66 terms

Financial Economics ch. 2

Money Market
A subsector of the debt market.
Consists of every short term debt securities that are highly marketable.
Many of these securities trade in large denominations and so are out of reach of individual investors.
Money Market Mutual Funds (MMMF's)
However, are easily accessible to small investors.
Pool the resources of many investors and purchase a wide variety of money market securities on their behalf.
Treasury bills (T-bills)
Most marketable of all money market instruments.
Represent the simplest form of borrowing.
The government raises money by selling bills to the public. Investors buy the bills at a discount from the stated maturity value. At maturity, the holder receives from the government a payment equal to the face value of the bill. The difference between the purchase price and the ultimate maturity value represents the investors earnings.
Bank-discount method
The bills discount from its maturity, or face, value is "annualized" based on a 360-day year and then reported as a percentage of face value.
Certificates of deposit (CD's)
A time deposit with a bank.
Time deposits may be withdrawn on demand.
The bank pays interest and principle to the depositor only at the end of the fixed term of a CD.
Treated as bank deposits by the Federal Deposit Insurance Corporation, so they are insured for up to $250,000 in the event of a bank insolvency.
Capital investments
Working capital
Commercial paper
The typical corporation is a net borrower of both long-term funds (for ___) and short-term funds (for ___).
Large, well known companies often issue their own short term unsecured debt notes directly to the public, rather than borrowing from banks. These notes are called ___.
Commercial paper (CP)
Mature up to 270 days
Small investors can invest in commercial paper only indirectly, through MMMF's.
Considered to be a fairly safe asset.
Trades in secondary markets and so is quite liquid.
A. Time to maturity
B. Credit rating
The yield on CP depends on its:
Asset backed commercial paper
Issued by banks
Short term CP typically was used to raise funds for the institution to invest in other assets--> subprime mortgages. These assets in turn were used as collateral for the CP - hence the label "asset backed."
Bankers acceptances
Starts as an order to a bank by a banks customer to pay a sum of money at a future date, typically within 6 months.
Sold at a discount from the face value of the payment order.
When the bank endorses the order for payment as "accepted," it assumes responsibility for ultimate payment to the holder of the acceptance.
An ACCEPTANCE may be traded in secondary markets much like any other claim on the bank.
Bankers Acceptances are considered very safe assets.
Used widely in foreign trade where the creditworthiness of one trader is unknown to the trading partner.
Dollar denominated deposits at foreign banks or foreign branches of American banks.
By locating outside the United States, these banks escape regulation by the Federal Reserve Board.
Despite the tag "Euro," these accounts need not be in European Banks.
Most Eurodollar deposits are for large sums, and most are time deposits of less than six months maturity.
Less liquid and riskier
Higher yields
The advantage of Eurodollar CD's over Eurodollar time deposits is that the holder can sell the asset to realize its cash value before maturity. Eurodollar CD's are considered ___ &___ than domestic CD's, and so offer ___.
Repurchase Agreements (Repos/RP's)
Short-term, usually OVERNIGHT, borrowing.
The dealer sells securities to an investor on an overnight basis, with an agreement to buy back those securities the next day at a slightly higher price. The increase in price is the overnight interest.
Considered very safe in terms of credit risk because the loans are collateralized by the securities.
Term Repo
Essentially an identical transaction, except the term of the implicit loan can be 30 days or more.
Reverse Repo
The mirror image of a repo.
The dealer finds an investor holding government securities and buys them with an agreement to resell them at a specified higher price on a future date.
Brokers calls
Individual who buy stocks on margin borrow part of the funds to pay for the stocks from their broker. The broker in turn may borrow the funds from a bank, agreeing to repay the bank immediately (on call) if the bank requests it.
The rate paid on such loans is usually about one percentage point higher than the rate on short term treasury bills.
Federal Funds
Funds in the banks reserve account.
Some banks have more funds than required by the fed and some banks have a shortage of Federal Funds.
Banks with excess funds lend to banks with a shortage.
These loans, which are usually overnight transactions, are arranged at a rate of interest called the FEDERAL FUNDS RATE.
Fed Funds Rate
The ___ commands great interest as a key barometer of monetary policy.
London Interbank Offer Rate (LIBOR)
The rate at which large banks in London are willing to lend money among themselves.
This rate has become the premier short term interest rate quoted in the European money market and serves as a reference rate for a wide range of transactions.
Bond Market
Composed of longer term borrowing or debt instruments than those that trade in the money market.
Comprise the fixed-income capital market
Promise either a fixed stream of income or stream of income that is determined according to a specified formula.
Treasury notes and bonds.
Coupon Payments
The U.S. government borrows funds in large part by selling ___&___.
Both bonds and notes make semiannual interest payment called ___.
Yield to Maturity
A measure of the annualized rate of return to an investor who buys the bond and holds it until maturity.
Inflation-Protected Treasury Bonds (TIPS --> Treasury Inflation Protected Securities)
Bonds that are linked to an index of the cost of living in order to provide their citizens with an effective way to hedge inflation risk.
The principle amount on these bonds is adjusted in proportion to increases in the Consumer Price Index (CPI).
Provide a constant stream of income in real (inflation adjusted) dollars.
The real interest rates that you earn on these securities are risk-free if you hold them to maturity.
Federal agency debt
Some government agencies issue their own securities to finance their activities.
The major mortgage related agencies are the:
i. Federal Home Loan Bank (FHLB)
ii. The Federal National Mortgage Association (FNMA-->Fannie Mae)
iii. Government National Mortgage Association (GNMA--> Ginnie Mae)
International Bonds
Many firms borrow abroad and many investors buy bonds from foreign issuers.
Referred to as Eurobonds
A bond denominated in a currency other than that of the country in which it is issued.
Ex. A dollar-denominated bond sold in Britain would be called a Euro-dollar bond.
Ex. Yen-denominated bonds sold outside Japan would be called a Euro-yen bond.
Municipal bonds
Issued by state and local governments.
Similar to treasury and corporate bonds, except their interest income is exempt from federal income taxation (usually exempt from state and local as well).
Capital gains taxes, however, must be paid if the bonds mature or are sold for more than the investors purchase price.
Vary widely in maturity.
General Obligation Bonds
Type of municipal bond.
Backed by the "full faith and credit" of the issuer.
Revenue Bonds
Type of municipal bond.
Issued to finance particular projects and are backed either by the revenues from that project or by the municipal agency operating the project.
Ex. Typical issuers are
Turnpike or port authorities
Industrial Development Bond
A revenue bond that is issued to finance commercial enterprises, such as the construction of a factory that can be operated by a private firm.
Gives the firm access to the municipality's ability to borrow at tax-exempt rates, and the federal government limits the amount of these bonds that may be issued.
a. Corporate bonds
b. Mortgage backed securities
> (greater than)
If r(1 - t) is ___ than rm, the investor does better holding the taxable bonds. Otherwise, the tax-exempt municipals provide higher after tax returns.
Equivalent Taxable Yield
The rate a taxable bond would need to offer in order to match the after tax yield on the tax free municipal.
Rm = r(1-t)

T = investors combined federal plus local marginal tax rate
r = total before tax rate of return available on taxable bonds
r(1 - t) = after tax rate available on those securities
rm = rate on municipal bonds
Rate on municipal bonds formula (Rm):
r = Rm / (1-t)
Equivalent taxable yield formula (r):
t = 1 - (Rm/r)
What equation is used to find the tax bracket at which investors are indifferent between taxable and tax exempt bonds.
The higher the yield ratio, the ___ the cutoff tax bracket, and ___ individuals will prefer to hold municipal debt.
Corporate Bonds
The means by which private firms borrow money directly from the public.
Typically pay semiannual coupons over their lives and return face value to the bondholder at maturity.
Default risk is a real consideration--> much higher risk than treasury bonds.
Secured bonds
Bonds that have specific collateral backing them in the event of bankruptcy.
Unsecured bonds.
Have no collateral
Subordinated Debentures
Unsecured bonds.
Have a lower priority claim to the firm's assets in the event of bankruptcy.
Callable Bonds
A type of corporate bond that gives the firm the option to repurchase the bond from the holder at a stipulated call price.
Convertible Bonds
A type of corporate bond that gives the bondholder the option to convert each bond into a stipulated number of shares of stock.
Mortgage-backed security
Either an ownership claim in a pool of mortgages or an obligation that is secured by such a pool.
Subprime mortgages
Riskier loans made to financially weaker borrowers.
Common stocks
Also known as equity securities.
Represent ownership shares in a corporation.
Closely held firms
A corporation whose stock is not publically traded.
Owners of the firm also take an active role in its management.
What are the 2 most important characteristics of common stock as an investment?
a. Residual claim
Means the stockholders are the last in line of all those who have a claim on the assets and income of the corporation.
b. Limited Liability
Means that the most shareholders can lose in event of failure of the corporation is their original investment.
Corporate stockholders at worst have worthless stock.
Dividend Yield
Annual dividend per dollar paid for the stock.
Ignores capital gains.
Price to earnings ratio (P/E Ratio)
The ratio of the current stock price to last years earnings.
Tells us how much stock purchasers must pay per dollar of earnings.
Preferred stocks
Promises to pay to its holder a fixed stream of income each year.
Doesn't give the holder voting power regarding the firms management.
Unpaid dividends cumulate and must be paid in full before any dividends may be paid to holders of common stock.
American Depository Receipts (ADR's)
Certificates traded in U.S. markets that represent ownership in shares of a foreign company.
Each ADR may correspond to ownership of a fraction of a foreign share, one share, or several shares of the foreign corporation.
Created to make it easier for foreign firms to satisfy U.S. security registration requirements.
Most common way for U.S. investors to invest in and trade the shares of foreign corporations.
Dow Jones Industrial Average (DJIA)
Best known measure of the performance of the stock market.
Originally, calculated as the average price of the stocks included in the index. The % change in the DJIA would then be the % change in the average price of the 30 shares.
Price-weighted average
Otherwise known as the Dow.
Measures the return (excluding dividends) on a portfolio that holds one share of each stock.
The amount of money invested in each company in that portfolio is therefore proportional to the company's share price.
Standard & Poor's Indexes
Represents an improvement over the Dow Jones averages in two ways:
1. More broadly based index of 500 firms.
2. It is a market value weighted index.
Index funds
Yield a return equal to that of the particular index and so provide a low-cost passive investment strategy for equity investors.
Exchange-traded fund (ETF)
A portfolio of shares that can be bought or sold as a unit, just as a single share would be traded.
Equally weighted index
Do not correspond to buy-and-hold portfolio strategies.
To reset the portfolio to equal weights, you would need to rebalance: sell some ABC stock and/or purchase more XYZ stock.
An averaging technique, by placing equal weight on each return, corresponds to a portfolio strategy that places equal dollar values in each stock.
Bond Market Indicators
Measure the performance of various categories of bonds.
3 most well-known groups of indexes are those of:
1. Merill Lynch
2. Barclays
3. Salmon Smith Barney
Major problem with these indexes--> true rates of return on many bonds are difficult to compute because bonds trade infrequently, which makes it hard to get reliable, up to date prices. These so called matrix-prices may differ from true market values.
Futures and options
Derivative assets
___&___provide payoffs that depend on the values of other assets, such as commodity prices, bond and stock prices, or market index values. For this reason, these instruments sometimes are called ___.
Call option
Gives its holder the right to purchase an asset for a specified price, called the EXERCISE/STRIKE PRICE, on or before some specified expiration date.
Stock price
Exercise price
When the market price ___ the exercise price, the option holder may "call away" the asset for the exercise price and reap a benefit equal to the difference between the ___ price and the ___ price. Otherwise, the option will be left unexercised. If not exercised before the expiration date, the option expires and no longer has value.
Put option
Gives its holder the right to sell an asset for a specified exercise price on or before a specified expiration date.
"call options"
"Put options"
Profits on ___ increase when the asset increases in value, profits on ___ increase when the asset value falls.
Future contracts
Calls for delivery of an asset (or, in some cases, its cash value) at a specified delivery or maturity date, for an agreed-upon price, called the futures price, to be paid at contract maturity.
Call options
The ___ to purchase an asset at an agreed upon price versus the ___ to purchase it distinguishes a call option from a long position in a futures contract. ___ must be purchased; ___ investments are entered into without cost. The purchase price of an option is called the ___.
Represents the compensation the purchaser of the call must pay for the ability to exercise the option only when it is profitable to do so.