Chapter 2 Markets and Instruments

1
Chapter 2 Markets and Instruments

• Distinguish between money markets and capital
  markets
• Introduce money market instruments
• Introduce capital market instruments
• Fixed income instruments and basic calculations
• Properties of Equities
• Indices
• Derivatives

2
Types of Markets

• Money Markets
• Short term
• Easily marketable
• Highly liquid
• Typically very low risk
• Capital Markets
• Longer term
• Less liquid
• Involve greater risk

3
Money Markets

• T-Bills (detail following)
• Commercial Paper (only the larger more
  established companies can access this market)
• Issued by Corporations
• 270 days or less because over 270 days must be
  registered with SEC
• Usually issued in multiples of 100,000 or more
• Rated for credit quality by the rating agencies
• Certificate of Deposit
• Time deposit with a bank (may not be withdrawn on
  demand)
• Greater than 100,000 can be sold
• Short-term CDs are highly marketable

4
Money Markets

• Bankers Acceptance
• Order to pay a sum of money at a future date
• Tradable and very safe, bank guarantees
• Fed Funds
• Bank deposits
• Eurodollars
• Dollar denominated deposits in foreign banks
• Escape regulation by the Federal Reserve Board
• Repos and Reverses
• Reverses - Agreements by dealers in government
  securities to borrow securities and sells
  securities to an investor overnight or longer and
  agrees to buy them back at a higher price
• Repo is the same scenario in reverse

5
Money Markets

• Federal Funds
• Banks account with the Federal Reserve Bank
• Banks are required to keep a minimum balance with
  the Federal Reserve Bank depending on their
  portfolio of accounts fed funds
• Brokers Calls
• Individuals who buy stocks on margin borrow the
  funds from their broker
• Broker in turn borrow from a bank
• Rate is 1 higher than the rate on short-term
  T-Bills
• LIBOR Market
• London Inter Bank Offered Rate
• Rate large banks in London lend money among
  themselves
• Become international now

6
Treasury Bills Most Marketable

• Issued by the U.S. Government to fund short term
  obligations
• Exempt from state local taxes
• Sold At discount to Face Value (Zero Coupon
  Bonds)
• Face Value Paid _at_ Maturity
• Trade in Large Denominations
• 52 weeks in duration or less
• Issued by the government via silent auction
• Highly Liquid

7
Bank Discount Yield
-
P
360
000
,
10



r
BD
n
000
,
10

Face amount 10,000 P Purchase price n
days to maturity from actual sale (or purchase)

• 3 Issues with BD yield
• 360 days vs. 365
• Compared to FV vs. purchase price
• Simple interest vs. compound interest

8
Calculating T-Bill Price

• Example The Wall Street Journal for Thursday,
  December 23, 1999, lists the following quote
  under Treasury Bonds, Notes and Bills as of the
  market close on Wednesday, December 22, 1999
• Days
• to Ask
• Maturity Mat. Bid Asked Chg. Yld.
• Mar 23 00 91 5.38 5.37 -0.04 5.52
• What is the asked dollar price of the T-Bill with
  a face value of 10,000?

9
Bond Equivalent Yield
Actual Days in Year Normal year 365 days Leap
year 366 days
10
Calculating Bond Equivalent Yield - BEY

• Calculate the asked yield (Bond equivalent yield)
  and compare it to that given by The Wall Street
  Journal using the price of 9,864.26 for the
  10,000 face value T-Bill calculated previously.

11
Effective Annual Yield
Effective annual yield
Actual Days in Year Normal year 365 days Leap
year 366 days
12
Calculating Effective Annual Yield

• Calculate the effective annual yield using the
  price of 9,864.26 for the 10,000 face value
  T-Bill calculated previously.

13
Yield Relationships
BD Differences increase with the longer the time to
maturity and the higher the discount rates.
14
Capital Markets

• Long-Term Fixed Income
• Equities
• Derivatives

15
Fixed Income

• Treasury Notes (up to 10 years) Bonds (10 to 30
  years)
• Municipal Bonds
• Corporate Bonds
• Mortgage Securities
• Federal Agency Bonds

16
Treasury Bonds and Notes
Wednesday, December 22, 1999
Maturity Ask Rate Mo/Yr Bid
Asked Chg. Yld. 8¾ Nov
03-08 10710 10712 - 3 6.57

• Semi annual coupon payments
• Denominations of 1,000 or more
• Callable bonds
• Premium and discount bonds

17
Treasury Notes Bonds

• Notes (less 10 years)
• Bonds (10 30 years)
• Quoted as a of par value
• Differences
• Maturity
• Call provision some notes were callable not
  recently
• Yield calculated based on call date if trading at
  a premium and maturity if trading at a discount

18
Municipal Bonds

• Issued by State Local Government
• Two Types
• General Obligation
• Revenue Bonds
• Tax Exempt (Usually federal exempt

19
Municipal Returns

• Rm Rt (1-t)
• Equivalent taxable yield
• Rety Rm /(1-t)

20
Corporate Bonds

• Semiannual Payment
• Default Risk
• Optionality
• Collateral
• Priority

21
Corporate Bonds
Wednesday, December 22, 1999
Cur Net Bonds Yld Vol Close
Chg. RalsP 85/822 8.1 5 106 1/2
-2 3/8

• Semiannual coupon payment
• Interest rate risk
• Default risk
• Seniority
• Secured vs, unsecured bonds

22
Mortgages Agency Bonds

• Fixed (30 year, 15 year)
• Adjustable Rate Mortgage (ARM)

23
Mortgage Liability Mismatch
24
Financial Innovation- CMO

• Pooling assets
• Selling security
• Lender removes liability asset
• Captures Spread

25
Common Stock

• Shares of ownership in a corporation
• Right to residual claims
• Right to vote on corporate matters
• Limited Liability

26
Investor Equity Return

• Dividend Yield of Price change

27
Preferred Stock

• Debt Equity Characteristics
• Fixed Dividend Payout
• No Contractual obligation
• Cumulative, Non-Cumulative
• Voting, Non Voting
• Note Corporations that own preferred stock can
  exclude 70 of dividends paid for tax purposes
• Corporation pays taxes on preferred dividends
  unlike interest (double taxation, just like
  common dividends for individual investors)

28
Derivatives

• Call Option (right to purchase on or before a
  certain date for a predetermined price)
• If you buy a call you have limited loss and
  unlimited gain
• If you sell a call you have limited gain but
  unlimited loss if you do not own the underlying
  security naked option)
• Put Option (right to sell on or before a
  certain date for a predetermined price)
• If you buy a put you have limited loss and
  unlimited gain
• If you sell a put you have limited gain and your
  loss is limited to the exercise price of the
  asset in the contract but it is a significant
  loss
• US option vs. European Option not on or before
  a certain date it is only ON a certain date
• Futures Forwards

29
Derivatives

• Strike Price or exercise price price the
  transaction will occur at if it occurs at all
• In the money / Out of the money
• Long Position
• Short Position

30
Index Construction
31
Indices

• Price Weighted
• Market (Dollar) Weighted
• Equal Weighted

32
Chapter Concepts

• Role of investment bankers in primary issues
• Identify the various security markets
• Describe the role of brokers
• Compare trading practices in stock exchanges with
  those in dealer markets
• Buy Stock on Margin and Sell Stock Short

33
Primary Markets

• Types of Transactions IPOs, New Issuances, and
  private Placements
• Red Herring Prospectus
• Underpricing

34
Investment Banking Arrangements

• Underwritten vs. Best Efforts
• Underwritten firm commitment on proceeds to the
  issuing firm.
• Best Efforts no firm commitment.
• Negotiated vs. Competitive Bid
• Negotiated issuing firm negotiates terms with
  investment banker.
• Competitive bid issuer structures the offering
  and secures bids.

35
Public Offerings

• Public offerings registered with the SEC and
  sale is made to the investing public.
• Shelf registration (Rule 415, since 1982)
• Initial Public Offerings (IPOs)
• Evidence of underpricing
• Performance

36
Private Placements

• Private placement sale to a limited number of
  sophisticated investors not requiring the
  protection of registration.
• Dominated by institutions.
• Very active market for debt securities.
• Not active for stock offerings.

37
Organization of Secondary Markets

• Organized exchanges
• OTC market
• Third market
• Fourth market

38
Organized Exchanges

• Auction markets with centralized order flow.
• Dealership function can be competitive or
  assigned by the exchange (Specialists).
• Securities stock, futures contracts, options,
  and to a lesser extent, bonds.
• Examples NYSE, AMEX, Regionals, CBOE.

39
OTC Market

• Dealer market without centralized order flow.
• NASDAQ largest organized stock market for OTC
  trading information system for individuals,
  brokers and dealers.
• Securities stocks, bonds and some derivatives.
• Most secondary bonds transactions

40
Third Market

• Trading of listed securities away from the
  exchange.
• Institutional market to facilitate trades of
  larger blocks of securities.
• Involves services of dealers and brokers

41
Fourth Market

• Institutions trading directly with institutions
• No middleman involved in the transaction
• Organized information and trading systems
• ECN Development

42
Exchange Orders

• Market
• Limit
• Good til Cancelled
• Stop Loss, Stop Buy

43
Trading on Exchanges
The specialist
NYSE Makes a market The brokers broker Maintains
the limit order book Maintains a fair and orderly
market
44
Trading on Exchanges
Block orders - at least 10,000 shares DOT
SuperDOT - direct to specialist Settlement
Three business days
45
Trading on the OTC

• Negotiated market
• No specialist
• NASDAQ computer system

46
Costs of Trading

• Explicit Costs
• Brokers commissions
• Bid-Ask Spread
• Implicit Costs
• Impact
• Timing
• Opportunity

47
Liquidity

• Liquidity Demanding
• Market dominated by buyers
• Impact costs incurred by buyers
• Liquidity Supplying
• Seller Dominated
• Impact costs is a gain to buyer as costs are
  dropping

48
Style Liquidity

• Value Managers-Liquidity Suppliers
• Momentum Managers- Liquidity Demanders

49
Cost of Trading
Impact of trading costs on returns
50
Margin Trading

• Using only a portion of the proceeds for an
  investment.
• Borrow remaining component.
• Margin arrangements differ for stocks and futures.

51
Stock Margin Trading

• Maximum margin
• Currently 50
• Set by the Fed
• Maintenance margin
• Minimum Margin Level
• Margin call
• Requires additional funds

52
Actual Margin
53
Rate of Return with Margin
54
Margin Trading - Initial Conditions

• X Corp 70
• 50 Initial Margin
• 40 Maintenance Margin
• 1000 Shares Purchased
• Initial Position
• Stock 70,000 Borrowed 35,000
• Equity
  35,000

55
Margin Trading - Maintenance Margin

• Stock price falls to 60 per share
• New Position
• Stock 60,000 Borrowed 35,000
• Equity
  25,000
• Margin 25,000/60,000 41.67

56
Margin Trading - Margin Call

• How far can the stock price fall before a margin
  call?
• (1000P - 35,000) / 1000P 40
• P 58.33
• 1000P - Amount Borrowed Equity

57
Leverage

• Borrowing magnifies ROE

58
Leverage
Example An investor purchases 100 shares of
stock at 100 per share using 10,000 of her own
money and borrows nothing. The stock price rises
to 130 per share (ignoring any dividends). What
is the return on the total investment? ... the
return on equity? ROA ROE
59
Leverage
Example An investor purchases 100 shares of
stock at 100 per share using 5,000 of her own
money and borrows 5,000. The stock price rises
to 130 per share (ignoring any dividends). What
is the return on the total investment? ... the
return on equity? ROA ROE
60
Short Sales

• Purpose to profit from a decline in the price
  of a stock or security.
• Mechanics
• Borrow stock through a dealer.
• Sell it and deposit proceeds and margin in an
  account.
• Closing out the position buy the stock and
  return to the party from which it was borrowed.

61
Short Sales
62
Short Sale - Initial Conditions

• Z Corp 100 Shares
• 50 Initial Margin
• 30 Maintenance Margin
• 100 Initial Price
• Sale Proceeds 10,000
• Margin Equity 5,000
• Stock Owed 10,000

63
Short Sale - Maintenance Margin

• Stock Price Rises to 110
• Sale Proceeds 10,000
• Initial Margin 5,000
• Stock Owed 11,000
• Net Equity 4,000
• Margin (4000/11000) 36

64
Short Sale - Margin Call

• How much can the stock price rise before a margin
  call?
• (15,000 - 100P) / (100P) 30
• P 115.38
• Initial margin plus sale proceeds

65
Regulation of Securities Markets

• Government Regulation
• Self-Regulation
• Circuit Breakers
• Insider Trading
• ECNs and Fragmentation