Chapter 2: Markets and Instruments

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Chapter 2 Markets and Instruments

• Objective To introduce the features of various
  security types
• Money market
• Fixed income capital market
• Equity securities
• Stock and bond market indices
• Derivative markets

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• Money markets include short-term, liquid and
  low-risk debt securities.
• Mostly sold in minimum denomination of 100,000.
• Investor mostly financial institutions and
  institutional investors.
• Sold on a discounted basis, e.g., buy at 960
  today and receive face value of 1,000 at
  maturity.

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1. The Money Market

• Treasury bills
• Governments short-term debt primarily sold to
  banks, investment dealers and the Bank of Canada.
• Maturities of 3, 6, and 12 months
• Highly liquid, and default-free.
• Sold biweekly via auction.
• Offered in denominations of 1,000, 5,000,
  100,000 and 1 million.

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• Certificate of deposit
• Time deposit with a bank
• Guaranteed investment certificate (GIC) similar
  time deposit for smaller amount.
• CD and GIC are nontransferable.
• Some CDs over 100,000 are negotiable (known as
  bearer deposit note BDNs).
• In U.S. CDs are negotiable in a highly liquid
  market.

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• Commercial Paper
• Short-term unsecured debt notes of well-known
  corporations
• Often backed by a bank line of credit
• Typical maturity of one or two months, often
  rolled over
• Fairy safe asset in view of short maturity
• Minimum denomination of 50,000

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• Bankers Acceptances
• An order to a bank (by a banks customer) to pay
  a sum of money to the bearer on a given date.
• Eurodollars
• U.S. dollar-denominated deposits at foreign banks
  outside the U.S. or foreign branches of U.S.
  banks.
• Mostly time deposits of large amount
• Eurodollar CDs are negotiable
• Euro deposits and CDs are available in all major
  currencies.

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• Repurchase Agreements (repos or RPs)
• Short-term (usually overnight) borrowing between
  dealers in government securities
• Dealer A sells government securities to an
  investor B with an agreement to buy the
  securities the following day at a higher price.
• Net effect Dealer A takes an overnight loan, and
  provides the securities as collateral.

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• Reverse repos
• The mirror image of repos.
• Dealer A buys securities from investor B,
  agreeing to sell them back at a specified higher
  price on a future date.
• The LIBOR market
• The London Interbank Offered Rate (LIBOR) is the
  lending rate among large banks in London.
• It serves as a reference rate for a wide range of
  transactions.

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Yields on Money Market Instrument

• Example Consider a T-bill sold at 960 with a
  maturity of 182 days, and a 1,000 par value.
  What is the yield?
• The yield for 182 days is (where Pprice)
• (1,000-960)/P r (1)
• ? r4.167
• The yield for 365 days is then
• 4.167 (365/182) 8.357 p.a. (2)
• The bond equivalent yield is 8.357.
• Alternatively, one can consider compounding
• (14.167)2 1 8.508 p.a.
• The effective annual yield is 8.508.

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• In U.S., one uses
• 1,000 in the denominator of (1), instead of P,
  and
• 360 days in (2), instead of 365 days.
• The resulting yield is the bank discount yield.
• One can convert the bank discount yield to the
  bond equivalent yield
• rBEY (365d)/(360 dn),
• where dbank discount yield, and
• nmaturity in days.

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2. Fixed Income Capital Market

• Longer-term borrowing instruments than those in
  the money market.
• Some bonds are callable
• Government of Canada Bonds
• Also known as Canada bonds
• Maturities up to 40 years
• Generally noncallable
• Makes semiannual coupon payments
• The yield is the bond equivalent yield.
• For callable bonds trading at a premium, the
  yield is calculated to the first call date.
• For callable bonds trading at a discount, the
  yield is calculated to the maturity. Why does it
  make sense?

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• Provincial and Municipal Bonds
• U.S. municipal bonds are exempt from federal,
  state and local taxes. But the tax advantage is
  not available to Canadian investors.
• Corporate Bonds
• Default risk is a real consideration
• Secured and unsecured (debenture), and
  subordinated bonds
• Callable, retractable and extendible, and
  convertible bonds.

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• Mortgage-Backed Securities (MBS)
• MBS is an ownership claim in a pool of mortgages
  or a new security secured by such a pool.
• A bank pools its mortgage loans and sells the
  claim to the cash flows from the mortgage loans.
• The bank collects principal and interest payments
  from the borrower, and pass-through these
  payments to the holder of the MBS.
• MBS holders face the prepayment risk of
  underlying mortgage loans.

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3. Equity securities

• Common stock
• Common stocks represent ownership in a
  corporation
• One share one vote.
• Agency problems alleviated by
• CEO compensation scheme
• Oversight by the board of directors and outsiders
  such as regulators, security analysts, large
  institutional shareholders
• Discipline by the market (threat of a proxy
  contest, and a takeover)
• Residual claim and limited liability

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• Preferred stock
• Fixed dividends, usually cumulative.
• Priority over common
• Tax treatment
• Income Trusts
• An income trust holds underlying assets, and
  distribute the income from the assets to unit
  holders.
• The income generated by the income trust, and
  flowed-through to investors are virtually
  tax-free, offering a high yield to investors.

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4. Stock and bond indices

• Uses
• Track average returns
• Comparing performance of managers
• Factors in constructing an index
• Composite stocks
• Representative?
• Broad or narrow?
• How is it constructed?

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Toronto Stock Exchange indices

• SP/TSX Composite Index
• It contains over 220 large cap stocks
• A market-value weighted index, giving more weight
  to large, highly valued stocks
• SP/TSX 60
• SP/TSX MidCap and TSX SmallCap
• SP/TSX Venture index
• Index funds

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US indices

• Dow Jones Industrial Average
• Index of 30 large blue-chip stocks since 1896
• Price-weighted average
• Adjusted for price changes due to stock split
• Standard Poors 500 Composite
• NASDAQ Composite
• NYSE Composite
• Wilshire 5000

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• Foreign and international stock market indices
• Most are value-weighted
• Nikkei, FTSE, DAX
• International indices (MSCI)
• Bond market indicators are published by
• Scotia Capital (Canada) Lehman Brothers, Merrill
  Lynch, Salomon Brothers (U.S.)

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5. Derivatives markets

• Options
• Basic Positions
• Call (Buy)
• Put (Sell)
• Terms
• Exercise Price
• Expiration Date
• Underlying Assets

• Futures
• Basic Positions
• Long (Buy)
• Short (Sell)
• Terms
• Delivery Date
• Underlying Assets

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Derivative Securities-Quotes

• Options
• Bid price
• Ask price
• Last price
• Open interest
• Underlying asset price
• Cash settlement
• Physical delivery

• Futures
• Settlement price
• Change
• Open interest
• Underlying asset price
• Cash settlement
• Physical delivery