ECO3223 Exam 2 Study GuideLecture 6Computing Interest Rates on Money Market AssetsTwo Methods:- 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 anotherComputing Investment Rate (see outline)Interest Income= Par Value (paid at Maturity) – purchase priceInvestment Base= purchase priceComputing the Bank Discount (DR)- Differs from the IR in 2 wayso Investment Base=Par Valueo Computed on the basis of 360 day year*The IR is always GREATER than the DRPresent Value and Future Value CalculationsPresent Value Calculations- used to determine today’s value of claims received in the futureEx) 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 BondsCorporate bonds represent claims to:- Semi annual coupon payments for the life of the bond- Par value to be received when the bond maturesEx) see outline2 Generic Bonds- Zero-Coupon or Pure Discount Bonds: claim is only on the Par Value receivedat maturity- Standard Coupon Bond: claims on semi-annual coupon payments plus the Par Value received at maturity Pricing Coupon Bond Ex) see outlineBond Rates and Bond Pricing Ex) see outlineConclusion: Inverse relationship between Bond Interest Rates and Bond PricesCoupon Bond Pricing Ex) see outlineYield to Maturity (YTM)- the investor’s expected rate of return IF the bond is purchased at its market price and held to maturityIn the Example: the Bond is “selling below Par” and the YTM is above the Coupon RatePrimary 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 bondso Asses the market demand for the bonds to determine the YTM required to sell the bonds at Paro 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 ParDefault Premium in Corporate Bonds- YTM (corporate bond) = Risk Free Rate + Default Risk Premiumo YTM increases  Default Risk increasesRisk Categories by Rating AgenciesInvestment Grade Bond Ratings: AAA to BBBHigh Yield or Junk Bonds: BB to CBonds in Default: DTrading Day: May 28, 2013Bond 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 tradingday- 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?Lecture 7The Price Discovery Process- Process by which a valuation is made of corporate stock involving:o Competitive equity marketo Large number of traderso All publicly available information is quickly incorporated into stock price Shorting a Stock- An investor:o Identifies a stock that he feels is overvaluedo Borrows shares of that stock and agrees to return them at a future date along with a fee for the use of the stocko Sells the shares at the current market price, which is believed to be “too high”o At the future date, repurchases the stock (which he hopes will be at a lower price)o Returns the shares along with the promised feeOrganized Stock Exchange- Trading:o Takes place in a centralized location on the floor of the exchangeo Traditionally conducted in “open outcry” auction marketso 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 orderso 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 worldwideo Takes place electronically in decentralized marketso Traders quote “bid prices” at which they will buy a stock and “asked prices” at which they will sell the stocko Traders act as principals who take positions of risk by maintaining portfolio holdings of the stocks in which they tradeo Is efficient, with brokers able to observe the best price for their clientsfrom among the bid and asked prices of traders that are continuously updated throughout the dayNASDAQ and Circuit Breakers- Example of OTC Market: National Associations of Securities Dealers Automated Quotation (NASDAQ)- Private organization that sets and enforces rigorous ethical standards amongtraders- 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 NYSECircuit 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 NYSEo Financial disclosure, publish quarterly earnings reports, maintain active market in the stock o Sufficient size: 1.1 million shares minimum, worth at least $100 milliono 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 listingMost major exchanges around the world have listing requirements, albeit the NYSE’sare 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 TradingUnlike the past when listed stocks could only be traded on a single exchange, today many of the major corporations worldwide are listed on multiple exchangesElectronic Communication Networks (ECNs): electronic trading platforms that can trade across exchanges- Enable extended trading hours - Enhance the speed of placing and filing ordersMergers of stock exchanges (such as NYSE Group and Euronext) in addition to ECNs have encouraged trend toward ever-winding global 24/7 tradingStock Price and Corporate