derivative securties
financial contracts whose values are derived from the values of underlying assets
capital market securities
bonds mortgages stocks
money market securities
NCDs, commerical paper, treasury bills
Financial Markets
financial market is a market in which financial assets (securities) can be purchased or sold
primary markets
markets in which users of funds (e.g. corporations, governments) raise funds by issuing financial instruments
e.g., the sale of new corporate stock or new Treasury securities
secondary market
markets where financial instruments are traded among investors (e.g. NYSE, NASDAQ)
Secondary vs primary
primary market the issuer gets money for debts, where secondary market is traded from investor to investor
organized exchange
A visible marketplace for secondary market transactions
over the counter
Some transactions occur in the over-the-counter (OTC) market (a telecommunications network)
money markets
markets that trade debt securities with maturities of one year or less (e.g. CD's, U.S. Treasury bills)
capital markets
markets that trade debt (bonds) and equity (stock) instruments with maturities of more than one year
money market sec. charaticistics
Liquid
Low expected return
Low degree of risk
capital market sec
bonds, mortgages, stocks . Capital market securities have a higher expected return and more risk than money market securities
Market Efficiency- 3 forms
Strong-Include private info, public info, and past info
semi-strong-public and past info
weak- past info
Overview of Financial Institutions
Role: channeling funds from surplus units to deficit units.
Depository Institutions
accepts deposits from surplus units and provide credit to deficit units
Nondepository institutions
Generate funds from sources other than deposits
federal fund rate
banks charge each other on loans of excess reserves
depository institution examples
commercial banks, savings institutions, and credit unions
nondepository institutions
finance companies, mutual funds, security firms, insurance companies, pension funds.
loanable funds theory
market interest rate is determined by the factors that control the supply of and demand for loanable funds.
interest inelastic
insensitive to interest rates. ex. federal gov. demand for funds.
foreign demand relationship with U.S interest rates
U.S interest rates and foreign demand will be INVERSELY related
interest inelastic reasoning for gov.
Expenditures and tax policies are independent of the level of interest rates
factors affecting interest rates
economic growth. inflation , and the FED.
inflation
inflation causes demand curve to shift to the right ( ppl want to borrow) and supply curve shift to left (household increase consumption.
Fisher effect
The relationship between interest rates and expected inflation. states that the real rate of interest is the difference between the nominal rate less the expected inflation rate.
fisher effect
real rate= (1+ nominal/1+ inflation)-1
Fed affect on money supply
Fed increases money supply, it increases supply for loanable funds, which decreases interest rates
Budget deficit
A high deficit means a high demand for loanable funds by the government. Shifts the demand schedule outward (to the right). Interest rates increase
Crowding-out" Effect
Given a certain amount of loanable funds supplied to the market, excessive government demand for funds tends to "crowd out" the private demand for funds. Gov williing to pay whatever for fund and private sector may not, so they are crowded out.
Foreign flows of funds
The interest rate for a currency is determined by the demand for and supply of that currency. Shifts in the flows of funds between countries cause adjustments in the supply of funds available in each country
Credit (default) risk
Definition: The risk that a security's issuer will default on that security by being late on or missing an interest or principal payment
investment grade bonds
bonds that are rated as Baa or better by Moody's and BBB or better by Standard and Poor's.(medium quality)
Liquidity
Definition: the degree to which the securities can easily be converted to cash without a loss in value
tax status
Investors are more concerned with after-tax income than before-tax income.Taxable securities have to offer a higher before-tax yield to be preferred
tax status equation
after tax= before tax(1-Tax)
Term structure
the relationship between maturity and yield to maturity
yield differentials
measured in Basis points. 100 basis points equals 1 percent. 4.3% and 4% is a 30 basis pt difference.
Yield differentials of money market securities
Commercial paper, certificates of deposit, bankers acceptances . Yields are just slightly higher than the risk-free T-bills
Yield differentials of capital market securities
Municipal(munis) bonds have the lowest before-tax yield. Treasury bonds may have higher before-tax yield than munis but have lowest after-tax yield .Corporate bonds may have highest yields
Estimating the Appropriate Yield
appropriate yield= yield of debt sec+ DP+LP+TA
Pure Expectations Theory
emphasizes the impact of an expected change in interest rates. Current long-term interest rates are based on investors expectations of future interest rates, which means that current long-term rates are combinations of current and expected future short-te
Pure expectations theory
suggests that the shape of the yield curve is determined solely by expectations of future interest rates.The yield curve will become upward sloping if interest rates are expected to rise. The yield curve will become downward sloping if interest rates are
Liquidity premium theory
the yield curve changes as the liquidity premium changes over time due to investor preferences. The preference for short-term securities places upward pressure on the slope of the yield curve
liquidity premium theory
0<LP1<LP2<LP3<LPN.......
Liquidity premium theory
A flat yield curve means the market is expecting a slight decrease in interest rates. A slight upward slope means no expected change in interest rates
Segmented market theory
Investors and borrowers choose securities with maturities that satisfy their forecasted cash needs.The market segmentation theory assumes that investors and borrowers
are generally unwilling to shift from one maturity sector to another without adequate co
segmented market theory cont'
Individual investors and FIs have preferred investment horizons (habitats) dictated by the nature of the liabilities they hold. ex. Pension funds and life insurance companies prefer long-term investments. Commercial banks prefer short-term investments
Segmented market theory
Limitations of the theory
Some borrowers and savers have the flexibility to choose
among various maturity markets. e.g., Corporations may initially obtain short term funds if they expect long-term interest rates to decline
FED's five major components
Federal Reserve district banks
Member banks
Board of Governors
Federal Open Market Committee (FOMC)
Advisory committees
Federal Reserve District Banks
12 national districts
New York is considered most important
Roles:
1.) clear checks
2.) replace old currency
3.) provide loans to member banks
4.) economic research
Member banks
All national banks are required to be members of the Fed
State-chartered banks are not required to be members
About 35% of all banks are members
Member banks hold about 70% of all bank deposits in the U.S. economy
Board of Governors
Composed of 7 members appointed by the President for a 14 year non-renewable term.
Role of bored is to:
Regulate commercial banks
Control monetary policy
Federal Open Market Committee (FOMC)
The FOMC consists of the 7 members of the Board of Governors plus the presidents of five Fed district banks
Main goals:
1.) achieve stable economic growth
2.) stabilize inflation
Advisory committees
The Federal Advisory Council
Makes recommendations to the Fed about economic and banking issues
The Consumer Advisory Council
Represents the financial institutions industry and its consumers
The Thrift Institutions Advisory Council
Offers views on issues
what are the three advisory committees?
The federal advisory council, the consumer advisory council, and the thrift institutions advisory council.
what are the three Monetary Policy Tools?
Open Market Operations
Adjusting the Discount Rate
Adjusting the Reserve Requirement Ratio
Open Market Operations
Buying and selling of government securities through trading desk:
Fed purchase of Securities: increase in money supply
Fed sale of Securities: decrease in money supply
Feb use of repurchase agreements
Repurchase agreement
Purchasing securities with the agreement to sell back the securities at a specified date in the near future
m1, m2, and m3
m1-most narrow, includes currency held by the public and checking deposits at depository institutions.
m2- everything in m1 plus savings accounts and small time deposits, money market deposit accounts, and some other items.
m3-include all m2 plus large ti
Adjusting the Discount Rate
Influences the market interest rates
To increase the money supply, the Fed can authorize a reduction in the discount rate, Encourages depository institutions to borrow from the Fed
To decrease the money supply, the Fed can increase the discount rate, Disc
Adjusting the Reserve Requirement Ratio
The reserve requirement ratio is the proportion of bank deposits that must be held as reserves.
Reserve Requirement Adjustments affect Money Growth because higher reserves lead to less borrowing and lower reserves lead to more borrowing
Historically set b
Comparison of monetary policy tools
The most frequent monetary policy tool is open market operations
Open market operations can be used without signaling the Fed's intentions and can be easily reversed
Adjustments in the discount rate only work if depository institutions respond to the adju
major characteristics of money market instruments
Short-Term Maturity
High Quality Issues
Good Liquidity
Money Markets Securities
Treasury Bills
Commercial Paper
Negotiable Certificates of Deposit
Repurchase Agreements
Federal Funds
Banker Acceptances
Treasury Bills
Maturities of 4-week, 13-week and 26-week. Issued weekly, sold at auction (Competitive/Noncompetitive Bidding)
Minimum denomination of $1000
Backed by the federal government and free of default risk
High liquidity:
Short maturity
Strong secondary market
Treasury Bills
No interest paid on T-bills (coupon rate is zero), issued at a discount from their par (or face) value
T-bill prices are quoted as "discount rates"
When a bill matures, the investor receives the face value.
Commercial paper
Is a short-term debt instrument issued by well-known, creditworthy firms
Is typically unsecured
Has a minimum denomination of $100,000
Has a normal maturity between 20 and 45 days, but can be as short as 1 day or as long as 270 days
Has no active secondar
Commercial paper
The risk of default depends on the issuer's financial condition and cash flow
Commercial paper rating serves as an indicator of the potential risk of default
Corporations can more easily place commercial paper that is assigned a top-tier rating
Junk comme
Negotiable CDs
Are issued by large commercial banks and other depository institutions as a short-term source of funds
Have a minimum denomination of $100,000
Have a typical maturity between two weeks and one year
Have a secondary market
Repurchase agreements
A reverse repo refers to the purchase of securities by one party from another with an agreement to sell them
Transactions amounts are usually for $10 million or more
Common maturities are from 1 day to 15 days and for one, three, and six months
There is n
Federal Funds
The federal funds market allows depository institutions to lend or borrow short-term funds from each other at the federal funds rate. The rate is influenced by the supply and demand for funds in the federal funds market. Commercial banks are the most acti
Banker's Acceptances
Banker's Acceptance indicates that a bank accepts responsibility for a future payments
Are commonly used for international trade transactions
An unknown importer's bank may serve as the guarantor
Exporters frequently sell an acceptance before the payment
letter of credit (L/C)
represents a commitment by that bank to back the payment owed to the exporter.
yield to maturity
reflects the annualized yield that is paid by the issuer over the life of the bond.
Background on Bonds
Definition:
Long-term debt securities that are issued by government agencies or corporations
Characteristics:
Face or par value : the payment to the bondholder at the maturity of the bond
Coupon rate: A bond's annual interest payment per dollar of par val
Types of Bonds
Treasury and Federal Agency Bonds
Municipal Bonds
Corporate Bonds
Treasury Bonds
Treasury notes or bonds
Issued by The U.S. Treasury to finance federal government expenditures
Maturities:
T-Note: 1- 10 years
T-Bonds:10 years or more
An active secondary market exists
Treasury Bonds
T bonds can be bid on thru auction competitive or noncompetitive
Stripped Treasury bonds
One security represents the principal payment only (PO) and a second security represents the interest payments only (IO)
Investors who desire a lump sum payment can choose the PO part
Investors desiring periodic cash flows can select the IO part
Degrees o
Inflation-indexed Treasury bonds
In 1996, the Treasury started issuing inflation-indexed bonds that provide a return tied to the inflation rate
The coupon rate is lower than the rate on regular Treasuries, but the principal value increases by the amount of the inflation rate every six mo
Savings bonds
Issued by the Treasury
Have a 30-year maturity and no secondary market
Interest on savings bonds is not subject to state and local taxes
three federal agency bonds?
Ginnie Mae, Fannie Mae, Freddie Mac.
Ginnie Mae issues bonds and purchases mortgages that are insured by the FHA and the VA
Freddie Mac issues bonds and purchases conventional mortgages
Fannie Mae issues bonds and purchases residential mortgages
Municipal Bonds
Issued by local and state governments
Types
General Obligation Bonds
bonds backed by the full faith and credit of the issuer(gov's ability to tax)
Revenue Bonds
bonds sold to finance a specific revenue generating project and are backed by cash flows from
Municipal Bonds
Interest income is normally exempt from federal taxes
Interest income earned on bonds that are issued by a municipality within a particular state is exempt from state income taxes
Municipal Bonds
Yields offered on municipal bonds differs from the yield on a Treasury bond with the same maturity because:
Of a risk premium to compensate for default risk
Of a liquidity premium to compensate for less liquidity
The federal tax exemption of municipal bon
Corporate Bonds
Corporations issue corporate bonds to borrow for long-term periods
Corporate bonds have a minimum denomination of $1,000
Larger bonds offerings are achieved through public offerings registered with the SEC
maturities between 10 and 30 years
Interest paid
Corporate Bonds
Bond indenture : specifies the rights and obligations of the issuer and the bondholder
Sinking-fund provision: A requirement to retire a certain amount of the bond issue each year
Protective covenants:Are restrictions placed on the issuing firm designed t
Characteristics of corporate bonds
Call provisions:
Require the firm to pay a price above par value when it calls its bonds
The difference between the call price and par value is the call premium
Are used to:
Issue bonds with a lower interest rate
Retire bonds as required by a sinking-fund
Corporate Bonds
Low- and zero-coupon bonds:Are issued at a deep discount from par value
Variable-rate bonds:Allow investors to benefit from rising market interest rates over time
Allow issuers of bonds to benefit from declining rates over time
Convertible bonds:Allow inv
Junk bonds
Have a high degree of credit risk
Size of the junk bond market
More than 4,000 junk bond offerings, $600 billions
Participation in the junk bond market
mutual funds, life insurance companies, and pension funds