FINA 4310

Slide 1:FINA 4310Survey of InvestmentsDr. MayhewSpring 2002

Unit 2: Financial Markets & Instruments

Slide 2:Topics

Money Market Fixed Income Capital Market Equity Markets Market Indexes Derivative Markets

Slide 3:Financial Markets: Debt Market

Money Market Fixed Income Capital Market Equity Markets Derivative Markets Money Market Fixed Income Capital Market

Slide 4:Financial Markets: Capital Market

Money Market Fixed Income Capital Market Equity Markets Derivative Markets Fixed Income Capital Market Equity Markets

Slide 5:Outstanding Debt (Billions) Source: Bond Market Association

Slide 6:Who Owns U.S. Treasury Debt? As of 2000:Q4. Source: Bond Market Association

Slide 7:Money Market (BKM 2.1)

Short-term debt Usually, maturity is one-year or less Low Risk High Liquidity Large Denominations �Cash Equivalent� Money Market Mutual Funds

Slide 8:Money Market Instruments

U.S. Treasury Bills (T-Bills) Commercial Paper Certificates of Deposit Eurodollars Federal Funds Repurchase Agreements (Repos)

Slide 9:Marketable Short-term DebtYear 2000. Source: Bond Market Association

Slide 10:Treasury Bills (T-Bills)

Discount Bonds No explicit interest rate Interest rate implicit in the price Initially sold at auction Maturities: 4 weeks, 13 weeks, 26 weeks 52 week T-bills discontinued in Feb 2001 Then they trade on secondary market

Slide 12:Commercial Paper

Short-term unsecured debt issued by firms Typically 30 days or less (can be up to 270) Mostly issued by financial firms GMAC GE Capital Ford Motor Credit Co. Sold on a discount basis (like T-bills) Default is possible

Slide 13:Certificates of Deposit (CDs)

Time deposit with a bank Maturity and interest rate specified Available to individual investors Most insured up to $100,000 by FDIC More information available from the CD FAQ at FISN (a private investment advisory service)

Slide 15:Eurodollars

Dollar-denominated deposits in foreign banks or foreign branches of U.S. banks (not just European) Not subject to U.S. bank regulations Important cash management tool for large institutions Denominations of $1 Million or more

Slide 16:Eurodollar Creation

Ownership of demand deposits is transferred to a foreign bank U.S. Corporation U.S. Bank U.S. Corporation U.S. Bank Foreign Bank Demand Deposit Demand Deposit Eurodollar Deposit

Slide 17:Eurodollar Loans

U.S. Corp. U.S. Bank Foreign Bank Foreign Office of U.S. Bank Foreign Corp. Eurodollar Loan Interbank Eurodollar Deposit Demand Deposit Eurodollar Deposit

Slide 18:Federal Funds

Short-term unsecured loans settled in immediately available funds Mostly overnight loans Large players [Increments of $1 Million] Banks & S&Ls U.S. Treasury Foreign Governments Used by banks to meet reserve requirements

Slide 19:Repurchase Agreements (Repos)

Like Federal Funds, but collateralized by government securities Typically used for overnight borrowing

Slide 20:Money Market Mutual Funds

Mutual fund that invests only in money market instruments Gives small investors access to money market Can be used as a �sweep account� Accounting system: Net Asset Value = $1 Makes it appear like a cash account

Slide 21:Money Market Mutual FundsExample: Schwab Money Market Fund 

$45 Billion in Assets (June, 2001) 45% Commercial Loans About 80 Different Issuers Commercial Paper and Asset-backed Securities 42% Certificates of Deposit Issued by about 40 different banks 6% Repurchase Agreements 3% Bank Notes 2% Variable Rate Loans 2% Promissory Notes

Slide 22:Money Market Mutual FundsExample: Schwab Government Money Fund

$2.7 Billion in Assets (June, 2001) 53% Agency Notes Federal Home Loan Mortgage Corporation (Freddie Mac) Federal National Mortgage Association (Fannie Mae) Federal Home Loan Bank 47% Repurchase Agreements Credit Suisse First Boston Salomon Smith Barney UBS Paine Webber

Slide 23:Fixed-income Capital Market(Bond Market) (BKM 2.2)

Treasury Notes and Bonds Agency Bonds Municipal Bonds Corporate Bonds Foreign Government Bonds

Slide 24:Treasury Notes and Bonds

Longer-term government debt Explicit interest rate (�Coupon rate�) Semi-annual coupon payments Small increments ($1,000) Initially sold to the public by auction Active secondary market Notes: initial maturity up to 10 years Bonds: over 10 years, up to 30 years

Slide 25:Treasury Notes and Bonds

Prices are quoted per $100 of face value A bond trading for $100 is said to be �trading at par� Coupon rate set prior to auction Often, rate chosen so bonds will sell near par If market interest rates subsequently rise (fall), bond will sell below (above) par

Slide 28:Agency Bonds

Debt issued by government-sponsored enterprises or government agencies Federal Home Loan Bank System Federal Home Loan Mortgage Corporation Federal National Mortgage Association Student Loan Marketing Association Farm Credit System

Slide 30:Municipal Bonds

Debt issued by state governments local governments other governmental agencies Usually Tax-Free Pre-tax yield lower than taxable bond Best for those in high tax brackets

Slide 31:Corporate Bonds

Debt issued by private companies Higher chance of default than government bonds Default risk rated by bond rating agencies Yield tends to be higher for lower-rated bonds

Slide 33:Equity Markets(Stock Market) (BKM 2.3)

Shareholders, as �owners� of the firm Decide who will manage the firm Participate in important decisions by voting Have claim to residual profits (after debtholders are paid) �Publicly held� firms Anyone may buy shares Must adhere to rigorous reporting standards Typically trade on exchanges

Slide 34:Market Capitalization of Equity

�Market Cap� Measures the total value of all the firm�s stock N = number of shares outstanding P = current share price Market cap = N x P Example: General Electric Date: 12/28/01 N = 9.93 Billion P = $40.73 Market cap = $404.4 Billion

Slide 35:Major Stock ExchangesMarket Cap (December 2000) Source: FIBV

NYSE: $11.5 Trillion

Slide 36:Preferred Stock

Stock with fixed dividend Dividends cumulate if not paid Cannot pay dividend on common until preferred dividend is paid Similar to Corporate Bond Due to tax treatment, preferred stock yield is higher for corporate investors Does not make sense for an individual investor

Slide 37:Common Stock, Preferred Stock, and Corporate Bonds

Common stock, preferred stock, and bonds Are securities issued by a firm to raise capital Generate cash flow from the firm to investor Bonds Preferred Common Lifetime: Finite Infinite Infinite Cash flows: Fixed Fixed Variable Interest Dividend Dividend Priority: First Second Third

Slide 38:Market index

Weighted average of many security prices Measures price level for a particular market An index is not a traded asset Exchange-traded funds based on an index Can be viewed as the price of a hypothetical portfolio

Slide 39:Index characteristics

Asset class Stock, Bond, Commodity Geographic Scope Global, Regional, Single-Country Diversification Whole Market, Sector, Industry

Slide 40:Index characteristics Overview

Size (stock indexes) Large-cap, Mid-cap, Small-cap Style (stock indexes) Value, Growth, Blend Risk class (bond indexes) Government, Investment-grade, High-yield Maturity (bond indexes) Short, Medium, Long

Slide 41:Market index providers

Standard and Poors (S&P 500) Dow Jones (DJIA) MSCI Russell Datastream Barra Goldman Sachs Wilshire Lehman Salomon S.B. Exchanges: NYSE NASDAQ

Slide 42:International stock indexes

Japan: Nikkei 225 Overview UK: FTSE 100 Germany: DAX France: CAC 40 Canada: TSE 300 Hong Kong: Hang Seng

Slide 43:Uses of market indexes

Benchmark for portfolio evaluation Basis for Index Mutual Funds Basis for Exchange-Traded Funds Basis for Futures and Option contracts Proxy for the Market Portfolio Measuring a stock�s Beta Measuring Market Risk Measuring Value at Risk

Slide 44:Price-weighted index

N Stocks Pi = Price of Stock i Example: Dow Jones Industrial Average N = 30

Slide 45:Divisor for price-weighted index

For DJIA, originally N=12 and Divisor=12 Can be chosen to make index start at 100 Adjusted for� Changes in the set of stocks Stock splits Stock dividends Spinoffs, mergers

Slide 46:Example of divisor change

Slide 47:High volatility

Has the stock market been unusually volatile in the past few years? Of the 10 biggest one-day DJIA increases and the 10 biggest one-day decreases, how many have occurred since 1997? Look for answer here Important to distinguish between point changes and percentage changes

Slide 48:Derivative Markets (BKM 2.5)

Traditional derivative securities Contract between two parties Value derived from value of an �underlying� asset Futures Commodity Futures Currency Futures Treasury Bond Futures Options Swaps

Slide 49:Futures Contracts

Two Parties: Long and Short Price is negotiated today for a sale of the underlying asset at a specified time in the future Long party agrees to buy underlying asset Short party agrees to sell underlying asset Value of the contract depends on what happens to underlying price

Slide 50:Futures Contracts Example: Corn Futures

Short: Jones agrees to sell 5,000 bushels of Corn in July 2002 for $2.23/bushel Long: Cargill agrees to buy 5,000 bushels of Corn in July 2002 for $2.23/bushel No money changes hands today $2.23 is the �Delivery Price�

Slide 51:Corn Example, continued

If in July 2002 Corn is at $2.50/bushel: Jones has lost .27/bushel on the contract Cargill has gained .27/bushel If in July 2002 Corn is at $2.00/bushel: Jones has gained .23/bushel on the contract Cargill has lost .23/bushel

Slide 52:Options

Call Option Two parties, the buyer and the writer Contract specifies: Underlying asset Strike price Expiration date Buyer pays a premium to the writer today Option buyer has the right to purchase the underlying asset from the writer

Slide 53:OptionsExample: Microsoft Call Option

Mayhew buys a July 70 MSFT call Hull Trading writes a July 70 MSFT call Mayhew pays $650 premium to Hull Mayhew has the right (but not the obligation) to buy 100 shares of Microsoft for $70/share any time prior to the 3rd Friday of July If buyer chooses to exercise the option, writer is obligated to sell the underlying shares

Slide 54:Microsoft Example, cont.

If in July, Microsoft is at $80, Mayhew exercises option Pays (70 x 100 = ) $7000 Receives 100 shares of MSFT (worth $8000) Payoff = $8,000 - $7,000 = $1,000 Profit = $1,000 - $650 = $350 Hull is obligated to sell Receives $7,000, delivers stock Payoff = -$1,000 Profit = -$350

Slide 55:Microsoft Example, cont.

If in July, Microsoft is at $68 Mayhew does not exercise option Payoff = 0 Profit = -$650 Hull keeps the premium Profit = $650

Slide 56:Options

Put Option Buyer pays a premium to the writer today Option buyer has the right to SELL the underlying asset to the writer