5/21/2025

Financial markets segments

Money Market Capital Market
Chapter 2 • Short-term, marketable, • Include longer term and
Asset Classes and Financial Instruments liquid, low risk debt riskier securities
securities • Three segments
(Part 1) • Money market • Longer-term debt markets
instruments sometimes • Equity markets
called cash equivalents • Derivative markets

1
5-1 2

2.1 The Money Market 2.1 The Money Market

Money Market Instruments • Treasury Bills
• Issuer: Federal government
• Treasury Bills • Repos and
Reverses • Denomination: $100, commonly $10,000
• Certificates of
Deposit • Brokers’ Funds • Maturity: 4, 13, 26, or 52 weeks
• Commercial Paper • Federal Funds • Liquidity: High
• Bankers’ • LIBOR (London • Default risk: None
Acceptances Interbank Offer
• Interest type: Discount
• Eurodollars Rate)
• Taxation: Federal owed; exempt from state and
local
3 4

Figure 2.1 Treasury Bills (T-Bills) 2.1 The Money Market

• Certificates of Deposit (CDs)
• Issuer: Depository institutions
• Denomination: Any, $100,000 or more
marketable
• Maturity: Varies, typically 14-day minimum
• Liquidity: CDs of 3 months or less are liquid if
marketable
• Default: First $100,000 ($250,000) insured
• Interest type: Add on
• Taxation: Interest income fully taxable
Source: The Wall Street Journal Online, July 7, 2011.

5 6

1
 5/21/2025

2.1 The Money Market 2.1 The Money Market

• Commercial Paper (CP) • Bankers’ Acceptances
• Issuer: Large creditworthy corporations, financial • Originate when a purchaser authorizes a bank to
institutions pay a seller for goods at later date (time draft)
• Denomination: Minimum $100,000 • When purchaser’s bank “accepts” draft, it
• Maturity: Maximum 270 days, usually 1-2 months becomes contingent liability of the bank and a
• Liquidity: CP of 3 months or less is liquid if marketable marketable security
• Default risk: Unsecured, rated, mostly high quality • Eurodollars
• Interest type: Discount • Dollar-denominated (time) deposits held outside
• Taxation: Interest income fully taxable U.S.
• New Innovation: Asset-backed commercial paper • Pay higher interest rate than U.S. deposits
7 8

2.1 The Money Market 2.1 The Money Market

• Federal Funds • Repurchase Agreements (RPs) and
• Depository institutions must maintain deposits Reverse RPs
with Federal Reserve Bank • Short-term sales of securities with an agreement to
• Federal funds—trading in reserves held on repurchase the securities at higher price
deposit at Federal Reserve • RP is a collateralized loan; many RPs are
overnight, though “term” RPs may have a 1-month
• Key interest rate for economy
maturity
• LIBOR (London Interbank Offer Rate) • Reverse RP is lending money and obtaining
• Rate at which large banks in London (and security title as collateral
elsewhere) lend to each other • “Haircuts” may be required, depending on collateral
• Base rate for many loans and derivatives quality
9 10

2.1 The Money Market Figure 2.2 Spreads on CDs and Treasury Bills
• Brokers’ Calls
• Call money rate applies for investors buying
stock on margin
• Loan may be “called in” by broker

11 12

2
 5/21/2025

2.1 The Money Market 2.1 The Money Market

• Money Market Instrument Yields • Bank Discount Rate (T-bill quotes)
• Yields on money market instruments not always $10,000 - P
r = x 360 $10,000 = Par
directly comparable BD $10,000 n

• Factors influencing “quoted” yields rBD = bank discount rate

P = market price of the T-bill
• Par value vs. investment value
n = number of days to maturity
• 360 vs. 365 days assumed in a year (366 leap
year) • Example: 90-day T-bill, P = $9,975
• Simple vs. compound interest
$10,000 - $9,975 360
r BD = × =1%
$10,000 90
13 14

2.1 The Money Market 2.1 The Money Market

• Bond Equivalent Yield • Bond Equivalent Yield
• Can’t compare T-bill directly to bond P = price of the T-bill
rBD = 1%
n = number of days to maturity
• 360 vs. 365 days
10,000 - P 365
×
• Return is figured in par vs. price paid r
BEY
=
n
P
• Adjust bank discount rate to make it
comparable • Example Using Sample T-Bill

r = 10,000 − 9,975 365

×
BEY 90
9,975

rBEY = .00251 × 4.0556 = .0513 = 1.016%

15 16

2.1 The Money Market 2.1 The Money Market

• Effective Annual Yield • Money Market Instruments
rBD = 1%
365 • Treasury bills: Discount
rBEY = 1.016%
 $10,000  P  n
rEAY = 1    1 r = 1.02% • Certificates of deposit: BEY
 P  EAY
• Commercial paper: Discount
P = price of the T-bill
• Bankers’ acceptances: Discount
n = number of days to maturity
• Eurodollars: BEY
• Example Using Sample T-Bill
365 • Federal funds: BEY
 $10,000  $9,975  90
rEAY = 1   1 • Repurchase agreements and reverse RPs:
 $9,975  Discount
rEAY = 1.02%
17 18

3
 5/21/2025

2.2 The Bond Market Figure 2.3 Listing of Treasury Issues

• Capital Market—Fixed-Income Instruments
•Government Issues—U.S. Treasury Bonds and Notes
• Bonds vs. notes
• Denomination
• Interest type
• Risk? Taxation?
• Variation: Treasury Inflation Protected Securities
(TIPS)
• Principal adjusted for increases in the Consumer Price
Index
• Marked with a trailing “i” in quote sheets
Source: Compiled from data from The Wall Street Journal Online, July 6, 2011.
19 20

Yield to Maturity
• Yield to maturity: the interest rate that equates
2.2 The Bond Market
the present value of cash flow payments received
from a debt instrument with its market price today • Government Issues
Example: A coupon bond pays interest annually. The face • Agency issues (federal government)
value of the bond is $1000 and the coupon rate is 9%. The • Most are home-mortgage-related
time to maturity of the bond is 3 years. The current market
price of the bond is $950. Find the YTM of the bond? • Issuers: FNMA, FHLMC, GNMA, Federal
Home Loan Banks
For this coupon bond, you will receive the interest each year =
9%*1000 = 90. The term to maturity is 3 years so you will receive • Risks of these securities?
both coupon payment and the principal (face value) at the end of the
year 3 = 90 + 1000 = 1090. • Implied backing by the government
950 = 90/(1+YTM) + 90/(1+YTM)2 + 1090/(1+YTM)3 • In September 2008, federal government
took over FNMA and FHLMC

4-21 © 2016 Pearson Education, Inc. All rights reserved.

22

2.2 The Bond Market Table 2.2 Equivalent Taxable Yields

• Government Issues
• Municipal bonds
Tax-Exempt Yield
• Issuer? Marginal Tax Rate 1% 2% 3% 4% 5%
• Differ from treasuries and agencies? 20% 1.25% 2.50% 3.75% 5.00% 6.25%
• Risk? 30 1.43 2.86 4.29 5.71 7.14
• General obligation vs. revenue 40 1.67 3.33 5.00 6.67 8.33
• Industrial development 50 2.00 4.00 6.00 8.00 10.00

• Taxation?

rtax exempt = rtaxable x (1 – Tax rate) rtax exempt = rtaxable x (1 – Tax rate)
r = Interest rate

23 24

4
 5/21/2025

Figure 2.4 Outstanding Tax-Exempt Debt 2.2 The Bond Market

• Private Issues
• Corporate Bonds
• Investment grade vs. speculative grade
• Mortgage-Backed Securities
• Backed by pool of mortgages with “pass-through” of
monthly payments; covers defaults
• Collateral
• Traditionally all mortgages conform, since 2006 Alt-A and
subprime mortgages are included in pools
• Private banks purchased and sold pools of subprime
mortgages
• Issuers assumed housing prices would continue to
rise
25 26

Figure 2.6 Mortgage-Backed Securities Outstanding Table 2.7 The U.S. Bond Market

Sector Size ($ billion) % of Market

Treasury 9,434.6 29.5%
Federal agency and gov't
sponsored enterprise 6,437.3 20.1%
Corporate 4,653.9 14.6%
Tax-exempt* 2,636.7 8.3%
Mortgage-backed 6,908.0 21.6%
Other asset-backed 1,877.9 5.9%
Total 31,948.4 100.0%

* Includes private purpose tax-exempt debt.

Source: Flow of Funds Accounts of the United States: Flows & Outstanding, Board of
Governors of the Federal Reserve System, June 2011.

27 28

Slide 4.30

2.3 Equity Securities Common share versus Bond

Characteristic Common stock Bond
• Capital Market-Equity 1. Term to maturity NO YES
• Common stock 2. Kind of security Equity: Stockholders are Debt: The debt-holders
owners of the issuer are creditors of the issuer
• Residual claim
3. Accounting Dividend is not the Interest of the bond is the
• Limited liability accounting cost accounting cost of the
issuer
• Preferred stock
4. Payment for holders Depend on the Independent of the
• Fixed dividends: Limited gains, nonvoting performance of the issuer performance of the
issuer
• Priority over common
5. Priority to get paid After the preferred shares Before preferred shares
• Tax treatment: Preferred/common dividends
not tax-deductible to issuing firm; corporate
tax exclusions on 70% of dividends earned
Watson and Head, Corporate Finance: Principles and Practice PowerPoints on the Web, 6th Edition © Pearson Education Limited 2014
29

5
 5/21/2025

Slide 4.31 Slide 4.32

Forms of Business Organization in the U.S. Partnership

Advantages:
Sole • Single Owner
Proprietorship
• Two or more owners
• More capital available
• General
Partnership • Limited • Relatively easy to start
• Income taxed once as
• C-Corporation personal income
Corporation • S-Corporation
• Limited Liability Company (LLC)
1-31 1-32
Watson and Head, Corporate Finance: Principles and Practice PowerPoints on the Web, 6th Edition © Pearson Education Limited 2014 Watson and Head, Corporate Finance: Principles and Practice PowerPoints on the Web, 6th Edition © Pearson Education Limited 2014

Slide 4.33 Slide 4.34

Corporation
Partnership
Disadvantages: Advantages:
• Unlimited liability • Limited liability
General partnership
Limited partnership • Unlimited life

• Partnership dissolves when one • Separation of ownership

partner dies or wishes to sell and management

• Difficult to transfer ownership • Transfer of ownership is

easy
• Easier to raise capital
1-33 1-34
Watson and Head, Corporate Finance: Principles and Practice PowerPoints on the Web, 6th Edition © Pearson Education Limited 2014 Watson and Head, Corporate Finance: Principles and Practice PowerPoints on the Web, 6th Edition © Pearson Education Limited 2014

Slide 4.35

Corporation 2.3 Equity Securities

• Capital Market-Equity
Disadvantages:
• Depository receipts
• Separation of ownership
• American Depository Receipts (ADRs), also
and management
called American Depository Shares (ADSs)
• Double taxation (income • Certificates traded in the U.S. representing
taxed at the corporate ownership in foreign security
rate and then dividends
taxed at the personal
rate)

1-35
Watson and Head, Corporate Finance: Principles and Practice PowerPoints on the Web, 6th Edition © Pearson Education Limited 2014
36

6
 5/21/2025

2.3 Equity Securities

• Capital Market-Equity
• Capital gains and dividend yields
• Buy a share of stock for $50, hold for 1 year, collect
$1 dividend, and sell stock for $54
• What were dividend yield, capital gain yield, and total
return? (Ignore taxes)
• Dividend yield = Dividend / Pbuy = $1/$50 = 2%
• Capital gain yield = (Psell – Pbuy) / Pbuy = ($54 –
$50)/$50 = 8%
• Total return = Dividend yield + Capital gain yield = 2%
+ 8% = 10%
37