Chapter 1:

- Primary markets :
• Markets in which users of funds raise funds through new issues of financial instruments, such as stocks and bonds
• Include issues of equity by firms initially going public, referred to as initial public offerings (IPOs)
- Secondary markets : Markets that trade financial instruments once they are issued
- Secondary markets offer the following:
• Liquidity, or the ability to turn an asset into cash quickly at its fair market value
• Information about the prices or the value of investments
• Trading with low transaction costs
- Financial institutions perform the essential function of channeling funds from those with surplus funds to those with shortages of funds
- In a world without FIs, the level of funds flowing between suppliers and users would likely be quite low due to the following reasons:
• Monitoring costs: A supplier of funds who directly invests in a fund user’s financial claims faces a high cost of monitoring the fund
user’s actions in a timely and complete fashion
• Liquidity costs
FIs act as asset transformers, financial claims issued by an FI that are
more attractive to investors than are the claims directly issued by
• Price risk
- Additional benefits FIs corporations
• Maturity intermediation
• Denomination intermediation
• Reduce transaction cost
- Economic functions FIs provide to the financial system as a whole:
• Transmission of monetary policy
• Credit allocation
• Intergenerational wealth transfers or time intermediation
• Payment services
- FIs face various types of risks : Default risk ( credit risk), Foreign echange risk and country ( sovereign) risk, Interest rate risk, Market risk (
asset price risk), Off-balance sheet risk, Liquidity risk, Technology and operational risk, Insolvency risk
- Regulations of FIs:
• Failures of FIs can cause widespread panic and withdrawal runs on institutions
• FIs are regulated to prevent market failures, as well as associated costs on the economy and society at large
- Enterprise risk management:
• Recognizes the importance of managing the combined impact of the full spectrum of risks as an interrelated risk portfolio
• Seeks to embed risk management as a component in all critical decisions throughout FI
• Stresses importance of building strong risk culture
- Financial technology, or fintech, refers to the use of technology to deliver financial solutions in a manner that competes with traditional
financial methods
• Includes services such as cryptocurrencies (e.g., bitcoin) and blockchain
• Fintech risk involves the risk that fintech firms could disrupt business of financial services firms in the form of lost customers and
lost revenue
• Supports models of peer-to-peer mass collaboration

Chapter 4
Structure of the Federal Reserve Systems:
• 12 Federal Reserve Banks in cities throughout the U.S.
• 12 Federal Reserve Banks in cities throughout the U.S.
Balance sheet of the Federal Reserve
- Liabilities
• Major liabilities on the Fed’s balance sheet are currency in circulation and reserves, the sum of which is referred to as the Fed’s
monetary base or money base
• Total reserves can be classified into two categories:
o Required reserves are those the Fed requires banks to hold by law
o Excess reserves are additional over and above required reserves
- Assets
• Major assets are Treasury and government agency (i.e., Fannie Mae, Freddie Mac) securities, Treasury currency, and gold and foreign
exchange
• Interbank loans are a small portion of total assets, but they plan an important role in implementing monetary policy
Federal Reserve uses the following to implement monetary policy: Open market operations - Discount rate - Reserve requirements
Open market operations: Open market operations are the primary determinant of changes in bank excess reserves in the banking system. Directly impact
the size of the money supply and/or the level of interest rates (e.g., the fed funds rate)
Discount rate: is the rate of interest Federal Reserve Banks charge on loans to FIs in their district
- Raising the discount rate signals a desire to see a tightening of monetary conditions and higher interest rates in general
- Lowering the discount rate signals a desire to see more expansionary monetary conditions and lower interest rates in general
Reserve Requirements: determine the minimum amount of reserve assets that DIs must maintain by law to back transaction deposit accounts held as
liabilities on their balance sheets
 • Requirement is usually set as a ratio of transaction accounts
• Very rarely used by the Federal Reserve as a monetary policy tool
- A(n) decrease (increase) in the reserve requirement ratio means that DIs may hold fewer (must hold more) reserves against their transaction
accounts, allowing them to lend out a greater (smaller) percentage of their deposits and increasing (decreasing) credit availability in the economy
- Decrease in the reserve requirement results in a multiplier increase in the supply of bank deposits and thus the money supply
Change in bank deposits =(1/new reserve requirement) x increase in reserves created by reserve requirements change
- Increase in the reserve requirement results in a multiple contraction in deposits and a decrease in the money supply
Change in bank deposits =(1/new reserve requirement) x decrease in reserves created by reserve requirements change

Effects of Monetary tools on various economic variables

Expansionary Activities Contractionary Activities
- Open market purchases of securities - Open market sales of securities
All else constant, reserve accounts of banks increase All else constant, reserve accounts of banks decrease
- Discount rate decrease - Discount rate increase
All else constant, interest rates in the economy decrease All else constant, interest rates in the economy increase
- Reserve requirement ration decreases - Reserve requirement ration increases
All else constant, bank reserves increase All else constant, bank reserves decrease
Money supply versus Interest rate targeting: Federal Reserve can successfully target only one of these two variables (money supply or interest rates) at
any one moment
- If the money supply is the target variable used to implement monetary policy, interest rates must be allowed to fluctuate relatively freely
- If an interest rate (e.g., fed funds rate) is the target, bank reserves and the money supply must be allowed to fluctuate relatively freely

Chapter 5
- Money markets trade debt securities or instruments with maturities of less than one year
• Once issued, money market instruments trade in active secondary markets
• Need for money markets arises because the immediate cash needs of individuals, corporations, and governments do not necessarily
coincide with their receipts of cash
- Money market instruments share basic characteristics:
• Generally sold in large denominations ($1m to $10m units)
• Low default risk, the risk of late or nonpayment of principal and/or interest
• Must have an original maturity of one year or less
Bond equivalent yield Effective annual interest return ( less than 1 year)

Interest on discount yield Discount yield can be converted into a bond equivalent yield in
the following manner:

- Money market instruments

• Treasury bills: short-term obligation issued by the US government
Discount yield on a T-bill ( Commercial paper i chang ) Bond equivalent yield on T-bill

• Federal funds: short- term funds transferred between financial institutions usually for no more than 1 day
• Repurchase agreements: agreements involving the sale of securities by one party to another with a promise to repurchase the
securities at a specified date and price
o Repurchase agreements are arranged directly between two parties or with the help of brokers and dealers

• Commercial paper: short-term unsecured promissory notes issued by a company to raise short-term cash
• Negotiable certificates of deposit: bank-issued time deposits that specify an interest rate and security date are negotiable ( saleable on
secondary market)
o A negotiable certificate of deposit (CD) is a bank-issued, fixed maturity, interest-bearing time deposit that specifies an
interest rate and maturity date and is negotiable
o Bearer instruments: whoever holds the CD when it matures receives the principal and interest
 o May be traded any number of times in the secondary market
o Negotiable CD rates are negotiated between the bank and the CD buyer
• Banker’s acceptance: time drafts payable to a seller of goods, with payment guaranteed by a bank
o Many BAs arise from international trade transactions
o Payable to the bearer at maturity
o Traded in secondary markets
o Denominations determined by the size of the original transaction, but often trade in secondary markets in round lots of
$100,000 and $500,000
- Eurodollar market: is the market in which Eurodollars trade
• As an alternative to the Eurodollar market, companies can also obtain short-term funding by issuing Eurocommercial paper
• Rate offered for sale on Eurodollar funds is known as the London Interbank Offered Rate (LIBOR)
Chap 6: Bond Markets
- Equity and debt instruments with maturities of more than one year trade in capital markets
- Bonds are long-term debt obligations issued by corporations and government units
• Proceeds from a bond issue are used to raise funds to support long-term operations of the issuer
• If the terms of the repayment are not met by the bond issuer, the bond holder (investor) has a claim on the assets of the bond issuer
- Bond markets are markets in which bonds are issued and traded
• Treasury notes (T-notes) and bonds (T-bonds)
• Municipal bonds
• Corporate bonds
- Treasury notes and bonds (T-notes and T-bonds) are issued by the U.S. Treasury to finance the national debt and other government
expenditures
• T-notes and T-bonds are backed by the full faith and credit of the U.S. government and are, therefore, default risk free
• T-notes and T-bonds pay relatively low rates of interest (yields to maturity) to investors
• T-notes and T-bonds pay coupon interest (semiannually)
• T-bills have an original maturity of one year or less, T-notes have original maturities from over 1 to 10 years, while T-bonds have
original maturities from over 10 years
• Like T-bills, once issued T-notes and T-bonds trade in very active secondary markets
• Treasury issued two types of notes and bonds: fixed principal and inflation-indexed
o Both types pay interest twice per year
o Principal value used to determine the percentage interest payment (coupon) on inflation-indexed bonds is adjusted to reflect
inflation (measured by the CPI)
- The national debt (ND) reflects the historical accumulation of annual federal government deficits or expenditures (G) minus taxes (T) over the last
N
200-plus years NDt = ∑ (Gt − Tt )
t =1
- Separate Trading of Registered Interest and Principal Securities (STRIPS) is a Treasury security in which the periodic interest payment is
separated from the final principal payment.
• May be used to immunize against interest rate risk
- Accrued interest is the portion of the coupon payment accrued between the last coupon payment and the settlement day
• Paid by the buyer to the seller if the T-note or T-bond is purchased between interest payment dates
INT Actual number of days since last coupon payment
Accrued interest = ×
2 Actual number of days in coupon period Clean price + Accrued price = Dirty price
- Municipal bonds are securities issued by state and local governments; primary reasons for issuances are the following:
o Fund imbalances between expenditures and receipts
o Finance long-term capital outlays
• Attractive to household investors because interest is exempt from federal and most state/local income taxes
• General obligation (GO) bonds are backed by the full faith and credit of the issuer
• Revenue bonds are sold to finance specific revenue-generating project and are backed by the cash flows from that project

- The after-tax (or equivalent tax-exempt) yield on a taxable bond can be calculated as follows:
- The yield on a tax-exempt municipal bond can be calculated as follows:

- Corporate bonds are long-term obligations issued by corporations

- A bond indenture is the legal contract that specifies the rights and obligations of the bond issuer and the bond holders
• Contains several covenants associated with a bond issue
 • Bond covenants describe rules and restrictions placed on the bond issuer and bond holders
- Corporate bonds characteristics
Bearer versus Registered Bonds
• Bearer bonds have coupons attached to the bonds, and the holder presents the coupons to the issuer for payments of interest when
they come due
• Registered bonds are those in which the owner is recorded by the issuer and the coupon payments are mailed to the registered owner
Term versus Serial Bonds
• Term bonds are those in which the entire issue matures on a single date
• Serial bonds mature on a series of dates, with a portion of the issue paid off on each
Mortgage bonds are issued to finance specific projects, which are pledged as collateral for the bond issue
Debentures and Subordinated Debentures
• Debentures are bonds backed solely by the general credit worthiness of the issuing firm, unsecured by specific assets or collateral
• Subordinated debentures are bonds that are unsecured and are junior in their rights to mortgage bonds and regular debentures
Convertible bonds may be exchanged for another security of the issuing firm at the discretion of the bond holder
Bonds issued with stock warrants give the bond holder the option to detach the warrants to purchase common stock at a prespecified price up to
a prespecified date
Callable bonds
• Many corporate bond issues include a call provision, which allows the issuer to require the bond holder to sell the bond back to the
issuer at a given (call) price— usually set above the par value of the bond
• The difference between the call price and the face value on the bond is the call premium
Sinking fund provision is a requirement that the issuer retire a certain amount of the bond issue each year
- Bond Market participants:
• The major issuers of debt market securities are federal, state and local governments, as well as corporations
• The major purchasers of capital market securities are households, businesses, government units, and foreign investors
- International aspects of bond markets:
• International bond markets are those markets that trade bonds that are underwritten by an international syndicate, offer bonds to
investors in different countries, issue bonds outside the jurisdiction of any single country, and offer bonds in unregistered form
o For bond issuers, the existence of sophisticated international bond markets increases the available financing options and
range of assets
o International bond market placements can also increase risk for an issuer
• International bonds can be classified into three main groups:
Eurobonds are long-term bonds issued and sold outside the country of the currency in which they are denominated (e.g., dollar-
denominated bonds issued in Europe or Asia)
Foreign bonds are long-term bonds issued by firms and governments outside of the issuer’s home country and are usually
denominated in the currency of the country in which they are issued rather than in their own domestic currency
Sovereign bonds are government-issued, foreign currency-denominated debt
Chapter 7. MORTGAGE MARKET
- Mortgages are loans to individuals or businesses to purchase homes, land, or other real property
- Many mortgages are securitized
Securitization occurs when securities are packaged and sold as assets backing a publicly traded or privately held debt
instrument
- Mortgages differ from bonds and stocks
lMortgages are backed by a specific piece of real property
lPrimary mortgages have no set size or denomination
lPrimary mortgages generally involve a single investor
lComparatively little information exists on mortgage borrowers
● Four basic types of mortgages are issued by financial institutions (mortgages market)
1.Home mortgages are used to purchase one- to four-family dwellings (called “single-family mortgages”)
2.Multifamily dwelling mortgages are used to purchase apartment complexes, townhouses, and condominiums
3.Commercial mortgages are used to finance the purchase of real estate for business purposes
4.Farm mortgages are used to finance the purchase of farms
● Mortgage Characteristics
- All mortgage loans are backed by a specific piece of property that serves as collateral to the mortgage loan
- A down payment is a portion of the purchase price of the property a financial institution requires the mortgage
borrower to pay up front
- Federally insured mortgages
- A mortgage is amortised when the fixed principal and interest payments fully pay off the mortgage by its maturity
date
- Balloon payment mortgages require fixed monthly interest payments for a 3- to 5-year period, at which point full
payment of the mortgage principal is due
- Fixed-rate mortgages lock in the borrower’s interest rate
- Adjustable-rate mortgages (ARMs) have interest rates tied to some market interest rate
- Discount points are fees or payments made when a mortgage loan is issued (at closing)
lOne discount point paid up front is equal to 1 percent of the principal value of the mortgage
- Mortgage contracts generally require the borrower to pay an assortment of fees to cover the mortgage issuer’s
costs of processing the mortgage
lE.g., application fee, title search, title insurance, appraisal fee, loan origination fee, closing agent and review fees, etc.
- Mortgage refinancing occurs when a mortgage borrower takes out a new mortgage and uses the proceeds
obtained to pay off the current mortgage
lMortgages are most often refinanced when a current mortgage has an interest rate that is higher than the current interest
rate
● Mortgage armortization
- The fixed monthly payment made by a mortgage borrower generally consists partly of repayment of the principal
borrowed and partly of the interest on the outstanding (remaining) balance of the mortgage
- An amortization schedule shows how the fixed monthly payments are split between principal and interest
● Mortgage payments The present value of a mortgage can be written as:

● Other Types of Mortgages:

- Jumbo mortgages are those that exceed the conventional mortgage conforming limits
- Subprime mortgages are mortgages to borrowers who have weakened credit histories
- Alt-A mortgages are considered riskier than a prime mortgage and less risky than a subprime mortgage
- Option ARMs are adjustable rate mortgages that offer the borrower several monthly payment options: Minimum
payment option, Interest-only payment, 30-year fully amortizing payment, 15-year fully amortizing payment
● Secondary Mortgage Markets
- FIs remove mortgages from their balance sheets through one of two mechanisms:
+ By pooling recently originated mortgages together and selling them in the secondary market
+ By securitizing mortgages (i.e., by issuing securities backed by newly originated mortgages)
- Advantages of securitization:
+ FIs can reduce their liquidity risk, interest rate risk, and credit risk
+ FIs generate fee income, which helps to offset the effects of regulatory constraints
● Mortgage Sales
- Mortgage sales occur when an FI originates a mortgage and sells it to an outside buyer
- lFIs have sold mortgages and commercial real estate among themselves for over 100 years
● Mortgage-Backed Securities
- Securitization of mortgages involves the pooling of a group of mortgages with similar characteristics, the removal
of these mortgages from the balance sheet, and the subsequent sale of interests in the mortgage pool to
secondary market investors
 - Mortgage-backed securities allow mortgage issuers to separate the credit risk exposure from the lending process
itself
- There are three major types of mortgage-backed securities: Pass-through security, Collateralized mortgage
obligation (CMO), Mortgage-backed bond
- Collateralized mortgage obligations (CMOs) are mortgage-backed bonds with multiple bond holder classes, or
tranches
+ Each bond holder class has a different guaranteed coupon
+ Mortgage prepayments retire only one tranche at a time, so all other trances are sequentially prepayment
protected
- Mortgage-backed bonds (MBBs)
+ MBBs are bonds collateralized by a pool of assets, also called asset-backed bonds
+ The relationship for MBBs is one of collateralization rather than securitization; the cash flows on the mortgages
backing the bond are not necessarily directly connected to interest and principal payments on the MBB
● Pass-Through Securities
- Pass-through mortgage securities “pass through” promised payments of principal and interest on pools of
mortgages created by FIs to secondary market participants holding interests in the pools
- Three agencies are directly involved in the creation of mortgage-backed pass-through securities: Government
National Mortgage Association (GNMA; Ginnie Mae), Federal National Mortgage Association (FNMA; Fannie
Mae), Federal Home Loan Mortgage Corporation (FHLMC; Freddie Mac)
- Private mortgage issuers, such as banks and thrifts, also purchase mortgage pools, but they do not conform to
government-related issuer standards
Chapter 8. STOCK MARKETS
● Common Stock
- Two types of corporate stock exist: Common stock, Preferred stock
- All public corporations issue common stock, but few issue preferred stock
- Common stock is the fundamental ownership claim in a public or private corporation, and many characteristics
differentiate it from other types of securities: Discretionary dividend payments, Residual claim status, Limited
liability, Voting rights
● Dividends
- Dividends are discretionary, and are thus not guaranteed
+ Payment and size of dividends are determined by the board of directors of the issuing firm
- Dividends are taxed twice – once at the firm level and once at the personal level
+ May partially avoid this double taxation effect by holding stocks in growth firms that reinvest most of their
earnings to finance growth rather than paying larger dividends
- The return to a stockholder over a period t-1:

● Residual Claim
- Common stockholders have the lowest priority claim in the event of bankruptcy (i.e., they have a residual claim)
- Only after all senior claims are paid are common stockholders entitled to what assets of the firm are left
+ Senior claims may be payments owed to creditors such as the firm’s employees, bond holders, the government
(taxes), and preferred stockholders
- Residual claim feature associated with common stock makes it riskier than bonds as an investable asset
● Limited liability
- Limited liability implies that common stockholder losses are limited to the amount of their original investment in
the firm if the company’s asset value falls to less than the value of the debt it owes
+ In contrast, sole proprietorship or partnership stock interests mean the stockholders may be liable for the firm’s
debts out of their total private wealth holdings if the company experiences financial difficulties
● Voting Rights
- Common stockholders control the firm’s activities indirectly by exercising their voting rights in the election of the
board of directors
- Typical voting rights arrangement is to assign one vote per share of common stock
- Some firms are organized as dual-class firms, where two classes of common stock are outstanding, with different
voting and/or dividend rights for each class
- Two methods of electing a board are generally used: Cumulative voting, Straight voting
● Proxy Votes
- Most shareholders do not attend annual meetings
- A proxy is a voting ballot sent by a corporation to its stockholders
+ When returned to the issuing firm, a proxy allows stockholders to vote by absentee ballot or authorizes
representatives of the stockholders to vote on their behalf
● Preferred Stock
- Preferred stock is a hybrid security that has characteristics of both bonds and common stock
+ Similar to common stock in that it represents an ownership interest in the issuing firm, but like a bond it pays a
fixed periodic (dividend) payment
- Dividends are generally fixed (paid quarterly)
- Preferred stockholders generally do not have voting rights in the firm, but most stock may be converted to
common stock at any time the investor chooses
- Typically, preferred stock is nonparticipating and cumulative
+ Nonparticipating preferred stock means the dividend is fixed regardless of any increase of decrease in the issuing
firm’s profits, while participating preferred stock means actual dividends paid in any year may be greater than
promised dividends
+ Cumulative preferred stock means that any missed dividend payments go into arrears and must be made up
before any common stock dividends can be paid, while dividends of noncumulative preferred stocks do not go
into arrears and are never paid
● Primary Stock Markets
- Primary stock markets are markets in which corporations raise funds through new issues of stocks
+ Most primary market transactions go through investment banks
- Investment bank can conduct a primary sale using either a firm commitment or best efforts underwriting basis
+ The investment bank guarantees the corporation a price for the newly issued securities
+ Best efforts underwriting occurs when the underwriter does not guarantee a price to the issuer
- A syndicate is a group of investment banks working in concert to sell and distribute a new issue; the lead banks in
the syndicate is the originating house
- An initial public offering (IPO) is the first public issue of a financial instrument by a firm
- A seasoned offering is the sale of additional securities by a firm whose securities are currently publicly traded
+ Preemptive rights give existing stockholders the ability to maintain their proportional ownership
- Registration of a stock can be a lengthy process
+ A red herring prospectus is a preliminary version of the prospectus that describes a new security issue
+ Shelf registration allows firms that plan to offer multiple issues of stock over a two-year period to submit one
registration statement (i.e., master registration statement)
● Stock Exchanges
- Secondary stock markets are the markets in which stocks, once issued, are traded by investors
+ In secondary market transactions, funds are exchanged, usually with the help of a securities broker or firm acting
as an intermediary between the buyer and seller of the stock
+ Original issuer of the stock is not involved in this transfer of stocks or funds
- Two major U.S. stock markets are the following: NYSE Euronext, NASDAQ
● Trading Process
- All transactions occurring on the NYSE occur at a specific place on the floor of the exchange (trading post), and
each stock is assigned a special market maker (a specialist)
+ Specialists often organize themselves as firms due to large amount of capital needed to serve the market-making
function
- Three types of transactions can occur at a given post:
+ Brokers trade on behalf of customers at the “market” price (market order)
+ Limit orders are left with a specialist to be executed
+ Specialists transaction for their own account
- Majority of orders sent to brokers are of two types:
+ A market order is an order to transact at the best price available when the order reaches the post
+ limit order is an order to transact at a specified price
● Program Trading
- Program trading is the simultaneous buying and selling of a portfolio of at least 15 different stocks valued at more
than $1m, using computer programs to initiate the trades
+ Criticized for impact on stock market prices and increased volatility
- NYSE introduced circuit breakers, which served as trading curbs, to account for increased volatility
+ Circuit breakers are an imposed halt in trading that gives buyers and sellers time to assimilate incoming
information
+ Limit up-limit down (LULD) rules halts trading on individual stocks if the stock price moves outside the following

price band:
● Controversial Trading Practices
- Flash trading is a practice in which, for a fee, traders are allowed to see incoming buy or sell orders milliseconds
earlier than general market traders
- Naked access allows some traders to rapidly buy and sell stocks directly on exchanges using a broker’s computer
code without exchanges or regulators always knowing who is making the trades
- Dark pools of liquidity are trading networks that provide liquidity but that do not display trades on order books
● The NASDAQ and OTC Market
- Securities not sold on one of the organized exchanges are traded over the counter (OTC)
+ OTC markets do not have a physical trading floor; rather, transactions are completed via an electronic market
- NASDAQ was the world’s first electronic stock market
+ Primarily a dealer market, where dealers are the market makers who stand ready to buy or sell particular
securities
+ In contrast to the NYSE, NASDAQ is a negotiated market
+ Small Order Execution System (SOES) provides automatic order execution for individual traders with orders of less
than or equal to 1,000 shares
 ● Choice of Market Listing
- Firms listed with the NYSE Euronext must meet the listing requirements of the exchange
+ Requirements are extensive
- Reasons a NYSE listing is attractive to a firm: Improved marketability of the firm’s stock, Publicity for the firm,
Improved access to the financial markets
- Firms that do not meet the requirements of the NYSE Euronext exchange listings trade on the NASDAQ
+ Most NASDAQ firms are smaller, of regional interest, or unable to meet the listing requirements of the organized
exchanges
+ Over time, many NASDAQ firms apply for NYSE listing
● Electronic Communications Networks and Online Trading
- Major stock markets currently open at 9:30 am eastern time and close at 4:00 pm eastern time
- ECNs are computerized systems that automatically match orders between buyers and sellers and serve as an
alternative to traditional market making and floor trading
● Stock Market Indexes
- A stock market index is the composite value of a group of secondary market-traded stocks
+ Dow indexes are price-weighted averages
+ NYSE is a value-weighted index
- Wilshire 5000 Index is the broadest stock market index and possibly the most accurate reflection of the overall
stock markets
● Market participants
- Holders of corporate stock from 1994 through 2019:
+ Households, mutual funds and foreign investors
+ Together, these holdings totaled approximately 74% in 2019
- U.S. stock ownership rates are highly related to income, but also vary by age (62% of U.S. adults aged 30 to 64,
31% of those aged 18 to 29, 54% of those aged 65 and older)
● International Aspects of Stock Markets
- U.S. stock markets are the world’s largest
- European markets grew in importance during the 2000s, as a result of implementing the euro, a common
currency, in 2002
- International stock markets are attractive to investors because some risk can be eliminated by holding stocks
issued by corporations in foreign countries
- International diversification can also introduce risk: Information about foreign stocks is less complete and timely
than that for U.S. stocks, Foreign exchange risk, Political (sovereign risk)
● American Depository Receipts (ADRs)
- An ADR is a certificate that represents ownership of a foreign stock
- Three main types of ADR issuances
lLevel 1 ADRs are the most common and most basic of the ADRs (have the least amount of regulatory requirements)
lLevel 2 ADRs can be listed on the major stock exchanges, but they have more regulatory requirements than Level 1 ADRs
lLevel 3 ADRs represent the most respected ADR level a foreign company can achieve in the U.S. markets

Chapter 10. DERIVATIVE SECURITIES MARKET

- A derivative security is an agreement between two parties to exchange a standard quantity of an asset at a
predetermined price at a specified date in the future
+ Payoff is linked to another, previously issued security
+ As the value of the underlying security to be exchanged changes, the value of the derivative security changes
+ Involves the transference of risk
- Traders can experience large losses if the price of the underlying asset moves against them significantly
- Derivative securities markets are those in which derivative securities trade
● Spot Markets
- A spot contract is an agreement to transact involving the immediate exchange of assets and funds
lUnique feature of a spot market is the immediate and simultaneous exchange of cash for securities, or what is often called
delivery versus payment
- Spot transactions occur because the buyer of the assets believes its value will increase in the immediate future
(over the investor’s holding period)
lIf the value of the asset increases as expected, the investor can sell the asset at its higher price for a profit
● Forward Markets: Forward Contracts
- A Forward contract is an agreement to transact involving the future exchange of a set amount of assets at a set
price
- Commercial banks, investment banks, and broker-dealers are the major forward market participants, acting as
both principals and agents
- Each forward contract is originally negotiated between the FI and the customer
lA risk of default (by either party) exists
lRecently, credit derivative instruments have been developed to better allow FIs to hedge credit risk
- Advent of secondary market trading has resulted in an increase in the standardization of forward contracts
● Futures Markets: Futures Contracts
- A futures contract is an agreement to transact involving the future exchange of a set amount of assets for a price
that is settled daily
lTraded on an organized exchange
- Very similar to a forward contract
lOne difference is that the default risk on futures is significantly reduce by the futures exchange guaranteeing to indemnity
counterparties against credit or default risk
lAnother difference relates to the contract’s price, which in a future is marked to market daily
- Unless a systematic financial market collapse threatens an exchange itself, futures are essentially risk-free
- Futures trading occurs on organized exchanges
lChicago Board of Trade (CBOT) and the New York Mercantile Exchange (NYMEX), both of which are part of the CME Group
lFinancial futures market trading was introduced in 1972
- Most trading takes place in trading “pits” using an open-outcry auction method among exchange members
lFloor brokers place trades from the public, while professional traders trade for their own account
lPosition traders take a position based on their expectations about the future direction of the prices of the underlying
assets
lDay traders generally take a position within a day and liquidate it before day’s end, while scalpers take positions for very
short periods of time (e.g., minutes)
- Futures trades may be placed as market or limit orders
- Order may be for long position (mua) or short position (bán)
- Clearinghouse is the unit that oversees trading on the exchange and guarantees all trades made by the exchange
traders
- Holder of a futures contract has two choices for liquidating his or her position:
1.Liquidate position before the futures contract expires
2.Hold the futures contract to expiration
- Traders in futures (as well as option) markets can be either speculators, hedgers, or arbitrageurs
● Clearinghouse function in the futures markets

● Margin Requirements on Futures Contracts

- Brokerage firms require customers to post only a portion of the value of the futures (and options) contracts,
called an initial margin, any time they request a trade
lAmount of the margin varies according to type of contract traded and quantity of futures contracts traded
lIf losses on the customer’s futures position occur and the level of the funds in the margin account drops below a stated
level (i.e., maintenance margin), the customer receives a margin call
- Futures are leveraged instruments, meaning traders post and maintain only a small portion of the value of their
futures position in their accounts
● Options
- An option is a contract that gives the holder the right, but not the obligation, to buy or sell the underlying asset at
a specified price within a specified period of time
+ Call option gives the purchaser (or buyer) the right to buy an underlying security (e.g., a stock) at a prespecified
price called the exercise or strike price (X) lPay call premium
+ Put option gives the option buyer the right to sell an underlying security (e.g., a stock) at a prespecified price to
the writer of the put option lPay put premium
● Options value
- Model most commonly used to price and value options is the Black-Scholes pricing model
- Black-Scholes model examines five factors that affect the price of an option:
1.The spot price of the underlying asset
2.The exercise price on the option
3.The option’s exercise date
4.Price volatility of the underlying asset
5.The risk-free rate of interest
- Time value of an option is the difference between an option’s price (or premium) and its intrinsic value
● Options Market
- An American option can be exercised at any time before (and on) the expiration date
- A European option can be exercised only on the expiration date
- The trading process for options is similar to that for futures contracts
● Options Concluded
- The underlying asset on a stock option is the stock of a publicly traded company
- The underlying asset on a stock index option is the value of a major stock market index (e.g., DJIA or S&P 500)
- The underlying asset on a futures option is a futures contract
- Two alternative credit option derivatives exist to hedge credit risk on a balance sheet:
1.A credit spread call option’s payoff increases as the (default) risk premium or yield spread on a specified benchmark bond
of the borrower increases above some exercise spread
2.A digital default option pays a stated amount in the event of a loan default
● Swaps
- A swap is an agreement between two parties to exchange a series of cash flows for a specific period of time at a
specified interval
 - An interest rate swap is an exchange of fixed-interest payments for floating-interest payments by two
counterparties
lAllows the swap parties to put in place long-term protection against interest rate risk
lThe swap buyer makes the fixed-rate
lThe swap seller makes the floating-rate
- A currency swap is a swap used to hedge against exchange rate risk from mismatched currencies on assets and
liabilities
- Credit swaps (i.e., credit default swaps) were developed to better allow FIs to hedge their credit risk
lTotal return swap involves swapping an obligation to pay interest at a specified fixed or floating rate for payments
representing the total return on a loan of a specified amount
lPure credit swaps remove the “interest rate”-sensitive element…
- Swaps are not standardized contracts
lGenerally heterogeneous in terms of maturities, indexes used to determine payments, and timing of payments
- Swap dealers (usually FIs) keep markets liquid by matching counterparties or by taking positions themselves
- Unlike futures and options markets, swap markets were historically governed by very little regulation
● Caps, Floors and Collars
- Caps, floors, and collars are derivative securities that have many uses, especially in helping an FI to hedge interest
rate risk
- A cap is a call option on interest rates, often with multiple exercise dates
- A floor is a put option on interest rates, often with multiple exercise dates
- A collar is a position taken simultaneously in a cap and a floor (buying cap and selling floor)
● Hypothetical Path of Interest Rates
- Cap Agreement - Floor Agreement

- Buying a call option - Writing a call option

- Buying a put option - Writing a put option

● International Aspects of Derivative Securities Markets

- Between 1999 – 2018, global OTC trading far outweighed exchange trading
lIn both markets, interest rate contracts dominated
- Markets were heavily impacted as a result of the financial crisis of 2008
- U.S. markets and currencies dominate global derivative securities markets
lThe euro and European derivative securities markets are a strong second (and, in some areas, exceed that of the U.S.)