1 Chapter 3 Financial Markets And Instruments ©Thomson/South-Western 2006

2 Saving  Investment  Economic Growth Saving allows people to transfer their economic resources from consumption now to the opportunity to consume goods in the future. The investment in capital goods makes labor more efficient, allowing for more output and consumption later on. The greater the proportion of current output saved and invested, the more rapid will be a nation’s rate of long-term economic growth.

3 Financial Markets And The Flow Of Funds Financial institutions and markets provide the mechanism for this transfer of funds from savers to investors. Both borrowers and savers exist among households, business firms, state and local government units, and foreign entities. Financial markets allow savers’ funds to be matched with borrowers’ needs.

4 Figure 3-1

5 Financial Markets Direct Capital Markets shares of stock bonds other debt instruments Indirect Capital Markets (financial intermediaries as middlemen) banks money markets mutual funds life insurance companies

6 An Example of Financial Intermediation A commercial bank issues a savings account to an individual and uses the proceeds to fund a loan to a local farmer to purchase a new tractor. The primary claim is the bank’s loan agreement with the business owner ; the secondary claim is the savings account. In this case, the bank serves as a “middleman” between the saver and the business owner.

7 3 Attributes Of Financial Instruments  Liquidity the ease with which an asset may be converted into money  Risk the possibility that the owner of an asset will be unable to recover the full value of funds originally invested  Yield the rate of return on an asset, expressed as a percentage per year

8 Attributes Of Financial Instruments  Liquidity The ease with which an asset may be converted into money Need 3 properties -Can convert to money quickly -No cost to convert -Can convert at fair price (no loss of principal) Land, Stock, Cash, Check, Savings account, Arts (paintings), Jewelries Which one has more/less liquidity?

9 Attributes Of Financial Instruments 2. Risk The possibility that the owner of an asset will be unable to recover the full value of funds originally invested -Default risk: Borrowers don’t pay back -Market risk: Market price falls  get loss if sell 3. Yield The rate of return on an asset, expressed as a percentage per year -Interest yield -Dividend yield

10 Liquidity, Risk, and Yield: Their Relationship Liquidity and yield relate inversely—the less liquid an asset is, the more the investor will demand to compensate for ILLIQUIDITY. Risk and yield relate positively—the more risk investors take on, the more return they expect. Liquidity and risk relate inversely—the more liquid an asset is, the less risky it will be because the investor can get out easily.

11 Classification Of Financial Markets Debt & equity markets Primary & secondary markets Organized exchanges & over-the-counter markets Cash & derivative markets Money & capital markets

12 Debt & Equity Markets Debt instruments agree to pay a specific amount of money at some specified future date. Examples: government securities, corporate bonds, Mortgages, short-term money market instruments Bondholders are paid first in case of bankruptcy. $ 50 $ 1,000 $ If you buy 1 bond contract with $ 1,000 par, 5% coupon rate, 5 years to maturity

13 Debt & Equity Markets Equities are financial claims that give the owner a right to share in the net income of the corporate issuer. Companies issue and sell common stocks. Stockholders gain dividend income and capital gain. dividend 1 Future Price 5 dividend dividend 3 dividend 4 dividend 5 If you buy 1 share of stock, you pay at today’s market price and sell at the market price in the future

14 Primary & Secondary Markets PRIMARY SECURITIES MARKET: market involved in creating and issuing new securities, mortgages, and other claims to wealth SECONDARY SECURITIES MARKET: market for transferring existing securities between investors $ $ $ Company FI $ $ $ Securities Investor I I I I

15 Primary & Secondary Markets Primary markets offer new issues, usually through investment banks and/or underwriting syndicates. Investment bank; an institution that specializes in providing information & counsel to companies on financial analysis & issues. Underwriting; when investment bank stands ready to purchase the entire issue and then sell the shares to the public.

16 Primary & Secondary Markets Secondary markets trade previously issued (2nd- hand) securities. Secondary markets provide: primary markets with liquidity a continuing flow of information about company conditions (through stock prices and bond yields). Can be “organized stock exchange (OSE)” or “over-the- counter (OTC).”

17 OSEOTC Formal marketInformal market Tangible physical locationUse telecom network Trading floorNo trading floor Investors trade throughDealers make trading Brokers and Dealers Ex; NYSE, AMEX, SET Ex; NASDAQ

18 Cash & Derivative Markets Cash markets involve transactions in which the buyer pays the seller for the asset up front (make payment and delivery immediately) If you buy 100 shares of stock, in cash market, you pay at today’s market price and get the shares today

19 Cash & Derivative Markets Derivative instruments are transactions in which the buyers and sellers arrange for a specified price at a specified time (date of settlement and delivery in the future) Futures contract: agreement to buy/sell Options contract: right to buy/sell If you buy 100 shares of stock, in derivative market, you sign contract today writing the price & date of settlement with the seller On the settlement date, you buy at the price specified in the contract

20 Money Versus Capital Markets Money markets trade in short-term debt (less than one year maturity) instruments, typically in massive quantities. Issued by governments, banks, and other private firms High degree of liquidity and relatively low default risk. Capital markets exchange longer-term securities issued by government and private concerns. Government bonds, Corporate bonds, Corporate stocks

21 Money Markets (Short-term securities) 1. Commercial Paper 2. Negotiable CDs 3. U.S. Treasury Bills 4. Repurchase Agreements 5. Eurodollars 6. Federal Funds 7. Banker's Acceptances

22 1. Commercial paper Unsecured promissory notes Issued by well-known companies For day-to-day business needs 2. NCD Issued by banks, Issued to depositors $100, T-bills Issued by Government through bid auctions Money Markets (Short-term securities)

23 4. Repurchase agreements (RP) Agreement between buyer (large co.) and seller (banks, financial institutions) Seller sells T-bills & agrees to buy back at a higher price 1-14 days 5. Eurodollars Time deposits denominated in U.S. dollars In foreign banks, U.S. banks in foreign countries Money Markets (Short-term securities)

24 6. Federal funds Deposits at the Fed. (reserves) Overnight loan between the banks (interbank loan) Banks with excess reserves lend (sell federal funds) Banks with deficit reserves borrow (buy federal funds) At “federal funds rate” Money Markets (Short-term securities)

25 7. Bankers’ acceptances (bank draft) Check issued by importer and guaranteed by bank Used in export and import ExporterInvestors $ $$ Bank draft Importer Bank draft cars Bank $ $$ Bank draft Money Markets (Short-term securities)

26 ____________ Issued by Government Issued through bid auctions ____________ Issued by well-known companies Companies use fund to finance day-to-day operations ____________ Check guaranteed by reputable bank As a form of payment between importer and exporter Money Markets (Short-term securities)

27 ____________ Agreement that the bank sells T-bills and agrees to buy back at a higher price ____________ Allow banks in deficit reserves to borrow from banks in excess reserves ____________ Banks issued to depositors Money Markets (Short-term securities)

28 Capital Markets (Long term securities) 1.Corporate Stocks 2.Corporate Bonds 3.Municipal Bonds 4.U.S. Government (Treasury) Notes, Bonds 5.Mortgages 6.MBS

29 Capital Markets (Long term securities) 1. Common Stocks Bull period: firms issue new shares Bear period: firms buy back existing shares 2. Corporate Bonds Call features Convertible features 3. Municipal Bonds Issued state, local governments, Interest income earned is not taxable

30 Capital Markets (Long term securities) 4. U.S. Government Notes, Bonds Absence of default risk 5. Mortgages Loans financing the purchase of real property Fixed, Variable rate 6. MBS (Mortgage-Backed Securities) Pool of mortgages into one portfolio Package a group of mortgages into standard contracts Sell to investors

31 Capital Markets (Long term securities) MBS: Pool of mortgages into one portfolio Mortgage 1 $2,000,000 $ 10,000,000 MBS 10,000 contracts (1 contract=$1,000) Bank Mortgage 2 $3,000,000 Mortgage 3 $5,000,000 Bank sells these MBS to investors

32 U.S. Government Securities How trading is done Through a network of Government securities dealers Dealers hold inventories of Gov. Securities They stand ready to buy at “Bid price” and sell at “Ask price” Dealers do not charge commission/brokerage fee They earn income from spread Spread = Ask price – Bid price

33 U.S. Government Securities Why they are important Fed implements Monetary policy by trading these securities Ease Monetary policy (to boost the economy) Fed buys Gov. securities from financial market Fed injects more money supply into financial system Tight Monetary policy (to slow down) Fed sells Gov. securities Fed takes money supply from financial system

34 U.S. Government Securities Types of Government Securities T-Bills (Short-term securities: 3, 6, 12 months) T-Notes (Long-term securities: 1 – 10 years) T-Bonds (Long-term securities: 10 – 30 years) TIPS (Treasury inflation-protected securities)

35 T-Bills Issued on a competitive bidding Quoted in annual rates of return (not in price) Traded at discount from face value (par) of $1, $ 940 $ 1,000 $ 960$ 980$ 990 Example: Government issues 10 million T-bills with maturity 120 days

36 T-Bills Annual rates of return (discount rate) Market price

37 Discount Rates and Prices: example Let the face value of a T-Bill = $1000, the current price = $944. There are 180 days to maturity. Find the discount (interest) rate. r = 1000 – 944 x r = x 2r = or 11.2% 180 r = 1000 – Px Days

38 Discount Rates and Prices: example Let the face value of a T-Bills = $1000, the discount rate = 4.55%. There are 240 days to maturity. Find the current price Price = 1000 – (1000 x 4.55% x 240) 360 Price = 1000 – = Price = 1000 – (1000 x r x days) 360

39

40 Treasury Notes and Bonds Both are issued through three methods: Auction Same as Treasury bills Exchange The Treasury offers existing owners of maturing notes and bonds a choice of several new issues Subscription The public is first notified of the coupon rate and other features of a new issue, and investors subscribe for their desired amounts When oversubscribed each investor gets a pro rata share

41 Current Yield Formula The current yield refers simply to the annual payment (coupon) divided by the price. Y c = R/P where Y c is the current yield, R is the annual coupon payment in dollars, P is the market price.

42 Current Yield Example Market price of 5-years treasury bond is $1,020. the bond is paying a coupon of $50 per year. Find the current yield. Y c = Y c = or 4.9%

43 Yield to Maturity Formula The average yield over the life of the security Y m = R + (C/N) where Y m is the Yield to Maturity, R is the annual coupon payment in dollars, C is the capital gain/loss = 1,000 – P P is the market price N is number of years remaining to maturity. (1000+P)/2

44 Yield to Maturity Example The market price of the bond is $980. Coupon payment is 6% annually. There are 5 years remaining to maturity. Find YTM of this bond. Y m = R + (C/N) R = $60 C = 1,000 – P = 1,000 – 980 = $20 P = $980 N = 5 years (1000+P)/2 = 6.46%

45 Treasury Inflation Protection Securities (TIPS) A form of U.S. Government debt designed to protect investors against inflation Pay out income each year based on the fixed coupon rate Principal amount is indexed to the nation's consumer price index (CPI) Ex; if inflation = 4% then $1,000-par bond  $1,040

46 Exercise 1. A corporate bond with a coupon rate of 7% matures in 4 years. Its price is currently $1, Calculate the current yield on this bond - Calculate the yield to maturity on this bond 2. What is the price of a T-bill that exhibits a discount rate of 4% if it matures in 360 days? 90 days? 3. Calculate the price of a T-bill that matures in 30 days if it has a discount rate of 7%. How does your answer change if the discount rate is 9%? How can you explain this change?