦ Low maintenance fees and expenses ♦ Tax efficient ♦ Dividends ♦ All day trading ♦ Buy on margin ♦ Sell short
38
What is a Spider?
39
More on Spider
40
Even more on Spider
41
QQQQ
42
“Primary” and Secondary Market ETF Fund Company
Buy / Sell
Investor A
Market Maker
Lend
Borrow
Buy / Sell
ETF Buy / Sell
Share B Share A Share C
Investor B
43
SECTION 4
Equity Derivatives
Futures ♦ Exchange traded contract to buy or sell an asset or collection of assets at a future date at a price agreed upon today ♦ Futures can be written on shares and indexes ♦ In the US, single name stock futures are “new” ♦ Settlement may be physical or cash ♦ Forwards are the OTC analogue
45
Derivative - Future versus Spot
0
Value of a future
Value of a share
♦ A Future has a risk profile which is very similar to that of the underlying
share price today
Price Risk
share price
0
share price
Price Risk
Capital
46
Why futures? ♦ Economic Rationale
♦ Practical considerations
♦ Equivalent economic exposure to underlying
♦ Liquidity – often more liquid than the underlying
♦ Asset allocation / rebalancing made easy
♦ Transaction costs – trade the entire index with one bid/offer, low commissions
♦ Access to foreign markets ♦ Less exposure to currency than investment in the underlying
♦ Offset – trade out of position easily ♦ Cash settlement – no need to transact underlying shares ♦ Mark to market – realise daily P/L
47
What does this say?
48
Word Equity Futures
49
Equity swaps ♦ In a swap two parties agree to exchange cash flows from different investments. ♦ In the equity world generally one side pays an interest rate while the other pays a equity return. ♦ An equity swap is a contract between two counterparties to exchange the economic performance of one asset (e.g. cash) for the economic performance of another asset (e.g. equities).
USD LIBOR +/- spread
PARTY A
PARTY B Price Return of a Equity Index
50
Equity swap: Example ♦ Investor would like to have exposure to the S&P but can not invest directly. ♦ Investor asks the bank to invest $100 for them. ♦ Investor accepts both the potential gain and loss in the market. ♦ How much will that cost? ♦ The bank needs to borrow money to buy the stock and has to pay interest (LIBOR). ♦ Therefore, assuming there are no other costs, the cost of a swap will be my borrowing costs (LIBOR) plus my profit margin.
51
SECTION 5
Certificates
Certificates ♦ Redemption amount equal to spot price of underlying at maturity – One for one exposure – Tracks the performance of an asset or strategy
♦ Usually, no coupons are paid to holder ♦ Cost efficient way to execute investment strategy not easily achieved with traditional investments ♦ Wholesale and retail investor dealing sizes ♦ Certificates are usually cash settled – Cash settled at the price of the underlying on expiry – No stamp duty in UK, Switzerland, Germany
53
Certificates ♦ Fixed maturity or open ended – Fixed term usually 3-5 years – Issuer has the right to stipulate expiry of open-end certificates once a year
♦ Often listed on stock exchanges – Fast and transparent exposure to investment products – Simple execution similar to share dealing – Traded through stock broker – Liquid (market making is required by exchange) – Low cost, minimal bid/offer spread
♦ Also called – Tracker certificates – Benchmark certificates – Performance linked notes
54
Open-end Certificate on DAX Deutsche Börse: Certificate
Deutsche Börse: DAX
55
Diverse range of underlyings ♦ Country Index – DAX, CAC40, FTSE, S&P500, Nasdaq,…
♦ Multinational Index PERLES – DJ Euro Stoxx 50, DJ GlobalTitans, …
♦ Sector Certificates – DJ Stoxx sectors, FTSE Global sectors, … – Biotech basket, fuel cell basket, data highway basket, EU enlargement basket
♦ Pre-determined investment strategy – Issuer acts as calculation agent – Clear investment policy, non manager reliant – Growth, Value, PEG – Long/short
56
Diverse investment strategies “The Euro PEG 20 Certificate has a clearly defined and disciplined investment strategy… Every quarter, 20 companies with the lowest Price-Earnings-to-growth (PEG-ratio) from DJ STOXX Index are selected.”
DJ Islamic Market Titans 100 Index Open End Certificate “The Dow Jones Islamic Market Indexes were created for people who wish to invest according to Islamic investment guidelines. The indexes track Shari`ah compliant stocks from around the world, providing Islamic investors with comprehensive tools based on a truly global investing perspective.”
Open End Certificate on FTSE4GOOD EUR 50 “The FTSE4Good Europe 50 is a price-index for socially responsible investment. The criteria for the relevant selection are the environmental sustainability, social issues and human rights. The FTSE4Good Europe 50 Index is designed with the support of UNICEF, the United Nations Childrens’s Fund, and uses data provided by EIRIS, the Ethical Investment Research Service. Index Reviews occur on a semi-annually basis in March and September.”
57
Selling an Index “short” - UBS Shorty ♦ Similar to short SMI future – Fixed notional – Leverage about 5.5 at issuance
♦ Speculate on a decline in the index ♦ Add to a portfolio to effective way to hedge against market weakness
– Easy and transparent
“Initial Margin” “Trade is closed when this level is reached”
Short Term: No asset premium to collect
58
SECTION 6
Equity Options
Derivative - Calls versus Puts ♦ Calls and puts represent different aspects of the price risk – Options allow us to separately trade the upside and downside risk
OTM Call, ITM Put Long Call “good risk”
Share price today
Value
Value
ATM Options
Share price today
0 strike price
0 Strike price
Short Put “bad risk”
Short Put
Long Call
Price Risk 60
Options ♦ Call
♦ Put
♦ A buyer’s option
♦ A seller’s option
♦ Right to buy
♦ Right to sell
♦ An underlying (DAX, VOD, FTSE)
♦ An underlying
♦ at a fixed price
♦ at a fixed price
(4500, 100 , 5000)
♦ on (European)
♦ on (European)
♦ or before (American)
♦ or before (American)
♦ fixed time (19/12/07)
♦ fixed time
61
Why Options? ♦ Economic Rationale
♦ Common uses:
♦ Price and Transfer risk
♦ Owner of IBM shares:
♦ Price mainly determined by the risk of the underlying ♦ Options are “naturally” leveraged ♦ Price = small % of underlying ♦ Speculators like leverage ♦ Investors can use it to reduce risk
– Sells call options and / or – Buys put options
♦ Investor – Buys Calls or Puts – Benefits from increase ordecrease in share price – Limited loss
62
Example ♦ IBM = USD95 ♦ Investor owns shares – Sells 3 month 100 Call for USD3 – If IBM trades above 100 in 3 months investor has earned 8% return for 3 months
♦ Or ♦ Investor owns shares – Has a profit since they were bought at 80 – Buys the 3 month 90 Put for USD2 – Locks in 10% gain (90 – 80 – 2 = 8 = 10% of 80) – Allows the investor to “stay long”
63
Options – They’re a BIG Business!
64
Summary ♦ From the issuer’s point of view equity is a way to finance the company’s operations and assets ♦ From the investor’s point of view equity is a way to earn a return from the success of a company’s business ♦ Theory says that only market risk is rewarded so investors should diversify their equity investments ♦ The financial markets provide many ways for investors to “get long” or short and to target exactly the risk they are willing to take on
65
Fixed Income Markets Introduction to Financial Markets
SECTION 1
Bonds
Bonds are securities ♦ They are (like) pieces of paper, – which represent money that has been borrowed by the issuer
♦ Whilst the issuer may raise $500m – an investor may buy $100,000 of the bond.
♦ This is one distinction between bonds and loans – bonds are divided up into smaller, more liquid, pieces
2
Bond Markets ♦ Issuance – primary market – CP / ECP – MTNs / EMTNs – Eurobonds – Global Bonds – High Yield – Emerging Market
♦ Secondary trading – Providing liquidity – Credit analysis and research – Providing indices
3
EuroSterling Bonds
4
Bond Characteristics ♦ Issue Size ♦ Currency of issue (may not be the same as the issuer’s home currency) ♦ Maturity ♦ Coupon Rate ♦ Coupon Frequency
♦ Price versus Face Amount – represented as a price or as a yield
5
5
01/07/2004
5
01/07/2005
100 5
01/07/2006
01/07/2006
Bonds ♦ Just a series of cash flows over time
6
Tesco - securities
7
Tesco - bonds
8
Tesco - bond
9
Why invest? ♦ Why would an investor buy these bonds rather than the comparable Gilt? ♦ What are they getting? ♦ What risks are they taking?
10
Bond Price and Yield ♦ The bond’s price is the price of a fixed set of a future cashflows ♦ How can you compare 2 bond investments? ♦ Is it better to pay 100 or 107 per cent of face?
11
Two Bonds – same borrower ♦ BOND A
♦ BOND B
♦ 3 year maturity
♦ 3 year maturity
♦ Price = 107
♦ Price = 100
Which one is the better investment?
12
Two Bonds – same borrower ♦ BOND A
♦ BOND B
♦ 3 year maturity
♦ 3 year maturity
♦ Price = 107
♦ Price = 100
♦ Coupon = 7.25%
♦ Coupon = 4.00%
13
Two Bonds – same borrower ♦ BOND A
♦ BOND B
♦ 3 year maturity
♦ 3 year maturity
♦ Price = 107
♦ Price = 100
♦ Coupon = 7.25%
♦ Coupon = 4.00%
♦ Yield = 4.5%
♦ Yield = 4.0%
14
SECTION 2
Government Bonds - for comparison
UK Gilt
16
Gilt price performance
17
Gilt yield
18
The yield curve: 3 year yield has hardly moved!
19
World Bond Mkts
20
US Govt bonds ♦ From June 2004:
21
World Bond Curves
22
Quality of issuer/borrower ♦ Who would you be more comfortable lending £1,000 to; UBS AG or me? ♦ How would you make it clear to me you felt this way? ♦ How about UBS AG vs UK Treasury? ♦ Rates market can be segmented: – LIBOR (London InterBank Offer Rate) / EURIBOR – deposits – futures – swaps – Government – T-bills – Treasury bonds/notes – Credit – Tesco – UBS AG – etc 23
Ratings S&P Moody's AAA Aaa AA+ Aa1 AA Aa2 AAAa3 A+ A1 Investment A A2 Grade AA3 BBB+ Baa1 BBB Baa2 BBBBaa3 ============================= BB+ Ba1 BB Ba2 Non BBBa3 Investment B+ B1 Grade B B2 BB3 24
SECTION 3
Back to Tesco Bonds
Tesco bond price
26
Tesco bond yield
27
Tesco bond spread
28
Forecasting performance ♦ If you want to forecast how an investment in these Tesco bonds will perform (over the next 1 year, say), what factors would you be thinking about?
29
Related Fixed Income Markets ♦ Deposits – Cash deposits – Deposit cash vs bond collateral (repo market)
♦ Futures (& options) – on deposit rates – on bond prices
♦ Interest rate swaps ♦ Credit derivatives – Credit default swaps
30
SECTION 4
Interest Rates
The Money Market ♦ Market for short-dated money – Money (short term) rather than capital (tends to be longer term) – Sometimes called STIR: short term interest rates
♦ Deposits – LIBOR
♦ Commercial paper often included ♦ Plus – FRAs – Short term interest rate futures – FX swaps
32
Types of interest rates
33
Time horizon and currencies ♦ If you believed interest rates are likely to rise would you charge the same interest rate to a 1-year borrower and a 2-year borrower? ♦ What if rates are ‘likely’ to fall? ♦ Different countries have very different borrowing costs in their own currency: – JPY (¥) – USD ($) – MXN
34
Deposit rates ♦client site
35
Deposit Index Rates ♦ LIBOR - London Inter-Bank offered rate – index of deposit rates polled from 16 London based international banks at 11am (London time) each day – remove top 4 and bottom 4 and average the remaining 8 – published for maturities up to 1year – used for USD, GBP, JPY, CHF
♦ For Euros – tend to use Euribor - Euro Interbank Offered Rate – about 50 prime banks polled for their rate for euro interbank term deposits within the euro zone – Also there is Eonia (Euro OverNight Index Average) which is an effective overnight rate computed as a weighted average of all overnight unsecured lending transactions in the interbank market
36
SECTION 5
Interest Rates Swaps
What are swaps? ♦ OTC agreements – not securities
♦ Interest Rate swap – agreement to exchange: – a series of cashflows based on a fixed interest rate for – a series of cashflows based on a periodically adjusting (floating) deposit market interest rate
38
What is an interest rate swap?
LIBOR1
1
LIBOR2
2
LIBOR3 LIBOR4
3
4
LIBOR5
5
Fixed rate – SWAP rate
♦ Exchange of cashflows ♦ Fixed rate (the swap rate) for floating rate (LIBOR deposit rates) ♦ LIBOR is known at the beginning of each period, and paid at the end.
39
But why?
40
Some interest rate swap terminology ♦ Swap rate (price) ♦ Paying and receiving (not buying and selling) ♦ Effective date ♦ Maturity date ♦ Notional ♦ Tenor
41
Hedging debt issuance - liability swap ♦ XYZ Corp (due to name recognition) can issue a five year fixed coupon 9% bond, but it wants floating debt ♦ In the Floating Rate market, XYZ can fund at LIBOR + 0.50% ♦ Swap Market: 8.52-8.54 ♦ Issue the bond and receive on the swap ♦ Cost of Floating Funding = LIBOR + 48
8.52% Bond
9%
Swap
XYZ LIBOR
42
Liability swap Issue fixed rate bond (borrow at fixed rates) and Receive fixed on swap has cashflows that look like Issuing a floating rate note (borrow at variable rates)
43
SECTION 6
Credit Derivatives
Credit Derivatives ♦ Contracts based on credit exposure – exposure to borrowers not paying debts (interest / principal)
♦ Allow isolation and trading of credit risk between counterparties ♦ Allow trading of credit risk without trading the underlying assets (bonds and loans) which have those risks. ♦ Changes the nature of ‘credit risk management’ – becoming more ‘actively’ managed
♦ Like any derivatives, used for – hedging – taking exposure – yield enhancement
45
Global Credit Derivatives Market US $ bn
5000 4500 4000 3500 3000 2500 2000 1500 1000 500 0
1997
1998
1999
2000
2001
2002
2004
Source: BBA Credit Derivatives Report 2001/2002
46
Global Credit Derivatives Market—the products CLNs and Repacks 9% Synthetic Securitisations 26%
Basket default swaps 5% Source:
Asset swaps 12% Credit Spread options 3%
Credit Default Swaps 45%
Risk, February 2001
47
Credit Default Swaps ♦ Credit (Default) swaps - most common type of credit derivative ♦ OTC agreement ♦ One party buys credit protection from the other, on a particular entity, on a certain face amount, ♦ for a certain period – typically 1-10 years
♦ Premium paid quarterly (quoted in bps per annum) ♦ If a credit event occurs, – trade terminates – the protection seller will – buy deliverable obligation (bond or loan) at par
48
Credit Default swap Before default Periodic payment
Protection Buyer
Protection Seller Credit Protection
On default Periodic payment
Protection Buyer
Deliverable Obligation
Protection Seller
Par
49
Some CDS prices Cost in b.p. for protection:
50
Foreign Exchange Markets Financial Markets Education
What does drive the FX Market?
1
What does drive the FX Market?
2
FX market ticks differently ♦ Market participants who lack a profit motive – Central banks manage exchange rates through market intervention – Corporations hedge cash flows and earnings – Equity managers exchange currencies to fund foreign equity transactions – Tourists buy foreign exchange to travel
♦ Estimate of the proportion of market participants who are price-takers is 90% (Mercer Investment Consulting, 2004) ♦ Largest and most liquid market in the World – Average daily turnover is $1.9 trillion (BIS Triennial Survey 2004) – 15 times average daily turnover of Global Equity markets ($130 billion – World Federation of Exchanges, 2003) – 40 times the average daily turnover of the NYSE ($46 billion, NYSE 2004)
3
FX and Risk Premium ♦ Underlying asset class expected to yield “good returns” – Pays coupon or dividend – Long term positive return (positive risk premium) – Is a strategic investment – Being long is generally good
♦ Investors are in general willing to take risk because they expect positive return (risk premium) ♦ Many investors do not have strong convictions about future currency movements – They do not expect a positive long term return on currency – No “safe” strategy in FX, long term trends unexpectedly reverse
♦ Currency often considered a “zero sum game” – Currency movements create additional risk which is not remunerated by a positive risk premium
4
Risk Premium 1000
Dividends not included
200 100
50
10 81
83
85
87 UKX
89 SPX
91
93 TPX
95
97
GBP
99 JPY
01
03
05
CHF
5
What is the “True Value” of a US Dollar ? ♦ What is the correct value of a US Dollar? ♦ What does it say on every piece of US currency, coin and note? ♦ Purchasing Power Parity
USD 3000 =
= CHF 3480
Law of One Price & Purchasing Power Parity (PPP) ♦ Law of one price – Price of identical goods are equal once converted into the same currency – Exchange rates ensure the “same price tag” on each good – The location of where a good is traded is irrelevant
♦ Purchasing Power Parity – the naïve form – Every investor consumes same basket of goods – Law of one price holds for all assets
7
Does Purchasing Power Parity hold? The Economist, Jun 9th 2005: “Economists lost some faith in PPP as a guide to exchange rates in the 1970s, after the world's currencies abandoned their anchors to the dollar. By the end of the decade, exchange rates seemed to be drifting without chart or compass. Later studies showed that a currency's purchasing power does assert itself over the long run. But it might take three to five years for a misaligned exchange rate to move even halfway back into line.”
8
Fast food and strong currencies The Economist, Jun 9th 2005: “Our index shows that burger prices can certainly fall out of line with each other. If he could keep the burgers fresh, an ingenious arbitrageur could buy Big Macs for the equivalent of $1.27 in China, whose yuan is the most undervalued currency in our table, and sell them for $5.05 in Switzerland, whose franc is the most overvalued currency. The impracticality of such a trade highlights some of the flaws in the PPP idea. Trade barriers, transport costs and differences in taxes drive a wedge between prices in different countries.”
9
The Big Mac Index – 2005
10
PPP & exchange rate ♦ If PPP holds between two countries then the exchange rate is determined by the rate of inflation in the two countries ♦ The growth rate of FORDOM is (inflationDOM – inflationFOR) ♦ If PPP holds and there is no inflation, then FX rates should not change ♦ IF PPP holds and inflation equals the risk-free rate the current FX forward will be the future FX spot
11
FX spot and PPP 180
♦ You have to be patient!
160
♦ You might have to wait some years
140 120 100 80 86
88
90
92 USDJPY
94
96
98
00
02
04
USDJPY assuming PPP
1.95 1.85 1.75 1.65 1.55 1.45 1.35 1.25 88
90
92
94
GBPUSD
96
98
00
02
04
GBPUSD assuming PPP 12
FX talk – Technical Analysis
13
Drivers of the Foreign Exchange Market ♦ Demand and Supply (the volume of cross-border trade is insufficient to account for the magnitude of foreign exchange transactions each year) ♦ Economics (Trade Flows, Current Account Deficits, Foreign Direct Investment,...) ♦ International Trade ♦ Global Investing ♦ Political News and Events ♦ Central Bank Involvement ♦ Hedge Funds ♦ Expectations ♦ Rumours (The Premature Demise of Alan Greenspan)
Overview of the Foreign Exchange Market ♦ Open and Active 24 hours ♦ Average Daily Volume estimated in excess of USD 1.5 Trillion 35.5 Billion daily average on the NYSE).
Major participants
Where (UBS)
What
Commercial Banks Central Banks Fund Managers Arbitrageurs HNW Individuals
(versus USD
Investment Banks Corporations Hedge Funds Speculators
Zurich, New York, Singapore
Spot, Forwards, Options
15
FX information News ♦ Fundamental ♦ Technical ♦ Dealing Floor Products ♦ Spot ♦ Forward ♦ Options
16
FX Products
Snapshot of FX market
18
What’s out there? ♦ Most important currencies - the MAJORS: USD
EUR
JPY
GBP
$
€
¥
£
CHF
19
Spot Exchange Rates ♦ A “Spot” Exchange Rate is simply the “current” price of one currency in terms of another currency ♦ In other product areas, they speak of “cash prices”, but that would be too confusing with foreign exchange
20
What is Spot “Dollar-Swiss” ♦ If someone says Dollar-Swiss, denoted USD|CHF, is 1.2190
This means the price of 1 _________ is 1.2190 _________ ♦ If someone says USD|CHF = 1.2190 it is interpreted as
USD 1 = CHF 1.2190
21
What is “Cable”? ♦ “Cable” refers to Sterling|Dollar (GBP|USD) ♦ If someone says GBP | USD is 1.8561
This means the price of 1 _________ is 1.8561 _________
♦ Sometimes USD is the asset (“Swissy”) ♦ Sometimes the price of the asset is quoted in USD (“Cable”) ♦ Which is the “American” Quote? ♦ Which is the “European” Quote?
22
Can really quote either way - reciprocity ♦ Typically the exchange rate between US Dollars and Swiss Francs is quoted in ‘European’ terms
USD|CHF = 1.2190 which means USD1 = CHF 1.2190 But can quote in ‘American’ terms: USD 0.8203 = CHF 1
♦ The quoting system is not applied on a consistent, universal basis ♦ In the InterBank market, USD | CHF is always quoted in European terms
23
Spot Quotes ♦ Everything in foreign exchange revolves around the “SPOT” quote ♦ Generally, a SPOT transaction refers to a two day forward trade (ie, it settles in two good business days in the future) ... except Canadian Dollar and Mexican Peso which, in North America, are (often) 1 day trades
24
The Typical Timing of Spot Trades
NOW
0
TOMORROW
1
SPOT
2
DAYS
25
Marketmaker Spot Quotes and Terminology The “figure” or “big figure” ♦ EUR|AUD:
1.6257 |1.6259 BID
“pips”
ASK/OFFER
♦ EUR|AUD:
1.62 57 | 59
The “handle”
26
Spot Quotes
USD | CHF = 1.2190
If USD | CHF changes to 1.2191 it has gone up one pip
♦ A “pip” is the smallest quoted unit of the spot price
27
Spot Quotes (continued)
USD | CHF = 1.2190
If USD | CHF rises to 1.2290 it is said to have risen by 1 “big figure”
28
Spot Quotes (continued) ♦ Most currencies are quoted to four decimal places (5 digits in total) USD|CHF = 1.2190 GBP|USD = 1.8561 ♦ But some currencies only look out two decimal places: (like the small ones vs. the Dollar - e.g., Yen) USD|JPY = 105.56
What is a “big figure” here? What is “the handle” here?
29
Market Jargon One Dollar, 3 Bucks Notation for 1 Million Two Yards of Yen
= One Million Dollars, Three Million Dollars = MM, Mio = Two Billion Yen
♦ Say in USD|CHF, quote = 1.1640-50 Yours, Mine
♦ If you (as a customer) buy Dollars , you would say “mine” (at 50)
♦ If you (as a market-taker) sell Dollars, you would say “yours”
♦ If you hear a broker’s market, 40-50, and Given, Paid
then hear given, it means someone just gave (sold) USD for (hit) the bid (40)
♦ Similarly, if someone paid, they’ve bought (and paid) at the offer
30
FX Forwards and Options – Corporate Hedging
Japanese hedger ♦ A Japanese car manufacturer just sold 1,000 cars to a European wholesaler for 10 million Euro ♦ The car manufacturer will receive the 10 million Euro in 3 months. ♦ A car costs 1.2 million JPY to produce ♦ The manufacturer gets 10,000 Euro per car in 3 months
32
How to hedge the FX risk? ♦ EURJPY Spot is 135 ♦ An exchange rate of 135 results in a 12.5% margin and is acceptable ♦ The company believes that the minimal (operating) margin to satisfy the shareholders is 7.5%, but the company believes that they should get more out of this trade ♦ Does the company have any FX risk? ♦ If yes, what should the company do?
33
How to get rid of FX risk - Currency Forwards ♦ An FX spot trade done today settles in 2 business days ♦ Trades that settle on any day later than the spot date are called forward trades ♦ An FX-forward trade is an agreement to exchange a fixed amount of one currency for a fixed amount of another currency at a fixed later date
34
What’s the intuition? ♦ Spot reflects the current value of EUR 1 in terms of JPY
EUROs are growing at 2.2% Yens are growing at 0.1%
♦ EUROs are becoming relatively more abundant. When supply goes up, price goes down
Forward is lower than Spot (There is a net benefit to carrying EUROs)
35
Forward Points ♦ In our example,
Spot trades at 134.92 3-month Forward trades at 134.19 Forward is lower than Spot (There’s a net benefit to holding EUROs)
♦ Forward Points are defined as Forward - Spot ♦ The Forward Points are -0.73 JPY ♦ more often reported as -73 (pips) ♦ and generally often the “-” is missing with 2-way markets ♦ The Market usually quotes Forward Points not Outright Forwards
36
Outrights versus Pips
37
(Short) Forward versus Put ♦ In our example the Japanese car manufacturer could sell 3-months 10 mm Euros 3-months forward at a price of 134.27 Jen per Euro ♦ He would trade away his exposure to the EURJPY exchange rate ♦ His operating margin goes to 11.89% ♦ What if the car manufacturer has a strong view that the EURO currency will strengthen in the next 3 months? ♦ A EURJPY exchange rate of 138 would yield an operating margin of 15%! ♦ But if he does not hedge and the market goes against him he might not make the 10% margin he needs
38
3 month 130 EUR put JPY call ♦ Buy insurance! ♦ 3 month standard 130 strike EUR put JPY call costs – 0.69% of EUR face – 0.93 JPY per EUR – 9,300,000 JPY (EUR face 10,000,000) – this results in a worst-case margin of 7.56%
4.1 -0.9
125
130
140
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Disclaimer This material has been prepared by UBS AG, or an affiliate thereof ("UBS"). In certain countries UBS AG is referred to as UBS SA. This material is for distribution only under such circumstances as may be permitted by applicable law. It has no regard to the specific investment objectives, financial situation or particular needs of any recipient. It is published solely for informational purposes and is not to be construed as a solicitation or an offer to buy or sell any securities or related financial instruments. No representation or warranty, either express or implied, is provided in relation to the accuracy, completeness or reliability of the information contained herein, nor is it intended to be a complete statement or summary of the securities, markets or developments referred to in the materials. It should not be regarded by recipients as a substitute for the exercise of their own judgement. Any opinions expressed in this material are subject to change without notice and may differ or be contrary to opinions expressed by other business areas or groups of UBS as a result of using different assumptions and criteria. UBS is under no obligation to update or keep current the information contained herein. UBS, its directors, officers and employees' or clients may have or have had interests or long or short positions in the securities or other financial instruments referred to herein and may at any time make purchases and/or sales in them as principal or agent. UBS may act or have acted as market-maker in the securities or other financial instruments discussed in this material. Furthermore, UBS may have or have had a relationship with or may provide or has provided investment banking, capital markets and/or other financial services to the relevant companies. Neither UBS nor any of its affiliates, nor any of UBS' or any of its affiliates, directors, employees or agents accepts any liability for any loss or damage arising out of the use of all or any part of this material. Options, derivative products and futures are not suitable for all investors, and trading in these instruments is considered risky. Past performance is not necessarily indicative of future results. Foreign currency rates of exchange may adversely affect the value, price or income of any security or related instrument mentioned in this presentation. Prior to entering into a transaction you should consult with your own legal, regulatory, tax, financial and accounting advisers to the extent you deem necessary to make your own investment, hedging and trading decisions. Any transaction between you and UBS will be subject to the detailed provisions of the term sheet, confirmation or electronic matching systems relating to that transaction. Clients wishing to effect transactions should contact their local sales representative. Additional information will be made available upon request.
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Disclaimer continued United Kingdom and rest of Europe: Except as otherwise specified herein, this material is communicated by UBS Limited, a subsidiary of UBS AG, to persons who are market counterparties or intermediate customers (as detailed in the FSA Rules) and is only available to such persons. The information contained herein does not apply to, and should not be relied upon by, private customers. Switzerland: These materials are distributed in Switzerland by UBS AG to persons who are institutional investors only. Italy: Should persons receiving this material in Italy require additional information or wish to effect transactions in the relevant securities, they should contact Giubergia UBS SIM SpA, an associate of UBS SA, in Milan. United States: These materials are distributed by UBS Securities LLC or UBS Financial Services Inc., subsidiaries of UBS AG, or solely to US institutional investors by UBS AG or a subsidiary or affiliate thereof that is not registered as a US broker-dealer (a "non-US affiliate"). Transactions resulting from materials distributed by a non-US affiliate must be effected through UBS Securities LLC or UBS Financial Services Inc. Canada: These materials are being distributed in Canada by UBS Securities Canada Inc., a subsidiary of UBS AG and a member of the principal Canadian stock exchanges & CIPF. Hong Kong: The materials relating to equities and other securities business, and related research, are being distributed in Hong Kong by UBS Securities Asia Limited. The material relating to corporate finance, foreign exchange, fixed income products and other banking business, and related research, are being distributed in Hong Kong by UBS AG, Hong Kong Branch. Singapore: These materials are distributed in Singapore by UBS Securities Singapore Pte. Ltd or UBS AG, Singapore Branch. Japan: The materials relating to equities, fixed income products, corporate finance and other securities business, and related research, are distributed in Japan by UBS Securities Japan Ltd. The materials relating to foreign exchange and other banking business, and related research, are distributed in Japan by UBS AG, Tokyo Branch. Australia: These materials are distributed in Australia by UBS AG (Holder of Australian Financial Services Licence No. 231087) and UBS Securities Australia Ltd (Holder of Australian Financial services Licence No. 231098). New Zealand: These materials are distributed in New Zealand by UBS New Zealand Ltd. © 2006 UBS. All rights reserved. UBS specifically prohibits the redistribution of this material and accepts no liability whatsoever for the actions of third parties in this respect.
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