4464-Chapter-02.ppt
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HFT 4464
Chapter 2
Financial Markets &
Financial Instruments
1
Chapter 2 Introduction
This chapter will provide an introduction to
financial markets and common financial
instruments.
Financial markets are where suppliers of
capital (firms) interact with buyers
(investors).
Often this is done through intermediaries
such as brokers.
2-2
Why Do People Invest?
Investing is not just something other
people do.
College education is an investment.
Investing is more than just hoping to
“make some money.”
It involves deferring present consumption
in the hopes of higher future consumption.
2-3
Equity Capital
Types of equity capital
Preferred stock
Common stock
This course focuses more on common
stock.
No guarantee of dividend
One share, one vote
Shareholders vote on key issues such as
composition of board of directors, choice
of auditing firm, and others.
2-4
Why Purchase Common Stock?
A purchaser is looking for at least one of
two possibilities:
1. Stream of dividend payments (current
income)
2. Increase in stock price (capital gain)
Holding period return:
{ ( (sales price – purchase price) + dividends ) / Purchase Price } x 100
2-5
Holding Period Return Example
You purchased a share of McDonald’s stock
one year ago for $18.00.
You earn $2.00 in dividends during the year.
Today you sell the stock for $18.50.
What is your holding period return?
(($18.50 – $18.00) + $2) / $18.00 = 0.1389
0.1389 x 100 = 13.89% (before taxes)
2-6
Bonds
Held by lenders
Receive repayment over time
Semi-annual interest payments
At maturity, amount is repaid (principal)
This is a series of cash flows that has value
Priced on an index relative to 100
If a $1,000 bond sells for “102,” it sells for
$1,020
2-7
How to Interpret Bond Information
Bond
Curr. Yld
Hilton 73/4 04
7.2%
Vol
40
Close Chg
101
+1/2
The Hilton bond pays 7.75% interest and matures in
2004.
The annual interest divided by the current price is
7.2 percent. (Note: this is not the return you will
receive if you hold the bond till maturity.)
40,000 bonds were traded that day.
The bond closed at $1,010 which is $.50 higher
than the previous day. 2-8
Capital Markets
Represents a diverse group of investments
Stock market
Bond market
Mortgage market
Futures market
2-9
Stock Market
New York Stock Exchange (NYSE)
Founded in 1792
Physical
location on Wall Street in
New York
Approximately
2,800 companies
offering securities here
Membership
offered in the form of
seats
2-10
Stock Market
Nasdaq
National Association of Securities Dealers
and Automated Quotations
Not
a physical location like the NYSE
(“over the counter”)
Represents
Fastest
a network of securities dealers
growing securities market
Makes
use of “market makers”—help
ensure liquidity of trading
2-11
Bond Market
Corporate bonds can be traded through the
NYSE
Most bonds are traded over the counter
Bond ratings
The
lower the letter, the greater the quality
Quality refers to the risk of default
Companies rating bonds
Standard
and Poor’s
Moody’s
2-12
Important Features of Bonds
How are bond prices and interest rates
related?
As interest rates rise, bond prices fall.
Some bonds are callable.
Company can repurchase bonds at a
certain price during a certain time.
2-13
Mortgage Market
Pooling of home mortgages by
government agencies
FNMA
and GNMA are two examples.
Mortgages
are packaged and resold
as securities to investors.
Investors
are often large institutional
investors like pension funds.
2-14
Money Market
Market for short-term debt instruments
Certificates of Deposit
Commercial
paper
Investors
loan to large companies for a very
short period of time (9 months or less).
Treasury
Loans
Bills / Bonds
to the U.S. Treasury
Zero-Coupon bonds
Issued at a discount—no interest payments
2-15
Risk Free Rate
Raising Capital
Primary market
Initial Public Offering (IPO)
Common
stock is sold to underwriter
(investment banker)
Investment banker sells to clients
2003 scandal/settlement
Secondary market
Investor to investor, where most
trading occurs
2-16
Features of Stock Trading
Bid vs. ask
Bid
is the price you will pay to own a share
Ask is the price you would receive to sell
your share
Difference goes to broker
Average NYSE trade takes 22 seconds
Significant reliance upon computers
Trading halt in June 2001
2-17
Hedging Risk
We can add value by decreasing the risk
(variability) of cash flows.
The concept of insurance as hedging:
You buy insurance and if nothing
happens to your house, you still have
the house.
If your house is damaged, insurance
pays for it and the house is rebuilt.
2-18
Forward and Futures Contracts
Spot price—price paid for a commodity today
Change in commodity prices present, risk to
buyer and seller
Example: Orange juice grower (seller) and
restaurant owner (buyer)
Prices help growers determine what and how
much to produce and restaurants need to
establish menu price
2-19
Forward Contracts
An agreement to sell an asset at a fixed
price for delivery in the future.
Cash payment is not required until delivery.
However, each party must trust the other to
perform.
The unique nature of each contract makes
them difficult to sell to third parties.
2-20
Futures Contracts
Similar to forward contracts, except:
Terms
of contract are standardized, such as
amounts and delivery dates.
Clearinghouse acts as go-between to help
ensure performance.
Contracts are traded on the Chicago Board of
Trade or Chicago Mercantile Exchange.
Most contracts are never delivered.
Parties take opposite positions to offset
original position.
2-21
Foreign Exchange
As international trade barriers are removed,
more business is conducted away from
home country.
Nearly 65% of McDonald’s 2002 revenues
originated from outside the U.S.
U.S. companies must report financial
operations in U.S. currency.
2-22
Foreign Exchange Example
You operate a hotel in France and accept
the Euro.
When the Euro strengthens, this means it
takes fewer Euros to buy $1 worth of goods.
As the Euro strengthens, your profits
increase upon conversion.
100,000Euros x $1/1Euro = $100,000 usd
100,000Euros x $2/1Euro = $200,000 usd
2-23
Can we hedge this risk?
Similar to commodities, we want to lock in a
“price” for our Euros—an exchange rate at
a future date.
We can buy a forward or futures contract to
accomplish this.
Who would be on the other side of this
transaction?
A French company (or other company
accepting the Euro) operating in the U.S.
2-24
Lenders to the Hospitality Industry
Commercial banks
Traditionally largest lender
Bank makes a “spread”—difference
between interest rate on loans and rate on
deposits
Interest = principal x rate x time
Types of loans
Fully amortized (principal and interest)
Interest only
2-25
Lenders to the Hospitality Industry
Real Estate Investment Trusts (REITS)
There
are equity and mortgage REITS
Special tax treatment if they pass through at
least 95 percent of earnings to investors
Insurance companies and pension funds
Receive
large monthly cash flows from
premiums and contributions
Try to match assets (loans) to liabilities (policies
and pension needs)
2-26
Measures of Stock Market Performance
Dow Jones Industrial Average
Index of 30 large companies
Weighted by stock price
Standard and Poor’s 500 (S&P 500)
500 companies
Fairly common measure of overall stock
market performance
Movement is similar to the Dow
2-27
Some Stock Market Statistics
Mean—weighted average
Mean
Dow annual return (1950–2001) = 9.01%
Mean S&P 500 annual return = 9.63%
Returns in a single year have varied from –
30% to +44%
This uncertainty around the mean is called
variance
Another measure is standard deviation, the
square root of the variance
2-28
Some Stock Market Statistics
Can we measure the relationship between
two individual stocks, two stock indices, or
an individual stock and a stock index?
Correlation coefficient =
Range is from –1.0 to +1.0
+1.0 is perfect positive correlation
-1.0 is perfect negative correlation
The Dow and the S&P 500 are highly
positively correlated
2-29
Homework Assignment
Problems 1,2,3,5,9
30