ECO3223 Exam 2 Study Guide Lecture 6 Two Methods Computing Interest Rates on Money Market Assets Investment Rate IR actual annualized rate of return is of interest to the investor Bank Discount Rate DR used by traders in quoting rates to one another Computing Investment Rate see outline Interest Income Par Value paid at Maturity purchase price Investment Base purchase price Computing the Bank Discount DR Differs from the IR in 2 ways o Investment Base Par Value o Computed on the basis of 360 day year The IR is always GREATER than the DR Present Value and Future Value Calculations Present Value Calculations used to determine today s value of claims received in the future Ex Choose to take prize winnings as either Asset A Claim on 100 today Asset B Claim on 105 one year from today with certainty Assume Investor can purchase a risk free asset and earn an annualized rate of return of 7 on the investment see outline Pricing Corporate Bonds Corporate bonds represent claims to Semi annual coupon payments for the life of the bond Par value to be received when the bond matures Ex see outline 2 Generic Bonds Zero Coupon or Pure Discount Bonds claim is only on the Par Value received at maturity Standard Coupon Bond claims on semi annual coupon payments plus the Par Value received at maturity Pricing Coupon Bond Ex see outline Bond Rates and Bond Pricing Ex see outline Conclusion Inverse relationship between Bond Interest Rates and Bond Prices Coupon Bond Pricing Ex see outline Yield to Maturity YTM the investor s expected rate of return IF the bond is purchased at its market price and held to maturity In the Example the Bond is selling below Par and the YTM is above the Coupon Rate Primary Market for Corporate Bond Investment banks advise firms how to best raise funds in capital markets If bonds are recommended the investment bank o Sets the Par face value of each of the bonds o Asses the market demand for the bonds to determine the YTM required to sell the bonds at Par o Sets the coupon rate expected YTM Underwriting New Bond Issues Investment bank guarantees the firm will raise cash in the amount expected with the bonds selling at Par and most absorb any losses if the bond sells below Par Default Premium in Corporate Bonds YTM corporate bond Risk Free Rate Default Risk Premium o YTM increases Default Risk increases Risk Categories by Rating Agencies Investment Grade Bond Ratings AAA to BBB High Yield or Junk Bonds BB to C Bonds in Default D Trading Day May 28 2013 Bond Pricing Review Based on the Last Price which of the bonds traded above and below Par Suppose you didn t have the last price for the bond determine whether it was above high or low rating What happened to the bond price and the yield after the course of the trading day Which bond has the highest rating and which bond has the lowest Assume two bonds were issued at Par on the same day which of the bonds is seen to be riskier o Look at coupon rate which is higher Process by which a valuation is made of corporate stock involving o Competitive equity market o Large number of traders o All publicly available information is quickly incorporated into stock Lecture 7 The Price Discovery Process price Shorting a Stock An investor o Identifies a stock that he feels is overvalued o Borrows shares of that stock and agrees to return them at a future date along with a fee for the use of the stock o Sells the shares at the current market price which is believed to be o At the future date repurchases the stock which he hopes will be at a too high lower price o Returns the shares along with the promised fee Organized Stock Exchange Trading o Takes place in a centralized location on the floor of the exchange o Traditionally conducted in open outcry auction markets o Regulated by specialists One for each stock Match up buy and sell orders Act as broker and dealer Must buy or sell from their own account to ensure orderly trading when there is an imbalance in buy and sell orders o Most trading today is conduced electronically rather than through open outcry Over The Counter OTC Markets Trading o In stocks is mostly through OTC markets worldwide o Takes place electronically in decentralized markets o Traders quote bid prices at which they will buy a stock and asked prices at which they will sell the stock o Traders act as principals who take positions of risk by maintaining portfolio holdings of the stocks in which they trade o Is efficient with brokers able to observe the best price for their clients from among the bid and asked prices of traders that are continuously updated throughout the day NASDAQ and Circuit Breakers Example of OTC Market National Associations of Securities Dealers Automated Quotation NASDAQ Private organization that sets and enforces rigorous ethical standards among traders 5000 brokerages and 650 000 securities representatives Trading volume often exceeds that for the NYSE although the share price of NASDAQ stocks is much below those listed on the NYSE Circuit Breakers adopted by both organized and OTC markets in the United States to halt electronic programmed trading when stock prices fall too sharply Listing Requirements For NYSE o Financial disclosure publish quarterly earnings reports maintain active market in the stock o Sufficient size 1 1 million shares minimum worth at least 100 million o Sufficient investor interest according to daily trading volume Delisting could occur if the stock price falls to the point where the total value of the firm s stock falls below a threshold for continued listing Most major exchanges around the world have listing requirements albeit the NYSE s are among the most stringent Advantages of listing with major exchange Improves liquidity raises stock price lowers cost to the firm for raising money in the equity market Multiple Listings and Electronic Trading Unlike the past when listed stocks could only be traded on a single exchange today many of the major corporations worldwide are listed on multiple exchanges Electronic Communication Networks ECNs electronic trading platforms that can trade across exchanges Enable extended trading hours Enhance the speed of placing and filing orders Mergers of stock exchanges such as NYSE Group and Euronext in addition to ECNs have encouraged trend toward ever winding global 24 7 trading Stock Price and Corporate Earnings Share of Stock represents claims to a share of the firm s profits Stock Price and Dividends Management s Dividends Policy how to