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Assignment No. 4

M.com-4(A)

Roll no. L-1184

Financial Institution

Topic: Bond Market, Stock

Market and Mortgage

Market

Submitted to: Sir Abdul Qadeer

Submitted by: Zainab Shabbir

Dated: 21st June, 2020

The bond market

Purpose of the Capital Market:

Capital markets serve two purposes:

 Firstly, they bring together investors holding capital and companies

seeking capital through equity and debt instruments.
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 Secondly, and almost more importantly, they provide a secondary market where holders

of these securities can exchange them with one another at market prices.

Capital Market Participants:

Capital markets hosts a lot of participants that include companies, insurance funds,
pension funds, sovereign wealth funds, retail unit trusts, retirement trusts, brokers, custodians,
depositories, retail investors, foreign investors, banks, stock exchanges, market intelligence/data
providers, rating agencies, research houses and most importantly a regulatory body.

Capital Market Trading:

Capital market trading occurs in either the primary market or the secondary market:

 The primary market is where new issues of stocks and bonds are introduced. Investment
funds, corporations, and individual investors can all purchase securities offered in the
primary market.
 A secondary market is where the sale of previously issued securities takes place, and it
is important because most investors plan to sell long-term bonds before they reach
maturity and eventually to sell their holdings of stock. There are two types of exchanges
in the secondary market for capital securities: organized exchanges and over-the-counter
exchanges.

Types of Bonds:

Bonds are securities that represent a debt owed by the issuer to the investor. Bonds
obligate the issuer to pay a specified amount at a given date, generally with periodic interest
payments. The par, face, or maturity value of the bond is the amount that the issuer must pay at
maturity.

Coupon rate:
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A coupon payment on a bond is the annual interest payment that the bondholder receives
from the bond's issue date until it matures. Coupons are normally described in terms of the
coupon rate, which is calculated by adding the sum of coupons paid per year and dividing it by
the bond's face value.

Agency Bonds:

An agency bond is a security issued by a government-sponsored enterprise or by a federal

government department other than the U.S. Treasury. Some are not fully guaranteed in the same
way that U.S. Treasury and municipal bonds are. An agency bond is also known as agency debt.

 Bond Risks:
Like all bonds, agency bonds have interest rate risks. That is, a bond investor may buy
bonds only to find that interest rates rise. The real spending power of the bond is less than it was.
The investor could have made more money by waiting for a higher interest rate to kick in.
Naturally, this risk is greater for long-term bond prices.

Municipal bonds:

Just as the federal government needs funds to operate, local governments and public
entities, such as school districts, often issue municipal bonds to meet their financial needs.
Municipal bonds can be issued by states, cities, towns, or public commissions to provide money
for schools, hospitals, and other public works. These securities provide income that is free of
federal and, in some cases, state and local taxes. (Although income generated by most municipal
bonds is exempt from taxes, any capital gains earned from the sale of bonds are subject to all
federal and most state tax laws and certain bonds may be subject to the alternative minimum
tax.)

 Risk in municipal bond market :

Default rates are higher during periods when the economy is weak. This point out
that government is not exempt from financial distress. Unlike the federal government,
local governments cannot print money, and there are real limits on how high they can
raise taxes without driving the population away.
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Corporate bonds:

Corporate bonds, unlike U.S. Treasuries and municipal bonds, are fully taxable and may
carry greater risk. At the same time, they may offer higher returns than tax-advantaged bonds.
Corporate bonds are issued by corporations in the need of capital and are typically issued in
denominations of $1,000 with terms of 1 to 30 years. Unlike stocks, bonds do not give the holder
ownership interest in the corporation, as they are simply a tool used to lend the corporation funds
they need to meet their goals. Because corporate bonds generally carry greater risks than
government and municipal bonds, it is critical that investors understand the quality of the bond
they are considering for investment. To evaluate the credit quality of a bond, investors can look
to organizations that rate various corporate bonds, such as Moody’s Investors Service and
Standard & Poor’s. Those bonds rated Baa or above by Moody’s and BBB or above by Standard
& Poor’s are considered investment-grade. Bonds rated below investment grade are considered
more speculative and carry greater risk.

When large corporations need to borrow funds for long periods of time, they may issue bonds.

 The bond indenture is a contract that states the lender’s rights and privileges and the
borrower’s obligations.

Types of corporate bonds:

 Secured Bonds:
A secured bond is a type of bond that is secured by the issuer's pledge of a
specific asset, which is a form of collateral on the loan. In the event of a default,
the bond issuer passes the title of the asset onto the bondholders.
 Unsecured Bonds:
Unsecured bonds, also called debentures, are not backed by equipment, revenue,
or mortgages on real estate. Instead, the issuer promises that they will be repaid. This
promise is frequently called "full faith and credit."
 Junk bonds:
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Junk bonds are high-paying bonds with a lower credit rating than investment-

grade corporate bonds, Treasury bonds, and municipal bonds. Junk bonds are typically
rated 'BB' or lower by Standard & Poor's and 'Ba' or lower by Moody's.
The problem with the junk bond market was that there was a very real chance that the
issuing firms would default on their bond payments.

How do junk bonds work?

Junk bonds are bonds issued by companies with low credit ratings, as opposed to the
investment-grade bonds offered by corporations with better credit and longer track records.
Credit-starved companies offer to pay out high interest rates to investors like you, nice enough to
loan them your hard-earned money.
Investing in bonds:

The most common reason to invest in bonds is that the interest rate paid on bonds helps
to protect investors from the corrosive effect of inflation. Inflation eats away at our spending
power year after year. When a bond is first issued, the interest rate paid on the bond will exceed
the inflation rate because investors will not want the spending value of their money to erode due
to inflation. At a bare minimum, all investors should have the goal to earn returns greater than
inflation.
Bond investing provides the opportunity to earn a return at or greater than inflation
without the extreme volatility of the stock market. Insurance companies, banks, and pension
funds usually have significant investments in bonds because they don’t want the risk of stocks
but still need to beat inflation. Individual investors do the same thing.
What are the risks of investing in bonds?
 Number one is not getting your principal paid back. This is why credit rating agencies
are important—to provide insight on the quality of the issuer of the bond. A triple a
rating is the highest quality rating a company or government can get and that lower risk
results in lower borrowing costs for the company or government.
 The second risk is inflation. If inflation increases more than expected and exceeds the
yield on the bond, then the investor’s spending power is eroded.
 If you don’t need to take additional risk to reach your investment goals, bonds are the
safer bet. When you buy a traditional, high-quality bond, you know the interest that will
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be paid each year and you know the amount of principal to be paid at maturity. Knowing
the end result in advance makes the bond market boring, and provides the fuel for our
economy.
The mortgage market

A mortgage:

It is a long-term loan secured by real estate. A developer may obtain a mortgage loan to
finance the construction of an office building, or a family may obtain a mortgage loan to finance
the purchase of a home. In either case, the loan is amortized.

Amortized:

The borrower pays it off over time in some combination of principal and interest
payments that result in full payment of the debt by maturity.

Characteristics of residential mortgage:

The modern mortgage lender has continued to refine the long-term loan to make it more
desirable to borrowers.

Mortgage Interest Rates:

The interest rate borrowers pay on their mortgages is probably the most important factor in
their decision of how much and from whom to borrow. The interest rate on the loan is
determined by three factors: current long-term market rates, the life (term) of the mortgage, and
the number of discount points paid.

 Market rates: Long-term market rates are determined by the supply of and demand for
long-term funds, which are in turn influenced by a number of global, national, and
regional factors.
 Term: Longer-term mortgages have higher interest rates than shorter-term mortgages.
The usual mortgage lifetime is either 15 or 30 years.
 Discount points: Discount points (or simply points) are interest payments made at the
beginning of a loan. A loan with one discount point means that the borrower pays 1% of
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the loan amount at closing, the moment when the borrower signs the loan paper and
receives the proceeds of the loan.

Loan Terms: Mortgage loan contracts contain many legal and financial terms, most of which
protect the lender from financial loss.

 Collateral: One characteristic common to mortgage loans is the requirement that

collateral, usually the real estate being financed, be pledged as security. The lending
institution will place a lien against the property, and this remains in effect until the loan is
paid off.
 Down Payments: To obtain a mortgage loan, the lender also requires the borrower to
make a down payment on the property, that is, to pay a portion of the purchase price. The
balance of the purchase price is paid by the loan proceeds. Down payments (like liens)
are intended to make the borrower less likely to default on the loan.

Types of mortgage loans:

A number of types of mortgage loans are available in the market. Different borrowers
may qualify for different ones. A skilled mortgage banker can help find the best type of
mortgage loan for each particular situation.

Insured and Conventional Mortgages:

A conventional mortgage is one that's not guaranteed or insured by the federal

government. However, in general, conventional loans have stricter credit requirements than
government-backed loans like FHA loans. In most cases, you'll need a credit score of at least 620
and a debt-to-income ratio of 50% or less.

Fixed rate mortgage:

Rate refers to your interest rate. With a fixed rate mortgage, your lender guarantees your
interest rate will stay the same for a set amount of time (the ‘initial period’ of your loan), which
is typically anything between 1–10 years. When this initial period ends, you’ll be switched to the
lender’s default rate (or standard variable rate).
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Adjustable Rate Mortgage (Arm):

There are many different ARMs. The basic idea is that their interest rate changes over
time throughout the life of the loan. The rate changes reflect changes in the economy and the cost
of borrowing money. A common ARM is called the 5/1 loan — the interest rate stays the same
for the first five years and then is free to change for the remaining 25 years.

Interest-only mortgage:

Over the term of your loan, you don’t actually pay off any of the mortgage – just the
interest on it. Your monthly payments will be lower, but won’t make a dent in the loan itself. At
the end of your term, you have to pay the total amount in full. Usually, people with an interest
only mortgage will invest their mortgage, which they’ll then use to pay the mortgage off at the
end of the term.

Repayment mortgage:

Over the term of your mortgage, every month, you steadily pay back the money you’ve
borrowed, along with interest on however much capital you have left. At the end of the mortgage
term, you’ll have paid off the entire loan. The amount of money you have left to pay is also
called ‘the capital’, which is why repayment mortgages are also called capital and interest
mortgages.

Graduated-Payment Mortgages (GPM):

Graduated payment mortgages (GPMs) are a type of home loan. The payments on a

GPM start small and get larger as time goes on. This type of mortgage has a fixed interest rate.
The payments increase, often between 7 – 12% each year, until a maximum payment amount is
reached.
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Growing equity mortgages:

A growing-equity mortgage (GEM) is a type of fixed rate mortgage where the monthly

payments increase over time according to a set schedule, rather than remaining fixed and equal
over the loan term. The interest rate on the loan does not change, and there is never any negative
amortization.

Piggyback:

The piggyback occurs when you put a down payment of less than 20% and take two loans
of any type in combination to avoid paying Private Mortgage Insurance.

Reverse Annuity Mortgages (RAMs):

A reverse annuity mortgage (RAM) is a loan aimed at senior citizens who have paid off
their houses but cannot afford to stay there or need extra money for home repair, long-term care,
medical treatment, or other purposes. It allows a homeowner to convert into cash some of the
equity he or she has built up in the home.

Securitized mortgages:

A securitized mortgage gives the holder of the security, rather than the bank originating the
loan, the right a claim on the principal and interest payments on
that mortgage. Mortgages are securitized to remove them from a bank's balance sheet (which
reduces risk) and to improve its cash flow.

Mortgage-Backed Security:

A mortgage-backed security (MBS) is an investment similar to a bond that is made up of

a bundle of home loans bought from the banks that issued them. Investors in MBS receive
periodic payments similar to bond coupon payments. The MBS is a type of asset-backed
security.

Subprime loans:
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Increased in volume from being a negligible portion of the mortgage loan volume in the
1990s to 17% by 2006. Zero-down loans along with under qualified borrows led speculative
growth in home prices and a subsequent collapse when default rates and lack of real demand
became public.

The stock market:

A stock exchange, securities exchange, or bourse is a facility where stockbrokers and

traders can buy and sell securities, such as shares of stock and bonds and other financial
instruments.

Different Types of Stocks:

There are two main types of stocks: common stock and preferred stock.

Common Stock:

Common stock is, well, common. When people talk about stocks in general they are most
likely referring to this type. In fact, the majority of stock issued is in this form. We basically
went over features of common stock in the last section. Common shares represent ownership in a
company and a claim (dividends) on a portion of profits. Investors get one vote per share to elect
the board members, who oversee the major decisions made by management.

Over the long term, common stock, by means of capital growth, yields higher returns
than almost every other investment. This higher return comes at a cost since common stocks
entail the most risk. If a company goes bankrupt and liquidates, the common shareholders will
not receive money until the creditors, bondholders, and preferred shareholders are paid.

Preferred Stock:

Preferred stock represents some degree of ownership in a company but usually doesn't
come with the same voting rights. (This may vary depending on the company.) With preferred
shares investors are usually guaranteed a fixed dividend forever. This is different than common
stock, which has variable dividends that are never guaranteed. Another advantage is that in the
event of liquidation preferred shareholders are paid off before the common shareholder (but still
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after debt holders). Preferred stock may also be callable, meaning that the company has the
option to purchase the shares from shareholders at anytime for any reason (usually for a
premium).

How Stocks Are Sold?

Literally billions of shares of stock are sold each business day in the United States. The
orderly flow of information, stock ownership, and funds through the stock markets is a critical
feature of well-developed and efficient markets. This efficiency encourages investors to buy
stocks and to provide equity capital to businesses with valuable growth opportunities. Organized
Securities Exchanges Historically, the New York Stock Exchange (NYSE) has been the best
known of the organized exchanges. The NYSE first began trading in 1792, when 24 brokers
began trading a few stocks on Wall Street. The NYSE is still the world’s largest and most liquid
equities exchange. The traditional definition of an organized exchange is that there is a specified
location where buyers and sellers meet on a regular basis to trade securities using an open-outcry
auction model.

As more sophisticated technology has been adapted to securities trading, this model is
becoming less frequently used. The NYSE currently advertises itself as a hybrid market that
combines aspects of electronic trading and traditional auction-market trading. In March of 2006,
the NYSE merged with Archipelago, an electronic communication network (ECN) firm.

Over-the-Counter Markets If Microsoft’s stock is not traded on any of the organized

stock exchanges, where does it sell its stock? Securities not listed on one of the exchanges trade
in the over-the-counter (OTC) market. This market is not organized in the sense of having a
building where trading takes place. Instead, trading occurs over sophisticated
telecommunications networks. One such network is called the National Association of Securities
Dealers Automated Quotation System (NASDAQ). This system, introduced in 1971, provides
current bid and ask prices on about 3,000 actively traded securities. Dealers “make a market” in
these stocks by buying for inventory when investors want to sell and selling from inventory
when investors want to buy. These dealers provide small stocks with the liquidity that is essential
to their acceptance in the market. Total volume on the NASDAQ is usually slightly lower than
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on the NYSE; however, NASDAQ volume has been growing and occasionally exceeds NYSE
volume.

Organized Securities Exchanges:

Organized securities exchanges are tangible organizations that act as secondary markets
in which outstanding securities are resold. Organized exchanges account for about 59 percent of
the total dollar volume of domestic shares traded. The dominant organized exchanges are the
New York Stock Exchange and the American Stock Exchange, both headquartered in New York
City. There are also regional exchanges, such as the Chicago Stock Exchange and the Pacific
Stock Exchange (co-located in Los Angeles and San Francisco).

Over-the-counter markets:

An over-the-counter (OTC) market is a decentralized market in which market participants

trade stocks, commodities, currencies or other instruments directly between two parties and
without a central exchange or broker. Over-the-counter markets do not have physical locations;
instead, trading is conducted electronically.

Exchange Traded Funds (ETFs):

Exchange traded funds (ETFs) have become the latest market innovation to capture
investor interest. They were first introduced in 1990 and by 2007 over 400 separate ETFs were
being traded. In their simplest form, ETFs are formed when a basket of securities is purchased
and a stock is created based on this basket that is traded on an exchange. The makeup and
structure are continuing to evolve, but ETFs share the following features:

 They are listed and traded as individual stocks on a stock exchange. Currently, all
available offerings are traded on the American Stock Exchange.
 They are indexed rather than actively managed.
 Their value is based on the underlying net asset value of the stocks held in the index
basket. The exact content of the basket is public so that intraday arbitrage keeps the ETF
price close to the implied value.

The One-Period Valuation Model:

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Single Period Model, one of the discounted cash flow models, is an income valuation
approach that aims to find the fair value of a stock/firm using single projected cash flow value
and then discounting it with an appropriate discount rate. Taking all future streams of cash flow
into one single period and discounting is also referred as “Earnings Capitalization”.

This method is a substitute for the traditional discounting of all future cash flows.
However since it is a “single period” model, we need a single sum of an amount as the cash flow
for all future years or a single sum for 1 year holding period.

Rationale for Using Single Period Model:

This model is one of the simplest models to understand and calculate the value of a
firm/company/project and is still being used, however, certain limitations exist. The key reasons
for the wide usage of this model are as follows:

 Based on current year data:

Under the single period model; we do not need to forecast future cash flows and
current year data available is enough to value the company under consideration.
 Suitable for stable businesses:
This model is best suited for companies where earnings are stable and easily
predictable. In such a case, it becomes easy to assume an average earning amount which
shall be received for the remaining life of the company.
 User-friendly and simple model:
Since an assumption can be made that earnings and expenses will grow at the
same rate as the long term growth rate for cash flows; one need not estimate earnings and
expenses separately. This makes this model extremely user-friendly as one can take the
current financial data from annual reports and attach a constant growth rate to it.

Limitations of single-period model:

Based on single average:

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It assumes a single average and stable net cash flow/income till perpetuity which can lead
to substantial errors in valuation if the company under consideration is cyclic or is in growing
stage or decline phase or any other case where profitability or cash flows keep fluctuating.

 Not practical:
The single period model assumes revenues and expenses increase at the same rate
and hence considers a constantly grown rate for net income. However, in reality
expenditure may in some cases reduce over time due to economies of scale. In some
cases, expenditure may increase faster than revenues as companies may incur additional
capital expansion or advertisement expenditures. Since the rate at which revenues and
expense may not always, in all circumstance, grow at the same rate; this model may face
error in valuation due to the impractical approach.
 Different discount rate:
The discount rate (also known as the capitalization rate) may change over time.
The discount rate calculated using the Capital Asset Pricing Model (CAPM) which
pertains to equity may not be the discount rate applicable to the net income in the real
world scenario.

 Sensitivity
Since only one value is estimated and then discounted, the said value is more
sensitive than the multi-period model in estimation.

Conclusion:

The single period method of valuation is best suited in case of stable net income flows or
cases where it is extremely difficult to forecast future series of cash flows or in cases where the
holding period of the investment is 1 year. Selecting the appropriate discount rate may, however,
remain a challenging task and would entail estimation error.

The Gordon Growth Model:

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The Gordon Growth Model values a company's stock using an assumption of constant
growth in payments a company makes to its common equity shareholders. ... To estimate the
value of a stock, the model takes the infinite series of dividends per share and discounts them
back into the present using the required rate of return.

Where:

D0 = the most recent dividend paid

g = the expected constant growth rate in dividends

ke = the required return on an investment in equity

This model is useful for finding the value of stock, given a few assumptions:

 Dividends are assumed to continue growing at a constant rate forever. Actually, as long
as they are expected to grow at a constant rate for an extended period of time (even if not
forever), the model should yield reasonable results. This is because errors about distant
cash flows become small when discounted to the present.
 The growth rate is assumed to be less than the required return on equity, ke. Myron
Gordon, in his development of the model, demonstrated that this is a reasonable
assumption. In theory, if the growth rate were faster than the rate demanded by holders of
the firm’s equity, in the long run the firm would grow impossibly large.

Price earnings ratio:

The price earnings ratio (PE) is a widely watched measure of how much the market is
willing to pay for $1 of earnings from a firm. A high PE has two interpretations.

 A higher-than-average PE may mean that the market expects earnings to rise in the
future. This would return the PE to a more normal level.
 A high PE may alternatively indicate that the market feels the firm’s earnings are very
low risk and is therefore willing to pay a premium for them.

Stock market index:

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A stock market index is a measurement of the value of a section of the stock market and

is calculated from the prices of selected shares. It is a tool used by investors to describe
the market and to compare the return on specific investments.

Stock market indexes around the world are powerful indicators for global and country-
specific economies. In the United States the S&P 500, Dow Jones Industrial Average, and
Nasdaq Composite are the three most broadly followed indexes by both the media and investors.
In addition to these three indexes, there are approximately 5,000 others that make up the U.S.
equity market.