Primary market
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Secondary markets
- markets where existing financial instruments are traded among investors (e.g., exchange traded: NYSE; over-the-counter: Nasdaq; also ECNs
Money markets
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Capital Markets
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Depository institutions
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Non- depository institutions
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Financial institutions benefit to suppliers of funds
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Financial institutions benefit to the overall economy
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Risk faced by Financial institutions
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Nominal interest rates
- the interest rates actually observed in financial markets
- used to determine fair present value and prices of securities
- two components:
- opportunity cost (tvm)
- adjustments for individual security characteristics
loanable funds theory
- explains the interest rates and interest rate movements
- views level of interest rates as resulting from factors that affect the supply of and demand for loanable funds
- categorizes financial market participants (consumers, businesses, governments, an
Determinants of Household savings
- interest rates ( higher= more saving)
- income and wealth: the greater the wealth or income, the greater the amount saved
- attitudes about saving versus borrowing
- credit availability: the greater the amount of easily obtainable consumer credit the lo
Determinants of business demand for funds
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Government demand for funds
- US federal gov debt was 22.7 trillion as of september 2019
- national debt ( and interest payments on the national debt) have to be financed in large part by additional borrowing
- federal gov demand for loanable funds is " interest inelastic"
- many st
Determinants of foreign demand and supply of funds
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Determinants of interest rates for individual securities
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Fisher effect
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Rating agencies
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Liquidity risk premium
- the lower a security's liquidity, the higher the yield preferred by an investor
- debt securities with a short-term maturity or an active secondary market have greater liquidity
Unbiased expectations theory
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Market segmentation theory
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coupon rate
- periodic cash flow of a bond issuer contractually promises to pay to a bond holder; usually a fixed rate
- used to calculate the coupon payment
Required rate of return
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Expected rate of return
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realized rate of return
- interest rate actually earned on investments; can differ from the expected rate of return
premium bond
- yield to maturity is less than the coupon rate; fair present value of the bond is greater than the face or par value
discount bond
- yield to maturity is greater than the coupon rate; fair present value of the bond is less than the face of par value
par bond
- yield to maturity is equal to the coupon rate; fair present value of the bond is equal to the face or par value
duration
- is the weighted average time to maturity (measured in years) of a financial security
- measures the sensitivity ( or elasticity) of a fixed income security's price to small interest rate changes
- captures the coupon and maturity effects on volatility
Functions of the federal reserve
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structure of the federal reserve
-Divided into 12 Federal Reserve districts, each with a
district Federal Reserve Bank
- Federal Reserve Banks operate under the general
supervision of the Board of Governors of the Federal
Reserve
- The Office of the Comptroller of the Currency (OCC)
char
open market operations
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Expansionary (loose) monetary policy
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Restrictive ( tight) monetary policy
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Multiplier effect
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problems in conducting monetary policy
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Money market securities
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Money market debt
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Discount yields
- interest rate is quoted as a percent of par value or face value on an annual basis assuming a 360 day year
- t-bills
- commercial paper
Single payment yields
- interest rate is quoted as a percent of purchase price on an annual basis assuming a 360 day year
- negotiable CDs
- Fed Funds
- repurchase agreements
- both may be converted to a bond equivalent yield or comparison purposes
Bond equivalent yields
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Treasury bill auctions
- 4-, 13- and 26-week T-bills are auctioned weekly, 52-
week are auctioned monthly
- Bids are submitted by government securities dealers,
financial and nonfinancial corporations, and individuals
- Bids can be competitive or noncompetitive
- Competitive bi
Federal funds market
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Repurchase agreement
- the sale of a security with an agreement to buy the security back at a set price in the future
- repos are short-term collaterized loans (typical collateral is the U.S. treasury securities
-similar to a fed funds loan, but collaterized
- funds may be tr
Bonds
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Treasury notes and bonds characteristics
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Treasury Strips
- separate trading of registered interest and principal securities (aka "treasury zero 0 coupon bonds")
- treasury security in which the periodic interest payment is separated from the final principal payment, effectively creating two sets of securities -
Treasury TIPS
- TIPs - Treasury Inflation Protected Securities
- Currently 5-, 10-, and 30-year maturities are being
auctioned
- Provide returns tied to the inflation rate
- The coupon rate is lower than that of other Treasury bonds
- The principal value is increased b
Accrued interest
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Dirty price
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Clean price
the price without accounting for accrued interest
Municipal bonds
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general obligation bonds
bonds that are backed by the full faith and credit of the issuer
Revenue bonds
are sold to finance specific revenue generating projects and are backed by the cash flows from that project
Bond indenture
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mortgage bonds
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Convertible bonds
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sinking fund provision
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mortgages
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Collateral
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Down payment
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Private Mortgage Insurance (PMI)
- private mortgage insurance (PMI) is generally required when the loan-to-value ratio is more than 80% (i.e., the borrower makes a down payment of less than 20%. Example: $100,000 house; 20% down payment = $20,000; mortgage = $80,000; loan to value = 80,0
Federally insured mortgages
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Amortized mortgages
- have fixed principal and interest payments that fully pay off the mortgage by its maturity date
- fully amortized mortgages usually have maturities of 15 or 30 years
Fixed rate mortgage vs adjustable rate mortgage
- Fixed-rate mortgages lock in the borrower's interest rate
- Therefore, required monthly payments are fixed over the life of the mortgage and lenders assume interest rate risk
- Adjustable-rate mortgages (ARMs)
tie the borrower's interest rate to some ma
Balloon payment mortgages
- require fixed monthly interest payments for 3 to 5 years, at which point full payment of the mortgage principal is due
Points
- are fees or payments that might be made when a mortgage loan is u=issued
- each point costs the borrower 1 percent of the principal value
- the lender reduces the interest rate used to determine the payments on the mortgage in exchange for points paid
-
Escrow account for property and insurance
- if the lender maintains an
escrow account to pay the taxes and insurance when they are due, the borrower must prepay 2 to 3 months worth of the taxes and insurance
Mortgage refinancing
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Second mortgages and home equity loans
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reverse annuity mortgages
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FNHMA or Fannie Mae
- 1938 to buy mortgages from depository institutions so they could lend to other mortgage borrowers
- Mandate was to act as a secondary mortgage market facility that could purchase, hold, and sell mortgage loans
FHLMC or Freddie Mac
- formed in 1960s to facilitate financing of conventional mortgages
Ginnie mae
- began operations in 1968 when it split off from
Fannie Mae, and has two major functions
- Sponsoring mortgage-backed securities programs of financial institutions such as banks, thrifts, and mortgage bankers
- Acting as a guarantor to investors in mortg
mortgage backed securities
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pass through securities
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collateralized mortgage obligations
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mortgage backed bonds
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Common stock
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Limited liability
- implies that common stockholders can lose
no more than their original investment
- Common stockholders control the firm's activities indirectly by exercising their voting rights in the election of the board of directors
proxy
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Dual class stock
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Straight voting vs cumulative voting
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preferred stock
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private equity
- is stock that is not publically traded
- The business is privately held
- The owners cannot sell their shares to the public
Some business owners hope to go public so:
- They can obtain financing to support the firm's growth
- They can "cash out" by sell
angel investors
- Angel investors are wealthy investors who invest
in small startups, either by buying stock or
convertible debt in the company.
- The investments are not liquid because the stock
is privately held.
- Angel investors often seek returns of at least 20x
to
venture capital funds
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private equity funds
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primary markets
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seasoned offering
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preemptive rights
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shelf registration
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Red herring
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road show
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American Depository Receipts (ADRs)
- There are 3 types of ADRs:
- Level 1 ADRs trade OTC and are not required to meet U.S. GAAP nor issue annual reports
- Level 2 ADRs trade on the exchanges and must meet
exchange requirements and adhere to U.S. reporting
standards; may be established eith
Market efficiency
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Securities and Exchange Commission (SEC)
- primary regulator of stock markets. Responsibilities include:
- Promote full and fair disclosure of information on securities and ensure fair treatment of investors
- Enforce Securities Act of 1933/Securities Exchange Act of 1934
- Prosecute inside trad
Beta
-The beta of a stock is a measure of its market
risk
- The beta of the market, by definition, is equal to 1
- A stock with a beta greater than 1 is more volatile than
the market
- A stock with a beta less than 1 is less volatile than the
market
- Example:
foreign exchange markets
- markets in which one
currency is exchanged for another, either today (in the spot market) or at a set time in the future (in the forward market)
- Foreign exchange markets facilitate:
- Foreign trade
- Raising capital in foreign markets
- The transfer o
spot vs forward transactions
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Special Drawing Right (SDR)
- An SDR is essentially an artificial currency instrument
created by the International Monetary Fund (IMF) in 1969
- Intended to augment international liquidity
- Constructed from a basket of important national currencies, with the makeup re-evaluated eve
foreign exchange risk
- can come from holding foreign
assets and/or liabilities
- Suppose a firm makes an investment in a foreign country:
- Convert domestic currency to foreign currency at spot rates
- Invest in foreign country security
- Repatriate foreign investment and inv
Purchasing Power Parity (PPP)
- is the theory explaining the
change in foreign currency exchange rates as inflation rates in the countries change
- According to PPP, foreign currency exchange rates between two countries adjust to reflect changes in each country's price levels (or infl
Derivative
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speculation vs hedging
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long vs short position
long position - the purchase of a futures contract
short position - sale of a futures contract
clearinghouse
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open interest
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initial margin
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maintenance margin
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options
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American vs. European Options
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swaps
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