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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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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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Treasury bills (Part 2)
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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Treasury bills (Part 3)
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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Treasury bills (Part 3)
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
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