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ERIC WANG
Chapter21.pptx
2. Asset classes and financial instruments
Instructor: Seongcheol Paeng
6/24/2020
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2. Asset Classes and Financial Instruments
2.1 The Money Market
2.2 The Bond Market
2.3 Equity Securities (The Stock Market)
2.4 Stock and Bond Market Indexes
2.5 Derivative Markets
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2.1 The Money Market
The money market is a subsector of the fixed-income market. It consists of very short-term debt securities that usually are highly marketable.
Table 2.1 lists outstanding volume in 2015 for some of the major instruments in this market.
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2.1 The Money Market
Treasury Bills
The government raises money by selling bills to the public. Investors buy the bills at a discount from the stated maturity value.
At the bill’s maturity, the government pays the investor the face value of the bill.
The ask price is the price you would have to pay to buy a T-bill from a securities dealer.
The bid price is the slightly lower price you would receive if you wanted to sell a bill to a dealer.
The bid–ask spread is the difference in these prices, which is the dealer’s source of profit.
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2.1 The Money Market
Ex) days to maturity: 171, ASKED yield: .340%.
the bill at a discount from face value: .340% × (171/360) = .1615%.
a bill with $10,000 face value: $10,000 × (1 − .001615) = $9,983.85 (asked price)
bid yield: .350%,
$10,000 × (1 − .00350) × (171/360) = $9,983.375 (bid price)
gain: 1-$10,000/$9,983.85 = .001618 = .1618%.
Annualizing this gain using a 365-day year: .1618% × 365/171 = .345% (ASKED YIELD)
This last value is called the Treasury-bill’s bond-equivalent yield.
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2.1 The Money Market
Certificates of Deposit: A certificate of deposit, or CD, is a time deposit with a bank. Time deposits may not be withdrawn on demand. The bank pays interest and principal to the depositor only at the end of the fixed term of the CD.
Commercial Paper: Large, well-known companies often issue their own short-term unsecured debt notes rather than borrow directly from banks. These notes are called commercial paper. Very often, commercial paper is backed by a bank line of credit, which gives the borrower access to cash that can be used (if needed) to pay off the paper at maturity.
Bankers’ Acceptances: A banker’s acceptance starts as an order to a bank by a bank’s customer to pay a sum of money at a future date, typically within 6 months. Bankers’ acceptances are considered very safe assets because traders can substitute the bank’s credit standing for their own.
Eurodollars: Eurodollars are dollar-denominated deposits at foreign banks or foreign branches of American banks. By locating outside the United States, these banks escape regulation by the Federal Reserve. Despite the tag “Euro,” these accounts need not be in European banks, although that is where the practice of accepting dollar-denominated deposits outside the United States began. Eurodollar CDs are considered less liquid and riskier than domestic CDs, however, and thus offer higher yields.
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2.1 The Money Market
Repos and Reverses:
Dealers in government securities use repurchase agreements, also called “repos” or “RPs,” as a form of short-term, usually overnight, borrowing. The dealer sells government securities to an investor on an overnight basis, with an agreement to buy back those securities the next day at a slightly higher price.
A reverse repo is the mirror image of a repo. Here, the dealer finds an investor holding government securities and buys them, agreeing to sell them back at a specified higher price on a future date.
Federal Funds:
Just as most of us maintain deposits at banks, banks maintain deposits of their own at a Federal Reserve bank. Each member bank of the Federal Reserve System, or “the Fed,” is required to maintain a minimum balance in a reserve account with the Fed.
The required balance depends on the total deposits of the bank’s customers. Funds in the bank’s reserve account are called federal funds or fed funds.
In the federal funds market, banks with excess funds lend to those with a shortage. These loans, which are usually overnight transactions, are arranged at a rate of interest called the federal funds rate.
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2.1 The Money Market
Brokers’ Calls
Individuals who buy stocks on margin borrow part of the funds to pay for the stocks from their broker.
The broker in turn may borrow the funds from a bank, agreeing to repay the bank immediately (on call) if the bank requests it.
The LIBOR Market:
The London Interbank Offered Rate (LIBOR) is the rate at which large banks in London are willing to lend money among themselves.
This rate, which is quoted on dollar-denominated loans, has become the premier short-term interest rate quoted in the European money market, and it serves as a reference rate for a wide range of transactions.
For example, a corporation might borrow at a floating rate equal to LIBOR plus 2%.
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2.1 The Money Market
Yields on Money Market Instruments
The securities of the money market promise yields greater than those on default-free T-bills, at least in part because of greater relative riskiness.
In addition, many investors require more liquidity; thus they will accept lower yields on securities such as T-bills that can be quickly and cheaply sold for cash.
Figure 2.2 shows that bank CDs, for example, consistently have paid a premium over T-bills. Moreover, that premium increased with economic crises.
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2.2 The Bond Market
Treasury Notes and Bonds:
The U.S. government borrows funds in large part by selling Treasury notes and Treasury bonds.
T-notes are issued with maturities ranging up to 10 years, while bonds are issued with maturities ranging from 10 to 30 years.
Figure 2.3 is a listing of Treasury issues.
The bid price of the highlighted note, which matures in May 2019, is 99.8125.
This is the decimal version of . The minimum tick size, or price increment in the Treasury-bond market, is generally 1⁄128 of a point.
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2.2 The Bond Market
Treasury Notes and Bonds:
Although bonds are typically traded in denominations of $1,000 par value, prices are quoted as a percentage of par.
Thus, the bid price should be interpreted as 99.8125% of par, or $998.125 for the $1,000 par value bond.
Similarly, the ask price at which the bond could be sold to a dealer is 99.8281% of par, or $998.281.
The −.0859 change means that the closing price on this day fell by .0859% of par value (equivalently, by 11⁄128 of a point) from the previous day’s close. Finally, the yield to maturity based on the ask price is .933%.
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2.2 The Bond Market
Inflation-Protected Treasury Bonds
In the United States, inflation-protected Treasury bonds are called TIPS (Treasury Inflation Protected Securities). The principal amount on these bonds is adjusted in proportion to increases in the Consumer Price Index.
Federal Agency Debt
Some government agencies issue their own securities to finance their activities. These agencies usually are formed to channel credit to a particular sector of the economy that - Congress believes - might not receive adequate credit through normal private sources.
The major mortgage-related agencies are the Federal Home Loan Bank (FHLB), the Federal National Mortgage Association (FNMA, or Fannie Mae), the Government National Mortgage Association (GNMA, or Ginnie Mae), and the Federal Home Loan Mortgage Corporation (FHLMC, or Freddie Mac).
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2.2 The Bond Market
International Bonds
Many firms borrow abroad and many investors buy bonds from foreign issuers. In addition to national capital markets, there is a thriving international capital market, largely centered in London.
For example, a dollar-denominated bond sold in Britain would be called a Eurodollar bond. Similarly, investors might speak of Euroyen bonds, yen-denominated bonds sold outside Japan.
Municipal Bonds
Municipal bonds are issued by state and local governments. They are similar to Treasury and corporate bonds except that their interest income is exempt from federal income taxation.
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2.2 The Bond Market
Municipal Bonds
General obligation bonds are backed by the “full faith and credit” (i.e., the taxing power) of the issuer, while revenue bonds are issued to finance particular projects and are backed either by the revenues from that project or by the particular municipal agency operating the project.
Typical issuers of revenue bonds are airports, hospitals, and turnpike or port authorities.
Obviously, revenue bonds are riskier in terms of default than general obligation bonds.
Figure 2.4 plots outstanding amounts of both types of municipal securities.
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2.2 The Bond Market
Municipal Bonds
; ;
If we let t denote the investor’s combined federal plus local marginal tax bracket and denote the total before-tax rate of return available on taxable bonds, then (1 − t) is the after-tax rate available on those securities.
Figure 2.5 plots the ratio of 20-year municipal debt yields to the yield on Baa-rated corporate debt.
The default risk of these corporate and municipal bonds may be comparable, but certainly will fluctuate over time.
For example, the sharp run-up in the ratio in 2011 probably reflects increased concern at the time about the precarious financial condition of several states and municipalities, leading to higher credit spreads on their bonds.
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2.2 The Bond Market
Corporate Bonds
Corporate bonds are the means by which private firms borrow money directly from the public.
Default risk is a real consideration in the purchase of corporate bonds.
Mortgages and Mortgage-Backed Securities
As described in Chapter 1, a mortgage-backed security is either an ownership claim in a pool of mortgages or an obligation that is secured by such a pool.
Figure 2.6 illustrates the explosive growth of both agency and private-label mortgage-backed securities, at least until the crisis.
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2.2 The Bond Market
Mortgages and Mortgage-Backed Securities
Figure 2.7 documents the rapid growth of nonmortgage asset–backed securities, at least until 2007.
After the financial crisis, the market contracted as the perceived risks of credit card and home equity loans skyrocketed, but the asset-backed market is still substantial.
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2.3 Equity Securities
Common Stock as Ownership Shares
Common stocks, also known as equity securities or equities, represent ownership shares in a corporation.
Each share of common stock entitles its owner to one vote on any matters of corporate governance that are put to a vote at the corporation’s annual meeting and to a share in the financial benefits of ownership.
Managers have the authority to make most business decisions without the board’s specific approval.
The board’s mandate is to oversee the management to ensure that it acts in the best interests of shareholders.
We noted in Chapter 1 that such separation of ownership and control can give rise to “agency problems,” in which managers pursue goals not in the best interests of shareholders. However, there are several mechanisms that alleviate these agency problems.
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2.3 Equity Securities
Characteristics of Common Stock
The two most important characteristics of common stock as an investment are its residual claim and limited liability features.
Residual claim means that stockholders are the last in line of all those who have a claim on the assets and income of the corporation.
In a liquidation of the firm’s assets the shareholders have a claim to what is left after all other claimants such as the tax authorities, employees, suppliers, bondholders, and other creditors have been paid.
Limited liability means that the most shareholders can lose in the event of failure of the corporation is their original investment.
Unlike owners of unincorporated businesses, whose creditors can lay claim to the personal assets of the owner (house, car, furniture), corporate shareholders may at worst have worthless stock. They are not personally liable for the firm’s obligations.
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2.3 Equity Securities
Stock Market Listings
Figure 2.8 presents key trading data for a small sample of stocks traded on the New York Stock Exchange.
The NYSE is one of several markets in which investors may buy or sell shares of stock.
Yield: 0.92/29.87 = .0308, or 3.08%
The P/E ratio, or price–earnings ratio, is the ratio of the current stock price to last year’s earnings per share. The P/E ratio tells us how much stock purchasers must pay per dollar of earnings that the firm generates.
Finally, we see that GE’s stock price has decreased by 4.11% since the beginning of the year.
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2.3 Equity Securities
Preferred Stock
Preferred stock has features similar to both equity and debt. Like a bond, it promises to pay to its holder a fixed amount of income each year.
In this sense, preferred stock is similar to an infinite-maturity bond, that is, a perpetuity. It also resembles a bond in that it does not convey voting power regarding the management of the firm.
Preferred stock is an equity investment, however. The firm retains discretion to make the dividend payments to the preferred stockholders; it has no contractual obligation to pay those dividends.
Preferred stocks therefore make desirable fixed-income investments for some corporations.
Even though preferred stock ranks after bonds in terms of the priority of its claims to the assets of the firm in the event of corporate bankruptcy, it often sells at lower yields than corporate bonds.
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2.3 Equity Securities
Depository Receipts
American Depositary Receipts, or ADRs, are 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.
ADRs were created to make it easier for foreign firms to satisfy U.S. security registration requirements.
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2.4 Stock and Bond Market Indexes
Stock Market Indexes
The daily performance of the Dow Jones Industrial Average is a staple portion of the evening news report. Although the Dow is the best-known measure of the performance of the stock market, it is only one of several indicators.
The Nikkei Average of Tokyo and the Financial Times index of London
Dow Jones Industrial Average
The Dow Jones Industrial Average (DJIA) of 30 large, “blue-chip” corporations has been computed since 1896. Its long history probably accounts for its preeminence in the public mind. (The average covered only 20 stocks until 1928.)
Originally, the DJIA was calculated as the average price of the stocks included in the index. Thus, one would add up the prices of the 30 stocks in the index and divide by 30.
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2.4 Stock and Bond Market Indexes
Price-Weighted Averages
Portfolio: Initial value = $25 + $100 = $125 Final value = $30 + $90 = $120 Percentage change in portfolio value = −5/125 = −.04 = −4%
Index: Initial index value = (25 + 100)/2 = 62.5 Final index value = (30 + 90)/2 = 60 Percentage change in index = −2.5/62.5 = −.04 = −4%
The portfolio and the index have identical 4% declines in value. Notice that price-weighted averages give higher-priced shares more weight in determining performance of the index.
We conclude that a high-price stock can dominate a price-weighted average.
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2.4 Stock and Bond Market Indexes
Splits and Price-Weighted Averages
The index value before the stock split = 125/2 = 62.5.
We must find a new divisor, d, that leaves the index unchanged after XYZ splits and its price falls to $50.
Therefore, we solve for d in the following equation: (Price of ABC + Price of XYZ) / d = (25 + 50) / d = 62.5 which implies that the divisor must fall from its original value of 2.0 to a new value of 1.20.
Therefore, the return of the index is affected by the split.
The new value of the price-weighted average is (30 + 45)/1.20 = 62.5, the same as its value at the start of the year; therefore, the rate of return is zero, rather than the −4% return that we calculated in the absence of a split.
This example illustrates that the implicit weighting scheme of a price-weighted average is somewhat arbitrary, being determined by the prices rather than by the outstanding market values (price per share times number of shares) of the shares in the average.
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2.4 Stock and Bond Market Indexes
Dow Jones Industrial Average
Because the Dow Jones averages are based on small numbers of firms, care must be taken to ensure that they are representative of the broad market.
As a result, the composition of the average is changed every so often to reflect changes in the economy.
Table 2.5 presents the composition of the Dow industrials in 1928 as well as its composition as of mid-2016.
Many of the “bluest of the blue chip” companies in 1928 no longer exist, and the industries that were the backbone of the economy in 1928 have given way to some that could not have been imagined at the time.
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2.4 Stock and Bond Market Indexes
The Standard & Poor’s 500 Index
The Standard & Poor’s Composite 500 (S&P 500) stock index represents an improvement over the Dow Jones Averages in two ways.
First, it is a more broadly based index of 500 firms.
Second, it is a market-value-weighted index.
If one were to buy shares in each component firm in the index in proportion to its outstanding market value, the value-weighted index would perfectly track capital gains on the underlying portfolio.
Similarly, a price-weighted index tracks the returns on a portfolio comprised of an equal number of shares of each firm.
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2.4 Stock and Bond Market Indexes
Value-Weighted Indexes
The final value of all outstanding stock in our two-stock universe is $690 million. The initial value was $600 million.
Therefore, if the initial level of a market-value-weighted index of stocks ABC and XYZ were set equal to an arbitrarily chosen starting value such as 100, the index value at year-end would be 100 × (690/600) = 115.
The increase in the index reflects the 15% return earned on a portfolio consisting of those two stocks held in proportion to outstanding market values.
Unlike the price-weighted index, the value-weighted index gives more weight to ABC.
Note also from Tables 2.3 and 2.4 that market-value-weighted indexes are unaffected by stock splits.
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2.4 Stock and Bond Market Indexes
Other U.S. Market-Value Indexes
NASDAQ computes a Composite index of more than 3,000 firms traded on the NASDAQ market. The NASDAQ 100 is a subset of the larger firms in the Composite Index, but it accounts for a large fraction of its total market capitalization.
The ultimate U.S. equity index so far computed is the Wilshire 5000 index of the market value of essentially all actively traded stocks in the U.S.
Equally Weighted Indexes
Market performance is sometimes measured by an equally weighted average of the returns of each stock in an index.
Such an averaging technique, by placing equal weight on each return, corresponds to an implicit portfolio strategy that invests equal dollar values in each stock.
This is in contrast to both price weighting (which requires equal numbers of shares of each stock) and market-value weighting (which requires investments in proportion to outstanding value).
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2.4 Stock and Bond Market Indexes
Foreign and International Stock Market Indexes
Development in financial markets worldwide includes the construction of indexes for these markets. Among these are the Nikkei (Japan), FTSE (U.K.; pronounced “footsie”), DAX (Germany), Hang Seng (Hong Kong), and TSX (Canada).
A leader in the construction of international indexes has been MSCI (Morgan Stanley Capital International), which computes dozens of country indexes and several regional indexes.
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2.4 Stock and Bond Market Indexes
Bond Market Indicators
Just as stock market indexes provide guidance concerning the performance of the overall stock market, several bond market indicators measure the performance of various categories of bonds.
The three most well-known indexes are those of Merrill Lynch, Barclays, and the Citi Broad Investment Grade Bond Index.
Figure 2.9 shows the components of the U.S. fixed-income market in 2016.
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2.5 Derivative Markets
Futures, options, and related derivatives contracts provide payoffs that depend on the values of other variables such as commodity prices, bond and stock prices, interest rates, or market index values.
Options
A call option gives its holder the right to purchase an asset for a specified price, called the exercise or strike price, on or before a specified expiration date.
Calls therefore provide greater profits when stock prices increase and thus represent bullish investment vehicles.
In contrast, a put option gives its holder the right to sell an asset for a specified exercise price on or before a specified expiration date.
Whereas profits on call options increase when the asset increases in value, profits on put options increase when the asset value falls.
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2.5 Derivative Markets
Options
Call Option (Today 6/24/2020)
Ex) Purchasing Digital Camera $300 (8/1/2020), Option Premium: $10
If the price on 8/1/2020: $350, the holder will buy it because she/he can gain $40 ($350-$300-$10=$40).
If the price on 8/1/2020: $250, the holder will give it up because she/he will lose $60 ($250-$300-$10=-$60).
Put Option (Today 6/24/2020)
Ex) Selling Digital Camera $300 (8/1/2020), Option Premium: $10
If the price on 8/1/2020: $350, the holder will give it up because she/he will lose $60($300-$350-$10=-$60).
If the price on 8/1/2020: $250, the holder will sell it up because she/ he will gain $40($300-$250-$10=$40).
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2.5 Derivative Markets
Futures Contracts
A futures contract calls for delivery of an asset at a specified delivery or maturity date for an agreed-upon price, called the futures price, to be paid at contract maturity.
The long position is held by the trader who commits to purchasing the asset on the delivery date. The trader who takes the short position commits to delivering the asset at contract maturity.
A futures contract obliges the long position to purchase the asset at the futures price; the call option, in contrast, conveys the right to purchase the asset at the exercise price. The purchase will be made only if it yields a profit.
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Assignments
Problem Sets (Paraphrase with your own words.)
1. Explain Treasury Bills.
2. Explain Treasury Notes and Bonds.
3. Explain Municipal Bonds.
4. Explain Characteristics of Common Stock.
5. Explain the difference between Price-Weighted Index and Value-Weighted Index.
6. Explain Call Option and Put Option with examples.
Deadline: 6/29/2020 before the class
Submit it via email to [email protected]
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