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The Five Basic Financial Markets
I.
Introduction
Every economy must solve the basic problems of production and distribution of
goods and services. Financial markets perform an important function by allocating or
channeling funds for production and distribution. To produce goods, purchase
inventory, and invest in new machinery, firms must first obtain funds in financial
markets. Most financial markets consist of people who have money and are willing to
lend these resources, as well as people who need funds and are willing to borrow
money. The financial industry is essentially a service industry.
Another important function which financial markets perform is in reducing
individual risks. Whenever assets are held or transacted, certain risks can arise.
Financial markets can help spread these risks among a large group of people.
Financial markets do not lower the total amount of risk in the economy, but they can
efficiently distribute the risk over many individuals.
Financial markets also help to separate the ownership of assets from the
management and use of assets. People who have little knowledge of how to produce a
particular good can nevertheless own a company which produces that good. These
people only care that the good has been produced at the lowest cost possible and sold
at the highest price the market will bear. The stockholders, who are the owners, hire
specialized managers whose job it is to earn profits for them.
Therefore, financial markets help to allocate funds for production and
distribution, reduce individual risks to investors and asset holders, and separate the
ownership from the management of productive assets.
II. The Five Basic Markets
The five basic financial markets are the stock market, the bond market, the
money market, the futures market, and the options market. In addition to these
markets, we often consider the foreign exchange market and the credit market (i.e., the
market for bank loans). Most financial newspapers will provide detailed information
about transactions occurring in each of these markets.
Each of the five financial markets has a supply and demand. To effectively
analyze and fully understand the information published about these markets, one must
study both sides of the market. Another important point to note is that the markets are
not independent of each other. The stock market can affect, and can be affected by,
the bond market and money market. There is also a close relation between the stock
market and the options market. Finally, the emergence of financial futures has made
the stock and bond markets closely linked to the futures market.
The five financial markets are particularly important to the economy because
nearly all industries in the economy make use of them. When financial markets
experience problems, all sectors of the economy are affected. Stable financial markets
are essential to a stable economy. Let's consider each of these markets briefly.
III. Stock, Bond, and Money Markets
The stock market is where ownership claims on corporations are issued and
traded. Issuing stock is an important way for companies to finance their investment in
new machines, plant and equipment. Each ownership claim is called a share of stock
and entitles the buyer to a pro rata share in the profits of the company. These
distributed profits are called dividends.
The stock market affects the economy in many ways. First, it is an important
source of funds for firms. Second, changes in the value of stock affect the wealth of
consumers and thus their spending decisions. Third, it affects the cost of capital to
firms. Finally, changes in the stock market can affect the expectations of business and
households about the future direction of the economy.
In contrast to the stock market, the bond market does not sell ownership claims,
but rather issues and trades in debt claims. Both private firms and the government
borrow money in the bond market. Individuals who purchase these bonds can later
sell them for cash in the bond market to other individuals. Those individuals who
own the bonds are entitled to the interest paid semi-annually on them. Traders in the
bond market deal exclusively in debt whose maturity is longer than one year.
The bond market is very important to the economy since interest rates are
determined in this market. Higher long term interest rates can cause firms to postpone
their investment plans. Moreover, government bonds are important since they are an
alternative to taxes in financing government spending. Finally, large increases in the
value of government bonds may affect wealth, and hence spending in the economy.
The money market is very much like the bond market, except that it deals only in
short term debt having a maturity of less than or equal to one year. The shortest
maturity in the money market is just 24 hours. The money market is important
because it is here that the government uses it monetary policy to influence short term
interest rates, as well as the amount of short term credit. By changing short term
interest rates, the government may indirectly change long term interest rates and thus
investment and consumer durable spending.
IV. Futures and Options
Both futures and options markets were originally designed to help reduce the
individual risks of farmers and investors. If a farmer could sell a fixed amount of corn
or wheat at a fixed future price, then he could better know how much to plant and how
much his future income would be. The weather would still be an uncertain factor, but
at least it would not significantly affect profits. Selling corn or wheat futures allowed
these farmers to hedge their price risks. They could contract to sell a fixed amount of
a commodity at both a fixed price and a fixed time in the future.
Options are somewhat different from futures, but they also help reduce individual
risks. A call option on corporate stock gives the option holder the right to buy a fixed
amount of stock at a fixed price anytime within a specified period of time. A put
option is like a call option, but the holder of a put has the right to sell rather than buy
the stock. Call and put options can be used by investors to reduce the risk of
unexpected price changes in the stock they hold. Reducing risk without substantially
lowering return is probably the most important concept in all of finance. Options are
one means of achieving this.
V. Speculation and Efficient Markets
In addition to the usual suppliers and demanders in financial markets, another
important group which influences the markets are speculators. These people buy and
sell financial assets in hopes of making short term capital gains. Some economists
believe that because speculators make profits when markets are unstable, competition
between speculators will reduce such profits and therefore stabilize the market. If this
is true, then speculators help to stabilize financial markets. This is probably true when
speculators have different expectations about the market. However, if they have the
same expectation about the direction of the market, then a speculative bubble may
arise. A bubble occurs when most speculators react to rise in an asset's price by
expecting an additional rise in price in the future. Under these conditions, the price
will rise until a sufficient number of speculators become bearish. The bubble bursts
with the price of the asset plummeting. Considerations such as these lead us to
believe that speculators do not always help to stabilize financial markets.
Speculators play another important role. They accept the financial risks of other
investors who are more risk averse. A risk averter is someone who would not accept
an even chance of making or losing a given sum of money. Although there is an equal
probability of gaining or losing, the risk averter fears his loss more than he desires his
gain. Risk aversion is a key concept in the theory of finance. Speculators are people
who are more willing to accept these risks than the average investor. They have a
lower degree of risk aversion.
Because speculators are constant looking for short term capital gains, they will
consider all information relevant to asset prices. If an asset is found to be
undervalued, speculators will react quickly by attempting to buy it. Its price will rise
and therefore will better reflect the asset's underlying value. Information is thus
incorporated into the price very efficiently. We often say that the market has
discounted this information and that such information can no longer further affect the
price. An efficient market is one in which all relevant information about the asset is
currently reflected in its price.
Financial markets are generally considered good examples of efficient markets.
Their prices appear to contain all relevant information we would use in predicting
future prices. This makes it nearly impossible to forecast better than just using current
prices. Naturally, this raises the value of inside information since it gives the holder
of inside information a significant lead on the competition. Trading on inside
information is illegal, although such laws are hard to enforce.
Discussion Questions:
#1. What are the three functions which financial markets perform?
#2. What are the five popular financial markets and does Taiwan have these
markets?
#3. Why are financial markets more important than other markets?
#4. What is the difference between the stock market and the bond market?
#5. How does the bond market differ from the money market?
#6. What function do futures and options play in the economy?
#7. Who are speculators and what function do they play in financial markets?
#8. What is a speculative bubble and what causes it?
#9. What is an efficient market?
#10. What is inside information? Give some examples.
The Stock Market
I. Introduction
The stock market of a country can be divided into two large interrelated markets:
(1) the primary market, where newly issued shares are sold; and (2) the secondary
market, where outstanding shares are traded
In the primary market, a company needing funds can sell newly issued shares by
using an underwriter (usually a large brokerage firm). The primary market is a global
market, since newly issued shares can be sold anywhere the underwriter has a branch
office. The underwriter performs an important middleman service, since the issuing
company would generally not be able to sell its shares over such a large geographic
area. If the company is issuing a large amount of shares, then it may want to use a
large number of different security firms to underwrite these securities. Information
regarding the issuance will be contained in a prospectus, which can be obtained from
the underwriters.
Newly issued stock generally has a par or face value. However, when sold in the
primary market, it will have a price determined by supply and demand. Therefore,
except for some accounting relations, the par value is not of great importance. The
stock that is issued can be either common stock or preferred stock. Common stock
gives the owner voting rights in the stockholder meetings; however, it does not have a
fixed dividend like preferred stock. Moreover, preferred stock dividends must be paid
before any common stock dividends can be paid.
The importance of corporate stock is that it carries limited liability. If the
company amasses debts, the personal assets of the stockholders cannot be taken to pay
these debts. The stockholder is liable only for the money he or she has invested in the
stock.
After the stock has been issued and bought by investors, it becomes stock
outstanding. If the company buys back some of its stock previously issued, then the
stock outstanding will decrease. However, the total number of shares will not
decrease. Shares repurchased in a stock buyback plan are called treasury stock. The
number of shares outstanding is very important in calculating certain financial ratios
(e.g., the P/E ratio).
Outstanding shares in corporations are often traded in organized secondary
markets. Such companies are what we call listed corporations. The secondary
markets mainly consist of various stock exchanges and the over-the-counter (OTC)
market. Listings on stock exchanges or the OTC are very important because they
increase the liquidity of the stock. Very few people would be willing to purchase
stock if they thought they could not sell it when necessary. Liquidity is a measure of
how quickly an asset can be sold for cash without a large reduction in its price. A
strong secondary market raises the liquidity of the stock and thus its value to
investors.
The largest and most famous secondary market for stock is the New York Stock
Exchange (NYSE). in addition, many major American corporations are listed on the
American Stock Exchange (AMEX). Less well known corporations are listed on
other exchanges and the OTC. Foreign companies can also sometimes obtain listings
on these exchanges.
II. Understanding Stock Quotations in the Wall Street Journal
The most important source for understanding current developments in stock
markets is the Wall Street Journal (WSJ). In addition to providing quotations on the
previous trading day's closing session, it also contains valuable information on
specific companies, industries, as well as useful macroeconomic news. There are
European and Asian editions of the WSJ, which focus more on regional markets and
developments. The editorial pages are usually devoted to important issues affecting
politics and economics. The views expressed there are usually pro-business and very
conservative, but occasionally contributed pieces can be quite liberal.
The stock quotations found in the WSJ provide only a limited number of financial
indicators. For each stock, the high and low price for the past 52 weeks is given.
Next, the name of the company and its abbreviation appears. If the stock is preferred,
this will also be indicated. The last quarterly dividend per share, expressed on an
annualized basis, is reported. After this, the current yield of the stock is given, and is
computed by dividing the dividend by the current price. The P/E ratio comes next,
and refers to the current price divided by the most recent yearly earnings per share
ratio. The volume of shares traded during the day is shown next, and is expressed in
terms of 100s of shares. Finally, the high, low, and closing price for the day are
presented, along with the net change in price from the last trading session.
On any single day, the above information is not likely to be very helpful.
However, if one follows these quotations over time, it is possible to get some
understanding of the market's valuation of the equity. Each piece of information
provides a different facet of the stock's financial condition. Unfortunately, the
quotations by themselves, cannot provide sufficient information for adjusting one's
portfolio. To truly understand a particular stock, one must consider other sources of
information about the companies.
III. Balance Sheets and Income Statements
To clearly understand the financial condition of a corporation, one needs to study
both the balance sheets and income statements of the company.
An annual balance sheet lists the assets, liabilities and owners' equity of a
corporation. By definition, owners' equity is equal to all assets minus all liabilities.
The basic assets of a company include such things as cash, accounts receivable,
inventory, and plant and equipment. These assets are used to produce revenue for the
company. Total liabilities consist of mainly bank loans, accounts payable, and
corporate bonds outstanding. Each of these will require future payments of money by
the company. Owners' equity (or net worth) is composed of stock outstanding and
retained earnings. It is important to note that the balance sheet shows the above
information for one point in time, usually the last day of the year.
By contrast, the quarterly income statement shows the revenues and expenditures
made by the corporation during the past three months, usually compared with the
same period in the previous year. The income statement gives a concise picture of
how profits were made, income taxes were paid, and typically shows the earnings per
share of common stock. Often it is important to understand how net earnings were
made and not just how large they were.
Careful analysis of the balance sheets and income statements can help one
determine such things as whether a stock is currently undervalued, whether it may
become the target of a hostile takeover, or even whether current earnings have been
manipulated through clever accounting tricks.
IV. Stock Indexes and Selling Short
The NYSE has thousands of listed stocks, so it can often be difficult to judge the
overall direction of the market. To judge general movements in the market, we must
rely on a stock index. The most popular indexes are the three Dow Jones indexes: one
each for industrials, transportation companies, and utilities. There is also a very broad
based index called the NYSE Composite Index which considers the whole market. In
addition, there is the S&P 500 index which covers the top 500 corporations. The
NASDAQ index gives an average of a particular set of stocks trading OTC.
Over a period of a year, the stock index will be affected by the health of the
economy. Over shorter periods of time, there are many factors which affect the index,
such as changes in interest rates, money supply, earnings reports, trade and budget
deficits, and important political developments.
When the index rises steadily, we call it a bull market. By contrast, when most
stockholders and investors are wanting to sell their stock, we call it a bear market.
Sometimes, the market will rise too far and then suddenly drop. This is called a
market correction since the index was unrealistically high. We often say that the
market fell because of profit-taking.
Sometimes an investor feels that the market is going lower. He may choose to
short a particular stock. Selling stock short means that the investor borrows stock
from a broker and sells it now, with the intention of buying the same stock back at a
lower price. The investor must maintain a margin account with the broker. If the
stock the investor is shorting rises in price, he is required to increase the deposit in his
margin account. Shorting stock creates a risk of unlimited losses for the investor,
since the stock he is shorting can theoretically experience an unlimited rise in price.
Short sellers can limit this risk by hedging with call options, which we will discuss
later.
Discussion Questions:
#1. What is the difference between the primary and secondary market for stock?
#2. Who are underwriters and why are they important?
#3. What is meant by limited liability?
#4. What is the definition of liquidity?
#5. What is the difference between common and preferred stock?
#6. What information is given in the NYSE stock quotations in the WSJ?
#7. What are balance sheets and income statements?
#8. What are some US stock indexes?
#9. What is meant by bull and bear markets?
#10. What does it mean to sell stock short?
The Bond Market
I. Introduction
The bond market in the US is a vast market for debt claims which have
maturities longer than one year. Bonds can be broadly classified as (1) Federal
government,
(2) municipal, (3) corporate, and (4) Federal agency bonds. All bonds are issued in
the primary market, but new issues of Federal government bonds can be bought at any
Federal Reserve Bank, and therefore are not sold by underwriters or investment
bankers.
The bond market is an important source of funds for government and business.
For example, the US Treasury issues bonds to finance Federal government spending.
Usually, if the maturity of the debt is greater than one year and less than 10 years, then
these bonds are called Treasury Notes. The face value of T-Notes is usually $1000, so
they can be easily bought by individual investors. If the Treasury issues debt longer
than 10 years, then the bonds are called T-Bonds. The longest maturity for a T-Bond
is the bellwether 30 year bond, sometimes called the "benchmark bond" The interest
rate on the 30 year T-Bond is very closely watched, since it is quite sensitive to
economic and political developments. It also will be a major factor in influencing
long term corporate bond rates; an important determinant of private capital expansion
and modernization.
Most bonds have a face value, coupons, and a maturity. Corporate bonds are
generally registered bonds, while some types of government bonds are bearer bonds.
A registered bond is one in which the buyer's name is recorded and interest payments
are mailed directly to him. Bearer bonds do not involve the transfer of names when
bought and sold, and therefore losing them is like losing currency. The number of
years left till maturity of a bond is called the term of the bond. Therefore, a 20 year
bond that has been held for 5 years has a term of 15 years.
When the current price of a bond is greater than its face value, we say that the
bond is selling at a premium. If the price and face value are equal, then we say that it
is selling at par. Whenever the price is below the face value, we say that the bond is
selling at a discount.
II. The New York Bond Exchange
Like corporate stock, the secondary market in bonds consists of an exchange and
a large OTC market. Corporate bonds trade on the New York Bond Exchange, while
most Treasury issues exchange over the counter. The secondary market for bonds in
the US is several times larger than the secondary market in stock. Corporate bond
prices are usually quoted in 1/8's of ten dollar units. For example, a 10 year IBM
bond selling at 110 3/8 is really an IBM corporate bond having a face value of $1000
and selling for $1103.75 on the bond exchange.
There are three important types of interest rates associated with bond quotations.
The first is the coupon yield, which is just the coupon divided by the face value of the
bond. If the bond was issued at par, and later its price did not change at all, the
coupon yield would measure the actual interest earned on the bond. The second type
of rate is called the current yield. It is defined as the coupon divided by the current
price of the bond. The current yield does not include the capital gains or losses due to
the price of the bond rising above or falling below its face value. Finally, there is the
yield to maturity, which takes account of the effect of bonds selling above or below
par. To the investor, the yield to maturity is the most important of the three rates
above.
An important point to remember about interest rate quotations is that they are
often discussed in terms of basis points. For example, if an interest rate rises from
7.5% to 8.0%, we say that this is an increase of 50 basis points. Usually long term
interest rates will change only a few basis points during a trading day. Whenever
interest rates on bonds rise, bond prices must fall. Therefore, higher interest rates
mean capital losses for bond holders since the value of their bonds is falling.
The volume of transactions on the New York Bond Exchange is given in
thousands of dollars. Quotations in the newspaper show the name of the company
which issued the bonds, the coupon yield, and the maturity date. Next, the current
yield is given, along with the volume transacted. The high, low, and closing prices are
shown, as well as the net change in the closing price from the previous trading day.
III. Special Features of Bonds
Bonds often carry special features that must be considered by the investor. These
include such things as whether the bond is callable, whether the bond has a rating,
whether there are coupons, and whether the bond is convertible.
A bond is callable if the issuer can reclaim the bond, usually anytime after 5 to 10
years. When a bond is called, the holder must sell the bond back to the issuer. Call
provisions allow the issuers an opportunity to refinance their debt at lower interest. If
bond prices are expected to rise in the future, then the issuer can call the current debt
and issue debt later at lower interest.
Ratings on bonds are done by Moody's and Standard and Poors. These
companies give a highest rating (AAA) to corporations which are highly unlikely to
default on their obligations. Low ratings, such as C or D, are for corporations that
may not be able to service their debts -- some may even be in default. These bonds
are sometimes called junk bonds. Ratings give the potential investors important
information on the relative riskiness of a bond.
Sometimes bonds do not have coupons. These are called zero coupon bonds.
What happens is that a brokerage firm will buy US T-Bonds and will then issue a zero
coupon bond having a face value equal to the face value of the T-Bond. Wall Street
investors call these kinds of zero coupon bonds Treasury Strips. The coupon on the
T-Bond can also be sold in the same way.
Finally, corporations sometimes issue convertible bonds. These are the same as
regular bonds except that they have a feature that the bondholder can exchange the
bond for a fixed number of shares of stock. Convertibles combine many of the
characteristics of equity and debt. They offer fixed interest payments, while giving the
holder a chance to share in profits and ownership in the company. The price of
convertible bonds will move with the stock market, unlike regular types of bonds.
Often state and local governments will issue bonds. These are called municipals
and are free of Federal income tax. Because of this, the rate of interest is usually
lower than the same quality corporate bonds. Municipals are traded over the counter
and their prices are quoted on a bid-offer basis. A bid price is the price which dealers
are willing to buy the municipal. An offer (or asked) price is the price that the dealer
is willing to sell the municipal. Naturally, bid prices are lower than offer prices. A
dealer will keep an inventory of municipals to sell to investors at anytime over the
counter. Dealers therefore buy and sell for their own account.
Discussion Questions:
#1.
#2.
#3.
#4.
#5.
What are the four basic types of bonds in the US?
What is the difference between T-Notes and T-Bonds?
What is meant by face value, coupon, and maturity?
What is meant by a bond selling at par; at a premium; and at a discount?
Explain each of the following bond yields:
(i) coupon yield
(ii) current yield (iii) yield to maturity
#6. What do we mean by the term basis points”?
#7. What are four special features which bonds may have?
#8. Explain the term municipal?
#9. What is the difference between a dealer and a broker in bonds?
#10. What is the difference between bid and offer (or asked) prices?
The Money Market
I. Introduction
In the field of finance, the money market refers to a market for short term debt.
Any transaction, which involves the exchange of debt claims, having maturities less
than or equal to one year, are part of the money market. Sometimes these transactions
are for overnight credit only, and often they take the form of a short term loan or
accommodation.
Most small investors cannot transact in the money market because the face values
(or the denominations) of the instruments are too high, usually $10,000 and often
above $100,000. This means that most transactions are among banks, corporations,
pension funds, insurance companies, and the government. In addition to primary
markets in these debt claims, some instruments trade on secondary markets, usually
OTC.
The list of money market instruments is quite long and includes such things as
Treasury Bills (T-Bills), negotiable certificates of deposit (NCD's), bankers
acceptances (BA's), repurchase agreements (repos), commercial paper (CP's), Federal
funds and central bank loans, and Eurodollar loans. Each of these instruments are
created for a specific purpose. For example, the US Federal government issues T-
Bills to fund its spending rather than use taxes. Bankers acceptances result from
international trade, while commercial paper is often used to finance short term
expenses of business.
Once this debt has been issued, it can often be traded in secondary markets. This
is especially true of NCD's and T-Bills. However, CP's are generally not traded in the
US on a secondary market. The 90 day T-bill is a closely watched financial
instrument. Like all money market debt, its maturity is less than one year and its
interest rate is quoted on a discount basis. This means that the T-Bill always sells for
less than its face value. The discount rate on the T-Bill is calculated by expressing the
discount as a percentage of the face value, multiplying by 360, and then dividing by
the term of the bill. For example, a $1,000,000 90 day T-Bill having 30 days left till
maturity which is selling for $995,000 has a discount rate of 6.0%. Note however that
this does not mean that the annual rate of interest is 6.0%. The annual rate of interest
for this T-Bill is slightly higher at 6.2%. Discount rates are always less than their
annualized rates. Care must be taken when reading rates to avoid confusing discount
rates with annualized interest rates.
II. Examples and Uses of Money Market Instruments
Money market instruments arise in a number of ways. T-Bills are issued by the
Treasury Department of the US Federal Government, and are sold at auctions every
week. T-Bills can also be bought by wealthy individual investors at any Federal
Reserve Bank, but the lowest denomination is $10,000. Once T-Bills are sold they
can be traded in the secondary market over the counter. There is no established
exchange for T-Bills. T-Bills are an important investment tool for portfolio managers
who want to reduce their risks. We often say that the T-Bill rate is a riskless rate of
interest. The government will not default on this debt since it always has the power to
tax.
Negotiable certificates of deposit (NCD's) are issued by banks to attract funds to
lend and to meet reserve obligations. The term negotiable means that the holder of the
NCD can transfer ownership over the debt at any time. Often large businesses will
buy NCD's when they have a sudden increase in cash flow. Small investors rarely
have sufficient funds to purchase NCD's.
Commercial paper (CP) is basically a short term, unsecured promissory note. It
is often issued to finance short term current expenditures and to raise funds for
alternative investments. Only large and financially sound corporations can issue high
quality commercial paper. The maturity on most commercial paper is less than 270
days, since any maturity exceeding this must be registered with the Securities and
Exchange Commission (SEC), and such registration can be costly. Often large
corporations will issue commercial paper directly to investors, while smaller
corporations may use underwriters to sell them.
Federal Funds, or what we simply call Fed Funds, are very short term loans made
between banks. Each bank has an account with the central bank (called the Fed), and
banks which have surplus reserves can loan them to other banks which have deficit
reserves. The interest rate charged on such loans is called the Federal Funds rate.
Often Fed Funds are loaned for only 24 hours. An alternative to borrowing Fed Funds
is to borrow from the Fed itself. The interest rate charged by the Fed to banks for
these types of loans is called the Federal Reserve discount rate. Naturally, the Fed
Funds rate and the Federal Reserve discount rate are closely related and are carefully
watched by investors.
Bankers acceptances typically arise from international trade. When an exporter
sells goods internationally, he will receive his money in the form of a bank draft
which is accepted now for payment at a later date by the importer's bank. This draft is
really a short term debt claim owned by the exporter. If he wishes, he can discount
this bankers acceptance with his own bank. Once the draft has been accepted, it
becomes a negotiable instrument and part of the money market.
Repurchase agreements (or repos) often occur when a company has excess cash
and wants to invest it for a short period of time. The company can purchase a
financial instrument (e.g. a T-Bill) from a bank with the condition that the bank will
repurchase the same security 24 hours later at a slightly higher price. The bank gets
the use of the funds for 24 hours, and the company gets interest on its money. Repos
are an important alternative to Fed Funds and direct loans from the Fed.
Eurodollars consist of all US dollar deposits held in banks outside the US. These
banks are not necessarily located in Europe; they can be in Asia or Latin America, as
well. Such banks make short term US dollar loans, often to banks located in the US.
It is important to note that Eurodollar deposits are really claims to US dollars in the
US. The US dollars never leave the US banking system; instead when Eurodollars are
created the ownership of US dollars merely changes from US to foreign entities.
III. The Importance of the Money Market
The money market is where short term interest rates (or more precisely, discount
rates) are determined. When more money market instruments are issued, the supply of
short term debt increases and their prices fall. This causes short term interest rates to
rise. The supply of short term debt increases whenever there is a stronger demand for
liquidity. An increase in the supply of short term debt is often associated with an
increase in the demand for money the most liquid of all assets. This is why we call
this market the
money market”.
As one might expect, demand for short term debt is largely governed by the
amount of liquidity in the economy. That is, it is determined mainly by the supply of
money. If the government supplies more money to the economy, the short run effect
should be to raise the prices on money market instruments, and therefore to lower
their yields. Short term interest rates would therefore tend to fall when the supply of
money increases.
The importance of short term interest rates is that they are related to long term
interest rates through the term structure. The term structure of interest rates is a curve
showing the yields to maturity for short, middle, and long term debt. In general, the
term structure curve slopes upward since long term interest rates are greater than short
term interest rates. Unfortunately, there is no generally accepted theory explaining the
relationship between short term and long term rates. Higher short term rates may at
times cause long term rates to rise if credit is sufficiently restricted. At other times, it
may lower long term rates, if expected inflation falls. Ideally, reductions in short term
rates would lead to lower long term rates, and this would stimulate business and
consumer spending.
Another important aspect of the money market is that short term rates can have a
substantial effect on the movement of exchange rates. A change in short term interest
rates tends to attract funds from abroad. When these foreign funds are sold for US
dollars, the exchange rate falls and the US dollar appreciates. When the dollar
appreciates, US firms find it difficult to export, and therefore this source of demand
for US goods is weakened.
Short term interest rates generally rise when the economy is expanding and fall
during recessions. The reason for this is simple. As demand increases, firms find it
useful to borrow short term to finance greater inventory. Also, an expansion in the
economy causes new business starts to increase and leads to a rise in the demand for
liquidity to finance these startups. Consumer spending also rises during expansions
and creates an increased demand for funds in the banking sector, leading to greater
Fed Funds transactions and more repos. Recessions have exactly the opposite effect
on short term interest rates.
Discussion Questions:
#1. What are the basic money market instruments?
#2. Why is it difficult for small investors to invest in the money market?
#3. A $1,000,000 180 day T-Bill with a 50 day term is currently selling for $994,000.
What is its discount rate? What is its annualized interest rate?
#4. Explain what you know about each of the money market instruments.
#5. Assume short term interest rates are rising. Explain some reasons why they are
rising.
#6. How can changes in short term interest rates affect investment and consumer
spending?
#7. What is the term structure of interest rates?
#8. What are Eurodollars and how are they used?
#9. How can short term interest rates affect exports and imports?
#10. Does Taiwan have a money market? If so, describe it.
The Futures Market
I.
Introduction
The futures market is a worldwide collection of exchanges which trade
standardized contracts in products for future delivery at a fixed price. The largest
futures exchanges can be found in New York, Chicago, and London, but futures are
also traded in many of the largest Asian cities. Another name typically used for
futures markets is commodity markets. A wide variety of products are traded on the
futures market, and include such categories of products as grains and meat, fibers,
food, lumber and rubber, fuels, metals, financial instruments and money, stock
indexes, and foreign currencies. Starting in the 1970's, financial futures began to grow
in popularity, and now constitute the majority of futures contracts traded. Because
futures have value depending on some underlying product, we often call them a
derivative financial instrument. Their value is derived from the value of another
product. Any financial instrument whose value depends on the value of an underlying
product is called a derivative. An option is another example of a financial derivative.
The central element of futures markets is the futures contract. To understand it
clearly, consider the case of corn futures traded on the Chicago Board of Trade
(CBOT). Each contract is for 500 bushels of corn and will have an expiration date,
say March 2001. This contract will have a price for the corn to be delivered after
expiration of the agreement. For example, the price per bushel might be $2.85 1/2. If
one is selling futures (called the short), then one is agreeing to sell 5000 bushels in
March of 2001 at $2.85 1/2 per bushel. The price of the contract would be $14,275 =
($2.85 1/2 per bushel)(5000 bushels). If one is buying corn futures (called the long),
then one is agreeing to buy 5000 bushels of March corn at $2.85 and a half. However,
many people buy and sell these contracts without worrying about delivery of the corn.
They can offset their position by simply entering on the other side of the market. A
long could offset his position by selling, while a short could offset his position by
buying futures.
The futures price on the contract will change from day to day. For example, if
corn futures are priced at $2.85 and a half per bushel today, they may be higher or
lower tomorrow. If today the price (per bushel) is $2.85 1/2, and tomorrow the price is
$2.87, then whoever is long futures tomorrow is agreeing to buy 5000 bushels at $2.87
per bushel at expiration of the contract. One can experience profits or losses when
one buys or sells futures. If today I am long (buy) corn futures, and the futures price
rises, then I make a profit. If I am short (sell) corn futures, and the futures price rises,
then I will have a loss.
When one buys or sells futures, one must make a deposit with the broker. This
money is called the initial margin (say 5% of the value of the contract being bought or
sold). As the futures price changes, one may be asked to add to this to keep a
minimum amount called the maintenance margin. For example, suppose that you go
short (sell) March 2001 corn futures at $2.85 1/2. The price of the contract is
$14,275. Assume that you are required to deposit $714 as an initial 5% margin.
Furthermore, suppose that the maintenance margin is $500. Whatever happens to the
futures price, you must have at least $500 on deposit with your broker. Now suppose
that the next day, the corn futures price rises to $2.90 which means that the contract
price rises to $14,500 = ($2.90)(5000). Note that you are selling 5000 bushels at
$14,275, while the current contract price allows a seller to get $14,500. You have a
LOSS of $225. This $225 will be deducted from your margin account which means
that you now have $489 ($714 - $225). Now you have fallen below your maintenance
margin of $500, and your broker will demand that you deposit additional funds. Your
contract is now priced at $14,500, which means that you are now agreeing to sell 5000
bushels of corn in March of 2001 at $14,500. Any subsequent changes in price will be
credited or charged to your margin account. This process is called daily settlement
and is an important difference between futures and forward markets. You can offset
your position at any time by simply going long (buying) an identical corn futures
contract.
II.
Futures Quotations
Basic quotations on futures prices are published in each issue of the Wall Street
Journal. The quotations will give the product being traded; the exchange on which it
is traded; the quantity of product for each contract; the unit of denomination of the
price for the future; the expiration date for the future; the opening, high, low, and
settlement price during the day; the change in settlement price from the previous
trading day; the high and low price over the lifetime of the future; and the open
interest (i.e. the number of outstanding contracts for the future).
III. Futures, the Spot Market, and the Value of News
Perhaps the most obvious variable influencing the futures price of a product is
its spot or cash price. The spot price of a product is the price which must be paid for
immediate ownership of that product. Cash or spot price quotations are usually
published on the same page of the Wall Street Journal as the futures prices. Typically,
as spot prices on products rise, the futures prices on such products will also rise.
Another important relation between spot and futures markets is that the futures
price will always converge to the spot price as the futures contract nears expiration.
Any difference between these two prices will always be arbitraged away as the
contract expires. Therefore, the effect of changes in spot prices on futures prices will
be greater for contracts which are due to expire soon.
To effectively trade in futures markets, one must be extremely knowledgeable
about the supply and demand conditions for the product in which one is trading.
Economic and political news will affect the futures markets. This is perhaps easiest to
see by considering the 1990 Persian Gulf War and the dramatic effect it had on
petroleum futures. However, smaller news stories such as labor strikes in South
Africa or political upheavals in Russia can have substantial effects on some
commodities such as gold. Poor weather in Colombia or Brazil can affect coffee
futures. Since this news is global in nature, and since the markets react so quickly to
such reports, futures traders must have quick access to such information to trade
effectively.
IV.
Types of Futures
Besides the more mundane types of futures such as wheat, copper, and natural
gas, a wide variety of financial futures are being traded each day all over the world.
These include futures on stock indexes such as the S&P 500; futures on T-Notes and
T-Bonds; and futures on T-Bills and Eurodollars. Foreign currency futures were
introduced in 1972 and have grown in volume every year. Most trading is
concentrated in British pounds, Japanese yen, Swiss and French francs, as well as
German marks.
For stock index futures there is no physical delivery of the index when the
contract expires. Instead, a cash equivalent settlement is made when the contract
expires. Stock index futures are especially useful for fund managers who are seeking
to hedge the systematic risk of their portfolios. Systematic risk refers to risk in a
portfolio which cannot be eliminated by diversifying the portfolio. It is the risk
created by general movements in the market.
It is important to realize that the price quotations of futures in bonds, bills, and
Eurodollars are not the actual prices at which one buys and sells. They are subject to
conversion factors. These conversion factors are somewhat complicated, so they will
not be discussed here. In addition, such things as the delivery date, maturity of the
bond, and the accrued interest will affect the actual price of the futures. Naturally, one
must make a careful study of each of these factors in order to trade effectively.
Discussion Questions:
#1. What is the meaning of going long and going short in the futures market?
#2. Suppose that you are long corn futures and the futures price rises. Do you make
money or lose money? Why?
#3. What is meant by offsetting one's futures position?
#4. Explain the concepts of initial and maintenance margins?
#5. What information is given in the Wall Street Journal on futures quotations?
#6. What categories of futures products are commonly traded?
#7. Why does news affect the futures markets? Give some examples.
#8. Suppose you must pay 1 million British pounds 3 months later. You believe that
the
pound will appreciate. How could you use currency futures to hedge yourself?
#9. What kind of risk can be hedged using stock index futures?
#10. In 1997, Taiwan plans to introduce stock index futures. Who would use these
futures?
The Options Market
I.
Introduction
The options market is a market where the right to buy and sell an asset (usually
corporate stock), at a fixed price anytime within a specified period of time, is traded.
The right to buy an asset is called a call option, while the right to sell an asset is called
a put option. In the stock options market, a call option contract gives its holder the
right to call away stock at a fixed price from a person called the writer anytime within
a specified period. Similarly, a put option contract gives its holder the right to sell to
or put to the writer 100 shares of stock.
Options are financial derivatives because their value depends on the value of the
underlying asset. Like any financial instrument, options have prices which are called
premiums. To buy a call or put option, one must pay the options premium. This
premium is paid to the writer or seller of the option. Writers are investors who create
and then sell their call or put options. Naturally, buyers can always sell their calls or
puts to other buyers. Therefore, the options market has two sides -- the buyers of calls
and puts and the sellers and writers of calls and puts.
All options have an exercise price which is also called their strike price. For
example, a call option gives its holder the right to buy 100 shares from the writer at
the strike price. If the call option is not used or exercised during this period, then it
expires and its holder (the buyer) loses the premium paid for the option. The same
will be true for put options. Therefore, each option has an expiration date. The
premium on this option will change over its lifetime.
Ideally, one would like to buy an option having a low premium and then offset
the option when its premium rises. For example, suppose that you buy a call option
on stock X and the price of stock X in the secondary market advances. The value of
this call will also advance. If you now wanted to take your profits, you could simply
instruct your broker to sell this call option. Note that you never actually bought 100
shares of stock X from the writer. You simply bought the call at a low premium, sold
it at a higher premium, and then took your profit.
Buyers of call and put options can lose money. If an investor buys put options
and the underlying stock price rises or doesn't change much, the option may be
worthless. The buyer will lose the premium he paid for the option. The writer, who
received the premium, profits in this case. The buyer also has to worry about when
exactly the stock will fall in price. If the stock falls after the put option has expired,
then once again he has lost his premium. Therefore, buyers of puts and calls must be
confident of both the direction and timing of changes in the stock's price. Three
things can happen to a stock price, and two of these are bad for the options buyer!
The writer (or seller) of options gets his profit from the premiums the option
buyer pays. The writer of a call option will make money if the stock price doesn't
change much or if it drops in price. He loses money if the stock price rises, and since
this rise can be substantial, the writer's losses can be very large. The writer of a put
option will similarly lose money if the underlying stock price declines. This loss can
similarly be quite large.
II. Options Quotations
For corporate stock options, the Wall Street Journal gives basic information
needed to keep abreast of the market. Each option is identified by its underlying
stock. For example, suppose that it is the month of March. Options are selling on
CITICORP which is a bank holding company which owns the US based CITIBANK.
The options being traded on CITICORP will be identified in the newspaper as
CITICP. Under this will be given the most recent closing price for CITICORP stock
on the NYSE. Next, the strike price on the option will be given, say $35. After this
will come the expiration month, which we can assume is July. The volumes and
premiums for both calls and puts are then listed. For example, the call's price might
be $5 5/8 = $5.625 per option, and its volume that day might be only 19 contracts. The
put might have a premium of $1 3/16 = $1.1875 per option and a volume of 222
contracts traded. The standard contract involves 100 options (each option is on 1
share of stock), so that the total number of options transacted would be the
(volume)(100). Thus, if an investor buys one call contract, he pays a total premium of
$562.50, while to get one put contract he pays $118.75. Options can have different
strike prices and different expiration dates. For example, there may be a CITICORP
July option with a strike price of $45, while there may also be CITICORP April
options with a strike price of $35.
III. Hedging With Options
Like futures, options can be used to reduce the individual risks of holding an
underlying asset. For example, suppose that you are holding 100 shares of IBM stock.
You feel that IBM stock is likely to decline in the next three months. But, even if it
does, you feel it is best to continue to hold your shares. Perhaps this is because you
bought IBM at a very low price and if you sell it you must pay considerable taxes on
your capital gains. You would like to defer these taxes to the future. To hedge this
price risk you could buy a put options contract (equal to 100 separate options). You
would pay the writer a premium for this put. If IBM stock rose in price, then you
would make money on your underlying shares, but you would also lose on the puts.
The gains and losses would cancel. Conversely, if IBM's stock price fell in the
secondary market, then the puts would increase in value, so you would be hedged
against this price decline. The worse case would be if IBM's stock did not change in
price. In this case, you would simply lose the premiums you paid for the puts.
Calls can also be used to hedge price risks. Suppose you did not own IBM stock,
but you felt that IBM stock was going lower. You decide to sell IBM short in the
stock market. You would borrow 100 shares from your broker and immediately sell
these on the NYSE. If IBM stock moved lower, then you could buy the stock back
later, return the stock to the broker (with interest), and still make a profit. But,
shorting IBM stock exposes you to the risk of unlimited losses. If IBM stock rose
instead of falling, then you stand to lose a great deal of money. You can hedge this
risk by purchasing a call option on IBM stock. If IBM's price rises, then you lose
money on your shorting of IBM stock, but this is then balanced by the rise in your
call's premium.
Often firms having future obligations denominated in foreign currencies will
hedge their exchange risks by using foreign currency options. For example, suppose a
German importer must pay 1 million USD after 3 months. He is afraid that the
deutschmark (DM) will depreciate relative to the USD. To hedge his exchange risk he
could buy DM put options. If the DM did depreciate, his put options would increase
in value and cancel his exchange losses. Note that the company can hedge its risks by
being long (buying) puts, but it cannot hedge itself by going short (selling or writing)
calls on the DM. Note also that if the exchange rate does not change by much, then
the company will suffer losses equal to the premiums it has paid for the put options.
Therefore, the company must be very confident that the DM will depreciate
substantially within 3 months in order for its strategy to be correct.
IV. Important Aspects of Options
There are a number of important concepts which are related to the options
market. Let's consider some of these now.
First, if the stock price is greater than the strike price, the option is said to be in
the money for a call option and out of the money for a put option. Calls will out of the
money and puts will be in the money when the stock price is less than the option's
strike price. When the stock price is equal to the strike price, then both the call and
the put are said to be at the money”.
Second, premiums on calls and puts that are quoted in the newspaper are equal to
the price paid on the last transaction. Since premiums are determined on a bid-asked
basis, it is not clear which of these (bid or asked) is given in the newspaper. If the last
transaction was for an investor to sell an option, then the quotation is a bid price. If
the last transaction was for an investor to buy an option, then the price quoted was an
asked price.
Third, not only can one buy and sell options on a company stock, but stock
index options can also be traded. The Chicago Board Options Exchange trades stock
index options on the S&P 100, S&P 500, and the NASDAQ 100. Both the NYSE and
the AMEX also trade stock index options. Around 40% of all options volume is now
due to stock index options trading.
Finally, the sale or writing of options requires a margin deposit to be established,
and this margin will depend on the nature of the option. For example, a call can be
written in two ways covered and uncovered. A covered call means that the writer of
the option already owns the underlying stock. An uncovered call (sometimes called a
naked call) is one where the writer does not own the underlying stock.
Discussion Questions:
#1. What is a call option?
#2. Suppose I want to buy IBM put options. What do I expect about IBM's stock
price?
#3. Explain each of the following terms:
(a) options writer
(e) premium
(b) expiration month
(f) covered call
(c) strike price
(g) offset
(d) bid and asked prices
(h) stock index option
#4. What information is given in options quotations?
#5. When would one use a put option to hedge?
#6. When would one use a call option to hedge?
#7. What is the difference between a futures contract and an options contract?
#8. What is the difference between selling stock short and being short in the options
market?