1. Spring-03 http://pluto.mscc.huji.ac.il/~mswiener/zvi.html Investments Zvi Wiener 02-588-3049 mswiener@mscc.huji.ac.il Investments, BKM Ch 2

2. Zvi WienerBKM Ch 2 slide 2 Markets and Instruments Money Market (up to 1 year to maturity) The Fixed-Income Capital Market Equity Securities Stock and Bond Market Indexes Derivative Markets

3. Zvi WienerBKM Ch 2 slide 3 Money Markets US Treasury Bills (T-Bills) Certificates of Deposit (CD) Commercial paper (CP) Bankers’ acceptances Eurodollars Repos and Reverses Federal Funds

4. Zvi WienerBKM Ch 2 slide 4 US Treasury Bills Initial maturities are 91-182 days, offered weekly 52 weeks, offered monthly Competitive and noncompetitive (10-20%) bids. The investor buys the instrument at discount bid-ask (spread) represents the profit for the dealer quotes use the bank discount yield. Exempt of state and local taxes.

5. Zvi WienerBKM Ch 2 slide 5 Bank Discount Yield $10,000 par T-bill at $9,600 with 182 DTM. $400(360/182) = $791.21 thus the bank discount yield is 7.91% r BD =(10,000-P)/10,000 ·360/n effective annual yield is: (1+400/9600) 2 -1=8.51% bond equivalent yield is: r BEY =(10,000-P)/P ·365/n

6. Zvi WienerBKM Ch 2 slide 6 Certificates of Deposit Time deposits with commercial banks. It may not be withdrawn upon demand. Large CDs can be sold prior to maturity. Insured by FDIC up to $100,000 (Federal Depository Insurance Corporation)

7. Zvi WienerBKM Ch 2 slide 7 Commercial Paper Unsecured short term debt (corporations). Maturity is up to 270 days. CP is issued in multiples of $100,000. Small investors buy it through mutual funds. Most issues have credit rating. Treated for tax purposes as regular debt. LC backed (letter of credit) optional. In summer 1989 three companies defaulted.

8. Zvi WienerBKM Ch 2 slide 8 Bankers’ acceptances Orders to a bank by a customer to pay a given sum at a given date. Backed by bank. Traded in secondary markets. Widely used in international commerce, because the creditworthiness is supplied by a bank.

9. Zvi WienerBKM Ch 2 slide 9 Eurodollars Dollar denominated time deposits in foreign banks. Most are for large amounts and with maturity of less than 6 months.

10. Zvi WienerBKM Ch 2 slide 10 Repos and Reverses Repurchase agreements (RPs) used by dealers in government securities. Term repo has a maturity of 30 days or more. Reverse repo is the result of a dealer finding an investor buying government securities with an agreement to sell them at a specified price at a specified future date. Failure of dealers in 1985 - credit risk.

11. Zvi WienerBKM Ch 2 slide 11 Federal Funds Commercial banks that are members of the Federal Reserve System (Fed) are required to maintain a minimum reserve balance with Fed. Banks with excess reserves lend (usually overnight) to banks with insufficient reserves. For more on Fed see Siegel-9

12. Zvi WienerBKM Ch 2 slide 12 Brokers’ Calls Brokers borrow funds to loan to investors who wish to buy stock on margin. The broker agrees to repay the loan upon the call of the bank. The rate is higher because of the credit risk component.

13. Zvi WienerBKM Ch 2 slide 13 LIBOR London Interbank Offer Rate (LIBOR) is the rate at which the large London banks lend among themselves. This rate serves often as an anchor for floating rate agreements which for example can be set at LIBOR + 3%

14. Zvi WienerBKM Ch 2 slide 14 Yields on Money Market Instruments In general, money market instruments are quite safe. However, T-bills are the safest of the money money instruments. As a result the other instruments provide a slightly higher yield.

15. Zvi WienerBKM Ch 2 slide 15 Fixed-Income Capital Markets T-Notes - initial maturity of 10 years (or less). T-Bonds - initial maturities of 10-30 years. Par (also called face or principal) $1,000. Interest (coupons) paid semiannualy.

16. Zvi WienerBKM Ch 2 slide 16 RateMo/YrBid AskedChg.Ask Yld 8 3 / 4 Aug 00n105:16 105:18+87.55 Rate coupon payment 8 3 / 4 % of $1,000; paid semiannually; $43.75 per bond each 6 mo. Maturity = August 2000n = note Bid =105:16 means 105 16 / 32 =105.5% at the price $1055 buyer is willing to buy. Ask=105:18 means 105 18 / 32 =105.5625% at the price $1055.625 seller is willing to sell.

17. Zvi WienerBKM Ch 2 slide 17 “Callable Bond” Option What is this call option? Who has this option, who pays for it? When is it optimal to exercise the call option? Why does it make sense to calculate yields on discount bonds to maturity and yields on premium bonds to the first call?

18. Zvi WienerBKM Ch 2 slide 18 Federal Agency Debt Some federal agencies issue their own debt. They are not legally backed by the Treasury. Treasury would assist in the event of distress. These issues are very safe. Yield is only slightly more than Treasury issues. FNMA, GNMA, FHLMC

19. Zvi WienerBKM Ch 2 slide 19 Municipal Bonds (Munis) Issued by state and local governments and agencies. Interest (not capital gains!) is exempt from federal taxes. General Obligations are backed by the taxing power of the issuer. Revenue bonds are backed only by revenues from specific projects. Industrial Development bond is issued to finance a private projects.

20. Zvi WienerBKM Ch 2 slide 20 Interest from Munis Is not subject to federal income tax. Hence the yields are lower. r ·(1- t) = r m r- before tax return on taxable bond r m - return on municipal bond t- marginal tax rate Attractive to wealthy investors.

21. Zvi WienerBKM Ch 2 slide 21 Corporate Bonds Used to generate long-term funds. The primary difference is the default risk. Backed by specific assets (like mortgages). By the financial strength of the firm only (debentures). Callable at a call price (firm). Convertible, may be exchanged to a stock (investor).

22. Zvi WienerBKM Ch 2 slide 22 Equities Represent ownership in a corporation. Each common stock entitles to one vote. Shareholders vote for board members. A proportional share of financial benefits. Management usually solicits for proxy votes.

23. Zvi WienerBKM Ch 2 slide 23 Ownership Closely held corporation - stocks are not traded. Tender offer to buy stocks at a stipulated price. Owner of more than 5% must report. Insiders must report and are restricted.

24. Zvi WienerBKM Ch 2 slide 24 Residual Claim government (taxes) employees (including pensions) bond holders other creditors Limited liability means that the maximum loss is the original investment.

25. Zvi WienerBKM Ch 2 slide 25 Preferred Stock A hybrid security with characteristics of both equity and debt. Similar to an infinite bond. No voting rights. Can not demand for a bankruptcy. Cumulative fixed or adjustable dividends. May be redeemable or convertible.

26. Zvi WienerBKM Ch 2 slide 26 Dow Jones Average Created in the late 19th century by Charles Dow initially 10 rails and 2 industrial companies 4 years later 18 rails and 2 industrials Dow Industrial average, May 26, 1896 1916 the Dow was increased to 20 stocks in 1928 - 30 stocks It represents about 20% of the US market

27. Zvi WienerBKM Ch 2 slide 27 Calculation of the DJIA sum of prices divided by the number of stocks Why is it now 8000? the denominator is adjusted when there is a split a stock pays a large dividend (10% or more) a firm is replaced by another How to invest in DJIA?

28. Zvi WienerBKM Ch 2 slide 28 S&P Started on March 4, 1957; calculated back to 1926 Base value was 10 - average value in 1941-1943 it covers about 80% of the market capitalization it is a market-value-weighted index How is it affected by a stock split? How one can invest in S&P 500?

29. Zvi WienerBKM Ch 2 slide 29 Market Capitalization (1993?)

30. Zvi WienerBKM Ch 2 slide 30 Indexes DJIA, 30 stocks, NYSE, price weighted S&P 500, NYSE, NASDAQ, value weighted NYSE all NYSE stock, value weighted NASDAQ, all NASDAQ, value weighted Wilshire 5000, value weighted Value Line, 1700 stocks, price weighted Lehman Brothers - bonds FTSE, 100 large stocks, value weighted Nikkei 225, price weighted

31. Zvi WienerBKM Ch 2 slide 31 Index Arbitrage classical arbitrage, used by professional traders when the index is not equal to the basket it relies on computers to capitalize on such discrepancies and execute the baskets quickly. Is also known as program trading.

32. Zvi WienerBKM Ch 2 slide 32 Derivatives Options Call - a right to buy at strike Put - a right to sell at strike European, American, Exotic. Futures and Forwards (obligation) long position - will buy short position - will sell

33. Zvi WienerBKM Ch 2 slide 33 Summary Money market US government Notes and Bonds Municipal bonds r ·(1- t) = r m Common Stocks Preferred Stocks Stock Market Indexes Derivatives (Options, Futures, Forwards)

34. Zvi WienerBKM Ch 2 slide 34 Home Assignment read BKM-2 problems 2, 3, 4, 8, 13 (3 rd edition) problems 2, 3, 4, 10, 16 (5 th edition)