International Financial Investment
Lecture 2: Asset Classes and Financial Instruments
Nan-Wei Han
Department of Statistics and Information Science
Fu Jen Catholic University
February 16, 2025
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Financial Markets
• Money markets: short-term, marketable, liquid, low-risk debt securities.
• Capital markets: longer term and riskier securities. Divided into four segments:
- Longer-term bonds
- Equity
- Options
- Futures
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Money Market Securities I
• Treasury Bills (T-bills)
- Government-issued debt sold to the public.
- Ask price: the price you pay to buy a T-bill from a securities dealer.
- Bid price: lower price you receive if you sell a T-bill to a dealer.
- Bid-ask spread: difference in ask price and bid price; dealer’s source of profit.
- Bank-discount method
Days until maturity
Ask price = Face value × 1 − Asked yield ×
360
- Bond equivalent yield
Bond equivalent yield =
365
Face value − Asked price
×
Asked price
Days until maturity
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Money Market Securities II
• Certificates of Deposit (CD)
- Bank pays interest and principal to the depositor only at maturity.
- Time deposit cannot be withdrawn on demand
- Insured up to $250,000 by FDIC.
• Commercial paper
- Short-term unsecured debt notes, often issued by large, well-known companies and
backed by a bank line of credit
• Bankers’ acceptance
- An order to a bank by a customer to pay a sum of money at a future date
• Repurchase agreements (Repos)
- Short-term, often overnight, sales of securities with an agreement to repurchase them
at a slightly higher price
- Term Repo: The term of the implicit loan can be 30 days or more.
- Reverse Repo: dealer buys government securities from an investor, agreeing to sell them
back on a future date
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Money Market Securities III
• Federal funds
- Funds in a bank’s reserve account at the Federal Reserve
- Loans arranged at federal funds rate
• Money market funds: mutual funds that invest in money market instruments.
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The Bond Market
The bond market is composed of longer-term borrowing or debt instruments than those
that trade in the money market
• Treasury notes and bonds
• Corporate bonds
• Municipal bonds
• Mortgage securities
• Federal agency debt
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Debt Instruments I
• Treasury notes and Treasury bonds
- Notes—maturities range up to 10 years
- Bonds—maturities range from 10 to 30 years.
• Inflation-protected treasury bonds
- Government-issued bonds linked to a cost of living index.
- Provide citizens with an effective hedge against inflation risk.
- In the United States, they are called TIPS
• Federal agency debt
- Agencies formed to channel credit to a particular sector that Congress believes might
not receive adequate credit through private sources
• Municipal Bonds
- Tax-exempt bonds issued by state and local governments
equivalent taxable yield = rtaxable =
rmuni
1−t
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Debt Instruments II
- General obligation—backed by general taxing power of issuer
- Revenue—backed by proceeds from the project or agency they are issued to finance.
Typically issued by airports, hospitals, etc.
• Corporate bonds
- Private firms borrow money directly from the public
- Secured bonds: specific collateral backed
- Unsecured bonds: debenture
- Subordinated debentures: lower priority debenture
- May come with options attached: Callable; Convertible
• Mortgage- and asset-backed securities
- Ownership claim in a pool of mortgages or an obligation that is secured by such a pool
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Equity Securities I
• Common stock
- Represent ownership shares in a corporation.
- Each share entitles owner to one vote.
- Corporation controlled by board of directors elected by shareholders.
- Residual claim: last in line of all who have a claim on the assets and income of the
corporation
- Limited liability: shareholders can lose a maximum of their original investment in the
event of corporate failure
• Preferred stock: has features similar to both equity and debt
- Promises to pay a fixed amount of income each year in preference to the common stock
(behaves as perpetuity)
- Does not convey voting power
- No contractual obligation to pay, but dividends owed accumulate
- Preferred stock payments are dividends rather than interest; not a tax-deductible
expense for the firm
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Equity Securities II
• Depository Receipts
- American Depository Receipts (ADRs): Certificates traded in U.S. markets that
represent ownership in shares of a foreign company
- Each ADR may correspond to ownership of a fraction of a foreign share, one share, or
several shares of the foreign corporation
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Stock Market Indexes
• Price weighted: Dow Jones Industrial Average
• Market-value weighted: S&P 500, Russell 3000
• Equally weighted: S&P 500 Equal-weight Index
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Example
Stock
ABC
XYZ
Total
Initial Price
$25
$100
Final Price
$30
$90
Shares
20
1
Initial Market Value
$500
$100
$600
Final Market Value
$600
$90
$690
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Price-Weighted
• Index:
Initial index value: (25 + 100)/2 = 62.5
Final index value: (30 + 90)/2 = 60
Percentage change in index: −2.5/62.5 = −4%
• Portfolio comprised of equal number of shares:
• ABC: +20%
• XYZ: −10%
• Percentage change in portfolio value: 20% ∗ (25/125) − 10%(100/125) = −4%
• It gives higher-priced shares more weight in determining the performance of the index
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Market-Value Weighted
• Index:
Percentage change in index = (690 − 600)/600 = 15%
• Portfolio: Buy shares in each component in proportional to its market value:
• ABC: +20%
• XYZ: −10%
• Percentage change in portfolio value: 20% ∗ (500/600) − 10%(100/600) = 15%
• It gives higher-market-value shares more weight in determining the performance of
the index
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Equally Weighted
• Index:
Percentage change in index = (20% − 10%)/2 = 5%
• Portfolio: Invest equal dollar values in each stock
• ABC: +20%
• XYZ: −10%
• Percentage change in portfolio value: 20% ∗ (1/2) − 10%(1/2) = 5%
• Placing equal weight on each return
• DO NOT correspond to buy-and-hold portfolio strategy
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Derivatives
A derivative is a security that gets its value from the values of another asset, such as
commodity prices, bond and stock prices, or market index values
Futures
Options
• Calls for delivery of an asset (or cash
• Call Option: Gives holder the right to
value) at a specified delivery or maturity
purchase an asset for a specified price,
date for an agreed-upon price to be
called the exercise or strike price, on or
paid at contract maturity.
before a specified expiration date.
• Long position held by the trader who
• Put Option: Right to sell the underlying
commits to purchasing the asset on the
asset at the strike or exercise price
delivery date
• Short position held by the trader who
commits to delivering the asset at
contract maturity
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Comparisons
A derivative is a security that gets its value from the values of another asset, such as
commodity prices, bond and stock prices, or market index values
Options
• Right, but not obligation, to buy or sell
• Option is exercised only when it is
profitable
• Options must be purchased at a
premium
Futures
• Obliged to make or take delivery
• Long (short) position must buy (sell) at
the futures price
• Futures contracts are entered into
without cost
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