Financial Markets and
Institutions
6th Edition
Jeff Madura
高等教育出版社改编
CH1
Role of Financial Markets and
Institutions
Chapter Objectives
 Describe the types of financial
markets
 Describe the role of financial
institutions with financial markets
 Identify the types of financial
institutions that facilitate transactions
Overview of Financial Markets
 Financial markets provide for financial
intermediation--financial savings (Surplus
Units) to investment (Deficit Units)
 Financial markets provide payments system
 Financial markets provide means to manage
risk
 To position risk and return for financial
tools(the nature of financial market)
Overview of Financial Markets
 Broad Classifications of Financial
Markets
Money versus Capital Markets
Primary versus Secondary Markets
Organized versus Over-the-Counter
Markets
Primary vs. Secondary Markets
 PRIMARY
 New Issue of
Securities(ipo)
 Exchange of Funds
for Financial Claim
 Funds for Borrower;
an IOU for Lender
 SECONDARY
 Trading Previously
Issued Securities
 No New Funds for
Issuer
 Provides Liquidity for
Seller
Money vs. Capital Markets
 Money
 Short-Term, < 1
Year
 High Quality
Issuers
 Debt Only
 Primary Market
Focus
 Liquidity Market-Low Returns
 Capital
 Long-Term, >1Yr
 Range of Issuer
Quality
 Debt and Equity
 Secondary Market
Focus
 Financing
Investment--Higher
Returns
Organized vs. Over-the-Counter
Markets
 Organized
 Visible
Marketplace
 Members Trade
 Securities Listed
 New York Stock
Exchange
 OTC
 Wired Network of
Dealers
 No Central,
Physical Location
 All Securities
Traded off the
Exchanges
Securities Traded in Financial
Markets
 Money Market Securities
 Debt securities Only
 Capital market securities
 Debt and equity securities
 Derivative Securities
 Financial contracts whose value is derived from the
values of underlying assets
 Used for hedging (risk reduction) and speculation
(risk seeking)
Debt vs. Equity Securities
Debt Securities: Contractual obligations (IOU) of
Debtor (borrower) to Creditor (lender)
 Investor receives interest
 Capital gain/loss when sold
 Maturity date
Debt vs. Equity Securities
Equity Securities: Claim with ownership
rights and responsibilities
 Investor receives dividends if declared
 Capital gain/loss when sold
 No maturity date—need market to sell
Valuation of Securities
 Value a function of:
 Future cash flows
 When cash flows are received
 Risk of cash flows
 Present value of cash flows
discounted at the market required
rate of return(CAPM)
 Value determined by market
demand/supply
 Value changes with new information
Financial Market Efficiency
 Security prices reflect available
information
 New information is quickly included
in security prices
 Investors balance liquidity, risk, and
return needs
Financial Market Regulation
Why Government Regulation?
 To Promote Efficiency
 High level of competition
 Efficient payments mechanism
 Low cost risk management contracts
Financial Market Regulation
Why Government Regulation?
 To Maintain Financial Market Stability
 Prevent market crashes
 Circuit breakers
 Federal Reserve discount window
 Prevent Inflation--Monetary policy
 Prevent Excessive Risk Taking by Financial
Institutions
 可以参考商业银行管理学的有关美国金融管制的内容。
Financial Market Regulation
Why Government Regulation?
 To Provide Consumer Protection
 Provide adequate disclosure
 Set rules for business conduct
 To Pursue Social Policies
 Transfer income and wealth
 Allocate saving to socially desirable areas
 Housing
 Student loans
Financial Market Globalization
 Increased international funds flow
 Increased disclosure of information
 Reduced transaction costs
 Reduced foreign regulation on capital
flows
 Increased privatization
Results:
Increased financial integration-capital flows to highest expected riskadjusted return
Role of Financial Institutions in
Financial Markets
 Information processing
 Serve special needs of lenders
(liabilities) and borrowers (assets)
 By denomination and term
 By risk and return
 Lower transaction cost
 Serve to resolve problems of market
imperfection
Role of Financial Institutions in
Financial Markets
Types of Depository Financial Institutions
Commercial
Banks
$5 Trillion
Total Assets
Savings
Institutions
$1.3 Trillion
Total Assets
Credit Unions
$.5 Trillion
Total Assets
Types of Non-depository
Financial Institutions






Insurance companies
Mutual funds
Pension funds
Securities companies
Finance companies
Security pools
Role of Non-depository
Financial Institutions
 Focused on capital market
 Longer-term, higher risk
intermediation
 Less focus on liquidity
 Less regulation
 Greater focus on equity investments
Trends in Financial Institutions
 Rapid growth of mutual funds and
pension funds
 Increased consolidation of financial
institutions via mergers
 Increased competition between
financial Institutions
 Growth of financial conglomerates
Global Expansion by Financial
Institutions




International expansion
International mergers
Impact of the single European currency
Emerging markets
本章小结




对金融市场本质的理解
对金融市场结构进行理解
对我国金融市场结构进行调查
对我国金融市场的功能与美国金融市场的差
异进行分析
CH2
Determination of Interest Rates
Chapter Objectives
 Explain Loanable Funds Theory of
Interest Rate Determination
 Identify Major Factors Affecting the
Level of Interest Rates
 Explain How to Forecast Interest
Rates
Relevance of Interest Rate
Movements
 Changes in interest rates impact the real
economy
 Investment spending
 Interest sensitive consumer spending such as
housing
 Interest rate changes affect the values of all
securities
 Security prices vary inversely with interest
rates
 Varying interest rates impact retirement funds
and retirement income
CONTINUE
 Interest rates changes impact the
value of financial institutions
 Managers of financial institutions closely
monitor rates
 Interest rate risk is a major risk
impacting financial institutions
Loanable Funds Theory of
Interest Rate Determination
 Theory of how the general level of
interest rates are determined
 Explains how economic and other
factors influence interest rate
changes
 Interest rates determined by demand
and supply for loanable funds
29
Loanable Funds Theory, cont.
 Demand = borrowers, issuers of
securities, deficit spending unit
 Supply = lenders, financial investors,
buyers of securities, surplus spending
unit
 Assume economy divided into sectors
 Slope of demand/supply curves
related to elasticity or sensitivity of
interest rates
30
Sectors of the Economy
 Household Sector--Usually a net
supplier of loanable funds
 Business Sector—Usually a net
demander in growth periods
 Government Sectors
 States—Borrow for capital projects
 Federal—Borrow for capital projects and
deficit spending
 Foreign Sectors—Net supplier since
early 1980’s
31
Demand for Loanable Funds
 Sum of sector demand (quantity) at
varying levels of interest rates
 Sector cash receipts in period less
than outlays = borrower
 Quantity demanded inversely related
to interest rates
 Variables other than interest rate
changes cause shift in demand curve
32
Demand for Loanable Funds
Interest
Rate
Quantity of Loanable Funds
Loanable Funds Theory
 Households demand loanable funds to
finance housing,
Household
Demandautomobiles,
for Loanablehousehold
Funds
items
 These purchases result in installment debt.
Installment debt increases with the
level of income
 There is an inverse relationship between
the interest rate and the quantity of
loanable funds demanded
Loanable Funds Theory
Business Demand for Loanable Funds
 Businesses demand loanable funds to
invest in assets
 Quantity of funds demanded depends on
how many projects to be implemented
 Businesses choose projects by calculating
the project’s Net Present Value
 Select all projects with NPV≥0 （RULE）
Loanable Funds Theory
Government Demand for Loanable Funds
 When planned expenditures exceed
revenues from taxes, the government
demands loanable funds
 Municipal (state and local) governments
issue municipal bonds
 Federal government and its agencies
issue Treasury securities and federal
agency securities.
Loanable Funds Theory
Government Demand for Loanable Funds
 Federal government expenditure and tax
policies are independent of interest rates
 Government demand for funds is
interest-inelastic
D
Interest
 NOTICE
Rate
Quantity of Loanable Funds
Loanable Funds Theory
Foreign Demand for Loanable Funds
 A foreign country’s demand for U.S.
funds is influenced by the differential
between its interest rates and U.S. rates
 The quantity of U.S. loanable funds
demanded by foreign investors will be
inversely related to U.S. interest rates
Loanable Funds Theory
Aggregate Demand for Loanable Funds
 The aggregate demand for loanable
funds is the sum of the quantities
demanded by the separate sectors
 The aggregate demand for loanable
funds is inversely related to interest
rates
Sector Supply of Loanable
Funds
 Households are major suppliers of
loanable funds
 Businesses and governments may
invest (loan) funds temporarily
 Foreign sector a net supplier of funds
in last twenty years
 Federal Reserve’s monetary policy
impacts supply of loanable funds
40
Supply of Loanable Funds
 Sum of sector supply (quantity) at
varying levels of interest rates
 Sector cash receipts in period greater
than outlays—lender
 Quantity supplied directly related to
interest rates
 Variables other than interest rate
changes causes a shift in the supply
curve
41
Interest
Rate
S
Quantity of Loanable Funds
Loanable Funds Theory
 Equilibrium Interest Rate
 Aggregate Demand
DA = Dh + Db + Dg + Dm + Df
 Aggregate Supply
SA = Sh + Sb + Sg + Sm + Sf
In equilibrium, DA = SA
(IMPORTANT)
Graphic Presentation
Interest
Rates
Supply of
Loanable Funds
Demand for
Loanable Funds
Quantity of Loanable Funds
Loanable Funds Theory
 Graphic Presentation
 When a disequilibrium situation exists,
market forces should cause an
adjustment in interest rates until
equilibrium is achieved




Example: interest rate above equilibrium
Surplus of loanable funds
Rate falls
Quantity supplied reduced, quantity
demanded increases until equilibrium
General Equilibrium Interest
Rate
 Means of explaining how economic factors
affect interest rate levels
 Interest rate level where quantity of aggregate
loanable funds demanded = supply
 Surplus and shortage conditions
 Surplus- Quantity demanded < quantity
supplied followed by market interest rate
decreases
 Shortage Government interest rate ceilings
below market interest rates
46
Interest Rate Changes
 + Directly related to level of
economic activity or growth rate of
economic activity
 + Directly related to expected
inflation
 – Inversely related to rates of money
supply changes
 对于利率变化的影响因素要特别注意！
47
Economic Forces That Affect
Interest Rates
 Economic Growth
 Expected impact is an outward shift in
the demand schedule without obvious
shift in supply
 New technological applications with
+NPV’s
 Result is an increase in the equilibrium
interest rate
Economic Forces That Affect
Interest Rates: The Fisher Effect
 Lenders want to be compensated for expected
loss of purchasing power (inflation) when they
lend
 Nominal Interest Rates = Sum of real rate plus
expected rate of inflation, i n = E(I ) + i r
 Expected Real Rate (ex ante) = expected
increase in purchasing power in period
 Realized Real Rate (ex post) = nominal rates
less actual rate of inflation in period
49
Economic Forces That Affect
Interest Rates
 Inflation
 The Fisher Effect
 Nominal Interest Rates = Sum of Real Rate
plus Expected Rate of Inflation
in = ir + E(I)
Figure 2.12
20
Annualized
Real
Interest Rate
15
Annualized
Inflation
Annualized
T-Bill
Rate
10
5
0
-5
1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999
Year
Economic Forces That Affect
Interest Rates
 Inflation（注意：要从市场供求两个方面分析）
 If inflation is expected to increase
 Households may reduce their savings to make
purchases before prices rise
 Supply shifts to the left, raising the equilibrium
rate
 Also, households and businesses may borrow
more to purchase goods before prices increase
 Demand shifts outward, raising the equilibrium
rate
Economic Forces That Affect
Interest Rates
 Money Supply
 When the Fed increases the money supply,
it increases supply of loanable funds
 Places downward pressure on interest
rates
Economic Forces That Affect
Interest Rates
 Federal Government Budget Deficit
 Increase in deficit increases the quantity
of loanable funds demanded
 Demand schedule shifts outward, raising
rates
 Government is willing to pay whatever is
necessary to borrow funds, “crowding
out” the private sector
Economic Forces That Affect
Interest Rates
 Foreign Flows
 In recent years there has been massive
flows between countries
 Driven by large institutional investors
seeking high returns
 They invest where interest rates are high
and currencies are not expected to weaken
 These flows affect the supply of funds
available in each country
 Investors seek the highest real after-tax,
exchange rate adjusted rate of return
around the world
Forecasting Interest Rates
 Attempts to forecast demand/supply
shifts
 Forecast economic sector activity and
impact upon demand/supply of
loanable funds
 Forecast incremental effects on
interest rates
 Forecasting interest rates has still
been very difficult
56
Summary
 Economic Growth
 Expected inflation
 Government budgets
 Increased foreign supply of
loanable funds
 需要注意：当前对利率的预测几乎均无效。
57
CH3
Structure of Interest Rates
Chapter Objectives
 why individual interest rates differ or
why security prices vary or change
 why rates vary by term or maturity,
called the term structure of interest
rates
59
Factors Affecting Security Yields
 Risk-averse investors demand higher
yields For added riskiness
 Risk is associated with variability Of
returns
 Increased riskiness generates lower
security prices or higher investor
required rates of return
60
Factors Affecting Security Yields
 Security yields and prices are affected
by levels and changes in:





Default risk (also called Credit Risk)
Liquidity
Tax status
Term to maturity
Special contract provisions such as
embedded options
Default risk Affecting Security
Yields
 Benchmark—risk-free rate for given
maturity
 Default risk premium = risky security yield
– treasury security yield of same maturity
 Default risk premium = market expected
default loss rate
 Rating agencies set default risk ratings
 Anticipated or actual ratings changes
impact security prices and yields
 注意：后面两条用于分析证券的违约风险大小。
Liquidity Affecting Security Yields
 The Liquidity of a security affects the
yield/price of the security
 A liquid investment is easily
converted to cash At minimum
transactions cost
 Investors pay more (lower yield) for liquid
investment
 Liquidity is associated with short-term,
low default risk, marketable securities
63
Tax Affecting Security Yields
 Tax status of income or gain on
security impacts the security yield
 Investor concerned with after-tax
return or yield
 Investors require higher yields For
higher taxed securities
64
Tax Affecting Security Yields
Yat = Ybt(1
–
T)
Where:
Yat = after-tax yield
Ybt = before-tax yield
T = investor’s marginal tax rate
Maturity Affecting Security Yields
 Term to maturity
 Interest rates typically vary by maturity.
 The term structure of interest rates
defines the relationship between
maturity and yield.
 The Yield Curve is the plot of current
interest yields versus time to maturity.
Yield Curve
Yield
%
Time to Maturity
An upward-sloping yield curve indicates that Treasury
Securities with longer maturities offer higher annual yields
Yield Curve Shapes
Normal
Level or Flat
Inverted
Other Factors Affecting Security Yields
 Special Provisions
 Call Feature: enables borrower to buy back the
bonds before maturity at a specified price
 Convertible bonds
 The appropriate yield to be offered on a
debt security
Yn = Rf,n + DP + LP + TA + CALLP + COND
Estimating the Appropriate
Yield
Yn = Rf,n + DP + LP + TA + CALLP
+ COND
Where:
Yn = yield of an n-day security
Rf,n = yield on an n-day Treasury
(risk-free) security
DP= default premium (credit risk)
LP = liquidity premium
TA = adjustment for tax status
CALLP = call feature premium
COND = convertibility discount
The Term Structure of Interest
Rates
Theories Explaining Shape of Yield Curve
 Pure Expectations Theory
 Liquidity Premium Theory
 Segmented Markets Theory
Pure Expectations Theory
Explaining Shape of Yield Curve
 Long-term rates are average of
current short-term and expected
future short-term rates
 Yield curve slope reflects market
expectations of future interest rates
 Investors select maturity based on
expectations
Pure Expectations Theory
Explaining Shape of Yield Curve
 Assumes investor has no maturity
preferences and transaction costs are
low
 Long-term rates are averages of
current short rates and expected
short rates
注意：Forward rate: market’s forecast of
the future interest rate
Pure Expectations Theory
Explaining Shape of Yield Curve
UpwardSloping
Yield Curve
 Expected higher
interest rate levels
 Expansive
monetary policy
 Expanding
economy
DownwardSloping
Yield Curve
 Expected lower
interest rate levels
 Tight monetary
policy
 Recession soon?
74
Liquidity Premium Theory
Explaining Shape of Yield Curve
 Investors prefer short-term, more liquid,
securities
 Long-term securities and associated risks
are desirable only with increased yields
 Explains upward-sloping yield curve
 When combined with the expectations
theory, yield curves could still be used to
interpret interest rate expectations
Segmented Markets Theory
Explaining Shape of Yield Curve
 Theory explaining segmented, broken
yield curves
 Assumes investors have maturity
preference boundaries, e.g., short-term
vs. long-term maturities
 Explains why rates and prices vary
significantly between certain maturities
Uses of The Term Structure of
Interest Rates
 Forecast interest rates
 Forecast recessions（See Exhibit
3.14.，next page）
 Investment and financing
decisions
Interest Rate Differential (10-Year Rate
Minus Three-Month Rate)
Exhibit 3.14 Yield Curve as a
Signal for Recessions
7
6
5
4
3
2
1
0
–1
–2
–3
–4
1955
1960
1965
1970
1975
1980
1985
1990
1995
2000
2001
Year
*The general shape of the yield curve is measured as the differential between annualized 10-year and three-month interest rates.
Recessionary periods are shaded.
Treasury Debt Management and
the Yield Curve
 U.S. Treasury attempts to finance federal debt
at the lowest overall cost
 Treasury uses a mixture of Bills, Notes, and
Bonds to finance periodic deficits and refinance
outstanding securities
 Treasury focuses on short-term issuance,
phasing out 30-year bonds
 Treasury 10-year bond now the standard issue
 Leave the long-term issuance to private issuers
Historic Review of the Term
Structure
 Yield curves levels and shapes at various
times indicate:
 Inflation expectations
 phase of business cycle
 Monetary policy at the time
 Usually high positive slope in short-term
 Represents demand for liquidity
 Short-term securities desired; higher prices;
lower rates
 Short-term securities provide liquidity with
maturity
Exhibit 3.17 Yield Curves at
Various Points in Time
17
16
Annualized Treasury Security Yields
15
February 17, 1982
14
13
January 2, 1985
12
11
10
9
August 2, 1989
8
October 22, 1996
7
October 15, 2000
6
5
September 18, 2001
4
3
2
0
5
10
15
20
Number of Years to Maturity
25
30
Exhibit 3.18 Change in Term
Premium Over Time
20
Percentages
15
10
5
30-year
T-Bond
Yield
Three-month
T-Bill
Rate
0
1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001
Year
International Structure of
Interest Rates
 Capital flows to the highest expected
after-tax, real (inflation and other
risk-adjusted), foreign exchange
adjusted rates of return
International Structure of
Interest Rates
 Yield differences between countries
are related to:





Expected changes in forex rates
Varied expected real rates of return
Varied expected inflation rates
Varied country and business risk
Varied central bank monetary policy
CH 4
The Fed and Monetary Policy
Chapter Objectives
 Identify the Fed’s role in monetary
policy
 Describe the tools the Fed uses to
influence monetary policy
 Explain how changes in regulation in
the 1980s affected the Fed and
monetary policy
Federal Reserve System: Third
U. S. Central Bank
 First Bank of the United States
(1791–1811)
 Second Bank of the United States
(1816–1836)
 Federal Reserve System (1913–)
87
Structure of the Federal
Reserve System
12 Fed District Banks
Member Commercial Banks
7 Members of Board of Governors
14 year terms for Governors
12 Open Market Committee (FOMC)
Members
 Advisory Committees to Fed from
private sector





88
Functions of the Federal
Reserve System
 Effect Monetary Policy
 U.S. Central Bank In International
Area
 Fiscal Agent of U.S. Treasury
 Facilitate Efficient Payments System
 Regulate Banks and Bank Holding Co.
 Enforce Consumer Credit Laws
89
Organization of the Federal
Reserve
 Federal Reserve District Banks
 12 districts
 Districts divided by population at 1912–13
 District bank size related to economic wealth
of district
 District banks owned by private member
banks
 Board of Directors of district banks
 Three appointed by Board of Governors
 Three professional bankers
 Three business persons in district
Organization of the Federal
Reserve
 Member Banks
 Must meet requirements of the Federal
Reserve Board of Governors to be a
member bank
 Nationally chartered banks must be
member banks
 State chartered banks may be member
banks
 35% of banks controlling 70% of all
deposits are members
Organization of the Federal
Reserve
 Board of Governors
 7 individuals appointed by the U.S.
president and confirmed by the Senate
 U.S. president appoints one of the 7 chair
whose 4-year term is renewable
 Offices in Washington, D.C.
 Serve nonrenewable 14-year terms
 Independence of Federal Reserve
 Staggered terms of Governors
 Budget separate from Congress
Organization of the Federal
Reserve
 Board of Governors has two main
functions:
 Regulate commercial banks
 Supervise and regulate member banks
and bank holding companies
 Oversight of 12 Fed district banks
 Establish consumer finance regulations
after Congressional legislation
Organization of the Federal
Reserve
 Establish and effect monetary
policy
 Direct control over two tools of monetary
policy
 Set reserve requirements
 Approve discount rate set by district banks
 Indirect control in a third area
 Governors are members of the Federal
Open Market Committee
Organization of the Federal
Reserve
 Federal Open Market Committee
(FOMC) meets every 6 weeks
 12 members
 7 from the Board of Governors
 President of the New York Fed
 4 other district bank presidents appointed
on a rotating basis
 Other presidents participate but do not vote
on monetary policy matters
Organization of the Federal
Reserve
 Federal Open Market Committee （FOMC）
Monetary policy goals of:
 Make monetary policy decisions to achieve
goals
 Forward decisions to N.Y. Fed open market
desk
 Advisory committees from private sector
are a part of overall structure of the Fed
Fed’s Influence on Economy
 Fed influences liquidity (supply of
loanable funds) in money market to
influence:
Liquidity,
Money Supply
and
Interest Rates
Business and Consumer
Borrowing/Spending
Goals of
Growth
Price Stability
Job Growth
Tools of Monetary Policy
Open
Market Op.
Tools of
Monetary
Policy
Reserve Req.
Discount
Rate
How Fed Controls Money
Supply
 Banks must maintain reserves as
percent of deposits
 Reserves kept as deposits in Fed
(plus vault cash)
 Fed controls level of member
bank reserve deposits in Fed
 Fed influences bank deposit
portion of money supply
99
Monetary Policy Tools
 Open market operations involve the purchase or
sale of government securities based on FOMC
directives sent to N.Y. Fed Trading Desk
 Open market purchase of government securities:
 Purchase securities from government securities
dealers
 Increase bank deposits and bank reserves,
money market liquidity and, in time…
 Increases the money supply
Exhibit 4.4
Increase in
deposits
at banks
Required reserves
held on
new deposits
Funds received from
new deposits that
can be lent out
$100 million
$10 million
$90 million
$90 million
$9.0 million
$81 million
$81 million
$8.1 million
$72.9 million
Open market operations and
interest rates
 Most rates are market determined but Fed
influences federal funds interest rate
 Fed purchase of securities results in an
injection of additional funds into the bank
system
 Shifts supply of federal funds to the right
 Lowers federal funds rate
 Lower rates spread to other money market
securities
 More funds available for money market
and bank lending
Adjusting the discount rate

Depository institutions borrow from Fed
for three reasons:
 Adjustment credit for short-term reserve
deficiencies
 Seasonal credit to agricultural banks
 Extended credit for longer-term liquidity
problems of problem banks
 Lower discount rate
 More bank borrowing from Fed, bank
reserves expand, money supply increases
Monetary Policy Tools
 Adjusting the reserve requirement
ratio
 Proportion of deposits at depository
institutions set aside to meet their
reserve requirements
 Increase in lending or expansion limited
by ($) reserves bank must hold the meet
reserve requirements (%)
 Total dollar expansion effect as follows:
Dollar amount of open market
Fed purchase or discount loan
1
×RR
Increasing the money supply
 Open market operation purchase of
securities via the Trading Desk in the
secondary market
 Discount rate lowered to encourage
borrowing at the discount window
 Reserve requirements lowered
Decreasing the money supply
 Open market operation sale of securities
via the Trading Desk in the secondary
market
 Discount rate raised to encourage
borrowing at the discount window
 Reserve requirements raised
Monetary Policy Deposit
Expansion Provides




Excess Reserves to Lend
Loan/Deposit Expansion
Loans Finance Spending
Potential Expansion = Added $
Reserves  1/Required Reserve Ratio
107
Limiting Factors to Deposit
Expansion
 Banks may not lend excess reserves
 Public may not re-deposit payments
In expansion process (cash drains)
 Lowers deposit expansion multiplier
 Other fed functions impact member
bank reserve level
108
Federal Reserve Policy
Emphasis




Money Supply Growth
Interest Rate Levels
Price Level Changes
Real Economic Activity
109
Monetary Control Act of 1980
 the MCA required all depository
institutions to
 Meet the same reserve requirements
 Hold noninterest-bearing reserves
 Promptly report deposit levels to the Fed
 the MCA allowed all depository
institutions
 To offer transaction accounts
 Access to the discount window
第4章总结
 了解美联储体系的构成
 了解美联储的功能
 了解货币政策的目的及手段
CH 5
Monetary Theory and Policy
Chapter Objectives
 Learn the well-known theories of
monetary policy
 Review the tradeoffs involved in
monetary policy
 Learn how analysts monitor and
forecast Fed’s monetary policy
113
Monetary Policies
 How does money affect the real
economy?
 How does varying money supply
growth impact spending?
 How does monetary policy in the
financial sector impact real economic
sector investment and spending?
114
Keynesian Theory
 Developed by John Maynard Keynes
and his students
 Initially attempted to explain
inadequacy of monetary policy during
Great Depression
 Effectiveness of monetary policy
depends upon the sensitivity
(elasticity) of economy to changes in
interest rates
115
Keynesian Theory, cont.
 Advocates fiscal policy
 Focused on government
deficit/surplus spending to impact
economic activity
 Monetary policy transmitted
slowly via bank credit policy and
interest rates
 A proactive economic policy
116
Exhibit 5.3
Fed
Treasury
Securities
$
Investors
Bank Funds
Increase
Interest Rates
Decrease
Aggregate
Spending
Increases
Bank Funds
Decrease
Interest Rates
Increase
Aggregate
Spending
Decreases
Restrictive Monetary
Policy
Fed
Treasury
Securities
$
Investors
Inflation
Decreases
Monetary Theories
 Quantity theory
 Based on equation of exchange
 MV = PGQ
M=
amount of money in the economy
V=
velocity, average number of times each
dollar changes hands during the year
PG = weighted average price level of goods
and services in the economy
Q=
quantity of goods and services sold
Monetary Theories
 Quantity theory’s assumptions
 PGQ is the total value of goods and
services produced
 Assume V constant or predictable—
changing M impacts total spending
 M should grow at rate of output capacity,
Q
 Faster M growth increases PG or inflation
Monetarist Monetary Theories
 Monetarists
 Velocity is affected by




Income levels
Frequency income is received
Use of credit cards
Inflationary expectations
 Velocity changes found to be predictable
and not related to fluctuations in money
supply
Monetarist vs. Keynesian
Theories
 Monetarist
 Let economic
problems resolve
themselves
 Low growth reduces
borrowing and
lowers interest
rates
 Problem: It takes
time
 Keynesian
 Need to take action
to lower interest
rates
 High money growth
to fix a recession by
lowering rates
 Problem: Might
ignite inflation
Monetarist vs. Keynesian
Theories
 Monetarist
 Low, stable growth
in the money
supply
 Focus on
maintaining low
inflation and will
tolerate what they
call natural
unemployment
 Keynesian
 Actively manage
the money supply
 Willing to tolerate
inflation that helps
reduce
unemployment
Rational Expectations Theory
 Households and businesses act in
their own self-interest
 Individuals anticipate effects of
government policy changes
 Expansionary monetary policy signals
future inflation and interest rates
increase (security prices fall)
 Rational expectations may nullify
intended effects of monetary policy
123
Tradeoff of Monetary Policy
Goals
 Goals of the Monetary Policy
 Steady GDP growth
 Low unemployment
 Stable price levels
 Tradeoffs
 Lowering unemployment by stimulating
the economy may increase inflation
 Lowering inflation by slowing the
economy may increase unemployment
Economic Indicators Monitored
by the Fed
 Indicators of economic growth




Gross Domestic Product or GDP
Industrial production
National income
Unemployment
 Indicators of Inflation
 Producer price indexes
 Consumer price Indexes
 Other indicators
Economic Indicators Monitored
by the Fed
 How the Fed uses indicators
 Fed meets to decide course of monetary
policy
 Assesses recent reports on indicators of
growth and inflation
 Uses indicators to anticipate how the
economy will change
 Decides the appropriate monetary policy
given possible conditions
Lags in Monetary Policy
 Recognition lag
 Most economic problems revealed by statistics, not
observation
 Fed quick to see changes in economy
 Implementation lag
 Fed acts quickly to implement change in monetary
policy
 Fiscal policy via Congress takes a long time
 Impact Lag
 Takes time for monetary changes to have full impact
 Fiscal policy tax changes have unpredictable results
Assessing the Impact of
Monetary Policy
 How does the policy change affect
financial market participants?
 Depends on the kinds of securities you trade
 Depends on your expectations about how
the changes affect on the economy
 Forecasting money supply movements
 Financial market participants look at actual
growth compared to Fed targets
 Growth outside range could signal Fed policy
changes
Assessing the Impact of
Monetary Policy
 Improved communication at the Fed
 Fed more willing to disclose its intentions
since 1999
 Immediate feedback to public and financial
markets about “bias” on rates
 Market reaction to reported money
supply levels
 Thursday release of money supply data
 Try to determine future trends in interest
rates
Assessing the Impact of
Monetary Policy
 Anticipating reported money supply
levels
 Securities and financial market professionals
cannot profit on information available to all
at the same time
 Try to forecast and anticipate changes
 Trying to figure out the future course of
interest rates and Fed policy
 Market reaction to discount rate
adjustment
Assessing the Impact of
Monetary Policy
 Market reaction to discount rate
adjustment
 Monitor changes to determine policy
 Some changes are technical or intended
to bring the discount rate in line with
market rates
 Financial market participants try to
anticipate changes
 Discount rate seems to preceded market
interest rate movements since 1980
Exhibit 5.9
Federal Open
Market Committee
(FOMC)
Supply of
Loanable Funds
Money Supply
Targets
Inflationary
Expectations
Demand for
Loanable Funds
Equilibrium
Interest Rates
Cost of
Household Credit
(Including Mortgage
Rates)
Household
Consumption
Cost of Capital
for Corporations
Residential
Construction
Economic
Growth
Corporate
Expansion
Assessing the Impact of
Monetary Policy
 Forecasting the impact of monetary
policy
 Even if financial market participants
correctly anticipate changes in the
money supply there are still problems
 Not a stable relationship between money
supply and economic variables over time
 Examples include the relationship between
economic growth and the money supply
Integrating Monetary and Fiscal
Policies
 History
 Executive branch usually most concerned
with employment and growth
 Fed and administration may differ on
priorities of price stability or growth
needs
 Agreement when inflation and
unemployment are at relatively low
levels
Exhibit 5.12
U.S.
Monetary
Policy
U.S.
Fiscal
Policy
U.S.
Personal
Income
Tax Rates
U.S.
Budget
Deficit
U.S.
Business
Tax Rates
U.S.
Personal
Income
Level
U.S.
Household
Demand
for Funds
Government
Demand
for Funds
Savings
by U.S.
Households
Supply
of Funds
in U.S.
Demand
for Funds
in U.S.
U.S.
Interest
Rate
U.S.
Business
Demand
for Funds
Integrating Monetary and Fiscal
Policies
 Combined monetary and fiscal policy
effects
 Fiscal policy usually has a larger influence on the
demand for loanable funds
 Monetary policy usually has a larger influence on the
supply of loanable funds
 Monetizing the debt
 Should the Fed help finance a federal budget deficit
created by fiscal policy?
 Forecasted surpluses, debt reduction, and U.S.
Treasury securities
Integrating Monetary and Fiscal
Policies
 Market assessment of integrated
policies
 Financial markets assess both fiscal and
monetary policy
 Markets monitor a wide range of
information and data
 Forecast how loanable funds supply and
demand will change
Forecasting Money Supply
 Watch weekly federal reserve data
releases
 Observe changes with announced fed
ranges of money growth
 Markets attempt to estimate changes
in monetary policy direction and . . .
 Anticipate interest rate changes
138
第五章总结




主要熟悉美国货币政策的制定流程
了解货币政策与财政政策的结合点
了解宏观调控政策的机理
关注宏观调控政策对于财务决策的影响
CH 6
Money Markets
Chapter Objectives
 Provide a background on money
market securities
 Explain how institutional investors
use money markets
Money Market Securities
 Maturity of a year or less
 Debt securities issued by corporations
and governments that need shortterm funds
 Large primary market center
 Purchased by corporations and
financial institutions
 Secondary market for securities
Money Market Securities






Treasury Bills
Commercial paper
Negotiable certificates of deposits
Repurchase agreements
Federal funds
Banker’s acceptances
143
Money Market Securities
 Treasury bills
 Issued to meet the short-term needs of
the U.S. government
 Attractive to investors
 Minimal default risk—backed by Federal
Government
 Excellent liquidity for investors
 Short-term maturity
 Very good secondary market
Money Market Securities
Competitive Bidding
 Treasury bill auction
 Bid process used to sell T-bills
 Bids submitted to Federal Reserve banks
by the deadline
 Bid process
 Accepts highest bids
 Accepts bids until Treasury needs generated
Money Market Securities
Noncompetitive Bidding
 Treasury bill auction—noncompetitive bids
($1 million limit)
 May be used to make sure bid is accepted
 Price is the weighted average of the accepted
competitive bids
 Investors do not know the price in advance so
they submit check for full par value
 After the auction, investor receives check from
the Treasury covering the difference between
par and the actual price
Money Market Securities
 Estimating T-bill yield
 No coupon payments
 Par value received at maturity
 Yield at issue is the difference between
the selling price and par value adjusted
for time
 Yield based on the difference between
price paid for T-bill and selling price
adjusted for time if sold prior to maturity
in secondary market
Money Market Securities
 Calculating T-Bill Annualized Yield
YT =
SP – PP
PP

365
n
YT = The annualized yield from investing in a T-bill
SP = Selling price
PP = Purchase price
n = number of days of the investment (holding period)
Money Market Securities
 T-bill yield for a newly issued security
T-bill discount =
Par – PP
PP

360
n
T-bill discount = percent discount of the purchase price from par
Par = Face value of the T-bills at maturity
PP = Purchase price
n = number of days to maturity
Money Market Securities
Commercial Paper







Short-term debt instrument
Alternative to bank loan
Dealer placed vs. directly placed
Used only by well-known and creditworthy firms
Unsecured
Minimum denominations of $100,000
Not a large secondary market
Money Market Securities
 Commercial paper backed by bank
lines of credit
 Bank line used if company loses credit
rating
 Bank lends to pay off commercial paper
 Bank charges fees for guaranteed line of
credit
Money Market Securities
 Estimating commercial paper yields
YCP =
Par – PP
PP

360
n
YCP = Commercial paper yield
Par = Face value at maturity
PP = Purchase price
n = number of days to maturity
Money Market Securities
Negotiable Certificates of Deposit (NCD)
 Issued by large commercial banks
 Minimum denomination of $100,000 but
$1 million more common
 Purchased by nonfinancial corporations
or money market funds
 Secondary markets supported by dealers
in security
Money Market Securities
 NCD placement
 Direct placement
 Use a correspondent institution
specializing in placement
 Sell to securities dealers who resell
 Sell direct to investors at a higher price
 NCD premiums
 Rate above T-bill rate to compensate for
lower liquidity and safety
Money Market Securities
Repurchase Agreements
 Sell a security with the agreement to repurchase it at
a specified date and price
 Borrower defaults, lender has security
 Reverse repo name for transaction from lender
 Negotiated over telecommunications network
 Dealers and brokers used or direct placement
 No secondary market
Money Market Securities
 Estimating repurchase agreement
yields
Repo Rate =
SP – PP
PP

360
n
Repo Rate = Yield on the repurchase agreement
SP = Selling price
PP = Purchase price
n = number of days to maturity
Money Market Securities
Federal Funds
 Interbank lending and borrowing
 Federal funds rate usually slightly higher than T-bill
rate
 Fed district bank debits and credits accounts for
purchase (borrowing) and sale (lending)
 Federal funds brokers may match up buyers and
sellers using telecommunications network
 Usually $5 million or more
Exhibit 6.5
Purchase Order
5
Shipment of Goods
3
American Bank
(Importer’s Bank)
Shipping Documents & Time Draft
2
L/C Notification
Exporter
L/C (Letter of Credit) Application
Importer
1
4
6
L/C
7 Shipping Documents & Time Draft
Draft Accepted (B/ACreated)
Japanese Bank
(Exporter’s Bank)
Money Market Securities
Bankers Acceptance
 A bank takes responsibility for a future payment of
trade bill of exchange
 Used mostly in international transactions
 Exporters send goods to a foreign destination and
want payment assurance before sending
 Bank stamps a time draft from the importer
ACCEPTED and obligates the bank to make good on
the payment at a specific time
Money Market Securities
Bankers Acceptance
 Exporter can hold until the date or sell
before maturity
 If sold to get the cash before maturity, price
received is a discount from draft’s total
 Return is based on calculations for other
discount securities
 Similar to the commercial paper example
Major Participants in Money
Market
 Participants





Commercial banks
Finance, industrial, and service companies
Federal and state governments
Money market mutual funds
All other financial institutions (investing)
 Short-term investing for income and liquidity
 Short-term financing for short and permanent
needs
 Large transaction size and telecommunication
network
161
Valuation of Money Market
Securities
 Present value of future cash flows at
maturity (zero coupon)
 Value (price) inversely related to
discount rate or yield
 Money market security prices more
stable than longer term bonds
 Yields = risk-free rate + default risk
premium
162
Exhibit 6.7
International
Economic
Conditions
U.S.
Fiscal
Policy
U.S.
Monetary
Policy
U.S.
Economic
Conditions
Short-Term
Risk-Free
Interest
Rate
(T-bill Rate)
Issuer’s
Industry
Conditions
Issuer’s
Unique
Conditions
Risk
Premium
of Issuer
Required Return
on the Money
Market Security
Price of the
Money Market
Security
Interaction Among Money
Market Yields
Securities are close investment substitutes
Investors trade to maintain yield differentials
T-Bill is the benchmark yield in money market
Yield changes in T-bills quickly impacts other
securities via dealer trading
 Yield differentials determined by risk
differences between securities
 Default risk premiums vary inversely with
economic conditions




164
Globalization of Money Markets
 Money market rates vary by country




Segmented markets
Tax differences
Estimated exchange rates
Government barriers to capital flows
 Deregulation Improves Financial
Integration
 Capital Flows To Highest Rate of
Return
165
Globalization of Money Markets
 Performance of international
securities
 Yield for an international investment
Yf
SPf – PPf
=
PPf
Yf = Foreign investment’s yield
SPf = Investment’s foreign currency selling price
PPf = Investment’s foreign currency purchase
Chapter Concepts Summary
 Surplus units channel investments to
securities issued by deficit units
 Debt securities markets
 Money Market
 Capital Market
 Money market securities
 Short-term
 High quality
 Very good liquidity
CH 7
Bond Markets
Chapter Objectives
 Provide informational background on
U.S. Treasury, state and municipal,
and corporate Bonds
 Calculate bond yield from quote
 Explain the role of bonds to
institutional investors
 Discuss the globalization of bond
markets
Background on Bonds
 Bonds represent long-term debt
securities
 Contractual
 Promise to pay future cash flows to investors
 The issuer of the bond is obligated to
pay:
 Interest (or coupon) payments periodically usually
semiannually
 Par or face value (principal) at maturity
 Primary vs. secondary market for bonds
Background on Bonds
Bond Interest Rates
The issuer’s cost of financing with
bonds is the coupon rate
 Determined by current market rates
and risk
 Usually fixed throughout term
 Determines periodic interest payments
Background on Bonds
Bond Yield to Maturity
The yield to maturity (TYM) is the yield
that equates the future coupon and
principal payments with the bond price
 The YTM is the investor’s expected rate of
return if the bond is held to maturity
 The actual YTM may vary from the expected
because of risks assumed by the investors
U. S. Treasury Bonds
 Issued by the U.S. Treasury to finance federal
government expenditures
 Maturity
 Notes, < 10 Years
 Bonds, > 10 to 30 Years
 Active OTC Secondary Market
 Semiannual Interest Payments
 Benchmark Debt Security for Any Maturity
Treasury Bonds
 Treasury Bond Quotations
8.38 Aug. 2013-18
103:05
103.11 YTM?




Coupon rate
Maturity date
Bid/Ask price as percent of face value
Fractions of price in 32nds
 Example: Bid price 103:05, Ask price 103:11
 Yield to Maturity (YTM)
Federal Agency Bonds
 Government National Mortgage
Association (GNMA)
 Issues bonds and uses proceeds to
purchase insured FHA and VA mortgages
 A U.S. Government Agency
 Backed by explicit guarantee of Federal
Government
 Example of social allocation of capital
Federal Agency Bonds
 Federal Home Loan Mortgage
Association (Freddie Mac)
 Issues bonds and uses proceeds to
purchase conventional mortgages
 A U.S. government-sponsored agency
 No explicit guarantee of bonds by federal
government, but credit risk is very low
 Used to provide liquidity for thrifts and
support of home ownership
Municipal Bonds
 State and local government obligations
 Revenue bonds vs. general obligation
Bonds
 Investor interest income exempt from
federal income tax
 Tax Reform Act of 1986 placed
limitations on tax-exempt bond issuance
for private purposes
Corporate Bonds
 When corporations want to borrow for
long-term periods they issue corporate
bonds
Usually pay semiannual interest
Most have maturities between 10-30 years
Public offering vs. private placement
Limited exchange, larger OTC secondary
market
 Investors seek safety of principal and steady
income




Exhibit 7.5
Financial Institution
Participation in Bond Markets
Commercial banks and savings
and loan associations (S&Ls)
• Purchase bonds for their asset portfolio.
•
• Sometimes
place municipal bonds for municipalities.
• Sometimes issue bonds as a source of secondary capital.
Finance companies
• Commonly issue bonds as a source of long-term funds.
Mutual funds
• Use funds received from the sale of shares to purchase bonds. Some bond mutual funds
specialize in particular types of bonds, while others invest in all types.
Brokerage rms
• Facilitate bond trading by matching up buyers and sellers of bonds in the secondary market.
Investment banking rms
• Place newly issued bonds for governments and corporations. They may place the bonds
and assume the risk of market price uncertainty or place the bonds on a best-efforts basis
in which they do not guarantee a price for the issuer.
Insurance companies
• Purchase bonds for their asset portfolio.
Pension funds
• Purchase bonds for their asset portfolio.
CH 8
Bond Valuation and Risk
Chapter Objectives
 Demonstrate how bond market prices are
established and influenced by interest rate
movements
 Identify the factors that affect bond prices
 Explain how the sensitivity of bond prices to
interest rates is dependent on particular bond
characteristics
 Explain the benefits of diversifying the bond
portfolio internationally
Bond Valuation Process
 Bonds are debt obligations with longterm maturities issued by governments
or corporations to obtain long-term
funds
 Commonly purchased by financial
institutions that wish to invest funds for
long-term periods
 Bond price (value) = present value of
cash flows to be generated by the bond
Bond Valuation Process
 Impact of the Discount Rate on Bond
Valuation
 Discount rate = market-determined yield
that could be earned on alternative
investments of similar risk and maturity
 Bond prices vary inversely with changes in
market interest rates
 Cash flows are contractual and remain the same
each period
 Bond prices vary to provide the new owner the
market rate of return
Bond Valuation Process
 Bond Price = present value of cash flows
discounted at the market required rate of
return




C = Coupon per period (PMT)
Par = Face or maturity value (FV)
i = Discount rate (i)
n = Compounding periods to maturity
C
+
PV =
(1+ i)1
C + Par
C
+…
(1+ i)2
(1+ i)n
Bond Valuation Process
 Consider a $1000, 10% coupon (paid annually)
bond that has three years remaining to
maturity. Assume the prevailing annualized
yield on other bonds with similar risk is 12
percent. Calculate the bond’s value.
 The expected cash flows of a coupon
bond includes periodic interest payments,
and…
 A final $1000 payoff at maturity
 Discounted at the market rate of return
of 12%
Bond Valuation Process
 Valuation of Bonds with Semiannual
Payments
 Most bonds pay interest
semiannually
 Double the number of
compounding periods (N) and
halve the annual coupon amount
(PMT) and the discount rate (I)
Relationships Between Coupon
Rate, Required Return, and
Bond Price
Zero-Coupon Bonds





No periodic coupon
Pays face value at maturity
Trade at discount from face value
No reinvestment risk
Considerable price risk
Relationships Between Coupon
Rate, Required Return, and
Bond Price
 Discount bonds are bonds priced below face
value; premium bonds above face value
 Discounted bond
 Coupon < Market rates
 Rates have increased since issuance
 Adverse risks factors that may have occurred
 Price risk—depends on maturity
 Default risk may have increased
 Fisher effect of higher expected inflation
Relationships Between Coupon
Rate, Required Return, and
Bond Price
 Premium bond
 Coupon > Market
 Rates decreased since issuance
 Favorable risk experience
 Price risk—depends on maturity
 Default risk might have decreased as
economic activity has increased
 Low inflation expectations
Relationships Between Coupon
Rate, Required Return, and
Bond Price
Bond Maturity and Price Variability
 Long-term bond prices are more sensitive to
given changes in market rates than shortterm bonds
 Changes in rates compounded many times
for later coupon and maturity value,
impacting price (PV) significantly
 Short-term securities have smaller price
movements
Exhibit 8.4
1,800
1,600
1,400
1,200
1,000
5-Year Bond
10-Year Bond
20-Year Bond
800
600
400
200
0
0
5
8
10
12
Required Return (Percent)
15
20
Relationships Between Coupon
Rate, Required Return, and
Bond Price
Coupon Rates and Price Variability
 Low coupon bond prices more sensitive
to change in interest rates
 PV of face value at maturity a major
proportion of the price
Explaining Bond Price
Movements
 The price of a bond should reflect the
present value of future cash flows
discounted at a required rate of
return
 The required return on a bond is
primarily determined by
 Prevailing risk-free rate
 Risk premium
Explaining Bond Price
Movements
 Factors that affect the risk-free rate
 Changes in returns on real investment
 Financial investment an alternative to real
investment
 Opportunity cost of financial investment is the
returns available from real investment
 Federal Government deficits/surplus position
 Inflationary expectations




Consumer price index
Federal Reserve monetary policy position
Oil prices and other commodity prices
Exchange rate movements
Explaining Bond Price
Movements
 Factors that affect the credit or default
risk premium
 Strong economic growth
 High level of cash flows
 Investors bid up bond prices; lower default
premium
 Weak economic growth




Lower profits and cash flows
Impact on specific industries varied
Investors flee from risky bonds to Treasury bonds
Bond prices fall; default premiums increase
Exhibit 8.8
U.S.
Fiscal
Policy
U.S.
Monetary
Policy
U.S.
Economic
Conditions
Long-Term
Risk-Free
Interest Rate
(Treasury
Bond Rate)
Issuer’s
Industry
Conditions
Risk
Premium
of Issuer
Required
Return
on the
Bond
Bond Price
Issuer’s
Unique
Conditions
Sensitivity of Bond Prices to
Interest Rate Movements
 Bond Price Elasticity = Bond price
sensitivity for any % change in market
interest rates
 Bond Price Elasticity =
(% Change In Price)/(% Change In
Interest Rates)
 Increased elasticity means greater price
risk
Sensitivity of Bond Prices to
Interest Rate Movements
 Calculate the price sensitivity of a
zero-coupon bond with 10 years until
maturity if interest rates go from
10% to 8%.
 First, calculate the price of the bond for
both rates
 When k = 10%, PV = $386
 When k = 8%, PV = $463
Sensitivity of Bond Prices to
Interest Rate Movements
Calculate the bond elasticity:
$463  $386
percentP
$386
Pe 

 .997
8%  10%
percentk
10%
Bond elasticity or price sensitivity to changes in
interest rates approaches the limit at –1 for zero-coupon
bonds. Price sensitivity is lower for coupon
bonds. The inverse relationship between k and p
causes the negative numbers
Sensitivity of Bond Prices to
Interest Rate Movements
 Price-Sensitive Bonds
 Longer maturity—more price variation
for a change in interest rates
 Lower coupon rate bonds are more price
sensitive (the PV is a greater % of
current value)
 Zero-coupon bonds most sensitive,
approaching –1 price elasticity
 Greater for declining rates than for
increasing rates
Sensitivity of Bond Prices to
Interest Rate Movements
Duration
 Measure of bond price sensitivity
 Measures the life of bond on a PV basis
 Duration = Sum of discounted, timeweighted cash flows divided by price
Sensitivity of Bond Prices to
Interest Rate Movements
Duration
 The longer a bond’s duration, the greater
its sensitivity to interest rate changes
 The duration of a zero-coupon bond =
bond’s term to maturity
 The duration of any coupon bond is
always less than the bond’s term to
maturity
Sensitivity of Bond Prices to
Interest Rate Movements
 Modified duration is an easily
calculated approximate of the
duration measure
DUR
DUR* 
(1  k )
DUR* is a linear approximation of DUR which measures
the convex relationship between bond yields and prices
Bond Investment Strategies
Used by Investors
Matching Strategy
 Create bond portfolio that will generate
income that will match their expected
periodic expenses
 Used to provide retirement income from
savings accumulation
 Estimate cash flow needs then select bond
portfolio that will generate needed income
Bond Investment Strategies
Used by Investors
Laddered Strategy
 Funds are allocated evenly to bonds in several
different maturity classes
 Example: ¼ funds invested in bonds with 5 years
until maturity, ¼ in10-year bonds, ¼ in 15-year bonds,
and ¼ in 20-year bonds
 Investor receives average return of yield curve over
time as maturing bonds are reinvested
Bond Investment Strategies
Used by Investors
Barbell Strategy
 Allocated funds to short-term bonds and
long-term bonds
 Short-term bonds provide liquidity from
maturity
 Long-term bonds provide higher yield
(assuming up-sloping yield curve)
Bond Investment Strategies
Used by Investors
Interest Rate Strategy
 Funds are allocated in a manner that
capitalizes on interest rate forecasts
 Example: if rates are expected to decline,
move into longer-term bonds
 Problems:
 High transaction costs because of higher trading
 Difficulty in forecasting interest rates
Foreign Exchange Rates and
Interest Rates
 Country interest rate differences reflect
expected future spot foreign exchange
rates
 Expected future spot foreign exchange
rates (forward forex rates) reflect expected
inflation differences between countries
 Expected return on foreign bond portfolio
related to return on bonds adjusted for
expected changes in forex rates
208
Diversifying Bonds
Internationally
 Investor may diversify by:




Credit risk
Country risk
Foreign exchange risk
Interest rate risk
 Seek lower total variability of returns
per level of risk assumed
209
CH 9
Mortgage Markets
Chapter Objectives
 Describe characteristics of residential
mortgages
 Describe the common types of creative
mortgage financing
 Explain the role of the federal government
in supporting the development of the
secondary mortgage market
 Relate the development and use of
mortgage-backed securities
Residential Mortgage
Characteristics
Insured vs. Conventional Mortgages
 Federal and private insurance guarantees repayment
in the event of borrower default
 Limits on amounts, borrower requirements
 Borrower pays insurance premiums
 Federal insurers include Federal Housing
Administration and Veterans Administration
Residential Mortgage
Characteristics
Fixed rate loans have a constant,
unchanging rate
 Interest rate risk can hurt lender rate of
return
 If interest rates rise in the market, lender’s cost of
funds increases
 No matching increase in fixed-rate mortgage
return
 Borrowers lock in their cost and have to
refinance to benefit from lower market rates
Residential Mortgage
Characteristics
 Adjustable-rate mortgages
 Rates and the size of payments can change
 Maximum allowable fluctuation over year and
life of loan
 Upper and lower boundaries for rate changes
 Lenders stabilize profits as yields move with cost
of funds
 Uncertainty for borrowers whose mortgage
payments can change over time
Residential Mortgage
Characteristics
Mortgage Maturities
 Trend shows increased popularity of
15-year loans
 Lender has lower interest rate risk if the
term or maturity of the loan is lower
 Borrower saves on interest expense over
loan’s life but monthly payments higher
Residential Mortgage
Characteristics
Mortgage Maturities
 Balloon payments
 Principal not paid until maturity
 Forces refinancing at maturity
 Amortizing mortgages
 Monthly payments consist of interest and principal
 During loan’s early years, most of the payment
reflects interest
Creative Mortgage Financing
 Graduated-payment mortgage (GPM)
 Small initial payments
 Payments increase over time then level
off
 Assumes income of borrower grows
 Growing-equity mortgage
 Like GPM low initial payments
 Unlike GPM, payments never level off
Creative Mortgage Financing
 Second mortgage used in conjunction
with first or primary mortgage
 Shorter maturity typically for 2nd mortgage
 1st mortgage paid first if default occurs so
2nd mortgage has a higher rate
 If used by sellers, makes a home with an
assumable loan more affordable
 Shared-appreciation mortgage
 Below market rate but lender shares in
home’s price appreciation
Activities in the Mortgage
Markets
 How the secondary market facilitates
mortgage activities
 Selling loans
 Origination, servicing and funding are
separate business activities and may be
“unbundled”
 Secondary market exists for loans
 Securitization
 Pool and repackage loans for resale
 Allows resale of loans not easily sold on an
individual basis
Activities in the Mortgage
Markets
 Unbundling of mortgage activities
provides for specialization in:




Loan origination
Loan servicing
Loan funding
Any combination of the above
Institutional Use of Mortgage
Markets, December, 2002
 Federally related mortgage pools
 37% of all mortgages, mostly residential
 Commercial banks
 Dominate commercial mortgage market
 Hold 23.3% of all mortgages
 Savings institutions
 Primarily residential mortgages
 Hold 10% of all mortgages
 Life insurance companies
 Commercial mortgages
 Hold 3% of all mortgages
Institutional Use of Mortgage
Markets
 Mortgage companies
 Originate and quickly sell loans
 Do not maintain large portfolios
 Government agencies including
Fannie Mae and Freddie Mac
 Brokerage firms
 Investment banks
 Finance companies
Valuation of Mortgages
 Market price of mortgages is present value
of cash flows
C  PRIN
PM  
t
(1  k )
t 1
n
Where:
PM = Market price of a mortgage
C = Interest payment and PRIN is principal
k = Investor’s required rate of return
t = maturity
Valuation of Mortgages
 Periodic payment commonly includes
payment of interest and principal
 Required rate of return determined by
risk-free rate, credit risk and liquidity
 Risk-free interest rate components
and relationship




+ inflationary expectations
+ economic growth
– change in the money supply
+ budget deficit
Valuation of Mortgages
 Economic growth affects the risk
premium
 Strong growth improves borrowers’ income
and cash flows and reduces default risk
 Weak growth has the opposite affect
 Potential changes in mortgage prices
monitored by reviewing inflation,
economic growth, deficits, housing, and
other predictor economic statistics
Exhibit 9.8
U.S.
Fiscal
Policy
U.S.
Monetary
Policy
Long-Term
Risk-Free
Interest Rate
(T-Bond Rate)
U.S.
Economic
Conditions
Issuer’s
Industry
Conditions (for
Commercial
Mortgages)
Prepayment
Risk
Premium
of Issuer
Risk
Premium
of Issuer
Required Return
on the
Fixed-Rate
Mortgage
Price of
Fixed-Rate
Mortgage
Issuer’s
Unique
Conditions
Risk from Investing in
Mortgages
 Interest rate risk
 Present value of cash flows or value of
mortgage changes as interest rate
changes
 Long-term fixed-rate mortgages
financed by short-term funds results in
risks
 To limit exposure to interest rate risk
 Sell mortgage shortly after origination (but
rate may change in that short period of time)
 Make adjustable rate mortgages
Risk from Investing in
Mortgages
 Prepayment risk
 Borrowers refinance if rates drop by
paying off higher rate loan and financing
at a new, lower rate
 Investor receives payoff but has to invest
at the new, lower interest rate
 Manage the risk with ARMs or by selling
loans
Risk from Investing in
Mortgages
 Credit risk can range from default to late
payments
 Factors that affect default
 Level of borrower equity
 Loan-to-value ratio often used
 Higher use of debt, more defaults
 Borrowers income level
 Borrower credit history
 Lenders try to limit exposure to credit risk
Risk from Investing in
Mortgages
 Measuring risk
 Use sensitivity analysis to review various
“what if” scenarios covering everything
from default to prepayments
 Incorporate likelihood of various events
 Review effect on cash flows
 Institution tries to measure risks and use
information to restructure or manage
risk
Use of Mortgage-Backed
Securities
 Securitization is an alternative to the
outright sale of a loan
 Group of mortgages held by a trustee
serves as collateral for the securities
 Institution can securitize loans to
avoid interest rate risk and credit risk
while still earning service fees
 Payments passed through to investors
can vary over time
Use of Mortgage-Backed
Securities
Ginnie Mae mortgage-backed
securities
 Government National Mortgage
Association
 Guarantees timely interest and principal
payments to investors
 Pool of loans with the same interest rate
 Purchasers receive slightly lower rate
than that on the loans to cover service
and guarantee
Use of Mortgage-Backed
Securities
 Fannie Mae mortgage-backed
securities
 Uses funds from mortgage-backed passthrough securities to purchase
mortgages
 Channel funds from investors to
institutions that want to sell mortgages
 Guarantee timely payments to investors
 Some securities strip (securitize) interest
and principal payment streams for
separate sale
Use of Mortgage-Backed
Securities
 Publicly issued pass-through
securities (PIPS)
 Backed by conventional mortgages
instead of FHA or VA mortgages
 Private mortgage insurance
 Participation certificates (PCs)
 Freddie Mac sells and uses funds to
finance origination of conventional
mortgages from financial institutions
Use of Mortgage-Backed
Securities
 Collateralized mortgage obligations (CMOs)
 Semi-annual payments differ from other
securities’ monthly payments
 Segmented into classes
 First class has quickest payback
 Any repaid principal goes first to investors
in this class
 Investors choose a class to fit maturity
needs
 One concern is payback speed when rates
drop
Use of Mortgage-Backed
Securities
 CMOs (cont.)
 Can be segmented into interest-only IO
or principal-only PO classes
 High return for IO reflect risks
 Useful investment but be aware of the
risks
 1992 failure of Coastal States Life
Insurance due to CMO investments
 Some CMO mutual funds
 Regulators have increased scrutiny
Use of Mortgage-Backed
Securities
 Mortgage-backed securities for small
investors
 In the past, high minimum denominations
 Unit trusts created to allow small investor
participation
 Mutual funds
 Advantages
 Can purchase in secondary market without
purchasing the need to service loans
 Insured
 Liquid
CH 10
Stock Offerings and Investor
Monitoring
Chapter Objectives
 Describe the stock exchanges where
stocks are traded
 Analyze the process of the initial
public offering of stock by a company
 Be able to interpret a stock quote
 Explain the institutional use of stock
markets
 Describe the globalization of stock
markets
Background on Common Stock
 Common stock = certificate representing
equity or partial ownership in a
corporation
Issued in primary market by corporations
that
need long-term funds
Stock is then traded in the secondary
market, creating liquidity for investors
and company
Background on Common Stock
Ownership and Voting Rights
 Owners of common stock vote on:




Election of board of directors
Authorization to issue new shares
Amendments to corporate charter
Other major events
 Many investor assign their vote to
management via a proxy
 Households own about half of all common
stock, the rest is owned by institutional
investors
Background on Preferred Stock
 Represents equity or ownership interest, but
usually no voting rights
 Trade voting rights for stated fixed annual
dividend
 Dividend paid before common if dividends are
declared by board of directors
 Dividend may be omitted
 Cumulative provision
 If common dividend paid, preferred dividend
fixed
Public Placement of Stock
 Initial public offerings (IPOs)
 First-time offering of shares to the public
 Firm must provide information to public
 Registration statement to SEC
 Prospectus
 Firm is assisted by an investment banker
 Performance of IPOs
 Price generally rises on first day
 Longer-term performance of IPOs is poor
Public Placement of Stock
 Secondary stock offerings
 New stock issued by firm that already
has shares outstanding
 Shelf Registration
 1982 SEC rule
 Allows firms to place securities without
the time lag associated with registering
with SEC
Stock Secondary Markets
Organized Exchanges
 Execute secondary market transactions
 Examples: NYSE, AMEX, Midwest, Pacific
 NYSE is largest, controlling 80 percent of
value of all organized exchanges
 Must own a seat on exchange in order to
trade
 Trading resembles an auction
Stock Secondary Markets
Over-the-Counter Market
 No trading floor or specific location
 Telecommunications network
 Nasdaq
 National Association of Securities Dealers
Automatic Quotations
 Thousands of small firms, plus high-tech giants
 Pink sheets
 Tiny firms that do not meet requirements for
NASDAQ
Stock Secondary Markets
 Trend: Consolidation of stock
exchanges
 Market microstructure
 Specialists, floor brokers, and marketmakers
 Role of specialists
 Types of orders
 Market order
 Limit order
 Stop order
Stock Secondary Markets
 Changes in technology




Online trading
Real-time quotes
Company information
Electronic Communications Networks (ECNs)
 Margin requirements
 Specify amount of borrowed versus amount
in cash
Stock Secondary Markets
 Purchasing stock on margin
 Borrow a portion of the funds from broker
 Margin is the amount of equity an investor
provide
 Magnifies returns (both good and bad)
 Short sales
 Borrow stock and sell
 Repay stock loan, hopefully at a lower price
 Investor able to have potential profit from
decline in stock price
Regulation of Trading on Stock
Exchanges
n
Securities Act Of 1933 and 1934
n
Securities And Exchange Commission
n
National Association Of Securities Dealers
(NASD)
n
Regulate minimum information for investor and
broker/dealer business practices
n
Circuit breakers
Stock Quotation
 Stock Quotation
 52-week price range (high/low and
YTD% change)
 Stock symbol
 Dividend annualized and dividend yield
 Price-earnings ratio
 Volume in round lots
 Previous day’s price close and net daily
change
 Remainders in cents, not eighths
Exhibit 10.6
YTD %
change
Hi
Lo
Stock
Sym
DIV
Yld%
PE
Vol 100s
Last
Net Chg
110.3
121.88
80.06
IBM
IBM
.56
.6
20
71979
93.77
11.06
Year-to-date
percentage
change in
stock price
Highest
price
of the
stock
in this
year
Lowest
price
of the
stock
in this
year
Annual
dividend
paid per
year
Dividend
yield, which
represents
the annual
dividend as
a percentage
of the prevailing stock
price
Priceearnings
ratio based
on the
prevailing
stock price
Trading
volume
during the
previous
trading day
Closing
stock
price
Name
of stock
Stock
Symbol
Change in the
stock price
on the previous trading
day from the
close on the
day before
Stock Indexes
 Dow Jones Industrial Average
 Price-weighted average
 30 large U.S. firms
 Standard and Poor’s (S&P) 500
 Value-weighted
 500 large U.S. firms
 New York Stock Exchange Indexes
 Other Stock Indexes
 Amex, NASDAQ
Stock Indexes
 Investing in stock indexes
 Indexing
 Has become very popular
 Lower transactions costs
 Studies find that actively-managed funds
do not outperform stock indexes
 Examples of publicly traded stock
indexes
 SPDRs
 Diamonds
Stock Market Performance
 Comparing stock performance to
bond performance
Investor Trading Decisions
 Stock value = proportional value of
total company
 Investor return = dividend yield +
capital gain/loss
 New information translated into
trading decisions impacting
supply/demand for shares
 New equilibrium price established
until new information appears
Exhibit 10.8
New
Favorable
Information
Disclosed
to Investors
New
Unfavorable
Information
Disclosed
to Investors
Increased
Valuation
of
Security
by Investors
Reduced
Valuation
of
Security
by Investors
Increased
Demand for
Security
Reduced
Supply of
Security
for Sale
Reduced
Demand for
Security
Increased
Supply of
Security
for Sale
Increase in
Equilibrium
(Market)
Price of
Security
Decrease in
Equilibrium
(Market)
Price of
Security
Institutional Participation in
Stock Markets
 Program trading by institutions
 Simultaneously buying and selling of a
portfolio of at least 15 different stocks valued
at more than $1 million
 Most commonly used by securities firms
 Program refers to the use of computers
 Impact on stock volatility
 Often blamed for rise or fall in stock market
 Studies show that program trading does not
increase volatility
Investor Monitoring of Firms in
the Stock Market
 Communication with the firm
 Effort to place pressure on management
 Institutional investors
 CALPERS
 TIAA
 Proxy contest
 Shareholder lawsuits
Corporate Monitoring of Firms
in the Stock Market
Market for corporate control
 Stock price declines due to poor
management
 Subject to possible takeover
 Barriers to market for corporate
control
 Antitakeover amendments
 Poison pills
 Golden parachutes
Corporate Monitoring of Their
Own Stock in the Stock Market
 Stock repurchases
 Dividend alternative or undervalued stock
 Excessive cash relative to +NPV investments
 Leveraged buyouts (LBO)
 If managers believe the stock price
undervalued, they may buy the outstanding
shares with borrowed funds
 Stock offerings
 Signals overvalued shares
Globalization of Stock Markets
 Barriers to international stock trading
have decreased
 Reduction in information costs
 Reduction in exchange rate risk
 Foreign stock offerings in the United
States
 International placement process
 Global stock exchange characteristics
 Emerging stock markets
Globalization of Stock Markets
 Methods used to invest in foreign
shares




Direct purchases
American Depository Receipts (ADRs)
International mutual funds
World equity benchmark shares
CH 11
Stock Valuation
And Risk
Chapter Objectives
 Explain the general steps necessary to value
stocks and the commonly used valuation
models
 Learn the factors that affect stock prices
 Explain methods of determining the required
rate of return on stocks
 Learn how to measure the risk of stocks
 Learn how to measure performance of stock
 Explain the concept of stock market efficiency
Stock Valuation Methods
 The price of a share of stock is the total value of
the company divided by the number of shares
outstanding
 Stock price by itself doesn’t represent firm value
 Stock price is determined by the demand and
supply for the shares
 Investors try to value stocks and purchase those
that are perceived to be undervalued by the
market
 New information creates re-evaluation
Stock Valuation Methods
Price-Earnings (PE) Method
 Apply the mean PE ratio of publicly
traded competitors
 Use expected earnings rather than
historical
 Equation:
Firm’s
Stock
ratio
Price
=
Expected EPS  Mean industry PE
Stock Valuation Methods
Price-Earnings (PE) Method
 Reasons for different valuations
 Different earnings forecasts
 Different PE multipliers
 Different comparison or benchmark firms
 Limitations of the PE method
 Errors in forecast or industry composite
 Based on PE, which some analysts
question
Stock Valuation Methods
Dividend Discount Method
 The price of a stock reflects the present
value of the stock's future dividends
 t = period
 Dt = dividend in period t
 k = discount rate

Dt
Price  
t
t 1 (1  k)
Stock Valuation Methods
Dividend Discount Method
 Relationship between DDM and PE
Ratio for valuing firms
 PE multiple is influenced by required rate
of return of competitors and their
expected growth rate
 When using PE multiple method, the
investor implicitly assumes that k and g
will be similar to competitors
Stock Valuation Methods
Dividend Discount Method
 Limitations of the Dividend Discount
Model
 Potential errors in estimating dividends
 Potential errors in estimating growth rate
 Potential errors in estimating required
return
 Not all firms pay dividends
 Technology firms
Stock Valuation Methods
Dividend Discount Method
 Adjusting the Dividend Discount
Model
 Value of stock is determined by
 Present value of dividends over investment
horizon
 Present value of selling price at the end
 To forecast the selling price, the investor
can estimate the firm’s EPS in the year
they plan to sell, then multiply by the
Determining the Required Rate
of Return to Value Stocks
 Capital Asset Pricing Model (CAPM)
 Used to estimate the required return on
publicly traded stock
 Assumes that the only relevant risk is
systematic (market) risk
 Uses beta to measure risk rather than
standard deviation of returns
Rj = Rf + j(Rm – Rf)
Determining the Required Rate
of Return to Value Stocks
Rj = Rf + j(Rm – Rf )
 Capital Asset Pricing Model (CAPM)
 Estimating the risk-free rate and the
market risk premium
 Proxy for risk-free rate is the yield on newly
issued Treasury bonds
 The market risk premium, or (Rm-Rf ), can
be estimated using a long-term average of
historical data.
Determining the Required Rate
of Return to Value Stocks
Rj = Rf + j(Rm – Rf)
 Estimating the firm’s beta
 Beta measures systematic risk
 Reflects how sensitive individual stock’s returns are
relative to the overall market
 Example: beta of 1.2 indicates that the stock’s
return is 20% more volatile than the overall market
 Investor can look up beta in a variety of sources
such as Value Line or Yahoo! Finance (Profile)
 Computed by regressing stock’s returns on returns
of the market, usually represented by the S&P 500
index or other market proxy
Determining the Required Rate
of Return to Value Stocks
 Arbitrage Pricing Model
 Differs from CAPM in that it suggests a
stock’s price is influenced by a set of
factors rather than just the return on the
market
 Factors may include things like:
 Economic growth
 Inflation
 Industry effects
 Problem with APT: factors are unspecified
and must be defined
Factors that Affect Stock Prices
 Economic factors
 Interest rates
 Most of the significant stock market declines
occurred when interest rates increased
substantially
 Market’s rise in 1990s: low interest rates; low
required rates of return
 Exchange rates
 Foreign investors purchase U.S. stocks when
dollar is weak or expected to appreciate
 Stock prices of U.S. companies also affected by
exchange rates
Factors that Affect Stock Prices
 Market-related factors
 January effect
 Noise trading
 Trading by uninformed investors pushes
stock price away from fundamental value
 Market maker spreads
 Trends
 Technical analysis
 Repetitive patterns of price movements
Factors that Affect Stock Prices
 Firm-specific factors






Expected +NPV investments
Dividend policy changes
Significant debt level changes
Stock offerings and repurchases
Earnings surprises
Acquisitions and divestitures
Factors that Affect Stock Prices
 Integration of factors affecting stock
prices
 Evidence on factors affecting stock
prices
 Fundamental factors influence stock prices, but
they do not fully account for price movements
 Smart-money investors
 Noise traders
 Excess volatility
 Indicators of future stock prices
 Things that affects cash flows and required
returns
 Variance in opinions about indicators
Exhibit 11.3
International
Economic
Conditions
U.S.
Fiscal
Policy
U.S.
Monetary
Policy
U.S.
Economic
Conditions
Stock Market
Conditions
Market
Risk
Premium
Risk-Free
Interest
Rate
Expected
Cash Flows
to Be
Generated
by the
Firm
Firm’s
Risk
Premium
Required Return
by Investors
Who Invest in
the Firm
Price of the
Firm’s
Stock
Industry
Conditions
Firm-Specific
Conditions
Firm’s
Systematic
Risk
(Beta)
Analysts and Stock Valuation
 Stock analysts interpret “valuation
effect” of new information for
investors
 Analysts’ opinions impact stock
buying/selling
 Analysts’ ratings seldom recommend
sell
 Income of analyst may come from
investment banking side of business
selling company shares
 Companies shun analysts who
Analysts and Stock Valuation,
cont.
 Analyst may obtain “new” information
with company executives in
conference call
 Other investors are not privy to
information
 Regulation FD (Fair Disclosure) from SEC
requires “release” of new significant
information at the same time as
teleconference calls with analysts.
 Other analyst recommendations
 Value Line
Measures of Stock Risk
 Market price volatility of stock
 Indicates a range of possible returns
 Positive and negative
 Standard deviation measure of variability
 Volatility of a stock portfolio depends
upon:
 Volatility of individual stocks in the
portfolio
 Correlation coefficients between stock
returns
 Proportion of total funds invested in each
Measures of Stock Risk
 Beta of a stock
 Measures sensitivity of stock’s returns
to market’s returns
 Beta of a stock portfolio
 Weighted average of the betas of the
stocks that comprise the portfolio
 p = wi  i
Measures of Stock Risk
 Value at Risk
 Estimates the largest expected loss to a
particular investment position for a
specified confidence level
 Warns investors about the potential
maximum loss that they may incur with
their investment portfolio
 Focuses on the “loss” side of possible
returns
 Used to analyze risk of a portfolio
Applying Value at Risk
 Methods of determining the maximum
expected loss
 Use of historical returns
 Example: count the percent of total days that
a stock drops a certain level
 Use of standard deviation
 Used to derive boundaries for a specific
confidence level
 Use of beta
 Used in conjunction with a forecast of a
maximum market drop
 Beta serves as a multiplier of the expected
Applying Value at Risk
 Deriving the maximum dollar loss
 Apply the maximum percentage loss to
the value of the investment
 Common adjustments to the valueat-risk applications




Investment horizon desired
Length of historical period used
Time-varying risk
Restructuring the investment portfolio
Forecasting Stock Price
Volatility and Beta
 Methods of forecasting stock price
volatility
 Historical method
 Time-series method
 Implied standard deviation
 Derived from the stock option pricing model
 Forecasting a stock portfolio's volatility
 One method involves forecasts of individual
volatility levels and using correlation coefficients
 Forecasting a stock portfolio’s beta
 Forecast changes in individual stock betas
Stock Performance
Measurement
 Sharpe Index
 Assumes total variability is the
appropriate measure of risk
 A measure of reward relative to risk
R - Rf
Sharpe Index 

Stock Performance
Measurement
 Treynor Index
 Assumes that beta is the appropriate type
of risk
 Measure of risk-adjusted return
 Higher the value; the higher the return
relative to the risk-free rate
R - Rf
Treynor Index 

CH 12
Market Microstructure and Strategies
Chapter Objectives
 Describe typical common stock
transactions and their execution
 Explain the role of electronic
communications networks (ECNs)
 Describe the regulation of stock
transactions
 Explain how barriers to international
stock transactions have been reduced
Stock Market Transactions
Placing an Order
 Market order to buy/sell at the best
possible price
 Limit order is a market order with a
specific price maximum or minimum
 Discount vs. full-service broker
 Placing an order via the Internet
Margin Trading
 Buying stock on margin= borrowing
to buy stock
 Federal Reserve sets margin
requirements (%) or proportion of
funds buyer must put down
 Used to dampen speculation and market
crashes
 Currently 50%; half down, half borrowed
 Broker may set higher margin
requirements
Margin Trading, cont.
Sort Out All the “Margins”
 Customer establishes account with
broker (margin account)
 Initial margin—broker’s minimum
margin requirement for stock
purchase
 Maintenance margin—minimum
proportion of equity/total value of
Margin Trading, cont.
 Margin trading magnifies returns to
investor
 Investor must pay interest on borrowed funds
 Investor returns higher/lower with lower equity than
a 100% purchase
 Margin Call
 Stock price falls below maintenance margin
requirements
 Margin call is a request for cash to maintain
maintenance margin
 Broker/lender may sell stock to protect loan
Short Selling
 In a short sale, investor borrows and
sells stock
 Promises to pay back stock later
 Short seller hopes stock price declines to
provide gain
 Short seller covers dividend payments
while borrowing stock
 Limited gain; unlimited losses
 Short Interest Ratio as market forecast
Investing in Stock Indexes
 Investor may buy stock or stock
derivative securities
 The value of derivative securities follow
underlying stock prices or prices of
specific stock portfolios (index)
 Lower transaction costs
 Stock index returns have matched
actively managed portfolios
 Exchange-traded funds (ETFs) designed
to match major stock indexes
Exchange-Traded Funds (ETFs)
vs. Indexed Mutual Funds
 Both ETFs and indexed mutual funds
 Share price adjusts in response to change in
index
 Pay dividends earned in added shares
 Lower management fees than actively managed
mutual funds
 ETFs are different from mutual funds in that
they
 May be traded on an exchange any time during
the day
 May be purchased on margin and sold short
 Capital gains tax only
 Value of ETF shares = underlying value of shares
Types of Exchange-Traded
Funds (ETFs)
 Cube (QQQ)
 Tracks Nasdaq100 index
 Traded on Amex
 Investors may speculate on future of
technology stocks
 Purchase on margin
 Sell short
 Spider (S&P Depository Receipt)
 Tracks S&P 500 index
 Trade at one-tenth S&P 500 Index level
How Trades Are Executed
Floor Broker
 Floor brokers fulfill trade orders on
exchange trading floor
 May work for the brokerage house or
serve as their agent
 Completes the physical trade with
other floor participants
How Trades Are Executed
Specialists
 Specialists serve as brokers,
matching buy/sell orders in a few,
specific stocks on the exchange
 Serve as a dealer, buying/selling to
complete transaction
 Serve to maintain fair and orderly
market
How Trades Are Executed
Market-Makers
 Market-makers have dealer positions
in specific stocks and complete
transactions on NASDAQ market
 No specific location as with specialists
on exchanges—telecommunications
link
 Specialists and market-makers
provide continuous market liquidity
Electronic Communications
Networks (ECNs)
 Automated systems for disclosing and
executing stock trades
 Focus on institutional market trading
with large-size trades and lower
spreads
 A programmed market vs. trading by
people
 Started on NASDAQ; spreading to
exchange-traded stocks
 ECNs specialize by types orders:
Program Trading
 Trading completed by computer “program”
 Initial use with institutional, large order, high
volume to take advantage of technology
 NYSE listed stocks dominate program trading
 Trading a function of parameters set in
“program,” such as “over-valued shares”
 Used also to manage portfolio risk
 Portfolio insurance—use of stock index
futures
 Protect gain or minimize loss in portfolio
Program Trading, cont.
 Program trading associated with
increased volatility of stock market or
inciting significant market declines
 Research has refuted claim that program
trading has increased stock market
volatility
 Has not been the initial “starter” of sharp
market declines
 NYSE implemented “collars” or curbs to
program trading in volatile periods
 Circuit breakers—market “time out”
Regulation of Stock Trading
 Purpose of stock trading regulation
 To make market more efficient
 Promote and preserve competition
 Prevent unfair or unethical trading practices
 Provide adequate disclosure of
information
 To prevent market failure—circuit
breakers
 Securities Act of 1933 and SEC Act of 1934
 SEC uses surveillance system to watch trading
 Insider trading
 Attempts to corner market
Securities and Exchange
Commission
 Congress provided SEC with broad
powers to regulate stock markets
 May prescribe accounting standards and
the extent of financial disclosure
 Establish regulations for stock trading
and disclosure from “insiders”
 Regulates stock market participants to
maintain a fair and orderly market
Structure of the SEC
 Five Commissioners
 Appointed by president
 Confirmed by Senate
 Five-year staggered terms
 President appoints Chair
 SEC Divisions
 Division of Corporate Finance
 Division of Market Regulation
 Division of Enforcement
SEC Oversight of Corporate
Disclosure
 Regulation Fair Disclosure (FD), October,
2000
 Requires corporations to disclose relevant information
broadly to investors at the same time
 Forbade old practice of providing selected analysts
new information during teleconference calls
 Means of disclosing new information




Company Web site—Web cast
8-k form filing
News release
Above simultaneously with conference call
SEC Oversight of Analysts’
Recommendations
 Sell-side analysts rewarded for success of
underwriting(sale of securities)
 Analysts’ information used by investors
 Recommend “buy” or “sell”
 Few “sell” recommendations before
collapse of Internet companies
 Do analysts “tout” stocks after they are aware
of “negative” information?
 Should analysts’ high income be shared with
investors who lost money in stock?
Three Traditional Barriers to
International Stock Trading
Reduce Transaction Costs
 Increased consolidation and increased
efficiency of international stock exchanges
 Computerized order flow/matching provide
more objective, fairer trading, lowering bid/ask
differentials
 Transaction costs lowered by competition,
technology, and less regulation
Three Traditional Barriers to
International Stock Trading
Reduce Information Costs
 Information on foreign stocks now more
accessible
 More uniform accounting standards between
countries
 Increased disclosure reduces information
gathering costs
Three Traditional Barriers to
International Stock Trading
Reduce Exchange Rate Risk
 Investing in foreign stocks denominated in
foreign currency exposes investor to forex risk
 Changes in foreign exchange rates changes
actual return from expected
 Exchange rate risk reduced as single currency
adopted—euro example
CH 13
Financial Futures Markets
Chapter Objectives
 Explain how financial futures
contracts are valued
 Explain the use of futures to
speculate or hedge based on
anticipated interest rate changes
 Explain the use of stock index futures
to speculate or hedge based on
anticipated stock price movements
 Describe how financial institutions
participate in futures markets
Background on Financial
Futures
 Futures are a derivative security
 Derivatives
 Securities whose value is derived from the
value of some underlying asset or financial
instrument
 Derivative security prices related to factors
affecting prices in the spot market
 For example, bond futures prices are related
to what is happening in markets where
bonds are bought and sold for immediate
delivery
Background on Financial
Futures
 Standardized agreement to deliver or
take delivery of a financial instrument
at a specified price and date
 Price is determined by traders for
standardized contracts
 The underlying financial instrument
 Settlement date
 Form of delivery for underlying asset
 Trading on organized exchanges
provides liquidity and guaranteed
settlement
Background on Financial
Futures
 Exchange members trade contracts in
trading pits
 Organized exchanges include Chicago
Board of Trade and Chicago
Mercantile Exchange
 Only members or those leasing
privileges can transact business on
the floor of the exchange
 Commission brokers
 Floor traders
 Regulated by the Commodities
Background on Financial
Futures
Steps Involved in Trading Futures






Establish account and initial margin
Maintenance margin and margin call
Order to trading floor
Open outcry trading
Clearinghouse function
Daily market-to-market of contracts
Background on Financial
Futures
Purpose of Trading Financial Futures
 To Speculate
 Take a position with the goal of profiting from
expected changes in the contract’s price
 No position in underlying asset
 To Hedge
 Minimize or manage risks
 Have position in spot market with the goal to
offset risk
Interpreting Financial Futures
Tables
 Futures contract prices reported in
the financial press
 Columns of information for each
maturity month that is trading
 Open, high, low and the settlement or
closing price
 Change in the closing price from the
previous day
 Open interest or how many contracts are
outstanding for a particular maturity
Valuation of Financial Futures
 Futures contract price related to the price
of the underlying asset
 Inverse relationship between debt contract
prices and interest rates applies to futures
prices
 Futures contract price reflects the expected
price of the underlying asset or index as of
the settlement date
 Anything that affects the price of the
underlying asset affects the futures price
 Impact of opportunity costs or benefits
Bond Futures Contract Price
Changes
 Prices of Treasury bond futures move
with spot market
 Correlation of price movements in
spot and futures important to hedgers
and speculators
 Market participants in futures monitor
the same kinds of economic indicators
and interest rate information as
 Investors who own bonds
 Investors who expect to buy bonds
 Borrowers who might plan on issuing
Exhibit 13.3 Framework for
Futures Price Changes Over
Time
International
Economic
Conditions
Expected
Movements in
Treasury
Bond Prices
Not Embedded
in Existing
Prices
U.S.
Fiscal
Policy
U.S.
Monetary
Policy
Long-Term
Risk-Free
Interest
Rate
(Treasury
Bond Rate)
Short-Term
Risk-Free
Interest
Rate
(Treasury
Bill Rate)
Required
Return
on Treasury
Bond
Required
Return
on Treasury
Bill
Price of
Treasury
Bond
Price of
Treasury
Bill
Price of
Treasury
Bond
Futures
Price of
Treasury
Bill
Futures
U.S.
Economic
Conditions
Expected
Movements in
Treasury
Bill Prices
Not Embedded
in Existing
Prices
Speculating with Interest Rate
Futures
 Long position; purchase futures contracts
 Strategy to use if speculator anticipates
interest rates will decrease and bond prices
will increase
 Buy a futures contract and if rates drop the
contract’s price rises above what it cost to
purchase and exchange adds gain with
daily settlement to investor’s account
 If interest rates rise instead of fall, futures
contract price drops and investor’s account
is reduced by daily loss
Exhibit 13.4 Potential Payoff
From Speculative Futures
Position
Profit or
Loss from
Purchasing
a Futures
Contract
Profit or
Loss from
Selling
a Futures
Contract
0
0
S
Market
Value
of the
Futures
Contract
as of the
Settlement
Date
S
Market
Value
of the
Futures
Contract
as of the
Settlement
Date
Risks of Trading Futures
Contracts
 Market risk
 Speculators win or lose based on
changing market value of futures
contracts
 Hedgers, with a position in the
underlying asset, are not significantly
impacted by contract price volatility
 Basis risk
 Futures contract prices do not vary in
exactly the same way as the underlying
asset’s price
 Price correlation of contract and
Risk of Trading Futures
Contracts
 Dealing with basis risk
 Identify futures contract with price
changes closely related to the underlying
asset
 Cross hedging
 Liquidity risk
 Price distortions if a contract is not
widely traded
 Need a counterparty to close position
Risk of Trading Futures
Contracts
 Credit risk
 Counterparty defaults
 Not a risk on exchange-traded contracts
where exchange serves as the counterparty
 Prepayment risk
 Assets (e.g. loans) prepaid sooner than
their designated maturity
 Leaves hedger without an offsetting spot
position in a speculative position
Risk of Trading Futures
Contracts
 Operational risk
 Inadequate management or controls
 For example, hedging firm’s employees
do not understand how futures contract
values respond to market conditions
 Lack of controls may result in speculative
positions
Regulation in the Futures
Markets
 More awareness about systemic risk
given recent events in the markets
 Problems at one firm can affect other
firm’s ability to honor contractual
agreements
 Regulators want participants to have
sufficient collateral to back their
positions
 Accounting regulators goal is
disclosure so risks are clear
Institutional Use of Futures
Markets
 Most activity is for hedging, not
speculating
 Many kinds of institutions uses futures






Commercial banks
Savings institutions
Securities firms
Mutual funds
Pension funds
Insurance companies
CH 14
Options
Markets
Chapter Objectives
 Explain how stock options are used to
speculate
 Explain why stock option premiums
vary
 Explain how options are used by
financial institutions to hedge their
security portfolios
Stock Options
 An option contract grants the buyer,
who has paid a premium to the seller
(writer), the right to buy or sell the
underlying asset at a stated price
within a specific period of time
 The premium paid to the writer is the
cost of the option
 Buyer has the “option,” but not the
obligation, to exercise the option
337
Background on Options
 A call option buyer has right but not
the obligation to buy the underlying
asset at a set exercise or “strike”
price for a specified period of time
 A put option buyer has the right but
not the obligation to sell the
underlying asset at a set “strike” price
for a specified period of time
 Note components of an option:
specific quantity of asset, price, and
Background on Options
 Premium is the price the buyer of the
put or call pays to buy an option
contract
 Seller or writer of the option contract
 Receives the premium up front
 Has an ongoing obligation to sell (call) or
buy (put) if the buyer decides to exercise
the option contract
 Current market price of the
underlying asset or financial
instrument is called the spot price
Background on Options
 Call options
 “In-the-money” means the call option’s
strike or exercise price is lower than the
market price for the underlying financial
instrument
 The holder of the call can buy the stock at a
price below the current market price
 The call premium (price) of the option
would also be higher by the “in-the-money”
 At-the-money means the strike price
equals the market price of the underlying
asset
Background on Options
 Put option
 In-the-money means the put option’s
strike or exercise price is higher than the
market price for the underlying financial
instrument
 Put options give the investor an
opportunity to make money from falling
prices
 Investor has locked in a sale price,
making the price of the option (premium)
higher as the stock price decreases
 At-the-money means the strike price
equals the market price of the underlying
Background on Options
 Expiration is the date when the contract
matures
 American-style options contracts can be
exercised any time up until they expire
 European-style options can only be
exercised just before their expiration
 Option contracts guaranteed by a
clearinghouse to make sure sellers or
writers fulfill their obligations
 Stock options specify 100 shares of
stock
Stock Option Quotations
 Options quotations available in the
financial press and on the Internet
 Typically more than one option contract
for a company’s stock
 Many contracts trade for the same stock
but with different strike prices and
expiration dates
 Quotes indicate the volume, premium,
strike price and maturity
Exhibit 14.1 McDonald’s Stock
Option Quotations
McDonald’s
Strike
Exp.
Vol.
Call
Vol.
Put
45
Jun
180
4½
60
2¾
45
Oct
70
5¾
1 20
3¾
50
Jun
360
11/8
40
51/8
50
Oct
90
3½
40
6½
Speculating with Call Options
 BUY A CALL: Speculator thinks a stock price
will appreciate above a particular strike
price
 Buyer of call pays premium for the right but
not the obligation to buy stock at the strike
price
 If the stock price appreciates above the
strike price the option contract is in-themoney and buyer of the call would exercise
or sell the option at a price including the
“in-the-money” and a premium
 If the stock price does not appreciate,
buyer of the call does not exercise and
Speculating with Call Options
 If stock price rises above call’s strike
price, buyer exercises and purchases
shares at a price below their current
market price
 Breakeven occurs once stock price is
high enough above strike to cover
premium’s cost
 Net gain or loss equals
+ Price received for selling stock (spot
price)
Speculating with Call Options
Breakeven = Strike + Premium
Call
Buyer
+
0
Call
Writer
Strike Price
Speculating with Put Options
 BUY A PUT: Speculator thinks a stock price will
depreciate below a particular strike price
 Buyer of put pays premium for the right but
not the obligation to sell stock at the strike
price
 If the stock price depreciates below the strike
price the option contract is in-the-money and
buyer of the put would exercise
 If the stock price does not depreciate, buyer of
the put does not exercise and losses are
limited to the cost of the premium
Speculating with Put Options
 If stock price falls below strike, buyer of
a put exercises and sells shares at a
price above their current market price
 Breakeven occurs once stock price is low
enough below strike to cover premium’s
cost
 Net gain or loss equals
+Price received for selling stock (strike
price)
- Amount paid for the shares (spot
market)
Speculating with Put Options
Breakeven = Strike - Premium
+
Put Seller
0
Put Buyer
Strike Price or At-The-Money
Determinants of Call Option
Premiums
 The greater the current market price of the
underlying asset compared to the exercise
price, the higher the premium for a call option
 Greater volatility of the underlying
financial asset means higher call
option premiums
 For a call, the longer the time to
maturity, the higher the premium
Determinants of Put Option
Premiums
 The lower the current market price of
the underlying asset compared to the
exercise price, the higher the
premium for a put option
 Volatility and maturity issues the
same as for call options
Exhibit 14.11 Stock Option
Premium Changes Over Time
International
Economic
Conditions
U.S.
Fiscal
Policy
U.S.
Monetary
Policy
Issuer’s
Industry
Conditions
U.S.
Economic
Conditions
Stock
Market
Conditions
U.S.
Risk-Free
Interest
Rate
Issuer’s
Risk
Premium
Market Risk
Premium
Expected
Cash Flows
Generated
by the Firm
for Investors
Required
Return on
the Stock
Option’s
Exercise
Price
Price
of Firm’s
Stock
Stock Price
Relative to
Option’s
Exercise
Price
Option’s
T ime
until
Expiration
Stock Option’s
Premium
Expected
Volatility of
Stock Prices
over the
Period Prior
to Option
Expiration
CH 15
Foreign Exchange
Derivative
Market
Chapter Objectives
 Explain how various factors affect
exchange rates
 Describe how foreign exchange risk
can be hedged with foreign exchange
derivatives
 Describe how to use foreign exchange
derivatives to capitalize (speculate)
on expected exchange rate
movements
Background On Foreign
Exchange Markets
 Exchanging currencies is needed
when:
 Trade (real) prompts need for forex
 Capital flows (financial) prompts need for
forex
 Foreign exchange trading
 Via global telecommunications network
between mostly large banks
 Bid/ask spread
356
Foreign Exchange Rates
 Quoted two ways:
 Foreign currency per U.S. dollar
 Dollar cost of unit of foreign exchange
 Appreciation/depreciation of currency
 Appreciation = more forex to buy $
 Purchase more forex with $
 Depreciation = foreign goods cost more
$
 Total return to foreign investor
decreases
357
Background on Foreign
Exchange Markets
 Exchange rate quotations are
available in the financial press and on
the Internet with spot exchange rate
quotes for immediate delivery
 Forward exchange rate is for delivery
at some specified future point in time
 Forward premium is the percent
annualized appreciation of a currency
 Forward discount is the percent
annualized depreciation of a currency
Background on Foreign
Exchange Markets
 Exchange rates involve different kinds
of quotes for comparing the value of
the U.S. dollar to various foreign
currencies
 1 unit of foreign currency worth some
amount of U.S. dollars—e.g. $.70 U.S.
per Canadian Dollar
 1 U.S. dollar’s value in terms of some
amount of foreign currency– e.g.
CD$1.43 per U.S. dollar
 Note reciprocal relationship
Background on Foreign
Exchange Markets
 Cross-exchange rates are foreign
exchange rates of two currencies
relative to a currency.
 Value of one unit of currency A in
units of currency B = value of
currency A in $ divided by value of
currency B in $
 British Pound = $1.4555; Euro =
$.8983
 Value of Pound in Euros =
$1.4555/$.8983 or…
Background on Foreign
Exchange Markets
 Currency terminology
 Appreciation means a currency’s value
increases relative to another currency
 Depreciation means a currency’s value
decreases relative to another currency
 Supply and demand influences the
values of currencies
 Many factors can simultaneously
affect supply and demand
Background on Foreign
Exchange Markets
Background on Foreign Exchange Markets
 1944–1971 known as the Bretton
Woods Era
 Government maintained exchange rates
within a 1% range
 Required government intervention and
control
 By 1971 the U.S. dollar was clearly
Background on Foreign
Exchange Markets
 Smithsonian Agreement (1971)
among major countries allowed dollar
devaluation and widened boundaries
around set values for each currency
 No formal agreements since 1973 to
fix exchange rates for major
currencies
 Freely floating exchange rates involve
values set by the market without
government intervention
 Dirty float involves some government
Classification of Exchange Rate
Arrangement
 There is a wide variation in how
countries approach managing or
influencing their currency’s value
 Float with periodic intervention
 Pegged to the dollar or some kind of
composite
 Some countries have both controlled and
floating rates
 Some arrangements are temporary and
others more permanent
Factors Affecting Exchange
Rates: Real Sector
 Differential country inflation rates
affect the exchange rate for euros
and dollars if inflation is suddenly
higher in Europe
 Theory of Purchasing Power Parity
suggests the exchange rate will
change to reflect the inflation
differential—influence from real sector
of economy
 Currency of the higher inflation
country (euro) depreciates compared
to the lower inflation country ($)
Factors Affecting Exchange
Rates: Financial Sector
 Differential interest rates affect
exchange rates by influencing capital
flows between countries
 For example, the interest rates are
suddenly higher in the United States
than in Europe
 Investors want to buy dollardenominated securities and sell
European securities
 Euros are sold, dollars bought to buy
U.S. securities
Factors Affecting Exchange
Rates
 Direct intervention occurs when a
country’s central bank buys/sells
currency reserves
 For example, the U.S. central bank,
the Federal Reserve sells one
currency and buys another
 Sale by central bank creates excess
supply and that currency’s value drops
relative to the one purchased
 Market forces of supply and demand can
overwhelm the intervention
Factors Affecting Exchange
Rates
 Indirect intervention involves
influencing the factors that affect
exchange rates rather than central
bank purchases or sales of currencies
 Interest rates, money supply and
inflationary expectations affect
exchange rates
 Historical perspective on indirect
intervention
 Peso crisis in 1994
Factors Affecting Exchange
Rates
 Some countries use foreign exchange
controls as a form of indirect
intervention to maintain their
exchange rates
 Place restrictions on the exchange of
currency
 May change based on market
pressures on the currency
 Venezuela in mid-1990s illustrates
the issues involved in controlling
Movements in Exchange Rates
 Foreign exchange rate changes can
have an important effect on the
performance of multinational firms
and economic conditions
 Many market participants forecast
rates
 Market participants take positions in
derivatives based on their expectations
of future rates
 Speculators attempt to anticipate the
direction of exchange rates
Forecasting Exchange Rates:
Technical
 Technical forecasting is a technique
that uses historical exchange rate
data to predict the future
 Uses statistics and develops rules
about the price patterns—depends on
orderly cycles
 If price movements are random, this
method won’t work
 Models may work well some of the
time and not work other times
Forecasting Exchange Rates:
Fundamental
 Fundamental forecasting is based on
fundamental relationships between
economic variables and exchange
rates
 May be statistical and based on
quantitative models or be based on
subjective judgement
 Regression used to forecast if values
of influential factors have a lagged
impact
 Not all factors are known and some
Forecasting Exchange Rates:
Fundamental
 Limitation of fundamental forecasting
methods:
 Some factors that are important to
determining exchange rates are not
easily quantifiable
 Random events can and do affect
exchange rates
 Predictor models may not account for
these unexpected events
Forecasting Exchange Rates:
Market-Based
 Market-based forecasting uses market
indicators like the spot and forward
rates to develop a forecast
 Spot rate: recognizes the current
value of the spot rate as based on
expectations of currency’s value in
the near future
 Forward rate: used as the best
estimate of the future spot rate based
on the expectations of market
Forecasting Exchange Rates:
Mixed
 Mixed forecasting is used because no
one method has been found superior
to another
 Multinational corporations use a
combination of methods
 Assign a weight to each technique
and the forecast is a weighted
average
 Perhaps a weighted combination of
technical, fundamental, and market-
Forecasting Exchange Rate
Volatility
 Market participants forecast not only
exchange rates but also volatility
 Volatility forecast
 Recognizes how difficult it is to forecast
the actual rate
 Provides a range around the forecast
Forecasting Exchange Rate
Volatility
Methods Used To Forecast Volatility
 Volatility of historical data
 Use a times series of volatility
patterns in previous periods
 Derive the exchange rate’s implied
standard deviation from the currency
option pricing model
Major Factors Affecting Forex
 Differential inflation rates between
countries
 Differential interest rates between
countries
 Governmental Intervention
378
Forecasting Foreign Exchange
Rates




Technical forecasting
Fundamental forecasting
Market-based forecasting
Mixed forecasting
379
CH 16
Mutual Fund
Operations
Chapter Objectives
 Explain the concept of mutual fund
operation
 Explain various types of mutual funds
 Describe the various types of stock
and bond mutual funds
 Describe the characteristics of money
market funds
Background on Mutual Funds
 Mutual funds offer a way for small investors to
diversify when they could not do so on their
own with the purchases of individual stocks
 Comparison to depository institutions
 Like depository institutions, mutual funds
repackage proceeds from individuals to
make investments
 Bank deposits are a liability contract, but a
mutual fund represents partial ownership
 No federal insurance with mutual fund
shares
Background on Mutual Funds
 Mutual funds adhere to a variety of
federal and state regulations
 Securities and Exchange Commission (SEC)
regulates
 Funds must register and provide a
prospectus to investors
 Disclosure since 1993 of manager’s name
and length of time employed in that position
 Mutual fund itself is exempt from
income taxation if fund distributes 90
percent of taxable income
Mutual fund prospectus information
 The minimum amount of investment
required
 The investment objective of the fund
 The return on the fund over the past year,
the past three years and the the past five
years
 The exposure of the fund to various types of
risk
 Services the fund offers
 Management fees incurred that investors
pay
Background on Mutual Funds
 Estimating the net asset value
 Net asset value is the value per share
 Estimated daily
 Determine the market value of all the
securities in the fund
 Any interest or dividends added in
 Expenses subtracted
 Divide by the number of shares
 Dividends lower NAV
 NAV quotes
Mutual Fund Distributions
Earned Income from Dividends or Coupon Payments
Capital Gains from the Sale of Securities in Fund
Mutual Fund Price Appreciation
Background on Mutual Funds
 Mutual fund classifications depend on
the type of securities the fund invests
in and can include
 Stock or equity mutual funds
 Bond mutual funds
 Money market mutual funds
 Family of funds offered by investment
companies
 Investor able to allocate then transfer
funds among funds
Exhibit 24.2 Distribution of
Investment in Mutual Funds
Money
Market Funds
$1,845 billion
27%
Stock Funds
$3,962 billion
57%
Hybrid Funds
$349 billion
5%
Bond Funds
$808 billion
11%
Background on Mutual Funds
 Management of mutual funds
 Managers invest in a portfolio of
securities to meet the objectives of the
fund
 Cover management costs with fees which
are typically around one percent of total
assets per year
 Managers adjust the composition of their
portfolios in response to market and
economic conditions
Background on Mutual Funds
 Expenses
 Fees include management plus recordkeeping and clerical fees
 Expense ratio = annual expenses/fund
NAV
 Passed on to investors since NAV is
reduced by fees
 Investor should compare expense ratios
 Active marketing expenses and
compensation increases expenses—
12b-1 expenses
Background on Mutual Funds
 Corporate control by mutual funds
 Mutual funds are large shareholders in
companies whose stock they hold
 Managers may serve on the board of
directors of companies in which the fund
invests
 Companies try to satisfy mutual fund
managers in order to keep them from
selling their stake in the firm
Load versus No-Load Mutual
Funds
 Classification refers to whether or not
there is a sales charge
 No-load means funds are promoted,
bought and sold directly via the
mutual fund
 Load funds
Open-End versus Closed-End
Funds
 Closed-end funds
 Mutual fund does not repurchase the shares they
sell—similar to direct common stock investment
 Investors must sell shares on an exchange
 Number of outstanding shares is constant
 Value of shares related to expectations of portfolio
and determined in market
 Open-end “mutual” funds
 Willing to repurchase investor shares at any time
 Number of shares outstanding does not remain
constant
 NAV determined by fund daily
Stock Mutual Fund Categories
 Growth funds for investors who want
high returns with moderate risk
 Mutual fund invests in companies that are expected
to grow at a higher than average rate
 Generate an increase in investment value rather than
steady income
 Capital appreciation or aggressive
growth funds
 High but unproven growth potential stocks
 Higher risk
Stock Mutual Fund Categories
 Growth and income funds try to offer growth
but with some stability of income
 International and global funds allow investment
in foreign securities without the costs involved
in purchasing and monitoring individual stocks
 Returns affected by stock prices
 Returns also affected by foreign exchange rates
 A global mutual fund invests in some U.S.
stocks
Stock Mutual Fund Categories
 Internet funds focus on investments in
Internet companies
 Specialty funds focus on a group of
companies sharing a particular
characteristic
 Index funds are designed to simply
match the performance of an existing
stock index
 Multifund funds invest in a portfolio of
different mutual funds
Exhibit 24.3 Growth in Number
of Equity and Bond Funds
8000
Bond Funds
7000
Stock Funds
6000
5000
4000
3000
2000
1000
0
1978
1985
1990
1995
Year
1999
2001
Exhibit 24.4 Investment in
Bond and Stock Mutual Funds
5000
Bond Funds
4000
Stock Funds
3000
2000
1000
0
1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000
Year
Exhibit 24.5 Distribution of
Aggregate Mutual Fund Assets
Municipal Bond
$269 Billion
Long-Term U.S. Gov’t
5%
$309 Billion
6%
Cash
$277 Billion
5%
Corporate Bonds
$349 Billion
7%
Preferred Stock
$28 Billion
1%
Common Stock
$3,882 Billion
76%
Bond Fund Investment
Objectives
 Risks of bond funds
 Interest rate risk
 Credit risk
 Tax implications of bond fund investments
 Income bond funds vary in terms their
exposure to credit risk and focus on periodic
coupon payments and attract investors who are
 Interested in periodic income since prices are volatile
 Plan to hold the fund long term
Bond Fund Investment
Objectives
 Tax-free funds for high tax bracket
investors
 High-yield or junk bond funds invest
in bonds with a high risk of default
 International and global bond funds
 International bond funds contain bonds issued by
governments or corporations from other countries
 Global funds may contain both U.S. and foreign
bonds
Bond Fund Investment
Objectives
 Maturity classifications
 Interest rate sensitivity depends on the
maturity of bonds
 Funds are typically segmented based on
maturity
 Intermediate-term funds invest in bonds
with 5 to 10 years remaining to maturity
 Long-term funds invest in maturities of 15
to 30 years
Bond Fund Investment
Objectives
 Asset allocation funds
 Funds that contain a variety of
investments
 Composition among stocks, bonds and
money market securities is based on
manager’s expectations
Growth and Size of Mutual
Funds
 Volume and mix in the kind of funds
varies over time
 Overall investment via mutual funds
much higher in recent years
 New kinds of funds target customers
with different risk preferences
Performance of Stock Mutual
Funds
 Both investors and managers closely
monitor performance as modeled by the
equation below
 PERF= f ( MKT,  SECTOR,  MANAB)
Where:
PERF = Performance
MKT = General stock market conditions
SECTOR = Conditions in the fund’s sector
MANAB = The ability of the fund’s management
Performance of Stock Mutual
Funds
 Change in market conditions
 Close relationship between performance
and market conditions
 Change in sector conditions
 Depends on the focus of the fund
 Index funds
 Asian funds
 Change in management ability includes both
managers’ skills and operating efficiency
Performance of Stock Mutual
Funds
 Performance of closed-end stock
funds
 Driven by the same factors that
influence open-ended funds
 Fixed supply of the fund’s shares
 Additional issues
 Performance is affected by changes in the
premium or discount relative to NAV
 If the fund’s premium increases relative to
NAV, return to fund holders increases
Performance of Bond Mutual
Funds
 Performance of bond mutual funds as
shown in the model below
 PERF= f ( Rf,  RP,  CLASS,  MANAB)
Where:
PERF = Performance
Rf = Risk free interest rates
RP =Risk premium
CLASS =the classification of the bond fund
MANAB = The ability of the bond fund’s management
Performance of Bond Mutual
Funds
 Change in the risk free rate
 Bond prices are inversely related to the
risk- free rate
 When rates decline, most bond funds
perform well
 Change in the risk premium
 If required risk premiums increase, bond
prices fall
 Linked to economic condition:
 Risk premiums increase in recessions
 Risk premiums decrease in boom times as
investors buy riskier investments
Performance of Bond Mutual
Funds
 Impact of the bond fund’s
classification
 Some funds target a specific risk or
maturity
 Classification may have more impact
than any other factor
 Change in management abilities
 Performance of closed-end bond
funds is affected by all of the other
factors and changes in the premium
or discount
Performance of Mutual Funds
 Investors should diversify among
different kinds of funds to reduce
volatility
 Research on stock mutual fund
performance
 Using return only is not valid
 Mutual funds typically do not outperform
the market
 Evaluate mutual fund expenses
 Research on bond mutual funds
 Bond mutual funds underperform bond
indexes
Money Market Funds
 Money market funds are portfolios of
short-term assets
 Can include check-writing privileges for
investors
 Number of checks per month may be
restricted
 Shareholders get periodic statements
 Liquid, “cash” balance for investor
Money Market Funds
 Asset composition of money market
funds
 Individual funds concentrate in assets
that reflect the fund’s objective
 Money market securities of varying
maturity
 Maturity of money market funds
 Varies over time with market conditons
 Risk increases with term
Exhibit 24.7 Composition of
Money Market Fund Assets
Other
$303 billion
20%
U.S. Treasury
Securities
$91 billion
6%
Commercial Paper
$620 billion
41%
Other U.S. Securities
$189 billion
13%
Repurchase
Agreements
$186 billion
12%
CDs
$123 billion
8%
Money Market Funds
 Risk of money market funds
 Credit risk minimized by the short-term
nature of maturities
 Returns for money market funds fall as
interest rates in the economy fall
 Expected returns are low relative to
stock and bond funds
 Consistent positive returns over time
 Lower credit risk
 Lower interest rate risk
Money Market Funds
 Management of money market funds
 Managers try to maintain the overall
objective of the fund
 Manage the composition of the assets
 Investors have a variety of choices when
it comes to money market funds
Money Market Funds
 Regulation of money market funds
 Securities Act of 1933 requires that
funds provide full information to
investors via a prospectus
 Investment Company Act of 1940
contains restrictions to prevent conflicts
of interest between investors and
mangers
 Funds are exempt from tax if 90% of
earnings are distributed to
shareholders
Hedge Funds
 Financial problems experienced by
Long-Term Capital Management
(LTCM)
 Hedge funds sell shares to wealthy
investors and financial institutions
 Historically unregulated
 Invest in derivatives, sell stock short,
and combine borrowing to magnify
returns
 LTCM experienced problems when
risky investments lost money
Real Estate Investment Trusts
 A real estate investment trust or REIT
is a closed-end mutual fund that
invests in real estate or mortgages
 Classifications
 Equity REIT
 Mortgage REIT
 Hybrid of the two
 Sometimes seen as an inflation hedge
 Performance influenced by interest
rates and area real estate
performance
Other Issues
 Mutual funds interact with banks,
savings institutions, finance
companies, securities firms, insurance
companies, and pension funds
 Mutual funds typically use all the
various financial markets including
money, bond, mortgage, stock,
futures, options, and swap markets
 Globalization is facilitated by mutual
funds
 Reduces transactions costs
CH 17
Securities Operations
Chapter Objectives
 Review and evaluate the key functions of
investment banking firms
 Describe the services provided by investment
banking firms when they assist in issuing new
stock issues
 Analyze the risks of securities firms
 Evaluate the key functions of brokerage firms
 Evaluate the key factors impacting the value of
securities firms
Investment Banking Services
 Investment banking firms (IBFs) assist in
raising capital for corporations and state and
municipal governments
 IBF’s serve both financing entities and
investors:
 Serve as an intermediary buying securities (promise
to pay) from issuing companies and selling them
(securities) to investors
 Generate fees for services rather than interest
income
 Sell investing services to institutional and other
investors
 Advise companies on mergers and acquisitions
 Value companies for sale or purchase
Investment Banking Services
Origination
Underwriting
Distribution
Investment
Banking
Services
Advising
How IBFs Facilitate New Stock
Issues
 Origination
 Company wishes to issue additional stock or
issue stock for the first time contacts IBF
 Gets advice on the amount to issue
 Helps determine stock price for first-time issues
 IBF assists with SEC filings
 Registration statement
 Prospectus—summary of registration statement
given to prospective investors
How IBFs Facilitate New Stock
Issues
 Underwriting stock
 Issuer and investment bank negotiate
the underwriting spread
 The difference between the net price given
the company and the selling price to
investors
 Incentive to under-price IPO’s
 The lead investment bank usually forms
an underwriting syndicate
 Other IBFs underwrite a part of the security
offering
 Helps spread the underwriting risk among
How IBFs Facilitate New Stock
Issues
 Distribution of stock
 Full underwriting vs. best efforts
 IBFs in the syndicate have retail
brokerage operations
 Other IBF added as part of selling group
 Corporation incurs flotation costs
 Underwriting spread
 Direct issuance costs—accounting, legal
fees, etc.
How IBFs Facilitate New Stock
Issues
 Advising
 The IBF acts as an advisor throughout
the process
 Corporations do not have the in-house
expertise
 Includes advice on:




Timing
Amount
Terms
Type of financing
How IBFs Facilitate New Bond
Issues
 Origination
 IBF may suggest a maximum amount of
bonds that should be issued based on
firm characteristics
 Decisions on coupon rate, maturity
 Benchmark with market prices of bonds of
similar risk
 Credit rating
 Bond issuers must register with the SEC
 Registration Statement
 Prospectus
How IBFs Facilitate New Bond
Issues
 Underwriting bonds
 Public utilities often use competitive bids
to select an IBF, versus…..
 Corporations typically select an IBF
based on reputation and prior working
experience
 The underwriting spread on bonds is
lower than that for stocks
 Can place large blocks with institutional
investors
 Less market risk
How IBFs Facilitate New Bond
Issues
 Distribution of bonds
 Prospectus
 Advertisements to public
 Flotation costs are typically in the range
of 0.5 percent to 3 percent of face value
How IBFs Facilitate New Bond
Issues
 Private placement of bonds
 Avoids underwriting and SEC registration
expenses
 Potential purchaser may buy the entire issue




Insurance companies
mutual funds
commercial banks
pension funds
 Demand may not be as strong, so price may
be less, resulting in a higher cost for issuing
firm
 Investment banks may be involved to
provide advice and find potential purchasers
How IBFs Facilitate Leveraged
Buyouts
 IBFs facilitate LBOs in three ways:
 They assess the market value of the LBO
firm
 They arrange financing
 Purchase outstanding stock held by
public
 Often invest in the deal themselves
 Provide advice
How IBFs Facilitate Arbitrage
 Arbitrage = purchasing of undervalued
shares and reselling the shares at a
higher price
 IBFs work with arbitrage firms to search
for undervalued firms
 Asset stripping
 A firm is acquired, and then its individual
divisions are sold off
 Sum of the parts is greater than the whole
 Kohlberg, Kravis, and Roberts
How IBFs Facilitate Arbitrage
 IBFs generate fee income from
advising arbitrage firms as well as a
commission on the bonds issued to
support arbitrage activity
 IBFs also provide bridge loans
 When fund raising is not expected to be
complete when the acquisition is initiated
 IBFs provide advice on takeover
defense maneuvers
How IBFs Facilitate Arbitrage
 History of arbitrage activity
 Greenmail is when a target company buys
back stock from arbitrage firm at a premium
over market price
 Arbitrage activity has been criticized
 Results in excessive financial leverage and risk
for corporations
 Restructuring sometimes results in layoffs
 Arbitrage helps remove managerial
inefficiencies
 Target shareholders can benefit from higher
share prices
Brokerage Services
 Market orders
 Requests by customers to buy or sell at
the prevailing market price
 Executed quickly, usually within minutes
 Limit orders
 Requests by customers to buy or sell
securities at a specified price or better
 Day orders
 Good-till-cancelled orders
Brokerage Services
 Short selling—gain from falling prices
 Investor sells shares they do not own
 Investor borrows the shares from their
broker (who borrows the shares from other
accounts)
 Later, the investor buys the stock and repays
the shares to the broker
 If the price has fallen the investor earns a profit
 Investor still seeks to buy low and sell high, but
the order is reversed
Brokerage Services
 Full-service versus discount
brokerage services
 Full-service firms provide investment
advice as well as executing transactions
 Discount brokerage firms only execute
security transactions upon request
 Online brokerage firms
Allocation of Revenue Sources
 Importance of brokerage
commissions has declined in recent
years
 Largest source of revenue has been
trading and investment profits
 Underwriting and margin interest also
make up a significant portion of
revenue
 Revenue from fees earned on
advising and executing acquisitions
Regulation of Securities Firms
 Regulated by the National Association
of Securities Dealers (NASD) and
securities exchanges
 The SEC regulates the issuance of
securities and specifies disclosure
rules for issuers
 Also regulates exchanges and brokerage
firms
 SEC establishes general guidelines,
while the NASD provides day-to-day
Regulation of Securities Firms
 The Federal Reserve determines the
credit limits (margin requirements) on
securities purchased
 The Securities Investor Protection
Corporation (SIPC) offers insurance on
brokerage accounts
 Insured up to $500,000
 Brokers pay premiums to SIPC to maintain
the fund
 Boosts investor confidence, increasing
economic efficiency
Regulation of Securities Firms
 Financial Services Modernization Act
of 1999
 Permitted banking, securities activities,
and insurance to be offered by a single
firm
 Varied financial services organized as
subsidiaries under special holding
company
 Financial holding companies regulated by
the Federal Reserve
Risks of Securities Firms
Market Risk
Credit Risk
Interest Rate
Risk
Exchange Rate
Risk
Risks of Securities Firms
 Market risk
 Securities firms’ activities are linked to
stock market conditions
 When stock prices are rising:




Greater volume of stock offerings
Increased secondary market transactions
More mutual fund activity
Securities firms take equity positions which
are bolstered when prices rise
Risks of Securities Firms
 Interest rate risk
 Performance of securities firms can be
sensitive to interest rate movements
because:
 Market values of bonds held as investments
increase as interest rates fall
 Lower rates can encourage investors to
withdraw money from banks and invest in
stocks
 Exchange rate risk
 Operations in foreign countries
 Investments in securities denominated in
foreign currency
Valuation of Securities Firms
 Value of a securities firm depends on
its expected cash flows and required
rate of return
V = f [E(CF),k]
Where:
V = Change in value of the securities firm
E(CF) = Change in expected cash flows
k = Change in required rate or return
Valuation of Securities Firms
 Factors that affect cash flows
E(CF)= f (ECON, Rf , INDUS, MANAB)
+
?
+
Where:
E(CF) = Expected cash flow
ECON = Economic growth
Rf = Risk free interest rate
INDUS = Prevailing industry conditions
MANAB = The ability of the security firm’s management
Valuation of Securities Firms
 Investors required rate of return
k = f(Rf , RP)
+
+
Where:
Rf = Risk free interest rate
RP = Risk premium
Interaction With Other Financial
Institutions
 Offer investment advice and execute security
transactions for financial institutions that maintain
security portfolios
 Compete against financial institutions that have
brokerage subsidiaries
 Glass-Steagall Act of 1933 separated the functions
of commercial banks and investment banking firms
 Financial Services Modernization Act of 1999
 Effectively repealed Glass-Steagall
 Commercial banks, securities firms, and insurance
companies will increasingly offer similar services
Globalization of Securities Firms
 Securities firms have increased their
presence in foreign countries
 Merrill Lynch has more than 500 offices
spread across the world
 Allows them to place securities in various
markets for corporations or governments
 International M&A
 Ability to handle transactions with foreign
securities
Globalization of Securities Firms
 Growth in international securities
transactions
 Created more business for large securities
firms
 International stock offerings
 Increased liquidity for issuing firm, avoiding
downward price pressure
 Growth in Latin America
 Increased business due to NAFTA
 Growth in Japan
 Some barriers to foreign securities firms still
exist
CH 18
Insurance Operations
Chapter Objectives
 Present the two major areas of insurance: 1)
life and health and 2) property and casualty
 Describe the different types of insurance
policies and their sources of funds
 Describe the main uses of insurance company
funds
 Explain the exposure of insurance companies
to various forms of risk
 Describe the regulatory environment of
insurance companies
Insurance Companies
 Provide contractual risk management
for:
 Risks of insurable asset losses (auto
insurance)
 Risks of liability claims (product liability)
 Risk of large medical costs (health
insurance)
 Risk of disability (disability insurance)
 Risk of premature death (life insurance)
 Risk of longevity (annuities)
Insurance Companies, cont.
 Major capital market intermediary
 Major investor in corporate (life) and
state and municipal bonds
(property/casualty)
 Major long-term commercial mortgage
lender (life)
 Mutual or stock form of ownership
 Premium and investment revenue
 Losses and loss adjustment expenses
Insurance Concepts
 Pure vs. financial risk
 Insure fortuitous, independent risk
occurrence
 Premium covers losses,
administrative expenses and profits
 Insured contracts for known loss
(premium) in return for protection
 Moral hazard and adverse selection
Background
 Life insurance companies
 Provide risk management contracts for
individuals and businesses
 Risk areas include premature death, health
maintenance costs, and disability
 Life insurance provides cash benefits to the
beneficiary of a policy on the policyholder’s death
 Life insurance premiums reflect
 Have portfolios of policies and use mortality figures
and actuarial tables to forecast claims
Types of Life Insurance Policies
Cash Value Insurance
Term Insurance
Group
Universal Life
Group
Variable Life
Term
Whole Life
Types of Life Insurance Policies
 Whole life insurance includes both a
death benefit (term insurance) and a
savings component that
 Builds a tax sheltered cash value amount
for the future for the owner of the policy
 Generates periodic cash flow payments
over the life of the policy for the
insurance company to reinvest
 Pays fixed death benefit at death
Types of Life Insurance Policies
 Term life insurance characteristics
 Temporary, providing death benefits only
over a specified term
 Premiums paid represent insurance only
with no saving component
 Considerably lower cost for the insured than
whole life—able to buy more insurance
protection for any amount of premium
 Term is for those who would rather invest
their savings in other contracts or securities
Types of Life Insurance Policies
 Variable life insurance
 Whole life with variable cash value amounts
 Cash values invested in equities and will vary with
the investment performance
 Flexible premium option since 1984
 Universal life insurance
 Combines the features of term and whole life
 Variable premiums over time—buys terms and
invests difference in a variety of investments
 Builds a varying cash value based on contributions
and investment performance
Types of Life Insurance Policies
 Group plans
 Employees of a corporation offered life
insurance or life insurance purchased on
life of employee
 Cash value or term insurance
 Low cost (term) because of its high
volume
 Can cover group members and
dependents
Health Care Insurance
 Health maintenance organizations or
HMOs
 Intermediaries between purchasers and
providers of health care
 Annual fee or premium
 Covers all medical expenses
 Medical staff is designated by the HMO
 Losses in recent years for HMOs
Sources of Life Insurance
Company Funds
 Cash value reserves—accumulated cash values
owed insureds (liability)
 Pension reserves—accumulated “insured”
pension commitments (liability)
 Annuity reserves—accumulated annuity
commitments (liability)
 Unearned premium income—premiums
received; not yet earned (liability)
 Loss reserves--losses incurred, not yet paid
 Capital funds
Uses of Life Insurance Company
Funds






Major investor in corporate bonds
Government securities
Common stock
Commercial mortgage
Real Estate
Policy loans to insured
Uses of Funds—Policy Loans
 Policy loans are loans to policyholders
 Whole life policies
 Borrow up to the cash value of the policy
 Guaranteed interest rate is stated in the
policy
 Usually used by borrowers during periods
of rising rates to lock in the lower rate
associated with their policy
Insurance Company Capital
 Capital
 Build capital by issuing new stock (stock companies)
or retaining earnings
 Used to finance investments in fixed assets
 Cushion against operating losses
 Capital requirements vary depending on asset risk
 Credibility with customers is also enhanced by
adequate capital
 Mutual companies owned by policyholders—includes
earnings retained over time
Regulation
 Insurance companies are highly regulated by
state insurance agencies
 The National Association of Insurance
Commissioners (NAIC)
 Provides coordination among states in regulatory
matters
 Adopted uniform regulatory reporting standards
 State Regulators
 Make sure insurance companies provide adequate
service
 States approve/review rates
 Agent licensure
 Forms are approved to avoid misleading wording
Regulation
 Insurance Regulatory Information
System
 Compiles financial information and lists
of insurers
 Calculates 11 ratios to assess and
monitor financial health
 Assessment system
 Ability of the company to absorb either
losses or a decline in the market value of
its investments
 Return on investment
 Relative size of operating expenses
Regulation
 Regulation of capital
 In 1994 companies were required to
report risk-based capital ratios to
insurance regulators
 Goals of requirements are to
 Discourage insurance companies from
excessive exposure
 Back higher risks with higher capital
 Reduce failures in the industry
Risks of Life Insurance
Companies
Pure Risk of Life
Insurance Policies
Pension
Commitments and
Annuities Contracts
Financial Risk
includes
Interest Rate Risk
Credit Risk
Market Risk
Liquidity Risk
Exposure to Financial Risks
 Interest rate risk
 Fixed rate assets in company portfolios
have market values sensitive to interest
rate changes
 Firm measures and manages risks
 Credit risk
 Mortgages, corporate bonds and real
estate holdings can involve default
 Investment-grade securities
 Diversify portfolio among debt issuers
Exposure to Financial Risks
 Market risk
 Exists because events like significant
market value decreases reduce capital
 Economic downturn affects real estate
investments
Exposure to Financial Risks
 Liquidity risk occurs because a high
frequency of claims may require the
life company to liquidate assets
 Life insurance companies have high cash
flow from premiums to offset normal
cash needs
 In case of large disaster (9/11) may be
forced to sell assets to generate cash
even if market value is low
 Companies try to balance the age
distribution of their customer base
 As interest rates rise, voluntary
terminations of policies occur
Asset Management
 Performance is significantly affected
by the performance of the assets
 Companies get premiums for several
years before paying out benefits
 Companies try to manage the risk of
losses with offsetting investment gains
or diversity of assets they hold
 Diversify into other businesses to offer a
wide variety of financial products
Property and Casualty
Insurance
 Property insurance (fire insurance)
 Casualty insurance (liability)
 Performance and financial bonding
PC Versus Life Insurance
Companies
 PC have shorter contracts
 PC have more varied risk areas
 Life companies larger due to longterm savings and pension contracts
 PC has wider distribution of
Occurrences
 PC’s need liquid, marketable assets
 PC’s earnings more volatile
Property Casualty Investment
Needs
 Tax sheltering--major municipal/state
bond investor
 Liquid, marketable assets
 Marketable corporate and government
bonds
 Listed common stock
 Inflation hedge--common stock
 Reinsurance contracts--manage pure
risks
Valuation of an Insurance
Company
 Value of an insurance company
depends on its expected cash flows
required
Vand
= f [E(CF),
k] rate of return
+
Where:
V = Change in value of the insurance company
E(CF) = Change in expected cash flows
k = Change in required rate or return
Valuation of an Insurance
Company
 Factors that affect cash flows
E(CF)= f (ECON, Rf , INDUS, MANAB)
+
?
+
Where:
E(CF) = Expected cash flow
ECON = Economic growth
Rf = Risk free interest rate
INDUS = Prevailing industry conditions for the company
MANAB = Management ability of company
Valuation of an Insurance
Company
 Investors required rate of return
k = f(Rf , RP)
+
+
Where:
Rf = Risk free interest rate
RP = Risk premium
Performance Evaluation
 Common indicators of company
performance are available
 Statistical analysis of performance
 Ratio analysis
 Trends over time
 Compare to industry average
Performance Evaluation
 The higher the liquidity ratio, the more
liquid the company
Invested Assets
Liquidity
Ratio
=
Loss Reserves and
Unearned Premium Reserves
Performance Evaluation
 Return on net worth or policyholders’
surplus is a profitability measure
Net Profits
Return on Equity =
Policyholders’ Surplus
Performance Evaluation
 Underwriting gains and losses or
underwriting profitability measured by the
net underwriting margin
 Profits include investment income, underwriting
profits and realized capital gains
 Ratios can be calculated to focus on various
sources of profits
Net Underwriting
Margin
Premium Income - Policy Expenses
=
Total Assets
Other Issues
 Insurance companies interact in a
variety of ways with other financial
institutions
 Insurance companies participate in a
full range of financial markets
 Multinational insurance companies
 Insurance companies operate in many
countries
 Some countries lack developed markets
for insurance
CH 19
Pension Fund
Operations
Chapter Objectives
 Describe the different types of private
pension funds and the terminology of
pension funds
 Describe the pension management
styles
 Explain how pension funds can
become underfunded and overfunded
 Describe the role of the Pension
Benefit Guaranty Corporation in
enhancing the safety of pension plans
Pension Fund Terminology
Summary
ERISA and
PBGC
Public vs.
Private
Under
Funded vs.
Over
Trusteed vs.
Insured vs.
SelfDirected
Defined
Benefit vs.
Contribution
Pension Fund Developments
 Pension plans are a recent
development
 Depression and union bargaining
after World War II
 From “pay as you go” to funded
pensions
 From defined benefit to defined
contribution pensions
 Pension funds have become a major
capital market participant
Background on Pension Funds
 Public pension funds
 Social security
 State and local governments
 Many public pensions are funded on a
pay-as-you-go system
 Pension fund is unfunded
 Current contributions support previous
employees
 Depends on current cash flows of entity
to support pensioners
 Many public pension plans are fully
funded
Types of Private Pension Plans
 Defined-benefit plan
 Annual contributions are determined by
the benefits “defined” in the plan paid at
retirement
 If value of pension assets exceeds (over
funded) current and future benefits owed,
employer may
 Reduce future contributions
 Distribute surplus to shareholders
 Occurred during stock and bond boom of
the 1990’s
Types of Private Pension Plans
 Defined-contribution plan
 Provides benefits determined by the
accumulated contributions and the fund’s
investment performance
 “Contributions” are designated in plan,
not amounts available at retirement
 Firm knows with certainty the amount of
the contribution
 Provides uncertain benefits to
participants
Types of Private Pension Plans
Under-funded Pension Plan
 Future pension obligations of a definedbenefit plan are uncertain because
obligations are fixed payments to retirees
and payments depend on salary level,
retirement ages and life expectancies
 Over-optimistic projections (estimated rates of
return) can mean inadequate cash to cover
obligations
 High risk investments might be used to generate
higher returns with varied results
 Many companies are under funded for they were
“pay-as-you-go” for many years before funding
Types of Private Pension Plans
Over-funded Pension Plan
 When investment returns for definedbenefit plans perform better than expected,
there are funds in excess of the amount
needed to meet obligations
 A portion of the surplus can be credited to
the income statement of a corporation
 Encourages exchange of defined benefit for
insured pension purchase (liquidation of
plan)
Pension Regulations
 Regulations vary depending on the
type of plan—defined benefit more
regulated
 Criticism of plans led to regulation
 Unfair treatment in terms of vesting or
service requirements needed to qualify
for a pension
 Some plans were underfunded and could
not pay the benefits they promised
 Employees did not benefit when plans
had excess earnings but received
Pension Regulations
 Employee Retirement Income
Security Act of 1974 (ERISA)




Vesting standards
Corrected under-funded plans
Fiduciary responsible investing
Pension Benefit Guarantee Corporation
 Enforced by U.S. Department of Labor
 Many pension plans cancelled after
ERISA after funding required
Pension Regulations
 The Pension Benefit Guaranty
Corporation
 Intended to provide insurance on
pension plans
 Federally chartered agency that
guarantees beneficiaries of defined
contribution plans get benefits
 Receives no government support
 Funds come from annual premiums and
other income from active pension plans
 Monitors plans
 Takes over failed plans (bankruptcy of
Pension Regulations
 Accounting regulations
 Allow companies to more quickly
recognize gains and losses
 May increase the volatility of funds’
returns
 Rules may affect portfolio composition
 Underfunded plans shown as a liability
on the balance sheet
 Volatility of returns also depends on the
composition of the portfolio
Pension Fund Management
 Management of “insured” portfolios
 Some plans are managed by life
insurance companies
 Insured plans purchase annuity policies
so the life insurance company can
provide benefits to the employees upon
retirement
 Retirement benefits are “assured” by
credit strength of life insurance company
 No federal insurance coverage
Pension Fund Management
 Management of trusteed portfolios
 Managed by the trust department of a
financial institution
 ERISA required that a fiduciary be
involved in managing retirees’ funds
 Corporations specify guidelines
 Returns
 Risks
 Some companies have allocation systems
to try and minimize risks
Pension Fund Management
 Differences between trusteed and
insured portfolios
 Trusts offer higher returns with higher
risk via investment in stocks
 Mortgages are more important in
insurance company portfolios
 Both invest in bonds
 Risky investments by pension funds
include LBOs and stock speculation
Pension Fund Management
 Management of private versus public
pensions
 Private business vs. state, municipal
pensions
 Private pension portfolios dominated by
common stock
 Public pension portfolios more evenly
invested in stock, bonds and other credit
instruments
Pension Fund Management
 Pension funds use their large
ownership stakes in companies to
influence corporate policies and
management
 Examples of government pension funds
that are actively involved in issues of
corporate control
 California Pension Employees Retirement
System or CalPERS
 New York State Government Retirement
Fund
 TIAA
Pension Fund Management
 Management of interest rate risk is
important if portfolios hold long-term,
fixed-rate bonds
 Funds willing to accept market
returns can purchase index portfolios
for bonds and stocks
 Futures are used to hedge market
downturns
 Approaches to risk vary
Performance of Pension Funds
 Determinants of a pension fund’s
stock portfolio performance
PERF= f (MKT, MANAB)
Where:
PERF = Performance
MKT = General market conditions
MANAB = The ability of the fund’s management
Performance of Pension Funds
 Stock portfolio performance closely
related to market conditions
 Changes in management ability
 Performance can vary depending on the
skills of the manager
 Efficiency of the fund affects expenses and
performance
Performance of Pension Funds
 Determinants of a pension fund’s
bond portfolio performance
PERF= f (Rf, RP, MANAB)
Where:
PERF = Performance
Rf = Risk-free interest rate
RP =Risk premium
MANAB = The ability of the fund’s management
Performance of Pension Funds
 Performance evaluation
 Compare to the passive strategy
benchmark
 Any difference from the benchmark
results from
 The manager’s shift in the proportions of
stocks and bonds
 The composition of bonds and stocks
Performance of Pension Funds
 Performance of pension portfolio
managers
 Research showed funds earned less than
a market index
 Expenses were not included in the study
 Companies might do better to invest in
index mutual funds