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Financial Markets: Stocks and Bonds.

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Financial Markets: Stocks and Bonds.

  1. 1. Ch. 15: Financial Markets <ul><li>Financial markets </li></ul><ul><ul><li>link borrowers and lenders. </li></ul></ul><ul><ul><li>determine interest rates, stock prices, bond prices, etc. </li></ul></ul><ul><li>Bonds </li></ul><ul><ul><li>a promise by the bond-issuer to pay some specified amount(s) in the future in exchange for some payment (the bond price) today. </li></ul></ul><ul><li>Stocks (equities) </li></ul><ul><ul><li>legal rights of ownership in an incorporated firm. </li></ul></ul><ul><ul><li>promise the stockholder a share of the corporte profits (dividends) </li></ul></ul>
  2. 2. The Bond Market. <ul><li>Maturity date : </li></ul><ul><li>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. </li></ul><ul><li>Coupon rate </li></ul><ul><li>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. </li></ul><ul><li>Yield to maturity </li></ul><ul><li>represents the effective interest rate that the bond-holder earns if the bond is held to maturity. </li></ul><ul><li>Bond price </li></ul><ul><li>The price that the bond sells for. This fluctuates over the life of the bond. </li></ul><ul><ul><li>*If the bond price is equal to 100% of its maturity value, the bond sold at “par”. </li></ul></ul><ul><ul><li>If the bond price is below 100% of its maturity value, the bond price sold “below par”. </li></ul></ul>
  3. 3. The Bond Market <ul><li>20 year bond with maturity value of $1000 and coupon rate of 5% promises </li></ul><ul><ul><li>20 annual payments of .05*1000=$50 </li></ul></ul><ul><ul><li>$1000 payment at maturity (20 years from now). </li></ul></ul><ul><ul><li>If price is $1000 for this bond, the bond sold for par. </li></ul></ul>
  4. 4. The Bond Market. <ul><li>Computing yields on a bond. </li></ul><ul><li>The yield on a bond is the same as the internal rate of return . To calculate the yield to maturity, define NPV as follows: </li></ul><ul><li>NPV = CP1/(1+r) + CP2/(1+r) 2 + .... + CPT/(1+r) T + MV/(1+r) T - P </li></ul><ul><li>where CP1, CP2, ... CPT are the interest or coupon payments in periods 1 through T </li></ul><ul><li>MV is the payment received at maturity </li></ul><ul><li>P is the price paid for the bond. </li></ul><ul><li>The yield to maturity is the interest rate that makes the NPV on the bond purchase zero. </li></ul>
  5. 5. The Bond Market. <ul><li>One year bonds </li></ul><ul><ul><li>NPV = MV(1+cr)/(1+r) - P where cr is the coupon rate. </li></ul></ul><ul><ul><li>setting NPV=0 and solving for r provides the yield to maturity: </li></ul></ul><ul><ul><li>yield = [MV(1+cr)/P] - 1 </li></ul></ul><ul><li>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? </li></ul><ul><li>yield = [(1000)(1.05)/900] - 1 </li></ul><ul><li>=1050/900 -1 </li></ul><ul><ul><li>=16.67% </li></ul></ul><ul><li>As the price paid for a bond increases, the yield on the bond falls. </li></ul>
  6. 6. The Bond Market. <ul><li>Zero Coupon Bonds. </li></ul><ul><li>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. </li></ul><ul><li>NPV = MV/(1+r) T - P </li></ul><ul><li>setting NPV=0 and solving for r provides the yield: </li></ul><ul><li>yield = (MV/P) 1/T - 1 </li></ul><ul><li>For example, if you buy a zero coupon bond today for $1000 and it has a maturity value of $1500 in 10 years: </li></ul><ul><ul><li>yield = (1500/1000) 1/10 -1 = .0414 = 4.14% </li></ul></ul><ul><li>As the price paid for a bond increases, the yield on the bond falls. </li></ul>
  7. 7. The Bond Market. <ul><li>Determinants of bond yields </li></ul><ul><ul><li>Higher expected inflation will drive up yields. </li></ul></ul><ul><ul><li>Higher risk bonds must offer higher yields. </li></ul></ul><ul><ul><ul><li>Default risk. </li></ul></ul></ul><ul><ul><ul><ul><li>Debt rating agencies: </li></ul></ul></ul></ul><ul><ul><ul><ul><ul><li>Moody’s & Standard and Poors </li></ul></ul></ul></ul></ul><ul><ul><ul><ul><ul><li>AAA=superior quality </li></ul></ul></ul></ul></ul><ul><ul><ul><ul><ul><li>C=imminent default </li></ul></ul></ul></ul></ul><ul><ul><ul><ul><li>Diversification to reduce risk. </li></ul></ul></ul></ul><ul><ul><ul><li>Inflation risk. </li></ul></ul></ul><ul><ul><li>Term </li></ul></ul><ul><ul><ul><li>Longer term bonds have greater inflation and default risk. </li></ul></ul></ul>
  8. 8. The Bond Market. <ul><li>Yield curve </li></ul><ul><ul><li>Shows relationship between yield and term on government bonds </li></ul></ul><ul><ul><li>Slope of yield curve reflects </li></ul></ul><ul><ul><ul><li>Expectations of future short term interest rates </li></ul></ul></ul><ul><ul><ul><li>Greater risk of long term bonds </li></ul></ul></ul><ul><ul><li>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. </li></ul></ul><ul><ul><li>A steepening of the yield curve suggests that financial markets believe short term interest rates will be rising in the future. </li></ul></ul><ul><ul><ul><li>The bond market </li></ul></ul></ul><ul><ul><ul><li>The dynamic yield curve </li></ul></ul></ul>
  9. 9. The Stock Market <ul><li>Stocks (equities): </li></ul><ul><ul><li>legal rights of ownership in an incorporated firm. </li></ul></ul><ul><ul><li>promise the stockholder a share of the corporte profits (dividends) </li></ul></ul>
  10. 10. The Stock Market <ul><li>The “fundamental value” of a stock is the expected present value of all future dividends from a stock. </li></ul><ul><li>P = d 1 /(1+r) + d 2 /(1+r) 2 + d 3 /(1+r) 3 + ....d T /(1+r) T </li></ul><ul><ul><li>where T is the end of the firm’s life (which might be infinite) </li></ul></ul><ul><ul><li>d 1 , d 2 , ... d T represent dividend payments in years 1 through T. </li></ul></ul><ul><ul><li>r is the interest rate </li></ul></ul>
  11. 11. The Stock Market <ul><li>Given the fundamental value theory, stock prices will rise with: </li></ul><ul><ul><li>lower interest rates. </li></ul></ul><ul><ul><li>an increase in future expected dividends. </li></ul></ul><ul><ul><li>A lower tax rate on dividends. </li></ul></ul>
  12. 12. The Stock Market <ul><li>Efficient markets hypothesis: </li></ul><ul><ul><li>All stock prices represent their fundamental value at each point in time. </li></ul></ul><ul><ul><li>When new “information” arrives about a stock, its price immediately adjusts to reflect that new information. </li></ul></ul><ul><ul><li>It is impossible to consistently predict which way a stock price will move in the future and to consistently “beat the market”. </li></ul></ul>
  13. 13. The Stock Market. <ul><li>If the efficient markets hypothesis is true, </li></ul><ul><ul><li>financial advisors can assist you only in evaluating the risk and tax consequences of different stocks and concerns regarding income or growth, etc. </li></ul></ul><ul><ul><li>Financial advisors will not be able to consistently find stocks that will “beat the market”. </li></ul></ul><ul><li>The validity of the efficient markets hypothesis is controversial among economists. </li></ul>
  14. 14. The Stock Market <ul><li>Stock quotes </li></ul><ul><ul><li>Price </li></ul></ul><ul><ul><li>PE ratio (price-earnings ratio) </li></ul></ul><ul><ul><li>Volume (number of shares sold in previous day) </li></ul></ul><ul><ul><li>Change (change in from previous day) </li></ul></ul><ul><ul><li>52 week high and low </li></ul></ul><ul><ul><li>Beta (measures stock movements relative to market) </li></ul></ul>
  15. 15. The Stock Market <ul><li>Performance measures </li></ul><ul><ul><li>Broad indexes </li></ul></ul><ul><ul><ul><li>Dow Jones Industrial Average </li></ul></ul></ul><ul><ul><ul><li>Standard and Poor 500 </li></ul></ul></ul><ul><ul><ul><li>NASDAQ </li></ul></ul></ul><ul><li>For stock quotes and information </li></ul><ul><ul><li>http://money.cnn.com/ </li></ul></ul>
  16. 16. Options <ul><li>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). </li></ul>
  17. 17. Options Market <ul><li>Call option on a security: </li></ul><ul><ul><li>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. </li></ul></ul><ul><ul><li>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. </li></ul></ul>
  18. 18. Options Market <ul><li>Put option on a security: </li></ul><ul><ul><li>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. </li></ul></ul><ul><ul><li>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. </li></ul></ul>
  19. 19. Options Market <ul><li>The options market can be used for: </li></ul><ul><ul><li>speculation </li></ul></ul><ul><ul><li>reducing exposure to risk. </li></ul></ul>
  20. 20. Futures Market <ul><li>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. </li></ul><ul><li>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. </li></ul><ul><li>If the expected price of a commodity in the future rises, the futures price will rise. </li></ul><ul><li>The price in futures contracts provides an indicator of what people believe about the movement of prices in the future. </li></ul>
  21. 21. Mutual Funds <ul><li>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: </li></ul><ul><ul><li>index funds (S&P 500 or Willshire 5000) </li></ul></ul><ul><ul><li>international funds (invest in foreign securities; exchange rate risk) </li></ul></ul><ul><ul><li>bond funds (invest in bonds) </li></ul></ul><ul><ul><li>balanced funds (invest in bonds and stocks) </li></ul></ul><ul><ul><li>growth funds (invest in companies viewed as having high growth potential) </li></ul></ul><ul><ul><li>sector funds (invest in a particular sector of the economy; e.g. health, or financial services). </li></ul></ul><ul><ul><li>tax-exempt income funds (invest in tax exempt bonds) </li></ul></ul><ul><ul><li>money market funds (invest in short term government securities) </li></ul></ul><ul><li>The major advantage of mutual funds is that it allows a person to invest in the stock market and be diversified . </li></ul>

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