Chapter 2

Asset Classes and Financial Instruments

Francesco Celentano
HEC Lausanne

Financial Markets-Spring 2022

Different Assets and Financial Instruments

Financial markets are segmented in

1) Money market where short-term, liquid (meaning easy to sell at a
fair price on short notice), low risk debt securities are traded
2) Capital market where longer-term and riskier securities are traded
Since capital market securities are really different, we will subdivide
these markets in 1) bond (or longer debt) markets, 2) equity markets,
and 3) derivative markets where options and futures trade
In these slides, we will review the major assets traded on these markets
Money Market

Money Market consists of very short-term, highly marketable, highly

liquid and relatively low risk debt securities
Since these securities are often traded in large denominations, they
are out of reach of individual investors
However, money market funds are accessible to small investors as
these funds pool resources to buy a variety of money market securities
In the next slides, we will talk about some money market instruments
Government Bills
Government bills are instruments used by governments to borrow
In the USA they are usually called Treasury Bills while in Switzerland
they are usually called SNB Bills
They are issued at a discount from face value and return the face value
at maturity (the difference between these constitutes the interest)
They are characterized by having
- Large denominations
- Maturity from few (generally 4) weeks to 1 year
- High liquidity (they are probably the most marketable security)
- No default risk
- Sometimes special taxation regimes
Treasury Bill Listing
This is a partial listing of US treasury
bills from The Wall Street Journal
Columns 1 and 2 are easy while
column 5 reports the percentage
change from the previous listing
The bid price is the price an
individual would receive to sell a
treasury bill to a dealer
The asked price is the price an
individual would pay to buy a
treasury bill from a dealer
Rather than providing prices, this
table reports yields based on them
Column 6 reports the asked yield,
the return investors would receive if
they paid the asked price and held
the treasury bill to maturity
Certificates of Deposit
Certificates of Deposit are time deposits with a bank
Unlike checking accounts, they cannot be withdrawn on demand
The bank pays interest and principal to the depositor only at maturity
They are characterized by having
- Any denomination (marketability depends on amount)
- A maturity of at least 2 weeks
- High liquidity if the maturity is below 3 months
- Insurance below certain amounts (hence, no default risk)
- Normal taxation regimes
Commercial Paper Notes
Commercial Paper Notes are notes issued by large creditworthy firms
While unsecured, they are backed by bank line of credit
They are issued at a discount from face value and return the face value
at maturity (the difference between these constitutes the interest)
They are characterized by having
- Large denominations (for example, in the USA minimum $100K)
- Maturity below 9 months (but, usually, 1/2 months)
- Quite high liquidity if maturity is below 3 months
- Almost no default risk (since monitored, though unsecured)
- Normal taxation regimes
Asset-Backed Commercial Paper Notes

Historically, commercial paper non have been issued by non-financial

firms but this has changed after 2000
Specifically, financial institutions such as bank have started to issue
asset-backed commercial paper notes
These notes were used to raise funds to invest in other assets, like
subprime mortgages, and this lead to the 2007 financial crisis
Recently, long-term versions of these notes have been used for “good
deeds” (more on this in a bit)
Repurchase Agreements
Repurchase Agreements or repos are used by dealers in government
securities as a form of short-term, usually overnight, borrowing
A dealer sells securities to an investor overnight, with the agreement to
buy back those securities the next day at a slightly higher price
The difference between the two prices is the overnight interest and the
securities serve as collateral for the dealers’ one day loan
2 special types of repos are
Term repos, repos with maturity of 30 days or longer
Reverse repos, mirror of a repo
Brokers’ Call and Brokers’ Call Loans
Brokers’ call is the interest rate that an investor who buys stocks on
margin, meaning by funding the purchase by borrowing money from a
broker, has to pay to the broker lending money
The broker in turn usually borrows the funds from a bank, agreeing to
repay the bank immediately or “on call” if the bank requests it
This implies that the brokers’ loans themselves may be “called in”
These brokers’ loans are called brokers’ call loans
The rate is usually one percentage point greater than the rate on
benchmark short-term government bills
Banks Reserves at the Central Bank
Banks must maintain deposits of their own, usually called reserves, at
the local Central Bank
The minimum deposit depends on regulation and the total deposits of
the bank’s customers (check the Wikipedia page about Basel III)
These funds have different names (for example, in the USA fed funds)
Sometimes banks with excessive deposits lend to banks with a
shortage of them overnight at an interest rate
The latter is an important benchmark for the entire economy, since it’s
the rate at which banks lend to each other
Why the Overnight Banking Rate Matters
This is a plot of the spread between
the banking lending rate and the
government bill rate in the USA
This is a plot of the spread between
the US banking lending rate (called
the federal funds rate) and the
government bill rate (called the
treasury bill rate)
This is usually called the TED spread
At each crisis, it spiked up
LIBOR
The LIBOR (or London Interbank Offer Rate) is the premier short-term
interest rate quoted in the European money market
It should reflect the rate at which banks lend among each other (but it
was subject to some scandals related to manipulations)
While international interbank lending has declined over time, the
LIBOR is the base rate for many loans and derivatives
Moreover other countries and institutions have proposed alternatives
such as the Euribor and the Tibor while the USA have proposed to use
repo rate on treasury bills
Money Market Funds
Money market funds are investment funds that invest in money
market instruments
They are the main conduit for funds invested in money market
They have a huge size (for example, in the USA, they have $3.5T assets
under management) and they usually pose low risk to investors
However, the financial crisis of 2007 was a traumatic shock
Hence, investors have started to distinguish between
- Government funds that hold only government issued money
market instruments
- Prime funds that hold also other money market instruments
A Note on Yields on Money Market Instruments

Although money market securities are low risk, they are not all risk-free
As some of them offer yields greater than the government bills, they
have a greater risk (think about the previous graph about the spread)
Moreover, yields on money market instruments are not always
comparable as there are factors influencing them (like the investment
valuation, the number of days considered and the interest type)
Bond Market

Bond Market consists of long-term borrowing or debt securities

These instruments are called fixed-income securities because most of
them promise either 1) a fixed stream of income or 2) a stream of
income determined according to a specified formula
As these formulas have evolved, in practice these flows are far from
fixed, hence it is more appropriate to talk about bond or debt securities
In the next slides we will talk about some debt instruments
Government Bonds
Government Bonds are instruments used by governments to borrow
In the USA they are usually called Treasury notes while in the UK they
are usually called Gilts while Swiss bonds do not have a particular name
They make semiannual interest payments called coupon payments for
historical reasons and pay a so-called par value at maturity
They are characterized by having
- Not so large denominations (for example, in the USA, usually $1K)
- Maturity from 10 to 30 years
- Liquidity that depends on economic and market conditions
- Heterogeneous default risk
- Sometimes special taxation regimes

Treasury Bond Listing
This is a partial listing of US treasury
bonds from The Wall Street Journal
Columns 1 is easy while column 5
reports the percentage change from
the previous listing
The coupon is the interest rate to be
paid to the holder each period
Both prices are quoted as percentage
of par (for example, the 1st bid price
means that one would receive
$1000.4 by selling a $1000 par
value bond)
Column 6 reports the asked yield to
maturity, the annualized rate of
return by buying a bond for the asked
price and holding it until maturity
Notice that it is possible to buy
inflation-protected government
bonds that adjust the coupon rate to
hedge against inflation risk
Corporate Bonds
Corporate Bonds are instruments used by firms to borrow
They are really similar to government bonds but way riskier, as their
default risk is sensibly higher, and not subject to special tax regimes
While we will talk later about their characteristics, it is important to
distinguish between
Secured bonds, backed by collateral in the event of bankruptcy
Unsecured bonds, not backed by any collateral
Moreover, some bonds have special features, like
Callable bonds, that can be repurchased by the issuing firm
Convertible bonds, that can be converted in shares
Mortgage-Backed Securities

As for short term debt securities, it is possible to issue long term

securities backed by assets, or asset-backed securities
Recently, these notes have been used for many purposes among
which to fund green investments (if you are more interested, read here)
Mortgage-backed securities given an ownership claim in a pool of
mortgages or an obligation secured by such a pool
Mortgage-Backed Securities Outstanding
This is a plot from the Security Industry
& Financial Markets Association of the
amount of mortgage-backed securities
outstanding in the US
This is a plot of the amount of
mortgage-backed securities
outstanding in the US divided by
whether they were issued by a
government agency or by a private
corporation
Before the financial crisis the growth
of these securities was exponential
It seems that some years after the
crisis, the growth has restarted but at
lower rates
Equity Market

Equity Market is where stocks, or equity securities are traded

Equity securities represent ownership shares in corporations
There are 2 main types of stocks
1) Common stocks
2) Preferred stocks
Common Stocks

Common stocks entitles ownership to a company as each share gives

one vote on any matter of the firm governance
Common stocks are securities with 2 main characteristics
- Residual claim, as, in the case of firm’s bankruptcy, shareholders
have claim only on what is left after paying all other claimants
- Limited liability, as, in the case of firm’s bankruptcy, shareholders
can lose at most what they invested in the firm

Stock Market Listing
This is a partial listing of stocks traded
on the New York Stock Exchange from
Yahoo! Finance
Column 1 is the name of the
company of the stock
Column 2 is the symbol of the stock
Close is the closing or last price of the
stock on that day
Change is the change from the
previous trading date
52 week high is the highest price of
the stock over the previous 52 weeks
and 52 week low is the lowest price
over the previous 52 weeks
Div is the forecasted divided over the
coming year and Yield is the ratio of
Div over Close and represents the
implied dividend yield
P/E is the price-to-earnings ratio,
that is the ratio of the current stock
price to last year’s earnings
Preferred Stocks
Preferred Stocks have some features of both stocks and bonds
They promise a fixed stream of income each year but without voting
Since there is no contractual obligation to pay a payment, preferred
dividends are cumulative
That is, these payments cumulate and must be paid in full before any
dividend is paid to common stock holders
They usually have some of the tax advantage of debt for firms that
encourage firms to prefer preferred to common stocks
Bond and Stock Market Indexes
Before investing we want to check how markets are performing
Before buying stocks, one should check stock market indexes
Famous indexes are the US Dow Jones Industrial Average (DJIA) and
S&P500, or the Swiss Market Index (SWI) or the Financial Times Stock
Exchange 100 Index (FTSE 100 Index) and there are many others
It is important to always keep in mind that they are built with different
criteria and the latter ones might affect their performance
Similarly before investing in bonds, it is important to check bond
market indexes such as those of Merrill Lynch and Barclays
These indexes suffer the problem that bonds are traded infrequently
and as such prices might differ from market values
Derivative Market

Derivative Market is where derivative assets, or derivatives, are traded

Derivatives are securities which payoffs depend on the value of other
assets, such as stocks, bonds, commodities and even indexes
In other words, their values derive from the values of other assets
There are 2 main types of derivatives
- Options
- Futures
Options
There are 2 types of options
1) Call options that give their holders the right, but not the
obligation, to purchase a certain asset for a specified price, called
the exercise of strike price, on or before a specified expiration date
2) Put options that give their holders the right, but not the
obligation, to sell a certain asset for a specified price, called the
exercise of strike price, on or before a specified expiration date
Since options provide a right, investors have to pay a price to enter into
this type of contracts
Option Listing
Expiration is the date at which these
option contracts expire
Strike is the strike price (or exercise
price) of the options

This is a partial listing of stock options Call is the price to enter into 1 call
on Microsoft on September 4, 2019 option contract for 1 share
when the stock price was $137.49 Put is the price to enter into 1 put
obtained from Yahoo! Finance option contract for 1 share
Futures
Futures call for the delivery of an asset (or, in some cases, its cash
value) at a specified delivery or maturity date for an agreed-upon price,
called the futures price
There are 2 positions in a future contract
1) A long position is held by the investor who commits to purchase
the asset
2) A short position is held by the investor who commits to sell, or
deliver, the asset
Since futures provide an obligation, it is usually free for investors to
enter into this type of contracts (besides low commision fees)
Summary
In these slides we described the two types of financial markets, money
markets and capital markets
First, we have talked about the key assets traded on money markets,
that is governments bills, certificates of deposits, commercial paper
notes, repos and bank reserves and some of the key interest rates
Second, we have talked about the key assets traded on the 3 types of
capital markets, bond, equity and derivative markets, that is
government and corporate bonds, asset- and mortgage-backed
securities, common and preferred stocks, options and futures