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Understanding Asset Classes and Financial Instruments

Learn about different asset classes such as financial securities, money market instruments, bond market, and equity markets.

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Understanding Asset Classes and Financial Instruments

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  1. CHAPTER 2 Investments: Asset classes and financial instruments

  2. Financial Securities High Risk Low Risk Money Market (Short-term) Bond Market (Long-term) Common Stocks Preferred Stocks Options Futures Index

  3. 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

  4. 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)

  5. 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

  6. 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

  7. Table 2.2 Components of the Money Market

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

  9. Treasury Notes and Bonds • Maturities • Notes – maturities up to 10 years • Bonds – maturities in excess of 10 years • Par Value - $1,000 • Quotes – percentage of par, in 32nd

  10. Figure 2.4 Treasury Notes and Bonds

  11. 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

  12. 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

  13. Municipal Bonds Interest is exempt from Federal taxes After-tax return (taxable bond): After-tax return (Municipal bond):

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

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

  16. Figure 2.7 Investment Grade Bond Listings

  17. 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

  18. Mortgage backed securities fund fund payment payment payment pool all mortgage loans Banks sell mortgage backed securities Investors securitized fund 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 Mortgage loan fund payment Borrowers

  19. Figure 2.8 Mortgage-Backed Securities Outstanding

  20. Equity Markets • Common stock • Preferred stock • Depository receipts • stock market listing

  21. Equity Markets • Common stock • Right to vote • Right to share benefit • Proxy • Proxy fight • Characteristics • Residual claims • Limited liabilities

  22. 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

  23. 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

  24. Figure 2.9 Stock Market Listings

  25. Uses of Stock Indexes • Track average returns • Comparing performance of managers • Base of derivatives

  26. Examples of Other Indexes - Domestic • Dow Jones Industrial Average (30 Stocks) • Standard & Poor’s 500 Composite • NASDAQ Composite • NYSE Composite • Wilshire 5000

  27. Figure 2-10 Comparative Performance of Several Stock Market Indexes

  28. Examples of Indexes - International • Nikkei 225 & Nikkei 300 • FTSE (Financial Times of London) • Dax • Region and Country Indexes • EAFE • Far East • United Kingdom • MSCI: index of more than 50 country indexes

  29. Table 2.6 Sample of MSCI Stock Indexes

  30. Factors for Construction of Stock Indexes • Representative? • Broad or narrow? • How is it weighted? • Price weighted (DJIA) • Market weighted (S&P 500, NASDAQ) • Equal (Value Line Index)

  31. 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

  32. 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?

  33. 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

  34. 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.

  35. 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

  36. Table 2.4 Data to Construct Stock Price Indexes

  37. Bond Index • Computed monthly • Difficulty in measuring true returns • Best known: • Merrill Lynch • Lehman Brothers • Salomon Smith Barney

  38. DERIVATIVE MARKETS

  39. Options Basic Positions Call (Buy) Put (Sell) Terms Exercise Price Expiration Date Assets Futures Basic Positions Long (Buy) Short (Sell) Terms Delivery Date Assets Derivative Securities

  40. Options 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

  41. 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

  42. 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

  43. There is no free lunch! Derivatives Stocks Corporate Bonds T-Bonds Money

  44. Summary • Financial securities • Indices • Next class: Financial Market Trading

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