McGraw-Hill/Irwin Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 2 Financial Instruments

2-2 Major Types of Securities Debt Money market instruments Bonds Common stock Preferred stock Derivative securities

2-3 Markets and Instruments Money Market Debt Instruments Derivatives Capital Market Bonds Equity Derivatives

2-4 Money Market Instruments Treasury bills Certificates of deposit Commercial Paper Bankers Acceptances Eurodollars

2-5 Money Market Instruments (Cont.) Repurchase Agreements (RPs) and Reverse RPs Federal Funds Brokers’ Calls LIBOR Market

2-6 Bond Markets US Treasury Bonds and Notes Agency Issues (Fed Gov) International Bonds Municipal Bonds Corporate Bonds Mortgage-Backed Securities

2-7 Municipal Bond Yields Interest income on most municipals is not subject to tax To compare the yields on municipals to other bonds use equivalent taxable yield (municipal return) / (1 – tax rate) Or solve for the tax rate that equates the two yields Tax rate = 1 – (municipal rate/taxable rate)

2-8 Capital Market - Equity Common stock Residual claim Limited liability Preferred stock Fixed dividends - limited Priority over common Tax treatment

2-9 Stock Market Indexes Uses 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?

2-10 Examples of Indexes - Domestic Dow Jones Industrial Average (30 Stocks) Standard & Poor’s 500 Composite NASDAQ Composite NYSE Composite Wilshire 5000

2-11 Examples of Indexes - International Nikkei 225 & Nikkei 300 FTSE (Financial Times of London) Dax Region and Country Indexes EAFE Far East United Kingdom

2-12 Bond Indexes Lehman Brothers Merrill Lynch Salomon Brothers Specialized Indexes Merrill Lynch Mortgage

2-13 Construction of Indexes How are stocks weighted? Price weighted (DJIA) Market-value weighted (S&P500, NASDAQ) Equally weighted (Value Line Index) How returns are averaged? Arithmetic (DJIA and S&P500) Geometric (Value Line Index)

2-14 Averaging Methods Component Return A=10% B= (-5%) C = 20% Arithmetic Average [.10 + (-.05) +.2] / 3 = 8.33% Geometric Average [(1.1) (.95) (1.2)] 1/3 - 1 = 7.84%

2-15 Derivatives Securities Options Basic Positions Call (Buy) Put (Sell) Terms Exercise Price Expiration Date Assets Futures Basic Positions Long (Buy) Short (Sell) Terms Delivery Date Assets