Financial Markets 1

Transcription

1 Financial Markets 1 I. Market distinctions (rather than corporate bonds vs government bonds vs mortgages, which may be sold in different physical markets but are very similar) A. Capital market vs money market 1. Original maturity one year or less (money) vs more than one year 2. Money market: T bills, commercial paper, negotiable CDs 3. Capital market: mortgages, T-bonds, corporate bonds 4. Where to put stock? It never matures! so in capital market B. Primary market vs secondary market 1. Primary market = new, or sold for first time by the issuer a) Stock sold in an IPO is primary, thereafter in secondary market 2. Secondary = used 3. The existence of an efficient secondary market makes purchase in primary market more attractive, since can always sell in secondary. Would you buy a new house if there was no easy market for used ones? That is why firms benefit from a strong secondary market for their stock -- easier to sell it to raise funds in the first place. C. Spot market vs futures market 1. Arrange for immediate delivery (spot) or future delivery and payment (futures) 2. Function of futures markets a) For international trade, can offset exchange rate risk b) Reduce risk from price increases (for buyer) and decreases (for seller) c) Can speculate on future price changes II. Financial instruments A. Money market 1. T bills a) 3-12 month maturities b) Sold at a discount from face value, so a $10,000 one year T-bill will sell at $9,091 if interest rate is 10% (payment of $10,000 in one year will yield interest of $909, or 10% of initial price). c) Very liquid because of thickness of market and lack of risk (both default and interest rate) 2. Negotiable (large) CDs a) Issued by banks to raise large sums from big investors (rather than rely on small depositors for new funds) b) Text notes that while the minimum for trade in the secondary market is 2 million, can keep deposit insurance by packaging $100,000 CDs from

2 Financial Markets 2 different banks. 3. Commercial paper a) Short term bond issued by corporations, including financial institutions b) In last decade has become open to medium and small corporations c) Usually backed by a line of credit at a bank, so can be sure that they will be able to pay it off. d) Opens up a national market for short term borrowing from many sources rather than rely on your bank to give you a good rate. 4. Bankers' acceptances a) Bank will guarantee payment (for a fee) for an international sale (ship it now but buyer will not pay until later when it is received). With that guarantee, the exporter can sell the importer's IOU for money now, at a discount. The buyer will wait for payment. 5. Repurchase agreements a) Sell a financial instrument with agreement to buy it back later at a higher price. The difference is the interest and in the meantime the lender (the buyer) will have the instrument as collateral. b) Used by banks to raise short term funds. Many repos are overnight because that is when reserves are counted. 6. Fed funds a) Banks lend each other reserves overnight when one is caught short. Large banks now rely on these on a continuous basis. 7. Eurodollars a) Deposits in foreign banks that are measured in dollars. No risk from exchange rate changes. b) History = Soviet's did not want to put dollars in US banks but also wanted to keep holding nice safe liquid dollars, so put them in London banks. c) Not regulated like deposits at US banks! B. Capital Market 1. Stock a) ownership (equity) claims on profits and assets of firms b) preferred stock gets fixed dividend but first claim (after all debts) c) common stock gets variable dividend, for good or bad. they are the last in line d) exchanges (1) NYSE (2) NASDAQ

3 Financial Markets 3 e) indexes (1) DJIA: 30 industrial firms (non-financial) on NYSE (2) NASDAQ Composite (3) S&P 500 (4) Russell 2000: small cap (market capitalization $1.5 billion) stocks on NYSE and NASDAQ 2. Mortgages a) long term loans to buy residential housing, land or other structures b) property is the collateral, so default risk is less c) fixed or variable interest rate d) S&Ls and banks primary lenders e) promoted by FNMA and other quasi government agencies by purchasing mortgages and sell pass-through securities with guarantee on payment, giving money to initial lenders to make new loans 3. Corporate bonds a) issued by corporations for 2 to 30 years b) greater uncertainty about payment and smaller number means less active than T-bonds, but still fairly active, so fairly liquid c) if source of funds to pay off the loan is uncertain, risk is high enough to require high interest payment = junk bond, and are rated below "investment grade." 4. U.S. government securities (bonds) a) issued by U.S. Treasury for 2 to 30 years, in multiples of $1,000 (1) notes: 2 to 10 years (2) bonds: more than 10 years b) thick market means liquid (for capital market) c) Fed holds a lot, purchased as part of open market ops d) sold on a book-entry basis, that is, name of owner is recorded and they get the payment but not a printed bond e) Treasury will also separate the interest payments (coupons) from the principal, called stripping, to give zero-coupon bonds f) note and bond prices are stated in 1/32ns, equivalent to basis points, with a plus sign indicating an additional 1/64th is 100 plus 8/32 plus 1/64, or /64, or (1) bills are in decimal prices 5. U.S. government agency securities

4 Financial Markets 4 a) primarily issued to fund government lending programs b) agencies either owned by federal government or converted to governmentsponsored enterprise (GSE) c) includes Federal Home Loan Banks, Federal Home Loan Mortgage Corporation (Freddie Mac), Federal National Mortgage Association (Fannie Mae), Student Loan Marketing Association (Sallie Mae), and Resolution Funding Corporation (REFCO). (1) FHLB makes loans to S&Ls and commercial banks to make mortgages (2) Freddie Mac was converted to GSE in 1990, so owned by private investors (3) REFCO was formed to keep the S&L bailout off budget to avoid debt ceilings 6. State and local government bonds a) exempt from federal and state (for residents of that state) taxes, so popular with high income (so high tax bracket) households b) can participate through mutual funds that pass on tax exempt status c) revenue bonds = backed by income from the project (like dorms) d) general obligation bonds = backed by ability of government to tax C. Interest rates 1. prime rate: rate for best borrowers, with other rates set based on it 2. federal funds: rate charged on overnight loans to banks 3. T-bill: risk free short term interest rate 4. discount rate: rate charged by Fed to member banks 5. FNMA: low risk long term interest rate 6. London Interbank Offered Rate (LIBOR): rate on $ deposits in London banks between banks III. Market makers = brokers and dealers A. brokers arrange transactions, while dealers also buy/sell for themselves B. if you want to sell, your dealer may buy them from you and then sells them to another investor C. dealers help stabilize markets by absorbing temporary shortages and surpluses D. they both also collect and provide information to buyers and sellers E. profit by charging commissions and margin between bid (what they pay) and ask (what they charge) prices as dealers 1. in thick active markets, that margin will be very small F. their role as arbitragers causes rates to equalize across markets, whether from one

5 Financial Markets 5 instrument to another (T-bonds to mortgages) or one country to another