Lecture 2

Capital Markets
Financial Markets

 Financial markets can be segmented into

money markets and capital markets

Slide 2-2
Money market instruments

 Money market instruments include short-

term, marketable, liquid and low-risk debt
securities.
 Money market instruments are called cash
equivalents or just cash.

Slide 2-3
Money Market Instruments

 Treasury bills
 Certificates of Deposit and Bearer Deposit
Notes (BDNs)
 Commercial Paper
 Bankers Acceptances
 Eurodollars
 Repurchase Agreements (REPOs) and
Reverse REPOs
Slide 2-4
Treasury Bills

 T-bills are the most marketable of all money

market instruments
 Represent the simplest form of borrowing:
Government raises money by selling bills to
the public

Slide 2-5
Certificate of Deposit

 A certificate of Deposit or CD is a time deposit with a

bank
 Time deposits may not be withdrawn on demand, the
bank pays interest and principal to the depositor only
at the end of the fixed term of the CD.
 CDs can be sold to another investor if the owner
needs to cash in the certificate before its maturity
date (short term CDs are highly liquid)

Slide 2-6
Commercial Paper

 Large well-known companies often issue

their own short-term unsecured debt notes
rather than borrow directly from banks.
 These notes are called commercial paper

Slide 2-7
Banker’s acceptance

 A banker‟s acceptance starts as an order to a bank

by a bank‟s customer to pay a sum of money at a
future date, typically within 6 months.
 When the bank endorses the order for payment as
“accepted,” it assumes responsibility for the ultimate
payment to the holder of the acceptance.
 Banker‟s acceptance can be traded in secondary
markets
 Considered as safe assets

Slide 2-8
Eurodollar

 Eurodollars are dollar-denominated deposits

at foreign banks or foreign branches of
American banks
 Despite the “Euro” tag these accounts need
not be in European banks although that is
where the practice of accepting dollar-
denominated deposits outside the United
States began.

Slide 2-9
Repos and Reverse Repos

 Dealers in government securities use repurchase

agreements also called „repos‟
 Repos are short term usually overnight borrowing
 Dealer sells government securities to an investor on
an overnight basis, with the agreement to buy back
those securities the next day at a slightly higher
price.
 Repo vs Reverse Repo

Slide 2-10
Money Market Instrument Yields

 Yields on Money Market Instruments are not

always directly comparable
 Factors influencing yields
– Par value vs. investment value
– 360 vs. 365 days assumed in a year (366 leap year)
– Bond equivalent yield

Slide 2-11
Bond Equivalent Yield

1,000  P 365
rBE Y  
P n
P = price of the T-bill
n = number of days to maturity
Example: Using Sample T-Bill
90-day T-bill, P = $980

1,000  980 365

rBEY  
980 90
rBEY = .0204 x 4.0556 = .0828 = 8.28%
Slide 2-12
Bank Discount Rate (T-Bills)

1,000  P 360
rB D  
1,000 n
rBD = bank discount rate
P = market price of the T-bill
n = number of days to maturity
Example
90-day T-bill, P = $980

1,000  980 360

rBD    8%
1,000 90
Slide 2-13
Bond Equivalent Yield

 Impossible to compare T-bill directly to bond

– 360 vs 365 days
– Return is figured on par vs. price paid
 Adjust the bank discount rate to make it
comparable

Slide 2-14
Equivalence of yields

 US T-bills are quoted in bank discount yields

 Canadian T-bills are quoted in bond equivalent
yields
 Equivalence formula:
365  rBD
rBE Y 
360  (rBD  n)
 Also note that the effective annual yield is:
365
rBE Y
reff  (1  ) n
1
365 / n
Slide 2-15
Capital Markets

 Capital markets include longer term and

riskier securities.

 Securities in the capital market are much

more diverse than those found within the
money market.

Slide 2-16
Capital markets

 Longer-term bond markets

 Equity markets
 Derivative markets for options
 Derivative market for futures

Slide 2-17
 Capital Market -
Fixed Income Instruments

 Publicly Issued Instruments

– Government Bonds
 Privately Issued Instruments
– Corporate Bonds
– Mortgage-Backed Securities

Slide 2-18
Capital Market - Equity

 Common stock
– Residual claim
– Limited liability
– Corporate governance and restricted shares
 Preferred stock
– Fixed dividends - limited
– Priority over common
– Tax treatment

Slide 2-19
Stock Indexes

 Uses
– Track average returns
– Comparing performance of managers
– Base of derivatives
 Factors in constructing or using an Index
– Representative?
– Broad or narrow?
– How is it constructed?

Slide 2-20
Examples of Indexes

 Dow Jones Industrial Average (30 Stocks)

 Standard & Poor‟s 500 Composite
 NASDAQ Composite
 NYSE Composite
 TSE (Tokyo) - Nikkei 225 & Nikkei 300
 FTSE (Financial Times of London)

Slide 2-21
Construction of Indexes

 How are stocks weighted?

– Price weighted (DJIA)
– Market-value weighted (S&P500, NASDAQ, TSE
300)
– Equally weighted (Value Line Index)
 How returns are averaged?
– Arithmetic (DJIA and S&P500)
– Geometric (Value Line Index)

Slide 2-22
 Averaging Methods
Component Return
rA=10% rB= (-5%) rC = 20%
Arithmetic Average:
rA  rB  rC .10  (.05)  .2
ra    8.33%
3 3
Geometric Average:
rg  3 (1  rA)(1  rB)(1  rC)  1 
 3 (1.1)(.95)(1.2)  1  7.84%
Slide 2-23