Investments, 8 th edition Bodie, Kane and Marcus Slides by Susan Hine McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. CHAPTER 2 Asset Classes and Financial Investments

2-2 Major Classes of Financial Assets or Securities Money market securities (usually,less than one year) Capital market securities (longer than one year) Bond market Equity Securities Derivative markets Indexes

2-3 The Money Market Treasury bills (maturities of 28,91,182 days) minimum denomination of $100 –Bid and asked price –Bank discount method Certificates of Deposits (CD) time deposit with banks Commercial Paper Bankers Acceptances order to a bank by a customer to pay money to the holder of the order accepted

2-4 Figure 2.2 Treasury Bill Yields

2-5 How to convert Fig 2.2 to the price Bank discount method for the asked price of Apr 05 07: 4.90% x (90/360)=1.225% so a T-bill with $10,000 par value can be purchased for $10,000 x ( )=$9, Two flaws assuming 360 days fraction of par value rather than price the investor pays

2-6 How to convert... continued Now convert it into a rate over the price the investor pays: $(10,000-9,877.25)/$9,877.25= : 1.240% gain over 90 days Convert it into the annual rate: 1.240% x (365/90)=5.03% annual gain This is ASK YLD of Fig 2.2

2-7 The Money Market Continued Eurodollars: dollar-denominated deposits in non-US countries Repurchase Agreements (RPs) and Reverse Rps:overnight buy back/sell back agreement of government securities Brokers’ Calls: see Ch 3 for detail. Federal Funds: deposits at the Fed by banks are lent among them at the federal funds rate. LIBOR(London interbank offered rate) Market

2-8 Figure 2.1 Rates on Money Market Securities

2-9 Table 2.1 Major Components of the Money Market

2-10 Figure 2.3 The Spread between 3-month CD and Treasury Bill Rates

2-11 The Bond Market Treasury Notes and Bonds semiannual coupon payment  T note: maturities of 1 to 10 years  T bill: maturities of 10 to 30 years Inflation-Protected Treasury Bonds Federal Agency Debt

2-12 The Bond Market...continued International Bonds: eurodollar, euroyen bonds; Yankee, Samurai bonds Municipal Bonds Corporate Bonds Mortgages and Mortgage-Backed Securities

2-13 Treasury Notes and Bonds Maturities –Notes – maturities up to 10 years –Bonds – maturities in excess of 10 to 30 years Par Value - $1,000 Quotes – percentage of par value(face value)

2-14 Figure 2.4 Lisiting of Treasury Issues

2-15 How to read Figure 2.4 Issue of maturity, Feb 2014 RATE 4.000: this T note pays 4% x face value as coupon, annually. e.g. $1,000 face value note 0.04 x $1,000=$40 per year, $20 every 6 months. BID&ASKED: :09 means 9/32 points= means 96 9/32= Price=face value x %

2-16 How to read Figure continued e.g. face value=$1,000 bid price=$1,000 x %=$ similarly, ask price=$ CHG (bid ask spread is 1/32 here) +10 means today's closing price rose by 10/32=0.3125% of face value from the previous day's closing price. ASKYLD (as in T bills): yield to maturity harder to calculate because there are coupon payments contrary to T bills. See Ch. 14

2-17 Federal Agency Debt Major issuers –Federal Home Loan Bank –Federal National Mortgage Association (Fannie Mae) –Government National Mortgage Association (Ginnie Mae) –Federal Home Loan Mortgage Corporation (Freddie Mac)

2-18 Municipal Bonds Issued by state and local governments; exempt from federal as well as state and local tax of the issuing state Types –General obligation bonds –Revenue bonds (for particular objectives): airport, hospital, port etc. Industrial revenue bonds: for private enterprises Maturities – range up to 30 years

2-19 Figure 2.5 Tax-exempt Debt Outstanding

2-20 Municipal Bond Yields Interest income on municipal bonds is not subject to federal and sometimes not to state and local tax To compare yields on taxable securities a Taxable Equivalent Yield is constructed

2-21 Municipal Bonds continued How to compare taxable and tax exempt bonds Taxable bonds -Taxable bonds tax rate: t -before tax rate of return: r -after tax return r(1-t) tax exempt bonds -return rate: r m If r(1-t)>r m, we buy taxable bonds.

2-22 Municipal Bonds continued Equivalent taxable yield, r of the tax exempt bond can be found by: r(1-t)=r m or r= r m /(1-t) Or, given r and r m, we can find the tax rate which equalizes the gains of the two bonds: t=1-r m /r (r m /r is called yield rate )

2-23 Table 2.2 Equivalent Taxable Yields Corresponding to Various Tax-Exempt Yields

2-24 Figure 2.6 Ratio of Yields on Tax-Exempt to Taxable Bonds

2-25 Corporate Bonds Issued by private firms Semi-annual coupon payments Subject to larger default risk than government securities Options in corporate bonds –Callable: firm has option to repurchase at prefixed price. –Convertible: bond holder has option to convert to prefixed number of stock.

2-26 Developed in the 1970s to help liquidity of financial institutions. The problem for bank was to pay interest for short term deposits by customers and receive fixed interest for long term mortgages. adjustable rate mortgage mortgage backed security; Ginnie Mae, Fannie Mae, Freddie Mac Mortgages and Mortgage-Backed Securities

2-27 Proportional ownership of a pool or a specified obligation secured by a pool Market has experienced very high rates of growth Conforming mortgages Subprime mortgages Mortgages and Mortgage-Backed...

2-28 Figure 2.7 Mortgage-backed Securities Outstanding,

2-29 Equity Securities Shareholders → Board of directors → Managers Common stock –Residual claim –Limited liability Preferred stock (redeemable, convertible, adjustable rate) –Fixed dividends, normally –Priority over common – Tax treatment: unlike interest payment for debt

2-30 Equity Securities... Depository receipts American depository receipts: ownership in shares of a foreign company Stock market listings - Div (only part of possible gain) last quarterly div payment: $0.28 per share, annual div. payment: $0.28x4=$ YIELD equivalent to 1.12/37.56=0.03, i.e. 3%

2-31 Equity Securities... P/E (price earnings ratio) stock price/last year's earnings per share CHG stock price rose by 0.9% since the beginning of year.

2-32 Figure 2.8 Listing of Stocks Traded on the NYSE

2-33 There are several broadly based indexes computed and published daily There are several indexes of bond market performance Others include: –Nikkei Average –Financial Times Index Stock Market Indexes

2-34 Dow Jones Industrial Average Includes 30 large blue-chip corporations Computed since 1896 Price-weighted average: (P 1 +P P 30 )/30 Percentage change in DJIA= Percentage change in sum of 30 stock prices High price stock has bigger role in DJIA.

2-35 Example 2.2 Price-Weighted Average Portfolio: Initial value $25 + $100 = $125 Final value $30 + $ 90 = $120 Percentage change in portfolio value = 5/125 = -.04 = -4% Index: Initial index value (25+100)/2 = 62.5 Final index value ( )/2 = 60 Percentage change in index -2.5/62.5 = -.04 = -4%

2-36 Adjustment when there's stock split

2-37 Example 2.3 Splits and Price-Weighted... Suppose index is compose of 2 stocks. Initial index (25+100)/2 = 62.5 After split (25+100)/d Find d such that (25+100)/d = 62.5→d=1.2 From now on, we use 1.2 as divisor.

2-38 Broadly based index of 500 firms Market-value-weighted index Index funds Exchange Traded Funds (ETFs) Standard & Poor’s Indexes (S&P 500)

2-39 Example 2.4 Value weighted indexes Market value of ABC:$500 Market value of XYZ:$100 Market value weighted Index: ( )/divisor

2-40 Other U.S. Market-Value Indexes NASDAQ Composite NYSE Composite Wilshire 5000

2-41 Figure 2.9 Comparative Performance of Several Stock Stock Indexes,

2-42 Foreign and International Stock Market Indexes Nikkei (Japan) FTSE (Financial Times of London) Dax (Germany) MSCI (Morgan Stanley Capital International) Hang Seng (Hong Kong) TSX (Canada)

2-43 Derivatives Markets Options(American) Costs option price Right Basic Positions –Long:buyer of op. –Short:seller of op. –Call (Buy) – Put (Sell) Futures Free of charge Obligation Basic Positions –Long (Buy) – Short (Sell)

2-44 Derivatives Markets... Options(American) Terms –Exercise Price –Expiration Date –Assets See how price moves Futures Terms –Delivery Date –Delivery price:futures price –Assets

2-45 Figure 2.10 Trading Data on GE Options

2-46 Figure 2.11 Listing of Selected Futures Contracts