Topic 1. Financial Markets and Instruments
(chapter 1, 2)
Lecture Outline
1. What will we learn in this class?
2. What are the basic properties of financial markets?
3. Who are the major players in financial markets?
4. What are available for investing in the Fixed Income market?
5. What are available for investing in the Equity market?
6. Reading: textbook Chapter 1 & 2.
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Financial Advisor
- Financial markets and
instruments
- Security trading
- Mutual funds and ETFs
- Risk-return tradeoff
- Portfolio diversification
- Asset allocation
Security Analyst or Trader
- Equity valuation
- Asset pricing models
- Option market
- Bond market
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I. Financial Instruments
 Fixed-Income
 Money market: short-term (<1 year)
 Capital market: long-term (>1 year)
 Equity
 Derivative (see Topic 9)
II. Basic Properties of Financial Markets
There is almost always a risk-return tradeoff.
 You cannot enjoy higher returns without taking
higher risk
 There is rarely free lunch (risk-free profit,
arbitrage opportunity)
Example: Consider investment in
 S&P500 stock index
*10-year Treasury bond
* 3-month Treasury bills
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Return
Year
Average Annual Return: T-Bill: 3.36%;
Which one is more volatile?
T-Bond: 5.45%; S&P500 Stocks: 11.9%
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III. Major Players in the Financial Market
• Business Firms (net capital demanders)
• Households (net capital suppliers)
• Governments (can be both demanders and suppliers)
• Financial Intermediaries (connectors of demanders and
suppliers)
* Commercial banks: take deposits and lend loans to
businesses
* Investment companies: firms that manage funds for
investors, such as pension funds, mutual funds, hedge
funds
* Insurance companies
IV. Financial Instruments in Details
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The money market
1. Treasury Bills
 Short-term claims on U.S. government
Maturities: 4, 13, 26, 52 weeks
 Where to buy: directly from Treasury or from
government security dealers, www.treasurydirect.gov
 Sold at discount
a. No coupons payments
b. The return arises from the difference between
purchase price and face value
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 Taxes: income is taxable at the federal level but
exempt from all state and local taxes.
 Nominal return assumed to be riskfree
*Free of default risk & interest rate risk (risk free
asset)
2. Certificates of Deposit (CDs)
 Time deposits with a bank. Issued by banks and
credit unions to raise funds for financing their business
and held mostly by money market mutual funds
 Insured by FDIC up to $250,000
 Principle and interest paid at maturity
 Negotiability:
Non-negotiable: holder must wait until maturity to
obtain funds (withdrawal penalty)
Negotiable: holder can trade in a secondary market
(mostly CDs in denominations larger than $100,000)
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Spread between 3-month CD and T-bill rates
During crisis, investors lost confidence in banks. What
happened to CD yield?
*Risk-return tradeoff principle: perceived bank risk goes
up
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3. Commercial Paper (CP)
 Short-term unsecured notes issued by large, wellknown companies
Maturities typically 1-2 months (maximum of 270
days)
Maturities longer than 270 days would require
registration with the SEC, so are almost never used
 Sold at a discount with denominations of $100,000
(face value) and held by money market mutual funds
and pension funds
 CP is relatively safe assets
** Example of default:
On 9/15/2008, Lehman Brothers filed for bankruptcy, defaulted on a
large amount of commercial paper.
** Yield on CP is slightly __higher______ than that on T-bills with the
same maturity.
** During the financial crisis in September of 2008, the difference in
yield is more than 3% (CP 4.2%, 3-month T-bills 0.5%).
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 “Asset-backed” commercial paper
Before 2007, many banks issued “Asset-backed”
commercial paper to raise funds for investment in
subprime mortgages. When subprime mortgages began
defaulting in the summer of 2007, the banks were unable
to issue new CP to refinance their position as the old
paper matured.
= the 2008-09 financial crisis
4. Eurodollars
Dollar denominated deposits at foreign banks or
foreign branches of US banks
Eurodollar time deposit: is the liability of the US bank. (not tradable)
Eurodollar CDs: is the liability of a foreign branch of the US bank.
(tradable in the secondary market) ** (Riskier, offers higher
yield)*(Higher liquidity)
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5. Repurchase Agreements (Repos and reverses repos)
 Sale of a security with a commitment by the seller to
buy the security back from the purchaser at a specified
price at a designated future date. Basically a
collateralized loan, where the collateral is the security
Borrower A
(repo)
Lender B
(reverse repo)
*Borrower (seller) is doing a repo transaction; lender
(buyer) is doing a reverse repo transaction.
 Very low credit risk (collateralized)
 Dealer firms use the repo market to finance inventory
and cover short positions
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The fixed-income capital market
1. Treasury Notes and Bonds
 Only real difference between T-notes and T-bonds is
maturity
T-notes are issued with maturities up to 10 years,
whereas T-bonds are issued with maturities from 10 to 30
years
 T-notes and T-bonds pay coupons semi-annually and
they pay their face value ($1000) at maturity
147.023???
Meaning that 147.023% of face value = 147.023%*1000
= $1470.23
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2. Inflation-Protected Treasury Bonds
TIPS (Treasury Inflation-Protected Securities) in US
The face value (and coupon) is adjusted in proportional to
increases in the Consumer Price Index (CPI).
You can buy TIPS at www.treasurydirect.gov
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TIPS face value is $1000 at the issuance, suppose CPI
increases by 10%, what’s the new face value? (assume
coupon rate=4.5%)
New face value = $1000(1+10%) = $1100,
coupon = 4.5%*$1100 = $49.5
Question: Do TIPS bonds in general offer a higher, lower,
or the same yield as conventional treasury bonds with the
same coupon and maturity? Lower yield because of no
inflation risk. Risk-return trade-off
3. Municipal bonds (Munis)
 Issued by state and local governments
 Coupons from munis are exempt from federal income
taxation, and from state and local taxation in the issuing
state, though typically capital gains are taxable
 Yields on munis are lower than on similar risk taxable
bonds
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Suppose that
t: the investor’s federal plus local marginal tax rate
rtaxable: the total before-tax rate of return on taxable bonds
rmuni: the total rate of return on municipal bonds
After-tax return (rmuni) = Before-tax return (rtaxable)*(1-tax rate)
Equivalent taxable yield:
Cutoff tax bracket: the tax rate at which the after-tax yield
of the taxable bond is equal to yield on the municipal
bond, i.e.,
.
Example:
Suppose my tax bracket is 28%. Shall I prefer to earn a
6% taxable return or a 4% tax-free yield? What is the
equivalent taxable yield of the 4% tax-free yield?
Let’s find the after-tax return
(1) 6% taxable bond (after-tax yield=6%*(1-0.28) =
4.32%)- I pick this bond
(2) 4% tax-free bond (after-tax yield=4%)
equivalent taxable yield=4%/(1-0.28) = 5.55%
How about someone with a tax bracket of 38%?
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(1) 6% taxable bond (after-tax yield=6%*(1-0.38) =
3.72%)
(2) 4% tax-free bond (after-tax yield=4%) – this
investor will pick this bond
 Question: Who are more likely to buy munis, high taxbracket investors or low tax-bracket investors? high taxbracket investors
4. Mortgage-backed Securities
Ownership claim in a pool of mortgage or an obligation
that is secured by such a pool.
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Risk-return
trade-off
5. Corporate bonds
 Claims on fixed payments from a corporation
a. Typically receive semi-annual coupons over life
of bond
b. Receive face value ($1000) when bond matures
 Risk
a. Interest rate risk
b. Default risk (credit risk)
Corporate bonds are rated according to their default risk
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Moodys: Aaa, Aa, A, Baa, Ba, B, Caa, Ca, C,
D[1,2,3]
S&P: AAA, AA A, BBB, BB, B, CCC, CC, C,
D[+,-]
Investment grade (>=BBB or Baa)
“Junk bonds” or speculative grade (<BBB or Baa)
c. Bonds are generally less risky than stocks
Higher priority than stocks and can force firm into
bankruptcy if claims not paid
Secured bonds (paid first)
Unsecured bonds (debentures) (paid second)
 Low liquidity
Mostly traded over-the-counter
The equity market
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1. Common stocks
 Represent residual ownership of a corporation
a. May receive dividends on quarterly basis
b. Receive whatever is left over if a firm liquidates—
residual claim
*In the case of liquidation, a firm is going to pay as
follows:
- Creditors (secured bond, unsecured bond)
- Preferred stockholders
- Common stockholders
c. The most shareholders can lose is their original
investment—limited liability
d. Have voting rights
 Stock quotation
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Dividend yield
P/E ratio
2. Preferred Stocks
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 Somewhere between common stock and corporate bond
(hybrid)
 Bond-like features
a. Promise to pay fixed dividend
*Unpaid dividends cumulate and must be paid in full before any
dividends may be paid to common shareholders.
b. Usually no voting rights
c. Has lower priority than bonds but higher priority
than common stocks in liquidation
 Stock-like features
a. Failure to pay dividend does not cause bankruptcy
b. Preferred stock does not have a specific maturity
 Dividend payments are not tax-deductible for issuing
firms. But corporation may exclude 50% of dividends
received from preferred stocks in their taxable income.
3. American Depository Receipts
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American Depository Receipts (ADRs), are certificates
issued by U.S. banks and traded in U.S. stock markets that
represent ownership in shares of a foreign company.
Example
Alibaba Group Holding Limited (BABA):
IPO on September 18, 2014.
New York Stock
Exchange
1:1
China
Citi Group
(depositary bank)
ADRs were created to make it easier for foreign firms to
satisfy U.S. security registration requirements.
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ADRs provide an excellent way for investors to invest in
a foreign company while realizing any dividends and
capital gains in U.S. dollars.
4. Stock Market Indexes
Summary of 3 types of indexes:
(1) Price weighted: invests equal number of shares in each
stock, or $ amount proportional to the price of each firm.
Price weighted index level = average price of all stocks
(2) Market value weighted: invests $ amount proportional
to the market value (price*number of shares outstanding)
of each firm.
Return on a value-weighted index = % change of market
value of all stocks.
(3) Equally-weighted: invests equal $ amount in each
stock.
Return on an Equally-weighted index = average return of
all stocks.
 Dow Jones Indices
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- Industrial (30), Transportation (20), Utilities (15),
Composite (65)
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- Price-weighted index
** Price weighted portfolio is like holding the same number of
each stock in the portfolio.
Example:
Stock
ABC
XYZ
Total
Initial
Final
value of value of
Initial Price Final Price Shares stocks stocks
t=0
t=1
(million) t=0
t=1
$25
$30
20
500
600
100
90
1
100
90
600
690
- The Divisor is adjusted if a stock splits or a stock
dividend is paid
Example: Suppose stock XYZ splits 2:1 at initial time
Stock
Initial
Final
value of value of
Initial Price Final Price Shares stocks stocks
t=0
t=1
(million) t=0
t=1
25
ABC
XYZ
$25
50
$30
45
20
2
Total
500
100
600
90
600
690
With the 2:1 split, Index level(0)=
Without the 2:1 split: Index level(0)=
Examples of two DJIA companies
** There 3 problems with DJIA:
1. Price weighted index puts higher weights on stocks with
higher price, not higher market value.
2. Index return is sensitive to stock split because split changes
the weights of stocks used in the index.
3. Only contains 30 firms, how representative is it to the entire
market?
 Standard and Poor’s Indices
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- Standard & Poor’s Composite 500 index, Industrial
(400), Transportation (20), Utilities (40), Financial (40)
- More broadly based index
- Value-weighted index
** Value-weighted portfolio is like investing $$ amount
proportional to the market cap of each stock in the portfolio.
- Weight is proportional to the company’s market value,
which changes automatically with market price
- Return on value-weighted index is the return on the
entire market
Index return =
(Total market val ue of the entire index) End
1
(Total market val ue of the entire index) Beg
Example
Index level (0) is set to 100 pts (an arbitrary number), find
index level and index return of a value-weighted index
containing stock ABC and XYZ.
 Other value-weighted indexes
a. Russell 3000 index
Seek to be a benchmark of the entire U.S stock market,
maintained by FTSE Russell
b. Morgan Stanley Capital International (MSCI) indexes
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Value-weighted indices for international markets
c. Nasdaq index
 Equally-weighted index (e.g., QQQE)
** Equally-weighted portfolio is like investing equal dollar
values in each stock.
- Return on equally-weighted index is the average return
of all stocks within the index.
Index return =
Ret ABC  Ret XYZ
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Example: Find equally-weighted return of the index
containing stock ABC and XYZ.
Stock
ABC
XYZ
Total
Initial
Final
value of value of
Initial Price Final Price Shares stocks stocks
t=0
t=1
(million) t=0
t=1
500
$25
$30
20
(25*20)
600
100
90
1
100
90
600
690
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** Section 2.5 (Derivative Markets) is for future reading
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