Chapter 1 WHY STUDY FINANCIAL MARKETS AND INSTITUTIONS?

The basic function markets are to channel funds from savers who have an excess of fund to spenders who have a shortage of funds. Financial market can do either through direct finance in which borrower borrow fund directly from lender by selling them securities or through indirect finance which involve financial intermediary who stand between the lender-savers and the borrowerspenders and helps transfer funds from one to other. The channeling of funds improves the economic welfare of everyone in the society because it allows fund to move from people who have no productive investment opportunities to those who have such opportunities thereby contributing to increased efficiency in the economy. In addition directly benefits consumers by allowing them to make purchase when they need them most. Financial markets can be classified as debt and equity markets primary and secondary market , exchange and over the counter market and money and capital market a security (also called a financial instrument) is a claim on the issuers future income or assets (any financial claim or piece of property that is subject to ownership). A bond is a debt security that promises to make payments periodically for a specified period of time.1 debt markets, also often referred to generically as the bond market, are especially important to economic activity because they enable corporations and governments to borrow in order to finance their activities; the bond market is also where interest rates are determined. An interest rate is the cost of borrowing or the price paid for the rental of funds (usually expressed as a percentage of the rental of $100 per year). There are many interest rates in the economymortgage interest rates, car loan rates, and interest rates on many different types of bonds. A common stock (typically just called a stock) represents a share of ownership in a corporation. It is a security that is a claim on the earnings and assets of the corporation. Issuing stock and selling it to the public is a way for corporations to raise funds

To finance their activities. The stock market, in which claims on the earnings of corporations (shares of stock) are traded, is the most widely followed financial market in almost every country that has one; thats why it is often called simply the market. For funds to be transferred from one country to another, they have to be converted from the currency in the country of origin (say, dollars) into the currency of the country they are going to (say, euros). The foreign exchange market is where this conversion takes place, so it is instrumental in moving funds between countries. It is also important because it is where the foreign exchange rate, the price of one Countrys currency in terms of anothers, is determined. Banks are financial institutions that accept deposits and make loans. Included under the term banks are firms such as commercial banks, savings and loan associations, mutual savings banks, and credit unions. Banks are the financial intermediaries that the average person interacts with most frequently. A person who needs a loan to buy a house or a car usually obtains it from a local bank. Most Americans keep a large proportion of their financial wealth in banks in the form of checking accounts, savings accounts, or other types of bank deposits. Because banks are the largest financial intermediaries in our economy, they deserve careful study. However, banks are not the only important financial institutions. Indeed, in recent years, other financial institutions such as insurance companies, finance companies, pension funds, mutual funds, and investment banks have been growing at the expense of banks, and so we need to study them as well. We study banks and all these other institutions

CHAPTER: 2 AN OVERVIEW OF FINANCIAL SYSTEM

Financial markets (bond and stock) and financial intermediaries (banks, ins cos., pension funds) perform the econ function of channeling/directing funds from people who have a surplus of funds to those who have a shortage of funds .

Direct finance - when borrowers and savers deal directly with each other. Indirect finance - mutual funds, pension funds, insurance companies buy stocks and bonds. Debt vs. Equity - firms/individuals can obtain funds in two ways: Debt/fixed income - bonds, term loans, commercial paper, mortgages, etc. Short term debt - one year or less Intermediate-term - 1-10 years Long-term - +10 years (usually 30 years, some 40-50 year bonds) Equity - common stock have a ownership position. One share of 1m outstanding shares gives you a 1/1m claim to firm's net income and 1/1m claim to the firms assets. Residual claimant - you have a residual claim to the firms income after all others have been paid - interest, wages, taxes, etc. And you have a residual claim to a firm's assets in liquidation after all others have been paid. Mortgages - debt secured by real property (land and/or buildings). Largest debt market in us. Historically, mortgages were mostly available from s&ls. Now, due to de-regulation, commercial banks offer mortgages and private mortgage companies offer mortgages. Corporate bonds - 10-50 year long term debt instruments to finance expansion of firm. Unsecured debt Payable twice a year. Convertible bond: convertible to common stock at a fixed rate. Foreign bonds bonds sold in a foreign country, denominated in the foreign currency. Eurobonds - bonds sold overseas in a currency other than the currency of the country where it is sold Transactions costs - costs in terms of money and time, of executing a transaction. Matching up savers and borrowers, legal contract, etc.

Moral hazard - a problem of asymmetric info after the loan occurs. Risk (hazard) that the borrower might engage in activities that are undesirable (immoral) from the lender's point of view Economies of scale - banks can lower transaction costs because of economies of scale. They process thousands of loans, so they are efficient at matching borrowers/savers, having contracts drawn up, doing credit checks, sending out payment books, offering auto withdrawal etc.. Also, due to thousands of loans, they can absorb the losses from a few bad loans.

CHAPTER: 3 WHAT DOES INTEREST RATE MEAN AND WHAT IS THEIR ROLE IN VALUATION?
The yield to maturity, which is the measure that most accurately reflects the interest rate, is the interest rate that equates the present value of future cash flows of a debt instrument with its value today. Application of this principle reveals that bond prices and interest rates are negatively related When the interest rate rises, the price of the bond must fall The real interest rate is defined as the nominal interest rate minus the expected rate of inflation. It is a better measure of the incentives to borrow and lend than the nominal interest rate, and it is a more accurate indicator of the tightness of credit market conditions than the nominal interest rate. Duration, the average lifetime of a debt securitys stream of payments, is a measure of effective maturity, the term to maturity that accurately measures interestrate risk. Everything else being equal, the duration of a bond is greater the longer the maturity of a bond, when interest rates fall, or when the coupon rate of a coupon bond falls. Duration is additive: The duration of a portfolio of securities is the weighted average of the durations of the individual securities, with the weights reflecting the proportion of the portfolio invested in each. The greater the duration of a security, the greater the percentage change in the

market value of the security for a given change in interest rates. Therefore, the greater the duration of a security, the greater its interest-rate risk. Different debt instruments have very different streams of cash payments to the holder (known as cash flows), with very different timing. Thus, we first need to understand how we can compare the value of one kind of debt instrument with another before we see how interest rates are measured. A simple loan, which we have already discussed, in which the lender provides the borrower with an amount of funds, which must be repaid to the lender at the maturity date along with an additional payment for the interest. Many money market instruments are of this type: for example, commercial loans to businesses. A fixed-payment loan (which is also called a fully amortized loan) in which the lender provides the borrower with an amount of funds, which must be repaid by making the same payment every period (such as a month), consisting of part of the principal and interest for a set number of years. A coupon bond pays the owner of the bond a fixed interest payment (coupon payment) every year until the maturity date, when a specified final amount (face value or par value) is repaid. The coupon payment is so named because the bondholder used to obtain payment by clipping a coupon off the bond and sending it to the bond issuer, who then sent the payment to the holder. A discount bond (also called a zero-coupon bond) is bought at a price below its face value (at a discount), and the face value is repaid at the maturity date. Unlike a coupon bond, a discount bond does not make any interest payments; it just pays off the face value. Of the several common ways of calculating interest rates, the most important is the yield to maturity, the interest rate that equates the present value of cash flows received from a debt instrument with its value today. Because the concept behind the calculation of the yield to maturity makes good economic sense, financial economists consider it the most accurate measure of interest rates. To understand the yield to maturity better, we now look at how it is calculated for the four types of credit market instruments. The key in all these examples to

understanding the calculation of the yield to maturity is equating today value of the debt instrument with the present value of all of its future cash flow payments.

CHAPTER: 4 WHY DO INTEREST RATE CHANGES?

An asset is a piece of property that is a store of value. Items such as money, bonds, stocks, art, land, houses, farm equipment, and manufacturing machinery are all assets. Facing the question of whether to buy and hold an asset or whether to buy one asset rather than another, an individual must consider the following factors: Wealth, the total resources owned by the individual, including all assets Expected return (the return expected over the next period) on one asset relative to alternative assets Risk (the degree of uncertainty associated with the return) on one asset relative to alternative assets Liquidity (the ease and speed with which an asset can be turned into cash) relative to alternative assets We approach the analysis of interest-rate determination by studying the supply of and demand for bonds. Because interest rates on different securities tend to move together, in this chapter we will act as if there is only one type of security and a single interest rate in the entire economy. In Chapter 5, we will expand our analysis to look at why interest rates on different securities differ. The first step is to use the analysis of the determinants of asset demand to obtain a demand curve, which shows the relationship between the quantity demanded and the price when all other economic variables are held constant (that is, values of other variables are taken as given). You may recall from previous finance and economics courses that the assumption that all other economic variables are held constant is called ceteris paribus, which means other things being equal

In economics, market equilibrium occurs when the amount that people are willing to buy (demand) equals the amount that people are willing to sell (supply) at a given price. In the bond market, this is achieved when the quantity of bonds demanded equals the quantity of bonds supplied: Bd = Bs The theory of asset demand demonstrated at the beginning of the chapter provides a framework for deciding which factors cause the demand curve for bonds to shift. These factors include changes in four parameters: Wealth Expected returns on bonds relative to alternative assets Risk of bonds relative to alternative assets Liquidity of bonds relative to alternative assets

Certain factors can cause the supply curve for bonds to shift, among them these: Expected profitability of investment opportunities Expected inflation Government budget

CHAPTER: 5 THE RISK AND TERM STRUCTURE OF INTEREST RATE

Risk structure of interest rates is the analysis of why interest rates on bonds with the same maturity will vary, due to differences in risk Term Structure of interest rates looks at why interest rates on bonds with the same risk (e.g. T-bills) will vary due to differences in term to maturity. Moody's and Standard & Poors are the two national bond rating services that do financial analyses on companies and municipalities (cities, counties, states) and based on their evaluation and assessment of creditworthiness and default probability, they assign a bond rating in one of nine categories, from Aaa/AAA to C/D, using plusses and minuses. Financial statement analysis: look at debt ratios,

coverage ratios, cash flow ratios, etc. Last category C/D, is for a company in complete default, no interest payments being paid. EXPECTATIONS HYPOTHESIS 1. Bonds of different maturities are perfect substitutes. 2. Investors are risk neutral - no risk premium is required for long term bonds. 3. Shape of yield curve is determined by investors' expectations of future interest rates, future inflation. 4. Upward sloping yield curve means short term interest rates are expected to rise in the future. Downward sloping yield curve means short term interest rates are expected to fall in the future. Flat yield curve means short term interest rates will remain unchanged in the future. MARKET SEGMENTATION or SEGMENTED MARKETS (SM) Credit markets are segmented, separate and distinct, and the conditions of S and D in each market determine int. rates at different maturities. Opposite of EH bonds are NOT substitutes. Some lenders/borrowers only want short term bonds, others want long term. Investors and borrowers are concerned with specific maturities only. Interest rates are determined independently in separate markets with different maturities, without affecting other segments of the credit market. Investors or bond issuers only care about one segment of the bond market. LIQUIDITY PREMIUM (LP) Like the EH, the LP theory says that long-term rates will equal an average of expected future short-term rates but the LP modifies the EH by assuming that a) investors are risk-averse and b) therefore will demand a Liquidity Premium for long-term bonds because of interest rate risk. It would more accurately be a Risk Premium, but is usually called a Liquidity or Term Premium. We further assume c) that there is an increasing liquidity premium and the longer the maturity the greater the premium.

CHAPTER: 6 ARE FINANCIAL MARKETS EFFICIENT?

To better understand expectations, we examine the efficient markets hypothesis. Framework for understanding what information is useful and what is not However, we need to validate the hypothesis with real market data. The results are mixed, but generally supportive of the idea. Efficient markets have a great impact on stock exchange. Efficient market hypothesis is that in hypothesis which is also known as theory of efficient capital market. Our market is that much efficient in which prevail prices it reflect all the information of securities. Expected return depend on supply and demand and demand effect inflation and it gives the equilibrium return. In this case our interest is our expected return provided with condition that its holding period and maturity is same. If the return on optimal forecast and equilibrium return situation holds so its mean our financial market is efficient. Prices which we pay for securities their information available is forecasted and it effect demand and supply and hence we get equilibrium point. Best forecast we say it optimal forecast. Stronger Version of the Efficient Market Hypothesis Many financial economists take the EMH one step further in their analysis of financial markets. Not only do they define an efficient market as one in which expectations are optimal forecasts using all available information, but they also add the condition that an efficient market is one in which prices are always correct and reflect market fundamentals. This stronger view of market efficiency has several important implications in the academic field of finance: It implies that in an efficient capital market, one investment is as good as any other because the securities prices are correct.

 It implies that a securitys price reflects all available information about the intrinsic value of the security. Random-Walk Behavior of Stock Prices that is, future changes in stock prices should, for all practical purposes, be unpredictable If stock is predicted to rise, people will buy to equilibrium level; if stock is predicted to fall, people will sell to equilibrium level (both in concert with EMH) Thus, if stock prices were predictable, thereby causing the above behavior, price changes would be near zero, which has not been the case historically Technical Analysis means to study past stock price data and search for patterns such as trends and regular cycles, suggesting rules for when to buy and sell stocks

CHAPTER: 11 MONEY MARKET

Money (currency) is not actually traded in the money markets. The securities in the money market are short term with high liquidity; therefore, they are close to being money. They have low default risk They mature in one year or less from their issue date. In theory, the banking industry should handle the needs for short-term loans and accept short-term deposits. Banks also have an information advantage on the credit-worthiness of participants. The purpose of money market is they Provides a place for warehousing surplus funds for short periods of time .Borrowers from money market provide low-cost source of temporary funds Money Market Instruments Treasury Bills Federal Funds Repurchase Agreements

Negotiable Certificates of Deposit Commercial Paper Bankers Acceptance Eurodollars

The Treasury may accept both competitive and noncompetitive bids, and the price everyone pays is the highest yield paid to any accepted bid. Short-term funds transferred (loaned or borrowed) between financial institutions, usually for a period of one day. Repurchase agreement work similar to the market for fed funds, but nonbanks can participate. Negotiable Certificates of Deposit a bankissued security that documents a deposit and specifies the interest rate and the maturity date. Commercial paper is unsecured promissory notes, issued by corporations, which mature in no more than 270 days. The use of commercial paper increased significantly in the early 1980s because of the rising cost of bank loans. Bankers acceptance is an order to pay a specified amount to the bearer on a given date if specified conditions have been met, usually delivery of promised goods. Eurodollars is a Eurodollars represent Dollar denominated deposits held in foreign banks. The market is essential since many foreign contracts call for payment is U.S. dollars due to the stability of the dollar, relative to other currencies.

CHAPTER: 12 BOND MARKET

Capital Market Trading Primary market for initial sale (IPO) Secondary market Over-the-counter Organized exchanges. Treasury Bonds: Recent Innovation Treasury Inflation-Indexed Securities: the principal amount is tied to the current rate of inflation to protect investor purchasing power Treasury STRIPS: the coupon and principal payments are stripped from a T-Bond and sold as individual zero-coupon bonds. Treasury Bonds: Agency Debt although not technically Treasury securities, agency bonds are issued by government-sponsored entities, such as GNMA, FNMA, and

FHLMC. The debt has an implicit guarantee that the U.S. government will not let the debt default. Municipal Bonds Issued by local, county, and state governments Used to finance public interest projects. Provide financing for long-term capital assets Capital Market Participants: governments and corporations issue bond, and we buy them Capital Market Trading: primary and secondary markets exist for most securities of governments and corporations. Types of Bonds: includes Treasury, municipal, and corporate bonds Treasury Notes and Bonds: issued and backed by the full faith and credit of the U.S. Federal government Municipal Bonds: issued by state and local governments, tax-exempt, default able. Corporate Bonds: issued by corporations and have a wide range of features and risk Financial Guarantees for Bonds: bond insurance should the issuer default Bond Current Yield Calculation: how to calculation the current yield for a bond. Finding the Value of Coupon Bonds: determining the cash flows and discounting back to the present at an appropriate discount rate investing in Bonds: most popular alternative to investing in the stock market for long-term investments. Characteristics of Corporate Bonds Call Provisions Higher yield Sinking fund Interest of the stockholders Alternative opportunities Conversion Some debt may be converted to equity Similar to a stock option, but usually more limited. Secured Bonds Mortgage bonds Equipment trust certificates Unsecured Bonds Debentures Subordinated debentures Variable-rate bonds. Junk Bonds Debt that is rated below BBB Often, trusts and insurance companies are not permitted to invest in junk debt Michael Milken developed this market in the mid-1980s, although he was convicted of insider trading. Financial Guarantees for Bonds Some debt issuers purchase financial guarantees to lower the risk of their debt. The guarantee provides for timely payment of interest and principal, and is usually backed by large insurance companies. Bond yields are quoted using a variety of conventions, depending on both the type of issue and the market. We will examine the current yield calculation that is commonly used for long-term debt. Bonds are the most popular alternative to stocks for long-term investing. Even though the bonds of a corporation are less risky than its equity, investors still have risk.

CHAPTER: 13 THE STOCK MARKET

Investing in Stocks Represents ownership in a firm Earn a return in two ways Price of the stock rises over time Dividends are paid to the stockholder Stockholders have claim on all assets Right to vote for directors and on certain issues Two types Common stock Right to vote Receive dividends Preferred stock Receive a fixed dividend Do not usually vote. ECNs (electronic communication networks) allow brokers and traders to trade without the need of the middleman. They provide: Transparency: everyone can see unfilled orders Cost reduction: smaller spreads faster execution After-hours trading. ECNs However, ECNs are not without their drawbacks: Dont work as well with thinly-traded stocks Many ECNs competing for volume, which can be confusing Major exchanges are fighting ECNs, with an uncertain outcome Companies must meet an exchange's requirements to have their stocks and shares listed and traded there, but requirements vary by stock exchange: New York Stock Exchange: To be listed on the New York Stock Exchange (NYSE) a company must have issued at least a million shares of stock worth $100 million and must have earned more than $10 million over the last three years. NASDAQ Stock Exchange: To be listed on the NASDAQ a company must have issued at least 1.25 million shares of stock worth at least $70 million and must have earned more than $11 million over the last three years. London Stock Exchange: The main market of the London Stock Exchange has requirements for a minimum market capitalization (700,000), three years of audited financial statements, minimum public float (25 per cent) and sufficient working capital for at least 12 months from the date of listing. Exchange Traded Funds are a recent innovation to help keep transaction costs down while offering diversification. Represent a basket of securities Traded on a

major exchange Index to a specific portfolio (eg., the S&P 500), so management fees are low (although commissions still apply. Gordon Growth Model but it assumes that dividend grow at a constant rate, g. That is, Div(t+1) = Divt x (1 + g) Stock market indexes are frequently used to monitor the behavior of groups of stocks. Major indexes include the Dow Jones Industrial Average, the S&P 500, and the NASDAQ composite. Buying foreign stocks is useful from a diversification perspective. However, the purchase may be complicated if the shares are not traded in the U.S.American depository receipts (ADRs) allow foreign firms to trade on U.S. exchanges, facilitating their purchase. U.S. banks buy foreign shares and issue receipts against the shares in U.S. markets.

CHAPTER: 14 THE MORTGAGE MARKET

A long-term loan secured by real estate An amortized loan whereby a fixed payment pays both principal and interest each month Mortgages can be roughly classified along the following three dimensions: Mortgage Interest Rates Loan Terms Mortgage Loan Amortization Mortgage loan contracts contain many legal terms that need to be understood. Most protect the lender from financial loss. Collateral: usually the real estate being finance Down payment: a portion of the purchase price paid by the borrower

Types of mortgage loans Insured vs. Conventional Mortgages: if the down payment is less than 20%, insurance is usually required Fixed-Rate Mortgages: the interest rate is fixed for the life of the mortgage Adjustable-Rate Mortgages: the interest rate can fluctuate within certain parameters Graduated-Payment Mortgages (GPMs) Growing Equity Mortgages (GEMs) Shared-Appreciation Mortgages (SAMs) Equity Participation Mortgages Second Mortgages The securitization of mortgages developed because of problems dealing with single mortgages: risk of either default or prepayment and servicing. Pools of mortgages eliminated part of this problem through diversification. Reverse Annuity Mortgages (RAMs). Mortgage contracts make their mortgage portfolio having no uniformity as this they make pool and security introduce because on their back the asset is backed and this done by originator. Lender contract having no uniformity on their interest rate and makes pool and gives security to the investors. Investors when get the security give claim to them and lenders charge more from borrower because then they give to investors who having the asset backed. Different types of pass through securities are GNMA pass through, FHLMC pass through, private pass through.