Financial Economics Bocconi Lecture2

7/30/2019 Financial Economics Bocconi Lecture2

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INVESTMENTS | BODIE, KANE, MARCUSCopyright 2011 by The McGraw-H il l Companies, I nc. All ri ghts reserved.McGraw-Hill/Irwin

Topic 2: Asset Classes and

Financial Instruments


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INVESTMENTS | BODIE, KANE, MARCUS

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Asset Classes

Money market instruments

Capital market instruments Bonds

Equity Securities

Derivative Securities


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The Money Market

Subsector of the fixed-income market:Securities are short-term, liquid, low risk, andoften have large denominations

Money market mutual funds allow individualsto access the money market.


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Table 2.1 Major Components ofthe Money Market


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Treasury bills (Part 1)

Short-term debt of U.S. government

Investors buy the bills at a discount from thestated maturity value (the face value)

Initial maturities: 4, 13, 26, 52 weeks

Minimum denomination $100, but $10,000 muchmore common

Primary market (auction), secondary market(government securities dealer)

Exempt from all state and local taxes


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Financial press reports yields based on the T-bill prices Bid and asked price, bid-asked spread

Bank discount method: quoting convention thatannualizes (based on 360-day year) the discount as a %

of face value

where F is the face value, P is the purchase price and tis the days to maturity

Why is the bank discount yield not a meaningfulmeasure of the investors return?

t

360

F

PFrBD


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Financial press reports yields based on the T-bill pricesHow to interpret the ASK yield of 0.043?

The discount from par would be 0.043%*

(36 days to maturity/360) = 0.0043%

A bill with a par value of $10,000 istherefore selling for

$10000*(1-0.000043) = $9,999.57


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Holding period yield:

Effective annual yield:

Money-market yield/CD-equivalent yield:

Bond-equivalent yield (asked yield)=

PPFHPY

1HPY)(1EAY /t365

P

Fr

t

360HPYr BDmm

t

536HPY


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Money Market Securities

Bankers Acceptances:An order to a bank by a banks customer topay a sum of money on a future date

Eurodollars: dollar-denominated time deposits in banks outside theU.S.

Repos and Reverses: Short-term loan backed by government

securities. Repos: dealer sells T-bills to an investor on an overnight basis, with

an agreement to buy them back the next day at a slightly higherprice (implicit interest)

Term Repo: term of the implicit loan can be 30 days or more Reverse repo: dealer buys T-bills agreeing to sell them later at a

specified higher price on a future date Fed Funds: Very short-term loans between banks

Each member bank of the Federal Reserve System is required tomaintain a minimum balamce in a reserve account


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Yields on Money Market Instruments

Except for Treasury bills, money marketsecurities are not free of default risk

Both the premium on bank CDs and the TED

spread have often become greater duringperiods of financial crisis

During the credit crisis of 2008, the federalgovernment offered insurance to money market

mutual funds after some funds experiencedlosses Reserve Primary Fund broke the buck after the fall

of Lehman (value per share fell below $1)


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The TED spread = LIBOR-T-bill rate


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CD-T-bill Spread and correlation withfinancial crises


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The Bond Market

Treasury Notes and Bonds

Inflation-Protected Treasury Bonds

Federal Agency Debt International Bonds

Municipal Bonds

Corporate Bonds Mortgages and Mortgage-Backed

Securities


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The Bond Market

Inflation-Protected Treasury Bonds TIPS: Provide inflation protection

Principal amount is adjusted in proportion to increases in CPI

Federal Agency Debt

Debt of mortgage-related agencies such as Fannie Mae andFreddie Mac

Not explicitly insured by the federal government, widely assumedgovernment would step in to assist an agency nearing default

International Bonds Eurobonds: bonds denominated in a currency other than that of

the country in which they are issued

Yankee bonds: dollar-denominated bond sold in the US by anon-US issuer


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Municipal Bonds

Issued by state and local governments

Interest is exempt from federal income taxand sometimes from state and local tax

Types

General obligation bonds: Backed by taxing power of issuer

Revenue bonds: backed by projects revenues or by themunicipal agency operating the project.

Industrial development bond: revenue bond that is issued tofinance commercial enterprises such as the construction ofa factory that can be operated by a private firm


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Tax-exempt Debt Outstanding

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Municipal Bond Yields

To choose between taxable and tax-exemptbonds, compare after-tax returns on eachbond.

Let tequal the investors marginal tax

bracket Let requal the before-tax return on the

taxable bond and rm denote the municipalbond rate.

Ifr (1 - t ) > rm then the taxable bond givesa higher return; otherwise, the municipalbond is preferred.

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Table 2.2 Tax-Exempt Yield Table

The equivalent taxable yield is the rate that a taxable bond must offer to match theafter-tax yield on the tax-free muni.

The equivalent taxable yield is thus is simply the tax-free rate, rm , divided by (1-t).

We can also solve for cut-off tax bracket at which investors are indifferent betweentaxable and tax-exempt bonds. t =1- rm /r

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Corporate Bonds

Issued by private firms

Semi-annual interest payments

Subject to larger default risk than government securities

Types: Secured (specific collateral backing them in the event of bankruptcy)

Debentures (no collateral)

Subordinated debentures (lower priority claim to the firms assets in the

event of bankruptcy) Options in corporate bonds

Callable

Convertible

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Proportional ownership of a mortgagepool or a specified obligation secured bya pool

Produced by securitizing mortgages

Mortgage-backed securities are calledpass-throughs because the cash flows produced by

homeowners paying off their mortgages arepassed through to investors.

Mortgage-Backed Securities

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Figure 2.6 Mortgage-backed securitiesoutstanding

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Equity Securities

Common stock: Ownership Each share entitles its owner to one vote on any matters of

corporate governance that are put to a vote at the corporationsannual meeting and to a share in the financial benefits ofownership

Residual claim: stockholders are the last in line of all those whohave a claim on the assets and income of a corporation

Limited liability: the most shareholders lose in the event of afailure of the corporation is their original investment

American Depository Receipts: certificates traded in US

markets that represent ownership in shares of a foreigncompany

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Equity Securities

Preferred stock: Perpetuity Fixed dividends

No voting power regarding the management of the firm

Firm retains the discretion to make the dividend payments topreferred stockholders (no contractual obligation like bonds)

Priority over common: preferred dividends are cumulative

Tax treatment not tax deductible for the issuing firm, butcorporations can exclude up to 70% of dividends received fromdomestic corporations in the computation of taxable income. Asa result, preferred stock often sells at lower yields than

corporate bonds.

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Stock Market Indexes

Dow Jones Industrial Average Includes 30 large blue-chip corporations

Computed since 1896

Price-weighted average

The return on the index is equivalent to holding aportfolio that invests one share in each of the 30stocks of the index

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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 (30 + 90)/2 = 60Percentage change in index -2.5/62.5

= -.04 = -4%

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Adjustments to the divisor of DJIA

The averaging procedure is adjusted whenever a stock splits or pays astock dividend of more than 10%, or when a company is the group of30 industrial companies is replaced by another.

The divisor used to compute the average price is adjusted so as to

leave the price unchanged. Suppose XYZ undergoes a 2:1 stock split in the beginning of the

period. Price falls to $50, the number of shares outstanding doubles,leaving the market value of total shares unaffected.

Index value before split (100+25)/2=62.5

To find the divisor, d, solve (50+25)/d=62.5 Result: d=1.2Return on the index is affected by the split: Index value at the end ofthe period = (30+45)/1.2 = 62.5, so return now is 0, instead of -4%


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Investors can base their portfolios on an index: Buy an index mutual fund

The index fund yields a return equal to that of the benchmark indexand thus provides a low-cost passive investment strategy for equityinvestors.

Buy exchange traded funds (ETFs)

Portfolio of shares that can be bought or sold as a unit

Equally-weighted indexes: equally-weighted average of the returnsof each stock in the index

Implicit portfolio strategy that places equal dollar values on each stock

Unlike price-weighted and market-value-weighted indexes, this does notcorrespond to a simple buy-and-hold strategy. Needs rebalancing toreset portfolio to equal weights.

Indexes

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Other Indexes

U.S. Indexes

NYSE Composite

NASDAQ Composite

Wilshire 5000

Foreign Indexes

Nikkei (Japan)

FTSE (U.K.; pronounced

footsie) DAX (Germany),

CAC (France)

Hang Seng (Hong Kong)

TSX (Canada)

Bond Indexes

Difficult to compute truerates of return since a lot ofbonds trade only infrequently

Matrix prices calculated frombond-valuation models insteadof true market values

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Derivatives Markets

Options and futures provide payoffs that dependon the values of other assets such as commodityprices, bond and stock prices, or market index

values.

A derivative is a security that gets its value fromthe values of another asset.

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Options

Call: Right to buy underlying asset at the strikeor exercise price.

Value of calls decrease as strike price increases

Put: Right to sell underlying asset at the strike orexercise price.

Value of puts increase with strike price

Value of both calls and puts increase with timeuntil expiration.

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Futures Contracts

A futures contract calls for delivery of an asset(or in some cases, its cash value) at a specifieddelivery or maturity date for an agreed-upon

price, called the futures price, to be paid atcontract maturity.

Long position: Take delivery at maturity

Short position: Make delivery at maturity

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Comparison

Option

Right, but not obligation,to buy or sell; option is

exercised only when it isprofitable

Options must bepurchased

The premium is the priceof the option itself.

Futures Contract

Obliged to make or takedelivery. Long position

must buy at the futuresprice, short position mustsell at futures price

Futures contracts areentered into without cost

Financial Economics Bocconi Lecture2

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