the future market for U.S. Treasury bonds and notes is one of the most active markets for the forward delivery of an asset to be found anywhere in the world. Treasury bonds and notes are a popular investment medium for individuals and financial institutions because of their safety and liquidity. Nevertheless, there is substantial market risk involved with longer-term Treasury bonds and notes due to their lengthy maturities and relatively thin market. For example, Treasury bonds, which have original maturities stretching beyond 10 years, totaled only about $85 billion at year-end 1980, less than 10 percent of the total public debt of the United States and much less than half the volume of Treasury bills outstanding. Because the market for Treasury bonds is thinner than for bills, their price is more volatile, creating greater uncertainty for investors. Not surprisingly, then, Treasury bonds were among the first financial instruments for which a future market developed to hedge against the risk of price fluctuations.
Only those Treasury bonds which either have maturities of at least 15 years or cannot be called for at least 15 to 20 years from their date of delivery (depending on the exchange selected) are eligible for futures contracts. Moreover, all Treasury bonds delivered under futures contracts. Moreover, all Treasury bonds delivered under a futures contract must come from the same issue. The basic trading unit is $100,000(measured at par) with a coupon rate of 8 percent. Bonds with coupon rates above or below 8 percent are delivered at a premium or discount from their par values. Delivery of Treasury bonds is accomplished by look entry, and accrued interest is prorated. Price quotes in the market are expressed as a percentage of par values. The minimum price change which is recorded on published lists or in dealer quotations is one thirty-second of a point, or $31.25 per futures contract.
Contracts for U.S. Treasury notes and non-callable bonds with maturities of four to six years also are traded today. Like Treasury bond contracts, T-note contracts are priced as a percentage of their par (or face) value, based on an 8 percent coupon rate. The basic trading unit is $100,000 face value. Trading in Treasury note futures began at the Chicago Board of trade in June 1979, while Treasury bond contracts were first traded in August 1977
Saturday, September 19, 2009
the informal over-the-counter market
The large maturity of securities bought and sold in the United States, especially debt securities are traded over-the-counter (OTC) and not on organized exchanges. The customer places a buy or sell order with a bank, broker, or dealer which is ten relayed via telephone, by wire, or by computer terminal to the particular dealer or broker with securities to sell or an order to buy. Each broker or dealer seeks the best possible price on behalf of himself or his customer, and the resulting competition to find the "best deal" brings together traders located hundreds or thousands of miles apart. The prices of actively traded securities respond almost instantly to the changing forces of demand and supply so that security prices constantly hover at or near competitive, market-determined levels.
All money market instruments are traded in the over-the-counter markets as are the large majority of government (federal, state, and local) bonds and corporate bonds. While most common stocks are traded on the exchanges, an estimated one quarter to one third of all stocks are traded OTC. The OTC Market is generally preferred by financial institutions, especially commercial banks, bank holding companies, mutual funds, and insurance companies, because in many cases their shares are not actively traded and OTC trading and disclosure rules are less restrictive. The presence of financial institutions tends to give the OTC market a more conservative tone than the exchanges.
Many dealers in the OTC market act as principal instead of brokers as on the organized exchanges. That is, they take "positions of risk" by buying securities outright for their own portfolios as well as for retail customers. Several dealers will handle the same stock so the customer can shop around. All prices are determined by negotiation with dealers acquiring securities at a bid price and selling them at an asked price. The OTC market is regulated by a code of ethics established by National Association of security Dealers, a private organization which encourages ethical behavior among its members. Trading firms or their employees who break NASD‘S regulations may be fined, suspended, or thrown out of the organization.
One of the most important contributions of NASD in recent years has been the development of NASDAQ-the National Association of security Dealers Automated Quotations System. Launched in 1971, NASDAQ displays bid and asked prices for thousands of OTC-traded securities on video screens connected electronically to a central computer system. All NASD-member firms trading in a particular stock report their bid-ask price quotations immediately to NASDAQ. This nation-wide communications network allows dealers, brokers, and their customers to determine instantly the terms currently offered by major securities dealers.
All money market instruments are traded in the over-the-counter markets as are the large majority of government (federal, state, and local) bonds and corporate bonds. While most common stocks are traded on the exchanges, an estimated one quarter to one third of all stocks are traded OTC. The OTC Market is generally preferred by financial institutions, especially commercial banks, bank holding companies, mutual funds, and insurance companies, because in many cases their shares are not actively traded and OTC trading and disclosure rules are less restrictive. The presence of financial institutions tends to give the OTC market a more conservative tone than the exchanges.
Many dealers in the OTC market act as principal instead of brokers as on the organized exchanges. That is, they take "positions of risk" by buying securities outright for their own portfolios as well as for retail customers. Several dealers will handle the same stock so the customer can shop around. All prices are determined by negotiation with dealers acquiring securities at a bid price and selling them at an asked price. The OTC market is regulated by a code of ethics established by National Association of security Dealers, a private organization which encourages ethical behavior among its members. Trading firms or their employees who break NASD‘S regulations may be fined, suspended, or thrown out of the organization.
One of the most important contributions of NASD in recent years has been the development of NASDAQ-the National Association of security Dealers Automated Quotations System. Launched in 1971, NASDAQ displays bid and asked prices for thousands of OTC-traded securities on video screens connected electronically to a central computer system. All NASD-member firms trading in a particular stock report their bid-ask price quotations immediately to NASDAQ. This nation-wide communications network allows dealers, brokers, and their customers to determine instantly the terms currently offered by major securities dealers.
Limitations of the Liquidity preference Theory
Still, liquidity theory has important limitations. It is only a short-run approach to interest-rate determination because it assumes that income levels remain constant. In the longer run, interest rates are affected by changes in the level of income. Indeed, it is impossible to have a stable-equilibrium interest rate without also reaching an equilibrium level of income, savings, and investment. Then, too, liquidity preference considers only the supply and demand for money, whereas business, consumer, and government demands for credit clearly have an impact upon the cost of credit to these borrowers. A more comprehensive view of interest rates is needed which considers the important roles played by all actors in the financial system-businesses, households, and governments.
Securities Dealers Transactions
Trading among securities dealers and between dealers and their customers' amounts to billions of dollars a day. Average daily transactions in the U.S. government securities market were in excess of $13.1 billion in 1979. Indeed, so large is the government securities market that the volume of trading usually exceeds by four or five times the total volume of trading on the major U.S. stock exchange. The majority of traders by far are in treasury bills. It is also clear that government securities dealers trade heavily among themselves, usually trough brokers. Government security brokers do not take investment positions themselves but try to match bids and offers placed with them by dealers and other investors.
Dealerships are a cutthroat business where each dealer firm is out to maximize its returns from trading even if gains must be made at the expense of competing dealers, indeed, market analysts housed within each dealer firm study the daily price quotations of their competitors. If one dealer temporarily under prices some securities (I.e., offers excessively generous yields), other dealers are likely to rush in for a "hit" before the offering firm has a chance to correct its mistake. It is a business with little room for the inexperienced or slow-moving trader. Yet, as we have seen, the government securities dealers are essential to the smooth functioning of the financial markets and to the successful placement of billions of dollars in new U.S. government securities issued each year.
Dealerships are a cutthroat business where each dealer firm is out to maximize its returns from trading even if gains must be made at the expense of competing dealers, indeed, market analysts housed within each dealer firm study the daily price quotations of their competitors. If one dealer temporarily under prices some securities (I.e., offers excessively generous yields), other dealers are likely to rush in for a "hit" before the offering firm has a chance to correct its mistake. It is a business with little room for the inexperienced or slow-moving trader. Yet, as we have seen, the government securities dealers are essential to the smooth functioning of the financial markets and to the successful placement of billions of dollars in new U.S. government securities issued each year.
Friday, September 18, 2009
sources of Dealer financing
Where government security dealers do derives most of their funds to purchase and carry securities? Commercial banks are the largest single source of dealer funds, year in and year out. Indeed, half A dozen of the largest dealers are really dealer departments housed in some of the nation‘s largest banks. However, non-financial business corporations are the most rapidly growing source of funds for major securities dealers. Many industrial corporations. Today find the dealer loan market a convenient and safe way to dispose of temporarily idle monies. With wire transfer of funds between banks readily available, a company can lend a dealer millions of dollars in idle cash and recover those funds in a matter of hours if a cash emergency rears its head.
Dealer Positions in Securities
Dealer holdings of U.S. government and other securities are both huge and subject to erratic fluctuations. For example, during 1979, the roughly three dozen U.S. government security dealers held average daily positions of $3.2 billion in U.S. government securities and nearly $1.5 billion in the IOUs of various federal agencies. Three years earlier, in 1976, however, average daily dealer positions in U.S. government securities were more than double the average at almost $7.6 billion.
Why was there such a tremendous difference in the size of dealer portfolios during those years? Interest rates fell in 1976, creating ample opportunities for sizable dealer profits on securities held in long positions as market prices rose. In 1979, however, interest rates increased sharply, sending security prices downward. Fearing substantial losses, the dealers shifted out of long positions, especially in longer-term notes and bonds, and held mostly Treasury bills, whose prices are relatively stable. In fact, the dealers actually went short on 1-to-5-year and under-1-year government securities and held only nominal amounts of maturities exceeding 10 years
Why was there such a tremendous difference in the size of dealer portfolios during those years? Interest rates fell in 1976, creating ample opportunities for sizable dealer profits on securities held in long positions as market prices rose. In 1979, however, interest rates increased sharply, sending security prices downward. Fearing substantial losses, the dealers shifted out of long positions, especially in longer-term notes and bonds, and held mostly Treasury bills, whose prices are relatively stable. In fact, the dealers actually went short on 1-to-5-year and under-1-year government securities and held only nominal amounts of maturities exceeding 10 years
The Liquidity Premium View of The Yield Curve
the strong assumption underlying the unbiased expectations theory coupled with the real-world behavior of investors have caused many financial analysts to question the theory‘s veracity. securities dealers and analysts who trade actively in the financial markets frequently argue that other factors decides rate expectations also exert a significant impact on the character of the yield curve.
For example, in recent years most yield curves have sloped upward. Is there a built-in bias toward positively sloped yield curves due to factors other than interest-rate expectations? The liquidity premium view of the yield curve suggests that such a bias exists.
Longer-term securities tend to have more volatile market prices tan short-term securities. Therefore, the investor faces greater risk of capital loss when buying long-term financial instruments. To overcome this risk, it is argued, investors must be paid an extra return in the form of an interest-rate premium to encourage them to purchase long-term securities. This rate premium for the surrender of liquidity on longer-term issues, if it exists, would tend to give yield curves a bias toward an upward slope.
Why then do some yield curves slope downward? In such instances, expectations of declining interest rates plus other factors simply overcome the liquidity premium effect. The liquidity premium view does not preclude the important role of interest-rate expectations in influencing the shape of the yield curve. Even though expectations may be the dominant factor influencing the yield curve, however, other factors such as liquidity play an important role as well.
Moreover, the liquidity argument may help explain why yield curves tend to "flatten out" at the longest maturities. There are obvious differences in liquidity between a 1-year and 10-year bond, but it is not clear that major differences in liquidity exist between a 10-year bond and a 20-year bond, for example. Therefore, the size of the required liquidity premium paid to long-term investors may decrease for securities of the longest maturities
For example, in recent years most yield curves have sloped upward. Is there a built-in bias toward positively sloped yield curves due to factors other than interest-rate expectations? The liquidity premium view of the yield curve suggests that such a bias exists.
Longer-term securities tend to have more volatile market prices tan short-term securities. Therefore, the investor faces greater risk of capital loss when buying long-term financial instruments. To overcome this risk, it is argued, investors must be paid an extra return in the form of an interest-rate premium to encourage them to purchase long-term securities. This rate premium for the surrender of liquidity on longer-term issues, if it exists, would tend to give yield curves a bias toward an upward slope.
Why then do some yield curves slope downward? In such instances, expectations of declining interest rates plus other factors simply overcome the liquidity premium effect. The liquidity premium view does not preclude the important role of interest-rate expectations in influencing the shape of the yield curve. Even though expectations may be the dominant factor influencing the yield curve, however, other factors such as liquidity play an important role as well.
Moreover, the liquidity argument may help explain why yield curves tend to "flatten out" at the longest maturities. There are obvious differences in liquidity between a 1-year and 10-year bond, but it is not clear that major differences in liquidity exist between a 10-year bond and a 20-year bond, for example. Therefore, the size of the required liquidity premium paid to long-term investors may decrease for securities of the longest maturities
policy Implications of the expectations hypothesis
The expectations hypothesis has important implications for public policy. The theory clearly implies that changes in the relative amounts available of long-term versus short-term securities do not influence the shape of the yield curve unless investor expectations also are affected. For example, suppose the U.S. Treasury decided to refinance $100 billion of its maturing short-term IOUs by issuing $100 billion in long-term bonds. Would this government action affect the shape of the yield curve? Certainly, the supply of long-term bonds would be significant increased, while the supply of short-term securities would be sharply reduced. However, according to the expectations theory, the yield curve itself would be unchanged unless investors altered their expectations about the future course of short-term interest rates.
To cite one more example, the Federal Reserve System buys and sells U.S. government and federal agency securities almost daily in the money and capital markets in order to promote the nation‘s economic goals. Can the Fed influence the shape of the yield curve by buying one maturity of securities and selling another? Once again, the answer is no, unless the Federal Reserve can influence the interest-rate expectations of investors. Why? The reason lies in the underlying assumption of the unbiased expectations hypothesis: investors regard all securities, whatever their maturity, as perfect substitutes. Therefore, the relative amounts of long-term bonds versus short-term securities simply should not matter to investors
To cite one more example, the Federal Reserve System buys and sells U.S. government and federal agency securities almost daily in the money and capital markets in order to promote the nation‘s economic goals. Can the Fed influence the shape of the yield curve by buying one maturity of securities and selling another? Once again, the answer is no, unless the Federal Reserve can influence the interest-rate expectations of investors. Why? The reason lies in the underlying assumption of the unbiased expectations hypothesis: investors regard all securities, whatever their maturity, as perfect substitutes. Therefore, the relative amounts of long-term bonds versus short-term securities simply should not matter to investors
Bank Loans to Business
Commercial banks are direct competitors with the corporate note and bond markets in making both long-and short-term loans to business. At year-end 1980 total commercial and industrial loans extended by banks reached $330 billion, accounting for 35 percent of all loans granted by commercial banks operating in the United States. Business loans are the single largest asset item at most banks, regardless of their size. Moreover, commercial banks grant their loans to a wide variety of firms covering all major sectors of the business community.
In recent years the Federal Reserve Board as carried out surveys of business lending practices by banks across the United States. The Federal Reserve Survey indicates that bank loans to business firms tend to be short-term or medium-term maturity. For example, short-term commercial and industrial loans averaged just less than four years. Moreover, the short-term loans-which are used principally to purchase inventories, pay wages and salaries, and meet other current expenses-average considerably larger at most banks than long-term business loans, which are taken out mainly to purchase equipment and expand physical facilities.
The Federal Reserve survey suggests that longer-term business loans tend to carry higher average interest rates than shorter-term businesses loans. this is due, in part, to the greater risk associated with long-term credit, Moreover, yield curves have usually sloped upward in recent years, calling for higher average rates on long-term loans. especially interesting is the high proportion of business loans today which carry floating rather than fixed interest rates, the larger and longer-term a business loan is, the more likely its rate will float with market conditions. For example, just 35 percent of the sort-term business loans included in the August 1980 Federal Reserve Survey of U.S. banks carried floating interest rates, while almost twice as many of the long-term business loans-68percent-had floating rates. Clearly, banks become more determined to protect themselves against unexpected inflation and other adverse development through floating interest rates as the maturity and average size of a business loan increases.
In recent years the Federal Reserve Board as carried out surveys of business lending practices by banks across the United States. The Federal Reserve Survey indicates that bank loans to business firms tend to be short-term or medium-term maturity. For example, short-term commercial and industrial loans averaged just less than four years. Moreover, the short-term loans-which are used principally to purchase inventories, pay wages and salaries, and meet other current expenses-average considerably larger at most banks than long-term business loans, which are taken out mainly to purchase equipment and expand physical facilities.
The Federal Reserve survey suggests that longer-term business loans tend to carry higher average interest rates than shorter-term businesses loans. this is due, in part, to the greater risk associated with long-term credit, Moreover, yield curves have usually sloped upward in recent years, calling for higher average rates on long-term loans. especially interesting is the high proportion of business loans today which carry floating rather than fixed interest rates, the larger and longer-term a business loan is, the more likely its rate will float with market conditions. For example, just 35 percent of the sort-term business loans included in the August 1980 Federal Reserve Survey of U.S. banks carried floating interest rates, while almost twice as many of the long-term business loans-68percent-had floating rates. Clearly, banks become more determined to protect themselves against unexpected inflation and other adverse development through floating interest rates as the maturity and average size of a business loan increases.
Moody's Investor Service
Beginning in 1909, John Moody developed and published a simple system of letter grades which indicated the relative investment quality of corporate bonds. Today, Moody‘s Investor service rates thousands of issues of corporate and municipal bonds, commercial paper, short-term municipal notes, and preferred stock. these security ratings are reported in Moody‘s Bond Record, which is published monthly. In addition to assigning issue ratings, Moody‘s also notes for its subscribers the essential terms on each security issue; dates when interest, principal, or dividend payments are due; call provisions (if any); regulation status; bid and asked price quotations; yield to maturity; tax status; coverage; and amount of securities outstanding.
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