Chapter 2 (BKM) 1

Markets and InstrumentsChapter 2

Finance 650Spring 1999

Lecture notes prepared by:Dr. Susan D. Jordan

Chapter 2 (BKM) 2

The Money Market

Treasury Bills auction or primary market secondary market Treasury Auction Process

competitive versus noncompetitive

Chapter 2 (BKM) 3

Auction results

13-WeekApplications $26.11 BillionAccepted bids $7.52 BillionAccepted noncompetitively $1.43 billionAuction Price (Rate) 98.890 (4.390%)Coupon Equivalent 4.502%Bids at market yield 26%Cusip number 912795BH3

Results in WSJ and http://www.publicdebt.treas.gov/of/ofbills.htm

Chapter 2 (BKM) 4

TBill Formulas

P = Face [ 1 - rBD * (n/360)]

rBD = (F-P)/F * 360/n (bank discount yield)

rBEY = (F-P)/P * 365/n = (365* rBD )/(360 - t* rBD )

rBEY = bond (coupon) equivalent yield or APR effective annual yield = [1 + (F-P)/P ] 365/n - 1

= (F/P) 365/n - 1

Chapter 2 (BKM) 5

Secondary market transactions

From WSJ on Tuesday, August 25, 1998

Dealer’s selling price (your purchase price)

Dealer’s purchase price (your selling price)

Mat.Days toMat. Bid Asked Chg.

AskYld

Oct 29 ‘98 65 4.94 4.92 +0.10 5.03

Chapter 2 (BKM) 6

Money market instruments

Commercial PaperEurodollarCertificate of Deposit

Domestic Eurodollar Yankee Bear Market CD Bull Market CD

Chapter 2 (BKM) 7

Money market instruments (cont.)

Banker's AcceptanceRepurchase Agreement Repo RPFederal FundsBroker's callLIBOR rate -- London Interbank

Offered Rate

Reverse Repo

Chapter 2 (BKM) 8

The Fixed-Income Capital Market

Includes Treasury notes and bonds, corporate bonds, municipal bonds, mortgage securities, and federal agency securities.

Overview of Bond Features indenture term to maturity principal value coupon rate

Chapter 2 (BKM) 9

Bond features (cont.)

sinking fund debenture mortgage or secured bond income bond

Embedded Options convertible bond callable bond put bond exchangeable bond

Chapter 2 (BKM) 10

Treasury Notes and Bonds

Notes: original maturity of 2 to 10 yearsBonds: original maturity > than 10 years

Denominations of $1,000 or more Both make semiannual coupon payments Some T-Bonds may be called (last 5 years). T-bonds issued since Feb. 1985 not callable. Inflation-indexed Treasury securities

Chapter 2 (BKM) 11

Treasury quotesFrom WSJ Wednesday, August 28, 1997

If date is followed by p or n it is a noteNumbers to the right of the colon = 1/32

of a pointIf you purchase, you pay If you sell $1000 face, you receive Coupon rate of 7 = 7% of par ($70/year

or $35 semi)

RateMaturityMo/Yr Bid Asked Chg.

AskYld

7 Jul 06n 103:16 103:18 -6 6.47

103.5625% of par

$1035.00

Chapter 2 (BKM) 12

Treasury quotesFrom WSJ Wednesday, August 28, 1997

Yld = semiannual yield * 2 = Simple Interest = APR (Annual Percentage Rate ) = bond equivalent yield

Other Treasury bonds Flower bond Callable bonds (Maturity YR is a range)

yield on callables• discount bond = yield to maturity• premium bond = yield to first call

RateMaturityMo/Yr Bid Asked Chg.

AskYld

7 Jul 06n 103:16 103.18 -6 6.47

Chapter 2 (BKM) 13

Municipal Bonds

general obligation bondrevenue bond

industrial development bond or private purpose bond

tax anticipation bondEquivalent taxable yield

r(1-t) vs. rm or r vs. rm/(1-t)

7.20*(1-.20)= 5.767.20*(1-.30)= 5.04

Taxable bond yield = 7.20and tax-exempt yield = 5.31

Chapter 2 (BKM) 14

Corporate bonds

issued by private firms to borrow money from the public

Corp Bond Quotes from WSJ on Wed, Sept. 3, 1997

BondsCurYld Vol Close

NetChg.

ATT 63/404 6.7 10 1005/8 …

Current yield = 67.50/1006.25

Chapter 2 (BKM) 15

Equities

Common stock Residual claim and limited liability Two Basic Rights

Preemptive rightRight to control

• Proxy

Preferred stock fixed dividends priority over common tax treatment

Chapter 2 (BKM) 16

Stock market quotes

Dividends: annual disbursements based on last quarterly declaration

Yield: div/closePE: close/(last four EPS)

52 Weeks Vol NetLo Hi Stock Sym Div

Yld% PE 100s Hi Lo Close Chng

391/8 22 WalMart WMT .27 .7 27 19206 391/2 3715/16 385/161/2

So what was EPS for last four quarters?27 = 38.3125/E or $1.42

Chapter 2 (BKM) 17

Derivative Assets or Contingent Claims

Option Contract purchaser of an option contract has the right

to buy or sell the underlying at a stated price (the strike or exercise price) on or before a specified date (expiration).

Put: right to sell Call: right to buy Option Premium Writer/Seller Naked versus covered

Chapter 2 (BKM) 18

Option contract quotes

Call PutOption/ Strike Exp. Vol. Last Vol LastBestBuy 35 Sep 10 8 7/8 312 5/8

43 1/16 40 Sep 154 5 3/4 390 1 11/16

43 1/16 45 Sep 368 2 3/8 630 3 7/8

Chapter 2 (BKM) 19

Derivative Assets or Contingent Claims

Futures Contract calls for delivery of an asset (or its cash value)

on a specified date for an agreed upon price to be paid at the maturity date.

Long: commitment to purchase the underlying Short: commitment to deliver the underlying cash settlement for index options How is a long futures contract different from

long call?

Chapter 2 (BKM) 20

Futures quotes

S&P 500 Index (CME) - $250 times index

Open High Low Settle Chg High LowOpenInterest

Sept 103700 105600 101960 103100 -5.00 119940 879.20 365,506Dec 105900 106750 103200 104180 -5.00 121210 890.85 34,323Mr99 106950 107710 104300 105210 -5.00 122500 902.85 5,343June 107000 108730 105430 106220 -5.10 123810 914.85 1,883

Chapter 2 (BKM) 21

Stock Market Indicators

Provide an overall indication of aggregate market movements

Uses: track average returns base of derivatives measure systematic risk compare performance of managers

Chapter 2 (BKM) 22

Stock Market Indicators

SampleComputation

AverageArithmeticGeometric

Indexes Value-weighted or capitalization-weighted Equal-weighted

Chapter 2 (BKM) 23

Dow Jones Average & Indices

30-Stock Industrial Average (DJIA or DOW)20-Stock Transportation Average15-Stock Utilities Average65-Stock Composite AverageThe Dow Jones Equity Index

Chapter 2 (BKM) 24

DJIA

Price-weightedLarge, well-known cos (Blue chips)1884 with 11 stocks1928 => 30 stocksDivisor is not equal to # companiesDivisor adjusted:

Companies added/deleted Stock splits or stock dividends > 10%

Chapter 2 (BKM) 25

Consider a 2-stock sample

Price-weighted averageEqual-weighted indexValue-weighted index

Small IncPrice Quant (M)

MarketValue

Large CoPrice Quant (M)

MarketValue

Day 0 $110 10 $1100 $30 1000 $30,000Day 1 $154 10 $1540 $33 1000 $33,000

Return 40% 10%

Chapter 2 (BKM) 26

DOW or price-weighted average Day 0 = ($110+$30)/2 = 70 Day 1 = ($154+$33)/2 = 93.5 Change in DOW = 93.5/70 - 1 = 33.57%

Value-weighted Index (base = 100) Day 0 = (MV1 + MV2)/Base * 100 =100 Day 1 = (1540+33000)/31100 *100 =111.06 Change in Value = 111.06/100 -1 = 11.06%

Equal-weighted Index Change of (40% + 10%)/2 = 25%

Chapter 2 (BKM) 27

Consider 3 stocks

Stock Price # Shares Mkt ValueA $50 5 M $250 M

B $50 5 M $250 M

C $50 5 M $250 M

Chapter 2 (BKM) 28

Examples of domestic indices

Dow Jones Industrial AverageStandard & Poor’s 500 CompositeNasdaq CompositeNYSE CompositeWilshire 5000Value Line Composite

Chapter 2 (BKM) 29

Examples of international indices

Nikkei 225 & Nikkei 300FTSE (Financial Times of London)DaxRegion and Country Indexes

EAFE Far East United Kingdom

Chapter 2 (BKM) 30

Example of bond indices

Lehman BrothersMerrill LynchSalomon BrothersSpecialized Indexes

Merrill Lynch Mortgage