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FIN 330: FINAL
Primary Market
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The market in which newly issued securities are sold for the first time from corps to investors through a bank
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Secondary Market
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Markets that trade financial instruments after they are issued between investors through brokers
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money markets
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trade securities that mature at less than 1 year. (OTC-electronic)
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capital markets
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trade equity that matures at more than 1 year
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foreign exchange markets
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denominated in foreign currency
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derivative market
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payoffs linked to another asset due to agreement to exchange at predetermined price.
(transfers risk, acts as insurance)
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Roles of Financial Institutions
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1. monitor costs2. liquidity and price risk
3. reduce transaction cost
4. maturity intermediation
5. denomination intermediation
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delegated monitor
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collect info and trade funds on investor's behalf
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asset transformers
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financial claims issued by financial institution that are more attractive than company claims
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diversify |
FIs transfer risk to itself to reduce liquidity risk of investor's funds
(offer highly liquid, low price risk bonds)
ex) mortgages transformed into savings because cash is liquid
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economies of scale
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increase output, lower total cost results from increased efficiency
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maturity intermediation
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reduce risk savers face of matching asset and liability maturities
ex) convert LT mortgages to ST so investors can invest while still making payments
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denomination intermediation
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pooling funds of small savers and creating smaller assets that are more diversified
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Economic Functions of FIs
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1. transmission of monetary policy
2. credit allocation
3. intergenerated wealth transfers/time intermediation
4. payment services
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Risks of FIs
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1. credit/default risk
2. country/sovereign risk
3. IR risk
4. insolvency
5. liquidity risk
6. tech
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Trends in US
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1. More investors in equity
2. More people taking money out of banks
3. Savers prefer diversified portfolios over transformed financial claims
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financial service modernization act
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allows companies to be in more than one financial sector
(increases systematic risk, "originate and distribute" mortgage backed securities)
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Loanable Funds Theory
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IR results from supply and demand of loanable funds
(IR determines value of financial instruments)
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Relationship of QS/QD and IR
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IR rises as QS rises
IR falls as QD rises
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QS determinants
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1. IR and tax policy
2. income and wealth
3. savings vs. borrowing
4. credit availability
5. job security
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QS shifters
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1. wealth
2. risk
3. ST spending needs
4. monetary expansion
5. economic condition
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QD shifters
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1. economic condition
2. nonprice conditions
3. utility
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Yield Curve
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shows relations ship between YTM and time to maturity
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unbiased expectations theory
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yield curve reflects markets expectations of function
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liquidity premium theory
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investors only hold securities at premium to compensate for future uncertainty
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market segmentation theory
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investors and institutions have preferences and to change them, require higher IR
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IR determinants
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1. inflation
2. real IR
3. default/credit risk
4. liquidity risk
5. covenants
6. term to maturity
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IR measures
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1. coupon rate
2. required rate of return
3. expected rate of return
4. realized rate of return
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required rate of return
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finds fair PV.
compensations should receive for taking on more risk
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market efficiency |
speed that security prices adjust unexpectedly to maintain equality with fair PV
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Premium
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Market Rate < State Rate
sells higher than face value
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Discount |
Market > Stated
sells less than face value
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zero coupon bonds
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dont pay interest
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equity valuation
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finding PV of infinite cash flows discounted at appropriate rate
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nonconstant growth steps
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1. Find PV of divs during period of nonconstant growth
2. Find price at end of period 1 of nonconstant growth
3. Find PV of divs after period of nonconstant growth
4. Add components of stock price together
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pull to par
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bond prices and fair values approach par
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Bond relationships
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As time and IR rise, PV and payment fall
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Duration
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weighted average time to maturity using PV of CF as weights.
measures IR sensitivity.
When will you be paid back value of bond?
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Duration Relationships
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Duration falls as ROR rises.
Duration rises with maturity at decreasing rate.
Higher payment, Lower Duration.
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FOMC |
monetary policy making body of the fed
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open market operations
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purchases and sales of t bills by the fed
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discount rate
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interest rate on loans fed charges banks
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reserve requirement
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minimum amount of cash banks must hold
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Quantitative Easing
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creating money to buy bonds which decrease interest rates
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Treasury Bills and Fed Funds Rate Relationship
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To lower interest rates, the fed injects money into the market. Banks then give up t bills to make price go up.
(expansionary policy)
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treasury bills
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short term debt securities that government issues to cover debt
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competitive bids
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bidder specifies quantity and price, can make multiple bids. typically banks and government
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noncompetitive bids
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always get what you want. allows small investors to participate in market without large risk
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federal funds
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short term funds transferred between institutions. no collateral
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repurchase agreement
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sale of securities with promise to repurchase at specific time. with collateral.
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commercial paper
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short term unsecured promissory notes issued by company to raise short term cash
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negotiable CD
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bank issued time deposits that specify interest rate and maturity date and is negotiable
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bond
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long term debt instruments that raise funds for projects
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bankers acceptance
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time draft payable to seller of goods with guaranteed payment of bank on specified date
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LIBOR |
The London Interbank Offered Rate, the rate for interbank dollar loans in the foreign or Eurodollar market of a given maturity.
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STRIP
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security in which periodic interest payment is separate from principal payment
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accrued interest
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portion of coupon payment accrued between last coupon payment and settlement day
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TIPs
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inflation indexed bond
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firm commitment underwriting
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investment banker purchases offering from bond issuer and resells it to public
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best efforts offering
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investment banker acts as a placement agent for bond offering
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private placement
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securty issue placed withi few large bankers
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municipal bonds
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securities issued by local governments. no income tax
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bearer bond
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coupon attached, if you have bond you receive cash
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registered bond
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owner recorded by issuer. payments mailed to owner
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term bond
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entire issue matures on single date
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serial bond
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mature on series of dates, portion paid on each
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debenture |
backed solely by creditworthiness of firm
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dirty price
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full price with accrued interest
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clean price
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price without accrued interest (newspaper quotes)
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mortgage
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loans to purchase home, land, or other property. no set denomination. single investors. less extensive unaudited info
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discount points
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payments made when loan is issued at closing. 1% of 1% of principal mortgage value
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jumbo mortgages
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can't be securitized. exceed conventional limits
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subprime mortgages
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made out to borrowers with low credit ratings
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option ARM mortgage
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offer borrower different amount to pay each month
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home equity loan
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lets borrowers borrow on a line of credit secured with a second mortgage on their home
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reverse annuity mortgage
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borrower receives regular monthly payments from FI rather than making them
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securitized |
packaged and sold as assets backing debt instruments. increases liquidity, reduce interest rate and credit risk and effects of regulation
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dividends
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cash payments to shareholders taxed twice as income
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prospectus
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provides detail about investment for sale
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program trading
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simultaneous trading of stocks using computer programs to initiate trading
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stock index
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number that represents what's going on in industry
(Dow Jones, S&P 500)
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market efficiency
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speed at which financial security prices adjust to unexpected news pertaining to interest rates. Degree to which information that gives traders advantage
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spot rate
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immediate exchange of currencies at current exchange rate
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forward rate
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exchange rate agreed but currency exchanged in future
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purchasing power parity
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estimates amount of adjustment needed in order for equal purchasing power between countries
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interest rate parity
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relationship that links spot exchange rates, forward rates, and interest raate
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net exposure
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extent to which funds trading portfolio is exposed to market flunctuations
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Forwards
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An agreement to buy or sell a specific amount of an asset at a future date for a set price. involves non standardized assets
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futures
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agreement to exchange standardized asset for cash at later date and traded on organized exchange. little default risk and set price.
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options
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contract that gives holder right to buy/sell underlying asset at prespecified price and time period. (call or put options)
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swaps |
agreement to exchange specified periodic cash in future based on some underlying instrument or price
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caps and floors
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hedge risk by buying a call option to restrict changes in interest rates
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collar |
hedge risk by taking cap and floor position
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security firms and investment bank services
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transferring funds
low cost efficient middlemen
consulting
underwriting
security is retail.
investment is comercial
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venture capital
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professionally managed pool of money used to finance promising high risk firms
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mutual funds
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provide small investor the opportunity to invest in a liquid and diversified portfolio. more regulated.
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hedge funds
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invest for wealthy individuals and have less regulation and are less liquid. management and performance costs.
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exchange traded funds
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long term mutual funds that also replicate stock index prices every second. can be traded during the day
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Financial crisis
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interest rates dropped to 1% to stimulate economy which pushed demand and prices for housing up and mortgages down
banks financing houses lost $500 billion whne bubble burst
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