1. Investments: Asset classes and financial instruments
CHAPTER 2

2. Financial Securities Low Risk High Risk Money Market (Short-term)
Bond Market
(Long-term)
Common Stocks
Preferred Stocks
Options
Futures
Index

3. Money market instruments
T-bill
Issued by government
most marketable
minimum denomination: $1000
buy at a discount, return at par
issued weekly with maturities 28, 91, 182 days
Certificate of deposit (CD)
Pay interest and principal at maturity date
Par value > 100,000: negotiable
Par value <100,000: non-negotiable
Short-term CD (less than 3 months): highly marketable

4. Money market instruments
Commercial paper
Issued by large, well-known corporation
Short term, unsecured debt (less than 270 days), more than 270 day need SEC registration.
Fairly safe
Fairly liquid
banker acceptance
an order to a bank by a customer to pay a sum of money at a future date
safe (guaranteed by bank)

5. Money market instruments
Eurodollars: dollar denominated at foreign banks or American banks’ foreign branches
similar to domestic deposit
escape US regulation
riskier, less liquid, offer higher yield than domestic deposit
Repos (repurchase agreements)
short-term sales of government securities with an agreement to repurchase the securities at a higher price

6. Money market instruments
Federal funds
Funds in the accounts of commercial bank at the Fed
Federal fund rate: overnight loan rate among banks
LIBOR market: London Interbank Offer Rate: lending rate among banks in London market

7. Table 2.2 Components of the Money Market

8. Bond Market Treasury Notes and Bonds Federal Agency Debt
International Bonds
Inflation-Protected Bonds
Municipal Bonds
Corporate Bonds
Mortgages and Mortgage-Backed Securities

9. Treasury Notes and Bonds
Maturities
Notes – maturities up to 10 years
Bonds – maturities in excess of 10 years
Par Value - $1,000
Quotes – percentage of par, in 32nd

10. Figure 2.4 Treasury Notes and Bonds

11. Federal Agency Debt Major issuers If default, the government will help
Federal Home Loan Bank
Federal National Mortgage Association (“Fannie Mae”)
Government National Mortgage Association (“Ginnie Mae”)
Federal Home Loan Mortgage Corporation (“Freddie Mac”)
If default, the government will help
safe, yield is similar to T-bill

12. Municipal Bonds Issued by state and local governments Types
General obligation bonds: backed by state, city
Revenue bonds: backed by the revenue of project of state, city
tax exempt from federal tax (for investors)
example: consider 2 bonds
taxable bond: before tax yield = 8%, tax = 40%
municipal bond: yield = 6%
Which one is more attractive to investors?
Maturities – range up to 30 years

13. Municipal Bonds Interest is exempt from Federal taxes
advantage
Interest is exempt from Federal taxes
After-tax return (taxable bond):
After-tax return (Municipal bond):

14. Figure 2.6 Ratio of Yields on Tax-exempts to Taxables, 1955-2006

15. Corporate Bonds Issued by private firms Semi-annual interest payments
Subject to larger default risk than government securities
Options in corporate bonds
Callable
Convertible

16. Figure 2.7 Investment Grade Bond Listings

17. Mortgages and Mortgage-backed Securities
Developed in the 1970s to help liquidity of financial institutions
Proportional ownership of a pool or a specified obligation secured by a pool
Market has experienced very high rates of growth

18. Mortgage backed securities
fund
fund
payment
payment
payment
pool all mortgage loans
Banks
sell
mortgage backed
securities
Investors
securitized
fund
payment
Mortgage backed securities can be called pass through securities since the bank simply pass fund from investors to borrowers and pass interest payment and principal payment from borrowers to investors
Mortgage loan
fund
payment
Borrowers

19. Figure 2.8 Mortgage-Backed Securities Outstanding

20. Equity Markets Common stock Preferred stock Depository receipts
stock market listing

21. Equity Markets Common stock Characteristics Right to vote
Right to share benefit
Proxy
Proxy fight
Characteristics
Residual claims
Limited liabilities

22. Equity Markets Preferred stocks
Similar to both stocks and bond (hybrid security)
Similar to bond
Similar to stock
Priority over common stock
preferred dividend is cumulative
tax treatment
Preferred stock and bond are similar in the sense that they are both fixed income and have no voting power.
Bond has claims before preferred stock
Obviously preferred stock is riskier, why in practice the yield on preferred stock is smaller than that of bond

23. Equity Markets ADR: claims on ownership in foreign companies
Trading in the US, similar to US stocks
Total value of ADR currently is 657 (bil), about 2000 ADRs from 73 countries

24. Figure 2.9 Stock Market Listings

25. Uses of Stock Indexes Track average returns
Comparing performance of managers
Base of derivatives

26. Examples of Other Indexes - Domestic
Dow Jones Industrial Average (30 Stocks)
Standard & Poor’s 500 Composite
NASDAQ Composite
NYSE Composite
Wilshire 5000

27. Figure 2-10 Comparative Performance of Several Stock Market Indexes

28. Examples of Indexes - International
Nikkei 225 & Nikkei 300
FTSE (Financial Times of London)
Dax
Region and Country Indexes
EAFE
Far East
United Kingdom
MSCI: index of more than 50 country indexes

29. Table 2.6 Sample of MSCI Stock Indexes

30. Factors for Construction of Stock Indexes
Representative?
Broad or narrow?
How is it weighted?
Price weighted (DJIA)
Market weighted (S&P 500, NASDAQ)
Equal (Value Line Index)

31. Price Weighted Indices
DJIA is an example
30 blue chip companies
DJIA = (P1+P P30)/d where d is Dow divisor.
Originally d = 30
Currently, d = since d is adjusted for stock split, stock dividends, other corporate action, new companies coming into the index, old companies are taken out of the index

32. Example of Price-Weighted Index
Stock ABC sells initially at $25 a share with 20 million shares outstanding, while XYZ sells for $100 a share with 1 millions shares outstanding. The final price for ABC is $30, and the final price for XYZ is $90.
(a) Find the initial and the final price-weighted index composed of these two stocks. Assume the initial divisor is 2.
(b) Now if stock XYZ is split two for one, how should you adjust the divisor for the index?

33. DJIA Most quoted index in the world Criticisms Long history
easy to understand
indicates market’s basic trend reliably
30 companies account for 24-25% of US equity
Criticisms
Only 30 stocks
price weighted index: large price stocks dominate the index

34. S&P’s Composite 500 Market Value-Weighted Index
Stock ABC sells initially at $25 a share with 20 million shares outstanding, while XYZ sells for $100 a share with 1 millions shares outstanding. The final price for ABC is $30, and the final price for XYZ is $90.
Find the the value-weighted index composed of these two stocks at the final date. Assume the initial level of the index is 100.

35. Value Line Equally Weighted Index
Places equal weight on each return
Using data from Table 2.4
Start with equal dollars in each investment
ABC increases in value by 20%
XYZ decreases by 10%
Need to rebalance to keep equal weights

36. Table 2.4 Data to Construct Stock Price Indexes

37. Bond Index Computed monthly Difficulty in measuring true returns
Best known:
Merrill Lynch
Lehman Brothers
Salomon Smith Barney

38. DERIVATIVE MARKETS

39. Derivative 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

40. Options
Call option - the right to buy an asset at a specific price (exercise price) on or before a specific date
Put option - the right to sell an asset at a specific price (exercise price) on or before a specific date

42. Options Call options Put options
Same expiration date, exercise price increases, value of option decreases
Same exercise price, expiration date increases, value of option increases
Put options
Same expiration date, exercise price increases, value of option increases

43. Futures contracts
Obligation to purchase or sell an asset at a specific price at a specific future date
Long position: trader who commits to buy commodity/asset at delivery date
Short position: trader who commits to sell at the delivery date
Option is the right, futures is obligation

45. There is no free lunch! Derivatives Stocks Corporate Bonds T-Bonds
Money

46. Summary Financial securities Indices
Next class: Financial Market Trading