FINS5513 Lecture 1A

Financial Instruments; Equity Indices

 Financial Instruments &
Indices - Lecture Outline
BKM Chapters 1 and 2
❑ Financial markets
➢ Money market
➢ Bond market
➢ Equity markets
➢ Derivative markets

❑ Stock and bond market indices

➢ Price vs value vs equally weighted indices

Lecture 1A FINS5513 2
 Money Market
Instruments
Short term debts (maturity < 1 yr), highly marketable
❑ Treasury bills – T-Bills (Government issued)
❑ Certificates of Deposit - CDs (Bank issued)
❑ Commercial Paper - CP (Company issued)
❑ Bankers Acceptances
❑ Eurodollars: dollar-denominated time deposits in banks outside
the U.S.
❑ Repos and reverse repos: Short-term loan (typically overnight)
backed by government securities
❑ Fed Funds: Overnight loans between banks for Fed deposits
❑ Brokers’ Calls – rate brokers borrow from banks
❑ LIBOR Market – interbank lending. Reference rate for many loans

BKM 2.1
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 Money Market
Instruments (cont)
 LIBOR Market – interbank lending. Reference rate for
many loans
 Proposal to phase out at the end of 2021
◼ Small sample size
◼ Expert judgement
 Replacement
◼ SONIA: Sterling overnight interbank average rate (GBP)
◼ SOFR: Secured overnight funding rate (USD)
◼ TONA/ TONAR: Tokyo overnight average rate (JPY)
◼ ESTER / €STR: Euro short term rate (EUR)
◼ AONIA: RBA interbank overnight cash rate (“cash rate”) (AUD)

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 Bond Markets
Medium to long term debts (1 - 30+ years)
❑ US Treasury Notes and Bonds (T-Notes and T-Bonds)

❑ Inflation-Protected Treasury Bonds (TIPS)

❑ Federal Agency Issues eg Federal Home Loan Bank (FHLB)

❑ International Bonds
➢ Eurobonds – bond denominated in currency other than that of
the country where it’s issued
➢ E.g. Dollar bond sold in UK = Eurodollar bond
➢ Foreign bonds – bonds issued overseas, but with the overseas
denomination
➢ E.g. Yankee bond = dollar bond, sold in US, by non-US issuers
❑ Municipal Bonds – tax advantaged
❑ Corporate Bonds
❑ Mortgage-Backed Securities BKM 2.2
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 Equity Securities
❑ Common stock
➢ Limited liability
➢ Residual claim

❑ Preferred stock: Perpetuity

➢ Fixed dividends
➢ Dividends is cumulative; Priority over common stock

❑ American Depository Receipts (ADRs)

➢ Ownership of shares of foreign firms
➢ Easier for foreign firms to satisfy US requirements
➢ Most common way for US investors to invest in and trade the
shares of foreign corp

BKM 2.3
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 Stock Market Indices
❑ Many stock market indices exist:
➢ Dow Jones Industrial Average (DJIA): 30 large blue-chip stocks
➢ S&P500: 500 largest US stocks by market capitalisation;
➢ NASDAQ Composite; NYSE Composite; Wilshire 5000

❑ How are stocks weighted?

➢ Price weighted (DJIA)
➢ Market-value weighted (S&P500, NASDAQ)
➢ Equally weighted (Value Line Index)

❑ Index not traded but investors can base their portfolios on an index
➢ Buy an index mutual fund
➢ Buy exchange traded funds (ETFs) – next lecture

BKM 2.4
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 Price Weighted Index
❑ Price Weighted Index = average price of all stocks in the index
❑ Change in the index = return on a portfolio that invests one
share in each stock in the index
❑ Q1.1a)

BKM 2.4
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 Value Weighted Index
❑ Value Weighted Index = weighted average of the returns of each
security in the index
➢ Weights are proportional to current market capitalisation

❑ Q1.1b)

BKM 2.4
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 Stock Splits
❑ Value weighted indices are unaffected by stock splits as the total market
capitalization remains the same
❑ Price weighted index requires an adjustment factor (divisor)
➢ When a stock is removed from the index and replaced by another
stock
➢ For stock splits

❑ Q1.2a)

BKM 2.4
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 Stock Splits
❑ Q1.2b)

❑ These examples illustrate that price weighted indices change

arbitrarily with stock splits. The implicit weighting scheme of a
price weighted index is somewhat arbitrary
❑ See file “L1 PW vs VW Indices Stock Splits” for more examples

BKM 2.4
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 Bond Indices
❑ Major indices: Merrill Lynch, Barclay (formerly Lehman Brothers),
Citigroup
❑ Challenges:
➢ While a company may have 1 or 2 types of stocks, a company
may have many types of bonds – thousands of bonds on issue
➢ A significant number of bonds are illiquid and infrequently
traded
➢ Bond indices turn over more than stock indexes as the bonds
mature (highly dynamic)
❑ Will be briefly covered in Lecture week 9. See also text 16.3
Bond-Index Funds

BKM 2.4
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 This lecture
Overview of
❑ Financial markets
➢ Money market
➢ Bond market
➢ Equity markets
➢ Derivative markets

❑ Stock and bond market indices

➢ Price vs value vs equally weighted indices

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 Next Lecture
❑ BKM Chapters 3 and 4, including end-of-chapter questions

❑ Complete Case Study I Questions

❑ Focus on understanding securities trading and investment

companies

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