Investments: Asset classes and financial instruments

CHAPTER 2

Financial Securities

Financial Market

Fixed-income (Bonds) Equity (Stocks) Derivatives

Money Market(Short-term)

Common StocksPreferred Stocks

OptionsFutures

Low Risk High Risk

Bond Market(Long-term)

Index

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

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)

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

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

Table 2.2 Components of the Money Market

Bond Market

Treasury Notes and Bonds Federal Agency Debt International Bonds Inflation-Protected Bonds Municipal Bonds Corporate Bonds Mortgages and Mortgage-Backed

Securities

Treasury Notes and Bonds

MaturitiesNotes – maturities up to 10 yearsBonds – maturities in excess of 10 years

Par Value - $1,000 Quotes – percentage of par, in 32nd

Figure 2.4 Treasury Notes and Bonds

Federal Agency Debt

Major issuers 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

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

Interest is exempt from Federal taxes

After-tax return (taxable bond):

After-tax return (Municipal bond):

trr taxbeforetaxafter 1

taxbeforetaxafter rr

Municipal Bonds

Figure 2.6 Ratio of Yields on

Tax-exempts to Taxables, 1955-2006

Corporate Bonds

Issued by private firms Semi-annual interest payments Subject to larger default risk than

government securities Options in corporate bonds

CallableConvertible

Figure 2.7 Investment Grade Bond Listings

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

Mortgages and Mortgage-backed Securities

Mortgage backed securities

Banks

Mortgage loan

Borrowers

mortgage backed securities

pool all mortgage loans

securitizedInvestors

sell

fund

fund

fund

fund payment

payment

paymentpayment

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

Figure 2.8 Mortgage-Backed Securities Outstanding

Equity Markets

Common stock

Preferred stock

Depository receipts

stock market listing

Equity Markets

Common stock Right to vote Right to share benefit Proxy Proxy fight

Characteristics Residual claims Limited liabilities

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

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

Figure 2.9 Stock Market Listings

Track average returns Comparing performance of managers Base of derivatives

Uses of Stock Indexes

Examples of Other Indexes - Domestic

Dow Jones Industrial Average (30 Stocks) Standard & Poor’s 500 Composite NASDAQ Composite NYSE Composite Wilshire 5000

Figure 2-10 Comparative Performance of Several Stock Market Indexes

Examples of Indexes - International

Nikkei 225 & Nikkei 300 FTSE (Financial Times of London) Dax Region and Country Indexes

EAFEFar EastUnited Kingdom

MSCI: index of more than 50 country indexes

Table 2.6 Sample of MSCI Stock Indexes

Representative? Broad or narrow? How is it weighted?

Price weighted (DJIA)Market weighted (S&P 500, NASDAQ)Equal (Value Line Index)

Factors for Construction of Stock Indexes

Price Weighted Indices DJIA is an example 30 blue chip companies DJIA = (P1+P2+....+P30)/d where d is Dow divisor. Originally d = 30 Currently, d = 0.1248 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

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?

DJIA

Most quoted index in the world 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

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.

Value LineEqually 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

Table 2.4 Data to Construct Stock Price Indexes

Computed monthly

Difficulty in measuring true returns

Best known:Merrill LynchLehman BrothersSalomon Smith Barney

Bond Index

DERIVATIVE MARKETS

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

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

Options

Options

Call 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 Same exercise price, expiration date increases,

value of option increases

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

There is no free lunch!

Return

Risk

less risk

lessreturn

more risk

morereturn

Money

T-Bonds

Corporate Bonds

Stocks

Derivatives

Summary

Financial securities Indices Next class: Financial Market Trading