Financial Markets

1. Financial Markets • Financial markets • link borrowers and lenders. • determine interest rates, stock prices, bond prices, etc. • Bonds • a promise by the bond-issuer to pay some specified amount(s) in the future in exchange for some payment (the bond price) today. • Stocks (equities) • legal rights of ownership in an incorporated firm. • promise the stockholder a share of the corporte profits (dividends)

2. The Bond Market. Maturity date: • the specific future date on which the maturity value will be paid to the bond holder. • Bond maturity dates generally range from 3 months up to 30 years. Coupon rate • Between the date of issuance and the maturity date, the bond-holder receives an annual interest payment equal to the coupon rate times the maturity value. Yield to maturity • represents the effective interest rate that the bond-holder earns if the bond is held to maturity. Bond price • The price that the bond sells for. This fluctuates over the life of the bond. • If the bond price is equal to 100% of its maturity value, the bond sold at “par”. • If the bond price is below 100% of its maturity value, the bond price sold “below par”.

3. The Bond Market • 20 year bond with maturity value of $1000 and coupon rate of 5% promises • 20 annual payments of .05*1000=$50 • $1000 payment at maturity (20 years from now). • If price is $1000 for this bond, the bond sold for par.

4. Present Value PV of $X to be paid in T years • Amount that if deposited today would grow to $X in T years • $X/(1+r)T Example: $100 deposited today at 10% interest will grow to: $100(1.1) in 1 year $100(1.1)2 in 2 years $100(1.1)3in 3 years $100(1.1)T in T years i.e. (FV) Future value of x deposited today for T years =PV(1+r) T Rearrange above equation to solve for x PV of x to be received in T years = x/(1+r)T

5. The Bond Market. Computing yields on a bond. • The yield on a bond is the same as the internal rate of return. To calculate the yield to maturity, define net present value (NPV) as follows: NPV = CP1/(1+r) + CP2/(1+r)2 + .... + CPT/(1+r)T + MV/(1+r)T - P • CP1, CP2, ... CPT are the interest or coupon payments in periods 1-T • MV is the payment received at maturity • P is the price paid for the bond. • The yield to maturity is the interest rate that makes the NPV on the bond purchase zero.

6. The Bond Market. One year bonds NPV = MV(1+cr)/(1+r) - P where cr is the coupon rate. Setting NPV=0 and solving for r provides the yield to maturity: yield = [MV(1+cr)/P] - 1 • As the price paid for a bond increases, the yield on the bond falls. • If P=MV (i.e. pay par), yield=CR • If P>MV, (i.e. pay above par), yield<CR • If P<MV, (i.e. pay below par), yield>CR

7. The Bond Market. Zero Coupon Bonds. • With zero coupon bonds, no interest payments are made between the sale of the bond and its maturity. That is, there is a zero coupon rate. For such bonds, the yield calculations is straightforward. NPV = MV/(1+r)T - P • setting NPV=0 and solving for r provides the yield: yield = (MV/P)1/T - 1 • For example, if you buy a zero coupon bond today for $1000 and it has a maturity value of $1500 in 10 years: yield = (1500/1000)1/10 -1 = .0414 = 4.14% As the price paid for a bond increases, the yield on the bond falls.

8. The Bond Market. • Determinants of bond yields • Higher expected inflation will drive up yields. • Higher risk bonds must offer higher yields. • Default risk. • Inflation risk • Term • Longer term bonds have greater inflation and default risk.

9. The Bond Market. • Yield curve • Shows relationship between yield and term on government bonds • Slope of yield curve reflects • Expectations of future short term interest rates • Greater risk of long term bonds • If short term interest rates are expected to be constant in the future, yield curve will slope upward reflecting risk premia for longer term bonds. • A steepening of the yield curve suggests that financial markets believe short term interest rates will be rising in the future. • The dynamic yield curve (see link on web page)

10. The Stock Market • Stocks (equities): • legal rights of ownership in an incorporated firm. • promise the stockholder a share of the corporte profits (dividends)

11. The Stock Market • The “fundamental value” of a stock is the expected present value of all future dividends from a stock. • P = d1/(1+r) + d2/(1+r)2 + d3/(1+r)3 + ....dT/(1+r)T • where T is the end of the firm’s life (which might be infinite) • d1, d2, ... dT represent dividend payments in years 1 through T. • r is the interest rate

12. The Stock Market • Given the fundamental value theory, stock prices will rise with: • lower interest rates. • an increase in future expected dividends. • A lower tax rate on dividends.

13. The Stock Market • Efficient markets hypothesis: • All stock prices represent their fundamental value at each point in time. • When new “information” arrives about a stock, its price immediately adjusts to reflect that new information. • It is impossible to consistently predict which way a stock price will move in the future and to consistently “beat the market”.

14. The Stock Market. • If the efficient markets hypothesis is true, • financial advisors can assist you only in evaluating the risk and tax consequences of different stocks and concerns regarding income or growth, etc. • Financial advisors will not be able to consistently find stocks that will “beat the market”. • The validity of the efficient markets hypothesis is controversial among economists.

15. The Stock Market • Stock quotes (see, for example, • Price • Volume (number of shares sold in previous day) • EPS (earnings per share) • PE ratio (price-earnings ratio) • Beta (measures stock movements relative to market)

16. Mutual Funds Mutual Funds:a firm that pools money from many small investors to buy and manage a portfolio of assets and pays the earnings back to the investors. Mutual funds can be categorized in several ways. For example: • index funds (S&P 500 or Willshire 5000) • international funds (invest in foreign securities) • bond funds (invest in bonds) • money market funds (invest in short term government securities) • The major advantage of mutual funds is that it allows a person to invest in the stock market and be diversified.

17. Options Market • Put option on a security: • the right to put (sell) a security at the strike price up until the expiration date of the option to the person that issued the put. • If I sell you a put option on IBM with a strike price of $150 and an expiration date of 1/1/2009, then at any time between now and 2009 you can force me to buy a share of IBM for $150. You would exercise your put option only if the price of IBM falls below the strike price of $150.

18. Futures Market • A market for contracts that provide for future delivery of a good at some pre-specified price. Futures markets exist for commodities, bonds, and foreign currencies. • Example: If I agree to a 1/1/2009 futures contract to buy 1000 bushels of corn at $3.00 per bushel, I am committed to buying corn on that date at that price. The other party to the contract is committed to sell 1000 bushels at $3.00 per bushel. The person who agrees to buy corn has “bought” a futures contract. The person who agrees to sell the corn has “sold” a futures contract. • If the expected price of a commodity in the future rises, the futures price will rise. • The price in futures contracts provides an indicator of what people believe about the movement of prices in the future.