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Financial Markets and Institutions th Edition

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Financial Markets and Institutions th Edition Powered By Docstoc
					Financial Markets and
Institutions
6th Edition


  Jeff Madura
  高等教育出版社改编
CH1


  Role of Financial Markets and
  Institutions
Chapter Objectives
 Describe the types of financial
  markets

 Describe the role of financial
  institutions with financial markets

 Identify the types of financial
  institutions that facilitate transactions
Overview of Financial Markets
 Financial markets provide for financial
  intermediation--financial savings (Surplus
  Units) to investment (Deficit Units)
 Financial markets provide payments system
 Financial markets provide means to manage
  risk
 To position risk and return for financial
  tools(the nature of financial market)
Overview of Financial Markets

 Broad Classifications of Financial
  Markets
 Money versus Capital Markets

  Primary versus Secondary Markets



  Organized versus Over-the-Counter
    Markets
Primary vs. Secondary Markets

 PRIMARY                 SECONDARY
  New Issue of            Trading Previously
   Securities(ipo)          Issued Securities

                           No New Funds for
                            Issuer
  Exchange of Funds
   for Financial Claim

  Funds for Borrower;     Provides Liquidity for
   an IOU for Lender        Seller
Money vs. Capital Markets

 Money                  Capital
  Short-Term, < 1         Long-Term, >1Yr
   Year                    Range of Issuer
  High Quality             Quality
   Issuers                 Debt and Equity
  Debt Only               Secondary Market
  Primary Market           Focus
   Focus                   Financing
  Liquidity Market--       Investment--Higher
   Low Returns              Returns
Organized vs. Over-the-Counter
Markets
 Organized             OTC
  Visible               Wired Network of
   Marketplace            Dealers
  Members Trade         No Central,
  Securities Listed      Physical Location
  New York Stock        All Securities
   Exchange               Traded off the
                          Exchanges
Securities Traded in Financial
Markets
 Money Market Securities
   Debt securities Only

 Capital market securities
   Debt and equity securities


 Derivative Securities
   Financial contracts whose value is derived from the
    values of underlying assets
   Used for hedging (risk reduction) and speculation
    (risk seeking)
Debt vs. Equity Securities


Debt Securities: Contractual obligations (IOU) of
  Debtor (borrower) to Creditor (lender)
   Investor receives interest
   Capital gain/loss when sold
   Maturity date
Debt vs. Equity Securities



Equity Securities: Claim with ownership
rights and responsibilities
   Investor receives dividends if declared
   Capital gain/loss when sold
   No maturity date—need market to sell
Valuation of Securities
 Value a function of:
   Future cash flows
   When cash flows are received
   Risk of cash flows
 Present value of cash flows
  discounted at the market required
  rate of return(CAPM)
 Value determined by market
  demand/supply
 Value changes with new information
Financial Market Efficiency

 Security prices reflect available
  information

 New information is quickly included
  in security prices

 Investors balance liquidity, risk, and
  return needs
Financial Market Regulation

      Why Government Regulation?

  To Promote Efficiency

    High level of competition

    Efficient payments mechanism

    Low cost risk management contracts
Financial Market Regulation

        Why Government Regulation?

  To Maintain Financial Market Stability
    Prevent market crashes
       Circuit breakers
       Federal Reserve discount window

     Prevent Inflation--Monetary policy

     Prevent Excessive Risk Taking by Financial
      Institutions

 可以参考商业银行管理学的有关美国金融管制的内容。
Financial Market Regulation


        Why Government Regulation?

  To Provide Consumer Protection
    Provide adequate disclosure
    Set rules for business conduct
  To Pursue Social Policies
    Transfer income and wealth
    Allocate saving to socially desirable areas
       Housing
       Student loans
Financial Market Globalization
 Increased international funds flow
   Increased disclosure of information
   Reduced transaction costs
   Reduced foreign regulation on capital
    flows
   Increased privatization
  Results:     Increased financial
    integration--capital flows to highest
    expected risk-adjusted return
Role of Financial Institutions in
Financial Markets
 Information processing
 Serve special needs of lenders
  (liabilities) and borrowers (assets)
   By denomination and term
   By risk and return
 Lower transaction cost
 Serve to resolve problems of market
  imperfection
Role of Financial Institutions in
Financial Markets
  Types of Depository Financial Institutions

                      Savings       Credit Unions
                    Institutions     $.5 Trillion
   Commercial
                    $1.3 Trillion    Total Assets
      Banks
    $5 Trillion     Total Assets
   Total Assets
Types of Non-depository
Financial Institutions

   Insurance companies
   Mutual funds
   Pension funds
   Securities companies
   Finance companies
   Security pools
Role of Non-depository
Financial Institutions

 Focused on capital market
 Longer-term, higher risk
  intermediation
 Less focus on liquidity
 Less regulation
 Greater focus on equity investments
Trends in Financial Institutions

 Rapid growth of mutual funds and
  pension funds
 Increased consolidation of financial
  institutions via mergers
 Increased competition between
  financial Institutions
 Growth of financial conglomerates
Global Expansion by Financial
Institutions
   International expansion
   International mergers
   Impact of the single European currency
   Emerging markets
本章小结
   对金融市场本质的理解
   对金融市场结构进行理解
   对我国金融市场结构进行调查
   对我国金融市场的功能与美国金融市场的差
    异进行分析
  CH2


Determination of Interest Rates
Chapter Objectives
 Explain Loanable Funds Theory of
  Interest Rate Determination
 Identify Major Factors Affecting the
  Level of Interest Rates
 Explain How to Forecast Interest
  Rates
Relevance of Interest Rate
Movements
 Changes in interest rates impact the real
  economy
   Investment spending
   Interest sensitive consumer spending such as
    housing
 Interest rate changes affect the values of all
  securities
   Security prices vary inversely with interest
    rates
   Varying interest rates impact retirement funds
    and retirement income
CONTINUE
 Interest rates changes impact the
  value of financial institutions
   Managers of financial institutions closely
    monitor rates
   Interest rate risk is a major risk
    impacting financial institutions
Loanable Funds Theory of
Interest Rate Determination
 Theory of how the general level of
  interest rates are determined
 Explains how economic and other
  factors influence interest rate
  changes
 Interest rates determined by demand
  and supply for loanable funds


                                    29
Loanable Funds Theory, cont.

 Demand = borrowers, issuers of
  securities, deficit spending unit
 Supply = lenders, financial investors,
  buyers of securities, surplus spending
  unit
 Assume economy divided into sectors
 Slope of demand/supply curves
  related to elasticity or sensitivity of
  interest rates
                                        30
Sectors of the Economy

 Household Sector--Usually a net
  supplier of loanable funds
 Business Sector—Usually a net
  demander in growth periods
 Government Sectors
   States—Borrow for capital projects
   Federal—Borrow for capital projects and
    deficit spending
 Foreign Sectors—Net supplier since
  early 1980’s
                                              31
Demand for Loanable Funds

 Sum of sector demand (quantity) at
  varying levels of interest rates
 Sector cash receipts in period less
  than outlays = borrower
 Quantity demanded inversely related
  to interest rates
 Variables other than interest rate
  changes cause shift in demand curve

                                        32
Demand for Loanable Funds

    Interest
       Rate




               Quantity of Loanable Funds
Loanable Funds Theory

  Households demand loanable funds to
   finance housing, automobiles, household
  Household Demand for Loanable Funds
   items
  These purchases result in installment debt.
   Installment debt increases with the
   level of income
  There is an inverse relationship between
   the interest rate and the quantity of
   loanable funds demanded
Loanable Funds Theory

   Business Demand for Loanable Funds

  Businesses demand loanable funds to
   invest in assets
  Quantity of funds demanded depends on
   how many projects to be implemented
    Businesses choose projects by calculating
     the project’s Net Present Value
    Select all projects with NPV≥0 (RULE)
Loanable Funds Theory

  Government Demand for Loanable Funds

  When planned expenditures exceed
   revenues from taxes, the government
   demands loanable funds
  Municipal (state and local) governments
   issue municipal bonds
  Federal government and its agencies
   issue Treasury securities and federal
   agency securities.
Loanable Funds Theory
  Government Demand for Loanable Funds
  Federal government expenditure and tax
   policies are independent of interest rates
  Government demand for funds is
   interest-inelastic            D
  NOTICE          Interest
                   Rate



                         Quantity of Loanable Funds
Loanable Funds Theory

     Foreign Demand for Loanable Funds

  A foreign country’s demand for U.S.
   funds is influenced by the differential
   between its interest rates and U.S. rates
  The quantity of U.S. loanable funds
   demanded by foreign investors will be
   inversely related to U.S. interest rates
Loanable Funds Theory


   Aggregate Demand for Loanable Funds


  The aggregate demand for loanable
   funds is the sum of the quantities
   demanded by the separate sectors
  The aggregate demand for loanable
   funds is inversely related to interest
   rates
Sector Supply of Loanable
Funds
 Households are major suppliers of
  loanable funds
 Businesses and governments may
  invest (loan) funds temporarily
 Foreign sector a net supplier of funds
  in last twenty years
 Federal Reserve’s monetary policy
  impacts supply of loanable funds

                                       40
Supply of Loanable Funds

 Sum of sector supply (quantity) at
  varying levels of interest rates
 Sector cash receipts in period greater
  than outlays—lender
 Quantity supplied directly related to
  interest rates
 Variables other than interest rate
  changes causes a shift in the supply
  curve
                                       41
Interest
Rate                             S




           Quantity of Loanable Funds
Loanable Funds Theory
 Equilibrium Interest Rate
   Aggregate Demand
        DA = Dh + Db + Dg + Dm + Df

   Aggregate Supply
         SA = Sh + Sb + Sg + Sm + Sf

  In equilibrium, DA = SA   (IMPORTANT)
Graphic Presentation
 Interest                       Supply of
   Rates                        Loanable Funds




                                Demand for
                                Loanable Funds


            Quantity of Loanable Funds
Loanable Funds Theory
 Graphic Presentation
   When a disequilibrium situation exists,
    market forces should cause an
    adjustment in interest rates until
    equilibrium is achieved
       Example: interest rate above equilibrium
       Surplus of loanable funds
       Rate falls
       Quantity supplied reduced, quantity
        demanded increases until equilibrium
General Equilibrium Interest
Rate
 Means of explaining how economic factors
  affect interest rate levels
 Interest rate level where quantity of aggregate
  loanable funds demanded = supply
 Surplus and shortage conditions
   Surplus- Quantity demanded < quantity
     supplied followed by market interest rate
     decreases
   Shortage Government interest rate ceilings
     below market interest rates

                                               46
Interest Rate Changes

 + Directly related to level of
  economic activity or growth rate of
  economic activity
 + Directly related to expected
  inflation
 – Inversely related to rates of money
  supply changes
 对于利率变化的影响因素要特别注意!

                                          47
Economic Forces That Affect
Interest Rates
 Economic Growth
   Expected impact is an outward shift in
    the demand schedule without obvious
    shift in supply
   New technological applications with
    +NPV’s
   Result is an increase in the equilibrium
    interest rate
Economic Forces That Affect
Interest Rates: The Fisher Effect
 Lenders want to be compensated for expected
  loss of purchasing power (inflation) when they
  lend
 Nominal Interest Rates = Sum of real rate plus
  expected rate of inflation, i n = E(I ) + i r
 Expected Real Rate (ex ante) = expected
  increase in purchasing power in period
 Realized Real Rate (ex post) = nominal rates
  less actual rate of inflation in period


                                               49
Economic Forces That Affect
Interest Rates
 Inflation
   The Fisher Effect
     Nominal Interest Rates = Sum of Real Rate
      plus Expected Rate of Inflation



          in = ir + E(I)
Figure 2.12
20
                                                                                                 Annualized
                                                                                                 Real
                                                                                                 Interest Rate
15                                                                                               Annualized
                                                                                                 Inflation


                                                                                                 Annualized
10                                                                                               T-Bill
                                                                                                 Rate




 5




 0




-5
     1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999
                                                       Year
Economic Forces That Affect
Interest Rates
 Inflation(注意:要从市场供求两个方面分析)
  If inflation is expected to increase
    Households may reduce their savings to make
     purchases before prices rise
    Supply shifts to the left, raising the equilibrium
     rate
    Also, households and businesses may borrow
     more to purchase goods before prices increase
    Demand shifts outward, raising the equilibrium
     rate
Economic Forces That Affect
Interest Rates
 Money Supply
   When the Fed increases the money supply,
    it increases supply of loanable funds
   Places downward pressure on interest
    rates
Economic Forces That Affect
Interest Rates
 Federal Government Budget Deficit
   Increase in deficit increases the quantity
    of loanable funds demanded
   Demand schedule shifts outward, raising
    rates
   Government is willing to pay whatever is
    necessary to borrow funds, “crowding
    out” the private sector
Economic Forces That Affect
Interest Rates
 Foreign Flows
   In recent years there has been massive
    flows between countries
   Driven by large institutional investors
    seeking high returns
   They invest where interest rates are high
    and currencies are not expected to weaken
   These flows affect the supply of funds
    available in each country
   Investors seek the highest real after-tax,
    exchange rate adjusted rate of return
    around the world
Forecasting Interest Rates

 Attempts to forecast demand/supply
  shifts
 Forecast economic sector activity and
  impact upon demand/supply of
  loanable funds
 Forecast incremental effects on
  interest rates
 Forecasting interest rates has still
  been very difficult
                                      56
Summary


 Economic Growth
 Expected inflation
 Government budgets
 Increased foreign supply of
  loanable funds
 需要注意:当前对利率的预测几乎均无效。
                          57
 CH3


Structure of Interest Rates
Chapter Objectives


 why individual interest rates differ or
  why security prices vary or change

 why rates vary by term or maturity,
  called the term structure of interest
  rates


                                            59
Factors Affecting Security Yields

 Risk-averse investors demand higher
  yields For added riskiness
 Risk is associated with variability Of
  returns
 Increased riskiness generates lower
  security prices or higher investor
  required rates of return


                                       60
Factors Affecting Security Yields
 Security yields and prices are affected
  by levels and changes in:
     Default risk (also called Credit Risk)
     Liquidity
     Tax status
     Term to maturity
     Special contract provisions such as
      embedded options
 Default risk Affecting Security
Yields
 Benchmark—risk-free rate for given
  maturity
 Default risk premium = risky security yield
  – treasury security yield of same maturity
 Default risk premium = market expected
  default loss rate
 Rating agencies set default risk ratings
 Anticipated or actual ratings changes
  impact security prices and yields
 注意:后面两条用于分析证券的违约风险大小。
Liquidity Affecting Security Yields

 The Liquidity of a security affects the
  yield/price of the security
 A liquid investment is easily
  converted to cash At minimum
  transactions cost
 Investors pay more (lower yield) for liquid
  investment
 Liquidity is associated with short-term,
  low default risk, marketable securities

                                           63
Tax Affecting Security Yields


 Tax status of income or gain on
  security impacts the security yield
 Investor concerned with after-tax
  return or yield
 Investors require higher yields For
  higher taxed securities


                                        64
Tax Affecting Security Yields


           Yat = Ybt(1      –   T)

Where:
  Yat = after-tax yield
  Ybt = before-tax yield
  T = investor’s marginal tax rate
Maturity Affecting Security Yields
 Term to maturity
   Interest rates typically vary by maturity.
   The term structure of interest rates
    defines the relationship between
    maturity and yield.
     The Yield Curve is the plot of current
      interest yields versus time to maturity.
 Yield Curve


        Yield
          %



                   Time to Maturity
  An upward-sloping yield curve indicates that Treasury
Securities with longer maturities offer higher annual yields
Yield Curve Shapes




   Normal   Level or Flat   Inverted
Other Factors Affecting Security Yields

 Special Provisions
   Call Feature: enables borrower to buy back the
    bonds before maturity at a specified price
   Convertible bonds
 The appropriate yield to be offered on a
  debt security

Yn = Rf,n + DP + LP + TA + CALLP + COND
Estimating the Appropriate
Yield
  Yn = Rf,n + DP + LP + TA + CALLP
     + COND
Where:
   Yn = yield of an n-day security
   Rf,n = yield on an n-day Treasury
               (risk-free) security
   DP = default premium (credit risk)
   LP = liquidity premium
   TA = adjustment for tax status
   CALLP = call feature premium
   COND = convertibility discount
The Term Structure of Interest
Rates

    Theories Explaining Shape of Yield Curve


  Pure Expectations Theory
  Liquidity Premium Theory
  Segmented Markets Theory
Pure Expectations Theory
Explaining Shape of Yield Curve
  Long-term rates are average of
   current short-term and expected
   future short-term rates
  Yield curve slope reflects market
   expectations of future interest rates
  Investors select maturity based on
   expectations
Pure Expectations Theory
Explaining Shape of Yield Curve


  Assumes investor has no maturity
   preferences and transaction costs are
   low
  Long-term rates are averages of
   current short rates and expected
   short rates
   注意:Forward rate: market’s forecast of
    the future interest rate
Pure Expectations Theory
Explaining Shape of Yield Curve
                             Downward-
     Upward-                   Sloping
      Sloping                Yield Curve
    Yield Curve


 Expected higher         Expected lower
  interest rate levels     interest rate levels
 Expansive               Tight monetary
  monetary policy          policy
 Expanding               Recession soon?
  economy
                                              74
Liquidity Premium Theory
Explaining Shape of Yield Curve


  Investors prefer short-term, more liquid,
   securities
  Long-term securities and associated risks
   are desirable only with increased yields
  Explains upward-sloping yield curve
  When combined with the expectations
   theory, yield curves could still be used to
   interpret interest rate expectations
Segmented Markets Theory
Explaining Shape of Yield Curve


  Theory explaining segmented, broken
   yield curves
  Assumes investors have maturity
   preference boundaries, e.g., short-term
   vs. long-term maturities
  Explains why rates and prices vary
   significantly between certain maturities
Uses of The Term Structure of
Interest Rates

  Forecast interest rates
  Forecast recessions(See Exhibit
   3.14.,next page)
  Investment and financing
   decisions
      Exhibit 3.14 Yield Curve as a
      Signal for Recessions
Interest Rate Differential (10-Year Rate




                                            7
                                            6
       Minus Three-Month Rate)




                                            5
                                            4
                                            3
                                            2
                                            1
                                            0
                                           –1
                                           –2
                                           –3
                                           –4
                                                    1955      1960       1965       1970       1975       1980      1985        1990       1995      2000       2001
                                                                                                      Year
                                           *The general shape of the yield curve is measured as the differential between annualized 10-year and three-month interest rates.
                                           Recessionary periods are shaded.
Treasury Debt Management and
the Yield Curve
 U.S. Treasury attempts to finance federal debt
  at the lowest overall cost
 Treasury uses a mixture of Bills, Notes, and
  Bonds to finance periodic deficits and refinance
  outstanding securities
 Treasury focuses on short-term issuance,
  phasing out 30-year bonds
 Treasury 10-year bond now the standard issue
 Leave the long-term issuance to private issuers
Historic Review of the Term
Structure
 Yield curves levels and shapes at various
  times indicate:
   Inflation expectations
   phase of business cycle
   Monetary policy at the time
 Usually high positive slope in short-term
   Represents demand for liquidity
   Short-term securities desired; higher prices;
    lower rates
   Short-term securities provide liquidity with
    maturity
Exhibit 3.17 Yield Curves at
Various Points in Time
                                         17

                                         16

                                         15                                      February 17, 1982
                                         14
   Annualized Treasury Security Yields




                                         13
                                                                           January 2, 1985
                                         12

                                         11

                                         10

                                         9
                                                                       August 2, 1989
                                         8
                                                                            October 22, 1996
                                         7

                                         6                    October 15, 2000

                                         5
                                                           September 18, 2001
                                         4

                                         3

                                         2
                                              0   5   10          15             20            25    30
                                                       Number of Years to Maturity
Exhibit 3.18 Change in Term
Premium Over Time
                20




                15




                                                       30-year
                                                       T-Bond
                                                       Yield
  Percentages




                10




                5                                                   Three-month
                                                                    T-Bill
                                                                    Rate




                0
                     1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001
                                                                         Year
International Structure of
Interest Rates

 Capital flows to the highest expected
  after-tax, real (inflation and other
  risk-adjusted), foreign exchange
  adjusted rates of return
International Structure of
Interest Rates
 Yield differences between countries
  are related to:
     Expected changes in forex rates
     Varied expected real rates of return
     Varied expected inflation rates
     Varied country and business risk
     Varied central bank monetary policy
 CH 4


The Fed and Monetary Policy
Chapter Objectives
 Identify the Fed’s role in monetary
  policy
 Describe the tools the Fed uses to
  influence monetary policy
 Explain how changes in regulation in
  the 1980s affected the Fed and
  monetary policy
Federal Reserve System: Third
U. S. Central Bank
 First Bank of the United States
  (1791–1811)

 Second Bank of the United States
  (1816–1836)

 Federal Reserve System (1913–)

                                     87
Structure of the Federal
Reserve System
 12 Fed District Banks
 Member Commercial Banks
 7 Members of Board of Governors
 14 year terms for Governors
 12 Open Market Committee (FOMC)
  Members
 Advisory Committees to Fed from
  private sector
                                    88
Functions of the Federal
Reserve System
 Effect Monetary Policy
 U.S. Central Bank In International
  Area
 Fiscal Agent of U.S. Treasury
 Facilitate Efficient Payments System
 Regulate Banks and Bank Holding Co.
 Enforce Consumer Credit Laws

                                     89
Organization of the Federal
Reserve
 Federal Reserve District Banks
   12 districts
   Districts divided by population at 1912–13
   District bank size related to economic wealth
    of district
   District banks owned by private member
    banks
   Board of Directors of district banks
     Three appointed by Board of Governors
     Three professional bankers
     Three business persons in district
Organization of the Federal
Reserve
 Member Banks
  Must meet requirements of the Federal
   Reserve Board of Governors to be a
   member bank
  Nationally chartered banks must be
   member banks
  State chartered banks may be member
   banks
  35% of banks controlling 70% of all
   deposits are members
Organization of the Federal
Reserve
 Board of Governors
   7 individuals appointed by the U.S.
    president and confirmed by the Senate
   U.S. president appoints one of the 7 chair
    whose 4-year term is renewable
   Offices in Washington, D.C.
   Serve nonrenewable 14-year terms
   Independence of Federal Reserve
     Staggered terms of Governors
     Budget separate from Congress
Organization of the Federal
Reserve
 Board of Governors has two main
  functions:
 Regulate commercial banks
   Supervise and regulate member banks
    and bank holding companies
   Oversight of 12 Fed district banks
   Establish consumer finance regulations
    after Congressional legislation
Organization of the Federal
Reserve
 Establish and effect monetary
  policy
   Direct control over two tools of monetary
    policy
     Set reserve requirements
     Approve discount rate set by district banks
   Indirect control in a third area
     Governors are members of the Federal
      Open Market Committee
Organization of the Federal
Reserve
 Federal Open Market Committee
  (FOMC) meets every 6 weeks
   12 members
     7 from the Board of Governors
     President of the New York Fed
     4 other district bank presidents appointed
      on a rotating basis
     Other presidents participate but do not vote
      on monetary policy matters
Organization of the Federal
Reserve
 Federal Open Market Committee
  (FOMC)Monetary policy goals of:
   Make monetary policy decisions to achieve
    goals
   Forward decisions to N.Y. Fed open market
    desk
 Advisory committees from private sector
  are a part of overall structure of the Fed
Fed’s Influence on Economy
 Fed influences liquidity (supply of
  loanable funds) in money market to
  influence:

  Liquidity,                               Goals of
Money Supply     Business and Consumer      Growth
     and          Borrowing/Spending     Price Stability
Interest Rates                            Job Growth
Tools of Monetary Policy
                     Open
                   Market Op.




                   Tools of
                   Monetary
                    Policy

    Reserve Req.                Discount
                                  Rate
How Fed Controls Money
Supply
 Banks must maintain reserves as
  percent of deposits
 Reserves kept as deposits in Fed
  (plus vault cash)
 Fed controls level of member
  bank reserve deposits in Fed
 Fed influences bank deposit
  portion of money supply

                                     99
Monetary Policy Tools
 Open market operations involve the purchase or
  sale of government securities based on FOMC
  directives sent to N.Y. Fed Trading Desk
 Open market purchase of government securities:
   Purchase securities from government securities
    dealers
   Increase bank deposits and bank reserves,
    money market liquidity and, in time…
   Increases the money supply
Exhibit 4.4
   Increase in    Required reserves   Funds received from
     deposits         held on          new deposits that
    at banks        new deposits        can be lent out
   $100 million      $10 million          $90 million


   $90 million       $9.0 million         $81 million


   $81 million       $8.1 million         $72.9 million
 Open market operations and
 interest rates
 Most rates are market determined but Fed
  influences federal funds interest rate
 Fed purchase of securities results in an
  injection of additional funds into the bank
  system
      Shifts supply of federal funds to the right
      Lowers federal funds rate
      Lower rates spread to other money market
       securities
   More funds available for money market
    and bank lending
Adjusting the discount rate
     Depository institutions borrow from Fed
    for three reasons:
       Adjustment credit for short-term reserve
        deficiencies
       Seasonal credit to agricultural banks
       Extended credit for longer-term liquidity
        problems of problem banks
     Lower discount rate
       More bank borrowing from Fed, bank
        reserves expand, money supply increases
Monetary Policy Tools
 Adjusting the reserve requirement
  ratio
   Proportion of deposits at depository
    institutions set aside to meet their
    reserve requirements
   Increase in lending or expansion limited
    by ($) reserves bank must hold the meet
    reserve requirements (%)
   Total dollar expansion effect as follows:
  Dollar amount of open market      1
  Fed purchase or discount loan   ×RR
Increasing the money supply

  Open market operation purchase of
   securities via the Trading Desk in the
   secondary market
  Discount rate lowered to encourage
   borrowing at the discount window
  Reserve requirements lowered
Decreasing the money supply

  Open market operation sale of securities
   via the Trading Desk in the secondary
   market
  Discount rate raised to encourage
   borrowing at the discount window
  Reserve requirements raised
Monetary Policy Deposit
Expansion Provides
   Excess Reserves to Lend
   Loan/Deposit Expansion
   Loans Finance Spending
   Potential Expansion = Added $
    Reserves  1/Required Reserve Ratio




                                     107
Limiting Factors to Deposit
Expansion
 Banks may not lend excess reserves
 Public may not re-deposit payments
  In expansion process (cash drains)
 Lowers deposit expansion multiplier
 Other fed functions impact member
  bank reserve level



                                        108
Federal Reserve Policy
Emphasis

   Money Supply Growth
   Interest Rate Levels
   Price Level Changes
   Real Economic Activity




                             109
Monetary Control Act of 1980
 the MCA required all depository
  institutions to
   Meet the same reserve requirements
   Hold noninterest-bearing reserves
   Promptly report deposit levels to the Fed
 the MCA allowed all depository
  institutions
   To offer transaction accounts
   Access to the discount window
第4章总结
 了解美联储体系的构成
 了解美联储的功能
 了解货币政策的目的及手段
CH 5


  Monetary Theory and Policy
Chapter Objectives

 Learn the well-known theories of
  monetary policy
 Review the tradeoffs involved in
  monetary policy
 Learn how analysts monitor and
  forecast Fed’s monetary policy



                                     113
Monetary Policies

 How does money affect the real
  economy?
 How does varying money supply
  growth impact spending?
 How does monetary policy in the
  financial sector impact real economic
  sector investment and spending?


                                      114
Keynesian Theory

 Developed by John Maynard Keynes
  and his students
 Initially attempted to explain
  inadequacy of monetary policy during
  Great Depression
 Effectiveness of monetary policy
  depends upon the sensitivity
  (elasticity) of economy to changes in
  interest rates
                                     115
Keynesian Theory, cont.

 Advocates fiscal policy
 Focused on government
  deficit/surplus spending to impact
  economic activity
 Monetary policy transmitted
  slowly via bank credit policy and
  interest rates
 A proactive economic policy

                                       116
Exhibit 5.3
              Fed



                    Treasury
         $
                    Securities

                                 Bank Funds   Interest Rates   Aggregate
         Investors                                              Spending
                                  Increase       Decrease
                                                               Increases


   Restrictive Monetary
          Policy

              Fed



 Treasury
 Securities         $


                                 Bank Funds   Interest Rates   Aggregate    Inflation
         Investors                                             Spending
                                  Decrease       Increase                  Decreases
                                                               Decreases
Monetary Theories
 Quantity theory
    Based on equation of exchange
    MV = PGQ
M=    amount of money in the economy
V=    velocity, average number of times each
      dollar changes hands during the year
PG = weighted average price level of goods
      and services in the economy
Q=    quantity of goods and services sold
Monetary Theories
 Quantity theory’s assumptions
   PGQ is the total value of goods and
    services produced
   Assume V constant or predictable—
    changing M impacts total spending
   M should grow at rate of output capacity,
    Q
   Faster M growth increases PG or inflation
Monetarist Monetary Theories
 Monetarists
   Velocity is affected by
       Income levels
       Frequency income is received
       Use of credit cards
       Inflationary expectations
   Velocity changes found to be predictable
    and not related to fluctuations in money
    supply
Monetarist vs. Keynesian
Theories
 Monetarist              Keynesian
   Let economic            Need to take action
    problems resolve         to lower interest
    themselves               rates
   Low growth reduces      High money growth
    borrowing and            to fix a recession by
    lowers interest          lowering rates
    rates                   Problem: Might
   Problem: It takes        ignite inflation
    time
Monetarist vs. Keynesian
Theories
 Monetarist              Keynesian
   Low, stable growth      Actively manage
    in the money             the money supply
    supply                  Willing to tolerate
   Focus on                 inflation that helps
    maintaining low          reduce
    inflation and will       unemployment
    tolerate what they
    call natural
    unemployment
Rational Expectations Theory

 Households and businesses act in
  their own self-interest
 Individuals anticipate effects of
  government policy changes
 Expansionary monetary policy signals
  future inflation and interest rates
  increase (security prices fall)
 Rational expectations may nullify
  intended effects of monetary policy
                                     123
Tradeoff of Monetary Policy
Goals
 Goals of the Monetary Policy
   Steady GDP growth
   Low unemployment
   Stable price levels
 Tradeoffs
   Lowering unemployment by stimulating
    the economy may increase inflation
   Lowering inflation by slowing the
    economy may increase unemployment
Economic Indicators Monitored
by the Fed
 Indicators of economic growth
     Gross Domestic Product or GDP
     Industrial production
     National income
     Unemployment
 Indicators of Inflation
   Producer price indexes
   Consumer price Indexes
   Other indicators
Economic Indicators Monitored
by the Fed
 How the Fed uses indicators
   Fed meets to decide course of monetary
    policy
   Assesses recent reports on indicators of
    growth and inflation
   Uses indicators to anticipate how the
    economy will change
   Decides the appropriate monetary policy
    given possible conditions
Lags in Monetary Policy
 Recognition lag
   Most economic problems revealed by statistics, not
    observation
   Fed quick to see changes in economy
 Implementation lag
   Fed acts quickly to implement change in monetary
    policy
   Fiscal policy via Congress takes a long time
 Impact Lag
   Takes time for monetary changes to have full impact
   Fiscal policy tax changes have unpredictable results
Assessing the Impact of
Monetary Policy
 How does the policy change affect
  financial market participants?
   Depends on the kinds of securities you trade
   Depends on your expectations about how
    the changes affect on the economy
 Forecasting money supply movements
   Financial market participants look at actual
    growth compared to Fed targets
   Growth outside range could signal Fed policy
    changes
Assessing the Impact of
Monetary Policy
 Improved communication at the Fed
   Fed more willing to disclose its intentions
    since 1999
   Immediate feedback to public and financial
    markets about “bias” on rates
 Market reaction to reported money
  supply levels
   Thursday release of money supply data
   Try to determine future trends in interest
    rates
Assessing the Impact of
Monetary Policy
 Anticipating reported money supply
  levels
   Securities and financial market professionals
    cannot profit on information available to all
    at the same time
   Try to forecast and anticipate changes
   Trying to figure out the future course of
    interest rates and Fed policy
 Market reaction to discount rate
  adjustment
Assessing the Impact of
Monetary Policy
 Market reaction to discount rate
  adjustment
   Monitor changes to determine policy
   Some changes are technical or intended
    to bring the discount rate in line with
    market rates
   Financial market participants try to
    anticipate changes
   Discount rate seems to preceded market
    interest rate movements since 1980
Exhibit 5.9
                               Federal Open
                             Market Committee
                                 (FOMC)




                               Money Supply       Inflationary
          Supply of
                                  Targets        Expectations
       Loanable Funds




                                                   Demand for
                                                 Loanable Funds
                                  Equilibrium
                                Interest Rates




              Cost of                              Cost of Capital
         Household Credit                         for Corporations
       (Including Mortgage
               Rates)



                                                      Corporate
           Household             Residential          Expansion
          Consumption           Construction




                                 Economic
                                  Growth
Assessing the Impact of
Monetary Policy
 Forecasting the impact of monetary
  policy
   Even if financial market participants
    correctly anticipate changes in the
    money supply there are still problems
     Not a stable relationship between money
      supply and economic variables over time
     Examples include the relationship between
      economic growth and the money supply
Integrating Monetary and Fiscal
Policies
 History
   Executive branch usually most concerned
    with employment and growth
   Fed and administration may differ on
    priorities of price stability or growth
    needs
   Agreement when inflation and
    unemployment are at relatively low
    levels
Exhibit 5.12
          U.S.
        Monetary        U.S.
         Policy        Fiscal
                       Policy




             U.S.          U.S.         U.S.
          Personal        Budget     Business
           Income         Deficit    Tax Rates
          Tax Rates

              U.S.         U.S.     Government
           Personal     Household    Demand
            Income       Demand      for Funds
             Level      for Funds                   U.S.
                                                 Business
                                                  Demand
                                                 for Funds
           Savings
            by U.S.
          Households


            Supply                   Demand
           of Funds                  for Funds
            in U.S.                    in U.S.


                         U.S.
                       Interest
                         Rate
Integrating Monetary and Fiscal
Policies
 Combined monetary and fiscal policy
  effects
   Fiscal policy usually has a larger influence on the
    demand for loanable funds
   Monetary policy usually has a larger influence on the
    supply of loanable funds

 Monetizing the debt
   Should the Fed help finance a federal budget deficit
    created by fiscal policy?
   Forecasted surpluses, debt reduction, and U.S.
    Treasury securities
Integrating Monetary and Fiscal
Policies
 Market assessment of integrated
  policies
   Financial markets assess both fiscal and
    monetary policy
   Markets monitor a wide range of
    information and data
   Forecast how loanable funds supply and
    demand will change
Forecasting Money Supply

 Watch weekly federal reserve data
  releases
 Observe changes with announced fed
  ranges of money growth
 Markets attempt to estimate changes
  in monetary policy direction and . . .
 Anticipate interest rate changes


                                       138
第五章总结
   主要熟悉美国货币政策的制定流程
   了解货币政策与财政政策的结合点
   了解宏观调控政策的机理
   关注宏观调控政策对于财务决策的影响
CH 6


  Money Markets
Chapter Objectives
 Provide a background on money
  market securities
 Explain how institutional investors
  use money markets
Money Market Securities
 Maturity of a year or less
 Debt securities issued by corporations
  and governments that need short-
  term funds
 Large primary market center
 Purchased by corporations and
  financial institutions
 Secondary market for securities
Money Market Securities

   Treasury Bills
   Commercial paper
   Negotiable certificates of deposits
   Repurchase agreements
   Federal funds
   Banker’s acceptances



                                          143
Money Market Securities
 Treasury bills
   Issued to meet the short-term needs of
    the U.S. government
   Attractive to investors
     Minimal default risk—backed by Federal
      Government
     Excellent liquidity for investors
       Short-term maturity
       Very good secondary market
Money Market Securities

          Competitive Bidding
 Treasury bill auction
   Bid process used to sell T-bills
   Bids submitted to Federal Reserve banks
    by the deadline
   Bid process
     Accepts highest bids
     Accepts bids until Treasury needs
      generated
Money Market Securities

           Noncompetitive Bidding
 Treasury bill auction—noncompetitive bids
  ($1 million limit)
   May be used to make sure bid is accepted
   Price is the weighted average of the accepted
    competitive bids
   Investors do not know the price in advance so
    they submit check for full par value
   After the auction, investor receives check from
    the Treasury covering the difference between
    par and the actual price
Money Market Securities
 Estimating T-bill yield
   No coupon payments
   Par value received at maturity
   Yield at issue is the difference between
    the selling price and par value adjusted
    for time
   Yield based on the difference between
    price paid for T-bill and selling price
    adjusted for time if sold prior to maturity
    in secondary market
Money Market Securities
 Calculating T-Bill Annualized Yield

        SP – PP          365
YT =                 
          PP             n

YT = The annualized yield from investing in a T-bill
SP = Selling price
PP = Purchase price

n = number of days of the investment (holding period)
Money Market Securities
 T-bill yield for a newly issued security

                      Par – PP        360
T-bill discount =                
                         PP            n

T-bill discount = percent discount of the purchase price from par
Par = Face value of the T-bills at maturity
PP = Purchase price

n = number of days to maturity
Money Market Securities

               Commercial Paper
    Short-term debt instrument
    Alternative to bank loan
    Dealer placed vs. directly placed
    Used only by well-known and creditworthy firms
    Unsecured
    Minimum denominations of $100,000
    Not a large secondary market
Money Market Securities
 Commercial paper backed by bank
  lines of credit
   Bank line used if company loses credit
    rating
   Bank lends to pay off commercial paper
   Bank charges fees for guaranteed line of
    credit
Money Market Securities
 Estimating commercial paper yields

        Par – PP       360
YCP =              
          PP           n

YCP = Commercial paper yield
Par = Face value at maturity
PP = Purchase price

n = number of days to maturity
Money Market Securities
     Negotiable Certificates of Deposit (NCD)



  Issued by large commercial banks
  Minimum denomination of $100,000 but
   $1 million more common
  Purchased by nonfinancial corporations
   or money market funds
  Secondary markets supported by dealers
   in security
Money Market Securities
 NCD placement
   Direct placement
   Use a correspondent institution
    specializing in placement
   Sell to securities dealers who resell
   Sell direct to investors at a higher price
 NCD premiums
   Rate above T-bill rate to compensate for
    lower liquidity and safety
Money Market Securities

            Repurchase Agreements
  Sell a security with the agreement to repurchase it at
   a specified date and price
  Borrower defaults, lender has security
  Reverse repo name for transaction from lender
  Negotiated over telecommunications network
  Dealers and brokers used or direct placement
  No secondary market
Money Market Securities
 Estimating repurchase agreement
  yields
                SP – PP       360
Repo Rate =               
                     PP          n

Repo Rate = Yield on the repurchase agreement
SP = Selling price
PP = Purchase price

n = number of days to maturity
Money Market Securities

                  Federal Funds
  Interbank lending and borrowing
  Federal funds rate usually slightly higher than T-bill
   rate
  Fed district bank debits and credits accounts for
   purchase (borrowing) and sale (lending)
  Federal funds brokers may match up buyers and
   sellers using telecommunications network
  Usually $5 million or more
Exhibit 6.5
                                                 1     Purchase Order

                              Importer                                                              Exporter
                                                 5     Shipment of Goods
        L/C (Letter of Credit) Application




                                                                                                               Shipping Documents & Time Draft
                                                                                 L/C Notification
         2
                                                                                  4                                  6




                                             3   L/C

       American Bank                                                                 Japanese Bank
     (Importer’s Bank)                       7 Shipping Documents & Time Draft      (Exporter’s Bank)
                                               Draft Accepted (B/A Created)
Money Market Securities

              Bankers Acceptance
  A bank takes responsibility for a future payment of
   trade bill of exchange
  Used mostly in international transactions
  Exporters send goods to a foreign destination and
   want payment assurance before sending
  Bank stamps a time draft from the importer
   ACCEPTED and obligates the bank to make good on
   the payment at a specific time
Money Market Securities

            Bankers Acceptance
  Exporter can hold until the date or sell
   before maturity
  If sold to get the cash before maturity, price
   received is a discount from draft’s total
  Return is based on calculations for other
   discount securities
  Similar to the commercial paper example
Major Participants in Money
Market
 Participants
     Commercial banks
     Finance, industrial, and service companies
     Federal and state governments
     Money market mutual funds
     All other financial institutions (investing)
 Short-term investing for income and liquidity
 Short-term financing for short and permanent
  needs
 Large transaction size and telecommunication
  network
                                                     161
Valuation of Money Market
Securities
 Present value of future cash flows at
  maturity (zero coupon)
 Value (price) inversely related to
  discount rate or yield
 Money market security prices more
  stable than longer term bonds
 Yields = risk-free rate + default risk
  premium

                                           162
Exhibit 6.7
 International    U.S.                       U.S.         U.S.           Issuer’s                 Issuer’s
  Economic       Fiscal                    Monetary     Economic         Industry                  Unique
  Conditions     Policy                     Policy      Conditions      Conditions               Conditions




                          Short-T erm
                           Risk-Free                                                    Risk
                             Interest                                                Premium
                               Rate                                                  of Issuer
                          (T -bill Rate)




                                                      Required Return
                                                       on the Money
                                                      Market Security




                                                        Price of the
                                                       Money Market
                                                         Security
Interaction Among Money
Market Yields
 Securities are close investment substitutes
 Investors trade to maintain yield differentials
 T-Bill is the benchmark yield in money market
 Yield changes in T-bills quickly impacts other
  securities via dealer trading
 Yield differentials determined by risk
  differences between securities
 Default risk premiums vary inversely with
  economic conditions


                                                164
Globalization of Money Markets

 Money market rates vary by country
     Segmented markets
     Tax differences
     Estimated exchange rates
     Government barriers to capital flows
 Deregulation Improves Financial
  Integration
 Capital Flows To Highest Rate of
  Return
                                             165
Globalization of Money Markets
 Performance of international
  securities
 Yield for an international investment
            SPf – PPf
   Yf   =      PPf
    Yf = Foreign investment’s yield
   SPf = Investment’s foreign currency selling price

   PPf = Investment’s foreign currency purchase
Chapter Concepts Summary
 Surplus units channel investments to
  securities issued by deficit units
 Debt securities markets
   Money Market
   Capital Market
 Money market securities
   Short-term
   High quality
   Very good liquidity
CH 7


  Bond Markets
Chapter Objectives
 Provide informational background on
  U.S. Treasury, state and municipal,
  and corporate Bonds
 Calculate bond yield from quote
 Explain the role of bonds to
  institutional investors
 Discuss the globalization of bond
  markets
Background on Bonds
 Bonds represent long-term debt
  securities
   Contractual
   Promise to pay future cash flows to investors
 The issuer of the bond is obligated to
  pay:
   Interest (or coupon) payments periodically usually
    semiannually
   Par or face value (principal) at maturity
 Primary vs. secondary market for bonds
Background on Bonds

             Bond Interest Rates

   The issuer’s cost of financing with
   bonds is the coupon rate
      Determined by current market rates
       and risk
      Usually fixed throughout term
      Determines periodic interest payments
Background on Bonds

            Bond Yield to Maturity

   The yield to maturity (TYM) is the yield
   that equates the future coupon and
   principal payments with the bond price
    The YTM is the investor’s expected rate of
     return if the bond is held to maturity
    The actual YTM may vary from the expected
     because of risks assumed by the investors
U. S. Treasury Bonds
 Issued by the U.S. Treasury to finance federal
  government expenditures
 Maturity
   Notes, < 10 Years
   Bonds, > 10 to 30 Years
 Active OTC Secondary Market
 Semiannual Interest Payments
 Benchmark Debt Security for Any Maturity
Treasury Bonds
 Treasury Bond Quotations
  8.38 Aug. 2013-18        103:05
  103.11 YTM?
     Coupon rate
     Maturity date
     Bid/Ask price as percent of face value
     Fractions of price in 32nds
       Example: Bid price 103:05, Ask price 103:11
   Yield to Maturity (YTM)
Federal Agency Bonds

 Government National Mortgage
  Association (GNMA)
   Issues bonds and uses proceeds to
    purchase insured FHA and VA mortgages
   A U.S. Government Agency
   Backed by explicit guarantee of Federal
    Government
   Example of social allocation of capital
Federal Agency Bonds

 Federal Home Loan Mortgage
  Association (Freddie Mac)
   Issues bonds and uses proceeds to
    purchase conventional mortgages
   A U.S. government-sponsored agency
   No explicit guarantee of bonds by federal
    government, but credit risk is very low
   Used to provide liquidity for thrifts and
    support of home ownership
Municipal Bonds
 State and local government obligations
 Revenue bonds vs. general obligation
  Bonds
 Investor interest income exempt from
  federal income tax
 Tax Reform Act of 1986 placed
  limitations on tax-exempt bond issuance
  for private purposes
Corporate Bonds
 When corporations want to borrow for
  long-term periods they issue corporate
  bonds
   Usually pay semiannual interest
   Most have maturities between 10-30 years
   Public offering vs. private placement
   Limited exchange, larger OTC secondary
    market
   Investors seek safety of principal and steady
    income
Exhibit 7.5

       Financial Institution                                       Participation in Bond Markets

Commercial banks and savings   • Purchase bonds for their asset portfolio.
and loan associations (S&Ls)      •
                               • Sometimes place municipal bonds for municipalities.
                               • Sometimes issue bonds as a source of secondary capital.

Finance companies              • Commonly issue bonds as a source of long-term funds.

Mutual funds                   • Use funds received from the sale of shares to purchase bonds. Some bond mutual funds
                                 specialize in particular types of bonds, while others invest in all types.

Brokerage rms                  • Facilitate bond trading by matching up buyers and sellers of bonds in the secondary market.

Investment banking rms         • Place newly issued bonds for governments and corporations. They may place the bonds
                                 and assume the risk of market price uncertainty or place the bonds on a best-efforts basis
                                 in which they do not guarantee a price for the issuer.

Insurance companies            • Purchase bonds for their asset portfolio.

P en sio n f u nd s            • Purchase bonds for their asset portfolio.
CH 8


Bond Valuation and Risk
Chapter Objectives
 Demonstrate how bond market prices are
  established and influenced by interest rate
  movements
 Identify the factors that affect bond prices
 Explain how the sensitivity of bond prices to
  interest rates is dependent on particular bond
  characteristics
 Explain the benefits of diversifying the bond
  portfolio internationally
Bond Valuation Process
 Bonds are debt obligations with long-
  term maturities issued by governments
  or corporations to obtain long-term
  funds
 Commonly purchased by financial
  institutions that wish to invest funds for
  long-term periods
 Bond price (value) = present value of
  cash flows to be generated by the bond
Bond Valuation Process
 Impact of the Discount Rate on Bond
  Valuation
   Discount rate = market-determined yield
    that could be earned on alternative
    investments of similar risk and maturity
   Bond prices vary inversely with changes in
    market interest rates
     Cash flows are contractual and remain the same
      each period
     Bond prices vary to provide the new owner the
      market rate of return
Bond Valuation Process
  Bond Price = present value of cash flows
   discounted at the market required rate of
   return
      C = Coupon per period (PMT)
      Par = Face or maturity value (FV)
       i = Discount rate (i)
       n = Compounding periods to maturity

          C               C        C + Par
   PV =         +               +…
        (1+ i)1         (1+ i)2     (1+ i)n
Bond Valuation Process
 Consider a $1000, 10% coupon (paid annually)
  bond that has three years remaining to
  maturity. Assume the prevailing annualized
  yield on other bonds with similar risk is 12
  percent. Calculate the bond’s value.
   The expected cash flows of a coupon
    bond includes periodic interest payments,
    and…
   A final $1000 payoff at maturity
   Discounted at the market rate of return
    of 12%
Bond Valuation Process
 Valuation of Bonds with Semiannual
  Payments
   Most bonds pay interest
    semiannually
   Double the number of
    compounding periods (N) and
    halve the annual coupon amount
    (PMT) and the discount rate (I)
Relationships Between Coupon
Rate, Required Return, and
Bond Price

              Zero-Coupon Bonds

    No periodic coupon
    Pays face value at maturity
    Trade at discount from face value
    No reinvestment risk
    Considerable price risk
Relationships Between Coupon
Rate, Required Return, and
Bond Price
 Discount bonds are bonds priced below face
  value; premium bonds above face value
 Discounted bond
   Coupon < Market rates
   Rates have increased since issuance
   Adverse risks factors that may have occurred
      Price risk—depends on maturity
      Default risk may have increased
      Fisher effect of higher expected inflation
Relationships Between Coupon
Rate, Required Return, and
Bond Price
 Premium bond
   Coupon > Market
   Rates decreased since issuance
   Favorable risk experience
     Price risk—depends on maturity
     Default risk might have decreased as
      economic activity has increased
     Low inflation expectations
Relationships Between Coupon
Rate, Required Return, and
Bond Price

       Bond Maturity and Price Variability

  Long-term bond prices are more sensitive to
   given changes in market rates than short-
   term bonds
  Changes in rates compounded many times
   for later coupon and maturity value,
   impacting price (PV) significantly
  Short-term securities have smaller price
   movements
Exhibit 8.4
  1,800
  1,600

  1,400

  1,200

  1,000
                                               5-Year Bond
   800
                                               10-Year Bond
   600                                         20-Year Bond

   400
   200

     0
          0   5          8    10   12         15              20
                  Required Return (Percent)
Relationships Between Coupon
Rate, Required Return, and
Bond Price

       Coupon Rates and Price Variability

  Low coupon bond prices more sensitive
   to change in interest rates
  PV of face value at maturity a major
   proportion of the price
Explaining Bond Price
Movements
 The price of a bond should reflect the
  present value of future cash flows
  discounted at a required rate of
  return
 The required return on a bond is
  primarily determined by
   Prevailing risk-free rate
   Risk premium
Explaining Bond Price
Movements
 Factors that affect the risk-free rate
   Changes in returns on real investment
     Financial investment an alternative to real
      investment
     Opportunity cost of financial investment is the
      returns available from real investment
     Federal Government deficits/surplus position
   Inflationary expectations
       Consumer price index
       Federal Reserve monetary policy position
       Oil prices and other commodity prices
       Exchange rate movements
Explaining Bond Price
Movements
 Factors that affect the credit or default
  risk premium
   Strong economic growth
      High level of cash flows
      Investors bid up bond prices; lower default
       premium
   Weak economic growth
        Lower profits and cash flows
        Impact on specific industries varied
        Investors flee from risky bonds to Treasury bonds
        Bond prices fall; default premiums increase
Exhibit 8.8
    U.S.       U.S.           U.S.        Issuer’s     Issuer’s
   Fiscal    Monetary       Economic      Industry      Unique
   Policy     Policy        Conditions   Conditions   Conditions




              Long-T erm
              Risk-Free                      Risk
            Interest Rate                 Premium
              (T reasury                  of Issuer
             Bond Rate)


                             Required
                              Return
                              on the
                               Bond




                            Bond Price
Sensitivity of Bond Prices to
Interest Rate Movements
 Bond Price Elasticity = Bond price
  sensitivity for any % change in market
  interest rates
 Bond Price Elasticity =
  (% Change In Price)/(% Change In
     Interest Rates)
 Increased elasticity means greater price
  risk
Sensitivity of Bond Prices to
Interest Rate Movements
 Calculate the price sensitivity of a
  zero-coupon bond with 10 years until
  maturity if interest rates go from
  10% to 8%.
   First, calculate the price of the bond for
    both rates
     When k = 10%, PV = $386
     When k = 8%, PV = $463
Sensitivity of Bond Prices to
Interest Rate Movements
 Calculate the bond elasticity:
                   $463  $386
       percentP      $386
   P 
    e
                               .997
       percentk    8%  10%
                      10%

     Bond elasticity or price sensitivity to changes in
 interest rates approaches the limit at –1 for zero-coupon
       bonds. Price sensitivity is lower for coupon
     bonds. The inverse relationship between k and p
                causes the negative numbers
Sensitivity of Bond Prices to
Interest Rate Movements
 Price-Sensitive Bonds
   Longer maturity—more price variation
    for a change in interest rates
   Lower coupon rate bonds are more price
    sensitive (the PV is a greater % of
    current value)
   Zero-coupon bonds most sensitive,
    approaching –1 price elasticity
   Greater for declining rates than for
    increasing rates
Sensitivity of Bond Prices to
Interest Rate Movements

                  Duration

  Measure of bond price sensitivity
  Measures the life of bond on a PV basis
  Duration = Sum of discounted, time-
   weighted cash flows divided by price
Sensitivity of Bond Prices to
Interest Rate Movements

                  Duration

  The longer a bond’s duration, the greater
   its sensitivity to interest rate changes
  The duration of a zero-coupon bond =
   bond’s term to maturity
  The duration of any coupon bond is
   always less than the bond’s term to
   maturity
Sensitivity of Bond Prices to
Interest Rate Movements
 Modified duration is an easily
  calculated approximate of the
  duration measure
                   DUR
          DUR * 
                  (1  k )

  DUR* is a linear approximation of DUR which measures
   the convex relationship between bond yields and prices
Bond Investment Strategies
Used by Investors

              Matching Strategy

  Create bond portfolio that will generate
   income that will match their expected
   periodic expenses
  Used to provide retirement income from
   savings accumulation
  Estimate cash flow needs then select bond
   portfolio that will generate needed income
Bond Investment Strategies
Used by Investors

                 Laddered Strategy

  Funds are allocated evenly to bonds in several
   different maturity classes
  Example: ¼ funds invested in bonds with 5 years
   until maturity, ¼ in10-year bonds, ¼ in 15-year
   bonds, and ¼ in 20-year bonds
  Investor receives average return of yield curve over
   time as maturing bonds are reinvested
Bond Investment Strategies
Used by Investors

               Barbell Strategy


  Allocated funds to short-term bonds and
   long-term bonds
  Short-term bonds provide liquidity from
   maturity
  Long-term bonds provide higher yield
   (assuming up-sloping yield curve)
Bond Investment Strategies
Used by Investors

              Interest Rate Strategy

  Funds are allocated in a manner that
   capitalizes on interest rate forecasts
  Example: if rates are expected to decline,
   move into longer-term bonds
  Problems:
    High transaction costs because of higher trading
    Difficulty in forecasting interest rates
Foreign Exchange Rates and
Interest Rates
 Country interest rate differences reflect
  expected future spot foreign exchange
  rates
 Expected future spot foreign exchange
  rates (forward forex rates) reflect expected
  inflation differences between countries
 Expected return on foreign bond portfolio
  related to return on bonds adjusted for
  expected changes in forex rates

                                            208
Diversifying Bonds
Internationally
 Investor may diversify by:
     Credit risk
     Country risk
     Foreign exchange risk
     Interest rate risk
 Seek lower total variability of returns
  per level of risk assumed


                                        209
CH 9


  Mortgage Markets
Chapter Objectives
 Describe characteristics of residential
  mortgages
 Describe the common types of creative
  mortgage financing
 Explain the role of the federal government
  in supporting the development of the
  secondary mortgage market
 Relate the development and use of
  mortgage-backed securities
Residential Mortgage
Characteristics

    Insured vs. Conventional Mortgages

  Federal and private insurance guarantees repayment
   in the event of borrower default
  Limits on amounts, borrower requirements
  Borrower pays insurance premiums
  Federal insurers include Federal Housing
   Administration and Veterans Administration
Residential Mortgage
Characteristics
Fixed rate loans have a constant,
   unchanging rate
   Interest rate risk can hurt lender rate of
    return
      If interest rates rise in the market, lender’s cost of
       funds increases
      No matching increase in fixed-rate mortgage
       return
   Borrowers lock in their cost and have to
    refinance to benefit from lower market rates
Residential Mortgage
Characteristics

 Adjustable-rate mortgages
   Rates and the size of payments can change
     Maximum allowable fluctuation over year and
       life of loan
     Upper and lower boundaries for rate changes
   Lenders stabilize profits as yields move with cost
    of funds
   Uncertainty for borrowers whose mortgage
    payments can change over time
Residential Mortgage
Characteristics

            Mortgage Maturities


 Trend shows increased popularity of
  15-year loans
   Lender has lower interest rate risk if the
    term or maturity of the loan is lower
   Borrower saves on interest expense over
    loan’s life but monthly payments higher
Residential Mortgage
Characteristics

                Mortgage Maturities

 Balloon payments
   Principal not paid until maturity
   Forces refinancing at maturity
 Amortizing mortgages
   Monthly payments consist of interest and principal
   During loan’s early years, most of the payment
    reflects interest
Creative Mortgage Financing
 Graduated-payment mortgage (GPM)
   Small initial payments
   Payments increase over time then level
    off
   Assumes income of borrower grows
 Growing-equity mortgage
   Like GPM low initial payments
   Unlike GPM, payments never level off
Creative Mortgage Financing
 Second mortgage used in conjunction
  with first or primary mortgage
   Shorter maturity typically for 2nd mortgage
   1st mortgage paid first if default occurs so
    2nd mortgage has a higher rate
   If used by sellers, makes a home with an
    assumable loan more affordable
 Shared-appreciation mortgage
   Below market rate but lender shares in
    home’s price appreciation
Activities in the Mortgage
Markets
 How the secondary market facilitates
  mortgage activities
 Selling loans
   Origination, servicing and funding are
    separate business activities and may be
    “unbundled”
   Secondary market exists for loans
 Securitization
   Pool and repackage loans for resale
   Allows resale of loans not easily sold on an
    individual basis
Activities in the Mortgage
Markets
 Unbundling of mortgage activities
  provides for specialization in:
     Loan origination
     Loan servicing
     Loan funding
     Any combination of the above
Institutional Use of Mortgage
Markets, December, 2002
 Federally related mortgage pools
   37% of all mortgages, mostly residential
 Commercial banks
   Dominate commercial mortgage market
   Hold 23.3% of all mortgages
 Savings institutions
   Primarily residential mortgages
   Hold 10% of all mortgages
 Life insurance companies
   Commercial mortgages
   Hold 3% of all mortgages
Institutional Use of Mortgage
Markets
 Mortgage companies
   Originate and quickly sell loans
   Do not maintain large portfolios
 Government agencies including
  Fannie Mae and Freddie Mac
 Brokerage firms
 Investment banks
 Finance companies
Valuation of Mortgages
 Market price of mortgages is present value
  of cash flows
             C  PRIN
               n
   PM  
        t 1  (1  k )t


Where:
PM = Market price of a mortgage
C = Interest payment and PRIN is principal
k = Investor’s required rate of return
t = maturity
Valuation of Mortgages
 Periodic payment commonly includes
  payment of interest and principal
 Required rate of return determined by
  risk-free rate, credit risk and liquidity
 Risk-free interest rate components
  and relationship
     + inflationary expectations
     + economic growth
     – change in the money supply
     + budget deficit
Valuation of Mortgages
 Economic growth affects the risk
  premium
   Strong growth improves borrowers’ income
    and cash flows and reduces default risk
   Weak growth has the opposite affect
 Potential changes in mortgage prices
  monitored by reviewing inflation,
  economic growth, deficits, housing, and
  other predictor economic statistics
Exhibit 9.8
                                                             Issuer’s
     U.S.                       U.S.         U.S.
                                                             Industry         Issuer’s
    Fiscal                    Monetary     Economic
                                                           Conditions (for     Unique
    Policy                     Policy      Conditions
                                                            Commercial       Conditions
                                                            Mortgages)




               Long-Term                  Prepayment
                                                                Risk
                Risk-Free                      Risk
                                                             Premium
              Interest Rate                Premium
                                                             of Issuer
             (T-Bond Rate)                  of Issuer




                                         Required Return
                                              on the
                                           Fixed-Rate
                                            Mortgage




                                             Price of
                                           Fixed-Rate
                                            Mortgage
Risk from Investing in
Mortgages
 Interest rate risk
 Present value of cash flows or value of
  mortgage changes as interest rate
  changes
 Long-term fixed-rate mortgages
  financed by short-term funds results in
  risks
 To limit exposure to interest rate risk
   Sell mortgage shortly after origination (but
    rate may change in that short period of time)
   Make adjustable rate mortgages
Risk from Investing in
Mortgages
 Prepayment risk
   Borrowers refinance if rates drop by
    paying off higher rate loan and financing
    at a new, lower rate
   Investor receives payoff but has to
    invest at the new, lower interest rate
   Manage the risk with ARMs or by selling
    loans
Risk from Investing in
Mortgages
 Credit risk can range from default to late
  payments
 Factors that affect default
    Level of borrower equity
       Loan-to-value ratio often used
       Higher use of debt, more defaults
    Borrowers income level
    Borrower credit history
 Lenders try to limit exposure to credit risk
Risk from Investing in
Mortgages
 Measuring risk
   Use sensitivity analysis to review various
    “what if” scenarios covering everything
    from default to prepayments
   Incorporate likelihood of various events
   Review effect on cash flows
   Institution tries to measure risks and use
    information to restructure or manage
    risk
Use of Mortgage-Backed
Securities
 Securitization is an alternative to the
  outright sale of a loan
 Group of mortgages held by a trustee
  serves as collateral for the securities
 Institution can securitize loans to
  avoid interest rate risk and credit risk
  while still earning service fees
 Payments passed through to
  investors can vary over time
Use of Mortgage-Backed
Securities
 Ginnie Mae mortgage-backed
 securities
  Government National Mortgage
   Association
  Guarantees timely interest and principal
   payments to investors
  Pool of loans with the same interest rate
  Purchasers receive slightly lower rate
   than that on the loans to cover service
   and guarantee
Use of Mortgage-Backed
Securities
 Fannie Mae mortgage-backed
  securities
   Uses funds from mortgage-backed pass-
    through securities to purchase
    mortgages
   Channel funds from investors to
    institutions that want to sell mortgages
   Guarantee timely payments to investors
   Some securities strip (securitize) interest
    and principal payment streams for
    separate sale
Use of Mortgage-Backed
Securities
 Publicly issued pass-through
  securities (PIPS)
   Backed by conventional mortgages
    instead of FHA or VA mortgages
   Private mortgage insurance
 Participation certificates (PCs)
   Freddie Mac sells and uses funds to
    finance origination of conventional
    mortgages from financial institutions
Use of Mortgage-Backed
Securities
 Collateralized mortgage obligations (CMOs)
   Semi-annual payments differ from other
    securities’ monthly payments
   Segmented into classes
     First class has quickest payback
     Any repaid principal goes first to investors
      in this class
   Investors choose a class to fit maturity
    needs
   One concern is payback speed when rates
    drop
Use of Mortgage-Backed
Securities
 CMOs (cont.)
   Can be segmented into interest-only IO
    or principal-only PO classes
   High return for IO reflect risks
 Useful investment but be aware of
  the risks
   1992 failure of Coastal States Life
    Insurance due to CMO investments
   Some CMO mutual funds
   Regulators have increased scrutiny
Use of Mortgage-Backed
Securities
 Mortgage-backed securities for small
  investors
   In the past, high minimum denominations
   Unit trusts created to allow small investor
    participation
   Mutual funds
 Advantages
   Can purchase in secondary market without
    purchasing the need to service loans
   Insured
   Liquid
CH 10


  Stock Offerings and Investor
  Monitoring
Chapter Objectives

 Describe the stock exchanges where
  stocks are traded
 Analyze the process of the initial
  public offering of stock by a company
 Be able to interpret a stock quote
 Explain the institutional use of stock
  markets
 Describe the globalization of stock
  markets
Background on Common Stock
  Common stock = certificate representing
   equity or partial ownership in a
   corporation

  Issued in primary market by corporations
   that
  need long-term funds

   Stock is then traded in the secondary
   market, creating liquidity for investors
   and company
Background on Common Stock

          Ownership and Voting Rights
 Owners of common stock vote on:
     Election of board of directors
     Authorization to issue new shares
     Amendments to corporate charter
     Other major events
 Many investor assign their vote to
  management via a proxy
 Households own about half of all common
  stock, the rest is owned by institutional
  investors
Background on Preferred Stock
 Represents equity or ownership interest, but
  usually no voting rights
 Trade voting rights for stated fixed annual
  dividend
 Dividend paid before common if dividends are
  declared by board of directors
 Dividend may be omitted
   Cumulative provision
   If common dividend paid, preferred dividend
     fixed
Public Placement of Stock
 Initial public offerings (IPOs)
   First-time offering of shares to the public
   Firm must provide information to public
      Registration statement to SEC
      Prospectus
      Firm is assisted by an investment banker
   Performance of IPOs
      Price generally rises on first day
      Longer-term performance of IPOs is poor
Public Placement of Stock
 Secondary stock offerings
   New stock issued by firm that already
    has shares outstanding
 Shelf Registration
   1982 SEC rule
   Allows firms to place securities without
    the time lag associated with registering
    with SEC
Stock Secondary Markets

            Organized Exchanges

  Execute secondary market transactions
  Examples: NYSE, AMEX, Midwest, Pacific
  NYSE is largest, controlling 80 percent of
   value of all organized exchanges
    Must own a seat on exchange in order to
     trade
    Trading resembles an auction
Stock Secondary Markets
          Over-the-Counter Market
  No trading floor or specific location
  Telecommunications network
  Nasdaq
    National Association of Securities Dealers
     Automatic Quotations
    Thousands of small firms, plus high-tech giants
  Pink sheets
    Tiny firms that do not meet requirements for
     NASDAQ
Stock Secondary Markets
 Trend: Consolidation of stock
  exchanges
 Market microstructure
   Specialists, floor brokers, and market-
    makers
     Role of specialists
   Types of orders
     Market order
     Limit order
     Stop order
Stock Secondary Markets
  Changes in technology
      Online trading
      Real-time quotes
      Company information
      Electronic Communications Networks (ECNs)
  Margin requirements
    Specify amount of borrowed versus amount
     in cash
Stock Secondary Markets
  Purchasing stock on margin
    Borrow a portion of the funds from broker
    Margin is the amount of equity an investor
     provide
    Magnifies returns (both good and bad)
  Short sales
    Borrow stock and sell
    Repay stock loan, hopefully at a lower price
    Investor able to have potential profit from
     decline in stock price
Regulation of Trading on Stock
Exchanges
n Securities Act   Of 1933 and 1934
n Securities And   Exchange Commission
n National Association   Of Securities Dealers
 (NASD)
n Regulateminimum information for investor and
 broker/dealer business practices
n Circuit   breakers
Stock Quotation
 Stock Quotation
   52-week price range (high/low and
    YTD% change)
   Stock symbol
   Dividend annualized and dividend yield
   Price-earnings ratio
   Volume in round lots
   Previous day’s price close and net daily
    change
   Remainders in cents, not eighths
Exhibit 10.6


  YTD %
  change          Hi       Lo       Stock      Sym       DIV          Yld%            PE         Vol 100s      Last        Net Chg

   110.3       121.88     80.06      IBM        IBM      .56            .6            20          71979        93.77        1 1.06

Year-to-date   Highest   Lowest    Name       Stock    Annual     Dividend        Price-        Trading       Closing   Change in the
percentage     price     price     of stock   Symbol   dividend   yield, which    earnings      volume        stock     stock price
change in      of the    of the                        paid per   represents      ratio based   during the    price     on the previ-
stock price    stock     stock                         year       the annual      on the        previous                ous trading
               in this   in this                                  dividend as     prevailing    trading day             day from the
               year      year                                     a percentage    stock price                           close on the
                                                                  of the pre-                                           day before
                                                                  vailing stock
                                                                  price
Stock Indexes
 Dow Jones Industrial Average
   Price-weighted average
   30 large U.S. firms
 Standard and Poor’s (S&P) 500
   Value-weighted
   500 large U.S. firms
 New York Stock Exchange Indexes
 Other Stock Indexes
   Amex, NASDAQ
Stock Indexes
 Investing in stock indexes
   Indexing
   Has become very popular
     Lower transactions costs
     Studies find that actively-managed funds
      do not outperform stock indexes
 Examples of publicly traded stock
  indexes
   SPDRs
   Diamonds
Stock Market Performance
 Comparing stock performance to
  bond performance
Investor Trading Decisions
 Stock value = proportional value of
  total company
 Investor return = dividend yield +
  capital gain/loss
 New information translated into
  trading decisions impacting
  supply/demand for shares
 New equilibrium price established
  until new information appears
Exhibit 10.8
                                 Increased
                                Demand for
      New         Increased                  Increase in
                                  Security
   Favorable       Valuation                 Equilibrium
  Information          of                      (Market)
   Disclosed        Security                   Price of
  to Investors   by Investors    Reduced       Security
                                 Supply of
                                 Security
                                 for Sale




                                 Reduced
                                Demand for
      New         Reduced                    Decrease in
                                 Security
  Unfavorable     Valuation                  Equilibrium
  Information         of                      (Market)
   Disclosed       Security                    Price of
  to Investors   by Investors   Increased     Security
                                 Supply of
                                 Security
                                 for Sale
 Institutional Participation in
 Stock Markets
 Program trading by institutions
   Simultaneously buying and selling of a
    portfolio of at least 15 different stocks valued
    at more than $1 million
   Most commonly used by securities firms
   Program refers to the use of computers
   Impact on stock volatility
     Often blamed for rise or fall in stock market
     Studies show that program trading does not
      increase volatility
Investor Monitoring of Firms in
the Stock Market
 Communication with the firm
   Effort to place pressure on management
   Institutional investors
     CALPERS
     TIAA
 Proxy contest
 Shareholder lawsuits
Corporate Monitoring of Firms
in the Stock Market
Market for corporate control
   Stock price declines due to poor
    management
   Subject to possible takeover
 Barriers to market for corporate
  control
   Antitakeover amendments
   Poison pills
   Golden parachutes
Corporate Monitoring of Their
Own Stock in the Stock Market
 Stock repurchases
   Dividend alternative or undervalued stock
   Excessive cash relative to +NPV investments
 Leveraged buyouts (LBO)
   If managers believe the stock price
    undervalued, they may buy the outstanding
    shares with borrowed funds
 Stock offerings
   Signals overvalued shares
Globalization of Stock Markets
 Barriers to international stock trading
  have decreased
   Reduction in information costs
   Reduction in exchange rate risk
 Foreign stock offerings in the United
  States
 International placement process
 Global stock exchange characteristics
 Emerging stock markets
Globalization of Stock Markets
 Methods used to invest in foreign
  shares
     Direct purchases
     American Depository Receipts (ADRs)
     International mutual funds
     World equity benchmark shares
CH 11


  Stock Valuation
  And Risk
Chapter Objectives
 Explain the general steps necessary to value
  stocks and the commonly used valuation
  models
 Learn the factors that affect stock prices
 Explain methods of determining the required
  rate of return on stocks
 Learn how to measure the risk of stocks
 Learn how to measure performance of stock
 Explain the concept of stock market efficiency
Stock Valuation Methods
 The price of a share of stock is the total value of
  the company divided by the number of shares
  outstanding
 Stock price by itself doesn’t represent firm value
 Stock price is determined by the demand and
  supply for the shares
 Investors try to value stocks and purchase those
  that are perceived to be undervalued by the
  market
 New information creates re-evaluation
Stock Valuation Methods
       Price-Earnings (PE) Method

  Apply the mean PE ratio of publicly
   traded competitors
  Use expected earnings rather than
   historical
  Equation:
    Firm’s
    Stock    =   Expected EPS  Mean industry PE
    ratio
    Price
Stock Valuation Methods
        Price-Earnings (PE) Method

 Reasons for different valuations
   Different earnings forecasts
   Different PE multipliers
     Different comparison or benchmark firms
 Limitations of the PE method
   Errors in forecast or industry composite
   Based on PE, which some analysts
    question
Stock Valuation Methods
       Dividend Discount Method

  The price of a stock reflects the present
   value of the stock's future dividends
    t = period
    Dt = dividend in period t
    k = discount rate
                   
                            Dt
    Price       t 1   (1  k) t
Stock Valuation Methods
        Dividend Discount Method

 Relationship between DDM and PE
  Ratio for valuing firms
   PE multiple is influenced by required rate
    of return of competitors and their
    expected growth rate
   When using PE multiple method, the
    investor implicitly assumes that k and g
    will be similar to competitors
Stock Valuation Methods
        Dividend Discount Method

 Limitations of the Dividend Discount
  Model
   Potential errors in estimating dividends
   Potential errors in estimating growth rate
   Potential errors in estimating required
    return
   Not all firms pay dividends
     Technology firms
Stock Valuation Methods
        Dividend Discount Method

 Adjusting the Dividend Discount
  Model
   Value of stock is determined by
     Present value of dividends over investment
      horizon
     Present value of selling price at the end
   To forecast the selling price, the investor
    can estimate the firm’s EPS in the year
    they plan to sell, then multiply by the
Determining the Required Rate
of Return to Value Stocks
 Capital Asset Pricing Model (CAPM)
   Used to estimate the required return on
    publicly traded stock
   Assumes that the only relevant risk is
    systematic (market) risk
     Uses beta to measure risk rather than
      standard deviation of returns


          Rj = Rf + j(Rm – Rf)
Determining the Required Rate
of Return to Value Stocks
       Rj = Rf + j(Rm – Rf)

 Capital Asset Pricing Model (CAPM)
   Estimating the risk-free rate and the
    market risk premium
     Proxy for risk-free rate is the yield on newly
      issued Treasury bonds
     The market risk premium, or (Rm-Rf), can
      be estimated using a long-term average of
      historical data.
Determining the Required Rate
of Return to Value Stocks
              Rj = Rf + j(Rm – Rf)

 Estimating the firm’s beta
   Beta measures systematic risk
   Reflects how sensitive individual stock’s returns are
    relative to the overall market
   Example: beta of 1.2 indicates that the stock’s
    return is 20% more volatile than the overall market
   Investor can look up beta in a variety of sources
    such as Value Line or Yahoo! Finance (Profile)
   Computed by regressing stock’s returns on returns
    of the market, usually represented by the S&P 500
    index or other market proxy
Determining the Required Rate
of Return to Value Stocks
 Arbitrage Pricing Model
   Differs from CAPM in that it suggests a
    stock’s price is influenced by a set of
    factors rather than just the return on the
    market
   Factors may include things like:
     Economic growth
     Inflation
     Industry effects
   Problem with APT: factors are
    unspecified and must be defined
Factors that Affect Stock Prices
 Economic factors
   Interest rates
     Most of the significant stock market declines
      occurred when interest rates increased
      substantially
     Market’s rise in 1990s: low interest rates; low
      required rates of return
   Exchange rates
     Foreign investors purchase U.S. stocks when
      dollar is weak or expected to appreciate
     Stock prices of U.S. companies also affected by
      exchange rates
Factors that Affect Stock Prices
 Market-related factors
   January effect
   Noise trading
     Trading by uninformed investors pushes
      stock price away from fundamental value
     Market maker spreads
   Trends
     Technical analysis
     Repetitive patterns of price movements
Factors that Affect Stock Prices
 Firm-specific factors
     Expected +NPV investments
     Dividend policy changes
     Significant debt level changes
     Stock offerings and repurchases
     Earnings surprises
     Acquisitions and divestitures
Factors that Affect Stock Prices
 Integration of factors affecting stock
  prices
 Evidence on factors affecting stock
  prices
   Fundamental factors influence stock prices, but
    they do not fully account for price movements
     Smart-money investors
     Noise traders
     Excess volatility
 Indicators of future stock prices
   Things that affects cash flows and required
    returns
   Variance in opinions about indicators
Exhibit 11.3
   International             U.S.                    U.S.              U.S.         Industry      Firm-Specific
    Economic                Fiscal                  Monetary         Economic      Conditions      Conditions
    Conditions              Policy                   Policy          Conditions




                                                                    Stock Market
                                                                     Conditions
                                                                                            Firm’s
                                                                                           Systematic
                                                                                             Risk
                                                                                            (Beta)
                                                                       Market
                                                                        Risk
                                                                      Premium



                                              Risk-Free                Firm’s
                                               Interest                 Risk
                                                Rate                  Premium



                    Expected
                   Cash Flows                           Required Return
                     to Be                               by Investors
                   Generated                             Who Invest in
                     by the                                the Firm
                      Firm




                                     Price of the
                                       Firm’s
                                       Stock
Analysts and Stock Valuation
 Stock analysts interpret “valuation
  effect” of new information for
  investors
 Analysts’ opinions impact stock
  buying/selling
 Analysts’ ratings seldom recommend
  sell
   Income of analyst may come from
    investment banking side of business
    selling company shares
   Companies shun analysts who
Analysts and Stock Valuation,
cont.
 Analyst may obtain “new” information
  with company executives in
  conference call
   Other investors are not privy to
    information
   Regulation FD (Fair Disclosure) from SEC
    requires “release” of new significant
    information at the same time as
    teleconference calls with analysts.
 Other analyst recommendations
   Value Line
Measures of Stock Risk
 Market price volatility of stock
   Indicates a range of possible returns
   Positive and negative
   Standard deviation measure of variability
 Volatility of a stock portfolio depends
  upon:
   Volatility of individual stocks in the
    portfolio
   Correlation coefficients between stock
    returns
   Proportion of total funds invested in each
Measures of Stock Risk
 Beta of a stock
   Measures sensitivity of stock’s returns
    to market’s returns
 Beta of a stock portfolio
   Weighted average of the betas of the
    stocks that comprise the portfolio



         p =  wi  i
Measures of Stock Risk
 Value at Risk
   Estimates the largest expected loss to a
    particular investment position for a
    specified confidence level
   Warns investors about the potential
    maximum loss that they may incur with
    their investment portfolio
   Focuses on the “loss” side of possible
    returns
   Used to analyze risk of a portfolio
Applying Value at Risk
 Methods of determining the maximum
  expected loss
   Use of historical returns
     Example: count the percent of total days that
      a stock drops a certain level
   Use of standard deviation
     Used to derive boundaries for a specific
      confidence level
   Use of beta
     Used in conjunction with a forecast of a
      maximum market drop
     Beta serves as a multiplier of the expected
Applying Value at Risk
 Deriving the maximum dollar loss
   Apply the maximum percentage loss to
    the value of the investment
 Common adjustments to the value-
  at-risk applications
     Investment horizon desired
     Length of historical period used
     Time-varying risk
     Restructuring the investment portfolio
Forecasting Stock Price
Volatility and Beta
 Methods of forecasting stock price
  volatility
   Historical method
   Time-series method
   Implied standard deviation
     Derived from the stock option pricing model
 Forecasting a stock portfolio's volatility
   One method involves forecasts of individual
    volatility levels and using correlation coefficients
 Forecasting a stock portfolio’s beta
   Forecast changes in individual stock betas
Stock Performance
Measurement
 Sharpe Index
   Assumes total variability is the
    appropriate measure of risk
 A measure of reward relative to risk

                     R - Rf
      Sharpe Index 
                       
Stock Performance
Measurement
  Treynor Index
    Assumes that beta is the appropriate type
     of risk
    Measure of risk-adjusted return
    Higher the value; the higher the return
     relative to the risk-free rate

                      R - Rf
      Treynor Index 
                        
CH 12


  Market Microstructure and Strategies
Chapter Objectives
 Describe typical common stock
  transactions and their execution
 Explain the role of electronic
  communications networks (ECNs)
 Describe the regulation of stock
  transactions
 Explain how barriers to international
  stock transactions have been reduced
Stock Market Transactions

              Placing an Order

 Market order to buy/sell at the best
  possible price
 Limit order is a market order with a
  specific price maximum or minimum
 Discount vs. full-service broker
 Placing an order via the Internet
Margin Trading
 Buying stock on margin= borrowing
  to buy stock
 Federal Reserve sets margin
  requirements (%) or proportion of
  funds buyer must put down
   Used to dampen speculation and market
    crashes
   Currently 50%; half down, half borrowed
   Broker may set higher margin
    requirements
Margin Trading, cont.

       Sort Out All the “Margins”


 Customer establishes account with
  broker (margin account)
 Initial margin—broker’s minimum
  margin requirement for stock
  purchase
 Maintenance margin—minimum
  proportion of equity/total value of
Margin Trading, cont.
 Margin trading magnifies returns to
  investor
   Investor must pay interest on borrowed funds
   Investor returns higher/lower with lower equity than
    a 100% purchase
 Margin Call
   Stock price falls below maintenance margin
    requirements
   Margin call is a request for cash to maintain
    maintenance margin
   Broker/lender may sell stock to protect loan
Short Selling
 In a short sale, investor borrows and
  sells stock
 Promises to pay back stock later
 Short seller hopes stock price declines to
  provide gain
 Short seller covers dividend payments
  while borrowing stock
 Limited gain; unlimited losses
 Short Interest Ratio as market forecast
Investing in Stock Indexes
 Investor may buy stock or stock
  derivative securities
   The value of derivative securities follow
    underlying stock prices or prices of
    specific stock portfolios (index)
   Lower transaction costs
   Stock index returns have matched
    actively managed portfolios
   Exchange-traded funds (ETFs) designed
    to match major stock indexes
Exchange-Traded Funds (ETFs)
vs. Indexed Mutual Funds
 Both ETFs and indexed mutual funds
   Share price adjusts in response to change in
    index
   Pay dividends earned in added shares
   Lower management fees than actively managed
    mutual funds
 ETFs are different from mutual funds in that
  they
   May be traded on an exchange any time during
    the day
   May be purchased on margin and sold short
   Capital gains tax only
   Value of ETF shares = underlying value of
Types of Exchange-Traded
Funds (ETFs)
 Cube (QQQ)
   Tracks Nasdaq100 index
   Traded on Amex
   Investors may speculate on future of
    technology stocks
     Purchase on margin
     Sell short
 Spider (S&P Depository Receipt)
   Tracks S&P 500 index
   Trade at one-tenth S&P 500 Index level
How Trades Are Executed

                Floor Broker


 Floor brokers fulfill trade orders on
  exchange trading floor
 May work for the brokerage house or
  serve as their agent
 Completes the physical trade with
  other floor participants
How Trades Are Executed

                 Specialists


 Specialists serve as brokers,
  matching buy/sell orders in a few,
  specific stocks on the exchange
 Serve as a dealer, buying/selling to
  complete transaction
 Serve to maintain fair and orderly
  market
How Trades Are Executed

                Market-Makers

 Market-makers have dealer positions
  in specific stocks and complete
  transactions on NASDAQ market
 No specific location as with specialists
  on exchanges—telecommunications
  link
 Specialists and market-makers
  provide continuous market liquidity
Electronic Communications
Networks (ECNs)
 Automated systems for disclosing and
  executing stock trades
 Focus on institutional market trading
  with large-size trades and lower
  spreads
 A programmed market vs. trading by
  people
 Started on NASDAQ; spreading to
  exchange-traded stocks
 ECNs specialize by types orders:
Program Trading
 Trading completed by computer “program”
 Initial use with institutional, large order, high
  volume to take advantage of technology
 NYSE listed stocks dominate program trading
 Trading a function of parameters set in
  “program,” such as “over-valued shares”
 Used also to manage portfolio risk
    Portfolio insurance—use of stock index
     futures
    Protect gain or minimize loss in portfolio
Program Trading, cont.
 Program trading associated with
  increased volatility of stock market or
  inciting significant market declines
   Research has refuted claim that program
    trading has increased stock market
    volatility
   Has not been the initial “starter” of sharp
    market declines
 NYSE implemented “collars” or curbs to
  program trading in volatile periods
 Circuit breakers—market “time out”
Regulation of Stock Trading
 Purpose of stock trading regulation
   To make market more efficient
      Promote and preserve competition
      Prevent unfair or unethical trading practices
   Provide adequate disclosure of
    information
   To prevent market failure—circuit
    breakers
 Securities Act of 1933 and SEC Act of 1934
 SEC uses surveillance system to watch trading
   Insider trading
   Attempts to corner market
Securities and Exchange
Commission
 Congress provided SEC with broad
  powers to regulate stock markets
   May prescribe accounting standards and
    the extent of financial disclosure
   Establish regulations for stock trading
    and disclosure from “insiders”
   Regulates stock market participants to
    maintain a fair and orderly market
Structure of the SEC
 Five Commissioners
   Appointed by president
   Confirmed by Senate
 Five-year staggered terms
 President appoints Chair
 SEC Divisions
   Division of Corporate Finance
   Division of Market Regulation
   Division of Enforcement
SEC Oversight of Corporate
Disclosure
 Regulation Fair Disclosure (FD), October,
  2000
   Requires corporations to disclose relevant information
    broadly to investors at the same time
   Forbade old practice of providing selected analysts
    new information during teleconference calls
 Means of disclosing new information
     Company Web site—Web cast
     8-k form filing
     News release
     Above simultaneously with conference call
SEC Oversight of Analysts’
Recommendations
 Sell-side analysts rewarded for success of
  underwriting(sale of securities)
 Analysts’ information used by investors
    Recommend “buy” or “sell”
    Few “sell” recommendations before
     collapse of Internet companies
 Do analysts “tout” stocks after they are aware
  of “negative” information?
 Should analysts’ high income be shared with
  investors who lost money in stock?
Three Traditional Barriers to
International Stock Trading

            Reduce Transaction Costs

 Increased consolidation and increased
  efficiency of international stock exchanges
 Computerized order flow/matching provide
  more objective, fairer trading, lowering bid/ask
  differentials
 Transaction costs lowered by competition,
  technology, and less regulation
Three Traditional Barriers to
International Stock Trading

           Reduce Information Costs


 Information on foreign stocks now more
  accessible
 More uniform accounting standards between
  countries
 Increased disclosure reduces information
  gathering costs
Three Traditional Barriers to
International Stock Trading

           Reduce Exchange Rate Risk


 Investing in foreign stocks denominated in
  foreign currency exposes investor to forex risk
 Changes in foreign exchange rates changes
  actual return from expected
 Exchange rate risk reduced as single currency
  adopted—euro example
CH 13


  Financial Futures Markets
Chapter Objectives
 Explain how financial futures
  contracts are valued
 Explain the use of futures to
  speculate or hedge based on
  anticipated interest rate changes
 Explain the use of stock index futures
  to speculate or hedge based on
  anticipated stock price movements
 Describe how financial institutions
  participate in futures markets
Background on Financial
Futures
 Futures are a derivative security
 Derivatives
   Securities whose value is derived from the
    value of some underlying asset or financial
    instrument
   Derivative security prices related to factors
    affecting prices in the spot market
   For example, bond futures prices are related
    to what is happening in markets where
    bonds are bought and sold for immediate
    delivery
Background on Financial
Futures
 Standardized agreement to deliver or
  take delivery of a financial instrument
  at a specified price and date
 Price is determined by traders for
  standardized contracts
   The underlying financial instrument
   Settlement date
   Form of delivery for underlying asset
 Trading on organized exchanges
  provides liquidity and guaranteed
  settlement
Background on Financial
Futures
 Exchange members trade contracts in
  trading pits
 Organized exchanges include Chicago
  Board of Trade and Chicago
  Mercantile Exchange
 Only members or those leasing
  privileges can transact business on
  the floor of the exchange
   Commission brokers
   Floor traders
 Regulated by the Commodities
Background on Financial
Futures

        Steps Involved in Trading Futures

   Establish account and initial margin
   Maintenance margin and margin call
   Order to trading floor
   Open outcry trading
   Clearinghouse function
   Daily market-to-market of contracts
Background on Financial
Futures

    Purpose of Trading Financial Futures

 To Speculate
   Take a position with the goal of profiting from
    expected changes in the contract’s price
   No position in underlying asset
 To Hedge
   Minimize or manage risks
   Have position in spot market with the goal to
    offset risk
Interpreting Financial Futures
Tables
 Futures contract prices reported in
  the financial press
 Columns of information for each
  maturity month that is trading
   Open, high, low and the settlement or
    closing price
   Change in the closing price from the
    previous day
   Open interest or how many contracts are
    outstanding for a particular maturity
Valuation of Financial Futures
 Futures contract price related to the price
  of the underlying asset
 Inverse relationship between debt contract
  prices and interest rates applies to futures
  prices
 Futures contract price reflects the expected
  price of the underlying asset or index as of
  the settlement date
 Anything that affects the price of the
  underlying asset affects the futures price
 Impact of opportunity costs or benefits
Bond Futures Contract Price
Changes
 Prices of Treasury bond futures move
  with spot market
 Correlation of price movements in
  spot and futures important to hedgers
  and speculators
 Market participants in futures monitor
  the same kinds of economic indicators
  and interest rate information as
   Investors who own bonds
   Investors who expect to buy bonds
   Borrowers who might plan on issuing
Exhibit 13.3 Framework for
Futures Price Changes Over
Time
           International          U.S.      U.S.              U.S.
            Economic             Fiscal   Monetary          Economic
            Conditions           Policy    Policy           Conditions




                           Long-Term          Short-Term
                            Risk-Free          Risk-Free
                             Interest           Interest
                              Rate                Rate
                           (Treasury           (Treasury
                           Bond Rate)          Bill Rate)


                            Required          Required
                             Return            Return
                           on Treasury       on Treasury
                              Bond               Bill



                             Price of          Price of
                            Treasury           Treasury
                              Bond                Bill



        Expected                                                   Expected
     Movements in           Price of           Price of         Movements in
        Treasury            Treasury           Treasury            Treasury
      Bond Prices             Bond                Bill            Bill Prices
     Not Embedded           Futures            Futures          Not Embedded
       in Existing                                                in Existing
         Prices                                                     Prices
Speculating with Interest Rate
Futures
 Long position; purchase futures contracts
 Strategy to use if speculator anticipates
  interest rates will decrease and bond prices
  will increase
 Buy a futures contract and if rates drop the
  contract’s price rises above what it cost to
  purchase and exchange adds gain with
  daily settlement to investor’s account
 If interest rates rise instead of fall, futures
  contract price drops and investor’s account
  is reduced by daily loss
Exhibit 13.4 Potential Payoff
From Speculative Futures
Position
Profit or                     Profit or
Loss from                     Loss from
Purchasing                    Selling
a Futures                     a Futures
Contract                      Contract



         0                            0
             S   Market                   S   Market
                 Value                        V alue
                 of the                       of the
                 Futures                      Futures
                 Contract                     Contract
                 as of the                    as of the
                 Settlement                   Settlement
                 Date                         Date
Risks of Trading Futures
Contracts
 Market risk
   Speculators win or lose based on
    changing market value of futures
    contracts
   Hedgers, with a position in the
    underlying asset, are not significantly
    impacted by contract price volatility
 Basis risk
   Futures contract prices do not vary in
    exactly the same way as the underlying
    asset’s price
   Price correlation of contract and
Risk of Trading Futures
Contracts
 Dealing with basis risk
   Identify futures contract with price
    changes closely related to the underlying
    asset
   Cross hedging
 Liquidity risk
   Price distortions if a contract is not
    widely traded
   Need a counterparty to close position
Risk of Trading Futures
Contracts
 Credit risk
   Counterparty defaults
   Not a risk on exchange-traded contracts
    where exchange serves as the counter-
    party
 Prepayment risk
   Assets (e.g. loans) prepaid sooner than
    their designated maturity
   Leaves hedger without an offsetting spot
    position in a speculative position
Risk of Trading Futures
Contracts
 Operational risk
   Inadequate management or controls
   For example, hedging firm’s employees
    do not understand how futures contract
    values respond to market conditions
   Lack of controls may result in speculative
    positions
Regulation in the Futures
Markets
 More awareness about systemic risk
  given recent events in the markets
 Problems at one firm can affect other
  firm’s ability to honor contractual
  agreements
 Regulators want participants to have
  sufficient collateral to back their
  positions
 Accounting regulators goal is
  disclosure so risks are clear
Institutional Use of Futures
Markets
 Most activity is for hedging, not
  speculating
 Many kinds of institutions uses futures
     Commercial banks
     Savings institutions
     Securities firms
     Mutual funds
     Pension funds
     Insurance companies
CH 14


  Options
  Markets
Chapter Objectives
 Explain how stock options are used to
  speculate
 Explain why stock option premiums
  vary
 Explain how options are used by
  financial institutions to hedge their
  security portfolios
Stock Options

 An option contract grants the buyer,
  who has paid a premium to the seller
  (writer), the right to buy or sell the
  underlying asset at a stated price
  within a specific period of time
 The premium paid to the writer is the
  cost of the option
 Buyer has the “option,” but not the
  obligation, to exercise the option
                                       337
Background on Options
 A call option buyer has right but not
  the obligation to buy the underlying
  asset at a set exercise or “strike”
  price for a specified period of time
 A put option buyer has the right but
  not the obligation to sell the
  underlying asset at a set “strike”
  price for a specified period of time
 Note components of an option:
  specific quantity of asset, price, and
Background on Options
 Premium is the price the buyer of the
  put or call pays to buy an option
  contract
 Seller or writer of the option contract
   Receives the premium up front
   Has an ongoing obligation to sell (call) or
    buy (put) if the buyer decides to exercise
    the option contract
 Current market price of the
  underlying asset or financial
  instrument is called the spot price
Background on Options
 Call options
   “In-the-money” means the call option’s
    strike or exercise price is lower than the
    market price for the underlying financial
    instrument
     The holder of the call can buy the stock at a
      price below the current market price
     The call premium (price) of the option
      would also be higher by the “in-the-money”
   At-the-money means the strike price
    equals the market price of the underlying
    asset
Background on Options
 Put option
   In-the-money means the put option’s
    strike or exercise price is higher than the
    market price for the underlying financial
    instrument
   Put options give the investor an
    opportunity to make money from falling
    prices
   Investor has locked in a sale price,
    making the price of the option (premium)
    higher as the stock price decreases
   At-the-money means the strike price
    equals the market price of the underlying
Background on Options
 Expiration is the date when the contract
  matures
 American-style options contracts can be
  exercised any time up until they expire
 European-style options can only be
  exercised just before their expiration
 Option contracts guaranteed by a
  clearinghouse to make sure sellers or
  writers fulfill their obligations
 Stock options specify 100 shares of
  stock
Stock Option Quotations
 Options quotations available in the
  financial press and on the Internet
   Typically more than one option contract
    for a company’s stock
   Many contracts trade for the same stock
    but with different strike prices and
    expiration dates
   Quotes indicate the volume, premium,
    strike price and maturity
Exhibit 14.1 McDonald’s Stock
Option Quotations


              S t r i ke   Exp.   Vol .   Ca l l   Vol .   P ut

 McDonald’s     45         Jun    180     4½        60     2¾

                45         Oc t    70     5¾       1 20    3¾

                50         Jun    360     11/8      40     51/8

                50         Oc t    90     3½        40     6½
Speculating with Call Options
 BUY A CALL: Speculator thinks a stock price
  will appreciate above a particular strike
  price
 Buyer of call pays premium for the right but
  not the obligation to buy stock at the strike
  price
 If the stock price appreciates above the
  strike price the option contract is in-the-
  money and buyer of the call would exercise
  or sell the option at a price including the
  “in-the-money” and a premium
 If the stock price does not appreciate,
  buyer of the call does not exercise and
Speculating with Call Options
 If stock price rises above call’s strike
  price, buyer exercises and purchases
  shares at a price below their current
  market price
 Breakeven occurs once stock price is
  high enough above strike to cover
  premium’s cost
 Net gain or loss equals
     + Price received for selling stock (spot
     price)
Speculating with Call Options

           Breakeven = Strike + Premium

                                  Call
+                                 Buyer

0

                                    Call
-                                   Writer
           Strike Price
Speculating with Put Options
 BUY A PUT: Speculator thinks a stock price will
  depreciate below a particular strike price
 Buyer of put pays premium for the right but
  not the obligation to sell stock at the strike
  price
 If the stock price depreciates below the strike
  price the option contract is in-the-money and
  buyer of the put would exercise
 If the stock price does not depreciate, buyer of
  the put does not exercise and losses are
  limited to the cost of the premium
Speculating with Put Options
 If stock price falls below strike, buyer of
  a put exercises and sells shares at a
  price above their current market price
 Breakeven occurs once stock price is low
  enough below strike to cover premium’s
  cost
 Net gain or loss equals
     +Price received for selling stock (strike
     price)
     - Amount paid for the shares (spot
     market)
Speculating with Put Options

     Breakeven = Strike - Premium


+                                   Put Seller

0


-
                                    Put Buyer


    Strike Price or At-The-Money
Determinants of Call Option
Premiums
 The greater the current market price of the
  underlying asset compared to the exercise
  price, the higher the premium for a call option
 Greater volatility of the underlying
  financial asset means higher call
  option premiums
 For a call, the longer the time to
  maturity, the higher the premium
Determinants of Put Option
Premiums
 The lower the current market price of
  the underlying asset compared to the
  exercise price, the higher the
  premium for a put option
 Volatility and maturity issues the
  same as for call options
Exhibit 14.11 Stock Option
Premium Changes Over Time
    International     U.S.        U.S.             U.S.                                        Issuer’s
     Economic        Fiscal     Monetary         Economic                                      Industry
     Conditions      Policy      Policy          Conditions                                   Conditions




                                                   Stock
                                                  Market
                                                 Conditions

                       U.S.
                    Risk-Free
                     Interest
                       Rate                      Market Risk                Issuer’s
                                                  Premium                     Risk
                                                                            Premium




                                                                             Expected
                                                  Required
                                                                            Cash Flows
                                                 Return on
                                                                            Generated
                                                 the Stock
                                                                            by the Firm
                                                                           for Investors



                                Option’s                         Price
                                Exercise                       of Firm’s
                                 Price                           Stock



                                           Stock Price                  Option’s             Expected
                                           Relative to                   T ime              Volatility of
                                            Option’s                     until             Stock Prices
                                            Exercise                   Expiration             over the
                                              Price                                        Period Prior
                                                                                             to Option
                                                                                            Expiration



                                                                     Stock Option’s
                                                                        Premium
CH 15


  Foreign Exchange
  Derivative
  Market
Chapter Objectives
 Explain how various factors affect
  exchange rates
 Describe how foreign exchange risk
  can be hedged with foreign exchange
  derivatives
 Describe how to use foreign exchange
  derivatives to capitalize (speculate)
  on expected exchange rate
  movements
Background On Foreign
Exchange Markets
 Exchanging currencies is needed
  when:
   Trade (real) prompts need for forex
   Capital flows (financial) prompts need for
    forex
 Foreign exchange trading
   Via global telecommunications network
    between mostly large banks
   Bid/ask spread
                                            356
Foreign Exchange Rates

 Quoted two ways:
   Foreign currency per U.S. dollar
   Dollar cost of unit of foreign exchange
 Appreciation/depreciation of currency
   Appreciation = more forex to buy $
   Purchase more forex with $
   Depreciation = foreign goods cost more
    $
   Total return to foreign investor
    decreases                             357
Background on Foreign
Exchange Markets
 Exchange rate quotations are
  available in the financial press and on
  the Internet with spot exchange rate
  quotes for immediate delivery
 Forward exchange rate is for delivery
  at some specified future point in time
 Forward premium is the percent
  annualized appreciation of a currency
 Forward discount is the percent
  annualized depreciation of a currency
Background on Foreign
Exchange Markets
 Exchange rates involve different kinds
  of quotes for comparing the value of
  the U.S. dollar to various foreign
  currencies
   1 unit of foreign currency worth some
    amount of U.S. dollars—e.g. $.70 U.S.
    per Canadian Dollar
   1 U.S. dollar’s value in terms of some
    amount of foreign currency– e.g.
    CD$1.43 per U.S. dollar
   Note reciprocal relationship
Background on Foreign
Exchange Markets
 Cross-exchange rates are foreign
  exchange rates of two currencies
  relative to a currency.
 Value of one unit of currency A in
  units of currency B = value of
  currency A in $ divided by value of
  currency B in $
 British Pound = $1.4555; Euro =
  $.8983
 Value of Pound in Euros =
  $1.4555/$.8983 or…
Background on Foreign
Exchange Markets
 Currency terminology
   Appreciation means a currency’s value
    increases relative to another currency
   Depreciation means a currency’s value
    decreases relative to another currency
 Supply and demand influences the
  values of currencies
 Many factors can simultaneously
  affect supply and demand
Background on Foreign
Exchange Markets

   Background on Foreign Exchange Markets

 1944–1971 known as the Bretton
  Woods Era
   Government maintained exchange rates
    within a 1% range
   Required government intervention and
    control
 By 1971 the U.S. dollar was clearly
Background on Foreign
Exchange Markets
 Smithsonian Agreement (1971)
  among major countries allowed dollar
  devaluation and widened boundaries
  around set values for each currency
 No formal agreements since 1973 to
  fix exchange rates for major
  currencies
   Freely floating exchange rates involve
    values set by the market without
    government intervention
   Dirty float involves some government
Classification of Exchange Rate
Arrangement
 There is a wide variation in how
  countries approach managing or
  influencing their currency’s value
   Float with periodic intervention
   Pegged to the dollar or some kind of
    composite
   Some countries have both controlled and
    floating rates
   Some arrangements are temporary and
    others more permanent
Factors Affecting Exchange
Rates: Real Sector
 Differential country inflation rates
  affect the exchange rate for euros
  and dollars if inflation is suddenly
  higher in Europe
 Theory of Purchasing Power Parity
  suggests the exchange rate will
  change to reflect the inflation
  differential—influence from real sector
  of economy
 Currency of the higher inflation
  country (euro) depreciates compared
  to the lower inflation country ($)
Factors Affecting Exchange
Rates: Financial Sector
 Differential interest rates affect
  exchange rates by influencing capital
  flows between countries
 For example, the interest rates are
  suddenly higher in the United States
  than in Europe
 Investors want to buy dollar-
  denominated securities and sell
  European securities
 Euros are sold, dollars bought to buy
  U.S. securities
Factors Affecting Exchange
Rates
 Direct intervention occurs when a
  country’s central bank buys/sells
  currency reserves
 For example, the U.S. central bank,
  the Federal Reserve sells one
  currency and buys another
   Sale by central bank creates excess
    supply and that currency’s value drops
    relative to the one purchased
   Market forces of supply and demand can
    overwhelm the intervention
Factors Affecting Exchange
Rates
 Indirect intervention involves
  influencing the factors that affect
  exchange rates rather than central
  bank purchases or sales of currencies
 Interest rates, money supply and
  inflationary expectations affect
  exchange rates
 Historical perspective on indirect
  intervention
   Peso crisis in 1994
Factors Affecting Exchange
Rates
 Some countries use foreign exchange
  controls as a form of indirect
  intervention to maintain their
  exchange rates
 Place restrictions on the exchange of
  currency
 May change based on market
  pressures on the currency
 Venezuela in mid-1990s illustrates
  the issues involved in controlling
Movements in Exchange Rates
 Foreign exchange rate changes can
  have an important effect on the
  performance of multinational firms
  and economic conditions
 Many market participants forecast
  rates
   Market participants take positions in
    derivatives based on their expectations
    of future rates
   Speculators attempt to anticipate the
    direction of exchange rates
Forecasting Exchange Rates:
Technical
 Technical forecasting is a technique
  that uses historical exchange rate
  data to predict the future
 Uses statistics and develops rules
  about the price patterns—depends on
  orderly cycles
 If price movements are random, this
  method won’t work
 Models may work well some of the
  time and not work other times
Forecasting Exchange Rates:
Fundamental
 Fundamental forecasting is based on
  fundamental relationships between
  economic variables and exchange
  rates
 May be statistical and based on
  quantitative models or be based on
  subjective judgement
 Regression used to forecast if values
  of influential factors have a lagged
  impact
 Not all factors are known and some
Forecasting Exchange Rates:
Fundamental
 Limitation of fundamental forecasting
  methods:
   Some factors that are important to
    determining exchange rates are not
    easily quantifiable
   Random events can and do affect
    exchange rates
   Predictor models may not account for
    these unexpected events
Forecasting Exchange Rates:
Market-Based
 Market-based forecasting uses
  market indicators like the spot and
  forward rates to develop a forecast
 Spot rate: recognizes the current
  value of the spot rate as based on
  expectations of currency’s value in
  the near future
 Forward rate: used as the best
  estimate of the future spot rate based
  on the expectations of market
Forecasting Exchange Rates:
Mixed
 Mixed forecasting is used because no
  one method has been found superior
  to another
 Multinational corporations use a
  combination of methods
 Assign a weight to each technique
  and the forecast is a weighted
  average
 Perhaps a weighted combination of
  technical, fundamental, and market-
Forecasting Exchange Rate
Volatility
 Market participants forecast not only
  exchange rates but also volatility
 Volatility forecast
   Recognizes how difficult it is to forecast
    the actual rate
   Provides a range around the forecast
Forecasting Exchange Rate
Volatility

    Methods Used To Forecast Volatility

 Volatility of historical data
 Use a times series of volatility
  patterns in previous periods
 Derive the exchange rate’s implied
  standard deviation from the currency
  option pricing model
Major Factors Affecting Forex

 Differential inflation rates between
  countries
 Differential interest rates between
  countries
 Governmental Intervention




                                         378
Forecasting Foreign Exchange
Rates
   Technical forecasting
   Fundamental forecasting
   Market-based forecasting
   Mixed forecasting




                               379
CH 16


  Mutual Fund
  Operations
Chapter Objectives
 Explain the concept of mutual fund
  operation
 Explain various types of mutual funds
 Describe the various types of stock
  and bond mutual funds
 Describe the characteristics of money
  market funds
Background on Mutual Funds
 Mutual funds offer a way for small investors to
  diversify when they could not do so on their
  own with the purchases of individual stocks
 Comparison to depository institutions
   Like depository institutions, mutual funds
     repackage proceeds from individuals to
     make investments
   Bank deposits are a liability contract, but a
     mutual fund represents partial ownership
   No federal insurance with mutual fund
     shares
Background on Mutual Funds
 Mutual funds adhere to a variety of
  federal and state regulations
   Securities and Exchange Commission (SEC)
    regulates
   Funds must register and provide a
    prospectus to investors
   Disclosure since 1993 of manager’s name
    and length of time employed in that position
 Mutual fund itself is exempt from
  income taxation if fund distributes 90
  percent of taxable income
Mutual fund prospectus information
  The minimum amount of investment
   required
  The investment objective of the fund
  The return on the fund over the past year,
   the past three years and the the past five
   years
  The exposure of the fund to various types of
   risk
  Services the fund offers
  Management fees incurred that investors
   pay
Background on Mutual Funds
 Estimating the net asset value
   Net asset value is the value per share
   Estimated daily
     Determine the market value of all the
      securities in the fund
     Any interest or dividends added in
     Expenses subtracted
     Divide by the number of shares
     Dividends lower NAV
     NAV quotes
Mutual Fund Distributions


    Earned Income from Dividends or Coupon Payments



     Capital Gains from the Sale of Securities in Fund



             Mutual Fund Price Appreciation
Background on Mutual Funds
 Mutual fund classifications depend on
  the type of securities the fund invests
  in and can include
   Stock or equity mutual funds
   Bond mutual funds
   Money market mutual funds
 Family of funds offered by investment
  companies
   Investor able to allocate then transfer
    funds among funds
Exhibit 24.2 Distribution of
Investment in Mutual Funds


                   M oney
                Market Funds
                $1,845 billion
                    27%
                                 Stock Funds
                                 $3,962 billion
                                     5 7%
Hybrid Funds
 $349 billion
     5%         Bond Funds
                $808 billion
                   11%
Background on Mutual Funds
 Management of mutual funds
   Managers invest in a portfolio of
    securities to meet the objectives of the
    fund
   Cover management costs with fees which
    are typically around one percent of total
    assets per year
   Managers adjust the composition of their
    portfolios in response to market and
    economic conditions
Background on Mutual Funds
 Expenses
   Fees include management plus record-
    keeping and clerical fees
   Expense ratio = annual expenses/fund
    NAV
   Passed on to investors since NAV is
    reduced by fees
   Investor should compare expense ratios
 Active marketing expenses and
  compensation increases expenses—
  12b-1 expenses
Background on Mutual Funds
 Corporate control by mutual funds
   Mutual funds are large shareholders in
    companies whose stock they hold
   Managers may serve on the board of
    directors of companies in which the fund
    invests
   Companies try to satisfy mutual fund
    managers in order to keep them from
    selling their stake in the firm
Load versus No-Load Mutual
Funds
 Classification refers to whether or not
  there is a sales charge
 No-load means funds are promoted,
  bought and sold directly via the
  mutual fund
 Load funds
Open-End versus Closed-End
Funds
 Closed-end funds
   Mutual fund does not repurchase the shares they
    sell—similar to direct common stock investment
   Investors must sell shares on an exchange
   Number of outstanding shares is constant
   Value of shares related to expectations of portfolio
    and determined in market
 Open-end “mutual” funds
   Willing to repurchase investor shares at any time
   Number of shares outstanding does not remain
    constant
   NAV determined by fund daily
Stock Mutual Fund Categories
 Growth funds for investors who want
  high returns with moderate risk
   Mutual fund invests in companies that are expected
    to grow at a higher than average rate
   Generate an increase in investment value rather than
    steady income

 Capital appreciation or aggressive
  growth funds
   High but unproven growth potential stocks
   Higher risk
Stock Mutual Fund Categories
 Growth and income funds try to offer growth
  but with some stability of income
 International and global funds allow investment
  in foreign securities without the costs involved
  in purchasing and monitoring individual stocks
    Returns affected by stock prices
    Returns also affected by foreign exchange rates
 A global mutual fund invests in some U.S.
  stocks
Stock Mutual Fund Categories
 Internet funds focus on investments in
  Internet companies
 Specialty funds focus on a group of
  companies sharing a particular
  characteristic
 Index funds are designed to simply
  match the performance of an existing
  stock index
 Multifund funds invest in a portfolio of
  different mutual funds
Exhibit 24.3 Growth in Number
of Equity and Bond Funds
    8000


                  Bond Funds
    7000



    6000          Stock Funds


    5000



    4000



    3000



    2000



    1000




     0
           1978   1985          1990          1995   1999   2001
                                       Year
Exhibit 24.4 Investment in
Bond and Stock Mutual Funds
     5000


                                     Bond Funds



     4000                            Stock Funds




     3000




     2000




     1000




       0
            1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000
                                                   Year
Exhibit 24.5 Distribution of
Aggregate Mutual Fund Assets
                                        Municipal Bond
                                         $269 Billion
                   Long-Term U.S. Gov’t
                         $309 Billion        5%
                            6%
                Cash
             $277 Billion
                 5%

    Corporate Bonds
      $349 Billion
          7%

  Preferred Stock
    $28 Billion
        1%
                                                    Common Stock
                                                     $3,882 Billion
                                                         76%
Bond Fund Investment
Objectives
 Risks of bond funds
    Interest rate risk
    Credit risk
 Tax implications of bond fund investments
 Income bond funds vary in terms their
  exposure to credit risk and focus on periodic
  coupon payments and attract investors who
  are
    Interested in periodic income since prices are volatile
    Plan to hold the fund long term
Bond Fund Investment
Objectives
 Tax-free funds for high tax bracket
  investors
 High-yield or junk bond funds invest
  in bonds with a high risk of default
 International and global bond funds
   International bond funds contain bonds issued by
    governments or corporations from other countries
   Global funds may contain both U.S. and foreign
    bonds
Bond Fund Investment
Objectives
 Maturity classifications
   Interest rate sensitivity depends on the
    maturity of bonds
   Funds are typically segmented based on
    maturity
     Intermediate-term funds invest in bonds
      with 5 to 10 years remaining to maturity
     Long-term funds invest in maturities of 15
      to 30 years
Bond Fund Investment
Objectives
 Asset allocation funds
   Funds that contain a variety of
    investments
   Composition among stocks, bonds and
    money market securities is based on
    manager’s expectations
Growth and Size of Mutual
Funds
 Volume and mix in the kind of funds
  varies over time
 Overall investment via mutual funds
  much higher in recent years
 New kinds of funds target customers
  with different risk preferences
Performance of Stock Mutual
Funds
 Both investors and managers closely
  monitor performance as modeled by the
  equation below
 PERF= f ( MKT,  SECTOR,  MANAB)
Where:
 PERF = Performance
 MKT = General stock market conditions
 SECTOR = Conditions in the fund’s sector
 MANAB = The ability of the fund’s management
Performance of Stock Mutual
Funds
 Change in market conditions
   Close relationship between performance
    and market conditions
 Change in sector conditions
   Depends on the focus of the fund
     Index funds
     Asian funds
 Change in management ability includes both
  managers’ skills and operating efficiency
Performance of Stock Mutual
Funds
 Performance of closed-end stock
  funds
   Driven by the same factors that
    influence open-ended funds
   Fixed supply of the fund’s shares
   Additional issues
     Performance is affected by changes in the
      premium or discount relative to NAV
     If the fund’s premium increases relative to
      NAV, return to fund holders increases
Performance of Bond Mutual
Funds
 Performance of bond mutual funds as
  shown in the model below
 PERF= f ( Rf,  RP,  CLASS,  MANAB)
Where:
 PERF = Performance
 Rf = Risk free interest rates
 RP =Risk premium
 CLASS =the classification of the bond fund
 MANAB = The ability of the bond fund’s management
Performance of Bond Mutual
Funds
 Change in the risk free rate
   Bond prices are inversely related to the
    risk- free rate
   When rates decline, most bond funds
    perform well
 Change in the risk premium
   If required risk premiums increase, bond
    prices fall
   Linked to economic condition:
     Risk premiums increase in recessions
     Risk premiums decrease in boom times as
      investors buy riskier investments
Performance of Bond Mutual
Funds
 Impact of the bond fund’s
  classification
   Some funds target a specific risk or
    maturity
   Classification may have more impact
    than any other factor
 Change in management abilities
 Performance of closed-end bond
  funds is affected by all of the other
  factors and changes in the premium
  or discount
Performance of Mutual Funds
 Investors should diversify among
  different kinds of funds to reduce
  volatility
 Research on stock mutual fund
  performance
   Using return only is not valid
   Mutual funds typically do not outperform
    the market
   Evaluate mutual fund expenses
 Research on bond mutual funds
   Bond mutual funds underperform bond
    indexes
Money Market Funds
 Money market funds are portfolios of
  short-term assets
   Can include check-writing privileges for
    investors
   Number of checks per month may be
    restricted
   Shareholders get periodic statements
   Liquid, “cash” balance for investor
Money Market Funds
 Asset composition of money market
  funds
   Individual funds concentrate in assets
    that reflect the fund’s objective
   Money market securities of varying
    maturity
 Maturity of money market funds
   Varies over time with market conditons
   Risk increases with term
Exhibit 24.7 Composition of
Money Market Fund Assets

                                 Other
                               $303 billion
                                  20%

   U.S. Treasury
     Securities
    $91 billion                                       Commercial Paper
        6%                                              $620 billion
                                                           41%
                   Other U.S. Securities
                       $189 billion
                           13%


                                   Repurchase
                                   Agreements        CDs
                                   $186 billion   $123 billion
                                      12%            8%
Money Market Funds
 Risk of money market funds
   Credit risk minimized by the short-term
    nature of maturities
   Returns for money market funds fall as
    interest rates in the economy fall
   Expected returns are low relative to
    stock and bond funds
     Consistent positive returns over time
     Lower credit risk
     Lower interest rate risk
Money Market Funds
 Management of money market funds
   Managers try to maintain the overall
    objective of the fund
   Manage the composition of the assets
   Investors have a variety of choices when
    it comes to money market funds
Money Market Funds
 Regulation of money market funds
   Securities Act of 1933 requires that
    funds provide full information to
    investors via a prospectus
   Investment Company Act of 1940
    contains restrictions to prevent conflicts
    of interest between investors and
    mangers
 Funds are exempt from tax if 90% of
  earnings are distributed to
  shareholders
Hedge Funds
 Financial problems experienced by
  Long-Term Capital Management
  (LTCM)
   Hedge funds sell shares to wealthy
    investors and financial institutions
   Historically unregulated
   Invest in derivatives, sell stock short,
    and combine borrowing to magnify
    returns
 LTCM experienced problems when
  risky investments lost money
Real Estate Investment Trusts
 A real estate investment trust or REIT
  is a closed-end mutual fund that
  invests in real estate or mortgages
 Classifications
   Equity REIT
   Mortgage REIT
   Hybrid of the two
 Sometimes seen as an inflation hedge
 Performance influenced by interest
  rates and area real estate
  performance
Other Issues
 Mutual funds interact with banks,
  savings institutions, finance
  companies, securities firms, insurance
  companies, and pension funds
 Mutual funds typically use all the
  various financial markets including
  money, bond, mortgage, stock,
  futures, options, and swap markets
 Globalization is facilitated by mutual
  funds
   Reduces transactions costs
CH 17


  Securities Operations
Chapter Objectives
 Review and evaluate the key functions of
  investment banking firms
 Describe the services provided by investment
  banking firms when they assist in issuing new
  stock issues
 Analyze the risks of securities firms
 Evaluate the key functions of brokerage firms
 Evaluate the key factors impacting the value of
  securities firms
Investment Banking Services
 Investment banking firms (IBFs) assist in
  raising capital for corporations and state and
  municipal governments
 IBF’s serve both financing entities and
  investors:
   Serve as an intermediary buying securities (promise
    to pay) from issuing companies and selling them
    (securities) to investors
   Generate fees for services rather than interest
    income
   Sell investing services to institutional and other
    investors
   Advise companies on mergers and acquisitions
     Value companies for sale or purchase
Investment Banking Services



  Origination                Distribution
                Investment
                  Banking
                  Services
 Underwriting                 Advising
How IBFs Facilitate New Stock
Issues
 Origination
   Company wishes to issue additional stock or
    issue stock for the first time contacts IBF
     Gets advice on the amount to issue
     Helps determine stock price for first-time issues
   IBF assists with SEC filings
     Registration statement
     Prospectus—summary of registration statement
      given to prospective investors
How IBFs Facilitate New Stock
Issues
 Underwriting stock
   Issuer and investment bank negotiate
    the underwriting spread
     The difference between the net price given
      the company and the selling price to
      investors
     Incentive to under-price IPO’s
   The lead investment bank usually forms
    an underwriting syndicate
     Other IBFs underwrite a part of the security
      offering
     Helps spread the underwriting risk among
How IBFs Facilitate New Stock
Issues
 Distribution of stock
   Full underwriting vs. best efforts
   IBFs in the syndicate have retail
    brokerage operations
   Other IBF added as part of selling group
   Corporation incurs flotation costs
     Underwriting spread
     Direct issuance costs—accounting, legal
      fees, etc.
How IBFs Facilitate New Stock
Issues
 Advising
   The IBF acts as an advisor throughout
    the process
     Corporations do not have the in-house
      expertise
     Includes advice on:
         Timing
         Amount
         Terms
         Type of financing
How IBFs Facilitate New Bond
Issues
 Origination
   IBF may suggest a maximum amount of
    bonds that should be issued based on
    firm characteristics
   Decisions on coupon rate, maturity
     Benchmark with market prices of bonds of
      similar risk
     Credit rating
   Bond issuers must register with the SEC
     Registration Statement
     Prospectus
How IBFs Facilitate New Bond
Issues
 Underwriting bonds
   Public utilities often use competitive bids
    to select an IBF, versus…..
   Corporations typically select an IBF
    based on reputation and prior working
    experience
   The underwriting spread on bonds is
    lower than that for stocks
     Can place large blocks with institutional
      investors
     Less market risk
How IBFs Facilitate New Bond
Issues
 Distribution of bonds
   Prospectus
   Advertisements to public
   Flotation costs are typically in the range
    of 0.5 percent to 3 percent of face value
How IBFs Facilitate New Bond
Issues
 Private placement of bonds
   Avoids underwriting and SEC registration
    expenses
   Potential purchaser may buy the entire issue
       Insurance companies
        mutual funds
        commercial banks
        pension funds
   Demand may not be as strong, so price may
    be less, resulting in a higher cost for issuing
    firm
   Investment banks may be involved to
    provide advice and find potential purchasers
How IBFs Facilitate Leveraged
Buyouts
 IBFs facilitate LBOs in three ways:
   They assess the market value of the LBO
    firm
   They arrange financing
   Purchase outstanding stock held by
    public
   Often invest in the deal themselves
   Provide advice
How IBFs Facilitate Arbitrage
 Arbitrage = purchasing of undervalued
  shares and reselling the shares at a
  higher price
 IBFs work with arbitrage firms to search
  for undervalued firms
 Asset stripping
   A firm is acquired, and then its individual
    divisions are sold off
   Sum of the parts is greater than the whole
     Kohlberg, Kravis, and Roberts
How IBFs Facilitate Arbitrage
 IBFs generate fee income from
  advising arbitrage firms as well as a
  commission on the bonds issued to
  support arbitrage activity
 IBFs also provide bridge loans
   When fund raising is not expected to be
    complete when the acquisition is initiated
 IBFs provide advice on takeover
  defense maneuvers
How IBFs Facilitate Arbitrage
 History of arbitrage activity
   Greenmail is when a target company buys
    back stock from arbitrage firm at a premium
    over market price
   Arbitrage activity has been criticized
     Results in excessive financial leverage and risk
      for corporations
     Restructuring sometimes results in layoffs
   Arbitrage helps remove managerial
    inefficiencies
   Target shareholders can benefit from higher
    share prices
Brokerage Services
 Market orders
   Requests by customers to buy or sell at
    the prevailing market price
   Executed quickly, usually within minutes
 Limit orders
   Requests by customers to buy or sell
    securities at a specified price or better
     Day orders
     Good-till-cancelled orders
Brokerage Services
 Short selling—gain from falling prices
   Investor sells shares they do not own
   Investor borrows the shares from their
    broker (who borrows the shares from other
    accounts)
   Later, the investor buys the stock and repays
    the shares to the broker
     If the price has fallen the investor earns a profit
     Investor still seeks to buy low and sell high, but
      the order is reversed
Brokerage Services
 Full-service versus discount
  brokerage services
   Full-service firms provide investment
    advice as well as executing transactions
   Discount brokerage firms only execute
    security transactions upon request
   Online brokerage firms
Allocation of Revenue Sources
 Importance of brokerage
  commissions has declined in recent
  years
 Largest source of revenue has been
  trading and investment profits
 Underwriting and margin interest also
  make up a significant portion of
  revenue
 Revenue from fees earned on
  advising and executing acquisitions
Regulation of Securities Firms
 Regulated by the National Association
  of Securities Dealers (NASD) and
  securities exchanges
 The SEC regulates the issuance of
  securities and specifies disclosure
  rules for issuers
   Also regulates exchanges and brokerage
    firms
 SEC establishes general guidelines,
  while the NASD provides day-to-day
Regulation of Securities Firms
 The Federal Reserve determines the
  credit limits (margin requirements) on
  securities purchased
 The Securities Investor Protection
  Corporation (SIPC) offers insurance on
  brokerage accounts
   Insured up to $500,000
   Brokers pay premiums to SIPC to maintain
    the fund
   Boosts investor confidence, increasing
    economic efficiency
Regulation of Securities Firms
 Financial Services Modernization Act
  of 1999
   Permitted banking, securities activities,
    and insurance to be offered by a single
    firm
   Varied financial services organized as
    subsidiaries under special holding
    company
   Financial holding companies regulated by
    the Federal Reserve
Risks of Securities Firms

      Market Risk      Interest Rate
                            Risk




                      Exchange Rate
        Credit Risk
                           Risk
Risks of Securities Firms
 Market risk
   Securities firms’ activities are linked to
    stock market conditions
   When stock prices are rising:
       Greater volume of stock offerings
       Increased secondary market transactions
       More mutual fund activity
       Securities firms take equity positions which
        are bolstered when prices rise
Risks of Securities Firms
 Interest rate risk
   Performance of securities firms can be
    sensitive to interest rate movements
    because:
     Market values of bonds held as investments
      increase as interest rates fall
     Lower rates can encourage investors to
      withdraw money from banks and invest in
      stocks
 Exchange rate risk
   Operations in foreign countries
   Investments in securities denominated in
    foreign currency
Valuation of Securities Firms
 Value of a securities firm depends on
  its expected cash flows and required
  rate of return
                     V = f [E(CF),k]
Where:

V = Change in value of the securities firm
E(CF) = Change in expected cash flows
k = Change in required rate or return
Valuation of Securities Firms
 Factors that affect cash flows
E(CF)= f (ECON, Rf , INDUS, MANAB)
             +             ?       +
Where:
 E(CF) = Expected cash flow
 ECON = Economic growth
 Rf = Risk free interest rate
 INDUS = Prevailing industry conditions
 MANAB = The ability of the security firm’s management
Valuation of Securities Firms
 Investors required rate of return
k = f(Rf , RP)
        +     +

Where:

 Rf = Risk free interest rate

 RP = Risk premium
Interaction With Other Financial
Institutions
 Offer investment advice and execute security
  transactions for financial institutions that maintain
  security portfolios
 Compete against financial institutions that have
  brokerage subsidiaries
 Glass-Steagall Act of 1933 separated the functions
  of commercial banks and investment banking firms
 Financial Services Modernization Act of 1999
   Effectively repealed Glass-Steagall
   Commercial banks, securities firms, and insurance
     companies will increasingly offer similar services
Globalization of Securities Firms
 Securities firms have increased their
  presence in foreign countries
   Merrill Lynch has more than 500 offices
    spread across the world
     Allows them to place securities in various
      markets for corporations or governments
     International M&A
     Ability to handle transactions with foreign
      securities
Globalization of Securities Firms
 Growth in international securities
  transactions
   Created more business for large securities
    firms
     International stock offerings
     Increased liquidity for issuing firm, avoiding
      downward price pressure
   Growth in Latin America
     Increased business due to NAFTA
   Growth in Japan
     Some barriers to foreign securities firms still
      exist
CH 18


  Insurance Operations
Chapter Objectives
 Present the two major areas of insurance: 1)
  life and health and 2) property and casualty
 Describe the different types of insurance
  policies and their sources of funds
 Describe the main uses of insurance company
  funds
 Explain the exposure of insurance companies
  to various forms of risk
 Describe the regulatory environment of
  insurance companies
Insurance Companies

 Provide contractual risk management
  for:
   Risks of insurable asset losses (auto
    insurance)
   Risks of liability claims (product liability)
   Risk of large medical costs (health
    insurance)
   Risk of disability (disability insurance)
   Risk of premature death (life insurance)
   Risk of longevity (annuities)
Insurance Companies, cont.

 Major capital market intermediary
   Major investor in corporate (life) and
    state and municipal bonds
    (property/casualty)
   Major long-term commercial mortgage
    lender (life)
 Mutual or stock form of ownership
 Premium and investment revenue
 Losses and loss adjustment expenses
Insurance Concepts
 Pure vs. financial risk
 Insure fortuitous, independent risk
  occurrence
 Premium covers losses,
  administrative expenses and profits
 Insured contracts for known loss
  (premium) in return for protection
 Moral hazard and adverse selection
Background
 Life insurance companies
 Provide risk management contracts for
  individuals and businesses
   Risk areas include premature death, health
    maintenance costs, and disability
   Life insurance provides cash benefits to the
    beneficiary of a policy on the policyholder’s death
   Life insurance premiums reflect
   Have portfolios of policies and use mortality figures
    and actuarial tables to forecast claims
Types of Life Insurance Policies
   Cash Value Insurance   Term Insurance
           Group
       Universal Life          Group

        Variable Life

                               Term
          Whole Life
Types of Life Insurance Policies
 Whole life insurance includes both a
  death benefit (term insurance) and a
  savings component that
   Builds a tax sheltered cash value amount
    for the future for the owner of the policy
   Generates periodic cash flow payments
    over the life of the policy for the
    insurance company to reinvest
   Pays fixed death benefit at death
Types of Life Insurance Policies
 Term life insurance characteristics
   Temporary, providing death benefits only
    over a specified term
   Premiums paid represent insurance only
    with no saving component
   Considerably lower cost for the insured than
    whole life—able to buy more insurance
    protection for any amount of premium
   Term is for those who would rather invest
    their savings in other contracts or securities
Types of Life Insurance Policies
 Variable life insurance
   Whole life with variable cash value amounts
   Cash values invested in equities and will vary with
    the investment performance
   Flexible premium option since 1984
 Universal life insurance
   Combines the features of term and whole life
   Variable premiums over time—buys terms and
    invests difference in a variety of investments
   Builds a varying cash value based on contributions
    and investment performance
Types of Life Insurance Policies
 Group plans
   Employees of a corporation offered life
    insurance or life insurance purchased on
    life of employee
   Cash value or term insurance
   Low cost (term) because of its high
    volume
   Can cover group members and
    dependents
Health Care Insurance
 Health maintenance organizations or
  HMOs
   Intermediaries between purchasers and
    providers of health care
   Annual fee or premium
     Covers all medical expenses
     Medical staff is designated by the HMO
   Losses in recent years for HMOs
Sources of Life Insurance
Company Funds
 Cash value reserves—accumulated cash values
  owed insureds (liability)
 Pension reserves—accumulated “insured”
  pension commitments (liability)
 Annuity reserves—accumulated annuity
  commitments (liability)
 Unearned premium income—premiums
  received; not yet earned (liability)
 Loss reserves--losses incurred, not yet paid
 Capital funds
Uses of Life Insurance
Company Funds
   Major investor in corporate bonds
   Government securities
   Common stock
   Commercial mortgage
   Real Estate
   Policy loans to insured
Uses of Funds—Policy Loans
 Policy loans are loans to policyholders
   Whole life policies
   Borrow up to the cash value of the policy
   Guaranteed interest rate is stated in the
    policy
   Usually used by borrowers during periods
    of rising rates to lock in the lower rate
    associated with their policy
Insurance Company Capital
 Capital
   Build capital by issuing new stock (stock companies)
    or retaining earnings
   Used to finance investments in fixed assets
   Cushion against operating losses
   Capital requirements vary depending on asset risk
   Credibility with customers is also enhanced by
    adequate capital
   Mutual companies owned by policyholders—includes
    earnings retained over time
Regulation
 Insurance companies are highly regulated by
  state insurance agencies
 The National Association of Insurance
  Commissioners (NAIC)
   Provides coordination among states in regulatory
    matters
   Adopted uniform regulatory reporting standards
 State Regulators
   Make sure insurance companies provide adequate
    service
   States approve/review rates
   Agent licensure
   Forms are approved to avoid misleading wording
Regulation
 Insurance Regulatory Information
  System
   Compiles financial information and lists
    of insurers
   Calculates 11 ratios to assess and
    monitor financial health
 Assessment system
   Ability of the company to absorb either
    losses or a decline in the market value of
    its investments
   Return on investment
   Relative size of operating expenses
Regulation
 Regulation of capital
   In 1994 companies were required to
    report risk-based capital ratios to
    insurance regulators
   Goals of requirements are to
     Discourage insurance companies from
      excessive exposure
     Back higher risks with higher capital
     Reduce failures in the industry
Risks of Life Insurance
Companies


                            Financial Risk
     Pure Risk of Life
                               includes
    Insurance Policies
                          Interest Rate Risk
         Pension
                             Credit Risk
    Commitments and
                             Market Risk
    Annuities Contracts
                            Liquidity Risk
Exposure to Financial Risks
 Interest rate risk
   Fixed rate assets in company portfolios
    have market values sensitive to interest
    rate changes
   Firm measures and manages risks
 Credit risk
   Mortgages, corporate bonds and real
    estate holdings can involve default
   Investment-grade securities
   Diversify portfolio among debt issuers
Exposure to Financial Risks
 Market risk
   Exists because events like significant
    market value decreases reduce capital
   Economic downturn affects real estate
    investments
Exposure to Financial Risks
 Liquidity risk occurs because a high
  frequency of claims may require the
  life company to liquidate assets
   Life insurance companies have high cash
    flow from premiums to offset normal
    cash needs
   In case of large disaster (9/11) may be
    forced to sell assets to generate cash
    even if market value is low
   Companies try to balance the age
    distribution of their customer base
   As interest rates rise, voluntary
    terminations of policies occur
Asset Management
 Performance is significantly affected
  by the performance of the assets
   Companies get premiums for several
    years before paying out benefits
   Companies try to manage the risk of
    losses with offsetting investment gains
    or diversity of assets they hold
   Diversify into other businesses to offer a
    wide variety of financial products
Property and Casualty
Insurance
 Property insurance (fire insurance)
 Casualty insurance (liability)
 Performance and financial bonding
PC Versus Life Insurance
Companies
 PC have shorter contracts
 PC have more varied risk areas
 Life companies larger due to long-
  term savings and pension contracts
 PC has wider distribution of
  Occurrences
   PC’s need liquid, marketable assets
   PC’s earnings more volatile
Property Casualty Investment
Needs
 Tax sheltering--major municipal/state
  bond investor
 Liquid, marketable assets
   Marketable corporate and government
    bonds
   Listed common stock
 Inflation hedge--common stock
 Reinsurance contracts--manage pure
  risks
Valuation of an Insurance
Company
 Value of an insurance company
  depends on its expected cash flows
  and required
 V = f [E(CF), k] rate of return
           +
Where:

 V = Change in value of the insurance company
 E(CF) = Change in expected cash flows
 k = Change in required rate or return
Valuation of an Insurance
Company
 Factors that affect cash flows
 E(CF)= f (ECON, Rf , INDUS, MANAB)
               +              ?         +
Where:
 E(CF) = Expected cash flow
 ECON = Economic growth
 Rf = Risk free interest rate
 INDUS = Prevailing industry conditions for the company
 MANAB = Management ability of company
Valuation of an Insurance
Company
 Investors required rate of return
 k = f(Rf , RP)
        +       +

Where:
 Rf = Risk free interest rate

 RP = Risk premium
Performance Evaluation
 Common indicators of company
  performance are available
   Statistical analysis of performance
   Ratio analysis
     Trends over time
     Compare to industry average
Performance Evaluation
 The higher the liquidity ratio, the more
  liquid the company


                      Invested Assets
Liquidity   =
                      Loss Reserves and
 Ratio
                 Unearned Premium Reserves
Performance Evaluation
 Return on net worth or policyholders’
  surplus is a profitability measure


                          Net Profits
Return on Equity =
                     Policyholders’ Surplus
Performance Evaluation
 Underwriting gains and losses or
  underwriting profitability measured by the
  net underwriting margin
    Profits include investment income, underwriting
     profits and realized capital gains
    Ratios can be calculated to focus on various
     sources of profits


Net Underwriting       Premium Income - Policy Expenses
                   =
    Margin                     Total Assets
Other Issues
 Insurance companies interact in a
  variety of ways with other financial
  institutions
 Insurance companies participate in a
  full range of financial markets
 Multinational insurance companies
   Insurance companies operate in many
    countries
   Some countries lack developed markets
    for insurance
CH 19


  Pension Fund
  Operations
Chapter Objectives
 Describe the different types of private
  pension funds and the terminology of
  pension funds
 Describe the pension management
  styles
 Explain how pension funds can
  become underfunded and overfunded
 Describe the role of the Pension
  Benefit Guaranty Corporation in
  enhancing the safety of pension plans
Pension Fund Terminology
Summary

   Public vs.                  ERISA and
     Private                      PBGC

                Trusteed vs.
                Insured vs.
                Self-
                Directed
 Under
 Funded vs.                    Defined
 Over                          Benefit vs.
                               Contribution
Pension Fund Developments
 Pension plans are a recent
  development
 Depression and union bargaining
  after World War II
 From “pay as you go” to funded
  pensions
 From defined benefit to defined
  contribution pensions
 Pension funds have become a major
  capital market participant
Background on Pension Funds
 Public pension funds
   Social security
   State and local governments
 Many public pensions are funded on a
  pay-as-you-go system
   Pension fund is unfunded
   Current contributions support previous
    employees
   Depends on current cash flows of entity
    to support pensioners
 Many public pension plans are fully
  funded
Types of Private Pension Plans
 Defined-benefit plan
   Annual contributions are determined by
    the benefits “defined” in the plan paid at
    retirement
   If value of pension assets exceeds (over
    funded) current and future benefits owed,
    employer may
     Reduce future contributions
     Distribute surplus to shareholders
     Occurred during stock and bond boom of
      the 1990’s
Types of Private Pension Plans
 Defined-contribution plan
   Provides benefits determined by the
    accumulated contributions and the fund’s
    investment performance
   “Contributions” are designated in plan,
    not amounts available at retirement
   Firm knows with certainty the amount of
    the contribution
   Provides uncertain benefits to
    participants
Types of Private Pension Plans
            Under-funded Pension Plan
 Future pension obligations of a defined-
  benefit plan are uncertain because
  obligations are fixed payments to retirees
  and payments depend on salary level,
  retirement ages and life expectancies
   Over-optimistic projections (estimated rates of
    return) can mean inadequate cash to cover
    obligations
   High risk investments might be used to generate
    higher returns with varied results
   Many companies are under funded for they were
    “pay-as-you-go” for many years before funding
Types of Private Pension Plans
            Over-funded Pension Plan
 When investment returns for defined-
  benefit plans perform better than expected,
  there are funds in excess of the amount
  needed to meet obligations
 A portion of the surplus can be credited to
  the income statement of a corporation
 Encourages exchange of defined benefit for
  insured pension purchase (liquidation of
  plan)
Pension Regulations
 Regulations vary depending on the
  type of plan—defined benefit more
  regulated
 Criticism of plans led to regulation
   Unfair treatment in terms of vesting or
    service requirements needed to qualify
    for a pension
   Some plans were underfunded and could
    not pay the benefits they promised
   Employees did not benefit when plans
    had excess earnings but received
Pension Regulations
 Employee Retirement Income
  Security Act of 1974 (ERISA)
     Vesting standards
     Corrected under-funded plans
     Fiduciary responsible investing
     Pension Benefit Guarantee Corporation
 Enforced by U.S. Department of Labor
 Many pension plans cancelled after
  ERISA after funding required
Pension Regulations
 The Pension Benefit Guaranty
  Corporation
   Intended to provide insurance on
    pension plans
   Federally chartered agency that
    guarantees beneficiaries of defined
    contribution plans get benefits
   Receives no government support
   Funds come from annual premiums and
    other income from active pension plans
   Monitors plans
   Takes over failed plans (bankruptcy of
Pension Regulations
 Accounting regulations
   Allow companies to more quickly
    recognize gains and losses
   May increase the volatility of funds’
    returns
   Rules may affect portfolio composition
   Underfunded plans shown as a liability
    on the balance sheet
   Volatility of returns also depends on the
    composition of the portfolio
Pension Fund Management
 Management of “insured” portfolios
   Some plans are managed by life
    insurance companies
   Insured plans purchase annuity policies
    so the life insurance company can
    provide benefits to the employees upon
    retirement
   Retirement benefits are “assured” by
    credit strength of life insurance company
   No federal insurance coverage
Pension Fund Management
 Management of trusteed portfolios
   Managed by the trust department of a
    financial institution
   ERISA required that a fiduciary be
    involved in managing retirees’ funds
   Corporations specify guidelines
     Returns
     Risks
   Some companies have allocation systems
    to try and minimize risks
Pension Fund Management
 Differences between trusteed and
  insured portfolios
   Trusts offer higher returns with higher
    risk via investment in stocks
   Mortgages are more important in
    insurance company portfolios
   Both invest in bonds
 Risky investments by pension funds
  include LBOs and stock speculation
Pension Fund Management
 Management of private versus public
  pensions
   Private business vs. state, municipal
    pensions
   Private pension portfolios dominated by
    common stock
   Public pension portfolios more evenly
    invested in stock, bonds and other credit
    instruments
Pension Fund Management
 Pension funds use their large
  ownership stakes in companies to
  influence corporate policies and
  management
   Examples of government pension funds
    that are actively involved in issues of
    corporate control
     California Pension Employees Retirement
      System or CalPERS
     New York State Government Retirement
      Fund
     TIAA
Pension Fund Management
 Management of interest rate risk is
  important if portfolios hold long-term,
  fixed-rate bonds
 Funds willing to accept market
  returns can purchase index portfolios
  for bonds and stocks
 Futures are used to hedge market
  downturns
 Approaches to risk vary
Performance of Pension Funds
 Determinants of a pension fund’s
  stock portfolio performance
PERF= f (MKT, MANAB)
Where:
 PERF = Performance
MKT = General market conditions

 MANAB = The ability of the fund’s management
Performance of Pension Funds
 Stock portfolio performance closely
  related to market conditions
 Changes in management ability
   Performance can vary depending on the
    skills of the manager
   Efficiency of the fund affects expenses and
    performance
Performance of Pension Funds
 Determinants of a pension fund’s
  bond portfolio performance
PERF= f (Rf, RP, MANAB)
Where:
 PERF = Performance
 Rf = Risk-free interest rate
 RP =Risk premium
 MANAB = The ability of the fund’s management
Performance of Pension Funds
 Performance evaluation
   Compare to the passive strategy
    benchmark
   Any difference from the benchmark
    results from
     The manager’s shift in the proportions of
      stocks and bonds
     The composition of bonds and stocks
Performance of Pension Funds
 Performance of pension portfolio
  managers
   Research showed funds earned less than
    a market index
   Expenses were not included in the study
   Companies might do better to invest in
    index mutual funds

				
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posted:6/25/2012
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