finance 408 exam 2

capital market participants-

- A substantial amount of wealth is held in institutions - Individual wealth, but not owned directly by individuals

in the real world, what did obama do to taxes?

- Reverses Bush tax cuts - Munis provide more benefit to wealthy individuals, demand for munis rises

What was WHOOPs? how much did investors lose? what was it from?

- Washington Public Power Supply System (renamed WHOOPS) defaulted municipal bonds - Investors lose $225B because of falling energy costs and underestimation of project expenses - Orange County, Cali - Defaults of $1.4B

What happened on September 19th during the financial crisis?

-US Government provides deposit insurance for money market mutual funds — Slowed the bleeding, but funds still exiting commercial paper

what is a risk premium? what does it depend on?

-difference between risk free rate and rate on risky assets -depends on default risk and liquidity

what types of bonds are the most liquid? what type is the least? waht does this mean for their interest rates?

-treasury bonds are the most liquid — Corp bonds have less liquidity, and thus a higher rate of interest

observation 1 of term theory structure

> 1). Interest rates for bonds of differing maturities (but otherwise similar characteristics) move together — The 1 year interest rate is essentially a part of the 2 year rate, so when the 1 year rate rises, so too should the 2 year rate — This point checks out!

what are the 3 observations of term structure of interest rate curves?

> 1). Interest rates for bonds of differing maturities (but otherwise similar characteristics) move together > 2). When short term rates are low, yield curve is more likely to slope up (and vice versa) — When short term rates are high, yield curve is more likely to be flat or inverted > 3). Yield curves slope up most of the time

observation 2 of the term theory structure

> 2). When short term rates are low, yield curve is more likely to slope up (and vice versa) — If short term rates are low, they are more likely to rise to a normal level than to fall in the future. If investors think rates will rise, then the average return over longer time periods will be higher, so longer term maturities will require higher interest rates — This point checks out too!

observation 3 of the term theory structure?

> 3). Yield curves slope up most of the time — This would imply that investors almost always expected rates to rise - Would only be true if short term interest rates were perpetually low, but this would also mean that the series of low short term rates would lead to a low average rate for longer maturities. So the yield curve would not slope upwards - This point does not check out...

Bonds: Guarantees what did JP morgan do in 1995 in 2000 what did congress do what did the commodity futures modernization act do? what happened to CDs by 2008? how did CD's work (example: x,y,z) what did the losses on mortgages lead to?

> As it turns out, not all guarantees actually make sense! ─ In 1995, JPMorgan created the credit default swap (CDS) ─ In 2000, Congress removed CDSs from any oversight ─ Commodity Futures Modernization Act removed derivatives from oversight and prevented enforcing gaming laws against them ─ By 2008, the CDS market was over $62 trillion! (Though much of this netted out) ─ X owes $20B to Y, who owes $19B to Z, who owes $18B to X ─ 2008 losses on mortgages lead to huge payouts on this insurance

what is an ABCP?

> Asset Backed Commercial Paper (ABCP) — Commercial paper that is secured by a bundle of assets that acts as collateral

Purpose of Money Markets:

> Assist industries in securing short term loans when needed — Helps banks meet reserve requirements — Provides a cheap source of capital for companies to bridge short term needs > Provide a marketplace for short term interest rates to be set in an equilibrium setting — Short term rates affect long term rates > Help Central Bank — Short term rates serve as an indicator of monetary and banking conditions of the economy — Allows for swift implementation of policy on a large scale, as the money market can handle the volume and affects other markets > Provide a place for warehousing surplus funds for short periods of time — Most short term investors are not chasing large returns, but appreciate earning more than 0% - Cash holdings earn no return, which represents an opportunity cost to holders of cash - Opportunity Cost: The cost incurred by investing in an opportunity instead of the next best alternative — Highly liquid - Allows investors to quickly exit the market and reallocate their assets to other purposes (e.g. payroll, CapEx, etc) - Good place to wait if market conditions for stock or bond purchase are not quite right > Corporations and U.S. government use these markets because the timing of cash inflows and outflows are not well synchronized. — Money markets solve these timing issues — Corporations: Payment for inventory sold often comes 90-180 days later, but employees expect to be paid on time

What is the difference in banks and money markets? how & why?

> Banks are heavily regulated — Regulation rarely prevents activity, just makes it more expensive > Money markets are not — When information asymmetries are low, money markets have a cost advantage relative to banks for providing short term capital

Investing in Bonds: what are bonds the most popular alternative to for long term investing? even though the bonds of a corp are less risky than it's equity, what do investors still have? what 2 types?

> 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: price risk and interest rate risk

market segmentation- *****

> Bonds of differing maturities are completely separate — Not substitutes at all, and investors have strong preferences for certain maturities - College savings requires longer term investments - Firms with extra cash that they will use to fund a project next year have short term needs — Overall, investors may prefer shorter term bonds because of Interest Rate Risk and Reinvestment Risk - Require extra payment to hold longer term bonds > The preference for short term bonds explains the third fact — Yield Curves typically slope up > But market segmentation fails on the other two facts

Bonds: Calculating Yields what is the current yield?

> Calculating Yield on Bond is typically difficult without Excel or other financial calculator > Bond Traders develop Current Yield, which is a quick and dirty approximation of yields

what are capital markets consisted of?

> Capital Markets — Longer term - Maturities > 1 year — Economy Parking at the airport — Examples are Bond and Stock Markets

Money Market Instruments: What is traded here: what is commercial paper? what is the typical maturity? what kind of companies issue commercial paper? why are the issues with it's liquidity?

> Commercial Paper — Unsecured promissory notes that are issued by corporations - Maturity less than 270 days to avoid SEC regulations - Typical maturity is 20-45 days — Only the largest and most creditworthy companies issue commercial paper - No one wants to buy unsecured securities if default risk is higher — Liquidity - Less liquid because it is difficult to re-sell after purchase - More "liquid" because maturity is so short

Characteristics of Corp Bonds: conversion/ convertible bonds what can these debts be converted to? what are they similar to? what does it help alleviate? When do managers issue stock? what is this interpreted as? what do convertible bonds signal? what do investors do? what do investors do if the prices stay the same or fall? why is this option valuable?

> Conversion / Convertible Bonds ─ Some debt may be converted to equity ─ Similar to a stock option, but usually more limited ─ Helps alleviate information asymmetry between managers and markets ─ Managers only issue stock when market price is too high, usually interpreted as a negative signal ─ Convertible bonds signal managers think the firm will do better, and share price will rise. Investors see stock as more valuable and convert ─ If prices stay the same or fall, investors keep the bonds and earn interest ─ Option is valuable, requires less interest (cheaper for firm)

Money Market Instruments: What is traded here: What are euro dollars? what kind of returns does it pay higher than? why? what are they often used as? why? what are the euro dollar rates?

> Eurodollars (largest short term security worldwide) — Dollars held outside the US — Essential market, as many multinational companies demand payment in dollars because of the dollar's stability — Pays higher returns than depository rates in the US because they are not subject to the same (costly) regulations — Eurodollars are often used in place of cash to meet temporary shortfalls in reserve requirements > Eurodollar rates — London Interbank Bid Rate (LIBID): Rate paid by banks buying funds — London Interbank Offer Rate (LIBOR): Rate paid on funds that are sold

Money Market Instruments: What is traded here? what are Federal funds? what are repurchase agreements?

> Fed Funds — Short-term funds transferred (loaned or borrowed) between financial institutions - Usually overnight loans to meet reserve requirements > Repurchase Agreements (Repo) — Similar to Fed Funds, but non-banks can participate — Firm sells Treasury securities with an agreement to buy them back at a later date (usually 3-14 days) for a set price

what is a gse? what are examples?

> Government Sponsored Enterprise: U.S. agencies issue bonds as well — Not technically backed by government, but gov't unlikely to allow these to fail - Implicit guarantee — Sallie Mae (Student Loan), Farmers Home Administration, Federal Housing Administration, VA, Federal Land Banks

MMMF new rules: what implications does it have about... -fluctuations -how could they increase? -which funds has money shifted from? -What type of yields do Treasury MMMF's have, while rates are rising for ___________________? -what is the treasury department doing to meet demand? -when long term yields are at historic lows, what happens?

> Implications — Small fluctuations around $1 NAV so far — Could be larger if market stresses increase or interest rates move drastically higher — Money has shifted from Prime funds to Treasury funds — Treasury MMMFs have lower yields for investors, while commercial paper rates are rising — Treasury Department issuing more T-bills to meet demand - Shortening average maturity of debt when long term yields are at historic lows

according to the liquidity premium theory, what are interest rates on long term bonds an average of (plus what)? it also says bonds are substitutes but not ______________? what do investors prefer? in order to avoid which 2 kinds of risk? what must investors get?

> Interest rates on long term bonds are an average of the rates on short term bonds plus a liquidity premium > Bonds are substitutes, but not perfect substitutes — Investors still prefer short term bonds to avoid Interest Rate Risk and Reinvestment Risk - Must be compensated

what does the expectations theory explain about interest rates?

> Interest rates on long term bonds equal the average of the short term interest rates that people expect to occur over the life of the long term bond > Assumes that buyers do not prefer one bond type to another — Bonds with different maturities are perfect substitutes > Two choices — Purchase a single 2-year bond — Purchase a 1 year bond, then purchase a second 1 year bond

who issues municipal bonds? what are they used for? what are the two kinds/ what do they consist of? what is special about their default risks?

> Issued by local, county, and state governments > Used to finance public interest projects (schools, sports arenas) > Two kinds — General Obligation: Do not have specific assets or revenues allotted for their repayment — Revenue: Backed by the cash flow of a particular revenue generating project (toll roads) > Default risk "free" — They do default, but not often — Spectacular when they go

Junk Bonds: History Lesson when were junk bonds starting to be issued? what were the only junk bonds before that time? what happened to investors? what kind of bonds did investors invest in?

> Junk bonds were not issued (much) before late 1970s — Only junk bonds were firms that had gone bad — Investors were stuck with these bonds - Invested in AA bonds that slipped to BB bonds, couldn't sell

Junk Bonds: History Lesson did michael milken and drexel brunham lambert's idea work? what happened to firms who previously couldnt get credit? what did they create? what did that drive? what did the driving of mergers do? what did milken earn on each junk issuance? what was his total earnings from 83-87? what happened to milken in the late 80's? what then happened to the junk market, how many bankruptcies were there? how long was milken in prison? what did he retain?

> Milken's idea worked, junk bond trading soared — Many firms that were previously unable to get credit now could - Created new projects, drove growth - Drove mergers as well, since many are financed with debt and the additional issuance drives down credit rating — Milken earned 2-3% on each junk issuance - Total earnings between 1983-1987 was $1B+ > Milken got nailed for insider trading in late 80s — Crushed junk market, 250 bankruptcies — Milken spends 3 years in prison, but retains $400M+

what are money markets consisted of?

> Money Markets — Short term - Maturities < 1 year — Liquid — 15 minute parking for excess cash or obtaining cash — Examples include T-Bills, commercial paper

do money markets actually trade money? if not, who does? what do money markets trade?

> Money markets do not actually trade moneys (the Foreign Exchange markets do this) — Trades securities with very short term maturities and are highly liquid - This qualifies them as very close to money, hence the name

Money Market Instruments: What is traded here: What are negotiable certificates of deposits? what kind of security are they? what do the denominations range from? what is the bearer instrument?

> Negotiable Certificates of Deposit — A bank-issued security that documents a deposit and specifies the interest rate and the maturity date - Term security, not Demand security, because investor must wait until maturity to realize full value — Denominations range from $100,000 to $10 million — Bearer instruments: Whoever possesses them at maturity receives the principal and any interest

capital market participants- primary issuers of securities. why are federal bonds issued why are state and local govs issuing debt

> Primary issuers of securities: ─ Federal, State, and local governments: debt issuers ─ Federal bonds issued to finance national debt ─ State/Local governments issue to fund schools or prisons ─ Do not issue stock! ─ Why? - Government cannot sell ownership stakes - Plus, who wants ownership of that mess...

what are primary markets?

> Primary: Where new issues of stocks or bonds are introduced — Proceeds go to firm — IPOs and SEOs

Money Market Mutual Funds new rules: what are their protections? if liquidity drops below 30% what happens? what happens if they drop below 10%? what do redemption gates do? what happens if WEEKLY assets fall below 30%? what is the range of days this can be considered in?

> Protections — Liquidity fees: redemption fees may be implemented to help encourage investors to leave funds for liquidity purposes - If weekly liquid assets drop below 30%, a fee of up to 2% may be added - If weekly liquid assets drop below 10%, a fee of 1% must be added (unless it's not in the best interest of the fund) — Redemption Gates: the fund's board may temporarily suspend redemptions - If weekly liquid assets fall below 30%, gates may be raised - No more than 10 out of 90 days

what are secondary markets? what kind of liquidity does it have? what are the organized exchanges?

> Secondary: Where sale of preexisting securities takes place — High Liquidity — Organized exchanges (like NYSE, CBOT, LSE, etc) — Over-the-Counter exchanges

Characteristics of Corp Bonds secured bonds: what are they backed by? 2 examples unsecured bonds: what are they backed by? 6 examples

> Secured Bonds: Backed by an asset ─ Mortgage bonds ─ Equipment trust certificates > Unsecured Bonds: Backed by credit of issuer ─ Debentures ─ Subordinated debentures ─ Paid after debentures (higher risk) ─ Variable-rate bonds ─ May be secured or unsecured ─ Rate is tied to a market rate (T-bonds or LIBOR) and varies

Bonds: Guarantees why do some debt issuers purchase financial guarantees? what does the guarantee provide? what are they usually backed by?

> Some debt issuers purchase financial guarantees to lower the risk of their debt > The guarantee provides for timely payment of interest and principal, and are usually backed by large insurance companies — Like...AIG maybe? Ring any bells?

Stock Markets: what do they consist of? what does it represent? how many ways can you earn? what are they? what do stockholders have claim to? what is a residual claimant?

> Stock/Equity — Represents ownership stake in the firm — Earn returns in two ways - Price increases (Capital Gains) - May be driven by share repurchase programs - Cash disbursements (Dividends) > Stockholders have claim to all assets — Residual claimant: Claim after bondholders have been paid

what type of rates abd volatility do t-bills have? what kind of rates are more sensitive to inflation? what do spikes in inflation have on the average?

> T-bills usually have lower rate and higher volatility — Short term rates are more sensitive to inflation shifts - Spikes in inflation barely raise the average over longer time horizons

Even if we control default risk, liquidity, and income tax considerations,

> The term to maturity (the time until a bond expires) also affects interest rates — We've seen this with Interest Rate Risk and Reinvestment risk — This is true even if we control for default risk, liquidity, and income tax considerations

what type of returns do treasuries usually offer?

> Treasuries usually offer a return higher than inflation rate

Money Market Instruments: What is traded here? what are their maturities? what was the minimum denomination until 2008? after 2008? where are they purchased from? what are they issued at? interest? what do returns come from? what are the two rates associated with them?

> Treasury Bills — Varying maturities less than one year - 28, 91, and 182 day maturities — Minimum denomination of $1000 until 2008, then $100 - Purchased directly from federal government via TreasuryDirect — Issued at a discount, and no interest is paid - Returns come entirely from increases in security prices aka capital gains > Have two rates associated with them — Discount rate — Investment rate

who participates in money markets? how? 10

> U.S. Treasury Department — Sells securities to finance national debt > Federal Reserve System — Buys and sells short term securities to control money supply > Commercial Banks — Buy Treasuries, sell CDs and make short term loans > Businesses — Manage cash needs by buying and selling securities > Investment Companies — Trade on behalf of commercial accounts > Finance Companies — Lend funds to individuals > Insurance Companies — Maintain liquidity needs, especially in light of unexpected demand > Pension Funds — Maintain some level of liquidity to pay for withdrawals and make investments > Individuals — Purchase money market mutual funds > Money Market Mutual Funds — Allow small investors to participate through aggregation of funds

why would you want to lock in a higher rate for a longer period of time?

> Why would you want to lock in a higher rate for a longer time period? — Eliminates uncertainty — Paying 4% long term is better than paying a series of 1 year interest rates of 2%, 3%, 5%, 9%, 11%, 18%... - Projects that are profitable at 4% may not be profitable if short term rates rise

what is a yield curve?

A plot of the changes in yields as maturity increases, holding all else constant — Flat, Upward, Inverted

What happened when investors stopped purchasing ACBP's during the financial crisis?

Additionally, investors were no longer purchasing ACBP, which eliminated a source of short term funding for many companies. This greatly increased the strain on many firms as they tried to meet their credit obligations

When considering if money markets are really necessary, who else also handles short term financing needs? what kind of advantage do they have? how?

Are Money Markets Really Necessary? > Banks also handle short term financing needs > Banks have an information advantage — Continuous relationship with customers, creates better understanding of risks and results in better interest rates offered

what are bonds? what are the factors they are sold at? what happens if the repayment terms are violated?

Bonds are securities that represent debt owed by the issuer to the investor, and typically have specified payments on specific dates — Coupon Rate — Par/Face/Maturity Value — If repayment terms are violated, bond owner has claim against assets of bond issuer

Characteristics of corporate bonds: bond indenture: 2 Registered bonds: 3 Restrictive Covenants: 3

Characteristics of Corp Bonds > Bond Indenture — Outlines lender's rights and borrowers obligations — Describes collateral (if any) > Registered Bonds — No physical coupons to mail in, must register to receive interest payments ─ Replaced "bearer"bonds, which had physical coupons ─ IRS can track interest income this way > Restrictive Covenants ─ Mitigates conflicts with shareholder interests, protects bondholders ─ May limit dividends, new debt, ratios, etc. ─ Usually includes a cross-default clause

Characteristics of corporate bonds: call provisions- what are they? why? what is this a mechanism for? what must the firm do every year? What does it reduce? what is it a loophole to? who is it in the interest of? suppose theres a new NPV project with a huge return, but requires issuing new debt when existing debt does not allow issuance-- what does the company do? what does issuing a call do to capital structure? what kind of yield is required for calls? what is the typical call price? how much do interest rates have to adjust in order for a bond to be called?

Characteristics of Corp Bonds > Call Provisions: Require holder to sell back bond — Why? - If interest rates fall, company wishes to refinance ─ Mechanism to adhere to a sinking fund provision ─ Firm must repurchase a portion of debt every year ─ Reduces default probability ─ Loophole to avoid restrictions ─ Interest of the stockholders ─ New NPV project with huge return, but requires issuing new debt when existing debt does not allow issuance (so they issue call provisions) ─ Altering Capital Structure ─ Higher required yield, bondholders do not like this, Sam I am! ─ Call price is typically = Face Value + 1 Year of Coupons ─ Interest rates have to adjust a fair amount for bond to be called

Corporate bonds: what is their typical face value? when do they pay interest? when can they be redeemed? what is the degree of risk? how does the health of the company effect risk and interest rate demand?

Corporate Bonds > Typically have a face value of $1,000, although some have a face value of $5,000 or $10,000 > Pay interest semi-annually > Cannot be redeemed anytime the issuer wishes, unless a specific clause states this (call option) > Degree of risk varies with each bond, even from the same issuer — Health of company varies through time, so risk of company shifts and interest rate demanded varies proportionally

what is the cutoff point when referencing bond ratings?

Cutoff point occurs between Baa (BBB) and Ba (BB)

what do investors care about?

Investors care about the money they get to keep after taxes

what are the two money market cost advantages? what is the glass steagall act of 1933

Money Market Cost Advantages > Reserve Requirements — Apply to banks — Do not apply to money markets > Restrictions on interest — Glass-Steagall Act of 1933 placed limits on the rate of interest that banks could pay to depositors (savers). The high interest rates of the 1970s and 1980s allowed money market accounts (which are similar to bank accounts) to pay substantially higher rates of interest, and so money poured into the money markets

Money Market Mutual Funds: when were new rules made? what must prime and municipal funds distinguish between? based off of what? what do institutional prime and municipal funds HAVE to have now? What are their prices? which two prices are pegged?

Money Market Mutual Funds > New rules, Oct 2016 > Prime and Municipal funds must distinguish between Retail and Institutional fund types based on ownership > Institutional prime and municipal funds must now have floating NAV (not pegged to $1) — Prices of these funds fluctuate — Retail still pegged, as are Treasury MMMFs

why do municipal bonds grant more of an advantage to wealthy individuals?

Municipal bonds grant more of an advantage to wealthy individuals, because they have higher marginal tax rates

what does raising taxes for the wealthy actually mean?

Note that raising taxes on the wealthy doesn't mean they pay more in taxes, it means they shift to tax free securities!

what does research suggest about yield curves accuracy relative to time?

Research suggests the yield curves give relatively accurate information about future short term and long term interest rates, but are unreliable for intermediate term rates

What happened on September 16th during the financial crisis?

Reserve Fund breaks the buck — MMMFs traded with a Net Asset Value pegged to $1 because the investments did not produce capital gains/losses — Massive losses or overuse of leverage could result in MMMFs "breaking the buck" or falling below a Net Asset Value of $1 — $65B fund that had suffered losses of $785 million from Lehman's bankruptcy - Triggers a "run" on commercial paper - $172 billion in redemptions between 9/16 and 9/19

what are rising interest rates often associated with? what do inverted yield curves signal?

Rising interest rates are often associated with Economic Booms — The Fed tries to stem the tide of inflation from the Boom cycle by raising interest rates — Inverted yield curves may signal recessions (because interest rates are expected to fall)

What happened on October 26th during the financial crisis?

The Federal Reserve begins purchasing commercial paper — Market stabilizes, because Fed provides liquidity — By January, Fed owned 22.4% of commercial paper outstanding

what is a risk premium?

The interest rate spread between default free bonds and bonds with default risk (and otherwise identical characteristics

what is liquidity?

The property that a security can quickly and easily be converted to cash

for treasury bond interest rates, is there default risk? what kind of interest rates do they have? are they risk free? why? what factors go into that? which market usually has lower rates? what kind of maturitis & default risk does this market have? what types of risk does it have less of? or shifts in rates?

Treasury Bond Interest Rates > No default risk since the Treasury can print money to payoff the debt > Very low interest rates, often considered the risk-free rate — Not truly risk free - Inflation - Interest Rate Risk and Reinvestment Risk > Money market rates are usually lower — Shorter term to maturity, so default risk is low — Less risk of inflation or interest rate shifts

what is a default?

When a borrower cannot make payments on its debt on time

what did owners of ACBP's do when mortgage defaults started rising in the financial crisis?

When mortgage defaults started rising, owners of ABCP worried that the collateral securing their loans was worthless. Without FDIC to secure the value of the commercial paper itself, investors attempted to sell rapidly, which led to firesale prices

why do we need capital markets?

Why do we need Capital Markets? > Banks and Money Markets provide short term financing — Easy to obtain — Short term interest rates < long term interest rates

Bonds with __________ risk will always have a risk ___________. premiums increase when? who must be compensated? when do interest rates rise?

default risk, risk premium — Premium increases as default risk increases - Investors must be compensated — Interest rates rise as default risk increases

what does the shape of a yield curve help us with?

expected inflation

all treasury bonds are default risk free, except... what are they exempt from? what does this do to their rates?

municipal bonds. — Are tax exempt and rates therefore may be lower than default risk free securities even though "munis" sometimes default - Though very infrequently

What are Treasury Inflation-Indexed Securities: (tips)

the principal amount is tied to the current rate of inflation to protect investor purchasing power

what are Treasury Inflation-Indexed Securities? what are treasury STRIPS?

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

why were mortgage companies an easy target for being responsible for the financial crisis?

they cant publicly defend themselves

When we compare yields for bonds with differing maturities, but identical levels of default risk, liquidity, and income tax considerations, we are examining a ____________

yield curve

> Three types of t-bills, what are their maturities

— 1) T-Bills: <1 year maturities- 4, 13, 26, 52 week maturities — 2) T-Notes: 1-10 year maturities- 2, 3, 5, 7, 10 year maturities are most common — 3) T-Bonds: 10+ year maturities- Typically 20 and 30 years

What are Bankers Acceptances? when are these most common? what do they trade at?

— 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 - BA is bought, money goes to bank, bank delivers to seller once goods are delivered — Common when buyer and seller operate in different legal environments and the value of the object in question is large - Especially if seller does not wish to extend credit and buyer does not want to pay before delivery — Traded at a discount

waht default free bonds?

— Bonds with no risk of default — Traditionally US government securities - 1995-1996 and 2011-2013, not so much

in the real world, what did bush do to taxes?

— Bush Tax Cuts - Lowered the tax rate on wealthy people from 39% to 35% - Munis provide less of a benefit, demand for non-muni bonds increases - After tax rate on corp or Treasury bonds has risen while rate on munis stays constant

what are junk/speculative bonds? what do they typically have?

— Considered riskier investments - Have higher yields

what are investment grade bonds?

— Considered safer investments because default risk is lower — Many institutions are only allowed to invest in "Investment grade" securities - Some may only invest in AAA bonds

capital market participants-

— Corporations: Debt and Equity issuers - Distribution of financing from debt vs. equity is the firm's capital structure decision - Important source of financing - Collapse of stock and bond markets killed sources of funds for firms in 2008, wrecking the economy

who measures the risk of default?

— Credit Rating Agencies - Moody's, Fitch, Standard and Poor's

what did credit rating agencies do during the financial crisis to many CDO's?

— Credit rating agencies gave their highest rating (AAA or Aaa) to many CDOs - Including more then $3T worth of mortgages for people with bad credit and undocumented income - Hundreds of billions would later be downgraded to junk bond status - Half a trillion lost as a result

The interest rate demanded for a given level of risk for a bond depends on 3 things (holding time to maturity constant)

— Default Risk — Liquidity — Income Taxes

Bonds: Yields > For actual yield to maturity of a bond, what do you do? When bond price > face value, YTM < coupon rate what is this called? When bond price < face value, YTM > coupon rate, what is this called? When bond price = face value, what is the coupon rate? what is YTM?

— Educated guess and check -premium -discount - ytm= coupon rate YTM is the discount rate that equates the PV of all bond cash flows to the price of the bond

what is the term structure of interest rates?

— Explains why bonds with different maturities have different yields - Expectations - Market Segmentation - Liquidity Premium

what is the risk structure of interest rates?

— Explains why bonds with the same term to maturity have different yields - Default Risk - Liquidity - Income Taxes

> Agency Problems what is the issue with firms who have 100% debt? What kind of power do bondholders have? what does having owners provide a group with? what can a firm do to align managers incentives?

— Firms with 100% debt have no one to monitor - Bondholders do some via covenants, but have little power over the manager in most circumstances - Having owners provides a group with incentives to monitor firm performance - Can issue stock to managers to align their incentives

what do investors value? why?

— If a quick exit is needed, more likely to get full value -liquidity

what is expected inflation?

— Inflation is the economy-wide shift in prices

what is a spot rate?

— Interest rates we observe currently for given maturities

> Michael Milken and Drexel Burnham Lambert (IB) -when would investors take on higher risks? -what did they assume the role as? -how did they know traders were more likely to participate? -what did they acts as? to reduce what? -what did they do with debts? credits?

— Many investors would take on higher risk if rates reflected it — Assumed role as market maker for junk bonds to increase liquidity - Traders more likely to participate if they know they can get in and out — Acted as commercial bank with junk bond issuers to reduce probability of default and total loss - Renegotiate debts or advance credit

what are the Drawbacks of ECNs? 3

— Not good for low liquidity stocks (thinly-traded) — Lots of ECNs, all competing for volume, can be confusing — Provide direct competition for major exchanges, which introduces uncertainty, which markets do not like

why are STRIPS POPULAR? 7

— Popularity - Risk free - Cheap (sold at discount) - Low uncertainty if held to maturity - No Reinvestment Risk - Multiple maturities - 401(k) eligible - Active secondary market

how were ratings during the financial crisis?

— Ratings on collateralized debt obligations (such as mortgage backed securities) were less accurate

what are nominal interest rates made up of?

— Real interest rate — Expected Inflation

what are treasury STRIPS?

— Separate Trading of Registered Interest and Principal of Securities — Coupons and principal sold separately as individual zero coupon bonds - Sold at a discount

what is a forward rate?

— The expected interest rate on a given maturity at some date in the future

Money market characteristics: what denominations are money markets usually sold in? ($ amount)? what kind of markets does this classify them as? what kind of default risk do they have? if they dont go bankrupt today, what will likely happen tomorrow? what is their maturity term?

— Usually sold in large denominations ($1M+), which classifies them as wholesale markets — Low default risk - Intuitively, if a company isn't bankrupt today, they are not likely to be bankrupt tomorrow — Mature in one year or less from issue date