Ch. 15: Financial Markets

• Financial markets – link borrowers and lenders. – determine interest rates, stock prices, bond prices,

etc.• Bonds

– a promise by the bond-issuer to pay some specified amount(s) in the future in exchange for some payment (the bond price) today.

• Stocks (equities)– legal rights of ownership in an incorporated firm.– promise the stockholder a share of the corporte

profits (dividends)

The Bond Market.

Maturity date: • A bond's maturity date refers to the specific future date on which the

maturity value will be paid to the bond holder. Bond maturity dates when issued generally range from 3 months up to 30 years.

Coupon rate• Between the date of issuance and the maturity date, the bond-holder

receives an annual interest payment equal to the coupon rate times the maturity value.

Yield to maturity• represents the effective interest rate that the bond-holder earns if the bond

is held to maturity.Bond price• The price that the bond sells for. This fluctuates over the life of the bond.

– *If the bond price is equal to 100% of its maturity value, the bond sold at “par”. – If the bond price is below 100% of its maturity value, the bond price sold “below

par”.

The Bond Market

• 20 year bond with maturity value of $1000 and coupon rate of 5% promises– 20 annual payments of .05*1000=$50– $1000 payment at maturity (20 years from

now). – If price is $1000 for this bond, the bond sold

for par.

The Bond Market.• Computing yields on a bond.

• The yield on a bond is the same as the internal rate of return. To calculate the yield to maturity, define NPV as follows:

• NPV = CP1/(1+r) + CP2/(1+r)2 + .... + CPT/(1+r)T + MV/(1+r)T - P

• where CP1, CP2, ... CPT are the interest or coupon payments in periods 1 through T

• MV is the payment received at maturity• P is the price paid for the bond.

• The yield to maturity is the interest rate that makes the NPV on the bond purchase zero.

The Bond Market.One year bonds

– NPV = MV(1+cr)/(1+r) - P where cr is the coupon rate.

– setting NPV=0 and solving for r provides the yield to maturity:– yield = [MV(1+cr)/P] - 1

• For example, suppose you buy a one-year bond for $900. It has a maturity value of $1000 and a coupon rate of 5%. What is the yield?

• yield = [(1000)(1.05)/900] - 1=1050/900 -1

=16.67%

As the price paid for a bond increases, the yield on the bond falls.

The Bond Market.Zero Coupon Bonds.

• With zero coupon bonds, no interest payments are made between the sale of the bond and its maturity. That is, there is a zero coupon rate. For such bonds, the yield calculations is straightforward.

NPV = MV/(1+r)T - P

• setting NPV=0 and solving for r provides the yield:

yield = (MV/P)1/T - 1

• For example, if you buy a zero coupon bond today for $1000 and it has a maturity value of $1500 in 10 years:

yield = (1500/1000)1/10 -1 = .0414 = 4.14%

As the price paid for a bond increases, the yield on the bond falls.

The Bond Market.

• Determinants of bond yields– Higher expected inflation will drive up yields.– Higher risk bonds must offer higher yields.

• Default risk.– Debt rating agencies:

» Moody’s & Standard and Poors» AAA=superior quality» C=imminent default

– Diversification to reduce risk.

• Inflation risk.

– Term• Longer term bonds have greater inflation and default risk.

The Bond Market.

• Yield curve– Shows relationship between yield and term on

government bonds– Slope of yield curve reflects

• Expectations of future short term interest rates• Greater risk of long term bonds

– If short term interest rates are expected to be constant in the future, yield curve will slope upward reflecting risk premia for longer term bonds.

– A steepening of the yield curve suggests that financial markets believe short term interest rates will be rising in the future.

• The bond market• The dynamic yield curve

The Stock Market

• Stocks (equities):– legal rights of ownership in an incorporated

firm.– promise the stockholder a share of the

corporte profits (dividends)

The Stock Market

• The “fundamental value” of a stock is the expected present value of all future dividends from a stock.

• P = d1/(1+r) + d2/(1+r)2 + d3/(1+r)3 + ....dT/(1+r)T

– where T is the end of the firm’s life (which might be infinite)

– d1, d2, ... dT represent dividend payments in years 1 through T.

– r is the interest rate

The Stock Market

• Given the fundamental value theory, stock prices will rise with:– lower interest rates.– an increase in future expected dividends.– A lower tax rate on dividends.

The Stock Market

• Efficient markets hypothesis: – All stock prices represent their fundamental

value at each point in time. – When new “information” arrives about a stock,

its price immediately adjusts to reflect that new information.

– It is impossible to consistently predict which way a stock price will move in the future and to consistently “beat the market”.

The Stock Market.

• If the efficient markets hypothesis is true, – financial advisors can assist you only in evaluating the

risk and tax consequences of different stocks and concerns regarding income or growth, etc.

– Financial advisors will not be able to consistently find stocks that will “beat the market”.

• The validity of the efficient markets hypothesis is controversial among economists.

The Stock Market

• Stock quotes– Price– PE ratio (price-earnings ratio)– Volume (number of shares sold in previous

day)– Change (change in from previous day)– 52 week high and low– Beta (measures stock movements relative to

market)

The Stock Market

• Performance measures– Broad indexes

• Dow Jones Industrial Average• Standard and Poor 500• NASDAQ

• For stock quotes and information– http://money.cnn.com/

Options

• Options are contracts in which the terms of the contract are standardized and give the buyer the right, but not the obligation, to buy (call) or sell (put) a particular asset at a fixed price (the strike price) for a specific period of time (until expiration).

Options Market

• Call option on a security: – the right to call (buy) a security at the strike

price up until the expiration date of the option from the person that issued the call.

– If I sell you a call option on IBM with a strike price of $190 and an expiration date of 1/1/2009, you have the right to exercise the option until its expiration and force me to sell you IBM for $190. You will exercise the option only if IBM rises above the strike price of $190.

Options Market

• Put option on a security: – the right to put (sell) a security at the strike price up

until the expiration date of the option to the person that issued the put.

– If I sell you a put option on IBM with a strike price of $150 and an expiration date of 1/1/2009, then at any time between now and 2009 you can force me to buy a share of IBM for $150. You would exercise your put option only if the price of IBM falls below the strike price of $150.

Options Market

• The options market can be used for:– speculation– reducing exposure to risk.

Futures Market• A market for contracts that provide for future delivery of a good at

some pre-specified price. Futures markets exist for commodities, bonds, and foreign currencies.

• Example: If I agree to a 1/1/2009 futures contract to buy 1000 bushels of corn at $3.00 per bushel, I am committed to buying corn on that date at that price. The other party to the contract is committed to sell 1000 bushels at $3.00 per bushel. The person who agrees to buy corn has “bought” a futures contract. The person who agrees to sell the corn has “sold” a futures contract.

• If the expected price of a commodity in the future rises, the futures price will rise.

• The price in futures contracts provides an indicator of what people believe about the movement of prices in the future.

Mutual FundsMutual Funds: a firm that pools money from many small investors to

buy and manage a portfolio of assets and pays the earnings back to the investors. Mutual funds can be categorized in several ways. For example:– index funds (S&P 500 or Willshire 5000)– international funds (invest in foreign securities; exchange rate risk)– bond funds (invest in bonds)– balanced funds (invest in bonds and stocks)– growth funds (invest in companies viewed as having high growth

potential)– sector funds (invest in a particular sector of the economy; e.g. health, or

financial services).– tax-exempt income funds (invest in tax exempt bonds)– money market funds (invest in short term government securities)

• The major advantage of mutual funds is that it allows a person to invest in the stock market and be diversified.