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Financial Lecture Markets And Instruments
Lecture 2, BUS 136, Investments, UCR
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Financial Markets
Financial markets are "places" where people buy or sell financial assets or securities such as bonds, stocks, options, or futures. Examples:
Securities exchanges (with a centralized location):
New York Stock Exchange (NYSE): stocks and bonds American Stock Exchange (AMEX): stocks and options New York Mercantile Exchange (NYMEX): futures Chicago Board of Trade (CBOT): futures Chicago Board Option Exchange (CBOE): options Chicago Mercantile Exchange (CME): futures
Over the Counter (OTC) market (No physical location)
National Association of Securities Dealers Automated Quotation system(NASDAQ) - stocks
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Financial Markets
Financial markets are traditionally segmented into money markets and capital markets according to instruments/securities traded.
Money markets include short term, highly liquid and relatively low risk debt securities.
Capitals markets include longer term, relatively riskier securities. They are subdivided into longer-term debt markets, equity markets and derivative markets.
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Taxonomy of Markets
Money Markets or "cash" Market (a subsector of the fixed income market) Equity or Stock Markets Fixed Income Markets (Debt or Bond Markets)
Derivative Securities Markets (includes markets for futures, options, etc.)
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Money Market Instruments
Short Term Debt Instruments
Short-term (less than one year)
Liquid low-risk
Examples include
CD, commercial paper, t-bill, eurodollar, Federal funds, etc.
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Treasury Bills
Short-term government debt securities
Sold through auction by the U.S. Treasury Maturity of one year or less Interests are paid through discount sale investors buy the bills at a discount from the stated maturity value. Interests are tax-exempt at the state and local level
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CD, Commercial Paper, Eurodollar
A certificate of deposit (CD) is a time deposit with a bank money may not be withdrawn on demand. Commercial paper a short-term unsecured debt issued by large corporations with maturities of less than one or two months.
Eurodollar dollar-denominated deposits at a foreign banks or foreign branches of American Banks.
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Federal Funds
Commercial banks maintain deposits of their own at the Federal Reserve Bank (Fed) Fed is a bank of banks. Each bank must maintain a minimum balance in a reserve account with the Fed according to the total deposits of the bank's customers. Funds in those reserve accounts are called the Federal funds. Banks typically borrow federal funds from each other to satisfy reserve requirement at a rate called the federal funds rate.
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Bond Markets Instruments
Based on who the issuer is:
Treasury Notes and Bonds
Debt obligations of the federal government with original maturities of one year or more. Both pay semiannual coupons (i.e. interests) Investors' interests income is tax-exempt at the state and local level Notes are 1-10 years maturity, bonds are 10-30 years maturity
Federal Agency Debt
Debt obligations issued by some government agencies. Example: Mortgage backed securities issued by Mortgage agencies The Federal National Mortgage Association (Fannie Mae), the Government National Mortgage Association (Ginnie Mae), and the Federal Home Loan Mortgage Corporation (Freddie Mac). See yahoo company info: FRE, FNM
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Bond Markets Instruments
Based on who the issuer is.
Municipal Bonds
Long term debt issued by states and cities Two types: General obligation bonds and revenue bonds Investors' interest income is tax-exempt at the federal, state, and local level
Corporate Bonds
Long term debt issued by private corporations typically paying semiannual coupons and returning the face value of the bond at maturity. Have default risk measured by its credit rating Investors' interest income is taxed at the both the federal and state level.
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Municipal Bonds
Due to the tax-exempt status on interests, municipal bonds typically pay lower interest rates than private corporations and investors are willing to accept that.
Example Suppose that a municipal bond has a interest rate 4%, of while comparable taxable corporate bonds pay 5%. Which gives you the higher after-tax yield if your tax bracket is 30%?
5% 1 .30
Lecture 2, BUS 136, Investments, UCR
3.5%
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Bond Quotations
Sold in denominations of $1000; price quoted as percentage of face value; Numbers to the right of price colons represent 32nds of face value
Price can be higher or lower than the face value
Rate 43/4 105/8 51/4 Maturity Nov 08n Aug 15 Nov 28 Bid 100:05 156:31 101:17 Asked 100:06 157:05 101:18
Yield to Maturity
Ask Yield 4.73 5.38 5.15
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(100+05/32)% or 100.15625% of $1000 =$1001.5625
Lecture 2, BUS 136, Investments, UCR
Stocks/Equities
Common Stocks
Shareholder or Owner of the firm Residual Claimant last one to claim on the firm's assets/income
Limited Liability (not personally liable for the firm's obligations; In contrast, an owner or partner in a partnership would be personally liable for the partnership's obligations.)
Preferred Stocks
Fixed Dividends-not obligated to be paid every year
Cumulative Dividend Provisions
No voting power
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Stock Indexes
Uses
Track overall market or segment performance
Benchmark the performance of fund managers
Factors to consider in using an Index
Representative? Broad or narrow? How is it constructed?
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Popular Stock Indexes in the U.S.
Dow Jones Industrial Average (30 "Blue-Chip" Stocks)
Standard & Poor's 500 Composite (500 large company stocks) Nasdaq Composite
All stocks trading on Nasdaq (roughly 3,000)
Wilshire 5000
All NYSE, AMEX, and OTC stocks (roughly 7,000)
Russel 2000 (2000 smaller stocks) See http://finance.yahoo.com/indices
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Construction of Indexes
An index is just a portfolio of n stocks
Rp = w1 R1 + w2 R2 + ... wn Rn where wi (i=1, 2, ...,n) is the proportion of stock i in the portfolio value; sum(wi )=1.
How are stocks weighted?
Price-weighted index (DJIA): The index invests one share in each company; the amount invested in each company is proportional to that company's share price.
Stocks with higher prices affect the index more for the same percentage change.
Market value-weighted index(S&P500, NASDAQ, NYSE): the amount invested in each company is proportional to that company's market value
Stocks with higher market value affect the index more for the same percentage change. 2, BUS 136, Investments, UCR Lecture
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Construction of Indexes
In a price-weighted index, the average share price of all firms included in the index is measured at each point in time.
In a value-weighted index, the total market value of all firms included in the index is measured at each point in time.
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Construction of Indexes: Example
Based on the following, construct price and value-weighted indexes and compute the percentage change in each.
Price per Share Company ABC XYZ Shares Beginning Outstanding of Year 20 million 1 million $25 $100 End of Year $30 $90
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Construction of Indexes: Example
The price weighted index started at ($25 + $100)/2 = $62.5. It ended at ($30 + $90)/2 = $60. The percent change of the index is
60 62.5 62.5
4%
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Construction of Indexes: Example
For the value-weighted index, we compute the starting and ending market values:
Beginning Market Value Ending Market Value ABC XYZ 20 x $25 = $500 1 x $100 = $100 $600 20 x $30 = $600 1 x $90 = $90 $690
The percent change in the index is
690 600 15% 600
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Derivatives Securities
A derivative is a financial asset that is derived from an existing traded asset, typically a stock, bond or currency. A futures contract is an agreement made today to buy or sell an asset at a future time period at a price specified today.
Example: A March future on IBM stock with an agreed price of $100.
An option contract is an agreement that gives the owner the right, but not the obligation, to buy or sell an asset at a specified price for a set period of time.
example: A March call option on IBM stock with exercise price of $100.
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Derivatives Securities
Options
Futures
Two types
Call (Option to Buy)
Terms
Delivery Price Delivery Date
Put (Option to Sell)
Terms
Exercise Price
Assets
Expiration Date
Assets
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