Chapter 03 - How Securities Are TradedChapter Three How SECU.docx

Chapter 03 - How Securities Are Traded
Chapter Three
How SECURITIES Are TradedCHAPTER OVERVIEW
This chapter discusses how securities are traded on both the
primary and secondary markets, with detailed coverage of both
organized exchange and over the counter activities. Margin
trading and short selling are discussed along with detailed
examples of margin arrangements. The chapter discusses
elements of regulation and ethics issues associated with security
transactions.LEARNING OBJECTIVES
After studying this chapter the student should have considerable
insight as to how securities are traded on both the primary and
secondary markets. The student should understand the
mechanics, risk, and calculations involved in both margin and
short trading. The student should begin to understand some of
the implications, ambiguities, and complexities of the regulation
of securities markets.Presentation of Material
3.1 How Firms Issue Securities
Key characteristics of primary and secondary sales of securities
are presented here. The relationship between the primary
market terms and activity in the secondary market presents a
good opportunity for class discussion and relating the material
in the investment class to principles of finance.
Investment banking involves the sale of new issues of securities
to investors; Figure 3.1 shows the relationship between parties
involved in an underwritten offering. Shelf registrations allow
a firm that is regularly reporting to sell a limited amount of new
stock without going through a registered public offering. This
allows a firm more flexibility in selling additional shares.
Private placements allow a firm to sell securities without going

through a registered public offering. While most stock
offerings employ public offerings, many issues of debt are
completed using private placements. It is useful to discuss
differences in the markets for equity and bond when discussing
this material. Bond markets are dominated by financial
institutions and many of the special characteristics of bond
issues lend themselves to private placements. In some years the
volume of private placements exceeds public offerings of
corporate bond issues.
When a company sells securities to the general investing public
for the first time, the transaction is referred to as an Initial
Public Offering (IPO). The underwriting firms commonly
underprice IPOs leading to significant short-term performance
for some investors.
3.2 How Securities Are Traded
This section presents the major types of secondary markets.
The discussion of secondary markets should be focused on
services rather than institutional characteristics of our markets.
Discussion of different demands for services by different types
of investors can help students understand the recent
developments in our markets.
Orders for transactions in securities have different priorities.
Market orders are to be executed immediately at current market
prices. Price-Contingent Orders place price as the first priority.
Once a target price is reached, a price-contingent order becomes
a market order. Students should be familiar with Figure 3.5 and
understand the uses of each of these price-contingent orders.
The section continues with a discussion on the organization of
markets that facilitate trade. In specialists markets, a dealer is
charged to make an orderly market. The specialist is granted a
monopoly position and is highly regulated. A dealer market
features competition among dealers to make the market
efficient. Electronic Communication Networks (ECNs) allow

electronic interface among traders that bypasses the traditional
dealership function.
3.3 The Rise of Electronic Trading
This section discusses how the interaction of new technologies
and new regulations lead to electronic trading. In 1975, the
NYSE eliminated fixed commissions and National Market
System was created in the attempt to centralize trading across
exchange and enhance competition. The new order-handling
rules in 1994 on NASDAQ lead to narrower bid-ask spreads;
1997 and 2001 introduced the drop in the minimum tick size
from one-eighth to one-sixteenth, and to 1 cent, respectively.
Figure 3.6 illustrated the effect of minimum tick size on the
effective spread. In 2000, NASDAQ Stock Market emerged. In
2006 NYSE was renamed to NYSE Arca after acquiring the
electronic Archipelago Exchange. 2007 marked the creation of
National Market System (NMS) to link exchanges
electronically. Overall, the share of electronic trading in the US
rose from 16% to 80% in 2000s.
3.4 U.S. Markets
The domestic securities markets have undergone significant
reorganization and restructuring since the mid-1970s. For
example a major component of today’s market includes the
Nasdaq market system that links dealers, organized exchanges
and ECNs. Listing requirements on the NYSE and Nasdaq are
significantly different. The NYSE requires much larger market
value of shares in the hands of the public.
3.5 New Trading Strategies
This section presents new trading strategies that came into play
after the development of the electronic trading. Algorithmic
Trading uses computer programs to make trading decisions.
High-Frequency Trading employs special class of
algorithmic with very short order execution time. Dark Pools
are the trading venues that preserve anonymity, mainly relevant

in block trading. Special place in the OTC market takes Bond
Trading among bond dealers, with NYSE Bonds being the
largest centralized bond market of any U.S. exchanges.
3.6 Globalization of Stock Markets
Figure 3.8 demonstrates the biggest stock markets in the world
by domestic market capitalization, with NYSE-Euronext being
by far the largest equity market. The section discusses the
widespread trend to form international and local alliances and
mergers. Some of the examples include NYSE’s acquisition of
Archipelago (ECN), American Stock Exchange, and the merger
with Euronext; acquisition of Instinet/INET (ECN), Boston
Stock Exchange, and merger with OMX by NASDAQ to form
NASDAQ OMX Group.
3.7 Trading Costs
On some trades only a commission is paid; on others, only a
portion of the spread is paid; and many trades require both a
commission and a portion of the spread are paid. This point can
be made by contrasting orders on both listed and OTC stocks.
While the payment of a portion of the spread is not actually
reported, the concept is important when considering the total
cost of trading.
3.8 Buying on Margin
This section introduces margin trading. The use of actual
borrowing of funds contrasts with margin arrangement in
futures. While both futures and stock trading have maintenance
margins and margin calls which are similar, the costs of
borrowed funds must be factored into analysis of the returns of
stock margin trading. The degree of leverage available in
equities is set by the Federal Reserve Board and is far less than
is available in futures.
A sample margin trade is used to develop the concepts of
margin call and maintenance margin. The student’s

understanding of the concept is helped by explicit treatment of
the accounting for the problem using assets = liabilities +
equity. The initial position shows a 60% initial margin on a 100
share purchase of a stock that is selling for $100 per share. If
the stock drops to $70 as depicted in the example, the equity
falls to $3,000. The margin call price is then developed.
3.9 Short Sales
With the background developed in margin trading, the concept
of short selling is then covered. A brief description of the
mechanics of a short sale is shown here. While stock is
generally available for short sellers, sometimes short sellers are
not able to find additional stock to borrow when stock is called
back from loan. If the short seller is not able to find other stock
to borrow in that situation, he may be forced to close out her
position.
A sample calculation of margin, maintenance margin and margin
calls is developed for a short sale. The short sale involves 1000
shares of a stock that has an initial price of $100 with the
maintenance margin of 30%. The example works through
calculation of the margin position when the stock price rises to
$110. The amount borrowed and owed is no longer constant
with a short sale. The amount owed is actually equal to number
of shares shorted time the current price. The amount owed is
subtracted from the original sale proceeds plus the customer’s
margin to determine the equity. With a 30% maintenance
margin, the short seller will receive a margin call if the stock
price rises above $115.38.
3.10 Regulation of Securities Markets
Recent scandals have rocked the securities markets. This is an
area that has received and continues to receive enormous
amounts of coverage in the press. Numerous proposals for
additional regulation have appeared even before the costs and
efficiency of Sarbanes-Oxley can be assessed. The financial
crisis of 2008 has launched a new round of financial regulation

legislation.
Excel Applications
Two Excel models are available for margin trading and short
sales. These models allow the student to examine the impact of
margining combined with stock price volatility. Excel models
that cover material in this chapter are available on the Online
Learning Center (www.mhhe.com/bkm).
3-1
Copyright © 2014 McGraw-Hill Education. All rights reserved.
No reproduction or distribution without the prior written
consent of McGraw-Hill Education.
Chapter 01 - The Investment Environment
Chapter One
The Investment EnvironmentChapter Overview
The student is introduced to the general concept of investing—
to forego spending cash today in the hopes of increasing wealth
in the future. Real assets are differentiated from financial
assets, and the major categories of financial assets are defined.
The risk/return tradeoff and the reality that most assets are
efficiently priced most of the time are introduced. The role of
financial intermediaries is discussed. The chapter concludes
with a presentation of the financial crisis of 2008, its causes and
its implications, as well as regulatory attempts to address those
consequences.Learning Objectives
After studying this chapter, students should have an
understanding of the overall investment process and understand
some key elements involved in the investment process.

Students should understand differences in financial and real
assets and be able to identify the major components of the
investment process. Students should be able to describe a
derivative security and understand how it is used. Finally,
students should understand the causes and effects of the
financial crisis of 2008.Presentation of Chapter Material
1.1 Real Assets versus Financial Assets
The main elements of the chapter are presented here. The
concept of giving up current consumption to invest in assets
that allow greater consumption in the future is the key notion to
start discussion of the chapter material. The discussion of real
and financial assets can be used to discuss key differences in
the assets and their appropriateness as investment vehicles.
Summary statistics for balance sheets and net worth for US
households are presented.
1.2 Financial Assets
Fixed income securities include both long-term and short-term
instruments. The essential element of debt securities and the
other classes of financial assets is the fixed or fixed formula
payments that are associated with these securities. Common
stock that features residual payments to the owners can be
contrasted with the relatively certain debt claims. A derivative
security is a security whose performance is based on or tied to
another asset or financial security. The discussion of derivative
securities presented here should be brief and used to highlight
the discussion of innovation in our markets. Students may find
interest in key elements of each derivative and how these
elements relate the properties to debt and equity securities.
1.3 Financial Markets and the Economy
Financial assets (and hence markets where they are traded) play
a big role in developed economies by allowing to make the most
of the economy's real assets. Markets encourage allocation of
capital to firms that have the best prospects in the view of the

market participants. Markets allow participants to adjust
consumption and to choose levels of risk that are appropriate.
Financial markets also allow for separation of management and
ownership. Current issues related to corporate governance and
ethics issues are presented here, which provides students a great
opportunity for discussion.
1.4 The Investment Process
Section 1.4 describes the major components of the investment
process. Two of the major elements in the investment process,
asset allocation and security selection, can be used to discuss
the content and coverage in the course. Previewing the concept
of risk-return trade-off is important for the development of
portfolio theory and many other concepts developed in the
course. The discussion of active and passive management styles
is related to the concept of market efficiency.
1.5 Markets are Competitive
The two major elements of active management are security
selection and timing. Material in later chapters can be
previewed in terms of emphasis on elements of active
management. On the other hand the essential element related to
passive management is holding an efficient portfolio. Here,
efficiency means not only diversification, but also appropriate
risk levels, cash flow characteristics and administration costs.
1.6 The Players
The major participants in the financial markets are discussed
here. Governments, households and businesses can be issuers
and investors in securities. Financial intermediaries include
many groups who bring issuers and investors together.
Investment bankers perform many specialized services for
businesses and operate in the primary market.
1.7 The Financial Crisis of 2008
Section 1.7 presents the Financial Crisis of 2008, with emphasis
on its antecedents and its significance in the future of the

financial world. It begins with events leading up to the crisis
and introduces the important Case-Shiller Index of U.S. housing
prices (of which the students should be familiar). The
discussion turns to the mechanics of the mortgage pass-through
security (instructors will note that the generalized idea of
securitization is presented here as well). The cash flow for
these securities is depicted graphically in Figure 1.4. The
authors also discuss in detail the role government sponsored
entities Fannie Mae and Freddie Mac played in the crisis.
The text introduces mortgage derivatives in this section,
focusing on collateralized debt obligations (CDOs) and credit
default swaps (CDS). This sections ties these derivatives with
the all important concept of systemic risk (where problems in
one financial sector spill over to other sectors). Students will
need to tie together several disparate concepts here for a strong
understanding of how this crisis occurred.
This section then describes the sub-prime housing meltdown,
the subsequent credit freeze and the impact these events had on
the real economy. The government’s response is presented.
Students can have great discussions on the effectiveness of the
various fiscal and monetary actions during this time.
1.8 Outline of the Text
In this section, the authors divide the text into seven
independent learning Parts, with several chapters in each Part.
This can be useful for instructors when developing the course
syllabus.
1-1
Chapter 02 - Asset Classes and Financial Instruments
Chapter Two

Asset Classes and Financial InstrumentsChapter Overview
This chapter describes the financial instruments traded in the
primary and secondary markets. The broad market place is
divided into Money Markets and Capital Markets. The chapter
begins with Money Market characteristics and examples of
Money Markets instruments. It then presents the Capital
Markets. The four subdivisions of Capital Markets are
discussed: Longer-term bonds, equity, futures and
options.Learning Objectives
Upon completion of this chapter the student should have a
thorough understanding of the various financial instruments
available to the potential investor. The student should have an
insight as to the interpretation, composition, and calculation
process involved in the various market indexes presented on the
evening news. The student should have some understanding of
the basics of options and futures.PRESENTATION OF
MATERIAL
2.1 The Money Market
The major money market instruments are presented here. In
describing the individual instruments, it is helpful for the
students’ understanding of the market to integrate discussion of
institutional characteristics of the instruments. For example,
commercial banks are the major participants for many of the
instruments. If students have adequate backgrounds from
prerequisite classes, discussion of characteristics of
marketability, liquidity, and default risk may be appropriate.
Discussion of the concepts should be delayed to later chapters if
students’ backgrounds are not adequate.
2.2 The Bond Market
Debt instruments are issued by both public and private entities.
The Treasury and Agency issues have the direct or implied
guaranty of the federal government. Since state and local
entities issue municipal bonds, performance on these bonds does
not have the same degree of safety. Since the interest income

on municipal bonds is not subject to federal taxes, the taxable
equivalent yield is used for comparison.
Key characteristics of the Treasury Notes and Bonds are
described here. Debt of federal agencies has become a very
significant component of the debt market. Major issuers of
agency debt are described. Municipal bonds issued by state and
local governments can be general obligation bonds or revenue
bonds. General obligation bonds are considered less risky since
they are backed by the full taxing power of the government
entity. Revenue from specific projects is dedicated to revenue
bonds. Interest income on most municipal bonds is not subject
to taxes. To compare the yield on municipals with other taxable
securities the taxable equivalent yield is used.
Bonds issued by private corporations are subject to greater
default risk than bonds issued by government entities.
Corporate bonds often contain imbedded options such as the call
feature which allows an existing corporation to repurchase the
bond from issuers when rates have fallen. Bonds backed by
mortgages have grown to compose a major element of the bond
market. Such bonds can represent proportional shares of a pool
of mortgages or specific portion of a pool of mortgages. The
mortgage backed market has grown rapidly in recent years.
2.3. Equity Securities
Two key points are relevant in the discussion of equity
instruments. First, it should be emphasized that with the issue
of common stock owners having a residual claim to the earnings
of the firm. The priorities of debt holders and preferred
stockholders are contrasted with common shareholders. Second,
the differences in preferred stock and common stock dividends
should be emphasized. Preferred shareholders have a priority
claim to income in the form of dividends. Preferred
stockholders are limited to the fixed dividend while common
shareholders do not have limits. The partial tax exemption on
dividends of one corporation being received by another
corporation is important in discussing preferred stock.

2.4 Stock and Bond Market Indexes
The uses of stock indexes provide a good starting point for the
discussion of the structure and construction of stock indexes.
Motivational factors include tracking average returns, making
comparisons of managers’ performance to average performance
and, increasingly, indexes are used as a base for derivative
instruments. Discussion of the factors in constructing or using
an index focuses the students' attention on key differences in
the indexes. For example, the DJIA captures the returns from
the bluest of blue chips.
The major factor to contrast in the discussion is whether the
index is price weighted or market value weighted. The third
possibility is equal weighting. While this method is not too
commonly observed in published indexes, it is commonly used
in research. Example 2.2 provides an example of price
weighting which is used in the DJIA. An example of a broad-
based index is the Standard & Poor Index. It provides an
example of a market-value-weighted index as compared to the
price-weighted average computed in Example 2.2. The
examples of market-value indexes used in the text shows their
diversity. The Wilshire, being the broadest of the indexes,
captures the overall domestic market.
The international indexes represent the most popular indexes
used by investors. They include only a small example of what it
available but they are representative of the major types of
indexes and major countries. The text has several examples of
greater detail in several exhibits.
2.5 Derivative Markets
Basic positions and terms for options and futures are described
here. The basic positions and terms are used to contrast the
differences in futures and options. The essential difference is
that while an option confers the right but not the requirement to
exercise, a futures contract represents a firm commitment to buy
or sell for future delivery. The text provides discussion of
options for individual stocks and on agricultural futures

contracts. The extension to discussion of other assets enhances
understanding of the uses and differences of options and
futures.
2-1
Chapter Three
How Securities Are Traded
INVESTMENTS | BODIE, KANE, MARCUS
How firms issue securities
Primary vs. secondary market
Privately held vs. publicly traded companies
Initial public offerings
Market transactions
Short selling and buying on margin
Rise of electronic trading and globalization of stock markets
Market regulation

Chapter Overview
3-‹#›
Primary Market
Market for newly-issued securities
Firms issue new securities through underwriter (investment
banker) to public
Secondary Market
Investors trade previously issued securities among themselves
How Firms Issue Securities
3-‹#›
Privately Held Firms
Up to 499 shareholders
Middlemen have formed partnerships to buy shares and get
around the 499-investor restrictions
Raise funds through private placement
Lower liquidity of shares
Have fewer obligations to release financial statements and other
information

3-‹#›
Publicly Traded Companies
Raise capital from a wider range of investors through initial
public offering, IPO
Seasoned equity offering: The sale of additional shares in firms
that already are publicly traded
Public offerings are marketed by investment bankers or
underwriters
Registration must be filed with the SEC
3-‹#›
Figure 3.1 Relationship Among a Firm Issuing Securities, the
Underwriters, and the Public
3-‹#›

Shelf Registration
SEC Rule 415: Allows firms to register securities and gradually
sell them to the public for two years
Shares can be sold on short notice and in small amounts without
incurring high floatation costs
3-‹#›
Initial Public Offerings
Road shows to publicize new offering
Bookbuilding to determine demand for the new issue
Degree of investor interest in the new offering provides
valuable pricing information
3-‹#›
Initial Public Offerings
Underwriter bears price risk associated with placement of
securities:
IPOs are commonly underpriced compared to the price they
could be marketed (ex.: Groupon)

Some IPOs, however, are well overpriced (ex.: Facebook);
others cannot even fully be sold
3-‹#›
Types of Markets:
Direct search
Buyers and sellers seek each other
Brokered markets
Brokers search out buyers and sellers
Dealer markets
Dealers have inventories of assets from which they buy and sell
Auction markets
Traders converge at one place to trade
How Securities are Traded
3-‹#›
Bid and Asked Prices
Bid Price
Bids are offers to buy.
In dealer markets, the bid price is the price at which the dealer
is willing to buy.

Investors “sell to the bid.”
Bid-asked spread is the profit for making a market in a security.
Ask Price
Asked prices represent offers to sell.
In dealer markets, the asked price is the price at which the
dealer is willing to sell.
Investors must pay the asked price to buy the security.
3-‹#›
Market Order:
Executed immediately
Trader receives current market price
Price-Contingent Order:
Traders specify buying or selling price
A large order may be filled at multiple prices
Types of Orders
3-‹#›
Figure 3.5 Price-Contingent Orders
3-‹#›

Dealer markets
Electronic communication networks (ECNs)
True trading systems that can automatically execute orders
Specialists markets
Maintain a “fair and orderly market”
Have been largely replaced by ECNs
Trading Mechanisms
3-‹#›
In the US, the share of electronic trading rose from 16% to 80%
in 2000s and was triggered by an interaction of new
technologies and new regulations
1975: Elimination of fixed commissions on the NYSE
1994: New order-handling rules on NASDAQ, leading to
narrower bid-ask spreads
The Rise of Electronic Trading
3-‹#›
1997 and 2001: Reduction of minimum tick size from one-
eighth to one-sixteenth, and 1 cent, respectively
2000: Emergence of NASDAQ Stock Market
2006: NYSE is renamed to NYSE Arca after acquiring the

electronic Archipelago Exchange
2007: Creation of National Market System (NMS) to link
exchanges electronically
The Rise of Electronic Trading
3-‹#›
Figure 3.6 The Effective Spread Fell Dramatically as the
Minimum Tick Size Fell
(Value-weighted average of NYSE-listed shares)
3-‹#›
NASDAQ
Lists about 3,000 firms
Originally, NASDAQ was primarily a dealer market with a price
quotation system
Today, NASDAQ’s Market Center offers a sophisticated
electronic trading platform with automatic trade execution
Large orders may still be negotiated through brokers and dealers
U.S. Markets

3-‹#›
The New York Stock Exchange
The largest U.S. stock exchange as measured by the value of the
stocks listed on the exchange
Automatic electronic trading runs side-by-side with traditional
broker/specialist system
SuperDot : Electronic order-routing system
DirectPlus: Fully automated execution for small orders
Specialists: Handle large orders and maintain orderly trading
U.S. Markets
3-‹#›
ECNs
Private computer networks that directly link buyers with sellers
for automated order execution over multiple exchanges
Compete in terms of the speed they can offer
Latency: The time it takes to accept, process, and deliver a
trading order
Major ECNs include Direct Edge, BATS, and NYSE Arca
U.S. Markets
3-‹#›

Algorithmic Trading
The use of computer programs to make trading decisions
High-Frequency Trading
Special class of algorithmic with very short order execution
time
Dark Pools
Trading venues that preserve anonymity, mainly relevant in
block trading
New Trading Strategies
3-‹#›
Bond Trading
Most bond trading takes place in the OTC market among bond
dealers
NYSE Bonds is the largest centralized bond market of any U.S.
exchange
Market for many bond issues is “thin” and is subject to liquidity
risk
New Trading Strategies
3-‹#›

Widespread trend to form international and local alliances and
mergers
NYSE acquired Archipelago (ECN), American Stock Exchange,
and merged with Euronext
NASDAQ acquired Instinet/INET (ECN), Boston Stock
Exchange, and merged with OMX to form NASDAQ OMX
Group
Chicago Mercantile Exchange acquired Chicago Board of Trade
and New York Mercantile Exchange
Globalization of Stock Markets
3-‹#›
Figure 3.8 The Biggest Stock Markets in the World by Domestic
Market Capitalization
3-‹#›
NYSE-Euronext (US) NASDAQ-OMX Tokyo London
Euronext (Europe) Shanghai Hong Kong Toronto
Brazil Australia Deutsche Börse BME (Spanish)
India11795.6 3845 3325 3266 2447 2357 2258 1912 1229
1198 1184 1031 1007
$ Billion

Brokerage Commission: Fee paid to broker for making the
transaction
Explicit cost of trading
Full service vs. discount brokerage
Spread: Difference between the bid and asked prices
Implicit cost of trading
Trading Costs
3-‹#›
Borrowing part of the total purchase price of a position using a
loan from a broker
Investor contributes the remaining portion
Margin refers to the percentage or amount contributed by the
investor
You profit when the stock rises
Buying on Margin
3-‹#›
Initial margin is set by the Fed
Currently 50%
Maintenance margin

Minimum equity that must be kept in the margin account
Margin call if value of securities falls too much
Buying on Margin
3-‹#›
Share price $100
60% Initial Margin
40% Maintenance Margin
100 Shares Purchased
Initial Position
Stock $10,000 Borrowed $4,000
Equity $6,000
Example 3.1
Margin Trading: Initial Conditions
3-‹#›
Stock price falls to $70 per share
New Position
Stock $7,000 Borrowed $4,000
Equity $3,000
Margin% = $3,000/$7,000 = 43%
Example 3.1

Margin Trading: Margin Call
3-‹#›
How far can the stock price fall before a
margin call? Let maintenance margin = 30%
Equity = 100P - $4000
Percentage margin = (100P - $4,000)/100P
(100P - $4,000)/100P = 0.30
Solve to find:
P = $57.14
Example 3.2
Margin Trading: Maintenance Margin
3-‹#›
Purpose
To profit from a decline in the price of a stock or security
Mechanics
Borrow stock through a dealer
Sell it and deposit proceeds and margin in an account
Closing out the position: Buy the stock and return to the party
from which it was borrowed
Short Sales

3-‹#›
Dot Bomb 1000 Shares
50% Initial Margin
30% Maintenance Margin
$100 Initial Price
Sale Proceeds $100,000
Margin & Equity $50,000
Stock Owed 1000 shares
Example 3.3
Short Sale: Initial Conditions
3-‹#›
Example 3.3
Short Sale: Dot Bomb falls to $70 per share
Assets
$100,000 (sale proceeds)
$50,000 (initial margin)
Liabilities
$70,000 (buy shares)
Equity
$80,000

Profit = Ending equity – Beginning equity
= $80,000 - $50,000 = $30,000
= Decline in share price x Number of shares sold short
3-‹#›
How much can the stock price rise before a margin call?
($150,000* - 1000P)/(1000P) = 30%
P = $115.38
* Initial margin plus sale proceeds
Example 3.3
Short Sale: Margin Call
3-‹#›
34
Major regulations:
Securities Act of 1933
Securities Act of 1934

Securities Investor Protection Act of 1970
Self-Regulation
Financial Industry Regulatory Authority
CFA Institute standards of professional conduct
Regulation of Securities Markets
3-‹#›
Sarbanes-Oxley Act
Public Company Accounting Oversight Board
Independent financial experts to serve on audit committees of
boards of directors
CEOs and CFOs personally certify firms’ financial reports
Boards must have independent directors
Regulation of Securities Markets
3-‹#›
Officers, directors, major stockholders must report all
transactions in firm’s stock
Insiders do exploit their knowledge
Jaffe study:
Inside buyers > Inside sellers = Stock does well
Inside sellers > Inside buyers = Stock does poorly

Insider Trading
3-‹#›
Chapter Two
Asset Classes and Financial Instruments
1
Asset allocation → Asset classes
Money markets vs. capital markets
Types of money market instruments
Capital market securities:
Bonds
Equity
Derivatives

Chapter Overview
2-‹#›
Subsector of the fixed-income market: Securities are short-term,
liquid, low risk, and often have large denominations
Money market mutual funds allow individuals to access the
money market
The Money Market
2-‹#›
3
Table 2.1 Major Components of
the Money Market
2-‹#›

4
Treasury bills: Short-term debt of U.S. government
Bid and asked price
Bank discount method
Certificates of deposit: Time deposit with a bank
Commercial paper: Short-term, unsecured debt of a company
Money Market Securities
2-‹#›
5
Bankers’ Acceptances: An order to a bank by a bank’s customer
to pay a sum of money on a future date
Eurodollars: Dollar-denominated time deposits in banks outside
the U.S.
Repos and reverses: Short-term loan backed by government
securities.
Fed funds: Very short-term loans between banks

Money Market Securities
2-‹#›
6
Except for Treasury bills, money market securities are not free
of default risk
Both the premium on bank CDs and the TED spread have often
become greater during periods of financial crisis
During the credit crisis of 2008, the federal government offered
insurance to money market mutual funds after some funds
experienced losses
Yields on Money Market Instruments
2-‹#›
7
Treasury Notes and Bonds

Inflation-Protected Treasury Bonds
Federal Agency Debt
International Bonds
Municipal Bonds
Corporate Bonds
Mortgages and Mortgage-Backed Securities
The Bond Market
2-‹#›
8
Treasury Notes and Bonds
Maturities
Notes – Maturities up to 10 years
Bonds – Maturities from 10 to 30 years
Par Value - $1,000
Interest paid semiannually
Quotes – Percentage of par
Bond Market Securities
2-‹#›

9
Inflation-Protected Treasury Bonds
TIPS: Provide inflation protection
Federal Agency Debt
Debt of mortgage-related agencies such as Fannie Mae and
Freddie Mac
International Bonds
Eurobonds and Yankee bonds
2-‹#›
10
Municipal Bonds
Issued by state and local governments
Interest is exempt from federal income tax and sometimes from
state and local tax
Types
General obligation bonds: Backed by taxing power of issuer
Revenue bonds: backed by project’s revenues or by the
municipal agency operating the project.

2-‹#›
11
Figure 2.4 Tax-Exempt Debt
Outstanding
2-‹#›
12
Industrial revenue bonds 1979 1980 1981 1982 1983 1984 1985
1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007
2008 2009 2010 2011 2012 35 46 59 75 84 104
127 117 116 116.4 115.5 115.2 114 118.3
124.9 131.69999999999999 134.80000000000001
137.9 142 147.80000000000001
152.80000000000001 154.19999999999999
157.69999999999999 160.80000000000001 164.2
169.4 218.2 272.39999999999975 341.5
409.7 447.5 482.3 497.4 496.3 General
obligation 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988
1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
2011 2012 293 303 318 347 381 409 536 591 668

725 794 839 901 1059.8 1124.9000000000001
1080.7 1027.5 1014.1 1063.0999999999999
1148.5 1167.0999999999999 1189 1294.5 1437.9
1557.9 1673 2569.5 2675.4 2804.7 2819.2
2922.1 2988.1 2939.3 2931.7
$ Billion
To choose between taxable and tax-exempt bonds, compare
after-tax returns on each bond.
Let t equal the investor’s marginal tax bracket
Let r equal the before-tax return on the taxable bond and rm
denote the municipal bond rate.
If r(1 - t ) > rm, then the taxable bond gives a higher return;
otherwise, the municipal bond is preferred.
Municipal Bond Yields
2-‹#›
13
Table 2.2 Tax-Exempt Yield Table
The equivalent taxable yield is simply the tax-free rate, rm,

divided by (1 - t).
2-‹#›
14
Corporate Bonds
Issued by private firms
Semi-annual interest payments
Subject to larger default risk than government securities
Options in corporate bonds
Callable
Convertible
2-‹#›
15
Mortgage-Backed Securities
Proportional ownership of a mortgage pool or a specified
obligation secured by a pool

Produced by securitizing mortgages
Mortgage-backed securities are called pass-throughs because the
cash flows produced by homeowners paying off their mortgages
are passed through to investors.
Most were issued by Fannie Mae and Freddie Mac
2-‹#›
16
Mortgage-Backed Securities
Traditionally, were comprised of conforming mortgages, which
met standards of credit worthiness
Later on, “Private-label” issuers securitized large amounts of
subprime mortgages, made to financially weak borrowers
Fannie and Freddie were allowed and even encouraged to buy
subprime mortgage securities
2-‹#›

17
Figure 2.6 Mortgage-Backed Securities Outstanding
2-‹#›
18
Private issuers 1979 1980 1981 1982 1983 1984 1985 1986 1987
1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
2010 2011 2012 278.2 326.3 406.2 563 592.5
659.1 773.4 870.6 1060.5999999999999
1443.7 2131.3000000000002 2767.5 2947.6
2587.1 2199.6999999999998 1901.4 1679.2
1623.2 Federal agencies 1979 1980 1981 1982 1983
1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005
2006 2007 2008 2009 2010 2011 2012 94.8 114 129 178.5
244.9 289 368.9 531.6 670.4 745.3
869.5 1019.9 1156.5 1272 1355.6 1472.1
1570.3 1711.4 1825.8 2018.4
2234.6999999999998 2493.1999999999998 2831.8
3158.6 3326.7 3374.6 3548.5 3841.1
4464.4000000000005 4961.4000000000005 5376.7
1139.5 1304.8 1329.9
$ Billions

Common stock: Ownership
Residual claim
Limited liability
Preferred stock: Perpetuity
Fixed dividends
Priority over common
Tax treatment
American Depository Receipts
Certificates traded in U.S. markets that represent ownership in
shares of a foreign company
Equity Securities
2-‹#›
19
Dow Jones Industrial Average
Includes 30 large blue-chip corporations
Computed since 1896
Price-weighted average
Stock Market Indexes
2-‹#›

20
Portfolio: Initial value $25 + $100 = $125
Final value $30 + $90 = $120
Percentage change in portfolio value
= 5/125 = -.04 = -4%
Index: Initial index value (25+100)/2 = 62.5
Final index value (30 + 90)/2 = 60
Percentage change in index -2.5/62.5
= -.04 = -4%
Example 2.2 Price-Weighted Average
2-‹#›
21
Standard & Poor’s 500
Broadly based index of 500 firms
Market-value-weighted index
Investors can base their portfolios on an index
Buy an index mutual fund
Buy exchange traded funds (ETFs)
Stock Market Indexes

2-‹#›
22
Other Indexes
U.S. Indexes
NYSE Composite
NASDAQ Composite
Wilshire 5000
Foreign Indexes
Nikkei (Japan)
FTSE (U.K.; pronounced “footsie”)
DAX (Germany),
Hang Seng (Hong Kong)
TSX (Canada)
2-‹#›
23
A derivative is a security that gets its value from the values of
another asset, such as commodity prices, bond and stock prices,
or market index values

Derivatives Markets
2-‹#›
24
Options
Call: Right to buy underlying asset at the strike or exercise
price
Value of calls decreases as strike price increases
Put: Right to sell underlying asset at the strike or exercise price
Value of puts increase with strike price
Value of both calls and puts increases with time until expiration
Derivatives Markets
2-‹#›
25
Futures Contracts
An agreement made today regarding the delivery of an asset (or
in some cases, its cash value) at a specified delivery or maturity

date for an agreed-upon price, called the futures price, to be
paid at contract maturity
Long position: Take delivery at maturity
Short position: Make delivery at maturity
Derivatives Markets
2-‹#›
26
Comparison
Option
Right, but not obligation, to buy or sell; option is exercised
only when it is profitable
Options must be purchased
The premium is the price of the option itself.
Futures Contract
Obliged to make or take delivery; long position must buy at the
futures price, short position must sell at futures price
Futures contracts are entered into without cost
2-‹#›
27

Chapter One
The Investment Environment
Role of financial assets in the economy: Real vs. financial
assets
Risk–return trade-off and the efficient pricing
Financial crisis 2008
Connections between the financial system and the “real” side of
the economy
Lessons learned for evaluating systemic risk
Chapter Overview
1-‹#›
2

Real Assets vs. Financial Assets
Real Assets
Determine the productive capacity and net income of the
economy
Examples: Land, buildings, machines, knowledge used to
produce goods and services
Financial Assets
Claims on real assets, do not contribute directly to the
productive capacity of the economy.
Examples: Stocks, bonds
1-‹#›
3
Fixed income or debt
Promise either a fixed stream of income or a stream of income
determined by a specified formula
Common stock or equity
Represent an ownership share in the corporation
Derivative securities
Provide payoffs that are determined by the prices of other assets
Financial Assets
1-‹#›

4
Investment in currency
Investment in real assets through commodity futures
Corporations invest in the commodity futures to hedge the risk
Other Types of Investment
1-‹#›
5
The Informational Role
Capital flows to companies with best prospects
Consumption Timing
Use securities to store wealth and transfer consumption to the
future
Allocation of Risk
Investors can select securities consistent with their tastes for
risk, which benefits the firms that need to raise capital as
security can be sold for the best possible price
Financial Markets and the Economy
1-‹#›

6
Separation of Ownership and Management
Agency problems arise when managers start pursuing their own
interests instead of maximizing firm's value
Mechanisms to mitigate agency problems:
Tie managers' income to the success of the firm (stock options)
Monitoring from the board of directors
Monitoring from the large outside investors and security
analysts
Takeover threat
1-‹#›
7
Corporate Governance and Corporate Ethics
Accounting Scandals
Examples – Enron, Rite Aid, HealthSouth
Auditors: Watchdogs of the firms
Analyst Scandals
Arthur Andersen
Sarbanes-Oxley Act
Tighten the rules of corporate governance

1-‹#›
8
Portfolio: Collection of investment assets.
Asset allocation
Choice among broad asset classes
Security selection
Choice of securities within each asset class
The Investment Process
1-‹#›
9
“Top-down” approach
Asset allocation followed by security analysis to evaluate which
particular securities to be included in the portfolio
“Bottom-up” approach
Investment based solely on the price-attractiveness, which may

result in unintended heavy weight of a portfolio in only one or
another sector of the economy
The Investment Process
1-‹#›
10
Risk-Return Trade-Off
Higher-risk assets are priced to offer higher expected returns
than lower-risk assets
Efficient Markets
In fully efficient markets when prices quickly adjust to all
relevant information, there should be neither underpriced nor
overpriced securities
Markets Are Competitive
1-‹#›
11
Passive Management
Holding a highly diversified portfolio
No attempt to find undervalued securities

No attempt to time the market
Active Management
Finding mispriced securities
Timing the market
Markets Are Competitive
1-‹#›
12
Demanders of capital – Firms
Suppliers of capital – Households
Governments – Can be both borrowers or lenders
The Players
1-‹#›
13
Financial Intermediaries: Pool and invest funds
Investment Companies
Banks

Insurance companies
Credit unions
The Players
1-‹#›
14
Universal Bank Activities
Investment Banking
Underwrite new securities issues
Sell newly issued securities to public in the primary market
Investors trade previously issued securities among themselves
in the secondary markets
Commercial Banking
Take deposits and make loans
1-‹#›
15

Antecedents of the Crisis:
“The Great Moderation”: A time in which the U.S. had a stable
economy with low interest rates and a tame business cycle with
only mild recessions
Historic boom in housing market
Financial Crisis of 2008
1-‹#›
16
Figure 1.1 Short-Term LIBOR and Treasury-Bill Rates and the
TED Spread
1-‹#›
17
3-month LIBOR 35091 35122 35151 35182
35212 35243 35273 35304 35335 35365
35396 35426 35457 35488 35516 35547
35577 35608 35638 35669 35700 35730
35761 35791 35822 35853 35881 35912
35942 35973 36003 36034 36065 36095
36126 36156 36187 36218 36246 36277

36307 36338 36368 36399 36430 36460
36491 36521 36552 36583 36612 36643
36673 36704 36734 36765 36796 36826
36857 36887 36918 36949 36977 37008
37038 37069 37099 37130 37161 37191
37222 37252 37 283 37314 37342 37373
37403 37434 37464 37495 37526 37556
37587 37617 37648 37679 37707 37738
37768 37799 37829 37860 37891 37921
37952 37982 38013 38044 38073 38104
38134 38165 38195 38226 38257 38287
38318 38348 38379 38410 38438 38469
38499 38530 38560 38591 38622 38652
38683 38713 38744 38775 38803 38834
38864 38895 38925 38956 38987 39017
39048 39078 39109 39140 39168 39199
39229 39260 39290 39321 39352 39382
39413 39443 39474 39505 39534 39565
39595 6.05 6.1 6.29 6.39 6.6199999999999966
6.78 6.72 6.68 6.8199999999999976 6.76 6.74 6.4
5.52 5.0999999999999996 4.88 4.3199999999999976
4 3.79 3.68 3.4870000000000001 2.597
2.2319999999999998 2.08 1.883 1.862000000
0000001 1.9200000000000004 2.0309999999999997
1.91 1.9 1.86 1.82 1.82 1.81 1.7000000000000004
1.43 1.3800000000000001 1.35 1.34 1.29 1.31 1.28
1.1164000000000001 1.117599999999999
1.141999999999999 1.1597999999999991 1.1657
1.1700000000000008 1.157 1.131999999999999
1.125 1.111 1.175999999999999
1.3080000000000001 1.6040000000000001
1.6950000000000001 1.7900000000000005
2.0049999999999999 2.1579999999999999 2.403
2.5579999999999998 2.7440000000000002
2.9099999999999997 3.0994999999999981
3.2107000000000001 3.3291999999999997

3.5045000000000002 3.6949999999999998
3.8719999999999977 4.0549999999999962
4.2519999999999998 4.4139999999999997
4.5297999999999998 4.6795 4.8192000000000004
4.9898000000000033 5.1479999999999961
5.2335000000000003 5.5084999999999997
5.4889000000000001 5.4014000000000024
5.3724999999999996 5.3728999999999996
5.3684999999999965 5.3599999999999977
5.3599999999999977 5.3597999999999999
5.3478999999999965 5.3554999999999975
5.3594999999999997 5.3593000000000002
5.3597000000000001 5.4837000000000033 5.4939
5.1464999999999996 4.9620999999999986
4.9794000000000036 3.9175999999999997
3.0876000000000001 2.7825000000000002
2.7947000000000002 2.6923999999999997
2.7654000000000001 2.7921 2.806299999999998
3.1217000000000001 4.0586000000000002
2.2791000000000001 1.829399999999999
1.2107999999999992 1.242599999999999
1.266699999999999 1.1062000000000001
0.81659999999999999 0.62070000000000058
0.51529999999999998 0.42450000000000027
0.29800000000000026 0.28310000000000002 0.2681
0.25310000000000005 0.25010000000000004 0.2505
0.26840000000000008 0.31160000000000027
0.45850000000000002 0.53690000000000004
0.51029999999999998 0.3626000000000002
0.29140000000000027 0.28880000000000022
0.28690000000000027 0.30270000000000002
0.30340000000000023 0.31190000000000023
0.30840000000000023 0.28140000000000021
0.26070000000000004 0.2478000000000001
0.24990000000000018 0.29320000000000002
0.35020000000000001 0.40650000000000008

0.47530000000000022 0.55570000000000042
0.5659000000000004 0.50319999999999998
0.47330000000000022 0.46680000000000021
0.46650000000000008 3-month T-bill 35091 35122
35151 35182 35212 35243 35273 35304
35335 35365 35396 35426 35457 35488
35516 35547 35577 35608 35638 35669
35700 35730 35761 35791 35822 35853
35881 35912 35942 35973 36003 36034
36065 36095 36126 36156 36187 36218
36246 36277 36307 36338 36368 36399
36430 36460 36491 36521 36552 36583
36612 36643 36673 36704 36734 36765
36796 36826 36857 36887 36918 36949
36977 37008 37038 37069 37099 37130
37161 37191 37222 37252 37283 37314
37342 37373 37403 37434 37464 37495
37526 37556 37587 37617 37648 37679
37707 37738 37768 37799 37829 37860
37891 37921 37952 37982 38013 38044
38073 38104 38134 38165 38195 38226
38257 38287 38318 38348 38379 38410
38438 38469 38499 38530 38560 38591
38622 38652 38683 38713 38744 38775
38803 38834 38864 38895 38925 38956
38987 39017 39048 39078 39109 39140
39168 39199 39229 39260 39290 39321
39352 39382 39413 39443 39474 39505
39534 39565 39595 5.53 5.6199999999999966
5.72 5.6599999999999975 5.48 5.71 6.03 6.13 6.05
6.1899999999999986 6.03 5.73 4.8599999999999977
4.7300000000000004 4.2 3.86 3.55 3.57 3.46 3.3
2.3499999999999988 2.0099999999999998
1.7500000000000004 1.7100000000000004
1.7300000000000004 1.7600000000000005
1.7600000000000005 1.7400000000000004

1.7100000000000004 1.6700000000000008
1.6800000000000008 1.6600000000000001 1.54
1.42 1.2 1.2 1.159999999999999 1.1800000000000008
1.1200000000000001 1.1100000000000001
1.0900000000000001 0.89000000000000024
0.9400000000000003 9 0.96000000000000041
0.93 0.94000000000000039 0.91 0.93 0.9
0.94000000000000039 0.93 0.96000000000000041
1.06 1.31 1.42 1.57 1.6800000000000008 1.87
2.2000000000000002 2.1800000000000002 2.48
2.72 2.73 2.84 2.9299999999999997 3.06 3.34 3.44
3.4699999999999998 3.8899999999999997 3.86
3.9899999999999998 4.37 4.51 4.5199999999999996
4.6499999999999977 4.74 4.87 4.9700000000000024
4.92 4.7699999999999987 4.95 4.9000000000000004
4.8899999999999997 4.99 5.01 4.9000000000000004
4.79 4.5999999999999996 4.68 4.8199
999999999976 3.9099999999999997 3.72 3.84 3.08
3.29 1.9200000000000004 1.81 1.36 1.41 1.85 1.87
1.6500000000000001 1.6900000000000008 0.9
0.44000000000000011 1.0000000000000009E-2
0.11000000000000003 0.2400000000000001 0.26
0.2100000000000001 0.14000000000000001
0.14000000000000001 0.19000000000000006
0.1800000000000001 0.15000000000000011
0.14000000000000001 5.0000000000000017E-2
6.0000000000000039E-2 6.0000000000000039E-2
8.0000000000000071E-2 0.13 0.16000000000000006
0.16000000000000006 0.16000000000000006
0.1800000000000001 0.15000000000000011
0.14000000000000001 0.16000000000000006
0.12000000000000002 0.17 0.12000000000000002
0.15000000000000011 0.15000000000000011
9.0000000000000052E-2 4.0000000000000036E-2
6.0000000000000039E-2 3.0000000000000009E-2 0.1
2.0000000000000018E-2 2.0000000000000018E-2

1.0000000000000009E-2 1.0000000000000009E-2
1.0000000000000009E-2 3.0000000000000009E-2
9.0000000000000052E-2 8.0000000000000071E-2
8.0000000000000071E-2 9.0000000000000052E-2 TED
spread 35091 35122 35151 35182 35212
35243 35273 35304 35335 35365 35396
35426 35457 35488 35516 35547 35577
35608 35638 35669 35700 35730 35761
35791 35822 35853 35881 35912 35942
35973 36003 36034 36065 36095 36126
36156 36187 36218 36246 36277 36307
36338 36368 36399 36430 36460 36491
36521 36552 36583 36612 36643 36673
36704 36734 36765 36796 36826 36857
36887 36918 36949 36977 37008 37038
37069 37099 37130 37161 37191 37222
37252 37283 37314 37342 37373 37403
37434 37464 37495 37526 37556 37587
37617 37648 37679 37707 37738 37768
37799 37829 37860 37891 37921 37952
37982 38013 38044 38073 38104 38134
38165 38195 38226 38257 38287 38318
38348 38379 38410 38438 38469 38499
38530 38560 38591 38622 38652 38683
38713 38744 38775 38803 38834 38864
38895 38925 38956 38987 39017 39048
39078 39109 39140 39168 39199 39229
39260 39290 39321 39352 39382 39413
39443 39474 39505 39534 39565 39595
0.52 0.4800000000000002 0.56999999999999995
0.72999999999999943 1.139999999999999 1.07
0.68999999999999928 0.55000000000000004
0.77000000000000024 0.56999999999999895
0.71000000000000041 0.67000000000000071
0.65999999999999959 0.36999999999999944
0.68000000000000038 0.46 0.45 0.22000000000000006

0.22000000000000006 0.18 700000000000011
0.24700000000000011 0.22200000000000006
0.33000000000000035 0.17300000000000001
0.13200000000000001 0.16000000000000006
0.27100000000000002 0.17 0.19000000000000006
0.19000000000000006 0.14000000000000001
0.16000000000000006 0.27 0.28000000000000008
0.23 0.1800000000000001 0.19000000000000006
0.16000000000000006 0.17 0.2 0.19000000000000006
0.22640000000000007 0.17760000000000001
0.18200000000000011 0.22980000000000006
0.22570000000000007 0.26 0.22700000000000006
0.23200000000000001 0.18500000000000011
0.18100000000000011 0.21600000000000011
0.24800000000000011 0.29400000000000021
0.27500000000000002 0.22000000000000006
0.32500000000000023 0.2880000000000002
0.20300000000000001 0.37800000000000022
0.26400000000 000001 0.19000000000000006
0.36950000000000022 0.37070000000000008
0.39920000000000022 0.44450000000000012
0.3550000000000002 0.43200000000000022
0.58500000000000019 0.36200000000000027
0.55400000000000005 0.53979999999999995
0.30950000000000022 0.30920000000000097
0.46980000000000022 0.49799999999999944
0.49350000000000027 0.6385000000000004
0.51890000000000003 0.48140000000000027
0.60250000000000004 0.42289999999999944
0.46850000000000008 0.47000000000000097
0.37000000000000022 0.34980000000000033
0.44790000000000013 0.5655 0.75949999999999995
0.67930000000000046 0.5397000000000004
1.5736999999999992 1.7738999999999996 1.3065
1.8821000000000001 1.6894 1.9975999999999996
1.2775999999999992 1.4224999999999992 1.3847

0.84240000000000004 0.8954000000000002
1.1420999999999999 1.1163000000000001
2.2216999999999998 3.6185999999999998
2.2690999999999999 1.7193999999999996
0.97080000000000022 0.98260000000000003 1.0567
0.96619999999999995 0.67660000000000076
0.43070000000000008 0.33530000000000038
0.27450000000000002 0.15800000000000011 0.2331
0.20810000000000001 0.19310000000000005 0.1701
0.12050000000000002 0.10840000000000002
0.15160000000000001 0.29850000000000027
0.35690000000000022 0.36030000000000023
0.22260000000000005 0.13139999999999999
0.16880000000000006 0.11690000000000003
0.18270000000000011 0.15340000000000012
0.16190000000000007 0.21840000000000018
0.24140000000000011 0.20069999999999999
0.2178000000000001 0.14990000000000012 0.2732
0.33020000000000027 0.39650000000000035
0.46530000000000021 0.54570000000000041
0.53590000000000004 0.41320000000000001
0.39330000000000037 0.38680000000000037
0.37650000000000022
Interest Rates (%)
Figure 1.3 The Case-Shiller Index of U.S. Housing Prices
1-‹#›

18
CSXR 1987.0833333333314 1987.1666666666679
1987.25 1987.3333333333314 1987.4166666666686
1987.5 1987.5833333333314 1987.6666666666679
1987.75 1987.8333333333314 1987.9166666666686
1988 1988.0833333333314 1988.1666666666679
1988.25 1988.3333333333314 1988.4166666666686
1988.5 1988.5833333333314 1988.6666666666679
1988.75 1988.8333333333314 1988.9166666666686
1989 1989.0833333333314 1989.1666666666679
1989.25 1989.3333333333314 1989.4166666666686
1989.5 1989.5833333333314 1989.6666666666679
1989.75 1989.8333333333314 1989.9166666666686
1990 1990.0833333333314 1990.1666666666679
1990.25 1990.3333333333314 1990.4166666666686
1990.5 1990.5833333333314 1990.6666666666679
1990.75 1990.8333333333314 1990.9166666666686
1991 1991.0833333333314 1991.1666666666679
1991.25 1991.3333333333314 1991.4166666666686
1991.5 1991.5833333333314 1991.6666666666679
1991.75 1991.8333333333314 1991.9166666666686
1992 1992.0833333333314 1992.1666666666679
1992.25 1992.3333333333314 1992.4166666666686
1992.5 1992.5833333333314 1992.6666666666679
1992.75 1992.8333333333314 1992.9166666666686
1993 1993.0833333333314 1993.1666666666679
1993.25 1993.3333333333314 1993.4166666666686
1993.5 1993.5833333333314 1993.6666666666679
1993.75 1993.8333333333314 1993.9166666666686
1994 1994.0833333333314 1994.1666666666679
1994.25 1994.3333333333314 1994.4166666666686
1994.5 1994.5833333333314 1994.6666666666679
1994.75 1994.8333333333314 1994.9166666666686
1995 1995.0833333333314 1995.1666666666679

1995.25 1995.3333333333314 1995.4166666666686
1995.5 1995.5833333333314 1995.6666666666679
1995.75 1995.8333333333314 1995.9166666666686
1996 1996.0833333333314 1996.1666666666679
1996.25 1996.3333333333314 1996.4166666666686
1996.5 1996.5833333333314 1996.6666666666679
1996.75 1996.8333333333314 1996.9166666666686
1997 1997.0833333333314 1997.1666666666679
1997.25 1997.3333333333314 1997.4166666666686
1997.5 1997.5833333333314 1997.6666666666679
1997.75 1997.8333333333314 1997.9166666666686
1998 1998.0833333333314 1998.1666666666679
1998.25 1998.3333333333314 1998.4166666666686
1998.5 1998.5833333333314 1998.6666666666679
1998.75 1998.8333333333314 1998.9166666666686
1999 1999.0833333333314 1999.16 66666666679
1999.25 1999.3333333333314 1999.4166666666686
1999.5 1999.5833333333314 1999.6666666666679
1999.75 1999.8333333333314 1999.9166666666686
2000 2000.0833333333314 2000.1666666666679
2000.25 2000.3333333333314 2000.4166666666686
2000.5 2000.5833333333314 2000.6666666666679
2000.75 2000.8333333333314 2000.9166666666686
2001 2001.0833333333314 2001.1666666666679
2001.25 2001.3333333333314 2001.4166666666686
2001.5 2001.5833333333314 2001.6666666666679
2001.75 2001.8333333333314 2001.9166666666686
2002 2002.0833333333314 2002.1666666666679
2002.25 2002.3333333333314 2002.4166666666686
2002.5 2002.5833333333314 2002.6666666666679
2002.75 2002.8333333333314 2002.9166666666686
2003 2003.0833333333314 2003.1666666666679
2003.25 2003.3333333333314 2003.4166666666686
2003.5 2003.5833333333314 2003.6666666666679
2003.75 2003.8333333333314 2003.9166666666686
2004 2004.0833333333314 2004.1666666666679

2004.25 2004.3333333333314 2004.4166666666686
2004.5 2004.5833333333314 2004.6666666666679
2004.75 2004.8333333333314 2004.9166666666686
2005 2005.0833333333314 2005.1666666666679
2005.25 2005.3333333333314 2005.4166666666686
2005.5 2005.5833333333314 2005.6666666666679
2005.75 2005.8333333333314 2005.9166666666686
2006 2006.0833333333314 2006.1666666666679
2006.25 2006.3333333333314 2006.4166666666686
2006.5 2006.5833333333314 2006.6666666666679
2006.75 2006.8333333333314 2006.9166666666686
2007 2007.0833333333314 2007.1666666666679
2007.25 2007.3333333333314 2007.4166666666686
2007.5 2007.5833333333314 2007.6666666666679
2007.75 2007.8333333333314 2007.9166666666686
2008 2008.0833333333314 2008.1666666666679
2008.25 2008.3333333333314 2008.4166666666686
2008.5 2008.5833333333314 2008.6666666666679
2008.75 2008.8333333333314 2008.9166666666686
2009 2009.0833333333314 2009.1666666666679
2009.25 2009.3333333333314 2009.4166666666686
2009.5 2009.5833333333314 2009.6666666666679
2009.75 2009. 8333333333314
2009.9166666666686 2010 2010.0833333333314
2010.1666666666679 2010.25 2010.3333333333314
2010.4166666666686 2010.5 2010.5833333333314
2010.6666666666679 2010.75 2010.8333333333314
2010.9166666666686 2011 2011.0833333333314
2011.1666666666679 2011.25 2011.3333333333314
2011.4166666666686 2011.5 2011.5833333333314
2011.6666666666679 2011.75 2011.8333333333314
2011.9166666666686 2012 2012.0833333333314
2012.1666666666679 2012.25 2012.3333333333314
62.82 63.39 63.87 64.569999999999993
65.56 66.59 67.540000000000006 68.25
68.86999999999999 69.42 69.76 0000000000005

70.22 70.45 70.77 71.11999999999999
71.649999999999991 72.48 73.63 74.81
75.7 76.400000000000006 76.900000000000006
77.28 77.58 77.989999999999995 78.36
79.11999999999999 79.83 80.52
81.239999999999995 81.66 82.08 82.25
82.440000000000026 82.43 82.35 82.29
82.149999999999991 82.02 82.05 82.01
82.19 82.1 81.86 81.39 80.84 80.09
79.38 78.53 77.77 77 76.86 77.31
78.02 78.61 78.930000000000007 78.88
78.679999999999978 78.31 77.989999999999995
77.739999999999995 77.510000000000005 77.31
77.36 77.61999999999999 77.940000000000026
77.95 77.989999999999995 77.760000000000005
77.45 77.09 76.679999999999978 76.56
76.28 75.910000000000025 75.83
76.040000000000006 76.510000000000005 76.61
76.59 76.47 76.22 76.02
75.709999999999994 75.709999999999994 75.63
75.73 76.03 76.489999999999995
77.040000000000006 77.400000000000006 77.64
77.569999999999993 77.5 77.23
76.989999999999995 76.819999999999993 76.64
76.38 76.36 76.599999999999994
76.940000000000026 77.260000000000005 77.47
77.430000000000007 77.260000000000005 76.95
76.679999999999978 76.56 76.440000000000026
76.489999999999995 76.84 77.33 77.78
78.099999999999994 78.36 78.36999999999999
78.36 78.23 78.11999999999999 78.08 77.98
78.290000000000006 78.760000000000005 79.42
80.25 80.86 81.410000000000025
81.569999999999993 81.83 81.98 82.31
82.7 83.13 83.86999999999999 84.69 85.77
87.03 88.14 89.01 89.58 89.8 89.76

89.82 90.06 90.48 91.31 92.55 93.69
95.1 96.28 97.31 97.990000000000023 98.48
98.94000000 0000026 99.51 100 100.81
102.24000000000002 104.01 105.98 107.83
109.02 110.07 110.9 111.75 112.6 113.56
114.58 115.45 116.69 117.94000000000005
118.94000000000005 120.03 121.01
121.99000000000002 122.89 123.46000000000002
123.78 123.64 123.93 124.45 125.92 127.95
130.33000000000001 132.76 135.04 137.04
138.62 140.12 141.26 142.18
142.86000000000001 143.59 144.84
146.44999999999999 148.16999999999999
149.69999999999999 151.65 153.60999999999999
155.76999999999998 157.70999999999998
159.55000000000001 161.26999999999998 162.9
164.82000000000011 167.91 171.58 175.43
179.45000000000007 182.69 184.95000000000007
186.91 188.65 190.08 191.42000000000004
193.35000000000011 195.87 199.20999999999998
202.51 205.76 208.86 211.65 214.13
216.76999999999998 219.07 220.81 221.91
222.46 223.38000000000011 223.75 224.99
225.99 226.29 226.17 225.54 225.1
224.73999999999998 223.94 222.39000000000001
221.31 220.46 219.67 218.94 218.34 217.37
216.3 214.63 212.73 209.76 205.26 200.67
196.07 190.6 186.12 183.35000000000011
181.56 180.52 178.67 176.70999999999998
173.35000000000011 169.67 165.95000000000007
162.09 157.96 154.60999999999999
151.47999999999999 150.44 151.19
153.35000000000011 155.94999999999999 158.07
158.76999999999998 158.68 158.33000000000001
158.16 157.87 156.85000000000011
156.20999999999998 157.35000000000011 159.41

161.06 162.23999999999998 162.01 161 158.9
157.5 156.04 154.36000000000001
152.38000000000011 150.91 151.78
153.33000000000001 154.87 156.33000000000001
156.51 155.60999999999999 153.54 151.41
149.60999999999999 148.04 146.69999999999999
146.51 148.4
Index (January 2000 = 100)
Changes in Housing Finance
Old Way
Local thrift institution made mortgage loans to homeowners
Thrift’s major asset: A portfolio of long-term mortgage loans
Thrift’s main liability: Deposits
“Originate to hold”
New Way
Securitization: Fannie Mae and Freddie Mac bought mortgage
loans and bundled them into large pools
Mortgage-backed securities are tradable claims against the
underlying mortgage pool
“Originate to distribute”
1-‹#›
19
Securitization: Buying mortgage loans from originators and

bundling them into mortgage-backed securities
Replacement of low-risk conforming mortgages with
nonconforming “subprime” loans
Trend toward low-documentation and then no-documentation
loans and rising allowed leverage on home loans (loan-to-value
ratio)
Low adjustable-rate mortgages (ARMs) that “maxed out”
borrowers' paying capacity at low rates
Changes in Housing Finance
1-‹#›
20
Figure 1.4 Cash Flows in a Mortgage Pass-Through Security
1-‹#›
21

Collateralized debt obligations (CDOs)
Mortgage pool divided into slices or tranches to concentrate
default risk
Senior tranches: Lower risk, highest rating (AAA)
Junior tranches: High risk, low or junk rating
Estimated ratings significantly underestimated the inherent risk
Mortgage Derivatives
1-‹#›
22
Default probabilities were estimated on the historical data
covering the rising housing market
Geographic diversification did not reduce risk as much as
anticipated
Agency problems with rating agencies
Why Was Credit Risk Underestimated?
1-‹#›
23
A CDS is an insurance contract against the default of the

borrower
Investors bought sub-prime loans and used CDSs to insure their
safety
Some big swap issuers did not have enough capital to back their
CDSs when the market collapsed resulting in the failure of CDO
insurance
Credit Default Swap (CDS)
1-‹#›
24
Systemic Risk: A potential breakdown of the financial system in
which problems in one market spill over and disrupt others.
One default may set off a chain of further defaults
Waves of selling may occur in a downward spiral as asset prices
drop
Potential contagion from institution to institution, and from
market to market
Rise of Systemic Risk
1-‹#›

25
Banks had a mismatch between the maturity and liquidity of
their assets and liabilities
Liabilities were short and liquid
Assets were long and illiquid
Constant need to refinance the asset portfolio
Banks were very highly levered, giving them almost no margin
of safety
1-‹#›
26
Investors relied too much on credit enhancement through
structured products like CDS
CDS traded mostly over-the-counter, with no posted margin
requirements and little transparency
Opaque linkages between financial instruments and institutions
1-‹#›

27
2000-2006: Sharp increase in housing prices caused many
investors to believe that continually rising home prices would
bail out poorly performing loans
2004: Interest rates began rising
2006: Home prices peaked
2007: Housing defaults and losses on mortgage-backed
securities surged
The Shoe Drops
1-‹#›
28
2008: Troubled firms include Bear Stearns, Fannie Mae, Freddie
Mac, Merrill Lynch, Lehman Brothers, and AIG
Money market breaks down
Credit markets freeze up
Federal bailout to stabilize financial system
The Shoe Drops
1-‹#›

29
Mechanisms to mitigate systemic risk
Stricter rules for bank capital, liquidity, and risk management
practices
Increased transparency, especially in derivatives markets (eg.:
standardize CDS contracts so they can trade in centralized
exchanges)
Office of Credit Ratings within the SEC to oversee the credit
rating agencies
The Dodd-Frank Reform Act
1-‹#›
30
FIN7013-8 Week 1 Assignment Grading Rubric:

Grading Rubric
Criteria
Content (8 points) Points
Fully answered the questions 8
Organization (2 points)
Used proper APA citation and formatting 1
Paper was long enough 1
Total 10
Week 1 - Assignment: Evaluate Financial Markets, Securities,
and Institutions Along with Associated Risks
Instructions
In a paper, provide an evaluation of the following points:
1. Financial engineering has been disparaged as nothing more
than paper shuffling. Critics argue that resources used for
rearranging wealth (that is, bundling and unbundling financial
assets) might be better spent on creating wealth (that is,
creating real assets). Evaluate this criticism. Are any benefits
realized by creating an array of derivative securities from
various primary securities?
2. Why would you expect securitization to take place only in
highly developed capital markets?
3. What is the relationship between securitization and the role

of financial intermediaries in the economy? What happens to
financial intermediaries as securitization progresses?
Support your paper with minimum of five (5) resources. In
addition to these specified resources, other appropriate
scholarly resources, including older articles, may be included.
Length: 5-7 pages not including title and reference pages
Your paper should demonstrate thoughtful consideration of the
ideas and concepts presented in the course and provide new
thoughts and insights relating directly to this topic. Your
response should reflect scholarly writing and current APA
standards.
Features of Financial Systems
Some basic features of the financial system include: financial
markets, financial securities, and financial institutions.
Financial markets (security markets) are usually categorized as:
(a) primary markets whereby securities are originally issued,
and (b) secondary markets whereby seasoned securities are
traded among investors.
Financial securities (debt or equity) are most commonly
grouped into money market (i.e., by large institutions and
government) and capital market (stock and bond market)
securities. The money market securities are debt securities
where the re-payment is expected to be within one year. Capital
market securities have a maturity beyond one year and are
commonly issued to fund long term asset purchases.
The financial institutions within the financial system help to
transfer money and risk among investors and institutions.

Commercial banks are an example and the best known among
the financial institutions. Commercial banks take in the deposits
of individual savers or investors as well as business
organizations and pool the funds to create business, consumer,
and mortgage loans.
Review the resources listed in the Books and Resources area
below to prepare for this week's assignments
Resources:
Edu, I. (2012, September 10). Financial markets [Video file].
https://www.youtube.com/watch?time_continue=14&v=P_bqDg
kZmuY
Metrick, A. (2012, October 17). The financial system [Video
file].
https://www.youtube.com/watch?v=JlIizkvJCoE
Bodie, Z., Kane, A., & Marcus, A. J. (2013). Investments New
York, NY McGraw-Hill-Irwin.

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