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Unlike common stock, where the market price is based on expectations for future earnings and growth, pricing for both preferred stock and bonds is totally different.
Both preferred stock and bonds are called "fixed income" securities because they either have a fixed dividend rate or fixed interest rate, expressed as a percentage of par value.
The market for interest rates is dynamic - it is not static. As market interest rates move, the pricing of these securities adjusts to make their yield competitive with the current market
For example, assume that a company issues 10% $100 par preferred when market rates are at 10%. This issue gives a return that is competitive with the market and will be priced at $100 par. Any purchaser will get $10 of annual dividends / $100 purchase price = 10% dividend yield (which equals the current market rate)
If market interest rates double to 20%, then any new preferred stock issue will have a dividend rate of 20%. For this "old" 10% issue to be competitive with the market, its price must fall to $50 in the market. Any purchaser will receive 10% of $100 par = $10 of annual dividends / $50 purchase price = 20% dividend yield (which equals the current market rate).
If market interest rates fall by half to 5%, then any new preferred stock issue will have a dividend rate of 5%. For this "old" 10% issue to be competitive with the market, its price will rise to $200 in the market. Any purchaser will receive 10% of $100 par = $10 of annual dividends / $200 purchase price = 5% dividend yield (which equals the current market rate).
To summarize: Any fixed income security's market price is directly interest rate sensitive. The price will move inversely to market interest rate movements.
If market rates move up, the price of fixed income securities fall (to make their yields competitive with the market).
If market rates move down, the price of fixed income securities rise (to make their yields competitive with the market).
A CMO is a Collateralized Mortgage Obligation. These are created by broker-dealers who make bulk purchases of Fannie Mae, Ginnie Mae and Freddie Mac pass-through certificates (which are issued in $25,000 minimums) and place them into a trust.
The trust is then dividend into $1,000 units that can be sold to investors. However, CMOs are a "derivative security," where by financial engineering, the cash flows from the underlying securities are cut into varying maturities and varying risk categories.
In this manner, a $25,000 certificate can be refashioned into $1,000 selling units that can meet a variety of investor needs.
The "risk" categories relate principally to the risk of the security being "prepaid" if market interest rates drop after issuance and the homeowners in the underlying mortgage pool prepay their mortgages to refinance at lower current market rates. Then the CMO holder is repaid principal at a faster rate, and these proceeds, if reinvested in new CMOs, will be reinvested at lower current market rates. This is called "prepayment risk." Note that this risk is much lower for CMOs than for actually owning the underlying mortgage-backed pass through certificates, since by dividing and sequencing the expected cash flows, each CMO "tranch" has a much better defined maturity that is less susceptible to prepayment risk as compared to the underlying MBS.
Note that CMOs are rated "AAA" because they have virtually no default risk, since the underlying securities are government agency issues.
CMOs make monthly payments to the certificate holders; and each payment is a combined payment of both interest and principal. The purchaser must continually reinvest these payments to maintain the overall rate of return on the investment - and if interest rates are dropping over this time frame, then the overall investment return will fall. This is reinvestment risk.
The securities market is categorized into the New Issue Market, called the Primary Market, and the Trading Market, called the Secondary Market
The Secondary Market is trading of issued securities. This market is sub-categorized into the:
First Market
Second Market
Third Market
Fourth Market
The names come from how trading of securities has evolved over time.
First Market: Trading of listed securities on an exchange floor. Before the telephone was invented, traders had to physically meet to trade. Exchange floors have been around in the U.S. since the 1780s.
Second Market: Trading of unlisted securities that take place OTC - Over-The-Counter. The OTC market developed in the early 1900s once the telephone was invented. For equities, it includes NASDAQ, the OTCBB (Over-The-Counter Bulletin Board) and the Pink Sheets.
Third Market: Trading of listed securities that takes place OTC between so-called Third Market Makers. These are OTC Market Makers that compete with the exchanges. This market started in the 1960s, trades 24 hours a day, is mainly an institutional market, and now accounts for about 30% of trading in listed stocks.
Fourth Market: Trading of both listed and unlisted stocks that takes place directly between institutions on so-called ECNs- Electronic Communications Networks. Some of these systems are Instinet and Archipelago. The advantage is very fast, cheap trading. These systems started in the 1970s, but came into their own when fast cheap computer networks became available in the 1990s.
The securities market is categorized into the New Issue Market, called the Primary Market, and the Trading Market, called the Secondary Market
The Secondary Market is trading of issued securities. This market is sub-categorized into the:
First Market
Second Market
Third Market
Fourth Market.
The names come from how trading of securities has evolved over time.
First Market: Trading of listed securities on an exchange floor. Before the telephone was invented, traders had to physically meet to trade. Exchange floors have been around in the U.S. since the 1780s.
Second Market: Trading of unlisted securities that take place OTC - Over-The-Counter. The OTC market developed in the early 1900s once the telephone was invented. For equities, it includes NASDAQ, the OTCBB (Over-The-Counter Bulletin Board) and the Pink Sheets.
Third Market: Trading of listed securities that takes place OTC between so-called Third Market Makers. These are OTC Market Makers that compete with the exchanges. This market started in the 1960s, trades 24 hours a day, is mainly an institutional market, and now accounts for about 30% of trading in listed stocks.
Fourth Market: Trading of both listed and unlisted stocks that takes place directly between institutions on so-called ECNs- Electronic Communications Networks. Some of these systems are Instinet and Archipelago. The advantage is very fast, cheap trading. These systems started in the 1970s, but came into their own when fast cheap computer networks became available in the 1990s.
The securities market is categorized into the New Issue Market, called the Primary Market, and the Trading Market, called the Secondary Market
The Secondary Market is trading of issued securities. This market is sub-categorized into the
First Market
Second Market
Third Market
Fourth Market.
The names come from how trading of securities has evolved over time.
First Market: Trading of listed securities on an exchange floor; and on the NASDAQ System. Before the telephone was invented, traders had to physically meet to trade. Exchange floors have been around in the U.S. since the 1780s.
Second Market: Trading of unlisted securities that take place OTC - Over-The-Counter. The OTC market developed in the early 1900s once the telephone was invented. For equities, the OTCBB (Over-The-Counter Bulletin Board) and the Pink Sheets.
Third Market: Trading of listed securities that takes place OTC between so-called Third Market Makers. These are OTC Market Makers that compete with the exchanges. This market started in the 1960s, trades 24 hours a day, is mainly an institutional market, and now accounts for about 30% of trading in listed stocks.
Fourth Market: Trading of both listed and unlisted stocks that takes place directly between institutions on so-called ECNs- Electronic Communications Networks. Some of these systems are Instinet and Archipelago. The advantage is very fast, cheap trading. These systems started in the 1970s, but came into their own when fast cheap computer networks became available in the 1990s.
The securities market is categorized into the New Issue Market, called the Primary Market, and the Trading Market, called the Secondary Market
The Secondary Market is trading of issued securities. This market is sub-categorized into the
First Market
Second Market
Third Market
Fourth Market.
The names come from how trading of securities has evolved over time.
First Market: Trading of listed securities on an exchange floor. Before the telephone was invented, traders had to physically meet to trade. Exchange floors have been around in the U.S. since the 1780s. NASDAQ is an exchange market, too.
Second Market: Trading of unlisted securities that take place OTC - Over-The-Counter. The OTC market developed in the early 1900s once the telephone was invented. For equities, it includes the OTCBB (Over-The-Counter Bulletin Board) and the Pink Sheets.
Third Market: Trading of listed securities that takes place OTC between so-called Third Market Makers. These are OTC Market Makers that compete with the exchanges. This market started in the 1960s, trades 24 hours a day, is mainly an institutional market, and now accounts for about 30% of trading in listed stocks.
Fourth Market: Trading of both listed and unlisted stocks that takes place directly between institutions on so-called ECNs- Electronic Communications Networks. Some of these systems are Instinet and Archipelago. The advantage is very fast, cheap trading. These systems started in the 1970s, but came into their own when fast cheap computer networks became available in the 1990s.
OTC firms are called broker-dealers because they can act either as a broker or as a dealer in a transaction
When a firm acts as a dealer, it is a principal buying the security into inventory (at the dealer's bid price) or selling the security out of inventory (at the dealer's ask price).
The profit to the dealer for being a market maker or dealer is the spread, which is the difference between the bid and ask price that is earned for each round-turn trade performed by the dealer (a buy and a sell)
Some dealers are wholesalers that only trade with other brokerage firms; other dealers are large brokerage firms that have their own dealer subsidiary.
When a dealer receives a buy order from another broker, it sells to that broker at the ask. The broker then charges its customer a commission for executing that trade. Thus, the customer pays the ask price + a commission in this transaction
When a dealer receives a sell order from another broker, it buys from that broker at the bid. The broker then charges its customer a commission for executing that trade. Thus, the customer receives the bid price - a commission in this transaction
When a large brokerage firm that owns a dealer receives a buy order from one of its customers, it sells to the customer directly out of inventory and charges the customer a mark-up on the transaction. Thus, the customer pays the ask price + a mark-up in this transaction.
When a large brokerage firm that owns a dealer receives a sell order from one of its customers, it buys from the customer directly into its inventory and charges the customer a mark-down on the transaction. Thus, the customer receives the bid price - a mark-down in this transaction.
During periods of inflation, prices of goods and services are rising. This reduces peoples' purchasing power, if their incomes do not keep up with rising prices.
There are various theories for why inflation occurs. These are:
Demand-Pull Inflation: There is so much excess demand for a specific item that the price can be pushed up without demand lessening. For example, if you drive 30 miles back and forth to work, and gas prices triple, you still must buy the same amount of gasoline to get back and forth to work. Your demand for gasoline to get back and forth to work will not fall (unless you change jobs or get a more fuel efficient vehicle - both of which take time)
Cost-Push Inflation: As manufacturers see their material and labor costs rise, they keep increasing their product prices to match. As consumers see product prices rise, they demand wage increases to match, which leads to more product price increases, etc.
In inflationary periods, market interest rates rise because bond investors demand to be compensated for their increased purchasing power risk. Stock prices fall because corporate profits erode as companies cannot increase prices fast enough to cover their increasing costs.
The only assets that do well in an inflationary environment are hard assets such as real estate and commodities such as gold.
Deflation is a period when prices of goods and services are falling. This increases purchasing power. Deflationary periods rarely happen (in not-so- recent U.S. history, the last deflationary period was during the depression of the 1930s).
The Federal Reserve System ù known as the "Fed," consists of 12 district banks in major cities around the country, with the "lead" bank being the New York Fed. The system is overseen by the Board of Governors of the Fed (FRB) in Washington, D.C.
The FOMC - Federal Open Market Committee - meets every 6 weeks and looks at economic growth in each region.
If the FOMC believes that the economy is growing too slowly, it will take action to increase credit availability to stimulate the economy.
If the FOMC believes that the economy is growing too rapidly, it will take action to decrease credit availability to slow down the economy.
Thus, the Fed is controlling "monetary policy." The Fed has 4 tools to do this, which you can memorize by the acronym "DORM."
D - Discount Rate: The Fed sets the rate at which member banks can borrow from the Federal Reserve's "discount window." To loosen credit, the Fed can lower the discount rate; to tighten credit, the Fed can increase the discount rate.
O - Open Market Operations: The New York Fed is a trading partner with the major commercial banks. Every day, it trades with these banks in the "open market." To loosen credit, the Fed buys securities from the banks, giving them cash to lend out. To tighten credit, the Fed sells securities to the banks, draining them of cash, so they must reduce their lending.
R - Reserve Requirements: Every bank must keep a portion of money deposited on reserve and the bank can lend out the balance. To loosen credit, the Fed can lower the reserve requirement. To tighten credit, the Fed can increase the reserve requirement.
M - Margin on Securities: The Federal Reserve has the power to set margin percentages on securities trades. Regulation T of the FRB controls credit on securities from brokers to customers. Regulation U of the FRB controls credit on securities from banks to customers.