Financial Markets

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Financial Markets Institutions
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Mutual Funds

• Total assets in U.S. Mutual funds is over 5
  trillion
• 1971- 94 of industry assets were in equity funds
• Today, 51 of the assets are in stock funds
• 16 are in bond funds
• 26 are in money market funds
• 7 hybrid funds
• Funds that invest in a mix of equity and debt
  securities

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Mutual Funds

• Regulated by SEC
• Investment Company Act of 1940
• Purpose is to foster public confidence
• Imposes very strict controls on mutual funds
• Prohibits fund sponsor from selling securities to
  the fund
• Requires the funds assets to be held by
  independent custodian
• Strict limits on leveraging
• Requires independent directors

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Mutual Funds

• Lack of barriers to enter
• Sponsored by
• Investment advisory firms
• Brokerage firms
• Insurance companies
• Banks
• Foreign firm
• Open market environment
• Encourages competition

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Mutual Funds

• Growth
• Multiple distribution channels
• Directly from mutual fund companies
• Employer-sponsored retirement plans
• 401 (k)
• Over 1 trillion in mutual funds
• Full service brokers
• Discount brokers
• Insurance agents
• Financial planners
• Banks

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Mutual Funds

• Offer family of funds
• Fidelity
• Vanguard
• TD Waterhouse
• Smith Barney
• Typically can move from one fund to another
  without costs

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Mutual Funds

• Taxation of Mutual Funds
• Must distribute 90 of their net investment
  income earned to not pay taxes
• Capital gain distributions must occur annually

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Regulation of Funds

• Investment Company Act of 1940
• Must register with SEC
• File periodic reports
• Distribution channels are everywhere
• Supermarkets
• Advisors
• Variable annuities

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Types of Mutual Funds

• Open Mutual Funds
• Fund is priced at fair market value
• The closing market value for listed public
  securities
• Prices all of the funds holdings at the market
  close and adds up their value
• Subtracts amounts owing and adds amounts to be
  received by the fund
• Divides this net amount by the number of units
  outstanding to strike the NAV
• Any purchases and withdrawals for the day receive
  this unit value

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Types of Mutual Funds

• Money Market Funds
• Bond Funds
• Asset Allocation Funds/Growth Income
• Stocks and bonds
• Stock Funds
• Global International
• Sector Funds
• Index Funds
• Socially Responsible Funds

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Open Mutual Funds

• Keep some of their money in MM for redemptions
• May do short term borrowing for redemptions

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Closed Mutual Funds

• Financial securities traded on the stock market
• Sponsor creates a trust fund
• Raises funds through an underwriter
• Their value is what investors will pay for them
• Same as stocks and bonds
• Many trade at discount to their NAV

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Closed Mutual Funds

• Examples of Closed Mutual Funds
• From Morningstar
• the majority of closed-end funds are bond funds

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Open End v. Closed End

• One big difference between the two formats is
  that open-end funds sell new shares and redeem
  existing shares for investors every day, causing
  net assets to fluctuate--often wildly--even if
  the NAV isnt changing much.
• With some exceptions, closed-end funds sell
  shares to investors only once, in an initial
  public offering (IPO).
• When shareholders want to sell their closed-end
  fund shares, they must sell to other investors
  through brokers, as with a common stock.
• Most closed-end funds are listed on the New York
  Stock Exchange.

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Closed End Funds

• Sold at Premiums and Discounts from NAV-The two
  prices of a closed-end fund means that it usually
  is bought and sold at a price higher or lower
  than its NAV.
• Most closed-end funds sell at discounts to their
  NAV.
• For years, academics and other researchers have
  come up with a variety of theories why thats so,
  but none of the theories has proven itself
  consistently enough to be considered a definitive
  explanation.
• For buyers, the opportunity to purchase a fund at
  a discount is a key advantage of the closed-end
  structure.
• If a fund performs well, investors may push the
  share price to a premium, or at least a narrower
  discount. Thus shareholders reap the benefits not
  only of the fund's NAV advance, but the
  exaggerated effects of its market-price movement.

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Closed End Funds History
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Closed End Funds

• No Redemptions, No Inflows
• The managers of closed-end funds have one
  advantage over their open-end counterparts.
• Because closed-end funds have fixed asset bases,
  their managers don't need to meet sudden
  redemption requests from panicky shareholders,
  nor can they be forced to invest vast new inflows
  of cash in a market that already seems pricey.

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Closed End Funds

• A closed-end fund issues a set number of shares
  in an initial public offering, just like a stock,
  and it only issues more shares if it makes a
  secondary offering, also like a stock. After the
  IPO, the fund's shares can only be traded on the
  secondary market.

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Alternative to Mutual Funds

• Exchange traded funds (ETF)
• Mutual funds can only be transacted at the end of
  the day (closing Price)
• EFT
• Act like mutual funds
• Trade like stocks
• Open ended but act like close ended funds
• QQQ (tracks Nasdaq 100)
• SPY

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EFT (Exchanged-Traded Funds)

• Introduced in 1993
• Similar to mutual funds
• Trade like stocks
• Open ended
• Like closed ended mutual funds
• Sell at premium or discount from their NAV
• Started on AMEX with SP 500
• Not actively managed

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EFT v. Closed End Funds v. Open End Funds

• How They're SimilarBoth ETFs and closed-end
  funds represent portfolios of securities (stocks,
  bonds, cash, etc.), just like open-end mutual
  funds.
• A key way they differ from open-end mutual
  funds--is that they are traded on an exchange
• About three quarters of ETFs are traded on the
  American Stock Exchange
• About three-quarters of closed-end funds are
  traded on the New York Stock Exchange

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EFT v. Open End Funds

• Taxation
• Owner is taxed on dividends and capital gains
• Open End Funds
• May have to sell some assets for redemptions
• Will trigger gains/loses
• EFT
• Upon redemptions
• No taxable event to the remaining investors
• Only subject to gains/losses when investor sells
  their shares
• Very low portfolio turnover
• Less likely to realize significant capital gains

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EFT Examples

• SPDRS (SPY)-SP 500
• Diamonds (DIA)-Dow Jones
• QQQ (QQQ)-Nasdaq 100 index

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EFT v. Closed End v. Open End Funds

• And How They're Different
• Cost
• The average ETF in Morningstar's database has an
  expense ratio of 0.46, while the average
  closed-end fund has an expense ratio of 1.38.
• Can be bought and sold intraday
• Very flexible
• Limit orders
• Stop orders
• Short sell orders
• Buy on margin

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Share Classes of Mutual Funds

• No Load
• No commissions
• Class A-Front Load (charged at time of purchase)
• The SEC does not limit the size of sales load a
  fund may charge, but the NASD (National
  Association of Securities Dealers) does not
  permit mutual fund sales loads to exceed 8.5.
• The percentage is lower if a fund imposes other
  types of charges.
• Most funds do not charge the maximum

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Share Classes of Mutual Funds

• Class B-Deferred Sales charge or back end load
• The most common type of back-end sales load is
  the "contingent deferred sales load," also
  referred to as a "CDSC," or "CDSL.
• The amount of this type of load will depend on
  how long the investor holds his or her shares and
  typically decreases to zero if the investor hold
  his or her shares long enough.
• Example, a contingent deferred sales load might
  be 5 if an investor holds his or her shares for
  one year, 4 if the investor holds his or her
  shares for two years, and so on until the load
  goes away completely. The rate at which this fee
  will decline will be disclosed in the funds
  prospectus.
• Class C- Charged if redeemed during the first
  year

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Capital Gains and Dividends affect the Purchase
Price

• Funds asset decrease when distributes capital
  gains or dividend
• NAV drops proportionally
• No value lost
• Received either cash or additional shares to
  equal the decrease of NAV

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Affect of Dividend Paid

• You own 1,000 shares of a fund with NAV 10.50
• Fund distributes dividend of .50/share and NAV
  drops to 10.00
• You now own 1,000 shares _at_ 10/share for a total
  value of 10,000
• You also have 500 as distributed or an
  additional 50 shares of the fund if reinvested

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Investment Banking
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Investment Banking Functions

• Corporate finance
• Work to help companies raise capital
• Mergers and Acquisitions
• Setting up deals for buys and sells
• Project Finance
• Funding projects
• Trading
• Sales and trading of stocks, etc

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Investment Banking Functions

• Structured Finance
• Creation of financing vehicles to redirect cash
  flows to investors
• Asset-backed securities (CP, CMO, etc)
• Advisor
• Equity Fixed Income Research
• Assigned to an industry or region
• Public Finance
• Market for municipal bonds
• Retail Brokerage
• Institutional Sales
• Rating Analysts

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Investment Banking

• Top Investment Banking Firms
• Merrill Lynch
• Goldman Sachs Co
• Salomon Smith Barney/Citigroup
• Morgan Stanley/Dean Witter
• Lehman brothers
• Deutsche Bank
• J.P. Morgan Co
• PaineWebber Group
• Prudential securities
• AG Edwards sons

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Insurance Companies
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Insurance Companies

• Financial intermediaries function as risk bearers
• Provide lifetime benefits of retirement policies
• Annuities
• Different types of risk
• Life
• Health
• Property Casualty
• Liability
• Disability
• Long-term care

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Insurance Companies

• Collects premiums and invests the receipts in
  portfolio
• Payments contingent on potential future events
• Policy is a liability

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Insurance Regulation

• State level
• Each state sets its own regulations as to
• Types of securities eligible for investment
• How the value of the securities must be reported
• Pension funds
• Must comply with ERISA (Employee Retirement
  Security Income Act of 1974)

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Forms of Insurance Companies

• Stock
• Shares are owned by independent shareholders
• Traded publicly
• Shareholders only care about performance
• Dividends
• Stock appreciation

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Forms of Insurance Companies

• Mutual company
• No stock
• No external owners
• Policyholders are the owners
• Care about their insurance policies
• Companies ability to pay on the policy

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Types of Life Insurance

• Just insurance protection
• Term policy
• Permanent Life
• Whole life
• Cash value accumulate
• May be borrowed
• If cancel get cash value
• Variable Life
• No guaranteed or fixed cash value
• May allocate payments to investment accounts

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Types of Insurance Companies

• Fixed Annuities
• Single payment
• Policyholder gets fixed payments for life
• Universal Life
• Pays market rate
• Buys term insurance
• Insurance company charges a fee instead of living
  off spread of premiums and returns

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Insurance Companies

• Assets usually consist of debt
• Bonds to match maturities and liabilities

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Pension Funds
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Pension Funds

• Set up to pay retirement benefits
• Types
• Defined Benefit Plan
• Guarantee retirement benefits
• Plan buy annuities from insurance companies
• Shifts risk
• Called insured pension plans
• Misnomer because the insurance company may
  default
• PBGC (Pension Benefit Guaranty Corporation)
• Established under ERISA (Employee Retirement
  Security Income Act)
• Provides benefits in the event the sponsor
  discontinues the plan

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Pension Funds

• Defined Contribution Plan
• No guarantees by employer
• 401 (k)
• Cash Balance Pension Plan
• Each account is credited for the appropriate
  amount

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Pension Fund Regulations

• ERISA Act of 1974
• Employee Retirement Income Security Act
• Minimum funding standards
• Fiduciary responsibility
• Minimum investing standards
• After 5 years a participant is entitled to 25 of
  accrued pension benefits
• Created PBGC for vested benefits

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Mortgage Markets
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Mortgage Market

• Pledge of real property to secure a bond
• Insurance is available under
• VA
• FHA
• Private mortgage corporations
• Bonds secured by real property
• Originated by banks and mortgage bankers
• Long term bonds
• Fixed rate
• Variable rate

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Mortgage Market

• Original lenders income comes from
• Origination fees
• Percent of the borrowed amount
• Selling the mortgage for a higher price on the
  secondary market
• Servicing fees
• Escrow accounts

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Mortgage Banking

• Make loans to large developers
• They do not hold the loans
• Sell the immediately in the secondary market
• Federal Home Loan Mortgage Corporation (FHLMC)
  Freddie Mac
• Federal National Mortgage Association (FNMA)
  Fannie Mae
• Mortgagee charges service fees to above

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Mortgage Backed Securities

• Asset securitization
• Pooling of mortgages
• Issuing securities backed by the cash flows of
  the mortgages
• Thrift originates mortgages
• Sells them to an investment banker (agency)
• Creates a security backed by that pool
• Credit risk is shifted to the investor
• Thrift will continue to service the mortgage for
  a fee

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Securitization of Mortgage Loans

• FHA
• VA
• Private Mortgage Insurance
• FNMA FHLMC
• Purchase mortgages
• Provide thrifts with liquidity
• GNMA (Ginnie Mae
• Guarantee securities issued by private entities
  who pool mortgages together
• Use the mortgages as collateral for the security
  sold

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GNMA

• Largest type of mortgage securities outstanding
• Guaranteed by the full faith and credit of U.S.
• Payment Principle Interest
• Only mortgages insured or guaranteed by either
• FHA
• VA
• Farmers Home Administration
• Can be included in the mortgage pool

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Mortgage Securities

• Federal Home Loan Mortgage Corporation
• Second largest agency of securities outstanding
• Security is called a participation certificate
  (PC)
• Mortgages consist of conventional mortgages
• Guarantee only the timely payment of interest
• Principle is passed through as it is collected

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Mortgage Securities

• Federal National Mortgage Association (FNMA)
• Guaranteed by Fannie Mae
• Interest and principal
• Not obligations of the U.S. government

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Prepayment Risk

• Unknown cash flow
• Depends on prepayments
• Principle
• Pay-offs

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Commercial Backed Securities

• Issued by private entities
• No government guarantees
• CMBS