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Financial Markets: Stocks and Bonds.

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  • 1. Ch. 15: Financial Markets
    • Financial markets
      • link borrowers and lenders.
      • determine interest rates, stock prices, bond prices, etc.
    • Bonds
      • a promise by the bond-issuer to pay some specified amount(s) in the future in exchange for some payment (the bond price) today.
    • Stocks (equities)
      • legal rights of ownership in an incorporated firm.
      • promise the stockholder a share of the corporte profits (dividends)
  • 2. The Bond Market.
    • Maturity date :
    • A bond's maturity date refers to the specific future date on which the maturity value will be paid to the bond holder. Bond maturity dates when issued generally range from 3 months up to 30 years.
    • Coupon rate
    • Between the date of issuance and the maturity date, the bond-holder receives an annual interest payment equal to the coupon rate times the maturity value.
    • Yield to maturity
    • represents the effective interest rate that the bond-holder earns if the bond is held to maturity.
    • Bond price
    • The price that the bond sells for. This fluctuates over the life of the bond.
      • *If the bond price is equal to 100% of its maturity value, the bond sold at “par”.
      • If the bond price is below 100% of its maturity value, the bond price sold “below par”.
  • 3. The Bond Market
    • 20 year bond with maturity value of $1000 and coupon rate of 5% promises
      • 20 annual payments of .05*1000=$50
      • $1000 payment at maturity (20 years from now).
      • If price is $1000 for this bond, the bond sold for par.
  • 4. The Bond Market.
    • Computing yields on a bond.
    • The yield on a bond is the same as the internal rate of return . To calculate the yield to maturity, define NPV as follows:
    • NPV = CP1/(1+r) + CP2/(1+r) 2 + .... + CPT/(1+r) T + MV/(1+r) T - P
    • where CP1, CP2, ... CPT are the interest or coupon payments in periods 1 through T
    • MV is the payment received at maturity
    • P is the price paid for the bond.
    • The yield to maturity is the interest rate that makes the NPV on the bond purchase zero.
  • 5. The Bond Market.
    • One year bonds
      • NPV = MV(1+cr)/(1+r) - P where cr is the coupon rate.
      • setting NPV=0 and solving for r provides the yield to maturity:
      • yield = [MV(1+cr)/P] - 1
    • For example, suppose you buy a one-year bond for $900. It has a maturity value of $1000 and a coupon rate of 5%. What is the yield?
    • yield = [(1000)(1.05)/900] - 1
    • =1050/900 -1
      • =16.67%
    • As the price paid for a bond increases, the yield on the bond falls.
  • 6. The Bond Market.
    • Zero Coupon Bonds.
    • With zero coupon bonds, no interest payments are made between the sale of the bond and its maturity. That is, there is a zero coupon rate. For such bonds, the yield calculations is straightforward.
    • NPV = MV/(1+r) T - P
    • setting NPV=0 and solving for r provides the yield:
    • yield = (MV/P) 1/T - 1
    • For example, if you buy a zero coupon bond today for $1000 and it has a maturity value of $1500 in 10 years:
      • yield = (1500/1000) 1/10 -1 = .0414 = 4.14%
    • As the price paid for a bond increases, the yield on the bond falls.
  • 7. The Bond Market.
    • Determinants of bond yields
      • Higher expected inflation will drive up yields.
      • Higher risk bonds must offer higher yields.
        • Default risk.
          • Debt rating agencies:
            • Moody’s & Standard and Poors
            • AAA=superior quality
            • C=imminent default
          • Diversification to reduce risk.
        • Inflation risk.
      • Term
        • Longer term bonds have greater inflation and default risk.
  • 8. The Bond Market.
    • Yield curve
      • Shows relationship between yield and term on government bonds
      • Slope of yield curve reflects
        • Expectations of future short term interest rates
        • Greater risk of long term bonds
      • If short term interest rates are expected to be constant in the future, yield curve will slope upward reflecting risk premia for longer term bonds.
      • A steepening of the yield curve suggests that financial markets believe short term interest rates will be rising in the future.
        • The bond market
        • The dynamic yield curve
  • 9. The Stock Market
    • Stocks (equities):
      • legal rights of ownership in an incorporated firm.
      • promise the stockholder a share of the corporte profits (dividends)
  • 10. The Stock Market
    • The “fundamental value” of a stock is the expected present value of all future dividends from a stock.
    • P = d 1 /(1+r) + d 2 /(1+r) 2 + d 3 /(1+r) 3 + ....d T /(1+r) T
      • where T is the end of the firm’s life (which might be infinite)
      • d 1 , d 2 , ... d T represent dividend payments in years 1 through T.
      • r is the interest rate
  • 11. The Stock Market
    • Given the fundamental value theory, stock prices will rise with:
      • lower interest rates.
      • an increase in future expected dividends.
      • A lower tax rate on dividends.
  • 12. The Stock Market
    • Efficient markets hypothesis:
      • All stock prices represent their fundamental value at each point in time.
      • When new “information” arrives about a stock, its price immediately adjusts to reflect that new information.
      • It is impossible to consistently predict which way a stock price will move in the future and to consistently “beat the market”.
  • 13. The Stock Market.
    • If the efficient markets hypothesis is true,
      • financial advisors can assist you only in evaluating the risk and tax consequences of different stocks and concerns regarding income or growth, etc.
      • Financial advisors will not be able to consistently find stocks that will “beat the market”.
    • The validity of the efficient markets hypothesis is controversial among economists.
  • 14. The Stock Market
    • Stock quotes
      • Price
      • PE ratio (price-earnings ratio)
      • Volume (number of shares sold in previous day)
      • Change (change in from previous day)
      • 52 week high and low
      • Beta (measures stock movements relative to market)
  • 15. The Stock Market
    • Performance measures
      • Broad indexes
        • Dow Jones Industrial Average
        • Standard and Poor 500
        • NASDAQ
    • For stock quotes and information
      • http://money.cnn.com/
  • 16. Options
    • Options are contracts in which the terms of the contract are standardized and give the buyer the right, but not the obligation, to buy (call) or sell (put) a particular asset at a fixed price (the strike price) for a specific period of time (until expiration).
  • 17. Options Market
    • Call option on a security:
      • the right to call (buy) a security at the strike price up until the expiration date of the option from the person that issued the call.
      • If I sell you a call option on IBM with a strike price of $190 and an expiration date of 1/1/2009, you have the right to exercise the option until its expiration and force me to sell you IBM for $190. You will exercise the option only if IBM rises above the strike price of $190.
  • 18. Options Market
    • Put option on a security:
      • the right to put (sell) a security at the strike price up until the expiration date of the option to the person that issued the put.
      • If I sell you a put option on IBM with a strike price of $150 and an expiration date of 1/1/2009, then at any time between now and 2009 you can force me to buy a share of IBM for $150. You would exercise your put option only if the price of IBM falls below the strike price of $150.
  • 19. Options Market
    • The options market can be used for:
      • speculation
      • reducing exposure to risk.
  • 20. Futures Market
    • A market for contracts that provide for future delivery of a good at some pre-specified price. Futures markets exist for commodities, bonds, and foreign currencies.
    • Example: If I agree to a 1/1/2009 futures contract to buy 1000 bushels of corn at $3.00 per bushel, I am committed to buying corn on that date at that price. The other party to the contract is committed to sell 1000 bushels at $3.00 per bushel. The person who agrees to buy corn has “bought” a futures contract. The person who agrees to sell the corn has “sold” a futures contract.
    • If the expected price of a commodity in the future rises, the futures price will rise.
    • The price in futures contracts provides an indicator of what people believe about the movement of prices in the future.
  • 21. Mutual Funds
    • Mutual Funds: a firm that pools money from many small investors to buy and manage a portfolio of assets and pays the earnings back to the investors. Mutual funds can be categorized in several ways. For example:
      • index funds (S&P 500 or Willshire 5000)
      • international funds (invest in foreign securities; exchange rate risk)
      • bond funds (invest in bonds)
      • balanced funds (invest in bonds and stocks)
      • growth funds (invest in companies viewed as having high growth potential)
      • sector funds (invest in a particular sector of the economy; e.g. health, or financial services).
      • tax-exempt income funds (invest in tax exempt bonds)
      • money market funds (invest in short term government securities)
    • The major advantage of mutual funds is that it allows a person to invest in the stock market and be diversified .