Chapter 02_Hand-Out 1

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CHAPTER 2

MARKETS AND FINANCIAL INSTRUMENTS

2.1 THE MONEY MARKET

The money market is a sub-sector of the fixed-income market. It consists of veryshort-term debt securities that usually are highly marketable. Many of thesesecurities trade in large denominations, and so are out of the reach of individualinvestors. Money market funds, however, are easily accessible to small investors.

1. Treasury Bills

U.S. Treasury bills (T-bills) are the most marketable of all money marketinstruments. T-bills represent the simplest form of borrowing: The governmentraises money by selling bills to the public. Investors buy the bills at a discountfrom the stated maturity value. At the bills maturity, the holder receives fromthe government a payment equal to the face value of the bill. The difference

between the purchase price and ultimate maturity value constitutes the investorsearnings.

T-bills are issued with initial maturitiesof 4, 13, 26, or 52 weeks. Individuals

can purchase T-bills directly, at auction, or on the secondary market from agovernment security dealer. Sales are conducted via auction, at which investorscan submit competitive or noncompetitive bids.- A competitive bid is an order for a given amount of bills at a specificoffered price. The offer is filled only if the bid is high enough relative to other

bids to be accepted.- A noncompetitive bid is an unconditional offer to purchase bills at theaverage price of the successful competitive bids. The Treasury ranks bids byoffering price and accepts bids in order of descending price until the entire issueis absorbed.

Unlike most other money market instruments, which sell in minimumdenominations of $100,000, T-Bills sell in minimum denominations of only$100, although $10,000 denominations are far more common. The incomeearned in T-bills is exempt from all state and local taxes, anothercharacteristic distinguishing them from other money market instruments.

The ask price is the price you would have to pay to buy a T-Bill from ssecurity dealer. The bid price is the slightly lower you would receive if you

wanted to sell l a bill to a dealer. The bid-asked spread is the difference inthese prices, which is dealers source of profit.

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Type of yields: example

- Bank Discount Yields /BDY/:n

360x

PV

PPVrBDY

=

- Effectual Annual Rate /EAR/

- Bond Equivalent Yield /BEY/:n

365x

P

PPVrBEY

=

T-bills and other money-market yields are not quoted in the financial pages aseffective annual rates of return. Instead, bank discount method is used. In thisapproach, the bills discount from par value (PV) is annualized based on a360-day year. The yield reported in the financial pages is the bond equivalentyield, BEY. This is the bills yield over its life, assuming that it is purchased forthe asked price. (The BEY is the return on the bill over the period corresponding to its

remaining maturity multiplied by the number of such periods in a year.)

This approach still, however, uses a simple interest procedure to annualize, alsoknown as annual percentage rate, or APR, and so problems still remain incomparing yields on bills with different maturities (n). Nevertheless, yields onmost securities with less than a year to maturity are annualized using a simpleinterest approach.

2. Certificate of Deposit

Certificate of Deposit/CD/ is a time deposit with a bank. Time deposits may notbe withdrawn on demand. The bank pays interest and principal to the depositoronly at the end of the fixed term of the CD. CDs issued in denominationsgreater than $100,000 are usually negotiable, however; that is, they can be soldto another investor if the owner needs to cash in the certificate before itsmaturity date. CDs are treated as bank deposits by the Federal DepositInsurance Corporation, so they are currently insured for up to $250,000 in theevent of a bank insolvency.

3. Commercial Paper

Large, well-known companies often issue their own short-term unsecured debtnotes rather than borrow directly from banks. These notes are calledcommercial paper/CP/. Very often CP is backed by a bank line of credit, whichgives the borrower access to cash that can be used (if needed) to pay off the

paper at maturity. CP maturities range up to 270 days; more often, CP is issuedwith maturities of less than 1 or 2 months. Usually, it is issued in multiples of$100,000. CP is considered to be a fairly safe asset, because a firms condition

presumably can be monitored and predicted over a term as short as one month.Many firms issue commercial paper intending to roll it over at maturity, that is,

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issue new paper to obtain the funds necessary to retire the old paper. Whilemost CP is issued by nonfinancial firms, in recent years there was a sharpincrease in asset-backed commercial paperissued by financial firms such as

banks. This was short-term CP typically used to raise funds for the institution to

invest in other assets. These assets were in turn used as collateral for the CP hence the label asset backed.

4. Bankerss Acceptance

A bankers acceptance /BA/ starts as an order to a bank by a banks costumer topay a sum of money at a future date, typically within 6 months. At this stage it issimilar to a postdated check. When the bank endorses the order for payment as"accepted", it assumes responsibility for ultimate payment to the holder of theacceptance. At this point, the acceptance may be traded in secondary marketslike any other claim on the bank. Bankers' acceptances are considered very safeassets because traders can substitute the bank's credit standing for their own.They are used widely in foreign trade where the creditworthiness of one tarderis unknown to the trading partner.

5. Eurodollars

Eurodollars are dollar-denominated deposits at foreign banks, or foreignbranches of American banks. By locating outside the USA, these banks escape

regulation by the Fed. Most Eurodollar deposits are for large sums, and most aretime deposits of less than six months' maturity. A variation on the Eurodollar timedeposit is the Eurodollar certificate of deposit. A Eurodollar CD resembles adomestic bank CD except that it is the liability of a non-U.S. branch of a bank,typically a London branch. The advantage of Eurodollar CDs over Eurodollartime deposits is that the holder can sell the asset to realize its cash value beforematurity. Eurodollar CDs are considered less liquid and riskier than domesticCDs, however, and thus offer higher yields.

6. Repos and Reverses

Dealers in government securities use repurchase agreements, also called reposor RPs as a form of short-term, usually overnight, borrowing. The dealer sellsgovernment 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 inthe price is the overnight interest. The increase in the price is the overnightinterest. The dealer thus takes out a one-day loan from the investor, and thesecurities serve as collateral. A term repo is essentially an identical transaction,

except that the term of the implicit loan can be 30 days or more. A reserverepo isthe mirror image of a repo. Here, the dealer finds an investor holding government

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securities and buys them, agreeing to sell them back at a specified higher price ona future date.

7. Federal Funds

Just as most of us maintain deposits at banks, banks maintain deposits of theirown at a Federal Reserve Bank. Each member bank of the Federal ReserveSystem, or "the Fed," is required to maintain a minimum balance in a reserveaccount with the Fed. The required balance depends on the total deposits of the

bank's customers. Funds in the bank's reserve account are called federal funds,or fed funds. At any time, some banks have more funds than required at the Fed.Other banks, primary big banks in New York and other financial centers, tend tohave a shortage of federal funds. In the federal funds market, banks with excessfunds lend to those with a shortage. These loans, which are usually overnighttransactions, are arranged at a rate of interest called the federal funds rate.

8. The LIBOR market

The London Interbank Offered Rate(LIBOR) is the rate at which large banks inLondon are willing to lend money among themselves. This rate, which is quotedon dollar-denominated loans, has become the premier short-term interest ratequoted in the European money market, and it serves as a reference rate for awide range of transactions. For example, a corporation might borrow at a

floating rate equal to LIBOR plus 2%. There is also a similar rate calledEURIBOR (European Interbank Offered Rate) ate which banks in the euro zoneare willing to lend euros among themselves.

2.2 THE BOND MARKET

The bond market is composed of longer-term borrowing or debt instrumentsthan those that trade in the money market. This market includes Treasury notes

and bonds, corporate bonds, municipal bonds, mortgage securities, and federalagency debt. These instruments are sometimes said to comprise the fixedincome capital market, because of most of them promise either a fixed streamof income or a stream of income that is determined according to a specificformula. In practice these formulas can result in a flow of income that is farfrom fixed

1. Treasury Notes and Bonds

Treasury (T)-note are issued with maturities ranging up to 10 years, whilebonds are issued with maturities ranging from 10 to 30 years. Both notes and

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bonds may be issued in increments of $100 but far more as commonly trade indenominations of $1,000. Both make semiannual interest payments calledcoupon payments, a name derived from pre-computer days, when investorswould literally clip coupons attached to the bond and present a coupon to an

agent of the issuing firm to receive the interest payment. The only majordistinction between T-notes and T-bonds is that T-bonds may be callable duringa given period, usually the last 5 years of the bonds life.

The yield to maturity (YTM) reported in the financial pages (see Figure 2.3 inthe textbook) is calculated by determining the semiannual yield and thendoubling it, rather than compounding it for two half-year periods. This use of asimple interest technique to annualize means that the yield is quoted on anannual percentage rate (APR) basis rather than as an effective annual yield. TheAPR method in this context is also called the bond equivalent yield.

2. Inflation Protected Treasury Bonds

Around the world governments of many countries, including the U.S., haveissued bonds that are linked to an index of the cost of living in order to providetheir citizens with an effective way to hedge the inflation risk. In the U.S.inflation-protected Treasury Bonds are called TIPS (Treasury Inflation-Protected Securities). The principle amount on these bonds is adjusted in

proportion to increases in the Consumer Price Index (CPI). Therefore, they

provide a constant stream of income in real (inflation-adjusted) dollars. Yieldson TIPS bonds should be interpreted as real on inflation-adjusted interest rates.

3. Federal Agency Debt

Some government agencies issue their own securities to finance theiractivities. The majority of debt is issued in support of farm credit and homemortgages. These agencies usually are formed to channel credit to a particularsector of the economy that Congress believes might not receive adequate

credit through normal private sources. The major mortgage-related agenciesare the Federal Home Loan Bank (FHLB), the Federal National MortgageAssociation (Fannie Mae), the Government National Mortgage Association(Ginnie Mae), and the Federal Home Loan Mortgage Corporation (FreddieMac). Some of these agencies are government owned, and therefore can beviewed as branches of the U.S. government. Thus their debt is fully free ofdefault risk. Ginnie Mae (GNMA) is an example of a government-ownedagency. Other agencies, such as the farm credit agencies, the Federal HomeLoan Bank, Fannie Mae, and Freddie Mac, are merely federally sponsored.

Although the debt of federal agencies in not explicitly insured by the Federalgovernment, it has long been assumed that the government would assist an

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agency nearing default. Those believes were validated when Fannie Mae andFreddie Mac encountered severe financial distress in September 2008.

3. International Bonds

Many firms borrow abroad and many investors buy bonds from foreignissuers. A Eurobondisa bond denominated in a currency other than that ofthe country in which it is issued. For example, a dollar-denominated bond soldin Britain would be called a Eurodollar bond. Similarly, investors might speakof Euroyen bonds, yen-denominated bonds sold outside Japan. Since the newEuropean currency is called the euro, the term Eurobond may be confusing. Itis best to think of them simply as international bonds.

4. Municipal Bonds

Municipal bonds are issued by state and local governments. They are similar toTreasury and Corporate bonds except that their income is exempt from federalincome taxation. The interest income also is exempt from state and local taxationin the issuing state.There are basically two types of municipal bonds. G eneral obligation bonds,which are backed by the "full faith and credit" (i.e., the taxing power) of theissuer, while revenue bonds, are issued to finance particular projects and are

backed either by the revenues from that project or by the particular municipal

agency operating the project. Typical issuers of revenue bonds are airports,hospitals, and turnpike, or port authorities. Obviously, revenue bonds are riskierin terms of default than general obligation bonds. (An industrial development bond isa revenue bond issued to finance commercial enterprises, such as the construction of a factory

that can be operated by a private firm.)

The key feature of municipal bonds is theirtax-exemptstatus. Because investorspay neither federal nor state taxes on the interest proceeds, they are willing toaccept lower yields on these securities. These lower yields represent a huge

savings to state and local governments. Correspondingly, they constitute a hugedrain of potential tax revenue from the federal government, and the governmenthas shown some dismay over the explosive increase in use of industrialdevelopment bonds.

An investor choosing between taxable and tax-exempt bonds must compare after-tax return on each bond. One way to compare bonds is to determine the interestrate on taxable bonds that would be necessary to provide an after-tax return equalto that of municipals. To derive this value, we set after-tax yields equal, and solve

for the equivalent taxable yield of the tax-exempt bond. This is the rate a taxablebond (r) must offer to match the after-tax yield on the tax-free municipal (rm).

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r(1 t) = rm, or r = rm/(1 t)

Thus, the equivalent taxable yield (ETY) is simply the tax-free rate divided by (1

t). Table 2.2 in the textbook provides ETYs for several municipal yields andtax rates.

5. Corporate Bonds

Corporate bonds are the means by which private firms borrow money directlyfrom the public. These bonds are similar in structure to Treasury issues theytypically pay semiannual coupons over their lives and return the face value to the

bondholder at maturity. They differ most importantly from Treasury bonds indegree of risk. Default risk is a real consideration in the purchase of corporate

bonds. For now, we will distinguish only among 1) secured bonds, which havespecific collateral backing them in the event of firm bankruptcy; 2) unsecured

bonds, called debentures, which have no collateral; and 3) subordinateddebentures, which have a lower priority claim to the firm's assets in the event of

bankruptcy.

Corporate bonds often come with options attached. Callable bonds give the firmthe option to repurchase the bond from the holder at a stipulated call price.Convertible bonds give the bondholder the option to convert each bond into a

stipulated number of shares of stock. These options are treated in more detail inChapter 14.

6. Mortgage and Mortgage-Backed Securities

Because of the explosion in mortgage-back securities, almost anyone can investin a portfolio of mortgage loans, and these securities become a major componentof the fixed-income market.

Fixed-rate mortgage have posed difficulties to lenders in years of increasinginterest rates. Because banks and thrift institutions traditionally issued short-termliabilities (deposits) and held long-term assets (fixed-rate mortgages) theysuffered losses when interest rates increased and the rates paid on depositsincreased while mortgage income remained fixed. The adjustable-ratemortgagewas a response to this interest rate risk. These mortgages require the borrower to

pay an interest rate that varies with some measure of the current market interestrate. For example, the interest rate might be set at 2 percentage points above thecurrent rate on one-year Treasury bills and might be adjusted once a year.

Usually, the contract sets a limit, or cap, on the maximum size of an interest ratechange within a year and over the life of the contract.

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A mortgage-backed security is either an ownership claim in a pool ofmortgages or an obligation that is secured by such a pool. These claimsrepresent securitization of mortgage loans. Mortgage lenders originate loans and

then sell packages of these loans in the secondary market. Specifically, they selltheir claim to the cash inflows from the mortgages as those loans are paid off.The mortgage originator continues to service /manage/ the loan, collecting

principal and interest payments, and passes these payments along to thepurchaser of the mortgage. For this reason, these mortgage-backed securitiesare calledpass-throughs.

Although pass-through securities often guarantee payment of interest andprincipal, they do not guarantee the rate of return. Holders of mortgage pass-throughs therefore can be severely disappointed in their returns in years wheninterest rates drop significantly. This is because homeowners usually have anoption to prepay, or pay ahead of schedule, the remaining principal outstandingon their mortgages (i.e.,prepayment option).

Most pass-throughs have traditionally being compound ofconforming mortgages,which means that the loans must satisfy certain underwriting guidelines (standardsfor the creditworthiness of the borrower) before they may be purchased by FannieMae or Freddie Mac. In the years leading up to 2008 however, a large amount of

subprime mortgages, that is, riskier loans made to financially weaker borrowers,

were bundled and sold by private-label issuers. In September 2008 bothagencies faced insolvency and were taken over by the federal government. Figure2.6 in the textbook illustrates the explosive growth of both agency and private-label mortgage-backed securities since 1979.

2.3 EQUITY SECURITIES

1. Common Stock as Ownership Shares

Common stocks, also known as equity securities or equities, representownership shares in a corporation. Each share of common stock entitles itsowner to one vote on any matters of corporate governance that are put to a voteat the corporation's annual meeting and to a share in the financial benefits ofownership (e.g., the right to any dividends that the corporation may choose todistribute).The common stock of most large corporations can be bought or sold freely onone or more stock exchanges. A corporation whose stock is not publicly traded

is said to be closely held. In most closely held corporations, the owners of thefirm also take an active role in its management. Therefore, takeovers are

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generally not an issue.

The two most important characteristics of common stocks as an investment are itsresidual 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 andincome of the corporation. In a liquidation of the firms assets the shareholdershave a claim to what is left after all other claimants such as tax authorities,employees, suppliers, bondholders, and other creditors have been paid. Limitedliability means that the most shareholders can lose in the event of failure of thecorporation is their original investment. Unlike owners of unincorporated businesswhose creditors can lay claims to the personal assets of the owner (house, car,furniture), corporate shareholders may at worst have worthless stock.

Total return to an investor in common stock comes from dividends and capitalgains, or appreciation in the value of the stock. (Low-dividend-yield firms presumablyoffer greater prospects for capital gains, or investors would not be willing to hold the low-yieldfirms in their portfolio.)

2. Preferred Stock

Preferred stockhas features similar to both equity and debt. Like a bond, it promises to pay to its holder a fixed amount of income each year. In alsoresembles a bond in that it does not convey voting power regarding the

management of the firm. Preferred stock is an equity investment, however. Thefirm retains discretion to make the dividend payments to the preferredstockholders; it has no contractual obligation to pay those dividends. Instead, pre-ferred dividends are usually cumulative; that is, unpaid dividends cumulate andmust be paid in full before any dividends may be paid to holders of commonstock. (In contrast, the firm does have a contractual obligation to make the interest paymentson the debt. Failure to make these payments sets off corporate bankruptcy proceedings.)

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. Italso may be convertible into common stock at some specified conversion ratio.Adjustable-rate preferred stock in another variation that, like adjustable-ratebonds, ties the dividend to current market interest rates.

2.4 STOCK AND BOND MARKET INDEXES

1. Stock Market Indexes

The Dow Jones Industrial Average (DJIA) of 30 large, "blue-chip"

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corporations has been computed since 1896. Its long history probably accountsfor its preeminence in the public mind (The average covered only 20 stocks until1928). Originally, the DJIA was calculated as the simple average price of thestocks included in the index. Thus, if there were 30 stocks in the index, one

would add up the price of the 30 stocks in the index and divide by 30. Thepercentage change in the DJIA would then be the percentage change in theaverage price of the 30 shares.

Because the Dow index corresponds to a portfolio that holds one share of eachcomponent stock, it is called a price-weighted average. The amount of moneyinvested in each company in that portfolio is proportional to the company'sshare price. The price-weighted averages give higher-priced shares moreweights in determining performance of the index (see Example 2.2 in thetextbook). You might wonder why the DJIA is now (in early 2010) at a level ofabout 11,000 it if is supposed to be the average price of the 30 stocks in theindex. The DJIA no longer equals the average price of the 30 stock in the index

because the averaging procedure is adjusted whenever a stock splits or pays astock dividend of more than 10%, or when one company in the group of 30industrial firms is replaced by another. (When these events occur, the divisor used tocompute the average price is adjusted so as to leave the index unaffected by the event. SeeExample 2.3 in the textbook.)

Because the Dow Jones Averages are based on small numbers of firms, care

must be taken to ensure that they are representative of the broad market. As aresult, the composition of the average is changed every so often to reflectchanges in the economy. Dow Jones & Company also computes aTransportation Average of 20 airline, trucking and railroad companies, a PublicUtility Average of 15 electric and natural gas utilities, and a Composite Averagecombining the 65 firms of the three separate averages. Each is a price-weightedaverage, and thus overweighs the performance of high-priced stocks.

The Standard & Poors Composite 500 (S&P 500) stock index represents an

improvement over the Dow Jones Averages in two ways. First, it is a morebroadly based index of 500 firms. Second, it is a market-value-weighted index.The S&P 500 is computed by calculating the total market value of the 500firms in the index and the total market value of those firms on the previous dayof trading. The percentage increase in the total market value from one day to thenext represents the increase in the index. The rate of return of the index equalsthe rate of return that would be earned by an investor holding a portfolio of all500 firms in the index in proportion to their market values, except that the indexdoes not reflect cash dividends paid by those firms. (Unlike the price-weightedindex, the value-weighted index gives more weight to the stock with the higher total marketvalue. See Example 2.4 in the textbook.)

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The ultimate U.S. equity index so far computed is the Wilshire 5000 index of themarket value of all NYSE and American Stock Exchange (Amex) stocks plusactively traded Nasdaq stocks. Despite its name, the index actually includes about

6,000 stocks. The performance of this and other indexes appears daily in The WallStreet Journal. Market performance is sometimes measured by an equallyweighted average of the returns of each stock in an index. Such an averagingtechnique, by placing equal weight on each return, corresponds to an implicit

portfolio strategy that places equal dollar values on each stock. This is in contrastto both price weighting (which requires equal numbers of shares of each stock)and market value weighting (which requires investments in proportion tooutstanding value).

Development in financial markets worldwide includes the construction ofindexes for these markets. Among these are Nikkei (Japan), FTSE (U.K.), DAx(germany), Hang Seng (Hong Kong), and TSX (Canada). A leader in this fieldhas been MSCI (Morgan Stanley Capital International), which computes over50 country indexes and several regional indexes. Table 2.6 in the textbook

presents many of the indexes computed by MSCI.

2. Bond Market Indicators

The three most well-known groups of indexes are those of Merrill Lynch,Barclays (formerly, the Lehman Brothers), and Salomon Smith Barney (nowpart of Citigroup). The major problem with bond market indexes is that truerates of return on many bonds are difficult to compute because the infrequencywith which the bonds are traded makes reliable up-to-date prices difficult toobtain. In practice, some prices must be estimated from bond valuation models.These matrix prices differ from the market values.

2.5 DERIVATIVE MARKETS

One of the most significant developments in financial markets in recent years hasbeen the growth of futures, options, and related derivatives markets. Theseinstruments provide pay offs that depend on the values of other assets such ascommodity prices, bond and stock prices, or market index values. For thisreason these instruments sometimes are called derivative assets. Their valuesderive from the values of other assets.

1. Options

A call option gives its holder the right to purchase an asset for a specified price,

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Chapter 02_Hand-Out 1

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