Securities Analysis 3FB3 February 25 , 2014
Chapter 2: Financial Markets and Instruments
2.1 The Money Market
The money market is a subsector of the fixedincome market. It consists of ST debt securities
that usually are highly marketable. Many of these securities trade in high denominations so they
are out of reach of individual investors. However, money market funds (mutual funds) are easily
accessible to small investors.
Treasury bills (tbills) are the most marketable of all Canadian money market instruments.
Simplest form of borrowing, government raises money by selling bills to public. At maturity,
holder receives a payment equal to FV from government. The difference in purchase price and
maturity value constitute investor’s earnings.
Tbills with initial maturities of 3, 6, 12 months are issued biweekly. Sales are conducted by
auction where chartered banks and authorized dealers can submit only competitive bids. A
competitive bid is a an order for a given quantity of bills at a specific offered price. Order is
filled only if the bid is high enough relative to other bids to be accepted.
Noncompetitive bid is an unconditional offer, such bids can be submitted only for bonds.
They are purchased by charted banks, investment deals, Bank of Canada, and individuals who
get them on secondary market. They are highly liquid. Offered in denominations of $1000,
$5000, $25000, $100000, and $1 million.
Certificates of Deposit and Bearer Deposit Notes
Certificate of deposit – time deposit with a chartered bank. They may not be withdrawn on
demand. Bank pays interest and principal to depositor at end of fixed term. A similar time deposit
for smaller amount is a guaranteed investment certificate (GIC).
These are nontransferable, unless over $100,000, then negotiable.
Bearer deposit notes (BDNs) are these marketable CDs.
Commercial paper is when large well known companies issue their own ST unsecured debt
notes, instead of borrowing from banks. Usually backed by a bank line of credit. Maturities range
up to one ear, longer maturities would require registration under the Ontario Securities Act.
Usually under one or two months and minimum denominations of $50,000. Considered a fairly
BA’s start as an order to a bank by a bank’s customer to pay a sum of money at a future date,
typically within 6 months. Similar to postdated cheque. In return for a stamping fee, bank
endorses order for payment and assumes responsibility for ultimate payment to holder of the
acceptance, making it second only to tbills in terms of default security. Can now be traded in
secondary markets. Acceptances sell at a discount from the face value of the payment order, just
as Tbills sell at a discount from pay value, with a similar calculation for yield.
Eurodollars [Type text] [Type text] [Type text]
Eurodollars are US dollar denominated deposits at foreign banks or foreign branches of
American banks. Most Eurodollar deposits are for large sums, most are time deposits of less than
six months. A variation on the Eurodollar time deposit is the Eurodollar certificate of deposit. A
Eurodollar CD resembles a US domestic bank CD, except it is the liability of a non US branch of
a bank (typically London branch). The advantage of Eurodollar CDs over Eurodollar time
deposits is that the holder can sell the asset to realize its cash value before maturity. Eurodollar
CDs are less liquid and riskier than US CDs, thus offer a higher yield. Firms also issue
Eurodollar bonds, dollar denominated bonds in Europe, but bonds are not a money market
investment because of their long maturities!!
*Money market items have short maturities, thus a bond isn’t in the money market*
Eurocurrency: instruments denominated in all major currencies when located outside the country
of currency. I.e. euroCanadian dollars, when issued in Canadian dollar denominations.
Repos and Reverses
Dealers in government securities use repurchase agreements (repos or RPs) as a form of ST,
usually overnight borrowing.
A term repo is essentially an identical transaction, except that the term of the implicit loan can be
30 days or more. Repos are considered very safe in terms of credit risk, because loans are backed
by government securities. A reverse repo is when the dealer finds an investor holding
government securities and buys them, agreeing to sell them back at a specified higher price on a
Brokers’ Call Loans
People buy stocks on margin and thus borrow part of funds to pay for stocks from broker, broker
in turn borrows the funds from bank, agreeing to repay immediately on call, if bank requests it.
Rate paid on these loans is usually closely related to rate on ST tbills.
The LIBOR Market
The London Interbank Offered Rate (LIBOR) is the rate at which large banks in London are
willing to lend money among themselves. Become the premier ST interest rate quoted in
European money market.
Yields on Money Market Instruments
Most money market securities are low risk, but not risk free.
Tbill yields are not quoted in the financial pages as effective annual rates of return. Instead, the
bond equivalent yield is used.
$1000 par value Tbill sold at $960 with a maturity of halfyear, 182 days.
$40 * (360/182) = $80.22
$80.22 / $960 = bond equivalent yield of 8.356 percent per year
The bond equivalent yield is not an accurate measure of the effective annual rate of return.
Halfyear holding period return on bill: 4.17 percent
40/960 = 0.0417
The compound interest annualized rate of return, or effective annual yield is therefore:
(1.0417) – 1 = .0851 = 8.51% Securities Analysis 3FB3 February 25 , 2014
We can highlight the source of the discrepancy between the bond equivalent yield and the
effective annual yield by examining the bond equivalent yield formula
rBEY = (1000 – P / P) * (365 / n)
P is bond price, n is maturity of the bill in days
The annualization technique uses simple interest rather than compound interest, multiplication by
365/n does not account for the ability to earn interest on interest, which is the essence of
The quoted yields for US Tbills use a formula similar. The resulting yield is known as the bank
discount yield. Part of the difference in yields between Canadian and US bills can be attributed
to the method of quoting yields. A convenient formula relating the bond equivalent yield to the
bank discount yield is
R BEY = (365 * d) / 360 – ( d * n)
Where d is the discount yield.
To find true market price of a bill, when give three months Tbill BEY, rearrange first equation:
P = 1000 / [1+r BEY * (n/365)]
This first deannualizes the BEY to obtain the actual proportional interest rate, then discounts the
pay value of 1000 to obtain sale price.
The BEY is the bill’s yield over its life, assuming it is purchased for auction bid price and
annualized using simple interest techniques. This yield uses a simple interest procedure to
annualize, known as annual percentage rate (APR)
2.2 The Bond Market
Bond market is composed of longer term borrowing instruments. This includes Government of
Canada bonds, provincial and municipal bonds, corporate bonds, and mortgage securities. Bonds
can be callable, this allows the issuer to redeem the bond at par value, or at a stated premium
prior to maturity. These instruments are sometimes said to make up the fixed income capital
market, because most of them promise either a fixed stream of income or a stream of income
determined according to a specific formula. More straightforward to call these securities either
debt instruments or bonds.
Government of Canada Bonds
Nonmarketable securities are known as Canada Savings Bonds (CSBs) or Canada Premium
Bonds (CPBs), issued every year starting Nov 1. They bear little interest rate risk. The CSBs are
perfectly liquid, can be cashed any time prior to maturity at FC plus accrued interest. CPBs can
only be cashed in Nov of succeeding years, so somewhat like 365 day deposits.
Government of Canada bonds, Canadas, or Canada bonds, are longerterm marketable debt
securities issued by the federal government. Varying maturities, up to 40 years. Considered part
of money market when term is less than three years!
Canada bonds are generally noncallable and make semiannual coupon payments.
Yield to maturity is calculated by determining the semiannual yield and then doubling it, rather
than compounding it for two halfyear periods. This use of a simple interest technique to
annualize means that the yield is quoted on an annual percentage rate (APR) basis, rather than an
effective annual yield. The APR method in this context is also called the BEY.
Current yield = Annual coupon income / price [Type text] [Type text] [Type text]
Provincial and Municipal Bonds
These are considered extremely safe assets, even though not as safe as comparable Canada
bonds. Thus, a small yield spread can be observed in the figure between Canada bonds and
provincial bonds, as well as between the bonds of various provinces.
US municipal bonds are exempt from federal income tax and from state and local tax in the
issuing state. Thus, quoted yield is an aftertax yield. This explains why the quoted yields on
municipals are lower than the quoted (beforetax) yields on other, comparable bonds.
Tax advantage is not available to Canadian investors, so US municipal bonds would not be
Corporate bonds enable private firms to borrow money directly from the public. These are
similar in structure to government issues, but differ in terms of degree of risk. Default risk is a
real consideration in corporate bonds. Secured bonds have a specific collateral back them in the
event of a firm bankruptcy, unsecured bonds are called debentures and have no collateral, and
subordinated debentures have a lowerpriority claim to the firm’s assets in the event of
Corporate bonds usually come with options attached. Callable bonds give the firm the option to
repurchase the bond from the holder at a stipulated call price. Retractable and extendible bonds
give the holder the option to redeem the bonds earlier and later than the stated maturity date.
Convertible bonds give the bondholder the option to convert each bond into a stipulated number
of shares of stock.
A Eurobond is a bond denominated in a currency other than that of the country in which it is
issued. I.e. Euroyen bonds ▯yendenominated bonds sold outside Japan. Think simply as
international bond. Many firms also issue bonds in foreign countries in currency of investors, i.e.
yankee bond is a dollardenominated bond sold in US by nonUS issuer. I.e. Samurai bonds are
yendenominated bonds sold in Japan by nonJapanese issuers.
Mortgages and MortgageBacked Securities
Variable rate mortgage – require the borrower pay an interest rate that varies with some
measure of the current market interest rate. This contract shifts the risk of fluctuations in interest
rates from the lender to the borrower.
Banks are willing to offer lower rates on variable rate mortgages than on conventional fixedrate
A mortgage backed security (MBS) is either an ownership claim in a pool of mortgages or an
obligation secured by such a pool. Mortgage lenders originate loans and then sell packages of
these loans in the secondary market. MBSs are called passthroughs. MBSs can be traded like
any other bond, the cash flow can be considered risk free, even if individual borrowers default on
their mortgages, because the National Housing Act (NHA) ensures the timely payment of
principal and interest.
However, they do not guarantee the rate of return.
2.3 Equity Securities
Common Stock as Ownership Shares th
Securities Analysis 3FB3 February 25 , 2014
Common stocks, equity securities, or equities, represent ownership shares in a corporation.
Members of BOD are elected at annual meeting. Shareholders who do not attend the annual
meeting can vote by proxy, empowering another party to vote in their name.
Several mechanisms to alleviate agency problems: compensation schemes that link success of
manager to that of firm, oversight by the BOD and outsiders like security analysis, the threat of a
proxy contest in which unhappy shareholders attempt to replace current management team, and
threat of takeover by another firm.
Special type of common stock, restricted shares, have no voting rites, or only restricted coting
rights, but otherwise participates fully in the financial benefits of share ownership. They
sometimes carry different financial benefits for their holders. They also have some legal
protection in case of tender offers.
A corporation whose stock is not publicly traded is said to be closely held. Here, owners of firm
also take an active rol