Financial Markets and Instruments Chapter 2

Major Classes of Financial Assets or Securities 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

r BD = bank discount rate P= market price of the T-bill n= number of days to maturity r BD = 10,000 - P x 360 n 90-day T-bill, P = $9,800 r BD = 10, ,800 10,000 x =8% Example Bank Discount Rate (T-Bills)

Bond Equivalent Yield Can’t compare T-bill directly to bond vs 365 days - Return is figured on par vs. price paid Adjust the bank discounted rate to make it comparable

P = price of the T-bill n = number of days to maturity r BEY = 10,000 - P P x 365 n r BEY = 10, ,800 x r BEY =.0204 x =.0828 = 8.28% Example Using Sample T-Bill Bond Equivalent Yield

Capital Market - Fixed Income Instruments 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

Stock 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?

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

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

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)

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%

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