Financial Markets and Instruments

1
Lecture II

• Financial Markets and Instruments

2
Markets and Instruments

• Money Marketincludes short-term, marketable,
  liquid, low risk debt securities (cash
  equivalents)
• Debt Instruments
• Derivatives
• Capital Market includes longer-term riskier
  securities
• Fixed income capital markets (longer-term)
• Treasury bonds notes, Federal agency debts,
  Municipal bonds, Corporate bonds,
  Mortgage-backed securities. Bonds
• Equity markets
• common stocks, preferred stocks
• Derivatives
• options, futures

3
Money Market Instruments

• Treasury bills
• Certificates of deposit
• Commercial Paper
• Bankers Acceptances
• Eurodollars
• Repurchase Agreements (RPs) and Reverse RPs
• Federal Funds

4
Treasury Bills

• The government raises money by selling bills to
  the public. Investors buy the bills at a discount
  from the stated maturity value.
• most marketable discount bond
• maturities 91, 182 days, 52-week bills
• minimum denomination 10,000
• interest (income) exempt from all state and
  local taxes (not from federal tax)
• T.B yields are quoted as the bank discount
  yield

5
Bank Discount Yield

• rBD 10,000 - P x 360
• 10,000 n
• where P the bond price n the maturity
  in days rBD the bank discount yield
  10,000 par value.
• To determine the T-bills true market price P
  10,000 x 1 - rBD x n/360
• Ex. T-bill sold at 9,500 with a maturity of a
  half year (182 days)
• rBD (500/10,000) x (360/182) 0.0989
  (9.89)
• Effective annual yield reay
• ( 1 500/9,500 )2 - 1 0.1080 (10.8)

6
Certificate of Deposits (CD)

• a time deposit with a bank
• The bank pays interest and principal to the
  depositor only at the end of the fixed term of
  the CD.
• denomination gt 100,000 are usually negotiable
• Can be sold to another investor if the owner
  needs to cash in the CD before its maturity date.
• insured up to 100,000 by the FDIC

7
Commercial Paper (CP)

• short-term, unsecured debt (promissory) notes
  issued by large corporations with strong credit
  ratings
• the biggest source of short-term funding for
  blue-chip U.S. corporations
• maturities up to 270 days. Bought by money market
  funds, insurance companies, and any firm needing
  to park extra cash
• issued in multiples of 100,000, about 1.6
  trillion market
• Small investors can invest in commercial paper
  only indirect, via money market mutual funds.
• fairly safe

8
Bankers Acceptance

• widely used in foreign trade (creditworthiness)
• an order to a bank by a banks customer to pay a
  sum of money at a future date
• the bank endorses the order for payment
  (accepted)
• The acceptance may be traded in secondary markets
  like any other claims on the bank.
• Acceptances sell at a discount from the face
  value of the payment order.

9
Eurodollars (CD)

• dollar-denominated deposits at foreign banks or
  foreign branches of American banks
• Despite the tag Euro, these accounts need not
  be in European banks.
• the liability of a non-US branch of a bank less
  liquid, riskier than domestic CDs, offer higher
  yields, no FDIC protection.

10
Repos and Reverses

• Repurchase agreement
• Short-term, usually overnight borrowing
• the dealer sells government securities to an
  investor on an overnight basis, with an agreement
  to buy back these securities the next day at a
  slightly higher price.
• A reverse repo is the mirror image of a repo.
• Buy government securities from an investor and
  agree to sell them back at a specified higher
  price on a future date

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Federal Funds

• member bank maintains reserve requirement in
  federal funds
• arise as a way for banks to transfer balances to
  meet reserve requirement
• F. F. rate on very short-term loans among
  Financial Institutions.

12
LIBOR market (London Interbank Offered Rate)

• the rate at which large banks in London are
  willing to lend among themselves
• serves as a reference rate, in the European money
  market

13
Note

• The risk premium over T-bills (i.e., the spread)
  increases with economic uncertainty (or crisis)
  because investors demand a greater premium on
  debt subject to default risk.

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Capital Market - Fixed Income Instruments

• Publicly Issued Instruments
• US Treasury Bonds and Notes
• Agency Issues (Fed Gov)
• Municipal Bonds
• Privately Issued Instruments
• Corporate Bonds
• Mortgage-Backed Securities

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Treasury Notes and Bonds

• maturities up to 10 years/ 10 - 30 years
• denominations of 1,000 or more
• coupon bonds semiannual payments
• T. bonds (not notes) may be callable
• Quoations
• Coupon 43/447.50/year
• Bid 9112/3291.375 of par value
• Ask 9114/32 91.4375 of par value
• YTM6.08 based on the ask price

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Federal Agency Debt

• Home mortgages FHLB, FNMA (Fannie Mae), GNMA
  (Ginnie Mae), FHLMC (Freddie Mac)
• FHLB borrow money by issuing sec. and lend this
  money to SL to be lent in turn to individual
  home buyers
• Farm Credit related agencies (banks)
• If the agencies are government owned, their debt
  is fully free of default risk.

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International Bonds

• Borrow money abroad
• A Eurobond is a bond denominated in a currency
  other than that of the country in which it is
  issued.
• A dollar-denominated bond sold in London
• A foreign bond is to issue bonds in foreign
  countries but in the currency of the investors.
• Yankee bond

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Municipal Bonds

• issued by state and local governments
• general obligation bonds and revenue bonds
  (airport, hospital, etc)
• tax-exempt interest income is exempt from
  federal income tax also is exempt from state
  local taxation in the issuing state capital
  gains are not exempt

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Equivalent Taxable Yield

• the equivalent taxable yield of the municipal
• r rm / (1 - t),
• where rm the rate on municipal bonds t the
  investors marginal tax bracket r the total
  before-tax rate of return on taxable bonds.
•  
• Ex. rm 10 t 28 then r 13.89,
• if t 36 then r
  15.625
• ? the higher the bracket, the more valuable the
  tax-exempt feature of municipals.
•  
• Ex. A municipal bond carries a coupon of 6 and
  is trading at par to a taxpayer in a 36 tax
  bracket, this bond would provide a taxable
  equivalent yield of 9.375.

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Corporate Bonds

• semiannual coupons
• default risk
• secured bonds collateral
• unsecured bonds ( debentures)
• subordinated debentures
• lower priority claim
• callable bonds
• The option to repurchase the bond from the holder
  at a stipulated call price
• convertible bonds

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Mortgages Mortgage-backed securities

• fixed rate/ adjustable rate
• Ex, 2 above the current rate on one-year T-bills
  and might be adjusted once a year.
• Set a cap
• securitization of mortgage loans ex. A 10
  coupon GNMA
• called pass-throughs

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Equity Securities

• Common stock
• ownership shares in a corporation
• Residual claim
• Limited liability

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Equity Securities

• Preferred stock
• hybrid of equity debt
• like a bond, pays fixed dividends (perpetuity),
  but no voting power
• like a stock, the failure to pay dividends ? no
  bankruptcy dividends are cumulative
  (non-cumulative exists)
• not tax-deductible expenses for the firm
• corporations (not individuals) may exclude 70 of
  dividends received from domestic corporations in
  the computation of their taxable income
  (advantage over bonds)
• a firm's preferred stock often sells at yields
  below its bond
• may be callable (redeemable) by the issuing firm
• may be convertible into common stock

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Understand the Different Types and Uses of
Indices

• Key Types of Indices
• Asset Class
• Stocks large cap, small cap., mid cap.,
  international, emerging markets, etc.
• Bonds long-term, short-term, corporate bonds,
  government bonds, convertible bonds, etc.
• Other Asset Classes real estate, currencies,
• Geographical
• Global, Regional, Country, Industry
• Investment Style
• Growth, Blend, Value

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Geographical Indices

• Global
• Follows the performance of a set of assets from a
  specific set of countries, i.e., MSCI World, MSCI
  AC Free. International includes only countries
  outside the US
• Regional
• Follows the performance of a set of assets from a
  specific region of the world , i.e., MSCI EAFE,
  DJ Asia
• Country
• Follows the performance of a specific set of
  assets from a specific country , i.e., SP 500,
  Russell 5000, Dow Jones
• Industry
• Follows the performance of a set of assets from a
  specific industry, whether global, regional, or
  country.

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Investment Style Indices

• Growth
• These indices follow a portfolio of stocks that
  are expected to achieve accelerated growth,
  whether because of increased earnings, dominant
  market position, or other factors
• Value
• This indices follow on stocks that are currently
  undervalued by the market. It is generally
  determined by using price-book or price-earnings
  ratios, discounted cash flow models, or other
  means.

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Uses of Indices

• Uses
• 1. Tracks average returns for a specific asset
  class
• 2. Used to compare performance of mutual fund
  managers in similar asset classes
• 3. Use as a base on which derivatives are
  structured
• Key Questions in Constructing or using an Index
• Is it representative of the performance or assets
  desired?
• Is it broad or narrow, i.e. how many securities
  in the index?
• How is it constructed, i.e. price, market cap,
  equal, or float weighted?

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How they are Indexes Constructed

• How are stocks weighted?
• Price weighted DJIA, Nikkei
• Market-value weighted SP 500, NASDAQ, some
  MSCI country/regional indices
• Equally weighted Value Line Index, MSCI Equal
  Weighted Indices

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How They Are UsedThe Importance of
Understanding Indices

• Indices are the standard from which an analyst or
  portfolio manager is judged
• Get to know your standard in detailyour career
  (and bonus) depends on it!
• How is it weighted?
• How often are the constituents changed?
• Which are the biggest companies in the index?
• What strategies can help you to beat the index?
• If you dont know what is in your index and how
  it is calculated, how can you ever expect to beat
  it (and hence advance in your job)?
• Knowledge is power!

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Stock Market Indexes

• Dow Jones Averages
• DJIA 30 large blue chip corporations since
  1896
• 1896 12 stocks 1916 20 stocks 1928 30
  stocks
• price-weighted average
• DJIAt ?P/30 simple average of prices
• the ? in the DJIA measures the return on a
  portfolio that invests one share in each of the
  30 stocks in the index
• DJIAt
• the divisor adjusted for stock splits
  replacements

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What is a Blue Chip Stock?

• Blue chip stocks is a general term that is
  loosely applied to companies that are generally
  considered to be leaders in their industry, are
  typically very large in terms of market
  capitalization (the number of shares outstanding
  multiplied by their current market price), are
  considered to be mature (ie. they are not
  necessarily rapidly growing in terms of sales or
  stock price) and often pay a substantial and
  consistent cash dividend.

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Dow Jones Averages

• Companies included in the average are those
  selected by Dow Jones Company, publisher of the
  Wall Street Journal
• The composition of the average changes over time
  as companies are dropped because of a merger or
  bankruptcy has occurred, because a companys
  trading activity is low, or because a company not
  in the average becomes very prominent.
• When a company is replaced by another company,
  the average is readjusted in such a way as to
  provide comparability with earlier values.

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Dow Jones Averages

• The use of the DJIA as a performance benchmark is
  sometimes criticized for the fact that
  high-priced stocks have a greater impact on the
  value of the index than low-price stocks. That
  is, changes in the price of a 100 stock like IBM
  will have a greater impact on the value of the
  DJIA than changes in the price of a 30 stock
  like Intel.

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Dow Jones Averages

• Example If firm B were to split two for one ()
• ___________________________________________
• firm initial final shares(mil)
  initial final
• price(0) price(1)
  value value
• A 20 25 20
  400 500
• B 40 30 5
  200 150
• B 20 15 10
  200 150
•  
• DJIA0 (2040)/230 DJIA1 (2530)/227.5
• After a split (20 20)/d 30 ,
• ? d 1.333 (new divisor)
• After a split
• DJIA0 (20 20)/d 40/1.333 30 ( DJIA0
  w/o split)
• DJIA1 (25 15)/d 40/1.333 30 (? DJIA1 w/o
  split)
• Due to UTX stock split on 6/10/2005 the new DJIA
  divisor is now  .13033708.

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Dow Jones Averages

• Example If firm B were to split two for one ()
• ___________________________________________
• firm initial after shares(mil)
  final final
• price split
  price shares
• A 25 25 200
  30 200
• B 100
• B 50 45 20
  45 20
•  
• DJIA0 (25100)/262.5
• After a split (25 50)/d 62.5 ,
• ? d 1.2 (new divisor)
• DJIA1(3045)/1.262.5
• If stock XYZ had not split 2 for 1, the level of
  the price-weighted index at the close of trading
  on date 1 would have been
• DJIA1(3090)/260

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Citicisms of the DJIA

• Limited sample size
• 30 nonrandomly selected blue-chip stocks make up
  the average
• the stocks selected are the largest and most
  pretigious companies in various industries.
• The DJIA, therefore, probably reflects price
  movements for large, mature, blue-chip firms
  rather than the typical company listed on the
  NYSE
• Several studies have pointed out that the DJIA
  has not been a volatile as other market indexes
  and that the long-run returns on the DJIA are not
  comparable to other NYSE stock indexes.

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Citicisms of the DJIA

• Weighting Scheme
• because the DJIA is price weighted, when
  companies split their stock, their prices
  decline, and therefore their weight in the DJIA
  is reduced - even though they may be large and
  important.
• Therefore, the weight scheme casues a downward
  bias in the DJIA, because the stocks that have
  higher growth rates will have higher prices, and
  because such stocks tend to split, they will
  consistently lose weight within the index.

38
Dow Jones Averages

• Dow Jones Averages 30 industrials, 20
  transportation, 15 utilities ? 65 composite
• the DJIA based on small number of firms not
  value-weighted
• as of Nov. 1, 1999
• In Microsoft Corp., Intel Corp., Home Depot
  Inc., and SBC Communications inc.
• Out Chevron, Goodyear, Sears Roebuck, Union
  Carbide
• as of April 1, 2004
• Out ATT Corp., Eastman Kodak Co., and
  International Paper,
• In Verizon Communications Inc., a company formed
  after the breakup of the old ATT, insurer
  American International Group Inc., and Pfizer
  Inc., the nation's biggest drugmaker.
• recognize trends within the U.S. stock market,
  including the continued growth of the financial
  and health care sectors,"

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Dow Jones Averages

• Currently Alcoa, Allied Signal, American
  Express, American International Group Inc,
  Boeing, Caterpillar, Citigroup, Coca-Cola,
  DuPont, Exxon, General Electric, General Motors,
  Hewlett-Packard, Home Depot, IBM, Intel, Johnson
  Johnson, McDonald, Merck, Microsoft, 3M, JP
  Morgan, Pfizer, Phillip Morris, Proctor Gamble,
  SBC Communications, United Technologies, Verizon
  Communications, Wal-Mart Stores, Walt Disney.

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Standard Poors Indexes

• the SP 500 improvement over the DJIA
• a more broadly based index of 500 firms
• a market-value-weighted index unaffected by
  stock splits
• 400 industrials, 20 transportation, 40 utilities,
  40 financial indexes
• the SP index funds provide a low-cost passive
  investment strategy
• ? SP 500 Index ? P it Q it / ? P it-1 Q it-1
• total mkt value today/ total mkt value on
  prev. day
•  81 of the mkt value of companies on the NYSE

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Value-Weighted Stock Indexes

• If we set VWI0 (date 0 index level) equal to 100,
  the closing level of the value-weighted index at
  date 1, VWI1 , will be
• which is equal to 115, giving a return for the
  value-weighted index of 15.

42
Value-Weighted Stock Indexes

• In a value-weighted series, there is an automatic
  adjustment for stock splits and other capital
  changes (since the decreased price of the share
  is offset by an equal and opposite effect of an
  increase in the number of shares outstanding).
• In a value-weighted index, the importance of
  individual stocks in the sample depends on the
  market value of the stocks. Therefore, a
  specified percentage change in the value of a
  large company has a greater impact than a
  comparable percentage change in a small company.

43
Value-weight Indexes

• Price changes for the large market value stocks
  in a value-weighted index will dominate changes
  in the index over time.
• This value-weighted effect was prevalent on U.S.
  stock markets (NYSE, OTC) in 1998 when the market
  was being driven by large growth stocks - that
  is, almost all of the gain for the year was
  attributable to the largest 50 of the SP 500
  Index.

44
Other market indexes

• the NYSE Index a mkt value-weighted composite
  index of all NYSE listed stocks
• the AMEX Index also mkt value-weighted
• the NASDAQ (National Assoc. Sec. Dealers
  Automatic Quotations) mkt value-weighted
• the Wilshire 5,000 Index the mkt-value of all
  NYSE AMEX stocks plus actively traded OTC
  stocks
• called total mkt index
• includes about 7,000 stocks
• Russell 2000 small stock ( mkt capitalization
  below 1.5 bill) performance

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Equally Weighted Index

• places equal weight on each return
• corresponds to an implicit portfolio strategy
  that places equal dollar value on each stock
• Ex. Stocks A B C
• return 10 -6 15
• An equally weighted arithmetic avg rA
• rA (0.10 - 0.06 0.15)/3 0.06333
• An equally weighted geometric avg rG
• rG (1.10)(0.94)(1.15) 1/3 - 1.0 0.0594
• The Value Line Index an equally weighted
  geometrical avg of the performance of about 1,700
  firms

46
Construction of Indexes

• How are stocks weighted?
• Price weighted DJIA, Nikkei
• Market-value weighted SP 500, NASDAQ, some
  MSCI country/regional indices
• Equally weighted Value Line Index, MSCI Equal
  Weighted Indices
• How returns are averaged?
• Arithmetic (DJIA and SP500)
• Geometric (Value Line Index)

47
Foreign Stock Mkt Indexes

• the Nikkei 225 a price-weighted average of the
  largest Tokyo Stock Exchange stocks
• the Nikkei 300 is a value-weighted index
• Topix market value -weighted index
• The Tokyo Stock Price Index('TOPIX') is a
  composite index of all common stocks listed on
  the First Section of the Tokyo Stock Exchange
  (TSE).
• The index is basically a measure of the changes
  in aggregate market value of TSE common stocks.
  The base for each of the index is the aggregate
  market value of its component stocks as of the
  close on January 4, 1968, the first trading day
  of the year.

48
Foreign Stock Mkt Indexes

• the FTSE 100 (footsie)
• a value-weighted index of 100 of the largest
  London Stock Exchange corporations published by
  Financial Times of London
• the DAX index is the premier German stock index
• MSCI (Morgan Stanley Capital International) stock
  indexes
• computes over 50 country indexes and several
  regional indexes market-value weighted indexes
  of other non-US stock markets
• EAFE (Europe, Australia, Far East), the World
  Index