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Markets and Instruments Chapter 2

Markets and Instruments Chapter 2. Finance 650 Spring 1999. Lecture notes prepared by: Dr. Susan D. Jordan. The Money Market. Treasury Bills auction or primary market secondary market Treasury Auction Process competitive versus noncompetitive. Auction results.

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Markets and Instruments Chapter 2

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  1. Markets and InstrumentsChapter 2 Finance 650 Spring 1999 Lecture notes prepared by: Dr. Susan D. Jordan Chapter 2 (BKM)

  2. The Money Market • Treasury Bills • auction or primary market • secondary market • Treasury Auction Process • competitive versus noncompetitive Chapter 2 (BKM)

  3. Auction results Results in WSJ and http://www.publicdebt.treas.gov/of/ofbills.htm Chapter 2 (BKM)

  4. TBill Formulas • P = Face [ 1 - rBD * (n/360)] • rBD = (F-P)/F * 360/n (bank discount yield) • rBEY = (F-P)/P * 365/n = (365* rBD)/(360 - t* rBD ) • rBEY = bond (coupon) equivalent yield or APR • effective annual yield = [1 + (F-P)/P ] 365/n - 1 • = (F/P) 365/n - 1 Chapter 2 (BKM)

  5. Secondary market transactions • From WSJ on Tuesday, August 25, 1998 • Dealer’s selling price (your purchase price) • Dealer’s purchase price (your selling price) Chapter 2 (BKM)

  6. Money market instruments • Commercial Paper • Eurodollar • Certificate of Deposit • Domestic • Eurodollar • Yankee • Bear Market CD • Bull Market CD Chapter 2 (BKM)

  7. Money market instruments (cont.) • Banker's Acceptance • Repurchase Agreement Repo RP • Federal Funds • Broker's call • LIBOR rate -- London Interbank Offered Rate Reverse Repo Chapter 2 (BKM)

  8. The Fixed-Income Capital Market • Includes Treasury notes and bonds, corporate bonds, municipal bonds, mortgage securities, and federal agency securities. • Overview of Bond Features • indenture • term to maturity • principal value • coupon rate Chapter 2 (BKM)

  9. Bond features (cont.) • sinking fund • debenture • mortgage or secured bond • income bond • Embedded Options • convertible bond • callable bond • put bond • exchangeable bond Chapter 2 (BKM)

  10. Treasury Notes and Bonds • Notes: original maturity of 2 to 10 years • Bonds: original maturity > than 10 years • Denominations of $1,000 or more • Both make semiannual coupon payments • Some T-Bonds may be called (last 5 years). • T-bonds issued since Feb. 1985 not callable. • Inflation-indexed Treasury securities Chapter 2 (BKM)

  11. Treasury quotesFrom WSJ Wednesday, August 28, 1997 • If date is followed by p or n it is a note • Numbers to the right of the colon = 1/32 of a point • If you purchase, you pay • If you sell $1000 face, you receive • Coupon rate of 7 = 7% of par ($70/year or $35 semi) 103.5625% of par $1035.00 Chapter 2 (BKM)

  12. Treasury quotesFrom WSJ Wednesday, August 28, 1997 • Yld = semiannual yield * 2 = Simple Interest = APR (Annual Percentage Rate ) = bond equivalent yield • Other Treasury bonds • Flower bond • Callable bonds (Maturity YR is a range) • yield on callables • discount bond = yield to maturity • premium bond = yield to first call Chapter 2 (BKM)

  13. Municipal Bonds • general obligation bond • revenue bond • industrial development bond or private purpose bond • tax anticipation bond • Equivalent taxable yield • r(1-t) vs. rm or r vs. rm/(1-t) Taxable bond yield = 7.20 and tax-exempt yield = 5.31 7.20*(1-.20)= 5.76 7.20*(1-.30)= 5.04 Chapter 2 (BKM)

  14. Corporate bonds • issued by private firms to borrow money from the public • Corp Bond Quotes from WSJ on Wed, Sept. 3, 1997 Current yield = 67.50/1006.25 Chapter 2 (BKM)

  15. Equities • Common stock • Residual claim and limited liability • Two Basic Rights • Preemptive right • Right to control • Proxy • Preferred stock • fixed dividends • priority over common • tax treatment Chapter 2 (BKM)

  16. Stock market quotes • Dividends: annual disbursements based on last quarterly declaration • Yield: div/close • PE: close/(last four EPS) So what was EPS for last four quarters? 27 = 38.3125/E or $1.42 Chapter 2 (BKM)

  17. Derivative Assets or Contingent Claims • Option Contract • purchaser of an option contract has the right to buy or sell the underlying at a stated price (the strike or exercise price) on or before a specified date (expiration). • Put: right to sell • Call: right to buy • Option Premium • Writer/Seller Naked versus covered Chapter 2 (BKM)

  18. Option contract quotes Chapter 2 (BKM)

  19. Derivative Assets or Contingent Claims • Futures Contract • calls for delivery of an asset (or its cash value) on a specified date for an agreed upon price to be paid at the maturity date. • Long: commitment to purchase the underlying • Short: commitment to deliver the underlying • cash settlement for index options • How is a long futures contract different from long call? Chapter 2 (BKM)

  20. Futures quotes Chapter 2 (BKM)

  21. Stock Market Indicators • Provide an overall indication of aggregate market movements • Uses: • track average returns • base of derivatives • measure systematic risk • compare performance of managers Chapter 2 (BKM)

  22. Stock Market Indicators • Sample • Computation • Average • Arithmetic • Geometric • Indexes • Value-weighted or capitalization-weighted • Equal-weighted Chapter 2 (BKM)

  23. Dow Jones Average & Indices • 30-Stock Industrial Average (DJIA or DOW) • 20-Stock Transportation Average • 15-Stock Utilities Average • 65-Stock Composite Average • The Dow Jones Equity Index Chapter 2 (BKM)

  24. DJIA • Price-weighted • Large, well-known cos (Blue chips) • 1884 with 11 stocks • 1928 => 30 stocks • Divisor is not equal to # companies • Divisor adjusted: • Companies added/deleted • Stock splits or stock dividends > 10% Chapter 2 (BKM)

  25. Consider a 2-stock sample • Price-weighted average • Equal-weighted index • Value-weighted index Chapter 2 (BKM)

  26. DOW or price-weighted average • Day 0 = ($110+$30)/2 = 70 • Day 1 = ($154+$33)/2 = 93.5 • Change in DOW = 93.5/70 - 1 = 33.57% • Value-weighted Index (base = 100) • Day 0 = (MV1 + MV2)/Base * 100 =100 • Day 1 = (1540+33000)/31100 *100 =111.06 • Change in Value = 111.06/100 -1 = 11.06% • Equal-weighted Index • Change of (40% + 10%)/2 = 25% Chapter 2 (BKM)

  27. Consider 3 stocks Chapter 2 (BKM)

  28. Examples of domestic indices • Dow Jones Industrial Average • Standard & Poor’s 500 Composite • Nasdaq Composite • NYSE Composite • Wilshire 5000 • Value Line Composite Chapter 2 (BKM)

  29. Examples of international indices • Nikkei 225 & Nikkei 300 • FTSE (Financial Times of London) • Dax • Region and Country Indexes • EAFE • Far East • United Kingdom Chapter 2 (BKM)

  30. Example of bond indices • Lehman Brothers • Merrill Lynch • Salomon Brothers • Specialized Indexes • Merrill Lynch Mortgage Chapter 2 (BKM)

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