Financial Markets & Instruments

Investments Term 3 (2013-15)

Outline
What is investment? Real and financial assets Financial markets Axioms of finance What determines price?

What is Investment?
Deployment of money or resources in expectation of future benefits
Real or financial assets Benefits commensurate with risk Ability to convert back to money or resources

Real vs. Financial Assets

Real assets
Assets used to produce goods and services Examples: factories, land, human capital

Financial assets
Claims on real assets such as
Stocks Bonds

Derivatives (contingent claims)

Savings of US Households

Source: Fed Reserve

Savings of Indian Households

Benefits of Financial Assets

Allocation of capital
Financing of projects

Allocation of risk
Diversification (risk-sharing) Hedging

Consumption smoothing
Moving consumption over time through saving and borrowing

Separation of ownership and control

Investors and managers can be different

Important Financial Assets

1. Money market securities 2. Fixed Income securities 3. Equities 4. Derivatives

I. Money Market Securities

Very short-term borrowing instrument (up to 1 year)
Working capital Cash flow smoothing Government is a major issuer

Usually issued by reputable issuers No coupons (adjustment in price) Highly liquid (high volume/low cost of trading)

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Money Market Securities

Treasury bills Federal Funds
Certificates of Deposit (CDs) Repurchase Agreements (Repos) Bankers Acceptance

Commercial Paper (CPs) Eurodollars LIBOR Market

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Crisis in the CP Market

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II. Fixed Income Securities

Borrowing instruments for longer maturities (greater than 1 year)

Funding longer duration projects Financing deficit

Issued by governments, municipalities, corporates Pre-specified cash-flows (coupons and principal)

Valuation through time value of money (TVM) Example: a 10-year, 8%, semi-annual coupon bond with $1000 face value

Risk of default varies

Credit rating of issuances

Liquidity varies

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Treasury Bonds
Two types
Treasury notes (1-10 years maturity) Treasury bonds (10-30 years maturity)

Semi-annual coupon payments Regular issues (often preannounced schedule) Proceeds used to fund government expenditure/deficit Attractive for investors with longer durations
Pensions/insurance companies

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A Concept Question
Which bond would pay a higher interest rate?
A 10-year T-bond or a 1-year T-note? A US government 1o-year T-bond or Zimbabwean government 10-year T-bond?

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Muni Bonds
Issued by state and local governments
Exempt from federal income tax Exempt from (issuing) state and local tax General obligation bonds (for no specific purpose and backed by full faith of credit of the issuer, i.e., taxes)

Two types

Revenue bonds (for a specific purpose like building a bridge and backed by revenue generated by the project)

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A Concept Question
A muni bond pays 4% interest. A Treasury bond of similar maturity pays 5% interest.
If your marginal tax rate is 20%, which bond would you prefer?

What if the tax rate is 30%?

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Corporate Bonds
Issued by companies for longer term maturities Significant default risk
Investment grade Non-investment grade (junk)

Seniority Embedded features

Callable/puttable Convertible

Less liquid

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III. Equity Securities

Ownership in a firm Future cash-flows (dividends) are uncertain Involves risk and variable liquidity Maturity is indefinite Two types
Preferred equity or stock (fixed dividend, non-voting, senior) Common equity or stock (residual dividend, voting rights, junior)

Common stock
Valuation: TVM + risk adjustment

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Googles Stock Price Over Last 5 Years

http://finance.yahoo.com

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Equity Market Performance

Dow Jones Industrial Average (DJIA)
Price-weighted index Includes 30 blue-chip companies

Standard & Poors Composite 500 Index (S&P 500)

Value-weighted index Includes 500 firms across varied sectors

S&P BSE Sensex

Value-weighted index 30 stocks

CNX NSE Nifty Index

Value-weighted index 50 stocks

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Google vs. S&P500

http://finance.yahoo.com

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Long-term Performance of Stocks, Bonds and Treasury Bills

Source: Ibbotson and Associates

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IV. Derivative Securities

Securities whose cash flows depend on values of other assets
Examples: options, futures, swaps, bonds with option features (convertible or callable bonds)

Options are rights to buy (sell) the underlying asset Futures are obligations to buy (sell) the underlying asset Swaps are exchanges of one type of cash flow for another

Valuation: TVM + risk + option adjustment

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Axioms Governing Investment Theory

1. Investors prefer more to less 2. Investors are risk averse in general 3. Money paid in the future is worth less than the same amount today 4. Financial markets are mostly competitiveno arbitrage

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Equilibrium Prices
What determines the price?
In economic theory? In reality?

What is the equilibrium price? What is the mechanism that drives prices towards equilibrium?
Price Supply

P*=40

Demand
Q*=20,000 40,000 Quantity

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Financial Market Setup

RETURN

Search Issuers
(Needers of Capital/ Risk Originators)

Transact
Enforce

Investors
(Providers of Capital/ Risk Takers)

RISK

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Financial Market Setup

RETURN

Search Issuers
(Needers of Capital/ Risk Originators)

Transact
Enforce

Investors
(Providers of Capital/ Risk Takers)

REGULATORS
RISK

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Asset Markets
Primary market
Issuance of new securities

Secondary market
Exchange of existing securities between investors

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Primary Markets
Raises capital Price-setting mechanism differs
Government securities: typically auctioned Corporate securities, federal agency debt, municipal bonds, mortgage-backed securities: typically underwritten by investment banks

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Secondary Markets
Investors can:
Trade with each other directly or Trade with each other with the help of brokers or Trade with dealers

Brokers dont commit any capital while dealers commit their own capital to the transaction Exchanges facilitate meeting of buyers and sellers

Clearing and settlement firms ensure agreement to terms and exchange of funds between the buyer and seller
Can guarantee the performance of the trade

Depositories maintain records and custody of securities