Ch.2 Asset Classes and Financial Instruments

• 1. Money markets is a subsector of debt markets with short-term, highly liquid, and relatively low risk debt instruments. (Figure 2-1)

• 1) Treasury bill: short term government securities issued at a discount from face value and returning the face amount at maturity.

• - initial maturity: 4, 13, 26 or 52 weeks. • - denomination: minimum is $100. $10000 is

common.• - exempt from state and local tax

• Asked price: you have to pay to buy T-Bill from dealers.• Bid price: price you would receive when you sell T-Bill to

dealers.• Price information is reported using the bank-discount

method (360 days in a year). It means that the bill’s discount from par value is annualized based on 360 day year, then reported as a percentage of par value.

• e.g) Asked 0.07 means dealers are willing to sell T-Bill at a discount of 0.07%*(245/360) = 0.0476%. Price is 10000*(1-0.000476) =$9,995.236

maturity Days to mat

Bid Asked CHG Ask yield

Mar 08 12

245 0.085 0.070 0.005 0.071

• Bid 0.085 means that dealer is willing to buy T-bill at [1-0.00085*(245)/360]=9994.215.

• Asked Yield (Bond-equivalent yield): return you will receive if you purchase at a asked price and hold a T-Bill until maturity, based on 365 day-year. In our example, 10000/9995.236 -1 = 0.000477 or 0.0477%. Then 0.0477%*365/245=0.71%%.

• 2) Certificates of Deposit: bank time deposit. It can not be withdrawn on demand until maturity. At the maturity, the holder will receive principal amounts and interest.

• - maturity : 3months or more.• - FDIC insures up to $100,000 in the event of bank

insolvency.

• 3) Commercial paper (CP): short term unsecured debt issued by large Corporations.

• - maturity: up to 270 days. Longer maturity need registration. Common maturity is less than 2 months.

• - common denomination: $100,000.• Asset backed commercial paper: commercial

paper is issued to buy an asset. The asset is collateral of that commercial paper.

• 4) Bank acceptance: an order to a bank by a customer to pay a sum of money in the future, typically within 6 months.

• Acceptance and payment of money must be endorsed by bank.

• Acceptance sells at a discount from the face value of the payment.

• 5)Eurodollar: dollar denominated deposits at foreign banks and foreign branch at American Bank. Most of Eurodollar is a time deposit of a less than 6 month.

• - escape regulation from Federal Reserve Board.• - Eurodollar CD• - Eurodollar bond: dollar-denominated bonds outside the US.

• 6) Repos and Reverses• Repurchase agreements (repos): short term sales of

government securities with an agreement to repurchase the securities at a higher price. Generally it is sold on an overnight basis.

• Term repo: terms of loan can be 30 days or more.• Reverse repo: buying government securities with an

agreement to resell them to original holders.

• 7) Brokers’ calls: In a margin contract, a broker borrow funds from banks and agree to pay back immediately when banks call. It is one point + rate on short term T-bill. (One basis point = 0.01%)

• 8) Federal Funds: Each member bank of Federal Reserve System is required to maintain a minimum balance in a reserve account with the Fed. Funds in the bank’s reserve is call “Federal Funds or Fed Funds.” Some banks with more fed funds than a required amount lend the fund to other banks with a shortage at a rate called federal funds rate (similar to the rate of the short term loans). It evolves to a short term source of financing - overnight.

• 9) LIBOR market• LIBOR: lending rate among banks in the London market.

It is commonly quoted as a reference rate for short term borrowing. E.g) LIBOR + 2 points.

• EURIBOR (European Interbank Offer Rate): Euros lending rate among banks in the euro zone.

10 ) Yields on Monday Market InstrumentsMoney market securities yield greater than those on default-free T-bill. This difference is called “(risk) premium.” That premium increases with economic crises.- TED spread: difference between the LIBOR and the Treasury-bill rate.

2. 2 Bond Market• Market for long term borrowing or debt instruments.

• 1) Treasury notes and bonds: debt obligations of the federal government with original maturities of 1 year or more.

• - T- notes are issued with original maturities ranging up to 10 years while T-bonds are issued with maturities ranging 10 to 30 years.

• - common denomination: $1000• - semi annual coupon payment• - bid and asked prices are quoted at 1/64 of a point (tick

size) and as a percentage of par value ($1000).• E.g) 112.9375 means 112+60/64 =112.9375. Actual

bond price is $1129.375. -0.438 change means price decreased by 0.438% of $1000.

• 2) Inflation-protected T-Bonds (TIPS): The principal amount on these bonds is adjusted on proportion to increase in the consumer price index. Cash flow to lenders is adjusted to reflect inflation. If you hold this to maturity, the real interest rate you earn is risk free rate.

• - i means TIPS in a quotation table. • 3) Federal agency debt: Debts issued by government

agencies to finance their activities. • Mortgage related agencies: Federal Home Loan Bank

(FHLB), Federal National Mortgage Association (FMA, or Fannie Mae), etc

• 4) International Bonds.• - Eurobond: a bond denominated in a currency

other than that of the country where it is issued. e.g) Eurodollar bond is a dollar-denominated bond traded outside US.

• - Yankee bond: a dollar denominated bond traded at US but issued by non-US issuers.

• -Samurai bond: a yen denominated bond traded at Japan but issued by non-Japanese issuers.

• 5) Municipal bonds issued by state and local governments.

• - Tax exemption from federal level, issuing state, and local level.

• - Capital gains is taxed.• - General obligation bond is a bond backed by full faith

and credit of the issuer.• - Revenue bond is a bond backed by revenue from the

project or municipal agency operating the project. It is riskier than general obligation bond. E.g) construction of airport, hospital, ect.

• - Industry development bond is a revenue bond in which the project is operated by private firm.

- Maturity: except for tax anticipation note, muni bonds generally are long term up to 30 years.

- Tax anticipation notes: short term notes issued to pay expenses before actual tax collection.

- How to convert tax exempt yield (rm) to equivalent taxable yield (r)?

r(1-t) =rm

r=rm/(1-t)t=1-rm/r

Here rm/r is called a “yield ratio.” the higher the yield ratio, the lower the cutoff tax bracket and the more individuals will prefer municipal bonds.

• 6) Corporate bonds: long term debt issued by private corporation typically paying semi-annual coupons and returning the face value at maturity.

• - default risk.• - secured bonds vs unsecured bonds

(debenture)• - callable bond vs convertible bond

• 7) Mortgage and mortgage backed securities• Most mortgage comes with fixed interest rate and

monthly payment over the life of mortgage • Fixed rate mortgage vs Adjustable rate mortgage. • Mortgage backed security: ownership claim in a

pool of mortgage or an obligation that is issued by such a pool. The mortgage originator continuously services the loan, collects principal and interest payments and pass these payments to purchasers of mortgage backed securities. It is a reason why mortgage backed securities are called “pass-throughs.”

• Conforming mortgage vs Subprime mortgage

2.3 Equity market

• 1) Common stock• (1) Ownership shares in a publicly held

corporation. Shareholders have voting rights and may receive dividends.

• - proxy votes• - residual claims• - limited liabilities

• (2) stock market listings• Figure 2.8• - SYMBOL: • - CLOSE: closing price• - CHG: changes from previous day’s price• - VOLUME: number of the stock traded• -DIV: annualized dividend payment• -YIELD: dividend yield• -P/E: current stock price to last year’s earnings.• -YTD%CHG: percentage price change since the beginning

of the year.

• 2) Preferred stock: non-voting shares in a corporation, usually paying a fixed stream of dividends.

• - cumulative• - non-tax deductible dividend• - redeemable preferred stock: a company can call back

its preferred stocks.

• 3) Depository Receipts (ADR): certificates traded in US markets that represent ownership in shares of a foreign company. It is a common way for US investors to invest in foreign firms.

2.4. Market index

• Dow Jones Industrial Average (DJIA): price-weighted average of 30 large, blue-chip corporations since 1986.

• Price-weighted average: adding prices of individual stocks / divisor. The divisor is the number of stocks composing index but adjusted to reflect the stock split or stock dividends. It is like a portfolio composed of only each stock for each firm.

• Example 2.2 at page 41

Initial price Final price Shares I-value F-value

• ABC 25 30 20 500 600• XYZ 100 90 1 100 90

• Initial index = (25+100)/2 = 62.5• Final index= (30+90)/2=60• % change = (60-62.5)/62.5= - 4%

• If XYZ has a stock split (to 2), • (25+(100/2))/ d = 62.5. here d is new divisor.

• 2) Standard & Poor’s index: market value weighted index of large size (cap) 500 firms.

• Market value weighed: a weighted average of returns of each security with weights proportional to outstanding market value.

• • Ex) using the previous tables• Initial market value weighted number= 500+100 =600• Final market value weighted number= 600+90 =690• Change is (690-600)/600 = 15%.• If a previous day’s index is assumed to be 100, today market

valued weighted index is 100*(1+0.15) = 115.

• - not influenced by stock split.• - not include dividends

• 3) Other US market value index: NYSE, NASDAQ, Wilshire 5000.

• 4) Equal weighted index: computed from simple average of returns. It is a portfolio placing equal dollar values in each stock and is not responding to buy and hold portfolio strategies. That is, if one of securities lost its value, you need to rebalance by buying the value losing securities.

• 5)Foreign and International Stock Market - Index:

- Nikkei (Japan), FTSE (UK), DAX (Germany), Hang Seng (Hong Kong), and TSX (Toronto).

- MSCI (Morgan Stanley Capital International) reflecting international markets. Table 2.6.

• 6) Bond market indicators: Merrill Lynch, Barclays(former Lehman Brothers), Salomon Smith Barney.

• 2.5 Derivative markets• Derivative asset or contingent claim: a security with

a payoff that depends on the prices of other securities.

1) Call option: the right to buy an asset at a specified prices on or before a specified expiration date.

• - Each option contract is for the purchase of 100 shares, with quotations made on a per share basis.

2) Put option: the right to sell an asset at a specified exercise price on or before a specified expiration date to the put option writer.

• E.g) Figure 2.9• Strike: Strike/Exercise price of an underlying asset• Last: the last price of an option to purchase one

underlying asset. Thus quoted price * 100.• Trading volume: the number of traded option contracts.• Open interest: the number of outstanding option

contracts• Features: (1) negative (positive) relationship between a

call (put) option price and underlying asset price. (2) positive relationship between an option price and the time to be expired.

• 3) Futures contracts obligates traders to purchase or sell an asset at an agreed-upon price at a specified future price.

• E.g) Corn. Each contract delivers 5000 bushels. Future contract is priced at 1/8 cent after apostrophe. That is, 672’2 means $672/100+2/800 = $6.7225 per bushel. Price of corn is 5000* quoted price. (Figure 2.10)

• - margin account.

• 4) difference between option and futures contracts• - right and obligation• - option should be purchased but futures is contracted.