LECTURE 1
Basics of Investment,
Asset Classes and
Financial Instruments
AF3316 Investments
Mr. Shaojun Zhang, Ph.D. ASA
School of Accounting and Finance
The Hong Kong Polytechnic University
Warren Buffett has said
"Investing is not a game
where the guy with the
160 IQ beats the guy
with 130 IQ....What's
needed is a sound
intellectual framework for
making decisions and the
ability to keep emotions
from corroding that
framework."
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John C. Bogle
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Founder and retired CEO of The
Vanguard Group
• Named one of the "world’s 100 most
powerful and influential people" by
Time magazine in 2004
• Institutional Investor's Lifetime
Achievement Award (2004)
• Named one of the investment
industry’s four "Giants of the 20th
Century" by Fortune magazine in 1999
• Awarded the Woodrow Wilson Award
from Princeton University for
"distinguished achievement in the
Nation’s service" (1999)
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Six Lessons for Investors from the
Financial Tsunami
-- John C. Bogle, Wall Street Journal, January 9-11, 2009
1)
Beware of market forecasts, even by experts.
2)
Never underrate the importance of asset allocation.
3)
Mutual funds with superior performance records
often falter.
4)
Owning the market remains the strategy of choice.
5)
Look before you leap into alternative asset classes.
6)
Beware of financial innovation.
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Defining Investment
•
Essential Nature of Investment
–
–
Defer present consumption for future consumption
Intertemporal consumption opportunities
Consumption next year
Future
value
Slope = -(1+r)
Lending
•
Endowment
Present value of the endowment
Borrowing
Consumption this year
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Defining Investment
• The existence of a financial market makes
lending and borrowing possible.
• Resources entering into the financial
system become assets (capital goods).
– An asset is something that can generate future cash
flow(s).
– The cost of acquiring an asset and the cash flows it
generates constitute the return of the asset.
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Financial versus Real Assets
• Real Assets
– Assets used to produce goods and services
• Financial Assets
– Claims on real assets
• Major Classes of Financial Assets or Securities
– Debt
• Money market instruments, e.g., bank certificates of deposit
• Capital market instruments, e.g., corporate bonds
– Common stock
– Preferred stock
– Derivative securities
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Financial System
The Firm
Financing
Decisions
The
World
Investment
Decisions
Exchange of Money
and Real Assets
Financial
Markets
Exchange of Money
and Financial
Assets
Investors
Financial
Intermediaries
1.Corporate
Financial
Management
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3. Financial Markets
and Intermediaries 2. Investments
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Table 1.1
Balance Sheet of U.S. households, 2019
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CHAPTER 2
Asset Classes and
Financial Instruments
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Major Classes of Financial Assets
or Securities
•
•
•
•
•
Money market
Bond market
Equity markets
Indexes
Derivative markets
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THE MONEY MARKET
• Very short-term, highly liquid, and
relatively low-risk debt securities
• Trade in large denominations
• Money market mutual funds
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Components of the Money Market
TABLE 2.2
Major components
of the money market
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Money Market Instruments
• Treasury bills (T-bills)
– Issued weekly, 28, 91, and 182 days, $1,000
• Certificate of deposit (CD)
– Fixed term, transferable, insured by FDIC
• Commercial Paper (CP)
– Backed by a bank line of credit
• Bankers’ Acceptances
– Bank’s credit, with six months
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Figure 2.1 Treasury Bills
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Money Market Instruments
• Eurodollars
– Dollar deposits at foreign banks
• Repurchase Agreement (repo, or RP)
– Overnight borrowing
– Term repo, reverse repo
• Brokers’ Calls
– Repay the bank immediately (on call)
• Federal Funds (fed funds)
– Funds in banks’ reserve account
• LIBOR Market
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Figure 2.2 Spread between 3-month
CD and T-bill rates
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THE BOND MARKET
• Fixed-income capital market
• Longer-term borrowing or debt
instruments than those money market
securities
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Bond Market
•
•
•
•
•
•
•
Treasury Notes and Bonds
Federal Agency Debt
International Bonds
Inflation-Protected Bonds
Municipal Bonds
Corporate Bonds
Mortgages and Mortgage-Backed
Securities
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Treasury Notes and Bonds
• Maturities
– Notes – maturities up to 10 years
– Bonds – maturities from 10 to 30 years
• Par Value - $1,000
• Semiannual interest payments
• Coupon rate – percentage of par value
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Figure 2.3 Treasury Notes
and Bonds
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Federal Agency Debt
• Major issuers
– Federal Home Loan Bank (FHLB)
– Federal National Mortgage Association
(FNMA, or Fannie Mae)
– Government National Mortgage Association
(GNMA, or Ginnie Mae)
– Federal Home Loan Mortgage Corporation
(FHLMC, or Freddie Mac)
– Mortgage pass-through securities
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Municipal Bonds
• Issued by state and local governments
• Types
– General obligation bonds
– Revenue bonds
• Industrial revenue bonds
• Maturities – range up to 30 years
• Interest income on municipal bonds is not
subject to federal and sometimes state
and local tax
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Figure 2.4 Outstanding Tax-exempt Debt
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Tax-exempt Debt between 1979 and 2008
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Municipal Bond Yields
• To compare yields on taxable securities a
Taxable Equivalent Yield is constructed
r (1-t) = rm
or r = rm / (1-t)
• Cutoff tax bracket
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t = 1- rm / r
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Table 2.2 Equivalent Taxable Yields
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Figure 2.5 Ratio of Yields on
Municipal Debt to Corporate Baa-rated Debt
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Corporate Bonds
• Issued by private firms
• Semi-annual interest payments
• Subject to larger default risk than
government securities
• Options in corporate bonds
– Callable
– Convertible
• Bond ratings
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FIGURE 10.8
Definitions of
Each Bond
Rating Class
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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
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Figure 2.6 Mortgage-Backed
Securities Outstanding
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EQUITY SECURITIES
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Equity Securities
• Common stock
– Ownership shares, voting and cash flow rights
– Residual claim
– Limited liability
• Preferred stock
– Fixed annual payment, no voting power
– Priority over common stock
– Tax treatment
• Depository receipts https://hkstockadr.com/
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Figure 2.8 Stock Market Listings
Components of Hang Seng Index
https://finance.yahoo.com/quote/%5EHSI/co
mponents?p=%5EHSI
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STOCK AND BOND MARKET
INDEXES
https://finance.yahoo.com/world-indices/
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Stock Market Indexes in the U.S.
•
•
•
•
•
•
Dow Jones Industrial Average (30 Stocks)
Standard & Poor’s 500
NASDAQ 100
NASDAQ Composite
NYSE Composite
Wilshire 5000
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International Market Indexes
•
•
•
•
•
•
Hang Seng Index
SSE Composite Index/Shenzhen Component
Nikkei 225 & Nikkei 300
FTSE (Financial Times of London)
Dax
Region and Country Indexes
– EAFE
– Far East
– United Kingdom
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Table 2.6 Sample of MSCI Stock Indexes
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Factors for Construction of
Stock Indexes
• Representative?
– DJ railway index, DJ transportation index, DJ
utilities index, DJIA
• Broad or narrow?
– DJIA, S&P 100, S&P 500, Wilshire 5000
• How is it weighted?
– Price weighted (DJIA)
– Market weighted (S&P 500, NASDAQ)
– Equal (Value Line Index)
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DERIVATIVE MARKETS
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Derivative Securities
Options
• Basic Positions
– Call (Buy)
– Put (Sell)
• Terms
– Exercise Price
– Expiration Date
– Assets
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Futures
• Basic Positions
– Long (Buy)
– Short (Sell)
• Terms
– Delivery Date
– Assets
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