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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 = CP 1/(1+r) + CP 2/(1+r)2 +. . + CPT/(1+r)T + MV/(1+r)T - P • CP 1, CP 2, . . . 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 = d 1/(1+r) + d 2/(1+r)2 + d 3/(1+r)3 +. . d. T/(1+r)T – where T is the end of the firm’s life (which might be infinite) – d 1, d 2, . . . d. T 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: 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.