BUS322 – Chapters 9, 10, 11, 12 & 25 1

Financial and Real Estate Markets

• Money Markets• Capital Markets• Mortgage Markets• Financial Derivative Markets

BUS322 – Chapters 9, 10, 11, 12 & 25 2

The Money Markets• Money Markets

– Money market securities are usually sold in large denominations

– They have low default risk

– They mature in one year or less from their issue date

• Purpose

•Investors in Money Market: Provides a place for warehousing surplus funds for short periods of time

•Borrowers from money market provide low-cost source of temporary funds

BUS322 – Chapters 9, 10, 11, 12 & 25 3

Interest Rates of Money Market Instruments

BUS322 – Chapters 9, 10, 11, 12 & 25 4

Participants in Money Markets

• U.S. Treasury Department

• Federal Reserve System

• Commercial Banks

• Businesses

• Investment and Securities Firms

• Individuals (mostly through money market mutual funds)

BUS322 – Chapters 9, 10, 11, 12 & 25 5

Money Market Instruments

• Treasury Bills

• Federal Funds

• Repurchase Agreements

• Negotiable Certificates of Deposit

• Commercial Paper

• Banker’s Acceptance

• Eurodollars

BUS322 – Chapters 9, 10, 11, 12 & 25 6

Treasury Bills

1. Short-term borrowings of the federal government (US Treasury Department)

2. Usually sold at discount

BUS322 – Chapters 9, 10, 11, 12 & 25 7

Discounting Example

• You pay $9850 for a 91-day T-bill. It is worth $10,000 at maturity. What is its annualized yield?

iyt F PP

365

n

BUS322 – Chapters 9, 10, 11, 12 & 25 8

Federal Funds

• Short-term funds transferred (loaned or borrowed) between financial institutions, usually for a period of one day

• Having excess reserve -> loan (sell) federal funds

• Fed can influence the rate by setting target

BUS322 – Chapters 9, 10, 11, 12 & 25 9

Federal Funds

Figure 8.2: Federal Funds and Treasury Bill Interest Rates, January 1990–January 2002

BUS322 – Chapters 9, 10, 11, 12 & 25 10

Negotiable Certificates of Deposit

• A bank-issued security that documents a deposit and specifies the interest rate and the maturity date

• Denominations range from $100,000 to $10 million

BUS322 – Chapters 9, 10, 11, 12 & 25 11

Negotiable Certificates of DepositComparing Interest on CDs and T-bills

Figure 8.3: Interest Rates on Negotiable Certificates of Deposit and on Treasury Bills, January 1990–January 2002

BUS322 – Chapters 9, 10, 11, 12 & 25 12

Commercial Paper

• Unsecured promissory notes, issued by corporations, that mature in no more than 270 days

• Banks also issue commercial paper, but have reserve requirement on bank-issued commercial paper

BUS322 – Chapters 9, 10, 11, 12 & 25 13

Figure 8.4: Return on Commercial Paper and the Prime Rate, January 1990–January 2002

Commercial PaperComparing Interest on Commercial Paper to Bank Prime Rate

BUS322 – Chapters 9, 10, 11, 12 & 25 14

Banker’s Acceptances

• An order to pay a specified amount to the bearer on a given date if specified conditions have been met, usually delivery of promised goods

• Used in international trade

• Have secondary markets

BUS322 – Chapters 9, 10, 11, 12 & 25 15

Repo (Repurchase agreement)

• Buyer purchase securities with an agreement that the seller will repurchase them in short period of time, anywhere from 1 to 15 days from the original date of purchase.

• Implicitly the buyer is a lender, seller is borrower• Buyer is compensated with the interest• This contract has secondary market

BUS322 – Chapters 9, 10, 11, 12 & 25 16

Eurodollars

• Dollar denominated deposits held in foreign banks

• Used as alternative to fed fund for banks around the world– London interbank bid rate (LIBID)

• The rate paid by banks buying funds

– London interbank offer rate (LIBOR)• The rate offered for sale of the funds

BUS322 – Chapters 9, 10, 11, 12 & 25 17

Figure 8-6: Interest Rates on Money Market Securities, 1990–2002

BUS322 – Chapters 9, 10, 11, 12 & 25 18

Money Market Mutual Funds

• Open-end investment funds that invest only in short-term securities

• No fee for purchasing or redeeming shares

• Minimum initial investment of $500 to $20,000

• Check-writing privileges– No fee for writing checks– No minimum check amount

• Earn 0.5% to 1% higher return than interest earned on money in the bank

• Low risk of default, low rate of risk

• Popular to small investors

BUS322 – Chapters 9, 10, 11, 12 & 25 19

Money Market Fund Assets

Figure 8.8: Average Distribution of Money Market Fund Assets, 2001

BUS322 – Chapters 9, 10, 11, 12 & 25 20

Capital Markets

• Original maturity is greater than one year

• Best known capital market securities:– Stocks and bonds

• Primary issuers of securities:– Federal and local governments– Corporations

• Largest purchasers of securities:– You and me

BUS322 – Chapters 9, 10, 11, 12 & 25 21

Capital Market Trading

1. Primary market for initial sale (IPO)

2. Secondary market– Over-the-counter

– Organized exchanges (i.e., NYSE)

BUS322 – Chapters 9, 10, 11, 12 & 25 22

Want to be listed on the NYSE?

• You will need at least:

1. 2000 stockholders, each owning at least 100 shares

2. A minimum of 1.1 million shares traded publicly

3. Pretax earnings of $2.5 million at the time of listing

4. $2 million in pretax earning in each of the two prior years

5. A total of $100 million in market value of publicly traded shares

BUS322 – Chapters 9, 10, 11, 12 & 25 23

Treasury Bonds

•No default risk

•Very low interest rates

BUS322 – Chapters 9, 10, 11, 12 & 25 24

Compare 20-Year Treasury Bonds to 90-Day Treasury Bills

Figure 9-4: Interest Rates on Treasury Bills and Treasury Bonds, 1973–2002 (January of each year)

BUS322 – Chapters 9, 10, 11, 12 & 25 25

Municipal Bonds

1. Issued by local, county, and state governments

2. Used to finance public interest projects

3. Tax-free municipal interest rate = taxable interest rate (1 marginal tax rate)

4. Two types– General obligation bonds

– Revenue bonds

5. NOT default-free

BUS322 – Chapters 9, 10, 11, 12 & 25 26

Comparing Revenue and General Obligation Bonds

Figure 9-5: Issuance of Revenue and General Obligation Bonds, 1984–2000 (End of year)

BUS322 – Chapters 9, 10, 11, 12 & 25 27

Corporate Bonds

• Face value of $1,000

• Pay interest semi-annually

• Can be redeemed anytime the issuer wishes

• Degree of risk varies with each bond

• Interest rate varies with level of risk

BUS322 – Chapters 9, 10, 11, 12 & 25 28

Characteristics of Corporate Bonds

• Registered Bonds

• Restrictive Covenants

• Call Provisions – Higher yield– Sinking fund– Interest of the stockholders – Alternative opportunities

• Conversion and Convertible Bonds

BUS322 – Chapters 9, 10, 11, 12 & 25 29

Convertible Bonds

• The bond that can be converted into certain shares of common stocks at the discretion of the bondholder.– Conversion ratio

BUS322 – Chapters 9, 10, 11, 12 & 25 30

Types of Corporate Bonds

• Secured Bonds– Mortgage bonds

– Equipment trust certificates

• Unsecured Bonds– Debentures

– Subordinated debentures

– Variable-rate bonds

• Junk Bonds

BUS322 – Chapters 9, 10, 11, 12 & 25 31

Stock

1. Represents ownership in a firm

2. Earn a return in two ways– Price of the stock rises

over time– Dividends are paid to the

stockholder

3. Stockholders have claim on all assets

4. Right to vote for directors and on certain issues

5. Two types– Common stock

• Right to vote• Receive dividends

– Preferred stock• Receive a fixed dividend• Do not usually vote

BUS322 – Chapters 9, 10, 11, 12 & 25 32

Stock Prices

BUS322 – Chapters 9, 10, 11, 12 & 25 33

30 Stocks in the Dow Jones Industrial Average

BUS322 – Chapters 9, 10, 11, 12 & 25 34

Stocks

• ADR – American Depository Receipts– A US bank buys the shares of a foreign company and

places them in its vault. The bank then issue receipts against these shares, and these receipts can be traded domestically, usually on the NASDAQ.

• In US dollars

• No need to meet disclosure rules required by SEC

BUS322 – Chapters 9, 10, 11, 12 & 25 35

Mortgage Market

• Definition– Mortgage is a long-term loan secured by real estate by

developer and family

– Commercial mortgage and residential mortgage

– A mortgage is amortized• The borrower pays it off over time in some combination of

principal and interest payment that result in full payment of the debt by maturity

BUS322 – Chapters 9, 10, 11, 12 & 25 36

Types of Mortgage loans

– Insured mortgage: Guaranteed by Federal Housing Administration or Veterans Administration, applicants need meet certain qualifications

• Serve in the military

• Low incomer

– Conventional mortgage: insured by private mortgage insurance (PMI): loan-to-value exceeding 80%

– Fixed or adjustable rate mortgages (ARM)

– Innovative mortgage contracts, e.g.,• Graduated-payment mortgage

• Second mortgage

BUS322 – Chapters 9, 10, 11, 12 & 25 37

Mortgage Market

• Primary Mortgage Market (see page 302)– Constituted by commercial banks, S&Ls, commercial

banks, life insurance companies, and mortgage pools

– Sell loans after they lend money

– Diversify their risk in the secondary market

• Secondary Mortgage Market– buy mortgage from the primary market

– Bundle mortgages and offer securitized mortgage-backed assets

BUS322 – Chapters 9, 10, 11, 12 & 25 38

Mortgage Market

• Major participants in the secondary market– Fannie Mae (Federal National Mortgage Association)

– Ginnie Mae (Government National Mortgage Association)

– Freddie Mac (Federal Home Loan Mortgage Corp)

• Securitization of Mortgages– Mortgages are too small to be wholesale instruments

– Sell mortgage backed security• Mortgage pool

• Mortgage pass-through – is a kind of special debt

BUS322 – Chapters 9, 10, 11, 12 & 25 39

Types of securitized mortgage/Debt• Mortgage Pool• Mortgage pass through: a security created when one or more

holders of mortgages from a collection of mortgages and sell shares in a pool

• Mortgage-backed security (MBS): make mortgage a security, similar ideas: asset-backed security (ABS)

• Collateralized mortgage obligations (CMO)• Collateralized bond obligations (CBO)• Collateralized debt obligations (CDO)• The largest market dealer for securitized asset is Bear Sterns

BUS322 – Chapters 9, 10, 11, 12 & 25 40

Derivative Market

• See definitions in chapter 23• Option

– Call– put

• Futures and forward– Long– short

• Swap– Financial contracts that obligate each party to the contract to exchange

a set of payments it owns for another set of payments owned by another party