Finance 305: Test 1

Future Value Formula

FV = Future Value (value after t periods)
PV = Present Value
r = Interest rate (per period)
t= time (amount of compounding periods)

Formula for finding the PV of multiple cash flows

C0 = Present Cash flow

r = Discount rate

C1= Cash flow at end of period

Annuity Definition

A stream of fixed payments lasting a fixed number of periods.
(Bonds, leases, mortgages, pensions etc)

PV of annuity formula

C = Fixed payment each period
R= The discount rate per period
T = total number of payments

Discount Rate synonyms

• Interest Rate

• Risk free rate

PV of annuity formula downsides

• assumes first cash flow comes in 1 period (not now)

• Time period must be finite, cannot be infinite.

Perpetuity Definition

an annuity that pays indefinitely

PV of annuity formula

C/r

r = Discount rate
C = Cash flow

PV of Growing Perpetuity formula

r = discount rate per period
g = constant growth rate of payments
C = cash flow you get one period from now.

PV of growing perpetuity creator

Myron Gordon

What is the Price Discovery Process

interactions of buyers and sellers in a financial market determine the price of a traded asset.

3 Economic functions of financial markets

• buyers + sellers set the market

• option for liquidity

• financial markets reduce search and information cost of transaction

Explicit Search Costs Definition

the money spent to advertise the desire to buy/sell

Implicit search Costs Definition

the value of the time spent in locating a counterparty

Information costs

the costs associated with assessing financial assets

What is a Primary Market ?

• New security issues are sold to initial buyers

• typically involve and investment bank underwriting the offer.

What is a secondary market?

• Securities previously issued are bought and sold

• NASDAQ and NYSE are examples

• involves brokers and dealers

What is much larger, market for corporate bonds or total equity issuance

corporate bonds

When does a firm acquire new funds

when securities are first sold in primary markets

Who gets the money when an investor sells a security

the investor

Benefits of secondary markets for issuing corporations

• makes it easier to raise cash (selling)

• Provides price information for future primary market sales.

Broker definition

a third party in a trade that acts on behalf of a buyer or seller who wishes to execute an order.
- They get commission for their service
- they are an “agent”

Dealer definition

an entity that acts as an intermediary in a trade by buying and selling for its own account.

• They commit their own capital to accommodate

• they are a “principal” in a trade

• potential income earned is the bid-ask spread.

Exchanges Definition

trading venues where buyers and sellers meet in one centralized location to conduct trades (NYSE)

What are the products traded on an exchange called

listed products.

Over the counter markets (OTC) definition

A network geographically dispersed dealers who are linked to one another by telecommunications systems

What was and is the NASDAQ

Was: OTC
Is: Stock exchange

What are money markets?

• Debt securities with maturities of 1 year or less are traded.

• Little or no risk of capital loss but lower return

Capital Markets

Notes + Bonds + Stocks
- Trade long term debt and equity
- substantial risk of capital loss but higher returns.

Treasury Bill Definition

Short term obligations issued by the US government

Federal funds

short-term funds transferred between financial institutions usually for no more than one day.

Repurchase agreements

agreements involving the sale of securities by one party to another with a promise by the seller to repurchase the same securities from the buyer at a specified date and price.

Commercial Paper

short-term unsecured debt issued by a company to raise short-term cash

Negotiable certificates of deposit

bank-issued time deposits that specify an interest rate and maturity date and are negotiable.

Money market largest % chunk

Federal funds and repos : 40%

Corporate Stock Definition

ownership claim in a public corporation

Corporate bonds Definition

long-term bonds issued by corporations

Mortgages Definition

loans to individuals or businesses to purchase a real property.

Treasury bonds Definition

long-term bonds issued by the US Government

State and local government bonds definition

long-term bonds issued by state and local governments

U.S government agency bonds

long-term bonds collateralized by a pool of assets and issued by agencies of the US government

Bank and consumer loans definition

loans to commercial banks and individuals

Largest chunk of capital market

Corporate stocks: 58%

2 ways a firm can obtain funds from financial markets

1. Issuing debt instruments (loans and bonds)

2. Issuing Equity claims (residual claims) (paid after debt holders)

Securities that are hybrids of debt and equity

• Convertible Bonds

• Preferred Equity

Internal Market Definition

the financial market of a given country.

The External Market falls __ the jurisdiction of a given country

outside

Other names for the external market

• International market

• Offshore Market

• Euromarket

Domestic (internal market segment) Definition

issuing/trading securities of entities from within the country

Foreign (external market segment) Definition

issuing/trading securities of entities from outside the country

American Depository Receipts (ADRs) Definition

recipts on holdings of foreign stocks by a depository bank like JP Morgan

Foreign Market Nicknames

US - Yankee Market

Japan - Samurai Market

UK - Bulldog market

Foreign Bonds Definition

• bonds in foreign markets

Canada- Maple bonds

Netherlands- Rembrandt bonds

Spain- Matador bonds

Russia- Matrioshka bonds

Australia- Kangaroo bonds

China- Panda bonds

Korea- Arirang bonds

External Market synonyms

the off-shore market

• Euromarket

Eurocurrencies

money deposited outside of its home country

Eurodollars

U.S dollar deposits outside the US.

Eurobonds

bonds denominated in one country’s currency but issued in a different country

Eurodollar bonds

U.S dollar denominated bonds issued outside the US

Euroyen bonds

Japanese yen-denominated bonds issued outside Japan

The Eurobond market is larger than the ________

US corporate bond market

Reasons for Globalization of markets rapid growth

1. pool of savings in other countries has increased

2. International investors look around for best opportunities

3. Transactions costs have decreased

4. Information on foreign markets is more accessible

5. Economic growth in East Asia has inflated their markets

6. Deregulation in many countries has allowed international investors greater access.

What country has the highest stock market capitalization

the US

Bond Definition

a certificate that shows a borrower owes a specified sum and the dates on which the interest and principal must be paid

- a form of government or corporate long term borrowing.

Maturity

The length of the bond’s life

Face Value (Par Value / Principal Amount) Definition

The amount promised to be paid back at the bond’s maturity

Bonds are called __ because their payments are known

fixed income securities.

Coupon Rate Definition

The amount the lenders are paid on a periodic basis, reported as a percentage of face value.

Market Value Definition

How much the bond is currently worth in the market, which may be different from the face value.

• Price bond is trading at in the market

Yield to Maturity Definition

The return from holding the bond from the present until its maturity date and collecting its payments along the way.
- the average return from buying the bond today and holding till maturity

Bond Pricing Formula

P = Price

C = Coupon (coupon rate x face value)

Y = YTM

T = # of periods until bond matures

F = the principal repaid at maturity

Bond Price Equation

C =. Coupon payment per period

Y = discount rate

M = number of periods till maturity

F = the face value repaid at maturity

Higher bond price implies a __ yield

lower

Can two bonds with the same maturity and cousins have different prices?

Yes if the market perceives them as having different default risk.

Higher risk bonds will have a lower risk and a __ yield

higher

If the YTM is equal to the coupon rate

The bond sells at par (face value)

Bond sells at a discount if YTM is __ than the coupon

larger

Bond sells at a premium if YTM is __ than the coupon

smaller

Relationship between interest rates and bond prices

inverse relationship

Interest rate risk definition

The sensitivity of bond prices to changes in interest rates.

Bonds with longer maturity have __ interest rate risk

more

Bonds with smaller coupon rates have __ interest rate risk.

more

Treasury Bill maturity length (bond)

Less than 1 year

Treasury note maturity length (bond)

1-10 years

Treasury bond maturity length (bond)

10-30 years

Risks for Treasury bonds

• Reinvestment risk

• inflation

• interest rate risk.

Primary Market: Treasury Securities

The US Treasury sells its securities in auctions

Secondary Market : Treasury Securities

Treasury securities are actively traded in OTC markets

Treasury bonds trade in bundles of __ units

100

Accrued interest definition

the fraction of the next coupon I should receive since I held on to the bond during the last coupon cycle.

Accrued Interest Equation

Dirty Price Equation

Clean Price + Accrued Interest

Treasury STRIPS definition.

Coupon and principal payments are stripped from Treasury notes/bonds and sold as individual zero-coupon bonds

Treasury STRIPS synonyms

Treasury zero-coupon bonds

Why are STRIPS useful

• Helps move money more flexibility to have more cash on hand

TIPS (Treasury Inflation Protected Securities)

• The principal amount is tied to the current rate of inflation to protect investors purchasing power.

• The principal value of a TIPS bond can increase or decrease every six months by the amount of US inflation (or deflation)

What happens when TIPS bonds mature

investors receive the adjusted principal or original principal, whichever is greater.

Treasury FRN

• Maturity of 2 years and quarterly coupons

• the coupon rate fluctuates based on the 13-week treasury bill rate

Agency Bond Definition

a security issued by a federal government department (other than the US Treasury) or by a government sponsored enterprise.

Federal Government Agencies

Ginnie Mae (Government National Mortgage Association)

Government Sponsored Enterprises

Fannie Mae

Freddie Mac

Sallie Mae