Ch. 15: Financial Markets

• Financial markets – link borrowers and lenders. – determine interest rates, stock prices, bond prices,

etc.• Bonds

– a promise by the bond-issuer to pay some specified amount(s) in the future in exchange for some payment (the bond price) today.

• Stocks (equities)– legal rights of ownership in an incorporated firm.– promise the stockholder a share of the corporte

profits (dividends)

The Bond Market.Maturity date: • A bond's maturity date refers to the specific future date on which the

maturity value will be paid to the bond holder. Bond maturity dates when issued generally range from 3 months up to 30 years.

Coupon rate• Between the date of issuance and the maturity date, the bond-

holder receives an annual interest payment equal to the coupon rate times the maturity value.

Yield to maturity• represents the effective interest rate that the bond-holder earns if

the bond is held to maturity.Bond price• The price that the bond sells for. This fluctuates over the life of the

bond. – *If the bond price is equal to 100% of its maturity value, the bond sold at

“par”. – If the bond price is below 100% of its maturity value, the bond price sold

“below par”.

The Bond Market

• 20 year bond with maturity value of $1000 and coupon rate of 5% promises– 20 annual payments of .05*1000=$50– $1000 payment at maturity (20 years from

now). – If price is $1000 for this bond, the bond sold

for par.

Present ValuePV of $X to be paid in T years

Amount that if deposited today would grow to $X in T years $X/(1+r)T

Example: $100 deposited today at 10% interest will grow to:

$100(1.1) in 1 year$100(1.1)2 in 2 years$100(1.1)3 in 3 years$100(1.1)T in T years

i.e. (FV) Future value of $x deposited today=$x(1+r) T

Rearrange above equation to solve for x $x = FV/(1+r) T

If you deposit $1000 in your account today and it earns 6% interest, what will your account balance be in 5 years? (Give your answer to nearest dollar without dollars sign – e.g. 2372)

20

If you want to have $1000 in your account in 15 years, how much you put in your account today if the interest rate is 6%? (Give your answer to nearest dollar without dollars sign – e.g. 237)

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The Bond Market.Computing yields on a bond.

• The yield on a bond is the same as the internal rate of return. To calculate the yield to maturity, define net present value (NPV) as follows:

NPV = CP1/(1+r) + CP2/(1+r)2 + .... + CPT/(1+r)T + MV/(1+r)T - P

• CP1, CP2, ... CPT are the interest or coupon payments in periods 1-T

• MV is the payment received at maturity• P is the price paid for the bond.

• The yield to maturity is the interest rate that makes the NPV on the bond purchase zero.

The Bond Market.One year bonds

NPV = MV(1+cr)/(1+r) - P where cr is the coupon rate.Setting NPV=0 and solving for r provides the yield to maturity:

yield = [MV(1+cr)/P] - 1

– As the price paid for a bond increases, the yield on the bond falls.

– If P=MV (i.e. pay par), yield=CR– If P>MV, (i.e. pay above par), yield<CR– If P<MV, (i.e. pay below par), yield>CR

As the price of bonds rise, interest rates fall.

True

False

50%50%1. True

2. False

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Suppose you buy a one-year bond for $900. It has a maturity value of $1000 and a coupon rate of 5%. What is the yield? (Give your answer to nearest one-tenth of a percent; do not include % sign -- e.g. 10.4)

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Suppose you buy a one-year bond for $1020. It has a maturity value of $1000 and a coupon rate of 5%. What is the yield? (Give your answer to nearest one-tenth of a percent; do not include % sign -- e.g. 10.4)

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The Bond Market.Zero Coupon Bonds.

• With zero coupon bonds, no interest payments are made between the sale of the bond and its maturity. That is, there is a zero coupon rate. For such bonds, the yield calculations is straightforward.

NPV = MV/(1+r)T - P

• setting NPV=0 and solving for r provides the yield:

yield = (MV/P)1/T - 1

• For example, if you buy a zero coupon bond today for $1000 and it has a maturity value of $1500 in 10 years:

yield = (1500/1000)1/10 -1 = .0414 = 4.14%

As the price paid for a bond increases, the yield on the bond falls.

Suppose you buy a 5 year zero coupon bond for $900 with a maturity value of $1000. What is the yield? (Give your answer to nearest one-tenth of a percent; do not include % sign -- e.g. 10.4)

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The Bond Market.

• Determinants of bond yields– Higher expected inflation will drive up yields.– Higher risk bonds must offer higher yields.

• Default risk.– Debt rating agencies:

» Moody’s & Standard and Poors» AAA=superior quality» C=imminent default

– Diversification to reduce risk.

• Inflation risk.

– Term• Longer term bonds have greater inflation and default risk.

The Bond Market.

• Yield curve– Shows relationship between yield and term on

government bonds– Slope of yield curve reflects

• Expectations of future short term interest rates• Greater risk of long term bonds

– If short term interest rates are expected to be constant in the future, yield curve will slope upward reflecting risk premia for longer term bonds.

– A steepening of the yield curve suggests that financial markets believe short term interest rates will be rising in the future.

• The bond market

The Stock Market

• Stocks (equities):– legal rights of ownership in an incorporated

firm.– promise the stockholder a share of the

corporte profits (dividends)

The Stock Market

• The “fundamental value” of a stock is the expected present value of all future dividends from a stock.

• P = d1/(1+r) + d2/(1+r)2 + d3/(1+r)3 + ....dT/(1+r)T

– where T is the end of the firm’s life (which might be infinite)

– d1, d2, ... dT represent dividend payments in years 1 through T.

– r is the interest rate

The Stock Market

• Given the fundamental value theory, stock prices will rise with:– lower interest rates.– an increase in future expected dividends.– A lower tax rate on dividends.

The Stock Market

• Efficient markets hypothesis: – All stock prices represent their fundamental

value at each point in time. – When new “information” arrives about a stock,

its price immediately adjusts to reflect that new information.

– It is impossible to consistently predict which way a stock price will move in the future and to consistently “beat the market”.

The Stock Market.

• If the efficient markets hypothesis is true, – financial advisors can assist you only in evaluating the

risk and tax consequences of different stocks and concerns regarding income or growth, etc.

– Financial advisors will not be able to consistently find stocks that will “beat the market”.

• The validity of the efficient markets hypothesis is controversial among economists.

The Stock Market

• Stock quotes (e.g. www.google.com/finance)

– Price– PE ratio (price-earnings ratio)– Volume (number of shares sold in previous

day)– Change (change in from previous day)– 52 week high and low– Beta (measures stock movements relative to

market)

Mutual FundsMutual Funds: a firm that pools money from many small investors to

buy and manage a portfolio of assets and pays the earnings back to the investors. Mutual funds can be categorized in several ways. For example:– index funds (S&P 500 or Willshire 5000)– international funds (invest in foreign securities)– bond funds (invest in bonds)– balanced funds (invest in bonds and stocks)– growth funds (invest in companies viewed as having high growth

potential)– sector funds (invest in a particular sector of the economy; e.g. health, or

financial services).– tax-exempt income funds (invest in tax exempt bonds)– money market funds (invest in short term government securities)

• The major advantage of mutual funds is that it allows a person to invest in the stock market and be diversified.

A stock with very high expected earnings growth that is likely to have:

A higher PE ra

...

A lower P

E rat..

.

A higher beta

A lower b

eta

25% 25%25%25%

20

1. A higher PE ratio

2. A lower PE ratio

3. A higher beta

4. A lower beta

If you thought that the stock market was going to rise sharply over the next six months, stock with a ______ should be especially attractive.

a higher P

E ra...

a lower P

E rat..

.

a higher b

eta

a lower b

eta

25% 25%25%25%

20

1. a higher PE ratio

2. a lower PE ratio

3. a higher beta

4. a lower beta

Options

• Options are contracts in which the terms of the contract are standardized and give the buyer the right, but not the obligation, to buy (call) or sell (put) a particular asset at a fixed price (the strike price) for a specific period of time (until expiration).

Options Market

• Call option on a security: – the right to call (buy) a security at the strike

price up until the expiration date of the option from the person that issued the call.

– If I sell you a call option on IBM with a strike price of $190 and an expiration date of 1/1/2009, you have the right to exercise the option until its expiration and force me to sell you IBM for $190. You will exercise the option only if IBM rises above the strike price of $190.

Options Market

• Put option on a security: – the right to put (sell) a security at the strike price up

until the expiration date of the option to the person that issued the put.

– If I sell you a put option on IBM with a strike price of $150 and an expiration date of 1/1/2009, then at any time between now and 2009 you can force me to buy a share of IBM for $150. You would exercise your put option only if the price of IBM falls below the strike price of $150.

Suppose that you bought a put option on IBM for $3 and it has an exercise price of $12. The option expires in 6 months. If IBM is selling for $14,

You should exe

rcise

the ...

You should not e

xercise

...

50%50%

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1. You should exercise the option

2. You should not exercise the option.

Suppose that you bought a put option on IBM for $3 and it has an exercise price of $12. The option expires in 6 months. If IBM is currently selling for $8, you should

not exercise t... exercise the o... exercise the o...

33% 33%33%

20

1. not exercise the option.

2. exercise the option and you will make a $1 profit (net of purchase price)

3. exercise the option and you will make a $5 profit (net of purchase price)

Suppose that you bought a call option on IBM for $3 and it has an exercise price of $12. The option expires in 6 months. If IBM is currently selling for $20, you should

Not exercise t... Exercise the o... Exercise the o...

33% 33%33%

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1. Not exercise the option.

2. Exercise the option since you will make a profit of $5 (net of purchase price).

3. Exercise the option since you will make a profit of $8 (net of purchase price).

Futures Market• A market for contracts that provide for future delivery of a good at

some pre-specified price. Futures markets exist for commodities, bonds, and foreign currencies.

• Example: If I agree to a 1/1/2009 futures contract to buy 1000 bushels of corn at $3.00 per bushel, I am committed to buying corn on that date at that price. The other party to the contract is committed to sell 1000 bushels at $3.00 per bushel. The person who agrees to buy corn has “bought” a futures contract. The person who agrees to sell the corn has “sold” a futures contract.

• If the expected price of a commodity in the future rises, the futures price will rise.

• The price in futures contracts provides an indicator of what people believe about the movement of prices in the future.

Suppose that you have private information that the price of oil will be much lower in six months. To

profit from this private information, you could:

Sell o

il in th

e futu

res ma...

Buy oil in th

e futu

res m

...

50%50%

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1. Sell oil in the futures market

2. Buy oil in the futures market

Which of the following would cause the price of oil to rise in the futures market?

News t

hat the ...

News t

hat a w

a...

News t

hat OPEC...

All of t

he abo...

25% 25%25%25%

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1. News that the demand for oil will be low due to a forecast for a warm winter.

2. News that a war is very likely to occur in the middle east which will disrupt oil production.

3. News that OPEC will increase oil production to increase revenues.

4. All of the above.