Financial Securities

1. Financial Securities Riccardo Colacito

2. Major classes of Financial Securities

3. Money Market

4. Money Market common characteristics • Short term • Highly liquid • Low risk

5. Treasury Bills • Sell at discount price • Maturities: 1-3-6 month • Bid-Ask spread • Bank discount method • Bond equivalent yield • Data @ St. Louis Fed

6. Historical 3-Month T-bill

7. Certificates of Deposit • Time deposit with a bank • May not be withdrawn on demand

8. Figure 2.3 Spreads on CDs and Treasury Bills • Spread is higher during economic crises

9. Fed Fund rate • Rate at which commercial banks borrow from Federal Reserve

10. Money Market: other • Commercial paper • Short term • Unsecured debt notes • Issued to public (rather than banks) • Eurodollars • Dollar denominated deposits at foreign banks • Repos • Sell securities today & buy them back tomorrow • LIBOR • Lending rate among banks in London

11. Bond Market

12. Treasury Notes and Bonds • Maturities • Notes – maturities up to 10 years • Bonds – maturities in excess of 10 years • 30-year bond • 2001 Treasury suspended sales • 2006 Treasury resumed sales • Par Value - $1,000 • Quotes – percentage of par

13. Figure 2.4 Treasury Notes, Bonds and Bills

14. Term spread • 10-year T-bond yield higher return almost always • Inverted yield curve usually predicts recession • Interesting article in the Journal of Econometics

15. Municipal Bonds • Issued by state and local governments • Types • General obligation bonds • Revenue bonds • Industrial revenue bonds • Maturities – range up to 30 years

16. Figure 2.6 Outstanding Tax-exempt Debt

17. 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

18. Equivalent Taxable Yields • Need to equate: r(1-t)=rm • The higher rm/r, the lower the cutoff tax bracket.

19. Figure 2.7 Ratio of Yields on Tax-exempts to Taxables

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

21. Figure 2.8 Corporate Bond Prices

22. 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

23. Figure 2.9 Mortgage-backed Securities Outstanding

24. Bond Market: other • Federal agency debt • Government agencies that issue their own securities • Int’l bonds • Eurobond: bond denominated in a currency other than that of the country in which it is issued

25. Stocks

26. Equity Markets • Common stock • Residual claim • Limited liability • Preferred stock • No voting power • Fixed dividends • Priority over common • Tax treatment

27. Figure 2.10 Listing of Stocks Traded on the NYSE Online quotes: http://finance.yahoo.com/

28. Example of quote of Yahoo Finance • E.g. Microsoft (MSFT) • Can you find: Hi-Lo, dividend yield, PE ratio,…?

29. Stocks

30. Stock Indexes • Uses of Stock Indexes • Track average returns • Comparing performance of managers • Base of derivatives • Factors for Construction of Indexes • Representative? • Broad or narrow? • How is it weighted?

31. Construction of Indexes • How are stocks weighted? • Price weighted (DJIA) • Market-value weighted (S&P500, NASDAQ) • Equally weighted (Value Line Index)

32. Price weighted average • Initial Value = ($25 + $100)/2 = $62.5 • Final Value = ($30 + $90)/2 = $60 • Percentage change = -2.5/62.5 = -4%

33. Price weighted average (cont’d) • An average computed by adding the prices of the stocks and dividing by a “divisor”. • What happens if there is a split? • The averaging procedure is adjusted (i.e. the divisor changes to leave the index unaffected)

34. Price weighted average (splits) • Initial Value = ($25 + $50)/d = $62.5 d=1.2 • Final Value = ($30 + $45)/d = $60 • Percentage change = -2.5/62.5 = -4% $50 $50 $45 $45 2

35. Dow Jones (example of price weighted) • 3M Co. (NYSE: MMM) (conglomerates, "manufacturing") • ALCOA Inc. (NYSE: AA) (aluminum) • Altria Group Inc. (NYSE: MO) (tobacco, foods) • American Express Co. (NYSE: AXP) (credit services) • American International Group Inc. (NYSE: AIG) (property & casualty insurance) • AT&T Inc. (NYSE: T) (telecoms) • Boeing Co. (NYSE: BA) (aerospace/defense) • Caterpillar Inc. (NYSE: CAT) (farm & construction equipment) • Citigroup Inc. (NYSE: C) (money center banks) • Coca-Cola Co. (NYSE: KO) (beverages) • E.I. du Pont de Nemours & Co. (NYSE: DD) (chemicals) • Exxon Mobil Corp. (NYSE: XOM) (major integrated oil & gas) • General Electric Co. (NYSE: GE) (conglomerates, media) • General Motors Corp. (NYSE: GM) (auto manufacturers) • Hewlett-Packard Co. (NYSE: HPQ) (diversified computer systems) • Home Depot Inc. (NYSE: HD) (home improvement stores) • Honeywell International Inc. (NYSE: HON) (conglomerates) • Intel Corp. (NASDAQ: INTC) (semiconductors) • International Business Machines Corp. (NYSE: IBM) (diversified computer systems) • Johnson & Johnson (NYSE: JNJ) (consumer and health care products conglomerate) • JPMorgan Chase & Co. (NYSE: JPM) (money center banks) • McDonald's Corp. (NYSE: MCD) (restaurant franchise) • Merck & Co. Inc. (NYSE: MRK) (drug manufacturers) • Microsoft Corp. (NASDAQ: MSFT) (software) • Pfizer Inc. (NYSE: PFE) (drug manufacturers) • Procter & Gamble Co. (NYSE: PG) (consumer goods) • United Technologies Corp. (NYSE: UTX) (conglomerates) • Verizon Communications Inc. (NYSE: VZ) (telecoms) • Wal-Mart Stores Inc. (NYSE: WMT) (discount, variety stores) • Walt Disney Co. (NYSE: DIS) (entertainment) Look this up on Yahoo Finance (“^DJI”)

36. A better weighting scheme? • Price weighted: weighting scheme is a little arbitrary • Wouldn’t it be better to give weights proportional to outstanding market value? • Value weighted indexes

37. Value weighted average • Initial Value = $500 + $100 = $600 • Final Value = $600 + $90 = $690 • Percentage change = 90/600 = 15%

38. Comparison of weighting schemes • Price weighted: -4% • Value weighted: +15%

39. S&P500 vs Dow Jones

40. Equivalent portfolio strategies • Price weighted index • Invest an equal amount in ABC and XYZ • Hold the portfolio for one period • Value weighted index • Invest in ABC and XYZ an amount that is proportional to their market capitalization • Hold the portfolio for one period

41. Equally weighted return • Return on ABC = 5/25 = 20% • Return on XYZ = -10/100 = -10% • Average return = (20%-10%)/2 = 5%

42. Examples of Indexes - Int’l • Nikkei 225 & Nikkei 300 • FTSE (Financial Times of London) • Dax • Region and Country Indexes • EAFE • Far East • United Kingdom

43. Summary

44. Options • Call • Right to buy an asset at a specified price on or before a specified expiration date • Put • Right to sell an asset at a specified price on or before a specified expiration date

45. Example Current Stock Price Call Price Exercise Price 88.64 3.82 85.00 88.82

46. Summary

47. Futures • Deliver an asset at a specified delivery or maturity date for an agreed upon price (futures price) to be paid at contract maturity. • Long position: commits to purchasing • Short position: commits to delivering • Option: right to purchase/sell • Futures: obligation to purchase/sell

48. Summary