Investments Background and Issues Real vs Financial Assets

Investments: Background and Issues • Real vs Financial Assets – Real assets are used to produce goods and services – Financial assets are claims on real assets – All financial assets are derivative assets (i. e. , prices derived from their underlying assets) – Why financial assets exist?

– Financial Market • Channel funds from the surplus units (typically from the consumer sector) to the deficit units (from the business sectors or government) • Financial intermediaries are institutions help the fund flows in the financial market for efficient fund allocation • Means to overcome market impediments, e. g. , taxes

Financial Intermediaries • Brokerage Function Financial intermediaries that bring together buyers and sellers to complete the transaction and charges a fee, e. g. , investment banks • Asset Transformation Financial intermediaries that pool short-term funds and transform them into longer-term assets, e. g. , commercial banks

Market Structures • Direct Market buyers and sellers find each other directly, e. g. , resale of real assets • Brokered Market Broker brings buyer and sellers together, e. g. , direct placement of debt • Dealer Market Dealer purchases the asset and later sells it to the investor, e. g. , OTC market • Auction market All transactions converge in one place to buy or sell, e. g. , NYSE continuous vs discrete auction market

Recent Developments in Financial MKT • Globalization – Integration of financial markets across nations, e. g. , mutual fund flows 1993, mutual funds invested in LDC grew substantially, but correction later. • Securitization Package assets and sell off to market, e. g. , A/R loans • Credit Enhancement allows insurance company to back credit of a corporation • Financial Engineering unbundling and bundling of existing assets to create new instruments (dual funds)

Financial Instruments • Money Market (short-term) Tbill: when issued with maturities if 13 -w, 26 -w or 52 w and are sold at a discount basis DY = [(10, 000 -price)/10, 000](360/n) where DY= discount yield n = days to maturity BEY = [(10, 000 -P)/P](365/n) • BEY is the bond equivalent yield Effective Yield is the yield to maturity that equates the present value of the Tbill face value to its current price

• Certificate of Deposit (CD): time deposit instrument with banks. Denominations equal to or less $100, 000 due to FDIC insurance limit. • Commercial paper: Corporate IOUs, less than 270 -day maturity due to SEC rule Increasing importance instruments that shapes the banking industry • Bankers Acceptance: trade discount instrument backed by banks. • Eurodollar CD: deposits with Eurobonds • Federal Funds: bank deposits at FRB as reserve. Excess amount than required can be loaned out on a overnight basis to satisfy the FRB requirement

Capital Market Instruments • Treasury notes/bonds: medium to long-term federal government debt instruments at a fixed rate. • Corporate Bonds: private firms’ debt issues • Mortgages and Mortgage-backed Securities: a portfolio of mortgage loans or claims in a pool of mortgage loans. • Preferred stocks: dividend typically cumulative; institutions may have 70% exclusion tax consideration • Common Stocks:

Stock Index • Price-Weighted Indice: Dow Jones Industrial Index (DJIA), 30 stocks. Suppose two stocks, their prices are $25 and $100 Index = (25+100)/divisor Since there is 2 stocks, divisor=2 Index = (25+100)/2 = 62. 5 If (1) the new price of first one is $ 30 and the second stock undertakes 2/1 split and its new price is $45, then: New Divisor = (25+50)/62. 5= 1. 25 New Index = (30+45)/1. 25 = 62. 5 (same!) • Value-Weighted Index: e. g. , S&P 500

• Bond Indexes: there are many bond indexes, such as Lehman Brothers, and Ibbotson that indicate overall bond market conditions. • Other Instruments Options: a right to buy/sell a security in the future Futures: an obligation to buy or sell in the future

Hong Kong Money Market • Interbank Market: – most important component of the money market in HK – a short-term unsecured loans between deposit-taking institutions (licensed banks, restricted licensed banks and deposit-taking companies) – maturity: overnight to 12 -months – quote: bid-ask spread using HIBOR (Hong Kong Interbank Offered Rate) as a reference rate – its liquidity is influenced by Hong Kong Monetary Authority (HKMA)

– when HK$ is under pressure to depreciate from the $7. 8/US$, HKMA will raise the interbank rate to induce more dollars to interbank market. • Repo Market – HKMA provides a discount window called the Liquidity Adjustment Facility (LAF) for banks between 4: 00 -5: 00 pm, i. e. , after the close of the interbank market – banks sell securities at discount to HKMA and repurchasing back next day. – Two types of securities are acceptable in – in the repo market: (1) securities issued by the statutory bodies, such as Mass Transit Railway Corporation and Provisional Airport Authority, (2) Securities that are not lower than A- (S&Ps) or A 3 (Moody’s) if issued by banks, and not lower than A (S&Ps) or A 2 (Moody’s) issued by non-banks

• Exchange Fund Market: – exchange fund bill (short-term) started in 1990 and later managed by HKMA – its maturity: 91 -day, 182 -day, and 364 -day – size: HK$1. 5 b, 1 b and 0. 5 b – Exchange Fund Notes are longer-maturity with 2 -y, 3 -y, 5 -y, and 7 -yr • Commercial Paper (CP) – short-term, 30 -days to 1 -yr – unsecured and mainly primary market – Firms only issued CP if highly rated by rating agencies (S&P, Moody) – minimum size, HK 500, 000, institutional participants in the market • Negotiable CD – large denominations in HKD (70%) and foreign currencies – most in 3 -year maturity, primary market

• Bankers’ Acceptance – largely denominated in foreign currency with 10% in HK$ – 3 -6 months maturity, which is the time for shipment and settlement of goods – lenders are largely banks and deposittaking companies – the rate is typically below HIBOR