Chapter 1 Financial Markets and Institutions Chapter 1 Financial Markets and Institutions Overview Introduction to financial markets Introduction

ction to financial institutions Review of terms

Student Notes

Financial Markets Channel through which financial assets are exchanged. Process also known as funds intermediation. Surplus Units suppliers of funds, because they spend less than they receive. Households are the only net supplier of funds. Deficit Units users of funds, because they spend more than they receive. Households, corporations, and governments can all be deficit units.

Financial Markets Money Markets markets that trade debt instruments with maturities of up to one year. Treasury bills, commercial paper, federal funds, negotiable CDs, repurchase agreements, and bankers acceptances. Capital Markets markets that trade equity and debt instruments with maturities of more than one year. Stocks, bonds, and mortgages. Primary Markets markets in which corporations raise funds through new issues of securities, such as stocks and bonds. May be first-time issues by firms initially going public, the sale of additional new shares of an already publicly traded firm, or first time debt issuances. Secondary Markets markets in which existing securities are traded. Organized Exchanges physical meeting place and communication facilities are provided for members to conduct their transactions.

Chapter 1 Financial Markets and Institutions

Student Notes

Over-the-Counter (OTC) markets no central location. Financial claims can be traded by phoning an OTC dealer or by using a computer system. Efficiency Simply the idea that the market accurately prices the securities that are traded in them. Markets can be weak, semi-strong, or strong form efficient. Regulation Most important regulator is the Securities and Exchange Commission (SEC). Globalization Increased integration. It is becoming easier to acquire information about foreign companies and invest accordingly.

Financial Institutions Institutions serve as intermediaries because markets are not perfect. Depository Institutions receive deposits and make loans. Commercial Banks most dominant depository institution. Savings Institutions take in deposits and provide mortgage loans. Credit Unions take in deposits and provide retail loans. Nondepository Financial Institutions do not accept deposits from consumers. Finance Companies Spans a variety of fringe companies. Consumer finance companies Business finance companies Sales finance companies Nondepository Financial Institutions (cont.) Mutual Funds primary investment tool of many households. Securities Firms multiproduct firms that usually specialize in several market related activities. Examples include brokerage houses, underwriters, investment banks, and market makers. Nondepository Financial Institutions (cont.)

Chapter 1 Financial Markets and Institutions

Student Notes

Hedge Firms sells shares to upscale investors and are allowed to invest in risky assets. Largely unregulated. Insurance Companies receive money from premiums and invest in financial securities. Pension Funds Governments and companies allow employees to invest money in securities. Competition U.S. banks face increasing foreign competition. Consolidation Banks continue to consolidate as regulations have relaxed. Global Expansion U.S. banks, insurance companies, and securities firms have expanded into foreign countries in recent years.

Key Trends Affecting Banks Service Proliferation rapidly expanding services. Rising Competition financial service firms entering other markets. Government Deregulation fewer restrictions. Technological Change ATMs, Point of Sale terminals, online payments, etc. Consolidation and Geographic Expansion roll-up of the industry continues. Convergence the movement of financial institutions across product lines. Globalization largest banks compete with each other internationally.

Chapter 2 Determination of Interest Rates Chapter 2 Determination of Interest Rates Overview Introduction to interest rates Interest rate theories Economic forces that affect rates

Student Notes

Interest Rates the price of borrowing money. Relevance of Interest Rates Direct influence on the valuation of debt securities. Indirect influence on nearly all other financial instruments. ie. Stocks, exchange rates, derivative securities.

Loanable Funds Theory rates are determined by the interaction between supply and demand for funds. Demand: Individuals and Households Businesses Governments Foreign Demand Aggregate Demand

Supply: Individuals and Households only net saver of funds Businesses Governments Foreigners

Chapter 2 Determination of Interest Rates Equilibrium Rate

Student Notes

Factors that Cause the Supply Curve to Shift Wealth as total wealth increases, the supply curve shifts out. Risk as the risk decreases, the supply curve shifts out. Near-Term Spending Needs when participants have fewer spending needs, the supply curve shifts out. Monetary Expansion policy objects to allow expansion, the supply curve shifts out. Economic Conditions as domestic economic conditions improve relative to other countries, foreign inflows increase and the supply curve shifts out.

Factors that Cause the Demand Curve to Shift Economic Conditions during periods of economic growth, market participants borrow more heavily. The increase in demand increases the interest rate.

Economic Forces that Affect Interest Rates Economic Growth demand increases with growth and rates rise. Inflation Expected inflation decreases supply and increases demand, pushing rates higher. Fisher Effect nominal rate = real rate + expected inflation Economic Forces that Affect Interest Rates Money Supply The Fed can affect the supply, and, therefore the interest rates. Budget Deficit Government deficits increase demand for funds, crowding out private demand, driving rates higher. Foreign Flows U.S. rates are increasingly more tied to the interest rates of other countries. Unified Germany Economic expansion drove rates up internationally. Japans Recession Weak economic growth lowers rates internationally. Asian Crisis Funds fled to more stable markets, driving rates down. 5

Chapter 2 Determination of Interest Rates

Student Notes

Summary Economic forces affect supply and demand of money.

Interest Rates Over Time General Decline we have seen a general decline in interest rates since the early 1980s. Volatility Rates were particularly volatile in the early 80s. Fed changed policies in the early 80s creating instability. Fed regained control in the late 80s and have been relatively stable.

Key Interest Rates Federal Reserve Discount Rate The rate the Fed charges banks that borrow from it. Federal Funds Rate the rate banks charge when they make short-term loans to each other. Treasury Bills short-term government securities. Commonly used as a benchmark real interest rate. Prime Rate a base rate that large, money center banks charge their best customers. London Interbank Offer Rate (LIBOR) the rate that European banks charge each other. Mortgage Rates reflect conditions in financial markets, in general.

Forecasting Interest Rates Economic Models estimating the statistical relationships between measures of the output of goods and services in the economy and the level of interest rates. Flow-of-Funds Accounting shows the movement of savings through the economy in a structured and comprehensive manner.

Chapter 3 Structure of Interest Rates Chapter 3 Structure of Interest Rates Overview Factors Affecting Yields Among Securities Term Structure Uses of the Term Structure

Student Notes

Factors Affecting Yields Among Securities Inflation actual or expected inflation. Real Interest Rates the interest rate that would exist on a security if no inflation were expected over the holding period of a security. Fisher Effect the relationship among nominal interest rates, real interest rates, and expected inflation. Nominal Rate = Real Rate + Expected Inflation Base Interest Rate Treasury securities. Credit (Default) Risk the risk that a securitys issuer will default on that security by missing an interest or principal payment. Liquidity The risk that a security can be sold at a fair market price in a short period of time. Tax Status Taxable securities must pay a higher yield than similar tax exempt securities. Municipal Securities Free of federal taxes and may be free of state and local taxes. im = ic(t tf) im= ic(t tf ts) Term to Maturity The length of time until the principal amount borrowed becomes payable. Special Provision call features, convertibility options, and other provisions will influence the yield of the security. 7

Chapter 3 Structure of Interest Rates

Student Notes

Actual Yield Differentials

Term Structures of Interest Rates the relationship between yield and term to maturity on securities that differ only in length of time to maturity; graphically approximated by the yield curve. Pure Expectations Theory the yield curve reflects the markets current expectations of future short-term rates. Liquidity Premium Theory investors will hold long-term maturities only if they are offered a premium to compensate for future uncertainty. Preferred Habitat Theory the shape of the yield curve is determined by future interest rates and a risk premium, to induce market participant to shift out of their preferred habitat. Segmented Markets Theory the shape of the yield curve is determined by supply of and demand for securities within each maturity sector. Research Results

Uses of the Term Structure Forecast Interest Rates they yield curve can be used to assess the general expectations of investors and borrowers about future interest rates. Forecast Business Cycle provides information about the market expectations of future business activity. Investment Decisions investors can take advantage of different rates and ride the yield curve to make a profit. Financing Decisions by assessing the prevailing rates on securities for various maturities, firms can estimate the rates to be paid on bonds with different maturities. Impact of Debt Management Treasury decisions about debt financing can impact the yield curve. Historical Review Upward sloping.

Chapter 4 Functions of the Fed Chapter 4 Functions of the Fed Chapter Objectives History Established in 1913 to control bank panics. 12 largely autonomous Federal Reserve banks were established. Providing the Money Supply prints and issues currency. Maintaining the Safety of the Financial System Facilitation of the Payments System Conducting Monetary Policy Monitoring International Financial Transactions Explain the U.S. Federal Reserve System Introduce monetary tools used by the Fed Other monetary policy issues

Student Notes

Organization Federal Reserve District Banks 12 banks Member Banks All chartered banks must be members. Board of Governors Key administrative body Regulate commercial banks Control monetary policy Federal Open Market Committee (FOMC) directs the open market actions of the Fed. Advisory Committees Advises on consumer issues.

Monetary Policy Tools

Chapter 4 Functions of the Fed Open Market Operations buying or selling of Treasury securities.

Student Notes

Purchase of Treasuries Fed uses cash to buy Treasuries, usually from banks. Sale of Treasuries Fed sells a portion of its Treasuries, usually to banks. Technical Operations carried out through trading desk at New York Fed. o Policy Directive o Straight (outright) transactions o Repurchase Agreements o Agency Operations Adjusting the Discount Rate it is the rate a financial institution must pay to borrow reserve deposits from the Fed. Adjusting the Reserve Requirement Ratio determines the amount of money that financial institutions must keep on hand.

Miscellaneous Fed Emphasis on Money Supply Monetary Control Act of 1980 (DIDMCA) Global Monetary Policy Single European Policy

10

Chapter 5 The Fed and Monetary Policy Chapter 5 Fed and Monetary Policy Chapter Objectives Review Goals of Fed and Monetary Policy Review Fed Policy Explain the Impact of Monetary Policy

Student Notes

Goals of U.S. Monetary Policy Price Level Stability unstable price levels deter economic growth. Inflation the continuous rise in the average price level. Usually caused by an external economic shock in the supply of a crucial material. When confronted with a supply shock, the fed has two options: Nonaccommodation Accommodation High Employment (or low unemployment) between 4% and 6% is considered full capacity. Economic Growth increase in an economys output of goods and services. Stability in Foreign Currency Exchange Rates widely fluctuating exchange rates increases uncertainty into the economy.

Trade-offs and Conflicts Among Policies Raise the rate of growth in the money supply by providing more reserves. Reduce the rate of monetary expansion by reducing the reserves in the banking system.

Recent Federal Reserve Policy 1970 1979: Targeting the Fed Funds Rate. 1979 1982: Targeting the banking systems nonborrowed reserves. 1983 Present: Back to the Fed Funds Rate.

11

Chapter 5 The Fed and Monetary Policy Economic Indicators Monitored by the Fed Indicators of Economic Growth Gross Domestic Product (GDP) Indicators of Inflation Producer and Consumer Price Indices Other Indicators Commodity prices Lags in Monetary Policy

Student Notes

Recognition Lag the lag between the time a problem arises and the time it is recognized. Implementation Lag the lag from the time a serious problem is recognized until the time the Fed implements a policy to resolve it. Impact Lag the lag until the policy has its full impact on the economy.

Assessing the Impact of Monetary Policy Forecasting Money Supply Movements Improved Communication from the Fed. Market Reaction to Reported Money Supply Levels. Anticipating Reported Money Supply Levels. Market Reaction to Discount Rate Adjustments Integrating Monetary and Fiscal Policies History Generally, both the Fed and the government have been concerned with maintaining economic growth and low unemployment. Combining Policy Effects Monetizing the Debt Action by the Fed to counteract the effects of sales of Treasury securities by the Treasury.

Global Effects of Monetary Policy

12

Chapter 5 The Fed and Monetary Policy

Student Notes

Impact of the Dollar a weak dollar increases exports, which stimulates economy and may drive up inflation. Transmission of Interest Rates Fed Policy during the Asian Crisis

13

Chapter 7 Bond Markets Chapter 6 Money Markets Detail the participants and their roles. Explain different money market securities Examine valuations.

Student Notes

Money Markets Characteristics of the Money Market Debt instruments that have a maturity of 1 year or less. Highly liquid financial claims with negligible risk of loss. Transaction size are very large (usually $1,000,000 to $10,000,000) No formal organization, such as the NYSE for the equity markets.

Money Market Participants Participants Commercial Banks Most important class of buyers and sellers of money market instruments. Federal Reserve System open-market operations. U.S. Treasury finance the federal deficit. Corporations use to balance their cash position. Money Market Mutual Funds purchase 1/3 of commercial paper. Pension funds the other institutions

Money Market Securities Securities Treasury Bills U.S. Treasury Department issues various types of debt to finance the national debt. Treasury Bill Auction systematic, regular procedure. o Competitive bids

14

Chapter 7 Bond Markets

Student Notes

o Noncompetitive bids Estimating the Yield Estimating the discount Commercial Paper short-term, unsecured promissory note. Ratings Moodys and Standard & Poors Placement with institutions o Directly placed paper o Dealer-placed paper Secondary Market secondary trading is limited. Backing Commercial Paper not asset backed. Slightly higher return than Treasury securities. Finance companies are frequent issuers. Estimating the Yield Negotiable Certificates of Deposit (NCDs) A bank time deposit that is negotiable. Placement corporate treasuries Premium often, rate is above T-bill yield Repurchase Agreements (Repos) sale of a short-term security with the condition that the seller will buy it back at a predetermined price. Estimating the Yield Federal Funds commercial banks borrow and lend excess reserve balances to each other. Bankers Acceptances a bank accepts the responsibility to repay a loan to its holder. Facilitates international trade.

15

Chapter 7 Bond Markets Steps involved Money Market Securities Final Notes Institutional use Valuation Limited price movements Risk Globalization of Money Markets Performance of Foreign Money Market Securities

Student Notes

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Chapter 7 Bond Markets Chapter 7 Objectives To identify the different types of Treasury securities To identify the characteristics of municipal securities To outline the types of corporate debt securities

Student Notes

Treasury Securities Treasury Bills Treasury securities with a maturity of less than one year. These are sold on a discount basis. Treasury Notes Securities with maturities between 2 and 10 years. These are coupon securities. Treasury Bonds Securities with maturities greater than 10 years. These are coupon securities. Treasury Inflation Protection Securities (TIPS) A Treasury coupon security (either note or bond) whose coupon rate is tied to the rate of inflation. Primary Market Treasuries are sold in frequent well-publicized auctions.

Competitive bids Noncompetitive bids

Secondary Market over-the-counter market where a group of dealers offer continuous bid and as prices on outstanding Treasuries. Stripped Treasury Securities Separating all coupon and principal payments into individual securities. For instance, a 10-year semiannual note would convert into 21 separate STRIPS. Quotations The bid price and the ask price are quoted per hundred of dollars of par value. Salomon Brothers scandal Salomon took over a Treasury bond auction. Brady Bonds U.S. Treasury department restructuring program for delinquent LDC debt.

Federal Agency Securities Federal Agencies generally, a private company that was originated by the federal government.

17

Chapter 7 Bond Markets

Student Notes

The Farm Credit System Housing Credit Agencies Export-Import Bank Student Loan Marketing Association (Sallie Mae) Small Business Administration (SBA)
Municipal Bonds State and local government bonds General obligation bonds provide basic services. Revenue bonds used to finance a specific revenue-producing project.

Corporate Bonds Corporate Bonds debt contracts requiring borrowers to make periodic payments of interest an to repay principal at the maturity date. Characteristics

Sinking-fund provision requires the bond retire a specific dollar amount of bonds each
year.

Protective Covenants Limit dividends or additional debt. Call Provisions an option of the issuer to retire bonds before their maturity. Bond Collateral Mortgage bonds Equipment Trust Certificates Collateral Bonds Debentures

18

Chapter 7 Bond Markets

Student Notes

Zero- Coupon Bonds Do not pay coupons. Variable-Rate Bonds Coupon is tied to an interest rate rather than fixed. Convertibility allows investors to exchange the bond for a stated number of shares of
the firms common stock. Junk Bonds Corporate bonds with high default risk.

Market Size 25% of outstanding corporate bonds are junk. Risk Premium Substantially higher interest rate. Performance volatile. Contagion price shocks affect entire junk bond market.
Restructuring through bonds

Leverage Buyouts investor group issues debt to fund the purchase of a company. Capital Structure changes
Bond Markets Eurobond Market a bond issued in a country other than the currency it is denominate in.

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Chapter 8 Bond Valuation and Risk Chapter 8 Chapter Objectives Review the bond valuation process; and Review bond characteristics.

Student Notes

Bond Valuation Process Bond a security that obligates the issuer to make specified payments to the bondholder. Characteristics

Par Value face value of the bond. Coupon specified number of dollars of interest paid each period. Coupon Rate The annual coupon divided by par value. Maturity Date when principal amount is due. Yield to Maturity The rate of return earned on a bond if it is held to maturity.
Bond Valuation the present value of the cash flows. Changing bond values over time New bonds are generally priced to sell at par value. The price of seasoned bonds often vary widely from par value.

If the market interest rate equals the coupon rate, a fixed rate bond will sell at its
par value.

Market interest rate rises above coupon rate, a fixed rate bond sells below
(discount) its par value.

Market interest rate falls below coupon rate, a fixed rate bond sell above
(premium) its par value.

The price of the bond approaches its par value as it approaches maturity. Market interest rate falls below coupon rate, a fixed rate bond sell above
(premium) its par value.

The price of the bond approaches its par value as it approaches maturity.
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Chapter 8 Bond Valuation and Risk

Student Notes

Bond Risk Assessing the Riskiness of a Bond Interest Rate Risk risk of a decline in a bonds price due to an increase in market interest rates. Reinvestment Rate Risk The risk that a decline in interest rates will lead to a decline in income from a bond portfolio. Default Risk The risk that the issuer will be late or unable to make a payment.

Mortgage bonds backed by fixed assets. Debentures not secured by fixed assets but is a general obligation of the firm. Subordinated Debentures claim is lower than senior debt.
Bond Price Bond Price Movements Risk-Free Rate General interest levels affect all bonds.

Inflationary Expectations Economic Growth Money Supply Growth Budget Deficit

Default Risk Premium Changing credit situations will affect bond prices.

Bond Price Sensitivity Bond Price Elasticity the sensitivity of bond prices to changes in the required rate of return.

Coupon Rate The lower a bonds coupon rate, the greater the price sensitivity. Maturity Longer-term bonds have greater price sensitivity.

21

Chapter 8 Bond Valuation and Risk Bond Pricing Theorems

Student Notes

Bond prices and market interest rates move in opposite directions. When a bonds coupon rate is greater (less) than the markets required return, the
bonds market value will be greater (less) than its par value.

The price of longer-term bonds will change more than that of shorter-term bonds,
for a given change in market rates.

The price of lower-coupon bonds will change more than that of higher-coupon
bonds, for a given change in market interest rates. Duration bond price volatility varies directly with maturity and inversely with coupon rate. Duration considers both coupon rate and maturity.

Portfolio the weighted average of bond durations. Using Duration to Reduce Interest Rate Risk Zero Coupon Approach Maturity-Matching Approach Duration-Matching Approach
Bond Investment Strategies Bond Investing

Matching Strategy Matching future cash outflows with coupon and principal
payments.

Laddered Strategy Spreading an investment over several different maturity

classes.

Barbell Strategy Investment is divided between short- and long-term bonds. Interest Rate Strategy Use forecasts to develop a bond investment strategy.
International Bonds Return and Risk of International Bonds

22

Chapter 8 Bond Valuation and Risk

Student Notes

Foreign Interest Rates Differentials Credit Risk Differentials Exchange Rate Fluctuations International Bond Diversification

23

Chapter 9 Mortgage Markets Chapter 9 Mortgage Markets Chapter overview Examine unique nature of market. Review the evolution of the secondary markets. Examine the characteristics of different mortgages.

Student Notes

Mortgage Markets Unique Nature of the Mortgage Market

Secured by the pledge of real property. Made for varying amounts and maturities. Issuers are typically small, unknown entities. Secondary market growing Highly regulated and supported by the federal government.
Residential Mortgage Characteristics

Standard Fixed-Rate Mortgages lender takes a lien on real property in exchange for
payment.

Conventional Mortgages not insured by a federal government agency.

Private Mortgage Insurance (PMI) insures against default for borrowers with less than a 20% down payment. Historically, there has been no penalty for prepayment. However, this is not always the case. Residential Mortgage Characteristics

Standard Fixed-Rate Mortgages lender takes a lien on real property in exchange for
payment.

Insured Mortgages payment is guaranteed by a federal government agency.

24

Chapter 9 Mortgage Markets

Student Notes

Federal Housing Authority (FHA) allows a much smaller down payment and
guarantees payment.

Veterans Administration (VA) insures mortgages of military veterans and does not
require a down payment. Adjustable-Rate Mortgages (ARMs) interest rate adjusts with the general level of rates. Interest rate risk is shifted to the borrower. Maturities Traditional maturity is 30 years and 15 year mortgages have become more popular. Others include 3, 5, or 7 year balloon mortgages.

Creative Mortgages Graduated-Payment Mortgage lower payments in the first few years and growing through time. Balloon Mortgage a fixed-rate mortgage that expires at a predetermined time (3, 4, 5, or 7 years). The unpaid balance is then due. Growing-Equity Mortgage calls for rising payments over time resulting in a faster payoff. Second Mortgage loans secured by liens on properties that are already mortgaged. Reverse Annuity Mortgage (RAM) Provides regular monthly payments to the homeowner with the home as collateral.

Mortgage Market Secondary Market originators can sell mortgages in the secondary markets to both public and private purchasers. Valuation the present value if the future cash flows. Prices of existing mortgages are relatively volatile due to their long term nature.

Investment Risk Interest Rate Risk the value of fixed rate mortgages decline as interest rates rise. Prepayment Risk falling interest rates encourage refinancing. Credit Risk the likelihood that a borrower will default on the loan.

Mortgage-Backed Securities

25

Chapter 9 Mortgage Markets

Student Notes

Pass-Throughs payments of principal and interest on pools of mortgages are passed through to holders of securities in the pool. Government National Mortgage Association (GNMA Ginnie Mae) pass throughs on a pool of federally insured mortgage loans. Federal National Mortgage Association (Fannie Mae) issues a variety of pass-through securities similar to Ginnie Maes. Publicly Issued Pass-Through Securities (PIP) issued by private institutions. Federal Home Loan Mortgage Corporation (Freddie Mac) assists lenders with securitization of conventional mortgages.

Participation Certificates (PCs) different from Ginnie Maes in that: Contain conventional mortgages Not federally insured Various interest rates Much larger pools
Collateralized Mortgage Obligations consists of a series of related debt obligations, called tranches, which pay various borrowers with different priorities. Other Mortgage-Backed Securities

Mutual Funds several mutual funds have been established to buy Ginnie Mae securities. Fannie Mae or Freddie Mac debt general obligation securities are basically secured by
mortgages.

Mortgage-Backed Securities Pass throughs

26

Chapter 11 Stock Valuation and Risk Chapter 10 Stock Markets Overview Types and locations of trading Trading mechanics and arrangements Public placements Monitoring of firms Globalization

Student Notes

Background on Common Stock Common Stock represents basic ownership claim in a corporation. Owners expect capital gains and possibly dividends. Value based on expected future cash flows.

Trading Locations Organized Exchanges consist of physical locations where buyers and sellers meet on a trading floor.

Auction System trading mechanism placing competing buyers and sellers against each other.

Over-the-Counter (OTC) dispersed traders linked via a computer system.

Negotiated System individual buyers negotiate with individual sellers.

Stock (Organized) Exchanges consist of physical locations where buyers and sellers meet on a trading floor.

New York Stock Exchange (NYSE) most popular stock exchange. Specialists market makers in a stock. Commission brokers execute orders for customers. Floor brokers execute orders for other exchange members.

27

Chapter 11 Stock Valuation and Risk Floor traders trade solely for themselves.

Student Notes

Over-the-Counter (OTC) dispersed traders linked via a computer system.

NASDAQ a computer network linking thousands of market-making participants. Other OTC Markets subscriber markets where trading is via the telephone. OTC Bulletin Board (OTCBB) Pink Sheets

Alternative Trading Systems electronic communications networks or crossing networks that link two parties for direct trading of stocks.

Types of Transactions Long Purchase purchasing securities with the expectation that it will increase in value. Margin Trading the use of borrowed funds to purchase securities. Purchased securities are used a collateral.

Initial Margin minimum amount that must be provided by investor at time of purchase. Maintenance Margin minimum amount that an investor must maintain in the margin account. Margin Call notification of the need to add cash to a margin account.

Short Selling selling borrowed securities with the expectation that the price will fall.

Trading Mechanics Types of Orders price and conditions of an order.

Market order an order to buy or sell stock at the best price available when the order is placed. Limit order an order to buy at or below a specified price. Or, sell at or above a specified price. fill-or-kill order day order

28

Chapter 11 Stock Valuation and Risk good-till-canceled (GTC) order

Student Notes

Stop-loss order an order to sell a stock when its price reaches or drops below a specified level.

Trading Arrangements Retail Stock Trading buying and selling of stocks by individuals. Institutional Trading buying and selling by financial institutions such as mutual funds and pension funds.

Block Trades trades of at least 10,000 shares or market value of $200,000 or greater. Program Trades buying and/or selling of a large number of different stocks simultaneously. Asset allocation trades Index arbitrage

Stock Indexes Dow Jones Industrial Average stock market average made up of 30 high-quality industrial stocks. Standard and Poors (S&P) measures the current price of a group of stocks. New York Stock Exchange Composite current price of the stocks listed on the NYSE. Other Indexes AMEX, Nasdaq, Value Line, Wilshire 5000

Preferred Stock Debt/Equity hybrid represents ownership in a company but pays a fixed dividend amount. Preferential treatment preferred dividends are paid before common dividends can be paid and cumulate if they are not paid. Bankruptcy preference as well. Nonparticipating usually no voting rights. Institutional tax advantages other companies are able to deduct preferred dividends received. Not attractive for individual investors.

Public Placement of Stock 29

Chapter 11 Stock Valuation and Risk

Student Notes

Initial Public Offerings (IPOs) the first issuance of common stock by a firm to the public.

Venture Capital (VC) firms that invest in private companies with the expectation of taking them public. Underwriters an investment bank must be hired to take the company pubic. Details price range, number of shares, lockup period, and other details must be established and filed with the SEC. Road Show managers and underwriters travel to different cities to meet with institutional investors to sell the company. Offering the underwriter sets the price the number of shares and begins trading when the market opens. Building the Book

Initial Return typically, the return on the first day is substantial. Flipping process of selling soon after trading has begun.

Lockup Agreement underwriter restricts managers, VCs, and other insiders from selling their shares for at least six months. Long-run Performance generally poor.

Secondary Stock Offerings an initial offering of stock by a firm that has other stock already publicly held. Shelf-Registration a company must register stock offerings with the SEC. Once the registration is complete, the company waits for favorable market conditions.

Monitoring of Firms Shareholder Activism shareholders take an active role in managing the company.

CALPERS Socially conscious mutual funds

Corporate Monitoring

Acquisition poorly run companies become targets.

30

Chapter 11 Stock Valuation and Risk

Student Notes

Barriers Anti-takeover Amendments Poison Pills Golden Parachutes

Self-Monitoring

Stock Repurchases a firm purchases its own stock when it believes it is undervalued. Leveraged Buyouts use of debt financing to purchase the company.

Globalization of Stock Markets International Investment Performance performance varies among countries and through time. Investing in foreign stocks

Indirect investment Purchase shares of U.S. based MNC Purchase international mutual fund

Direct investment Purchasing stocks on foreign exchanges Purchase stocks of foreign companies trading on U.S. exchanges. Purchasing American Depository Receipts (ADRs)

31

Chapter 11 Stock Valuation and Risk Chapter 11 Stock Valuation and Risk Overview Stock Valuation Methods Estimating the Required Return and Growth Rate Other Factors that Affect Stock Prices Stock Performance Measurement Stock Market Efficiency

Student Notes

Stock Valuation Methods Discounted Cash-Flow Valuation Techniques the present value of some expected cash flows. Dependent on two estimated inputs:

Growth Rates Discount Rates

Dividend Discount Model value of stock is the present value of all future dividends.

Zero Growth Model Dividends stay the same each year. Infinite Constant Growth Model Dividends grow at roughly the same percent each year. Supernormal Growth Model Dividends grow at higher rate for a period of time before settling into a constant growth.

Present Value of Operating Cash Flows Deriving the value of the total firm from operating cash. Present Value of Free Cash Flows Deriving the value using free cash. Relative Valuation Techniques provides information about how the market is currently valuing stock at several levels.

Contends that valuing firms is accomplished by a comparison to other firms.

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Chapter 11 Stock Valuation and Risk

Student Notes

Provides information current valuation but it does not provide guidance on whether current valuations are appropriate.

Price to Earnings (P/E) Ratio determine how many dollars one is willing to pay for a dollar of expected earnings. Price to Cash Flow (P/CF) Ratio cash flow values are generally less prone to manipulation than earnings. Price to Sales (P/S) Ratio strong sales growth is a requirement for a growth company. Little chance of manipulation.

Estimating the Inputs Required Rate of Return will be the discount rate for most cash flow models.

Risk-Free Rate the absolute minimum rate an investor should require. Expected Inflation if investors expect inflation, they should increase their required nominal risk-free rate. Risk Premium the risk associated with a specific stock or portfolio of stocks.

Growth Rates estimates of the growth rate of cash flows, earnings, and dividends are required.

Estimating Growth from Fundamentals dividend growth is determined by the growth rate of earnings and the payout ratio. Estimating Growth based on History time-series growth rates should provide a trend and the amount of variability.

Factors that Affect Stock Prices Economic Factors

Interest Rates generally, an inverse relationship exists between stock prices and the level of interest rates. Exchange Rates currency strength affect market prices in many ways.

Market-Related Factors

Anomalies January effect, small firm effect, day of the week effect, etc.

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Chapter 11 Stock Valuation and Risk Firm-Specific Factors

Student Notes

Dividends indication about the future of the company. Secondary Offerings dilution adversely affects stock price. Repurchases indication the firm is undervalued.

Firm-Specific Factors

Earnings Surprises changes may indicate future trends. Acquisitions and Divestitures Acquirers adversely affected, targets positively affected. Expectations

Evidence stock prices are affected by factors other than fundamental factors. Indicators Price movements are often used as an indicator.

Stock Risk Measures of Risk

Standard Deviation Variation Beta

Stock Performance Measurement Sharpe Index measures the risk premium per unit of total risk, measured by the stocks standard deviation. Treynor Index measures the risk premium of a stock per unit of nondiversifiable risk, measured by the beta.

Stock Market Efficiency Forms of Efficiency

Weak-Form Efficient past data on stock prices is of no use in predicting future prices.

34

Chapter 11 Stock Valuation and Risk

Student Notes

Semistrong-Form Efficient publicly available information is of no use in predicting future prices. Strong-Form Efficient no information, public or private, allows investors to consistently beat the market.

35

Chapter 12 Market Microstructure and Strategies Chapter 12 Objectives Examine methods of researching stocks Examine methods of trading stocks Introduce alternatives (index funds) to investing in stocks.

Student Notes

Stock Market Investing Research there are numerous resources to use when researching stocks. Some include:

Valueline Websites Yahoo, Nasdaq, Morningstar, Bloomberg Edgar Online access to SEC filings at www.sec.gov

Placing an Order open an account with a broker. Full-service, discount, or online brokers are available.

Market Order an order to buy or sell a stock at the best possible price. Limit Order an order that specifies the price to buy or sell the stock at. Stop Loss Order a conditional market order whereby the investor directs the sale of a stock if it drops to a given price. Stop Buy Order a conditional market order if the stock rises above a given price.

Margin Transactions the investor pays for the stock with some ash and borrows the remaining through the broker, putting up the stock for collateral.

Initial Margin 50 percent of the value of the stock. Maintenance Margin 25 percent of the value of the stock. Margin Call requirement to add more equity or sell the stock.

Short Selling the sale of stock that is not owned with the intent of purchasing it in the future at a lower price.

Specifically, you would borrow the stock from another investor, sell it in the market, and replace it at a later date.

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Chapter 12 Market Microstructure and Strategies

Student Notes

Investing in Stock Indexes investor can select mutual funds the shadow a specific index or opt for exchange traded funds.

Exchange-Traded Funds (ETFs) baskets of securities that are traded, like individual stocks, on an exchange. Can be bought and sold throughout the day. Very low expense ratio. However, commissions must be paid on trades.

Trade Execution Floor Brokers independent members of an exchange who act as brokers for other members. Specialists or Market-Makers

Serve as brokers to match buy and sell orders. Maintain limit order book. Maintain fair and orderly market when necessary by buy and selling from their own account.

Electronic Communication Networks (ECNs) displays customer orders electronically and provide access to pricing information.

Rising in popularity.

Program Trading computerized trading that involves the buying or selling of a portfolio of stocks.

Collars NYSE applies program trading curbs when the Dow moves 160 points either up or down. Circuit Breakers NYSE halts trading if the market moves down by 10%.

Regulation of Stock Trading Securities and Exchange Commission (SEC) created in 1934 to enforce newly enacted securities laws.

Division of Corporate Finance Division of Market Regulation

37

Chapter 12 Market Microstructure and Strategies

Student Notes

Division of Investment Management Division of Enforcement

38

Chapter 13 Financial Futures Markets Chapter 13 Financial Futures Markets Detail the background on futures Introduce the trading and mechanisms Examine commodity and financial futures

Student Notes

Background on Futures Futures Contract A commitment to deliver a certain amount of some specified item at some specified date in the future.

Commodity Futures Financial Futures Options versus Futures future contract involves an obligation from both parties.
Option does not.

Forwards versus Futures forward is tailored to meet the needs of the purchaser.
Future is standardized. Trading Futures Participants hedgers and speculators. Both are needed for the market to work.

Hedgers enter into futures contract to protect a current position of loss of value. Speculators attempting to earn profits on price swings. Important in creating
liquidity. Trading Mechanics futures are readily traded in the market.

Long position purchasing a futures contract. Short position selling a futures contract. Liquidating a position entering into an opposite futures contract.
Margin Trading putting up only a fraction of the total price in cash. The margin usually ranges from 2 10% of the value of the contract.

Commodities 39

Chapter 13 Financial Futures Markets

Student Notes

Basic Characteristics four major segments include: grains and oilseeds, livestock and meat, food and fiber, and metal and petroleum.

Contract every commodity has its own specifications regarding amounts and
quality.

Price behavior commodities react to economic, political, and international

pressures.

Return on investment only return comes from price movement. High returns are
possible due to the volatility of prices and the high leverage. Trading Commodities

Speculating attempt to capitalize on the wide price swings. Spreading combining two or more different contracts into one position to
achieve gains and limit losses.

Hedging used by producers and processors to protect a position in a product or

commodity. Financial Futures Financial Futures Market created in the early 1980s. Its level of trading has far surpassed the level of trading in commodities. These are derivative securities because they derive their value from the assets that underlie them.

Currency Futures futures contracts of foreign currencies. Interest Rate Futures futures contracts on debt securities. Stock-Index Futures futures contracts on broad based measures of stock market
performance.

Trading Stock-Index Futures predicting the future course of the stock market. Hedging Other Securities
Options on Futures give the purchasers the right to buy or sell a single futures contract. 40

Chapter 13 Financial Futures Markets

Student Notes

Limits the loss exposure to the price of the option. Downside risk is limited.

41

Chapter 14 Options Markets Chapter 14: Options Markets Chapter Objectives Review options and their application Review trading strategies

Student Notes

Options Option a security that gives the holder the right to buy or sell a certain amount of an underlying financial asset at a specified price.

Call gives the purchaser the right to buy securities at a stated price for a specified time
period.

Put gives the purchaser the right to sell securities at a stated price for a specified time
period.

Advantages
Leverage Ability to earn profit on price declines Limited downside loss for purchasers

Disadvantages
No ownership benefit Limited time frame Complex

Stock Option Provisions

Strike (exercise) price the state price at which you can buy a security with a call or sell
a security with a put.

Expiration date Quotes - WSJ

42

Chapter 14 Options Markets Options Pricing and Trading Profit Potential of Options

Student Notes

Call limited loss to the premium and unlimited possible gains if the stock moves higher. Put limited loss to the premium and unlimited possible gains if the stock moves lower.
Fundamental Value of Options Value depends ultimately on the exercise price and the prevailing market price of the underlying stock.

Call (market price strike price) x 100 Put (strike price market price) x 100 In-the-money
Call strike price < market price Put strike price > market price

Out-of-the-money no value
Call strike price > market price Put strike price < market price

Stock Option Premiums Fundamental value the higher (lower) the market price for a call (put), the greater the value. Time premium the longer the time to expiration, the greater the size of the premium. Price volatility premium the more volatile the stock, the greater the premium.

Trading Strategies Buying for speculation buy low and sell high. Hedging purchasing an option to offset a current position in equities. Option Writing and Spreading 43

Chapter 14 Options Markets

Student Notes

Writing Options do so because they do not believe the price is going to move that far.
Naked Options options written on a security not owned by the writer Covered Options options written on a security owned by the writer.

Options Spreading combining two or more options with different strike prices and/or expiration dates into a single transaction.

Stock Index Options Index Options a put or call option written on a specific stock market index, such as the S&P 500.

Investment uses
Speculation offer investors the opportunity to play the market with a small amount of money. Hedging allows an investor to protect a current portfolio from downside risk.

Other Types of Options Interest Rate Options options written on fixed-income (debt) securities. Currency Options options written on foreign currencies. LEAPS (Long-Term Equity AnticiPation Securities) expiration dates that extend out as far as two years.

44

Chapter 15 Interest Rate Derivative Markets Chapter 15: Interest Rate Derivative Markets Chapter Objectives Review swaps and their application Review Interest Rate Caps, Floors, and Collars.

Student Notes

Swap Background Swap an agreement whereby two parties (called counterparties) agree to exchange periodic payments. Notional Amount (Principal) the dollar amount of the payments exchanged is based on some predetermined dollar principal.

Types of Swaps Interest Rate Swap the counterparties swap payments in the same currency based on an interest rate.

Plain Vanilla one set of payments is fixed and the other is variable. Coupon Swap one party pays the other the fixed-coupon rate, and the other pays
the coupon rate on a floating-rate instrument.

Basis Swap the parties exchange payments based upon floating-rate indexes, but
each coupon is determined by a different rate.

Application useful ways of tailoring the interest rate risk desired. Reasons why
a firm needs to alter their interest rate risk: Interest rate exposure has changed over time Two different firms have advantages in markets they prefer to not be in.

Swap Interpretation Essentially, two parties enter into multiple forward contracts. Why do they exist? In many markets, forwards and futures do not extend out as far as that of a typical swap. Swap is transactionally efficient one contract to handle what it would have taken multiple forward contracts to handle. 45

Chapter 15 Interest Rate Derivative Markets

Student Notes

Increased liquidity

Interest Rate Caps, Floors, and Collars Interest Rate Cap a series of interest rate calls, designed to limit the cost of a loan with multiple interest payments Interest Rate Floor a series of interest rate puts, designed to protect the return on a loan with multiple interest payments. Interest Rate Collar a combination of the purchase of an interest rate cap and the sale of an interest rate floor.

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Chapter 16 Foreign Exchange Derivative Markets Chapter 16: Foreign Exchange Derivative Markets Chapter Objectives Give background on foreign exchange markets Introduce foreign exchange derivative instruments

Student Notes

Foreign Exchange Markets Background

Foreign currency is simply another asset. Exchange rate is the price at which the asset can be bought. Volatility of exchange rates should be viewed as a source of risk.
Spot Market the market for immediate delivery of foreign currency. Forward Contract a contract between a bank and a customer.

Exchange a specified amount. Exchange on a specific date. Exchange for a specified price.
Futures Contract agreement between two parties to exchange foreign currency.

Standardized amount Traded on an exchange Specified maturity dates Speculators and hedgers participate Contract interpretation Closing a position enter into an opposite position. Credit risk limited due to market restrictions.
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Chapter 16 Foreign Exchange Derivative Markets

Student Notes

Currency option purchaser receives the right to buy or sell a currency at a later date at an agreed price.

No obligation for the purchaser. Call right to buy a currency at the strike price on or before the expiration date. Put right to sell a currency at the strike price on or before the expiration date.
Currency swap an agreement between two parties to trade payments in different currencies.

48

Chapter 17 Commercial Bank Operations Chapter 17 Commercial Bank Operations Look at bank regulations Determine sources and uses of funds Look at off-balance-sheet activities

Student Notes

Financial Conglomerates Financial Services Modernization Act allows banks to offer a wide variety of products, including insurance and underwriting services. Diversified Services are there benefits to customers? Diversified Services are there benefits to banks?

Bank Sources of Funds Demand Deposits checking accounts Savings Deposits important source for small banks. Time Deposits have a maturity date

Certificates of Deposit (CDs) fixed interest rate and maturity date Negotiable Certificates of Deposit (jumbo CDs) denominations of $100,000 or
greater. Money Market Deposit Accounts pays an interest rate. Federal Funds Purchased borrowing from another banks reserves. Federal Reserve borrowing borrowing funds from the district Federal Reserve bank. Repurchase Agreements (RPs) banks sells securities and simultaneously contracts to repurchase the same securities. Eurodollar Borrowings short-term deposits at foreign banks. Bonds large commercial banks may issue bonds. Capital equity ownership of a bank. 49

Chapter 17 Commercial Bank Operations

Student Notes

Bank Uses of Funds Cash vault cash, Fed reserves, balances at other banks, collections. Bank Loans primary business activity of a commercial bank.

Business Loans usually secured by an asset.

Bridge Loan cash for a specific transaction. Seasonal Loan term financing to handle the fluctuations of the business cycle. Long-Term Asset Loan loan for a specific asset.

Loan Participations a group of banks cooperate to underwrite large loans. Consumer Loans bank loans to individuals. Real Estate Loans mortgage loans.
Investment in Securities primarily consists of U.S. government bonds, municipal securities, and bonds issued by U.S. government agencies. Fed Funds Sold lending of excess bank reserves to other commercial banks. Reverse Repurchase Agreements counterparty to a repurchase agreement. Eurodollar Loans short-term loans denominated in dollars and made outside the U.S. Fixed Assets the bank.

Off-Balance Sheet Activities Loan Commitments promise by a bank to lend money according to the terms outlined in the commitment. Standby Letters of Credit bank promise to pay a third party in the event that the banks customer fails to pay. Derivative Securities interest rate and currency forwards, futures, options, and swaps. 50

Chapter 17 Commercial Bank Operations

Student Notes

51

Chapter 19 Bank Management Chapter 19 Bank Management Chapter Objectives Examine the goals of bank management Examine how to measure and manage risk Review bank mismanagement

Student Notes

Goals of Bank Management Maximize shareholder wealth Managing Liquidity asset and liability management Asset Management deposits, investments, loan repayments, and asset sales. Liability Management certain types of bank liabilities are very sensitive to interest rate changes. Securitization grouping like assets and selling the securities to investors.

Managing Interest Rate Risk Methods of Assessing Interest Rate Risk Gap Analysis the rate sensitivity of bank earnings as measured by the gap between the maturity of assets and liabilities. Duration Measurement measuring the gap between the durations. Regression Analysis how performance has historically been influenced by interest rate movements. Methods of Reducing Interest Rate Risk Maturity Matching matched funding of loans. Floating-Rate Loans loans that adjust to current interest rates. Interest Rate Futures Contracts take offsetting position in futures markets. Interest Rate Swaps exchange periodic cash flows based on specified interest rates. 52

Chapter 19 Bank Management

Student Notes

Interest Rate Caps buy calls on interest rate movements. Managing Credit Risk Tradeoff between Credit Risk and Return the lower the risk, the lower the expected return. Measuring Credit Risk credit analysis and collateral. Diversifying Credit Risk avoid concentrating assets among a single firm or firms in the same industry.

Other Issues Measuring Market Risk Value-at-Risk (VAR) method to determine possible losses. Bank Capital Management maintain adequate amounts of capital. Provides a financial cushion Maintains public confidence Provides protection to depositors Source of funds for growth Restructuring shifted revenues away from interest margins to fee income Acquisitions growth quickly achieved through acquisitions. Bank Mismanagement Penn Square Bank loans concentrated with energy companies. Continental Illinois Bank small core deposit base so it relied on borrowed funds. Bank of New England concentrated loans on commercial real estate. Implications risk is greatly increased with lack of diversity and aggressive loan strategies.

53

Chapter 20 Bank Performance Chapter 20 Bank Performance Chapter Objectives Examine the factors that affect cash flows.. Review the factors that affect the required rate of return. Examine performance evaluation.

Student Notes

Factors that Affect Cash Flows Economic Growth strong economic growth increases expected future cash flows. Risk-Free Interest Rate interest rates are inversely related to the value of a bank. Industry Conditions regulations have a large impact on the industry. Management Abilities skilled management increases cash flows.

Factors that Affect the Required Return Risk-Free Rate inversely related to value. Risk Premium also inversely related to value. Economic conditions has a large impact.

Performance Evaluation Interest Income has been declining in recent years. Is still comparatively large for small banks. Interest Expense interest paid on deposits and other borrowed funds. Net Interest Income difference between interest income and interest expense. Noninterest Income fees charged for services. Noninterest Expense expenses not related to the payment of interest on deposits.

Bank Performance Evaluation Return on Assets (ROA) Net Income/Total Assets tells how much profit is generated with a given amount of assets.

54

Chapter 20 Bank Performance

Student Notes

Return on Equity (ROE) Net Income/Total Equity the amount of profits in relation to the capital contribution to the firm.

55

Chapter 21 International Banking Chapter 21 International Banking Global Bank Regulations Uniform Global Regulations

Student Notes

Uniform Regulations for Banks Operating in the U.S. foreign banks subject to same regulations as U.S. banks. Uniform Regulations across Europe one set of rules for banks operating in Europe. Uniform Capital Adequacy Guidelines 4% capital to assets ratio. Global Bank Competitions Competitions in Foreign Countries more competition in other companies. Competition in the U.S. many foreign banks have established branches in the U.S. Impact of the Euro increased competition for financial services across Europe.

Risks of Multinational Banks Credit Risk more difficult to obtain credit information abroad. Exchange Rate Risk currency value and exchange controls. Country Risk closely tied to political developments in a country. Settlement Risk risk that it may not receive money due to default and have little recourse. Interest Rate Risk forecasting becomes more difficult with the level of international involvement. Combining all Types of Risk asset management becomes very complex.

International Debt Crisis Latin and South America many countries defaulted in the early 1980s. Reducing Bank Exposure to LDC Debt Selling LDC Loans 56

Chapter 21 International Banking

Student Notes

Debt-Equity Swaps Boosting Loan Loss Reserves Brady Plan voluntary debt-relief measures allowing banks various exit instruments. Brady Bonds an exit bond that exchanged debt for lower principal and interest amounts. Country Risk Assessment Economic Indicators evaluates the countrys economic environment. Debt Management measures the fiscal policy of the country. Political Factors risk of unexpected change in the political environment. Structural Factors evaluation of the natural resources of the country. Overall Rating each variable generates a rating which is then weighted to created an average score.

57