chapter 2_investments-asset classes and financial instruments

Money Market Instruments• Subsector of the debt market • Short-term debt securities that are highly marketable • Trade in large denominations and are out of the reach of individua l inve

Chapter 2

Asset Classes and Financial Instruments

2.1 The Money Market

2-2

Money Market Instruments

• Subsector of the debt market

• Short-term debt securities that are highly marketable

• Trade in large denominations and are out of the reach of individua

l investors.

• However, money market mutual funds are easily accessible to sma

ll investors

2-3

Treasury Bills (T-bills)

Treasury bills

- Issued by Federal Government

- Denomination $100, commonly $10,000

- Maturity 4, 13, 26, or 52 weeks

- Liquidity Highly liquid

- Default risk None

- Taxation Federal taxes owed, exempt from state and local taxes

2-4

Certificates of Deposit (CD)

Certificates of Deposit

- Issued by Depository Institutions

- Denomination Any, $100,000 or more are marketable

- Maturity Varies, typically 14 day minimum

- Liquidity 3 months or less are liquid if marketable

- Default risk First $100,000 ($250,000) is insured

- Taxation Interest income is fully taxable

2-5

- Liquidity 3 months or less are liquid if marketable

- Default risk Unsecured, Rated, Mostly high quality

- Taxation Interest income is fully taxable

2-6

Federal Funds and LIBOR

- Usually overnight transactions at the Federal funds rate

- Key interest rate for the economy

LIBOR (London Interbank Offer Rate)

- Rate at which large banks in London (and elsewhere) lend to each other

- Base rate for many loans and derivatives

2-7

Brokers’ Calls

Call Money Rate

- Investors who buy stock on margin borrow money from their brokers to purchase stock The borrowing

rate is the call money rate

- Usually about 1 % + the rate on short-term T-bills

2-8

Yields on Money Market Instruments

Most money market securities are of low risk, not risk-free

Money market securities promise yields greater than those on default-free T-bills

For example, investors who want more liquidity will accept lower yields on securities that can be more quickly and cheaply sold for cash

2-9

Figure 2.3 Spreads on CDs and Treasury Bills

2-10

2.2 The Bond Market

2-11

Capital Market - Fixed Income Instruments

• Composed of longer-term borrowing or debt instruments t han those that trade in the money market.

• Treasury notes and bonds, corporate bonds, municipal bo nds, mortgage securities, and federal agency debt

2-12

US Treasury Notes and Bonds

 Issued by the U.S government

 Maturities T-notes: Maturities ranging up to 10 years T-bonds: Maturities ranging from 10 to 30 years

 Denomination: Commonly trade in denominations of $1,000

 Semiannual interest payments called coupon payments

2-13

Figure 2.3 Listing of Treasury Issues

2-14

Source: Compiled from data from The Wall Street Journal Online, July 6, 2011

Federal Agency Debt

Issued by government agencies to finance their activities

These agencies are formed for public policy reasons to channel credit a particular sector of the economy

Most are home mortgage related

- Issuers: FNMA, FHLMC, GNMA, Federal Home Loan BanksRisk of these securities?

- Not explicitly insured by the federal government, but implied backing by the government.

- In September 2008, Federal government took over FNMA and FHLMC.

2-15

Municipal Bonds

Issued by state and local governments

Similar to Treasury and corporate bonds, except their interest income is exempt from federal income taxation and state/local taxation

The higher the bracket, the more valuable the tax-exempt feature of municipals

2-16

Figure 2.4 Outstanding Tax Exempt Debt

2-17

Corporate Bonds

Issued by private firms

These bonds are structured much like Treasury issues

The difference from Treasury bonds is in risk

- Investment grade vs speculative grade

- Secured vs Unsecured

 Secured bonds: specific collateral backing

 Unsecured bonds: Called debentures, No collateral

 Subordinated debentures: a lower priority claim to the firm’s asset in the event of bankruptcy

2-18

Mortgage-Backed Securities

A security backed by a pool of mortgages

Mortgage lenders originate loans and then sell packages of these loans

in the secondary market

- Sell their claim to the cash inflows from the mortgages

In the year leading up to 2008, a large amount of subprime mortgages, that is, riskier loans made to financially weaker borrowers, were bundl

ed and sold by private label issuers

Pool issuers assumed housing prices would continue to rise, but they began to fall as far back as 2006 with disastrous results for the markets

2-19

Figure 2.6 Mortgage Backed Securities Outstanding

2-20

2.3 Equity Securities

2-21

Capital Market - Equity

Common stock

- Residual claim

In the event of bankruptcy or liquidation, what will stockholders receive?

: Stockholders are the last in line of all those who have a claim on the assets and income of the corporation (Debtholders – preferred – common)

- Limited liability

What is the maximum loss on a stock purchase?

: Can only lose your initial investment

In the event of the firm’s bankruptcy, corporate stockholders at worst have worthless stock

2-22

Capital Market - Equity

Preferred stock

- Features similar to both equity and debt

1) Debt feature: Pay to its holder a fixed stream of income each

year (i.e perpetuity) Also, it does not give the holder voting power

2)Equity feature: Retain discretion to make the dividend payments to

the preferred stockholders

- Priority over common in the event of corporate bankruptcy

- Tax treatment

Preferred & common dividends are not tax deductible to the issuing firm Corporate tax exclusion on 70% dividends earned

2-23

Capital Market - Equity

Depository Receipts

- American Depository Receipts (ADRs) also called American Depository Shares (ADSs) are certificates traded in t

he U.S that represent ownership in a foreign security

2-24

Capital Market - Equity

2-25

Capital Market - Equity

Capital Gains and Dividend Yields

You buy a share of stock for $50, hold it for one year, collect a $1.00 dividend and sell the stock for $54 What were your dividend yield, capital gain yield and total return? (Ignore taxes)

- Dividend yield = Dividend / Pbuy

Track average returnsComparing performance of managersBase of derivatives

Factors in constructing or using an index Representative?

Broad or narrow?

How is it constructed?

2.4 Stock and Bond Market Indexes

2-27

Construction of Indexes

How are stocks weighted?

- Price weighted (DJIA)

: Add up the prices of the stock and divide by a given divisor Higher priced shares get more

weight

- Market-value weighted (S&P500, NASDAQ)

: Calculate a weighted average of the returns of each security in the index, with weights prop

ortional to outstanding market value.

- Equally weighted (Value Line Index)

: Measured by an equally weighted average of the returns of each stock in an index

2-28

Examples of Indexes - Domestic

Dow Jones Industrial Average (30 Stocks)

Standard & Poor’s 500 Composite

NASDAQ Composite (> 3000 firms)

NYSE Composite

Wilshire 5000 (> 6000 stocks)

2-29

Table 2.5 Companies in the Dow Then & Now

2-30

Examples of International Indices

2-31

• Derivative Asset/Contingent Claim

: Security with payoff that depends on the price of other securities

Figure 2.9 Stock Options on Apple

2-33

2.5 Derivative Markets

• Using the Stock Options on Apple

- The right to buy 100 shares of stock at a stock price of $355 using the July contract would cost $560 (ignoring commissions)

- You will make money if stock price increases above $355 + $5.60 = $360.60 by contract expiration

- When should you write it?

2.5 Derivative Markets

• Using the Stock Options on Apple

- How does the exercise or strike price affect the value

of a call option? A put option? Why?

- How does a greater time to contract expiration affect the value of a call option? A put option? Why?

- Contract seller (short) delivers underlying commodity

at contract expiration for agreed-upon price

Futures are the obligation to buy or sell in the future whereas

at a preset price whereas options give the holder the right to b

uy or sell in the future.

2-36

2.5 Derivative Markets

Figure 2.10 Futures Contracts

Corn futures prices in the Chicago Board of Trade, July 8, 2011

2-37

2.5 Derivative Markets

- Contract size: 5,000 bushels of corn

- Price quote for Dec 12 contract: 614’0 translates to a price of $6.14 + 0/8 cent per bushel, or $6.14

- If you bought the Dec 12 contract, what are you agreeing to do?

• Purchase 5,000 bushels of corn in December for 5,000 × $6.14 = $30,700

- What is your obligation if you sell the Dec 12 contract?

- How does this contract differ from an option?

Derivatives Securities

Options Basic Positions