FIN 430

Financial Markets & Institutions Study Guide

Introduction

• Real vs. Financial Assets: Real assets are physical or intangible assets used to produce goods and services (e.g., real estate, machinery, patents). Financial assets are claims on the income or cash flows generated by real assets or other issuers (e.g., stocks, bonds, bank deposits).

• Financial Markets: Physical or electronic venues where financial instruments (assets) are traded between buyers and sellers, facilitating capital formation, liquidity, and risk allocation.

• Financial Institutions: Intermediaries (e.g., commercial banks, investment banks, insurance companies, mutual funds) that mobilize funds from savers to borrowers and provide financial services.

• Primary vs. Secondary Markets: Primary markets are where securities are created and issued for the first time by corporations or governments to raise new capital (e.g., IPOs). Secondary markets are where previously issued financial securities are traded among investors (e.g., NYSE, Nasdaq), providing liquidity without directly raising funds for the original issuer.

• Money vs. Capital Markets: Money markets trade short-term, highly liquid debt instruments with maturities of one year or less. Capital markets trade long-term financial debt instruments (bonds) and equity securities (stocks) with maturities exceeding one year.

Money Markets

• Money Market Characteristics & Importance: Money markets feature short-term instruments ($\le 1 \text{ year}$), low default risk, high liquidity, and large denomination trades. They provide short-term liquidity management for corporations, banks, and governments to earn interest on excess cash or meet short-term funding gaps.

• Discount Yield ($i_{py}$ or $y_d$), Bond Equivalent Yield ($BEY$), and EAR:

  • Discount Yield ($y_d$): Quoted on a 360-day year based on face value ($F$) rather than purchase price ($P$).

    $y_d = \left(\frac{F - P}{F}\right) \times \left(\frac{360}{n}\right)$

  • Bond Equivalent Yield ($BEY$): Converts a discount or single-payment yield to a standard annual percentage yield based on a 365-day year and purchase price ($P$).

    $BEY = \left(\frac{F - P}{P}\right) \times \left(\frac{365}{n}\right)$

  • Effective Annual Rate ($EAR$): Accounts for annual compounding over $n$ days to maturity.

    $EAR = \left(1 + \frac{BEY}{365/n}\right)^{365/n} - 1 = \left(1 + \frac{F - P}{P}\right)^{365/n} - 1$

• Single Payment Yield ($i_{spy}$), BEY, and EAR:

  • Single Payment Yield ($i_{spy}$): Interest paid at maturity expressed relative to face value using a 360-day year (e.g., Fed funds, negotiable CDs).

    $i_{spy} = \left(\frac{\text{Interest Earned}}{P}\right) \times \left(\frac{360}{n}\right)$

  • Converting $i_{spy}$ to $BEY$:

    $BEY = i_{spy} \times \left(\frac{365}{360}\right)$

  • Converting $i_{spy}$ to $EAR$:

    $EAR = \left(1 + i_{spy} \times \frac{n}{360}\right)^{365/n} - 1$

• Money Market Instruments:

  • T-Bills: Short-term obligations issued by the U.S. federal government sold at a discount with zero default risk.

  • Federal Funds: Short-term unsecured loans of reserves between financial institutions, typically overnight.

  • Repurchase Agreements (Repos): Short-term collateralized loans where one party sells securities with an agreement to buy them back later at a higher price.

  • Negotiable CDs: Large-denomination (100k+) bank-issued time deposits that can be traded in secondary markets.

  • Commercial Paper: Unsecured, short-term corporate debt issued to raise cash for immediate operational needs (maturities up to 270 days).

  • Banker’s Acceptance: A time draft drawn on a bank to finance international trade, backed by a commercial bank guarantee.

Bonds

• Bond Characteristics: Long-term debt obligations where the issuer agrees to make periodic interest (coupon) payments and repay the principal (face/par value) at maturity.

• T-Notes and T-Bonds: Treasury notes (maturities of 2–10 years) and Treasury bonds (maturities of 20–30 years) issued by the U.S. government to fund operations; pay semiannual coupons and are free of credit default risk.

• Municipal Bonds & Tax Comparison: Debt obligations issued by state and local governments. Interest income is generally exempt from federal (and often state/local) income taxes.

  • Equivalent Taxable Yield (ETY$</strong></span><strong>):</strong> Compares a tax-exempt yield (<span style="font-family: "Google Sans Text", sans-serif; line-height: 1.15;">$r_m$</span>) to a taxable bond yield (<span style="font-family: "Google Sans Text", sans-serif; line-height: 1.15;">$r$):

    $ETY = \frac{r_m}{1 - t}$

    (where $t$ is the marginal income tax rate)

• Corporate Bonds: Debt securities issued by corporations to raise long-term capital.

  • Characteristics: Higher default risk than Treasuries, monitored by rating agencies (S&P, Moody's, Fitch).

  • Callable Bonds: Give the issuer the option to buy back (retire) the bond before maturity at a preset call price (usually exercised when interest rates drop).

  • Convertible Bonds: Give the bondholder the right to exchange the bond for a fixed number of shares of the issuing firm's common stock.

• Investment Grade vs. Junk Bonds: Investment grade bonds are rated BBB-/Baa3 or higher, indicating low to moderate credit risk. Junk bonds (speculative/high-yield) are rated below BBB-/Baa3, carrying higher default risk but offering higher yields to compensate investors.

Bond Valuation

• Bond Pricing & Yield Calculation:

  $P = \sum_{t=1}^{N} \frac{C}{(1 + r)^t} + \frac{F}{(1 + r)^N}$

  (where $C$ is coupon payment, $F$ is face value, $r$ is period yield, and $N$ is total compounding periods)

  • Excel Functions:

    • PV(rate, nper, pmt, [fv]): Calculates bond price ($P$).

    • RATE(nper, pmt, pv, [fv]): Calculates period yield ($r$).

    • PRICE(settlement, maturity, rate, yld, redemption, frequency): Calculates bond price per $100 par value.</p></li><li><p><code>YIELD(settlement, maturity, rate, pr, redemption, frequency)</code>: Calculates annual yield to maturity.</p></li></ul></li></ul></li><li><p><strong>Discount, Premium, and Par Bonds:</strong></p><ul><li><p><strong>Par Bond:</strong> Coupon rate = Yield to Maturity (<span style="font-family: "Google Sans Text", sans-serif; line-height: 1.15;">$YTM$</span>); Price = Par Value.</p></li><li><p><strong>Discount Bond:</strong> Coupon rate < Yield to Maturity (<span style="font-family: "Google Sans Text", sans-serif; line-height: 1.15;">$YTM$</span>); Price < Par Value.</p></li><li><p><strong>Premium Bond:</strong> Coupon rate > Yield to Maturity (<span style="font-family: "Google Sans Text", sans-serif; line-height: 1.15;">$YTM$); Price > Par Value.

  • Relationship Between Price and Yield: Inverse relationship. As yield increases, bond price decreases; as yield decreases, bond price increases.

  • Relationship Between Time to Maturity and Price: As a bond approaches maturity, its price converges toward its par value (assuming yield remains constant). Long-term bonds exhibit greater price sensitivity to interest rate changes than short-term bonds.

  • Clean Price vs. Full Price:

    • Clean Price (Flat Price): The quoted bond price excluding accrued interest.

    • Full Price (Dirty/Invoice Price): The total price paid by the buyer, including clean price plus interest accrued since the last coupon date.

      $\text{Full Price} = \text{Clean Price} + \text{Accrued Interest}$

      $\text{Accrued Interest} = C \times \left(\frac{\text{Days Since Last Coupon}}{\text{Days in Coupon Period}}\right)$

  • Corporate Bond Yields:

    • Price Calculation: Discount future promised cash flows (coupons and face value) using the required rate of return.

    • Expected Yield vs. Stated Yield: Stated yield (Yield to Maturity) is the maximum yield calculated using all promised cash flows assuming zero default. Expected yield accounts for default risk and recovery rate probabilities, reflecting the expected cash flow return (Stated Yield $\ge$ Expected Yield).