Chapter
2
Asset Classes and
Financial Instruments
Bodie, Kane, and Marcus
Essentials of Investments
Eleventh Edition
2.1 Asset Classes
Fixed Income
Asset Classes
Equity
Derivatives
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2
2.1 Fixed Income: Money Markets
Money
Markets
Fixed Income
Capital
Markets
Asset Classes
Equity
Derivatives
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3
2.1 The Money Market
• Subsector of the fixed-income market
• Short-term
• Liquid
• Low risk
• Often have large denominations
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4
2.1 The Money Market: Treasury Bills
• Treasury Bills (Similar in SA)
• Issuer: Governments
• Maturity: 4, 13, 26, or 52 weeks (91 and 180
days in SA)
• Liquidity: High
• Default risk: None
• Interest type: Discount (NB to differentiate
discount rate from add-on rate and effective rate)
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5
2.1 The Money Market: Certificates of Deposit (CDs)
• Certificates of Deposit (CDs)
• Issuer: Depository institutions (Banks)
• Maturity: Varies, typically 14-day
minimum
• Liquidity: CDs of 3 months or less are
liquid
• Interest type: Add-on rate
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6
2.1 The Money Market: Commercial Paper
• Commercial Paper (CP)
• Issuer: Large creditworthy corporations, financial
institutions
• Maturity: Maximum up to 360 days, usually 1-2
months
• Liquidity: CP of 3 months or less is more liquid
• Default risk: Unsecured, rated, mostly high quality
• Interest type: Discount
• New Innovation: Asset-backed commercial paper
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7
2.1 The Money Market: Instruments
• Bankers’ Acceptances
• Purchaser authorizes a bank to pay a seller for goods at later date (time
draft)
• When purchaser’s bank “accepts” draft, it becomes contingent liability of
the bank ( and marketable)
• Federal Funds
• Depository institutions must maintain deposits with Federal Reserve Bank in US
(at SARB in SA)
• Federal funds—trading in reserves held on deposit at Federal Reserve (called
reserve funds (or interbank market) in SA)
• Federal Funds rate
= key interest rate for US economy (called interbank
overnight call deposit rates in SA – not publicly available)
• Estimate = South African Benchmark Overnight Rate (SABOR) in SA
• NB! SABOR < Repo rate - see SA rates slide
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8
2.1 The Money Market: Instruments
• Eurodollars
• Dollar-denominated (time) deposits held
outside U.S.
• Pay higher interest rate than U.S. deposits
• LIBOR (London Interbank Offer Rate)
• Rate at which large banks in London (and
elsewhere) lend to each other (usually 112 months)
• Base rate for many loans and derivatives
• In SA: JIBAR
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Eurodollar versus Libor on usd
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2.1 The Money Market: Repurchase Agreements
• Repurchase Agreements (RPs)
• Short-term sale of securities + promise to repurchase at
higher price
• RP is a collateralized loan
• Many RPs are overnight
• “Term” RPs may have a 1-month maturity
• Reverse RPs
• Lending money; obtaining security title as collateral
• “Haircuts” may be required
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11
2.1 The Money Market: Brokers’ Calls
• Brokers’ Calls
• Call money rate applies for investors buying
stock on margin
• Loan may be “called in” by broker
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13
Figure 2.2 Spreads on CDs and Treasury Bills
5.0
OPEC I
4.5
4.0
Financial crisis
Percentage points
3.5
OPEC II
3.0
Penn Square
2.5
Market crash
2.0
1.5
LTCM
1.0
0.5
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2014
2012
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1998
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1970
0.0
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2.1 The Money Market: Instrument Yields
• NB for Assessment: Be able to convert MM
yields.
• Yields on money market instruments not always
directly comparable
• Factors influencing “quoted” yields
• Par value vs. investment value
• 360 vs. 365 days assumed in a year (366 leap
year)
• Simple vs. compound interest
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2.1 The Money Market: Treasury Bills
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2.1 The Money Market: Treasury Bills
• Bank Discount Rate (T-bill quotes)
r
BD
=
$10,000 − P
$10,000
x
360
n
$10,000 = Par
rBD = bank discount rate
P
= market price of the T-bill
n
= number of days to maturity
• Example: 90-day T-bill, P = $9,875
r BD =
$10,000
- $9,875
$10,000
360
= 5%
×
90
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2.1 The Money Market
• Nominal annual yield (Nominal Annual Compounded rates)
• Can’t compare discount instruments (e.g. T-bill) that use
discount rate (i.e. d) directly to add-on instruments (e.g. NCD)
that use nominal rates (i.e. NAC)
• Return is based on par value (for d) vs. price paid (for NAC)
• Example with annual compounding:
• Return =R500; Par is R10000; Maturity = 1 year (360 day-count) so
n = 1 and compound frequency is once (i.e. m = 1)
• Calculate the Nominal Annual Compounded Annually (NACA)
• Discount price is R10000-R500 = R9500
• d = R500/R10000 = 5%
• Nominal yield (i.e. NACA) = R500/R9500 = 5.26%
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2.1 The Money Market
• Nominal annual rates (NAC)
• Can’t compare discount instruments (e.g. T-bill) directly to add-on
instruments (e.g. NCD)
• Others NAC rates:
 Nominal Annual Compounded Semi Annually (NACSA) when m = 2
 Nominal Annual Compounded Quarterly (NACQ) when m = 4
 Nominal Annual Compounded Weekly (NACW) when m = 52
 Nominal Annual Compounded Daily (NACD) when m = 360
• You should be able to convert discount rate to make it comparable (i.e.
convert d to NAC or NAC to d to compare instruments)
• Click here to see easy method for converting
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19
2.1 THE MONEY MARKET
•
Bond Equivalent Yield (a NAC but with 365 day-count so BEY =
NAC365)

Can’t compare T-bill directly to bond
• 360 days (for d) vs. 365 days (for BEY)
• Return is figured in par (for d) vs. price paid (for BEY)
• Example with annual compounding:
• Return =R500; Par is R10000; Maturity = 1 year (360 day-count) so n =
1 and compound frequency is once (i.e. m = 1)
•
Discount price is R10000-R500 =R9500
• d = R500/R10000 = 5%
• NAC360 = R500/R9500 = 5.263%
• NAC365 (i.e. BEY) = R500/R9500 x 365/360 = 5.336%
 You should be able to adjust discount rate or NAC to make it
comparable to BEY instruments

Click here to see easy method for converting
2.1 THE MONEY MARKET
•
Bond Equivalent Yield (BEY): Example Using Sample T-Bill but
compound frequency of 4 (i.e. m = 4)
FV = Face value of TB = 10000
P = price of the T-bill
d = 5%
90 = number of days in compound period
m = compound frequency (quarterly = 360/90 = 4)
so
NAC = ?
and
BEY = ?
•
TB discount price = 10000 – (0.05 x 90/360) = 9875
•
Nominal yield (i.e. Nominal Annual Compounded Quarterly (NACQ in this case):
NACQ
=
FV − P
360
×
P
•
NACQ =
90
10,000 − 9,875
×
9,875
360
90
= 5.0633%
BEY in this case:
BEY =
FV − P
365
×
P
BEY
90
=
10,000 − 9,875
365
×
9,875
90
For method without using P and FV, see slides below
=
5.1336%
INTEREST CALCULATIONS
•
•
•
Possible to convert rates without knowing P or FV
Discount rate (d) < Nominal yield (NAC) < BEY < AEY
Discount rate = d (e.g. 5% p.a. for 90 day instrument = 0.25 of a year, so: n = 0.25).
Need n for time value of money calculations (see this linked slide)
•
Compounding frequency in a year = 360/90, so: m = 4. We need m for
interest rate conversions.
•
Nominal Annual rate Compounded m times per year (e.g. NACQuarterly (NACQ))
𝑑=
d=
𝑁𝐴𝐶
× 100
𝑁𝐴𝐶
1+(
)
𝑚
0.050633
1+(
0.050633
)
4
= 5%
× 100
Very
NB!
𝑁𝐴𝐶𝑄 =
d=
𝑑
𝑑
1−( )
𝑚
0.05
0.05
1−( 4 )
× 100
× 100
= 5.0633%
INTEREST CALCULATIONS
•
Possible to convert rates without knowing P or FV
•
•
Discount rate (d) < Nominal yield (NAC) < BEY< AEY
Money Market: Compounding frequency in a year = 360/90, so:
“money market m” = mm = 4.
Bond Market: Compounding frequency in a year = 365/90, so:
“bond market m” = mb = 4.0555.
𝑚𝑏
𝐵𝐸𝑌 = 𝑁𝐴𝐶 ×
× 100
𝑚𝑚
So: NAC360 → BEY365:
•
See textbook example
•
•
= 0.050633 ×
𝑑=
d=
𝐵𝐸𝑌
𝑚𝑚
×
× 100
𝐵𝐸𝑌
𝑚
𝑏
1+( 𝑚 )
𝑏
0.051336
0.051336
1+( 4.0555 )
×
= 5%
4
×
4.0555
100
𝐵𝐸𝑌 =
4.0555
× 100 = 5.1336%
4
𝑑
𝑑
1 − (𝑚 )
×
𝑚𝑏
× 100
𝑚𝑚
𝑚
d=
0.05
0.05
1−( 4 )
×
4.0555
×
4
= 5.1336%
100
𝐵𝐸𝑌 =
𝑑
𝑑
1 − (𝑚 )
×
𝑚𝑏
× 100
𝑚𝑚
𝑚
d=
0.0007
0.0007
1−(1.4694)
×
1.4898
×
1.4694
= 0.0710%
100
This is 0.070%, so in
decimal format it is
0.00070
mm = 360/245 =1.4694
mb = 365/245=1.4898
𝐵𝐸𝑌 =
𝑑
𝑑
1 − (𝑚 )
×
𝑚𝑏
× 100
𝑚𝑚
𝑚
d=
0.0018
0.0018
1−(1.0084)
×
1.0224
×
1.0084
= 0.1828%
100
This is 0.18%, so in
decimal format it is
0.0018
mm = 360/357 =1.0084
mb = 365/357=1.0224
2.1 THE MONEY MARKET
•
Annualise nominal rates to include compound interest =
Effective Annual Yield (EAY) or Annual Effective Yield (AEY)
d = 5%
•
Example from previous slide:
NACQ = 5.0633%
BEY = 5.1336%
•
𝐴𝐸𝑌360 = (1 +
𝐹𝑉 −𝑃 360
) 90
𝑃
− 1 = (1 +
10000 −9875 360
) 90
9875
−1
𝑨𝑬𝒀𝟑𝟔𝟎 = 5.1602%
•
𝐴𝐸𝑌365 = (1 +
𝐹𝑉 −𝑃 365
) 90
𝑃
− 1 = (1 +
10000 −9875 365
) 90
9875
−1
𝑨𝑬𝒀𝟑𝟔𝟓 = 5.234%
For method without using P and FV, see slides below
INTEREST CALCULATIONS
• AEY360 = (1+NAC/mm)mm -1
AEY360= 1 +
𝑁𝐴𝐶 𝑚𝑚
𝑚𝑚
AEY360= 1 +
− 1 × 100
0.050633 4
4
− 1 × 100
= 5.1602%
•
or: if discount rate is used:
AEY360= 1 −
𝑑 −𝑚𝑚
𝑚𝑚
AEY360= 1 −
− 1 × 100
0.05 −4
4
− 1 × 100
= 5.1602%
•
or: if FV formula is used
n
PV(1+AEY) = FV (where n = investment period)
9875 (1+AEY)
0.25
= 10000
Thus: AEY = (10000/9875)(1/0.25) -1 = 5.1602%
From previous example: FV = R10000
PV = 10000-(10000x0.05x(90/360)) = R9875
n = 90 days = 0.25 years
INTEREST CALCULATIONS
•
AEY365 = (1+NAC/mm)mb -1 AEY365 = (1+BEY/mb)mb -1
AEY365= 1 +
𝑁𝐴𝐶 𝑚𝑏
𝑚𝑚
AEY365= 1 +
AEY365= 1 +
− 1 × 100
0.050633 4.0555
4
− 1 × 100
0.051336 4.0555
4.0555
− 1 × 100
= 5.234%
or: if discount rate is used:
AEY365= 1 −
𝑑 −𝑚𝑏
𝑚𝑚
AEY365= 1 −
0.05 −4.0555
4
− 1 × 100
− 1 × 100
= 5.234%
•
𝑚𝑏
AEY365= 1 +
− 1 × 100
= 5.234%
•
𝐵𝐸𝑌 𝑚𝑏
or: if FV formula is used
n
PV(1+AEY) = FV (where n = investment period)
9875 (1+AEY)
0.24657
= 10000
Thus: AEY = (10000/9857)(1/0.24657) -1 = 5.234%
From previous example: FV = R10000
PV = 10000-(10000x0.05x(90/360)) = R9875
n = 90 days = 90/365 = 0.24657 years
MAKE SURE YOU CAN YOU DO THESE
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.
13.
14.
15.
16.
17.
18.
d  NAC
NAC  d
d  BEY
BEY  d
d  AEY360
AEY360  d
d  AEY365
AEY365  d
NAC  BEY
BEY  NAC
NAC  AEY360
AEY360  NAC
NAC  AEY365
AEY365  NAC
BEY  AEY365
AEY365 BEY
BEY  AEY360
AEY360 BEY
2.1 The Money Market: Instrument Yield
Money Market Instrument
Instrument Yield
Treasury Bills
Discount
Certificates of Deposit
Bond Equivalent Yield or NAC
Commercial Paper
Discount
Bankers’ Acceptances
Discount
Eurodollars
Bond Equivalent Yield or NAC
Federal Funds
Bond Equivalent Yield
Repurchase Agreements
Discount
Reverse RPs
Discount
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30
2.2 Fixed Income: Capital (Bond) Markets
Money
Markets
Fixed Income
Capital
Markets
Asset Classes
Equity
Derivatives
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31
2.2 THE BOND MARKET
• Capital Market—Fixed-Income Instruments
• Government Issues—U.S. Treasury Bonds and Notes
•
•
•
•
Variation: Treasury Inflation Protected Securities (TIPS)
•
•
•
Bonds vs. notes
Interest type
Risk
Principal adjusted for increases in the Consumer Price Index
Agency issues (federal government) (Just Read)
Municipal bonds (Just Read)
Figure 2.3 Listing of Treasury Issues
For SA bonds, see:
http://www.sharenet.co.za/free/gilts.phtml
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33
2.2 The Bond Market: Private Issue
• Corporate Bonds
• Investment grade vs. speculative grade
• Mortgage-Backed Securities
• Backed by pool of mortgages with “pass-through” of monthly
payments; covers defaults
• Collateral
• Traditionally all mortgages conform, since 2006 Alt-A and subprime
mortgages are included in pools
• Private banks purchased and sold pools of subprime mortgages
• Issuers assumed housing prices would continue to rise
• See diagrams on next 2 slides (explain ABS (i.e. MBS) and
CDOs in 2-3 sentences each.
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34
2.2 The Bond Market
• Mortgage-Backed Securities
• Private banks purchased and sold pools of
subprime mortgages
• Issuers assumed housing prices would continue
to rise
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35
Simple ABSs and CDOs
MBS
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36
Figure 2.6 Mortgage-Backed Securities Outstanding
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37
Figure 2.7 Asset-Backed Securities Outstanding
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38
Figure 2.9 The U.S. Fixed-Income Market
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39
2.3 Equity
Money
Markets
Fixed Income
Capital
Markets
Asset Classes
Equity
Derivatives
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40
2.3 Equity Securities: Instruments
• Equity Securities
• Common stock
• Residual claim
• Limited liability
• Preferred stock
• Priority over common
• Fixed dividends: Limited gains
• Nonvoting
• Tax treatment: Dividends Withholdings Tax (DWT)
of 15% in SA
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41
2.3 Equity Securities: Instruments
• Depository receipts
• American Depositary Receipts (ADRs), also
called American Depositary Shares (ADSs)
• Certificates traded in the U.S. representing
ownership in foreign security
• Also in SA: See article on BB and
http://www.jse.co.za
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42
2.3 Equity Securities: Returns
• Capital gains and dividend yields
• Buy a share of stock for $50, hold for 1 year, collect
$1 dividend, and sell stock for $54 What were
dividend yield, capital gain yield, and total return?
Total Return 
PSell  PBuy  Div
PBuy

$54  50  1
 10%
$50
Div $1
Dividend Yield 

 2%
PBuy $50
Capital Gains Yield 
PSell  PBuy
PBuy
$54  50

 8%
$50
Total return = Dividend yield + Capital gain yield = 2% + 8% = 10%
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43
Figure 2.8 Listing of stocks traded on NYSE
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44
2.4 Stock and Bond Market Indexes
• Uses
• Track average returns
• Compare performance of managers
• Base of derivatives
• Factors in constructing/using index
• Representative?
• Broad/narrow?
• How is it constructed?
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45
2.4 Stock and Bond Market Indexes
• Examples of Indexes—USA
• Dow Jones Industrial Average (30 stocks)
• Standard & Poor’s 500 Composite
• NASDAQ Composite (>3,000 firms)
• Wilshire 5000 (>6,000 stocks)
• Examples of Indexes—SA
• ALSI
• ALSI 40
• INDI
• FINI
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46
2.4 Stock and Bond Market Indexes
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47
2.4 Stock and Bond Market Indexes
https://www.sashares.co.za/jse-top-40/#gs.wn6r4r
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48
2.4 Stock and Bond Market Indexes
•Constructing Market Indexes
• Weighting schemes
 Price-weighted average: Computed by
adding prices of stocks and dividing by
“divisor”
 Market value-weighted index: Return equals
weighted average of returns of each
component security, with weights proportional
to outstanding market value
 Equally weighted index: Computed from
simple average of returns
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49
2.4 Stock and Bond Market Indexes
• Construction of Indexes
• How are stocks weighted?
• Price weighted (DJIA)
• Market value weighted (S&P 500, NASDAQ)
• Equally weighted (Value Line Index)
• How much money do you put in each stock in
the index?
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50
2.4 STOCK AND BOND MARKET INDEXES
Stock
Price-Weighted
Series
•
Price0
Quantity0
P1
Q2
A
$10
40
$15
40
B
50
80
25
160
C
140
50
150
50
Time 0 index value: (10 + 50 + 140)/3 = 200/3 = 66.7
Time 1 index value: (10 + 25 + 140)/Denom = 66.67
Denominator = 2.624869
Time 1 index value: (15 + 25 + 150)/2.624869 = 72.38
Other problems:
•
•
•
•
•
•
Similar % change movements in higher-price stocks cause
proportionally larger changes in the index
Splits arbitrarily reduce weights of stocks that split in index
2.4 STOCK AND BOND MARKET INDEXES
Stock
•
Price1
Quantity1
P2
Q2
A
$10
40
$15
40
B
50
80
25
160
C
140
50
150
50
Market Value-Weighted Series
IndexV = (15  40)  (25 160)  (150  50)
(10  40)  (50  80)  (140  50)
•
This value could be
anything (e.g. 50236). It
is the index value from
the previous period
100  106.14
Equal-Weighted Series
•
Let’s assume you invest $300 in each
(15  30)  (25 12)  (150  2.143)
100  119.05
IndexE =
(10  30)  (50  6)  (140  2.143)
• NB! Easier way for Equal-weighted Index: Calculate % change in
each share’s market value and then simply average the % changes
2.4 STOCK AND BOND MARKET INDEXES
Case 1
Stock
•
P1
Q1
P2
Case 2
Q2
P2
Q2
A
$10
40
$12
40
$10
40
B
100
80
100
80
100
80
C
50
200
50
200
60
200
Why do the two differ?
•
Case 1: 20% change in price of small-cap firm
IndexV =
•
(12  40)  (100  80)  (50  200)
100  100.43
(10  40)  (100  80)  (50  200)
Let’s assume you invest $100 in each stock
(12 10)  (100 1)  (50  2)
100  106.67
IndexE =
(10 10)  (100 1)  (50  2)
2.4 STOCK AND BOND MARKET INDEXES
Case 1
Stock
•
P1
Q1
P2
Case 2
Q2
P2
Q2
A
$10
40
$12
40
$10
40
B
100
80
100
80
100
80
C
50
200
50
200
60
200
Case 1 VW = 100.43
Case 1 EW = 106.67
Why do the two differ?
•
Case 2: 20% change in price of large-cap firm
IndexV = (10  40)  (100  80)  (60  200) 100  110.86
(10  40)  (100  80)  (50  200)
•
Assume $100 investment in each stock
(10 10)  (100 1)  (60  2)
100  106.67
IndexE = (10 10)  (100 1)  (50  2)
ALSI INDEX IN SA










When you hear on the radio that the JSE All Share Index rose 0,75%, you have an indication of
the value by which the market rose that day. The All Share Index is a market capitalisation
weighted index, which means price movements of bigger companies have more importance.
For example, a gain of 2% by PPC (JSE:PPC) on a given day means a lot more than, say, a 5% fall
in the price of tiny brick maker Brikor (JSE:BIK). An index attempting to measure what the
market is doing will obviously give more weight to PPC.
Old fashioned stock market indices measured the change in the total market capitalisations of all
shares on the market. Bigger market caps correctly had more influence.
But a large number of companies are controlled outright, which means a large percentage of their
shares never trade. Today's more sophisticated indices take account of that fact.
Modern indices, such as the JSE/FTSE All Share Index, eliminate shares owned by founders, their
families, directors and employee share schemes, also those locked up in strategic holdings or
owned by government. They count only the "free float".
Because of share price moves, every quarter some shares move into the Alsi 40 and others move
out. While there are always 40 shares in the Alsi 40, those ranking from 35-40 are regarded as a
buffer. To cater for new entrants, those ranking from 40-45 are kept in a reserve list. All those
ranking above 35 at the end of a quarter are automatically included and those that fall below 46
are dropped. Those between 35 and 46 are the JSE's reserve list to allow for comings and goings.
The indices are calculated every 15 seconds by computer. To that extent the indices are live and
can be plotted minute by minute by intra-day traders.
The indices have become more important in the past ten years as more and more investment funds
track the market. On the grounds that it is difficult to beat the market, more and more funds
simply "buy the market". They mirror various stock market indexes. A well-known local index
tracker is Satrix.
A company whose share price rises and finds itself suddenly in the Alsi 40, gets a second whammy
as investment funds become obliged to buy its shares. A company that drops out will quickly
experience selling pressure.
The top 40 shares therefore trade at a premium. Which is all very nice for the companies and their
managements - but it means it is difficult for an investor to find neglected bargains in the Alsi 40.
DISTRIBUTION
(MARKET CAPITALISATION) WEIGHTS ON
THE FTSE/JSE ALL SHARE INDEX
OF
https://www.sashares.co.za/jse-top-40/#gs.wn6r4r
2.5 Derivative Markets
• Derivative Asset/Contingent Claim
• Security with payoff that depends on the price
of other securities
• Call Option
• Right to buy an asset at a specified price on or
before a specified expiration date
• Put Option
• Right to sell an asset at a specified exercise
price on or before a specified expiration date
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
58
2.5 Derivative Markets
• Options
• Futures
• Basic Positions
• Call (Buy/Sell?)
• Put (Buy/Sell?)
• Basic Positions
• Long (Buy/Sell?)
• Short (Buy/Sell?)
• Terms
• Exercise price
• Expiration date
• Terms
• Delivery date
• Deliverable item
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
59