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Chapter 2 Asset Classes and Financial Investments

Financial markets are traditionally segmented into money markets and capital
markets. Money market instruments include short-term, marketable, liquid, lowrisk debt securities.Capital markets, in contrast, include longer term and riskier
securities. Securities in the capital market are much more diverse than those
found within the money market. For this reason, we will subdivide the capital
market into four segments: longer term bond markets, equity markets, and the
derivative markets for options and futures.
The money market
The money market is a subsector of the fixed-income market. It consists of very
short-term debt securities that usually are highly marketable. Many of these
securities trade in large denominations, and so are out of the reach of individual
investors. Money market funds, however, are easily accessible to small investors.
These mutual funds pool the resources of many investors and purchase a wide
variety of money market securities on their behalf.
Treasury Bills
U.S. Treasury bills (t-bills) are the most marketable of all money market
instruments. Treasury bills represent the simplest form of borrowing: The
government raises money by selling bills to the public. Investors buy the bills at a
discount from the stated maturity, the holder receives from the government a
payment equal to the face value of the bill. The difference between the purchase
price and ultimate maturity value constitutes the investors earnings.
The asked price is the price you would have to pay to buy a treasury bill from a
securities dealer. The bid price is the slightly lower price you would receive if you
wanted to sell a bill to a dealer. The bid-asked spread is the difference in these
prices, which is the dealers source of profit.
The first two yields in Figure 2.1 (page 57) are reported using the bank-discount
method. This means that the 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.
Certificates of Deposit
A certificates of deposit, or CD, is a time deposit with a bank. Time deposits may
not be withdrawn on demand. The bank pays interest and principal to the
depositor only at the end of the fixed term of the CD.
Commercial Paper
Large, well-known companies often issue their own short-term unsecured debt
notes rather than borrow directly from banks. These notes are called commercial
paper. Very often commercial paper is backed by a bank line of credit, which
gives the borrower access to cash that can be used to pay off the paper at
Bankers Acceptances
A bankers acceptance starts as an order to a bank by a banks customer to pay
sum of money at a future date, typically within 6 months. When the bank

endorses the order for payment as accepted, it assumes responsibility for

ultimate payment to the holder of the acceptance. At this point, the acceptance
may be traded in secondary markets like any other claim on the bank.

Eurodollars are dollar-denominated deposits at foreign banks or foreign branches
of American banks. By locating outside the United States, these banks escape
regulation by the Federal Reserve. These accounts need not to be in European
banks, although that is there the practice of accepting dollar-denominated
deposits outside the United States began.
Repos and Reverses
Dealers in government securities use repurchase agreements, also called repos
or RPs, as a form of short-term, usually overnight, borrowing. 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. The increase in
the price is the overnight interest. The dealer thus takes out a 1-day loan from
the investor, and the securities serve as collateral.
A term repo is essentially an identical transaction, expect that the term of the
implicit loan can be 30 days or more.
Repos are considered very safe in terms of credit risk because the loans are
backed by the government securities. A reverse repo is the mirror image of a
repo. Here, the dealer finds an investor holding government securities and buys
them, agreeing to sell them back at a specified higher price on a future date.
Federal Funds
Banks maintain deposits of their own at a Federal Reserve bank. Each member
bank of the Federal Reserve System, or the fed is required to maintain a
minimum balance in a reserve account with the Fed. The required balance
depends on the total deposits of the banks customers. Funds in the banks
reserve account are called federal funds. At any time, some banks have more
funds than required at the Fed. Other banks, primarily big banks in New York and
other financial centers, tend to have a shortage of federal funds.
Brokers Calls
Individuals who buy stocks on margin borrow part of the funds to pay for the
stocks from their broker. The broker in turn may borrow the funds from a bank,
agreeing to repay the bank immediately (on call) if the bank requests it.
The LIBOR Market
The London Interbank Offered Rate (LIBOR) is the rate at which large banks in
London are willing to lend money among themselves.
2.2 The Bond Market
The bond market is composed of longer term borrowing or debt instruments than
those that tade in the money market. This marked includes Treasury notes and

bonds, corporate bonds, municipal bonds, mortgage securities, and federal

agency debt.
Treasury Notes and Bonds
The U.S. government borrows funds in large part by selling Treasury notes and
Treasury bonds. T-notes are issued with maturities ranging up to 10 years, while
bonds are issued with maturities ranging from 10 to 30 years.
Both notes and bonds make semiannual interest payments called coupon
payments, a name derived from precomputer days, when investors would literally
clip coupons attached to the bond and present a coupon to receive the interest
Inflation- Protected Treasury Bonds
In the United States inflation-protected Treasury bonds are called TIPS. The
principal amount on these bonds is adjusted in proportion to increases in the
Consumer Price Index. Therefore, they provide a constant stream of income in
real (inflation-adjusted) dollars.
Federal Agency Debt, International bonds, municipal bonds, corporate
bonds, Mortgages and Mortgage- Backed Securities: page 63-69. + se
2.3 Equity Securities
Common stocks, also known as equity securities or equities, represent ownership
shares in a corporation. Each share of common stock entitles its owner to one
vote on any matters of corporate governance that are put to a vote at the
corporations annual meeting and to a share in the financial benefits of
The two most important characteristics of common stock as an investment are its
residual claim and limited liability features. Residual claim means that
stockholders are the last in line of all those who have a claim on the assets and
income of the corporation.
Limited liability means that the most shareholders can lose in the event of failure
of the corporation is their original investment.
Preferred Stock
Preferred stock has features similar to both equity and debt. Like a bond, it
promises to pay to its holder a fixed amount of income each year.

Money market securities are very short-term debt obligations. They are usually
highly marketable and have relatively low credit risk. Their low maturities and low
credit risk ensure minimal capital gains or losses. These securities trade in large
denominations, but they may be purchased indirectly through money market
Much of U.S. government borrowing is in the form of Treasury bonds and notes.
These are coupon-paying bonds usually issued at or near par value. Treasury
notes and bonds are similar in design to coupon-paying corporate bonds.
Municipal bonds are distinguished largely by their tax-exempt status. Interest
payments (but not capital gains) on these securities are exempt from deferral
income taxes.
Mortgage pass-through securities are pools of mortgages sold in one package.
Owners of pass-troughs receive the principal and interest payments made by the
borrowers. The originator that issued the mortgage merely services it, simply
passing through the payments to the purchasers of the mortgage. A deferral
agency may guarantee the payment of interest and principal on mortgages
pooled into its pass-through securities, but these guarantees are absent in
private-label pass-troughs.
Common stock is an ownership share in a corporation. Each share entitles its
owner to one vote on matters of corporate governance and to a prorated share of
the dividends paid to shareholders. Stock, or equity, owners are the residual
claimants on the income earned by the firm.
Preferred stock usually pays fixed dividends for the life of the firm; it is a
perpetuity. A firms failure to pay the dividend due on preferred stock, however,
does not precipitate corporate bankruptcy. Instead, unpaid dividends simply
cumulate. Newer varieties of preferred stock include convertible and adjustablerate issues.
Many stock market indexes measure the performance of the overall market. The
Dow Jones averages, the oldest and best-known indicators, are price-weighted
indexes. Today, many broad-based, market- value- weighted indexes are
computed daily. These include the Standard & Poors 500 stock index, the NYSE
index, the NASDAQ index, the Wilshire 5000 index, and indexes of many non-U.S.
stock markets.
A call option is a right to purchase an asset at a stipulated exercise price on or
before an expiration date. A put option is the right to sell an asset at some
exercise price. Calls increase in value while puts decrease in value as the price of
the underlying asset increases.
A futures contract is an obligation to buy or sell an asset at a stipulated futures
price on a maturity date. The long position, which commits to purchasing, gains if
the asset value increases while the short position, which commits to delivering,