THE MONEY MARKET
(THE FINANCIAL MARKET)
■ Households purchase stocks and bonds from firms.
■ Households supply funds to this market in the expectation of
earning income in the form of dividends on stocks and interest on
bonds.
■ Households also demand (borrow) funds from this market to
finance various purchases.
■ Firms borrow to build new facilities in the hope of earning more in
the future.
■ The government borrows by issuing bonds.
■ The rest of the world borrows from and lends to the money
market.
Ways in which firms borrow or raise money
to finance their investments
■ One way to do this is to borrow from a bank. The bank loans the
money to the firm, the firms uses the money to buy the factory or
machine, and the firm pays back the loan (with interest) to the bank
over time.
■ Another possible way for a firm to borrow money is for the firm to issue
a bond. If you buy a bond from a firm, you are making a loan to the
firm.
■ A third way for a firm to finance an investment is for it to issue
additional shares of stock.
Bonds and stocks
■ A bond is a contract between a borrower and a lender, in
which the borrower agrees to pay the loan at some time in
the future, along with interest payments along the way.
■ A share of stock is an ownership claim on a firm, entitling its
owner to a profit share. When profits are paid directly to
shareholders, the payment is called a dividend.
Bonds
■ A bond is a contract between a borrower and a lender, in which
the borrower agrees to pay the loan at some time in the future,
along with interest payments along the way. The bond also
specifies the flow of interest to be paid in the meantime.
■ Bonds are issued with a face value (abbrev. O)
■ Bonds come with a maturity date (which is the date the borrower
agrees to pay the lender the face value of the bond).
■ Third, there is a fixed payment of a specified amount that is paid
to the bondholder each year (known as a coupon – abbrev. C).
The current yield
■ Current yield is an investment's annual income divided by the
current price of the security. This measure examines the
current price of a bond, rather than looking at its face value.
■ Current yield represents the return an investor would expect to
earn, if the owner purchased the bond and held it for a year.
■ However, current yield is not the actual return an investor
receives if he holds a bond until maturity.
𝑎𝑛𝑛𝑢𝑎𝑙 𝑐𝑜𝑢𝑝𝑜𝑛 𝑝𝑎𝑦𝑚𝑒𝑛𝑡
𝐶
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑦𝑖𝑒𝑙𝑑 =
=
𝑏𝑜𝑛𝑑 𝑝𝑟𝑖𝑐𝑒
𝑃
Current yield - stocks
■ Current yield may also be calculated for stocks by taking the
dividends received for a stock and dividing that amount by
the stock’s current market price.
Current yield (stock) =
𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑
𝑠𝑡𝑜𝑐𝑘 𝑝𝑟𝑖𝑐𝑒
=
𝐷
𝑃
Yield to Maturity
■ Yield to maturity is the total return anticipated on a bond if
the bond is held until it matures. Yield to maturity is
considered a long-term bond yield but is expressed as an
annual rate.
𝐶
P=
1+𝑒
+
𝐶
(1+𝑒)2
+ ⋯+
Where:
P = the price
O= the face value of the bond
n = the number of years to maturity
e = the yield to maturity
𝐶+𝑂
(1+𝑒)𝑛
The coupon rate
■ The coupon rate, or coupon payment, is the yield the bond
paid on its issue date. The coupon rate is the interest rate
paid on a bond by its issuer for the term of the security.
annual coupon payment
Coupon rate =
bond face value
Example: if a bond has a face value of $1,000 and made
interest or coupon payment of $100 per year, its coupon rate
100
is
= 10%.
1 000
Bond value and interest rate
■ Once the bonds are sold in the market, their value depends
on the evolution of the interest rate.
Bond value =
Coupon
Interest rate
Example: A bond brings a coupon of 10 000 lei, when the
interest rate is 20%. Which is the bond value in the market?
Bond value =
Coupon
Interest rate
=
10 000
20%
= 50 000 lei
STOCK MARKET SPECULATORS
■ The prices of securities rise and fall continuously during trading. Thus,
the appearance of speculators.
■ The speculators attempt to make money in both rising and falling
markets.
■ Speculators buy and sell stocks, attempting to anticipate price
movements in order to profit.
■ Speculators are not genuine investors, they buy securities with a hope
to sell them in future at a profit.
■ They are not interested in holding the securities for longer period.
■ They are interested only in price differentials.
Types of speculators (I)
■ Bull: A bull is an optimistic speculator. He expects a rise in the price of
securities in which he deals. Therefore, he enters into purchase
transactions with view to sell them at a profit in the future. If his
expectation becomes a reality, he shall get the price difference
without actually taking delivery of the securities.
■ Bear: A bear is the pessimistic speculator who expects a sharp fall in
the prices of certain securities. He enters into selling contracts in
certain securities on a future date. If the price of the security falls as
he shall get the price difference.
Types of speculators (II)
■ Stag: A stag is considered as a cautious investor when compared to
the bulls or bears. He is a speculator who simply applies for fresh
shares in new companies with the sole object of selling them at a
premium or profit as soon as he gets the shares allotted.
■ Lame Duck: When a bear is unable to meet his commitment
immediately, he is said to be struggling like a lame duck.
Examples
■ An investor buys 500 stocks of a company at 200 lei each, based on a
contract with a maturity of 6 months. At the maturity date, the stocks
value 250 lei each. Which is the result of this operation? Does the
investor win or lose and how much?
■ An investor sells 700 stocks of a company at 500 lei each, based on a
contract with a maturity of 6 months. At the maturity date, the stocks
value 400 lei each. Which is the result of this operation? Does the
investor win or lose and how much?
References
■ Case, K., Fair, R., Oster, S., Principles of Macroeconomics, 11th ed.,
Pearson, 2014.
■ Raja Krishnan, M., Speculators - Meaning, Types, Speculative
Transactions, Advantages and Limitations, March 2019, available
from https://www.slideshare.net/RajaKrishnanM/speculatorsmeaning-types-speculative-transactions-advantages-and-limitations
■ https://www.investopedia.com