FINANCE 102

March 05

2020

UW FARMSAMarket Research Team

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March 05, 2020

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Macroeconomics & Portfolio Management

Public Equity & Private Equity

Bonds & Structured Credit

Intermission: Finance at RBC

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FOREX

Forward, Future, Swap, and Option

Different Investment Funds

MACROECONOMICS

Stages of the Business Cycle

Business Cycle: describes the rise and fall in production output of goods in an economy.

● Peak

● Recession

● Trough

● Recovery

● Expansion

Sector Performance

● Aggressive stocks do

well in early stages

● Defensive stocks do

better in late stages

Sector: An area of the economy in which businesses share the same or a related product or service.

Macro Factors

Macroeconomic Factors: factors that currently affect or in the future may affect business. Examples - Interest Rates, Inflation, Unemployment

Macro Factors

Example Indicators: Manufacturing Data (ISM), Non-Farm Payrolls, Consumer Price Index (CPI)

Macro Factors

PORTFOLIO

MANAGEMENT

Asset Allocation

Asset Mix: proportion of each asset class held in a portfolio relative to the overall portfolio value

• Allocation of principle to equities, fixed

income, commodities, exotics, cash (mm)

• Strategy of diversification to minimize risk

• Eliminate diversifiable risk, remaining risk

is taken on in order to capture return

Sample Allocation

Equities Fixed Income Cash

Asset Performance

Key Considerations

2

43

1Time Horizon- Time to Maturity- Timing of Cash Flows- Liquidity Requirements

Risk Tolerance- Investment Objective- Risk/Return Trade Off- Income Stability

Rebalancing- Frequency (Cost of Spread)- Cross Asset Synergy- Portfolio Strategy- Review Methodology

Investor Profile- Degree of Financial

Literacy/Interest- Ability to Monitor- Sector/Market Exposure

PUBLIC EQUITY

Public Equity

Public Equity: is an asset class where individuals or organizations can buy ownership and shares of a public company through the public market

- Public Equity is a liquid asset

- Over 630,000 companies traded around the world

- New York Stock Exchange is the largest stock market in the world- Equity Market Capitalization of over 19

trillion US Dollars

Technical Analysis

Technical Analysis: Uses historical price movement to identify trends and make predictions of price action in the future

- Core Principle of Technical Analysis- Market Prices Reflect all relevant information

impacting the market

- Technical Indicators- heuristic or mathematical calculations based on

the price, volume or open interest of a security

Efficient MarketHypothesis:Shares traded at their fair value price and all information is represented in the price

Technical Indicators

Technical Indicators:- Moving Average- Bollinger Bands- Relative Strength Index (RSI)

Moving Average Indicator: Lagging indicator that helps smooth out price action from price fluctuations

Moving Average

Golden Cross:- Short term moving average

crosses above the long term moving average

- Creates a buy signal, predicting future growth

Moving Average

Death Cross:- Short term moving average

crosses below the long term moving average

- Creates a sell signal, predicting future losses

Fundamental Analysis

Fundamental Analysis: Is a process used to evaluate the value of a company using the metrics of the past, other businesses, and sectors.

Inefficient Markets Hypothesis: States that shares do not trade at their fair value, but rather can be underpriced or overpriced

Intrinsic Value

Discounted Cash Flows

- FV is Future Cash Flows

- i is Discount rate

Comparative Analysis

Company Name Price Per Share

($)

Market Cap

(B)

Earnings per

share

Price to

Earnings (x)

P/E to Growth

(x)

Procter and

Gamble Co.

$123 $305.57 $1.78 69.52 3.54

McCormick Inc. $153 $20.345 $5.24 29.20 1.73

Clorox Co. $173 $21.747 $6.35 27.36 4.91

Sector Average 25.33 2.28

Comparative Analysis of Consumer Staples Companies shares

Comparative Analysis: Is a process used to evaluate the value of a company using the metrics of the past, other businesses, and sectors.

PRIVATE EQUITY &

VENTURE CAPITAL

What is Private Equity and Venture Capital?

• Alternative investments targeting companies in private markets

Private Equity (PE)

• Primarily invests in mature companies or growth equity

• Can specialize into certain sectors or be sector agnostic

• Larger deals

• Acquires controlling stakes

Venture Capital (VC)

• Invests in start-ups and growing companies with limited capital

• Most prominent in Tech, Biotech, and Cleantech industries

• Smaller deals

• Acquires minority stakes

Growth as an asset class

Why has the asset class grown?

• Liability-Driven Investors beset by low Fixed Income returns

• Avoids the scrutiny of public markets

• Historically higher returns than public equities

How do firms earn returns?

“Good private equity investors create a lot more economic value

than they destroy”— Bill Ackman, CEO Pershing Square Capital

Private Equity

• Uses leverage to acquire companies

• Improve firms operationally

• Sell firms for a higher multiple

Venture Capital

• Growth of company size and valuation

• Cash flow from equity investment allows

for capital expenditures

• Sell equity stake when company is larger

3 ways to generate value

1. Multiple expansion

2. Operational improvement

3. Deal structure

BONDS

What is a Bond?

• A debt financing instrument

• A form of I.O.U

• Legal Agreement

• Features:

• Par value

• Maturity Date

• Coupon Rate

• Payment Frequency

How to Price a Bond?

C1 C2 C3

Price?

t=1 t=2 t=3

……

t=N

CN+Par ValueVanilla Coupon Bond

Interest Risk (y)

• Inverse relation between interest rate

and bond price

• Positive relation between interest rate

and bond yield

Scenarios Bond Price Bond Yield

Interest Rate Increases

Decreases Increases

Interest Rate Decreases

Increases Decreases

Major Players

Major Issuers (Borrower)

• Governments (Federal, Provincial,

Municipal)

• Infrastructure Establishment

• Government Financing

• Corporations

• Capital expenditures

• The use of leverage

• Hedging (Derivatives)

Major Holders (Lenders)

• Central bank

• Monetary policy

• Mutual Funds

• Insurance Companies

• Investment banks

• Pension Plans

• Households are not major players

Credit Risk

• Credit rating

• Investment grade vs High-yield

• Government bonds considered risk free (Treasury bill)

• Credit ratings are assigned by rating agencies

• S&P (AAA, AA+,…)

• Moody’s Investors Service (Aaa, Aa1, …)

Treasury Bill/Notes/Bond (US)

Points of Comparison

Treasury Bill Treasury Notes Treasury Bond

Maturity

Zero Coupon Bond

• A bond with only one cashflow

• Provides insight to the interest rate over the years

Price?

t=N

Par Value

Zero Coupon Bond

Spot Rate

Yield Curve

0

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9

0 1 2 3 4 5

Sp

ot

Rate

Time to Maturity

Yield Curve (Spot Rate)

Yield Curve

STRUCTURED CREDIT

What is Structured Credit?

• Financial assets such as loans and mortgages are packaged into interest-

bearing securities backed by those assets and issued to investors

Asset-backed securities (ABS)

Mortgage-backed securities (MBS)

• Residential mortgage-backed securities (RMBS)

• Commercial mortgage-backed securities (CMBS)

Non-Real Estate

• Debt-related consumer products (Auto-loans, consumer credit)

• Corporate contracts (Equipment leases, aircraft leases, shipping)

Collateralized debt obligations (CDOs)

• Tranches of debt from ABS separated by credit rating

Structured Credit Products

Senior, AAA, 3%Mezz., BBB, 5%Junior, B, 7%

Investing in Structured Credit

• Given low correlation with other Fixed Income securities, ABS can be a robust

diversification and yield-enhancing tool for institutional portfolios

What happened in the Financial Crisis?

“I am not responsible for the financial crisis, I

hate to tell you” — Jamie Dimon, CEO JP. Morgan

1. Strong housing market

• Home prices increasing in the United States

• Increase in high-risk subprime mortgage lending

2. Growth of the MBS and CDO market

• Credit rating agencies lacked due diligence (S&P, Moody’s)

• Credit ratings did not reflect the risk profile of underlying loans in debt tranches

3. Mortgage defaults skyrocket and the housing bubble bursts

• People could no longer afford their mortgages and MBS cash flows dried up

• Homes, or the collateral on the MBS and CDOs no longer held previous value

• Everyone lost money….. except Michael Burry

Since the Financial Crisis

• While ABS have again risen in popularity, RMBS and Subprime Mortgage growth

continues to be muted – the stigma remains

FINANCE AT RBC

Opportunities at RBC

• RBC Capital Markets• Investment Banking and Debt Capital Markets (DCM)• Sales and Trading• Global Research• Corporate Banking• Derivatives Solutions

• RBC Wealth Management• RBC Global Asset Management (GAM)• RBC Dominion Securities

• RBC Economics

Highlights of the firm

• Largest bank in Canada by market capitalization

• RBC Capital Markets• Top Canadian investment bank in Canada and the United States• Highest S&T volume across Canadian banks in most products

• RBC Wealth Management• Top 15 wealth manager globally by AUM

• For a co-op student• High access to internal networking• Truly diverse and inclusive workplace

FOREX

What is Forex?

Forex: is a marketplace where various national currencies are traded, also known as the Foreign Exchange Market

• World’s most traded market per day

○ 5.1 Trillion vs 257 Billion USD/day for equities

• 24 Hours a day, 5 days a Week

• Most liquid, accessible worldwide

• Decentralized, over-the-counter

How to Trade Forex

Day-To-Day Speculation

Selling your currency at hand to buy another currency through a

financial institution

FX Spot Derivative, is a contract between two parties to buy one currency against selling

another

Major Currency Pairs:

EUR/USD USD/JPYGBP/USD USD/CHFUSD/CAD AUD/USD

EUR/GBP

Currency Pairs

Currency Pair: Quotation of two currencies, with the value of one currency being quoted against the other

1 pip = 0.0001 = 0.01%

Forex and Economics

Effects of Macroeconomic Changes on Value of Currencies

Factor Response in

Increase

Response in Decrease

Interest Rate ↑ ↓

Inflation ↓ ↑

Unemployment Rate ↓ ↑

Manufacturing ↑ ↓

Gross Domestic Product

(GDP)

↑ ↓

Forex Speculation Strategies

Hedging to Minimize Risk Triangular Arbitrage

Hedging: Strategy to minimize risk of loss from an unexpected market event

In forex, the two most common strategies consist of:- Obtaining a spot contract in

opposite directionEx: If buying EUR/USD, also sell it

- Obtaining forex options

Definition: Rare exchange rate mismatching between three foreign currency pairs.

1.5000

100.0070.00 ¥105,000

FUTURES AND

FORWARDS

Futures vs. Forwards

Both involve an agreement to trade an asset at a later date with the price already predetermined.

Characteristics Futures Forwards

Execution On an exchange Over-the-counter

Maturity > 1 1

Affected by Market? Yes No

Commodities

Commodities Trading

● Commodities can be bought and sold directly in the spot market.

● Commodities can be traded using derivatives contracts, ie. Futures and Options

● Certain market conditions provide optimal opportunities to invest in certain commodity sectors

A good that is interchangeable with another good of the same type.

Commodities

Categories

ex. Crude oil, Natural Gas

Energy Metals Livestock Agriculture

ex. Gold, Silver, Copper

ex. Live Cattle, Eggs, Pork Belly

ex. Soybean, Sugar, Coffee

Futures vs. Forwards

Futures and forwards intuitively are hedging tools.

Producer Hedge Consumer HedgeNew Market Price

($)Price Equation ($) Net Price ($)

25 25 - 5

2020 20

17 17 + 3

New Market Price ($)

Price Equation ($) Net Price ($)

30 30 - 10

2020 20

10 10 + 10

Ex: Assume a futures contract needs to be locked in at $20 in 1 year

Commodities Current Example

Ex. Coffee

SWAPS

What is a swap?

• Exchange of one financial feature for the other between two parties

• Over-the-counter contract

• Cash flows based on notional principal amount

• Two legs of cash flows

Benchmark Interest Rate

Fixed Rate: fixed interest rate for

discounting on a set of cash flows

Floating Rate: interest rate based

on a benchmark + x bps

Benchmark Rate

• Risk free rate is too stable to

represent market condition

• Historically: LIBOR (phase out

by the end of 2021)

• Substitutes:

• Canada: CORRA

• US: SOFR

• Europe: ESTR

• UK: SONIA

Interest Rate Swap (IRS)

Party Fixed Floating

Y 5.0% CORRA + 10bps

X 6.5% CORRA + 100bps

Interest Rate Swap: an customized

contract that allow two parties to

exchange fixed/floating rates

Analysis

• Party Y:

• Want to have floating rate

• Absolute advantage on both

• Comparative advantage on fixed

• Party X:

• Want to have fixed rate

• Comparative advantage on floating

• Potential Saving: 60 bps

Interest Rate Swap (IRS)

Party Initial IRS Result Saving

Y 5.0% Pay CORRA + 100 bps CORRA – 20 bps 30 bps

X CORRA + 100bps Pay 6.2% 6.2% 30 bps

Financial intermediaries might take spread from this saving

Direct Selection

Party Direct Selection

Y CORRA + 10 bps

X 6.5%

Specialize and use IRS

Split the potential saving

equally: 30 bps each

Cross Currency Swaps

• Exchange denominated in different currencies.

• Principal : Exchange in beginning = Exchange in end.

• Interest : Fixed rate, floating rate or both.

• Take place between countries

Uses of Cross Currency Swaps

• Purchase less expensive debt

• Hegde against exchange rate fluctuations

• Against Financial Crisis

• US Federal Reserve vs European Central Banks

OPTIONS

Options

Key Features

● Put/Call

● American/European

● Strike price

● Underlying Asset

● Expiration Date

● Premium/Discount

Call/Put Premium

Payoff

K

Payoff

K

Profit/Loss

K

P

Profit/Loss

K

P

Nothing is free

Buy/Write

Call Option Put Option

Buy (Long)

Purchase a call option

Purchase a put option

Write (Short)

Sell a call option

Sell a put option

Reversed

Payoff

/Profit

Charts

K

K K

K

PayoffProfit

Volatility of an Option Investment

• Option premium is usually much less than the

price of the underlying asset

• The return is much more volatile than its

underlying asset

• consider an investment of $1000

• Stock: 200 shares

• Call: 1000 calls

Payoff

K=10

P=1

A: S=2 B: S=20

15

-3

Scenario Stock Price

StockProfit

Option Profit

StockReturn %

OptionReturn %

A 2 -600 -1000 -60% -100%

B 20 3000 10000 +300% +1000%

Option Strategies: Covered Call

Covered Call

• Long a stock, write a call

• Limited profit but quick

premium revenue

• Given start with a stock

portfolio

Profit/Loss

K

P

Long a Stock

Write a Call

Covered Call

Option Strategies: Protective Put

Protective Put

• Long a stock, long a put

• Limited loss

• Resembles a long on call option

• Given start with a stock portfolio

Profit/Loss

K

P

Long a Stock

Long a Put

Protective Put

Option Strategies: Straddle and Strangle

Profit/Loss

K

Profit/Loss

K1 K2

Straddle

• Long a call and put at the

same strike price

• Profit on volatility

• Expensive premium cost

Strangle

• Long a call at a higher

strike price and put at a

lower strike price

• Cheaper but need larger

price volatility

Long a Call at K

Long a Put at K

Straddle

Long a Call at K2

Long a Put at K1Strangle

Greeks

change in underlying priceGreeks are the sensitivities of an option’s price to given factors, ie. underlying price, risk-free rate, volatility, etc.

Delta ∆ Vega 𝜈 Theta 𝜃 Gamma 𝛤 Rho 𝜌Greeks

Sensitive Factors

underlying asset’s price

underlying asset’s volatility

time to maturity Change in Delta Risk-free rate

Mutual Funds

• Carrier made up of a pool of money collected from various investors

• Open-end fund

• Closed-end fund

• Net Asset Value per share = Price of Fund share

Advantages

• Diversified

• Low investment requirements

• Expert management

Disadvantages

• High fees/expense

• Over-diversification

• Dilution

ETF

A Similar Concept to Mutual Funds

Common Types of ETFs

• INDEX

• Commodity

• Inverse

• Industries

• Foreign Markets

• Actively Managed

Why Choose an ETF Over a Mutual Fund?

Let’s talk differences!

HEDGE FUNDS

Hedge Fund Definition

1. Alternative investments, only accessible by accredited investors

2. Large variety of asset exposure, management strategies (regulation)

3. Fee structure (2 and 20), rather than flat expense ratio

4. Restriction on redemptions (lockup period, notice period)

Universe of StrategiesEv

ent

Dri

ven • Merger

Arbitrage• Distressed +

Restructuring• Activist

Shareholder• Special

Situations (mergers, acquisitions, bankruptcy)

Rel

ativ

e V

alu

e • Fixed-Income Convertible Arbitrage

• Fixed-Income Asset Backed

• Fixed Income General

• Volatility• Multi-Strategy

Mac

ro S

trat

egie

s • Macro Trends• Long-short

positions• Profit from

view on overall market direction

Equ

ity

Hed

ge • Market Neutral• Fundamental Growth

• Fundamental Value

• Quantitative Directional

• Short Bias• Sector Specific

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