Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin 1 Financial Markets Overview The Federal Reserve System, Money, Bond, Equity, Currency and Commodity Markets

Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin 2 Major Duties and Responsibilities of the Federal Reserve System Conducting monetary policy Supervising and regulating depository institutions Maintaining the stability of the financial system Providing payment and other financial services to the U.S. government, the public, FIs and foreign official institutions Conducting monetary policy Supervising and regulating depository institutions Maintaining the stability of the financial system Providing payment and other financial services to the U.S. government, the public, FIs and foreign official institutions

Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin 3 Structure of the Federal Reserve System 12 FR Banks plus 10 branches located in major U.S. cities A 7-member Board of Governors in Washington, DC The Federal Open Market Committee (FOMC) 12 FR Banks plus 10 branches located in major U.S. cities A 7-member Board of Governors in Washington, DC The Federal Open Market Committee (FOMC)

Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin 4 Federal Open Market Committee (FOMC) The major monetary policy-making body of the FR System Main responsibilities are to formulate policies to promote full employment, economic growth, price stability, and a sustainable pattern of international trade Open market operations—the purchase and sale of U.S. government and federal agency securities Sets ranges for growth of monetary aggregates and directs the FR in foreign exchange markets The major monetary policy-making body of the FR System Main responsibilities are to formulate policies to promote full employment, economic growth, price stability, and a sustainable pattern of international trade Open market operations—the purchase and sale of U.S. government and federal agency securities Sets ranges for growth of monetary aggregates and directs the FR in foreign exchange markets

Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin 5 Objective of Monetary Policy To influence the amount of reserve in the banking system… which affects interest rates and availability of credit and… ultimately affects the levels of employment, output, prices and inflation To influence the amount of reserve in the banking system… which affects interest rates and availability of credit and… ultimately affects the levels of employment, output, prices and inflation

Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin 6 Monetary Policy Tools Open Market Operations –primary determinate of changes in excess reserves in the banking system impacting the size of the money supply and/or interest rates The Discount Rate –the rate of interest FR Banks charge on emergency loans to depository institutions Reserve Requirements –determine the minimum amount of reserve assets that depository institutions must maintain by law to back transaction deposits held as liabilities Open Market Operations –primary determinate of changes in excess reserves in the banking system impacting the size of the money supply and/or interest rates The Discount Rate –the rate of interest FR Banks charge on emergency loans to depository institutions Reserve Requirements –determine the minimum amount of reserve assets that depository institutions must maintain by law to back transaction deposits held as liabilities

Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin 7 Impact of Monetary Policy on Various Economic Variables Expansionary Activities Contractionary Activities Impact on Reserves Credit availability Money supply Interest rates Security prices

Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin 8 Definition and Purpose of Money Markets The Money Markets are associated with the issuance and trading of short-term (less than 1 year) debt obligations of large corporations, FIs and governments 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 (less than 1 year) debt obligations of large corporations, FIs and governments 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 © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin 9 Money Market Instruments 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 specified interest rate and 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 specified interest rate and maturity Banker Acceptances - time draft payable to seller of goods, with payment guaranteed by a bank

Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin 10 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. Virtually default risk free. 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. Virtually default risk free.

Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin 11 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 Individual competitive bidders 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 a weighted-average of the rate on 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 Individual competitive bidders 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 a weighted-average of the rate on winning competitive bids; get preferential allocation.

Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin 12 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 © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin 13 Secondary Market T-bill Transaction Federal Reserve Bank of New York Transfers $10m. In T-bills from J.P. Morgan Chase to Lehman Brothers Transaction recorded in Fed’s Book-Entry System J.P. Morgan Chase 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 Chase sell $50,000 in T-bills FRBNY -$50,000 in T-bills from J.P. Morgan Chase’s account + $50,000 T-bill to Individual

Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin 14 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 © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin 15 Calculating T-bill Yields from Discount Rates i T-bill (dy) = P F - P O  360 P F h Where: i T-bill = Annualized yield on the T-bill P F = Price (face value) paid to the T-bill holder P O = Purchase price of the T-bill h = Number of days until the T-bill matures Example: i T-bill (dy) = $10,000 - $9,650  360 = 6.92% $10, i T-bill (dy) = P F - P O  360 P F h Where: i T-bill = Annualized yield on the T-bill P F = Price (face value) paid to the T-bill holder P O = Purchase price of the T-bill h = Number of days until the T-bill matures Example: i T-bill (dy) = $10,000 - $9,650  360 = 6.92% $10,

Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin 16 Federal Funds Short-term funds transferred between FIs, 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 Federal Funds Yields –single-payment loans - they pay interest only once, at maturity. –Fed fund transactions take the form of short-term (mostly overnight) unsecured loans Short-term funds transferred between FIs, 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 Federal Funds Yields –single-payment loans - they pay interest only once, at maturity. –Fed fund transactions take the form of short-term (mostly overnight) unsecured loans

Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin 17 Overview of the Bond Markets A bond is a promise to make periodic coupon payments and to repay principal at maturity; breach of this promise is an event of default Bonds 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; breach of this promise is an event of default Bonds carry original maturities greater than one year so bonds are instruments of the capital markets Issuers are corporations and government units.

Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin 18 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 years; bonds years. 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 years; bonds years.

Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin 19 Treasury Strips A Treasury security in which the individual interest payments are separated from the principal payment Effectively creates sets of securities--one for each semiannual interest payment and 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 developed by securities firms; only available through FIs and government securities brokers A Treasury security in which the individual interest payments are separated from the principal payment Effectively creates sets of securities--one for each semiannual interest payment and 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 developed by securities firms; only available through FIs and government securities brokers

Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin 20 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 © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin 21 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 © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin 22 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 © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin 23 Corporate Bonds All long-term bonds issued by corporations. Minimum denominations publicly traded corporate bonds is $1,000. Generally pay interest semi-annually. 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 semi-annually. Bond indenture –legal contract that specifies the rights and obligations of the bond issuer and the bond holder

Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin 24 Types of Corporate Bonds Mortgage bonds –issued to finance specific projects which are pledged as collateral Equipment Trust Certificates –bonds collateralized with tangible non-real estate property 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 Equipment Trust Certificates –bonds collateralized with tangible non-real estate property 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 © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin 25 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 bonds –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 bonds –bonds that include a requirement that the issuer retire a certain amount of the bond issue each year

Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin 26 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 © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin 27 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 © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin 28 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 © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin 29 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 © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin 30 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 © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin 31 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 regularly (they elect a board, who chooses a CEO, etc.)

Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin 32 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 Market Trading of shares among investors (no cash received by issuer).

Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin 33 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

Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin 34 Calculating Stock Returns R t = P t - P t-1 + D t P t-1 P t-1 Where: R t = Return over period from t-1 to t P t = Stock price at time t P t-1 = Stock price at time t-1 D t = Dividends paid over time t - 1 to t P 1 - P t-1 = Capital gain over time t - 1 to t R t = $45 - $40 + $4 $40 $40 = 12.5% % = 22.5% R t = P t - P t-1 + D t P t-1 P t-1 Where: R t = Return over period from t-1 to t P t = Stock price at time t P t-1 = Stock price at time t-1 D t = Dividends paid over time t - 1 to t P 1 - P t-1 = Capital gain over time t - 1 to t R t = $45 - $40 + $4 $40 $40 = 12.5% % = 22.5%

Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin 35 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

Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin 36 Characteristics of Preferred Stock Similar to common stock in that it represents an ownership interest but, like bonds, pays a fixed periodic dividend (a “hybrid” security). 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 © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin 37 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 © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin 38 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 issuer on the syndicate’s behalf Red herring proxy - a preliminary version of the prospectus describing a new security

Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin 39 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

Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin 40 Trading on NYSE and AMEX Order Order Order Investor Shares Broker Shares Comm Shares Market or Maker or Cash Cash Floor Cash Other Floor Broker Broker Order Order Order Investor Shares Broker Shares Comm Shares Market or Maker or Cash Cash Floor Cash Other Floor Broker Broker

Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin 41 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)

Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin 42 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 Delegates certain regulatory responsibilities to the markets (Self-Regulatory Organizations, SROs) for the day-to-day surveillance of activity.

Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin 43 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 FX rates Currency depreciation/appreciation - when a country’s currency falls/rises in value relative to other currencies

Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin 44 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

Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin 45 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 © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin 46 Commodity Markets Spot Markets – trades commodities (energy, metals, agriculture, etc.) for physical delivery via OTC. Derivative Markets – facilitates participants to hedge and speculate on the future price of the underlying commodity (can, but infrequently, leads to physical delivery), via both exchanges & OTC.