FINANCIAL MARKETS OF THE EUROPEAN UNION

1
FINANCIAL MARKETS OF THE EUROPEAN UNION ROY
DAHLSTEDT LASK3002 UNIVERSITY OF VAASA
2
Roy Dahlstedt
Helsinki School of
Economics
Department of Economics
Economicum building
Arkadiankatu 7
Helsinki
2. floor, room A 220
Office hours for students mo 9 -
11 Tel. [phone]
E-mail roy.dahlstedt_at_hse.fi
3
LASK3002 Financial Markets of the European Union
Objectives A knowledge of the mechanisms
of foreign exchange rates. An insight into the
European Central Bank monetary policy
instruments. A familiarity with the money markets
and their products and interest rates in Finland
and in the European Union a basic yield
calculation ability. A familiarity with the
capital/ Eurobond markets in Finland and in the
European Union with a basic yield calculation
ability. An understanding of the basics of stock
valuation and a familiarity with the European
stock exchanges and capital market
integration. Contents How to study money and
capital markets? Currencies and foreign exchange
rates. The European money market and bank
liquidity as the platform of the monetary policy
of the European Central Bank. The money markets
and the money market instruments in Finland and
in Europe, the European reference rates ( e.g.
Euribor ) and money market integration. The
national capital markets and the pan-European
(Eurobond) capital market in the making. Eurobond
issues and market analysis. The integration
process of the European national stock
markets. Analysis of the basic types of money and
capital market products, pricing calculation
exercises, current cases reading the press. The
concept of market efficiency explained. Literature
PETER HOWELLS KEITH BAIN The Economics of
Money, Banking and Finance, a European Text, 4th
edition, FT.Prentice Hall 2008, isbn
978-0-273-71039-4, chapters 1,8,9,10,11,15,16,17,1
8,21,22,23,24,25. Articles distributed as
handouts during lectures Lecturer
Dr.Sc.(Econ.), docent Roy Dahlstedt Evaluation
1. Lectures 30 h, Dr.Sc.(Econ.), docent Roy
Dahlstedt 2. Exam. Teaching Spring 2009
4
Lectures 5. March, 2009 12 18
Palomäki A 201 6. March, 2009 8 12
Palomäki A 201 12. March, 2009 12 18
Palomäki A 201 13. March, 2009 8 12
Palomäki A 201 19. March, 2009 12 18
Palomäki A 201 20. March, 2009 8 12
Palomäki A 201
Exam opportunities 1. 28th of March,
2009 2. 16th of May, 2009 3. autumn
2009, to be confirmed later Exam
requirements - textbook, as specified -
lectures, with lecture materials - lecture
handouts
5
CONTENTS 1. International Capital and Money
Market Concepts 1.1. Maturity 1.2.
Marketplaces, Exchanges 1.3. Market Operators
1.4. The Importance of the Market 1.5.
Market Products/Instruments 2. The European
Money Markets and Products 2.1. Market
Products and Their Yields 2.2. Market
Reference Rates Eonia, Euribor,Eurepo 2.3. An
Overview of the Markets 2.4. Case 3. The
European Central Banks Monetary Policy
Instruments and Money Market Liquidity 3.1.
The European Central Bank, the European System of
Central Banks 3.2. The Targets and
Transmission of Monetary Policy Measures 3.3.
The Minimum Reserve System and the Standing
Facilities 3.4. The Open Market Operations
3.5. Case 4. The European Debt Capital Markets
and Products 4.1. The Stereotype Product the
Fixed Coupon Bond 4.2. Yield Calculation for
a Fixed Coupon Bond 4.3. International Bond
Issues, Eurobonds 4.4. Bond Market Segments
and European Marketplaces An Overview 4.5.
The Pricing of Risks in Yields the Risk
Premium 4.6. The Pricing of Maturity in
Yields the Term Structure 4.7. Case 5.
The European Stock Markets 5.1. Stocks and
Public Listing of Companies 5.2. Stock
Portfolios and Market Indices 5.3.
Concentration and Competition among the European
Stock Exchanges 5.4. Diversification of a
Security Portfolio 5.5. Rate of Return
Calculation for Equities and the P/E-ratio
5.6. Case 6. A Note on the Importance of Forward
Products and Markets


6
1. International Capital and Money Market
Concepts 1.1. Maturity
1 DAY 3 DAYS
6 MONTHS 1 YEAR


cash moneycurrency spot foreign
exchange markets
Money Markets
short end
long end
overnight, t.o.m/ t/n liquidity market
treasury/government

private/corporate
central bank






Capital Markets


debt markets equity markets


treasury/government


private/corporate






domestic



international )




domestic international

) Government bond, international sovereign
bond Government bond, domestic treasury
bond ( money market treasury bill ) Domestic
bond denominated in the currency of the
domestic market ( borrowers view )
International foreign bond, eurobond
Foreign bond denominated in the currency of the
foreign market ( borrowers view ) Eurobond
denominated in some ( international ) currency
other than that of the
market Eurodollarbond denominated in US
dollars, sold outside of US Euroeurobond
denominated in Euros, sold outside of the
euroarea ( for instance if a Swedish
firm sells a Euro-denominated bond in the
euroarea market, it is a foreign bond (
foreign market, the currency of the market ) if
the firm sells the bond in Sweden it is a
Euroeurobond ( domestic market, foreign currency
) ) Eurodollar US dollar deposit/asset in
a bank outside of the United States (
jurisdiction )
7
1.2. Marketplaces, Exchanges
The Banking Industry
Customers
equity
OTC
volume of trade in bonds other
Private Institutions
Retail Trade
Interbank
OTC
Wholesale Trade
Exchanges
volume of trade in equity bonds other
b r o k e r s
Specialized Exchanges have limited product
sortiments Clearing and Settlement Business
connected with markets
The geographical concentration of markets
8
1.3. Market Operators industrial firms insurance
companies counties, cities states (
sovereign) private persons pension funds other
funds ( investment funds, hedge funds, etc.) fund
managers investment banks broker firms ( dealers
) banks ( allround ) central banks government
agencies and institutions International financial
institutions ( World Bank, IMF etc. )
1.4. The Importance of the Market 1. market
price 2. market expectations 3. allocation 4.
conversion 5. hedging risk externally close
position diversification 6. liquidity 7.
information 8. know-how
9
1.5. Market Products/Instruments certificate of
deposit (CD) repurchase agreement
(repo) commercial paper (CP) zero coupon/discount
bond treasury bill ( T-bill ) straight bond
(plain vanilla) medium term note
(MTN) debenture floating rate note
(FRN) convertible (bond) bondwarrant treasury
bond ( T-bond, long bond ) swap ( currency,
interest rate ) forward rate agreement ( FRA
) financial future option ( currency, index,
stock, other ) (common) stock depositary receipt
(DR) etc.
10

2. The European Money Markets and Products 2.1.
Market Products and Their Yields
Zero coupon / Discount bond
No coupons - yield based solely on price
changes Initial data 100 Nominal value of
bond, euros 0 coupon
3 months time left to
expiry 95 market
price of paper in euros a)
buy and hold 95 pay
market price 100 at
expiry receive face/nominal value
100 - 95 yield on 3 months
5 / 95 5.26 yield as
percent of invested cap
4 5.26 21.04 yield on p.a. basis



b) take an interest
rate position 95
pay market price 98
expect to get when sold after 1 month ( expect
money price up, market
rate of interest down see the calculation
for next investor below !!! )
3 yield in euros on one month, which
is 3 / 95 12
37.89 annual (p.a.)
the next investor will get 2 / 98 6 12.24
annual

yield money price
100
21
98
95
12
0 1 2
3
time
expiry
11

the buyer of the paper is a lender, the seller of
the paper is a borrower the expected fall of the
market interest rate is beneficial to the
borrower, therefore he buys ( long position ) in
the longer end ( 3 months) and sells (short
position ) in the shorter end ( 2 months )
position
The rules of quoting short-term zero-coupon
bonds Quote short-term zero-coupon bonds of
banks, homogeneous by general acceptance, expiry
in e.g. 3 m
(osto) 12.85 - 80
(myynti)
( buy )
( sell ) the banks
buy-quotation the bank will buy the paper from
the customer at a money price which
is such that the bank will get a
yield-to-maturity ( if held to maturity ) of
12.85 p.a.! in an economists
words the bank will give the customer a loan for
three months ( bank lending ) at
this annual interest rate the
banks sell- quotation the bank will sell this
kind of paper from its portfolio to the custo-
mer at a money price which is such
that paying that price the customer will earn a
yield-to- maturity ( if held till
maturity ) of 12.80 p.a. in an
economists words the bank will borrow from the
customer ( bank borrowing ) for
three months at this annual interest rate
spread 12.85 - 12.80 0.05 p.a., that is,
5 basis points These are called price
quotations money prices are not used but can of
course be calculated
12
Note ! the original length of
maturity of the paper is irrelevant, the
important thing is the time left from
the present to maturity in general, pricing
moneys of different length and their markets are
always based on the remaining
length to maturity. Note ! The
above quotation system is one where imaginary
papers are being bought and sold and quoted
An alternative system, also in use, is
one where money is being quoted, bought and sold.
)
Note ! The market rate of interest
is calculated as the average of quoted prices,
not transaction prices !

Notice the homogeneity assumption/agreement !
/ / / / /
/ / / / /
/ / / / /
Bank A Bank B Bank C
homogeneity assumption/agreement
homogeneity assumption/agreement
12.12.2000
1 month homogeneous paper
6 month homogeneous paper
1 month paper 6 month paper buy sell
buy sell
Bank A quotes Bank B quotes Bank C quotes
12.85 -80 12.95 -90 12.80
-75 13.00 -95 12.82 -80
12.98 -92
These are the market rates of interest of this
day !
Average of buy-quotes 12.82
12.97
market rate of interest (spot)
13
As in the above, in many markets it is the
convention to standardize the length of money (
in this case expiry dates move )
1 month 3
months
6 months

1 month 3
months
6 months

t0
t1
Also, in many markets it is the convention to
standardize the expiry dates of money ( in this
case the length of money is variable )
E
E
E
t0
t1
14
EXAMPLES OF INTERNATIONAL ( EURO-)
MONEY MARKET INSTRUMENTS Euro Fixed Time
Deposit
Euro Certificate of Deposit
Eurocommercial Paper (
Euronote )
1) short-term
short-term

short-term 2) interbank-market instrument
intended for
non-bank clients
interbank-market instrument for
funding/liquidity purposes
money market operations
for funding/liquidity
purposes 3) no secondary markets
bearer paper /
secondary market
bearer paper / secondary market 4) loan contract

loan contract
zero-coupon
bond 5) outside the jurisdiction of US
outside the jurisdiction of
US outside
the jurisdiction of US 6) unsecured

unsecured
unsecured 7) unrated

unrated

unrated 8) European trading centered in London
European trading centered in
London European trading
centered in London
other major money market products overnight
money deposits tomorrow next money
deposits repurchase (repo) agreements -
collateral
15

• 2.2. Market Reference Rates Eonia, Euribor,
  Eurepo
• Euribors ( European Interbank Offered Rate ) are
  used primarily in European money markets as
  short-term reference rates,
• for money market deposits and debt securities.
• The product is Euro Certificate of Term Deposit,
  a euro-denominated certificate of a deposit of a
  certain time period.
• The lengths of the money ( the term ) are
  standardized, starting from every banking day and
  running for 1 week, 2 weeks,
• and 1 12 months, in one-month intervals.
• The market rates of interest of these lengths of
  moneys are expressed as annual rates, as averages
  of interest( offer ) quotations,
• using a 360-day year.
• The days market rates are calculated on the
  basis of quotations given daily by 49 appointed
  banks, some of which are
• eurobanks, some EU-non-euro-banks, and some
  non-EU-banks.
• Notice, that quotations are for the required
  interest rate on an offered deposit.
• Notice, that the calculation is based on
  quotations, not transaction prices ( if we were
  to make this kind of a deposit with

Eurepo 38 appointed banks give their daily
quotations for maturities T/N, 1-3 weeks,
1,2,3,6,9,12 months.
16
2.3. An Overview of the Markets Material will be
handed out at lectures
17
CASE Case material will be handed out in
advance at lectures students are expected to
familiarize themselves with the material and be
prepared to discuss the case with the class.
18
3. The European Central Banks Monetary Policy
Instruments and Money Market Liquidity 3.1.
The European Central Bank, the European System of
Central Banks

19
3.2. The Targets and Transmission of Monetary
Policy Measures
The monetary policy instruments contained in the
different systems of the central bank Immediate
targets money market interest rates, the
liquidity in the banking industry,
foreign exchange rate Intermediate targets the
amount of money and credit in circulation, the
interest rates in the capital markets, the
prices of various types of assets Final targets
price stability, economic growth, employment,
external balance (exports/imports)
Monetary policy measure
Expectations in the market
Money market interest rates
Foreign exchange rates
Exports/imports, current acc.
Interest rates in the capital markets
Domestic demand
Aggregate demand
Economic growth, employment
Price level stability/inflation
20
3.3. The Minimum Reserve System and the
Standing Facilities - The reserve requirement is
a percentage of those of the banks deposits (
liabilities ), which are pointed out by the
central bank - The percentage is determined by
the central bank, and there may be different
percentages for different types of
liabilities - The money must be deposited in a
current account, which the bank must have at its
national central bank - The bank may lift
money from its current account and deposit money
into its current account freely but at the end
of each month the average of the daily saldos of
the account must be at least the reserve
requirement stipulated above - The central bank
pays an interest on the daily saldo, which is
the marginal rate of the main refinancing
operation ( cf. later ) - The national central
banks approve financial institutions into this
system others do not have a right to use a
central bank current account, cannot work in the
pan-european interbank payments system (
Target ) and are obliged to keep the requirement
deposited in the central bank at all times.
21
STANDING FACILITIES ( LIQUIDITY
CREDIT FACILITY ) - Marginal Lending Facility
and Deposit Facility - The financial
institutions which are counterparties in the
Minimum Reserve System can use these
facilities - The central bank stipulates the
lending and deposit rates - Money is borrowed
from the central bank and deposited into the
central bank for one day in these facilities (
overnight money ) - In practice, the central
bank lending rate will determine the ceiling of
the interbank overnight market rate and the
central bank deposit rate will determine the
floor of the interbank market rate also, the
interest rate spread in the interbank market will
be limited by the central bank rates and the
level of the market rate is controlled by the
central bank
22
3.4. The Open Market Operations A. The
Main Refinancing Operations - This
operation is a weekly auction, where the central
bank is selling cash money as a
one-week loan to the financial institutions which
are counterparties in the Minimum
Reserve System - The financial
institutions make their bids, stating the amount
of money they would like to buy and
the price of that money (interest rate) they
would be willing to pay, for a one-week
loan ( ! ) - The loan will be paid
back to the central bank after one week ( repo
agreement ) at the same time, in
that weeks auction, new money is sold the net
of the repayments and the new loans
determines whether the money market is being
tightened or lightened by the central
bank - The central bank, in the
auction, predetermines a minimum bid price after
having received the bids the central
bank will set these in order, from the highest
interest bid down, and determines the
amount of money to be sold the last bidder to
get money is the marginal bidder,
his/hers is the marginal rate. Everyone pays this
marginal rate. The minimum bid rate
is the ECBs main refinancing operation rate (
also known as repo rate and auction
rate ) the ECBs principal monetary policy
instrument ( principal steering rate ). B.
The Longer-term Refinancing Operations -
This operation is a monthly auction, the same
financial institutions may partake as
above, the central bank is selling three-month
loans on the basis of the bids, repo-
agreements are used - In this case the
central bank predetermines the amount of money to
be sold the bank does not intend to
send interest rate signals to the market this is
purely a longer-term liquidity regulation
device C. The Fine-tuning Operations
- Executed on an ad-hoc basis
- Managing the liquidity situation in the
market - Different types of money
market instruments can be used a small-scale
auction may be held or one or more
national central banks or the ECB itself may buy
and/or sell on the market with
bilateral transactions D. The Structural
Operations - Adjust the position of the
ESCB vis-a-vis the European money market ( E
). Open market operations on the international
foreign exchange market
23
CASE Case material will be handed out in
advance at lectures students are expected to
familiarize themselves with the material and be
prepared to discuss the case with the class.
24
4. The European Debt Capital Markets and
Products 4.1. The Stereotype Product the Fixed
Coupon Bond bearer general issue /
public offering coupon / fixed interest / fixed
income annual or semi-annual coupon dates
bullet guarantees priority face value /
denomination currency of denomination maturity
/ expiry Yield from 1) coupon
2) market price / invoice price
3) exchange rate
4) coupon reinvestment Market
price depends on 1) interest rate expectations
2)
debtor/credit risk, other risks
3) exchange rate
expectations
4) liquidity
other factors
25
ORIGINATION
Supply of debt finance/financial investor/


Demand for debt finance/real investor/ buyer
of instrument/lender/demand for


financial investor/seller of instrument/ instrumen
t/creditor/asset/(banks borrowing)


borrower/supply of instrument/debtor/


liability/ (banks lending) bank client


bank client
money debt contract paper
assets
banks
debts
banks
money debt contract paper
Retail market/client market


Retail market/client market
Interbank Intermediation Market making
26
4.2. Yield Calculation for a Fixed Coupon Bond


An investment is always an income stream. By
calculating the present values of income streams
they become comparable. The present value of an
income stream is calculated by discounting
elements of the stream with a discount
coefficient ( embodying the discount rate which
is either the market interest rate or yield ) to
the present moment and adding . If the present
value of the stream is already known ( the market
price of the investment at present time ) , the
discount coefficient ( the yield embodied in the
market price ) can be deduced when the stream is
known.
6
8
7
7
Discounted Income stream present value of Income
stream Expenditure Example Discounting
C or P
t 0 t 1 t 2
t 3 T
92.59 100 / (
1 0.08 ) exp 1 100 income stream

1 0.08
discount coefficient, 0.08 is the

discount
rate ( 8 )

92.59 present value of income stream 100
when

discounted over one time period (exp is
1)






27
Let us adopt the following definitions 1)
expected present value
or
2 ) the cost of investment or price
t
1) - 2)
3 ) expected net present value
Rate of Return when productive/real investment
Yield when equity/financial investment
four basic types of security 1) coupon,
fixed rate note/bond 2) floating rate
note/bond 3) zero coupon bond/note 4) common
stock, dividend, no maturity
28
In the following we calculate the yield of a
fixed coupon bond, for instance a
euro-denominated Finnish government bond,
which is considered credit risk free, and which
is not redeemed before maturity but the total
principal/nominal value will be paid to
the bearer at expiry ( a bullet loan ). We
ask what is the condition which makes the income
from the investment equal to the cost of the
investment ? That is with what condition is
the present value of the income stream from the
bond equal to the price paid for the bond
? That is when is the net present value of the
bond zero ? We write an equation on the left
side the cost ( the price of the bond ) of the
investment is equal to, on the right side, the
present value of the income stream ( from the
bond ) from the investment we have now set the
net present value ( remember the definition above
) equal to zero. The answer to the question
above can be calculated, observing that we know
all of the terms in the equation except YTM in
the discount factor YTM can be solved from the
equation. This is by definition the bonds
yield-to-maturity ( Note ! to maturity ! )
Why are we interested in a condition which sets
the result of our investment ( the net present
value ) equal to zero ? The YTM tells us how
large a discount factor can be applied to the
income stream without making the net present
value negative. That is what is the rate of
growth of the capital invested ( the price ) up
till the day of expiry. That is if compared
with some market rate of interest, of this same
market or some other market, is this investment
giving us an income stream which is better than
the average stream on the market ( the market
rate of interest is the yield given by the
average income stream on the market) and can
therefore be discounted with a larger discount
factor than the market rate of interest. That
is with comparable calculations, what is the
rate of growth of this investment in comparison
to alternatives with different income streams.
29

• On a certain market, defined by the
  characteristics of the product, the rules and
  conventions obeyed on the market and, often, a
  limited
• number of operators, the average yield of the
  individual papers traded, at any time, is the
  market rate of interest on that market at that
• time.

• From the above YTM calculation one can see,
  that given the income stream, the yield is
  singularly dependent on the price paid for the
  bond

One can also see, that if the bond is sold before
expiry, in which case, in the calculation, the
selling price is used instead of the face value,
YTM depends on both the buying price and the
selling price the higher the selling price/ the
lower the buying price, the better yield Notice,
that you cannot know the selling price in
advance, and so the yield calculation is risky
you have to use an expectation of price.
Note ! YTM-calculation is routinely made to
maturity and with the face value, if there is no
particular reason to do otherwise !

• If the bond has been bought with the
  buy-and-hold strategy, what is the importance of
  the price changes of the bond after buying
  wealth effect

• Given the buying price, the larger the ( fixed )
  coupon the better the yield.
• If the buying price is the same as the nominal
  value/face value ( a par bond ), the YTM is the
  same as the coupon rate. If the buying price
• is above par the yield is less than the coupon
  rate and contrariwise.
• Notice the general mathematical form of the YTM
  equation P C / Y ( C constant )
• The function is non-linear and the relation
  between P and Y is inverted a reduction in the
  bonds money price is a simultaneous
• increase in the yield and contrariwise.

• The calculation presented above solves for the
  annual yield of the bond ( if the unit of t is
  one year ) and assumes, that the investor
• gets a coupon payment, which is made annually,
  1,2,T times. The investor buys the bond at the
  coupon (payment) date (C ) ( the coupon
• is paid to the previous bearer, for the past
  year ) and will get the next coupon payment after
  one year if still owns the bond after one year.
• Note ! If some other time unit is used ( e.g.
  t runs for number of months ), everything works
  analogously always express yield on annual
• basis ( p.a. ). To enable this, if one month
  is the time period used and t runs for the number
  of months, use YTM / 12 in the denominator,
• or calculate YTM for one month and then
  multiply by 12 for the annual yield.

If the bond is bought
while the coupon period is running ( at buy B) ,
the buying price will include the
part of the annual coupon ( for
the first part of the year ) to which the
previous bearer is entitled, and the buyer
will then get ( in the next coupon day ) the
coupon for the whole previous
coupon period ( year ).
C C
C
buy
buy B
30
Kuponki(korko)/ Nimellisarvo Coupon/ Face value
(Osto)hinta/price
Tuotto ( hinta )
Yield ( price )
Markkinakorko Market rate of interest

• The yield will increase either because of a
  higher coupon or a lower buying price ( discount
  ). The coupons of the bonds being traded
• on the market ( secondary market ) cannot be
  changed, so the increase of yield takes place
  through the decrease of buying price.
• The market rate of interest is determined by
  the prices of the papers.
• An increase in the market rate of interest
  probably has an effect on the coupons of new
  issues of bonds ( primary market ) raising them
• the price of the bonds stands close to par
  value and there are no discounts.
• The YTM-calculation encloses three of the four
  yield elements ( above ) the coupon and the
  buying price explicitly and the reinvestment
• rate implicitly the yield effect of a change
  in the exchange rate must be calculated
  separately.
• If one takes the view of the borrower
  everything works the same way, only the
  nomenclature changes income stream is
  expenditure
• stream, market price is the amount borrowed, at
  expiry one pays the face value and the yield is
  the cost of the loan in annual percentages.

2)
The calculation makes the assumption ( implicit )
that all coupon payments are immediately
reinvested with an interest rate which is the
same as the calculated yield percentage ! If it
turns out that a coupon payment can be reinvested
on the market with a higher rate this will of
course be done. Consequently, the yield of the
investment will ultimately be better than
calculated. With decreasing market rates the
opposite will be true. These reinvestment rates
cannot be known in advance the actually
realizing yield of our investment will be
dependent on the future market rates, therefore
there is a risk. The yield-to-maturity is an
approximation !
3) The YTM-equation cannot normally be solved
manually. Trial and error must be used if a
suitable computer program is not available.
31
Examples
140
120
YTM C10
100 Vuosi/year


100
osto/buy
myynti/sell

osto/

buy
0-kuponki/ 0-coupon
YTM
80
Par- bond 100 10/ (1YTM)1 10/ (1YTM)2
10/ (1YTM)3 10/ (1YTM)4 100/ (1YTM)4
YTM 10 p.a.
C 10 nimellisarvosta/of nominal
value Bond, juoksuaika 2 vuotta, hinta 80, C 10
80 10/ (1YTM)1
10/ (1YTM)2 100/ (1YTM)2 maturity 2 years,
price 80, C10 YTM 23.68
p.a. Bond, pitoaika 2 vuotta, hinta 100,
odotettu myyntihinta 80, C10

100 10/ (1YTM)1 10/ (1YTM)2 80/
(1YTM)2 YTM 0 p.a.

maturity 2 years, price 100, expected selling
price 80, C10
Nollakuponkibondi, juoksuaika 2 vuotta hinta 80
80 100/ (1YTM)2 YTM 11.80 p.a.
tai, yksinkertaista
korkolaskua käyttäen 20/80 ½
12.50 p.a.
Zero-coupon bond, maturity 2 years, price 80
using simple interest calculation
Semiannual bond, maturity 1½ years price 102, C
7 102
3.50 / ( 1 YTM/2 )1 3.50 / ( 1YTM/2 )2

3.50 / ( 1 YTM/2 )3
100 / ( 1 YTM/2 )3

YTM 5.59 p.a.
32
4.3. International Bond Issues - The
International Bond Market, Eurobonds

Debtor
Emission


New Issue

Primary Market
Stock of
Debt
(Paper)
EUROPEAN

BOND MARKET / Banking Industry/ Investors

Secondary Market


Maturity
Debtor




33

Customer

Lead Manager (Investment Bank)

Preparing emission

-analyze the economic status of the
borrower and the

nature of the financing requirement

-planning the characteristics of
the issue (no details yet )

-analyze the market situation and the
requirements for
the
issue
-name
co-managers, set up management group

-prepare brochure, contracts,
other documentation

-meet with the group and agree on
responsibilities

Undertake the issue

-underwrite preliminary contracts (see later )

with underwriters and
sellers
-control of
sales
-collect and
forward to borrower

-during the subscription period ( see later )
collect
and analyze
market feedback and settle ( with borrower)

the critical details of
the loan underwrite the final ( marke-

ting ) contracts with the
consortium
Co-manager
Co-manager Co-manager Co-manager
Co-manager Co-manager

-name underwriters and sellers for the
consortium
-control
the sales of the loan

- buy part of the loan to own portfolio

-collect and
forward Underwriter


Underwriter
The Organisation and Management of a New Issue
of an International Bond Loan
-buy loan and sell it to customers ( investors )
or keep in own portfolio guarantees the
quota -name sellers
Seller


Seller
-mark or subscribe a quota to be sold -sell or
buy to own portfolio no guarantee of quota,
unsold may be returned
34
New Issue Process
5-10 days
15 days
Announcement Day
Offering Day
Closing Day
Subscription
Stabilization
period
period Announcement Day The Lead
Manager send a telex/fax/e-mail introducing the
borrower, the guarantor, an the overall features
of the planned loan as well as conditions,
without crucial details to the members of the
consortium, together with an invitation to the
underwriters and sellers to participate in
the sales campaign. Also, the documentation and
the preliminary contracts are mailed to the
consortium for signing ( the socalled open
priced - method ). Subscription Period The
answers and feedback information together with
the undersigned preliminary contracts are
returned to the Lead Manager. The Lead Manager (
bookrunner ) reanalyzes the market situation on
the basis of this information and decides, in
cooperation with the borrower, upon the details
of the loan. The loan contract is undersigned
with the borrower. The loan is allocated to the
subscribers ( underwriters and sellers ) in
proportion to subscriptions. Offering Day The
final contracts with the underwriters and sellers
are signed and they are informed of the
details of the loan, as well as of their
quotas. Stabilization Period The management
group will try to stabilize the (secondary)
market price of the loan at the issue price if
the price starts to rise from the issue price the
borrower may find the coupon or other conditions
of the loan overtly favorable ( the borrower is
paying too much for the debt ) and critice the
management group/lead manager for bad judgement
or even incompetence on the other hand, if the
price of the paper starts to fall immediately
after issue some of the investors may find
themselves having paid an excess price for the
paper and having already sustained a loss ( in
wealth ) and blaming their banker ( the
underwriter, seller ) for giving bad advice,
selling bad stuff. Closing Day collection of the
loan, tombstone ( If a group of investment
banks buy up the loan by a mutual agreement, the
loan is called syndicated, and the group a
consortium )
35
4.4. Bond Market Segments and European
Marketplaces An Overview
Contemporary material which will be delivered at
lectures
36
4.5. The Pricing of Risks in Yields the Risk
Premium 1) Interest Rate Risk Fixed coupon
1. Price Risk 2.
Reinvestment Risk Floating rate the above
plus Coupon Risk 2) Default/Credit Risk 3)
Liquidity Risk 4) Inflation Risk 5) Exchange
Rate Risk 6) Call Risk 7) Country Risk
RISK AVERSION - RISK NEUTRALITY - RISK LOVING
B is risk-averse
Bs non-gamble utility Bs
gamble utility
U
tuotto
RA(AI) RA(AC)

E ( R )



RA(AD)
preemio R(f)
RN
0.5 U(0)
0.5 U(100) tai/or
RL(LC)
tai 0
50 100

riski/risk


U(50)
f
f
B is risk-averse
tai
tai
A is risk-neutral
preemio
tuotto yield
tuotto/yield
A B risk- risk- neutral
averse
a)
probability 0.5 win 100 Which game ?
probability 0.5 win 0
b) secured 50
37
4.6. The Pricing of Maturity in Yields the
Term Structure
Tuotto/yield
E1
eräpäivät/expiry dates
E2

E3
tuoton laskentapäivät
T0
E1 E2 E3
dates of calculation of yield
eräpäivät/expiry
dates
Tuotto/yield

T0 tuoton

lasken
T1 päivät

dates of


calculation E1
E2 E3 of
yield
eräpäivät/expiry dates
Tuotto/yield
T0 T1
E1 E2 E3
eräpäivät/expiry dates
laskenta- päivät/dates of calculation of y.
38
TERM STRUCTURE OF INTEREST RATES ACCORDING TO
THE EXPECTATIONS HYPOTHESIS IN PLAIN WORDS HOW
THE EXPECTATIONS CONCERNING THE FUTURE SHORT
RATE CAN EXPLAIN THE TERM STRUCTURE AND MAY
PREDICT, ON THE AVERAGE, THE FUTURE SHORT RATE
Yield / Market Interest Rate
The million euro question where do all
these original expectations come from ?
yield curve at t0
5 4
F1
Time in months / expiry dates / closing dates
T0 T1
T2
From expectations concerning the short rate to
the long rate At time T0 we expect the
central bank to raise the one-month rate ( which
is at 4 ) to 5 , we expect this raise
to take place at T1 The raise means that
the money prices of papers will fall We
start to sell the papers we possess which expire
at time T2, with the intention of buying them
back at time T1 after their money price
has fallen The money price of T2-papers
falls immediately ( increased supply ) and with
it the long rate ( T0 T2 ) rises
close to the expected 5 the expected raise of
the short rate is realized in advance on the
market as a rise of the long rate ! The
general conclusion the long rate is a measure of
the markets expectation as to the future short
rate ( term structure ! )
1
2
From the long rate to the financial futures
rate We can mathematically show that for the time
interval T1 T2 ( financial future F1
)there is a rate which, together with the rate of
4 for the first month, gives an investor a
return which is equal to an investment for two
months at 5 this is how the expectations (
which are embedded in the two-month rate of 5
) determine a (theoretically correct ) rate for
the financial futures contract T1 T2 (
financial futures F1 ), already at time T0 !
3
From the financial futures rate to the average
realization The Unbiased Forward Rate Hypothesis
claims that operators ( majority ? ) use the
financial futures market rate in formulating
their expectations as to the future short rate,
because this is close to the theoretically
correct rate. If we now make the assumption that
the market is efficient, this financial futures
rate will be realized as the short rate at time
T1, on the average.
39
CASE Case material will be handed out in
advance at lectures students are expected to
familiarize themselves with the material and be
prepared to discuss the case with the class.
40
5. The European Stock Markets 5.1. Stocks and
Public Listing of Companies Lecture commentary
on - A stock - Stock financing - Primary,
secondary market - Stock financing vs. debt
financing - Stocks vs. bonds as financing
instruments - Ownership - Stock investor risk -
Risks in stock financing vs. bond financing -
Stock emissions - Initial public offering (IPO) -
Dematerializing
41
5.2. Stock Portfolios and Market Indices
Stock Exchange 1 / list
Exchange 2 / list
Exchange 3 / list country 1

country 2
country 3
Pankit ja rahoitus Vakuutus Sijoitus Kuljetus ja
liikenne Kauppa Muut palvelut Metalliteollisuus Me
tsäteollisuus Monialayritykset Energia Elintarvike
teollisuus Rakennusteollisuus Tietoliikenne ja
elektr Kemianteollisuus Viestintä ja
kustannus Muu teollisuus
Pankit ja rahoitus Vakuutus Sijoitus Kuljetus ja
liikenne Kauppa Muut palvelut Metalliteollisuus Me
tsäteollisuus Monialayritykset Energia Elintarvike
teollisuus Rakennusteollisuus Tietoliikenne ja
elektr Kemianteollisuus Viestintä ja
kustannus Muu teollisuus
Pankit ja rahoitus Vakuutus Sijoitus Kuljetus ja
liikenne Kauppa Muut palvelut Metalliteollisuus Me
tsäteollisuus Monialayritykset Energia Elintarvike
teollisuus Rakennusteollisuus Tietoliikenne ja
elektr Kemianteollisuus Viestintä ja
kustannus Muu teollisuus
banking insurance investment transportation trade
otherservice metal industries forestry multisector
energy food processing construction communication
s chemical industries publishing other industries
banking insurance investment transportation trade
otherservice metal industries forestry multisector
energy food processing construction communication
s chemical industries publishing other industries
banking insurance investment transportation trade
otherservice metal industries forestry multisector
energy food processing construction communication
s chemical industries publishing other industries
Country- based portfolio Correlation
between Price developments In national
stock markets Secondarily sector- based
Sector-based portfolio Correlation between
performance of productive sectors Secondarily
country-based
42
STOCK MARKET INDICES IN EUROPE
Country/Exchange - lists Market indices
1. Dow Jones Stoxx ( DJ Stoxx ) Geographical
Europe EU ( not Luxembourg ) plus Norway,
Switzerland Eurozone EMU ( not Luxembourg
) Europe ex UK EU ( not Luxembourg, Great
Britain ) plus Norway, Switzerland Europe ex
Eurozone EU less EMU, plus Norway,
Switzerland Nordic region Finland, Sweden,
Norway, Denmark 2. Morgan Stanley Capital
International ( MSCI ) Europe EMU
1. Morgan Stanley Capital International (
MSCI ) eight sector indices, 38 industry
indices Europe, EMU, Europe less Great
Britain, 1. Standard Poors ( S
P ) S P Euro Index EMU 160 companies
S P Euro Plus Index EMU plus Denmark,
Norway, Sweden,
Switzerland 200 companies 2.
Financial Times International ( FTSE ) FTSE
Eurotop 100 Great Britain, Germany, France,
Switzerland,
Netherlands, Italy, Sweden, Spain, Belgium
100 companies
FTSE E - stars EMU 29 companies FTSE
Eurobloc 100 EMU 100 companies FTSE
Eurotop 300 Europe 300 companies

Aggregate/General market index
Country sector indices
Aggregate/General sector index
Company Index
43
Nasdaq (Dubai)

Stockholm Stock Exchange OM Stockholm AB/ OM
Group Copenhagen Stock Exchange Helsinki
Stock Exchange, HEX Helsinki Derivatives
Exchange Amsterdam Exchanges Brussels Stock
Exchange Dublin Stock Exchange London Stock
Exchange Liffe Paris Stock Exchange
Matif-Monep Vienna Stock Exchange Frankfurt
Stock Exchange/ Deutsche Börse/ Euroboard
Deutsche Terminbörse Zurich/Swiss Stock
Exchange/SWX Milan Stock Exchange Miff Madrid
Stock Exchange Meff
5.3. EUROPEAN EXCHANGES COMPETITION AND CONCENTR
ATION
OMX
Norex
EDX London
Oslo Reykjavik Tallin
NYSE
Riga
Euronext
Luxembourg Warsaw
Qatar Dubai


Lisbon
Chicago Board of Trade / Chicago Mercantile Exchan
ge
Seaq International London

Tradepoint
Newex/Eastern Eur.
Eurex
Virt-x
equity trading/ exchange
derivatives trading/ exchange
44
Integration of exchanges
Lista/ List X
Lista/ List Y
Lista/ List Z
Meklari X
Meklari Y Meklari
Z
broker/dealer
broker/dealer
broker/dealer
Sijoittaja Investor
Lista/ List X Lista/
List Y Lista/ List Z
broker/dealer
Meklari Y
platform
Sijoittaja/Investor
45
5.4. Diversification of a Security
Portfolio Market price uncertainty ( market
) risk volatility standard deviation/variance
Single Asset
Invest 90 for 1 year buy one share for instance
90 USD for one IBM-share ( no dividends ). After
one year, possible outcomes with probabilities (
probability distribution ) bull market
probability 50 stock price( estimate ) 130
rate of return (130/90)-1 0.44444.4 pa bear
market probability 50 stock price (estimate )
80 rate of return ( 80/90)-1 -0.111-11.1
pa The distribution is defined by two measures
1) Expected rate of return ( the mean/average
of the distribution ) 2) Standard deviation (
square root of variance ) of the distribution (
volatility risk). 1) The expected rate of
return is ( 0.50 0.444 ) ( 0.50 -0.111 )
0.1665 16.65 pa 2) The standard deviation
of the distribution the risk Consider four
alternative assets
possible outcomes with
probabilities ( after one year ) expected
RR Asset A ( Treasury Bill ) RR
6 1 ( 100 )
6 Asset B
(bad) RR 10 0.25
(normal) RR
0 0.25

(good) RR 20 0.50
7.5 Asset
C (bad) RR
-20 0.25
(normal) RR 10 0.50
( good)
RR 40 0.25
10 Asset D
(bad) RR 0 0.25

(normal) RR 10 0.50
(good) RR 20
0.25
10 Calculate the variance and standard
deviation ( risk ) of these assets Asset A
variance 0, standard deviation 0 Asset B
variance 0.25(-0.10 0.075)2 0.25(0
0.075)2 0.50(0.20 0.075)2 0.016861.7
st.deviation 0.1298 13
Asset C variance 0.25(-0.20 0.10)2
0.50(0.10 0.10)2 0.25(0.40 0.10)2
0.0454.5 st.deviation
0.2121 21.2 Asset D variance 0.25(0
0.10)2 0.50(0.10 0.10)2 0.25(0.20
0.10)2 0.0050.5
st.deviation 0.07077.1

46

• Mean variance ( also risk return )
  setting
• 6 0
• 7.5 1.7
• 10 4.5
• 10 0.5

Risk neutrality only expected return is relevant
C or D (indifferent) Risk aversion if
equal expected returns, choose less risk
D over C if equal risks
choose higher expected return
if risk is larger, expected return must be
larger D over B

D over A if a risk
premium of 4-points

is subjectively enough
to compensate

for the (increased) risk Risk
loving if equal expected return