Investments: Background and
Issues
• Real vs Financial Assets
– Real assets are used to produce goods and services
– Financial assets are claims on real assets
– All financial assets are derivative assets (i.e., prices
derived from their underlying assets)
– Why financial assets exist?
– Financial Market
• Channel funds from the surplus units
(typically from the consumer sector) to the
deficit units (from the business sectors or
government)
• Financial intermediaries are institutions help
the fund flows in the financial market for
efficient fund allocation
• Means to overcome market impediments,
e.g., taxes
Financial Intermediaries
• Brokerage Function
Financial intermediaries that bring together buyers
and sellers to complete the transaction and charges
a fee, e.g., investment banks
• Asset Transformation
Financial intermediaries that pool short-term funds
and transform them into longer-term assets, e.g.,
commercial banks
Market Structures
• Direct Market
buyers and sellers find each other directly, e.g., resale of real assets
• Brokered Market
Broker brings buyer and sellers together, e.g., direct placement of
debt
• Dealer Market
Dealer purchases the asset and later sells it to the investor, e.g.,
OTC market
• Auction market
All transactions converge in one place to buy or sell, e.g., NYSE
continuous vs discrete auction market
Recent Developments in
Financial MKT
• Globalization
– Integration of financial markets across nations, e.g., mutual
fund flows
1993, mutual funds invested in LDC grew substantially, but
correction later.
• Securitization
Package assets and sell off to market, e.g., A/R loans
• Credit Enhancement
allows insurance company to back credit of a corporation
• Financial Engineering
unbundling and bundling of existing assets to create new
instruments (dual funds)
Financial Instruments
• Money Market (short-term)
Tbill: when issued with maturities if 13-w, 26-w or 52w and are sold at a discount basis
DY = [(10,000-price)/10,000](360/n)
where DY= discount yield
n = days to maturity
BEY = [(10,000-P)/P](365/n)
• BEY is the bond equivalent yield
Effective Yield is the yield to maturity that equates the
present value of the Tbill face value to its current price
• Certificate of Deposit (CD):time deposit
instrument with banks. Denominations equal
to or less $100,000 due to FDIC insurance
limit.
• Commercial paper: Corporate IOUs, less
than 270-day maturity due to SEC rule
Increasing importance instruments that shapes
the banking industry
• Bankers Acceptance: trade discount
instrument backed by banks.
• Eurodollar CD: deposits with Eurobonds
• Federal Funds: bank deposits at FRB as
reserve. Excess amount than required can be
loaned out on a overnight basis to satisfy the
FRB requirement
Capital Market Instruments
• Treasury notes/bonds: medium to long-term federal
government debt instruments at a fixed rate.
• Corporate Bonds: private firms’ debt issues
• Mortgages and Mortgage-backed Securities: a
portfolio of mortgage loans or claims in a pool of
mortgage loans.
• Preferred stocks: dividend typically cumulative;
institutions may have 70% exclusion tax consideration
• Common Stocks:
Stock Index
• Price-Weighted Indice: Dow Jones Industrial Index
(DJIA), 30 stocks.
Suppose two stocks, their prices are $25 and $100
Index = (25+100)/divisor
Since there is 2 stocks, divisor=2
Index = (25+100)/2
= 62.5
If (1) the new price of first one is $ 30 and the second
stock undertakes 2/1 split and its new price is $45, then:
New Divisor = (25+50)/62.5= 1.25
New Index = (30+45)/1.25 = 62.5 (same!)
• Value-Weighted Index: e.g., S&P 500
• Bond Indexes: there are many bond
indexes, such as Lehman Brothers, and
Ibbotson that indicate overall bond market
conditions.
• Other Instruments
Options: a right to buy/sell a security
in the future
Futures: an obligation to buy or sell
in the future
Hong Kong Money Market
• Interbank Market:
– most important component of the money market in HK
– a short-term unsecured loans between deposit-taking
institutions (licensed banks, restricted licensed banks and
deposit-taking companies)
– maturity: overnight to 12-months
– quote: bid-ask spread using HIBOR (Hong Kong Interbank
Offered Rate) as a reference rate
– its liquidity is influenced by Hong Kong Monetary
Authority (HKMA)
– when HK$ is under pressure to depreciate from the
$7.8/US$, HKMA will raise the interbank rate to induce
more dollars to interbank market.
• Repo Market
– HKMA provides a discount window called the Liquidity
Adjustment Facility (LAF) for banks between 4:00-5:00
pm, i.e., after the close of the interbank market
– banks sell securities at discount to HKMA and
repurchasing back next day.
– Two types of securities are acceptable in
– in the repo market: (1) securities issued by the statutory
bodies, such as Mass Transit Railway Corporation and
Provisional Airport Authority, (2) Securities that are
not lower than A- (S&Ps) or A3 (Moody’s) if issued by
banks, and not lower than A (S&Ps) or A2 (Moody’s)
issued by non-banks
• Exchange Fund Market:
– exchange fund bill (short-term) started in 1990 and later managed by
HKMA
– its maturity: 91-day, 182-day, and 364-day
– size: HK$1.5b, 1b and 0.5 b
– Exchange Fund Notes are longer-maturity with 2-y, 3-y, 5-y, and 7-yr
• Commercial Paper (CP)
– short-term, 30-days to 1-yr
– unsecured and mainly primary market
– Firms only issued CP if highly rated by rating agencies (S&P,
Moody)
– minimum size, HK500,000, institutional participants in the market
• Negotiable CD
– large denominations in HKD (70%) and
foreign currencies
– most in 3-year maturity, primary market
• Bankers’ Acceptance
– largely denominated in foreign currency
with 10% in HK$
– 3-6 months maturity, which is the time
for shipment and settlement of goods
– lenders are largely banks and deposittaking companies
– the rate is typically below HIBOR