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Asset allocation
Security selection
--- introduce you to the important
features of broad classes of securities
Financial markets --- segmented into
money markets and capital markets
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Money Market (short-term, low-risk debt )
Treasury bills
Certificates of deposit
Commercial paper
Bankers acceptances
Eurodollars
Repos and reverses
Brokers calls
Federal funds
LIBOR (London InterBank Offer Rate)
Capital Market (long-term and riskier securities)
Bond Market
Treasury notes and bonds
Treasury Inflation Protected Securities (TIPS)
Federal agency debt
International bonds
Municipal bonds
Corporate bonds
Mortgages and mortgage-backed securities
Equity Market
Common stocks
Preferred stocks
Depository Receipts
Derivative Market
Options
Futures
Debt Market
Equity Market
Derivative Market
Treasury debt
--money market instruments
--capital market instruments
Non-Treasury debt
--money market instruments
--capital market instruments
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Debt Market
Money market:
Treasury Bills: <= 1 year; zero coupon
---Short-term government securities with maturities ranging from 4
weeks to 52 weeks. (4, 13, 26, 52 weeks)
---Bills are sold at a discount from their face value.
Capital market:
Treasury Notes: 1-10 years; semiannual coupon
Treasury Bonds: 10-30 years; semiannual coupon
Treasury Inflation Protected Security (TIPS): 5, 10, 30 years;
semiannual coupon
hedge inflation risk
---par value increases with inflation, which is measured by Consumer
Price Index
---While the interest rate remains fixed, the coupon payment varies
with inflation
http://treasurydirect.gov
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Money market:
Commercial Paper = short-term unsecured debt issued by large
corporations (maturities up to 270 days; longer maturities require
registration with SEC)
Certificates of deposit = (or fixed deposit, term deposit), time
deposits with a bank
Eurodollars = dollar-denominated time deposits in banks outside the
U.S. (foreign banks or foreign branches of American banks)
LIBOR = (London InterBank Offered Rate), the rate at which large
banks in London are willing to lend money among themselves.
Bankers Acceptances = An order to a bank by a banks customer to
pay a sum of money on a future date, typically within 6 months.
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Money market:
Repos and Reverses: Short-term loan backed by
government securities.
--- Repos:::Repurchase agreements
--- 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; It is
like a 1-day loan from the investor.
--- Reverse repos :::The dealer buys the government
securities from an investor and agree to sell them back at a
specified higher price on a future date.
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Federal Funds:
---Each member bank in the Fed system is required
to maintain a minimum balance in a reserve account
with a Fed reserve bank.
---Funds in the banks reserve account are called
federal fund.
---Some banks have more funds than required;
Some banks have a shortage of fed funds.
---Banks with excess funds lend to those with a
shortage
---Very short-term loans between banks with federal
funds rate.
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Capital market:
International Bonds: firms borrow abroad and investors buy bonds
from foreign issues.
For example,
---Eurobonds, a bond dominated in a currency other than that of the
country in which it is issued. A dollar-dominated bond sold in London
would be called Eurodollar bond
---Samurai bonds, yen-dominated bond sold in Japan by non-Japanese
issuers
---Yankee bonds, dollar-dominated bond sold in the united states by
non-U.S. issuer
---Dim Sun bonds, Chinese yuan-dominated bond issued in Hong Kong.
Fund their operations in China and to reduce their foreign exchange
risks.
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Municipal Bonds: issued by state and local governments in U.S.
---interest income is exempt from federal income taxation
---interest income is exempt from state income taxation in the
issuing state
Corporate Bonds: issued by private firms.
---Semiannual coupon( annual payments in some countries)
---Subject to larger default risk than government securities
high yield
---options in corporate bonds: Callable, Convertible
Federal Agency Debt: Debt of mortgage-related agencies such
as Fannie Mae and Freddie Mac.
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Mortgage-backed securities or mortgage pass-through
--- Mortgage loans are bought by agencies and bundled into a large pool
that could be traded like a security.
--- Cash flows: homeowner (principle and interest payment)
originator(banks) agency (such as, Freddie Mac or Fannie Mae)
investor (mutual fund, hedge fund, pension fund, et.)
--- conforming mortgages, the loans must satisfy certain underwriting
guidelines (standards for the creditworthiness of the borrower)
--- subprime mortgages, riskier loans made to financially weaker
borrowers
--- Fannie and Freddie were allowed and even encouraged to buy
subprime mortgage loans.
---Sep,2008: Fannie and Freddie got taken over by the federal government.
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How to choose?
1. Compare after-tax returns on each bond
2. Compute Equivalent Taxable Yields for
tax-exempt bond and compare it with the
before-tax rate of the taxable bond
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2-6
( )
1
m
r tax r =
: before tax return on taxable bonds
: marginal tax rate
: return on municipal bonds
m
r
tax
r
1
m
r
r
tax
=

Equivalent taxable yields:

Rich people Marginal tax rate is high
equivalent taxable yield is high tend to
hold municipals
Suppose your tax bracket is 30%.
Would you prefer to earn a 6% taxable return
or a 4% tax-free return?
What is the equivalent taxable yield of the 4%
tax-free yield?
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Common stock
Preferred stock
American/Global Depository Receipts
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Ownership stake in a corporation
Residual claim
--stockholders are the last in the line of all those who have a
claim on the assets and income of the corporation.
--claim to what is left after all other claimants such as the tax
authorities, employees, suppliers, bondholders, and other
creditors are paid off.
Limited liability
-- The most the stockholders can lose in the event of failure of
the corporation is their original investment in the stock.
-- if your equity value is $500, the most money you can lose is
$500.
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Capital Gains and Dividend Yields
You buy a share of stock for $50, hold it for one year, collect a
$1.00 dividend and sell the stock for $54. What were your
dividend yield, capital gain yield and total return? (Ignore
taxes)
Dividend yield: = Dividend / P
buy
$1.00 / $50 = 2%
Capital gain yield: = (P
sell
P
buy
)/ P
buy
($54 - $50) / $50 = 8%
Total return: = Dividend yield + Capital gain yield
2% + 8% = 10%
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Equity investment
No voting rights
The firm promises to pay its holder a fixed
amount of income each year as dividend
The firm has no contractual obligation to pay
those dividends.
However, the unpaid dividends to preferred stock
holders must be paid in full before any dividends
may be paid to holders of common stock.
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Common stock Preferred Stock Bond
Have voting right
Yes
(one share, one
vote)
No No
Fixed stream of income
(dividends or coupon)
No Yes Yes
Payment obligation
(dividends or coupon)
No No Yes
Tax-deductible for the firm?
(dividends or coupon)
No No,
In US, 70% of dividends
received from domestic
corporations is
excluded from firm
taxable income
Yes
Priority of claim when liquidating 3 2 1
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Measure the performance of the stock market
Dow Jones Industrial Average (DJIA)
Includes 30 large blue-chip corporations: a corporation with a national reputation for quality, reliability, and the ability to operate
profitably in good and bad times.
Computed since 1896
Price-weighted average index
Standard & Poors Indexes ( S&P 500)
Broadly based index of 500 firms
Market-value-weighted index
NASDAQ Composite
An index of more than 3000 firms traded on the NASDAQ market
Market-value-weighted index
NYSE Composite
An index of all firms listed in NYSE
Market-value-weighted index
Wilshire 5000 index
An index of the market value of essentially all actively traded stocks in the U.S.
Market-value-weighted index
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How are stocks weighted average in the index?
Price weighted Average(DJIA)
invest 1 share in each stock in an index portfolio, the investment in
each stock in that portfolio is proportional to the stock price.
index is the value of the portfolio divide by the number of stocks in the
portfolio
DJIA was computed as the average of the 30 stock prices originally.
Market-value -weighted average (S&P500, NASDAQ Composite,
NYSE Composite, Wilshire5000)
investment in each stock in the index portfolio is proportional to the
market value of each stock
Equally weighted average (Value Line Index)
= invest $1 in each stock in the index portfolio
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Hypothetical two-stock version of the DJIA
Price weighted index
Initial index value: (25+100)/2=62.5
Final index value: (30+90)/2=60
Percentage change in index =return= (60-
62.5)/62.5=-4%
Stock Initial
Price
Final
Price
Outstanding
Shares
Initial
market Value
Final
market Value
A $25 $30 20 million $500 million $600 million
B $100 $90 1 million $100 million $90 million
Total $600 million $690 million
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-- A index portfolio consists of stock A and B which are held in
proportion to their market value
Initial market value of the portfolio: $500M+$100M =$600 M
Final market value of the portfolio: $600M+$90M =$690M
If the initial level of a market-value-weighted index of stocks A and B
were set equal to a chosen starting value such as 100,
The final index value would be = 100*690/600=115
The index increases (115-100)/100=15% = return of the index
portfolio
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-- invest 1 dollar in each stock in the index portfolio
Initial value of the portfolio: $1+$1 =$2
Final value of the portfolio:
($1/25)*$30+($1/100)*$90=$2.1
If the initial level of an equally-weighted index of stocks A
and B were set equal to a chosen starting value such as
100,
The final index value would be = 100*2.1/2=105
The index increases (105-100)/100=5% = return of the
portfolio
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
based on the values of another asset.
Options and futures provide payoffs that
depend on the values of other assets such as
commodity prices, bond and stock prices, or
market index values.
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Call option: right to purchase an asset for a specific strike
price (X), on or before some specified expiration date (T).
Put option: right to sell an asset for a specific strike
price (X), on or before some specified expiration date (T)
European Option: you have to exercise the option at
the expiration date (T).
American Option: you can exercise the option any time before
the expiration date (T).
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A Dec. 31st, 2009 expiration call option on a share of IBM with an
exercise price $100 was selling on Jan. 1st, 2009, for $5 (option
price)
T: expire on Dec.31, 2009
X: exercise price = $100
S
0
: current stock price = $101
C: option price = $5 (initial investment)
S
T
: stock price on expiration date
( )
( )
( )
if $110 110 10 10 / 100%
if $105 Payoff 105 5 Return 5 / 0
i
5 1
f $100 0 0 / 10
5
5 5
5 5
1 0
0
0
%
00
T
T
T
S
S
S
= = =


= = = = =


< =


Example of a European Call Option
What is the return if you buy one share of stocks initially?
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What is the return if you buy one share of
stock initially?
S
0
: current stock price = $101
S
T
: future stock price = $110, or 105, or
$100
Return = (S
T
- S
0
)/ S
0
=>(110-101)/101=9/101
=>(105-101)/101=4/101
=>(100-101)/101=-1/101
A Dec.31st, 2013 expiration put option on a share of
Google with an exercise price $880 was selling on Jan.
1st, 2013, for $10 (put option price)
T: expire on Dec. 31st, 2013
X: exercise price = $880
S
0
: current stock price = $882
C: option price = $10 (initial investment)
S
T
: stock price on expiration date
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_
i S
1
= $9uu
i S
1
= $87u
i S
1
= $8Su
Poyo =_
u
88u - 87u = 1u
88u - 8Su = Su
Return =
0-10
10
= -1uu%
10-10
10
= u
30-10
10
= 2uu%
A futures contract calls for delivery of an asset (or in some
cases, its cash value) for an agreed-upon price (X, called
futures price), at a specified delivery or maturity date (T).
-- Long position: who commits to purchasing the asset on
the delivery date,
-- short position: who commits to delivering the asset on the
delivery date.
Two distinctions between options and futures:
--Option (right to buy/sell)
-- Futures (obligation to buy/sell)
---Option (must be purchased)
--- Futures (free to enter into a futures contract)
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A long position trader enters a corn futures
contract on Oct.16
th
, 2012
Each contract calls for delivery of 5000 bushels
of corn on Dec, 2012.
The future price is 3.7125 per bushel
At contract maturity, corn is selling for 3.9125
per bushel.
The profit of the long position trader =
5000*($3.9125-$3.7125)=$1000
The short position trader lost $1000.
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Money market vs. capital market
T-bills/notes/bonds
Commercial paper, Eurodollars, International
/corporate bonds
Municipal bonds: Equivalent taxable yields
Preferred stock vs. common stock / bond
Stock market index (price/value/equal-
weighted)
Option and futures
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