Money Market Instrument Yields

Yields on Money Market Instruments are not always directly comparable

Factors influencing yields Par value vs. investment value 360 vs. 365 days assumed in a year (366

leap year) Bond equivalent yield

P = price of the T-bill

n = number of days to maturityExample: Using Sample T-Bill

rBEY = .0204 x 4.0556 = .0828 = 8.28%

Bond Equivalent Yield

n365

PP000,1

rBEY

90365

980800,9000,1

rBEY

rBD = bank discount rateP = market price of the T-billn = number of days to maturity

Example90-day T-bill, P = $980

Bank Discount Rate (T-Bills)

n360

000,1P000,1

rBD

%890

360000,1

980000,1rBD

Bond Equivalent Yield

Impossible to compare T-bill directly to bond 360 vs 365 days Return is figured on par vs. price paid

Adjust the bank discount rate to make it comparable

Capital Market - Fixed Income Instruments

Publicly Issued Instruments Canada Bonds Provincial Government Bonds Municipal Bonds

Privately Issued Instruments Corporate Bonds Mortgage-Backed Securities

Canada Bonds

Non marketable (Sold November 1st)

Canada savings bonds: can be cashed in any time

Canada Premium Bonds: Can be cashed in November of succeeding years only

Marketable Canada Bonds

Varying maturity, up to 40 years

Considered part of the money market when maturity is less than 3 years

Interest rate at date of issue is such that

the bond can be sold at par value

Coupon paid in two semiannual installments

Yield to maturity

Calculated by determining the semi-annual yield and doubling it

Annual Percent Rate (APR), not effective annual rate

Yield for callable bond selling at a premium is up to the first call date

For a discount bound, Yield is to maturity

Provincial and Municipal Bonds

Similar to Canada bonds but generally with a higher YTM

U.S. municipal bonds are exempt of taxes

Corporate Bonds

Riskier than government bonds

Secured bonds have collateral backing

Unsecured bonds, or debentures, have no collateral

Features of bonds

Callable bonds: the firm has the option to repurchase the bond before maturity at a specified price

Retractable: holder has the option to redeem the bond

Extendable: holder has the option to keep the bond after maturity date

Convertible: can be converted to a certain number of shares

Mortgages and MBS

Mortgage-Backed Security (MBS): Ownership claim in a pool of mortgages

The mortgage originator keeps collecting principal and interest for the but borrower but then passes the payments to the MBS holder

Ex: mortgage of $100,000 at 10% over 30 yearsmonthly payment is 877.57$833.33 interest, $44.24 principal

MBS

First introduced in Canada by the Canadian Mortgage and Housing Corporation (CMHC) in 1987

MBS are guaranteed by the federal government (no risk)

Yield still higher than T-Bill due to the callable feature, depriving holder from potential capital gains

Equity Securities

Equities: ownership shares in a corporation

Common stock: voting share, allows to participate in directors elections

Some common stocks may have restricted voting rights, usually come with better financial benefits

Equity Securities

Common stocks are residual claims on the liquidation value of the firm

Financial benefits are dividends and/or capital appreciation

Listing

Board Lots and Odd Lots

A board lot is normally 100 shares

1,000 shares if the stock price is below $5

25 shares if the stock price is above $100

Odd lots are not board lots Stock brokers may charge odd-lot

differential

Preferred Stocks

Stocks to which a fixed amount of income is paid each year

Income is dividend, failure to pay it does not mean bankruptcy

Preferred stock holders are paid before common stock holders

No voting power

Preferred Stocks

Advantage for the firm: income need not be paid

Disadvantage: dividends are not tax deductible

Should yield on preferreds be greater or lower than similar bonds? Interest income is taxed more than dividends: yields on preferreds can be lower for that

Stock Indexes

Uses Track average returns Comparing performance of managers Base of derivatives

Factors in constructing or using an Index Representative? Broad or narrow? How is it constructed?

Examples of Indexes – Canadian

TSE 300 Composite IndexIntroduced in 1977TSE 300 for 1975 = 1,000

TSE 35 Introduced to stimulate index futures and options trading

TSE 100 S&P/TSE 60

Created to mimic the TSE 300TSE 60 = 100 in Jan 29, 1982

Examples of Indexes - US

Dow Jones Industrial Average (30 Stocks) Standard & Poor’s 500 Composite NASDAQ Composite NYSE Composite Wilshire 5000

Construction of Indexes

How are stocks weighted? Price weighted (DJIA) Market-value weighted (S&P500, NASDAQ,

TSE 300) Equally weighted (Value Line Index)

How returns are averaged? Arithmetic (DJIA, S&P500, Value Line) Geometric (Value Line Index)

Averaging Methods (Value Line)

Component ReturnrA=10% rB= (-5%) rC = 20%

Arithmetic Average:

%33.83

2.)05.(10.3

rrrra

CBA

1)r1)(r1)(r1(rg 3 CBA

Geometric Average:

%84.71)2.1)(95)(.1.1(3

Bond Indexes

Lehman Brothers Merrill Lynch Salomon Brothers Scotia Capital (Canada) Specialized Indexes

Merrill Lynch Mortgage

Derivatives Securities

Options Basic Positions

Call (Buy) Put (Sell)

Terms Exercise Price Expiration Date Underlying Assets

Futures Basic Positions

Long (Buy) Short (Sell)

Terms Delivery Date Underlying Assets

Derivative Securities-Quotes

Options Bid price Ask price Last price Open interest Underlying asset

price

Futures Settlement price Change Open interest Underlying asset

price Physical delivery