Financial and Real Estate Markets Money Markets Capital Markets Mortgage Markets Financial Derivative Markets

The Money Markets Money Markets Purpose Money market securities are usually sold in large denominations They have low default risk They mature in one year or less from their issue date Purpose Investors in Money Market: Provides a place for warehousing surplus funds for short periods of time Borrowers from money market provide low-cost source of temporary funds

Interest Rates of Money Market Instruments

Participants in Money Markets U.S. Treasury Department Federal Reserve System Commercial Banks Businesses Investment and Securities Firms Individuals (mostly through money market mutual funds)

Money Market Instruments Treasury Bills Federal Funds Repurchase Agreements Negotiable Certificates of Deposit Commercial Paper Banker’s Acceptance Eurodollars

Treasury Bills Short-term borrowings of the federal government (US Treasury Department) Usually sold at discount

Discounting Example You pay $9850 for a 91-day T-bill. It is worth $10,000 at maturity. What is its annualized yield?

Federal Funds Short-term funds transferred (loaned or borrowed) between financial institutions, usually for a period of one day Having excess reserve -> loan (sell) federal funds Fed can influence the rate by setting target

Federal Funds Figure 8.2: Federal Funds and Treasury Bill Interest Rates, January 1990–January 2002

Negotiable Certificates of Deposit A bank-issued security that documents a deposit and specifies the interest rate and the maturity date Denominations range from $100,000 to $10 million

Negotiable Certificates of Deposit Comparing Interest on CDs and T-bills Figure 8.3: Interest Rates on Negotiable Certificates of Deposit and on Treasury Bills, January 1990–January 2002

Commercial Paper Unsecured promissory notes, issued by corporations, that mature in no more than 270 days Banks also issue commercial paper, but have reserve requirement on bank-issued commercial paper

Commercial Paper Comparing Interest on Commercial Paper to Bank Prime Rate Figure 8.4: Return on Commercial Paper and the Prime Rate, January 1990–January 2002

Banker’s Acceptances An order to pay a specified amount to the bearer on a given date if specified conditions have been met, usually delivery of promised goods Used in international trade Have secondary markets

Repo (Repurchase agreement) Buyer purchase securities with an agreement that the seller will repurchase them in short period of time, anywhere from 1 to 15 days from the original date of purchase. Implicitly the buyer is a lender, seller is borrower Buyer is compensated with the interest This contract has secondary market

Eurodollars Dollar denominated deposits held in foreign banks Used as alternative to fed fund for banks around the world London interbank bid rate (LIBID) The rate paid by banks buying funds London interbank offer rate (LIBOR) The rate offered for sale of the funds

Figure 8-6: Interest Rates on Money Market Securities, 1990–2002

Money Market Mutual Funds Open-end investment funds that invest only in short-term securities No fee for purchasing or redeeming shares Minimum initial investment of $500 to $20,000 Check-writing privileges No fee for writing checks No minimum check amount Earn 0.5% to 1% higher return than interest earned on money in the bank Low risk of default, low rate of risk Popular to small investors

Money Market Fund Assets Figure 8.8: Average Distribution of Money Market Fund Assets, 2001

Capital Markets Original maturity is greater than one year Best known capital market securities: Stocks and bonds Primary issuers of securities: Federal and local governments Corporations Largest purchasers of securities: You and me

Capital Market Trading Primary market for initial sale (IPO) Secondary market Over-the-counter Organized exchanges (i.e., NYSE)

Want to be listed on the NYSE? You will need at least: 2000 stockholders, each owning at least 100 shares A minimum of 1.1 million shares traded publicly Pretax earnings of $2.5 million at the time of listing $2 million in pretax earning in each of the two prior years A total of $100 million in market value of publicly traded shares

Treasury Bonds No default risk Very low interest rates

Compare 20-Year Treasury Bonds to 90-Day Treasury Bills Figure 9-4: Interest Rates on Treasury Bills and Treasury Bonds, 1973–2002 (January of each year)

Municipal Bonds Issued by local, county, and state governments Used to finance public interest projects Tax-free municipal interest rate = taxable interest rate  (1  marginal tax rate) Two types General obligation bonds Revenue bonds NOT default-free

Comparing Revenue and General Obligation Bonds Figure 9-5: Issuance of Revenue and General Obligation Bonds, 1984–2000 (End of year)

Corporate Bonds Face value of $1,000 Pay interest semi-annually Can be redeemed anytime the issuer wishes Degree of risk varies with each bond Interest rate varies with level of risk

Characteristics of Corporate Bonds Registered Bonds Restrictive Covenants Call Provisions Higher yield Sinking fund Interest of the stockholders Alternative opportunities Conversion and Convertible Bonds

Convertible Bonds The bond that can be converted into certain shares of common stocks at the discretion of the bondholder. Conversion ratio

Types of Corporate Bonds Secured Bonds Mortgage bonds Equipment trust certificates Unsecured Bonds Debentures Subordinated debentures Variable-rate bonds Junk Bonds

Stock Represents ownership in a firm Earn a return in two ways Price of the stock rises over time Dividends are paid to the stockholder Stockholders have claim on all assets Right to vote for directors and on certain issues Two types Common stock Right to vote Receive dividends Preferred stock Receive a fixed dividend Do not usually vote

Stock Prices

30 Stocks in the Dow Jones Industrial Average

Stocks ADR – American Depository Receipts A US bank buys the shares of a foreign company and places them in its vault. The bank then issue receipts against these shares, and these receipts can be traded domestically, usually on the NASDAQ. In US dollars No need to meet disclosure rules required by SEC

Mortgage Market Definition Mortgage is a long-term loan secured by real estate by developer and family Commercial mortgage and residential mortgage A mortgage is amortized The borrower pays it off over time in some combination of principal and interest payment that result in full payment of the debt by maturity

Types of Mortgage loans Insured mortgage: Guaranteed by Federal Housing Administration or Veterans Administration, applicants need meet certain qualifications Serve in the military Low incomer Conventional mortgage: insured by private mortgage insurance (PMI): loan-to-value exceeding 80% Fixed or adjustable rate mortgages (ARM) Innovative mortgage contracts, e.g., Graduated-payment mortgage Second mortgage

Mortgage Market Primary Mortgage Market (see page 302) Constituted by commercial banks, S&Ls, commercial banks, life insurance companies, and mortgage pools Sell loans after they lend money Diversify their risk in the secondary market Secondary Mortgage Market buy mortgage from the primary market Bundle mortgages and offer securitized mortgage-backed assets

Mortgage Market Major participants in the secondary market Fannie Mae (Federal National Mortgage Association) Ginnie Mae (Government National Mortgage Association) Freddie Mac (Federal Home Loan Mortgage Corp) Securitization of Mortgages Mortgages are too small to be wholesale instruments Sell mortgage backed security Mortgage pool Mortgage pass-through – is a kind of special debt

Types of securitized mortgage/Debt Mortgage Pool Mortgage pass through: a security created when one or more holders of mortgages from a collection of mortgages and sell shares in a pool Mortgage-backed security (MBS): make mortgage a security, similar ideas: asset-backed security (ABS) Collateralized mortgage obligations (CMO) Collateralized bond obligations (CBO) Collateralized debt obligations (CDO) The largest market dealer for securitized asset is Bear Sterns

Derivative Market See definitions in chapter 23 Option Call put Futures and forward Long short Swap Financial contracts that obligate each party to the contract to exchange a set of payments it owns for another set of payments owned by another party