Financial Markets And Financial Instruments - Part I

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1 Financial Markets And Financial Instruments - Part I Financial Assets Real assets are things such as land, buildings, machinery, and knowledge that are used to produce goods and services. Financial assets represent claims on real assets or income generated by them. They do not contribute to the productive capacity of the economy directly. What is a Securities Market? A securities market is a place where you buy or sell financial assets such as bonds, stocks, options, or futures. Examples of organized exchanges Over the Counter (OTC) market Primary and Secondary Markets The primary market for securities refers to the initial sale of securities to the public by a firm. The secondary market is where previously issued securities are then traded among individuals and institutions. Taxonomy of Markets Money Markets or cash Fixed Income Capital Markets (Bond Markets) Equity Capital Markets (Stock Markets) Derivative Securities Markets International stock and bond markets Money Market Instruments Debt Instrument Short-term (less than one year) Marketable Liquid low-risk No coupon 1

2 Money Markets Money Market Instrument Market Value ($Billion, 1999) Certificates of Deposit $1,574.4 Commercial Paper $715.0 Treasury Bills $371.2 Repurchase Agreements $272.1 Eurodollar Deposits $149.4 Source: Economic Report of the President, 1999 Price The face value is assumed to be $10,000 What is the price of a money market instrument that pays $10,000 in three month? Return 10,000 P Holding Period Return = P 10,000 P 365 AnnualizeReturn = P n 10,000 P Effective AnnualYield = 1+ P 365 n 1 Money Market Yields Bank Discount Yield 10,000 P 360 r BDY = 10,000 n Bond Equivalent Yield 10,000 P 365 r BEY = P n What is the relation between BDY and BEY? Bank Discount Yield Example Consider a 90-day T-bill with a $10,000 face value and a current price, P, of $9,800. What is the Bank Discount Yield? Bond Equivalent Yield Example Continued Consider a 90-day T-bill with a $10,000 face value and a current price, P, of $9,800. What is the Bond Equivalent Yield? 2

3 Treasury Bills Yields, not prices are quoted. Maturity Days to Maturity BDY BEY Bid Asked Ask Yield Dec Feb May Treasury Bills Although it isn t listed, we can find the ask price of the T-bill maturing in May of 1999 using the quoted Bond equivalent yield or Bank discount yield. 10,000 P 365 rbey = P n P = n r BEY Treasury Bills Solving the BEY formula for P, we have: T-bill Price We can also calculate the price from the asked Bank discount yield Bond Markets Treasury Bonds Federal Agency Debt Municipal Bonds Interest income is tax-exempt at the federal, state, and local level Corporate Bonds Default risk; credit rating Treasury Bond Quotations Yield to maturity Price denominated in 32nds of par Rate Maturity Bid Asked Ask Yield 4 3/4 Nov 08n 100:05 100: Yield to Maturity 10 5/8 Aug :31 157: /4 Nov :17 101:

4 Municipal Bonds Tax Considerations Example Suppose that a municipal bond has a yield of 4%, while comparable taxable bonds pay 5%. Which gives you the higher after-tax yield if your tax bracket is 30%? Stocks Common Stocks Ownership in the firm Residual Claimant Limited Liability Voting rights Preferred Stocks Fixed Dividends No voting rights Uses Stock Indexes Track overall market or segment performance Compare to performance of portfolio managers Base of derivatives Passive investment through mutual funds Popular U.S. Stock Indexes Dow Jones Industrial Average Standard & Poor s 500 Composite Index Nasdaq Composite Index Wilshire 5000 Index Russell 2000 Index (2000 small stocks) International Stock Indexes Nikkei 225 (Japan) FTSE (Financial Times of London) Hang Seng Index (HK) Construction of Indexes Market capitalization-weighted or Value-weighted Price-weighted Which is more natural? 4

5 Construction of Indexes Value-weighted index is more natural because: large stocks are economically more important and should get more weight On average everyone hold the stocks in proportion to the market capitalization weights Construction of Indexes: Example Based on the following information, construct price and value-weighted indexes and compute the percentage change in each. Price per Share Company Shares Outstanding Beginning of Year End of Year ABC 200 million $30 $39 XYZ 50 million $80 $140 Construction of Indexes: Example What is the market cap of ABC? What is the market cap of XYZ? What is the return of ABC? What is the return of XYZ? Construction of Indexes: Example Note the average initial price was $110/2 = $55. The average ending price was $179/2 = $89.5. The percent change is: Construction of Indexes: Example Beginning Market Value Ending Market Value ABC 200 x $30 = $6, x $39 = $7,800 XYZ 50 x $80 = $4, x $140 = $7,000 Average $5,000 $7,400 The percent change in the index is Construction of Indexes: Example What were the portfolio weights of ABC and XYZ in the price-weighted index and the value-weighted index at the beginning? In the price weighted index In the value-weighted index 5

6 Construction of Indexes: Example Recall that the return of ABC is 30% and the return of XYZ is 75% The price-weighted index return is The value-weighted index return is The price-weighted index return is higher because XYZ gets more weight and XYZ s return is higher Derivatives A derivative asset is a financial asset that is derived from an existing traded asset. A futures contract is an agreement made today to buy or sell an asset at a future time period at a price specified today. An option contract is an agreement that gives the owner the right, but not the obligation, to buy or sell an asset at a specified price for a set period of time. Problem 2.2 T-bill, 180 days to maturity and a price of $9,600. BDY=8%. What is BEY? Problem 2.6 T-bill with 90 day maturity sells at a bank discount yield of 3%. What is the price of the bill? Problem 2.6 What is the 90 day holding period return? Problem 2.6 What is the effective annual yield? What is the BEY? 6

7 Problem 2.7 Find the price of a six month T-bill with a par value of $100,000 and a BDY of 9.18%. Problem 2.12 Tax rate 28%. Corporate bond offers 9%. What must municipals offer for investor to prefer them to corporate bonds? Financial Markets And Financial Instruments - Part II How Securities are Traded? Brokerage Accounts You can choose from two types of accounts to open Cash account Margin account To open an account, you need to choose a broker Full-service Discount Online Brokers Commissions Commissions ($50 share price) 200 Shares 500 Shares 1,000 Shares Full-Service Brokers $200 $250 $400 A.G. Edwards Merrill Lynch Discount Brokers $100 $150 $200 Charles Schwab Fidelity Brokerage Deep Discount Brokers $60 $100 $125 Olde Discount Quick & Reilly Source: Fundamentals of Investments, Corrado & Jordan (2000). 7

8 Commissions: Online Brokers Broker Internet Address Commission for Simple Stock Transaction Charles Schwab $29.95, up to 1,000 shares Fidelity Investments $25, up to 1,000 shares DLJdirect $20, up to 1,000 shares E*Trade $14.95, up to 5,000 shares Waterhouse $12, up to 5,000 shares Ameritrade $8, no share limits Spread BID ASK Spread =.125 The spread, or difference between a stock s BID and ASK price, represents a form of transactions costs when buying or selling a stock. Source: Fundamentals of Investments, Corrado & Jordan (2000). Types of Orders Market Orders Market Order Limit Order Stop-loss Order Market orders are simply buy and sell orders that are to be executed immediately at current market prices. Assume the Bid-Ask prices for Microsoft stock are $25.20 $ A market sell order will be executed at $25.20 and a market buy order will be executed at $ Limit Orders Specify the prices at which they are willing to buy or sell a stock. If the stock price falls below the limit on a limit buy order then the trade is to be executed. Correspondingly, a limit-sell order will be executed if the stock price goes above the specified limit. Limit Orders Assume the Bid-Ask prices for Microsoft stock are $25.20 $ A limit buy order at $25 can not be executed immediately. But it will be executed if the ask falls to $25 or below. A limit sell order at $25.50 can not be executed immediately. But it will be executed if the bid rises to $25.50 or above. 8

9 Stop Loss Orders Stop loss orders are similar to limit orders in that they will not be executed unless the stock hits a price limit. If the stock price falls below the limit on a stop loss sell order then the trade is to be executed. Correspondingly, a stop loss buy order will be executed if the stock price goes above the specified limit. Stop loss Orders Assume the Bid-Ask prices for Microsoft stock are $25.20 $ A stop loss sell order at $25 will not be executed immediately. But it will be executed if the ask falls to $25 or below. A stop loss buy order at $25.50 will not be executed immediately. But it will be executed if the bid rises to $25.50 or above. Auction Market Model (NYSE) Floor-based Single Specialist Order-driven Capital commitment limited to one firm Trade halts for volume imbalances Limit orders Dealer Market Model (Nasdaq) Screen-based Competing Market Makers Quote-driven Capital commitment from multiple firms Continuous order flow Arbitrage Opportunity An Example A pure arbitrage opportunity is a when you can make an immediate profit without taking any risk and without committing any capital. This is achieved usually by simultaneously buying and selling the same or similar security at advantageous prices. MM1 MM2 MM3 MM4 BID MM OFFER MM

10 There is no free lunch in financial markets One of the basic principles in finance is that there is no arbitrage opportunity or there is no free lunch. Limits to Arbitrage In practice, there are limits to arbitrage Transactions costs Short sale constraints Noise trader risk Fundamental risk Idiosyncratic volatility Short horizon What is Liquidity? Liquidity is a broad and elusive concept that generally denotes the ability to trade large quantities quickly, at low cost, and without moving the price. Bid-ask spread, quoted depth, trading volume are some of the proxies for liquidity. Why is Liquidity Important? Liquidity affects prices. Consider two otherwise identical securities. One is very liquid and the other is illiquid. Which one would you like to pay more for? The liquid one or the illiquid one? Low Prices High Returns Liquidity premium. Margin Purchase Brokers extend credit toward purchase or carry of securities via margins Margin is the portion of investment value that is not borrowed Interest paid at the Call Loan rate Shares kept in street name Initial margin set by Fed at 50% minimum Maintenance margin is set by exchange (NYSE requires 25%) Margin Account Equity Margin = Market Value of Position 10

11 An Example Assume an initial margin requirement of 55% and maintenance margin of 40%. With $5,500 of equity capital, you can buy 100 shares at $100 per share with a margin loan from the broker or else only 55 shares. What is your margin if price rises to $120? Or falls to $80? At what price will your broker issue a margin call? An Example What is your margin if price rises to $120? Amount you borrowed was Market Value of position is now Your margin is now Or as a percent: 7,500 12,000 = 62.5% An Example Or what if price falls to $80? Amount you borrowed was Market Value of position is now Your margin is now Or as a percent: 3,500 = 43.75% 8,000 An Example At what price will your broker issue a margin call? Account Equity Margin = Market Value of Position 100 P $4, = 100 P Solving for P, we get Another Example You are Bullish on ICM. The current price is $50 per share and you have $5,000 of your own to invest. You borrow an additional $5,000 from your broker at a call loan rate of 8% per annum. What will your rate of return be if ICM s price rises 10% over the next year? (Ignore dividends) How far would the year-end price need to fall to get a margin call if the maintenance margin is 30%? Another Example What will your rate of return be if ICM s price rises 10% over the next year? You now owe your broker The new market price is $55, so your position is now worth Your equity is Your rate of return is then 11

12 Another Example How far would the year-end price need to fall to get a margin call if the maintenance margin is 30%? Solving for P, we get P =. Short Sales Short sales allow investors to profit from a decline in a security s price by selling securities they do not own. How? By borrowing from another investor. SEC Rules: Short sale must be identified to the exchange Executed only on an uptick Short Sales: Example You are bearish on ICM. The current market price is $50 per share and you want to sell short 100 shares. How much cash and securities must you put into your brokerage account if the broker s initial margin requirement is 50%? How high can the price go before you get a margin call if the maintenance margin is 30%? Short Sales: Example How much cash and securities must you put into your brokerage account if the broker s initial margin requirement is 50%? You are shorting A 50% initial margin would require another Short Sales: Example How high can the price go before you get a margin call if the maintenance margin is 30%? Account Equity Margin = Market Value of Position 7, P.30 = 100 P Solving for P, we get P = Short Interest Short interest of a stock is the total number of shares have been short. Short interest ratio or days to cover number of days required to cover all the short positions at the average daily trading volume 12

13 Problem 3.13 Intel is $40 per share. You buy 500 shares using $15,000 your own money and borrow the rest. The rate on margin loan is 8%. A. What is your return if price immediately goes to $44, $40, $36? Problem 3.13 If $44, return = If $40, return = If $36, return = Problem 3.13 B. If the maintenance margin is 25%, at what price do you receive a margin call? P= C. At what price do you receive a margin call if you put down only $10,000 of your own money? P= Problem 3.13 D. What is your return if price is $44, $40, $36 in a year? E. At what price you receive a margin call in a year? Problem 3.14 Sell short 500 shares of Intel with current price of $40. You give your broker $15,000. A. If $44, If $40, If $36, B. At what price you receive a margin call? P= Problem 3.14 C. What if Intel pays a dividend of $1? 13

14 Problem 3.15 Bid: $55 ¼ Ask: $55 ½ A. Market buy order executed at $55 ½ B. Market sell order executed at $55 ¼ C. The limit sell at $ will not be executed. D. The limit buy at $ will be executed against the limit sell order. Before 2000, this limit order will not be executed. 14