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HFT 4464

HFT 4464. Chapter 2 Financial Markets & Financial Instruments. Chapter 2 Introduction. This chapter will provide an introduction to financial markets and common financial instruments. Financial markets are where suppliers of capital (firms) interact with buyers (investors).

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HFT 4464

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  1. HFT 4464 Chapter 2 Financial Markets & Financial Instruments

  2. Chapter 2 Introduction • This chapter will provide an introduction to financial markets and common financial instruments. • Financial markets are where suppliers of capital (firms) interact with buyers (investors). • Often this is done through intermediaries such as brokers.

  3. Why Do People Invest? • Investing is not just something other people do. • College education is an investment. • Investing is more than just hoping to “make some money.” • It involves deferring present consumption in the hopes of higher future consumption.

  4. Equity Capital • Types of equity capital • Preferred stock • Common stock • This course focuses more on common stock. • No guarantee of dividend • One share, one vote • Shareholders vote on key issues such as composition of board of directors, choice of auditing firm, and others.

  5. Why Purchase Common Stock? • A purchaser is looking for at least one of two possibilities: 1. Stream of dividend payments (current income) 2. Increase in stock price (capital gain) • Holding period return: { ( (sales price – purchase price) + dividends ) / Purchase Price } x 100

  6. Holding Period Return Example • You purchased a share of McDonald’s stock one year ago for $18.00. • You earn $2.00 in dividends during the year. • Today you sell the stock for $18.50. • What is your holding period return? (($18.50 – $18.00) + $2) / $18.00 = 0.1389 0.1389 x 100 = 13.89% (before taxes)

  7. Bonds • Held by lenders • Receive repayment over time • Semi-annual interest payments • At maturity, amount is repaid (principal) • This is a series of cash flows that has value • Priced on an index relative to 100 • If a $1,000 bond sells for “102,” it sells for $1,020

  8. How to Interpret Bond Information BondCurr. YldVolCloseChg Hilton 73/4 04 7.2% 40 101 +1/2 The Hilton bond pays 7.75% interest and matures in 2004. • The annual interest divided by the current price is 7.2 percent. (Note: this is not the return you will receive if you hold the bond till maturity.) • 40,000 bonds were traded that day. • The bond closed at $1,010 which is $.50 higher than the previous day.

  9. Calculating Bond Yield • Bond Yield: • (Face Value of Bond x Interest Rate) /Current Price of Bond • Current Price of Bond from Current Yield: • (Current Price of Bond x Yield)/Face Value of Bond

  10. Capital Markets • Represents a diverse group of investments • Stock market • Bond market • Mortgage market • Futures market

  11. Stock Market • New York Stock Exchange (NYSE) • Founded in 1792 • Physical location on Wall Street in New York • Approximately 2,800 companies offering securities here • Membership offered in the form of seats

  12. Stock Market • Nasdaq • National Association of Securities Dealers and Automated Quotations • Not a physical location like the NYSE (“over the counter”) • Represents a network of securities dealers • Fastest growing securities market • Makes use of “market makers”—help ensure liquidity of trading

  13. Bond Market • Corporate bonds can be traded through the NYSE • Most bonds are traded over the counter • Bond ratings • The lower the letter, the greater the quality • Quality refers to the risk of default • Companies rating bonds • Standard and Poor’s • Moody’s

  14. Important Features of Bonds • How are bond prices and interest rates related? • As interest rates rise, bond prices fall. • Some bonds are callable. • Company can repurchase bonds at a certain price during a certain time.

  15. Mortgage Market • Pooling of home mortgages by government agencies • FNMA and GNMA are two examples. • Mortgages are packaged and resold as securities to investors. • Investors are often large institutional investors like pension funds.

  16. Money Market • Market for short-term debt instruments • Certificates of Deposit • Commercial paper • Investors loan to large companies for a very short period of time (9 months or less). • Treasury Bills / Bonds • Loans to the U.S. Treasury • Zero-Coupon bonds • Issued at a discount—no interest payments • Risk Free Rate

  17. Raising Capital • Primary market • Initial Public Offering (IPO) • Common stock is sold to underwriter (investment banker) • Investment banker sells to clients • 2003 scandal/settlement • Secondary market • Investor to investor, where most trading occurs

  18. Features of Stock Trading • Bid vs. ask • Bid is the price you will pay to own a share • Ask is the price you would receive to sell your share • Difference goes to broker • Average NYSE trade takes 22 seconds • Significant reliance upon computers • Trading halt in June 2001

  19. Hedging Risk • We can add value by decreasing the risk (variability) of cash flows. • The concept of insurance as hedging: • You buy insurance and if nothing happens to your house, you still have the house. • If your house is damaged, insurance pays for it and the house is rebuilt.

  20. Forward and Futures Contracts • Spot price—price paid for a commodity today • Change in commodity prices present, risk to buyer and seller • Example: Orange juice grower (seller) and restaurant owner (buyer) • Prices help growers determine what and how much to produce and restaurants need to establish menu price

  21. Forward Contracts • An agreement to sell an asset at a fixed price for delivery in the future. • Cash payment is not required until delivery. • However, each party must trust the other to perform. • The unique nature of each contract makes them difficult to sell to third parties.

  22. Futures Contracts • Similar to forward contracts, except: • Terms of contract are standardized, such as amounts and delivery dates. • Clearinghouse acts as go-between to help ensure performance. • Contracts are traded on the Chicago Board of Trade or Chicago Mercantile Exchange. • Most contracts are never delivered. • Parties take opposite positions to offset original position.

  23. Foreign Exchange • As international trade barriers are removed, more business is conducted away from home country. • Nearly 65% of McDonald’s 2002 revenues originated from outside the U.S. • U.S. companies must report financial operations in U.S. currency.

  24. Foreign Exchange Example • You operate a hotel in France and accept the Euro. • When the Euro strengthens, this means it takes fewer Euros to buy $1 worth of goods. • As the Euro strengthens, your profits increase upon conversion. • 100,000Euros x $1/1Euro = $100,000 usd • 100,000Euros x $2/1Euro = $200,000 usd

  25. Can we hedge this risk? • Similar to commodities, we want to lock in a “price” for our Euros—an exchange rate at a future date. • We can buy a forward or futures contract to accomplish this. • Who would be on the other side of this transaction? • A French company (or other company accepting the Euro) operating in the U.S.

  26. Lenders to the Hospitality Industry • Commercial banks • Traditionally largest lender • Bank makes a “spread”—difference between interest rate on loans and rate on deposits • Interest = principal x rate x time • Types of loans • Fully amortized (principal and interest) • Interest only

  27. Lenders to the Hospitality Industry • Real Estate Investment Trusts (REITS) • There are equity and mortgage REITS • Special tax treatment if they pass through at least 95 percent of earnings to investors • Insurance companies and pension funds • Receive large monthly cash flows from premiums and contributions • Try to match assets (loans) to liabilities (policies and pension needs)

  28. Measures of Stock Market Performance • Dow Jones Industrial Average • Index of 30 large companies • Weighted by stock price • Standard and Poor’s 500 (S&P 500) • 500 companies • Fairly common measure of overall stock market performance • Movement is similar to the Dow

  29. Some Stock Market Statistics • Mean—weighted average • Mean Dow annual return (1950–2001) = 9.01% • Mean S&P 500 annual return = 9.63% • Returns in a single year have varied from –30% to +44% • This uncertainty around the mean is called variance • Another measure is standard deviation, the square root of the variance

  30. Some Stock Market Statistics • Can we measure the relationship between two individual stocks, two stock indices, or an individual stock and a stock index? • Correlation coefficient =  • Range is from –1.0 to +1.0 • +1.0 is perfect positive correlation • -1.0 is perfect negative correlation • The Dow and the S&P 500 are highly positively correlated

  31. Homework Assignment Problems 1,2,3,6,7

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