Market Vocabulary
Market: a place where goods are bought and sold
This can be a very wide definition, covering many types of
transactions
How do markets evolve?
What types of markets are there?
Market Vocabulary
Barter Market: Most basic, exchange of goods and services
Most common accepted form of commerce prior to the
invention of currency
1626: Peter Minuet trades beads, knives and kettles for...
Issues:
Equality of value
Often a necessity to bring goods to a central place
Market Vocabulary
Currency
• 650 AD: China issues paper "value tokens"
• Marco Polo brings the idea to the European continent
• 17th Century: Sweden takes the lead in issuing paper currency;
other countries gradually followed the Swedish example
• 20th Century:
• Easier facilitation of international trade and investment
• Bretton Woods Agreement in 1944; fixed exchange rates
• Establishment of foreign exchange market with floating
exchange rates
Market Vocabulary
Cash or Spot Market:
Purchase items with a currency, with delivery either
immediate or delivered within a short amount of time
Most common type of market we know today
Goods and services can range from very simple to very
complex financial instruments
Market Vocabulary
Financial Market: A place where financial assets are bought and sold –
most common is a stock exchange like NYSE, but doesn’t need to be a
physical location (National Association of Securities Dealers
Automated Quotation System - NASDAQ)
Primary Market: Transaction between the creator of the security (issuer)
and the first owner
Secondary Market: Owners sell the security to a new owner, typically in
a financial market
Derivative Securities: Securities whose prices are dependent or “derived”
from another security’s price – options, futures, etc.
Futures Markets
Futures / Forward Markets: Agree to terms at present time, but
currency exchange and delivery is in the future, often several months
The term “futures” is most commonly used when the asset being
purchased is a standardized contract
The term “forward” is most commonly used when the asset being
purchased is non-standardized; amount, quality shape and form need
negotiated between the buyer and seller
The evolution of futures markets have given many industries an enhanced
stability for risk management, budgeting, planning and confidence in
production inputs and outputs
Futures Markets
“Underlying” assets traded can be very diverse:
Tangible items: commodities, animals, production inputs, metals,
stocks, bonds, etc ----- quoted in terms of the price of the item
Intangible items: Stock indexes, currency exchange rates, interest rates
The evolution of futures markets have given many industries an enhanced
stability for risk management, budgeting, planning and confidence in
production inputs and outputs
Futures Markets
Chicago Mercantile Exchange
CMEGroup
Largest U.S. Futures Exchange
20 S. Wacker Drive, Chicago, IL
www.cmegroup.com
Agricultural Products:
Beef, Dairy, Hogs, Lumber, Fertilizer
Financial Products:
Equity Index Futures (S&P 500, NASDAQ), Interest Rate Futures (TBill), Foreign Currency Futures (Euro)
Futures Markets
141 West Jackson Boulevard (Jackson and LaSalle)
Ceres, the Roman goddess of agriculture
Agricultural Products:
Corn, Soybeans, Wheat, Oats
Financial Products:
Equity Index Futures (Dow), Interest Rate Futures (Treasury Notes),
Metal Futures (Gold, Silver)
Combined with CMEGroup in 2008
Futures Markets
See sample copies of lean hog and lumber futures
contracts…
Compare contract sizes, settlement procedures, etc.
http://www.cmegroup.com/trading/agricultural/livestock/leanhogs_contract_specifications.html#prodType=undefined
http://www.cmegroup.com/trading/agricultural/lumber-and-pulp/random-lengthlumber_contract_specifications.html
Futures Markets
The increasing importance of “creditworthiness”
• Many everyday things we currently buy or sell can be thought of as a
slight tendency use of forward markets --- online sales, etc
• How strong a belief do I have that the counterparty is “going to
deliver”
• Going to deliver can have many aspects
• One time only or recurring?
• Are the deliveries the same or different in size?
• Physical delivery or financial settlement?
Spot and Forward Rates
Spot rates: rates derived from the prices of interest rate
securities – usually zero-coupon securities like CD’s,
money market securities, T-Bills, etc.
Forward rates: rates derived from spot rates that are implied
for periods of time in the future
Example: If a one year CD yields 5.50%, a two-year CD
yields 5.80% and a three-year CD yields 6.20%, then what
does it imply about a one-year rate one year from today?
Spot and Forward Rates
The facts imply there is some rate, f, that will be effective one
year from today for a one-year period that satisfies:
(1+.0550) * (1 + f) = (1 + .0580)2
f = .061 or 6.10%
Spot and Forward Rates
Note that derivation of spot and forward rates is dependent
upon the set of assets in the marketplace.
Example:
Price of Asset 1= $89.60; cash flow = $100 in 2 years
Price of Asset 2= $96.25; cash flow = $7 in 1 year, $100 in 2
years
Price of Asset 3= $91.53; cash flow = $4 in 1 year, $4 in 2
years, $100 in 3 years
Spot and Forward Rates
Note that derivation of spot and forward rates is dependent upon the set of
assets in the marketplace.
Example:
Price of Asset 1= $89.60; cash flow = $100 in 2 years
Price of Asset 2= $96.25; cash flow = $7 in 1 year, $100 in 2 years
Price of Asset 3= $91.53; cash flow = $4 in 1 year, $4 in 2 years, $100 in
3 years
1-Year spot rate = 5.26%
2-Year spot rate = 5.64%
3-Year spot rate = 5.92%
Spot and Forward Rates
There is a general relationship between the spot curve and the forward
curve dependent upon the characteristics of the spot curve….
If the spot curve is increasing, forward rates are greater than spot rates
If the spot curve is level, forward rates are equal to spot rates
If the spot curve is decreasing, forward rates are less than spot rates
Other interest rate ideas
Equivalent Taxable Yield
Earnings on some investments are deemed to exempt from federal income
tax, such as debt securities issued by states and local municipalities;
these are often called municipal bonds or “muni” bonds
In order to compare alternative investment choices, investors must
calculate the equivalent taxable yield on muni bonds
Equivalent Taxable Yield = Tax-Free Yield / (1 – Tax Rate)
Also, can calculate the tax rate where the investor becomes indifferent
between taxable and tax-free yields
Tax Cutoff Bracket = 1 – (Tax-Free Yield / Taxable Yield)
Other interest rate ideas
Example: Investor has a tax rate of 32% and a Muni bond
yields 6%
Equivalent Taxable Yield = Tax-Free Yield / (1 – Tax Rate)
= .06 / (1 – .32)
= .06 / .68
= .0882 = 8.82%
Other interest rate ideas
Example: A muni bond has a yield of 5.25% versus a taxable investment
of 7.00%
Tax Cutoff Bracket
= 1 – (.0525/ .0700)
= 1 – .75
= .25 = 25%
If the tax rate is less than 25%, say 10%, then the Equivalent Taxable
Yield on the muni bond would be (.0525 / .90) = 5.83% and the taxable
investment would be preferable
If the tax rate is greater than 25%, say 40%, then the Equivalent Taxable
Yield on the muni bond would be (.0525 / .60) = 8.75% and the muni
bond would be preferable