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FIN 200 Investments

CHAPTER 2CHAPTER 2

Asset Classes

and

Financial Investments

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Major Classes of Financial Assets or Securities

Money market instruments Short-term, marketable, liquid, low-risk debt securities

Capital market instruments are more diverse Bond market (long term) Equity Securities Indexes Derivative markets (options and futures)

You had 1 week to do the reading so now it is time to participate. Explain the instruments above.

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The Money Market(a subsector of the fixed income market which trades in large amounts and out of reach of individual investors, but available

through pooled investments such as mutual funds) Treasury bills

Maturities of 28, 91 or 182 days Minimum denomination of $100 Income exempt from local and state tax in USA

Asked price = the price (slightly higher) you pay to buy a T-bill from a securities dealer

Bid price = the price (slightly lower price) you receive when you sell a T-bill to a securities dealer

The bid minus the ask is the dealer’s profit

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Figure 2.2 Treasury Bill YieldsNote in order

1.Maturity date2.Days to maturity3.Bid and Asked amounts4.The change from the previous day the markets were open5.The ask yield is the original amount of interest offered when sold the first time, prior to this resale offering.

The bill’s discount from par value is “annualized” based on a 360 day year (this practise dates to before computers and is used because 360 is easier to divide, having more multiples than 365)

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Bank discount methodA way to quote the price for bonds. It is calculated as the annualized yield assuming a 360 day year.

See explanation on previous slide.

Certificates of Deposits (time deposits)May not be withdrawn on demand but can be sold to another investor if the owner needs the cash before maturity. They are insured up to $100,00 in the event of bank insolvency in USA.

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Commercial PaperRather than borrow from banks, large corporations can issue short-term unsecured debt to a maximum of 270 days, but most often 30 or 60 days.Usually in multiples of $100,000 to money market funds.Because of the short term loans, investors have less risk.Question. Why is there less risk than some other investments?Read last paragraph of Commercial Paper page 26 and summarize it in your note books.

Bankers AcceptancesFor example: The bank gives me a letter (acceptance) agreeing to pay $100,000 to the bearer of the note (usually no longer than 6 months). I can trade the acceptance however I choose. The holder of the acceptance is as safe as the credit worthiness of the bank which promises to make the payment. The bank has taken the risk on their customer (me), which others may not have been willing to do.

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Repurchase Agreements (RPs) A securities dealer sells government securities to

an investor, over night, until the next morning agreeing to buy them back (the next morning) for more.

The investor makes a safe profit over night and the securities dealer uses the money, for some other reason.

The government securities serve as collateral.Question. Provide an example of when a transaction of this

sort may be used.

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Brokers’ CallsExample: some people borrow money to pay for stocks from their broker. The broker may borrow the money from the bank but agree to repay the bank immediately upon being asked (on call). This is a fast way for individuals to borrow money to invest. Question. Why would some people do this?Answer. Their own money is being used elsewhere and the extra cost of borrowing is considered ‘the cost of doing business’

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Federal FundsAll banks are required to keep a percentage of their own deposits (from their own customers) in the Federal Reserve Bank.Some banks may have more than necessary and some less, in which case, the banks with less, borrow from those with more. The loans are usually over night and repaid in the morning.The interest rate is called the ‘federal funds rate’.

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Definition of the Day U-Shaped Recover

What does it mean?A type of economic recession and recovery that resembles a "U" shape in charting. Specifically, a U-shaped recovery represents the shape of the chart of certain economic measures, such as employment, GDP and industrial output. A U-shaped recovery involves a gradual decline in these metrics followed by a gradual rise back to its previous peak. Compared to a V-shaped recovery, the U-shaped recovery takes longer to reach levels seen prior to the start of the recession.

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LIBOR MarketLondon Interbank Offered Rate (LIBOR)The LIBOR is the rate that large banks in London are willing to lend money to each other.Example. A large corporation may borrow money at the LIBOR rate plus 2%.Because the LIBOR changes, the rate that the corporation pays will also change. This is referred to a floating rate, because it changes.

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Figure 2.1 Rates on Money Market SecuritiesRemember that historical rates do not reflect past or future offers or returns.

Remember that in the 1980’s mortgage rates were as high as 18%, which made it possible for lenders to earn more than today and willing to pay more interest when borrowing, than today.

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Table 2.1 Major Components of the Money Market

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The Bond Market

• Treasury Notes and Bonds

• Inflation-Protected Treasury Bonds

• Federal Agency Debt

• International Bonds

• Municipal Bonds

• Corporate Bonds

• Mortgages and Mortgage-Backed Securities

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Treasury Notes and Bonds

Maturities

– Notes – maturities up to 10 years

– Bonds – maturities from 10 to 30 years

Par Value: denominations of $1,000 or more

Interest is paid semi annually (two times a year) and are called coupon payments (from before computers – tear off coupons)

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Figure 2.4 Lisiting of Treasury IssuesThe bid price of the note is 96 9/32 or 96.281

If the seller was willing to sell it for the bid of 96.281% of the par (what it can be redeemed for) then the cost would be $962.81 and it would pay 4.61% semi-annually and be redeemed for $1000 if held to maturity.

Conversely, if the buyer was willing to pay 96 10/32 or 96.3125% of the par value, then it would sell for 963.13 and pay 4.61% semi-anually and be redeemed for $1000 if held to maturity.

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The yield to maturity does not use the compounding method.

The yield to maturity is calculated by determining the semiannual yield and then doubling it, rather than compounding it.

Example. If the yield was 10%, the annual amount would be calculated and half paid every 6 months.

This is also referred to as the Annual Percentage Rate (APR).

This is also called the bond equivalent.

Questions. From Figure 2.4, what were the bid price, asked price, and yield to maturity of the 4¾ May 2014 Treasury note.What was its asked price the previous day?

Answer.

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Inflation-protected Treasury BondsLow riskLinked to an index of the cost of living to provide citizens with a good way to avoid having their money earn less than inflationIn the USA, one investment is called TIPS (Treasury Inflation-Protected Securities)The lower case letter i means that the bond is inflation indexed.

See chapter 14 for more about this topic

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Federal Agency DebtSome federal US agencies issue their own securities to finance their activities.

This occurs when Congress believes that a particular sector of the economy needs more funding than the private sector is able to provide at this time, in order to meet the needs of citizens.

Some of these agencies are government owned and free of default risk.

The agencies are not owned but sponsored. Sponsored agencies are not insured by the

government, but it is commonly accepted that the government would step in with assistance if the agency neared default.

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International BondsMany investors buy bonds that are issued in foreign countries.

London has a thriving international capital market.

ExampleA Eurobond is a bond in a currency other than that of the country from where it was issued.

A London issued bond, that is denominated in dollars is called a Eurodollar bond.

A Euroyen bond is a bond issued outside of Japan, issued in Yen.

It is best to simply think of these bonds as International Bonds.

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Municipal BondsIssued by state and local governmentsThey are similar to Treasury and corporate bonds but the interest income is exempt from federal income taxation and interest income in the issuing state.Capital gains must be paid on municipal “munis” when they mature or if sold for more than the purchase price.

Example. Purchase price is $950. redemption price is $1000. Interest earned is 5%. The capital gain is the $50 and is taxable, but the interest is not.

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Two types of municipal bonds include,

General Obligation Bonds Are backed by the “full faith and credit” of the issuer.

This means that the issuer has the ability to tax citizens, so the money to repay can be raised by taxation if the funds are not available.

Revenue Bonds Issued to finance projects which repay the debt from

the revenues of the project that they were issued to finance. Examples include airports, hospitals, and turnpike or port authorities. Revenue bonds are riskier than General Obligation Bonds.

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Industrial Development Bonds issued to finance commercial enterprises, such as

construction or a factory that will be operated by a private firm These bonds give the firm access to the municipality’s abi8lity

to borrow at a tax-exempt rate. The federal government limits the amount of these bonds that

may be issued. Investors do not pay state or federal tax so they are willing to

accept lower yields.

NOTE. See footnote 2 on page 31.Although interest on industrial development bonds usually is

exempt from federal tax, it can be subject to the alternative minimum tax if the bonds are used to finance projects of for-profit companies.

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Corporate BondsPrivate firms borrow money directly from the public.They are similar to Treasury issues and usually pay semiannual coupons over the life of the bond and then return the face value at maturity.The main difference is the degree of risk – default risk must be considered.Secured Bonds

Have specific collateral backing in the case of bankruptcyUnsecured Bonds

Called debentures and have no collateralSubordinated debentures

Have a lower priority claim to the firm’s assets in the case of bankruptcy

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Corporate Bonds (continued)

Callable bonds give a firm the option to repurchase (buy back) the fond from the holder at a stipulated price (agreed upon in the contract)

Convertible bonds give the bondholder the option to convert each into a stipulated number of shares of stock

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The history of mortgages

Historically, mortgages have been at fixed rates for long period (15 – 30 years) with fixed monthly payments from the borrower.

Banks traditionally issue a lot of shorter term loans (shorter loan periods than mortgages)

During periods when interest rates increased and the interest banks paid on the amount their customers had on deposit, the banks took a loss or suffered much smaller profits.

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Adjustable Rate Mortgage

Created by the lender (bank) to reduce the bank’s risk of decreased profits in times of increasing interest rates

The mortgage interest rate will vary, up or down, based on an agreed current market rate such a T-bills or the Prime Rate of the National Bank of Canada Example. The mortgage rate may be 2% higher than the

agreed market rate

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Because the risk has been shifted to the borrower, lenders are willing to offer lower rates, knowing that they will not risk decreased profit margins if interest rates climb.

A personal example

For the past 5 years, mortgage interest rates have been very low in Canada but have started to rise. I was paying between 1.9% and 3% between 2007 and 2011 but as rates began to increase, I changed from an adjustable rate which fluctuated monthly, and locked in at 4.5% fixed rate for the next 5 years.

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• Developed in the 1970s to help financial institutions to free up their own investments to make more loans

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

• Market has experienced very high rates of growth

Mortgages and Mortgage-Backed Securities

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Mortgage Backed Securities ownership claim in a pool of mortgages or an obligation that

is secured by such a pool Mortgage lenders (commonly banks) make the loans and

then sell packages of these loans in the secondary market. They sell the claim to the to the cash inflows from the

mortgages as the loans are paid off They sell the claim to the cash inflows (principal and interest)

fro mthe mortgages as the loans are paid off

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Mortgage Backed Securities

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

Mortgage lenders (commonly banks) make the loans and then sell packages of these loans in the secondary market.

They sell the claim to the to the cash inflows from the mortgages as the loans are paid off

They sell the claim to the cash inflows (principal and interest) fro mthe mortgages as the loans are paid off

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The bank continues to service the loan, collecting principal and interest payments and passes them along to the purchaser of the mortgage. This is why they are called pass throughs

Mortgage backed pass throughs were first introduced by the US Government National Mortgage Association (GNMA – Ginnie Mae) in 1970 and are guaranteed fro the US government to ensure payment even if the borrower defaults

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Although payment of principal and interest is guaranteed, the rate of return is not guaranteed

Holders of mortgage backed securities face the risk of poor return based on the following market fluctuations Adjustable rates affect the amount of interest collected Interest rates can drop from one year to the next year Homeowners have the option to prepay, or pay ahead of

schedule, the remaining principal outstanding on their mortgages.

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Figure 2.7 Mortgage-backed Securities Outstanding, 1979-2007

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Federal Agency Debt

• Major issuers

– Federal Home Loan Bank

– Federal National Mortgage Association

– Government National Mortgage Association

– Federal Home Loan Mortgage Corporation

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Municipal Bonds

• Issued by state and local governments

• Types

– General obligation bonds

– Revenue bonds

• Industrial revenue bonds

• Maturities – range up to 30 years

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Figure 2.5 Tax-exempt Debt Outstanding

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Municipal Bond Yields

• Interest income on municipal bonds is not subject to federal and sometimes not to state and local tax

• To compare yields on taxable securities a Taxable Equivalent Yield is constructed

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Table 2.2 Equivalent Taxable Yields Corresponding to Various Tax-Exempt

Yields

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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

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Equity Securities

• Common stock

– Residual claim

– Limited liability

• Preferred stock

– Fixed dividends -limited

– Priority over common

– Tax treatment

• Depository receipts

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Figure 2.8 Listing of Stocks Traded on the NYSE

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• There are several broadly based indexes computed and published daily

• There are several indexes of bond market performance

• Others include:

– Nikkei Average

– Financial Times Index

Stock Market Indexes

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Dow Jones Industrial Average

• Includes 30 large blue-chip corporations

• Computed since 1896

• Price-weighted average

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Example 2.2 Price-Weighted Average

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%

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• Broadly based index of 500 firms

• Market-value-weighted index

• Index funds

• Exchange Traded Funds (ETFs)

Standard & Poor’s Indexes

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Other U.S. Market-Value Indexes

• NASDAQ Composite

• NYSE Composite

• Wilshire 5000

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Figure 2.9 Comparative Performance of Several Stock Stock Indexes, 2001-2006

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Foreign and International Stock Market Indexes

• Nikkei (Japan)

• FTSE (Financial Times of London)

• Dax (Germany)

• MSCI (Morgan Stanley Capital International)

• Hang Seng (Hong Kong)

• TSX (Canada)

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Derivatives Markets

Options

• Basic Positions

– Call (Buy)

– Put (Sell)

• Terms

– Exercise Price

– Expiration Date

– Assets

Futures

• Basic Positions

– Long (Buy)

– Short (Sell)

• Terms

– Delivery Date

– Assets

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Figure 2.10 Trading Data on GE Options

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Figure 2.11 Listing of Selected Futures Contracts