Money and Capital Markets

Chapter 8

Introduction Market for U.S. government securities is

the center of the money and capital markets

U.S. Treasury has to sell many hundred billion dollars worth of securities each year to pay off maturing issues and finance current government operations

Provides reference point for money market (debt less than one year) and capital markets (long-term debt/equities)

The Government Bond Market

When U.S. government runs a deficit, the Treasury Department borrows money by selling government bonds

Sell to anyone willing to lend money to U.S. government

Treasury issues a wide variety of maturities and types of government securities

The Government Bond Market

U.S. securities are basically two types Marketable [63%]--bought/sold in

financial markets Nonmarketable [37%]--sell back to

Treasury

U. S. Treasury Securities Treasury Bills (T-bills)

most liquid issued each week on a discount basis maturities of 13, 26, 52 weeks

Treasury Notes (T-notes) original maturities of 2, 3, 5, 7, 10 years coupon issues – semiannual payments

Treasury Bonds maturities of 10 to 30 years. Similar to Notes.

Strips

Dealers market the coupons and the body of the security separately as zero-coupon securities.

Stripped Treasury Securities TIGRs - 1982 Merrill Lynch CATS - 1982 Salomon Brothers STRIPS - 1985

Inflation-Indexed Treasury Bonds

1996, Treasury announced that it would periodically issue inflation-indexed bonds that would provide returns tied to the inflation rate.

Coupon is low Principal increases by the amount

of the inflation rate every six months.

Owners of Marketable Government Securities Federal Reserve

Purchases Open Market Operations—mostly T-bills

Provides Fed with most of its income Private Sector

Commercial banks Individuals Insurance companies/Pension Funds Money market mutual funds

Owners - continued

Foreigners Now own about 37% of U.S. national debt Without foreign purchases, U.S. interest

rates would be much higher Foreigners are attracted to U.S.

securities: Political stability Financial freedom—Dollar is easily traded Relative high interest rates

U. S. Treasuries

Sold through auctions (first-price, sealed-bid auction)

Registered and issued in book entry form

Default-free Highly liquid Interest income exempt from state

taxation

Treasury Bills Sold on a bank discount basis.

Yield on a discount basis—Calculated as face value minus purchase price divided by the face value

Bond equivalent yield or coupon equivalent yield.

More accurate measure since it uses purchase price rather than face value

Bid and Offer Quotes on Treasury Bills3 month Maturity Bid Ask YieldJan 18 ‘96 93 5.27 5.25 5.41

Bank Discount Basis

The quoted yield on a bank discount basis is not a meaningful measure for 2 reasons: based on face value rather than actual

dollar amount invested. annualized according to a 360-day rather

than a 365-day year - making it difficult to compare T-bills with treasury notes and bonds which pay interest on a 365 day basis.

Computing Yields on Treasury Bills

BANK DISCOUNT BASIS:

where yD = discount yield, F = Face value ($100), P = Price, T = the number of days to maturity, and 360 is the number of days in the year.

TF

PFyD

360

Computing Yields on Treasury Bills

Coupon equivalent yield:

where yBEY = coupon equivalent yield, F = Face value ($100), P = Price, T = the number of days to maturity, and 365 is the number of days in the year.

TP

PFyBEY

365

Computing Yields on Treasury Bills

Examples based on the March 30, 1998 T-bill Auction:P (26 week T-bill) = 97.434 yD = 5.075 percent T = 182 daysYIELD ON A BANK DISCOUNT BASIS:

COUPON EQUIVALENT:

050756.0182

360

100

434.97100

Dy

05282.0182

365

434.97

434.97100

BEYy

How the Market Works

Most trading takes place in over-the counter markets

Trading in government securities averages more than 20 times trading on the New York Stock Exchange

Increasingly traded around the clock in different parts of the world

How the Market Works Dealers get much of their inventory of

bonds by bidding at competitive auctions Three- and six-month T-Bills are auctioned

weekly Notes are auctioned on a regular scheduled

basis The Treasury issues new securities to

Raise new funds Replace funds of maturing securities

T-Bill Auction The treasury allocates bills to competitive

bidders from the low-yield bid to the high-yield bid until the amount of the auction minus the non competitive bids is distributed.

Noncompetitive bidders pay the weighted average price of the competitive bids accepted.

Stop yield - highest yield accepted by the Treasury.

Auctions At closing time of auction

Treasury does following: Ranks bids from highest price down Selects bids in this order until

amount sold equals amount scheduled to be sold

Therefore, successful bidders purchase bills at different prices and will earn different yields

Auctions Multiple-price, sealed-bid auction

Bidders pay what they bid. Provides incentives for bidders to acquire more

information than is socially desirable. Bidders want to balance the gain from a lower

winning bid against the risk of not winning. English Auction

Uniform-price, sealed-bid auction Price paid by a winning bidder does not depend on

that bidder’s bid. Dutch Auction.

Salomon Brothers Scandal 1990 Treasury bond auction

Bought 65% of an auction – exceeding the 35% maximum Other dealers that had made commitments that

they were unable to fill had to obtain bonds from SB.

SB could charge high prices since they controlled most of the bonds.

August 1991, the Treasury Department barred SB from bidding on Treasury securities for clients.

May 1992, SB paid fines of $190 million to the SEC and Justice Department.

Changes in Procedure

Electronic Bidding Noncompetitive bids are accepted electronically over

Fedline, 1992. Fedline - a general communications system that links

9,000 depository institutions with the Federal Reserve Banks.

Dutch Auctions September 1992, experimented with a Dutch Auction on

two- and five-year bonds. All successful bidders pay the price of the lowest accepted bid. (Second-price, sealed-bid auction).

Discontinued because of unpopularity with dealers.

Security Dealers’ Profits

•Bid-Ask Spread•Capital Gains or Losses•Coupon Payments

Bid-Ask Spread

• The ask price is what the dealer will sell the security

• The bid price is what the dealer is willing to buy the security for.

• The spread represents profit.

Coupon payments

• The interest that the dealer earns on securities held in its inventory.

• The difference between the coupon return (rate) and the cost of borrowing (rate) is called the “carry” for the security.

• Dealers borrow funds from banks and through the market for repurchase agreements by borrowing on securities in inventory.

Market for Repurchase Agreementsa.k.a., the REPO Market

•A repurchase agreement is the sale of a security with the commitment by the seller to repurchase the security at an agreed upon future date, the maturity of the repo. A repo is then a way of borrowing funds using a security as collateral. •A reverse-repo is the purchase of a security with an agreement to resell the security to the original seller. A reverse-repo is a way of investing funds with the security as collateral.•The market is used by dealers for funding and the Fed to carry out Open Market transactions for monetary policy.

Repurchase Agreements(Repos) A dealer needs to finance $10 million of

a Treasury security that is purchased and plans to hold overnight.

A customer of the dealer has excess funds of $10 million.

The customer might be a municipality with tax receipts that it has just collected, and no immediate need to disburse the funds.

Repurchase Agreements Enhance the liquidity of the

government securities market. Although collateral is provided, still

have credit risk. Must monitor value of collateral. Physical delivery of securities to a

custodian is the safest way to take collateral.

Bank-Related Securities

CDs Large CDs $100,000 Negotiable

Eurodollars Dollar-denominated time deposits LIBOR – London Interbank Offered Rate

Overnight rate for Eurodollar lending Tends to follow U.S. rates

Corporate Debt Securities

Corporate bonds are not risk free. Some have security, some are subordinated to other debtor claims, and some have conversion and call features.

Commercial Paper

Corporate Bonds Corporations borrow across all maturity

ranges—mainly at the long end High-quality corporate bonds usually

yield more than government bonds and are safer than corporate stocks

Bonds have prior claim before stocks—payment of interest is first priority

Being long term, these bonds are subject to interest-rate risk—interest rises, prices fall

Corporate Bond Features Callable bonds

Issuer has right to pay off the bond before maturity date

Bond option will be exercised if it is in the interest of the borrower

These carry higher interest rate Convertible bonds—holders have

right to convert to common stock at predetermined price

Corporate Bond Ratings

Corporate bonds differ in quality—danger of default by borrower U.S. government is safest Various bond rating agencies

Standard and Poors Moodys

Investment grade—highest quality bonds

Corporate Junk Bonds Junk bonds

Very risky, but pay high interest to compensate for risk

Tend to perform well when the economy is strong, but extremely risky when economy does poorly

Michael Milken [convicted of securities fraud] and Drexel, Burnham Lambert [bankrupt in 1990] are two examples of problems in the junk bond market

Purchasers of Corporate Bonds Life insurance and pension/retirement

funds hold most corporate bonds Schedule cash flow based on life expectancies Hold to maturity—little need for quick

liquidation Foreigners also hold large amount of

corporate bonds Generally traded in over-the-counter

market—usually by telephone

Commercial Paper

Unsecured short-term IOU issued by a corporation.

Maximum maturity of 270 days. May be interest bearing or discounted. Can be issued directly or through

dealers. May be rated. Unrated paper is issued

at substantially higher yields.

Commercial Paper Two categories of issuers:

Finance companies associated with well known manufacturing companies

Nonfinancial companies--generally to finance inventory

Usually purchased directly from issuer by large institutional investors

Commercial Paper

Because of possibility of default, yields are typically higher than Treasury Bills, but tend to move closely together

Not much of a secondary market—investors generally redeem with issuer

GE Capital Corporation

Largest and most active direct issuer in the US. Commercial paper outstanding in

excess of $70 billion. www.gecapital.com

Municipal Securities

Issued by state and local governments

Lowest yield because interest earnings are exempt from federal tax

By law Congress does have the power to tax, but has decided not to tax this source of revenue

Municipal Securities General Obligation Bonds Revenue Bonds

General Obligation bonds are safer and generally pay less interest than Revenue bonds.

Short-term tax-anticipation notes (TANs) bond-anticipation notes (BANs)

Not much of a secondary market

Municipal Securities “Serial” maturity form

Portion of the issue matures each year until entire issue is retired

Each portion carries its own interest rate and is separate from the rest of the issue

In essence a 10 year serial bond is really 10 separate issues, each maturing at different times

Sold through underwriting syndicates who sell to ultimate investors at slightly higher prices

Mortgage Securities Most complicated of all debt instruments Borrowing by individuals using real

estate as collateral Most mortgages are insured by some

type of government agency minimizing potential default of borrowers Governmental National Mortgage

Association Federal Home Loan Mortgage Corporation

Mortgage Securities Mortgages can be repaid prior to maturity

date Prepayment or refinancing due to lower rates Investors are not sure of maturity Investments undesirable to institutional investors

Innovations in mortgage terms Shorter maturity period Adjustable rate—minimizes interest rate risk of

lender Balloon payments—low front end with large lump

sum payment at end

Collateralized Mortgage Obligations (CMOs) Developed to reduce uncertainty and

broaden the appeal of mortgages Number of mortgages are placed in a trust Interest and principal repayments are

divided by trustee into four (or more) segments according to a predetermined formula

Investors select which segment from which to receive their payments

Makes the cash flow more predictable High yields = High risk

The Stock Market Structure of the Stock Market

About 84 million individual shareholders in U.S.

During past decade institutional investors (pension funds, mutual funds, and insurance) have begun to dominate the market

Stock Market—refers principally to secondary market for common stock

Primary issues are handled through investment banks

Stock (Equity) Exchanges

Stock exchanges: Organized marketplaces for corporate

equities and bonds.Over-the-counter (OTC) stocks:

Equity shares offered by companies that do not meet listing requirements for major stock exchanges, or choose not to be listed there, and instead are traded in decentralized markets.

Stock (Equity) Exchanges New York Stock Exchange (NYSE)

The oldest (1792) and largest exchange where roughly half of the stock trading in the United States is done.

Shares of more than 3,000 companies are traded there. The number of NYSE membership positions, called “seats,” is fixed.

National Association of Securities Dealers Automated Quotation (Nasdaq):

The electronic network over which most over-the-counter stocks are traded.

Structure of the NYSE Posts—location where individual stocks are

traded Traders—receive orders from brokerage houses Specialists—individuals who maintain orderly

trading for securities in their charge May just match publicly tendered buy and sell orders Floor traders stand at posts and compete for orders not

matched by specialists If neither of these occur, specialists will buy or sell for

their own account to prevent excessive price swings

Order Flow On floor-based markets, specialists function primarily

to match buy orders with sell orders throughout the trading day. This model works best in a balanced-volume situation, one is which buy and sell orders are relatively equal.

On particularly heavy trading days, keeping up with the flow of transactions can be a challenge for the single specialist, who may request that the market temporarily halt trading in a stock if order imbalances occur.

Structure of the OTC Market

Network of dealers and brokers who deal via telephone and computer terminals

National Association of Securities Dealers Automated Quotation System [NASDAQ]—Shows bid and asked prices of OTC traded securities

NASDAQ Structure of multiple market participants. Multiple market participants trade a

company’s stock through a sophisticated computer and telecommunications network.

These participants are divided into two groups: Market Makers Electronic communications networks (ECNs) -

trading systems which bring additional customer orders into Nasdaq.

Market Makers Market Makers are independent dealers that compete

for investor orders by displaying their buy and sell interest - plus customer limit orders - in Nasdaq-listed stocks.

Market Makers increase the visibility of shares through their combined sponsorship. By standing committed to buy and sell shares of a company’s stock, Market Makers help meet investor demand and create an environment of immediate and continuous trading of a stock.

Order Flow on the NASDAQ Each Market Maker competes for order flow by displaying bid

(buy) and ask (sell) quotations on screen. When an order is received, the Market Maker will immediately purchase for or sell from his or her own trading account, or seek the other side of the trade until it is executed, often in a matter of seconds.

Because Nasdaq distributes trading in a stock among multiple market participants, fluctuations in volume can quickly be absorbed - even on particularly heavy trading days.

No halts for order imbalances may occur on Nasdaq.

Secondary Market Trading

Electronic Communications Networks provide trading in NASDAQ securities

The Island allows the public to view the “order book” in real time.

DiscountofRateAnnual

DividendAnnualExpectedicePr

What determines whether stock prices rise or fall? Stocks (equities) represent ownership

company Investor receives future cash flows in

form of dividends In its simplest form the price of a stock

with constant dividends forever is:

Stock prices continued Therefore, the price will rise if:

Expected future dividends increases Annual rate of discount decreases

The discount rate is higher than the government bond rate to compensate for the risk of stocks

However, the discount rate will follow movements in the government bond rate

Stock prices continued Therefore, price of stocks move in same

direction of earnings and inversely with interest rates

To predict movements of stock prices must predict: Expected future earnings Expected future interest rates This requires knowledge of future

movements of the entire economy

Money and Stock Prices

Some economists believe that fluctuations in the money supply will provide key to movements in stock prices

Increase in money supply will increase stock price: Individuals hold larger cash that they need Spend some on stock which increases

demand and increases price (assume supply fixed in short-run)

Opposite for a decrease in money supply

Money and Stock Prices Therefore, rapidly expanding money

supply generally leads to higher stock prices; inadequate growth of money leads to a fall

Difficult to determine if stock and money growth are related to each other or reacting to a third causal force

However, other economic forces may cause stock prices and growth of money supply to move in opposite directions