HFT 4464 Chapter 2 Financial Markets Financial Instruments
- Slides: 30
HFT 4464 Chapter 2 Financial Markets & Financial Instruments 1
Chapter 2 Introduction n 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. 2 -2
Why Do People Invest? n n 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. 2 -3
Equity Capital n n Types of equity capital u Preferred stock u Common stock This course focuses more on common stock. u No guarantee of dividend u One share, one vote u Shareholders vote on key issues such as composition of board of directors, choice of auditing firm, and others. 2 -4
Why Purchase Common Stock? n n 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 2 -5
Holding Period Return Example n n You purchased a share of Mc. Donald’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 x 100 = 13. 89% (before taxes) 2 -6
Bonds n n n Held by lenders Receive repayment over time u Semi-annual interest payments u 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 2 -7
How to Interpret Bond Information Bond Curr. Yld Hilton 73/4 04 7. 2% Vol 40 Close Chg 101 +1/2 The Hilton bond pays 7. 75% interest and matures in 2004. n n n 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. 2 -8
Capital Markets n Represents a diverse group of investments u Stock market u Bond market u Mortgage market u Futures market 2 -9
Stock Market n New York Stock Exchange (NYSE) u Founded in 1792 u Physical location on Wall Street in New York u Approximately 2, 800 companies offering securities here u Membership offered in the form of seats 2 -10
Stock Market n Nasdaq u National Association of Securities Dealers and Automated Quotations u Not a physical location like the NYSE (“over the counter”) u Represents u Fastest a network of securities dealers growing securities market u Makes use of “market makers”—help ensure liquidity of trading 2 -11
Bond Market n Corporate bonds can be traded through the NYSE n Most bonds are traded over the counter n Bond ratings u The lower the letter, the greater the quality u Quality refers to the risk of default n Companies rating bonds u Standard and Poor’s u Moody’s 2 -12
Important Features of Bonds n n How are bond prices and interest rates related? u As interest rates rise, bond prices fall. Some bonds are callable. u Company can repurchase bonds at a certain price during a certain time. 2 -13
Mortgage Market n Pooling of home mortgages by government agencies u FNMA and GNMA are two examples. u Mortgages are packaged and resold as securities to investors. u Investors are often large institutional investors like pension funds. 2 -14
Money Market n Market for short-term debt instruments u Certificates of Deposit u Commercial paper « Investors loan to large companies for a very short period of time (9 months or less). u Treasury « Loans Bills / Bonds to the U. S. Treasury « Zero-Coupon bonds « Issued at a discount—no interest payments 2 -15 « Risk Free Rate
Raising Capital n Primary market u Initial Public Offering (IPO) « Common stock is sold to underwriter (investment banker) « Investment banker sells to clients « 2003 scandal/settlement n Secondary market u Investor to investor, where most trading occurs 2 -16
Features of Stock Trading n Bid vs. ask u Bid is the price you will pay to own a share u Ask is the price you would receive to sell your share u Difference goes to broker n Average NYSE trade takes 22 seconds n Significant reliance upon computers n Trading halt in June 2001 2 -17
Hedging Risk n n We can add value by decreasing the risk (variability) of cash flows. The concept of insurance as hedging: u You buy insurance and if nothing happens to your house, you still have the house. u If your house is damaged, insurance pays for it and the house is rebuilt. 2 -18
Forward and Futures Contracts n n 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 2 -19
Forward Contracts n n 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. 2 -20
Futures Contracts n Similar to forward contracts, except: u Terms of contract are standardized, such as amounts and delivery dates. u Clearinghouse acts as go-between to help ensure performance. u Contracts are traded on the Chicago Board of Trade or Chicago Mercantile Exchange. n n Most contracts are never delivered. Parties take opposite positions to offset original position. 2 -21
Foreign Exchange n n n As international trade barriers are removed, more business is conducted away from home country. Nearly 65% of Mc. Donald’s 2002 revenues originated from outside the U. S. companies must report financial operations in U. S. currency. 2 -22
Foreign Exchange Example n n n 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, 000 Euros x $1/1 Euro = $100, 000 usd 100, 000 Euros x $2/1 Euro = $200, 000 usd 2 -23
Can we hedge this risk? n n 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. 2 -24
Lenders to the Hospitality Industry n Commercial banks u Traditionally largest lender u Bank makes a “spread”—difference between interest rate on loans and rate on deposits u Interest = principal x rate x time u Types of loans «Fully amortized (principal and interest) «Interest only 2 -25
Lenders to the Hospitality Industry n Real Estate Investment Trusts (REITS) u There are equity and mortgage REITS u Special tax treatment if they pass through at least 95 percent of earnings to investors n Insurance companies and pension funds u Receive large monthly cash flows from premiums and contributions u Try to match assets (loans) to liabilities (policies and pension needs) 2 -26
Measures of Stock Market Performance n n Dow Jones Industrial Average u Index of 30 large companies u Weighted by stock price Standard and Poor’s 500 (S&P 500) u 500 companies u Fairly common measure of overall stock market performance u Movement is similar to the Dow 2 -27
Some Stock Market Statistics n Mean—weighted average u Mean Dow annual return (1950– 2001) = 9. 01% u Mean S&P 500 annual return = 9. 63% n n n 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 2 -28
Some Stock Market Statistics n n n 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 is perfect positive correlation -1. 0 is perfect negative correlation The Dow and the S&P 500 are highly positively correlated 2 -29
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