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FIN 330: Exam 2
Money Market
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-involve debt instrument with maturities of 1 year or less
short-term
-have active secondary markets
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Money Market Participants
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-U.S Treasury
-Federal Reserve
-Commercial Banks
-Mutual Funds
-Brokers and Dealers
-Corporations
-Other Financial Institutions
-Individuals
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Treasury Bills
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short-term debt obligations issued by government
-Fed Reserve buys and sells T-bills to implement monetary policy
-default risk free, highly liquid, little interest rate risk
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Auctions
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*13 and 26-week bills are auctioned weekly
-bids submitted by gov securities dealers, financial and nonfinancial corps, and individuals
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Competitive Bids
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specify bid price and desired quantity of T-bills
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Noncompetitive Bidders
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get preferential allocation and agree to pay lowest price of winning competitive bids
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Secondary Market
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largest of any U.S money market instrument
-22 primary dealers "make" market in T-bills by buying majority sold at auction and by creating active secondary market
-primary dealers trade for themselves and customers
-Tbill purchases and sales are book-entry transactions conducted over Fedwire
-T-bills sold on discount basis
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Federal Funds Rate
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target rate in conduct of monetary policy
-short term, unsecured loans(overnight)
-banks with excess reserves lend, banks with deficient reserves borrow
-fed funds are single payment loans and use single-payment yields
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Repurchase Agreement (REPO)
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sale of a security with agreement to buy back at set price in future
-short term collateralized loans
-Reverse purchase agreement is opposite side of repo (purchase with agreement to sell back in future)
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Negotiable Certificate of Deposit (CD)
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bank-issued time deposit that specifies interest rate and maturity date
-bearer instruments and are salable in secondary market
-denominations range from $100,000 to $10 million; $1 million being most common
-often purchased by money market mutual funs with pools of funds from individual investors
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Banker's Acceptance (BA)
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time draft payable to a seller of goods with payment guaranteed by a bank
-used in international transactions to finance trade in good that have yet to be shipped form foreign exporter to importer
-exporters prefer that banks act as payment guarantors before sending goods to importers
-bearer instrument and are salable in secondary markets
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Commercial Paper (CP)
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largest money market in terms of dollars outstanding
-unsecured short term corporate debt issued to raise short term funds
-sold in large denominations with maturities between 1 and 270 days
-sold to investors indirectly through brokers and dealers
-held by investors until maturity and has no active secondary market
-yields are quoted on a discount basis
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Capital Markets
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involve equity and debt instruments with maturities of more than 1 year
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Bonds
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long term debt obligations issued by corporations and government units
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Bond Markets
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markets in which bonds are issued and traded
-treasury notes and bonds
-municipal bonds
-corporate bonds
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Bond Market Participants
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major issuers of debt market instruments are federal, state and local govs, and corporations
-major purchasers of capital market securities are households, businesses, gov units, and foreign investors
-business and financial firms = suppliers of munis and corp bonds
-foreign investors and govs = suppliers of t-notes and bonds
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Treasury Notes and Bonds
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issued by U.S Treasury to finance national debt and other gov expenditures
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Crowding Out Effect
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the increased public debt will decrease the amount of funds available for other expenses and investments in private sector
-as investors lock a greater portion of their funds in US treasuries, they will have fewer funds to spend for consumption, private investments, etc.
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Treasury Notes and Bonds Characteristics
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-Default Risk free
-low returns
-interest rate risk
-liquidity risk
-semi-annual coupon interest set at intervals of 1/8 of 1%
-Tnotes have maturities from 1-10 years
-Tbonds have maturities from over 10 years
-issued in minimum denominations of $1,000
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Treasury Inflation Protection Securities (TIPS)
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inflation-indexed bonds
the principal value is adjusted by the percentage change in the Consumer Price Index (CPI)
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Separate Trading of Registered Interest and Principal Securities (STRIPS)
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zero coupon bonds
-created by financial institutions and gov security brokers and dealers
-periodic interest payments separated form each other and from principal payment
-used to immunize against interest rate risk
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T-notes and bond Auctions
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-2 year notes auctioned monthly
-3,5,10 year notes auctioned quarterly
-30 year bonds auctioned semi-annually
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Municipal Bonds
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securities issued by state and local govs
-used to fund imbalances between expenditures and receipts or to finance long term capital outlays
-interest is exempt from federal and local taxes
-trade infrequently due mainly to a lack of info on bond issuers
-less risky, don't move with market as much as stocks do
-higher yield than US Treasuries
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General Obligation Bonds (GO)
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backed by full faith and credit of the issuing municipality
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Revenue Bonds
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sold to finance specific revenue generating projects
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Firm Commitment Underwriting
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public offering of Munis made through an investment bank, where investment bank guarantees price for newly issued bonds by buying entire issue and reselling to public
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Best Efforts Offering
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public offering in which investment bank does not guarantee firm price
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Private Placement
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bonds sold on semi-private basis to qualified investors
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Corporate Bonds
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long term bonds issued by corporations
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Bond Indenture
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legal contract that specifies rights and obligations of the issuer and holders
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Bearer Bonds
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bonds which coupons are attached
-bond holder presents coupons to issuer for payments of interest when they come due
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Registered Bonds
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owners identification info is recorded by issuer and coupon payments are mailed to owner
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Convertible Bonds
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bonds that may be exchanged for another security of the issuing firm at the discretion of bond holder
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Callable Bonds
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- called when interest rates in market decrease
-firms call the bonds and reissue new bonds at lower interest rate, which decreases cost of borrowing
-bonds that allow issuer to force bond holder to sell bond back to issuer at price above par value
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Bond Ratings
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2 major agencies = Moody's and S&P
-rated by perceived default risk
-may be either investment or speculative grade
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Mortgages
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loans to individuals or businesses to purchase homes, land, or other real property
-many mortgages are securitized
-packages and sold as assets backing publicly traded or privately held debt instruments
-backed by specific piece of real property
-primary mortgages have no set size or denomination
-involve only single investor
-little info exists on mortgage borrowers
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Four Types of Mortgages issued by financial institutions
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-Home Mortgages
-Multi-family Dwellings
-Commercial Mortgages
-Farm mortgages
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Mortgage Characteristics
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-Collateral
-Down Payment (No insurance if 20%)
-Federally insured mortgages
-Conventional Mortgages
-Amortized Mortgages
-Balloon Mortgages
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Fixed Rate Mortgages
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-lock in borrower's interest rate
-Required monthly payments are fixed over life of mortgage
-lenders assume interest rate risk
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Adjustable Rate Mortgages
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-tie borrower's interest rate at some market interest rate or interest rate index
-required monthly payments can change over life of mortgage
-yearly interest rate changes often capped
-borrowers assume interest rate risk
-can increase default risk
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Other Mortgage Fees
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-application fee
-title search
-title insurance
-appraisal fee
-loan origination fee
-closing agent and review fees
-other fees
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Mortgage Refinancing
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-when borrower takes out new mortgage and uses proceeds to pay off existing mortgage
-most often refinanced when existing mortgage has higher interest rate than prevailing rates
-borrowers must balance savings of lower monthly payment with costs of refinancing
-new interest rate should be 2% points less
than refinanced mortgage rate
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Discount Points
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fees or payments made when mortgage loan is issued
-each point costs 1% of principal value
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Mortgage Amortization
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each fixed monthly payment consists partly of repayment of principal and partly of interest on outstanding mortgage balance
-amortization schedule shows how fixed monthly payments are split between principal and interest
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Secondary Mortgage Markets
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-Financial institutions remove mortgages from balance sheets by :
1) pooling recent mortgages together and selling in secondary market
2)securitizing mortgages
-advantages of securitization are:
1) Fi's can reduce liquidity, interest, and credit risk of loan portfolios
2)Fi's generate income from origination and service fees
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Federal National Mortgage Association (FNMA or Fannie Mae)
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established by gov in 1930's to buy mortgages from thrifts so they could make more mortgage loans
-make securitization easier
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Government National Mortgage Association (GNMA or Ginnie Mae) and Federal Home Loan Mortgage Corp (FHLMC or Freddie Mac)
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created in 1960's
-encouraged continued expansion of housing market
-provided direct and indirect guarantees that allow for creation of mortgage backed securities
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Mortgage Sales
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occur when an FI originates a mortgage and sells it to an outside buyer
-large banks often sell parts of their loans to smaller banks
-allow FI's to manage credit risk, achieve better asset diversification, and improve their liquidity and interest rate risk options
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Mortgage Sellers
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-money center banks
-smaller banks
-foreign banks
-investment banks
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Mortgage Buyers
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-foreign and domestic banks
-insurance companies
-pension funds
-close end bank loan mutual funds
-nonfinancial corporations
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How Mortgage Backed Securities (MBS) are Created
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-Borrowers applies for mortgage
-mortgage bank lends funds to borrower
-mortgage bank pools together mortgages on its books and sells as single bond to investment bank
-investment bank divides purchased bond into securities
-securities are MBS that are secured by mortgage or collection of mortgages
-value of shares are backed by interest and principal payments that original borrowers are making on mortgages
-investment bank sells MBS to investors
-when large number of borrowers stop making payments on mortgages, entire system falls apart
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Overview of Stock Markets
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-primary stock markets allow suppliers of funds to raise equity capital
-secondary stock markets are most closely watched and reported
-stockholders = legal owners of corp
-have right to share in firms profits
-are residual claimants
-have limited liability
-have voting rights
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Common Stock
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fundamental ownership claim in public or private corp
-dividends are discretionary and not guaranteed
-limited liability= stockholders can't lose more than invested
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Common Stockholders
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-have lowest priority claim in event of bankruptcy
-control firm's activities indirectly by exercising voting rights in election of BOD
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Cumulative Voting
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number of votes assigned to each stockholder equals number of shares held multiplied by number of directors to be elected
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Proxy Vote
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allows stockholders to vote by absentee ballot
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Preferred Stock
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-hybrid security that has characteristics of both bonds and common stock
-fixed divided paid quarterly
-no voting rights unless dividend payments are missed
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Primary Stock Markets
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markets in which corps raise funds through new issues of stocks, mostly through investment banks
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Investment banks
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-act as distribution agents in best efforts underwriting
-act as principals in firm commitment underwriting
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Syndicate
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group of investment banks working in concert to issue stock
-lead underwriter is the originating house
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Initial Public Offering (IPO)
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first public issue of financial instruments by a firm
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Seasoned Offering
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sale of additional securities by firm whose securities are already publicly traded
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Preemptive Rights
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give existing stockholders ability to maintain their proportional ownership
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Red Herring Prospectus
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preliminary version of the prospectus that describes a new security issue
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Shelf Registration
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allows firms to offer multiple issues of stock over a 2 year period with only one registration statement
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Secondary Stock Market
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markets in which stocks are traded among investors
-NYSE
-NASDAQ
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NYSE
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-trading occurs at specific place on floor of exchange called trading post
-each stock has special marker called Specialist that maintains liquidity for stock at all times
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3 Transactions occur at Trading Post
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-market order is an order to transact at best price available when order reaches trading post
-limit order is order to transact at specified price
-specialists transact own account
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Program Trading
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simultaneous buying and selling of a portfolio of at least 15 different stocks valued at more than 1 million using computer programs to initiate trades
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Circuit Breakers
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give investors time to make informed choices during periods of high market volatility
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Exchange Traded Funds (ETFs)
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pioneered by former AMEX (now NYSE)
-index funds that are listed on an exchange and can be traded intraday and shorted
-prices may not exactly match index
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NASDAQ
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worlds first electronic market and has no physical trading floor
-provides continuous trading for most active stocks traded over the counter (OTC)
-primarily a dealer market where dealers act as market makers
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Small Order Execution System (SOES)
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provides automatic order execution for orders less than or = to 1,000 shares
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Stock Market Index
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composite value of a group of secondary market traded stocks
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Price weighted Index
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Dow Jones
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Value Weighted Indexes
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-NYSE
-S&P 500
-NASDAQ Composite
-Wilshire 5000
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Securities Exchange Commission (SEC)
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primary regulator of stock markets
-promote full and fair disclosure of info on securities and ensure fair treatment of investors
-enforce Securities Act of 1933
-Prosecute inside trading
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Financial Industry Regulatory Authority (FINRA)
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regulator for all U.S securities firms
-oversees registering and educating brokers and dealers, examining security firms, making rules, enforcing laws, and conducting dispute arbitration
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