Saint Cloud State University Money Markets and Liquidity Discussion hi, I just want you to type your own opinions on your own words without sources, its a

Saint Cloud State University Money Markets and Liquidity Discussion hi,

I just want you to type your own opinions on your own words without sources, its a discussion. Answer these two related questions in different word files, 2 word files in total about 1-2 paragraphs each one. READ the discussions carefully and type your thoughts and opinions on your own words carefully:

Topics :

1- Money markets are where liquidity is bought and sold. What does this mean and why is it significant?

2- How is a Treasury STRIP created and why are they important? Chapter 6
Bond Markets
Bond Markets
⚫
⚫
⚫
Capital markets are markets for equity and debt
instruments with original issue maturities of more
than one year
Bonds are long-term debt obligations issued by
corporations and government units
Bond markets are markets in which bonds are
issued and traded
⚫
⚫
⚫
Treasury notes (T-notes) and bonds (T-bonds)
Municipal bonds
Corporate bonds
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reproduction or further distribution permitted without the prior written consent of McGraw-Hill Education.
Bond Market Instruments
Outstanding, 1994 – 2016
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reproduction or further distribution permitted without the prior written consent of McGraw-Hill Education.
Treasury Notes and Bonds
⚫
⚫
⚫
Treasury notes and bonds (T-notes and Tbonds) are issued by the U.S. Treasury to finance
the national debt and other government
expenditures
The annual federal deficit is equal to annual
expenditures (G) less taxes (T) received
The national debt (ND) is the sum of historical
annual federal deficits:
N
NDt =  (Gt − Tt )
t =1
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reproduction or further distribution permitted without the prior written consent of McGraw-Hill Education.
Composition of the U.S. National
Debt
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reproduction or further distribution permitted without the prior written consent of McGraw-Hill Education.
Treasury Notes and Bonds
Continued
⚫
⚫
⚫
⚫
Default risk free: backed by the full faith and credit of
the U.S. government
Low returns: low interest rates (yields to maturity)
reflect low default risk
Interest rate risk: because of their long maturity, Tnotes and T-bonds experience wider price fluctuations
than money market securities when interest rates
change
Liquidity risk: older issued T-bonds and T-notes trade
less frequently than newly issued T-bonds and T-notes
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reproduction or further distribution permitted without the prior written consent of McGraw-Hill Education.
Treasury Notes and Bonds
Concluded
⚫
⚫
⚫
⚫
T-notes have original maturities from over 1 to 10 years
T-bonds have original maturities from over 10 years
Issued in minimum denominations (multiples) of $100
May be either fixed principal or inflation-indexed
⚫
Principal value used to determine the coupon on inflation-indexed
bonds is adjusted to reflect inflation (measured by the CPI)
⚫
⚫
⚫
In other words, the semiannual coupon payments and the final principal
payment of inflation-indexed bonds are based on the inflation-adjusted
principal value of the security
Trade in very active secondary markets
Prices are quoted as percentages of face value, while coupon
rates are set at intervals of 0.125 (or 1/8 of 1) percent
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reproduction or further distribution permitted without the prior written consent of McGraw-Hill Education.
Sample Treasury Bond Quote
$1,000 par Treasury Bond
⚫
⚫
⚫
Maturity
Coupon
Bid
Asked
Chg
Asked Yld
11/15/2045
3.000
107.6563
107.6865
0.0938
2.624
Maturity mo/yr: Month and year, the bond matures November
15, 2045, but it may be callable before that time.
Coupon: Coupon rate of 3% or $30.00 per year but paid
semiannually ($1,000 face).
Bid: The closing price per $100 of par the dealer will pay to
buy the bond; the seller would receive this price from selling
to the dealer. In this case, 107.6563% of $1,000 or $1,076.56.
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reproduction or further distribution permitted without the prior written consent of McGraw-Hill Education.
Sample Treasury Bond Quote
Continued
⚫
⚫
⚫
Maturity
Coupon
Bid
Asked
Chg
Asked Yld
11/15/2045
3.000
107.6563
107.6865
0.0938
2.624
Asked: The closing price per $100 of par the dealer requires
to sell the bond; the buyer would pay this price to the dealer.
In this case, 107.6865% of $1,000 or $1,076.87.
Chg: The change from the prior closing ASKED price. In this
case, the ASKED price increased 0.0938 from the prior
quoted closing ask price
Asked Yld = Promised compound yield rate if purchased at
the Asked price. In this case, the yield is 2.624%
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reproduction or further distribution permitted without the prior written consent of McGraw-Hill Education.
Treasury STRIPS
⚫
Separate Trading of Registered Interest and Principal
Securities (STRIPS), a.k.a. “Treasury zero bonds” or
“Treasury zero-coupon bonds”
⚫
Treasury security in which the periodic interest payment is
separated from the final principal payment, effectively creating
two sets of securities – one set for each semiannual interest
payment and one for the final principal payment
⚫
Created by the U.S. Treasury in response to the separate
trading of Treasury security principal and interest that had
been developed by securities firms
⚫
STRIPS may be used to immunize against interest rate risk
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reproduction or further distribution permitted without the prior written consent of McGraw-Hill Education.
Treasury Note and Bond Yields
⚫
Prices quoted in the financial press (i.e., “clean
prices”) are calculated as:
Vb = the present value of the bond
M = the par (i.e., face) value of the bond
INT = annual interest payment = par value * coupon rate
N = the number of years until the bond matures
m = the number of times per year interest is paid
rb = interest rate used to discount cash flows on the bond
Accrued Interest
⚫
Accrued interest must be paid by the buyer of a
bond to the seller of a bond if the bond is purchased
between interest payment dates.
⚫
⚫
It is the portion of the coupon payment accrued between
the last coupon payment and the settlement day
The price of the T-bond or T-note with accrued
interest is called the full price or the dirty price,
while the price without accounting for accrued
interest is the clean price.
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reproduction or further distribution permitted without the prior written consent of McGraw-Hill Education.
Accrued Interest Continued
⚫
Accrued interest on T-notes and T-bonds is
calculated as:
Accrued interest =
⚫
INT Actual number of days since last coupon payment

2
Actual number of days in coupon period
The full (or dirty) price of a T-note or T-bond is the
sum of the clean price (Vb) and the accrued interest
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reproduction or further distribution permitted without the prior written consent of McGraw-Hill Education.
Accrued Interest Example
⚫
You buy a 6% coupon $1,000 par T-bond 59 days after the last
coupon payment. Settlement occurs in two days. You become
the owner 61 days after the last coupon payment (59+2), and
there are 121 days remaining until the next coupon payment.
The bond’s clean price quote is 120.59375. What is the full or
dirty price (sometimes called the invoice price)?
Accrued Interest =
⚫
⚫
$60
61

= $10.05
2
(121 + 61)
The clean price is 120.59375% of $1,000 or $1,205.9375.
Thus, the dirty price is $1,205.9375 + $10.05 = $1,215.9875.
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reproduction or further distribution permitted without the prior written consent of McGraw-Hill Education.
T-Note and Bond Markets
⚫
The primary market of T-notes and T-bonds is
similar to that of T-bills; the U.S. Treasury sells Tnotes and T-bonds through competitive and
noncompetitive Treasury auctions
⚫
⚫
⚫
2-, 3-, 5-, and 7-year notes are auctioned monthly
10-year notes and 30-year bonds are auctioned quarterly
(Feb, May, Aug, and Nov)
Most secondary trading occurs directly
through brokers and dealers
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reproduction or further distribution permitted without the prior written consent of McGraw-Hill Education.
T-Note and Bond Markets
Continued
⚫
⚫
Competitive and non-competitive bidders
Competitive bidders submit bid yields, highest
bid accepted is call the ‘stop out yield’
⚫
⚫
All noncompetitive bidders and competitive bidders
who bid less than the stop out receive their full
allotment. Bidders at the stop out yield may receive a
prorata share of their allotment.
T-Note or Bond coupon rate is rounded down from
stop yield to the nearest 1/8th if needed.
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reproduction or further distribution permitted without the prior written consent of McGraw-Hill Education.
T-Note and Bond Markets
Concluded
⚫
The stop out yield on a 10 year Treasury is 2.14%. What
price would every successful bidder pay for a $1,000 par
bond?
⚫
⚫
⚫
The annual coupon will be rounded down to the nearest 1/8th or
to 2 1/8th or 2.125%. The semiannual coupon is
(2.125%/2)*$1,000 = $10.625. Thus:
1 − 1.0107 −20 $1,000
Price = $10.625
+
= $998.6561
20
0.0107
1.0107
All investors would pay a quoted price of 99.86561 per
$100 of par
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reproduction or further distribution permitted without the prior written consent of McGraw-Hill Education.
Municipal Bonds
⚫
Municipal bonds are securities issued by state and local
governments and are repaid using tax receipts or revenues
generated from a project
⚫
⚫
to fund imbalances between expenditures and receipts
to finance long-term capital outlays
⚫
Attractive to household investors because interest is exempt
from federal and most local income taxes
⚫
General obligation (GO) bonds are backed by the full faith
and credit of the issuer
Revenue bonds are sold to finance specific revenuegenerating projects and are backed by the cash flows from
that project
⚫
Municipal Bonds Continued
⚫
Compare municipal bond returns with fully
taxable corporate bonds by finding the after tax
return for corporate bonds:
ia = ib(1 – t)
ia = after-tax rate of return on a taxable corporate bond
ib = before-tax rate of return on a taxable bond
t = marginal total income tax rate of the bond holder
⚫
Alternately, convert municipal interest rates to
tax equivalent rates of return: ib = ia/(1 – t)
Municipal Bond Rates & Taxes
⚫
For a 28% tax bracket, what is the equivalent after
tax rate of a 6% corporate yield?
⚫
⚫
ia = 6%(1- 0.28) = 4.32%
For a 28% tax bracket, what corporate taxable yield
is equivalent to a 4.5% municipal bond rate?
⚫
ib = 4.5% / (1-0.28) = 6.25%
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reproduction or further distribution permitted without the prior written consent of McGraw-Hill Education.
Municipal Bonds Concluded
⚫
⚫
Primary markets
⚫
Firm commitment underwriting: a public offering of municipals
made through an investment bank, where the investment bank
guarantees a price for the newly issued bonds by buying the
entire issue and then reselling it to the public
⚫
Best efforts offering: a public offering in which the investment
bank does not guarantee a firm price and acts more as a placing
or distribution agent (for a fee)
⚫
Private placement: bonds are sold on a semi-private basis to
qualified investors (generally FIs)
Secondary markets: Municipals trade infrequently due
mainly to a lack of information on bond issuers
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reproduction or further distribution permitted without the prior written consent of McGraw-Hill Education.
Corporate Bond Characteristics
⚫
Corporate bonds are long-term obligations issued
by corporations
⚫
⚫
⚫
⚫
⚫
Minimum denomination on publicly traded corporate bonds
is $1,000
A bond indenture is the legal contract that specifies
the rights and obligations of the bond issuer and the
bond holders
Bearer versus registered bonds
Term versus serial bonds
Mortgage bonds are secured debt issues
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reproduction or further distribution permitted without the prior written consent of McGraw-Hill Education.
Corporate Bonds Characteristics
Continued
⚫
⚫
Debentures and subordinated debentures
Convertible bonds versus nonconvertible bonds
rcvb = yield on a convertible bond
rncvb = yield on a nonconvertible bond
opcvb = value of the conversion option to the bond holder
⚫
Stock warrants give bond holders the opportunity
to purchase common stock at a prespecified price
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reproduction or further distribution permitted without the prior written consent of McGraw-Hill Education.
Corporate Bond Characteristics
Concluded
⚫
Callable bonds versus noncallable bonds
rncb = yield on a noncallable bond
rcb = yield on a callable bond
opcb = value of the issuer’s option to call the debt early
⚫
A sinking fund provision is a requirement that the
issuer retire a certain amount of the bond issue early
over a number of years, especially as the bond
approaches maturity
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reproduction or further distribution permitted without the prior written consent of McGraw-Hill Education.
The Trading Process for
Corporate Bonds
⚫
⚫
Primary sales are identical to that of municipals
(i.e., either occur through a public sale or a private
placement)
Secondary markets
⚫
⚫
⚫
The exchange market (e.g., NYSE Bonds)
The over-the-counter (OTC) market
Bond ratings
⚫
⚫
⚫
The three major bond rating agencies are Moody’s,
Standard & Poor’s (S&P), and Fitch Ratings
Bonds are rated by perceived default risk
Bonds may be either investment or speculative (i.e.,
junk) grade
Bond Credit Ratings
Rates on Treasury Bonds
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reproduction or further distribution permitted without the prior written consent of McGraw-Hill Education.
Corporate Bond Quote Example
⚫
⚫
⚫
⚫
Issuer
Name
Symbol
Coupon
Maturity
Moody’s/S&P/
Fitch
High
Low
Last
Change
Yield
%
Philip Morris
Intl
PM3975964
2.625 %
03/06/2023
A2/A/A
95.335
93.521
93.772
0.858
3.388
Issuer name, ticker symbol and coupon
Maturity month and year
Bond rating by the three major ratings agencies
High, Low, and Last prices in decimal form as a percent of par
⚫
⚫
⚫
Daily high price was $953.35
Change is the change from the prior day’s last price
Yield % is the promised yield to maturity using the last price
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reproduction or further distribution permitted without the prior written consent of McGraw-Hill Education.
Bond Market Indexes
⚫
Managed by major investment banks
⚫
⚫
⚫
E.g., Barclays, Merrill Lynch
Reflect both the monthly capital gain and loss on
bonds plus any interest (coupon) income earned
Changes in values of bond indexes can be used by
bond traders to evaluate changes in the investment
attractiveness of bonds of different types and
maturities
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reproduction or further distribution permitted without the prior written consent of McGraw-Hill Education.
Bond Market Participants
⚫
⚫
The major issuers of debt market securities are federal,
state and local governments, as well as corporations
The major purchasers of capital market securities are
households, businesses, government units, and foreign
investors
⚫ Financial firms (e.g., banks, insurance companies,
and mutual funds) are the major suppliers of funds for
municipal and corporate bonds
⚫ Foreign investors and financial firms are the major
suppliers of funds for Treasury securities (including Tbills, T-notes, and T-bonds)
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reproduction or further distribution permitted without the prior written consent of McGraw-Hill Education.
Bond Market Securities Held by
Various Groups of Market
Participants
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reproduction or further distribution permitted without the prior written consent of McGraw-Hill Education.
International Aspects of Bond
Markets
⚫
Motivations for international bond investing
⚫
⚫
⚫
Potentially higher returns
Better diversification
Additional complexities in international bond
investing
⚫
Higher risk; political risks higher and potential for
capital flight in lesser developed markets
⚫
⚫
⚫
Greek crisis in Europe is an example
Lower recourse in the event of non-repayment
Foreign exchange rate movements can significantly
impact returns
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reproduction or further distribution permitted without the prior written consent of McGraw-Hill Education.
International Aspects of Bond
Markets Continued
⚫
⚫
International bond markets involve unregistered bonds
that are internationally syndicated, offered
simultaneously to investors in several countries, and
issued outside of the jurisdiction of any single country
Eurobonds are long-term bonds issued outside the
country of the currency in which they are denominated
⚫
⚫
Foreign bonds are long-term bonds issued outside of
the issuer’s home country and usually denominated in
the currency of the country in which they are issued
⚫
⚫
E.g., dollar-denominated bonds issued in Europe or Asia
E.g., Japanese company issues a dollar-denominated public
bond rather than a yen-denominated bond in the U.S.
Sovereign bonds are government-issued debt
International Debt Securities
Issued, 1994 – 2015
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reproduction or further distribution permitted without the prior written consent of McGraw-Hill Education.
Distributions of International
Bonds Outstanding by Type of
Issuer, March 2016
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reproduction or further distribution permitted without the prior written consent of McGraw-Hill Education.
Chapter Five
Money Markets
Money Markets
⚫
⚫
Money markets involve debt instruments with original
maturities of one year or less
Money market debt
⚫
⚫
⚫
⚫
⚫
Issued by high-quality (i.e., low default risk) economic units that
require short-term funds
Purchased by economic units that have excess short-term funds
Little or no chance of principal loss
Low rates o…
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