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Chapter 4: Financial Markets

1. Overview of Financial Markets A financial market is a market in which financial assets (securities) can be purchased or sold Financial markets facilitate financing and investing by households, firms, and government agencies Participants that provide funds are called surplus units e.g., households

Participants that enter markets to obtain funds are deficit units e.g., the government

Role of Financial Markets 1.

Liquidity: Ensure owners can buy and sell financial instruments cheaply. Keeps transactions costs low.

2.

Information: Pool and communication information about issuers of financial instruments.

3.

Risk sharing: Provide individuals a place to buy and sell risk

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2. Types of Financial Markets 1.

Classified according to the characteristics of participants and securities involved: primary or secondary markets.

2.

Categorize by the way they trade: centralized exchange or not.

3.

Group based on the characteristics of instrument they trade: debt market, equity market and derivative market

4.

Group based on term of instruments: money market and capital market

Primary Market vs Secondary Market A primary market is a market in which securities are bought and sold for the first time. In this market, the firm selling securities actually receives the money raised A secondary market is a market where people can buy and sell existing securities. In this market, the issuing firm does not receive any new financing. The securities are simply transferred from one investor to another

Primary Market Funds

Primary Market Securities

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Secondary Market Funds

Secondary Market Securities

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Centralized Exchange vs OTC Centralized exchanges - buyers and sellers meet in a central, physical location. Over-the-counter markets (OTC) - decentralized markets of securities not listed on an exchange where market participants trade over the telephone, facsimile or electronic network instead of a physical trading floor

Money Market vs Capital Market Money Market Trade short term (1 year or less) debt instruments (e.g. T-Bills, Commercial Paper) Major money centers in Tokyo, London and New York

Capital Market Trades long term securities (Bonds, Stocks) NYSE, ASE, over-the-counter (Nasdaq and other OTC)

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Debt and Equity Markets vs Derivative Markets In debt and equity markets, actual claims are bought and sold for immediate cash payments. In derivative markets, investors make agreements that are settled later.

3. Money Market Securities Money market securities are debt securities with a maturity of one year or less Characteristics: Liquid Low expected return Low degree of risk

Money Market Securities a.

Treasury Bills (T-Bills)

b. Negotiable Certificate of Deposits (NCDs) c.

Commercial Papers

d. Banker’s Acceptance e. Repurchase f.

Eurodollars

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a. Treasury Bills Issued by the Federal Government, to finance national debt and new deficits Are sold through an auction Generally viewed as having zero default risk -> risk-free asset After initial sale, they have an active secondary market.

T-Bills Pricing Treasury bills The price is dependent on the investor’s required rate of return:

Pm  Par /(1  i ) n Treasury bills do not pay interest To price a T-bill with a maturity less than one year, the annualized return can be reduced by the fraction of the year in which funds would be invested

Examples 1. A one-year Treasury bill has a par value of $10,000. Investors require a return of 7 percent on the T-bill. What is the price investors would be willing to pay for this T-bill? 2. A 6-month Treasury bill has a par value of $10,000. Investors require a return of 8 percent on the T-bill. What is the price investors would be willing to pay for this T-bill?

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T-Bills Estimating the yield T-bills are sold at a discount from par value The yield is influenced by the difference between the selling price and the purchase price If a newly-issued T-bill is purchased and held until maturity, the yield is based on the difference between par value and the purchase price

T-Bills The annualized yield is:

YT 

SP  PP 365  PP n

Estimating the T-bill discount The discount represents the percent discount of the purchase price from par value for newly-issued T-bills:

T - bill discount



Par  PP 360  Par n

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Examples 1. An investor buys a 3-month (91-day), $100,000 par value Treasury bill for $98,500. What is the annualized yield for this investor? What is the quoted discount for the T-bill?

2. Suppose the investor plans to sell the bill in one month (30 days) at a price of $99,250. What is the expected annual yield for this investor?

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b. NCDs NCDs are interest-bearing securities issued by banks to raise money for loans Denominations: $100,000 and above (Large Time Deposits) They have maturities of one year or less. NCDs offer a premium above the T-bill yield to compensate for less liquidity and safety. Premiums are generally higher during recessionary periods NCDs have a secondary market

c. Commercial Papers Are unsecured debt issued by corporations with good credit ratings to finance short-term debt (e.g. inventories) Most buyers are large institutions. Are typically established for a maturity range from 0 to 90 days

d. Banker’s Acceptance A bankers' acceptance (BA) is a short-term credit investment created by a non-financial firm and guaranteed by a bank to make payment. Are commonly used for international trade transactions Exporters frequently sell an acceptance before the payment date Have an active secondary market facilitated by dealers. Acceptances are traded at discounts from face value in the secondary market.

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Sequence of Steps in the Creation of A Banker’s Acceptance 1

Purchase Order

5

Shipment of Goods

Importer

2

Exporter

4 L/C Notification

L/C Application

6 Shipping Documents & Time Draft L/C Japanese Bank Shipping Documents (Exporter’s Bank) 7 & Time Draft Accepted

3 American Bank (Importer’s Bank)

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e. Repurchase Agreement One party sells securities to another with an agreement to repurchase them at a specified date and price 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 no secondary market for repos

f. Eurodollars - Eurodollars are U.S.-dollar denominated deposits at banks outside of the United States. This market evolved in Europe (specifically London), hence the name, but eurodollars can be held anywhere outside the United States. - Buyers and sellers are large institutions.

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4. Capital Market Securities Capital market instruments are those with a maturity of more than one year Bonds and mortgages Stocks

Capital market instruments have a higher expected return and more risk than money market securities

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a. Bonds Are “IOUs” issued by the borrower and sold to investors. The issuer promises to repay the face amount on the maturity date and to pay interest each year in the amount of the coupon rate times the face value.

Bonds Treasury Bonds: are issued by the federal government.

Municipal Bonds: are issued by state and local governments.

Corporate Bonds: are issued by corporations.

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b. Bank Loans “Issued” by various borrowers, “held” by banks.

Secured versus unsecured loans Secured Loans -- Has collateral (e.g. consumer and commercial mortgages) Unsecured Loans -- No collateral (e.g. credit cards)

c. Stocks Companies can also raise funds by selling shares of stock - Common stocks - Preferred stocks

Common stocks Common stock is a security that represents equity ownership in a corporation, provides voting rights, and entitles the holder to a share of the company’s success in the form of dividends and any capital appreciation in the value of the security. Common stockholders are residual owners of the firm. They earn a return only after all other security holder claims (debt and preferred equity) have been satisfied in full. Dividend on common stock are neither fixed nor guaranteed. Thus, a company can choose to reinvest all of the profits in a new project and pay no dividends.

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Preferred Stocks Preferred stock is an equity security. However, preferred stockholders have preference with regard to: Dividends: They are paid before the common stockholders. Claim on assets: They are paid before common stockholders if the firm goes bankrupt and sells or liquidates its assets.

Preferred Stocks Preferred stock is also referred to as a hybrid security as it has features of both common stock and bonds. Preferred stock is similar to common stocks in that: It has no fixed maturity date, The nonpayment of dividends does not result in bankruptcy of the firm, and The dividends are not deductible for tax purposes.

Preferred stock is similar to corporate bonds in that: The dividends are typically a fixed amount, and There are no voting rights.

5. Derivative securities Derivative securities are financial contracts whose values are derived from the values of underlying assets Speculating with derivatives allow investors to benefit from increases or decreases in the underlying asset Risk management with derivatives generates gains if the value of the underlying security declines

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Derivative securities 1.

Forward Contracts

2. Future Contracts 3.

Options

4. Swaps

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