Financial and Real Estate Markets
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Money Markets
Capital Markets
Mortgage Markets
Financial Derivative Markets
BUS322 – Chapters 9, 10, 11, 12 & 25
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The Money Markets
• Money Markets
– Money market securities are usually sold in large
denominations
– They have low default risk
– They mature in one year or less from their issue date
• Purpose
•Investors in Money Market: Provides a place for
warehousing surplus funds for short periods of time
•Borrowers from money market provide low-cost source of
temporary funds
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Interest Rates of Money Market Instruments
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Participants in Money Markets
•
U.S. Treasury Department
•
Federal Reserve System
•
Commercial Banks
•
Businesses
•
Investment and Securities Firms
•
Individuals
(mostly through money market mutual funds)
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Money Market Instruments
• Treasury Bills
• Federal Funds
• Repurchase Agreements
• Negotiable Certificates of Deposit
• Commercial Paper
• Banker’s Acceptance
• Eurodollars
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Treasury Bills
1. Short-term borrowings of the federal government
(US Treasury Department)
2. Usually sold at discount
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Discounting Example
• You pay $9850 for a 91-day T-bill. It is worth
$10,000 at maturity. What is its annualized yield?
F  P 365
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Federal Funds
• Short-term funds transferred (loaned or
borrowed) between financial institutions,
usually for a period of one day
• Having excess reserve -> loan (sell) federal
funds
• Fed can influence the rate by setting target
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Federal Funds
Figure 8.2: Federal Funds and Treasury Bill Interest Rates, January 1990–January 2002
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Negotiable Certificates of Deposit
• A bank-issued security that documents a
deposit and specifies the interest rate and the
maturity date
• Denominations range from $100,000
to $10 million
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Negotiable Certificates of Deposit
Comparing Interest on CDs and T-bills
Figure 8.3: Interest Rates on Negotiable Certificates of Deposit and on Treasury Bills,
January 1990–January 2002
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Commercial Paper
• Unsecured promissory notes, issued by
corporations, that mature in no more than
270 days
• Banks also issue commercial paper, but have
reserve requirement on bank-issued
commercial paper
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Commercial Paper
Comparing Interest on Commercial Paper to Bank Prime Rate
Figure 8.4: Return on Commercial Paper and the Prime Rate, January 1990–January 2002
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Banker’s Acceptances
• An order to pay a specified amount
to the bearer on a given date if specified
conditions have been met, usually delivery
of promised goods
• Used in international trade
• Have secondary markets
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Repo (Repurchase agreement)
• Buyer purchase securities with an agreement that the
seller will repurchase them in short period of time,
anywhere from 1 to 15 days from the original date of
purchase.
• Implicitly the buyer is a lender, seller is borrower
• Buyer is compensated with the interest
• This contract has secondary market
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Eurodollars
• Dollar denominated deposits held
in foreign banks
• Used as alternative to fed fund for banks
around the world
– London interbank bid rate (LIBID)
• The rate paid by banks buying funds
– London interbank offer rate (LIBOR)
• The rate offered for sale of the funds
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Figure 8-6: Interest Rates on Money Market
Securities, 1990–2002
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Money Market Mutual Funds
• Open-end investment funds that invest only in short-term
securities
• No fee for purchasing or redeeming shares
• Minimum initial investment of $500 to $20,000
• Check-writing privileges
– No fee for writing checks
– No minimum check amount
• Earn 0.5% to 1% higher return than interest earned
on money in the bank
• Low risk of default, low rate of risk
• Popular to small investors
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Money Market
Fund Assets
Figure 8.8:
Average Distribution
of Money Market
Fund Assets, 2001
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Capital Markets
• Original maturity is greater than one year
• Best known capital market securities:
– Stocks and bonds
• Primary issuers of securities:
– Federal and local governments
– Corporations
• Largest purchasers of securities:
– You and me
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Capital Market Trading
1. Primary market for initial sale (IPO)
2. Secondary market
– Over-the-counter
– Organized exchanges (i.e., NYSE)
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Want to be listed on the NYSE?
• You will need at least:
1. 2000 stockholders, each owning at least 100 shares
2. A minimum of 1.1 million shares traded publicly
3. Pretax earnings of $2.5 million at the time of listing
4. $2 million in pretax earning in each of the two prior
years
5. A total of $100 million in market value of publicly traded
shares
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Treasury Bonds
•No default risk
•Very low interest rates
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Compare 20-Year Treasury Bonds
to 90-Day Treasury Bills
Figure 9-4: Interest Rates on Treasury Bills and Treasury Bonds, 1973–2002 (January of each year)
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Municipal Bonds
1. Issued by local, county, and state governments
2. Used to finance public interest projects
3. Tax-free municipal interest rate =
taxable interest rate  (1  marginal tax rate)
4. Two types
– General obligation bonds
– Revenue bonds
5. NOT default-free
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Comparing Revenue and General
Obligation Bonds
Figure 9-5: Issuance of Revenue and General Obligation Bonds, 1984–2000 (End of year)
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Corporate Bonds
• Face value of $1,000
• Pay interest semi-annually
• Can be redeemed anytime the issuer wishes
• Degree of risk varies with each bond
• Interest rate varies with level of risk
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Characteristics of Corporate Bonds
• Registered Bonds
• Restrictive Covenants
• Call Provisions
–
–
–
–
Higher yield
Sinking fund
Interest of the stockholders
Alternative opportunities
• Conversion and Convertible Bonds
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Convertible Bonds
• The bond that can be converted into certain shares of
common stocks at the discretion of the bondholder.
– Conversion ratio
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Types of Corporate Bonds
• Secured Bonds
– Mortgage bonds
– Equipment trust certificates
• Unsecured Bonds
– Debentures
– Subordinated debentures
– Variable-rate bonds
• Junk Bonds
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Stock
1. Represents ownership
in a firm
2. Earn a return in two ways
– Price of the stock rises
over time
– Dividends are paid to the
stockholder
3. Stockholders have claim
on all assets
4. Right to vote for directors
and on certain issues
5. Two types
– Common stock
•
•
Right to vote
Receive dividends
– Preferred stock
•
•
Receive a fixed dividend
Do not usually vote
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Stock
Prices
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30 Stocks in the Dow Jones
Industrial Average
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Stocks
• ADR – American Depository Receipts
– A US bank buys the shares of a foreign company and
places them in its vault. The bank then issue receipts
against these shares, and these receipts can be traded
domestically, usually on the NASDAQ.
• In US dollars
• No need to meet disclosure rules required by SEC
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Mortgage Market
• Definition
– Mortgage is a long-term loan secured by real estate by
developer and family
– Commercial mortgage and residential mortgage
– A mortgage is amortized
• The borrower pays it off over time in some combination of
principal and interest payment that result in full payment of the
debt by maturity
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Types of Mortgage loans
– Insured mortgage: Guaranteed by Federal Housing
Administration or Veterans Administration, applicants need
meet certain qualifications
• Serve in the military
• Low incomer
– Conventional mortgage: insured by private mortgage
insurance (PMI): loan-to-value exceeding 80%
– Fixed or adjustable rate mortgages (ARM)
– Innovative mortgage contracts, e.g.,
• Graduated-payment mortgage
• Second mortgage
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Mortgage Market
• Primary Mortgage Market (see page 302)
– Constituted by commercial banks, S&Ls, commercial
banks, life insurance companies, and mortgage pools
– Sell loans after they lend money
– Diversify their risk in the secondary market
• Secondary Mortgage Market
– buy mortgage from the primary market
– Bundle mortgages and offer securitized mortgage-backed
assets
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Mortgage Market
• Major participants in the secondary market
– Fannie Mae (Federal National Mortgage Association)
– Ginnie Mae (Government National Mortgage Association)
– Freddie Mac (Federal Home Loan Mortgage Corp)
• Securitization of Mortgages
– Mortgages are too small to be wholesale instruments
– Sell mortgage backed security
• Mortgage pool
• Mortgage pass-through – is a kind of special debt
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Types of securitized mortgage/Debt
• Mortgage Pool
• Mortgage pass through: a security created when one or more
holders of mortgages from a collection of mortgages and sell
shares in a pool
• Mortgage-backed security (MBS): make mortgage a security,
similar ideas: asset-backed security (ABS)
• Collateralized mortgage obligations (CMO)
• Collateralized bond obligations (CBO)
• Collateralized debt obligations (CDO)
• The largest market dealer for securitized asset is Bear Sterns
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Derivative Market
• See definitions in chapter 23
• Option
– Call
– put
• Futures and forward
– Long
– short
• Swap
– Financial contracts that obligate each party to the contract to exchange
a set of payments it owns for another set of payments owned by another
party
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