Money Market Securities

Money Market Securities – low-risk, fixed-income, short-term contracts

Certificate of Deposit – bank account that pays you a higher interest rate in return for locking
your money away for a fixed period (GIC -> Canada) ->cannot cash issue before expiry without
penalty
Commercial Paper-> unsecured, short-term debt issued by a private corporation to finance short-
term liabilities (guaranteed by the banks)
Banker’s Acceptance- post-dated cheque (guaranteed by the bank) and is typically used by firms
with no credit history
T-Bill- short-term debt obligation (fixed income contract) backed by the government with
maturity of one year or less
Repo rates- when a firm needs cash, it sells T-bills to someone with a promise of buying them
back at a slightly higher price

Value of a perpetuity = C/r Value of a growing perpetuity = C/(r-g)

If coupon rate = interest rate, C = r*F, V= F
Bond Equivalent Yield- annual rate of return, assuming simple interest

*the higher the interest rate, the future counts for less (NPV Analysis)
Nominal interest (i) = extra dollars we get at the end of the period
Real interest (r) = extra goods we can buy at the end of the period
Inflation rate = change in prices
Yield to Maturity- the rate of interest (annualized) that equates the price of the bond to the
present value of cash flows (annualized rate of return)
Current Yield – bond’s annual return based on its annual coupon payments and current price
1+𝑖
1+𝑟 =
1+𝜋
𝑛
𝑝 ∗ (1 + 𝑖)365 = 1000 (EAY calculation)
Fisher’s Equation
𝑖 = 𝑟 + 𝜋 𝑒 , where 𝜋 𝑒 =expected inflation
Why would investor choose to invest in stock market rather than money market?
 - Historically higher long-term returns
- Participate in the growth of a specific company or industry
- Preferential treatment in taxes
Why would investor choose to invest in money market rather than stock market?
- Short-term liquidity
- Lower risk
- Highly marketable
- Minimal capital gains or losses
- Low transaction costs

If a bond is selling at a discount (P< 1000), d < rBEY

Coupon Rate = C/F (F is face value of the bond)
Current Yield = C/P (P is purchase price)
*private bonds have higher rate of return because of increased risk
Convertible Bond -bond where the holder has an option of converting the bond into a
(prespecified) # of shares upon maturity
Callable bond- bond where the issuer has option of redeeming the bond back before maturity
date at a pre-specified price, or on or after a prespecified date
*As interest rates rise, incentive to call the bond decreases as refinancing is more costly

Yield Spread – difference in the rate of return between government and corporate bonds
Lower risk = lower returns = government bonds

Retractable bond – lender (holder) has the option of forcing the issuer the redeem the bond
before the maturity date at a pre-specified price, or on or after a prespecified date.
*An investor might exercise the retraction option due to unfavorable economic conditions such
as a rise in interest rates. An increase in interest rates would translate into lower bond price
*increase in interest rates increases incentive to retract the bond as lending at higher rates
is more attractive

Extendible bond- option of holding the bond after the maturity date
*investors benefit from this bond during period of declining interest rates. When interest rates
fall the price of longer-term bonds rise to a greater degree than the price of shorter-term bonds.
*Since issuers continue paying interest on bonds that have been extended, the bonds will sell at a
higher price (and lower yield) than other bonds because there is the possibility for a higher
return.

*all other things equal, straight bonds have a higher price than callable bonds
* if interest rates get higher, there is no incentive to refinance -> callable option is worthless
Rate of return – (1000 – p)/ p

Real Assets- assets used to produce goods and services affects the capital, efficiency and
productivity of the economy (tangible) -> size of the cake
Financial Assets – exchange of money through contracts (securities) between buyers and sellers

Primary Market- issuer of the contract is the seller

Secondary Market- exchange among investors
𝑐2 𝑒2
𝑐1 + ≤ 𝑒1 +
1+𝑟 1+𝑟
𝑐2 ≤ (𝑒1 − 𝑐1 )(1 + 𝑟) + 𝑒2
Players in the Financial Market
1) Government
a. Buy or sell bonds in the open market
b. Determines the interest rate by fiscal and monetary policy
i. Increased interest rate -> crowding out (lower private investment)
Fiscal Policy- the use of government spending and tax policies to influence economic
conditions e.g. demand for goods and services
Monetary Policy- how central bank monitors supply of money and interest rate to control
output, prices and employment
 Change the reserve ratio -> increase would mean money supply decreases
 Buy/selling of government bonds  buying increases the money supply

2) Firms- profitable projects will go unfinanced without financial institutions

3) Investors- better off because they can smooth consumption over their lifetimes
4) Intermediaries- middlemen who bring buyers and sellers together
Investment Managers
-people who give advice to investors on what assets to buy/sell
Investment Bankers
-advises companies on what price the IPO should be set at
Indifference Curve
- Set of all points (c1,c2) that give you the same utility score
- Downwards sloping (only upwards sloping if two negative externalities)
- 𝐴~𝐶, 𝐴~𝐵
*difference between borrowing rate and lending rate is bank’s income
Economies of Scale
- Average cost is a decreasing function of the number of users
- Cost advantage experienced by a firm when level of output is increased
Agency Problem
- Conflict of interest between the agent (person hired) and the principal (owner,
shareholders)
- Information asymmetry
o Moral Hazard
 one party to an agreement engages in risky behavior because it knows
the other party bears the consequences of their actions
o Adverse Selection
 either the buyer or the seller has information about an aspect of product
quality that the other party does not.
Market for Lemons
-issues that arise regarding the value of investment or product in the product due to asymmetric
information between buyers and sellers
-no willing to pay more than average price
-This reduces the average quality of used cars available and increases the risk of buying a
lemon
- sellers of good cars/products might remove them from the market

Contract Theory
-set up contracts which “align” the agent’s incentive with the principal’s
Derivative
-contracts whose value depends on another asset (e.g. options, futures)

Fixed income contracts -> Cts are known

Equity contracts -> Cts are random variables

Properties of Financial Securities

- Cash flows {Ct}
- Time until maturity
- The rate of return (yield)
- Risk involved
o Default risk (unable to make payments on their debt obligations)
o Interest rate risk (rise in the interest rate will drive down value of the security)
- Marketability -> can we transfer ownership

1000 − 𝑝 365
𝑟𝐵𝐸𝑌 = ∗ (𝑛 − 𝑑𝑎𝑦 𝑏𝑜𝑛𝑑)
𝑝 𝑛
1000 − 𝑝 360
𝑑= ∗ (𝐴𝑚𝑒𝑟𝑖𝑐𝑎𝑛 𝑇 − 𝑏𝑖𝑙𝑙 𝑜𝑟 𝑑𝑖𝑠𝑐𝑜𝑢𝑛𝑡)
1000 𝑛
*if a bond is selling at a discount (P<1000), d < rBEY
𝑟𝐵𝐸𝑌 𝑛
(1 + ) = 1 + 𝐸𝐴𝑌
𝑛
*real interest rate depends on the productivity of the country
Under the Fisher Hypothesis, an increase in inflation leads to an increase in nominal interest rate

*assets generating the same cash flow should cost the same

Bond Markets
- Government Bonds
o Federal
 Canada Premium Bond – cannot redeem before maturity
 Canada Savings bond- redeemable before maturity
o Provincial
o Municipal
- Corporate Bonds
 o Callable
o Convertible
o Retractable
o Extendible
An increasing yield spread
- Holding corporate bonds is getting riskier
o Bad future news for the economy
Equities
- Ownership contract unlike loan contracts
- Select the Board of Directors who hires CEOs and management
- Voting rights for common shares
- Equity Markets
o Primary -> How is the IPO determined? (Initial Price Offering)
o Secondary -> Brokerage Markets and types of orders
 Direct Search -> seller and buyer get together
 Dealer Markets -> have inventory of stocks (buy/sell)
 Broker Market-> don’t have inventory but gets buyers and sellers
together
 Auction -> buyers and sellers get under one roof and exchange assets
Four Properties
- Residual Claims
o Shareholders come after bondholders, government, taxes, interest payments
- Limited Liability
o The maximum one can lose is the price of the share purchased
- Rights to the Profits
- Voting Rights
Types of Shares
- Common Shares
o Class A (1 share > 1 vote)
o Class B (1 share = 1 vote)
- Preferred Shares
o Specifies the dividends that would be paid in subsequent years
o No voting rights
o In between bond (payments pre-specified) and equity contracts (if dividends are
not honored, no bankruptcy requirements)
o Protection Clauses
 Cumulative Clause:
 The first time the firm issues dividends, it must pay off all past
dividend claims to the preferred shareholders
  First in Line
 Preferred shareholders get first in line for dividend payments
 Restoration of Voting Rights
 After a period with no dividends, preferred shares can get voting
rights
How can we calculate the rate of return of equity?
- HPR (Holding Period Return)
- P0= Price today
- P1= Price in one year
- D = Dividend paid Annually
𝑃1 +𝐷−𝑃0
- 𝐻𝑃𝑅 = 𝑃0

The later the first payment, the smaller the present value
𝑃 1+𝑔 𝑛
𝐺𝑟𝑜𝑤𝑖𝑛𝑔 𝑃𝑒𝑟𝑝𝑒𝑡𝑢𝑖𝑡𝑦 = ( ) ∗ [1 − ( ) )
𝑟−𝑔 1+𝑟
Stock Index
Objective:
 We want to come up with an index (a number) that would reflect the overall health of
the financial industry
Three Basic Questions:

 What are the firms to include in calculating the index?

o Dow Jones – 30 firms 3M, Disney, Dow Chemicals, Amex, Microsoft, Visa
o TSX- 1500 firms used in the index calculations
o S&P 500 -500 firms
o NASDAQ – tech stocks
 Should we have different indices for different industries?
o Different indices for different sectors
 How to calculate the indices?
o There are n companies {1,2,… n}
o PWI
 Each firm has a weight wi =pi (without normalization)
 P1 = price of a share
 DJIA =
 d is a constant (typically chosen such that the base year = 100)
o MVWI
 𝑤𝑖 = 𝑝𝑖 ∗ 𝑛𝑖
 𝑝𝑖 = 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑎 𝑠ℎ𝑎𝑟𝑒
 𝑛𝑖 = # 𝑜𝑓 𝑜𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔 𝑠ℎ𝑎𝑟𝑒𝑠(without normalization)
  𝑇𝑆𝑋 = ∑𝑛𝑖=1 𝑝𝑖 ∗ 𝑛𝑖 /𝑑
o The two indices might not agree as far as directions go

How are the two indices affected by stock splits?

- Market Value Weighted Index (MVWI) remains the same
- Price weighted indices (PWI) are affected by the stock splits

ETF
- Exchange-traded fund
- Fund that moves the same way as the index itself

𝐸𝑛𝑑𝑖𝑛𝑔 𝐸𝑞𝑢𝑖𝑡𝑦 − 𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝐸𝑞𝑢𝑖𝑡𝑦

𝑅𝑎𝑡𝑒 𝑜𝑓 𝑅𝑒𝑡𝑢𝑟𝑛 =
𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝐸𝑞𝑢𝑖𝑡𝑦

Value of Equity = Value of Asset – Value of Loan

*Value of Loan includes interest rate if calculating rate of return at end of the year

Brokered Market
How are stock prices reported?
- Bid price
o Price at which we can sell
- Ask price
o Price at which we can buy
Bid-Ask Spread
- Difference between the bid and ask price

What are the kinds of orders we can give a broker?

- Market Buy Order
o We would like to purchase stock (x shares) at the current price
o When the actual transaction happens and the current price increases, the broker
will still purchase the share
o Execution is guaranteed, price is not guaranteed
 o Investor who wants to purchase shares is willing to pay at the available ask
price(s) until the order is filled

- Limit Order
o Price-contingent order
o We have to specify a price P^
o When the actual transaction is about to happen,
 P <= P^, then buy
 P > P^, then don’t
o Price is guaranteed, but the execution isn’t
o Investors specifies the price they are willing to purchase at; order can be
good for the day or good till canceled

- Stop-limit buy order

o Specify two prices P^1, P^2
 P^1 < P^2
o At price P^1, it becomes a market order with a limit price of P^2
 e.g. P^1 = 51.50 and P^2 = 52.50
o once the price is $51.50, the broker will try to make the transaction, but if the
price > $52.50, no trade will occur
o Investor specifies price they are willing to buy at should the market price
reach that level; the price is above the current market price; generally used
to limit losses after an investor has sold shares
-
Margin Orders
Motivation
- you believe that share prices will increase, but don’t have enough capital
Steps
1) Borrow money from your broker, buy the shares (put up your margin (equity))
2) A year later, sell the shares, pay back your brokers, and pocket the profits
*The broker keeps the shares for this period as collateral

𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑦𝑜𝑢𝑟 𝑒𝑞𝑢𝑖𝑡𝑦

𝑀𝑎𝑟𝑔𝑖𝑛 =
𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑎𝑠𝑠𝑒𝑡
Rules
- Our initial margin is typically 50%
- At no point of time can our margin < 30%. Or else, we get a margin call
Margin Call- demand from broker than an investor deposits additional money or securities so
that the account is brought to the minimum margin level