Finance 300 Financial Markets Lecture 17 Fall, 2001© Professor J. Petry

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Presentation transcript:

Finance 300 Financial Markets Lecture 17 Fall, 2001© Professor J. Petry

2 Housekeeping Agenda –Please note that your first Stewardship Report is due the class period after the next exam. The next exam is Monday/Tuesday, November 5 th, 6 th. Stewardship report is due Wednesday/Thursday, November 7 th & 8 th. –This Thursday, the Bond Analysis Project Sign-up form will be posted. It will be the same place as before, beginning at 1:00pm. Be sure you are in a group by then. If your group has changed, you need to advise me by next class.

3 Housekeeping Agenda Financial Markets are traditionally segmented into Money Markets and Capital Markets. –The Money Market includes short-term, highly liquid, and relatively low-risk debt instruments. Their security and liquidity result in their sometimes being referred to as “Cash” or “Cash Equivalents”. (T-bills, CDs, CP, Repos, etc) –Capital Markets include longer-term, relatively riskier securities than does the Money Market. Generally, the Capital Markets are divided into four segments: longer-term fixed income markets, equity markets, and the derivative markets for options and futures. –The Fixed Income Market—our focus since Chapter IV—spans both areas of Financial Markets. This is why our first Chapter on Fixed Income discussed the bond market generically (Chapter IV--The Debt Market).

4 Housekeeping Agenda –We are now moving systematically through the Fixed Income Portion of the Money Markets and Capital Markets. –Money Markets were covered in Chapter V. Unlike Capital Markets, Money Markets are exclusively fixed income markets. –The next two weeks, we will focus on the Fixed Income Capital Markets. This begins with Chapter VI (Government Bonds), and will extend into Chapter VII (Corporate & Other Issues). This material will constitute the material for Exam III, which will be given M/T November 5/6. We will finish the semester with Chapter VIII (Futures) and Chapter IX (Options).

5 Chapter VI – Government Bonds

6 Government Bond Market Components –US Treasury is single largest debt issuer in the world. It accounts for approximately 1/3 of the Fixed Income Debt Market in the US, or $3.5 trillion. –Until recently, debt issuance had been fueled by large government deficits. –Issues include Treasury Bonds and Treasury Notes. Treasury Bills are included in the Money Market. –Federal Agencies (Freddie Mac, Fannie Mae) and Municipalities (state and local governments) make up the remainder of government related debt. –(Corporate and asset backed fixed income securities are next chapter.)

7 Chapter VI – Government Bonds Treasury Notes & Treasury Bonds: Primary Market –There are ~40 primary market dealers. To become a dealer you must meet Federal Reserve Standards and capital requirements. You must also agree to bid in all Treasury market auctions and to make a market in Treasury Securities. –Auctions are held on a regular basis. They are similar to T-bill auctions, but Notes and Bonds are awarded on at the same market clearing yields for all participants—all purchases are at the same price.

8 Chapter VI – Government Bonds Treasury Notes & Treasury Bonds: Secondary Market –The secondary market is principally OTC (Over the Counter). OTC is an informal network of brokers and dealers who negotiate sales of securities, as opposed to them trading on a formal exchange (e.g. NYSE). –Inside Market: the market where treasury dealers trade with one another through brokers. –Government brokers: trade not for their own accounts, but for dealers. This provides the dealers anonymity. –Outside Market: the market where dealers trade with investors in the retail market. –When-Issued Market: An investor buys a security after the announcement of a bond issue, but before the bond is actually issued by the Treasury. The seller obtains and delivers the bond to the purchaser as soon as it is issued.

9 Chapter VI – Government Bonds Treasury Notes & Treasury Bonds: Secondary Market – Dealer’s Profit Come from three sources: bid-ask spread, inventory profits & carry. – Pricing of T-Notes & T-Bonds Specified in dollars per $100 face value, in 32nds. Occasionally you will see + after quote, which means to add 1/64. 98:12+ would therefore mean, 98 and 12/32 plus 1/64 = 98 and 25/64s. Maturity is always on the 15 th of the month.

10 Chapter VI – Government Bonds

11 Chapter VI – Government Bonds Treasury Notes & Treasury Bonds: Secondary Market – Accrued Accounting When government bonds/notes change hands between coupon payments, the spoils need to be divided between the seller and purchaser of the bond. Accrued accounting on government issues are based on the actual number of days in the month and in the year--including leap years. – Example: You buy the 4-3/4 of 01 on June 13, 2000 It pays coupons on August 15 th and February 15 th of $47,500/2=23,750. (The prices quoted in the WSJ are for round lots of $1,000,000.) The coupon period from Feb 15 th to Aug 15 th is 181 and from Aug 15 th to Feb 15 th is 184 days for total of 365. –Feb to Aug: 28-15, 31, 30, 31, 30, 31, 15 = 181; (2000 was leap year = 182) –Aug to Feb: 31-15, 30, 31, 30, 31, 31, 15 = 184

12 Chapter VI – Government Bonds Treasury Notes & Treasury Bonds: Secondary Market – Accrued Accounting Example (cont’d) The last coupon payment was Feb 15; the seller held for 119 days: (29- 15) ; You will hold for 63 days: (30-13) The coupon proceeds are divided accordingly. $23,750 x 63/182 = $8, $23,750 x 119/182 = $15, The Invoice Price is the base price of the bond plus accrued interest $987,500.00base price $15,528.85accrued interest $1,003,028.85invoice price

13 Chapter VI – Government Bonds Treasury Notes & Treasury Bonds: Secondary Market – Example: Things to Do: VI-1 On June 13, 2000 you put in an order for a $1,000, /8% May 2007 bond. 1.What is the price of this bond before accrued interest? 2.Accrued interest for how many days adds how much to the price of the bond? 3.What is the total invoice price of the bond? 4.When will you receive your first coupon? 5.How much will you receive on this first coupon date? 6.On the first coupon payment date you will have earned how much interest over how many days?