Market Vocabulary Market: a place where goods are bought and sold This can be a very wide definition, covering many types of transactions How do markets evolve? What types of markets are there?

Market Vocabulary Barter Market: Most basic, exchange of goods and services Most common accepted form of commerce prior to the invention of currency 1626: Peter Minuet trades beads, knives and kettles for... Issues: Equality of value Often a necessity to bring goods to a central place

Market Vocabulary Currency 650 AD: China issues paper "value tokens" Marco Polo brings the idea to the European continent 17th Century: Sweden takes the lead in issuing paper currency; other countries gradually followed the Swedish example 20th Century: Easier facilitation of international trade and investment Bretton Woods Agreement in 1944; fixed exchange rates Establishment of foreign exchange market with floating exchange rates

Market Vocabulary Cash or Spot Market: Purchase items with a currency, with delivery either immediate or delivered within a short amount of time Most common type of market we know today Goods and services can range from very simple to very complex financial instruments The Chinese make light Work of Payment: The Invention of Paper Money Around 650 AD, the emperor of China began to issue paper "value tokens" for general use. As Marco Polo reported enthusiastically in 1275, "I tell you that people are glad to take these tokens, because wherever they go in the empire of the great Khan, they can use them to buy and sell as if they were pure gold". Europeans had to wait until the 17th century when Sweden took the lead in issuing paper currency. Other countries gradually followed the Swedish example. The foreign exchange market (currency, forex, or FX) trades currencies. It lets banks and other institutions easily buy and sell currencies. [1] The purpose of the foreign exchange market is to help international trade and investment. A foreign exchange market helps businesses convert one currency to another. For example, it permits a U.S. business to import European goods and pay Euros, even though the business's income is in U.S. dollars. In a typical foreign exchange transaction a party purchases a quantity of one currency by paying a quantity of another currency. The modern foreign exchange market started forming during the 1970s when countries gradually switched to floating exchange rates from the previous exchange rate regime, which remained fixed as per the Bretton Woods system. The Bretton Woods system of monetary management established the rules for commercial and financial relations among the world's major industrial states in the mid 20th century. The Bretton Woods system was the first example of a fully negotiated monetary order intended to govern monetary relations among independent nation-states. Preparing to rebuild the international economic system as World War II was still raging, 730 delegates from all 44 Allied nations gathered at the Mount Washington Hotel in Bretton Woods, New Hampshire, United States, for the United Nations Monetary and Financial Conference. The delegates deliberated upon and signed the Bretton Woods Agreements during the first three weeks of July 1944.

Market Vocabulary Financial Market: A place where financial assets are bought and sold – most common is a stock exchange like NYSE, but doesn’t need to be a physical location (National Association of Securities Dealers Automated Quotation System - NASDAQ) Primary Market: Transaction between the creator of the security (issuer) and the first owner Secondary Market: Owners sell the security to a new owner, typically in a financial market Derivative Securities: Securities whose prices are dependent or “derived” from another security’s price – options, futures, etc.

Futures Markets Futures / Forward Markets: Agree to terms at present time, but currency exchange and delivery is in the future, often several months The term “futures” is most commonly used when the asset being purchased is a standardized contract The term “forward” is most commonly used when the asset being purchased is non-standardized; amount, quality shape and form need negotiated between the buyer and seller The evolution of futures markets have given many industries an enhanced stability for risk management, budgeting, planning and confidence in production inputs and outputs many things we currently buy or sell can be thought of as a slight tendency use of forward markets. Buying a computer ---- introduce the concept of “creditworthiness” --- how strong a belief do I have that the counterparty is “going to deliver” Going to deliver can have many aspects to it ---- is it one time or recurring? Are the deliveries the same or different in size (corporate bond)

Futures Markets “Underlying” assets traded can be very diverse: Tangible items: commodities, animals, production inputs, metals, stocks, bonds, etc ----- quoted in terms of the price of the item Intangible items: Stock indexes, currency exchange rates, interest rates The evolution of futures markets have given many industries an enhanced stability for risk management, budgeting, planning and confidence in production inputs and outputs

Futures Markets Chicago Mercantile Exchange CMEGroup Largest U.S. Futures Exchange 20 S. Wacker Drive, Chicago, IL www.cmegroup.com Agricultural Products: Beef, Dairy, Hogs, Lumber, Fertilizer Financial Products: Equity Index Futures (S&P 500, NASDAQ), Interest Rate Futures (T-Bill), Foreign Currency Futures (Euro) CME group is

Futures Markets 141 West Jackson Boulevard (Jackson and LaSalle) Ceres, the Roman goddess of agriculture Agricultural Products: Corn, Soybeans, Wheat, Oats Financial Products: Equity Index Futures (Dow), Interest Rate Futures (Treasury Notes), Metal Futures (Gold, Silver) Combined with CMEGroup in 2008

Futures Markets See sample copies of lean hog and lumber futures contracts… Compare contract sizes, settlement procedures, etc. http://www.cmegroup.com/trading/agricultural/livestock/lean-hogs_contract_specifications.html#prodType=undefined http://www.cmegroup.com/trading/agricultural/lumber-and-pulp/random-length-lumber_contract_specifications.html Note differences in delivery requirements due to perishable nature of some commodities

Futures Markets The increasing importance of “creditworthiness” Many everyday things we currently buy or sell can be thought of as a slight tendency use of forward markets --- online sales, etc How strong a belief do I have that the counterparty is “going to deliver” Going to deliver can have many aspects One time only or recurring? Are the deliveries the same or different in size? Physical delivery or financial settlement? Note differences in delivery requirements due to perishable nature of some commodities

Spot and Forward Rates Spot rates: rates derived from the prices of interest rate securities – usually zero-coupon securities like CD’s, money market securities, T-Bills, etc. Forward rates: rates derived from spot rates that are implied for periods of time in the future Example: If a one year CD yields 5.50%, a two-year CD yields 5.80% and a three-year CD yields 6.20%, then what does it imply about a one-year rate one year from today?

Spot and Forward Rates The facts imply there is some rate, f, that will be effective one year from today for a one-year period that satisfies: (1+.0550) * (1 + f) = (1 + .0580)2 f = .061 or 6.10%

Spot and Forward Rates Note that derivation of spot and forward rates is dependent upon the set of assets in the marketplace. Example: Price of Asset 1= $89.60; cash flow = $100 in 2 years Price of Asset 2= $96.25; cash flow = $7 in 1 year, $100 in 2 years Price of Asset 3= $91.53; cash flow = $4 in 1 year, $4 in 2 years, $100 in 3 years

Spot and Forward Rates Note that derivation of spot and forward rates is dependent upon the set of assets in the marketplace. Example: Price of Asset 1= $89.60; cash flow = $100 in 2 years Price of Asset 2= $96.25; cash flow = $7 in 1 year, $100 in 2 years Price of Asset 3= $91.53; cash flow = $4 in 1 year, $4 in 2 years, $100 in 3 years 1-Year spot rate = 5.26% 2-Year spot rate = 5.64% 3-Year spot rate = 5.92% 100 / ( 1 + x)^2 = 89.60 x = 5.64% 96.25 = 7 / 1+y + 100 / (1.0564)^2 y = 5.26% 91.53 = 4/(1.0564) + 4/1.0564^2 + 100/(1+z)^3 91.53 – 7.37 = 100(1+z)^3 z = 5.92%

Spot and Forward Rates There is a general relationship between the spot curve and the forward curve dependent upon the characteristics of the spot curve…. If the spot curve is increasing, forward rates are greater than spot rates If the spot curve is level, forward rates are equal to spot rates If the spot curve is decreasing, forward rates are less than spot rates

Other interest rate ideas Equivalent Taxable Yield Earnings on some investments are deemed to exempt from federal income tax, such as debt securities issued by states and local municipalities; these are often called municipal bonds or “muni” bonds In order to compare alternative investment choices, investors must calculate the equivalent taxable yield on muni bonds Equivalent Taxable Yield = Tax-Free Yield / (1 – Tax Rate) Also, can calculate the tax rate where the investor becomes indifferent between taxable and tax-free yields Tax Cutoff Bracket = 1 – (Tax-Free Yield / Taxable Yield)

Other interest rate ideas Example: Investor has a tax rate of 32% and a Muni bond yields 6% Equivalent Taxable Yield = Tax-Free Yield / (1 – Tax Rate) = .06 / (1 – .32) = .06 / .68 = .0882 = 8.82%

Other interest rate ideas Example: A muni bond has a yield of 5.25% versus a taxable investment of 7.00% Tax Cutoff Bracket = 1 – (.0525/ .0700) = 1 – .75 = .25 = 25% If the tax rate is less than 25%, say 10%, then the Equivalent Taxable Yield on the muni bond would be (.0525 / .90) = 5.83% and the taxable investment would be preferable If the tax rate is greater than 25%, say 40%, then the Equivalent Taxable Yield on the muni bond would be (.0525 / .60) = 8.75% and the muni bond would be preferable General overview then: Individuals of institutions with high marginal tax rates may have a larger preference to invest in tax-free assets; those with lower tax rates would prefer taxable assets