Module 1 Invest in Debt Securities – Economic Market questions Is this is a good time to invest in debt securities such as US government debt (Treasuries),

Module 1 Invest in Debt Securities – Economic Market questions Is this is a good time to invest in debt securities such as US government debt (Treasuries), municipals, corporates, foreign debt? What are the factors you would consider in making this investment (or not)? If you are willing to invest in debt, what are your preferences? Why? 2019/3/20
Module 1 Compiled
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Module 1 Study Guide and Deliverables
Introduction, Economic Principles of Financial
Financial Instruments and their Markets
Madura: Ch. 1, 6, 7, and 8
Discussions: 1.1: Introduce Yourself
1.2: Debt Securities – Would you buy today?
Initial post due by Wednesday, March 20 at 11:59
Reply posts due by Sunday, March 24 at 11:59 PM
Homework Exercise 01 – Interest Rates due by
Sunday, March 24 at 11:59 PM ET
Homework Exercise 02 – Bond Pricing due by
Sunday, March 24 at 11:59 PM ET
Sunday, March 24 at 7:00 PM ET
The Whole Landscape
This is the whole landscape of the financial markets and institutions, so it’s a very densely populated forest. It has a lot of moving parts
and also to some people many pieces of the jigsaw puzzle needs to be connected for you to understand the markets, the institutions, and
the participants within in order to put together this nice picture of the whole industry.… 1/39
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Market Definition
We begin our course by taking a moment to reflect on the generic meaning of markets. I think the best starting point is to ask ourselves
what makes Shaw’s, Whole Foods, Trader Joe’s or even your local grocery store a popular place to shop for groceries? I pose the following
questions as food for thought. Please take a moment to reflect on this before proceeding. While it may seem to be a facetious question,
in essence there is a lot of similarity across markets of all types and the characteristics which make for a good market tend to be fairly
As you will see, financial markets are similar in most respect to a grocery market, that is, it is a place where financial products are bought
and sold. Shoppers go there because of price, quality, and variety of products. In the case of financial markets, liquidity, transaction
volume and transaction cost, sometimes determine shoppers’ for preference one market over another. Just as important is the issue of
fairness in trading opportunity to all participants. By this, I mean the priority of sequence of transaction should be treated equally among
market participants of all sizes. Imagine yourself waiting patiently in line at a supermarket and have another customer leap frog the line to
be waited on first. The same issue holds true for financial markets. For example, during heavy selling of a particular stock when sale
orders from two traders arrive at the same the sale of stocks from a big brokerage firm should not take precedence over those of smaller
traders. Another issue is access to certain products. If you have been anxiously scouring Toys”R”Us to purchase this year’s “must have”
toys for Christmas, you might be disturbed to learn that friends of store employees were able to buy all of the limited supply. Yet that is
exactly what had occurred in the allotment of “hot” IPOs to favored customers of big brokerage houses over those of smaller ones. This
practice fell in the grey area of investment banking and largely has been eliminated. We will have ample opportunities during the class
discussion to explore some of these market practices (or mis-behaviors). Failure to address them or even the perception of it will drive… 2/39
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market participants away from such a market. This is one reason why financial markets flourish in North American and Europe and not in
some developing economies, which have a great deal of corruption, preferential treatment and inside information issues.
Also, keep in mind that there is more than one financial market. Indeed there are a myriad of markets for financial products many of which
overlap. They are segmented by the types of financial instruments that are bought and sold. For example, short-term markets like money
market products are distinct from that of longer-term investment products like stocks and bonds. As you will see later, even within the
money markets, they are further segmented into separate money market products.
Keep in mind that that the buyers in the financial market are lenders and investors while sellers are borrowers of funds. Connecting buying
and selling to lending and borrowing may be a bit confusing to some. Let me elaborate. In the case of financial markets or financial
products, regardless of type, basically what gets transacted is the borrowing and lending of money. When a person or business seeks to
borrow money, it does so in the financial market by selling a financial product. The more technical term is to “issue securities,” and often
the borrower is referred to as the “issuer”, for example, as in the issuance of bonds, or in this case of stocks, in an initial public offering,
i.e. an IPO. The counterparty or buyers would be lenders in the financial securities that are being issued. What they get at the end of the
transaction is the right to a stream of payments (such as interest payments, repayment of principal, dividends, and the like) historically
documented by a piece of paper, like a bond or stock certificate, but increasingly, most of the transactions now are recorded, debited and
credited in electronic form.
Financial Market
i… 3/39
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One of the unique features of a financial market is that the products of financial assets have no physical form, that is, the point of
transaction is debited and credited electronically whether they are stocks, bonds, currencies, and so forth. Although buyers and sellers
can transact either physically or electronically, the delivery of the product is ultimately electronic.
When we cover stock markets, one of the trends is a movement toward an electronic trading system like the NASDAQ. Even the New
York Stock Exchange, which has been the most high profile of the old system, with floor traders actively buying and selling securities on
behalf of their clients, has acquired foreign stock exchanges and at the same time, considering switching to an all electronic format. As of
January 24, 2007, all NYSE stocks can be traded via its electronic hybrid market (except for a small group of very high-priced stocks).
Customers can now send orders for immediate electronic execution or route orders to the floor for trade in the auction market. We also
see a proliferation of online trading brokerage funds. It gives individual online traders access to many diverse markets. The individual trader
connects to an online trading firm, such as E*TRADE. Orders placed are then routed to the relevant market. Almost all online trading
allows individuals to place stock orders on both New York Stock Exchange and NASDAQ, buy mutual funds and even stock derivatives.
Types of Financial Markets
The tables below describe the types of financial products that are available in various markets. We will be spending the first two weeks of
this course talking about money markets, bond markets, mortgage markets, stock markets and foreign exchange markets.
Financial Products “instruments”
Financial Instrument Characteristics
U.S. Treasury securities: T-bills, T-Notes, T-Bonds
Maturity (life of product)
Municipal State Bonds
Level of risk (the rate of return)
Corporate Bonds
Collateral vs. non-collateral
Commercial Papers
The participants
Tax issues, tax incentives
CDs, Mutual Funds
Money Market securities
Capital Market securities
Debt securities with a maturity < 1 Securities with a maturity > 1 year
Bonds and Mortgages
Low degree of risk
More risk than money market
Low expected return
Low expected return
Higher expected return
Bonds and Mortgages
Derivative Securities
Bonds: long-term debt obligations
Certificates representing partial
Financial contracts whose values
issued by corporations and
ownership in corporations
are derived from the values of
government agencies
Investors may earn a return by
underlying assets
Mortgages: long-term debt
receiving dividends and capital gains
Speculating with derivatives: allow
obligations created to finance the
Stocks have higher expected return
investors to benefit from increases
purchase of real estate (residential
and higher risk than long-term debt
or decreases in the underlying
and commercial)
Both specify the amount and timing
Risk management with derivatives:
of interest and principal payments
gains from derivative used to offset… 4/39
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declines of underlying security >
net gains of both moderated > lower
Markets, Products, Participants
The table below summarizes the products available in the money markets and the capital markets, their typical maturity and its
participants. Note that not all products once issued can be resold in the secondary market, but must be held to maturity. To address this
lack of liquidity, often those securities may be pledged in return for immediate access to funds, such as through the repo market.
Money Market
Issued by
Treasury Bills
Federal government
Certificates of
Common Investors
Households, firms and
financial institutions
Negotiable CDs
Large banks and savings institutions
Bank holding companies, finance
Federal Funds
companies, and other companies
Banks located outside the U.S.
Banks (exporting firms can sell it at a
discount to obtain funds)
Depository institutions
Firms and financial institutions
Market Activity
weeks, 1 year
Institutions, Households
13 weeks, 26
Banks and Savings institutions
Deposits (CDs)
7 days to 5
years or longer
2 weeks to 1
1 – 270 days
Firms and Governments
1 day to 1 year
30 – 270 days
Depository instituitons
1 – 7 days
1 – 15 days
3 – 30 years
Firms and financial
Capital Market Securities
Treasury Notes
and Bonds
Federal government
Households, firms and
financial institutions
Municipal Bonds State and local governments
Households and firms
10 – 30 years
Corporate Bonds Firms
Households and firms
10 – 30 years
Financial institutions
10 – 30 years
Households and firms
10 – 30 years
Individuals and firms
Equity Securities Firms
High (for stocks of
large firms)
Concept of Market Efficiency
Definition: A market is efficient when security prices fully reflect all available information.
We now introduce two important attributes of a financial market. Without these
characteristics, buyers and sellers are less inclined to participate in them. Note
In an efficient market, different investors may still
that one of the recent trends is the ubiquity of the internet. This instant
prefer different securities because of differences
availability of financial news, even to individual investors, has made the market
more efficient as well as more volatile than it was only a few years ago. Note
that there is an important difference between the availability of information
Desired liquidity… 5/39
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(access and quantity) versus its quality. Although financial disclosures in the
Risk preference
form of 10K (annual) and 10Q (quarterly) financial statements are wildly
Investment horizon
available to all, as we have seen in recent accounting scandals, the quality of
Tax status
some of this disclosures are misleading and not always accurate. The playing
field is far from level between individual investors and financial analysts. The
financial analysts sometimes have to dig deep, look at footnotes of the financial statements, and try to paint a complete picture of the
financial health of a company.
Impact of Asymmetric Information
Asymmetric information is information a firm’s managers have that is not available to
The valuation process is influenced by financial statements that are used to derive cash
flow estimates
Securities may be mispriced because of
Flexibility in accounting guidelines
Overestimation of earnings
The asymmetric information problem can be reduced if managers frequently disclose
financial data and information to the public or through increased regulation
Financial Market Regulation
Many regulators attempt to ensure that businesses disclose accurate information.
Key regulations:
Securities Act of 1933 – intended to secure complete disclosure of relevant financial
information on publicly offered securities
Securities Exchange Act of 1934 – extended the disclosure requirements to secondary
market issues
There are several regulatory responses to financial scandals, such as those including Enron, Worldcom and others, which involved
exaggerated earnings, failure to disclose relevant information and auditors not meeting their responsibilities. The Sarbanes-Oxley Act of
2002 required a CEO to “sign-off” on financial reporting.
There is a trend for more regulations which include:
provision of more complete and accurate financial information
more restrictions to ensure proper auditing by auditors
proper oversight by the firm’s board of directors
Market Definition (continued)
The main activity of the financial market is the transfer of capital between lenders and borrowers. This is facilitated by all sorts of financial
intermediaries. The matching of buyers to sellers is key in any well-functioning market. Compare their role to that of eBay or the
supermarket example described earlier. The next few slides offer a brief description of the roles. In Weeks 4 and 5 we will look at
commercial banks as well as some non-bank financial institutions who act as intermediaries of the financial markets.… 6/39
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Types of Financial Intermediaries
Commercial banks
Investment banks
Savings and loan associations
Mutual savings banks
Credit unions
Pension funds
Insurance companies
Mutual funds
Finance companies
Hedge funds
Foreign banks
Foreign institutions
In a perfect market that is efficient, all information about any securities for sale in primary and secondary markets would be continuously
and freely available to all investors. Also, information would be symmetric, whereby all information identifying investors in purchasing
securities as well as investors planning to sell securities would be freely available. Also, all securities are infinitely divisible. But markets
are imperfect and financial institutions, acting as intermediaries, are needed to resolve problems created by market imperfections.
Role of Depository Financial Institutions in Financial Markets
Depository financial institutions accept deposits from surplus units and provide credit to deficit units. These institutions are popular
deposits are liquid
they customize loans
they accept the risk of loans
they have expertise in evaluating creditworthiness
they diversify their loans
American depository financials institutions consist of:… 7/39
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Depository Institutions
Commercial banks
Savings and loan associations
Mutual savings banks
Credit unions
Commercial banks are the most dominant depository institution. They offer a wide variety of deposit accounts and they serve both the
public and the private sector. Savings institutions include savings and loan associations (S&Ls) and savings banks. They are mostly
owned by depositors (mutual). Their concentration is on residential mortgage loans. Credit unions are non-profit organizations and are taxexempt. They restrict their business to credit union members. They tend to be much smaller than other depository institutions.
Role of Non-depository Financial Institutions in Financial Markets
Non-depository financial institutions generate funds from sources other than deposits.
Non-depository Institutions
Investment banks
Pension funds
Insurance companies
Mutual fund companies
Finance companies
Investment banks perform non-depository financial services. They help businesses borrow money in the financial markets, issuing stocks
(e.g. Initial Public Offerings (IPOs) and bonds. They provide financial advice to businesses such as mergers and acquisitions, and
company restructuring. They also provide financial asset management. They trade in financial markets with their own capital.
Mutual fund companies sell shares to surplus units. They use funds to purchase a portfolio of securities. Some focus on capital market
securities (e.g., stocks or bonds) while some focus on money market securities (e.g., T-bills, commercial papers, etc.).
Insurance companies provide insurance policies to individual and firms for death, illness and damage to property. They charge premiums
which is their source of funds. They invest in stocks or bonds issued by corporations.
Pension fund companies manage pensions that are offered by most corporations and government agencies. They manage funds until they
are withdrawn from the retirement account. They invest in stocks that are issued by corporations and bonds that are issued by
corporations or government. Such investments can be in either domestic or foreign financial markets.… 8/39
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We conclude this segment of the course overview with the big picture of the various markets, its products and the participating
institutions. In this broad landscape, the trend of globalizations of financial markets as well as financial institutions continues, as
developed nations gradually deregulate this industry. With the advent of telecommunications and especially the ubiquity of the internet,
financial markets are no longer a domestic market or a North American market. It has become a global market. Coupled with the recent
development of globalization and the waves of cross border mergers and acquisitions, major financial institutions are no longer domestic in
operation; they are global institutions in a borderless market. Nothing prevents capital from being channeled from one end of the globe to
the other or even among financial markets. HSBC historically operated primarily in Hong Kong and mainland China. But its headquarters
are in London and it functions as a universal bank throughout almost every part of the world.
These are some of the broad trends that we will see throughout the course: the conversions of financial services, the globalization of
financial markets and financial institutions and the further consolation of financial institutions in the industry.
The Big Picture…
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