Investments: Asset classes
and financial instruments
CHAPTER 2
Financial Securities
Financial Market
Fixed-income (Bonds)
Equity (Stocks)
High Risk
Low Risk
Money Market
(Short-term)
Derivatives
Bond Market
(Long-term)
Common Stocks
Preferred Stocks
Index
Options
Futures
Money market instruments

T-bill






Issued by government
most marketable
minimum denomination: $1000
buy at a discount, return at par
issued weekly with maturities 28, 91, 182 days
Certificate of deposit (CD)




Pay interest and principal at maturity date
Par value > 100,000: negotiable
Par value <100,000: non-negotiable
Short-term CD (less than 3 months): highly marketable
Money market instruments

Commercial paper





Issued by large, well-known corporation
Short term, unsecured debt (less than 270 days),
more than 270 day need SEC registration.
Fairly safe
Fairly liquid
banker acceptance


an order to a bank by a customer to pay a sum of
money at a future date
safe (guaranteed by bank)
Money market instruments

Eurodollars: dollar denominated at foreign
banks or American banks’ foreign branches




similar to domestic deposit
escape US regulation
riskier, less liquid, offer higher yield than
domestic deposit
Repos (repurchase agreements)

short-term sales of government securities with an
agreement to repurchase the securities at a
higher price
Money market instruments

Federal funds



Funds in the accounts of commercial bank at the
Fed
Federal fund rate: overnight loan rate among
banks
LIBOR market: London Interbank Offer Rate:
lending rate among banks in London market
Table 2.2 Components of the
Money Market
Bond Market
Treasury Notes and Bonds
 Federal Agency Debt
 International Bonds
 Inflation-Protected Bonds
 Municipal Bonds
 Corporate Bonds
 Mortgages and Mortgage-Backed
Securities

Treasury Notes and Bonds

Maturities
– maturities up to 10 years
 Bonds – maturities in excess of 10 years
 Notes
Par Value - $1,000
 Quotes – percentage of par, in 32nd

Figure 2.4 Treasury Notes and Bonds
Federal Agency Debt

Major issuers
 Federal
Home Loan Bank
 Federal National Mortgage Association (“Fannie Mae”)
 Government National Mortgage Association (“Ginnie
Mae”)
 Federal Home Loan Mortgage Corporation (“Freddie
Mac”)


If default, the government will help
safe, yield is similar to T-bill
Municipal Bonds


Issued by state and local governments
Types




General obligation bonds: backed by state, city
Revenue bonds: backed by the revenue of project of state, city
tax exempt from federal tax (for investors)
example: consider 2 bonds




taxable bond: before tax yield = 8%, tax = 40%
municipal bond: yield = 6%
Which one is more attractive to investors?
Maturities – range up to 30 years
Municipal Bonds
Interest is exempt from Federal taxes
After-tax return (taxable bond):
raftertax  rbeforetax 1  t 
After-tax return (Municipal bond):
raftertax  rbeforetax
Figure 2.6 Ratio of Yields on
Tax-exempts to Taxables, 1955-2006
Corporate Bonds
Issued by private firms
 Semi-annual interest payments
 Subject to larger default risk than
government securities
 Options in corporate bonds

 Callable
 Convertible
Figure 2.7 Investment Grade Bond
Listings
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

Mortgage backed securities
fund
fund
payment
payment
Banks
pool all
mortgage loans
securitized
fund
sell
Investors
payment
Mortgage loan
fund
mortgage backed
securities
payment
payment
Borrowers
Mortgage backed securities can be
called pass through securities since the
bank simply pass fund from investors to
borrowers and pass interest payment and
principal payment from borrowers to
investors
Figure 2.8 Mortgage-Backed
Securities Outstanding
Equity Markets

Common stock

Preferred stock

Depository receipts

stock market listing
Equity Markets

Common stock
Right to vote
 Right to share benefit
 Proxy
 Proxy fight

 Characteristics
Residual claims
 Limited liabilities

Equity Markets

Preferred stocks
 Similar to both stocks
 Similar to bond
 Similar to stock
and bond (hybrid security)
 Priority
over common stock
 preferred dividend is cumulative
 tax treatment



Preferred stock and bond are similar in the sense that they
are both fixed income and have no voting power.
Bond has claims before preferred stock
Obviously preferred stock is riskier, why in practice the yield
on preferred stock is smaller than that of bond
Equity Markets
ADR: claims on ownership in foreign
companies
 Trading in the US, similar to US stocks
 Total value of ADR currently is 657 (bil),
about 2000 ADRs from 73 countries

Figure 2.9 Stock Market Listings
Uses of Stock Indexes
Track average returns
 Comparing performance of managers
 Base of derivatives

Examples of Other Indexes - Domestic
Dow Jones Industrial Average (30 Stocks)
 Standard & Poor’s 500 Composite
 NASDAQ Composite
 NYSE Composite
 Wilshire 5000

Figure 2-10 Comparative Performance
of Several Stock Market Indexes
Examples of Indexes - International
Nikkei 225 & Nikkei 300
 FTSE (Financial Times of London)
 Dax
 Region and Country Indexes

 EAFE
 Far
East
 United Kingdom

MSCI: index of more than 50 country
indexes
Table 2.6 Sample of MSCI Stock Indexes
Factors for Construction of
Stock Indexes



Representative?
Broad or narrow?
How is it weighted?
 Price
weighted (DJIA)
 Market weighted (S&P 500, NASDAQ)
 Equal (Value Line Index)
Price Weighted Indices
DJIA is an example
 30 blue chip companies
 DJIA = (P1+P2+....+P30)/d where d is Dow divisor.
 Originally d = 30
 Currently, d = 0.1248 since d is adjusted for stock
split, stock dividends, other corporate action, new
companies coming into the index, old companies
are taken out of the index

Example of Price-Weighted Index
Stock ABC sells initially at $25 a share with 20
million shares outstanding, while XYZ sells for $100 a
share with 1 millions shares outstanding. The final
price for ABC is $30, and the final price for XYZ is
$90.
(a) Find the initial and the final price-weighted index
composed of these two stocks. Assume the initial
divisor is 2.
(b) Now if stock XYZ is split two for one, how should
you adjust the divisor for the index?
DJIA

Most quoted index in the world
Long history
 easy to understand
 indicates market’s basic trend reliably
 30 companies account for 24-25% of US equity


Criticisms
Only 30 stocks
 price weighted index: large price stocks dominate
the index

S&P’s Composite 500
Market Value-Weighted Index

Stock ABC sells initially at $25 a share with
20 million shares outstanding, while XYZ sells
for $100 a share with 1 millions shares
outstanding. The final price for ABC is $30,
and the final price for XYZ is $90.
Find the the value-weighted index composed
of these two stocks at the final date. Assume
the initial level of the index is 100.
Value Line
Equally Weighted Index
Places equal weight on each return
 Using data from Table 2.4
Start with equal dollars in each investment
ABC increases in value by 20%
XYZ decreases by 10%
Need to rebalance to keep equal weights

Table 2.4 Data to Construct Stock
Price Indexes
Bond Index
Computed monthly
Difficulty in measuring true returns
Best known:
Merrill Lynch
Lehman Brothers
Salomon Smith Barney
DERIVATIVE MARKETS
Derivative Securities
Options
 Basic Positions
Futures
 Basic Positions
 Call
 Long
(Buy)
 Put (Sell)

Terms
 Exercise
Price
 Expiration Date
 Assets
(Buy)
 Short (Sell)

Terms
 Delivery
 Assets
Date
Options
Call option - the right to buy an asset at a
specific price (exercise price) on or before
a specific date
Put option - the right to sell an asset at a
specific price (exercise price) on or before a specific date
Options

Call options
Same expiration date, exercise price increases,
value of option decreases
 Same exercise price, expiration date increases,
value of option increases


Put options
Same expiration date, exercise price increases,
value of option increases
 Same exercise price, expiration date increases,
value of option increases

Futures contracts
Obligation to purchase or sell an asset at a
specific price at a specific future date
 Long position: trader who commits to buy
commodity/asset at delivery date
 Short position: trader who commits to sell
at the delivery date
 Option is the right, futures is obligation

There is no free lunch!
Return
Derivatives
more
return
less risk
Stocks more risk
less
return
Corporate Bonds
T-Bonds
Money
Risk
Summary
Financial securities
 Indices
 Next class: Financial Market Trading
