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Investments, BKM Ch 2

Investments, BKM Ch 2. Zvi Wiener 02-588-3049 mswiener@mscc.huji.ac.il. Markets and Instruments. Money Market (up to 1 year to maturity) The Fixed-Income Capital Market Equity Securities Stock and Bond Market Indexes Derivative Markets. Money Markets. US Treasury Bills (T-Bills)

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Investments, BKM Ch 2

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  1. Investments, BKM Ch 2 Zvi Wiener 02-588-3049 mswiener@mscc.huji.ac.il http://pluto.mscc.huji.ac.il/~mswiener/zvi.html

  2. Markets and Instruments • Money Market (up to 1 year to maturity) • The Fixed-Income Capital Market • Equity Securities • Stock and Bond Market Indexes • Derivative Markets BKM Ch 2

  3. Money Markets • US Treasury Bills (T-Bills) • Certificates of Deposit (CD) • Commercial paper (CP) • Bankers’ acceptances • Eurodollars • Repos and Reverses • Federal Funds BKM Ch 2

  4. US Treasury Bills • Initial maturities are • 91-182 days, offered weekly • 52 weeks, offered monthly • Competitive and noncompetitive (10-20%) bids. • The investor buys the instrument at discount • bid-ask (spread) represents the profit for the dealer • quotes use the bank discount yield. • Exempt of state and local taxes. BKM Ch 2

  5. Bank Discount Yield • $10,000 par T-bill at $9,600 with 182 DTM. • $400(360/182) = $791.21 thus the bank discount yield is 7.91% rBD=(10,000-P)/10,000 ·360/n • effective annual yield is: (1+400/9600)2-1=8.51% • bond equivalent yield is: rBEY=(10,000-P)/P ·365/n BKM Ch 2

  6. Certificates of Deposit • Time deposits with commercial banks. • It may not be withdrawn upon demand. • Large CDs can be sold prior to maturity. • Insured by FDIC up to $100,000 • (Federal Depository Insurance Corporation) BKM Ch 2

  7. Commercial Paper • Unsecured short term debt (corporations). • Maturity is up to 270 days. • CP is issued in multiples of $100,000. • Small investors buy it through mutual funds. • Most issues have credit rating. • Treated for tax purposes as regular debt. • LC backed (letter of credit) optional. • In summer 1989 three companies defaulted. BKM Ch 2

  8. Bankers’ acceptances • Orders to a bank by a customer to pay a given sum at a given date. • Backed by bank. • Traded in secondary markets. • Widely used in international commerce, because the creditworthiness is supplied by a bank. BKM Ch 2

  9. Eurodollars • Dollar denominated time deposits in foreign banks. • Most are for large amounts and with maturity of less than 6 months. BKM Ch 2

  10. Repos and Reverses • Repurchase agreements (RPs) used by dealers in government securities. • Term repo has a maturity of 30 days or more. • Reverse repo is the result of a dealer finding an investor buying government securities with an agreement to sell them at a specified price at a specified future date. • Failure of dealers in 1985 - credit risk. BKM Ch 2

  11. Federal Funds • Commercial banks that are members of the Federal Reserve System (Fed) are required to maintain a minimum reserve balance with Fed. • Banks with excess reserves lend (usually overnight) to banks with insufficient reserves. • For more on Fed see Siegel-9 BKM Ch 2

  12. Brokers’ Calls • Brokers borrow funds to loan to investors who wish to buy stock on margin. • The broker agrees to repay the loan upon the call of the bank. • The rate is higher because of the credit risk component. BKM Ch 2

  13. LIBOR • London Interbank Offer Rate (LIBOR) is the rate at which the large London banks lend among themselves. • This rate serves often as an anchor for floating rate agreements which for example can be set at LIBOR + 3% BKM Ch 2

  14. Yields on Money Market Instruments • In general, money market instruments are quite safe. However, T-bills are the safest of the money money instruments. • As a result the other instruments provide a slightly higher yield. BKM Ch 2

  15. Fixed-Income Capital Markets • T-Notes - initial maturity of 10 years (or less). • T-Bonds - initial maturities of 10-30 years. • Par (also called face or principal) $1,000. • Interest (coupons) paid semiannualy. BKM Ch 2

  16. Rate Mo/Yr Bid Asked Chg. Ask Yld 83/4 Aug 00n 105:16 105:18 +8 7.55 Rate coupon payment 83/4% of $1,000; paid semiannually; $43.75 per bond each 6 mo. Maturity = August 2000 n = note Bid =105:16 means 10516/32=105.5% at the price $1055 buyer is willing to buy. Ask=105:18 means 10518/32=105.5625% at the price $1055.625 seller is willing to sell. BKM Ch 2

  17. “Callable Bond” Option • What is this call option? • Who has this option, who pays for it? • When is it optimal to exercise the call option? • Why does it make sense to calculate yields on discount bonds to maturity and yields on premium bonds to the first call? BKM Ch 2

  18. Federal Agency Debt • Some federal agencies issue their own debt. • They are not legally backed by the Treasury. • Treasury would assist in the event of distress. • These issues are very safe. • Yield is only slightly more than Treasury issues. • FNMA, GNMA, FHLMC BKM Ch 2

  19. Municipal Bonds (Munis) • Issued by state and local governments and agencies. Interest (not capital gains!) is exempt from federal taxes. • General Obligations are backed by the taxing power of the issuer. • Revenue bonds are backed only by revenues from specific projects. • Industrial Development bond is issued to finance a private projects. BKM Ch 2

  20. Interest from Munis • Is not subject to federal income tax. • Hence the yields are lower. • r ·(1- t) = rm • r - before tax return on taxable bond • rm - return on municipal bond • t - marginal tax rate • Attractive to wealthy investors. BKM Ch 2

  21. Corporate Bonds • Used to generate long-term funds. • The primary difference is the default risk. • Backed by specific assets (like mortgages). • By the financial strength of the firm only (debentures). • Callable at a call price (firm). • Convertible, may be exchanged to a stock (investor). BKM Ch 2

  22. Equities • Represent ownership in a corporation. • Each common stock entitles to one vote. • Shareholders vote for board members. • A proportional share of financial benefits. • Management usually solicits for proxy votes. BKM Ch 2

  23. Ownership • Closely held corporation - stocks are not traded. • Tender offer to buy stocks at a stipulated price. • Owner of more than 5% must report. • Insiders must report and are restricted. BKM Ch 2

  24. Residual Claim • government (taxes) • employees (including pensions) • bond holders • other creditors • Limited liability • means that the maximum loss is the original investment. BKM Ch 2

  25. Preferred Stock • A hybrid security with characteristics of both equity and debt. • Similar to an infinite bond. • No voting rights. • Can not demand for a bankruptcy. • Cumulative fixed or adjustable dividends. • May be redeemable or convertible. BKM Ch 2

  26. Dow Jones Average • Created in the late 19th century by Charles Dow • initially 10 rails and 2 industrial companies • 4 years later 18 rails and 2 industrials • Dow Industrial average, Nay 26, 1896 • 1916 the Dow was increased to 20 stocks • in 1928 - 30 stocks • It represents about 20% of the US market BKM Ch 2

  27. Calculation of the DJIA • sum of prices divided by the number of stocks • Why is it now 8000? • the denominator is adjusted when • there is a split • a stock pays a large dividend (10% or more) • a firm is replaced by another • How to invest in DJIA? BKM Ch 2

  28. S&P • Started on March 4, 1957; calculated back to 1926 • Base value was 10 - average value in 1941-1943 • it covers about 80% of the market capitalization • it is a market-value-weighted index • How is it affected by a stock split? • How one can invest in S&P 500? BKM Ch 2

  29. Market Capitalization (1993?) BKM Ch 2

  30. Indexes • DJIA, 30 stocks, NYSE, price weighted • S&P 500, NYSE, NASDAQ, value weighted • NYSE all NYSE stock, value weighted • NASDAQ, all NASDAQ, value weighted • Wilshire 5000, value weighted • Value Line, 1700 stocks, price weighted • Lehman Brothers - bonds • FTSE, 100 large stocks, value weighted • Nikkei 225, price weighted BKM Ch 2

  31. Index Arbitrage • classical arbitrage, used by professional traders when the index is not equal to the basket • it relies on computers to capitalize on such discrepancies and execute the baskets quickly. Is also known as program trading. BKM Ch 2

  32. Derivatives • Options • Call - a right to buy at strike • Put - a right to sell at strike • European, American, Exotic. • Futures and Forwards (obligation) • long position - will buy • short position - will sell BKM Ch 2

  33. Summary • Money market • US government Notes and Bonds • Municipal bonds r ·(1- t) = rm • Common Stocks • Preferred Stocks • Stock Market Indexes • Derivatives (Options, Futures, Forwards) BKM Ch 2

  34. Home Assignment • • read BKM-2 • problems 2, 3, 4, 8, 13 (3rd edition) • • problems 2, 3, 4, 10, 16 (5th edition) BKM Ch 2

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