Chapter 2

Global Financial Instruments
2
Major Classes of
Financial Assets/Securities

Debt

Money market instruments

Bonds

Common stock

Preferred stock

Derivative securities
3
Financial Markets
Financial
Markets
Foreign Exchange
Market
Derivatives
Traditional
Financial
Markets
(Long-term)
Capital
Market
(Short-term)
Money
Market
T-ills
CD
C!
"
#epos$#everses
Federal %&nds
L'(# market
onds
Stocks
T-)otes$onds
M&nicipal *onds
Corporate onds
"S$MS
+hole sales market
#etail market
For,ard
F&t&res
(ption
S,ap
4
Money Market Instruments 1

!ort"term# marketable# lo$"risk securities
– Cas! e%uivalents

&reasury bill '&"Bill(
– !ort"term 'less t!an one year( )ov*t securities sold at a
discount and +ayin) off t!e face value at maturity
– Discount rate needs to be converted to a bond e%uivalent yield
'ee e,am+le later(
– &a,"e,em+t from all state and local ta,es# but not from fed ta,es
– Issued in auction markets- Com+etitive vs. noncom+etitive bids

Certificates of de+osit 'CD(
– &ime de+osit $it! a bank# +ayin) off interest and +rinci+al at
maturity# and ne)otiable before maturity
– &reated as a bank de+osit by t!e FDIC 'insured for u+ to
/011#111(
2
Money Market Instruments 2

3urodollars
– Dollar"denominated time de+osits at forei)n banks# $it! a
maturity less t!an 4 mont!s
– 3urodollar CD is a variation t!at is ne)otiable before maturity

Commercial Pa+er 'CP(
– !ort"term unsecured debt issued by a lar)e cor+. in
denomination of /011#111
– Fairly safe# but can default.
– 5ated by a ratin) a)ency suc! as 6P# Moody*s# etc.

Bankers* 7cce+tances 'B7(
– 8idely used in forei)n trade 'im+ort9e,+ort(
– 7 customer*s order acce+ted by a bank to make a +ayment at a
future date
– ells at a discount in secondary markets
4
Money Market Instruments 3

5e+urc!ase 7)reements '5Ps( and 5everse 5Ps
– !ort"term 'overni)!t( sales of )ov*t securities by dealers $it! an
a)reement to re+urc!ase t!em later at a !i)!er +rice
– It is like a 9& lo$"risk loan $it! t!e securities !eld as collateral
– 7 reverse re+o $orks in t!e o++osite direction

Federal Funds
– Banks* de+osits at t!e Federal 5eserve Bank to maintain a
re%uired minimum balance
– Banks $it! e,cess funds lend to t!ose $it! a s!orta)e at a rate
of t!e Federal fund rate 'Fed fund rate(

:IB;5 Market
– :IB;5- lendin) rate amon) lar)e banks in :ondon
– erve as a reference rate for a $ide ran)e of transactions
<
Discount Rate vs.
on! "#uivalent $iel!

Discount 5ates on money market instruments
are not directly com+arable to Bond 3%uivalent
=ield 'B3=(

&!ey need to be converted into B3= to be
com+arable $it! ot!er bond yields

341 vs. 342 days assumed in a year
>
ank Discount Rate %&'ills(
r
r
D D
- *ank disco&nt rate
- *ank disco&nt rate
!
!
- market price o% the T-*ill
- market price o% the T-*ill
n
n
- n&m*er o% days to mat&rity
- n&m*er o% days to mat&rity

r
r
D D
?
?

01#111
01#111
"
"
!
!
01#111
01#111
x
x

341
341
n
n
./-day T-*ill0 ! - 1.0234
./-day T-*ill0 ! - 1.0234
r
r
D D
?
?

01#111
01#111
"
"
@#><2
@#><2
01#111
01#111
x
x
341
341
@1
@1
?
?
2A
2A
(Example)
(Example)
@
on! "#uivalent $iel!
! - market price o% the T-*ill
! - market price o% the T-*ill
n - n&m*er o% days to mat&rity
n - n&m*er o% days to mat&rity

r
r
E5 E5
?
?

01#111
01#111
"
"
!
!
!
!
x
x

342
342
n
n
r
r
E5 E5
?
?

01#111
01#111
"
"
@#><2
@#><2
@#><2
@#><2
x
x
342
342
@1
@1
r
r
E5 E5
- 6/783 x 96/44: - 6/47; - 467;<
- 6/783 x 96/44: - 6/47; - 467;<
Example &sing the sample T-ill=
Example &sing the sample T-ill=

Convert t!e bank discount rate into B3= to
make it com+arable $it! ot!er bond yields
01
Ca)ital Market *
Fi+e! Income Instruments 1

B &reasury Cotes and Bonds
– Debt of t!e federal )ov*t $it! maturities of 0 year or more# +ayin)
off semiannual interests and +rinci+al at maturity
– Price %uoted in units of 0932 of a +oint
'3,( 001-14 ? 001 4932 ? 001.0><2 'A( of +ar B/0 mil
– =ield"to"maturity '=&M( is an annualiDed rate of return# based on
an annual +ercenta)e rate '7P5( or also called B3=
'3,( =&M ? semiannual yield ×2

Mort)a)e"Backed ecurities 'Federal 7)ency(
– ;$ners!i+ claim to cas! inflo$s from a mort)a)e +ool
– Interest and +rinci+al +ayments from borro$ers are +assed to
+urc!asers# and are called E+ass"t!rou)!sF
– GCM7 +ass"t!rou)!s 'since 0@<1(# and ot!ers 'FCM7# FG:MC(
– Market siDe is com+arable to cor+orate and &"bond markets
00
Ca)ital Market *
Fi+e! Income Instruments 2

Munici+al bond 'EmunisF(
– Issued by state and local )ov*t# and interest income is e,em+t
from federal and sometimes state and local ta, 'but ca+ital )ains
are ta,able(
– &o com+are yields on ta,able securities# $e com+ute a &a,able
3%uivalent =ield as follo$s
r
m
r =
1 – t
r
m
= muni bond yield
r - taxa*le e>&ivalent yield
t = marginal tax rate
r
m
= r×(1 – t)
02
Ca)ital Market *
Fi+e! Income Instruments 3

Cor+orate bonds
– :on)"term debt issued by +rivate cor+orations# +ayin) ty+ically
semiannual interests and +rinci+al at maturity
– ecured 'mort)a)e or collateral( vs. unsecured 'Debenture(
– Guaranteed vs. strai)!t bond
– ;+tion"embedded bonds- Callable# +uttable# convertible# etc.
– Current yield ? 7nnual cou+on 9 Current +rice
– =ield"to"maturity ? current yield H ca+ital )ain yield

International Bonds
– 3urobond- denominated in a currency ot!er t!an t!e issuin)
country# e.).# dollar"denominated bond issued in :ondon
– =ankee bond# amurai bond
03
Ca)ital Market ' "#uity

Common stock
– ;$ners!i+ s!ares of a +ublicly !eld cor+oration
– 3ntitled to )et votin) ri)!t and dividend +ayments
– 5esidual claim
– :imited liability
– Dividend yield ? 7nnual dividend 9 Current +rice
– P3 ratio ? Price 9 3P

Preferred stock
– Convotin) s!ares# usually +ayin) fi,ed dividends 'usually
cumulative(# like an infinite"maturity bond or a +er+etuity
– Priority over common stock !olders
– ometimes# callable and convertible
04
International "#uity

Global markets continue develo+in)# and more
o++ortunities of investin) abroad are available

7D5s '7merican De+ository 5ecei+ts(

Mutual funds like country funds or 83B '8orld
3%uity Benc!mark !ares(

Direct +urc!ase of forei)n securities

Provides diversification benefits# but are
e,+osed to forei)n e,c!an)e risk

Global information and analysis skills are re%uired
02
&otal nominal return in t,e -.S.
04
"#uity Risk .remium
0<
.erformance /y market sectors
0>
Risk vs. Return /y market sectors
0@
International Stock Returns
21
International Stock an! on! Returns
20

5e+resent t!e +erformance of t!e stock market as a
$!ole# e.).# DII7# 6P211# 8ils!ire 2111# etc.
– Bseful to track avera)e returns of t!e stock market
– Bseful as a benc!mark for t!e +erformance of fund mana)ers
– Bsed as base of derivatives

Many kinds of stock inde,es e,ist
– 5e+resentativeJ Broad or narro$J Go$ is it $ei)!tedJ
– Price"$ei)!ted inde,
K
Do$ Iones Industrial 7vera)e '31 blue"c!i+ stocks(
– Market value"$ei)!ted inde,
K
tandard 6 Poor*s 211# C7D7L Com+osite# 8ils!ire 2111
– 3%ually $ei)!ted inde,
K
Malue :ine Inde,
Stock In!e+es
22
Stock In!e+es ' Int0l

Cikkei 222 '+rice"$ei)!ted# lar)est &3 stocks(

Cikkei 311 'value"$ei)!ted# lar)est &3 stocks(

F&3 'value"$ei)!ted# lar)est 011 :3 stocks(

D7N 'German stock inde,(

5e)ional and Country Inde,es by MCI

37F3 '3uro+e# 7ustralia# Far 3ast(

Far 3ast

3M '3mer)in) markets(

B..# B.O.# etc. 'over 21 country inde,es(
23
1ils,ire 2333 In!e+
24
&o) 23 com)anies in S4.233 In!e+
22
Derivatives Securities
;+tions

Basic Positions
– Call '5i)!t to Buy(
– Put '5i)!t to ell(

&erms
– 3,ercise 'trike( Price
– 3,+iration Date
– Bnderlyin) 7ssets
Futures

Basic Positions
– :on) 'Commitment to Buy(
– !ort 'Commitment to ell(

&erms
– Futures +rice
– Delivery 'Maturity( Date
– Bnderlyin) 7ssets

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