Chapter 1 Financial Markets and Institutions

Student Notes

Chapter 1 Financial Markets and Institutions

Overview

Introduction to financial markets

Introduction to financial institutions

Review of terms

Financial Markets

Channel through which financial assets are exchanged. Process also known as funds
intermediation.

Surplus Units suppliers of funds, because they spend less than they receive.
Households are the only net supplier of funds.

Deficit Units users of funds, because they spend more than they receive. Households,
corporations, and governments can all be deficit units.

Financial Markets

Money Markets markets that trade debt instruments with maturities of up to one year.
Treasury bills, commercial paper, federal funds, negotiable CDs, repurchase agreements,
and bankers acceptances.

Capital Markets markets that trade equity and debt instruments with maturities of more
than one year.
Stocks, bonds, and mortgages.

Primary Markets markets in which corporations raise funds through new issues of
securities, such as stocks and bonds.
May be first-time issues by firms initially going public, the sale of additional new shares
of an already publicly traded firm, or first time debt issuances.

Secondary Markets markets in which existing securities are traded.

Organized Exchanges physical meeting place and communication facilities are
provided for members to conduct their transactions.

Chapter 1 Financial Markets and Institutions

Student Notes

Over-the-Counter (OTC) markets no central location. Financial claims can be traded

by phoning an OTC dealer or by using a computer system.

Efficiency Simply the idea that the market accurately prices the securities that are
traded in them. Markets can be weak, semi-strong, or strong form efficient.

Regulation Most important regulator is the Securities and Exchange Commission

(SEC).

Globalization Increased integration. It is becoming easier to acquire information about

foreign companies and invest accordingly.

Financial Institutions

Institutions serve as intermediaries because markets are not perfect.

Depository Institutions receive deposits and make loans.

Commercial Banks most dominant depository institution.
Savings Institutions take in deposits and provide mortgage loans.
Credit Unions take in deposits and provide retail loans.

Nondepository Financial Institutions do not accept deposits from consumers.

Finance Companies Spans a variety of fringe companies.
Consumer finance companies
Business finance companies
Sales finance companies

Nondepository Financial Institutions (cont.)

Mutual Funds primary investment tool of many households.
Securities Firms multiproduct firms that usually specialize in several market related
activities.
Examples include brokerage houses, underwriters, investment banks, and market makers.

Nondepository Financial Institutions (cont.)

Chapter 1 Financial Markets and Institutions

Student Notes

Hedge Firms sells shares to upscale investors and are allowed to invest in risky assets.
Largely unregulated.
Insurance Companies receive money from premiums and invest in financial securities.
Pension Funds Governments and companies allow employees to invest money in
securities.

Competition U.S. banks face increasing foreign competition.

Consolidation Banks continue to consolidate as regulations have relaxed.

Global Expansion U.S. banks, insurance companies, and securities firms have expanded
into foreign countries in recent years.

Key Trends Affecting Banks

Service Proliferation rapidly expanding services.

Rising Competition financial service firms entering other markets.

Government Deregulation fewer restrictions.

Technological Change ATMs, Point of Sale terminals, online payments, etc.

Consolidation and Geographic Expansion roll-up of the industry continues.

Convergence the movement of financial institutions across product lines.

Globalization largest banks compete with each other internationally.

Chapter 2 Determination of Interest Rates

Student Notes

Chapter 2 Determination of Interest Rates

Overview

Introduction to interest rates

Interest rate theories

Economic forces that affect rates

Interest Rates the price of borrowing money.

Relevance of Interest Rates

Direct influence on the valuation of debt securities.

Indirect influence on nearly all other financial instruments. ie. Stocks, exchange rates,
derivative securities.

Loanable Funds Theory rates are determined by the interaction between supply and demand for
funds.
Demand:

Individuals and Households

Businesses

Governments

Foreign Demand

Aggregate Demand

Supply:

Individuals and Households only net saver of funds

Businesses

Governments

Foreigners

Chapter 2 Determination of Interest Rates

Student Notes

Equilibrium Rate

Factors that Cause the Supply Curve to Shift

Wealth as total wealth increases, the supply curve shifts out.

Risk as the risk decreases, the supply curve shifts out.

Near-Term Spending Needs when participants have fewer spending needs, the supply
curve shifts out.
Monetary Expansion policy objects to allow expansion, the supply curve shifts out.
Economic Conditions as domestic economic conditions improve relative to other
countries, foreign inflows increase and the supply curve shifts out.

Factors that Cause the Demand Curve to Shift

Economic Conditions during periods of economic growth, market participants borrow

more heavily. The increase in demand increases the interest rate.

Economic Forces that Affect Interest Rates

Economic Growth demand increases with growth and rates rise.

Inflation Expected inflation decreases supply and increases demand, pushing rates
higher.
Fisher Effect nominal rate = real rate + expected inflation

Economic Forces that Affect Interest Rates

Money Supply The Fed can affect the supply, and, therefore the interest rates.

Budget Deficit Government deficits increase demand for funds, crowding out private
demand, driving rates higher.

Foreign Flows U.S. rates are increasingly more tied to the interest rates of other
countries.
Unified Germany Economic expansion drove rates up internationally.
Japans Recession Weak economic growth lowers rates internationally.
Asian Crisis Funds fled to more stable markets, driving rates down.
5

Chapter 2 Determination of Interest Rates

Student Notes

Summary Economic forces affect supply and demand of money.

Interest Rates Over Time

General Decline we have seen a general decline in interest rates since the early 1980s.

Volatility Rates were particularly volatile in the early 80s.

Fed changed policies in the early 80s creating instability.

Fed regained control in the late 80s and have been relatively stable.

Key Interest Rates

Federal Reserve Discount Rate The rate the Fed charges banks that borrow from it.

Federal Funds Rate the rate banks charge when they make short-term loans to each
other.

Treasury Bills short-term government securities. Commonly used as a benchmark

real interest rate.

Prime Rate a base rate that large, money center banks charge their best customers.

London Interbank Offer Rate (LIBOR) the rate that European banks charge each other.

Mortgage Rates reflect conditions in financial markets, in general.

Forecasting Interest Rates

Economic Models estimating the statistical relationships between measures of the

output of goods and services in the economy and the level of interest rates.

Flow-of-Funds Accounting shows the movement of savings through the economy in a

structured and comprehensive manner.

Chapter 3 Structure of Interest Rates

Student Notes

Chapter 3 Structure of Interest Rates

Overview

Factors Affecting Yields Among Securities

Term Structure

Uses of the Term Structure

Factors Affecting Yields Among Securities

Inflation actual or expected inflation.

Real Interest Rates the interest rate that would exist on a security if no inflation
were expected over the holding period of a security.
Fisher Effect the relationship among nominal interest rates, real interest rates,
and expected inflation.
Nominal Rate = Real Rate + Expected Inflation

Base Interest Rate Treasury securities.

Credit (Default) Risk the risk that a securitys issuer will default on that security by
missing an interest or principal payment.

Liquidity The risk that a security can be sold at a fair market price in a short period
of time.

Tax Status Taxable securities must pay a higher yield than similar tax exempt
securities.
Municipal Securities Free of federal taxes and may be free of state and local
taxes.
im = ic(t tf)
im= ic(t tf ts)

Term to Maturity The length of time until the principal amount borrowed becomes
payable.

Special Provision call features, convertibility options, and other provisions will
influence the yield of the security.
7

Chapter 3 Structure of Interest Rates

Student Notes

Actual Yield Differentials

Term Structures of Interest Rates the relationship between yield and term to maturity on
securities that differ only in length of time to maturity; graphically approximated by the
yield curve.

Pure Expectations Theory the yield curve reflects the markets current expectations
of future short-term rates.

Liquidity Premium Theory investors will hold long-term maturities only if they are
offered a premium to compensate for future uncertainty.

Preferred Habitat Theory the shape of the yield curve is determined by future
interest rates and a risk premium, to induce market participant to shift out of their
preferred habitat.

Segmented Markets Theory the shape of the yield curve is determined by supply of
and demand for securities within each maturity sector.

Research Results

Uses of the Term Structure

Forecast Interest Rates they yield curve can be used to assess the general
expectations of investors and borrowers about future interest rates.

Forecast Business Cycle provides information about the market expectations of

future business activity.

Investment Decisions investors can take advantage of different rates and ride the
yield curve to make a profit.

Financing Decisions by assessing the prevailing rates on securities for various

maturities, firms can estimate the rates to be paid on bonds with different maturities.

Impact of Debt Management Treasury decisions about debt financing can impact
the yield curve.

Historical Review Upward sloping.

Chapter 4 Functions of the Fed

Student Notes

Chapter 4 Functions of the Fed

Chapter Objectives

Explain the U.S. Federal Reserve System

Introduce monetary tools used by the Fed

Other monetary policy issues

History

Established in 1913 to control bank panics.

12 largely autonomous Federal Reserve banks were established.

Providing the Money Supply prints and issues currency.

Maintaining the Safety of the Financial System

Facilitation of the Payments System

Conducting Monetary Policy

Monitoring International Financial Transactions

Organization

Federal Reserve District Banks 12 banks

Member Banks All chartered banks must be members.

Board of Governors Key administrative body

Regulate commercial banks
Control monetary policy

Federal Open Market Committee (FOMC) directs the open market actions of the Fed.

Advisory Committees Advises on consumer issues.

Monetary Policy Tools

Chapter 4 Functions of the Fed

Student Notes

Open Market Operations buying or selling of Treasury securities.

Purchase of Treasuries Fed uses cash to buy Treasuries, usually from banks.
Sale of Treasuries Fed sells a portion of its Treasuries, usually to banks.
Technical Operations carried out through trading desk at New York Fed.
o Policy Directive
o Straight (outright) transactions
o Repurchase Agreements
o Agency Operations

Adjusting the Discount Rate it is the rate a financial institution must pay to borrow
reserve deposits from the Fed.

Adjusting the Reserve Requirement Ratio determines the amount of money that
financial institutions must keep on hand.

Miscellaneous

Fed Emphasis on Money Supply

Monetary Control Act of 1980 (DIDMCA)

Global Monetary Policy

Single European Policy

10

Chapter 5 The Fed and Monetary Policy

Student Notes

Chapter 5 Fed and Monetary Policy

Chapter Objectives

Review Goals of Fed and Monetary Policy

Review Fed Policy

Explain the Impact of Monetary Policy

Goals of U.S. Monetary Policy

Price Level Stability unstable price levels deter economic growth.

Inflation the continuous rise in the average price level. Usually caused by an
external economic shock in the supply of a crucial material. When confronted
with a supply shock, the fed has two options:
Nonaccommodation
Accommodation

High Employment (or low unemployment) between 4% and 6% is considered

full capacity.

Economic Growth increase in an economys output of goods and services.

Stability in Foreign Currency Exchange Rates widely fluctuating exchange rates

increases uncertainty into the economy.

Trade-offs and Conflicts Among Policies

Raise the rate of growth in the money supply by providing more reserves.
Reduce the rate of monetary expansion by reducing the reserves in the banking
system.

Recent Federal Reserve Policy

1970 1979: Targeting the Fed Funds Rate.

1979 1982: Targeting the banking systems nonborrowed reserves.

1983 Present: Back to the Fed Funds Rate.

11

Chapter 5 The Fed and Monetary Policy

Student Notes

Economic Indicators Monitored by the Fed

Indicators of Economic Growth Gross Domestic Product (GDP)

Indicators of Inflation
Producer and Consumer Price Indices
Other Indicators Commodity prices

Lags in Monetary Policy

Recognition Lag the lag between the time a problem arises and the time it is
recognized.

Implementation Lag the lag from the time a serious problem is recognized until
the time the Fed implements a policy to resolve it.

Impact Lag the lag until the policy has its full impact on the economy.

Assessing the Impact of Monetary Policy

Forecasting Money Supply Movements

Improved Communication from the Fed.
Market Reaction to Reported Money Supply Levels.
Anticipating Reported Money Supply Levels.
Market Reaction to Discount Rate Adjustments

Integrating Monetary and Fiscal Policies

History Generally, both the Fed and the government have been concerned with
maintaining economic growth and low unemployment.
Combining Policy Effects
Monetizing the Debt Action by the Fed to counteract the effects of sales of
Treasury securities by the Treasury.

Global Effects of Monetary Policy

12

Chapter 5 The Fed and Monetary Policy

Student Notes

Impact of the Dollar a weak dollar increases exports, which stimulates economy
and may drive up inflation.

Transmission of Interest Rates

Fed Policy during the Asian Crisis

13

Chapter 7 Bond Markets

Student Notes

Chapter 6 Money Markets

Detail the participants and their roles.

Explain different money market securities

Examine valuations.

Money Markets
Characteristics of the Money Market

Debt instruments that have a maturity of 1 year or less.

Highly liquid financial claims with negligible risk of loss.

Transaction size are very large (usually $1,000,000 to $10,000,000)

No formal organization, such as the NYSE for the equity markets.

Money Market Participants

Participants

Commercial Banks Most important class of buyers and sellers of money market
instruments.

Federal Reserve System open-market operations.

U.S. Treasury finance the federal deficit.

Corporations use to balance their cash position.

Money Market Mutual Funds purchase 1/3 of commercial paper.

Pension funds the other institutions

Money Market Securities

Securities

Treasury Bills U.S. Treasury Department issues various types of debt to finance the
national debt.
Treasury Bill Auction systematic, regular procedure.
o Competitive bids

14

Chapter 7 Bond Markets

Student Notes

o Noncompetitive bids
Estimating the Yield
Estimating the discount

Commercial Paper short-term, unsecured promissory note.

Ratings Moodys and Standard & Poors
Placement with institutions
o Directly placed paper
o Dealer-placed paper
Secondary Market secondary trading is limited.
Backing Commercial Paper not asset backed.
Slightly higher return than Treasury securities.
Finance companies are frequent issuers.
Estimating the Yield

Negotiable Certificates of Deposit (NCDs) A bank time deposit that is negotiable.

Placement corporate treasuries
Premium often, rate is above T-bill yield

Repurchase Agreements (Repos) sale of a short-term security with the condition that
the seller will buy it back at a predetermined price.
Estimating the Yield

Federal Funds commercial banks borrow and lend excess reserve balances to each
other.

Bankers Acceptances a bank accepts the responsibility to repay a loan to its holder.
Facilitates international trade.

15

Chapter 7 Bond Markets

Student Notes

Steps involved
Money Market Securities
Final Notes

Institutional use

Valuation

Limited price movements

Risk

Globalization of Money Markets

Performance of Foreign Money Market Securities

16

Chapter 7 Bond Markets

Student Notes

Chapter 7 Objectives

To identify the different types of Treasury securities

To identify the characteristics of municipal securities

To outline the types of corporate debt securities

Treasury Securities

Treasury Bills Treasury securities with a maturity of less than one year. These are sold on a
discount basis.

Treasury Notes Securities with maturities between 2 and 10 years. These are coupon
securities.

Treasury Bonds Securities with maturities greater than 10 years. These are coupon
securities.

Treasury Inflation Protection Securities (TIPS) A Treasury coupon security (either note or
bond) whose coupon rate is tied to the rate of inflation.

Primary Market Treasuries are sold in frequent well-publicized auctions.

Competitive bids
Noncompetitive bids

Secondary Market over-the-counter market where a group of dealers offer continuous bid
and as prices on outstanding Treasuries.

Stripped Treasury Securities Separating all coupon and principal payments into individual
securities. For instance, a 10-year semiannual note would convert into 21 separate STRIPS.

Quotations The bid price and the ask price are quoted per hundred of dollars of par value.

Salomon Brothers scandal Salomon took over a Treasury bond auction.

Brady Bonds U.S. Treasury department restructuring program for delinquent LDC debt.

Federal Agency Securities

Federal Agencies generally, a private company that was originated by the federal
government.

17

Chapter 7 Bond Markets

Student Notes

The Farm Credit System

Housing Credit Agencies
Export-Import Bank
Student Loan Marketing Association (Sallie Mae)
Small Business Administration (SBA)
Municipal Bonds
State and local government bonds

General obligation bonds provide basic services.

Revenue bonds used to finance a specific revenue-producing project.

Corporate Bonds
Corporate Bonds debt contracts requiring borrowers to make periodic payments of interest an
to repay principal at the maturity date.

Characteristics

Sinking-fund provision requires the bond retire a specific dollar amount of bonds each
year.

Protective Covenants Limit dividends or additional debt.

Call Provisions an option of the issuer to retire bonds before their maturity.
Bond Collateral
Mortgage bonds
Equipment Trust Certificates
Collateral Bonds
Debentures

18

Chapter 7 Bond Markets

Student Notes

Zero- Coupon Bonds Do not pay coupons.

Variable-Rate Bonds Coupon is tied to an interest rate rather than fixed.
Convertibility allows investors to exchange the bond for a stated number of shares of
the firms common stock.

Junk Bonds Corporate bonds with high default risk.

Market Size 25% of outstanding corporate bonds are junk.

Risk Premium Substantially higher interest rate.
Performance volatile.
Contagion price shocks affect entire junk bond market.

Restructuring through bonds

Leverage Buyouts investor group issues debt to fund the purchase of a company.
Capital Structure changes
Bond Markets

Eurobond Market a bond issued in a country other than the currency it is denominate in.

19

Chapter 8 Bond Valuation and Risk

Student Notes

Chapter 8 Chapter Objectives

Review the bond valuation process; and

Review bond characteristics.

Bond Valuation Process

Bond a security that obligates the issuer to make specified payments to the
bondholder.

Characteristics

Par Value face value of the bond.

Coupon specified number of dollars of interest paid each period.
Coupon Rate The annual coupon divided by par value.
Maturity Date when principal amount is due.
Yield to Maturity The rate of return earned on a bond if it is held to maturity.

Bond Valuation the present value of the cash flows.

Changing bond values over time New bonds are generally priced to sell at par
value. The price of seasoned bonds often vary widely from par value.

If the market interest rate equals the coupon rate, a fixed rate bond will sell at its
par value.

Market interest rate rises above coupon rate, a fixed rate bond sells below
(discount) its par value.

Market interest rate falls below coupon rate, a fixed rate bond sell above
(premium) its par value.

The price of the bond approaches its par value as it approaches maturity.
Market interest rate falls below coupon rate, a fixed rate bond sell above
(premium) its par value.

The price of the bond approaches its par value as it approaches maturity.
20

Chapter 8 Bond Valuation and Risk

Student Notes

Bond Risk
Assessing the Riskiness of a Bond

Interest Rate Risk risk of a decline in a bonds price due to an increase in market
interest rates.

Reinvestment Rate Risk The risk that a decline in interest rates will lead to a decline
in income from a bond portfolio.

Default Risk The risk that the issuer will be late or unable to make a payment.

Mortgage bonds backed by fixed assets.

Debentures not secured by fixed assets but is a general obligation of the firm.
Subordinated Debentures claim is lower than senior debt.
Bond Price
Bond Price Movements

Risk-Free Rate General interest levels affect all bonds.

Inflationary Expectations
Economic Growth
Money Supply Growth
Budget Deficit

Default Risk Premium Changing credit situations will affect bond prices.

Bond Price Sensitivity

Bond Price Elasticity the sensitivity of bond prices to changes in the required rate of
return.

Coupon Rate The lower a bonds coupon rate, the greater the price sensitivity.
Maturity Longer-term bonds have greater price sensitivity.

21

Chapter 8 Bond Valuation and Risk

Student Notes

Bond Pricing Theorems

Bond prices and market interest rates move in opposite directions.

When a bonds coupon rate is greater (less) than the markets required return, the
bonds market value will be greater (less) than its par value.

The price of longer-term bonds will change more than that of shorter-term bonds,
for a given change in market rates.

The price of lower-coupon bonds will change more than that of higher-coupon
bonds, for a given change in market interest rates.

Duration bond price volatility varies directly with maturity and inversely with
coupon rate. Duration considers both coupon rate and maturity.

Portfolio the weighted average of bond durations.

Using Duration to Reduce Interest Rate Risk
Zero Coupon Approach
Maturity-Matching Approach
Duration-Matching Approach
Bond Investment Strategies

Bond Investing

Matching Strategy Matching future cash outflows with coupon and principal
payments.

Laddered Strategy Spreading an investment over several different maturity

classes.

Barbell Strategy Investment is divided between short- and long-term bonds.

Interest Rate Strategy Use forecasts to develop a bond investment strategy.
International Bonds
Return and Risk of International Bonds

22

Chapter 8 Bond Valuation and Risk

Foreign Interest Rates Differentials

Credit Risk Differentials

Exchange Rate Fluctuations

International Bond Diversification

Student Notes

23

Chapter 9 Mortgage Markets

Student Notes

Chapter 9 Mortgage Markets

Chapter overview

Examine unique nature of market.

Review the evolution of the secondary markets.

Examine the characteristics of different mortgages.

Mortgage Markets

Unique Nature of the Mortgage Market

Secured by the pledge of real property.

Made for varying amounts and maturities.
Issuers are typically small, unknown entities.
Secondary market growing
Highly regulated and supported by the federal government.

Residential Mortgage Characteristics

Standard Fixed-Rate Mortgages lender takes a lien on real property in exchange for
payment.

Conventional Mortgages not insured by a federal government agency.

Private Mortgage Insurance (PMI) insures against default for borrowers with
less than a 20% down payment.
Historically, there has been no penalty for prepayment. However, this is not
always the case.

Residential Mortgage Characteristics

Standard Fixed-Rate Mortgages lender takes a lien on real property in exchange for
payment.

Insured Mortgages payment is guaranteed by a federal government agency.

24

Chapter 9 Mortgage Markets

Student Notes

Federal Housing Authority (FHA) allows a much smaller down payment and
guarantees payment.

Veterans Administration (VA) insures mortgages of military veterans and does not
require a down payment.

Adjustable-Rate Mortgages (ARMs) interest rate adjusts with the general level of rates.
Interest rate risk is shifted to the borrower.

Maturities Traditional maturity is 30 years and 15 year mortgages have become more
popular. Others include 3, 5, or 7 year balloon mortgages.

Creative Mortgages

Graduated-Payment Mortgage lower payments in the first few years and growing through
time.

Balloon Mortgage a fixed-rate mortgage that expires at a predetermined time (3, 4, 5, or 7

years). The unpaid balance is then due.

Growing-Equity Mortgage calls for rising payments over time resulting in a faster payoff.

Second Mortgage loans secured by liens on properties that are already mortgaged.

Reverse Annuity Mortgage (RAM) Provides regular monthly payments to the homeowner
with the home as collateral.

Mortgage Market

Secondary Market originators can sell mortgages in the secondary markets to both public
and private purchasers.

Valuation the present value if the future cash flows. Prices of existing mortgages are
relatively volatile due to their long term nature.

Investment Risk

Interest Rate Risk the value of fixed rate mortgages decline as interest rates rise.

Prepayment Risk falling interest rates encourage refinancing.

Credit Risk the likelihood that a borrower will default on the loan.

Mortgage-Backed Securities

25

Chapter 9 Mortgage Markets

Student Notes

Pass-Throughs payments of principal and interest on pools of mortgages are passed through
to holders of securities in the pool.

Government National Mortgage Association (GNMA Ginnie Mae) pass throughs on a pool
of federally insured mortgage loans.

Federal National Mortgage Association (Fannie Mae) issues a variety of pass-through

securities similar to Ginnie Maes.

Publicly Issued Pass-Through Securities (PIP) issued by private institutions.

Federal Home Loan Mortgage Corporation (Freddie Mac) assists lenders with
securitization of conventional mortgages.

Participation Certificates (PCs) different from Ginnie Maes in that:

Contain conventional mortgages
Not federally insured
Various interest rates
Much larger pools

Collateralized Mortgage Obligations consists of a series of related debt obligations, called

tranches, which pay various borrowers with different priorities.

Other Mortgage-Backed Securities

Mutual Funds several mutual funds have been established to buy Ginnie Mae securities.
Fannie Mae or Freddie Mac debt general obligation securities are basically secured by
mortgages.

Mortgage-Backed Securities Pass throughs

26

Chapter 11 Stock Valuation and Risk

Student Notes

Chapter 10 Stock Markets

Overview

Types and locations of trading

Trading mechanics and arrangements

Public placements

Monitoring of firms

Globalization

Background on Common Stock

Common Stock represents basic ownership claim in a corporation.

Owners expect capital gains and possibly dividends.

Value based on expected future cash flows.

Trading Locations

Organized Exchanges consist of physical locations where buyers and sellers meet on a
trading floor.

Over-the-Counter (OTC) dispersed traders linked via a computer system.

Auction System trading mechanism placing competing buyers and sellers against each
other.

Negotiated System individual buyers negotiate with individual sellers.

Stock (Organized) Exchanges consist of physical locations where buyers and sellers meet
on a trading floor.

New York Stock Exchange (NYSE) most popular stock exchange.

Specialists market makers in a stock.
Commission brokers execute orders for customers.
Floor brokers execute orders for other exchange members.

27

Chapter 11 Stock Valuation and Risk

Student Notes

Floor traders trade solely for themselves.

Over-the-Counter (OTC) dispersed traders linked via a computer system.

NASDAQ a computer network linking thousands of market-making participants.

Other OTC Markets subscriber markets where trading is via the telephone.
OTC Bulletin Board (OTCBB)
Pink Sheets

Alternative Trading Systems electronic communications networks or crossing networks that

link two parties for direct trading of stocks.

Types of Transactions

Long Purchase purchasing securities with the expectation that it will increase in value.

Margin Trading the use of borrowed funds to purchase securities. Purchased securities are
used a collateral.

Initial Margin minimum amount that must be provided by investor at time of purchase.

Maintenance Margin minimum amount that an investor must maintain in the margin
account.

Margin Call notification of the need to add cash to a margin account.

Short Selling selling borrowed securities with the expectation that the price will fall.

Trading Mechanics

Types of Orders price and conditions of an order.

Market order an order to buy or sell stock at the best price available when the order is
placed.

Limit order an order to buy at or below a specified price. Or, sell at or above a
specified price.
fill-or-kill order
day order

28

Chapter 11 Stock Valuation and Risk

Student Notes

good-till-canceled (GTC) order

Stop-loss order an order to sell a stock when its price reaches or drops below a
specified level.

Trading Arrangements

Retail Stock Trading buying and selling of stocks by individuals.

Institutional Trading buying and selling by financial institutions such as mutual funds and
pension funds.

Block Trades trades of at least 10,000 shares or market value of $200,000 or greater.

Program Trades buying and/or selling of a large number of different stocks

simultaneously.
Asset allocation trades
Index arbitrage

Stock Indexes

Dow Jones Industrial Average stock market average made up of 30 high-quality industrial
stocks.

Standard and Poors (S&P) measures the current price of a group of stocks.

New York Stock Exchange Composite current price of the stocks listed on the NYSE.

Other Indexes AMEX, Nasdaq, Value Line, Wilshire 5000

Preferred Stock

Debt/Equity hybrid represents ownership in a company but pays a fixed dividend amount.

Preferential treatment preferred dividends are paid before common dividends can be paid
and cumulate if they are not paid. Bankruptcy preference as well.

Nonparticipating usually no voting rights.

Institutional tax advantages other companies are able to deduct preferred dividends
received. Not attractive for individual investors.

Public Placement of Stock

29

Chapter 11 Stock Valuation and Risk

Student Notes

Initial Public Offerings (IPOs) the first issuance of common stock by a firm to the public.

Venture Capital (VC) firms that invest in private companies with the expectation of
taking them public.

Underwriters an investment bank must be hired to take the company pubic.

Details price range, number of shares, lockup period, and other details must be
established and filed with the SEC.

Road Show managers and underwriters travel to different cities to meet with
institutional investors to sell the company.

Offering the underwriter sets the price the number of shares and begins trading when
the market opens.
Building the Book

Initial Return typically, the return on the first day is substantial.

Flipping process of selling soon after trading has begun.

Lockup Agreement underwriter restricts managers, VCs, and other insiders from selling
their shares for at least six months.

Long-run Performance generally poor.

Secondary Stock Offerings an initial offering of stock by a firm that has other stock already
publicly held.

Shelf-Registration a company must register stock offerings with the SEC. Once the
registration is complete, the company waits for favorable market conditions.

Monitoring of Firms

Shareholder Activism shareholders take an active role in managing the company.

CALPERS

Socially conscious mutual funds

Corporate Monitoring

Acquisition poorly run companies become targets.

30

Chapter 11 Stock Valuation and Risk

Student Notes

Barriers
Anti-takeover Amendments
Poison Pills
Golden Parachutes

Self-Monitoring

Stock Repurchases a firm purchases its own stock when it believes it is undervalued.

Leveraged Buyouts use of debt financing to purchase the company.

Globalization of Stock Markets

International Investment Performance performance varies among countries and through

time.

Investing in foreign stocks

Indirect investment
Purchase shares of U.S. based MNC
Purchase international mutual fund

Direct investment
Purchasing stocks on foreign exchanges
Purchase stocks of foreign companies trading on U.S. exchanges.
Purchasing American Depository Receipts (ADRs)

31

Chapter 11 Stock Valuation and Risk

Student Notes

Chapter 11 Stock Valuation and Risk

Overview

Stock Valuation Methods

Estimating the Required Return and Growth Rate

Other Factors that Affect Stock Prices

Stock Performance Measurement

Stock Market Efficiency

Stock Valuation Methods

Discounted Cash-Flow Valuation Techniques the present value of some expected cash
flows.
Dependent on two estimated inputs:

Growth Rates

Discount Rates

Dividend Discount Model value of stock is the present value of all future dividends.

Zero Growth Model Dividends stay the same each year.

Infinite Constant Growth Model Dividends grow at roughly the same percent each year.

Supernormal Growth Model Dividends grow at higher rate for a period of time before
settling into a constant growth.

Present Value of Operating Cash Flows Deriving the value of the total firm from operating
cash.

Present Value of Free Cash Flows Deriving the value using free cash.

Relative Valuation Techniques provides information about how the market is currently
valuing stock at several levels.

Contends that valuing firms is accomplished by a comparison to other firms.

32

Chapter 11 Stock Valuation and Risk

Student Notes

Provides information current valuation but it does not provide guidance on whether
current valuations are appropriate.

Price to Earnings (P/E) Ratio determine how many dollars one is willing to pay for a dollar
of expected earnings.

Price to Cash Flow (P/CF) Ratio cash flow values are generally less prone to manipulation
than earnings.

Price to Sales (P/S) Ratio strong sales growth is a requirement for a growth company.
Little chance of manipulation.

Estimating the Inputs

Required Rate of Return will be the discount rate for most cash flow models.

Risk-Free Rate the absolute minimum rate an investor should require.

Expected Inflation if investors expect inflation, they should increase their required
nominal risk-free rate.

Risk Premium the risk associated with a specific stock or portfolio of stocks.

Growth Rates estimates of the growth rate of cash flows, earnings, and dividends are
required.

Estimating Growth from Fundamentals dividend growth is determined by the growth

rate of earnings and the payout ratio.

Estimating Growth based on History time-series growth rates should provide a trend
and the amount of variability.

Factors that Affect Stock Prices

Economic Factors

Interest Rates generally, an inverse relationship exists between stock prices and the
level of interest rates.

Exchange Rates currency strength affect market prices in many ways.

Market-Related Factors

Anomalies January effect, small firm effect, day of the week effect, etc.

33

Chapter 11 Stock Valuation and Risk

Student Notes

Firm-Specific Factors

Dividends indication about the future of the company.

Secondary Offerings dilution adversely affects stock price.

Repurchases indication the firm is undervalued.

Firm-Specific Factors

Earnings Surprises changes may indicate future trends.

Acquisitions and Divestitures Acquirers adversely affected, targets positively affected.

Expectations

Evidence stock prices are affected by factors other than fundamental factors.

Indicators Price movements are often used as an indicator.

Stock Risk

Measures of Risk

Standard Deviation

Variation

Beta

Stock Performance Measurement

Sharpe Index measures the risk premium per unit of total risk, measured by the stocks
standard deviation.

Treynor Index measures the risk premium of a stock per unit of nondiversifiable risk,
measured by the beta.

Stock Market Efficiency

Forms of Efficiency

Weak-Form Efficient past data on stock prices is of no use in predicting future prices.

34

Chapter 11 Stock Valuation and Risk

Student Notes

Semistrong-Form Efficient publicly available information is of no use in predicting

future prices.

Strong-Form Efficient no information, public or private, allows investors to

consistently beat the market.

35

Chapter 12 Market Microstructure and Strategies

Student Notes

Chapter 12 Objectives

Examine methods of researching stocks

Examine methods of trading stocks

Introduce alternatives (index funds) to investing in stocks.

Stock Market Investing

Research there are numerous resources to use when researching stocks. Some include:

Valueline

Websites Yahoo, Nasdaq, Morningstar, Bloomberg

Edgar Online access to SEC filings at www.sec.gov

Placing an Order open an account with a broker. Full-service, discount, or online brokers
are available.

Market Order an order to buy or sell a stock at the best possible price.

Limit Order an order that specifies the price to buy or sell the stock at.

Stop Loss Order a conditional market order whereby the investor directs the sale of a
stock if it drops to a given price.

Stop Buy Order a conditional market order if the stock rises above a given price.

Margin Transactions the investor pays for the stock with some ash and borrows the
remaining through the broker, putting up the stock for collateral.

Initial Margin 50 percent of the value of the stock.

Maintenance Margin 25 percent of the value of the stock.

Margin Call requirement to add more equity or sell the stock.

Short Selling the sale of stock that is not owned with the intent of purchasing it in the
future at a lower price.

Specifically, you would borrow the stock from another investor, sell it in the market, and
replace it at a later date.

36

Chapter 12 Market Microstructure and Strategies

Student Notes

Investing in Stock Indexes investor can select mutual funds the shadow a specific index or
opt for exchange traded funds.

Exchange-Traded Funds (ETFs) baskets of securities that are traded, like individual
stocks, on an exchange.
Can be bought and sold throughout the day.
Very low expense ratio. However, commissions must be paid on trades.

Trade Execution

Floor Brokers independent members of an exchange who act as brokers for other members.

Specialists or Market-Makers

Serve as brokers to match buy and sell orders.

Maintain limit order book.

Maintain fair and orderly market when necessary by buy and selling from their own
account.

Electronic Communication Networks (ECNs) displays customer orders electronically and

provide access to pricing information.

Rising in popularity.

Program Trading computerized trading that involves the buying or selling of a portfolio of
stocks.

Collars NYSE applies program trading curbs when the Dow moves 160 points either up
or down.

Circuit Breakers NYSE halts trading if the market moves down by 10%.

Regulation of Stock Trading

Securities and Exchange Commission (SEC) created in 1934 to enforce newly enacted
securities laws.

Division of Corporate Finance

Division of Market Regulation

37

Chapter 12 Market Microstructure and Strategies

Division of Investment Management

Division of Enforcement

Student Notes

38

Chapter 13 Financial Futures Markets

Student Notes

Chapter 13 Financial Futures Markets

Detail the background on futures

Introduce the trading and mechanisms

Examine commodity and financial futures

Background on Futures

Futures Contract A commitment to deliver a certain amount of some specified item

at some specified date in the future.

Commodity Futures
Financial Futures
Options versus Futures future contract involves an obligation from both parties.
Option does not.

Forwards versus Futures forward is tailored to meet the needs of the purchaser.
Future is standardized.
Trading Futures

Participants hedgers and speculators. Both are needed for the market to work.

Hedgers enter into futures contract to protect a current position of loss of value.
Speculators attempting to earn profits on price swings. Important in creating
liquidity.

Trading Mechanics futures are readily traded in the market.

Long position purchasing a futures contract.

Short position selling a futures contract.
Liquidating a position entering into an opposite futures contract.

Margin Trading putting up only a fraction of the total price in cash. The margin
usually ranges from 2 10% of the value of the contract.

Commodities
39

Chapter 13 Financial Futures Markets

Student Notes

Basic Characteristics four major segments include: grains and oilseeds, livestock
and meat, food and fiber, and metal and petroleum.

Contract every commodity has its own specifications regarding amounts and
quality.

Price behavior commodities react to economic, political, and international

pressures.

Return on investment only return comes from price movement. High returns are
possible due to the volatility of prices and the high leverage.

Trading Commodities

Speculating attempt to capitalize on the wide price swings.

Spreading combining two or more different contracts into one position to
achieve gains and limit losses.

Hedging used by producers and processors to protect a position in a product or

commodity.
Financial Futures

Financial Futures Market created in the early 1980s. Its level of trading has far
surpassed the level of trading in commodities.
These are derivative securities because they derive their value from the assets that
underlie them.

Currency Futures futures contracts of foreign currencies.

Interest Rate Futures futures contracts on debt securities.
Stock-Index Futures futures contracts on broad based measures of stock market
performance.

Trading Stock-Index Futures predicting the future course of the stock market.
Hedging Other Securities

Options on Futures give the purchasers the right to buy or sell a single futures
contract.
40

Chapter 13 Financial Futures Markets

Student Notes

Limits the loss exposure to the price of the option. Downside risk is limited.

41

Chapter 14 Options Markets

Student Notes

Chapter 14: Options Markets

Chapter Objectives

Review options and their application

Review trading strategies

Options

Option a security that gives the holder the right to buy or sell a certain amount of an
underlying financial asset at a specified price.

Call gives the purchaser the right to buy securities at a stated price for a specified time
period.

Put gives the purchaser the right to sell securities at a stated price for a specified time
period.

Advantages

Leverage

Ability to earn profit on price declines

Limited downside loss for purchasers

Disadvantages

No ownership benefit

Limited time frame

Complex

Stock Option Provisions

Strike (exercise) price the state price at which you can buy a security with a call or sell
a security with a put.

Expiration date
Quotes - WSJ

42

Chapter 14 Options Markets

Student Notes

Options Pricing and Trading

Profit Potential of Options

Call limited loss to the premium and unlimited possible gains if the stock moves higher.
Put limited loss to the premium and unlimited possible gains if the stock moves lower.
Fundamental Value of Options

Value depends ultimately on the exercise price and the prevailing market price of the
underlying stock.

Call (market price strike price) x 100

Put (strike price market price) x 100
In-the-money

Call strike price < market price

Put strike price > market price

Out-of-the-money no value

Call strike price > market price

Put strike price < market price

Stock Option Premiums

Fundamental value the higher (lower) the market price for a call (put), the greater the value.

Time premium the longer the time to expiration, the greater the size of the premium.

Price volatility premium the more volatile the stock, the greater the premium.

Trading Strategies

Buying for speculation buy low and sell high.

Hedging purchasing an option to offset a current position in equities.

Option Writing and Spreading

43

Chapter 14 Options Markets

Student Notes

Writing Options do so because they do not believe the price is going to move that far.

Naked Options options written on a security not owned by the writer

Covered Options options written on a security owned by the writer.

Options Spreading combining two or more options with different strike prices and/or
expiration dates into a single transaction.

Stock Index Options

Index Options a put or call option written on a specific stock market index, such as the S&P
500.

Investment uses

Speculation offer investors the opportunity to play the market with a small amount
of money.

Hedging allows an investor to protect a current portfolio from downside risk.

Other Types of Options

Interest Rate Options options written on fixed-income (debt) securities.

Currency Options options written on foreign currencies.

LEAPS (Long-Term Equity AnticiPation Securities) expiration dates that extend out as far
as two years.

44

Chapter 15 Interest Rate Derivative Markets

Student Notes

Chapter 15: Interest Rate Derivative Markets

Chapter Objectives

Review swaps and their application

Review Interest Rate Caps, Floors, and Collars.

Swap Background

Swap an agreement whereby two parties (called counterparties) agree to exchange

periodic payments.

Notional Amount (Principal) the dollar amount of the payments exchanged is based
on some predetermined dollar principal.

Types of Swaps

Interest Rate Swap the counterparties swap payments in the same currency based on
an interest rate.

Plain Vanilla one set of payments is fixed and the other is variable.
Coupon Swap one party pays the other the fixed-coupon rate, and the other pays
the coupon rate on a floating-rate instrument.

Basis Swap the parties exchange payments based upon floating-rate indexes, but
each coupon is determined by a different rate.

Application useful ways of tailoring the interest rate risk desired. Reasons why
a firm needs to alter their interest rate risk:

Interest rate exposure has changed over time

Two different firms have advantages in markets they prefer to not be in.

Swap Interpretation
Essentially, two parties enter into multiple forward contracts. Why do they exist?

In many markets, forwards and futures do not extend out as far as that of a typical
swap.

Swap is transactionally efficient one contract to handle what it would have taken
multiple forward contracts to handle.
45

Chapter 15 Interest Rate Derivative Markets

Student Notes

Increased liquidity

Interest Rate Caps, Floors, and Collars

Interest Rate Cap a series of interest rate calls, designed to limit the cost of a loan
with multiple interest payments

Interest Rate Floor a series of interest rate puts, designed to protect the return on a
loan with multiple interest payments.

Interest Rate Collar a combination of the purchase of an interest rate cap and the
sale of an interest rate floor.

46

Chapter 16 Foreign Exchange Derivative Markets

Student Notes

Chapter 16: Foreign Exchange Derivative Markets

Chapter Objectives

Give background on foreign exchange markets

Introduce foreign exchange derivative instruments

Foreign Exchange Markets

Background

Foreign currency is simply another asset.

Exchange rate is the price at which the asset can be bought.
Volatility of exchange rates should be viewed as a source of risk.

Spot Market the market for immediate delivery of foreign currency.

Forward Contract a contract between a bank and a customer.

Exchange a specified amount.

Exchange on a specific date.
Exchange for a specified price.

Futures Contract agreement between two parties to exchange foreign currency.

Standardized amount
Traded on an exchange
Specified maturity dates
Speculators and hedgers participate
Contract interpretation
Closing a position enter into an opposite position.
Credit risk limited due to market restrictions.
47

Chapter 16 Foreign Exchange Derivative Markets

Student Notes

Currency option purchaser receives the right to buy or sell a currency at a later date
at an agreed price.

No obligation for the purchaser.

Call right to buy a currency at the strike price on or before the expiration date.
Put right to sell a currency at the strike price on or before the expiration date.

Currency swap an agreement between two parties to trade payments in different

currencies.

48

Chapter 17 Commercial Bank Operations

Student Notes

Chapter 17 Commercial Bank Operations

Look at bank regulations

Determine sources and uses of funds

Look at off-balance-sheet activities

Financial Conglomerates

Financial Services Modernization Act allows banks to offer a wide variety of

products, including insurance and underwriting services.

Diversified Services are there benefits to customers?

Diversified Services are there benefits to banks?

Bank Sources of Funds

Demand Deposits checking accounts

Savings Deposits important source for small banks.

Time Deposits have a maturity date

Certificates of Deposit (CDs) fixed interest rate and maturity date

Negotiable Certificates of Deposit (jumbo CDs) denominations of $100,000 or
greater.

Money Market Deposit Accounts pays an interest rate.

Federal Funds Purchased borrowing from another banks reserves.

Federal Reserve borrowing borrowing funds from the district Federal Reserve bank.

Repurchase Agreements (RPs) banks sells securities and simultaneously contracts to

repurchase the same securities.

Eurodollar Borrowings short-term deposits at foreign banks.

Bonds large commercial banks may issue bonds.

Capital equity ownership of a bank.

49

Chapter 17 Commercial Bank Operations

Student Notes

Bank Uses of Funds

Cash vault cash, Fed reserves, balances at other banks, collections.

Bank Loans primary business activity of a commercial bank.

Business Loans usually secured by an asset.

Bridge Loan cash for a specific transaction.

Seasonal Loan term financing to handle the fluctuations of the business

cycle.

Long-Term Asset Loan loan for a specific asset.

Loan Participations a group of banks cooperate to underwrite large loans.

Consumer Loans bank loans to individuals.
Real Estate Loans mortgage loans.

Investment in Securities primarily consists of U.S. government bonds, municipal

securities, and bonds issued by U.S. government agencies.

Fed Funds Sold lending of excess bank reserves to other commercial banks.

Reverse Repurchase Agreements counterparty to a repurchase agreement.

Eurodollar Loans short-term loans denominated in dollars and made outside the
U.S.

Fixed Assets the bank.

Off-Balance Sheet Activities

Loan Commitments promise by a bank to lend money according to the terms

outlined in the commitment.

Standby Letters of Credit bank promise to pay a third party in the event that the
banks customer fails to pay.

Derivative Securities interest rate and currency forwards, futures, options, and
swaps.

50

Chapter 17 Commercial Bank Operations

Student Notes

51

Chapter 19 Bank Management

Student Notes

Chapter 19 Bank Management

Chapter Objectives

Examine the goals of bank management

Examine how to measure and manage risk

Review bank mismanagement

Goals of Bank Management

Maximize shareholder wealth

Managing Liquidity asset and liability management

Asset Management deposits, investments, loan repayments, and asset sales.

Liability Management certain types of bank liabilities are very sensitive to interest
rate changes.

Securitization grouping like assets and selling the securities to investors.

Managing Interest Rate Risk

Methods of Assessing Interest Rate Risk

Gap Analysis the rate sensitivity of bank earnings as measured by the gap
between the maturity of assets and liabilities.
Duration Measurement measuring the gap between the durations.
Regression Analysis how performance has historically been influenced by
interest rate movements.

Methods of Reducing Interest Rate Risk

Maturity Matching matched funding of loans.
Floating-Rate Loans loans that adjust to current interest rates.
Interest Rate Futures Contracts take offsetting position in futures markets.
Interest Rate Swaps exchange periodic cash flows based on specified interest
rates.
52

Chapter 19 Bank Management

Student Notes

Interest Rate Caps buy calls on interest rate movements.

Managing Credit Risk

Tradeoff between Credit Risk and Return the lower the risk, the lower the expected
return.

Measuring Credit Risk credit analysis and collateral.

Diversifying Credit Risk avoid concentrating assets among a single firm or firms in
the same industry.

Other Issues

Measuring Market Risk Value-at-Risk (VAR) method to determine possible losses.

Bank Capital Management maintain adequate amounts of capital.

Provides a financial cushion
Maintains public confidence
Provides protection to depositors
Source of funds for growth

Restructuring shifted revenues away from interest margins to fee income

Acquisitions growth quickly achieved through acquisitions.

Bank Mismanagement

Penn Square Bank loans concentrated with energy companies.

Continental Illinois Bank small core deposit base so it relied on borrowed funds.

Bank of New England concentrated loans on commercial real estate.

Implications risk is greatly increased with lack of diversity and aggressive loan
strategies.

53

Chapter 20 Bank Performance

Student Notes

Chapter 20 Bank Performance

Chapter Objectives

Examine the factors that affect cash flows..

Review the factors that affect the required rate of return.

Examine performance evaluation.

Factors that Affect Cash Flows

Economic Growth strong economic growth increases expected future cash flows.

Risk-Free Interest Rate interest rates are inversely related to the value of a bank.

Industry Conditions regulations have a large impact on the industry.

Management Abilities skilled management increases cash flows.

Factors that Affect the Required Return

Risk-Free Rate inversely related to value.

Risk Premium also inversely related to value. Economic conditions has a large
impact.

Performance Evaluation

Interest Income has been declining in recent years. Is still comparatively large for
small banks.

Interest Expense interest paid on deposits and other borrowed funds.

Net Interest Income difference between interest income and interest expense.

Noninterest Income fees charged for services.

Noninterest Expense expenses not related to the payment of interest on deposits.

Bank Performance Evaluation

Return on Assets (ROA) Net Income/Total Assets tells how much profit is
generated with a given amount of assets.

54

Chapter 20 Bank Performance

Student Notes

Return on Equity (ROE) Net Income/Total Equity the amount of profits in relation
to the capital contribution to the firm.

55

Chapter 21 International Banking

Student Notes

Chapter 21 International Banking

Global Bank Regulations

Uniform Global Regulations

Uniform Regulations for Banks Operating in the U.S. foreign banks subject to
same regulations as U.S. banks.
Uniform Regulations across Europe one set of rules for banks operating in
Europe.
Uniform Capital Adequacy Guidelines 4% capital to assets ratio.

Global Bank Competitions

Competitions in Foreign Countries more competition in other companies.

Competition in the U.S. many foreign banks have established branches in the U.S.

Impact of the Euro increased competition for financial services across Europe.

Risks of Multinational Banks

Credit Risk more difficult to obtain credit information abroad.

Exchange Rate Risk currency value and exchange controls.

Country Risk closely tied to political developments in a country.

Settlement Risk risk that it may not receive money due to default and have little
recourse.

Interest Rate Risk forecasting becomes more difficult with the level of international
involvement.

Combining all Types of Risk asset management becomes very complex.

International Debt Crisis

Latin and South America many countries defaulted in the early 1980s.

Reducing Bank Exposure to LDC Debt

Selling LDC Loans
56

Chapter 21 International Banking

Student Notes

Debt-Equity Swaps
Boosting Loan Loss Reserves

Brady Plan voluntary debt-relief measures allowing banks various exit instruments.
Brady Bonds an exit bond that exchanged debt for lower principal and interest
amounts.

Country Risk Assessment

Economic Indicators evaluates the countrys economic environment.

Debt Management measures the fiscal policy of the country.

Political Factors risk of unexpected change in the political environment.

Structural Factors evaluation of the natural resources of the country.

Overall Rating each variable generates a rating which is then weighted to created an
average score.

57