Investments: Background and Issues

• Real vs Financial Assets– Real assets are used to produce goods and services– Financial assets are claims on real assets– All financial assets are derivative assets (i.e., prices

derived from their underlying assets)– Why financial assets exist?

– Financial Market• Channel funds from the surplus units

(typically from the consumer sector) to the deficit units (from the business sectors or government)

• Financial intermediaries are institutions help the fund flows in the financial market for efficient fund allocation

• Means to overcome market impediments, e.g., taxes

Financial Intermediaries

• Brokerage Function Financial intermediaries that bring together buyers and sellers to complete the transaction and charges a fee, e.g., investment banks

• Asset TransformationFinancial intermediaries that pool short-term funds and transform them into longer-term assets, e.g., commercial banks

Market Structures

• Direct Marketbuyers and sellers find each other directly, e.g., resale of real assets

• Brokered MarketBroker brings buyer and sellers together, e.g., direct placement of debt

• Dealer MarketDealer purchases the asset and later sells it to the investor, e.g., OTC market

• Auction marketAll transactions converge in one place to buy or sell, e.g., NYSEcontinuous vs discrete auction market

Recent Developments in Financial MKT

• Globalization– Integration of financial markets across nations, e.g., mutual

fund flows1993, mutual funds invested in LDC grew substantially, but correction later.

• SecuritizationPackage assets and sell off to market, e.g., A/R loans

• Credit Enhancementallows insurance company to back credit of a corporation

• Financial Engineeringunbundling and bundling of existing assets to create new instruments (dual funds)

Financial Instruments

• Money Market (short-term)Tbill: when issued with maturities if 13-w, 26-w or 52-w and are sold at a discount basisDY = [(10,000-price)/10,000](360/n)where DY= discount yield

n = days to maturityBEY = [(10,000-P)/P](365/n)

• BEY is the bond equivalent yieldEffective Yield is the yield to maturity that equates the present value of the Tbill face value to its current price

• Certificate of Deposit (CD):time depositinstrument with banks. Denominations equal to or less $100,000 due to FDIC insurance limit.

• Commercial paper: Corporate IOUs, less than 270-day maturity due to SEC ruleIncreasing importance instruments that shapesthe banking industry

• Bankers Acceptance: trade discount instrument backed by banks.

• Eurodollar CD: deposits with Eurobonds

• Federal Funds: bank deposits at FRB as reserve. Excess amount than required can beloaned out on a overnight basis to satisfy theFRB requirement

Capital Market Instruments

• Treasury notes/bonds: medium to long-term federal government debt instruments at a fixed rate.

• Corporate Bonds: private firms’ debt issues

• Mortgages and Mortgage-backed Securities: a portfolio of mortgage loans or claims in a pool of mortgage loans.

• Preferred stocks: dividend typically cumulative; institutions may have 70% exclusion tax consideration

• Common Stocks:

Stock Index

• Price-Weighted Indice: Dow Jones Industrial Index (DJIA), 30 stocks.Suppose two stocks, their prices are $25 and $100 Index = (25+100)/divisorSince there is 2 stocks, divisor=2Index = (25+100)/2 = 62.5If (1) the new price of first one is $ 30 and the second stock undertakes 2/1 split and its new price is $45, then:New Divisor = (25+50)/62.5= 1.25New Index = (30+45)/1.25 = 62.5 (same!)

• Value-Weighted Index: e.g., S&P 500

• Bond Indexes: there are many bond indexes, such as Lehman Brothers, andIbbotson that indicate overall bond marketconditions.

• Other InstrumentsOptions: a right to buy/sell a security in the futureFutures: an obligation to buy or sell in the future

Hong Kong Money Market

• Interbank Market: – most important component of the money market in HK

– a short-term unsecured loans between deposit-taking institutions (licensed banks, restricted licensed banks and deposit-taking companies)

– maturity: overnight to 12-months

– quote: bid-ask spread using HIBOR (Hong Kong Interbank Offered Rate) as a reference rate

– its liquidity is influenced by Hong Kong Monetary Authority (HKMA)

– when HK$ is under pressure to depreciate from the $7.8/US$, HKMA will raise the interbank rate to induce more dollars to interbank market.

• Repo Market– HKMA provides a discount window called the Liquidity

Adjustment Facility (LAF) for banks between 4:00-5:00 pm, i.e., after the close of the interbank market

– banks sell securities at discount to HKMA and repurchasing back next day.

– Two types of securities are acceptable in

– in the repo market: (1) securities issued by the statutory bodies, such as Mass Transit Railway Corporation and Provisional Airport Authority, (2) Securities that arenot lower than A- (S&Ps) or A3 (Moody’s) if issued by banks, and not lower than A (S&Ps) or A2 (Moody’s) issued by non-banks

• Exchange Fund Market:– exchange fund bill (short-term) started in 1990 and later managed by

HKMA

– its maturity: 91-day, 182-day, and 364-day

– size: HK$1.5b, 1b and 0.5 b

– Exchange Fund Notes are longer-maturity with 2-y, 3-y, 5-y, and 7-yr

• Commercial Paper (CP)– short-term, 30-days to 1-yr

– unsecured and mainly primary market

– Firms only issued CP if highly rated by rating agencies (S&P, Moody)

– minimum size, HK500,000, institutional participants in the market

• Negotiable CD– large denominations in HKD (70%) and

foreign currencies

– most in 3-year maturity, primary market

• Bankers’ Acceptance– largely denominated in foreign currency

with 10% in HK$

– 3-6 months maturity, which is the timefor shipment and settlement of goods

– lenders are largely banks and deposit-taking companies

– the rate is typically below HIBOR