Markets Notes

Chapter 1 – Financial Markets and Institutions Student Notes

Chapter 1 – Financial Markets and Institutions

Overview

Introduction to financial markets

Introduction to financial institutions

Review of terms

Financial Markets

Channel through which financial assets are exchanged. Process also known as funds intermediation.

Surplus Units – suppliers of funds, because they spend less than they receive. Households are the only net supplier of funds.

Deficit Units – users of funds, because they spend more than they receive. Households, corporations, and governments can all be deficit units.

Financial Markets

Money Markets – markets that trade debt instruments with maturities of up to one year.

Treasury bills, commercial paper, federal funds, negotiable CDs, repurchase agreements, and banker’s acceptances.

Capital Markets – markets that trade equity and debt instruments with maturities of more than one year.

Stocks, bonds, and mortgages.

Primary Markets – markets in which corporations raise funds through new issues of securities, such as stocks and bonds.

May be first-time issues by firms initially going public, the sale of additional new shares of an already publicly traded firm, or first time debt issuances.

Secondary Markets – markets in which existing securities are traded. Organized Exchanges – physical meeting place and communication facilities are

provided for members to conduct their transactions.

Over-the-Counter (OTC) markets – no central location. Financial claims can be traded by phoning an OTC dealer or by using a computer system.

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Efficiency – Simply the idea that the market accurately prices the securities that are traded in them. Markets can be weak, semi-strong, or strong form efficient.

Regulation – Most important regulator is the Securities and Exchange Commission (SEC).

Globalization – Increased integration. It is becoming easier to acquire information about foreign companies and invest accordingly.

Financial Institutions

Institutions – serve as intermediaries because markets are not perfect.

Depository Institutions – receive deposits and make loans.

Commercial Banks – most dominant depository institution.

Savings Institutions – take in deposits and provide mortgage loans.

Credit Unions – take in deposits and provide retail loans.

Nondepository Financial Institutions – do not accept deposits from consumers.

Finance Companies – Spans a variety of fringe companies.

Consumer finance companies

Business finance companies

Sales finance companies

Nondepository Financial Institutions (cont.)

Mutual Funds – primary investment tool of many households.

Securities Firms – multiproduct firms that usually specialize in several market related activities.

Examples include brokerage houses, underwriters, investment banks, and market makers.

Nondepository Financial Institutions (cont.)

Hedge Firms – sells shares to upscale investors and are allowed to invest in risky assets. Largely unregulated.

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Insurance Companies – receive money from premiums and invest in financial securities.

Pension Funds – Governments and companies allow employees to invest money in securities.

Competition – U.S. banks face increasing foreign competition.

Consolidation – Banks continue to consolidate as regulations have relaxed.

Global Expansion – U.S. banks, insurance companies, and securities firms have expanded into foreign countries in recent years.

Key Trends Affecting Banks

Service Proliferation – rapidly expanding services.

Rising Competition – financial service firms entering other markets.

Government Deregulation – fewer restrictions.

Technological Change – ATMs, Point of Sale terminals, online payments, etc.

Consolidation and Geographic Expansion – roll-up of the industry continues.

Convergence – the movement of financial institutions across product lines.

Globalization – largest banks compete with each other internationally.

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Chapter 2 – Determination of Interest Rates Student Notes

Chapter 2 – Determination of Interest Rates

Overview

Introduction to interest rates

Interest rate theories

Economic forces that affect rates

Interest Rates – the price of borrowing money.

Relevance of Interest Rates

Direct influence on the valuation of debt securities.

Indirect influence on nearly all other financial instruments. ie. Stocks, exchange rates, derivative securities.

Loanable Funds Theory – rates are determined by the interaction between supply and demand for funds.

Demand:

Individuals and Households

Businesses

Governments

Foreign Demand

Aggregate Demand

Supply:

Individuals and Households – only net saver of funds

Businesses

Governments

Foreigners

Equilibrium Rate

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Factors that Cause the Supply Curve to Shift

Wealth – as total wealth increases, the supply curve shifts out.

Risk – as the risk decreases, the supply curve shifts out.

Near-Term Spending Needs – when participants have fewer spending needs, the supply curve shifts out.

Monetary Expansion – policy objects to allow expansion, the supply curve shifts out.

Economic Conditions – as domestic economic conditions improve relative to other countries, foreign inflows increase and the supply curve shifts out.

Factors that Cause the Demand Curve to Shift

Economic Conditions – during periods of economic growth, market participants borrow more heavily. The increase in demand increases the interest rate.

Economic Forces that Affect Interest Rates

Economic Growth – demand increases with growth and rates rise.

Inflation – Expected inflation decreases supply and increases demand, pushing rates higher.

Fisher Effect – nominal rate = real rate + expected inflation

Economic Forces that Affect Interest Rates

Money Supply – The Fed can affect the supply, and, therefore the interest rates.

Budget Deficit – Government deficits increase demand for funds, “crowding out” private demand, driving rates higher.

Foreign Flows – U.S. rates are increasingly more tied to the interest rates of other countries.

Unified Germany – Economic expansion drove rates up internationally.

Japan’s Recession – Weak economic growth lowers rates internationally.

Asian Crisis – Funds fled to more stable markets, driving rates down.

Summary – Economic forces affect supply and demand of money.

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Interest Rates Over Time

General Decline – we have seen a general decline in interest rates since the early 1980s.

Volatility – Rates were particularly volatile in the early 80s.

Fed changed policies in the early 80s creating instability.

Fed regained control in the late 80s and have been relatively stable.

Key Interest Rates

Federal Reserve Discount Rate – The rate the Fed charges banks that borrow from it.

Federal Funds Rate – the rate banks charge when they make short-term loans to each other.

Treasury Bills – short-term government securities. Commonly used as a benchmark “real” interest rate.

Prime Rate – a base rate that large, money center banks charge their best customers.

London Interbank Offer Rate (LIBOR) – the rate that European banks charge each other.

Mortgage Rates – reflect conditions in financial markets, in general.

Forecasting Interest Rates

Economic Models – estimating the statistical relationships between measures of the output of goods and services in the economy and the level of interest rates.

Flow-of-Funds Accounting – shows the movement of savings through the economy in a structured and comprehensive manner.

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Chapter 3 – Structure of Interest Rates Student Notes

Chapter 3 – Structure of Interest Rates

Overview

Factors Affecting Yields Among Securities

Term Structure

Uses of the Term Structure

Factors Affecting Yields Among Securities

Inflation – actual or expected inflation.

Real Interest Rates – the interest rate that would exist on a security if no inflation were expected over the holding period of a security.

Fisher Effect – the relationship among nominal interest rates, real interest rates, and expected inflation.

Nominal Rate = Real Rate + Expected Inflation

Base Interest Rate – Treasury securities.

Credit (Default) Risk – the risk that a security’s issuer will default on that security by missing an interest or principal payment.

Liquidity – The risk that a security can be sold at a fair market price in a short period of time.

Tax Status – Taxable securities must pay a higher yield than similar tax exempt securities.

Municipal Securities – Free of federal taxes and may be free of state and local taxes.

im = ic(t – tf)

im= ic(t – tf – ts)

Term to Maturity – The length of time until the principal amount borrowed becomes payable.

Special Provision – call features, convertibility options, and other provisions will influence the yield of the security.

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Chapter 3 – Structure of Interest Rates Student Notes

Actual Yield Differentials

Term Structures of Interest Rates – the relationship between yield and term to maturity on securities that differ only in length of time to maturity; graphically approximated by the yield curve.

Pure Expectations Theory – the yield curve reflects the market’s current expectations of future short-term rates.

Liquidity Premium Theory – investors will hold long-term maturities only if they are offered a premium to compensate for future uncertainty.

Preferred Habitat Theory – the shape of the yield curve is determined by future interest rates and a risk premium, to induce market participant to shift out of their preferred habitat.

Segmented Markets Theory – the shape of the yield curve is determined by supply of and demand for securities within each maturity sector.

Research Results

Uses of the Term Structure

Forecast Interest Rates – they yield curve can be used to assess the general expectations of investors and borrowers about future interest rates.

Forecast Business Cycle – provides information about the market expectations of future business activity.

Investment Decisions – investors can take advantage of different rates and ride the yield curve to make a profit.

Financing Decisions – by assessing the prevailing rates on securities for various maturities, firms can estimate the rates to be paid on bonds with different maturities.

Impact of Debt Management – Treasury decisions about debt financing can impact the yield curve.

Historical Review – Upward sloping.

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Chapter 4 – Functions of the Fed Student Notes

Chapter 4 – Functions of the Fed

Chapter Objectives

Explain the U.S. Federal Reserve System

Introduce monetary tools used by the Fed

Other monetary policy issues

History

Established in 1913 to control bank panics.

12 largely autonomous Federal Reserve banks were established.

Providing the Money Supply – prints and issues currency.

Maintaining the Safety of the Financial System

Facilitation of the Payments System

Conducting Monetary Policy

Monitoring International Financial Transactions

Organization

Federal Reserve District Banks – 12 banks

Member Banks – All chartered banks must be members.

Board of Governors – Key administrative body

Regulate commercial banks

Control monetary policy

Federal Open Market Committee (FOMC) – directs the open market actions of the Fed.

Advisory Committees – Advises on consumer issues.

Monetary Policy Tools

Open Market Operations – buying or selling of Treasury securities.

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Chapter 4 – Functions of the Fed Student Notes

Purchase of Treasuries – Fed uses cash to buy Treasuries, usually from banks.

Sale of Treasuries – Fed sells a portion of its Treasuries, usually to banks.

Technical Operations – carried out through trading desk at New York Fed.

o Policy Directive

o Straight (outright) transactions

o Repurchase Agreements

o Agency Operations

Adjusting the Discount Rate – it is the rate a financial institution must pay to borrow reserve deposits from the Fed.

Adjusting the Reserve Requirement Ratio – determines the amount of money that financial institutions must keep on hand.

Miscellaneous

Fed Emphasis on Money Supply

Monetary Control Act of 1980 (DIDMCA)

Global Monetary Policy

Single European Policy

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Chapter 5 – The Fed and Monetary Policy Student Notes

Chapter 5 – Fed and Monetary Policy

Chapter Objectives

Review Goals of Fed and Monetary Policy

Review Fed Policy

Explain the Impact of Monetary Policy

Goals of U.S. Monetary Policy

Price Level Stability – unstable price levels deter economic growth.

Inflation – the continuous rise in the average price level. Usually caused by an external economic shock in the supply of a crucial material. When confronted with a supply shock, the fed has two options:

Nonaccommodation

Accommodation

High Employment (or low unemployment) – between 4% and 6% is considered full capacity.

Economic Growth – increase in an economy’s output of goods and services.

Stability in Foreign Currency Exchange Rates – widely fluctuating exchange rates increases uncertainty into the economy.

Trade-offs and Conflicts Among Policies

Raise the rate of growth in the money supply by providing more reserves.

Reduce the rate of monetary expansion by reducing the reserves in the banking system.

Recent Federal Reserve Policy

1970 – 1979: Targeting the Fed Funds Rate.

1979 – 1982: Targeting the banking system’s nonborrowed reserves.

1983 – Present: Back to the Fed Funds Rate.

Economic Indicators Monitored by the Fed

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Indicators of Economic Growth – Gross Domestic Product (GDP)

Indicators of Inflation

Producer and Consumer Price Indices

Other Indicators – Commodity prices

Lags in Monetary Policy

Recognition Lag – the lag between the time a problem arises and the time it is recognized.

Implementation Lag – the lag from the time a serious problem is recognized until the time the Fed implements a policy to resolve it.

Impact Lag – the lag until the policy has its full impact on the economy.

Assessing the Impact of Monetary Policy

Forecasting Money Supply Movements

Improved Communication from the Fed.

Market Reaction to Reported Money Supply Levels.

Anticipating Reported Money Supply Levels.

Market Reaction to Discount Rate Adjustments

Integrating Monetary and Fiscal Policies

History – Generally, both the Fed and the government have been concerned with maintaining economic growth and low unemployment.

Combining Policy Effects

Monetizing the Debt – Action by the Fed to counteract the effects of sales of Treasury securities by the Treasury.

Global Effects of Monetary Policy

Impact of the Dollar – a weak dollar increases exports, which stimulates economy and may drive up inflation.

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Transmission of Interest Rates

Fed Policy during the Asian Crisis

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Chapter 7 – Bond Markets Student Notes

Chapter 6 Money Markets

Detail the participants and their roles.

Explain different money market securities

Examine valuations.

Money MarketsCharacteristics of the Money Market

Debt instruments that have a maturity of 1 year or less.

Highly liquid financial claims with negligible risk of loss.

Transaction size are very large (usually $1,000,000 to $10,000,000)

No formal organization, such as the NYSE for the equity markets.

Money Market ParticipantsParticipants

Commercial Banks – Most important class of buyers and sellers of money market instruments.

Federal Reserve System – open-market operations.

U.S. Treasury – finance the federal deficit.

Corporations – use to balance their cash position.

Money Market Mutual Funds – purchase 1/3 of commercial paper.

Pension funds the other institutions

Money Market SecuritiesSecurities

Treasury Bills – U.S. Treasury Department issues various types of debt to finance the national debt.

Treasury Bill Auction – systematic, regular procedure.

o Competitive bids

o Noncompetitive bids

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Estimating the Yield

Estimating the discount

Commercial Paper – short-term, unsecured promissory note.

Ratings – Moody’s and Standard & Poor’s

Placement – with institutions

o Directly placed paper

o Dealer-placed paper

Secondary Market – secondary trading is limited.

Backing Commercial Paper – not asset backed.

Slightly higher return than Treasury securities.

Finance companies are frequent issuers.


Negotiable Certificates of Deposit (NCDs) – A bank time deposit that is negotiable.

Placement – corporate treasuries

Premium – often, rate is above T-bill yield

Repurchase Agreements (Repos) – sale of a short-term security with the condition that the seller will buy it back at a predetermined price.


Federal Funds – commercial banks borrow and lend excess reserve balances to each other.

Banker’s Acceptances – a bank accepts the responsibility to repay a loan to its holder. Facilitates international trade.

Steps involved

Money Market SecuritiesFinal Notes

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Institutional use

Valuation

Limited price movements

Risk

Globalization of Money Markets

Performance of Foreign Money Market Securities

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Chapter 7 Objectives

To identify the different types of Treasury securities

To identify the characteristics of municipal securities

To outline the types of corporate debt securities

Treasury Securities

Treasury Bills – Treasury securities with a maturity of less than one year. These are sold on a discount basis.

Treasury Notes – Securities with maturities between 2 and 10 years. These are coupon securities.

Treasury Bonds – Securities with maturities greater than 10 years. These are coupon securities.

Treasury Inflation Protection Securities (TIPS) – A Treasury coupon security (either note or bond) whose coupon rate is tied to the rate of inflation.

Primary Market – Treasuries are sold in frequent well-publicized auctions.

¤ Competitive bids

¤ Noncompetitive bids

Secondary Market – over-the-counter market where a group of dealers offer continuous bid and as prices on outstanding Treasuries.

Stripped Treasury Securities – Separating all coupon and principal payments into individual securities. For instance, a 10-year semiannual note would convert into 21 separate STRIPS.

Quotations – The bid price and the ask price are quoted per hundred of dollars of par value.

Salomon Brothers scandal – Salomon took over a Treasury bond auction.

Brady Bonds – U.S. Treasury department restructuring program for delinquent LDC debt.

Federal Agency Securities

Federal Agencies – generally, a private company that was originated by the federal government.

¤ The Farm Credit System

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¤ Housing Credit Agencies

¤ Export-Import Bank

¤ Student Loan Marketing Association (Sallie Mae)

¤ Small Business Administration (SBA)

Municipal Bonds

State and local government bonds

General obligation bonds – provide basic services.

Revenue bonds – used to finance a specific revenue-producing project.

Corporate Bonds

Corporate Bonds – debt contracts requiring borrowers to make periodic payments of interest an to repay principal at the maturity date.

Characteristics

¤ Sinking-fund provision – requires the bond retire a specific dollar amount of bonds each year.

¤ Protective Covenants – Limit dividends or additional debt.

¤ Call Provisions – an option of the issuer to retire bonds before their maturity.

¤ Bond Collateral

Mortgage bonds

Equipment Trust Certificates

Collateral Bonds

Debentures

¤ Zero- Coupon Bonds – Do not pay coupons.

¤ Variable-Rate Bonds – Coupon is tied to an interest rate rather than fixed.

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¤ Convertibility – allows investors to exchange the bond for a stated number of shares of the firm’s common stock.

Junk Bonds – Corporate bonds with high default risk.

¤ Market Size – 25% of outstanding corporate bonds are junk.

¤ Risk Premium – Substantially higher interest rate.

¤ Performance – volatile.

¤ Contagion – price shocks affect entire junk bond market.

Restructuring through bonds

¤ Leverage Buyouts – investor group issues debt to fund the purchase of a company.

¤ Capital Structure changes

Bond Markets

Eurobond Market – a bond issued in a country other than the currency it is denominate in.

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Chapter 8 – Bond Valuation and Risk Student Notes

Chapter 8 – Chapter Objectives

Review the bond valuation process; and

Review bond characteristics.

Bond Valuation Process

Bond – a security that obligates the issuer to make specified payments to the bondholder.

Characteristics

¤ Par Value – face value of the bond.

¤ Coupon – specified number of dollars of interest paid each period.

¤ Coupon Rate – The annual coupon divided by par value.

¤ Maturity – Date when principal amount is due.

¤ Yield to Maturity – The rate of return earned on a bond if it is held to maturity.

Bond Valuation – the present value of the cash flows.

Changing bond values over time – New bonds are generally priced to sell at par value. The price of seasoned bonds often vary widely from par value.

¤ If the market interest rate equals the coupon rate, a fixed rate bond will sell at its par value.

¤ Market interest rate rises above coupon rate, a fixed rate bond sells below (discount) its par value.

¤ Market interest rate falls below coupon rate, a fixed rate bond sell above (premium) its par value.

¤ The price of the bond approaches its par value as it approaches maturity.

¤ Market interest rate falls below coupon rate, a fixed rate bond sell above (premium) its par value.

¤ The price of the bond approaches its par value as it approaches maturity.

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Bond Risk

Assessing the Riskiness of a Bond

Interest Rate Risk – risk of a decline in a bond’s price due to an increase in market interest rates.

Reinvestment Rate Risk – The risk that a decline in interest rates will lead to a decline in income from a bond portfolio.

Default Risk – The risk that the issuer will be late or unable to make a payment.

¤ Mortgage bonds – backed by fixed assets.

¤ Debentures – not secured by fixed assets but is a general obligation of the firm.

¤ Subordinated Debentures – claim is lower than senior debt.

Bond Price

Bond Price Movements

Risk-Free Rate – General interest levels affect all bonds.

¤ Inflationary Expectations

¤ Economic Growth

¤ Money Supply Growth

¤ Budget Deficit

Default Risk Premium – Changing credit situations will affect bond prices.

Bond Price Sensitivity

Bond Price Elasticity – the sensitivity of bond prices to changes in the required rate of return.

¤ Coupon Rate – The lower a bond’s coupon rate, the greater the price sensitivity.

¤ Maturity – Longer-term bonds have greater price sensitivity.

Bond Pricing Theorems

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¤ Bond prices and market interest rates move in opposite directions.

¤ When a bond’s coupon rate is greater (less) than the market’s required return, the bond’s market value will be greater (less) than its par value.

¤ The price of longer-term bonds will change more than that of shorter-term bonds, for a given change in market rates.

¤ The price of lower-coupon bonds will change more than that of higher-coupon bonds, for a given change in market interest rates.

Duration – bond price volatility varies directly with maturity and inversely with coupon rate. Duration considers both coupon rate and maturity.

¤ Portfolio – the weighted average of bond durations.

¤ Using Duration to Reduce Interest Rate Risk

Zero Coupon Approach

Maturity-Matching Approach

Duration-Matching Approach

Bond Investment Strategies

Bond Investing

¤ Matching Strategy – Matching future cash outflows with coupon and principal payments.

¤ Laddered Strategy – Spreading an investment over several different maturity classes.

¤ Barbell Strategy – Investment is divided between short- and long-term bonds.

¤ Interest Rate Strategy – Use forecasts to develop a bond investment strategy.

International Bonds

Return and Risk of International Bonds

Foreign Interest Rates Differentials

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Credit Risk Differentials

Exchange Rate Fluctuations

International Bond Diversification

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Chapter 9 – Mortgage Markets Student Notes

Chapter 9 – Mortgage Markets

Chapter overview

Examine unique nature of market.

Review the evolution of the secondary markets.

Examine the characteristics of different mortgages.

Mortgage Markets

Unique Nature of the Mortgage Market

¤ Secured by the pledge of real property.

¤ Made for varying amounts and maturities.

¤ Issuers are typically small, unknown entities.

¤ Secondary market growing

¤ Highly regulated and supported by the federal government.

Residential Mortgage Characteristics

¤ Standard Fixed-Rate Mortgages – lender takes a lien on real property in exchange for payment.

Conventional Mortgages – not insured by a federal government agency.

» Private Mortgage Insurance (PMI) – insures against default for borrowers with less than a 20% down payment.

» Historically, there has been no penalty for prepayment. However, this is not always the case.

Residential Mortgage Characteristics

¤ Standard Fixed-Rate Mortgages – lender takes a lien on real property in exchange for payment.

Insured Mortgages – payment is guaranteed by a federal government agency.

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Federal Housing Authority (FHA) – allows a much smaller down payment and guarantees payment.

Veterans Administration (VA) – insures mortgages of military veterans and does not require a down payment.

Adjustable-Rate Mortgages (ARMs) – interest rate adjusts with the general level of rates. Interest rate risk is shifted to the borrower.

Maturities – Traditional maturity is 30 years and 15 year mortgages have become more popular. Others include 3, 5, or 7 year balloon mortgages.

Creative Mortgages

Graduated-Payment Mortgage – lower payments in the first few years and growing through time.

Balloon Mortgage – a fixed-rate mortgage that expires at a predetermined time (3, 4, 5, or 7 years). The unpaid balance is then due.

Growing-Equity Mortgage – calls for rising payments over time resulting in a faster payoff.

Second Mortgage – loans secured by liens on properties that are already mortgaged.

Reverse Annuity Mortgage (RAM) – Provides regular monthly payments to the homeowner with the home as collateral.

Mortgage Market

Secondary Market – originators can sell mortgages in the secondary markets to both public and private purchasers.

Valuation – the present value if the future cash flows. Prices of existing mortgages are relatively volatile due to their long term nature.

Investment Risk

Interest Rate Risk – the value of fixed rate mortgages decline as interest rates rise.

Prepayment Risk – falling interest rates encourage refinancing.

Credit Risk – the likelihood that a borrower will default on the loan.

Mortgage-Backed Securities

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Pass-Throughs – payments of principal and interest on pools of mortgages are passed through to holders of securities in the pool.

Government National Mortgage Association (GNMA Ginnie Mae) – pass throughs on a pool of federally insured mortgage loans.

Federal National Mortgage Association (Fannie Mae) – issues a variety of pass-through securities similar to Ginnie Mae’s.

Publicly Issued Pass-Through Securities (PIP) – issued by private institutions.

Federal Home Loan Mortgage Corporation (Freddie Mac) – assists lenders with securitization of conventional mortgages.

¤ Participation Certificates (PCs) – different from Ginnie Mae’s in that:

Contain conventional mortgages

Not federally insured

Various interest rates

Much larger pools

Collateralized Mortgage Obligations – consists of a series of related debt obligations, called tranches, which pay various borrowers with different priorities.

Other Mortgage-Backed Securities

¤ Mutual Funds – several mutual funds have been established to buy Ginnie Mae securities.

¤ Fannie Mae or Freddie Mac debt – general obligation securities are basically secured by mortgages.

¤ Mortgage-Backed Securities – Pass throughs

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Chapter 11 – Stock Valuation and Risk Student Notes

Chapter 10 – Stock Markets

Overview

Types and locations of trading

Trading mechanics and arrangements

Public placements

Monitoring of firms

Globalization

Background on Common Stock

Common Stock – represents basic ownership claim in a corporation.

Owners expect capital gains and possibly dividends.

Value – based on expected future cash flows.

Trading Locations

Organized Exchanges – consist of physical locations where buyers and sellers meet on a trading floor.

¤ Auction System – trading mechanism placing competing buyers and sellers against each other.

Over-the-Counter (OTC) – dispersed traders linked via a computer system.

¤ Negotiated System – individual buyers negotiate with individual sellers.

Stock (Organized) Exchanges – consist of physical locations where buyers and sellers meet on a trading floor.

¤ New York Stock Exchange (NYSE) – most popular stock exchange.

Specialists – market makers in a stock.

Commission brokers – execute orders for customers.

Floor brokers – execute orders for other exchange members.

Floor traders – trade solely for themselves.

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Over-the-Counter (OTC) – dispersed traders linked via a computer system.

¤ NASDAQ – a computer network linking thousands of market-making participants.

¤ Other OTC Markets – subscriber markets where trading is via the telephone.

OTC Bulletin Board (OTCBB)

Pink Sheets

Alternative Trading Systems – electronic communications networks or crossing networks that link two parties for direct trading of stocks.

Types of Transactions

Long Purchase – purchasing securities with the expectation that it will increase in value.

Margin Trading – the use of borrowed funds to purchase securities. Purchased securities are used a collateral.

¤ Initial Margin – minimum amount that must be provided by investor at time of purchase.

¤ Maintenance Margin – minimum amount that an investor must maintain in the margin account.

¤ Margin Call – notification of the need to add cash to a margin account.

Short Selling – selling borrowed securities with the expectation that the price will fall.

Trading Mechanics

Types of Orders – price and conditions of an order.

¤ Market order – an order to buy or sell stock at the best price available when the order is placed.

¤ Limit order – an order to buy at or below a specified price. Or, sell at or above a specified price.

fill-or-kill order

day order

good-’till-canceled (GTC) order

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¤ Stop-loss order – an order to sell a stock when its price reaches or drops below a specified level.

Trading Arrangements

Retail Stock Trading – buying and selling of stocks by individuals.

Institutional Trading – buying and selling by financial institutions such as mutual funds and pension funds.

¤ Block Trades – trades of at least 10,000 shares or market value of $200,000 or greater.

¤ Program Trades – buying and/or selling of a large number of different stocks simultaneously.

Asset allocation trades

Index arbitrage

Stock Indexes

Dow Jones Industrial Average – stock market average made up of 30 high-quality industrial stocks.

Standard and Poor’s (S&P) – measures the current price of a group of stocks.

New York Stock Exchange Composite – current price of the stocks listed on the NYSE.

Other Indexes – AMEX, Nasdaq, Value Line, Wilshire 5000

Preferred Stock

Debt/Equity hybrid – represents ownership in a company but pays a fixed dividend amount.

Preferential treatment – preferred dividends are paid before common dividends can be paid and cumulate if they are not paid. Bankruptcy preference as well.

Nonparticipating – usually no voting rights.

Institutional tax advantages – other companies are able to deduct preferred dividends received. Not attractive for individual investors.

Public Placement of Stock

Initial Public Offerings (IPOs) – the first issuance of common stock by a firm to the public.

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¤ Venture Capital (VC) – firms that invest in private companies with the expectation of taking them public.

¤ Underwriters – an investment bank must be hired to take the company pubic.

¤ Details – price range, number of shares, lockup period, and other details must be established and filed with the SEC.

¤ Road Show – managers and underwriters travel to different cities to meet with institutional investors to sell the company.

¤ Offering – the underwriter sets the price the number of shares and begins trading when the market opens.

“Building the Book”

¤ Initial Return – typically, the return on the first day is substantial.

Flipping – process of selling soon after trading has begun.

¤ Lockup Agreement – underwriter restricts managers, VCs, and other insiders from selling their shares for at least six months.

¤ Long-run Performance – generally poor.

Secondary Stock Offerings – an initial offering of stock by a firm that has other stock already publicly held.

Shelf-Registration – a company must register stock offerings with the SEC. Once the registration is complete, the company waits for favorable market conditions.

Monitoring of Firms

Shareholder Activism – shareholders take an active role in managing the company.

¤ CALPERS

¤ Socially conscious mutual funds

Corporate Monitoring

¤ Acquisition – poorly run companies become targets.

¤ Barriers

Anti-takeover Amendments

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Poison Pills

Golden Parachutes

Self-Monitoring

¤ Stock Repurchases – a firm purchases its own stock when it believes it is undervalued.

¤ Leveraged Buyouts – use of debt financing to purchase the company.

Globalization of Stock Markets

International Investment Performance – performance varies among countries and through time.

Investing in foreign stocks

¤ Indirect investment

Purchase shares of U.S. based MNC

Purchase international mutual fund

¤ Direct investment

Purchasing stocks on foreign exchanges

Purchase stocks of foreign companies trading on U.S. exchanges.

Purchasing American Depository Receipts (ADRs)

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Chapter 11 – Stock Valuation and Risk

Overview

Stock Valuation Methods

Estimating the Required Return and Growth Rate

Other Factors that Affect Stock Prices

Stock Performance Measurement

Stock Market Efficiency

Stock Valuation Methods

Discounted Cash-Flow Valuation Techniques – the present value of some expected cash flows.

Dependent on two estimated inputs:

¤ Growth Rates

¤ Discount Rates

Dividend Discount Model – value of stock is the present value of all future dividends.

¤ Zero Growth Model – Dividends stay the same each year.

¤ Infinite Constant Growth Model – Dividends grow at roughly the same percent each year.

¤ Supernormal Growth Model – Dividends grow at higher rate for a period of time before settling into a constant growth.

Present Value of Operating Cash Flows – Deriving the value of the total firm from operating cash.

Present Value of Free Cash Flows – Deriving the value using free cash.

Relative Valuation Techniques – provides information about how the market is currently valuing stock at several levels.

¤ Contends that valuing firms is accomplished by a comparison to other firms.

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¤ Provides information current valuation but it does not provide guidance on whether current valuations are appropriate.

Price to Earnings (P/E) Ratio – determine how many dollars one is willing to pay for a dollar of expected earnings.

Price to Cash Flow (P/CF) Ratio – cash flow values are generally less prone to manipulation than earnings.

Price to Sales (P/S) Ratio – strong sales growth is a requirement for a growth company. Little chance of manipulation.

Estimating the Inputs

Required Rate of Return – will be the discount rate for most cash flow models.

¤ Risk-Free Rate – the absolute minimum rate an investor should require.

¤ Expected Inflation – if investors expect inflation, they should increase their required nominal risk-free rate.

¤ Risk Premium – the risk associated with a specific stock or portfolio of stocks.

Growth Rates – estimates of the growth rate of cash flows, earnings, and dividends are required.

¤ Estimating Growth from Fundamentals – dividend growth is determined by the growth rate of earnings and the payout ratio.

¤ Estimating Growth based on History – time-series growth rates should provide a trend and the amount of variability.

Factors that Affect Stock Prices

Economic Factors

¤ Interest Rates – generally, an inverse relationship exists between stock prices and the level of interest rates.

¤ Exchange Rates – currency strength affect market prices in many ways.

Market-Related Factors

¤ Anomalies – January effect, small firm effect, day of the week effect, etc.

Firm-Specific Factors

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¤ Dividends – indication about the future of the company.

¤ Secondary Offerings – dilution adversely affects stock price.

¤ Repurchases – indication the firm is undervalued.

Firm-Specific Factors

¤ Earnings Surprises – changes may indicate future trends.

¤ Acquisitions and Divestitures – Acquirers adversely affected, targets positively affected.

¤ Expectations

Evidence – stock prices are affected by factors other than fundamental factors.

Indicators – Price movements are often used as an indicator.

Stock Risk

Measures of Risk

¤ Standard Deviation

¤ Variation

¤ Beta

Stock Performance Measurement

Sharpe Index – measures the risk premium per unit of total risk, measured by the stock’s standard deviation.

Treynor Index – measures the risk premium of a stock per unit of nondiversifiable risk, measured by the beta.

Stock Market Efficiency

Forms of Efficiency

¤ Weak-Form Efficient – past data on stock prices is of no use in predicting future prices.

¤ Semistrong-Form Efficient – publicly available information is of no use in predicting future prices.

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¤ Strong-Form Efficient – no information, public or private, allows investors to consistently beat the market.

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Chapter 12 – Market Microstructure and Strategies Student Notes

Chapter 12 Objectives

Examine methods of researching stocks

Examine methods of trading stocks

Introduce alternatives (index funds) to investing in stocks.

Stock Market Investing

Research – there are numerous resources to use when researching stocks. Some include:

¤ Valueline

¤ Websites – Yahoo, Nasdaq, Morningstar, Bloomberg

¤ Edgar Online – access to SEC filings at www.sec.gov

Placing an Order – open an account with a broker. Full-service, discount, or online brokers are available.

¤ Market Order – an order to buy or sell a stock at the best possible price.

¤ Limit Order – an order that specifies the price to buy or sell the stock at.

¤ Stop Loss Order – a conditional market order whereby the investor directs the sale of a stock if it drops to a given price.

¤ Stop Buy Order – a conditional market order if the stock rises above a given price.

Margin Transactions – the investor pays for the stock with some ash and borrows the remaining through the broker, putting up the stock for collateral.

¤ Initial Margin – 50 percent of the value of the stock.

¤ Maintenance Margin – 25 percent of the value of the stock.

¤ Margin Call – requirement to add more equity or sell the stock.

Short Selling – the sale of stock that is not owned with the intent of purchasing it in the future at a lower price.

¤ Specifically, you would borrow the stock from another investor, sell it in the market, and replace it at a later date.

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Investing in Stock Indexes – investor can select mutual funds the shadow a specific index or opt for exchange traded funds.

¤ Exchange-Traded Funds (ETFs) – baskets of securities that are traded, like individual stocks, on an exchange.

Can be bought and sold throughout the day.

Very low expense ratio. However, commissions must be paid on trades.

Trade Execution

Floor Brokers – independent members of an exchange who act as brokers for other members.

Specialists or Market-Makers –

¤ Serve as brokers to match buy and sell orders.

¤ Maintain limit order book.

¤ Maintain fair and orderly market when necessary by buy and selling from their own account.

Electronic Communication Networks (ECNs) – displays customer orders electronically and provide access to pricing information.

¤ Rising in popularity.

Program Trading – computerized trading that involves the buying or selling of a portfolio of stocks.

¤ Collars – NYSE applies program trading curbs when the Dow moves 160 points either up or down.

¤ Circuit Breakers – NYSE halts trading if the market moves down by 10%.

Regulation of Stock Trading

Securities and Exchange Commission (SEC) – created in 1934 to enforce newly enacted securities laws.

¤ Division of Corporate Finance

¤ Division of Market Regulation

¤ Division of Investment Management

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¤ Division of Enforcement

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Chapter 13 – Financial Futures Markets Student Notes

Chapter 13 Financial Futures Markets

Detail the background on futures

Introduce the trading and mechanisms

Examine commodity and financial futures

Background on Futures

Futures Contract – A commitment to deliver a certain amount of some specified item at some specified date in the future.

¤ Commodity Futures

¤ Financial Futures

¤ Options versus Futures – future contract involves an obligation from both parties. Option does not.

¤ Forwards versus Futures – forward is tailored to meet the needs of the purchaser. Future is standardized.

Trading Futures

Participants – hedgers and speculators. Both are needed for the market to work.

¤ Hedgers – enter into futures contract to protect a current position of loss of value.

¤ Speculators – attempting to earn profits on price swings. Important in creating liquidity.

Trading Mechanics – futures are readily traded in the market.

¤ Long position – purchasing a futures contract.

¤ Short position – selling a futures contract.

¤ Liquidating a position – entering into an opposite futures contract.

Margin Trading – putting up only a fraction of the total price in cash. The margin usually ranges from 2 – 10% of the value of the contract.

Commodities

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Basic Characteristics – four major segments include: grains and oilseeds, livestock and meat, food and fiber, and metal and petroleum.

¤ Contract – every commodity has its own specifications regarding amounts and quality.

¤ Price behavior – commodities react to economic, political, and international pressures.

¤ Return on investment – only return comes from price movement. High returns are possible due to the volatility of prices and the high leverage.

Trading Commodities

¤ Speculating – attempt to capitalize on the wide price swings.

¤ Spreading – combining two or more different contracts into one position to achieve gains and limit losses.

¤ Hedging – used by producers and processors to protect a position in a product or commodity.

Financial Futures

Financial Futures Market – created in the early 1980s. Its level of trading has far surpassed the level of trading in commodities.

These are derivative securities because they derive their value from the assets that underlie them.

¤ Currency Futures – futures contracts of foreign currencies.

¤ Interest Rate Futures – futures contracts on debt securities.

¤ Stock-Index Futures – futures contracts on broad based measures of stock market performance.

¤ Trading Stock-Index Futures – predicting the future course of the stock market.

¤ Hedging Other Securities

Options on Futures – give the purchasers the right to buy or sell a single futures contract.

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Limits the loss exposure to the price of the option. Downside risk is limited.

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Chapter 14 – Options Markets Student Notes

Chapter 14: Options Markets

Chapter Objectives

Review options and their application

Review trading strategies

Options

Option – a security that gives the holder the right to buy or sell a certain amount of an underlying financial asset at a specified price.

¤ Call – gives the purchaser the right to buy securities at a stated price for a specified time period.

¤ Put – gives the purchaser the right to sell securities at a stated price for a specified time period.

¤ Advantages

Leverage

Ability to earn profit on price declines

Limited downside loss for purchasers

¤ Disadvantages

No ownership benefit

Limited time frame

Complex

Stock Option Provisions

¤ Strike (exercise) price – the state price at which you can buy a security with a call or sell a security with a put.

¤ Expiration date

¤ Quotes - WSJ

Options Pricing and Trading

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Profit Potential of Options

¤ Call – limited loss to the premium and unlimited possible gains if the stock moves higher.

¤ Put – limited loss to the premium and unlimited possible gains if the stock moves lower.

Fundamental Value of Options

Value – depends ultimately on the exercise price and the prevailing market price of the underlying stock.

¤ Call – (market price – strike price) x 100

¤ Put – (strike price – market price) x 100

¤ In-the-money

Call – strike price < market price

Put – strike price > market price

¤ Out-of-the-money – no value

Call – strike price > market price

Put – strike price < market price

Stock Option Premiums

Fundamental value – the higher (lower) the market price for a call (put), the greater the value.

Time premium – the longer the time to expiration, the greater the size of the premium.

Price volatility premium – the more volatile the stock, the greater the premium.

Trading Strategies

Buying for speculation – buy low and sell high.

Hedging – purchasing an option to offset a current position in equities.

Option Writing and Spreading

¤ Writing Options – do so because they do not believe the price is going to move that far.

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Naked Options – options written on a security not owned by the writer

Covered Options – options written on a security owned by the writer.

Options Spreading – combining two or more options with different strike prices and/or expiration dates into a single transaction.

Stock Index Options

Index Options – a put or call option written on a specific stock market index, such as the S&P 500.

¤ Investment uses –

Speculation – offer investors the opportunity to play the market with a small amount of money.

Hedging – allows an investor to protect a current portfolio from downside risk.

Other Types of Options

Interest Rate Options – options written on fixed-income (debt) securities.

Currency Options – options written on foreign currencies.

LEAPS (Long-Term Equity AnticiPation Securities) – expiration dates that extend out as far as two years.

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Chapter 15 – Interest Rate Derivative Markets Student Notes

Chapter 15: Interest Rate Derivative Markets

Chapter Objectives

Review swaps and their application

Review Interest Rate Caps, Floors, and Collars.

Swap Background

Swap – an agreement whereby two parties (called counterparties) agree to exchange periodic payments.

Notional Amount (Principal) – the dollar amount of the payments exchanged is based on some predetermined dollar principal.

Types of Swaps

Interest Rate Swap – the counterparties swap payments in the same currency based on an interest rate.

¤ Plain Vanilla – one set of payments is fixed and the other is variable.

¤ Coupon Swap – one party pays the other the fixed-coupon rate, and the other pays the coupon rate on a floating-rate instrument.

¤ Basis Swap – the parties exchange payments based upon floating-rate indexes, but each coupon is determined by a different rate.

¤ Application – useful ways of tailoring the interest rate risk desired. Reasons why a firm needs to alter their interest rate risk:

Interest rate exposure has changed over time

Two different firms have advantages in markets they prefer to not be in.

Swap Interpretation

Essentially, two parties enter into multiple forward contracts. Why do they exist?

In many markets, forwards and futures do not extend out as far as that of a typical swap.

Swap is transactionally efficient – one contract to handle what it would have taken multiple forward contracts to handle.

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Chapter 15 – Interest Rate Derivative Markets Student Notes

Increased liquidity

Interest Rate Caps, Floors, and Collars

Interest Rate Cap – a series of interest rate calls, designed to limit the cost of a loan with multiple interest payments

Interest Rate Floor – a series of interest rate puts, designed to protect the return on a loan with multiple interest payments.

Interest Rate Collar – a combination of the purchase of an interest rate cap and the sale of an interest rate floor.

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Chapter 16 – Foreign Exchange Derivative Markets Student Notes

Chapter 16: Foreign Exchange Derivative Markets

Chapter Objectives

Give background on foreign exchange markets

Introduce foreign exchange derivative instruments

Foreign Exchange Markets

Background

¤ Foreign currency is simply another asset.

¤ Exchange rate is the price at which the asset can be bought.

¤ Volatility of exchange rates should be viewed as a source of risk.

Spot Market – the market for immediate delivery of foreign currency.

Forward Contract – a contract between a bank and a customer.

¤ Exchange a specified amount.

¤ Exchange on a specific date.

¤ Exchange for a specified price.

Futures Contract – agreement between two parties to exchange foreign currency.

¤ Standardized amount

¤ Traded on an exchange

¤ Specified maturity dates

¤ Speculators and hedgers participate

¤ Contract interpretation

¤ Closing a position – enter into an opposite position.

¤ Credit risk – limited due to market restrictions.

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Chapter 16 – Foreign Exchange Derivative Markets Student Notes

Currency option – purchaser receives the right to buy or sell a currency at a later date at an agreed price.

¤ No obligation for the purchaser.

¤ Call – right to buy a currency at the strike price on or before the expiration date.

¤ Put – right to sell a currency at the strike price on or before the expiration date.

Currency swap – an agreement between two parties to trade payments in different currencies.

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Chapter 17 – Commercial Bank Operations Student Notes

Chapter 17 Commercial Bank Operations

Look at bank regulations

Determine sources and uses of funds

Look at off-balance-sheet activities

Financial Conglomerates

Financial Services Modernization Act – allows banks to offer a wide variety of products, including insurance and underwriting services.

Diversified Services – are there benefits to customers?

Diversified Services – are there benefits to banks?

Bank Sources of Funds

Demand Deposits – checking accounts

Savings Deposits – important source for small banks.

Time Deposits – have a maturity date

¤ Certificates of Deposit (CDs) – fixed interest rate and maturity date

¤ Negotiable Certificates of Deposit (jumbo CDs) – denominations of $100,000 or greater.

Money Market Deposit Accounts – pays an interest rate.

Federal Funds Purchased – borrowing from another bank’s reserves.

Federal Reserve borrowing – borrowing funds from the district Federal Reserve bank.

Repurchase Agreements (RPs) – banks sells securities and simultaneously contracts to repurchase the same securities.

Eurodollar Borrowings – short-term deposits at foreign banks.

Bonds – large commercial banks may issue bonds.

Capital – equity ownership of a bank.

Bank Uses of Funds

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Chapter 17 – Commercial Bank Operations Student Notes

Cash – vault cash, Fed reserves, balances at other banks, collections.

Bank Loans – primary business activity of a commercial bank.

¤ Business Loans – usually secured by an asset.

Bridge Loan – cash for a specific transaction.

Seasonal Loan – term financing to handle the fluctuations of the business cycle.

Long-Term Asset Loan – loan for a specific asset.

¤ Loan Participations – a group of banks cooperate to underwrite large loans.

¤ Consumer Loans – bank loans to individuals.

¤ Real Estate Loans – mortgage loans.

Investment in Securities – primarily consists of U.S. government bonds, municipal securities, and bonds issued by U.S. government agencies.

Fed Funds Sold – lending of excess bank reserves to other commercial banks.

Reverse Repurchase Agreements – counterparty to a repurchase agreement.

Eurodollar Loans – short-term loans denominated in dollars and made outside the U.S.

Fixed Assets – the bank.

Off-Balance Sheet Activities

Loan Commitments – promise by a bank to lend money according to the terms outlined in the commitment.

Standby Letters of Credit – bank promise to pay a third party in the event that the bank’s customer fails to pay.

Derivative Securities – interest rate and currency forwards, futures, options, and swaps.

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Chapter 19 – Bank Management Student Notes

Chapter 19 – Bank Management

Chapter Objectives

Examine the goals of bank management

Examine how to measure and manage risk

Review bank mismanagement

Goals of Bank Management

Maximize shareholder wealth

Managing Liquidity – asset and liability management

Asset Management – deposits, investments, loan repayments, and asset sales.

Liability Management – certain types of bank liabilities are very sensitive to interest rate changes.

Securitization – grouping like assets and selling the securities to investors.

Managing Interest Rate Risk

Methods of Assessing Interest Rate Risk

Gap Analysis – the rate sensitivity of bank earnings as measured by the gap between the maturity of assets and liabilities.

Duration Measurement – measuring the gap between the durations.

Regression Analysis – how performance has historically been influenced by interest rate movements.

Methods of Reducing Interest Rate Risk

Maturity Matching – matched funding of loans.

Floating-Rate Loans – loans that adjust to current interest rates.

Interest Rate Futures Contracts – take offsetting position in futures markets.

Interest Rate Swaps – exchange periodic cash flows based on specified interest rates.

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Chapter 19 – Bank Management Student Notes

Interest Rate Caps – buy calls on interest rate movements.

Managing Credit Risk

Tradeoff between Credit Risk and Return – the lower the risk, the lower the expected return.

Measuring Credit Risk – credit analysis and collateral.

Diversifying Credit Risk – avoid concentrating assets among a single firm or firms in the same industry.

Other Issues

Measuring Market Risk – Value-at-Risk (VAR) method to determine possible losses.

Bank Capital Management – maintain adequate amounts of capital.

Provides a financial cushion

Maintains public confidence

Provides protection to depositors

Source of funds for growth

Restructuring – shifted revenues away from interest margins to fee income

Acquisitions – growth quickly achieved through acquisitions.

Bank Mismanagement

Penn Square Bank – loans concentrated with energy companies.

Continental Illinois Bank – small core deposit base so it relied on borrowed funds.

Bank of New England – concentrated loans on commercial real estate.

Implications – risk is greatly increased with lack of diversity and aggressive loan strategies.

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Chapter 20 – Bank Performance Student Notes

Chapter 20 – Bank Performance

Chapter Objectives

Examine the factors that affect cash flows..

Review the factors that affect the required rate of return.

Examine performance evaluation.

Factors that Affect Cash Flows

Economic Growth – strong economic growth increases expected future cash flows.

Risk-Free Interest Rate – interest rates are inversely related to the value of a bank.

Industry Conditions – regulations have a large impact on the industry.

Management Abilities – skilled management increases cash flows.

Factors that Affect the Required Return

Risk-Free Rate – inversely related to value.

Risk Premium – also inversely related to value. Economic conditions has a large impact.

Performance Evaluation

Interest Income – has been declining in recent years. Is still comparatively large for small banks.

Interest Expense – interest paid on deposits and other borrowed funds.

Net Interest Income – difference between interest income and interest expense.

Noninterest Income – fees charged for services.

Noninterest Expense – expenses not related to the payment of interest on deposits.

Bank Performance Evaluation

Return on Assets (ROA) – Net Income/Total Assets – tells how much profit is generated with a given amount of assets.

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Chapter 20 – Bank Performance Student Notes

Return on Equity (ROE) – Net Income/Total Equity – the amount of profits in relation to the capital contribution to the firm.

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Chapter 21 – International Banking Student Notes

Chapter 21 International Banking

Global Bank Regulations

Uniform Global Regulations

Uniform Regulations for Banks Operating in the U.S. – foreign banks subject to same regulations as U.S. banks.

Uniform Regulations across Europe – one set of rules for banks operating in Europe.

Uniform Capital Adequacy Guidelines – 4% capital to assets ratio.

Global Bank Competitions

Competitions in Foreign Countries – more competition in other companies.

Competition in the U.S. – many foreign banks have established branches in the U.S.

Impact of the Euro – increased competition for financial services across Europe.

Risks of Multinational Banks

Credit Risk – more difficult to obtain credit information abroad.

Exchange Rate Risk – currency value and exchange controls.

Country Risk – closely tied to political developments in a country.

Settlement Risk – risk that it may not receive money due to default and have little recourse.

Interest Rate Risk – forecasting becomes more difficult with the level of international involvement.

Combining all Types of Risk – asset management becomes very complex.

International Debt Crisis

Latin and South America – many countries defaulted in the early 1980s.

Reducing Bank Exposure to LDC Debt

Selling LDC Loans

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Chapter 21 – International Banking Student Notes

Debt-Equity Swaps

Boosting Loan Loss Reserves

Brady Plan – voluntary debt-relief measures allowing banks various exit instruments.

Brady Bonds – an exit bond that exchanged debt for lower principal and interest amounts.

Country Risk Assessment

Economic Indicators – evaluates the country’s economic environment.

Debt Management – measures the fiscal policy of the country.

Political Factors – risk of unexpected change in the political environment.

Structural Factors – evaluation of the natural resources of the country.

Overall Rating – each variable generates a rating which is then weighted to created an average score.

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Markets Notes

Documents

Transcript of Markets Notes