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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
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Types of Markets
Money Markets:
Short term
Easily marketable
Highly liquid
Typically very low risk

Capital Markets:
Longer term
Sometimes less liquid
Usually involve greater risk
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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Time deposit with a bank (may not be withdrawn on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






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Money Markets
Bankers Acceptance
Order to pay a sum of money at a future date
Tradable and very safe, bank guarentees

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 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


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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
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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 @ Maturity

Trade in Large Denominations

52 weeks in duration or less

Issued by the government via silent auction

Highly Liquid

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Face amount = $10,000
P = Purchase price
n = days to maturity from actual sale
(or purchase)
Bank Discount Yield
n
P
r
BD
360
000 , 10 $
000 , 10 $


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

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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?
Calculating T-Bill Price
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*Actual Days in Year
Normal year = 365 days
Leap year = 366 days
r
P
P n
BEY
Actual Days in Year
=


-
$10,000
Bond Equivalent Yield
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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.
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1
000 , 10 $
1
(

+ =
|
|
.
|

\
|
-
n
Actual
EAY
P
P
r
Effective annual yield:
*Actual Days in Year
Normal year = 365 days
Leap year = 366 days
Effective Annual Yield
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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.
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BD < BEY EAY
Differences increase with the longer the time to maturity and
the higher the discount rates.
Yield Relationships
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Capital Markets
Long-Term Fixed Income

Equities

Derivatives
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Fixed Income
Treasury Notes (up to 10 years) & Bonds (10 to 30 years)

Municipal Bonds

Corporate Bonds

Mortgage Securities

Federal Agency Bonds
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Treasury Bonds and Notes
Semi annual coupon payments

Denominations of $1,000 or more

Callable bonds

Premium and discount bonds
Maturity Ask
Rate Mo/Yr Bid Asked Chg. Yld.

8 Nov 03-08 107:10 107:12 - 3 6.57
Wednesday, December 22, 1999
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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
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Municipal Bonds
Issued by State & Local Government

Two Types
General Obligation
Revenue Bonds

Tax Exempt (Usually federal exempt}
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Municipal Returns

R
m
= R
t
(1-t)

Equivalent taxable yield
R
ety
= R
m
/(1-t)
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Corporate Bonds
Semiannual Payment

Default Risk

Optionality

Collateral

Priority
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Cur Net
Bonds Yld Vol Close Chg.

RalsP 85/822 8.1 5 106 1/2 -2 3/8
Wednesday, December 22, 1999
Corporate Bonds
Semiannual coupon payment

Interest rate risk

Default risk

Seniority

Secured vs, unsecured bonds
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Mortgages Agency Bonds
Fixed (30 year, 15 year)

Adjustable Rate Mortgage (ARM)
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Mortgage Liability Mismatch
Assets Liabilities
Mortgage Note Receivable Short Term Borrowing
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Financial Innovation- CMO
Pooling assets

Selling security

Lender removes liability & asset

Captures Spread
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Common Stock
Shares of ownership in a corporation

Right to residual claims

Right to vote on corporate matters

Limited Liability
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Investor Equity Return

Dividend Yield + % of Price change
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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)
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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
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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
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Index Construction
Russell 1000 S&P 500
Security Inclusion Largest 1000 U.S.
companies ranked by
Market Cap
Committee Driven
Capitalization Free Float All Shares Outstanding
Security Replacement Reconstitute once a year; Rebalance twice a year.
Adds & removes as needed.
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Indices
Price Weighted

Market (Dollar) Weighted

Equal Weighted