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  1. 1. Markets and Instruments Chapter 2 Finance 650 Spring 1999 Lecture notes prepared by: Dr. Susan D. Jordan
  2. 2. The Money Market <ul><li>Treasury Bills </li></ul><ul><ul><li>auction or primary market </li></ul></ul><ul><ul><li>secondary market </li></ul></ul><ul><ul><li>Treasury Auction Process </li></ul></ul><ul><ul><ul><li>competitive versus noncompetitive </li></ul></ul></ul>
  3. 3. Auction results Results in WSJ and
  4. 4. TBill Formulas <ul><li>P = Face [ 1 - r BD * (n/360)] </li></ul><ul><li>r BD = (F-P)/F * 360/n (bank discount yield) </li></ul><ul><li>r BEY = (F-P)/P * 365/n = (365* r BD )/(360 - t* r BD ) </li></ul><ul><li>r BEY = bond (coupon) equivalent yield or APR </li></ul><ul><li>effective annual yield = [1 + (F-P)/P ] 365/n - 1 </li></ul><ul><ul><li>= (F/P) 365/n - 1 </li></ul></ul>
  5. 5. Secondary market transactions <ul><li>From WSJ on Tuesday, August 25, 1998 </li></ul><ul><li>Dealer’s selling price (your purchase price) </li></ul><ul><li>Dealer’s purchase price (your selling price) </li></ul>
  6. 6. Money market instruments <ul><li>Commercial Paper </li></ul><ul><li>Eurodollar </li></ul><ul><li>Certificate of Deposit </li></ul><ul><ul><li>Domestic </li></ul></ul><ul><ul><li>Eurodollar </li></ul></ul><ul><ul><li>Yankee </li></ul></ul><ul><ul><li>Bear Market CD </li></ul></ul><ul><ul><li>Bull Market CD </li></ul></ul>
  7. 7. Money market instruments (cont.) <ul><li>Banker's Acceptance </li></ul><ul><li>Repurchase Agreement Repo RP </li></ul><ul><li>Federal Funds </li></ul><ul><li>Broker's call </li></ul><ul><li>LIBOR rate -- London Interbank Offered Rate </li></ul>Reverse Repo
  8. 8. The Fixed-Income Capital Market <ul><li>Includes Treasury notes and bonds, corporate bonds, municipal bonds, mortgage securities, and federal agency securities. </li></ul><ul><li>Overview of Bond Features </li></ul><ul><ul><li>indenture </li></ul></ul><ul><ul><li>term to maturity </li></ul></ul><ul><ul><li>principal value </li></ul></ul><ul><ul><li>coupon rate </li></ul></ul>
  9. 9. Bond features (cont.) <ul><ul><li>sinking fund </li></ul></ul><ul><ul><li>debenture </li></ul></ul><ul><ul><li>mortgage or secured bond </li></ul></ul><ul><ul><li>income bond </li></ul></ul><ul><li>Embedded Options </li></ul><ul><ul><li>convertible bond </li></ul></ul><ul><ul><li>callable bond </li></ul></ul><ul><ul><li>put bond </li></ul></ul><ul><ul><li>exchangeable bond </li></ul></ul>
  10. 10. Treasury Notes and Bonds <ul><li>Notes: original maturity of 2 to 10 years </li></ul><ul><li>Bonds: original maturity > than 10 years </li></ul><ul><ul><li>Denominations of $1,000 or more </li></ul></ul><ul><ul><li>Both make semiannual coupon payments </li></ul></ul><ul><ul><li>Some T-Bonds may be called (last 5 years). </li></ul></ul><ul><ul><li>T-bonds issued since Feb. 1985 not callable. </li></ul></ul><ul><ul><li>Inflation-indexed Treasury securities </li></ul></ul>
  11. 11. Treasury quotes From WSJ Wednesday, August 28, 1997 <ul><li>If date is followed by p or n it is a note </li></ul><ul><li>Numbers to the right of the colon = 1/32 of a point </li></ul><ul><li>If you purchase, you pay </li></ul><ul><li>If you sell $1000 face, you receive </li></ul><ul><li>Coupon rate of 7 = 7% of par ($70/year or $35 semi) </li></ul>103.5625% of par $1035.00
  12. 12. Treasury quotes From WSJ Wednesday, August 28, 1997 <ul><li>Yld = semiannual yield * 2 = Simple Interest = APR (Annual Percentage Rate ) = bond equivalent yield </li></ul><ul><li>Other Treasury bonds </li></ul><ul><ul><li>Flower bond </li></ul></ul><ul><ul><li>Callable bonds (Maturity YR is a range) </li></ul></ul><ul><ul><ul><li>yield on callables </li></ul></ul></ul><ul><ul><ul><ul><li>discount bond = yield to maturity </li></ul></ul></ul></ul><ul><ul><ul><ul><li>premium bond = yield to first call </li></ul></ul></ul></ul>
  13. 13. Municipal Bonds <ul><li>general obligation bond </li></ul><ul><li>revenue bond </li></ul><ul><ul><li>industrial development bond or private purpose bond </li></ul></ul><ul><li>tax anticipation bond </li></ul><ul><li>Equivalent taxable yield </li></ul><ul><ul><li>r(1-t) vs. r m or r vs. r m /(1-t) </li></ul></ul>7.20*(1-.20)= 5.76 7.20*(1-.30)= 5.04 Taxable bond yield = 7.20 and tax-exempt yield = 5.31
  14. 14. Corporate bonds <ul><li>issued by private firms to borrow money from the public </li></ul><ul><li>Corp Bond Quotes from WSJ on Wed, Sept. 3, 1997 </li></ul>Current yield = 67.50/1006.25
  15. 15. Equities <ul><li>Common stock </li></ul><ul><ul><li>Residual claim and limited liability </li></ul></ul><ul><ul><li>Two Basic Rights </li></ul></ul><ul><ul><ul><li>Preemptive right </li></ul></ul></ul><ul><ul><ul><li>Right to control </li></ul></ul></ul><ul><ul><ul><ul><li>Proxy </li></ul></ul></ul></ul><ul><li>Preferred stock </li></ul><ul><ul><li>fixed dividends </li></ul></ul><ul><ul><li>priority over common </li></ul></ul><ul><ul><li>tax treatment </li></ul></ul>
  16. 16. Stock market quotes <ul><li>Dividends: annual disbursements based on last quarterly declaration </li></ul><ul><li>Yield: div/close </li></ul><ul><li>PE: close/(last four EPS) </li></ul>So what was EPS for last four quarters? 27 = 38.3125/E or $1.42
  17. 17. Derivative Assets or Contingent Claims <ul><li>Option Contract </li></ul><ul><ul><li>purchaser of an option contract has the right to buy or sell the underlying at a stated price (the strike or exercise price) on or before a specified date (expiration). </li></ul></ul><ul><ul><li>Put: right to sell </li></ul></ul><ul><ul><li>Call: right to buy </li></ul></ul><ul><ul><li>Option Premium </li></ul></ul><ul><ul><li>Writer/Seller </li></ul></ul>Naked versus covered
  18. 18. Option contract quotes
  19. 19. Derivative Assets or Contingent Claims <ul><li>Futures Contract </li></ul><ul><ul><li>calls for delivery of an asset (or its cash value) on a specified date for an agreed upon price to be paid at the maturity date. </li></ul></ul><ul><ul><li>Long: commitment to purchase the underlying </li></ul></ul><ul><ul><li>Short: commitment to deliver the underlying </li></ul></ul><ul><ul><li>cash settlement for index options </li></ul></ul><ul><ul><li>How is a long futures contract different from long call? </li></ul></ul>
  20. 20. Futures quotes
  21. 21. Stock Market Indicators <ul><li>Provide an overall indication of aggregate market movements </li></ul><ul><li>Uses: </li></ul><ul><ul><li>track average returns </li></ul></ul><ul><ul><li>base of derivatives </li></ul></ul><ul><ul><li>measure systematic risk </li></ul></ul><ul><ul><li>compare performance of managers </li></ul></ul>
  22. 22. Stock Market Indicators <ul><li>Sample </li></ul><ul><li>Computation </li></ul><ul><ul><li>Average </li></ul></ul><ul><ul><ul><li>Arithmetic </li></ul></ul></ul><ul><ul><ul><li>Geometric </li></ul></ul></ul><ul><li>Indexes </li></ul><ul><ul><li>Value-weighted or capitalization-weighted </li></ul></ul><ul><ul><li>Equal-weighted </li></ul></ul>
  23. 23. Dow Jones Average & Indices <ul><li>30-Stock Industrial Average (DJIA or DOW) </li></ul><ul><li>20-Stock Transportation Average </li></ul><ul><li>15-Stock Utilities Average </li></ul><ul><li>65-Stock Composite Average </li></ul><ul><li>The Dow Jones Equity Index </li></ul>
  24. 24. DJIA <ul><li>Price-weighted </li></ul><ul><li>Large, well-known cos (Blue chips) </li></ul><ul><li>1884 with 11 stocks </li></ul><ul><li>1928 => 30 stocks </li></ul><ul><li>Divisor is not equal to # companies </li></ul><ul><li>Divisor adjusted: </li></ul><ul><ul><li>Companies added/deleted </li></ul></ul><ul><ul><li>Stock splits or stock dividends > 10% </li></ul></ul>
  25. 25. Consider a 2-stock sample <ul><li>Price-weighted average </li></ul><ul><li>Equal-weighted index </li></ul><ul><li>Value-weighted index </li></ul>
  26. 26. <ul><li>DOW or price-weighted average </li></ul><ul><ul><li>Day 0 = ($110+$30)/2 = 70 </li></ul></ul><ul><ul><li>Day 1 = ($154+$33)/2 = 93.5 </li></ul></ul><ul><ul><li>Change in DOW = 93.5/70 - 1 = 33.57% </li></ul></ul><ul><li>Value-weighted Index (base = 100) </li></ul><ul><ul><li>Day 0 = (MV1 + MV2)/Base * 100 =100 </li></ul></ul><ul><ul><li>Day 1 = (1540+33000)/31100 *100 =111.06 </li></ul></ul><ul><ul><li>Change in Value = 111.06/100 -1 = 11.06% </li></ul></ul><ul><li>Equal-weighted Index </li></ul><ul><ul><li>Change of (40% + 10%)/2 = 25% </li></ul></ul>
  27. 27. Consider 3 stocks
  28. 28. Examples of domestic indices <ul><li>Dow Jones Industrial Average </li></ul><ul><li>Standard & Poor’s 500 Composite </li></ul><ul><li>Nasdaq Composite </li></ul><ul><li>NYSE Composite </li></ul><ul><li>Wilshire 5000 </li></ul><ul><li>Value Line Composite </li></ul>
  29. 29. Examples of international indices <ul><li>Nikkei 225 & Nikkei 300 </li></ul><ul><li>FTSE (Financial Times of London) </li></ul><ul><li>Dax </li></ul><ul><li>Region and Country Indexes </li></ul><ul><ul><li>EAFE </li></ul></ul><ul><ul><li>Far East </li></ul></ul><ul><ul><li>United Kingdom </li></ul></ul>
  30. 30. Example of bond indices <ul><li>Lehman Brothers </li></ul><ul><li>Merrill Lynch </li></ul><ul><li>Salomon Brothers </li></ul><ul><li>Specialized Indexes </li></ul><ul><ul><li>Merrill Lynch Mortgage </li></ul></ul>