Finance 300Financial Markets

Lecture 13

Professor J. Petry, Fall, 2002©

http://www.cba.uiuc.edu/jpetry/Fin_300_fa02/http://webboard.cites.uiuc.edu/

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HousekeepingMidterm #2 on Tuesday, October 15th.

30-40 multiple choice questionsIn class problems, TTDChapter V. I will not ask you to do problems from this

material. I will ask questions related to the basic characteristics of the money market instruments listed. Series VII style questions are indicative.

Office hours:Thursday 4-5 Friday 12-2Monday 12-2.

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Duration & Convexity Calcs

Volatility=Δ price/price =-[duration / (1 + yield)] * Δi = Corrected ΔP/P = -modified duration Δy + ½ Convexity Δy2

= = =Check this against actual price change. Actual = =

Duration & Convexity Calculation5 year 5% bond (annual coupon payment) Guaranteed Investment Contract, 5 yrs, $10,000 at 8% ann

duration convexityyear coupon NPV @ 7% NPV/V NPV/V*t NPV/V*t(t+1)

1 50 46.729 0.051 0.051 0.102

2 50 43.672 0.048 0.095 0.2853 50 40.815 0.044 0.133 0.5344 50 38.145 0.042 0.166 0.8315 1050 748.635 0.816 4.078 24.465

6 918.00 1.00 4.52 26.22

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Agenda of topics• Financial Markets are traditionally segmented into Money

Markets and Capital Markets. – The Money Market includes short-term, highly liquid, and relatively

low-risk debt instruments. Their security and liquidity result in their sometimes being referred to as “Cash” or “Cash Equivalents”. (T-bills, CDs, CP, Repos, etc). This is covered in Ch. V.

– Capital Markets include longer-term, relatively riskier securities than does the Money Market. Generally, the Capital Markets are divided into four segments: longer-term fixed income markets, equity markets, and the derivative markets for options and futures. Equities was Ch. 3, and derivates will come later.

– The Fixed Income Market—our focus since Chapter IV—spans both areas of Financial Markets. Our first Chapter on Fixed Income discussed the bond market generically (Chapter IV--The Debt Market). Chapter V is the Money Market. Chapter VI is Government Debt and Chapter VII is Corporate Debt.

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Money Market—Chapter V• Money market instruments

– Are debt instruments with an original term to maturity of one year or less.

– Debt securities generally, can be in the form of:• Interest bearing• Interest bearing at maturity• Discount notes

– The short-term nature of money market instruments are either interest bearing at maturity, or discount notes.

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Money Market—Chapter V• Key Money Market Rates

• Prime Rate. Base rate on corporate loans posted by at least 75% of the nations 30 largest banks.

• Discount Rate. The charge on loans to depository institutions by the Federal reserve Banks. Established by the FOMC as an indicator of monetary policy direction.

• Federal Funds. Reserves traded among commercial banks for overnight use in amounts of $1mn or more. FOMC targets this rate as a indicator of monetary policy direction.

• Call Money – 3.5%. The charge on loans to brokers on stock exchange collateral.

• Commercial Paper (CP) – Short term debt of corporations.• Overnight Repurchase Rate – 1.85%. Dealer financing

rate for overnight sale and repurchase of Treasury Securities.

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Money Market—Chapter V• Key Money Market Rates

• Treasury Bills. Issued by the US Treasury and backed by the “full faith and credit” of the US Government.

• Certificates of Deposit. Money market CDs are debt instruments issued by banks.