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The international financial system consists of the numerous rules, customs, instruments, facilities, markets, and organizations that enable international payments to be made and funds to flow across borders. The international financial system has experienced tremendous growth. New financial systems have been created, and the volume of transactions has exploded. The dramatic metamorphosis of international financial markets is driven by technological changes, the growth in world trade, and the breakdown of barriers to financial capital flows.
From an economic standpoint, development in the international financial system has made financial markets more efficient because funds (financial capital) can more easily flow around the world to wherever they will earn the highest return. Over time, as resources are allocated more efficiently, both developed and developing countries should experience greater economic growth. As a result, living standards around the world should rise more than they otherwise would have.
The international financial system includes the international money and capital markets and the foreign exchange market. The international money market trades short-term claims with an original maturity of one year or less; the international capital market trades capital market instruments including stocks, bonds, mutual funds, and mortgages, with an original maturity greater than one year. Many new international financial products have been created to facilitate the increased financial flows. These include various typer of mutual funds that allow investors to invest in developed and emerging economies.
A crucial part of the international financial system is the foreign exchange market, where foreign currencies are bought and sold in the course of trading goods, services, and financial claims (securities) among countries. This global market is woven together by the dealers in foreign currencies---mostly, the foreign exchange department of the largest commercial banks located in the world's major financial centers such as New York, London, Frankfurt, and Tokyo.
In the post-World War II period, the international financial system has operated under two distinct exchange rate regimes. The specific exchange rate regime affects the trading of all international financial instruments. During the first regime from 1944 to 1973, major industrial countries maintained a system of fixed exchange rates, and currency values rarely changed. Under the second regime which has been in effect since 1973, exchange rates fluctuate daily in response to changes in supply and demand (market forces). Governments also intervene in the flexible exchange rate system.
To be continued in the next post, The International Financial System from 1944 to 1973...
*SOURCE: THE FINANCIAL SYSTEM & THE ECONOMY, 3RD ED., 2003, MAUREEN BURTON & RAY LOMBRA, PG. 462*
Determining the Futures Price Financial futures are traded each day on exchanges around the world. The exchange delivers or accepts for delivery the futures contract at the specified future time and place at a price agreed upon today. The buyer or seller merely accepts the risk of a price change of the contract and agrees to pay off any financial losses or to receive any financial gains. There are several different futures prices depending on the expiration date of the futures contract. In this article, I pose the question, "How are those prices determined?" I hope that buzzers and alarms are going off in your head and that your immediate response is "supply and demand." Of course, you are right! But in this case, it may prove beneficial to look a little more closely at what determines the supply and demand for financial futures, and hence, their prices.
Perhaps the first and most important thing to point out is that the future price and the spot price are highly correlated---that is, they move up and down together. This is not accidental, but rather due to actions of individuals called arbitrageurs who seek a riskless profit.
Consider what happens if a futures contract for Treasury bonds to be delivered in three months is much higher than the present spot price. An arbitrageur could purchase the Treasury bonds in the spot market while selling a futures contract. Granted, she would incur some carrying costs in holding the Treasury bonds (or the gold or whatever), but as long as the futures prices were greater than the current spot price plus the carrying costs, she would make a riskless profit. (Carrying costs generally consist of the interest costs for the use of the funds to purchase the securities, less the interest earned on the securities while the arbitrageur is holding them, plus other transaction costs of the exchange.) On the other hand, if the future's price was below the spot price plus carrying costs, arbitrageurs (who owned some of the securities) would but futures, driving the futures price up, and sell in the spot market, driving the spot price down. Can you explain how a riskless profit can be made?
When and if such an opportunity for riskless profit opens up, arbitrageurs move in, purchase in the spot market (driving up the price), and vice versa. As the delivery date of the futures contract comes closer. The length of time in which funds are borrowed to establish the position is reduced. Therefore, as the delivery date nears, the carrying costs are reduced, and the future's price approaches the spot price. Arbitrage continues until the future's price is bid up (down) to the spot price plus carrying costs---a phenomenon called convergence. Thus, on the last day before the expiration date price is practically equal to the spot price, because the carrying costs are negligible since only one day is left. Hence, because futures prices are highly correlated with spot prices and because convergence occurs, futures prices are ultimately determined by the spot prices of underlying contract instruments.
Recap
The futures price is determined by supply and demand. If the futures price is above the spot price plus the carrying costs, and arbitrageur will sell a futures agreement while at the same time purchasing securities in the spot market. The increased supply of futures will push the price down until the difference between the spot price and the futures price is equal to the carrying costs. If the futures price is below the spot price plus carrying costs, arbitrageurs (who own some of the underlying instruments) will buy futures and sell in the spot market. The futures price will go up, and the spot price will come down until the difference equals the carrying costs. As the delivery date nears, the spot and the futures prices converge.
*SOURCE: THE FINANCIAL SYSTEM & THE ECONOMY, 3RD ED., 2003, MAUREEN BURTON & RAY LOMBRA, PGS. 445-447*
Financial Futures Prices of financial securities, stocks, and foreign currencies have become unstable during the past 40 years. Consequently, financial futures markets, which trade financial futures, appeared and are now used by most major financial institutions and other large corporations to manage risk.
Financial futures are contracts in which two parties agree to trade standardized quantities of financial instruments on standardized future dates, according to the terms (including the price) that are determined today. Financial futures can be used to reduce to reduce the risk associated with future price changes of financial instruments.
The futures price is set by bidding and offering in an auction-like setting on the floor of the exchange. Each financial instrument that is traded usually has its own pit (trading area on the floor) where authorized brokers gather to buy and sell for their customers. Bid and asked prices (to buy or sell) are called out until the brokers become aware of the prices in the market. The most favorable transactions (from the point of view of both of both the buyers and sellers) are consummated. Once an agreement is struck in the pit, the transaction becomes depersonalized and the agents of the buyer and seller never meet again for that transaction. Instead, a clearinghouse, operated by the exchange, takes on the responsibility of enforcing the contract. Both the buyer and the seller rely on the clearinghouse to execute the transaction. Specifically, the seller looks to the clearinghouse to deliver, and the buyer looks to the clearinghouse to pay the amount due on the delivery date. In this way, the default risk associated with a forward transaction is greatly reduced because the clearing house of the exchange assumes the obligation.
The futures contract is a standardized agreement to make a trade at a later date. In exchange for the small brokerage fee, the clearinghouse of the organized exchange guarantees that the terms will be met. To facilitate this guarantee, the exchange requires buyers and sellers of futures to put up a performance bond, called a margin requirement, set by the exchange. Brokers are required to collect margin requirements from their customers before they make any futures purchases or sales. Note that the performance bond or margin is required of both the seller and the buyer and that the brokerage fee plus the margin requirements are relatively small compared to the dollar value of the futures agreement.
In summary, financial futures markets have experienced spectacular growth in the past 40 years because the financial world has become a much more volatile place and financial futures can be used to reduce risks associated with this volatility. Because interest rate swings are larger, the prices of government securities (or the value of any fixed-rate instrument) oscillate more rapidly and over a broader range. Stock prices now fluctuate over, and flexible exchange rates have increased the movement of currency prices, while foreign trade in goods, services, and securities has escalated sharply. Futures markets may be used to hedge all of these risks.
Recap
Financial futures are standardized contracts in which two parties agree to trade financial futures at a future date according to terms, including the price, that are determined today. Financial futures are different from forward agreements because the quantities and delivery dates are standardized, and thus, the brokerage fees are relatively small. Financial futures markets exist for government securities, stock market indexes, Eurodollars, and foreign currencies. Both the buyer and the seller have obligations and rights. Financial futures can be used to hedge the risk of future changes in prices or to speculate. Organized exchanges trade the standardized contracts.
*SOURCE: THE FINANCIAL SYSTEM AND THE ECONOMY, 3RD ED., 2003, MAUREEN BURTON & RAY LOMBRA, PGS. 439-445*
Never let the future disturb you. You will meet it,
if you have to, with the same weapons of
reason which today arm you against the present.
---Marcus Aurelius
A Single Solution
It is 5:10 P.M. on Friday in late 2016. The CEO's meeting with his staff has run later than usual, and a sense of uneasiness pervades the room. Doz-All, a newly emerging conglomerate is involved in diversified financial and manufacturing areas. The mortgage banking division has committed to make $10 million in loans at 8 percent to be funded in 60 days; $25 million in bonds issued 10 years ago for start up money is maturing in three months, and the company plans to pay off the existing bondholders by issuing new bonds. The newly formed international division is converting $20 million to Japanese yen to invest in Japanese securities over the next few months. The stock adviser points out that although the corporation has a diversified portfolio, there is a general fear that the market may be heading down.
All of these situations expose the corporation to risks---the risk that the interest rates (and hence bond prices), stock prices, or foreign exchange rates will move in an unexpected direction causing the corporation to experience a loss. The senior vice president appears tired. She cannot help but perceive that the risks associated with everyday business seem to have escalated in recent years.
In the past three decades, financial prices, such as interest rates, stock prices, and exchange rates, have become more volatile. The greater volatility has created greater risks. The chief financial officer (CFO) is a young business school graduate whom senior management has come to rely on. He assures them that there are ways to deal with the increased risk, although doing so will cost money. In this case, however, his recommendations are the source of the tension felt in the room. To reduce Doz-All's risk exposure, the CFO is recommending that the corporation use the financial forward, futures, or options markets that have emerged in the past 40 years actually be used to reduce or manage the risks inherent in everyday business?
Risk-averse financial intermediaries and corporations use financial forward, futures, and options contracts in their everyday business for just this purpose---to reduce the risks associated with price fluctuations.
Forward Transactions
Financial forward transactions can be used to hedge the risks associated with price changes of any financial instruments. Although virtually all financial prices have become more volatile in recent decades, forward agreements are primarily and more widely used to deal with the risks created by price fluctuations in foreign exchange markets.
The exchange rate is the price of one currency in terms of another. Exchange rate risk is the risk that changes in the exchange rate will cause someone to experience unexpected losses. The more unpredictable and unstable exchange rates are the greater the exchange rate risk. Exchange rates have become much more volatile since the major industrialized countries adopted the flexible exchange rate system in 1973. Also, as international trade has increased and as financial markets have become more globalized, the demand for foreign financial instruments has soared. This has led to the increased trading of foreign currencies with more volatile prices and a dramatic increase in exchange rate risk for market participants. The participants have found ways to hedge this greater exchange rate risk through the development of foreign markets.
Large banks have many customers that operate on a global basis. These customers may know that they will receive and/or need foreign currencies on a future date. The foreign currencies are used by the bank's customers to purchase or to pay for goods, services, and financial instruments. For example, perhaps one U.S. company will be liquidating its holding of French stock in six months to pay off a maturing domestic bond issue while another U.S. company plans to increase its investment in Europe. The first company will be receiving euros; the latter company will need euros. Another customer may be an importer or an exporter, or a securities firm that sells domestic and foreign financial instruments globally. Large banks not only buy and sell foreign exchange at spot rates for present delivery, but they also buy and sell foreign exchange for future delivery at a forward rate. The forward rate for a foreign currency will gravitate toward the expected future spot exchange rate for that currency. The forward rate is affected by the same factors that affect spot rates. These factors, which affect the supply and demand for foreign exchange, include expected inflation and interest rate differentials between the two countries, the economic outlook in both countries, and domestic and foreign monetary and fiscal policies. The forward rate can be used as a market-based forecast of the future spot rate.
Limitations of Forward Agreements
As we have seen, forward transactions can reduce the risks of future price changes which reduce profit. But as with most things in life, appearances may not reveal the whole picture. The forward market in foreign currencies described previously, works well because large banks have developed the market. For other financial instruments such as stocks and bonds, forward markets are not as highly developed. In this case, there are two general problems with arranging forward agreements:
Finding partners may be difficult; the transactions costs may be high and outweigh the possible gain. Finding partners who want the exact amount of the financial instrument on the exact date can be difficult at best.
One party to the agreement may default, that is, not keep its part of the agreement. The party who is likely to default is the one who is worse off down the road by entering into the forward agreement earlier. Getting compliance may require legal action and may be costly, if not impossible.
Although volatile prices of financial instruments other than foreign exchange may lead to large losses that could be reduced with forward agreements, the forward markets are not highly developed. Consequently, the costs of finding a partner and then enforcing the forward contract may be prohibitively high. To minimize the costs and risks involved with arranging forward transactions, standardized agreements called futures contracts have been developed for many types of financial instruments including stocks, T-bills, notes, bonds, and foreign currencies.
Recap Forward contracts are agreements to buy or sell something at a price determined today for delivery on a later date. Forward assignments between individual market participants are arranged by intermediaries. In financial markets, forward contracts in the most widely traded currencies have been established by large commercial banks. In addition, to buying and selling foreign currencies at spot prices, the banks also buy and sell the major currencies at forward rates. In this case, the bank is an actual partner in the transaction. When there are not exact offsetting transactions, the bank has some exposure to exchange rate risk. Foreign currency forward agreements can be used to hedge exchange rate risk or to speculate about future currency values. Foreign markets are not highly developed for financial instruments other than foreign currencies.
*SOURCE: THE FINANCIAL SYSTEM & THE ECONOMY, 3RD ED., 2003, MAUREEN BURTON & RAY LOMBRA, PGS. 433-439*
The Secondary Mortgage Market and Mortgage-Backed Securities Secondary markets trade previously issued financial claims. Prior to 1970 only mortgages issued by the Federal Housing Administration (FHA) or the Veterans Administration (VA) were sold in secondary markets and these were sold directly to investors. The amount of market activity was very small. The Federal National Mortgage Association (Fannie Mae) had been created by Congress in 1938 but did not establish a secondary market for FHA and VA loans until 1972. Fannie Mae issued bonds and bought FHA- and VA-insured mortgages. Still the market did not grow to any significant extent and was even declining because of a decrease in VA loans.
In 1968, Congress created the Government National Mortgage Association (GNMA, or Ginnie Mae). In 1970, Ginnie Mae began a program in which it guaranteed the timely payment of interest and principal on bundles of $1 million or more of standardized mortgages. Small denomination mortgages (mortgages up to the FHA and VA limits) were standardized with regard to the debt-to-income ratios of borrowers and the loan-to-value ratios of properties. The standardized mortgages were packaged together in a bundle to be resold in secondary markets. Thus, Ginnie Mae guaranteed (for a fee) that the mortgage bundles would be repaid. The guarantee was backed up by the full faith and credit of the U.S. government. Ginnie Mae fostered the creation of large secondary markets that increased the liquidity of previously illiquid mortgages.
The secondary market in mortgages created by the Ginnie Mae guarantee operates as follows: Private financial institutions such as banks or savings and loans gather or pool several Ginnie Mae federally guaranteed mortgages into a bundle of say $1 million. They then sell all or parts of the $1 million security, called a mortgage-backed security, to third-party investors such as pension funds, mutual funds or individual investors. The principal and interest on the mortgage backed security are paid from the payments that borrowers make on the original mortgages. If investors need their funds back before the security matures, they can sell them in a secondary market for mortgage-backed securities. It operates similar to the secondary market in corporate bonds.
Despite the lack of default risk because of the government guarantee. Ginnie Mae securities are subject to an interest rate risk. Namely, since they are long-term instruments, if the interest rate rises after the securities have been issued, the value of the securities will fall.
Find information on the operations of the GNMA (Ginnie Mae) at www.ginniemae.gov.
In 1970, Congress authorized Fannie Mae to purchase conventional (non-VA or non-FHA-insured) mortgages. Congress also created the Federal Home Loan Mortgage Corporation (Freddie Mac) to lend further support to the VA, FHA, and conventional mortgage markets. Congress hoped to make housing more available by increasing the funds flowing into mortgages. The goal, which remains the same today was to expand the opportunities for low- and moderate-income families to purchase homes. Although Fannie Mae purchased and held mortgages, it did not pool the mortgages to create a mortgage-backed security until 1981. Freddie Mac issued their first mortgage-backed security in 1971. It resulted from a pool of conventional mortgages. Fannie Mae primarily buys the mortgages of thrifts.
Fannie Mae and Freddie Mac are government-sponsored enterprises (GSEs). They are exempt from state and local corporate income taxes. Fannie Mae and Freddie Mac provide loanable funds to the housing sector. They purchase conventional loans, package or pool the mortgages together, and issue mortgage-backed securities, using the pool of mortgages as collateral. The mortgages purchased by Fannie Mae and Freddie Mac may also be directly held by Fannie Mae and Freddie Mac as investments instead of being packaged and sold as mortgage-backed securities.
Investors who purchase Fannie Mae and Freddie Mac mortgage-backed securities can sell them in secondary markets if funds are needed before the securities mature. The secondary market for mortgage-backed securities are created by market makers who buy and sell previously issued mortgage-backed securities. Some mortgage-backed securities are traded on organized exchanges.
Investors in mortgage-backed securities face the risk that the mortgages will be prepaid before they mature because the property is sold or refinanced and that the return will fall short of expectations. To reduce this risk, collateralized mortgage obligations have been developed by Freddie Mac. Collateralized mortgage obligations redirect the cash flows (principal and interest) of mortgage-backed securities to various classes of bondholders, thus creating financial instruments with varying prepayment risks and varying returns. Those who are most risk adverse can choose an instrument where the principal will soon be repaid. Those who are willing to bear more risk can choose an instrument where the principal will not be repaid until later and hence is subject to a greater prepayment risk. In exchange for more prepayment risk, the investor receives a higher return. Needless to say, such provisions make attractive choices available to a wider range.
Private Mortgage-Backed Securities
In 1984, some private groups started to issue their own mortgage-backed securities. The new securities did not rely on the backing of Ginnie Mae and were not issued by corporations like Fannie Mae or Freddie Mac that had ties to the federal government. Such issuers of private mortgage-backed securities include, among others, commercial bankers, and investment banking firms. Privately issued mortgage-backed securities may also be sold in secondary markets. Again, the secondary markets are created by market makers who trade the previously issued securities. Securities issued by private issuers are rated by the major credit rating agencies. The credit rating may also be improved by obtaining insurance that guarantees the timely payments of principal and interest on the securities.
Recap
Fannie Mae and Freddie Mac are government sponsored enterprises (GSEs) that issue mortgage-backed securities and use the proceeds to purchase mortgages. Ginnie Mae guarantees the timely payment of principal and interest on mortgage-backed securities put together by private lenders. Ginnie Mae securities have an explicit government guarantee. Other private groups issue mortgage-backed securities without government involvement. Secondary markets trade previously issued mortgage-backed securities. Collateralized mortgage obligations redirect the cash flows (principal and interest) of mortgage-backed securities to various classes of bondholders, thus creating financial instruments with varying risks and varying returns.
*SOURCE: THE FINANCIAL SYSTEM & THE ECONOMY, 3RD ED., 2003, MAUREEN BURTON & RAY LOMBRA, PGS. 416-418*
The Anatomy of Mortgages A mortgage is a long-term debt instrument for which real estate is used as collateral to secure the loan in the event of a default by the borrower. If the borrower defaults, the property is usually sold to recoup some or all of the losses. Mortgages are assets to the holder (lender) and liabilities to the issuer (borrower) who signs the mortgage agreement. They are similar to bonds, with the caveat that the underlying real property or land serves as collateral.
Mortgages result from loans made to individuals or businesses to purchase land. Single- or multiple-family residential housing, commercial properties, or farms. Mortgages may also be made to finance new commercial or residential construction. The building (structure) or land serves as collateral. The bulk of mortgages are made to individuals to purchase residential property. Thus, households are the major borrowers in this market. In general, borrowers put down a minimum of 5 to 20 percent to purchase a property and take out a mortgage loan for the balance of the purchase price.
Mortgages have either a fixed or variable interest rate. With fixed-rate mortgages, the interest rate does not very over the life of the loan. Lenders are exposed to an interest rate risk---the risk that nominal interest rates will rise, causing the value of fixed-rate mortgages to decline. In addition, if long-term fixed-rates are funded with short-term deposits, the lending institution can experience a negative cash flow if the costs of liabilities rise above the earnings on assets. With variable-rate mortgages. the interest rate is adjusted as other market interest rates change. If rates move up, the interest rate on the mortgages increases, and vice versa. Thus, variable-rate mortgages reduce the interest rate risk of holding long-term mortgages because in the event that interest rates rise, loan payments and interest rates on the mortgages also rise.
An additional risk---the prepayment risk---is that mortgages will be prepaid early and that the funds will have to be reinvested at a lower return. This risk increases greatly when interest rates fall, particularly if they stay low for a significant period of time as borrowers refinance their mortgages to take advantage of the lower rates. This risk is much less for variable-rate loans than for fixed-rate loans because the interest rate on variable-rate loans will fall along with other rates.
Unlike a bond whereby the principal is repaid at maturity, the repayment of the principal on a mortgage is generally spread out over the life of the loan. Each month, a constant monthly payment is made that includes some part of the principal in addition to the interest payment. At the end of the loan, the mortgage has been fully repaid. This is known as amortization. Mortgages are usually made for up to 30 years, although in recent years, shorter-term mortgages have increased because they result in tremendous interest savings over the life of the loan.
Residential mortgages may also be insured by an agency of the federal government. The insurance guarantees the repayment of the principal and interest in the event that the borrower defaults. This eliminates the credit or default risk for the lender. The two federal agencies that guarantee mortgages are the Federal Housing Administration (FHA) and the Veterans Administration (VA). For a .5 fee, the FHA insures mortgage loans made by privately owned financial institutions up to a certain amount that varies by state depending on average housing costs. The loan limit is adjusted each year in response to changes in housing prices. Borrowers must meet certain conditions dealing with income and credit as defined by the FHA. FHA loans are designed to help low-income families purchase homes. With the government guarantee, the lender does not have to worry about the borrower defaulting. VA loans are similar to FHA loans, but are designed to insure the principal and interest payments on loans made to veterans. The purpose is to help those who have served the country in the military to purchase homes. FHA and VA loans generally have small or no down payments.
Conventional mortgages have no federal insurance and are made by financial institutions and mortgage brokers. Conventional loans generally require a 5 to 20 percent down payment. Conventional mortgages may or may not require the borrower to purchase private insurance that would make the principal and interest payments in the event the borrower defaults. The borrower pays a higher interest rate to cover the cost of the insurance. Generally, when the down payment or equity in the property is less than 20 percent, lenders require borrowers to obtain private mortgage insurance. Private mortgage insurance is purchased from a privately owned insurance company.
Mortgage rates, the size of mortgage you can afford, and a payment calculator are available on the internet at www.mortgagequotes.lycos.com.
Mortgages are long-term debt instruments used to purchase residential, commercial, and farm properties. The underlying property serves as collateral. Fixed-rate mortgages carry the risk to the lender that nominal interest rates will rise and the value of the mortgages will fall. When the interest rate falls borrowers will refinance at the lower rate, causing the lender to have to reinvest the funds at a lower rate. The interest rate on variable rate mortgages is adjusted as market rates change. The principal of a mortgage is generally amortized over the life of the loan. The principal and interest payments may be insured by the FHA or VA, which are agencies of the federal government. Conventional loans have no federal insurance and are made by financial institutions and mortgage brokers. Lenders may require borrowers with conventional loans to obtain private mortgage insurance.
*SOURCE: THE FINANCIAL SYSTEM & THE ECONOMY, 3RD ED., 2003, MAUREEN BURTON & RAY LOMBRA, PGS. 414-416*
Municipal Bonds Municipal Bonds (munis) are bonds issued by state, county, or local governments to finance public projects such as schools, utilities, roads, and transportation ventures. The interest on municipal securities is exempt from federal taxes as well as from state taxes for investors living in the issuing state. This allows for the issuer to borrow at a lower rate than if taxes would have to be paid on the interest earned.
Taxpayers in a tax bracket higher than the average marginal bracket can earn a higher return by investing in munis. The cost to the state, county or local government issuer is less than it would be if the interest income were not tax exempt. Thus, if the comparable corporate rate is 8 percent, the average marginal tax bracket is 25 percent and the muni rate is 6 percent. Taxpayers in a tax bracket above 25 percent can earn a higher after-tax return by investing in munis. In addition, in this case, municipalities can borrow at a 2 percent lower rate than if their interest income were not tax exempt.
Municipal bonds may be either general obligation bonds or revenue bonds. General obligation bonds are repaid out of general tax revenues. There has not been a default in the state-issued municipal bonds market in the last 100 years. This is not true for munis issued by local and county governments. Repayment of revenue bonds is tied to the success of a specific project that the bonds support. That is, the bondholder is paid back out of the cash flows of a particular project. There have been defaults on revenue bonds when specific projects did not generate the forecasted revenues.
Government Agency Securities
Government agency securities are issued by private enterprises that were publicly chartered by Congress to reduce the cost of borrowing to certain sectors of the economy. Government agency securities may be divided into two classes: government-sponsored enterprises and federally-related-institutions securities markets.
Areas where government-sponsored enterprises (GSEs) have been established include housing, farming, the savings and loan industry, and student loans. Among others, GSEs include the Federal Home Loan Banks, the Federal National Mortgage Association, the Federal Home Loan Mortgage Corporation, the Farm Credit System, and the Student Loan Marketing Association. All are privately owned and issue long-term securities (bonds) to assist in some aspect of lending, such as funding of mortgage loans, student loans and farm credit. In most cases, the federal government has no legal obligation to guarantee the timely payment of interest and principal. However, many market participants assume that the government does de facto guarantee the payments.
In addition to government agency securities, the Federal Financing Bank, created in 1973, issues bonds to borrow for several federally related institutions. Among others, these institutions include the Commodity Credit Corporation, the General Services Administration, the Government National Mortgage Association, the Rural Telephone Bank, the Small Business Administration, and the Tennessee Valley Authority. The bonds issued by the Federal Financing Bank are backed by the full faith and credit of the U.S. government.
The yield spread between government agency securities and U.S. government securities reflects differences in liquidity and risk. The yield can be significant because secondary markets do not have the breadth and depth of Treasuries.
Recap
Municipal securities are bonds issued by state, county, and local governments. The interest income on municipal securities is exempt from federal taxes and from state income taxes for investors in the state where the municipals were issued. Municipal securities may be either general obligation bonds or revenue bonds. Government agency securities are issued by government-sponsored enterprises and by the Federal Financing Bank.
*SOURCE: THE FINANCIAL SYSTEM & THE ECONOMY, 3RD ED., 2003, MAUREEN BURTON & RAY LOMBRA, PGS. 412-413*
The Treasury Bond Market U.S. governrment bonds, or Treasury bonds, are issued in the primary market by the Bureau of the Public Debt in minimum amounts of $1,000. Treasury bonds are sold in regularly scheduled competitive auctions that have historically been conducted during February, August, and November by the Federal Reserve System. Treasury notes and T-bills are sold in other regularly scheduled auctions. The Treasury decides the maturity structure and the amount of the various offerings. Information regarding Treasuries securities can be found on the Fed's Internet site at www.federalreserve.gov.
Treasury bonds are a full faith and credit obligation of the U.S. government. Consequently, investors view securities as being free from default risk. The federal government, with its power to tax or issue currency, will definitely pay back the principal and interest as scheduled. Because they are so highly liquid and free of default risk, interest rates on Treasury securities serve as a benchmark to judge the riskiness and liquidity of other securities.
However, Treasury bonds are not free of interest rate risk. If the interest rate goes up after the bonds are issued and before their maturity, the value of the bonds will go down. If the bonds are sold before maturity, the investor will receive less than the face value of the bonds and experience a capital loss.
The secondary market in treasury bonds is an over-the-counter market where a group of U.S. government securities dealers stands ready to buy or sell various issues of outstanding securities over the counter. Today Treasury securities are sold in secondary markets somewhere in the world 24 hours a day. An extensive and very active secondary market makes treasury bonds highly liquid. The dealers' profits stem from the spread between the bid (buying) and ask (selling) prices.
A desirable feature of treasury bonds is that the interest earned is exempt from state income taxes. Not all states have state income taxes and this feature is particularly beneficial in states with high income tax rates.
Treasury STRIPS are a type of government security first offered in 1984 and sold through depository institutions and government securities dealers. All newly issued treasury notes and bonds with maturities of 10 years or longer are eligible for the STRIPS program. STRIPS allow investors to register and trade ownership of the interest (coupon) payments and the principal amount of the security. The advantage of STRIPS is that the coupon and principal payments can be sold separately at a discount. STRIPS are sold in book entry form, meaning that the security is issued and accounted for electronically. The investor pays less today for the future payment than he or she will receive when the security matures. The interest the investor earns is the difference between what is paid today and what is received at maturity. Because the future payments are sold at a discount, the investor avoids uncertainty that coupon payments may have to be reinvested at a lower interest rate because rates have fallen since the security was issued. The future payments of the STRIPS securities are direct obligations of the U.S. government.
Inflation-indexed bonds are a more recent hybrid, first offered for sale by the Treasury in 1997. An inflation-indexed bond is one in which the principal amount is adjusted for inflation at the time when an interest (coupon) payment is made, usually every six months. Although the interest rate does not change, the interest payments are based on the inflation-adjusted principal, and the inflation-adjusted principal is received at maturity. Inflation-indexed bonds protect the investor from the ravages of inflation.
Recap
Treasury securities are sold in competitive auctions. They are considered to be free of default risk, and their interest rate serves as a benchmark to judge the risk and liquidity of other financial assets. The secondary market for government securities is a highly developed over-the-counter market. STRIPS are a government security that allows the investor to register and trade ownership of the coupon payments and the principal separately. The principal of inflation-indexed bonds is adjusted for inflation every six months. Although the interest rate does not change, the coupon rate is based on the inflation-adjusted principal at maturity.
*SOURCE: THE FINANCIAL SYSTEM & THE ECONOMY, 3RD ED., 2003, MAUREEN BURTON & RAY LOMBRA, PGS. 410-412*
