1、Money and Capital Markets,Chapter 8,Introduction,Market for U.S. government securities is the center of the money and capital markets U.S. Treasury has to sell many hundred billion dollars worth of securities each year to pay off maturing issues and finance current government operations Provides ref
2、erence point for money market (debt less than one year) and capital markets (long-term debt/equities),The Government Bond Market,When U.S. government runs a deficit, the Treasury Department borrows money by selling government bonds Sell to anyone willing to lend money to U.S. government Treasury iss
3、ues a wide variety of maturities and types of government securities,The Government Bond Market,U.S. securities are basically two types Marketable 63%-bought/sold in financial markets Nonmarketable 37%-sell back to Treasury,U. S. Treasury Securities,Treasury Bills (T-bills) most liquid issued each we
4、ek on a discount basis maturities of 13, 26, 52 weeks Treasury Notes (T-notes) original maturities of 2, 3, 5, 7, 10 years coupon issues semiannual payments Treasury Bonds maturities of 10 to 30 years. Similar to Notes.,Strips,Dealers market the coupons and the body of the security separately as zer
5、o-coupon securities. Stripped Treasury Securities TIGRs - 1982 Merrill Lynch CATS - 1982 Salomon Brothers STRIPS - 1985,Inflation-Indexed Treasury Bonds,1996, Treasury announced that it would periodically issue inflation-indexed bonds that would provide returns tied to the inflation rate. Coupon is
6、low Principal increases by the amount of the inflation rate every six months.,Owners of Marketable Government Securities,Federal Reserve Purchases Open Market Operationsmostly T-bills Provides Fed with most of its income Private Sector Commercial banks Individuals Insurance companies/Pension Funds M
7、oney market mutual funds,Owners - continued,Foreigners Now own about 37% of U.S. national debt Without foreign purchases, U.S. interest rates would be much higher Foreigners are attracted to U.S. securities: Political stability Financial freedomDollar is easily traded Relative high interest rates,U.
8、 S. Treasuries,Sold through auctions (first-price, sealed-bid auction) Registered and issued in book entry form Default-free Highly liquid Interest income exempt from state taxation,Treasury Bills,Sold on a bank discount basis. Yield on a discount basisCalculated as face value minus purchase price d
9、ivided by the face value Bond equivalent yield or coupon equivalent yield. More accurate measure since it uses purchase price rather than face value,Bid and Offer Quotes on Treasury Bills 3 month Maturity Bid Ask Yield Jan 18 96 93 5.27 5.25 5.41,Bank Discount Basis,The quoted yield on a bank discou
10、nt basis is not a meaningful measure for 2 reasons: based on face value rather than actual dollar amount invested. annualized according to a 360-day rather than a 365-day year - making it difficult to compare T-bills with treasury notes and bonds which pay interest on a 365 day basis.,Computing Yiel
11、ds on Treasury Bills,BANK DISCOUNT BASIS:where yD = discount yield, F = Face value ($100), P = Price, T = the number of days to maturity, and 360 is the number of days in the year.,Computing Yields on Treasury Bills,Coupon equivalent yield:where yBEY = coupon equivalent yield, F = Face value ($100),
12、 P = Price, T = the number of days to maturity, and 365 is the number of days in the year.,Computing Yields on Treasury Bills,Examples based on the March 30, 1998 T-bill Auction: P (26 week T-bill) = 97.434 yD = 5.075 percent T = 182 days YIELD ON A BANK DISCOUNT BASIS:COUPON EQUIVALENT:,How the Mar
13、ket Works,Most trading takes place in over-the counter markets Trading in government securities averages more than 20 times trading on the New York Stock Exchange Increasingly traded around the clock in different parts of the world,How the Market Works,Dealers get much of their inventory of bonds by
14、 bidding at competitive auctions Three- and six-month T-Bills are auctioned weekly Notes are auctioned on a regular scheduled basis The Treasury issues new securities to Raise new funds Replace funds of maturing securities,T-Bill Auction,The treasury allocates bills to competitive bidders from the l
15、ow-yield bid to the high-yield bid until the amount of the auction minus the non competitive bids is distributed. Noncompetitive bidders pay the weighted average price of the competitive bids accepted. Stop yield - highest yield accepted by the Treasury.,Auctions,At closing time of auction Treasury
16、does following: Ranks bids from highest price down Selects bids in this order until amount sold equals amount scheduled to be sold Therefore, successful bidders purchase bills at different prices and will earn different yields,Auctions,Multiple-price, sealed-bid auction Bidders pay what they bid. Pr
17、ovides incentives for bidders to acquire more information than is socially desirable. Bidders want to balance the gain from a lower winning bid against the risk of not winning. English Auction Uniform-price, sealed-bid auction Price paid by a winning bidder does not depend on that bidders bid. Dutch
18、 Auction.,Salomon Brothers Scandal,1990 Treasury bond auction Bought 65% of an auction exceeding the 35% maximum Other dealers that had made commitments that they were unable to fill had to obtain bonds from SB. SB could charge high prices since they controlled most of the bonds. August 1991, the Tr
19、easury Department barred SB from bidding on Treasury securities for clients. May 1992, SB paid fines of $190 million to the SEC and Justice Department.,Changes in Procedure,Electronic Bidding Noncompetitive bids are accepted electronically over Fedline, 1992. Fedline - a general communications syste
20、m that links 9,000 depository institutions with the Federal Reserve Banks. Dutch Auctions September 1992, experimented with a Dutch Auction on two- and five-year bonds. All successful bidders pay the price of the lowest accepted bid. (Second-price, sealed-bid auction). Discontinued because of unpopu
21、larity with dealers.,Security Dealers Profits,Bid-Ask Spread Capital Gains or Losses Coupon Payments,Bid-Ask Spread,The ask price is what the dealer will sell the security The bid price is what the dealer is willing to buy the security for. The spread represents profit.,Coupon payments,The interest
22、that the dealer earns on securities held in its inventory. The difference between the coupon return (rate) and the cost of borrowing (rate) is called the “carry” for the security. Dealers borrow funds from banks and through the market for repurchase agreements by borrowing on securities in inventory
23、.,Market for Repurchase Agreements a.k.a., the REPO Market,A repurchase agreement is the sale of a security with the commitment by the seller to repurchase the security at an agreed upon future date, the maturity of the repo. A repo is then a way of borrowing funds using a security as collateral. A
24、reverse-repo is the purchase of a security with an agreement to resell the security to the original seller. A reverse-repo is a way of investing funds with the security as collateral. The market is used by dealers for funding and the Fed to carry out Open Market transactions for monetary policy.,Rep
25、urchase Agreements (Repos),A dealer needs to finance $10 million of a Treasury security that is purchased and plans to hold overnight. A customer of the dealer has excess funds of $10 million. The customer might be a municipality with tax receipts that it has just collected, and no immediate need to
26、 disburse the funds.,Repurchase Agreements,Enhance the liquidity of the government securities market. Although collateral is provided, still have credit risk. Must monitor value of collateral. Physical delivery of securities to a custodian is the safest way to take collateral.,Bank-Related Securitie
27、s,CDs Large CDs $100,000 Negotiable Eurodollars Dollar-denominated time deposits LIBOR London Interbank Offered Rate Overnight rate for Eurodollar lending Tends to follow U.S. rates,Corporate Debt Securities,Corporate bonds are not risk free. Some have security, some are subordinated to other debtor
28、 claims, and some have conversion and call features. Commercial Paper,Corporate Bonds,Corporations borrow across all maturity rangesmainly at the long end High-quality corporate bonds usually yield more than government bonds and are safer than corporate stocks Bonds have prior claim before stockspay
29、ment of interest is first priority Being long term, these bonds are subject to interest-rate riskinterest rises, prices fall,Corporate Bond Features,Callable bonds Issuer has right to pay off the bond before maturity date Bond option will be exercised if it is in the interest of the borrower These c
30、arry higher interest rate Convertible bondsholders have right to convert to common stock at predetermined price,Corporate Bond Ratings,Corporate bonds differ in qualitydanger of default by borrower U.S. government is safest Various bond rating agencies Standard and Poors Moodys Investment gradehighe
31、st quality bonds,Corporate Junk Bonds,Junk bonds Very risky, but pay high interest to compensate for risk Tend to perform well when the economy is strong, but extremely risky when economy does poorly Michael Milken convicted of securities fraud and Drexel, Burnham Lambert bankrupt in 1990 are two ex
32、amples of problems in the junk bond market,Purchasers of Corporate Bonds,Life insurance and pension/retirement funds hold most corporate bonds Schedule cash flow based on life expectancies Hold to maturitylittle need for quick liquidation Foreigners also hold large amount of corporate bonds Generall
33、y traded in over-the-counter marketusually by telephone,Commercial Paper,Unsecured short-term IOU issued by a corporation. Maximum maturity of 270 days. May be interest bearing or discounted. Can be issued directly or through dealers. May be rated. Unrated paper is issued at substantially higher yie
34、lds.,Commercial Paper,Two categories of issuers: Finance companies associated with well known manufacturing companies Nonfinancial companies-generally to finance inventory Usually purchased directly from issuer by large institutional investors,Commercial Paper,Because of possibility of default, yiel
35、ds are typically higher than Treasury Bills, but tend to move closely together Not much of a secondary marketinvestors generally redeem with issuer,GE Capital Corporation,Largest and most active direct issuer in the US. Commercial paper outstanding in excess of $70 billion. ,Municipal Securities,Iss
36、ued by state and local governments Lowest yield because interest earnings are exempt from federal tax By law Congress does have the power to tax, but has decided not to tax this source of revenue,Municipal Securities,General Obligation Bonds Revenue Bonds General Obligation bonds are safer and gener
37、ally pay less interest than Revenue bonds. Short-term tax-anticipation notes (TANs) bond-anticipation notes (BANs) Not much of a secondary market,Municipal Securities,“Serial” maturity form Portion of the issue matures each year until entire issue is retired Each portion carries its own interest rat
38、e and is separate from the rest of the issue In essence a 10 year serial bond is really 10 separate issues, each maturing at different times Sold through underwriting syndicates who sell to ultimate investors at slightly higher prices,Mortgage Securities,Most complicated of all debt instruments Borr
39、owing by individuals using real estate as collateral Most mortgages are insured by some type of government agency minimizing potential default of borrowers Governmental National Mortgage Association Federal Home Loan Mortgage Corporation,Mortgage Securities,Mortgages can be repaid prior to maturity
40、date Prepayment or refinancing due to lower rates Investors are not sure of maturity Investments undesirable to institutional investors Innovations in mortgage terms Shorter maturity period Adjustable rateminimizes interest rate risk of lender Balloon paymentslow front end with large lump sum paymen
41、t at end,Collateralized Mortgage Obligations (CMOs),Developed to reduce uncertainty and broaden the appeal of mortgages Number of mortgages are placed in a trust Interest and principal repayments are divided by trustee into four (or more) segments according to a predetermined formula Investors selec
42、t which segment from which to receive their payments Makes the cash flow more predictable High yields = High risk,The Stock Market,Structure of the Stock Market About 84 million individual shareholders in U.S. During past decade institutional investors (pension funds, mutual funds, and insurance) ha
43、ve begun to dominate the market Stock Marketrefers principally to secondary market for common stock Primary issues are handled through investment banks,Stock (Equity) Exchanges,Stock exchanges: Organized marketplaces for corporate equities and bonds. Over-the-counter (OTC) stocks: Equity shares offe
44、red by companies that do not meet listing requirements for major stock exchanges, or choose not to be listed there, and instead are traded in decentralized markets.,Stock (Equity) Exchanges,New York Stock Exchange (NYSE) The oldest (1792) and largest exchange where roughly half of the stock trading
45、in the United States is done. Shares of more than 3,000 companies are traded there. The number of NYSE membership positions, called “seats,” is fixed. National Association of Securities Dealers Automated Quotation (Nasdaq): The electronic network over which most over-the-counter stocks are traded.,S
46、tructure of the NYSE,Postslocation where individual stocks are traded Tradersreceive orders from brokerage houses Specialistsindividuals who maintain orderly trading for securities in their charge May just match publicly tendered buy and sell orders Floor traders stand at posts and compete for order
47、s not matched by specialists If neither of these occur, specialists will buy or sell for their own account to prevent excessive price swings,Order Flow,On floor-based markets, specialists function primarily to match buy orders with sell orders throughout the trading day. This model works best in a b
48、alanced-volume situation, one is which buy and sell orders are relatively equal. On particularly heavy trading days, keeping up with the flow of transactions can be a challenge for the single specialist, who may request that the market temporarily halt trading in a stock if order imbalances occur.,S
49、tructure of the OTC Market,Network of dealers and brokers who deal via telephone and computer terminals National Association of Securities Dealers Automated Quotation System NASDAQShows bid and asked prices of OTC traded securities,NASDAQ,Structure of multiple market participants. Multiple market participants trade a companys stock through a sophisticated computer and telecommunications network. These participants are divided into two groups: Market Makers Electronic communications networks (ECNs) - trading systems which bring additional customer orders into Nasdaq.,
