Chapter2: Asset Classes + Financial Instruments

Financial markets are traditionally segmented into:

Money market (cash/cash equivalent) include short-term,
marketable, liquid, low-risk debt securities, trade in large
denominations.
Capital markets, include longer term and riskier securities, they
are much more diverse than those found within the money market.
They can be divided into three segments: long-term bond
markets, equity markets, and the derivative markets for options and
futures.

MONEY MARKET INSTRUMENTS

(US) T-BILLS: simplest form of borrowing, government raises money
by selling bills to the public. Investors buy them at a discount
depending on their maturity value. At maturity, the investor
receives a payment equal to the face value from government. The
difference between purchase price and maturity value = investors
earnings.
Initial maturity 4,13, 26, 52 weeks
Purchased at auction, directly or secondary market from
government dealer at the ask price (but you, as investor, would sell
at bid price)
Highly liquid (easily convertible to cash)
Low transaction costs = not much price risk
Sell in min denominations of $100 and/or $10,000
State and local tax exempt
CERTIFICATE OF DEPOSIT (CD): is a time deposit with a bank (cannot
be withdrawn until maturity). The bank pays interest and principal to
the depositor (us, the customers) at maturity.
Issued in denominations of $100,000 +
Can be sold to another investor, before maturity date, if depositor
needs immediate cash
ST CDs are highly marketable (maturities of +3months)
COMMERCIAL PAPER: companies often issues their own ST
unsecured debt notes rather than borrow directly from banks.
Considered to be safe assets.

 Backed by a bank line of credit (gives borrower access to cash)

Maturities range up to 270 days (longer maturities requires
registration with SEC)
Usually issued in multiples of $100,000
Asset backed commercial paper, are used by banks (assets are
used as collateral in case of default)
BANKERS ACCEPTANCES: a customer orders a bank to pay a sum of
money at a future date (typically 6 months), like a postdated check.
When bank endorses the order for payment as accepted, it
assumes responsibility for ultimate payment.
Considered very safe assets, traders can substitute the banks
credit rating for their own
Widely used in foreign trade but creditworthiness of each party is
not informed
Acceptances sell at discount from face value
EURODOLLARS: dollar denominated deposits at foreign banks/
branches of American banks. By being outside of the US, bank
escape regulation by the Fed Reserve. EuroDollar CDs are for large
sums with maturity of 6 months or less.
The holder can sell the asset to realize its cash value before
maturity
Considered less liquid and riskier, hence, provide higher yields
FEDERAL FUNDS: banks put deposits at their own bank which is the
Federal Reserve Bank (the Fed). Each member of the bank needs to
maintain a minimum balance in a reserve account (balance depends
on total deposit).
Banks with excess funds lend to those with a shortage
Overnight transactions are arranged at the fed funds rate, rate on
ST loans among institutions.
BROKERS CALLS: Individuals buy stocks on margin. They borrow
part of the funds to pay for the stocks from their broker. The broker,
in turn, may borrow the funds from a bank, agreeing to repay the
bank immediately (on call) if the bank requests it.
The rate paid on such loans is usually about 1% higher than the
rate on short-term T-bills.
THE LIBOR MARKET (LIBOR): rate at which large banks lend among

themselves in Europe, it is the premium ST interest rate.

it is used as a reference rate for a wide range of transactions (ie)
a rate may quoted as x% + LIBOR rate
LIBOR interest rates can be tied up to currencies other than the
US$

THE BOND MARKET INSTRUMENTS

It is composed of LT borrowing/debt instrument than those in money
market. They promise a fixed stream or a stream of income that is
determined according to a specific formula.
TREASURY NOTES AND BONDS: US government borrows funds
largely by selling T-Notes and T-Bonds. Yield to maturity is calculated
with semi annual yield and doubling it, for a yearly basis (APR).
Issues notes with maturities ranging up to 10 years, bonds are
issued with maturities from 10 to 30 years.
Notes and Bonds make semi-annual interest payments called
coupon payments.
Bonds are traded in denominations of $1000 par value, price is
quoted as percentage of par ie) 123.4567% = $1234,567
INFLATION PROTECTED T-BONDs (TIPS): principal amount on bonds
is adjusted in proportion to increases in the Consumer Price Index.
They provide a constant stream of income in real (inflation-adjusted)
dollars.
INTERNATIONAL BONDS: firms borrow abroad, and, some investors
buy bonds from foreign issuers. A Eurobond is a bond denominated
in a currency other than that of the country in which it is issued I.e.)
Yankee or Samurai bonds

MUNICIPAL BONDS: issued by state/local governments. They are tax

exempt so they receive lower yield, but, capital gains tax must be
paid by investors at maturity or if sold above purchase price. Vary
widely in maturity
General obligation bonds are backed by full faith and credit of the
issue
Revenue bonds are issued to a particular finance projects backed
by revenues from projector by municipal agency operating project;
they are riskier than general obligation bonds.

 Industrial Development bond is a revenue bond issued to

commercial enterprises, it gives firm access to municipalitys ability
to borrow as tax exempt.
Equivalent taxable yield of TAX EXEMPT BOND;

rm = r x (1 - t) rm = rate on municipal bonds

r= rm / (1 t) r=before tax return available on taxable bond
(cut off bracket) t = 1 (rm/r) t = federal+local marginal tax
bracket

after tax proceeds would be (1 t federal) x (1 t state)

If the equivalent taxables yield > the actual yields on taxable
bonds, the investor is better off after taxes holding municipal
bonds.
CORPORATE BONDS: means by which private firms borrow money
directly form the public; Pay semi-annual coupons; return face value
to bondholder at maturity.
Secured bonds have specific collateral backing them in event of
bankruptcy; Debentures (unsecured bonds) have no collateral
Subordinated debentures have a lower priority claim to firms
asset in even of bankruptcy
Callable bonds give the firm the option to repurchase the bond
from the holder at announced call price; Convertible bonds have the
option to convert into stipulated number of shares of stock
MORTGAGES AND MORTGAGE-BACKED SECURITIES: anyone can
invest in a portfolio of mortgage loans. It is an ownership claim in a
pool of mortgages or an obligation that is secured by such a pool.
(THIS IS WHAT CAUSED THE FINANCILA MARKET CRASH IN 2007
-2008)

EQUITY SECURITIES
COMMON STOCK also known as equity securities: they represent
ownership shares in a corporation, each share entitles its owner to
one vote on decision of corporate governance.
The firm is controlled by a board of directors elected by
shareholders who then, elect managers that run the firm on a daily
basis.

Managers have the authority to make most business decisions

without the boards approval. Separation of ownership and control
can give rise to agency problems.
the stock has residual claim, they are last in line to aquire a
claim in case of default. If managers can pay residual, it is in the
form of cash dividends and they can reinvest them to enhance
value.
It has limited liability where the most shareholders can lose is
their original investment
The NYSE is one of markets in which investors may buy/sell stock.
Price-earnings ratio (P/E) is the ratio of the current stock price,
it tells us how mcuh stock purchasers must pay per dollar of
earnings that the firm generates.
PREFFERED STOCK : have features of both equity and debt. It
promises to pay fixed income each year (like a bond) as a perpetuity
(contractual obligation). It is also an equity investment becasue of
its dividend payments. Although, managers do not have the
obligaiton to pay them out but they are cumulative over time.
Make a desirable fixed income investment for some corporations
They are not tax deductible epxenses
Often sell at lower yields than corporate bonds
It may be callable by issuing firm, they are redeemable, they are
also convertible into common stock.
AMERICAN DEPOSITORY RECEIPTS (ADRS): are certificates traded in
US market and represent ownership in shares of a foreign company,
it is the most common way for US investors to invest in and trade
the shares of foreign corporations.

STOCK AND BOND MARKET INDEXES

DOW JONES INDUSTRIAL AVERAGES (DIJA): demonstrate the average
performance (price of stocks) of 30 large, blue chip corporations.
The DIJA measures the return on a portfolio that invests one share in
each of the 30 stocks in the index.
it is called a price-weighted average
The averaging procedure is adjusted whenever a stock splits or
pays a stock dividend of more than 10%, or when another replaces
one company in the group of 30 industrial firms.
STANDARD AND POORs INDEXES (S&P500): demonstrates a broad
index of 500 firms. It is computed by calculationg the total market
value of the firms in the index and total market value of the previous
day.
it is a market-value weighted index
the index does not reflect cash dividends

 the rate of return of index equals the rate of return that would be
earned by an investor holding securities in all 500 firms.
Investors today can easily buy market indexes for their portfolios.
One way is to purchase shares in mutual funds that hold shares in
proportion to their representation in the S&P 500 or another index.