3301-2 - Purpose of the Capital Market Original maturity is...

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Purpose of the Capital Market • Original maturity is greater than one year, typically for long-term financing or investments] Treasury bonds (T-bonds) are issued by the U.S. Treasury to finance the national debt and other government expenditures. • The annual federal deficit equal to annual expenditures (G) less taxes (T) received • The national debt (ND) is the sum of historical annual federal deficits] Treasury Bonds • Default risk free: backed by the full faith and credit of the U.S. government • Low returns: low interest rates (yields to maturity) • Interest rate risk: long maturity, T-bonds experience wider price fluctuations than money market securities when interest rates change • Liquidity risk: older issued T-bonds trade less frequently than newly issued] Issued in minimum denominations (multiples) of $1,000] Bid: The closing price per $100 of par the dealer will pay to buy the bond; the seller would receive this price from selling to the dealer] Asked : The closing price per $100 of par the dealer requires to sell the bond; the buyer would pay this price to the dealer.] Chg : The change from the prior closing ASKED price. • Asked Yield = Promised compound yield rate if purchased at the Asked price.] When the bond is sold on dates different from coupon dates, the buyer pays “accrued interest.” 𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝐴𝐴 𝐴𝐴𝐴𝐴𝐴𝐴 = 𝐴𝐴 𝐴 /2 × 𝐴𝐴𝐴𝐴𝐴𝐴 𝐴𝐴𝐴 𝐴𝐴𝐴 𝐴𝐴 𝐴𝐴𝐴𝐴 𝐴𝐴𝐴𝐴𝐴 𝐴𝐴𝐴𝐴 𝐴𝐴𝐴𝐴𝐴𝐴 𝐴𝐴𝐴𝐴𝐴𝐴𝐴 / 𝐴𝐴𝐴𝐴𝐴𝐴 𝐴𝐴𝐴𝐴𝐴𝐴 𝐴𝐴 𝐴𝐴𝐴𝐴 𝐴𝐴 𝐴𝐴𝐴𝐴𝐴𝐴 𝐴𝐴𝐴𝐴𝐴𝐴 • The full (or dirty) price of a T-bond or T-note is the sum of the clean price and the accrued interest] Treasury Inflation-Indexed Securities: the principal amount is tied to the current rate of inflation to protect investor purchasing power – Principal (FV) adjusts for inflation based on CPI. – Fixed coupon rate determined by auction process – Minimum denomination is $1,000.] STRIPS have the periodic interest payments separated from each other and from the principal payment – one set reflects interest payments – one set reflects principal payments • STRIPS are used to immunize against interest rate risk]] The coupon rate of the auctioned bonds or notes is the stop-out yield rounded down to the nearest 1/8 percent. • The security price is set at the yield to maturity equal to the stop-out yield.] tax benefit: 𝐴𝐴 = 𝐴𝐴 (1 – 𝐴𝐴 x), 𝐴𝐴 = 𝐴𝐴 /(1 – 𝐴𝐴 x)] Secondary markets: Munis trade infrequently due mainly to a lack of information on bond issuers] Municipal Bonds • Low default probability • High recovery rate – GO bonds have almost 100% recovery rates since issuers can raise taxes for the payments.] Call Provision 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 (
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