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repurchase the
be 30 days or more. Repos are considered very safe in terms of credit risk because the loans
securities at a higher
are backed by the government securities. A reverse repo is the mirror image of a repo. Here,
price.
the dealer finds an investor holding government securities and buys them with an agreement
to resell them at a specified higher price on a future date.

Brokers™ Calls
Individuals who buy stocks on margin borrow part of the funds to pay for the stocks from their
broker. The broker in turn may borrow the funds from a bank, agreeing to repay the bank im-
mediately (on call) if the bank requests it. The rate paid on such loans is usually about one per-
centage point higher than the rate on short-term T-bills.


Federal Funds
Just as most of us maintain deposits at banks, banks maintain deposits of their own at the Fed-
eral Reserve Bank, or the Fed. Each member bank of the Federal Reserve System is required
to maintain a minimum balance in a reserve account with the Fed. The required balance de-
pends on the total deposits of the bank™s customers. Funds in the bank™s reserve account are
called Federal funds or Fed funds. At any time, some banks have more funds than required Federal funds
at the Fed. Other banks, primarily big New York and other financial center banks, tend to have Funds in the accounts
a shortage of Federal funds. In the Federal funds market, banks with excess funds lend to those of commercial banks
with a shortage. These loans, which are usually overnight transactions, are arranged at a rate at the Federal Reserve
Bank.
of interest called the Federal funds rate.
While the Fed funds rate is not directly relevant to investors, it is used as one of the barom-
eters of the money market and so is widely watched by them.


The LIBOR Market
The London Interbank Offer Rate (LIBOR) is the rate at which large banks in London are LIBOR
willing to lend money among themselves. This rate has become the premier short-term interest Lending rate among
rate quoted in the European money market and serves as a reference rate for a wide range of banks in the London
transactions. A corporation might borrow at a rate equal to LIBOR plus two percentage points, market.
for example. Like the Fed funds rate, LIBOR is a statistic widely followed by investors.
Bodie’Kane’Marcus: I. Elements of Investments 2. Global Financial © The McGraw’Hill
Essentials of Investments, Instruments Companies, 2003
Fifth Edition




30 Part ONE Elements of Investments




5.0
OPEC I
4.5

4.0

3.5 OPEC II
Percentage points




Penn
3.0
Square
2.5
Market
2.0 Crash
LTCM
1.5

1.0

0.5

0
1970 1975 1980 1985 1990 1995 2000




F I G U R E 2.2
Spread between three-month CD and T-bill rates



Yields on Money Market Instruments
Although most money market securities are of low risk, they are not risk-free. As we noted
earlier, the commercial paper market was rocked by the Penn Central bankruptcy, which pre-
cipitated a default on $82 million of commercial paper. Money market investments became
more sensitive to creditworthiness after this episode, and the yield spread between low- and
high-quality paper widened.
The securities of the money market do promise yields greater than those on default-free
T-bills, at least in part because of greater relative riskiness. Investors who require more liq-
uidity also will accept lower yields on securities, such as T-bills, that can be more quickly and
cheaply sold for cash. Figure 2.2 shows that bank CDs, for example, consistently have paid a
risk premium over T-bills. Moreover, that risk premium increases with economic crises such
as the energy price shocks associated with the Organization of Petroleum Exporting Countries
(OPEC) disturbances, the failure of Penn Square Bank, the stock market crash in 1987, or the
collapse of Long Term Capital Management in 1998.


2.2 THE BOND MARKET
The bond market is composed of longer-term borrowing or debt instruments than those that
trade in the money market. This market includes Treasury notes and bonds, corporate bonds,
municipal bonds, mortgage securities, and federal agency debt.
These instruments are sometimes said to comprise the fixed-income capital market, be-
cause most of them promise either a fixed stream of income or stream of income that is deter-
mined according to a specified formula. In practice, these formulas can result in a flow of
Bodie’Kane’Marcus: I. Elements of Investments 2. Global Financial © The McGraw’Hill
Essentials of Investments, Instruments Companies, 2003
Fifth Edition




31
2 Global Financial Instruments




F I G U R E 2.3
Listing of Treasury
issues
Source: From The Wall
Street Journal, October 19,
2001. Reprinted by
permission of Dow Jones &
Company, Inc. via
Copyright Clearance Center,
Inc. © 2001 Dow Jones &
Company, Inc. All Rights
Reserved Worldwide.




income that is far from fixed. Therefore, the term “fixed income” is probably not fully appro-
priate. It is simpler and more straightforward to call these securities either debt instruments or
bonds.


Treasury Notes and Bonds
The U.S. government borrows funds in large part by selling Treasury notes and bonds. Treasury notes or
T-note maturities range up to 10 years, while T-bonds are issued with maturities ranging from bonds
10 to 30 years. The Treasury announced in late 2001 that it would no longer issue bonds with Debt obligations of
maturities beyond 10 years. Nevertheless, investors often refer to all of these securities col- the federal
lectively as Treasury or T-bonds. They are issued in denominations of $1,000 or more. Both government with
original maturities of
bonds and notes make semiannual interest payments called coupon payments, so named be-
one year or more.
cause in precomputer days, investors would literally clip a coupon attached to the bond and
present it to an agent of the issuing firm to receive the interest payment. Aside from their dif-
fering maturities at issuance, the only major distinction between T-notes and T-bonds is that T-
bonds may be callable during a given period, usually the last five years of the bond™s life. The
call provision gives the Treasury the right to repurchase the bond at par value. While callable
T-bonds still are outstanding, the Treasury no longer issues callable bonds.
Figure 2.3 is an excerpt from a listing of Treasury issues in The Wall Street Journal. The
highlighted bond matures in August 2009. The coupon income or interest paid by the bond is
6% of par value, meaning that for a $1,000 face value bond, $60 in annual interest payments
will be made in two semiannual installments of $30 each. The numbers to the right of the
colon in the bid and ask prices represent units of 1„32 of a point.
Bodie’Kane’Marcus: I. Elements of Investments 2. Global Financial © The McGraw’Hill
Essentials of Investments, Instruments Companies, 2003
Fifth Edition




32 Part ONE Elements of Investments


The bid price of the highlighted bond is 110 6„32, or 110.1875. The ask price is 110 9„32, or
110.28125. Although bonds are sold in denominations of $1,000 par value, the prices are
quoted as a percentage of par value. Thus, the ask price of 110.28125 should be interpreted as
110.28125% of par or $1,102.8125 for the $1,000 par value bond. Similarly, the bond could
be sold to a dealer for $1,101.875. The 3 change means the closing price on this day fell 3„32
(as a percentage of par value) from the previous day™s closing price. Finally, the yield to ma-
turity on the bond based on the ask price is 4.43%.
The yield to maturity reported in the last column is a measure of the annualized rate of re-
turn to an investor who buys the bond and holds it until maturity. It is calculated by determin-
ing the semiannual yield and then doubling it, rather than compounding it for two half-year
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 as an effective annual yield. The APR
method in this context is also called the bond equivalent yield. We discuss the yield to matu-
rity in detail in Chapter 9.

Federal Agency Debt
Some government agencies issue their own securities to finance their activities. These agen-
cies usually are formed for public policy reasons to channel credit to a particular sector of
the economy that Congress believes is not receiving adequate credit through normal private
sources. Figure 2.4 reproduces listings of some of these securities from The Wall Street
Journal.
The major mortgage-related agencies are the Federal Home Loan Bank (FHLB), the Fed-
eral National Mortgage Association (FNMA, or Fannie Mae), the Government National Mort-
gage Association (GNMA, or Ginnie Mae), and the Federal Home Loan Mortgage Corporation
(FHLMC, or Freddie Mac).
Freddie Mac, Fannie Mae, and Ginnie Mae were organized to provide liquidity to the mort-
gage market. Until establishment of the pass-through securities sponsored by these govern-
ment agencies, the lack of a secondary market in mortgages hampered the flow of investment



F I G U R E 2.4
Listing of government
agency securities
Source: From The Wall Street
Journal, October 19, 2001.
Reprinted by permission of
Dow Jones & Company, Inc.
via Copyright Clearance
Center, Inc. © 2001 Dow
Jones & Company, Inc. All
Rights Reserved Worldwide.
Bodie’Kane’Marcus: I. Elements of Investments 2. Global Financial © The McGraw’Hill
Essentials of Investments, Instruments Companies, 2003
Fifth Edition




33
2 Global Financial Instruments


funds into mortgages and made mortgage markets dependent on local, rather than national,
credit availability. The pass-through financing initiated by these agencies represents one of the
most important financial innovations of the 1980s.
Although the debt of federal agencies is not explicitly insured by the federal government,
it is assumed the government will assist an agency nearing default. Thus, these securities are
considered extremely safe assets, and their yield spread over Treasury securities is usually
small.


<
1. Using Figures 2.3 and 2.4, compare the yield to maturity on one of the agency Concept
bonds with that of the T-bond with the nearest maturity date.
CHECK

International Bonds
Many firms borrow abroad and many investors buy bonds from foreign issuers. In addition to
national capital markets, there is a thriving international capital market, largely centered in
London, where banks of over 70 countries have offices.
A Eurobond is a bond denominated in a currency other than that of the country in which it
is issued. For example, a dollar-denominated bond sold in Britain would be called a Euro-
dollar bond. Similarly, investors might speak of Euroyen bonds, yen-denominated bonds sold
outside Japan. Since the new European currency is called the euro, the term Eurobond may be
confusing. It is best to think of them simply as international bonds.
In contrast to bonds that are issued in foreign currencies, many firms issue bonds in for-
eign countries but in the currency of the investor. For example, a Yankee bond is a dollar-
denominated bond sold in the U.S. by a non-U.S. issuer. Similarly, Samurai bonds are
yen-denominated bonds sold in Japan by non-Japanese issuers.


Municipal Bonds
Municipal bonds (“munis”) are issued by state and local governments. They are similar to municipal bonds
Treasury and corporate bonds, except their interest income is exempt from federal income tax- Tax-exempt bonds
ation. The interest income also is exempt from state and local taxation in the issuing state. issued by state and
Capital gains taxes, however, must be paid on munis if the bonds mature or are sold for more local governments.
than the investor™s purchase price.
There are basically two types of municipal bonds. These are general obligation bonds,
which are backed by the “full faith and credit” (i.e., the taxing power) of the issuer, and rev-
enue bonds, which are issued to finance particular projects and are backed either by the rev-
enues from that project or by the municipal agency operating the project. Typical issuers of
revenue bonds are airports, hospitals, and turnpike or port authorities. Revenue bonds are
riskier in terms of default than general obligation bonds.
A particular type of revenue bond is the industrial development bond, which is issued to fi-
nance commercial enterprises, such as the construction of a factory that can be operated by a
private firm. In effect, this device gives the firm access to the municipality™s ability to borrow
at tax-exempt rates.
Like Treasury bonds, municipal bonds vary widely in maturity. A good deal of the debt is-

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