What are three characteristics of money market securities?

1. Mature in less than a year (usually <120days)

2. Sold in large denominations--wholesale

3. Low default risk.

1. To "warehouse" excess funds and minimize opportunity cost.

2. To obtain short-term supplies of funds.

1. US Treasury department.

2. Federal Reserve system.

3. Commercial banks.

4. Businesses.

5. Investment/securities firms.

6. Individuals.

Treasury bills are issued at a discount from par. Investor's yield comes from an increase in the security's value over its term.

Discount rate % = [(FV-P)/FV](365/n)

**360 for annualized

Each week, the Treasury holds auctions of specific #s/types of T-Bills.

Competitive Bidding: The Treasury accepts bids by ascending yield until bidding equals the offer amount--this yield sets the price. (35% limit)

Noncompetitive Bidding: Specified # securities, sold at same price as competitive bidders.

A repo is a temporary sale of securities with an agreement to buy back the securities at a later date (3-14days).

Dealers use repos to 1) manage liquidity and 2) take advantage of changes in interest rates.

What is commercial paper?

What are the interest rate/risk characteristics?

What is the commercial paper market like?

Commercial paper securities are unsecured promissory notes issued by corporations, with maturities of under 270 days.

Interest rate depends on the issuer's level of risk, and there is no strong secondary market.

1. The exporter is paid immediately.

2. The exporter is not exposed to foreign exchange risk.

3. The exporter is protected from asymmetric information.

Eurodollars are dollars deposited in other countries, where rates of return are higher than in the domestic market.

Globally, Eurodollars function as substitutes of federal funds. They are exchanged overnight (LIBID: rate paid for buying funds, LIBOR: rate offered for sale)

Governments: issue bonds to fund debt and finance projects.

Corporations: issue bonds and stock to finance activities or protect capital for unexpected needs.

Households are the largest buyers of securities.

A call provision is an indenture provision that allows the issuer to force the holder to sell a bond back. Firms benefit b/c:

1. If interest rates fall enough, a firm can call the bond when price exceeds call price.

2. They can buy back bonds to satisfy the sinking fund provision.

3. Firms can retire bonds if its covenants prevent favorable practices.

Speculative junk bonds are bonds with high default risk (under Moody's Baa or S&Ps BBB) but with higher returns.

1. Low liquidity--Drexel assured a secondary market for junk bonds.

2. Default risk--Milken acted as a bank to reduce junk bond default risk.

Current yield is an approximation of the yield to maturity on long-term bonds.

Current yield = (Annual Coupon Payment)/(Price)

As a bond's time to maturity increases it behaves more like a perpetuity; current yield becomes an effective approximation of y2m.

1. The stock pays dividends over time.

2. The value of the stock rises.

1. Stock holders are residual claimants on the firm's assets--in default, they get paid after bond holders.

2. Dividends can be easily changed.

3. Stock price increases are not guaranteed.

**Stocks are more profitable than bonds.

1. Preferred stockholders receive a fixed dividend that never changes--operates like a bond.

2. Because dividends are consistent, price is stable.

3. Preferred stockholders do not vote unless the issuer has not paid dividends.

4. Preferred stock has higher asset claim.

1. Transparency--information about unfilled orders provides supply/demand info.

2. Cost reduction--transaction costs are lower, since the middleman is cut out.

3. Faster execution--ECNs are automated so trades are matched/confirmed faster.

4. After-Hrs trading--unlike exchanges, ECNs never close.

ETFs are baskets of securities that are traded in stock form.

1. Listed and traded as individual stocks on ASE.

2. Indexed, rather than actively managed.

3. Value based on net asset value of held stocks in the basket.

The price earnings ratio indicates how much the market is willing to pay for $1 earnings from the firm.

1. The market expects earnings to rise in the future.

2. The market feels the earnings are low-risk and is willing to pay a premium for them.

1. The Gordon growth model assumes a constant rate of growth, which does not happen because of competition.

2. Price depends heavily on return, but this value is uncertain.

3. Forecasting the dividend payout ratio is also difficult and uncertain.

The Securities Act was passed to:

1. require firms to tell the truth about their businesses.

2. require brokers, dealers, and exchanges to treat investors fairly.

1. Corporate Finance: collects documents that public firms are required to file.

2. Market Regulation: maintains rules for securities market participants.

3. Investment Management: establishes rules governing investment companies.

4. Enforcement: investigates violations of SEC rules.

1. Market rates--mortgage rates track along rates for Treasury bonds.

2. Term--longer term mortgages have higher interest rates b/c of greater interest-rate risk.

3. Discount points--percentage of loan interest made at beginning of loan (high DP = low int rt)

Second mortgages are loans that are secured by the same real estate used to secure a prior mortgage. They are junior to the first mortgage.

1. Second mortgages allow buyers to use their home equity as security for a second loan.

2. 

1. The originator packages the loan for an investor.

2. The investor holds the loan.

3. The servicing agent collects and passes through payments.

1. Economies of scale.

2. Geographic diversity (since they did not accept deposits).

1. Mortgages are too small to be wholesale instruments.

2. Mortgages have nonstandard characteristics.

3. Mortgages are costly to service relative to bonds.

4. Mortgages have unknown default risk.

Freddie Mac issues participation certificates (PCs). Differences from Ginnie Mae pools:

1. They are nonguaranteed mortgages

2. They are not federally insured.

3. They contain mortgages with different rates.

4. They are larger, with a higher minimum denomination.

Subprime loans are loans issued to borrowers who do not qualify for a loan at the usual market interest rate.

1. 2/28 ARMs

2. Piggyback loans

3. Stretch loans

4. Stated income loans

1. Goods produced in different countries are not identical.

2. Not all goods and services can be traded--ex. haircuts, houses, land, etc.

1. Relative price levels

2. Tariffs/quotas

3. Preferences for domestic/foreign goods

4. Productivity

How does an unsterilized intervention where domestic currency is sold affect:

a) international reserves

b) money supply

c) strength of national currency

a) International reserves will increase.

b) Money supply will increase.

c) National currency will depreciate--since increase in money supply raises price levels and lowers expected return.

The trade balance is the difference between a country's net exports and imports.

Deficit: Imports > Exports

Surplus: Exports > Imports

Surplus --> increasing claims on foreign wealth --> increase in holdings of foreign assets.

Deficit --> Other countries increasing claims on the United States --> decrease in US holdings of foreign assets.

The IMF sets rules for the maintenence of fixed exchange rates and makes loans to countries experiencing balance-of-payments difficulties.

The World Bank makes long-term loans to developing countries to build dams, roads, etc.

Countries with surpluses in their trade balance do not want to see their currencies appreciate because it makes their goods more expensive abroad and foreign goods cheaper domestically.

Likewise, countries with deficits in their trade balance do not want to see their currencies depreciate because it makes foreign goods more expensive for consumers and can stimulate inflation.