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Chapter Two

Asset Classes and Financial Instruments

No reproduction or further distribution permitted without the prior written consent of McGraw-Hill Education.

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Building an investment portfolio

Asset allocation involves making decisions about how much money to allocate to broad classes of assets

Security selection occurs when the investor selects specific assets from within each class

Financial markets

Money markets are made up of short-term, marketable, liquid, low-risk debt securities

Capital markets include longer term and riskier securities

Divided into four segments – longer term bond markets, equity markets, and the derivative markets for options and futures

Chapter Overview

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Treasury Bills (i.e., T-bills)

Simplest form of borrowing wherein the government raises money by selling bills to the public

Ask price is the price you would have to pay to buy a T-bill from a securities dealer

Bid price is the slightly lower price you would receive if you wanted to sell a bill to a dealer

Bid-ask spread is the difference in these prices, which is the dealer’s source of profit

Certificates of Deposit (CD)

Bank pays interest and principal to the depositor only at maturity

Time deposit cannot be withdrawn on demand

Money Market Securities (1 of 3)

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Many of the securities trading in the money market are in large denominations and out of the reach of individual investors.

Commercial paper

Short-tern 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

Eurodollars

Dollar-denominated deposits at foreign banks or foreign branches of American banks

Money Market Securities (2 of 3)

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Repurchase agreements

Short-term, often over-night, sales of securities with an agreement to repurchase them at a slightly higher price

Federal funds

Funds in a bank’s reserve account at the Federal Reserve Bank

Brokers’ calls

Investors may buy stocks on margin and brokers, in turn, may borrow the funds from a bank

Money Market Securities (3 of 3)

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LIBOR

LIBOR is the premier short-term interest rate quoted in the European money market

Based on surveys of rates reported by participating banks rather than actual transactions

Regulators have proposed phasing out LIBOR by 2021

Yields on Money Market Instruments

Most money market securities are low risk, but not risk-free

Money market funds are mutual funds that invest in money market instruments

Government funds hold short-term U.S. Treasury or agency securities

Prime funds also hold other money market instruments

The Money Market

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Spread between federal funds rate and Treasury bill rates

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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

The Bond Market

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Treasury notes and treasury bonds

U.S. government borrows funds in large part by selling T-notes and T-bonds

Notes – maturities range up to 10 years

Bonds – maturities range from 10 to 30 years

Inflation-protected treasury bonds

Many countries’ governments issue bonds linked to an index of the cost of living in order to provide their citizens with an effective way to hedge inflation risk

In the U.S., inflation-protected T-bonds are called TIPS

Debt Instruments (1 of 5)

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Federal agency debt

Agencies formed to channel credit to a particular sector that Congress believes might not receive adequate credit through private sources

E.g., FHLB, FNMA, GNMA, FHLMC

International bonds

International capital market centered in London

Eurobond is a bond denominated in a currency other than that of the country in which it is issued

Yankee bond is a dollar-denominated bond sold in the U.S. by a non-U.S. issuer

Debt Instruments (2 of 5)

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Municipal Bonds

Tax-exempt bonds issued by state and local governments

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.

Industrial development – revenue bond issued to finance commercial enterprises

Vary widely in maturity

Debt Instruments (3 of 5)

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Tax-Exempt Debt Outstanding

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Compare after-tax returns on each bond

Let t = investor’s combined tax bracket

Let rtaxable = before-tax return on the taxable bond

Let rtaxable(1-t) = after-tax rate

Let rmuni = municipal bond rate

rtaxable(1-t) > rmuni

Taxable bond gives a higher return; otherwise, the municipal bond is preferred

Municipal Bond Yields Taxable vs. Tax-Exempt Bonds

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Tax-Exempt Yield Table

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Corporate bonds

Means by which private firms borrow money directly from the public

Secured bonds

Unsecured bonds (i.e., debentures)

Subordinated debentures

Similar to Treasury issued securities in that they usually pay semiannual coupons and return face value to bondholder at maturity

Larger default risk than Treasury issued securities

May come with options attached

Callable or convertible options

Debt Instruments (4 of 5)

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Mortgage- and asset-backed securities

Ownership claim in a pool of mortgages or an obligation that is secured by such a pool

Conforming mortgages

Loans must satisfy certain underwriting guidelines before they may be purchased by Fannie Mae or Freddie Mac

Subprime mortgages

Riskier loans made to financially weaker borrowers

Debt Instruments (5 of 5)

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Mortgage-Backed Securities Outstanding

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Represent ownership shares in a corporation

Each share entitles owner to one vote

Corporation controlled by board of directors elected by shareholders

Residual claim

Stockholders are last in line of all who have a claim on the assets and income of the corporation

Limited liability

Most shareholders can lose in the event of failure of the corporation is their original investment

Equity Securities: Common Stock

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Dividend yield

Annual dividend payment expressed as a percent of the stock price

Capital gains

Amount by which the sale price of a security exceeds the purchase price

Price-earnings ratio

Ratio of a stock’s price to its earnings per share

Equity Securities: Stock Market Listings

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Preferred stock has features similar to both equity and debt

Like a bond, promises to pay a fixed amount of income each year

Does not convey voting power regarding the management of the firm

Contractual obligation to pay interest, but not dividends

Preferred stock payments are treated as dividends rather than interest, so they are not a tax-deductible expense for the firm

Equity Securities: Preferred Stock

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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

Equity Securities: Depository Receipts

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Dow Jones Industrial Average (DJIA)

Includes 30 large blue-chip corporations

Computed since 1896

Price-weighted average

Standard & Poor’s 500 (S&P 500)

Improvement over DJIA in two ways

More broadly based index of 500 firms

Market-value-weighted Index

Stock Market Indexes

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Note that investors can easily buy market indexes for their portfolio, either through index funds or exchange-traded funds.

U.S. market-value indexes

NYSE, NASDAQ, Wilshire 5000, CRSP

Equally weighted indexes

Do not correspond to buy-and-hold strategies

Foreign and international stock market indexes

Nikkei, FTSE, DAZ, Hang Seng, TSX

Other Indexes

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U.S. Fixed-Income Market ($b)

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Derivative asset is a claim whose value is directly dependent on or is contingent o the value of some underlying assets

Options

Futures

Derivative Markets

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Call option

Gives holder the right to purchase an asset for a specified price, called the exercise or strike price, on or before a specified expiration date

Put option

Gives holder the right to sell an asset for a specified exercise price on or before a specified expiration date

Derivatives Markets: Options

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Futures contract

Calls for delivery of an asset (or cash value) at a specified delivery or maturity date for an agreed-upon price, called the futures price, to be paid at contract maturity

Long position held by the trader who commits to purchasing the asset on the delivery date

Short position held by trader who commits to delivering the asset at contract maturity

Derivatives Markets: Futures Contract

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Options

Right, but not obligation, to buy or sell

Option is exercised only when it is profitable

Options must be purchased

The premium is the price of the option itself

Futures Contract

Obliged to make or take delivery

Long (short) position must buy (sell) at the futures price

Futures contracts are entered into without cost

Comparison

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