Asset classes and

financial instruments
Chapter 2

Dr. Lakshmi Kalyanaraman 1

Investment process
Asset allocation how much to allocate to broad classes
of assets

Security selection choice of specific assets in each

asset class

Dr. Lakshmi Kalyanaraman 2

Asset classes
Money market instruments

Capital market instruments

Bonds
Equity Securities
Derivative Securities

Dr. Lakshmi Kalyanaraman 3

Money Market
Subsector of fixed-income market

Short-term debt securities

Highly marketable, low risk

Trade in large denominations and so out of reach of individual

investors

Money market mutual funds provide access

Dr. Lakshmi Kalyanaraman 4
Capital markets
Longer-term
Riskier
Four segments:
1. long-term debt
2. equity
3. derivative markets for futures and options

Dr. Lakshmi Kalyanaraman 5

Money market securities

Dr. Lakshmi Kalyanaraman 6

Treasury Bills
Most marketable of all money market
instruments

Short term government security

Issued at a discount from face value

Matured at face value

Initial maturities 4,13,26 or 52 weeks

Dr. Lakshmi Kalyanaraman 7
Treasury Bills
Individuals can buy from Treasury or govt.
security dealers

Minimum denomination $100

Bid ask price

Dr. Lakshmi Kalyanaraman 8

Certificate of Deposit (CD)
Time deposit with a bank

May not be withdrawn on demand

Denominations larger than $100,000

Negotiable

Dr. Lakshmi Kalyanaraman 9

Commercial Paper
Short term unsecured debt issued by corporations to
the public

Sometimes backed by a bank line of credit which is

available for repayment

Maturities ranges from 30 days up to 270 days

Dr. Lakshmi Kalyanaraman 10

Commercial Paper
Denominations in multiples of $100,000 for one or two
months

Small investors access only through MMMFs

Traded in secondary markets, hence liquid

Asset backed commercial paper issued by banks to buy

other assets offered as collateral

Dr. Lakshmi Kalyanaraman 11

Bankers Acceptances
An order to a bank by a customer to pay a sum of
money at a future date, typically within 6 months
Similar to post dated check
When bank endorses the order for payment as
accepted, it assumes responsibility for payment
Acceptance may be traded in the secondary market
Generally used in foreign trade

Dr. Lakshmi Kalyanaraman 12

Eurodollars
Dollar-denominated deposits at foreign banks or foreign
branches of American banks
Deposits of large sums, time deposits of less than 6
months
Eurodollar CD liability of a non-US branch of a bank
Less liquid and more risky than domestic CDs and offer
higher yields

Dr. Lakshmi Kalyanaraman 13

Repurchase Agreements (Repos) and
Reverse
Short-term sales of government securities with an
agreement to repurchase the securities at a higher price
Over-night
Reverse repo mirror of repo
Buys and resells at a specified higher price

Dr. Lakshmi Kalyanaraman 14

 Federal Funds

Banks are required to keep a certain percentage of their

total deposits in a reserve account with Federal Fund

Federal funds market banks with excess funds lend to

banks with shortage at fed funds rate

Dr. Lakshmi Kalyanaraman 15

Brokers Calls
Investors borrow funds from brokers for margin trading
Brokers in turn borrow from banks with a commitment
to repay at call
Normally one percentage point higher than the rate on
short-term T bills

Dr. Lakshmi Kalyanaraman 16

LIBOR Market
Lending rate among banks in the London market

Dr. Lakshmi Kalyanaraman 17

Yields on Money Market
Instruments
Except for Treasury bills, money market
securities are not free of default risk
Securities of money market promise yields
greater than those on default-free T-bills
because of greater relative riskiness
Investors requiring more liquidity accept
lower yields

Dr. Lakshmi Kalyanaraman 2-18

Capital market securities

Dr. Lakshmi Kalyanaraman 19

Bond market
Long-term debt instruments
Fixed-income capital market

Dr. Lakshmi Kalyanaraman 20

Treasury notes and bonds
Issued by Government
T-notes are issued with maturities ranging up to 10
years
Bonds issued with maturities ranging from 10 to 30
years
Issued in increments of 100 but normally in $1,000
Semi-annual coupon payments

Dr. Lakshmi Kalyanaraman 21

Inflation-protected treasury bonds
Least risky
Principal amount of the bonds is adjusted in proportion
to increases in Consumer Price Index
Provide a constant-stream of income in real (inflation-
adjusted) dollars

Dr. Lakshmi Kalyanaraman 22

Federal agency debt
Issued by government agencies to finance their
activities

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International bonds
Firms borrow abroad
Eurobond is a bond denominated in a currency other
than that of the country in which it is issued
Ex: dollar-denominated bond sold in UK
Foreign bond is issued by a firm in foreign countries but
in the currency of investor

Dr. Lakshmi Kalyanaraman 24

Municipal bonds
Issued by state and local governments
Exempt from federal and local taxation
General obligation bonds: backed by full faith and
credit of the issuer
Revenue bonds : backed either by the revenues from
the project for which it funded or revenues of the
particular municipal agency operating the project

Dr. Lakshmi Kalyanaraman 25

Corporate Bonds
Issued by private firms
Semi-annual interest payments
Subject to larger default risk than
government securities
Options in corporate bonds
Callable
Convertible

Dr. Lakshmi Kalyanaraman 2-26

 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.

Dr. Lakshmi Kalyanaraman 2-27

Equity Securities

Common stock: Ownership

Residual claim
Limited liability
Preferred stock: Perpetuity
Fixed dividends
Priority over common
American Depository Receipts

Dr. Lakshmi Kalyanaraman 2-28

Stock and bond market indexes
Price-weighted indexes
Value-weighted indexes
Equally weighted indexes

Dr. Lakshmi Kalyanaraman 29

 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.

Dr. Lakshmi Kalyanaraman 2-30

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.

Dr. Lakshmi Kalyanaraman 2-31

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

Dr. Lakshmi Kalyanaraman 2-32

Comparison
Option Futures Contract
Right, but not Obliged to make or
obligation, to buy or take delivery. Long
sell; option is exercised position must buy at
only when it is the futures price, short
profitable position must sell at
Options must be futures price
purchased Futures contracts are
The premium is the entered into without
price of the option cost
itself.

Dr. Lakshmi Kalyanaraman 2-33