CHAPTER 2

1. Asset Classes and Financial Instruments CHAPTER 2

2. Major Classes of Financial Assets or Securities • Money market • Bond market • Equity markets • Indexes • Derivative markets

3. Historical Graph 2.1 THE MONEY MARKET

4. Money Market Instruments • Treasury bills • Certificates of deposits • Commercial Paper • Bankers Acceptances • Repos and Reverse RPs • Federal Funds

5. Treasury Bills • Initial Maturities: 28, 91, and 182 days • Issued: Weekly • Issued on a discount basis • Minimum Denomination: $1,000 • Interest income: taxable at the federal level but exempt from state and local taxes

6. Figure 2.2 Treasury Bills

7. Computation of Treasury Bill Prices • “Bank-Discount Method” • You buy at the “asked” yield • You sell at the “bid” yield • 4.9% x (90/360) = 1.225% • $10,000 x (1-0.01225) = $9,877.50: this is the price you buy at. • Likewise, you sell T-Bill at $10,000 x (1-0.0491 x (90/360) = $9,877.25

8. Computation of Treasury Bill Yields • “Bond-Equivalent Yield” in the last column: Ask Yield $10,000/$9,877.50 = 1.0124 or 1.24% 1.24% x (365/90) = 5.03%

9. Certificates of Deposits • Time deposit (as opposed to Demand deposit): The bank pays interest and principal at the end of the fixed term of the CD • CDs are protected by FDIC up to $100,000.

10. Commercial Paper • Large, well-known companies issue CPs to borrow from the public rather than from banks. • Denomination: Usually $100,000 • Maturity: No longer than 270 days • CPs are rated by rating agencies such as Standard and Poor’s and Moody’s. • Yield = f(maturity; credit rating)

11. Bankers’ Acceptances • An order to a bank by its customer to pay a sum of money at a future date (like a post-dated check) • Maturity: < 6 months • Once the bank endorses the order for payment as “accepted,” the acceptance may be traded in secondary markets • Widely used in foreign trade

12. Federal Funds • Banks are required to maintain a minimum balance in a reserve account with the Federal Reserve Bank or the Fed. • The required balance depends on the total deposit of the bank’s customers. • Federal Funds or Fed Funds = the funds in the bank’s reserve account • In the Federal Funds market, banks with excess funds lend to those with a shortage….Usually overnight transactions

13. Federal Fund Rate Federal Fund Rate: 3.5% as of January 22, 2008

14. Table 2.2 Components of the Money Market

15. 2.2 THE BOND MARKET

16. Bond Market • Treasury Notes and Bonds • Federal Agency Debt • International Bonds • Inflation-Protected Bonds • Municipal Bonds • Corporate Bonds • Mortgages and Mortgage-Backed Securities

17. Treasury Notes and Bonds • Maturities a. Notes: maturities up to 10 years b. Bonds: maturities 10 – 30 years • Par Value: $1,000 • Quotes : percentage of par

18. Figure 2.4 Treasury Notes and Bonds

19. Treasury Notes and Bonds • Bid Price = 96.09 == $96 9/32 = 96.281 == $962.81 is the price you sell at • Ask Price = 96.10 == $96 10/32 = 96.3125 == $963.125 is the price you buy at

20. Treasury Inflation Protected Securities (TIPS) • Principal Amount: Adjusted in proportion to changes in the Consumer Price Index to provide a constant stream of income in real (inflation-adjusted) dollars. • Reported yield on TIPS is lower than that on conventional Treasury bonds due to inflation adjustment. • Treasury offers a deflation-floor: TIPS holders will not receive back less than nominal principal value at maturity. However, semi-annual coupons are not protected against deflation. • $300 billion of TIPS outstanding vs. $800 billion of inflation-linked bonds worldwide. First TIPS was issued in January 1997.

23. Federal Agency Debt • Government-Sponsored Enterprises • Federal Farm Credit System Banks • Federal Home Loan Banks • Federal National Mortgage Association (FNMA or Fannie Mae) • Government National Mortgage Association (GNMA or Ginnie Mae) • Student Loan Marketing Association (Sallie Mae) • Federal Home Loan Mortgage Corporation (FHLMC or Freddie Mac) • Tennessee Valley Authority

24. Municipal Bonds (Munis) • Issued by state and local governments • Interest income: exempt from federal income taxation and exempt from state and local taxation in the issuing state • The “equivalent of taxable yield “ • Types • General obligation bonds…”full faith and credit” of the issuer • Revenue bonds Industrial development bond: to finance commercial enterprises operated by a private firm; one of revenue bonds

25. Figure 2.5 Outstanding Tax-exempt Debt

26. Municipal Bond Yields • Interest income on municipal bonds is not subject to federal and sometimes state and local tax • To compare yields on taxable securities a “Taxable Equivalent Yield” is constructed r (1-t) = rm

27. Table 2.3 Equivalent Taxable Yields

28. Figure 2.6 Ratio of Yields on Tax-exempts to Taxables, 1955-2006

29. Corporate Bonds • Issued by private firms • Semi-annual interest payments • Subject to larger default risk than government securities • Options in corporate bonds • Callable • Convertible

30. Figure 2.7 Investment Grade Bond Listings

31. Mortgages and Mortgage-backed Securities • 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

32. Figure 2.8 Mortgage-Backed Securities Outstanding

33. Summary of US Fixed Income Securities Markets Source: Securities Industry and Financial Markets Association

34. Equity Markets • Common stock • Residual claim • Limited liability • Preferred stock • Fixed dividends - limited • Priority over common • Usually cumulative • Preferred dividends are not tax deductible expenses for the paying firm • Corporations may exclude 70% of preferred dividend received in computing their taxable income • Depositary receipts; ADR….watch out typo

35. Figure 2.9 Stock Market Listings