Chapter 02_Hand-out 1

Chapter 02_Hand-out 1 - CHAPTER 2 MARKETS AND FINANCIAL...

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CHAPTER 2 MARKETS AND FINANCIAL INSTRUMENTS 2.1 THE MONEY MARKET The money market is a sub-sector of the fixed-income market. It consists of very short-term debt securities that usually are highly marketable. Many of these securities trade in large denominations, and so are out of the reach of individual investors. Money market funds, however, are easily accessible to small investors. 1. Treasury Bills U.S. Treasury bills (T-bills) are the most marketable of all money market instruments. T-bills represent the simplest form of borrowing. The government raises money by selling bills to the public. Investors buy the bills at a discount from the stated maturity value. At the bill’s maturity, the holder receives from the government a payment equal to the face value of the bill. T-bills with initial maturities of 91 days or 182 days are issued weekly. Offerings of 52-week bills are made monthly. Sales are conducted via auction , at which investors can submit competitive or noncompetitive bids. - A competitive bid is an order for a given amount of bills at a specific offered price. The offer is filled only if the bid is high enough relative to other bids to be accepted. - A noncompetitive bid is an unconditional offer to purchase bills at the average price of the successful competitive bids. The Treasury ranks bids by offering price and accepts bids in order of descending price until the entire issue is absorbed. The bid price is the price at which a customer can sell the bill to a dealer in the security, whereas the ask price is the price at which the customer can buy a security from a dealer. The difference in bid and ask prices is a source of profit to the dealer. The income earned on T-bills is exempt from all state and local taxes. Type of yields: example - Bank Discount Yields /BDY/: n 360 x PV P PV r BDY - = - Effectual Annual Rate /EAR/ - Bond Equivalent Yield /BEY/: n 365 x P P PV r BEY - = 1
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T-bills and other money-market yields are not quoted in the financial pages as effective annual rates of return. Instead, bank discount yield is used. In this approach, the bill’s discount from par value (PV) is “annualized” based on a 360-day year. The yield reported in the financial pages is the bond equivalent yield . This is the bill’s yield over its life, assuming that it is purchased for the ask price. (The BEY is the return on the bill over the period corresponding to its remaining maturity multiplied by the number of such periods in a year.) Note: It still, however, uses a simple interest procedure to annualize, also known as annual percentage rate, or APR, and so problems still remain in comparing yields on bills with different maturities ( n ). Nevertheless, yields on most securities with less than a year to maturity are annualized using a simple interest approach. 2. Certificate of Deposit
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This note was uploaded on 09/25/2011 for the course FINA 4320 taught by Professor John during the Spring '11 term at Houston Baptist.

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Chapter 02_Hand-out 1 - CHAPTER 2 MARKETS AND FINANCIAL...

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