Asset Classes and Financial Instruments Chapter 2 Asset Classes and Financial Instruments Describes the financial instruments traded in primary and secondary markets. Discusses Market indexes. Discusses options and futures.

Money Market Instruments TB (Discount, tax), CD ($100k, $250k, tax), CP Bankers’ Acceptances (int’l fin and biz) Eurodollars- Dollar denominated (time) deposits held outside the U.S.; higher interest Federal Funds - Key interest rate for the economy; Repos and Reverses LIBOR (London Interbank Offer Rate) Call Money Rate (buy stock on margin borrow money from their; the loan may be ‘called in’ 2-2

Commercial Paper Commercial Paper Issued by Maturity Denomination Liquidity Default risk Interest type Taxation Large creditworthy corporations and financial institutions Maximum 270 days, usually 1 to 2 months Minimum $100,000 3 months or less are liquid if marketable Unsecured, Rated, Mostly high quality Discount Interest income is fully taxable New Innovation: Asset backed commercial paper is backed by a loan or security. In summer 2007 asset backed CP market collapsed when subprime collateral values fell. 2-3

MMMF and the Credit Crisis of 2008 Between 2005 and 2008 money market mutual funds (MMMFs) grew by 88%. Why? MMMFs had their own crisis in 2008 when Lehman Brothers filed for bankruptcy on September 15. Some funds had invested heavily in Lehman’s commercial paper. On Sept. 16, Reserve Primary fund “broke the buck.” What does this mean? A run on money market funds ensued. The U.S. Treasury temporarily offered to insure all money funds to stop the run - (up to $3.4 trillion in these funds.) 2-4

Money Market Instrument Yields Yields on money market instruments are not always directly comparable Factors influencing “quoted” yields Par value vs. investment value 360 vs. 365 days assumed in a year (366 leap year) Simple vs. Compound Interest Par Value is the face value of the instrument. Investment value is what you paid for it. Some rate methods use 360 days instead of 365 days BEY uses simple instead of compound interest. Three popular yield measurements used in quotations: Bank Discount Rate Bond Equivalent Yield Effective Annual Yield 2-5

Bank Discount Rate (T-Bill quotes) $10,000 = Par Example 90-day T-bill, P = $9,875 r BD = $10,000 - $9,875 x 360 90 5% 10,000-P is the money you will earn in N days. BAD because uses the par value in the denominator, and uses simple interest. 2-6

Bond Equivalent Yield x Example Using Sample T-Bill r = 10,000 - 9,875 rBD=5% Example Using Sample T-Bill r BEY = 10,000 - 9,875 x 365 90 rBEY = .0127 x 4.0556 = .0513 = 5.13% Both the smaller denominator of the real price P and the larger numerator due to 365 days increases the yield when one uses the BEY calculation. 2-7

Effective Annual Yield rBD=5% rBEY=5.13% rEAY=5.23% Example Using Sample T-Bill r EAY = (1+ 9875 )365/90 10000 - The most realistic and correct value would come from the effective annual yield. It uses compound interest. rEAY = 5.23% 2-8

Money Market Instruments Treasury bills Certificates of deposit Commercial Paper Bankers Acceptances Eurodollars Federal Funds Repurchase Agreements (RPs) and Reverse RPs Discount BEY* * NOTE: CD, Euro$ and FF all use add on which is not quite the same as BEY, since the add on uses a 360 day year. Add on is not covered in the text. To convert from add on to BEY: BEY = Add on * (365/360) 2-9

Capital Market - Fixed Income Instruments Government Issues US Treasury Bonds and Notes Bonds versus Notes Denomination Interest type Risk? ____________________ Taxation? Fixed income have a defined stream of payments or coupons. Notes have a maturity up to and including 10 years, bonds beyond 10 years Minimum denomination is $100, but most have $1,000 denomination although many T-bonds are packaged and sold in multiples of $1,000. Pay interest semiannually with principal repaid at maturity (non-amortizing) Investors are federally taxed on capital gains and interest income, but interest income is exempt from state and local taxes. Municipal bonds are from local governments. Interest on municipal bonds is not taxed, so must use the taxable equivalent yield. Privately Issued instruments come from corporations, or are items like mortgage backed securities, where they pool a group of mortgages together and sell them to investors. Variation: Treasury Inflation Protected Securities (TIPS) Tips have principal adjusted for increases in the Consumer Price Index Marked with a trailing ‘i’ in the quote sheet (See Figure 2.4) 2-10

Capital Market - Fixed Income Instruments Government Issues Agency Issues (Fed Gov) Most are home mortgage related Issuers: FNMA, FHLMC, GNMA, Federal Home Loan Banks Risk of these securities? Implied backing by the government In September 2008, Federal government took over FNMA and FHLMC. FNMA and FHLMC together financed or backed about $5 trillion in home mortgages, that is about 50% of the U.S. market. 2-11

Capital Market - Fixed Income Instruments Government Issues Municipal Bonds Issuer? Differ from Treasuries and Agencies? Risk? G.O. vs Revenue Industrial development Taxation? Fixed income have a defined stream of payments or coupons. Publicly Issued come from the government. Municipal bonds are from local governments. Interest on municipal bonds is not taxed, so must use the taxable equivalent yield. Privately Issued instruments come from corporations, or are items like mortgage backed securities, where they pool a group of mortgages together and sell them to investors. r = interest rate 2-12

Capital Market - Fixed Income Instruments Private Issues Corporate Bonds Investment grade vs speculative grade Fixed income have a defined stream of payments or coupons. Publicly Issued come from the government. Municipal bonds are from local governments. Interest on municipal bonds is not taxed, so must use the taxable equivalent yield. Privately Issued instruments come from corporations, or are items like mortgage backed securities, where they pool a group of mortgages together and sell them to investors. 2-13

Capital Market - Fixed Income Instruments Mortgage-Backed Securities Pass-through A security backed by a pool of mortgages. The pool backer ‘passes through’ monthly mortgage payments made by homeowners and covers payments from any homeowners that default. Collateral: Traditionally all mortgages were conforming mortgages but since 2006, Alt-A and subprime mortgages were included in pools Conforming mortgages met traditional creditworthiness standards. Until about 2006, Fannie and Freddie only underwrote or guaranteed conforming mortgages. Under political pressure to make housing available to low income families, Fannie and Freddie began securitizing and backing subprime mortgages (mortgages to households with insufficient income to qualify for a standard mortgage) and so called “Alt-A” mortgages which lie between conforming and subprime. 2-14

Capital Market - Equity Common stock (ADRs) Preferred stock Fixed dividends: limited gains, non-voting Priority over common Tax treatment Preferred & common dividends are not tax deductible to the issuing firm Corporate tax exclusion on 70% dividends earned Residual Claim- Lowest priority in case of bankruptcy. First Debtholders, then preferred, then common. Limited Liability- Can only lose your initial investment Preferred- Have a fixed dividend stream that generally must be paid before common stock dividends Tax-Important to know that when one company owns stock in another, the dividends have a partial tax exemption. 2-15

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 $1.00 / $50 = 2% Capital gain yield: = (Psell – Pbuy)/ Pbuy ($54 - $50) / $50 = 8% Total return: = Dividend yield + Capital gain yield 2% + 8% = 10% 2-16

2.4 Stock and Bond Indexes How are stocks weighted? Price weighted (DJIA), 1 share each stock and invest cash and stock dividends proportionately. Market-value weighted (S&P500, NASDAQ), $ invested in each stock are proportional to market value Equally weighted (Value Line Index), same amount of $ in each stock Can anyone name some well know indexes. S&P, Dow,etc? Can use as a benchmark or as a passive portfolio. Often used as the base asset for derivatives. Is it based on the market value or price? 2-17

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) Dow is based on a price-weighted average. Narrow group. S&P 500- Much more broad market-value weighted index. Often used as the benchmark for the market. NASDAQ Composite-Very broad index of firms using the over-the-counter Nasdaq system. NYSE composite-Market value weighted of all NYSE stocks Wilshire 5000- largest index approx. 7000 stocks 2-18

2.5 Derivative Markets Futures Listed Call/Put (buy/sell) Option: Holder the right to buy/sell 100 shares of the underlying stock at a predetermined price on or before some specified expiration date. Futures 2-19

Derivatives Securities Options Basic Positions Call (Buy/Sell?) Put (Buy/Sell?) Terms Exercise Price Expiration Date Futures Basic Positions Long (Buy/Sell?) Short (Buy/Sell?) Terms Delivery Date Deliverable item A security with a payoff that depends on the price of another asset. Call- The right but not the obligation to buy an asset at a specified exercise price, up until a specified expiration date. Future- An obligation to buy or sell an asset at an agreed upon price at a specified future date. 2-20

Selected Problems 1. Find the after tax rate of return to a corporation that buys preferred stock at $40, holds it one year and sells it at $40 after collecting a $4 dividend. The firm’s tax rate is 30%. (Pretax rate or return = ____________ ) The total before-tax income is $4. After the 70% exclusion, taxable income is: 0.30  $4 = $1.20 taxable income Therefore Taxes owed are Tax rate  taxable income Taxes = 0.30  $1.20 = $0.36 After-tax income = $4 – $0.36 = $3.64 After-tax rate of return = $3.64 / $40 = 9.10% $4 / $40 = 10% These problems are similar to the problems in the text but the numbers used may be different. 2-21 21

3. An investor has a 30% tax rate and corporate bonds are paying 9% 3. An investor has a 30% tax rate and corporate bonds are paying 9%. What must munis pay to offer an equivalent after tax yield? 2-22 22

6. What would you expect to happen to the spread between yields on commercial paper and T-bills if the economy were to enter a steep recession? The spread will widen. Deterioration of the economy increases credit risk, that is, the likelihood of default. Investors will demand a greater premium on debt securities subject to default risk. 2-23