Essentials of Investments: Chapter 2 - Financial Markets and Instruments

Essentials of Investments: Chapter 2 - Financial Markets and Instruments presents Major Classes of Financial Assets or Securities, Markets and Instruments, Money Market Instrument Yields, Bank Discount Rate, Bond Equivalent Yield.

Chapter 2

Financial Markets and Instruments

• Debt

– Money market instruments – Bonds

• Common stock

• Preferred stock

• Derivative securities

Markets and Instruments

• Money Market

– Debt Instruments – Derivatives

• Capital Market

– Bonds – Equity – Derivatives

Money Market Instruments

• Treasury bills

• Certificates of deposit

• Commercial Paper

• Bankers Acceptances

• Eurodollars

• Repurchase Agreements (RPs) and Reverse RPs

• Federal Funds

Money Market Instrument Yields

• Yields on Money Market Instruments

are not always directly comparable Factors influencing yields

• Par value vs investment value

• 360 vs 365 days assumed in a year

(366 leap year)

• Bond equivalent yield

Interest rates that arise in connection with money market securities

.Bank discount rate (rBD )

.This is a rate that is used solely for determining the price of a MM security for trading purposes

.Bond equivalent yield (rBEY ) In general, a yield is an interest rate that (under very

specific, sometimes unrealistic, assumptions) represents

a rate of return

.rBEY is such a rate of return It is an annual percentage

rate (APR) For comparing different MM instruments, we often use the

effective annual rate (EAR) of the rBEY

Bank Discount Rate (T-Bills)

rBD = bank discount rate

P = market price of the T-bill

n = number of days to maturity

rBD = 10,000 - P

10,000 x 360 n

90-day T-bill, P = $9,875

rBD = 10,000 - 9,875

360

90 = 5%

Example

Bond Equivalent Yield

• Can’t compare T-bill directly to bond

– 360 vs 365 days – Return is figured on par vs price paid

• Adjust the bank discounted rate to make

it comparable

Bond Equivalent Yield

P = price of the T-bill

n = number of days to maturity

rBEY = 10,000 - P

365

n

rBEY = 10,000 - 9,875

9,875 x

365

90

rBEY = 0127 x 4.0556 = 0513 = 5.13%

Example Using Sample T-Bill

Publicly Issued Instruments

• US Treasury Bonds and Notes

• Agency Issues (Fed Gov)

• Municipal Bonds Privately Issued Instruments

• Corporate Bonds

• Mortgage-Backed Securities

Capital Market - Equity

• Common stock

– Residual claim – Limited liability

• Preferred stock

– Fixed dividends - limited – Priority over common

– Tax treatment

• Track average returns

• Comparing performance of managers

• Base of derivatives Factors in constructing or using an Index

• Representative?

• Broad or narrow?

• How is it constructed?

Stock Indexes

Examples of Indexes - Domestic

• Dow Jones Industrial Average (30 Stocks)

• Standard & Poor’s 500 Composite

• NASDAQ Composite

• NYSE Composite

• Wilshire 5000

Examples of Indexes - Int’l

• Nikkei 225 & Nikkei 300

• FTSE (Financial Times of London)

• Dax

• Region and Country Indexes

– EAFE – Far East – United Kingdom

Construction of Indexes

• How are stocks weighted?

– Price weighted (DJIA) – Market-value weighted (S&P500, NASDAQ)

– Equally weighted (Value Line Index)

.Suppose we have two stocks

#Shares Stock Pr 9/19/01 Pr 9/20/01 Return Outstand

A 100 120 20% 10M

B 10 9 –10% 500M

.Computation of a price-weighted index (like the Dow)

.Index on 9/19/01 (100+10)/2 = 55

Index on 9/20/01 (120+9)/2 = 64.5

Return on index 17.27%

.This is called a price-weighted index because the index

return is the price-weighted average of the component

(100/110) x 20% + (10/110) x –10% = 17.27%

.Portfolio: one share in each stock

.A market-value weighted average (like the S&P).

.Index on 9/19/01 = “100” (an arbitary base level) Market value of A = $100 x 10M = $1,000M

Market value of B = $10 x 500M = $5,000M Return on index is

(1,000/6,000) x 20% + (5,000/6000) x –10% = –5%

.Index on 9/20/01 = 100 x (1–5%) = 95 Portfolio: 1/6 in A; 5/6 in B

.An equally-weighted index (like the Wilshire 5000)

.Index on 9/19/01 = “100” (an arbitary base level)

.Return on index is

(20% + –10%)/2 = +5%

.Index on 9/20/01 = 100 x (1+5%) = 105

.Portfolio: equal amounts in A and B