1. McGraw-Hill/Irwin 2-1 Financial Markets and Instruments Financial Markets and Instruments Chapter 2

2. McGraw-Hill/Irwin 2-2 Chapter Overview The financial instruments traded in the primary and secondary markets. an overview discussion of money market, capital market instruments and derivative securities. The various market indexes. Options and futures.

3. McGraw-Hill/Irwin 2-3 Learning Objectives understanding of the various financial instruments available to the potential investor. have an insight as to the interpretation, composition, and calculation process involved in the various market indexes presented on the evening news. understanding of the basics of options and futures contracts.

4. McGraw-Hill/Irwin 2-4 Major Classes of Financial Assets or Securities Debt - Money market instruments: The money market is a subsector of the fixed-income market. It consists of very short-term debt securities that usually are highly marketable. - Bonds: The bond market is composed of longer-term borrowing instruments than those that trade in the money market. This market includes Treasury notes and bonds, corporate bonds, municipal bonds, mortgage securities, and federal agency debt. These instruments are sometimes said to comprise the fixed income capital market, because most of them promise either a fixed stream of income or a stream of income that is determined according to a specific formula.

5. McGraw-Hill/Irwin 2-5 Major Classes of Financial Assets or Securities Common stock Common stock ， also known as equity securities or equities, represent ownership shares in a corporation. The corporation is controlled by a broad of directors elected by the shareholders. The two most important characteristics of common stock as an investment are its residual claim and limited liability features. Residual claim means that stockholders are the last in line of all those who have a claim on the assets and income of the corporation. Limited liability means that the most shareholders can lose in the event of failure of the corporation is their original investment.

6. McGraw-Hill/Irwin 2-6 Major Classes of Financial Assets or Securities Preferred stock Preferred stock has features similar to both equity and debt. Like a bond, it promises to pay to its holder a fixed amount of income each year. And it does not convey voting power regarding the management of the firm. Preferred stock is an equity investment, however. The firm retains discretion to make the dividend payments to the preferred stockholders.

7. McGraw-Hill/Irwin 2-7 Major Classes of Financial Assets or Securities Derivative securities One of the most significant developments in financial markets in recent years has been the growth of futures, options, and related derivatives markets. These instruments provide payoffs that depend on the values of other assets such as commodity prices, bond and stock prices, or market index values.

8. McGraw-Hill/Irwin 2-8 Markets and Instruments Money Market -Debt Instruments -Derivatives Capital Market -Bonds -Equity -Derivatives Money market instruments include short-term, marketable, liquid, low-risk debt securities. In contrast, capital markets instrument include longer-term and riskier securities. Specifically, it is useful to describe examples of derivative securities （ options, futures contrasts ） that fit in both the capital and money markets.

9. McGraw-Hill/Irwin 2-9 Money Market Instruments Treasury bills U.S. Treasury bills (T-bills, or just bills, for short) are the most marketable of all money market instruments. T-bills represent the simplest form of borrowing: the government raises money by selling bills to the public. Investors buy the bills at a discount from the stated maturity value. At the bill’s maturity, the holder receives from the government a payment equal to the face value of the bill. The difference between the purchase price and ultimate maturity value constitutes the investor’s earnings. Individuals can purchase T-bills directly at auction or on the secondary market from a government securities dealer. T-bills are highly liquid; that is, they are easily converted to cash and sold at low transaction cost and with not much price risk.

10. McGraw-Hill/Irwin 2-10 Money Market Instruments Certificates of deposit A certificate of deposit, or CD, is a time deposit with a bank. Time deposits may not be withdrawn on demand. The bank pays interest and principal to the depositor only at the end of the fixed term of the CD. However, CDs can be sold to another investor if the owner needs to cash in the certificate before its maturity date.

11. McGraw-Hill/Irwin 2-11 Money Market Instruments Commercial Paper Large, well-known companies often issue their own short- term unsecured debt notes rather than borrow directly from banks. These notes are called Commercial Paper. Very often, commercial paper is baked by a bank line of credit, which gives the borrower access to cash that can be used (if needed) to pay off the paper at maturity. Commercial paper is considered to be a fairy safe asset, because a firm’s condition presumably can be monitored and predicted over a term as short as a month.

12. McGraw-Hill/Irwin 2-12 Money Market Instruments Bankers Acceptances A Bankers’ Acceptances starts as an order to a bank’s customer to pay a sum of money at a future date, typically within six months. Bankers’ acceptances are considered very safe assets because traders can substitute the bank’s credit standing for their own. Acceptances sell at a discount from the face value of the payment order, just as T-bills sell at a discount from par value.

13. McGraw-Hill/Irwin 2-13 Money Market Instruments Eurodollars Eurodollars are dollar-denominated deposits at foreign banks or foreign branches of American banks. By locating outside the United States, these banks escape regulation by the Federal Reverse Board. Most Eurodollars deposits are for large sums, and most are time deposits of less than six months’ maturity. Federal Funds Funds in the bank’s reverse account are called federal funds, or fed funds. In the federal funds market, banks with excess funds lend to those with a shortage. These loans, which are usually overnight transactions, are arranged at a rate of interest called the federal rate.

14. McGraw-Hill/Irwin 2-14 Money Market Instruments Repurchase Agreements (RPs) and Reverse RPs Dealers in government securities use repurchase agreements, also called “repos” or “RPs” as a form of short-term, usually overnight, borrowing. The dealer sells government securities to an investor on an overnight basis, with an agreement to buy back those securities the next day at a slightly higher price. The increase in the price is the overnight interest. A reverse repo is the mirror. The dealer finds an investor holding government securities and buys them, agreeing to sell them back at a specified higher price on a future date.

15. McGraw-Hill/Irwin 2-15 Money Market Instrument Yields Yields on Money Market Instruments are not always directly comparable. Factors influencing yields. Par value vs. investment value 360 vs. 365 days assumed in a year (366 leap year) Bond equivalent yield

16. McGraw-Hill/Irwin 2-16 Bank Discount Rate (T-Bills) R bd = bank discount rate P = market price of the bill n = number of days to maturity

17. McGraw-Hill/Irwin 2-17 Bond Equivalent Yield Can’t compare T-bill directly to bond: -360 vs 365 days -Return is figured on par vs. price paid Adjust the bank discounted rate to make it comparable.

18. McGraw-Hill/Irwin 2-18 Bond Equivalent Yield: Sample T-Bill

19. McGraw-Hill/Irwin 2-19 Capital Market - Fixed Income Instruments Publicly Issued Instruments -US Treasury Bonds and Notes -Agency Issues (Fed Gov) -Municipal Bonds Debt instruments are issued by both public and private entities. The Treasury and Agency issues have the direct or implied guaranty of the federal government. Since state and local entities issue municipal bonds, performance on these bonds does not have the same degree of safety. Since the interest income on municipal bonds is not subject to federal taxes, the taxable equivalent yield is used for comparison. Privately Issued Instruments -Corporate Bonds: Corporate bonds are the means by which private firms borrow money directly from the public. Corporate bonds differ most importantly from treasury bonds in degree of risk. Default risk is a real consideration in the purchase of corporate bonds. -Mortgage-Backed Securities : A mortgage-backed security is either an ownership claim in a pool of mortgages or an obligation that is secured by such a pool. Mortgage lenders originate loans and then sell packages of these loans in the secondary markets. This represents securitization of mortgage loans.

20. McGraw-Hill/Irwin 2-20 Capital Market - Equity Common stock -Residual claim: Residual claim means that stockholders are the last in line of all those who have a claim on the assets and income of the corporation. -Limited liability: Limited liability means the most shareholders can lose in the event of failure of the corporation is their original investment. Preferred stock -Fixed dividends – limited: Preferred stock has features similar to a bond, it promises to pay to its holder a fixed amount of income each year. In this sense preferred stock is similar to an infinite-maturity bond, that is, a perpetuity. It also resembles a bond in that it does not convey voting power regarding the management of the firm. -Priority over common: Even though preferred stock ranks after bonds in terms of the priority of its claim to the assets of the firm in the event of corporate bankruptcy, preferred stock often sells at lower yields than do corporate bonds. -Tax treatment: Preferred stock also differs from bonds in terms of its tax treatment for the firm. Because preferred stock payments are treated as dividends rather than interest, they are not tax-deductible expenses for the firm. -Callable : Preferred stock is issued in variations similar to those of corporate bonds. It may be callable by the issuing firm, in which case it is said to be redeemable. It also may be convertible into common stock at some specified conversion ratio.

21. McGraw-Hill/Irwin 2-21 Stock Indexes Uses -Track average returns -Comparing performance of managers -Base of derivatives Factors in constructing or using an Index - Representative? - Broad or narrow? - How is it constructed?

22. McGraw-Hill/Irwin 2-22 Examples of Indexes - Domestic Dow Jones Industrial Average (30 Stocks) Standard & Poor’s 500 Composite NASDAQ Composite NYSE Composite Wilshire 5000

23. McGraw-Hill/Irwin 2-23 Examples of Indexes - Int’l Nikkei 225 & Nikkei 300 FTSE (Financial Times of London) Dax Region and Country Indexes -EAFE -Far East -United Kingdom

24. McGraw-Hill/Irwin 2-24 Bond Indexes Lehman Brothers Merrill Lynch Salomon Brothers Specialized Indexes -Merrill Lynch Mortgage

25. McGraw-Hill/Irwin 2-25 Construction of Indexes How are stocks weighted? -Price weighted (DJIA) -Market-value weighted (S&P500, NASDAQ) -Equally weighted (Value Line Index) How returns are averaged? -Arithmetic (DJIA and S&P500) -Geometric (Value Line Index)

26. McGraw-Hill/Irwin 2-26 Averaging Methods Component Return A=10% B= (-5%) C = 20% Arithmetic Average [.10 + (-.05) +.2] / 3 = 8.33% Geometric Average [(1.1) (.95) (1.2)] 1/3 - 1 = 7.84%

27. McGraw-Hill/Irwin 2-27 Derivatives Securities Introduction One of the most significant developments in financial markets in recent years has been the growth of futures, options, and related derivatives market. These instruments provide pay-offs depend on the values of other assets such as commodity prices, bond and stock prices, or market index values. For this reason these instruments sometimes are called derivative assets, or contingent claims. Their values derive from or are contingent on the values of other assets.

28. McGraw-Hill/Irwin 2-28 Derivatives Securities( Options) Options Basic Positions -Call (Buy): A call option gives its holder the right to purchase an asset for a specified price, called the exercise or strike price, on or before a special expiration date. -Put (Sell): A put option gives its holder the right to sell an asset for a specified exercise price on or before a specified expiration date. Terms -Exercise Price -Expiration Date -Assets

29. McGraw-Hill/Irwin 2-29 Derivatives Securities (Futures) Futures : A futures contrast calls for delivery of an asset (or in come cases, its cash value) at a specified delivery or maturity date for an agreed-upon price, called the futures price, to be paid at contract maturity. Basic Positions -Long (Buy): The long position is held by the trader who commits to purchasing the asset on the delivery date. -Short (Sell): The trader who takes the short position commits to delivering the asset at contract maturity. Terms -Delivery Date -Assets