Chapter 2: Asset Classes and Financial Instruments

2.1 The Money Market

 Money market is a subsector of the fixed income market, consists of short term debt
securities that are highly marketable
 Treasury Bills- most marketable of all money market instruments
o T-Bills are highly liquid, not much price risk, income is exempt from state and local
taxes
o Asked price- price you would have to pay to buy a T-Bill from a securities dealer
o Bid price- slightly lower price you would receive if you wanted to sell a bill to a
dealer
o Bid-asked price- difference in prices which is the dealers source of profit
o Bank discount method- bills discount from its maturity or face value is “annualized”
based on a 360 day year and then reported as a percentage of face value.
 2 flaws:
 Assumes year only has 360 days
 Compute yield as a fraction of par value rather than of the price the
investor paid to acquire the bill
o Bond equivalent yield- annualizing return using a 365 days year
 Certificate of Deposit (CD)- time deposit with bank
o Bank pays interest and principle at the end of the fixed term
o Insured up to $250,000 by FDIC
 Commercial Paper- short term unsecured debt notes issued by large well known companies
o Backed by a bank line of credit
o Usually issued with maturities of less than 1-2 months
o There has been increase in asset backed commercial paper issued by financial firms
 Bankers’ Acceptances- 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
o Bank accepts, is responsible for payments. Acceptance can be traded
 Eurodollars- dollar dominated deposits at foreign banks or foreign branches of American
banks.
o Escape regulation of Fed
o Advantage of Eurodollar CDs over Eurodollar time deposits is that the holder can sell
the asset to realize its cash value before maturity
o Eurodollar CDs are less liquid and riskier than domestic CDs, thus offering higher
reward
 Repos and Reserves- form of short term, usually overnight borrowing
 o 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.
o Increase in price is overnight interest
o Term repo- same as repo but term of implicit loan can be 30 days or more
o Repos considered safe since loans are backed by government securities
o Reverse repo- mirror image of a repo; dealer finds investor holding government
securities and buys them agreeing to sell them at a specific higher price on a future
date.
 Federal Funds – funds in the bank’s reserve account
 Brokers’ Calls- Individuals who buy stocks on margin borrow part of the funds to pay for the
stocks from their broker Broker may borrow funds from a bank, agreeing to repay the bank
immediately (on call) if bank requests it
 London Interbank Offered Rate (LIBOR)- rate at which large banks in London are willing to
lend money among themselves
 Yields on Money Markets Instruments
o Securities of the money market promise greater yields than on T-bills because of
greater risk

2.2 The Bond Market

 Composed of longer term borrowing or debt instruments than those that trade in the money
market; includes treasury notes and bonds, corporate bonds, municipal bonds, etc
 Instruments are sometimes said to compromise the fixed income capital market because most
of them promise either a fixed stream of income or a stream of income that is determined by
a specific formula
 Treasury Notes and Bonds
o Notes and bonds make semiannual payments called coupon payments
o Yield to maturity- calculated by determining the semiannual yield and then doubling
it
 Inflation Protected Treasury Bonds
o Called TIPS (Treasury Inflation-Protected Securities)
o Principal amount of these bonds is adjusted in proportion to increases in Consumer
Price index so they provide constant stream of income in real dollars
o Yields on TIPS bonds should be interpreted as real interest rates
 Federal Agency Debt
o Formed to channel credit to a particular sector of the economy that Congress believes
might not receive adequate credit through normal private sources
 International Bonds
o Eurobond- bond dominated in a currency other than that of the country in which it is
issued
 Municipal Bonds- issued by state and local governments
 o Interest income is exempt from federal income taxation and state and local taxation in
the issuing state
o Two types of municipal bonds:
 General obligation bonds- backed by the hull faith and credit of the issuer
 Revenue bonds- issued to finance particular projects and are backed either by
the revenues from the project or by the particular municipal agency operating
that project. Ex: hospitals, port authorities, airports
 Industrial development bond- revenue bond that is issued to finance
commercial enterprises, such as the construction of a factory that can be
operated by a private firm
 Give firm the access to the municipality’s ability to borrow at tax exempt rates
but limited how many of these bonds can be issued
 Tax anticipation notes- short term notes; raise funds to pay for expenses
before the actual collection of taxes
 Key feature of municipal bonds is their tax exempt status
o Equivalent taxable yield- rate a taxable bond must offer to match the after tax yield
on the tax free municipal
 r(1-t)=rm
 If the equivalent taxable field exceeds the actual yields offered on taxable
bonds, the investor is better off after taxes holding municipal bonds
 High tax bracket investors tend to hold municipals
 Yield ratio rm/r is a key determinant of the attractiveness of municipal bonds;
higher the yield ratio the lower the cutoff tax bracket and the more indivudals
will prefer to hold municipal debt
 Corporate Bonds- means by which private firms borrow money directly from the public
o Typically pay semiannual coupons over their lives and return the face value to the
bondholder at maturity
o Secured bonds- have specific collateral backing them in the event of firm bankruptcy
o Unsecured bonds (debentures)- have no collateral
o Subordinated debentures- lower priority claim to the firm’s assets in the event of
bankruptcy
o Callable bonds- give firm option to repurchase the bond from the holder at a
stipulated call price
o Convertible bonds- give bondholder the option to convert each bond into a stipulated
number of shares of stock
 Mortgages and Mortgage Backed Securities
o Mortgage backed security- ownership claim in a pool of mortgages or an obligation
that is secured by such a pool
o Mortgage lenders originate loans and then sell packages of these loans in the
secondary market. They sell claim to the cash inflows from the mortgage as loan is
 paid off. Originator continues to service the loan, collecting principle and interest
payments, and passes these payments to the purchaser of the mortgage; Called pass
throughs
o Conforming mortgages- loans must satisfy certain underwriting guidelines before
they are purchased by Fannie Mae or Freddie Mac
o Subprime mortgages- riskier loans made to financially weaker borrowers were
bundled and sold by private label issuers

2.3 Equity Securities

 Common Stocks as Ownership Shares

o Common stocks- represent ownership shares in a corporation
o In closely held companies, owners of the firm take an active role in management
 Characteristics of Common Stock
o Residual claim- stockholders are the last in line of all those who have a claim on the
assets and income of the corporation
o Limited liability- most shareholders can lose in the event of failure of the corporation
is their original investment
 Stock Market Listings
o Dividend yield is only part of return on stock investment; ignores prospective capital
gains
o Price-earnings ratio- ratio of the current stock price to last year’s earnings per share;
tell us how much stock purchasers must pay per dollar of earnings that the firm
generates
 Preferred Stock
o Promises to pay holder fixed amount of income each year, is perpetuity.
o Firm has no obligation to pay dividends, preferred dividends are cumulatice
 Depositary Receipts
o Certificates traded in the US market that represent ownership in shares of a foreign
company
o ADR-American Depositary Receipt

2.4 Stock and Bond Market Indexes

 Dow Jones Averages

o Consists of 30 large “blue-chip”corporations
o Is price weighted average- correspons to a portfolio that holds a single share from
each corporation and is proportional to the company’s share price
 Standard & Poor’s Indexes
o More broadly bases index of 500 firms
o Market value weighted index
 o Computed by calculating the total market value of the 500 firms in the index and the
total market value of those firms on the previous day of trading
o Most markets today weight by the market value of free float, or by the value of shares
that are freely tradable among investors
o Index funds- yield a return equal to that of the index and provide a low cost passive
investment strategy for equity investors
o Exchange traded fund (FTF) – portfolio of shares that can be bought or sold as a unit
 Other US Market Value Indexes
o NYSE- published market value weighted composite index of all listed stocks; more
broadly based than S&P 500.
o NASDEQ
o Wilshire 5000- index of market value of all actively traded stocks in the US
 Equally Weighted Indexes
o Market performance sometimes measures by an equally weighted average of the
returns on each stock in the index
 Foreign and International Stock Market Indexes
o MSCI (Morgan Stanley Capital International) – computes over 50 country indexes
and several regional indexes
 Bond Market Indicators
o Three well known groups of indexes are those of Merrill Lynch, Barclays (formerly,
Lehman Brothers) and Salomon Smith Barney (now part of Citigroup)
o Major problem is that the true rates of return on many bonds are difficult to compute
because the infrequency with which the bonds trade makes reliable up to date prices
difficult to obtain.

2.5 Derivative Markets

 Derivative Assets- instruments that provide payoffs that depend on the values of other assets
such as commodity prices, bond and stock prices or market index values.
 Options
o Call option- gives holder the right the purchase an asset for a specified price, called
the exercise of strike price on or before the specified expiration date
o Put option- gives holder the right to sell an asset for a specified exercise price on or
before a specified expiration date.
 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
 Long position- held by trader who commits purchasing the asset on the delivery day
 Short position- commits to delivering the asset at contract maturity
 Futures contract obliges the long position to purchase the asset at the futures pice; call option
conveys the right to purchase the asset at the exercise price
 Purchase price of the option is called the premium