Week 1

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Chapter Two

Asset Classes and Financial Instruments

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Asset allocation → Asset classes

Money markets vs. capital markets

Types of money market instruments

Capital market securities:

Bonds

Equity

Derivatives

Chapter Overview

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Subsector of the fixed-income market: Securities are short-term, liquid, low risk, and often have large denominations

Money market mutual funds allow individuals to access the money market

The Money Market

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Table 2.1 Major Components of the Money Market

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Treasury bills: Short-term debt of U.S. government

Bid and asked price

Bank discount method

Certificates of deposit: Time deposit with a bank

Commercial paper: Short-term, unsecured debt of a company

Money Market Securities

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Bankers’ Acceptances: An order to a bank by a bank’s customer to pay a sum of money on a future date

Eurodollars: Dollar-denominated time deposits in banks outside the U.S.

Repos and reverses: Short-term loan backed by government securities.

Fed funds: Very short-term loans between banks

Money Market Securities

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Except for Treasury bills, money market securities are not free of default risk

Both the premium on bank CDs and the TED spread have often become greater during periods of financial crisis

During the credit crisis of 2008, the federal government offered insurance to money market mutual funds after some funds experienced losses

Yields on Money Market Instruments

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Treasury Notes and Bonds

Inflation-Protected Treasury Bonds

Federal Agency Debt

International Bonds

Municipal Bonds

Corporate Bonds

Mortgages and Mortgage-Backed Securities

The Bond Market

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Treasury Notes and Bonds

Maturities

Notes – Maturities up to 10 years

Bonds – Maturities from 10 to 30 years

Par Value - $1,000

Interest paid semiannually

Quotes – Percentage of par

Bond Market Securities

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Inflation-Protected Treasury Bonds

TIPS: Provide inflation protection

Federal Agency Debt

Debt of mortgage-related agencies such as Fannie Mae and Freddie Mac

International Bonds

Eurobonds and Yankee bonds

Bond Market Securities

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Municipal Bonds

Issued by state and local governments

Interest is exempt from federal income tax and sometimes from state and local tax

Types

General obligation bonds: Backed by taxing power of issuer

Revenue bonds: backed by project’s revenues or by the municipal agency operating the project.

Bond Market Securities

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Figure 2.4 Tax-Exempt Debt Outstanding

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Industrial revenue bonds 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 35 46 59 75 84 104 127 117 116 116.4 115.5 115.2 114 118.3 124.9 131.69999999999999 134.80000000000001 137.9 142 147.80000000000001 152.80000000000001 154.19999999999999 157.69999999999999 160.80000000000001 164.2 169.4 218.2 272.39999999999975 341.5 409.7 447.5 482.3 497.4 496.3 General obligation 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 293 303 318 347 381 409 536 591 668 725 794 839 901 1059.8 1124.9000000000001 1080.7 1027.5 1014.1 1063.0999999999999 1148.5 1167.0999999999999 1189 1294.5 1437.9 1557.9 1673 2569.5 2675.4 2804.7 2819.2 2922.1 2988.1 2939.3 2931.7

$ Billion

To choose between taxable and tax-exempt bonds, compare after-tax returns on each bond.

Let t equal the investor’s marginal tax bracket

Let r equal the before-tax return on the taxable bond and rm denote the municipal bond rate.

If r(1 - t ) > rm, then the taxable bond gives a higher return; otherwise, the municipal bond is preferred.

Municipal Bond Yields

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Table 2.2 Tax-Exempt Yield Table

The equivalent taxable yield is simply the tax-free rate, rm, divided by (1 - t).

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Corporate Bonds

Issued by private firms

Semi-annual interest payments

Subject to larger default risk than government securities

Options in corporate bonds

Callable

Convertible

Bond Market Securities

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Mortgage-Backed Securities

Proportional ownership of a mortgage pool or a specified obligation secured by a pool

Produced by securitizing mortgages

Mortgage-backed securities are called pass-throughs because the cash flows produced by homeowners paying off their mortgages are passed through to investors.

Most were issued by Fannie Mae and Freddie Mac

Bond Market Securities

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Mortgage-Backed Securities

Traditionally, were comprised of conforming mortgages, which met standards of credit worthiness

Later on, “Private-label” issuers securitized large amounts of subprime mortgages, made to financially weak borrowers

Fannie and Freddie were allowed and even encouraged to buy subprime mortgage securities

Bond Market Securities

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Figure 2.6 Mortgage-Backed Securities Outstanding

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Private issuers 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 278.2 326.3 406.2 563 592.5 659.1 773.4 870.6 1060.5999999999999 1443.7 2131.3000000000002 2767.5 2947.6 2587.1 2199.6999999999998 1901.4 1679.2 1623.2 Federal agencies 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 94.8 114 129 178.5 244.9 289 368.9 531.6 670.4 745.3 869.5 1019.9 1156.5 1272 1355.6 1472.1 1570.3 1711.4 1825.8 2018.4 2234.6999999999998 2493.1999999999998 2831.8 3158.6 3326.7 3374.6 3548.5 3841.1 4464.4000000000005 4961.4000000000005 5376.7 1139.5 1304.8 1329.9

$ Billions

Common stock: Ownership

Residual claim

Limited liability

Preferred stock: Perpetuity

Fixed dividends

Priority over common

Tax treatment

American Depository Receipts

Certificates traded in U.S. markets that represent ownership in shares of a foreign company

Equity Securities

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Dow Jones Industrial Average

Includes 30 large blue-chip corporations

Computed since 1896

Price-weighted average

Stock Market Indexes

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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%

Example 2.2 Price-Weighted Average

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Standard & Poor’s 500

Broadly based index of 500 firms

Market-value-weighted index

Investors can base their portfolios on an index

Buy an index mutual fund

Buy exchange traded funds (ETFs)

Stock Market Indexes

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Other Indexes

U.S. Indexes

NYSE Composite

NASDAQ Composite

Wilshire 5000

Foreign Indexes

Nikkei (Japan)

FTSE (U.K.; pronounced “footsie”)

DAX (Germany),

Hang Seng (Hong Kong)

TSX (Canada)

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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

Derivatives Markets

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Options

Call: Right to buy underlying asset at the strike or exercise price

Value of calls decreases as strike price increases

Put: Right to sell underlying asset at the strike or exercise price

Value of puts increase with strike price

Value of both calls and puts increases with time until expiration

Derivatives Markets

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Futures Contracts

An agreement made today regarding the delivery of an asset (or in some cases, its 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: Take delivery at maturity

Short position: Make delivery at maturity

Derivatives Markets

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Comparison

Option

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 position must buy at the futures price, short position must sell at futures price

Futures contracts are entered into without cost

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