Asset Classes and Financial Instruments
Financial
markets
Money
markets
Short-term,
marketable, liquid,
low-risk debt
securities
Capital
markets
Longer-term
and riskier
securities
Asset Classes and Financial Instruments
Financial
markets
Capital
markets
Money
markets
Longer-term
debt markets
Debt
markets
Equity
markets
Derivative
markets
Asset Classes and Financial Instruments
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The Money Market
Including short-term, highly liquid, and relatively low-risk
debt instruments
Trade in large denominations
Out of the reach of individual investors
How can small investors invest in the money market?
Invest in money market mutual funds
Asset Classes and Financial Instruments
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The Money Market
Treasury Bills
Short-term government securities issued at a discount from
face value
Investors receive full face value at maturity
Most marketable: easily converted to cash and sold at low
transaction cost and with little price risk
Simplest form of borrowing
Asset Classes and Financial Instruments
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The Money Market
Treasury Bills
Investors:
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Today: buying T-bills at a discount from the face value
Maturity: Receiving a payment = face value
Investors’ earning = Maturity value - purchase price
Investors earnings taxable only at the federal level
T-bill listing from WSJ
Asked price - Bid price = Bid-asked spread
Asset Classes and Financial Instruments
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The Money Market
Certificates of Deposit
Time deposit with a bank
May not be withdrawn on demand
Interest and principal paid at the end of the fixed term of
the CD
Treated as banks deposits by the FDIC -> fully insured
Asset Classes and Financial Instruments
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Commercial Paper
Short-term unsecured debt issued by large corporations
directly to the public
Sometimes, CP is backed by a bank line of credit ->
borrowers get access to cash that can be used if needed to
pay off the paper at maturity
CP characteristics:
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Short-term: up to 270 days
Large denominations in multiples of $100,000
Small investors can invest in CP only indirectly, through
money market mutual funds
Fairly safe and liquid
Asset Classes and Financial Instruments
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Bankers’ Acceptances
Stage 1: A bank’s customer orders his bank to pay a sum
of money at a future date, often within 6 months
Stage 2: The bank endorses the order for payment as
“accepted”
-> The order becomes banker’s acceptance
Banker’s acceptance
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Traded in secondary markets
Very safe assets
Widely used in foreign trade
Sold at a discount from the face value of the payment order
Asset Classes and Financial Instruments
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Eurodollars
Eurodollars are deposits:
■ denominated in dollars
■ at foreign banks or foreign branches of American banks
■ short-term (often less than 6 months)
■ for large sums
Why?
■ To avoid FDIC fees and regulations
Note: Eurodollars need not be in European banks
Asset Classes and Financial Instruments
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Repos and Reverses
Repos
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Repurchase agreement
■ Dealers sell government securities to an investor on an
overnight basis, with an agreement to buy back those
securities the next day at a slightly higher price.
■ The securities serve as collateral for the loan
■ Repos are very safe as backed by the government securities
Term repo: the term of the implicit loan can be 30 days or more
Reverse repo:
■ Dealers buy government securities from an investor with an
agreement to resell them at a higher price later
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Asset Classes and Financial Instruments
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Brokers’ Calls
Investors buy stocks on margin borrow part of the funds
(from their broker) to pay for the stocks
The broker borrow the funds from a bank, agreeing to
repay the bank immediately (on call) if the bank requests it.
Federal Funds
Funds in a bank’s reserve account at the Federal Reserve
Bank
Banks with excess funds lend to those with a shortage
Fed funds rate: the rate of interest on very short-term loans
among financial institutions
Asset Classes and Financial Instruments
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LIBOR market
London Interbank Offer Rate: the rate at which large banks
in London willing to lend money among themselves
Serving as a reference rate for a wide range of
transactions like the Fed funds rate
LIBOR interest rates may be tied to many currencies: U.S.
dollars, British pounds, Japanese yens, Euros, etc.
Asset Classes and Financial Instruments
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The Bond Market
What is a bond?
Longer-term borrowing or debt instruments
Debt instruments or bonds
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Treasury Notes and Bonds
Inflation-Protected Treasury Bonds
Federal Agency Debt
Municipal Bonds
Corporate Bonds
Mortgage and Mortgage-backed Securities
International Bonds
Asset Classes and Financial Instruments
□ Treasury Notes and Bonds:
■ issued by the U.S. government
■ T-notes: original maturities ranging up to 10 years
■ T-bonds: original maturities ranging from 10 to 30
years
□ Understanding a bond listing in WSJ
■ Coupon payment: semi-annual interest payment
■ Yield to maturity: annualized rate of return to an
investor who buys the bond and holds it until
maturity
Asset Classes and Financial Instruments
□ Inflation-Protected Treasury Bonds
■ TIPS (Treasury Inflation Protected Securities)
■ Principal amount adjusted in proportion to
increases in the CPI
■ denoted by i
■ Yield on TIPS: real or inflation-adjusted interest
rate
Asset Classes and Financial Instruments
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Federal Agency Debt
Government agencies issue their own securities to finance their
activities
Major mortgage-related agencies:
■ Federal Home Loan Bank (FHLB)
■ Federal National Mortgage Association (FNMA)
■ Government National Mortgage Association (GNMA)
■ Federal Home Loan Mortgage Corporation (FHLMC)
Debt of federal agency not explicitly insured by the federal
government but it has long been assumed that the government
would assist an agency nearing default
Example: 2008 FNMA and FHLMC crisis
Asset Classes and Financial Instruments
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Municipal Bonds
Issued by state and local governments
2 types of municipal bonds
General obligation bonds:
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Backed by the “full faith and credit” of the issuer
□ Revenue bonds:
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Issued to finance particular projects and backed by the
revenues from that project or by the municipal agency
operating the project
Example: airports, hospitals, turnpike, port authorities
Riskier in terms of default
Asset Classes and Financial Instruments
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Municipal Bonds
Key feature: tax-exempt status
Interest income exempt from federal income taxation
Interest income exempt from state and local taxation
in the issuing state
□ However, capital gains taxes if the bonds mature or
sold for more than the purchase price
Asset Classes and Financial Instruments
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Equivalent taxable yield: the rate a taxable bond need
to offer to match the after-tax yield on the tax-free
muni.
Asset Classes and Financial Instruments
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Tax-Exempt Yield
Marginal Tax Rate
1%
2%
3%
4%
5%
20%
1.25%
2.50%
3.75%
5.00%
6.25%
30%
1.43
2.86
4.29
5.71
7.14
40%
1.67
3.33
5.00
6.67
8.33
50%
2.00
4.00
6.00
8.00
10.00
The tax bracket at which investors are indifferent
between taxable and tax-exempt bonds
Asset Classes and Financial Instruments
□ Corporate Bonds
□ Long-term debt issued by private corporations
□ Corporate bonds vs. Treasury bonds:
■ Corporate bonds structured like Treasury bonds:
□ Paying semi-annual coupons
□ Returning the face value to the bondholder at
maturity
■ Corporate bonds have default risk
Asset Classes and Financial Instruments
□ Corporate Bonds
□ Different types of corporate bonds:
■ Secured bonds: with specific collateral backing
them in the event of firm bankruptcy
■ Unsecured bonds or debentures: no collateral
□ Subordinated debentures: lower priority claim to
the firm’s assets in the event of bankruptcy
Asset Classes and Financial Instruments
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Mortgages and Mortgage-backed securities
Mortgages
Fixed-rate mortgage vs. Adjustable-rate mortgage
Fixed-rate mortgage (Conventional mortgage)
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Conventional mortgage with equal, fixed monthly payment
Causing difficulties for banks in years of increasing interest rate
Issuing short-term liabilities (deposits) and holding long-term assets
Adjustable-rate mortgage
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Borrowers pay an interest rate varying with current market interest
rate
Example: 1-year T-bill rate + 2% and adjusted once a year
Shifting the risk of interest rate fluctuation to customers
Lower interest rate
Asset Classes and Financial Instruments
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Mortgages and Mortgage-backed securities
Mortgage-backed securities (pass-throughs)
Ownership claim in a pool of mortgages or an obligation secured
by such a pool
Mortgage lenders:
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Originating loans and then selling packages of these loans in the
secondary market
Selling their claims to the cash inflows from the mortgage
Servicing the loan, collecting principal and interest payments
Passing these payments along to the purchaser of the mortgage
Investors:
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Buying and selling mortgage-backed securities like any other bond
Asset Classes and Financial Instruments
□ International Bonds
□ Eurobond:
□ Bonds denominated in a currency other than that of
the country in which it is issued
■ Euro-dollar bond: Dollar-denominated bond sold
outside the U.S.
■ Euro-yen bond: Yen-denominated bonds sold
outside Japan
Asset Classes and Financial Instruments
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International Bonds
Many firms issue bonds in foreign countries but in the currency
of the investor
■ Yankee bond
■ Dollar-denominated bond sold in the U.S. by a non-U.S.
issuer
■ Samurai bond
■ Yen-denominated bond sold in Japan by non-Japanese
issuers
■ Dimsum bond
■ China yuan-denomiated bond sold in China by non-Chinese
issuers
Asset Classes and Financial Instruments
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Equity Securities
Common stock
■ Ownership share in a publicly held corporation
■ Shareholders have voting rights and may receive dividends
Corporation structure:
■ Board of directors
□ Elected by the shareholders
□ Selecting managers who run the corporation on a day-today basis
■ Managers
□ Making business decisions without the board’s approval
Agency problem
Asset Classes and Financial Instruments
□ Common stock characteristics:
□ Residual claim
■ Stockholders are the last in line of all those who
have a claim on the assets and income of the
corporation
□ Growing concern
■ Shareholders having claim to the part of
operating income left after interest and
income taxes have been paid
Asset Classes and Financial Instruments
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Residual claim
■ Stockholders are the last in line of all those who have a claim on the
assets and income of the corporation
□ Growing concern
□ In bankruptcy:
■ Shareholders having claim to what is left after all other
claimants have been paid
■ Other claimants: tax authorities, employees, suppliers,
bondholders, etc.
Asset Classes and Financial Instruments
□ Residual claim
■ Stockholders are the last in line of all those who
have a claim on the assets and income of the
corporation
□ Limited liability
■ The most shareholders can lose in the event of
bankruptcy is their original investment.
■ Not personally liable for the firm’s obligations
Asset Classes and Financial Instruments
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Common stock
■ Stock Market Listings
□ Dividend payment
□ Dividend yield
□ P/E ratio
□ Example:
□ AMGEN
□ HON
Asset Classes and Financial Instruments
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Equity Securities
Preferred Stock
Preferred stock has features similar to a debt
■ Promising to pay preferred stockholders a fixed stream of
income
■ Preferred stockholders don’t have voting power
Preferred stock: equity investment
■ The firm has no contractual obligation to pay preferred
dividends
□ Preferred dividends are cumulative: Unpaid preferred
dividends cumulate and must be paid in full before
common stock dividends.
■ Tax treatment: preferred dividends are not tax-deductible for
the firm
Asset Classes and Financial Instruments
□ Equity Securities
□ Preferred Stock
□ Investors: corporations rather than individuals
■ Corporations may exclude 70% of domestic
preferred dividends from taxable income
■ Preferred stocks are sold at lower yields than
bonds even though having higher risks (reflecting
the value of dividend exclusion)
Asset Classes and Financial Instruments
□ Equity Securities
□ Preferred Stock
□ Example: A preferred stock issued by Goldman Sachs
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30,000,000 shares
Perpetual
Non-cumulative
Face value: $25
Market price on 09/06/2020: $23.58
Discount: -$1.42 (5.68%)
Annualized dividend: $1.01112
Current yield: 4.29%
Original coupon: Greater of 0.67% above LIBOR or 4%
Asset Classes and Financial Instruments
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Equity Securities
Depository Receipts
American Depository Receipts (ADRs)
■ Certificates traded in U.S. markets
■ Representing ownership in shares of a foreign company
■ Objectives
□ making it easier for foreign firms to satisfy U.S security
registration requirements
□ making it easier for U.S. investors to invest in and trade
the shares of foreign corporation
■ The 10 most popular ADRs (September 15, 2020):
■ BABA, NIO, TSM, JD, PDD, VALE, AZN, GFI, BNTX, ASML
Asset Classes and Financial Instruments
□ Stock Market Indexes
□ Price-weighted index
■ Example: DJIA
□ Market value-weighted index
■ Example: S&P 500
Asset Classes and Financial Instruments
□ Stock Market Indexes
□ Price-weighted index: DJIA
□ Dow Jones Industrial Average (DJIA): since
1896
□ 30 large, “blue-chip” corporations
□ Current listing of DJIA corporations
Asset Classes and Financial Instruments
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Listing of DJIA companies Honeywell
3M
American
Express
Apple
Cisco
systems
The Home
Depot
Merck
Coca-cola Intel
Microsoft
Honeywell
Dow
Nike
Verizon
Amgen
Procter &
Gamble
Visa
IBM
Johnson &
Boeing
Salesforce Johnson
JP Morgan
Caterpillar Walgreen Chase
Chevron
United Health
Group
Goldman
Sachs
McDonald's Travelers
Wal-Mart
Walt Disney
Asset Classes and Financial Instruments
Asset Classes and Financial Instruments
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Asset Classes and Financial Instruments
□ Stock Market Indexes
□ DJIA
□ Price-weighted average
■ The Dow measures the return (excluding dividends)
on a portfolio that holds one share of each stock
■ The amount of money invested in each company =
share price
□ How to invest in DJIA?
□ SPDR Dow Jones Industrial Average ETF (DIA)
Asset Classes and Financial Instruments
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Stock Market Indexes
Standard & Poor’s Composite 500 (S&P 500)
Improvement over the Dow Jones:
500 firms
Market value-weighted index
S&P 500 by sectors
S&P 500’s largest constituents
Asset Classes and Financial Instruments
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Asset Classes and Financial Instruments
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Standard & Poor’s Composite 500 (S&P 500)
■ S&P 500 base period: 1941-1943
■ Actual total market value of the stocks in the Index during the
base period set equal to indexed value of 10
S&P 500 Index Implication
■ The S&P 500 Index value today is ………
■ The market value for the Index today is ……. times the
average market value of the Index during the base period 194143.
■ A portfolio of stocks exactly replicated the S&P 500 stock
portfolio over the past 77 years would have increased in value
by almost ………% not counting any dividends.
Asset Classes and Financial Instruments
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S&P 500 Index’s Rate of Return
■ The rate of return earned by an investor holding a portfolio of all 500
firms in the index in proportion to their market value
■ The rate of return excludes dividends paid by those firms
Date
1/3/2012
1/2/2013
1/2/2014
1/2/2015
1/4/2016
1/4/2017
1/4/2018
1/4/2019
1/4/2020
S&P 500
1,312.41
1,498.11
1,782.59
1,995.50
2,012.66
2,238.96
2,743.15
2,510.03
3,257.85
Return
2.04%
14.15%
18.99%
11.94%
0.86%
11.24%
22.52%
-8.50%
29.79%
Asset Classes and Financial Instruments
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S&P 500 Index’s Rate of Return during the Financial Crisis
Date
October 5,
2007
March 20,
2009
March 28,
2013
S&P 500
1,557.59
768.54
1,569.19
Return
-51%
Asset Classes and Financial Instruments
□ Investing in market indexes
■ Purchasing shares in index funds
□ Index funds: mutual funds that hold shares in
proportion to their representation in the S&P 500
□ Return on the index fund = return on the index
□ Low-cost passive investment strategy for equity
investors
■ Purchasing ETF (Exchange-Traded Fund)
□ ETF: a portfolio of shares that can be bought or
sold as a unit