INVESTMENTS | BODIE, KANE, MARCUS Chapter Two Asset Classes and Financial Instruments Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

INVESTMENTS | BODIE, KANE, MARCUS 2-2 Asset allocation → Asset classes Money markets vs. capital markets Types of money market instruments Capital market securities: Bonds Equity Derivatives Chapter Overview

INVESTMENTS | BODIE, KANE, MARCUS 2-3 Subsector of the fixed-income market: Securities are short-term, liquid, low risk, and often have large denominations Money market mutual funds allow individuals to access the money market The Money Market

INVESTMENTS | BODIE, KANE, MARCUS 2-4 The Money Market Money Market Instruments – Treasury Bills – Certificates of Deposit – Commercial Paper – Bankers’ Acceptances – Eurodollars – Repos and Reverses – Brokers’ Funds – Federal Funds – LIBOR (London Interbank Offer Rate)

INVESTMENTS | BODIE, KANE, MARCUS 2-5 The Money Market Treasury Bills Issuer: Federal government Denomination: $100, commonly $10,000 Maturity: 4, 13, 26, or 52 weeks Liquidity: High Default risk: None Interest type: Discount Taxation: Federal owed; exempt from state and local

INVESTMENTS | BODIE, KANE, MARCUS 2-6 Treasury Bills (T-Bills) Source: The Wall Street Journal Online, July 7, 2011.

INVESTMENTS | BODIE, KANE, MARCUS 2-7 The Money Market Bank Discount Rate (T-bill quotes) Example: 90-day T-bill, P = $9,875 r BD = $10,000 − P− P x 360 n r BD = bank discount rate P= market price of the T-bill n= number of days to maturity $10,000 = Par r BD = $10,000 - $9,875 $10,000 × =5%

INVESTMENTS | BODIE, KANE, MARCUS 2-8 The Money Market Bond Equivalent Yield Can’t compare T-bill directly to bond 360 vs. 365 days Return is figured in par vs. price paid Adjust bank discount rate to make it comparable

INVESTMENTS | BODIE, KANE, MARCUS 2-9 The Money Market Bond Equivalent Yield Example Using Sample T-Bill r BEY = 10,000 − P P × 365 n P = price of the T-bill n = number of days to maturity r BD = 5% r BEY = 10,000 − 9,875 × r BEY =.125 × = = 5.07%

INVESTMENTS | BODIE, KANE, MARCUS 2-10 The Money Market Effective Annual Yield Example Using Sample T-Bill r BD = 5% r BEY = 5.13% r EAY = 5.23% P = price of the T-bill n = number of days to maturity r EAY = 5.23% r EAY =

INVESTMENTS | BODIE, KANE, MARCUS 2-11 The Money Market Certificates of Deposit (CDs) Issuer: Depository institutions Denomination: Any, $100,000 or more marketable Maturity: Varies, typically 14-day minimum Liquidity: CDs of 3 months or less are liquid if marketable Default: First $100,000 ($250,000) insured Interest type: Add on Taxation: Interest income fully taxable

INVESTMENTS | BODIE, KANE, MARCUS 2-12 The Money Market Commercial Paper (CP) Issuer: Large creditworthy corporations, financial institutions Denomination: Minimum $100,000 Maturity: Maximum 270 days, usually 1-2 months Liquidity: CP of 3 months or less is liquid if marketable Default risk: Unsecured, rated, mostly high quality Interest type: Discount Taxation: Interest income fully taxable New Innovation: Asset-backed commercial paper

INVESTMENTS | BODIE, KANE, MARCUS 2-13 The Money Market Federal Funds Depository institutions must maintain deposits with Federal Reserve Bank Federal funds—trading in reserves held on deposit at Federal Reserve Key interest rate for economy LIBOR (London Interbank Offer Rate) Rate at which large banks in London (and elsewhere) lend to each other Base rate for many loans and derivatives

INVESTMENTS | BODIE, KANE, MARCUS 2-14 The Money Market Repurchase Agreements (RPs) and Reverse RPs Short-term sales of securities with an agreement to repurchase the securities at higher price RP is a collateralized loan; many RPs are overnight, though “term” RPs may have a 1-month maturity Reverse RP is lending money and obtaining security title as collateral “Haircuts” may be required, depending on collateral quality

INVESTMENTS | BODIE, KANE, MARCUS 2-15 What is a haircut? In finance, a haircut is a percentage that is subtracted from the market value of an asset that is being used as collateral. [1] The size of the haircut reflects the perceived risk associated with holding the asset.financemarket valuecollateral [1]

INVESTMENTS | BODIE, KANE, MARCUS 2-16 Except for Treasury bills, money market securities are not free of default risk Both the premium on bank CDs and the TED spread have often become greater during periods of financial crisis During the credit crisis of 2008, the federal government offered insurance to money market mutual funds after some funds experienced losses Yields on Money Market Instruments

INVESTMENTS | BODIE, KANE, MARCUS 2-17 Treasury Notes and Bonds Inflation-Protected Treasury Bonds Federal Agency Debt International Bonds Municipal Bonds Corporate Bonds Mortgages and Mortgage-Backed Securities The Bond Market

INVESTMENTS | BODIE, KANE, MARCUS 2-18 Treasury Notes and Bonds Maturities Notes – Maturities up to 10 years Bonds – Maturities from 10 to 30 years Par Value - $1,000 Interest paid semiannually Quotes – Percentage of par Bond Market Securities

INVESTMENTS | BODIE, KANE, MARCUS 2-19 Figure 2.3 Listing of Treasury Issues Source: Compiled from data from The Wall Street Journal Online, July 6, 2011.

INVESTMENTS | BODIE, KANE, MARCUS 2-20 Inflation-Protected Treasury Bonds TIPS: Provide inflation protection Federal Agency Debt Debt of mortgage-related agencies such as Fannie Mae and Freddie Mac International Bonds Eurobonds and Yankee bonds Bond Market Securities

INVESTMENTS | BODIE, KANE, MARCUS The Bond Market Government Issues Agency issues (federal government) Most are home-mortgage-related Issuers: FNMA, FHLMC, GNMA, Federal Home Loan Banks Risks of these securities? Are these securities risk-free?? Implied backing by the government

INVESTMENTS | BODIE, KANE, MARCUS The Bond Market Government Issues Municipal bonds State and local govt’s issue? Differ from treasuries and agencies? Risk? G.O. vs. revenue Industrial development Taxation? r tax exempt = r taxable x (1 – Tax rate) r = Interest rate

INVESTMENTS | BODIE, KANE, MARCUS 2-23 Table 2.2 Equivalent Taxable Yields r tax exempt = r taxable x (1 – Tax rate) Tax-Exempt Yield Marginal Tax Rate1%2%3%4%5% 20%1.25%2.50%3.75%5.00% 6.25% What does this mean? If two issues had identical risk, a 5% municipal bond would have the same return as a 6.25% taxable bond? Example: equal risk debt An 40% tax bracket investor must choose between a muni that will pay 3% and a corporate bond that will pay 4.75%???

INVESTMENTS | BODIE, KANE, MARCUS 2-24 Municipal Bonds Issued by state and local governments Interest is exempt from federal income tax and sometimes from state and local tax Types General obligation bonds: Backed by taxing power of issuer Revenue bonds: backed by project ’ s revenues or by the municipal agency operating the project. Bond Market Securities

INVESTMENTS | BODIE, KANE, MARCUS 2-25 Corporate Bonds Issued by private firms Semi-annual interest payments Subject to larger default risk than government securities Options in corporate bonds Callable Convertible Bond Market Securities

INVESTMENTS | BODIE, KANE, MARCUS 2-26 Mortgage-Backed Securities Proportional ownership of a mortgage pool or a specified obligation secured by a pool Produced by securitizing mortgages Mortgage-backed securities are called pass- throughs because the cash flows produced by homeowners paying off their mortgages are passed through to investors. Most were issued by Fannie Mae and Freddie Mac Bond Market Securities

INVESTMENTS | BODIE, KANE, MARCUS 2-27 Common stock: Ownership Residual claim Limited liability Voting rights Preferred stock: Perpetuity Fixed dividends Priority over common Tax treatment: Preferred/common dividends not tax-deductible to issuing firm; corporate tax exclusions on 70% of dividends earned Equity Securities

INVESTMENTS | BODIE, KANE, MARCUS Equity Securities Capital Market-Equity Depository receipts American Depository Receipts (ADRs), also called American Depository Shares (ADSs) Certificates traded in the U.S. representing ownership in foreign security

INVESTMENTS | BODIE, KANE, MARCUS Equity Securities Capital Market-Equity Capital gains and dividend yields Buy a share of stock for $50, hold for 1 year, collect $1 dividend, and sell stock for $54 What were dividend yield, capital gain yield, and total return? (Ignore taxes) Dividend yield = Dividend / P buy = $1/$50 = 2% Capital gain yield = (P sell – P buy ) / P buy = ($54 – $50)/$50 = 8% Total return = Dividend yield + Capital gain yield = 2% + 8% = 10%

INVESTMENTS | BODIE, KANE, MARCUS 2-30 How do you calculate holding period returns?

INVESTMENTS | BODIE, KANE, MARCUS 2-31 Example Beginning price $50 Ending price $54 Dividend $2 Dividend yield = 2/50 = 2% Capital gain yield = (54/50 -1)= 8% HPR (worksheet)

INVESTMENTS | BODIE, KANE, MARCUS Stock and Bond Market Indexes Uses Track average returns Compare performance of managers Base of derivatives Factors in constructing/using index Is it Representative? How Broad/narrow is it? How is it constructed?

INVESTMENTS | BODIE, KANE, MARCUS 2-33 Dow Jones Industrial Average Includes 30 large blue-chip corporations Computed since 1896 Price-weighted average Stock Market Indexes

INVESTMENTS | BODIE, KANE, MARCUS 2-34 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% Example 2.2 Price-Weighted Average

INVESTMENTS | BODIE, KANE, MARCUS 2-35 Standard & Poor’s 500 Broadly based index of 500 firms Market-value-weighted index Investors can base their portfolios on an index Buy an index mutual fund Buy exchange traded funds (ETFs) Stock Market Indexes

INVESTMENTS | BODIE, KANE, MARCUS 2-36 Other Indexes U.S. Indexes NYSE Composite NASDAQ Composite Wilshire 5000 Foreign Indexes Nikkei (Japan) FTSE (U.K.; pronounced “ footsie ” ) DAX (Germany), Hang Seng (Hong Kong) TSX (Canada)

INVESTMENTS | BODIE, KANE, MARCUS 2-37 A derivative is a security that gets its value from the values of another asset, such as commodity prices, bond and stock prices, or market index values Derivatives Markets

INVESTMENTS | BODIE, KANE, MARCUS 2-38 Options Call: Right to buy underlying asset at the strike or exercise price Value of calls decreases as strike price increases Put: Right to sell underlying asset at the strike or exercise price Value of puts increase with strike price Value of both calls and puts increases with time until expiration Derivatives Markets

INVESTMENTS | BODIE, KANE, MARCUS 2-39 Figure 2.9 Stock Options on Apple

INVESTMENTS | BODIE, KANE, MARCUS Derivative Markets Using the Stock Options on Apple (Call) The right to buy 100 shares of stock at a stock price of $355 using the July contract would cost $560 (ignoring commissions) Is this contract “in the money”? When should you buy this contract? Stock price was equal to $357.20; you will make money if stock price increases above $ $5.60 = $ by contract expiration When should you write it?

INVESTMENTS | BODIE, KANE, MARCUS 2-41 Futures Contracts An agreement made today regarding the delivery of an asset (or in some cases, its cash value) at a specified delivery or maturity date for an agreed- upon price, called the futures price, to be paid at contract maturity Long position: Take delivery at maturity Short position: Make delivery at maturity Derivatives Markets

INVESTMENTS | BODIE, KANE, MARCUS 2-42 Figure 2.10 Futures Contracts Corn futures prices in the Chicago Board of Trade, July 8, 2011

INVESTMENTS | BODIE, KANE, MARCUS Derivative Markets Corn futures prices in the Chicago Board of Trade, July 8, 2011 Contract size: 5,000 bushels of corn Price quote for Dec. 12 contract: 614’0 translates to a price of $ /8 cent per bushel, or $6.14 If you bought the Dec. 12 contract, what are you agreeing to do? Purchase 5,000 bushels of corn in December for 5,000 × $6.14 = $30,700 What is your obligation if you sell the Dec. 12 contract? How does this contract differ from an option?

INVESTMENTS | BODIE, KANE, MARCUS 2-44 Comparison Option Right, but not obligation, to buy or sell; option is exercised only when it is profitable Options must be purchased The premium is the price of the option itself. Futures Contract Obliged to make or take delivery; long position must buy at the futures price, short position must sell at futures price Futures contracts are entered into without cost