Fourth Edition 1 Chapter 2 Financial Securities

Fourth Edition 2 Outline Major assets traded. (ttp://finance.yahoo.com/?u)ttp://finance.yahoo.com/?u –Fixed income Money market instruments Bonds –Equity securities –Derivatives Understanding Index –Different index –Construction of index

Fourth Edition 3 Markets and Instruments Money Market(<=1 year) Capital Market(>1year) Fixed-incomeT-bill CD, Federal Funds.. Bonds (T-notes, T-bonds, Muni, Corporate bonds) EquityNACommon stock, Preferred stock

Fourth Edition 4 Money Market Instruments T(Treasury) bills: –Short-term government debt security –Issued at discount from face value and returning the face value at maturity Certificates of deposit –Time deposit with a bank –CD issued in denominations larger than $100,000 are usually negotiable-sellable in the secondary market Commercial Paper –Short term unsecured debt issued by large corp directly to the public.

Fourth Edition 5 Money Market Instruments Bankers Acceptances An order to a bank by a customer to pay a sum of money at a future date. Like postdated check, with bank endorsement Widely used in foreign trade Sell at discount in secondary market Eurodollars $ denominated deposits at foreign bank or foreign branches of US bank Can be traded in secondary market like CD before its maturity Federal Funds Deposits of banks at Fed Used for reserve requirements and transaction Banks with surplus lend to those with shortage Not directly sold to investors

Fourth Edition 6 Money market instruments Repurchases agreements and reverses Def. Short-term sales of government securities with an agreement of repurchase at a higher price Reverse repo: mirror image of a repo. Buys government securities with an agreement to resell them at a prespecified higher price Q: Who is who? A: Seller of security (borrower of funds) vs. Buyer (lender) Price increase is interest Security is collateral

Fourth Edition 7 Bonds Publicly Issued Instruments US Treasury Bonds and Notes Agency Issues (Fed Gov) Municipal Bonds Privately Issued Instruments Corporate Bonds Mortgage-Backed Securities

Fourth Edition 8 Equity Common stock –Residual claim –Limited liability Preferred stock –Fixed dividends - limited –Priority over common

Fourth Edition 9 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

Fourth Edition 10 Define option Option is the right to buy or sell an asset at a specified exercise price on or before a specified expiration date. Call Option: Put Option: Check:

Fourth Edition 11 Market and Exercise Price Relationships In the Money - exercise of the option would be profitable (without considering the cost/premium of the option) Call: market price>exercise price Put: exercise price>market price Out of the Money - exercise of the option would not be profitable Call: market price<exercise price Put: exercise price<market price At the Money - exercise price and asset price are equal

Fourth Edition 12 Uses Track average returns Comparing performance of managers Base of derivatives Stock Indexes

Fourth Edition 13 Examples of Indexes - Domestic Dow Jones Industrial Average (30 Stocks) Standard & Poor’s 500 Composite NASDAQ Composite NYSE Composite Dow Jones Wilshire 5000 –Included all stocks(over 5,000) traded in US with available data

Fourth Edition 14 Construction of Indexes How are stocks weighted? –Price weighted (DJIA) –Market-value weighted (S&P500, NASDAQ) –Equally weighted (Value Line Index)

Fourth Edition 15 Construction of Indexes Price weighted Initial PFinal PShares (M) Yahoo$25$3020 MSN100801

Fourth Edition 16 Construction of Indexes Price-weighted average –Adding the price and divided by a divisor (# of stocks or adjusted divisor) –Index0=(25+100)/2=62.5 –Index1=(30+80)/2=55

Fourth Edition 17 Construction of Indexes Price weighted-adjusting for splits P0#0P1#1 (M) Yahoo$2520$3020 MSFT1001$502

Fourth Edition 18 Construction of Indexes Price-weighted :adjusting for splits –Calculate new index value without split effect( from time 0 to 1, stock prices can change without split effects) index1=(30+100)/2=65 –With split, index1 should also equal 65 (30+50)/d=65 d=1.23 (30+50)/1.23=65 d is divisor

Fourth Edition 19 Construction of Indexes Market value-weighted –The weight is based on the market value of each component stock –Set initial level to an arbitrarily chosen starting value (e.t. 100) –New level: 100*(new market value 700/old initial market value 600)=116.67

Fourth Edition 20 Construction of Indexes Equal weighted –Each stock has the same weight –Set initial level to an arbitrarily chosen starting value (e.t. 100) –The %change of the index=the simple average of the %change of each component stock % change of Yahoo=(30-25)/25=20% % change of MSFT=(50-50)/50=0% % change of index=(20%+0%)/2=10% –New level: 100*(1+% change of the index) =100*(1+10%)=110