Finance 300 Financial Markets Lecture 17 Fall, 2001© Professor J. Petry

Finance 300Financial Markets

Lecture 17

Fall, 2001©

Professor J. Petry

http://www.cba.uiuc.edu/broker/fin300/fin300pp.htm

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HousekeepingAgenda

– Please note that your first Stewardship Report is due the class period after the next exam. The next exam is Monday/Tuesday, November 5th, 6th. Stewardship report is due Wednesday/Thursday, November 7th & 8th.

– This Thursday, the Bond Analysis Project Sign-up form will be posted. It will be the same place as before, beginning at 1:00pm. Be sure you are in a group by then. If your group has changed, you need to advise me by next class.

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HousekeepingAgenda• Financial Markets are traditionally segmented into Money Markets and

Capital Markets. – The Money Market includes short-term, highly liquid, and relatively low-risk

debt instruments. Their security and liquidity result in their sometimes being referred to as “Cash” or “Cash Equivalents”. (T-bills, CDs, CP, Repos, etc)

– Capital Markets include longer-term, relatively riskier securities than does the Money Market. Generally, the Capital Markets are divided into four segments: longer-term fixed income markets, equity markets, and the derivative markets for options and futures.

– The Fixed Income Market—our focus since Chapter IV—spans both areas of Financial Markets. This is why our first Chapter on Fixed Income discussed the bond market generically (Chapter IV--The Debt Market).

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HousekeepingAgenda

– We are now moving systematically through the Fixed Income Portion of the Money Markets and Capital Markets.

– Money Markets were covered in Chapter V. Unlike Capital Markets, Money Markets are exclusively fixed income markets.

– The next two weeks, we will focus on the Fixed Income Capital Markets. This begins with Chapter VI (Government Bonds), and will extend into Chapter VII (Corporate & Other Issues). This material will constitute the material for Exam III, which will be given M/T November 5/6. We will finish the semester with Chapter VIII (Futures) and Chapter IX (Options).

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Chapter VI – Government Bonds

The US Fixed Income MarketSector Size ($bln) % of MarketTreasury 3,545$ 33.4%Federal Agency 1,322$ 12.4%Tax-exempt 1,314$ 12.4%Corporate 1,660$ 15.6%Mortgage-backed 2,114$ 19.9%Asset Backed 672$ 6.3%

10,627$ 100.0%*As of June 1999; Economic Report of the President.

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Government Bond Market Components– US Treasury is single largest debt issuer in the world. It accounts for

approximately 1/3 of the Fixed Income Debt Market in the US, or $3.5 trillion.

– Until recently, debt issuance had been fueled by large government deficits.

– Issues include Treasury Bonds and Treasury Notes. Treasury Bills are included in the Money Market.

– Federal Agencies (Freddie Mac, Fannie Mae) and Municipalities (state and local governments) make up the remainder of government related debt.

– (Corporate and asset backed fixed income securities are next chapter.)

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Treasury Notes & Treasury Bonds: Primary Market– There are ~40 primary market dealers. To become a dealer you

must meet Federal Reserve Standards and capital requirements. You must also agree to bid in all Treasury market auctions and to make a market in Treasury Securities.

– Auctions are held on a regular basis. They are similar to T-bill auctions, but Notes and Bonds are awarded on at the same market clearing yields for all participants—all purchases are at the same price.

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Chapter VI – Government BondsTreasury Notes & Treasury Bonds: Secondary Market

– The secondary market is principally OTC (Over the Counter).• OTC is an informal network of brokers and dealers who negotiate sales of securities, as

opposed to them trading on a formal exchange (e.g. NYSE). – Inside Market: the market where treasury dealers trade with one another

through brokers.– Government brokers: trade not for their own accounts, but for dealers. This

provides the dealers anonymity. – Outside Market: the market where dealers trade with investors in the retail

market.– When-Issued Market: An investor buys a security after the announcement of

a bond issue, but before the bond is actually issued by the Treasury. The seller obtains and delivers the bond to the purchaser as soon as it is issued.

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– Dealer’s Profit• Come from three sources: bid-ask spread, inventory profits & carry.

– Pricing of T-Notes & T-Bonds• Specified in dollars per $100 face value, in 32nds.• Occasionally you will see + after quote, which means to add 1/64. 98:12+

would therefore mean, 98 and 12/32 plus 1/64 = 98 and 25/64s.• Maturity is always on the 15th of the month.

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Government Bonds & NotesRate Maturity Bid Ask Chg Ask Yld9 1/4 Aug 01 103:23 103:25 +3 5.864 3/4 Aug 01n 98:22 98:24 +3 5.86

8 Aug 02n 103:25 103:27 +7 6.087 1/2 Feb 04 103:31 104:01 +10 6.259 1/2 Feb 04n 110:14 110:16 +11 6.25

12 3/8 May 07 132:18 132:24 +20 6.4312 1/2 Aug 09-14 147:17 147:23 +23 6.70

13-Jun-00

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– Accrued Accounting• When government bonds/notes change hands between coupon payments, the

spoils need to be divided between the seller and purchaser of the bond. • Accrued accounting on government issues are based on the actual number of

days in the month and in the year--including leap years.– Example: You buy the 4-3/4 of 01 on June 13, 2000

• It pays coupons on August 15th and February 15th of $47,500/2=23,750. (The prices quoted in the WSJ are for round lots of $1,000,000.)

• The coupon period from Feb 15th to Aug 15th is 181 and from Aug 15th to Feb 15th is 184 days for total of 365. – Feb to Aug: 28-15, 31, 30, 31, 30, 31, 15 = 181; (2000 was leap year = 182)– Aug to Feb: 31-15, 30, 31, 30, 31, 31, 15 = 184

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– Accrued Accounting Example (cont’d)• The last coupon payment was Feb 15; the seller held for 119 days: (29-

15) + 31 + 30 + 31 + 13; You will hold for 63 days: (30-13) + 31 + 15• The coupon proceeds are divided accordingly.

$23,750 x 63/182 = $8,221.15$23,750 x 119/182 = $15,528.85

• The Invoice Price is the base price of the bond plus accrued interest$987,500.00 base price $15,528.85 accrued interest$1,003,028.85 invoice price

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– Example: Things to Do: VI-1 On June 13, 2000 you put in an order for a $1,000,000 12 3/8% May 2007

bond.1. What is the price of this bond before accrued interest?2. Accrued interest for how many days adds how much to the price of the

bond?3. What is the total invoice price of the bond?4. When will you receive your first coupon?5. How much will you receive on this first coupon date?6. On the first coupon payment date you will have earned how much interest

over how many days?

Number of Days By MonthJan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec31 28+ 31 30 31 30 31 31 30 31 30 31

Documents

Finance 300 Financial Markets Lecture 17 Fall, 2001© Professor J. Petry