2-1 Asset Classes and Financial Instruments CHAPTER 2 GLOBAL FINANCIAL INSTRUMENTS

2-1

Asset Classes and Financial Instruments

CHAPTER 2GLOBAL FINANCIAL

INSTRUMENTS

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2.1 THE MONEY MARKET

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Major Classes of Financial Assets or Securities

• Money market• Bond market• Equity markets• Indexes• Derivative markets

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Money Market Instruments

• Treasury bills issued by central bank to institutional buyers

• Certificates of deposits: Fixed deposits can be enchased earlier than maturity

• Commercial Paper: Short term unsecured debt issued by large corporations usually backed by credit lines to pay cash at maturity. CP maturity range up to 270 days, longer maturity requires SEC registration. Usual denomination of multiples of $100,000. Small investor only can invest through money market mutual funds.

• Bankers Acceptances: An order to a bank by a customer to pay a sum of money at a future date, which can then be traded in secondary market. This is widely used in foreign trade where the credit worthiness of one trader is unknown to the trading partner

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Money Market Instruments (Contd..)

• Eurodollars: Dollar denominated deposits at bank of countries other than USA or foreign branches of US banks to escape regulations of Federal Reserve Board. Most Eurodollar deposits are for large sums, and most are time deposits of less than six months’ maturity.

• Repurchase Agreements (RPs) and Reverse RPs: The dealer sells securities with an agreement to repurchase the securities at a higher price. Dealers in government securities use repurchase agreement, called repo as a form of short term borrowing.

• Federal Funds: Statutory reserve maintained by commercial banks with the central bank. Banks with a surplus of such fund can sell it to a bank in deficit in money market.

• LIBOR (London Interbank Offer Rate) Market: LIBOR is the rate at which large banks in London are willing to lend money among themselves. The rate has become the premier short-term interest rate quoted in the European money market and serves as a reference rate for a wide range of transactions.

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2.2 THE BOND MARKET

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Bond Market• Treasury Notes and Bonds

– T-notes maturity: up to 10 years– T-bonds maturity: in excess of 10 years

• Federal Agency Debt: Some government agencies issue their own securities to finance their activities. These agencies usually are formed for public policy reasons to channel credit through normal private sources. Although these are not as risk-free as treasury bonds but are very safe as government will assist an agency nearing default. Some of these agencies are:– Federal National Mortgage Association– Government National Mortgage Association– Federal Home Loan Mortgage Corporation– Federal National Mortgage Associations

• International Bonds– Largely centered in London, a Eurobond is a bond denominated

in any currency other than that of the country in which it is issued. For example, a Yankee bond is a dollar denominated bond sold in the U.S. by a non-US issuer.

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Bond Market (Contd..)• Municipal Bonds

– Issued by the state and local government. Maturity: Up to 30 years. Unlike treasury bonds, interest income on these is exempt from federal income taxation.

• Corporate Bonds– Issued by private corporations typically pay semiannual coupons– Default risk: secured bond (specific collateral backing them in the

event of firm bankruptcy), unsecured bond or debenture, subordinated debenture (lower priority in the event of bankruptcy)

– Callable (by the firm) and convertible (by the holder) bond• Mortgages and Mortgage-Backed Securities:

– Investors can invest in a portfolio of mortgage loans, and these securities have become major component of fixed-income market. Fixed rate mortgages can create considerable difficulties for banks in years of increasing interest rates. Because banks commonly issue short term liabilities (the deposits of their customers) and hold long term assets, such as fixed-rate mortgages, they suffer losses when interest rate increases. So the conventional form of fixed interest rate mortgage was a threat for commercial banks. Now the rate is adjustable.

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• 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

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Figure 2.8 Mortgage-Backed Securities Outstanding

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2.3 EQUITY SECURITIES

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Equity Markets

• Common stock– Residual claim– Limited liability– Owners of the firm (voting rights)

• Preferred stock– Fixed dividends – limited but cumulative– Priority over common– Redeemable (by the firm) & convertible – Tax treatment: Different from bond

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2.4 STOCK AND BOND MARKET INDEXES

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• There are several indexes worldwide such as:– Dow Jones Industrial Average (DJIA): If there are 30

stocks in the Index, one would add the value of the 30 stocks and divide by 30. Dividends excluded, so it is price weighted average.

– Nikkei Average

• Offer ways of comparing performance of managers

• Base of derivatives

Stock Market Indexes

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• Representative versus blue chips?

• Broad or narrow?• How is it weighted?

– Price weighted (DJIA)– Market weighted (S&P 500, NASDAQ)

Factors for Construction of Stock Indexes

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Table 2.4 Data to Construct Stock Price Indexes

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DJIA

Price-Weighted Average

• Using data from Table 2.4; example 2.2Initial value = $25 + $100 = $125Final value = $30 + $ 90 = $120Percentage change in portfolio value =Initial index value = (25 + 100)/2 = 62.5Final index value = (30 + 90)/2 = 60

Percentage change in index = (60-62.5)/62.5=-2.5/62.5 = -.04 = -4%

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S&P’s Composite 500 Computation of value weighted Index

Stocks Share price Number of shares Market value

Dec 31, 2005

A

B

C

Total

$10.00

15.00

20.00

1,000,000

6,000,000

5,000,000

$10,000,000

90,000,000

100,000,000

$200,000,000

Dec 31, 2006

A

B

C

Total

$12.00

10.00

20.00

1,000,000

12,000,000 (Split 2 for 1) 5,500,000 (10% stock div)

$12,000,000

120,000,000

110,000,000

$242,000,000

New Index Value=(Current Market Value/Base Value) x Beginning Index Value

=(242,000,000/$200,000,000)x100

=121

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2.5 DERIVATIVE MARKETS

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Derivative SecuritiesOptions

– Call (Buy)– Put (Sell)

• Call (Buy) Option gives the holder the right to purchase an asset for a specified price, called exercise price, on or before expiration date. If the holder expect that price would increase in future then he would go for call option. He would buy at a lower price (strike price) and sell at a higher price, and thereby, make money.

• Put (sell) option gives the holder the right to sell an asset for a specified price, called exercise price, on or before expiration date. If the holder expect that price would decrease in future then he would go for put option option. He would buy at a lower price and sell at a higher price (strike price), and thereby make money.

• Terms– Exercise Price– Expiration Date– Assets– Premium

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Call Option Payoffs: Buyer

–20

12020 40 60 80 100

–40

20

40

60

Stock price ($)

Op

tion

pay

offs

($) Buy

a ca

ll

Exercise price = $50

50

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Call Option Payoffs: Seller

–20

12020 40 60 80 100

–40

20

40

60

Stock price ($)

Op

tion

pay

offs

($)

Sell a call


50

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Contingency graph: Call Option

Exercise price = $50; option premium = $10

Seller of a call

Buyer of a call

–20

12020 40 60 80 100

–40

20

40

60

Stock price ($)

Op

tion

pay

offs

($)

50–10

10

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Put Option Payoffs: Buyer

–20

20 40 60 80 100

–40

20

0

40

60

Stock price ($)

Op

tion

pay

offs

($)

Buy a put


50

50

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Put Option Payoffs: Seller

–20

0 20 40 60 80 100

–40

20

0

40

–50

Stock price ($)

Op

tion

pay

offs

($)

Sell a put


50

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Put Option Profits

–20

20 40 60 80 100

–40

20

40

60

Stock price ($)

Op

tion

pay

offs

($)

Buyer of a put

Exercise price = $50; option premium = $10

–10

10Seller of a put

50

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Reading The Wall Street Journal

Option/Strike Exp. Vol. Last Vol. LastIBM 130 Oct 364 15¼ 107 5¼138¼ 130 Jan 112 19½ 420 9¼138¼ 135 Jul 2365 4¾ 2431 13/16

138¼ 135 Aug 1231 9¼ 94 5½138¼ 140 Jul 1826 1¾ 427 2¾138¼ 140 Aug 2193 6½ 58 7½

--Put----Call--

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138¼ 135 Aug 1231 9¼ 94 5½138¼ 140 Jul 1826 1¾ 427 2¾138¼ 140 Aug 2193 6½ 58 7½

--Put----Call--

This option has a strike price of $135;

a recent price for the stock is $138.25

July is the expiration month

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138¼ 135 Aug 1231 9¼ 94 5½138¼ 140 Jul 1826 1¾ 427 2¾138¼ 140 Aug 2193 6½ 58 7½

--Put----Call--

This makes a call option with this exercise price in-the-money by $3.25 = $138¼ – $135.

Puts with this exercise price are out-of-the-money.

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138¼ 135 Aug 1231 9¼ 94 5½138¼ 140 Jul 1826 1¾ 427 2¾138¼ 140 Aug 2193 6½ 58 7½

--Put----Call--

On this day, 2,365 call options with thisexercise price were traded.

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138¼ 135 Aug 1231 9¼ 94 5½138¼ 140 Jul 1826 1¾ 427 2¾138¼ 140 Aug 2193 6½ 58 7½

--Put----Call--

The CALL option with a strike priceof $135 is trading for $4.75.

Since the option is on 100 shares of stock, buying this option would cost $475 plus commissions.

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138¼ 135 Aug 1231 9¼ 94 5½138¼ 140 Jul 1826 1¾ 427 2¾138¼ 140 Aug 2193 6½ 58 7½

--Put----Call--

On this day, 2,431 put options with thisexercise price were traded.

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138¼ 135 Aug 1231 9¼ 94 5½138¼ 140 Jul 1826 1¾ 427 2¾138¼ 140 Aug 2193 6½ 58 7½

--Put----Call--

The PUT option with a strike price of $135 is trading for $.8125.

Since the option is on 100 shares of stock, buying this option would cost $81.25 plus commissions.

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Derivative Securities (Contd..)

Futures

A future contract calls for a delivery of an asset at a specified delivery or maturity date, for an agreed upon price, called future price, to be paid at the maturity of the contract.

• Basic Positions– Long (Buy) The long position is held by trader who commits to

purchasing the commodity on the delivery date. – Short (Sell) The short position is held by trader who commits to

delivering the commodity on the delivery date. • Terms

– Delivery Date– Assets

Documents

2-1 Asset Classes and Financial Instruments CHAPTER 2 GLOBAL FINANCIAL INSTRUMENTS