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


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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
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