Financial Markets and Instruments short

Financial Markets And Financial Instruments -Part IWhat 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) marketTaxonomy of Markets󰂄Money Markets or “cash”󰂄Fixed Income Capital Markets (Bond Markets)󰂄Equity Capital Markets (Stock Markets)󰂄Derivative Securities Markets󰂄International stock and bond marketsFinancial Assets󰂄Real assetsare things such as land, buildings, machinery, and knowledge that are used to produce goods and services.󰂄Financial assetsrepresent claims on real assets or income generated by them. They do not contribute to the productive capacity of the economy directly.Primary and Secondary Markets󰂄The primarymarket for securities refers to the initial sale of securities to the public by a firm.󰂄The secondarymarket is where previously issued securities are then traded among individuals and institutions.Money Market Instruments󰂄Debt Instrument󰂄Short-term (less than one year)󰂄Marketable󰂄Liquid󰂄low-risk󰂄No coupon1Money MarketsMoney 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 ReturnHoldingPeriodReturn=10,000−PPAnnualizeReturn=10,000−P365P×n365EffectiveAnnualYield=⎛⎜1+10,000−P⎞n⎝P⎟⎠−1Bank Discount Yield󰂄ExampleConsider 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?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?Money Market Yields󰂄Bank Discount Yieldr=10,000−P360BDY10,000×n󰂄Bond Equivalent Yieldr10,000−P365BEY=P×n󰂄What is the relation between BDY and BEY?Bond Equivalent Yield󰂄Example ContinuedConsider 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?2Treasury BillsYields, not prices are quoted.BDYBEYMaturity Days to Maturity Bid Asked Ask Yield Dec 31 ‘98 31 4.33 4.29 4.37 Feb 25 ‘99 87 4.42 4.41 4.52 May 13 ‘99 164 4.42 4.40 4.55 Treasury Bills󰂄Solving the BEY formula for P, we have: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 ratingTreasury 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.r10,000−P365BEY=P×n⇒P=3650000365+n×rBEYT-bill Price󰂄We can also calculate the price from the asked Bank discount yield Treasury Bond Quotations󰂄Yield to maturity󰂄Price denominated in 32nds of parYield to MaturityRate Maturity Bid Asked Ask Yield 43/4 Nov 08n 100:05 100:06 4.73 105/8 Aug 15 156:31 157:05 5.38 51/4 Nov 28 101:17 101:18 5.15 3Municipal Bonds󰂄Tax Considerations󰂄ExampleSuppose 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%?Stock IndexesUses󰂄Track overall market or segment performance󰂄Compare to performance of portfolio managers󰂄Base of derivatives󰂄Passive investment through mutual fundsInternational Stock Indexes󰂄Nikkei 225 (Japan)󰂄FTSE (Financial Times of London)󰂄Hang SengIndex (HK)Stocks󰂄Common Stocks󰂄Ownership in the firm󰂄Residual Claimant 󰂄Limited Liability󰂄Voting rights󰂄Preferred Stocks󰂄Fixed Dividends󰂄No voting rightsPopular U.S. Stock Indexes󰂄Dow Jones Industrial Average󰂄Standard & Poor’s 500 Composite Index󰂄NasdaqComposite Index󰂄Wilshire 5000 Index󰂄Russell 2000 Index (2000 small stocks)Construction of Indexes󰂄Market capitalization-weighted or Value-weighted󰂄Price-weighted󰂄Which is more natural?4Construction 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 weightsConstruction 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 Beginning Market Value Ending Market Value ABC 200 x $30 = $6,000 200 x $39 = $7,800 XYZ 50 x $80 = $4,000 50 x $140 = $7,000 Average $5,000 $7,400 󰂄The percent change in the index isConstruction 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 Beginning End of Outstanding of Year Year ABC 200 million $30 $39 XYZ 50 million $80 $140 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󰂄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 index5Construction 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’sreturn is higherProblem 2.2󰂄T-bill, 180 days to maturity and a price of $9,600. BDY=8%. What is BEY?Problem 2.6󰂄What is the 90 day holding period return?󰂄What is the BEY?Derivatives󰂄A derivative asset is a financial asset that is derived from an existing traded asset. 󰂄A futurescontract is an agreement made today to buy or sell an asset at a future time period at a price specified today.󰂄An optioncontract 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 2.6󰂄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 effective annual yield?6Problem 2.7󰂄Find the price of a six month T-bill with a par value of $100,000 and a BDY of 9.18%.Financial Markets And Financial Instruments -Part IIBrokerage 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 BrokersProblem 2.12󰂄Tax rate 28%. Corporate bond offers 9%. What must municipals offer for investor to prefer them to corporate bonds?How Securities are Traded?Commissions Commissions ($50 share price) 200 Shares 500 Shares 1,000 SharesFull-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).7Commissions: Online BrokersBroker Internet Address Commission for Simple Stock Transaction Charles Schwab www.schwab.com $29.95, up to 1,000 sharesFidelity Investments www.fidelity.com $25, up to 1,000 shares DLJdirect www.dljdirect.com $20, up to 1,000 shares E*Trade www.etrade.com $14.95, up to 5,000 sharesWaterhouse www.waterhouse.com $12, up to 5,000 shares Ameritrade www.ameritrade.com $8, no share limits Source: Fundamentals of Investments, Corrado& Jordan (2000).Types of Orders󰂄Market Order󰂄Limit Order󰂄Stop-loss OrderLimit 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.SpreadThe spread, or BIDASKdifference between a stock’s BID and ASK 30.2530.375price, represents a form of transactions costs when buying or selling a stock.Spread = .125Market Orders󰂄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 –$25.25.󰂄A market sell order will be executed at $25.20 and a market buy order will be executed at $25.25.Limit Orders󰂄Assume the Bid-Ask prices for Microsoft stock are $25.20 –$25.25.󰂄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.8Stop 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.Auction Market Model (NYSE)󰂄Floor-based󰂄Single Specialist󰂄Order-driven󰂄Capital commitment limited to one firm󰂄Trade halts for volume imbalances󰂄Limit ordersArbitrage Opportunity󰂄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.Stop loss Orders󰂄Assume the Bid-Ask prices for Microsoft stock are $25.20 –$25.25.󰂄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.Dealer Market Model (Nasdaq)󰂄Screen-based󰂄Competing Market Makers󰂄Quote-driven󰂄Capital commitment from multiple firms󰂄Continuous order flowAn ExampleBIDOFFERMM125.2525.5MM225.5MM25.625MM325.525.625MM425.525.625MM525.62525.759There 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”.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.Margin Purchase󰂄Brokers extend credit toward purchase or carry of securities via margins󰂄Marginis the portion of investment value that is notborrowed󰂄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%)Limits to Arbitrage󰂄In practice, there are limits to arbitrage󰂄Transactions costs󰂄Short sale constraints󰂄Noise trader risk󰂄Fundamental risk󰂄Idiosyncratic volatility󰂄Short horizonWhy 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 ÆHigh Returns ÆLiquidity premium.MarginMargin=Account EquityMarket Value of Position10An 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󰂄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:3,5008,000=43.75%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’srises 10% over the next year? (Ignore price dividends)󰂄How far would the year-end price need to fall to get a margin call if the maintenance margin is 30%?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:7,50012,000=62.5%An Example󰂄At what price will your broker issue a margin call?Margin=Account EquityMarket Value of Position.40=100×P−$4,500100×PSolving for P, we getAnother Example󰂄What will your rate of return be if ICM’sprice 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 ______________11Another ExampleHow 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: ExampleYou 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: ExampleHow high can the price go before you get a margin call if the maintenance margin is 30%?Margin=Account EquityMarket Value of Position.30=7,500−100×P100×PSolving for P, we get P= _____________Short Sales󰂄Short salesallow 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 uptickShort Sales: ExampleHow 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 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 volume12Problem 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󰂄B. If the maintenance margin is 25%, at what price do you receive a margin call?ÎP= _____󰂄C. At what price do you receive a margin call if you put down only $10,000 of your own money?ÎP= _____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?ÎP= __________Problem 3.13󰂄If $44, return = ________󰂄If $40, return = ________󰂄If $36, return = ________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󰂄C. What if Intel pays a dividend of $1?13Problem 3.15󰂄Bid: $55 ¼Ask:$55 ½󰂄A. Market buy order executed at $55 ½󰂄B. Market sell order executed at $55 ¼󰂄C. The limit sell at $55.375 will not be executed.󰂄D. The limit buy at $55.375 will be executed against the limit sell order. Before 2000, this limit order will not be executed.14