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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