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Chapter 2:

Asset Classes and Financial

Instruments

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Money Market: Subset of debt market. < 1 year short-

term debt instruments. Very liquid.

Capital Markets: Long-term debt, equity and derivative

securities. Riskier securities.

Financial Markets

Money Markets Capital Markets

Long-term

Debt (Bond)

Markets

Equity

Markets

Derivatives

Markets

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• Treasury Bills (T-bills): Government securities with

maturities ≤ 12 months, issued at a discount from face

(maturity) value. Minimum denominations of $100.

$10,000 more common. Income exempt from state and

local taxes.

The Money Market

Treasury Bill Yields. July 17, 2012

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T-Bills, continued…

Yields quoted on bank discount basis / yield:

100% x maturity todays

360 x

valueface

price - valueface yielddiscount bank

100% x maturity todays

365 x

price

price - valueface yield equivalent-bond

At a 0.125% ask yield, what is the price of a $10,000

par T-bill that matures in 156 days?

Express the above price on a bond-equivalent yield.

The Money Market

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• Certificates of Deposit (CDs): time deposits at

banks. Large denominations negotiable.

• Eurodollars: $ denominated deposits at foreign

banks or foreign branches of U.S. banks.

• Bankers Acceptances: future payment by third

party backed/endorsed/accepted by its bank.

• Commercial Paper: short-term (<270 days)

borrowing by large corporations. Backed by bank

lines of credit. Large denominations.

The Money Market

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• Repurchase Agreement (Repo): Dealer “sells”

securities to investor overnight and agrees to buy them

back the next day at higher price: a loan to the dealer.

Day 1

Day 2

Dealer

Dealer

Investor

Investor

Securities

$$

• Reverse Repo: Opposite of Repo: Dealer buys

securities, resells to investor next day: a loan to the

investor.

Securities

$$$

The Money Market

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• Brokers’ Calls: interest rate paid by brokerage firm

on bank loan. Repayable upon demand.

• Federal Funds Rate: bank to bank overnight lending

rate.

• LIBOR: (London interbank offered rate): rate at

which large banks in London are willing to lend

money to one another. Can be in British Pounds,

U.S. dollars, euros, yen, etc…

The Money Market

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Major Components of The Money Market:

September 2012

*Small denominations are less then $100,000

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• Treasury Notes and Treasury Bonds: Quoted as % of

par. i.e. 113.5391 = 113.5391% of par or $1,135.391

per $1,000 par value bond. Yield-to-maturity also

quoted. Notes, maturities of 1-10 years. Bonds, 10-30

years.

The Bond (Fixed Income) Market

July 17, 2012

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• Federal Agency Debt: debt issued by government

sponsored entities / government agencies. Predominant

issuers are the mortgage-related agencies → FHLB,

FNMA (Fannie Mae), GNMA (Ginnie Mae), FHLMC

(Freddie Mac). Implied gov’t backing.

• Mortgage backed securities (MBS): Proportional

ownership in a pool of mortgages. Periodic bond

payments to bondholders come from mortgages. Pass-

throughs. FNMA (Fannie Mae), FHLMC (Freddie Mac).

• International Bonds (Eurobonds): what currency?

The Bond Market

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• Municipal Bonds: State and local issuers. General

obligation and revenue bonds. Exempt from federal taxes

and state and local taxes in issuing state. General

obligation bonds vs. revenue bonds. Difference?

The Bond Market

𝑟 1 − 𝑡 = 𝑟𝑚

r = before tax rate of return (yield) on a taxable bond

t = investor’s combined marginal tax rate

rm = equivalent rate of return on a municipal bond

If an investor’s tax rate is 28%, which offers a higher after-tax

yield, a 6% taxable bond or a 4% tax-free bond?

What is the equivalent taxable yield of the 4% tax free bond?

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Marginal

Tax Rate

Tax-Exempt Yield

1% 2% 3% 4% 5%

20% 1.25% 2.50% 3.75% 5.00% 6.25%

30% 1.43% 2.86% 4.29% 5.71% 7.14%

40% 1.67% 3.33% 5.00% 6.67% 8.33%

50% 2.00% 4.00% 6.00% 8.00% 10.00%

The Bond Market

Equivalent Taxable Yields Corresponding to

Various Tax-Exempt Yields

𝑟 1 − 𝑡 = 𝑟𝑚

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• Corporate Bonds: Long-term borrowing by private

corporations. Secured vs. unsecured. Callable?

Convertible? Rated.

The Bond Market

http://finra-

markets.morningstar.com/BondCenter/TRACEMark

etAggregateStats.jsp

Some Current Corporate Bond

Market Data:

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The U.S. Fixed Income Market:

June 2012

Values in $ billions

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• Common stock: ownership, residual claim, dividend

and stock price, limited liability.

http://finance.yahoo.com/q?s=emc&ql=1

• Preferred stock: fixed dividend (cumulative), no vote

(most of the time). Often callable or convertible into

common shares.

• American Depository Receipts (ADRs): ownership in

shares of foreign company.

https://www.nyse.com/listings_directory/stock

Equity Markets

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Stock Market Indices

An Index: a basket or portfolio of securities designed to

track market changes.

• Representation: 20 stocks or 2,000 stocks? What type

of stocks? What industry or sector?

http://www.wsj.com/mdc/public/page/mdc_us_stocks.ht

ml?mod=mdc_topnav_2_3012

Weighing: Price weighted, market value weighted or

equally weighted index?

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Stock Market Indices: Price Weighted

Index

Stock Price t=1 Shares

(millions) Price t=2

Shares

(millions)

A $25 20 $30 20

B $100 1 $90 1

$25 + $100

= $125

$30 + $90

= $120

Index

Value

$125/2 =

62.5

$120/2 =

60

62.5 to 60 equals a -4% return. Same return as

owning a portfolio of one share of each stock.

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Stock Market Indices: Price Weighted

Index, adjusting for splits

Stock Price t=1 Shares

(millions)

At t=1’ Stock

B splits 2:1

Price t=2 Shares

(millions)

A $25 20 $30 20

B $100 1 $45 2

$25 + $100

=$125

$30 + $45

= $75

Index

Value

$125/2 =

62.5

$75/1.2 =

62.5

Need to preserve index value despite the stock split. We do

this by changing the divisor. New divisor = 1.2. Other issues?

5.62divisor new

$50)($25

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http://www.wsj.com/mdc/public/page/2_3022-

djiahourly.html

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Stock Market Indices: Market Value

Weighted Index

Stock Price

t=1

Shares

(millions)

Market Value

($millions)

Price

t=2

Shares

(millions)

Market

Value

($millions)

A $25 20 $500 $30 20 $600

B $100 1 $100 $90 1 $90

Market

Value $600 $690

Index

Value

100

(arbitrary

base)

$690/$600

x 100 115

100 to 115 equals a 15% return. Same return as

owning a portfolio of A and B with amounts of A and B

held in proportion to their relative market value.

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Stock Market Indices: Market Value

Weighted Index – What about splits?

Stock Price

t=1

Shares

(millions)

Market

Value

($millions)

At t=1’

Stock

B splits

2:1

Price

t=2

Shares

(millions)

Market

Value

($millions)

A $25 20 $500 $30 20 $600

B $100 1 $100 $45 2 $90

Market

Value $600

$690

Index

Value 100

$690/$600

x 100 115

Again, 100 to 115 equals a 15% return. Can

we say this about the price weighted index?

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Stock Market Indices: Equal Weighted Index

Stock Price

t=1

Price

t=2

% Return

1 to 2

Price

t=3

% Return

2 to 3

A $25 $30 20% $36 20%

B $100 $90 -10% $81 -10%

Average

% return 5% 5%

Index 100 105 (5%) 110.25 (5%)

t=1 t=2 t=3

A $50,000 $60,000 $72,000

B $50,000 $45,000 $40,500

Portfolio $100,000 $105,000 $112,500

% return 5% 7.14%

???

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• Like stock indices, a variety of different types exist.

Stale price quotes are common and can make them

difficult to accurately calculate.

• Common bond indices: Merrill Lynch, Barclays,

Citigroup, S&P Dow Jones

http://www.yieldbook.com/m/indices/browse.shtml

http://www.spindices.com/

https://research.stlouisfed.org/fred2/categories/32413

Bond Market Indices

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Derivative Markets

(Financial) Derivative: security with a payoff that

depends on the price of another security or asset

(the underlying asset).

Major classes traded → options and futures

Call option: the right to buy an asset at a

predetermined price (the strike or exercise price) on

or before a specific expiration date.

Put option: the right to sell an asset at a

predetermined price (the strike or exercise price) on

or before a specific expiration date.

http://finance.yahoo.com/q/op?s=WFM&date=1447977600

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Derivative Markets

http://www.cmegroup.com/trading/agricultural/grain-

and-oilseed/corn_quotes_globex.htm

Futures contract: a future transaction whose terms are

currently specified.

…Or, a contract that calls for delivery of an asset at a

specified delivery or maturity date for an agreed upon

price (the futures price) to be paid at contract delivery.

Long position = buyer, commits to purchasing at maturity

Short position = seller, commits to delivering at maturity

Consider a long position in one December 2015 corn

futures contract (1 contract = 5,000 bushels). Profit to long

position if in December the spot price = $4.00 per bushel?