Financial Markets
• Financial markets
– link borrowers and lenders.
– determine interest rates, stock prices, bond prices,
etc.
• Bonds
– a promise by the bond-issuer to pay some specified
amount(s) in the future in exchange for some
payment (the bond price) today.
• Stocks (equities)
– legal rights of ownership in an incorporated firm.
– promise the stockholder a share of the corporte
profits (dividends)
The Bond Market.
Maturity date:
– the specific future date on which the maturity value will be paid to the
bond holder.
– Bond maturity dates generally range from 3 months up to 30 years.
Coupon rate
– Between the date of issuance and the maturity date, the bond-holder
receives an annual interest payment equal to the coupon rate times the
maturity value.
Yield to maturity
– represents the effective interest rate that the bond-holder earns if the
bond is held to maturity.
Bond price
– The price that the bond sells for. This fluctuates over the life of the bond.
• If the bond price is equal to 100% of its maturity value, the bond sold
at “par”.
• If the bond price is below 100% of its maturity value, the bond price
sold “below par”.
The Bond Market
• 20 year bond with maturity value of $1000
and coupon rate of 5% promises
– 20 annual payments of .05*1000=$50
– $1000 payment at maturity (20 years from
now).
– If price is $1000 for this bond, the bond sold
for par.
Present Value
PV of $X to be paid in T years
 Amount that if deposited today would grow to $X in T years
 $X/(1+r)T
Example:
$100 deposited today at 10% interest will grow to:
$100(1.1) in 1 year
$100(1.1)2 in 2 years
$100(1.1)3 in 3 years
$100(1.1)T in T years
i.e. (FV) Future value of x deposited today for T years =PV(1+r) T
(compounding interest)
Rearrange above equation to solve for x
PV of x to be received in T years = x/(1+r) T
(discounting)
The Bond Market.
Computing yields on a bond.
• The yield on a bond is the same as the internal rate of
return. To calculate the yield to maturity, define net
present value (NPV) as follows:
NPV = CP1/(1+r) + CP2/(1+r)2 + .... + CPT/(1+r)T +
MV/(1+r)T - P
• CP1, CP2, ... CPT are the interest or coupon payments in
periods 1 through T
• MV is the payment received at maturity
• P is the price paid for the bond.
• The yield to maturity is the interest rate that makes the
NPV on the bond purchase zero.
The Bond Market.
One year bonds
NPV = MV(1+cr)/(1+r) - P where cr is the coupon rate.
Setting NPV=0 and solving for r provides the yield to
maturity:
yield = [MV(1+cr)/P] - 1
• As the price paid for a bond increases, the yield on
the bond falls.
• If P=MV (i.e. pay par), yield=CR
• If P>MV, (i.e. pay above par), yield<CR
• If P<MV, (i.e. pay below par), yield>CR
The Bond Market.
Zero Coupon Bonds.
• With zero coupon bonds, no interest payments are made between
the sale of the bond and its maturity. That is, there is a zero coupon
rate. For such bonds, the yield calculations is straightforward.
NPV = MV/(1+r)T - P
•
setting NPV=0 and solving for r provides the yield:
yield = (MV/P)1/T - 1
•
For example, if you buy a zero coupon bond today for $1000 and it has a
maturity value of $1500 in 10 years:
yield = (1500/1000)1/10 -1 = .0414 = 4.14%
As the price paid for a bond increases, the yield on the bond falls.
The Bond Market.
• Determinants of bond yields
– Higher expected inflation will drive up yields.
– Higher risk bonds must offer higher yields.
• Default risk.
• Inflation risk
– Term
• Longer term bonds have greater inflation and
default risk.
The Bond Market.
• Yield curve
– relationship between yield and term on government
bonds
– Slope of yield curve reflects
• Expectations of future short term interest rates
• Greater risk of long term bonds
– If short term interest rates are expected to be constant
in the future, yield curve will slope upward reflecting
risk premia for longer term bonds.
– A steepening of the yield curve suggests that financial
markets believe short term interest rates will be rising
in the future.
– The dynamic yield curve (see link on web page)
The Stock Market
• Stocks (equities):
– legal rights of ownership in an incorporated
firm.
– promise the stockholder a share of the
corporte profits (dividends)
The Stock Market
• The “fundamental value” of a stock is the expected
present value of all future dividends from a stock.
•
P = d1/(1+r) + d2/(1+r)2 + d3/(1+r)3 + ....dT/(1+r)T
– where T is the end of the firm’s life (which might be
infinite)
– d1, d2, ... dT represent dividend payments in years 1
through T.
– r is the interest rate
The Stock Market
• Given the fundamental value theory, stock
prices will rise with:
– lower interest rates.
– an increase in future expected dividends.
– A lower tax rate on dividends.
The Stock Market
• Efficient markets hypothesis:
– All stock prices represent their fundamental
value at each point in time.
– When new “information” arrives about a stock,
its price immediately adjusts to reflect that
new information.
– It is impossible to consistently predict which
way a stock price will move in the future and
to consistently “beat the market”.
The Stock Market.
• If the efficient markets hypothesis is true,
– financial advisors can assist you only in evaluating
the risk and tax consequences of different stocks and
concerns regarding income or growth, etc.
– Financial advisors will not be able to consistently find
stocks that will “beat the market”.
• The validity of the efficient markets hypothesis is
controversial among financial economists.
The Stock Market
• Stock quotes (see, for example,
– Price
– Volume (number of shares sold in previous
day)
– EPS (earnings per share)
– PE ratio (price-earnings ratio)
– Beta (measures stock movements relative to
market)
See finance.yahoo.com for stock quotes
Mutual Funds
Mutual Funds: a firm that pools money from many small
investors to buy and manage a portfolio of assets and
pays the earnings back to the investors. Mutual funds
can be categorized in several ways. For example:
– index funds (S&P 500 or Willshire 5000)
– international funds (invest in foreign securities)
– bond funds (invest in bonds)
– money market funds (invest in short term government
securities)
• The major advantage of mutual funds is that it allows a
person to invest in the stock market and be diversified.
Futures Market
• A market for contracts that provide for future delivery of a
good at some pre-specified price.
– commodities, bonds, and foreign currencies.
• A 1/1/2014 futures contract to buy 1000 bushels of corn at
$3.00 per bushel
– Buyer is committed to buying corn on that date at that price.
– Seller is committed to selling corn on that date at that price.
• If the expected price of a commodity in the future
rises, the futures price will rise.
• The price in futures contracts provides an indicator of
what people believe about the movement of prices in
the future.