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 reference 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 issues 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)




Treasury Notes (T-notes)



most liquid
issued each week on a discount basis
maturities of 13, 26, 52 weeks
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 zerocoupon 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 low
Principal increases by the amount of the
inflation rate every six months.
Owners of Marketable
Government Securities

Federal Reserve



Purchases Open Market Operations—mostly Tbills
Provides Fed with most of its income
Private Sector




Commercial banks
Individuals
Insurance companies/Pension Funds
Money 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 freedom—Dollar is easily traded
Relative high interest rates
U. 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 basis—Calculated as face value
minus purchase price divided 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
Jan 18 ‘96
Maturity
93
Bid
Ask Yield
5.27
5.25
5.41
Bank Discount Basis

The quoted yield on a bank discount
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 Tbills with treasury notes and bonds which pay
interest on a 365 day basis.
Computing Yields on Treasury Bills
BANK DISCOUNT BASIS:
 F  P  360 
yD  


 F  T 
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:
yBEY

 F  P  365
 

 P  T
where yBEY = coupon equivalent yield, F = Face value
($100), 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:
 100  97.434  360 
yD  

  0.050756
100

 182 
COUPON EQUIVALENT:
y BEY
 100  97.434  365
 
 0.05282

 97.434  182
How the Market 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 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 low-yield bid to the highyield 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
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.
Provides 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
bidder’s bid.
Dutch 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 Treasury 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 system 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 unpopularity 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 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.
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 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.
Repurchase 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
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 Securities

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 claims,
and some have conversion and call
features.
Commercial Paper
Corporate Bonds




Corporations borrow across all maturity
ranges—mainly 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 stocks—
payment of interest is first priority
Being long term, these bonds are subject to
interest-rate risk—interest 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 carry higher interest rate
Convertible bonds—holders have right to
convert to common stock at predetermined
price
Corporate Bond Ratings

Corporate bonds differ in quality—
danger of default by borrower


U.S. government is safest
Various bond rating agencies



Standard and Poors
Moodys
Investment grade—highest 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 examples 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 maturity—little need for quick liquidation
Foreigners also hold large amount of
corporate bonds
Generally traded in over-the-counter market—
usually 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 yields.
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, yields
are typically higher than Treasury Bills,
but tend to move closely together
Not much of a secondary market—
investors generally redeem with issuer
GE Capital Corporation

Largest and most active direct issuer in
the US.


Commercial paper outstanding in excess of
$70 billion.
www.gecapital.com
Municipal Securities



Issued 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


Short-term



General Obligation bonds are safer and generally
pay less interest than Revenue bonds.
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 rate 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
Borrowing 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
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 rate—minimizes interest rate risk of
lender
Balloon payments—low front end with large lump
sum payment 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 select 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)
have begun to dominate the market
Stock Market—refers 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 offered 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 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.
Structure of the NYSE



Posts—location where individual stocks are traded
Traders—receive orders from brokerage houses
Specialists—individuals 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 orders 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 balancedvolume 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.
Structure of the OTC Market


Network of dealers and brokers who
deal via telephone and computer
terminals
National Association of Securities
Dealers Automated Quotation
System [NASDAQ]—Shows bid and
asked prices of OTC traded securities
NASDAQ



Structure of multiple market participants.
Multiple market participants trade a
company’s 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.
Market Makers


Market Makers are independent dealers that compete
for investor orders by displaying their buy and sell
interest - plus customer limit orders - in Nasdaq-listed
stocks.
Market Makers increase the visibility of shares
through their combined sponsorship. By standing
committed to buy and sell shares of a company’s
stock, Market Makers help meet investor demand
and create an environment of immediate and
continuous trading of a stock.
Order Flow on the NASDAQ



Each Market Maker competes for order flow by
displaying bid (buy) and ask (sell) quotations on
screen. When an order is received, the Market Maker
will immediately purchase for or sell from his or her
own trading account, or seek the other side of the
trade until it is executed, often in a matter of seconds.
Because Nasdaq distributes trading in a stock among
multiple market participants, fluctuations in volume
can quickly be absorbed - even on particularly heavy
trading days.
No halts for order imbalances may occur on Nasdaq.
Secondary Market Trading


Electronic Communications Networks
provide trading in NASDAQ securities
The Island allows the public to view the
“order book” in real time.
What determines whether
stock prices rise or fall?



Stocks (equities) represent ownership
company
Investor receives future cash flows in form
of dividends
In its simplest form the price of a stock with
constant dividends forever is:
Pr ice 
Expected Annual Dividend
Annual Rate of Discount
Stock prices continued

Therefore, the price will rise if:




Expected future dividends increases
Annual rate of discount decreases
The discount rate is higher than the
government bond rate to compensate for the
risk of stocks
However, the discount rate will follow
movements in the government bond
rate
Stock prices continued


Therefore, price of stocks move in same
direction of earnings and inversely with
interest rates
To predict movements of stock prices must
predict:



Expected future earnings
Expected future interest rates
This requires knowledge of future
movements of the entire economy
Money and Stock Prices


Some economists believe that fluctuations in
the money supply will provide key to
movements in stock prices
Increase in money supply will increase stock
price:



Individuals hold larger cash that they need
Spend some on stock which increases demand
and increases price (assume supply fixed in shortrun)
Opposite for a decrease in money supply
Money and Stock Prices



Therefore, rapidly expanding money supply
generally leads to higher stock prices;
inadequate growth of money leads to a fall
Difficult to determine if stock and money
growth are related to each other or reacting
to a third causal force
However, other economic forces may cause
stock prices and growth of money supply to
move in opposite directions