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HFT 4464HFT 4464

Chapter 2Chapter 2

Financial Markets &Financial Markets &

Financial InstrumentsFinancial Instruments

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Chapter 2 Introduction

This chapter will provide an introduction to financial markets and common financial instruments.

Financial markets are where suppliers of capital (firms) interact with buyers (investors).

Often this is done through intermediaries such as brokers.

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Why Do People Invest?

Investing is not just something other people do.

College education is an investment.

Investing is more than just hoping to “make some money.”

It involves deferring present consumption in the hopes of higher future consumption.

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Equity Capital Types of equity capital

Preferred stockCommon stock

This course focuses more on common stock.No guarantee of dividendOne share, one voteShareholders vote on key issues such as

composition of board of directors, choice of auditing firm, and others.

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Why Purchase Common Stock?

A purchaser is looking for at least one of two possibilities:

1. Stream of dividend payments (current income)

2. Increase in stock price (capital gain)

Holding period return:

{ ( (sales price – purchase price) + dividends ) / Purchase Price } x 100

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Holding Period Return Example

You purchased a share of McDonald’s stock one year ago for $18.00.

You earn $2.00 in dividends during the year. Today you sell the stock for $18.50. What is your holding period return?

(($18.50 – $18.00) + $2) / $18.00 = 0.1389

0.1389 x 100 = 13.89% (before taxes)

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Bonds

Held by lenders Receive repayment over time

Semi-annual interest paymentsAt maturity, amount is repaid (principal)

This is a series of cash flows that has value Priced on an index relative to 100 If a $1,000 bond sells for “102,” it sells for

$1,020

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How to Interpret Bond Information

Bond Curr. Yld Vol Close Chg

Hilton 73/4 04 7.2% 40 101 +1/2

The Hilton bond pays 7.75% interest and matures in 2004.

The annual interest divided by the current price is 7.2 percent. (Note: this is not the return you will receive if you hold the bond till maturity.)

40,000 bonds were traded that day.

The bond closed at $1,010 which is $.50 higher than the previous day.

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Capital Markets

Represents a diverse group of investmentsStock marketBond marketMortgage marketFutures market

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Stock Market New York Stock Exchange (NYSE)

Founded in 1792

Physical location on Wall Street in New York

Approximately 2,800 companies offering securities here

Membership offered in the form of seats

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Stock Market Nasdaq

National Association of Securities Dealers and Automated Quotations

Not a physical location like the NYSE (“over the counter”)

Represents a network of securities dealers

Fastest growing securities market

Makes use of “market makers”—help ensure liquidity of trading

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Bond Market

Corporate bonds can be traded through the NYSE

Most bonds are traded over the counter

Bond ratings The lower the letter, the greater the quality Quality refers to the risk of default

Companies rating bonds Standard and Poor’s Moody’s

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Important Features of Bonds How are bond prices and interest rates

related?As interest rates rise, bond prices fall.

Some bonds are callable.Company can repurchase bonds at a

certain price during a certain time.

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Mortgage Market

Pooling of home mortgages by government agencies

FNMA and GNMA are two examples.

Mortgages are packaged and resold as securities to investors.

Investors are often large institutional investors like pension funds.

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Money Market Market for short-term debt instruments

Certificates of Deposit

Commercial paperInvestors loan to large companies for a very short period of time

(9 months or less).

Treasury Bills / BondsLoans to the U.S. TreasuryZero-Coupon bondsIssued at a discount—no interest paymentsRisk Free Rate

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Raising Capital

Primary marketInitial Public Offering (IPO)

Common stock is sold to underwriter (investment banker)

Investment banker sells to clients2003 scandal/settlement

Secondary marketInvestor to investor, where most trading

occurs

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Features of Stock Trading

Bid vs. ask Bid is the price you will pay to own a share Ask is the price you would receive to sell

your share Difference goes to broker

Average NYSE trade takes 22 seconds

Significant reliance upon computers

Trading halt in June 2001

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Hedging Risk

We can add value by decreasing the risk (variability) of cash flows.

The concept of insurance as hedging:You buy insurance and if nothing

happens to your house, you still have the house.

If your house is damaged, insurance pays for it and the house is rebuilt.

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Forward and Futures Contracts Spot price—price paid for a commodity today

Change in commodity prices present, risk to buyer and seller

Example: Orange juice grower (seller) and restaurant owner (buyer)

Prices help growers determine what and how much to produce and restaurants need to establish menu price

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Forward Contracts

An agreement to sell an asset at a fixed price for delivery in the future.

Cash payment is not required until delivery.

However, each party must trust the other to perform.

The unique nature of each contract makes them difficult to sell to third parties.

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Futures Contracts

Similar to forward contracts, except: Terms of contract are standardized, such as amounts

and delivery dates. Clearinghouse acts as go-between to help ensure

performance. Contracts are traded on the Chicago Board of Trade

or Chicago Mercantile Exchange.

Most contracts are never delivered.

Parties take opposite positions to offset original position.

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Foreign Exchange

As international trade barriers are removed, more business is conducted away from home country.

Nearly 65% of McDonald’s 2002 revenues originated from outside the U.S.

U.S. companies must report financial operations in U.S. currency.

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Foreign Exchange Example

You operate a hotel in France and accept the Euro.

When the Euro strengthens, this means it takes fewer Euros to buy $1 worth of goods.

As the Euro strengthens, your profits increase upon conversion.

100,000Euros x $1/1Euro = $100,000 usd 100,000Euros x $2/1Euro = $200,000 usd

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Can we hedge this risk?

Similar to commodities, we want to lock in a “price” for our Euros—an exchange rate at a future date.

We can buy a forward or futures contract to accomplish this.

Who would be on the other side of this transaction?

A French company (or other company accepting the Euro) operating in the U.S.

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Lenders to the Hospitality Industry

Commercial banksTraditionally largest lenderBank makes a “spread”—difference between

interest rate on loans and rate on depositsInterest = principal x rate x timeTypes of loans

Fully amortized (principal and interest)Interest only

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Lenders to the Hospitality Industry Real Estate Investment Trusts (REITS)

There are equity and mortgage REITS Special tax treatment if they pass through at

least 95 percent of earnings to investors

Insurance companies and pension funds Receive large monthly cash flows from

premiums and contributions Try to match assets (loans) to liabilities (policies

and pension needs)

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Measures of Stock Market Performance

Dow Jones Industrial AverageIndex of 30 large companiesWeighted by stock price

Standard and Poor’s 500 (S&P 500)500 companiesFairly common measure of overall stock

market performanceMovement is similar to the Dow

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Some Stock Market Statistics Mean—weighted average

Mean Dow annual return (1950–2001) = 9.01% Mean S&P 500 annual return = 9.63%

Returns in a single year have varied from –30% to +44%

This uncertainty around the mean is called variance

Another measure is standard deviation, the square root of the variance

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Some Stock Market Statistics

Can we measure the relationship between two individual stocks, two stock indices, or an individual stock and a stock index?

Correlation coefficient = Range is from –1.0 to +1.0 +1.0 is perfect positive correlation -1.0 is perfect negative correlation The Dow and the S&P 500 are highly

positively correlated

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Homework Assignment

Problems 1,2,3,5,9