Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Chapter One Introduction Dr. Ahmed Y Dashti.

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Why study Financial Markets and Institutions? They are the cornerstones of the overall financial system in which financial managers operate Individuals use both for investing Corporations and governments use both for financing They are the cornerstones of the overall financial system in which financial managers operate Individuals use both for investing Corporations and governments use both for financing

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Overview of Financial Markets Primary Markets versus Secondary Markets Money Markets versus Capital Markets Foreign Exchange Markets Primary Markets versus Secondary Markets Money Markets versus Capital Markets Foreign Exchange Markets

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Primary Markets versus Secondary Markets Primary Markets –markets in which users of funds (e.g. corporations, governments) raise funds by issuing financial instruments (e.g. stocks and bonds) Secondary Markets –markets where financial instruments are traded among investors (e.g. NYSE, NASDAQ) Primary Markets –markets in which users of funds (e.g. corporations, governments) raise funds by issuing financial instruments (e.g. stocks and bonds) Secondary Markets –markets where financial instruments are traded among investors (e.g. NYSE, NASDAQ) اسواق اولية اسواق ثانوية

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Money Markets versus Capital Markets Money Markets –markets that trade debt securities with maturities of one year or less (e.g. CD’s, U.S. Treasury bills) Capital Markets –markets that trade debt (bonds) and equity (stock) instruments with maturities of more than one year Money Markets –markets that trade debt securities with maturities of one year or less (e.g. CD’s, U.S. Treasury bills) Capital Markets –markets that trade debt (bonds) and equity (stock) instruments with maturities of more than one year اسواق نقدية اسواق راسمالية

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Foreign Exchange Markets “FX” markets deal in trading one currency for another (e.g. dollar for yen) The “spot” FX transaction involves the immediate exchange of currencies at the current exchange rate The “forward” FX transaction involves the exchange of currencies at a specified date in the future and at a specified exchange rate “FX” markets deal in trading one currency for another (e.g. dollar for yen) The “spot” FX transaction involves the immediate exchange of currencies at the current exchange rate The “forward” FX transaction involves the exchange of currencies at a specified date in the future and at a specified exchange rate

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Overview of Financial Institutions Institutions that perform the essential function of channeling funds from those with surplus funds to those with shortages of funds (e.g. banks, thrifts, insurance companies, securities firms and investment banks, finance companies, mutual funds, pension funds)

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Flow of Funds in a World without FIs: Direct Transfer Users of Funds (Corporations) Suppliers of Funds (Households) Financial Claims (Equity and debt instruments) Cash Example: A firm sells shares directly to investors without going through a financial institution

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Flow of Funds in a world with FIs: Indirect transfer Users of Funds FI (Brokers) FI (Asset transformers) Suppliers of Funds Financial Claims (Equity and debt securities) Financial Claims (Deposits and Insurance policies)

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Types of FIs Commercial banks –depository institutions whose major assets are loans and major liabilities are deposits Thrifts –depository institutions in the form of savings and loans, credit unions Insurance companies –financial institutions that protect individuals and corporations from adverse events Commercial banks –depository institutions whose major assets are loans and major liabilities are deposits Thrifts –depository institutions in the form of savings and loans, credit unions Insurance companies –financial institutions that protect individuals and corporations from adverse events (continued)

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Securities firms and investment banks –financial institutions that underwrite securities and engage in securities brokerage and trading Finance companies –financial institutions that make loans to individuals and businesses Mutual Funds –financial institutions that pool financial resources and invest in diversified portfolios Pension Funds –financial institutions that offer savings plans for retirement Securities firms and investment banks –financial institutions that underwrite securities and engage in securities brokerage and trading Finance companies –financial institutions that make loans to individuals and businesses Mutual Funds –financial institutions that pool financial resources and invest in diversified portfolios Pension Funds –financial institutions that offer savings plans for retirement

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Services Performed by Financial Intermediaries Monitoring Costs –aggregation of funds provides greater incentive to collect a firm’s information and monitor actions Liquidity and Price Risk –provide financial claims to savers with superior liquidity and lower price risk Monitoring Costs –aggregation of funds provides greater incentive to collect a firm’s information and monitor actions Liquidity and Price Risk –provide financial claims to savers with superior liquidity and lower price risk (continued)

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Transaction Cost Services –transaction costs are reduced through economies of scale Maturity Intermediation –greater ability to bear risk of mismatching maturities of assets and liabilities Denomination Intermediation –allow small investors to overcome constraints imposed to buying assets imposed by large minimum denomination size Transaction Cost Services –transaction costs are reduced through economies of scale Maturity Intermediation –greater ability to bear risk of mismatching maturities of assets and liabilities Denomination Intermediation –allow small investors to overcome constraints imposed to buying assets imposed by large minimum denomination size

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Services Provided by FIs Benefiting the Overall Economy Money Supply Transmission –Depository institutions are the conduit through which monetary policy actions impact the economy in general Credit Allocation –often viewed as the major source of financing for a particular sector of the economy (e.g. farming and real estate) Money Supply Transmission –Depository institutions are the conduit through which monetary policy actions impact the economy in general Credit Allocation –often viewed as the major source of financing for a particular sector of the economy (e.g. farming and real estate) (continued)

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Intergenerational Wealth Transfers –life insurance companies and pension funds provide savers with the ability to transfer wealth from one generation to the next Payment Services –efficiency with which depository institutions provide payment services directly benefits the economy Intergenerational Wealth Transfers –life insurance companies and pension funds provide savers with the ability to transfer wealth from one generation to the next Payment Services –efficiency with which depository institutions provide payment services directly benefits the economy Services Provided by FIs Benefiting the Overall Economy

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Risks Faced by Financial Institutions Interest Rate Risk Foreign Exchange Risk Market Risk Credit Risk Liquidity Risk Off-Balance-Sheet Risk Technology Risk Operation Risk Country or Sovereign Risk Insolvency Risk Interest Rate Risk Foreign Exchange Risk Market Risk Credit Risk Liquidity Risk Off-Balance-Sheet Risk Technology Risk Operation Risk Country or Sovereign Risk Insolvency Risk

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Regulation of Financial Institutions FIs provide vital financial services to all sectors of the economy; therefore, their regulation is in the public interest In an attempt to prevent their failure and the failure of financial markets overall FIs provide vital financial services to all sectors of the economy; therefore, their regulation is in the public interest In an attempt to prevent their failure and the failure of financial markets overall

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Globalization of Financial Markets and Institutions Financial Markets became more global as the value of stocks traded in foreign markets soared Foreign bond markets have served as a major source of international capital Globalization also evident in the derivative securities market Financial Markets became more global as the value of stocks traded in foreign markets soared Foreign bond markets have served as a major source of international capital Globalization also evident in the derivative securities market

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Factors Leading to Significant Growth in Foreign Markets The pool of savings from foreign investors has increased International investors have turned to U.S. and other markets to expand their investment opportunities Information on foreign investments and markets is now more accessible (e.g. internet) Some mutual funds allow ability to invest in foreign securities with low transaction costs Deregulation has enhanced globalization of capital flows The pool of savings from foreign investors has increased International investors have turned to U.S. and other markets to expand their investment opportunities Information on foreign investments and markets is now more accessible (e.g. internet) Some mutual funds allow ability to invest in foreign securities with low transaction costs Deregulation has enhanced globalization of capital flows

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Definition and Purpose of Money Markets The Money Markets are associated with the issuance and trading of short-term debt obligations of large corporations, FIs and government Only High-Quality Entities can borrow in the Money Markets and individual issues are large Investors in Money Market Instruments include corporations and FIs who have idle cash but are restricted to a short-term investment horizon The Money Markets essentially serve to allocate the nation’s supply of liquid funds among major short- term lenders and borrowers The Money Markets are associated with the issuance and trading of short-term debt obligations of large corporations, FIs and government Only High-Quality Entities can borrow in the Money Markets and individual issues are large Investors in Money Market Instruments include corporations and FIs who have idle cash but are restricted to a short-term investment horizon The Money Markets essentially serve to allocate the nation’s supply of liquid funds among major short- term lenders and borrowers

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Money Market Securities Treasury Bills - short-term obligations issued by the U.S. government Federal Funds - short-term funds transferred between financial institutions usually for no more than one day Repurchase Agreements - agreement involving the sale of securities between parties with a promise to repurchase the security at a specific date and price Commercial Paper - short-term unsecured promissory notes issued by a company to raise short-term cash Negotiable Certificates of Deposit - negotiable bank- issued time deposit with specific interest rate/maturity Banker Acceptances - time draft payable to seller of goods with payment guaranteed by a bank Treasury Bills - short-term obligations issued by the U.S. government Federal Funds - short-term funds transferred between financial institutions usually for no more than one day Repurchase Agreements - agreement involving the sale of securities between parties with a promise to repurchase the security at a specific date and price Commercial Paper - short-term unsecured promissory notes issued by a company to raise short-term cash Negotiable Certificates of Deposit - negotiable bank- issued time deposit with specific interest rate/maturity Banker Acceptances - time draft payable to seller of goods with payment guaranteed by a bank

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Money Market Instruments Outstanding, December 1990 and 1999 (in billions of dollars) Amount Outstanding 1990 1999 Amount Outstanding 1990 1999 Rate of Return 1990 1999 Treasury bills $527.0 $ 674.8 7.85% 5.23% Federal funds and repurchase agreements 372.3 1,006.1 8.10 5.30 Commercial paper 537.8 1,284.5 8.06 5.87 Negotiable certificates of deposit 546.9 836.8 8.15 6.05 Banker’s acceptance 52.1 8.3 7.93 5.24

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Treasury Bill Basics Issued by the U.S. Treasury to cover government budget deficits and to refinance maturing debt Standard Original Maturities of 13 weeks, 26 weeks, or 52 weeks Denominations are $1,000 but typical round lot is $5 million Issued by the U.S. Treasury to cover government budget deficits and to refinance maturing debt Standard Original Maturities of 13 weeks, 26 weeks, or 52 weeks Denominations are $1,000 but typical round lot is $5 million

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin The Auction Process for T-bills Amount of new 13-week and 26-week T-bills offered announced weekly Bids submitted by government securities dealers, financial and nonfinancial corporations and individuals Competitive bids limited to 35% total issue size, can submit more than one bid, allocations made beginning with highest bidder Noncompetitive bidders indicate quantity desired and agree to pay weighted-average of the winning competitive bids, get preferential allocation Amount of new 13-week and 26-week T-bills offered announced weekly Bids submitted by government securities dealers, financial and nonfinancial corporations and individuals Competitive bids limited to 35% total issue size, can submit more than one bid, allocations made beginning with highest bidder Noncompetitive bidders indicate quantity desired and agree to pay weighted-average of the winning competitive bids, get preferential allocation

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Treasury Auction Results Quantity of T-bills Bid Price 98.678% 1 2 3 4 5 6 7 SCSC STST Noncompetitive Bids 98.648% (P NC ) (stop-at price low bid accepted) $10,581.9m $11,778.1m

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin The Secondary Market for T-bills The largest of any U.S. money market security Approximately 30 financial institutions “make” a market in T-bills by buying and selling securities for their own accounts and by trading for their customers, including depository institutions, insurance companies, pensions funds, etc T-bills are the FOMC’s instrument of choice for its open market operations The largest of any U.S. money market security Approximately 30 financial institutions “make” a market in T-bills by buying and selling securities for their own accounts and by trading for their customers, including depository institutions, insurance companies, pensions funds, etc T-bills are the FOMC’s instrument of choice for its open market operations

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Secondary Market T-bill Transaction Federal Reserve Bank of New York Transfers $10m. In T-bills from J.P. Morgan to Lehman Brothers Transaction recorded in Fed’s Book-Entry System J.P. Morgan sells $10m. In T-bills Lehman Brothers buy $10m. In T-bills Fedwire Transaction Fedwire Transaction Individual buy $50,000 in T-bills Local Bank or Broker J.P. Morgan sell $50,000 in T-bills FRBNY -$50,000 in T-bills from J.P. Morgan’s account + $50,000 T-bill to Individual

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin T-bill Rates and Yields No interest paid on T-bills (coupon rate is zero), issued at a discount from their par (or face) value T-bill rates are quoted in Wall Street Journal Discount Yield –the price dealers are willing to pay T-bill holders to purchase their T-bills for them Asked –the discount yield based on the current purchase price set by dealers that is available to investors Spread –the percentage difference in the ask and bid yield, part of transaction cost, the profit for dealers No interest paid on T-bills (coupon rate is zero), issued at a discount from their par (or face) value T-bill rates are quoted in Wall Street Journal Discount Yield –the price dealers are willing to pay T-bill holders to purchase their T-bills for them Asked –the discount yield based on the current purchase price set by dealers that is available to investors Spread –the percentage difference in the ask and bid yield, part of transaction cost, the profit for dealers

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Calculating T-bill Yields from Discount Rates i T-bill (dy) = P F - P O  360 PF h Where: P F = Annualized yield on the T-bill P O = Price (face value) paid to the T-bill holder h = Number of days until the T-bill matures Example: i T-bill (dy) = $10,000 - $9,650  360 = 6.92% $10,000 182 i T-bill (dy) = P F - P O  360 PF h Where: P F = Annualized yield on the T-bill P O = Price (face value) paid to the T-bill holder h = Number of days until the T-bill matures Example: i T-bill (dy) = $10,000 - $9,650  360 = 6.92% $10,000 182

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Federal Funds Basics Short-term funds transferred between financial institutions, usually for a period of one day Federal Funds rate –the interest rate for borrowing fed funds –a focus or target rate in the conduct of monetary policy Short-term funds transferred between financial institutions, usually for a period of one day Federal Funds rate –the interest rate for borrowing fed funds –a focus or target rate in the conduct of monetary policy

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Trading in the Fed Funds Market Commercial banks conduct the majority of transactions in the fed funds market Banks with excess reserves lend fed funds, while banks with deficient reserves borrow fed funds Fed funds transactions can be initiated by either the lending or borrowing institution or handled through a broker Commercial banks conduct the majority of transactions in the fed funds market Banks with excess reserves lend fed funds, while banks with deficient reserves borrow fed funds Fed funds transactions can be initiated by either the lending or borrowing institution or handled through a broker

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Repurchase Agreements (RPs or Repos) An agreement involving the sale of securities by one party to another with a promise to repurchase the securities at a specified price on a specified date Essentially a collateralized fed funds loan with collateral in the form of securities (e.g. T-bills and Fannie Mae) Reverse repurchase agreement –involves the purchase of securities between parties with the promise to sell them back at a given date in the future An agreement involving the sale of securities by one party to another with a promise to repurchase the securities at a specified price on a specified date Essentially a collateralized fed funds loan with collateral in the form of securities (e.g. T-bills and Fannie Mae) Reverse repurchase agreement –involves the purchase of securities between parties with the promise to sell them back at a given date in the future

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Trading Process for Repurchase Agreements Arranged either directly between two parties or with the help of brokers and dealers The repo buyer arranges to purchase T-bills from the repo seller with an agreement that the seller will repurchase the T-bills within a stated period of time Arranged either directly between two parties or with the help of brokers and dealers The repo buyer arranges to purchase T-bills from the repo seller with an agreement that the seller will repurchase the T-bills within a stated period of time

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Commercial Paper An unsecured short-term promissory note issued by a corporation to raise short-term cash, often to finance working capital requirements The largest (in terms of dollar value) of the money market instruments Generally sold in denominations of $100,000, $250,000, $500,000 and $1 million with maturities of 1-270 days (if maturity is greater than 270 days, SEC requires registration) Generally held until maturity so there is not an active secondary market An unsecured short-term promissory note issued by a corporation to raise short-term cash, often to finance working capital requirements The largest (in terms of dollar value) of the money market instruments Generally sold in denominations of $100,000, $250,000, $500,000 and $1 million with maturities of 1-270 days (if maturity is greater than 270 days, SEC requires registration) Generally held until maturity so there is not an active secondary market

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Trading Process for Commercial Paper CPs are sold either directly to investors (25%) or indirectly through brokers and dealers such as investment banks or major bank subsidiaries Selling through brokers more expensive for issuer due to underwriting costs CPs are sold either directly to investors (25%) or indirectly through brokers and dealers such as investment banks or major bank subsidiaries Selling through brokers more expensive for issuer due to underwriting costs

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Negotiable Certificates of Deposits A bank-issued time deposit that specifies an interest rate and maturity date and is negotiable in the secondary market Bearer Instrument –whoever holds the CD when it matures receives the principal and interest Denominations that range from $100,000 to $10 million, $1 million being the most common Often purchased by money market mutual funds with pools of funds from individual investors A bank-issued time deposit that specifies an interest rate and maturity date and is negotiable in the secondary market Bearer Instrument –whoever holds the CD when it matures receives the principal and interest Denominations that range from $100,000 to $10 million, $1 million being the most common Often purchased by money market mutual funds with pools of funds from individual investors

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Trading Process for NCDs Banks issuing CDs post daily rates for the more popular maturities and subject to funding needs, tries to sell to investors who are likely to hold them as investments rather than sell them to the secondary market In some cases, the bank and investor negotiate the size, rate and maturity Secondary market consists of a linked network of approximately 15 brokers and allows investors to buy existing CD’s rather than new issues Banks issuing CDs post daily rates for the more popular maturities and subject to funding needs, tries to sell to investors who are likely to hold them as investments rather than sell them to the secondary market In some cases, the bank and investor negotiate the size, rate and maturity Secondary market consists of a linked network of approximately 15 brokers and allows investors to buy existing CD’s rather than new issues

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Banker’s Acceptances A time draft payable to a seller of goods with payment guaranteed by a bank Arise from international trade transactions and are used to finance trade in goods that have yet to be shipped from a foreign exporter (seller) to a domestic importer (buyer) Foreign exporters prefer that banks act as guarantors for payment before sending goods to importer A time draft payable to a seller of goods with payment guaranteed by a bank Arise from international trade transactions and are used to finance trade in goods that have yet to be shipped from a foreign exporter (seller) to a domestic importer (buyer) Foreign exporters prefer that banks act as guarantors for payment before sending goods to importer

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Trading Process for BAs Domestic Importer Foreign Exporter U.S. Bank Foreign Bank 1. Purchase order sent 2. Letter of credit requested 3. Notification of letter credit and draft authorization 4. Order shipped 5. Time draft and shipping papers sent to foreign bank 6. Time draft and shipping papers sent to U.S. bank; BA created 7. Payments sent to foreign bank 8. Payments sent foreign exporter 9. Payment to U.S. bank 10. Shipping papers delivered 1 4 3 5 8 6 7 10 2 9

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Money Market Participants Instrument Treasury bills Federal funds Repurchase agreement Commercial Paper Negotiable CDs Banker’s acceptances Principal Issuer U.S. Treasury Commercial banks FRS, Comm banks Brokers and dealers Other Fis Comm banks Other FIs, Corps Commercial banks Principal Investor FRS, Comm banks Brokers and dealers Other FIs, Corps Commercial banks FRS, Comm banks Brokers and dealers Other FIs, Corps Brokers and dealers Corporations Brokers and dealers Corps, Other FIs Comm banks, Corps Brokers and dealers

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin International Aspects of Money Markets While U.S. money markets are the largest, the international market is growing –U.S. securities bought/sold by foreign investors –foreign money market securities Euro money market instruments –Eurodollar deposits, Eurodollar CDs, Euro notes, Euro CP London Interbank Offered Rate (LIOR) –the rate paid on Eurodollars While U.S. money markets are the largest, the international market is growing –U.S. securities bought/sold by foreign investors –foreign money market securities Euro money market instruments –Eurodollar deposits, Eurodollar CDs, Euro notes, Euro CP London Interbank Offered Rate (LIOR) –the rate paid on Eurodollars

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Euronotes and Euro CPs Type of instrument 1995 1999 Euronotes $45.5 $72.8 Currency type U.S. dollar 27.9 30.6 Euro currencies 0.5 22.8 Japanese yen 0.4 1.5 Other 16.7 17.9 Issuer type FIs 41.4 61.2 Gov/state agencies 0.4 10.5 International Inst 1.2 ---- Corporations 2.5 1.1 Type of instrument 1995 1999 Euro CPs $87.0 $170.9 Currency type U.S. dollar 55.7 84.4 Euro currencies 9.1 52.3 Japanese yen 2.1 2.5 Other 20.0 31.7 Issuer type FIs 40.5 107.4 Gov/state agencies 14.2 15.1 International inst 2.1 5.1 Corporate issuers 30.2 43.2 Amount outstanding

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Overview of the Bond Markets A bond is a promise to make periodic coupon payments and to repay principal at maturity; breech of this promise is an event of default carry original maturities greater than one year so bonds are instruments of the capital markets issuers are corporations and government units A bond is a promise to make periodic coupon payments and to repay principal at maturity; breech of this promise is an event of default carry original maturities greater than one year so bonds are instruments of the capital markets issuers are corporations and government units

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Treasury Notes and Bonds T-notes and T-bonds issued by the U.S. treasury to finance the national debt and other federal government expenditures Backed by the full faith and credit of the U.S. government and are default risk free Pay relatively low rates of interest (yields to maturity Given their longer maturity, not entirely risk free due to interest rate fluctuations Pay coupon interest (semiannually), notes have maturities from 1-10 yrs, bonds 10-30 yrs T-notes and T-bonds issued by the U.S. treasury to finance the national debt and other federal government expenditures Backed by the full faith and credit of the U.S. government and are default risk free Pay relatively low rates of interest (yields to maturity Given their longer maturity, not entirely risk free due to interest rate fluctuations Pay coupon interest (semiannually), notes have maturities from 1-10 yrs, bonds 10-30 yrs

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Treasury Strips A treasury security in which the periodic interest payment is separated from the final principal payment Effectively creates two sets of securities--one for each semiannual interest payment one one for the final principal payment Often referred to as “Treasury zero-coupon bonds” Created by U.S. treasury in response to separate trading of treasury security principal and interest that been developed by securities firms, only available through FIs and gov securities brokers A treasury security in which the periodic interest payment is separated from the final principal payment Effectively creates two sets of securities--one for each semiannual interest payment one one for the final principal payment Often referred to as “Treasury zero-coupon bonds” Created by U.S. treasury in response to separate trading of treasury security principal and interest that been developed by securities firms, only available through FIs and gov securities brokers

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin The Primary Market in Treasury Notes and Bonds Similar to the primary market T-bill sales, the treasury sells T-notes and bonds through competitive and noncompetitive auctions Auction Pattern for Treasury Notes and bonds Security Purchase Minimum General Auction Schedule 2-year note $1,000 Monthly 5-year note $1,000 Feb, May-Aug, Nov 10-year note $1,000 Feb, May-Aug, Nov 30-year note $1,000 Feb, Aug, Nov Similar to the primary market T-bill sales, the treasury sells T-notes and bonds through competitive and noncompetitive auctions Auction Pattern for Treasury Notes and bonds Security Purchase Minimum General Auction Schedule 2-year note $1,000 Monthly 5-year note $1,000 Feb, May-Aug, Nov 10-year note $1,000 Feb, May-Aug, Nov 30-year note $1,000 Feb, Aug, Nov

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Secondary Market in Treasury Notes and Bonds Most secondary market trading occurs directly through brokers and dealers Wall Street Journal shows full list of Treasury securities that trade daily Most secondary market trading occurs directly through brokers and dealers Wall Street Journal shows full list of Treasury securities that trade daily

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Municipal Bonds (munis) Securities issued by state and local governments to fund either temporary imbalances between operating expenditures and receipts or to finance long-term capital outlays for activities such as school construction, public utility construction or transportation systems Tax receipts or revenues generated are the source of repayment Attractive to household investors because interest (but not capital gains) are tax exempt Securities issued by state and local governments to fund either temporary imbalances between operating expenditures and receipts or to finance long-term capital outlays for activities such as school construction, public utility construction or transportation systems Tax receipts or revenues generated are the source of repayment Attractive to household investors because interest (but not capital gains) are tax exempt

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Tax Exemption and Muni Yields i a = i b (1 - t) Where: i a = After-tax (equivalent tax exempt) rate of return on a taxable corp bond i b = Before-tax rate of return on a taxable bond t = Marginal income tax rate of the bond holder Example: You can invest in taxable corporate bonds that are paying 10% annually on munis. Your marginal tax rate is 28%, the after- tax rate of return on the taxable bond is: 10%(1-.28) = 7.2% i a = i b (1 - t) Where: i a = After-tax (equivalent tax exempt) rate of return on a taxable corp bond i b = Before-tax rate of return on a taxable bond t = Marginal income tax rate of the bond holder Example: You can invest in taxable corporate bonds that are paying 10% annually on munis. Your marginal tax rate is 28%, the after- tax rate of return on the taxable bond is: 10%(1-.28) = 7.2%

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Types of Municipal Bonds General Obligation Bonds –bonds backed by the full faith and credit of the issuer Revenue Bonds –bonds sold to finance a specific revenue generating project and are backed by cash flows from that project General Obligation Bonds –bonds backed by the full faith and credit of the issuer Revenue Bonds –bonds sold to finance a specific revenue generating project and are backed by cash flows from that project

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Primary Market Placement Choices for Munis General Public Offering –underwriter is selected either by negotiation or by competitive bidding –the underwriter offers the bonds to the general public Rule 144A Placement –bonds are sold on a semi-private basis to qualified investors (generally FIs) General Public Offering –underwriter is selected either by negotiation or by competitive bidding –the underwriter offers the bonds to the general public Rule 144A Placement –bonds are sold on a semi-private basis to qualified investors (generally FIs)

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Top Municipal Bond Underwriters Principal Amount Market No. of Underwriter (in millions $$) Share Issues Salomon Smith Barney $31,375.4 12.7% 403 Merrill Lynch 22,845.3 9.2% 312 Paine Webber 22,089.3 8.9% 420 Goldman Sachs 17,314.8 7.0% 233 Lehman Brothers 11,039.4 4.5% 169 Morgan Stanley Dean Witter 9,518.3 3.8% 226 Bear, Stearns 7,642.9 3.1% 108 First Union 6,373.8 2.6% 393 J.P. Morgan 5,660.7 2.3% 106 U.S. Bancorp Piper Jaffray 5,206.8 2.1% 538 Industry totals $219 billion Principal Amount Market No. of Underwriter (in millions $$) Share Issues Salomon Smith Barney $31,375.4 12.7% 403 Merrill Lynch 22,845.3 9.2% 312 Paine Webber 22,089.3 8.9% 420 Goldman Sachs 17,314.8 7.0% 233 Lehman Brothers 11,039.4 4.5% 169 Morgan Stanley Dean Witter 9,518.3 3.8% 226 Bear, Stearns 7,642.9 3.1% 108 First Union 6,373.8 2.6% 393 J.P. Morgan 5,660.7 2.3% 106 U.S. Bancorp Piper Jaffray 5,206.8 2.1% 538 Industry totals $219 billion

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Contracting Choices with the Underwriter Firm commitment underwriting –the issue of securities in which the investment bank guarantees the corp. a price for newly issued securities by buying the whole issue at a fixed price from the corporate issuer then seeks to resell to suppliers of funds (investors) at a higher price Best efforts underwriting –the issue of securities in which the underwriter does not guarantee a price to the issuer and acts more as a placing or distribution agent, bank acts as agent on a fee basis related to its success in placing the issue Firm commitment underwriting –the issue of securities in which the investment bank guarantees the corp. a price for newly issued securities by buying the whole issue at a fixed price from the corporate issuer then seeks to resell to suppliers of funds (investors) at a higher price Best efforts underwriting –the issue of securities in which the underwriter does not guarantee a price to the issuer and acts more as a placing or distribution agent, bank acts as agent on a fee basis related to its success in placing the issue

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Secondary Market for Munis Secondary market is thin (I.e. trades are relatively infrequent) due to a lack of information on bond issuers, who are generally much smaller than corporate bond issuers

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Corporate Bonds All long-term bonds issued by corporations Minimum denominations publicly traded corporate bonds is $1,000 Generally pay interest semiannually Bond indenture –legal contract that specifies the rights and obligations of the bond issuer and the bond holder All long-term bonds issued by corporations Minimum denominations publicly traded corporate bonds is $1,000 Generally pay interest semiannually Bond indenture –legal contract that specifies the rights and obligations of the bond issuer and the bond holder

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Types of Corporate Bonds Bearer bonds –coupons attached that are presented by the holder to the issuer for interest payments when due Registered bonds –the owner of the bond is recorded by the issuer and coupon payments are mailed to the registered owner Term bonds –entire issue matures on a single date Serial bonds –mature on a series of dates (continued) Bearer bonds –coupons attached that are presented by the holder to the issuer for interest payments when due Registered bonds –the owner of the bond is recorded by the issuer and coupon payments are mailed to the registered owner Term bonds –entire issue matures on a single date Serial bonds –mature on a series of dates (continued)

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Types of Corporate Bonds Mortgage bonds –issued to finance specific projects which are pledged as collateral Debentures –backed solely by the general credit of the issuing firm and unsecured by specific assets or collateral Subordinated debentures –unsecured debentures that are junior in their rights to mortgage bonds and regular debentures (continued) Mortgage bonds –issued to finance specific projects which are pledged as collateral Debentures –backed solely by the general credit of the issuing firm and unsecured by specific assets or collateral Subordinated debentures –unsecured debentures that are junior in their rights to mortgage bonds and regular debentures (continued)

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Types of Corporate Bonds Convertible bonds –may be exchanged for another security of the issuing firm at the discretion of the bond holder Stock Warrant –give the bond holder an opportunity to purchase common stock at a specified price up to a specified date Callable bonds –allow the issuer to force the bond holder to sell the bond back to the issuer at a price above the par value (call price) Sinking Fund Provisions –bonds that include a requirement that the issuer retire a certain amount of the bond issue each year Convertible bonds –may be exchanged for another security of the issuing firm at the discretion of the bond holder Stock Warrant –give the bond holder an opportunity to purchase common stock at a specified price up to a specified date Callable bonds –allow the issuer to force the bond holder to sell the bond back to the issuer at a price above the par value (call price) Sinking Fund Provisions –bonds that include a requirement that the issuer retire a certain amount of the bond issue each year

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Primary and Secondary Markets for Corp Bonds Primary sales of corp bonds occur through either a public sale (issue) or a private placement similar to municipal bonds Two secondary markets –the exchange market (e.g., the NYSE) –the over-the-counter (OTC) market OTC electronic market dominates trading in corp bonds Primary sales of corp bonds occur through either a public sale (issue) or a private placement similar to municipal bonds Two secondary markets –the exchange market (e.g., the NYSE) –the over-the-counter (OTC) market OTC electronic market dominates trading in corp bonds

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Bond Ratings Bonds are rated by the issuer’s default risk Large bond investors, traders and managers evaluate default risk by analyzing the issuer’s financial ratios and security prices Two major bond rating agencies are Moody’s and Standard & Poor’s (S&P) Bonds assigned a letter grade based on perceived probability of issuer default Bonds are rated by the issuer’s default risk Large bond investors, traders and managers evaluate default risk by analyzing the issuer’s financial ratios and security prices Two major bond rating agencies are Moody’s and Standard & Poor’s (S&P) Bonds assigned a letter grade based on perceived probability of issuer default

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Bond Credit Ratings Explanation Moody’s S&P Investment grade categories: Best quality; smallest degree of risk Aaa AAA High quality; slightly more long-term Aa1 AA+ risk than top rating Aa2 AA Aa3 AA Upper medium grade; possible A1 AA- impairment in the future A2 A+ A3 A- Medium grade; lack outstanding Baa1 BBB+ investment characteristics Baa2 BBB Baa3 BBB- Explanation Moody’s S&P Investment grade categories: Best quality; smallest degree of risk Aaa AAA High quality; slightly more long-term Aa1 AA+ risk than top rating Aa2 AA Aa3 AA Upper medium grade; possible A1 AA- impairment in the future A2 A+ A3 A- Medium grade; lack outstanding Baa1 BBB+ investment characteristics Baa2 BBB Baa3 BBB- (continued)

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Bond Credit Ratings Explanation Moody’s S&P Speculative investment grades: Speculative issues; protection may Ba1 BB+ be very moderate Ba2 BB Ba3 BB- Very speculative; may have small B1 B+ assurance of interest and principle B2 B payment B3 B- Issues in poor standing; may be in default Caa CCC Speculative in a high degree Ca CC Lowest quality; poor prospects of attaining C C real investment standing D Explanation Moody’s S&P Speculative investment grades: Speculative issues; protection may Ba1 BB+ be very moderate Ba2 BB Ba3 BB- Very speculative; may have small B1 B+ assurance of interest and principle B2 B payment B3 B- Issues in poor standing; may be in default Caa CCC Speculative in a high degree Ca CC Lowest quality; poor prospects of attaining C C real investment standing D

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Bond Market Indexes Managed by major investment banks Reflect both the monthly capital gain and loss on bonds plus any interest (coupon) income earned Changes in values of the broad market indexes can be used by bond traders to evaluate changes in the investment attractiveness of bonds of different types and maturities Managed by major investment banks Reflect both the monthly capital gain and loss on bonds plus any interest (coupon) income earned Changes in values of the broad market indexes can be used by bond traders to evaluate changes in the investment attractiveness of bonds of different types and maturities

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Bond Market Participants The major issuers of debt market securities are federal, state and local governments and corporations The major purchasers of capital market securities are households, businesses, government units and foreign investors Businesses and financial firms (e.g., banks, insurance companies, mutual funds) are the major suppliers of funds for all three types of bonds The major issuers of debt market securities are federal, state and local governments and corporations The major purchasers of capital market securities are households, businesses, government units and foreign investors Businesses and financial firms (e.g., banks, insurance companies, mutual funds) are the major suppliers of funds for all three types of bonds

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin International Aspects of Bond Markets International bond market –trades bonds that are underwritten by an international syndicate –offer bonds simultaneously to investors in several countries –issue bonds outside the jurisdiction of any single country –offer bonds in unregistered form International bond market –trades bonds that are underwritten by an international syndicate –offer bonds simultaneously to investors in several countries –issue bonds outside the jurisdiction of any single country –offer bonds in unregistered form

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Eurobonds, Foreign Bonds, Brady Bonds and Sovereign Bonds Eurobonds –long-term bonds issued and sold outside the country of the currency in which they are denominated (e.g., dollar- denominated bonds issued in Europe or Asia ) Foreign Bonds –long-term bonds issued by firms and governments outside of the issuer’s country, usually denominated in the currency of the country in which they are issued Brady Bonds and Sovereign Bonds –a bond that is swapped for an outstanding loan to a lesser developed country, sovereign bonds carry the creditworthiness of the lesser developed country Eurobonds –long-term bonds issued and sold outside the country of the currency in which they are denominated (e.g., dollar- denominated bonds issued in Europe or Asia ) Foreign Bonds –long-term bonds issued by firms and governments outside of the issuer’s country, usually denominated in the currency of the country in which they are issued Brady Bonds and Sovereign Bonds –a bond that is swapped for an outstanding loan to a lesser developed country, sovereign bonds carry the creditworthiness of the lesser developed country

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Mortgages and Mortgage-Backed Securities Mortgages are loans to individuals or businesses to purchase a home, land, or other real property Many mortgages are securitized –securities are packaged and sold as assets backing a publicly traded or privately held debt instrument Four basic categories of mortgages issued –home, multifamily dwelling, commercial, and farm Mortgages are loans to individuals or businesses to purchase a home, land, or other real property Many mortgages are securitized –securities are packaged and sold as assets backing a publicly traded or privately held debt instrument Four basic categories of mortgages issued –home, multifamily dwelling, commercial, and farm

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Mortgage Characteristics Lien - a public record attached to the title of the property that gives the FI the right to sell the property if the mortgage borrower defaults Down payment - a portion of the purchase price of the property a FI requires the mortgage borrower to pay up front Private mortgage insurance - insurance contract purchased by a mortgage borrower guaranteeing to pay the FI the difference between the value of the property and the balance remaining on the mortgage Lien - a public record attached to the title of the property that gives the FI the right to sell the property if the mortgage borrower defaults Down payment - a portion of the purchase price of the property a FI requires the mortgage borrower to pay up front Private mortgage insurance - insurance contract purchased by a mortgage borrower guaranteeing to pay the FI the difference between the value of the property and the balance remaining on the mortgage (continued)

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Federally insured mortgages - originated by FIs with repayment guaranteed by either the Federal Housing Administration (FHA) or the Veterans Administration (VA) Conventional mortgages - issued by FIs that are not federally insured Amortized - when the fixed principal and interest payments fully pay off the mortgage by its maturity date Balloon payment mortgages - requires a fixed monthly interest payment for a three- to five-year period with full payment of the mortgage principal required at the end of the period Federally insured mortgages - originated by FIs with repayment guaranteed by either the Federal Housing Administration (FHA) or the Veterans Administration (VA) Conventional mortgages - issued by FIs that are not federally insured Amortized - when the fixed principal and interest payments fully pay off the mortgage by its maturity date Balloon payment mortgages - requires a fixed monthly interest payment for a three- to five-year period with full payment of the mortgage principal required at the end of the period (continued)

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Fixed-rate mortgage - locks in the borrower’s interest rate and thus the required monthly payment over the life of the mortgage, regardless of market rate changes Adjustable-rate mortgage - where the interest rate is tied to some market interest rate with potential for change in required monthly payments over the life of the mortgage Discount points - interest payments made when the loan is issued (at closing). One discount point = 1 percent of the principle value of the mortgage Amortization schedule - schedule showing how the monthly mortgage payments are split between principal and interest Fixed-rate mortgage - locks in the borrower’s interest rate and thus the required monthly payment over the life of the mortgage, regardless of market rate changes Adjustable-rate mortgage - where the interest rate is tied to some market interest rate with potential for change in required monthly payments over the life of the mortgage Discount points - interest payments made when the loan is issued (at closing). One discount point = 1 percent of the principle value of the mortgage Amortization schedule - schedule showing how the monthly mortgage payments are split between principal and interest

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Calculation of Monthly Mortgage Payments PV = PMT(PVIFA i/12, n  12 ) Where: PV = Principal amount borrowed through the mortgage PMT = Monthly mortgage payment PVIFA = Present value interest factor of an annuity i = Annual interest rate on the mortgage n = Length of the mortgage in years PV = PMT(PVIFA i/12, n  12 ) Where: PV = Principal amount borrowed through the mortgage PMT = Monthly mortgage payment PVIFA = Present value interest factor of an annuity i = Annual interest rate on the mortgage n = Length of the mortgage in years

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Comparison of Monthly Mortgage Payments $150,000 home with 30-year mortgage at 8%, 0 points, 20% down $120,000 = PMT(PVIFA 8%/12, 30  12 ) PMT = $120,000/136.2835 = $880.52 $150,000 home with 15-year mortgage at 8%, 0 points, 20% down $120,000 = PMT(PVIFA 8%/12, 15  12 ) PMT = $120,000/104.6406 = $1146.78 $150,000 home with 30-year mortgage at 8%, 0 points, 20% down $120,000 = PMT(PVIFA 8%/12, 30  12 ) PMT = $120,000/136.2835 = $880.52 $150,000 home with 15-year mortgage at 8%, 0 points, 20% down $120,000 = PMT(PVIFA 8%/12, 15  12 ) PMT = $120,000/104.6406 = $1146.78

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Other Types of Mortgages Automatic rate-reduction mortgages - where the lender automatically lowers the rate on an existing mortgage when prevailing rates fall Graduated-payment mortgages - where borrowers make small payments early in the life of the mortgage, increased payments over the first 5-10 years and level off at the end of the mortgage period Growing-equity mortgages - where the initial payments are the same as a conventional mortgage but increase over a portion or the entire life of the mortgage Automatic rate-reduction mortgages - where the lender automatically lowers the rate on an existing mortgage when prevailing rates fall Graduated-payment mortgages - where borrowers make small payments early in the life of the mortgage, increased payments over the first 5-10 years and level off at the end of the mortgage period Growing-equity mortgages - where the initial payments are the same as a conventional mortgage but increase over a portion or the entire life of the mortgage (continued)

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Second mortgages - loans secured by a piece of real estate already used to secure a first mortgage Home equity loan - loans that let customers borrow on a line of credit secured with a second mortgage Shared-appreciation mortgage (SAM) - allows a home buyer to obtain a mortgage at an interest rate below current rates in exchange for a share in any appreciation of the property Equity-participation mortgage - similar to SAM except that an outside investor shares in the appreciation Reverse-annuity mortgage - where mortgage borrower receives regular monthly payments from a FI Second mortgages - loans secured by a piece of real estate already used to secure a first mortgage Home equity loan - loans that let customers borrow on a line of credit secured with a second mortgage Shared-appreciation mortgage (SAM) - allows a home buyer to obtain a mortgage at an interest rate below current rates in exchange for a share in any appreciation of the property Equity-participation mortgage - similar to SAM except that an outside investor shares in the appreciation Reverse-annuity mortgage - where mortgage borrower receives regular monthly payments from a FI

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Secondary Mortgage Market Advantages for FI to securitize –reduces liquidity risk, interest rate risk, and credit risk of FIs portfolio –FI retains income from origination fees and service fees FI’s remove mortgages from their balance sheet through one of two mechanisms –pool recently originated mortgages together and sell them in the secondary market –issue mortgage-backed securities that are backed by their newly originated mortgages Advantages for FI to securitize –reduces liquidity risk, interest rate risk, and credit risk of FIs portfolio –FI retains income from origination fees and service fees FI’s remove mortgages from their balance sheet through one of two mechanisms –pool recently originated mortgages together and sell them in the secondary market –issue mortgage-backed securities that are backed by their newly originated mortgages

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin History of Secondary Mortgage Markets Federal National Mortgage Association (FNMA or “Fannie Mae”) created during the Great Depression FHA and VA insured loans also created during this time Government National Mortgage Association (GNMA or “Ginnie Mae”) and Federal Home Loan Mortgage Corp. (FHLMC or “Freddie Mac”) created during 1960’s Wide variety of mortgage-backed securities have been developed and in 1999, approximately 50% of mortgages are securitized Federal National Mortgage Association (FNMA or “Fannie Mae”) created during the Great Depression FHA and VA insured loans also created during this time Government National Mortgage Association (GNMA or “Ginnie Mae”) and Federal Home Loan Mortgage Corp. (FHLMC or “Freddie Mac”) created during 1960’s Wide variety of mortgage-backed securities have been developed and in 1999, approximately 50% of mortgages are securitized

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Mortgage Sales Mortgage sale - sale of a mortgage originated by a bank with or without recourse to an outside buyer Allow FIs to manage credit risk and achieve better asset diversification, improves their liquidity risk FIs encouraged to sell loans for economic (generation of fee income) and regulatory reasons (reducing cost of reserve requirements) Major buyers of mortgage loans are domestic banks, foreign banks, insurance companies and pension funds, closed end bank loan mutual funds, and nonfinancial corporations Major sellers of mortgage loans are money center banks, small regional or community banks, foreign banks, investment banks Mortgage sale - sale of a mortgage originated by a bank with or without recourse to an outside buyer Allow FIs to manage credit risk and achieve better asset diversification, improves their liquidity risk FIs encouraged to sell loans for economic (generation of fee income) and regulatory reasons (reducing cost of reserve requirements) Major buyers of mortgage loans are domestic banks, foreign banks, insurance companies and pension funds, closed end bank loan mutual funds, and nonfinancial corporations Major sellers of mortgage loans are money center banks, small regional or community banks, foreign banks, investment banks

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Securitization of Mortgages Pass-through mortgage securities - mortgage- backed securities that “pass-through” promised payments of principal and interest on pools of mortgages created by financial institutions to secondary market participants holding interests in the pools Issued in standard denominations, usually $25,000 with increments of $5,000 beyond the minimum Three government owned or sponsored agencies involved - Ginnie Mae (GNMA), Fannie Mae (FNMA, and Freddie Mac (FHLMC) Pass-through mortgage securities - mortgage- backed securities that “pass-through” promised payments of principal and interest on pools of mortgages created by financial institutions to secondary market participants holding interests in the pools Issued in standard denominations, usually $25,000 with increments of $5,000 beyond the minimum Three government owned or sponsored agencies involved - Ginnie Mae (GNMA), Fannie Mae (FNMA, and Freddie Mac (FHLMC)

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Collateralized Mortgage Obligations CMO - a mortgage-backed bond issued in multiple classes or tranches –tranches - a bond holder class associated with a CMO Created by packaging and securitizing whole mortgage loans or resecuritizing pass-through securities Attractive to secondary mortgage market investors because they can choose a particular CMO class that fits their maturity needs CMO - a mortgage-backed bond issued in multiple classes or tranches –tranches - a bond holder class associated with a CMO Created by packaging and securitizing whole mortgage loans or resecuritizing pass-through securities Attractive to secondary mortgage market investors because they can choose a particular CMO class that fits their maturity needs

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Stock Markets Overview Stockholders are the legal owners of a corporation –they have a residual claim to all earnings and assets after debt and tax claims are satisfied –voting rights (e.g., to elect board of directors) –shareholders do not exercise control (elected board chooses CEO, etc.) Stockholders are the legal owners of a corporation –they have a residual claim to all earnings and assets after debt and tax claims are satisfied –voting rights (e.g., to elect board of directors) –shareholders do not exercise control (elected board chooses CEO, etc.)

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Primary and Secondary Markets Overview Primary Market –firm can raise equity capital in its initial public offering (IPO) –firm can raise equity capital in a subsequent seasoned equity offering (SEO) Secondary Markets –trading of shares among investors Primary Market –firm can raise equity capital in its initial public offering (IPO) –firm can raise equity capital in a subsequent seasoned equity offering (SEO) Secondary Markets –trading of shares among investors

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Stock Market Securities Two types of corporate stock exist –Common stock the fundamental ownership claim in a public corporation –Preferred stock a hybrid security that has characteristics of both bonds and common stock Two types of corporate stock exist –Common stock the fundamental ownership claim in a public corporation –Preferred stock a hybrid security that has characteristics of both bonds and common stock

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Calculating Stock Returns R 1 = P 1 - P t-1 + D 1 P t-1 P t-1 Where: P 1 = Stock price at time t D 1 = Dividends paid over time t - 1 to t P 1 - P t-1 = Capital gain over time t - 1 to t, and P t-1 R 1 = $45 - $40 + $4 $40 $40 = 12.5% + 10.0% = 22.5% R 1 = P 1 - P t-1 + D 1 P t-1 P t-1 Where: P 1 = Stock price at time t D 1 = Dividends paid over time t - 1 to t P 1 - P t-1 = Capital gain over time t - 1 to t, and P t-1 R 1 = $45 - $40 + $4 $40 $40 = 12.5% + 10.0% = 22.5%

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Characteristics of Common Stock Dividends –payment and size of dividends is determined by the board of directors of the issuing firm Residual Claim –in the event of liquidation, common stockholders have the lowest priority in terms of any cash distribution Limited Liability –common stockholders losses are limited to the amount of their original investment in the firm Voting Rights Dividends –payment and size of dividends is determined by the board of directors of the issuing firm Residual Claim –in the event of liquidation, common stockholders have the lowest priority in terms of any cash distribution Limited Liability –common stockholders losses are limited to the amount of their original investment in the firm Voting Rights

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Characteristics of Preferred Stock Similar to common stock in that it represents an ownership interest but, like bonds, pays a fixed periodic dividend Senior to common stock but junior to bonds Generally do not have voting rights Nonparticipating preferred stock –dividend is fixed regardless of any increase or decrease in the firm’s value Cumulative preferred stock –missed dividend payments go into arrears and must be made up before common stock dividends can be paid Similar to common stock in that it represents an ownership interest but, like bonds, pays a fixed periodic dividend Senior to common stock but junior to bonds Generally do not have voting rights Nonparticipating preferred stock –dividend is fixed regardless of any increase or decrease in the firm’s value Cumulative preferred stock –missed dividend payments go into arrears and must be made up before common stock dividends can be paid

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Issuance of Stock in the Primary Market Stocks Stocks Issuing Investment Investors Corporation Bank Funds Funds Investment bank conducts primary market sale of stock using firm commitment underwriting (guarantees corporation a fixed price for newly issued securities) or best efforts underwriting (no guarantee to issuer and acts more as a placing or distribution agent) Stocks Stocks Issuing Investment Investors Corporation Bank Funds Funds Investment bank conducts primary market sale of stock using firm commitment underwriting (guarantees corporation a fixed price for newly issued securities) or best efforts underwriting (no guarantee to issuer and acts more as a placing or distribution agent) (continued)

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Net proceeds - the guaranteed price at which the investment bank purchases the stock from the issuer Gross proceeds - the price at which the investment bank resells the stock to investors Underwriters’ spread - the difference between the gross proceeds and the net proceeds Syndicate - the process of distributing securities through a group of investment banks Originating house - the lead bank in the syndicate negotiates with the issuing company on behalf of the syndicate Red herring proxy - a preliminary version of the prospectus describing a new security Net proceeds - the guaranteed price at which the investment bank purchases the stock from the issuer Gross proceeds - the price at which the investment bank resells the stock to investors Underwriters’ spread - the difference between the gross proceeds and the net proceeds Syndicate - the process of distributing securities through a group of investment banks Originating house - the lead bank in the syndicate negotiates with the issuing company on behalf of the syndicate Red herring proxy - a preliminary version of the prospectus describing a new security

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Secondary Markets: Major U.S. Stock Exchanges New York Stock Exchange (NYSE) –buyers and sellers meet at the trading post to negotiate –specialist acts as a dealer (market maker), as necessary American Stock Exchange (AMEX) –trading system same as NYSE National Association of Securities Dealers Automated Quotation System (NASDAQ) –multiple dealers (market makers) compete for transactions in a given stock –each dealer/market maker posts a bid and offer price on the system’s network New York Stock Exchange (NYSE) –buyers and sellers meet at the trading post to negotiate –specialist acts as a dealer (market maker), as necessary American Stock Exchange (AMEX) –trading system same as NYSE National Association of Securities Dealers Automated Quotation System (NASDAQ) –multiple dealers (market makers) compete for transactions in a given stock –each dealer/market maker posts a bid and offer price on the system’s network

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Trading on NYSE and AMEX Order Order Order Investor Shares Broker Shares Floor Shares Market Broker Maker or Cash Cash Cash Other Floor Broker Order Order Order Investor Shares Broker Shares Floor Shares Market Broker Maker or Cash Cash Cash Other Floor Broker

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Two Common Types of Orders Market order – an order for the broker and market specialist to transact at the best price available when the order reaches the post Limit order – an order to transact at a specified price (the limit price) Market order – an order for the broker and market specialist to transact at the best price available when the order reaches the post Limit order – an order to transact at a specified price (the limit price)

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Stock Market Indexes The Dow Jones Industrial Average (the DJIA) –a price-weighted index of the values of 30 large (in terms of sales and total assets) corporations The NYSE composite index –a value-weighted index of all common stocks listed on NYSE the Standard & Poor’s 500 index –a value-weighted index of the stocks of 500 of the largest U.S. corporations listed on the NYSE and NASDAQ The NASDAQ composite index –a value-weighted index of three categories of NASDAQ companies: industrials, banks, and insurance companies The Dow Jones Industrial Average (the DJIA) –a price-weighted index of the values of 30 large (in terms of sales and total assets) corporations The NYSE composite index –a value-weighted index of all common stocks listed on NYSE the Standard & Poor’s 500 index –a value-weighted index of the stocks of 500 of the largest U.S. corporations listed on the NYSE and NASDAQ The NASDAQ composite index –a value-weighted index of three categories of NASDAQ companies: industrials, banks, and insurance companies

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Stock Market Participants Holders of Corporate Stock (in billions of dollars) % of 1994 1997 1999 Total Household sector $3,070.9 $5,689.6 $6,599.2 41.2 State and local gov. 10.6 79.0 111.0 0.7 Rest of world 397.7 919.5 1,168.1 7.3 Depository inst. 180.6 331.4 327.1 2.0 Life ins. co. 246.1 558.6 795.5 5.0 Other ins. co. 112.1 186.0 198.1 1.2 Private pension funds 996.3 1,863.9 2,211.9 13.8 Public pension funds 557.4 1,431.7 1,801.4 11.3 Mutual funds 709.6 2,018.7 2,701.5 16.9 Closed-end funds 31.9 50.2 39.4 0.3 Brokers and dealers 20.1 51.9 55.0 0.3 Holders of Corporate Stock (in billions of dollars) % of 1994 1997 1999 Total Household sector $3,070.9 $5,689.6 $6,599.2 41.2 State and local gov. 10.6 79.0 111.0 0.7 Rest of world 397.7 919.5 1,168.1 7.3 Depository inst. 180.6 331.4 327.1 2.0 Life ins. co. 246.1 558.6 795.5 5.0 Other ins. co. 112.1 186.0 198.1 1.2 Private pension funds 996.3 1,863.9 2,211.9 13.8 Public pension funds 557.4 1,431.7 1,801.4 11.3 Mutual funds 709.6 2,018.7 2,701.5 16.9 Closed-end funds 31.9 50.2 39.4 0.3 Brokers and dealers 20.1 51.9 55.0 0.3

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Other Issues Pertaining to Stock Markets Does the stock market forecast the economy? –Some evidence suggests that the stock market forecasts the economy but evidence is not reliable Market efficiency –the speed with which financial security prices adjust to unexpected news pertaining to interest rates or a stock-specific characteristic Random walk hypothesis –The theory that historical prices on a financial claim cannot help in predicting future prices Does the stock market forecast the economy? –Some evidence suggests that the stock market forecasts the economy but evidence is not reliable Market efficiency –the speed with which financial security prices adjust to unexpected news pertaining to interest rates or a stock-specific characteristic Random walk hypothesis –The theory that historical prices on a financial claim cannot help in predicting future prices

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Stock Market Regulation Stock markets and participants are subject to regulations imposed by the Securities and Exchange Commission (SEC) Main emphasis of SEC regulation is on full and fair disclosure of information on securities Securities Act of 1933/Securities Exchange Act of 1934 Delegates certain regulatory responsibilities to the markets for the day-to-day surveillance of activity Recently imposed regulations on financial markets intended to reduce excessive price fluctuations Stock markets and participants are subject to regulations imposed by the Securities and Exchange Commission (SEC) Main emphasis of SEC regulation is on full and fair disclosure of information on securities Securities Act of 1933/Securities Exchange Act of 1934 Delegates certain regulatory responsibilities to the markets for the day-to-day surveillance of activity Recently imposed regulations on financial markets intended to reduce excessive price fluctuations

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin International Aspects of Stock Markets European markets becoming an increasing force with introduction of a common currency, the Euro International stock markets allow investors to diversify by holding stocks issued by corporations in foreign countries Increased risk due to less complete information about foreign stocks, foreign exchange risk, and political risk European markets becoming an increasing force with introduction of a common currency, the Euro International stock markets allow investors to diversify by holding stocks issued by corporations in foreign countries Increased risk due to less complete information about foreign stocks, foreign exchange risk, and political risk

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Foreign Exchange Markets Overview Foreign exchange (FX) markets - markets in which cash flows from the sale of products or assets denominated in a foreign currency are transacted Foreign exchange rate - the price at which one currency can be exchanged for another currency Foreign exchange risk - risk that cash flows will vary as the actual amount of U.S. dollars received on a foreign investment changes due to a change in foreign exchange rates Currency depreciation/appreciation - when a country’s currency falls/rises in value relative to other currencies Foreign exchange (FX) markets - markets in which cash flows from the sale of products or assets denominated in a foreign currency are transacted Foreign exchange rate - the price at which one currency can be exchanged for another currency Foreign exchange risk - risk that cash flows will vary as the actual amount of U.S. dollars received on a foreign investment changes due to a change in foreign exchange rates Currency depreciation/appreciation - when a country’s currency falls/rises in value relative to other currencies

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Background and History of Foreign Exchange Markets Bretton Woods Agreement (1944-1977) - called for exchange rate of one currency for another to be fixed around a specific rate with government intervention - led to some currencies being overvalued and some undervalued Smithsonian Agreement (1971) - major countries allowed the dollar to be devalued and boundaries of exchange rate could fluctuate Smithsonian Agreement II (1973) - exchange rate boundaries eliminated altogether, free-floating exchange rate Bretton Woods Agreement (1944-1977) - called for exchange rate of one currency for another to be fixed around a specific rate with government intervention - led to some currencies being overvalued and some undervalued Smithsonian Agreement (1971) - major countries allowed the dollar to be devalued and boundaries of exchange rate could fluctuate Smithsonian Agreement II (1973) - exchange rate boundaries eliminated altogether, free-floating exchange rate

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Foreign Exchange Transactions Spot foreign exchange transaction: 0 1 2 3 mo Exchange Rate Agreed/Paid + Currency Delivered by between Buyer and Seller Seller to Buyer Forward exchange transaction 0 1 2 3 mo Exchange Rate Agreed Buyer Pays Forward Price between Buyer and Seller Seller Delivers currency Spot foreign exchange transaction: 0 1 2 3 mo Exchange Rate Agreed/Paid + Currency Delivered by between Buyer and Seller Seller to Buyer Forward exchange transaction 0 1 2 3 mo Exchange Rate Agreed Buyer Pays Forward Price between Buyer and Seller Seller Delivers currency

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Hedging with Forwards Transactional steps when FI hedges its FX risk by immediately selling one-year sterling loan proceeds in forward FX market –1. U.S.bank sells $100 M for pounds at spot exchange rate today and receives $100 M/1.6 =  L 62.5 M –2. Bank then lends the L 62.5 M to British customer at 15% for one year –3. Bank sells expected P & I proceeds from the sterling loan forward for dollars at today’s forward rate for one year –4. British borrower repays P & I in L 71.875 M –5 Bank delivers the sterling to buyer of one-year forward contract and receives $111.406 M

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Role of FIs in Foreign Exchange Transactions Net exposure - a FIs overall foreign exchange exposure in any given currency Net long (short) in a currency - a position of holding more (fewer) assets than liabilities in a given currency Four trading activities –purchase/sale of foreign currencies for trade transactions –purchase/sale of foreign currencies for investment –purchase/sale of foreign currencies for hedging –purchase/sale of foreign currencies for speculating Net exposure - a FIs overall foreign exchange exposure in any given currency Net long (short) in a currency - a position of holding more (fewer) assets than liabilities in a given currency Four trading activities –purchase/sale of foreign currencies for trade transactions –purchase/sale of foreign currencies for investment –purchase/sale of foreign currencies for hedging –purchase/sale of foreign currencies for speculating

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Purchasing Power Parity The theory explaining the change in foreign currency exchange rates as inflation rates in the countries change i US = IP US + RIR US and: i F = IP F + RIR F where: i US = Interest rate in the United States i F = Interest rate in France then: i US - i F = IP US - IP F The theory explaining the change in foreign currency exchange rates as inflation rates in the countries change i US = IP US + RIR US and: i F = IP F + RIR F where: i US = Interest rate in the United States i F = Interest rate in France then: i US - i F = IP US - IP F

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Interest Rate Parity The theory that the domestic interest rate should equal the foreign interest rate minus the expected appreciation of the domestic currency 1 + i USt = (1/S t )  (1 + i UKt )  F t where: 1 + i USt = 1 plus the interest rate on a U.S. investment maturing at time t 1 + i UKt = 1 plus the interest rate on a U.K. investment maturing at time t S t = S/ L spot exchange rate at time t F t = S/ L forward exchange rate at time t The theory that the domestic interest rate should equal the foreign interest rate minus the expected appreciation of the domestic currency 1 + i USt = (1/S t )  (1 + i UKt )  F t where: 1 + i USt = 1 plus the interest rate on a U.S. investment maturing at time t 1 + i UKt = 1 plus the interest rate on a U.K. investment maturing at time t S t = S/ L spot exchange rate at time t F t = S/ L forward exchange rate at time t

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Balance of Payment Accounts Balance of payment accounts - summary of all transactions between citizens of two countries Current account - the section of the balance of payment table that summarizes foreign trade in goods and services, net investment income, and gifts, grants, or aid given to other countries Capital accounts - the section of the balance of payment table that summarizes capital flows into and out of a country Balance of payment accounts - summary of all transactions between citizens of two countries Current account - the section of the balance of payment table that summarizes foreign trade in goods and services, net investment income, and gifts, grants, or aid given to other countries Capital accounts - the section of the balance of payment table that summarizes capital flows into and out of a country

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin U.S. Balance of Payment Accounts ($Bn) Current Accounts Exports of good, services, and income $312,189 Imports of goods, services, and income -390,934 Unilateral transfers, net -11,204 Total current accounts -$ 89,949 Balance on goods -92,145 Balance on services 18,320 Balance on investment income -4,920 Capital Accounts U.S. assets abroad, net -$101,483 Foreign assets in the U.S., net 207,319 Statistical discrepancy -15,887 Total capital accounts $ 89,949 Sum of current and capital accounts $ 0 Current Accounts Exports of good, services, and income $312,189 Imports of goods, services, and income -390,934 Unilateral transfers, net -11,204 Total current accounts -$ 89,949 Balance on goods -92,145 Balance on services 18,320 Balance on investment income -4,920 Capital Accounts U.S. assets abroad, net -$101,483 Foreign assets in the U.S., net 207,319 Statistical discrepancy -15,887 Total capital accounts $ 89,949 Sum of current and capital accounts $ 0

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Derivative Securities: Chapter Overview Derivative security –a financial security whose payoff is linked to another previously issued security An agreement between two parties to exchange a standard quantity of an asset at a predetermined price at a specified date in the future Derivative security –a financial security whose payoff is linked to another previously issued security An agreement between two parties to exchange a standard quantity of an asset at a predetermined price at a specified date in the future الدوات المالية المشتقة

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Examples of Derivatives Forward and futures contracts –currency forwards and futures –interest rate futures Options contracts call option –put option Swaps –currency swap –interest rate swap Forward and futures contracts –currency forwards and futures –interest rate futures Options contracts call option –put option Swaps –currency swap –interest rate swap العقود الاجلة و المستقبلية عقود الخيارات

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Forwards and Futures Both are agreements to deliver (or take delivery of) a specified asset at a future date Prices of both are tied to the current price of the asset in the “spot” market Spot contract –agreement to purchase (or sell) an asset immediately Both are agreements to deliver (or take delivery of) a specified asset at a future date Prices of both are tied to the current price of the asset in the “spot” market Spot contract –agreement to purchase (or sell) an asset immediately

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Forward Markets Forward contract –an agreement to transact involving the future exchange of a set amount of assets at a set price –participants hedge the risk that future spot prices on an asset will move against them FI’s are the major forward market participants and make a profit on the spread between the price at which they originate and sell forward contracts Forward contract –an agreement to transact involving the future exchange of a set amount of assets at a set price –participants hedge the risk that future spot prices on an asset will move against them FI’s are the major forward market participants and make a profit on the spread between the price at which they originate and sell forward contracts

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Futures Markets Futures contract –an agreement to transact involving the future exchange of a set amount of assets for a price that is settled daily - marked to market daily Initial margin –a deposit required on futures trades to ensure terms of any futures contract will be met Maintenance margin –the margin a futures trader must maintain once a futures position is taken. Futures contract –an agreement to transact involving the future exchange of a set amount of assets for a price that is settled daily - marked to market daily Initial margin –a deposit required on futures trades to ensure terms of any futures contract will be met Maintenance margin –the margin a futures trader must maintain once a futures position is taken. الهامش المبدئ الهامش المستمر

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Futures Trading Occurs on organized exchanges such as CBT and CME or IMM Open-outcry auction - traders face each other and “cry out” their offer to buy or sell Floor broker - Exchange members who place trades from the pubic Professional traders - Exchange members who trade for their own account Position traders - take a position in the futures market based on their expectations of future prices Occurs on organized exchanges such as CBT and CME or IMM Open-outcry auction - traders face each other and “cry out” their offer to buy or sell Floor broker - Exchange members who place trades from the pubic Professional traders - Exchange members who trade for their own account Position traders - take a position in the futures market based on their expectations of future prices (continued)

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Day traders - exchange members who take a position within a day and liquidate it before day’s end Scalpers - exchange members who take positions for very short periods of time, sometimes only minutes, in an attempt to profit from active trading Long position - a purchase of a futures contract Short position - a sale of a futures contract Clearinghouse - the unit that oversees trading on the exchange and guarantees all trades made by the exchange traders Open interest - total number of futures, put options, or call option contracts outstanding at the beginning of the day Day traders - exchange members who take a position within a day and liquidate it before day’s end Scalpers - exchange members who take positions for very short periods of time, sometimes only minutes, in an attempt to profit from active trading Long position - a purchase of a futures contract Short position - a sale of a futures contract Clearinghouse - the unit that oversees trading on the exchange and guarantees all trades made by the exchange traders Open interest - total number of futures, put options, or call option contracts outstanding at the beginning of the day

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Contract Time Lines Spot 0 1 2 3 months Price Agreed/Paid + Bonds delivered Forward 0 1 2 3 months Price Agreed Price paid/bonds delivered Marking to Market every day Futures 0 1 2 3 months Contract entered/Time 0 price EOM 3 price paid/bonds delivered Spot 0 1 2 3 months Price Agreed/Paid + Bonds delivered Forward 0 1 2 3 months Price Agreed Price paid/bonds delivered Marking to Market every day Futures 0 1 2 3 months Contract entered/Time 0 price EOM 3 price paid/bonds delivered

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Options A contract that gives the holder the right, but not the obligation, to buy or sell an asset at a prespecified price for a specified price within a specified period of time American option - can be exercised at any time before the expiration date European option - can only be exercised on the expiration date A contract that gives the holder the right, but not the obligation, to buy or sell an asset at a prespecified price for a specified price within a specified period of time American option - can be exercised at any time before the expiration date European option - can only be exercised on the expiration date

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Definitions of a Call and a Put Call option –an option that gives a purchaser the right, but not the obligation, to buy the underlying security from the writer of the option at a prespecified exercise price on a prespecified date Put option –an option that gives a purchaser the right, but not the obligation, to sell the underlying security to the writer of the option at a prespecified price on a prespecified date Call option –an option that gives a purchaser the right, but not the obligation, to buy the underlying security from the writer of the option at a prespecified exercise price on a prespecified date Put option –an option that gives a purchaser the right, but not the obligation, to sell the underlying security to the writer of the option at a prespecified price on a prespecified date خيار النداء خيار الإجبار

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Payoff Function for Call Options Payoff Payoff function Gain for Buyer +  C 0 Stock Price X A S at expiration C -  Payoff Payoff function Loss for writer Payoff Payoff function Gain for Buyer +  C 0 Stock Price X A S at expiration C -  Payoff Payoff function Loss for writer

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Payoff Function for Put Options Payoff Gain Payoff function for Writer +  P 0 Stock Price D X at expiration -  P Payoff function Payoff for buyer Loss Payoff Gain Payoff function for Writer +  P 0 Stock Price D X at expiration -  P Payoff function Payoff for buyer Loss

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Option Values Intrinsic value of an option –the difference between an option’s exercise price and the underlying asset’s price Time value of an option –the difference between an option’s price (or premium) and its intrinsic value Intrinsic value of an option –the difference between an option’s exercise price and the underlying asset’s price Time value of an option –the difference between an option’s price (or premium) and its intrinsic value القيمة الزمنية -المضارب القيمة الحقيقية

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Intrinsic value vs. the Before Exercise Value of a Call Option Value intrinsic value (option (stock price - exercise price) premium) Before exercise price $12.50 Time Value $10.00 ($2.50) X = $50 S = $60 Stock Price Value intrinsic value (option (stock price - exercise price) premium) Before exercise price $12.50 Time Value $10.00 ($2.50) X = $50 S = $60 Stock Price

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Option Markets Options traded on the floor of CBOE by floor brokers, professional traders or a market maker for the particular option being traded Stock options - the underlying asset on a stock option contract is the stock of a publicly traded company, generally 100 shares Stock index options - the underlying asset on a stock index option is the value of a major stock market index (e.g., the DJIA or S&P 500) Options give investors a way to hedge their existing stock portfolios Options traded on the floor of CBOE by floor brokers, professional traders or a market maker for the particular option being traded Stock options - the underlying asset on a stock option contract is the stock of a publicly traded company, generally 100 shares Stock index options - the underlying asset on a stock index option is the value of a major stock market index (e.g., the DJIA or S&P 500) Options give investors a way to hedge their existing stock portfolios

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Regulation of Futures and Options Markets The Commodity Futures Trading Commission (CFTC) is the primary regulator of futures markets –protects the trading public by seeking to prevent misrepresentation and/or market manipulation –approves new or proposed contracts to ensure they have economic purpose, conducts economic studies, enforces rules and provides regulatory surveillance The Securities and Exchange Commission (SEC) is the main regulator of stock options –regulates trading of stock options and stock index options The Commodity Futures Trading Commission (CFTC) is the primary regulator of futures markets –protects the trading public by seeking to prevent misrepresentation and/or market manipulation –approves new or proposed contracts to ensure they have economic purpose, conducts economic studies, enforces rules and provides regulatory surveillance The Securities and Exchange Commission (SEC) is the main regulator of stock options –regulates trading of stock options and stock index options

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Swaps An agreement between two parties to exchange assets or a series of cash flows for a specific period of time at a specified interval Allow firms to better manage their interest rate, foreign exchange and credit risk Basic principle involves the transacting parties restructuring their asset or liability cash flows in a preferred direction An agreement between two parties to exchange assets or a series of cash flows for a specific period of time at a specified interval Allow firms to better manage their interest rate, foreign exchange and credit risk Basic principle involves the transacting parties restructuring their asset or liability cash flows in a preferred direction

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Swaps Definitions Interest rate swap - an exchange of fixed-interest payments for floating-interest payments by two counterparties Swap buyer - a party that makes the fixed-rate payments in an interest rate swap transaction Notional principal - principal amount involved in a swap Swap seller - a party that makes the floating-rate payments in an interest rate swap transaction Currency swap - used to hedge against exchange rate risk from mismatched currencies on assets and liabilities Interest rate swap - an exchange of fixed-interest payments for floating-interest payments by two counterparties Swap buyer - a party that makes the fixed-rate payments in an interest rate swap transaction Notional principal - principal amount involved in a swap Swap seller - a party that makes the floating-rate payments in an interest rate swap transaction Currency swap - used to hedge against exchange rate risk from mismatched currencies on assets and liabilities

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Swap Transactions Direct arrangement of swap Floating-Rate Payments Money Center Bank Thrift Fixed-Rate Payments Swap arranged by third-party intermediary (swap agent) Floating-Rate Floating-Rate Payment Payment Money Center Bank Swap Agent Thrift Fixed-Rate Fixed-Rate Payment Payment Direct arrangement of swap Floating-Rate Payments Money Center Bank Thrift Fixed-Rate Payments Swap arranged by third-party intermediary (swap agent) Floating-Rate Floating-Rate Payment Payment Money Center Bank Swap Agent Thrift Fixed-Rate Fixed-Rate Payment Payment

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Fixed-Floating Rate Swap Money Center Bank Thrift 10% Short-Term Assets fixed Long-Term Assets (C&I indexed loans) (fixed-rate mortgages) Long-Term Liabilities Short-Term Liabilities (5-year, 10 % notes) LIBOR + 2% (1-year CDs) Money Center Bank Thrift 10% Short-Term Assets fixed Long-Term Assets (C&I indexed loans) (fixed-rate mortgages) Long-Term Liabilities Short-Term Liabilities (5-year, 10 % notes) LIBOR + 2% (1-year CDs)

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Caps, Floors, and Collars Cap –a call option on interest rates, often with multiple exercise dates Floor –a put option on interest rates, often with multiple exercise dates Collar –a position taken simultaneously in a cap and a floor Cap –a call option on interest rates, often with multiple exercise dates Floor –a put option on interest rates, often with multiple exercise dates Collar –a position taken simultaneously in a cap and a floor

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Chapter One Introduction Dr. Ahmed Y Dashti.

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Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Chapter One Introduction Dr. Ahmed Y Dashti.

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Presentation on theme: "Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Chapter One Introduction Dr. Ahmed Y Dashti."— Presentation transcript:

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