Chapter 11

Financial market

Salwa Elshorafa

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stock market is a system whereby a combination of buyers and sellers of a particular type of securities

The stock markets are considered one of the three elements of the financial markets (Financial Markets), consisting of:

* Money market by the banking system in which the primary role. * Capital market, which consists of investment banks and insurance companies

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* The stock market where trading in securities of financial instruments, shares and bonds issued by companies, banks or governments or other institutions, public bodies and are negotiable.

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Major Classes of Financial Assets/Securities Debt

– Money market instruments– Bonds

Common stock Preferred stock Derivative securities

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Financial Markets

FinancialMarkets

Foreign ExchangeMarket

Derivatives

TraditionalFinancialMarkets

(Long-term)CapitalMarket

(Short-term)MoneyMarket

T-BillsCDCPBARepos/ReversesFederal fundsLIBOR market

Bonds

Stocks

T-Notes/BondsMunicipal bondsCorporate BondsABS/MBS

Whole sales marketRetail market

ForwardFuturesOptionSwap

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Money Market Instruments 1

Short-term, marketable, low-risk securities – Cash equivalents

Treasury bill (T-Bill)– Short-term (less than one year) gov’t securities sold at a

discount and paying off the face value at maturity– Discount rate needs to be converted to a bond equivalent yield

(See example later)– Tax-exempt from all state and local taxes, but not from fed taxes– Issued in auction markets: Competitive vs. noncompetitive bids

Certificates of deposit (CD)– Time deposit with a bank, paying off interest and principal at

maturity, and negotiable before maturity– Treated as a bank deposit by the FDIC (insured for up to

$100,000)

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Money Market Instruments 2

Eurodollars– Dollar-denominated time deposits at foreign banks, with a

maturity less than 6 months– Eurodollar CD is a variation that is negotiable before maturity

Commercial Paper (CP)– Short-term unsecured debt issued by a large corp. in

denomination of $100,000– Fairly safe, but can default. – Rated by a rating agency such as S&P, Moody’s, etc.

Bankers’ Acceptances (BA)– Widely used in foreign trade (import/export)– A customer’s order accepted by a bank to make a payment at a

future date– Sells at a discount in secondary markets

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Money Market Instruments 3

Repurchase Agreements (RPs) and Reverse RPs– Short-term (overnight) sales of gov’t securities by dealers with an

agreement to repurchase them later at a higher price– It is like a S/T low-risk loan with the securities held as collateral– A reverse repo works in the opposite direction

Federal Funds– Banks’ deposits at the Federal Reserve Bank to maintain a

required minimum balance– Banks with excess funds lend to those with a shortage at a rate

of the Federal fund rate (Fed fund rate)

LIBOR Market– LIBOR: lending rate among large banks in London– Serve as a reference rate for a wide range of transactions

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Discount Rate vs. Bond Equivalent Yield

Discount Rates on money market instruments are not directly comparable to Bond Equivalent Yield (BEY)– They need to be converted into BEY to be

comparable with other bond yields – 360 vs. 365 days assumed in a year

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Bank Discount Rate (T-Bills)

rrBDBD = bank discount rate= bank discount rate

PP = market price of the T-bill= market price of the T-bill

nn = number of days to maturity= number of days to maturity

rrBDBD == 10,00010,000 -- PP10,00010,000

xx 360360nn

90-day T-bill, P = $9,87590-day T-bill, P = $9,875

rrBDBD == 10,00010,000 -- 9,8759,875

10,00010,000 x x

360360

9090== 5%5%

(Example)(Example)

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Bond Equivalent Yield

P = market price of the T-billP = market price of the T-bill

n = number of days to maturityn = number of days to maturity

rr BEYBEY == 10,00010,000 -- PP

PP xx 365365

nn

rrBEYBEY == 10,00010,000 -- 9,8759,875

9,8759,875 x x 365365

9090rrBEYBEY = .0127 x 4.0556 = .0513 = 5.13% = .0127 x 4.0556 = .0513 = 5.13%

Example using the sample T-Bill:Example using the sample T-Bill:

Convert the bank discount rate into BEY to make it comparable with other bond yields

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Capital Market :Fixed Income Instruments 1 US Treasury Notes and Bonds

– Debt of the federal gov’t with maturities of 1 year or more, paying off semiannual interests and principal at maturity

– Price quoted in units of 1/32 of a point(Ex) 110:06 = 110 6/32 = 110.1875 (%) of par U$1 mil

– Yield-to-maturity (YTM) is an annualized rate of return, based on an annual percentage rate (APR) or also called BEY(Ex) YTM = semiannual yield ×2

Mortgage-Backed Securities (Federal Agency)– Ownership claim to cash inflows from a mortgage pool– Interest and principal payments from borrowers are passed to

purchasers, and are called “pass-throughs”– GNMA pass-throughs (since 1970), and others (FNMA, FHLMC)– Market size is comparable to corporate and T-bond markets

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Capital Market :Fixed Income Instruments 2 Municipal bond (“munis”)

– Issued by state and local gov’t, and interest income is exempt from federal and sometimes state and local tax (but capital gains are taxable)

– To compare yields on taxable securities, we compute a Taxable Equivalent Yield as follows

rmr =

1 – t

rm = muni bond yield

r = taxable equivalent yield

t = marginal tax rate

rm = r×(1 – t)

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Capital Market :Fixed Income Instruments 3 Corporate bonds

– Long-term debt issued by private corporations, paying typically semiannual interests and principal at maturity

– Secured (mortgage or collateral) vs. unsecured (Debenture)– Guaranteed vs. straight bond– Option-embedded bonds: Callable, puttable, convertible, etc.– Current yield = Annual coupon / Current price– Yield-to-maturity = current yield + capital gain yield

International Bonds– Eurobond: denominated in a currency other than the issuing

country, e.g., dollar-denominated bond issued in London– Yankee bond, Samurai bond

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Capital Market - Equity Common stock

– Ownership shares of a publicly held corporation– Entitled to get voting right and dividend payments– Residual claim– Limited liability– Dividend yield = Annual dividend / Current price– PE ratio = Price / EPS

Preferred stock– Nonvoting shares, usually paying fixed dividends (usually

cumulative), like an infinite-maturity bond or a perpetuity– Priority over common stock holders– Sometimes, callable and convertible

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Total nominal return in the U.S.

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Equity Risk Premium

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Performance by market sectors

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International Stock and Bond Returns

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Represent the performance of the stock market as a whole, e.g., DJIA, S&P500, Wilshire 5000, etc.– Useful to track average returns of the stock market– Useful as a benchmark for the performance of fund managers– Used as base of derivatives

Many kinds of stock indexes exist– Representative? Broad or narrow? How is it weighted?– Price-weighted index

• Dow Jones Industrial Average (30 blue-chip stocks)– Market value-weighted index

• Standard & Poor’s 500, NASDAQ Composite, Wilshire 5000– Equally weighted index

• Value Line Index

Stock Indexes

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Stock Indexes - Int’l Nikkei 225 (price-weighted, largest TSE stocks) Nikkei 300 (value-weighted, largest TSE stocks) FTSE (value-weighted, largest 100 LSE stocks) DAX (German stock index) Regional and Country Indexes by MSCI

– EAFE (Europe, Australia, Far East)– Far East– EM (Emerging markets)– U.S., U.K., etc. (over 50 country indexes)

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Wilshire 5000 Index

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Top 20 companies in S&P500 Index

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Derivatives SecuritiesOptions Basic Positions

– Call (Right to Buy)– Put (Right to Sell)

Terms– Exercise (Strike) Price– Expiration Date– Underlying Assets

Futures Basic Positions

– Long (Commitment to Buy)– Short (Commitment to Sell)

Terms– Futures price– Delivery (Maturity) Date– Underlying Assets