Financial Markets

1
Financial Markets

• John G. Kooti

2
Financial Markets

• Real versus Financial Assets Markets
• The Role of Financial Markets
• Classification of Financial Markets
• Primary versus Secondary Markets
• Spot versus futures markets
• World, national, regional, and local markets

3
Real vs. Financial Asset Markets

• Real (Tangible Asset) Market is the market where
  real assets are traded. These assets include
  such products as wheat, auto, real estate,
  computers, and Machinery.
• Financial Asset Markets deal with financial
  assets such as stocks, bonds, notes, mortgages,
  and other claims on real assets.

4
Major Types of Financial Markets

• Money Markets
• Capital Markets
• Mortgage Markets
• Consumer credit markets

5
Primary vs. Secondary Markets

• Primary Markets---are the markets for primary
  securities (new issues of stocks and bonds)
• Secondary Markets are the markets for existing
  securities. Generally, investors other than the
  issuing firm buy or sell financial instruments
  such as bonds, stocks, options or future.

6
Financial Markets

• Money markets the market for short-term
  securities (maturity of one year or less).. The
  New York Commercial Paper and Treasury Bill
  markets are money markets.
• Capital Market is the market for long-term
  securities, such as notes, bonds, and stocks.

7
Financial Markets

• Consumer Credit Markets are loans for purchase of
  goods and services such auto loan, vacation loan,
  personal loan, etc.

8
The Capital Formation Process

• Direct Transfer
• Indirect Transfers through Investment Bankers
• Indirect Transfers through a Financial
  Intermediary

9
Transfer of Funds

• Direct when securities are sold directly to
  savers by the issuers.
• Indirect Transfer through investment banking is
  when the issuer sells the securities to the
  investment bank who in turn sells them to
  investors.

10
Transfer of Funds

• Indirect Transfer through Intermediaries--issuer
  sells the securities the intermediaries who in
  turn issue their own securities to savers.

11
Investment Banks

• Act as middlemen between savers and borrowers
  (issuers of securities). Example Merrill
  Lynch, Salomon Brothers, Dean Witter, and Goldman
  Sach.

12
Intermediaries

• Commercial banks
• Savings and loan associations
• Mutual saving banks
• Credit unions
• Life Insurance Companies
• Mutual funds
• Pension Funds

13
Stock Markets

• New York Stock Exchange (NYSE)
• American Stock Exchange (AMEX)
• Over-the-counter (OTC) markets
• Smaller regional markets

14
Organized Exchanges

• The organized security exchanges are formal
  organizations having tangible, physical locations
  and trading in designated securities. There are
  exchanges of stocks, bonds, commodities, future,
  and options. Two well known markets are NYSE and
  American Stock Exchange (AMEX)

15
Trading at the NYSE

• The NYSE is a continuous, secondary security
  market with a centralized exchange
• Trading can occurany time when the market is
  open (at this point between 930 a.m. and 400
  p.m.)
• Trading is in shares issued previously by a firm
• All trading occurs on the NYSE floor

16
Trading at the NYSE

• Suppose you wish to sell shares of a NYSE-listed
  firm such as GM. How would you do it?
• You need to locate a broker to assist you and
  instruct her or him on how you want to execute
  the trade.

17
Trading at the NYSE

• The broker will pass your order to a trader
  (market maker) who has a permission to trade at
  the NYSE, such as floor broker, or a competitive
  dealer.
• The floor broker will either trade directly on
  the floor with another broker (who wishes to buy
  GM shares) or trade with an individual called the
  specialist associated with GM.

18
Who is the Specialist?

• Each stock on the NYSE has a specialist
  associated to it who manages its purchases and
  sales and keeps an inventory of the stock.
• If you wish to sell GM stocks, the specialist is
  obligated to buy all GM stocks. The specialist
  sets the price.
• Of course, price can not be set arbitrarily.

19
How does the Specialist Compensated?

• The specialist supplies liquidity to the market
  by buying when you want to sell and selling when
  you want to buy.
• As a supplier of liquidity, the specialist seeks
  a compensation.
• As a demander of liquidity, you must pay for the
  service

20
The Specialist Compensation

• The ask is the selling price of the security by
  dealers
• The bid is the buying price of the security by
  dealers
• Spread is the difference between the ask and the
  bid
• The Specialist receives the spread between the
  bid and the ask

21
Liquidity Supply and Demand

• You may demand liquidity by placing a market
  order.
• Immediately sell 100 shares of GM shares at the
  best price you can get.
• You may supply liquidity by placing a limit order
  to sell GM shares
• Sell 100 shares of GM at a price of 54 or better
  as soon as possible.

22
Over-the-Counter Market

• Made of hundreds of brokers and dealers around
  the country who are connected electronically by
  telephones and computers.

23
Bond Markets

• Over-the-counter (OTC) markets
• New York Stock Exchange (NYSE)

24
Sources of Funds
25
Interest Rates

• Interest Rate is the price paid for borrowed
  money
• Fundamental Factors influencing Interest Rates
• Production Opportunities
• Time Preference for consumption
• Risk
• Expected inflation

26
Production Opportunities

• Refers to the returns that are available from
  investment in productive assets.
• The more productive the asset, the more willing
  to pay acquire the capital needed for investment.

27
Time Preference of Consumers

• Consumer preference for current consumption
  versus future consumption also affects interest
  rate. Thrift minded people are willing to accept
  lower rate to invest.

28
Inflation

• Refers to the tendency for prices to rise.
• The higher the expected rate of inflation, the
  higher the rate of return required.

29
Risk

• Default Risk - the chance that the issuer will
  default on a loan
• Maturity Risk is related to the length of the
  term. It reflects the interest rate risk. Longer
  term securities bear higher risk.
• Liquidity Risk is the risk related to the
  marketability of the security. Higher risk is
  associated with less marketable securities.

30
Other Factors Influencing Interest Rates

• Federal Reserve Board Policy
• Balance of Payments
• Taxes federal deficit

31
Components of Interest Rate

• The real risk-free rate of interest (k)
• The inflation premium (IP)
• The nominal risk-free rate (Krf K IP
• The default risk premium (DRP)
• The liquidity premium (LP)
• The maturity risk premium
• K Krf DRP LP MRP

32
Risk Free Rate of Return

• Risk free rate of return is the real risk-free
  rate plus expected rate of inflation. The
  Treasury bill is the closest security to risk
  free security.
• The T-bill is used as a proxy for long-term risk
  free rate. Long-term bonds have interest rate
  risk, while T-bill does not.

33
Risk Premium

• Default risk is the premium based on the
  probability that the issuer will default on the
  loan. It is measured by the difference between
  the interest rate on US Treasury Bonds and a
  corporate bond of equal maturity and
  marketability.

34
Risk Premium

• Liquidity Risk Premium is added to the rate of
  return on securities that are not liquid.
• The maturity Risk Premium (MRP) is a premium
  which reflects interest rate risk. Longer term
  securities have more interest rate risk than do
  shorter term securities.

35
Risk

• Shorter term treasury securities include only
  inflation premium.
• Long-term Treasury securities contain inflation
  and MRP
• The rate of short-term corporate securities is
  equal to the real risk free rate plus inflation
  DRP LP
• Long-term Corp. Bond has MRP in addition to the
  above.

36
Risk Premium
37
Term Structure of Interest Rate

• Is the relationship between interest rates, or
  yields, and the maturities of securities.
• The Yield Curve is a graph showing the
  relationship between interest rate and the
  maturities.
• The Yield curve is normally upward.
• term structure

38
Theories to Explain the Yield Curve

• Market Segment Theory
• Liquidity Preference Theory
• Expectation Theory

39
Segmented Theory

• The Market Segmented Theory--states that each
  borrower and lender has a preferred maturity, and
  that the slope of the yield curve depends on the
  supply and demand for short-term and long-term
  securities.

40
The Liquidity Theory

• States that investors generally prefer short-term
  securities t while borrowers generally prefer to
  borrow long-term.
• Long-term rate is generally higher than
  short-term rate.

41
Expectation Theory

• States that the yield curve depends on investors
  expectations about future interest rates. If
  inflation is expected to rise, the yield curve
  will be upward-sloping
• Conclusion is that all these theories have merit,
  and each of the above factors influences the
  shape of the curve.

42
Corporate Income Tax
43
Deductions from Incomes

• Depreciation
• Straight line
• Accelerated Cost Recovery
• Interest expenses
• Dividend income
• Operating losses

44
Corporate Income Tax

• The Tax Schedule
• The marginal tax rate is that rate paid on the
  next dollar of corporate income.
• The average tax rate is that rate paid on all
  corporate income.
• When are both equal to 34?
• Tax Problems
• Capital loss
• Capital gain

45
Tax Schedule
46
Calculation of Taxable Income
47
Tax Liability

• Tax Liability 3,413 .28(40,900 - 22,750)
  8,495

48
Calculation of Marginal Taxes

• Average Tax Rates Tax Liability / Taxable
  Income
• Marginal Tax Rate Change in Tax
  Liability/Change in Taxable Income

49
After Tax Yields

• A single individual in the 28 marginal tax
  bracket has two investment opportunities with
  the following yields
• 7 state of California municipal bonds
• 10 IBM corporate bonds
• Which alternative is the best?
• After tax yield BTY -Taxes BTY (1-T)