Topic 2: Asset Classes and Financial Instruments

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McGraw-Hill/Irwin

Copyright 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

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Asset Classes
Money market instruments Capital market instruments
Bonds Equity Securities Derivative Securities

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The Money Market

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.

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Table 2.1 Major Components of the Money Market

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Treasury bills (Part 1)

Short-term debt of U.S. government Investors buy the bills at a discount from the stated maturity value (the face value) Initial maturities: 4, 13, 26, 52 weeks Minimum denomination $100, but $10,000 much more common Primary market (auction), secondary market (government securities dealer) Exempt from all state and local taxes
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Treasury bills (Part 2)

Financial press reports yields based on the T-bill prices Bid and asked price, bid-asked spread Bank discount method: quoting convention that annualizes (based on 360-day year) the discount as a % of face value

rBD

F P 360 F t

where F is the face value, P is the purchase price and t is the days to maturity Why is the bank discount yield not a meaningful measure of the investors return?
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Treasury bills (Part 3)

Financial press reports yields based on the T-bill prices
How to interpret the ASK yield of 0.043? The discount from par would be 0.043%* (36 days to maturity/360) = 0.0043% A bill with a par value of $10,000 is therefore selling for $10000*(1-0.000043) = $9,999.57

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Treasury bills (Part 3)

Holding period yield: Effective annual yield:

HPY

F P P

EAY

(1 HPY) 365 /t 1

Money-market yield/CD-equivalent yield: 360 F rmm HPY rBD t P

365 Bond-equivalent yield (asked yield)= HPY t

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Money Market Securities

Certificates of Deposit: Time deposit with a bank
Negotiable when in denominations > $100,000 FDIC insured up to $250,000 as of the moment ST CDs highly marketable but market thins out at maturities exceeding 3 months

Commercial Paper: Short-term, unsecured debt of a company

Often backed up by a bank line of credit Maturities up to 270 days, typically < 2 months Asset-backed CP: issued by banks (financial institutions) to raise funds to invest in assets used as collateral

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Money Market Securities

Bankers Acceptances: An order to a bank by a banks 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.

Repos: dealer sells T-bills to an investor on an overnight basis, with an agreement to buy them back the next day at a slightly higher price (implicit interest) Term Repo: term of the implicit loan can be 30 days or more Reverse repo: dealer buys T-bills agreeing to sell them later at a specified higher price on a future date

Fed Funds: Very short-term loans between banks

Each member bank of the Federal Reserve System is required to maintain a minimum balamce in a reserve account
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Yields on Money Market Instruments

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
Reserve Primary Fund broke the buck after the fall of Lehman (value per share fell below $1)
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The TED spread = LIBOR-T-bill rate

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CD-T-bill Spread and correlation with financial crises

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The Bond Market

Treasury Notes and Bonds Inflation-Protected Treasury Bonds Federal Agency Debt International Bonds Municipal Bonds Corporate Bonds Mortgages and Mortgage-Backed Securities
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Treasury Notes and Bonds

Maturities
Notes maturities up to 10 years Bonds maturities from 10 to 30 yrs

Par Value - $1,000 Interest paid semiannually Quotes percentage of par Price of 102:29 = 102 +29/32= 102.906% of $1000 = $1029.06
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The Bond Market

Inflation-Protected Treasury Bonds
TIPS: Provide inflation protection Principal amount is adjusted in proportion to increases in CPI

Federal Agency Debt

Debt of mortgage-related agencies such as Fannie Mae and Freddie Mac Not explicitly insured by the federal government, widely assumed government would step in to assist an agency nearing default

International Bonds
Eurobonds: bonds denominated in a currency other than that of the country in which they are issued Yankee bonds: dollar-denominated bond sold in the US by a non-US issuer INVESTMENTS | BODIE, KANE, MARCUS

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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 projects revenues or by the municipal agency operating the project. Industrial development bond: revenue bond that is issued to finance commercial enterprises such as the construction of a factory that can be operated by a private firm INVESTMENTS | BODIE, KANE, MARCUS

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Tax-exempt Debt Outstanding

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Municipal Bond Yields

To choose between taxable and tax-exempt bonds, compare after-tax returns on each bond. Let t equal the investors marginal tax bracket Let r equal the before-tax return on the taxable bond and r m denote the municipal bond rate. If r (1 - t ) > r m then the taxable bond gives a higher return; otherwise, the municipal bond is preferred.
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Table 2.2 Tax-Exempt Yield Table

The equivalent taxable yield is the rate that a taxable bond must offer to match the after-tax yield on the tax-free muni.
The equivalent taxable yield is thus is simply the tax-free rate, rm , divided by (1-t). We can also solve for cut-off tax bracket at which investors are indifferent between taxable and tax-exempt bonds. t =1- rm /r

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Corporate Bonds
Issued by private firms Semi-annual interest payments Subject to larger default risk than government securities Types:
Secured (specific collateral backing them in the event of bankruptcy) Debentures (no collateral) Subordinated debentures (lower priority claim to the firms assets in the event of bankruptcy)

Options in corporate bonds

Callable Convertible

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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 passthroughs because the cash flows produced by homeowners paying off their mortgages are passed through to investors.

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Figure 2.6 Mortgage-backed securities outstanding

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Equity Securities
Common stock: Ownership
Each share entitles its owner to one vote on any matters of corporate governance that are put to a vote at the corporations annual meeting and to a share in the financial benefits of ownership Residual claim: stockholders are the last in line of all those who have a claim on the assets and income of a corporation Limited liability: the most shareholders lose in the event of a failure of the corporation is their original investment

American Depository Receipts: certificates traded in US markets that represent ownership in shares of a foreign company

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Equity Securities
Preferred stock: Perpetuity
Fixed dividends No voting power regarding the management of the firm Firm retains the discretion to make the dividend payments to preferred stockholders (no contractual obligation like bonds) Priority over common: preferred dividends are cumulative Tax treatment not tax deductible for the issuing firm, but corporations can exclude up to 70% of dividends received from domestic corporations in the computation of taxable income. As a result, preferred stock often sells at lower yields than corporate bonds.

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Stock Market Indexes

Dow Jones Industrial Average
Includes 30 large blue-chip corporations Computed since 1896 Price-weighted average

The return on the index is equivalent to holding a portfolio that invests one share in each of the 30 stocks of the index

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Example 2.2 Price-Weighted Average

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%
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Adjustments to the divisor of DJIA

The averaging procedure is adjusted whenever a stock splits or pays a stock dividend of more than 10%, or when a company is the group of 30 industrial companies is replaced by another. The divisor used to compute the average price is adjusted so as to leave the price unchanged. Suppose XYZ undergoes a 2:1 stock split in the beginning of the period. Price falls to $50, the number of shares outstanding doubles, leaving the market value of total shares unaffected. Index value before split (100+25)/2=62.5 To find the divisor, d, solve (50+25)/d=62.5 Result: d=1.2 Return on the index is affected by the split: Index value at the end of the period = (30+45)/1.2 = 62.5, so return now is 0, instead of -4%

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Standard & Poors Indexes

S&P 500
Broadly based index of 500 firms
Market-value-weighted index Rate of return on the index = rate of return on a portfolio of the 500 underlying stocks where the portfolio weights are proportional to the total market value of each stock (or in a modified measure, the market value of free float)

Market value weighted index of XYZ and ABC: the return would be (690-600)/600 = 15%
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Indexes
Investors can base their portfolios on an index:
Buy an index mutual fund
The index fund yields a return equal to that of the benchmark index and thus provides a low-cost passive investment strategy for equity investors.

Buy exchange traded funds (ETFs)

Portfolio of shares that can be bought or sold as a unit

Equally-weighted indexes: equally-weighted average of the returns of each stock in the index
Implicit portfolio strategy that places equal dollar values on each stock Unlike price-weighted and market-value-weighted indexes, this does not correspond to a simple buy-and-hold strategy. Needs rebalancing to reset portfolio to equal weights.

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Other Indexes
U.S. Indexes
NYSE Composite NASDAQ Composite Wilshire 5000

Bond Indexes
Difficult to compute true

rates of return since a lot of bonds trade only infrequently Matrix prices calculated from bond-valuation models instead of true market values

Foreign Indexes Nikkei (Japan) FTSE (U.K.; pronounced footsie) DAX (Germany), CAC (France) Hang Seng (Hong Kong) TSX (Canada)

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Derivatives Markets
Options and futures provide payoffs that depend on the values of other assets such as commodity prices, bond and stock prices, or market index values.
A derivative is a security that gets its value from the values of another asset.

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Options
Call: Right to buy underlying asset at the strike or exercise price.
Value of calls decrease 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 increase with time until expiration.

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Futures Contracts
A futures contract calls for 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

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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

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