CHAPTER 2

Asset Classes and Financial

Instruments

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McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.
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land, building, machine contribute directly to the productive
real Asset Classes capacity of the economy
generate NI to economy
>< Financial A are claims to the income generated by real A, can be used to produce G&S
allocate income, wealth among investors

• Money market instruments

debt sec (ST, highly marketable, low risk)

• Capital market instruments

– Bonds (fixed income)
– Equity Securities
– Derivative Securities values derive from the prices of other assets.
hedge risk
commodity
international trade: transfer money back and forth between dollars and other currencies

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The Money Market

• Subsector of the fixed-income market:

Securities are short-term, liquid, low
risk, and often have large
denominations

• Money market mutual funds allow

individuals to access the money
pool the resources of many investors, purchases a wide variety of money
market. market sec on their behalf

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Table 2.1 Major Components of

the Money Market

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Money Market Securities

at auction, secondary market
• Treasury bills: Short-term debt of U.S.
slightly
government buy at discount price sell at face value, exempt from taxes
buy
– Bid and asked price dealer's profit
lower price
received
– Bank discount method FV x (1-askedxmaturity/360)= asked price
from dealer
bond-equivalent yield (asked yield) = FV/asked price x365/maturity > asked
• Certificates of Deposit: Time deposit with a
negotiable>$100,000
bank not be withdraw on demand, repay principal and interest at the end of fixed term
sold when needs cash in certificate before maturity date
• Commercial Paper: Short-term, unsecured
debt of a company is backed by a bank line of credit
maturity less than 1,2 months => predict firm's performance => fairly safe A
asset-backed commercial paper: raise funds for institution to invest in other A
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Money Market Securities

• Bankers’ Acceptances: An order to a bank
by a bank’s customer to pay a sum of
money on a future date discount price
• Eurodollars: dollar-denominated time
foreign US banks
deposits in banks outside the U.S.
overnight, dealer sell sec to investor and buy back at slightly higher price
• Repos and Reverses: Short-term loan
backed by government securities.
• Fed Funds: Very short-term loans between
banks maintain minimum deposit in reserve acc
bank with excess fund lend to those with shortage
overnight, federal funds rate
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Yields on Money Market Instruments

• Except for Treasury bills, money market

securities are not free of default risk
• Both the premium on bank CDs and the
=/ LIBOR
rate and TED spread have often become greater
T-bills
during periods of financial crisis
• During the credit crisis of 2008, the federal
government offered insurance to money
market mutual funds after some funds
experienced losses

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The Bond Market

• Treasury Notes and Bonds

• Inflation-Protected Treasury
Bonds
• Federal Agency Debt
• International Bonds

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The Bond Market

• Municipal Bonds
• Corporate Bonds
• Mortgages and Mortgage-Backed
Securities

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Treasury Notes and Bonds

US government
• Maturities
– Notes – maturities up to 10 years
– Bonds – maturities from 10 to 30
years
• Par Value - $1,000
• Interest paid semiannually coupon payments
price • Quotes – percentage of par
-.0859 => closing price fell by -.0859
yield to maturity base on asked price .933

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The Bond Market

• Inflation-Protected Treasury Bonds

– TIPS: Provide inflation protection
adjusted principal, real/infaltion-adjusted i
• Federal Agency Debt
– Debt of mortgage-related agencies such as
Fannie Mae and Freddie Mac
• International Bonds
dollar bond sold in US by non-US issuer
– Eurobonds and Yankee bonds
sold in foreign countries, foreign currencies

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Municipal Bonds

• Issued by state and local governments

• Interest is exempt from federal income
tax and sometimes from state and local
tax

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Municipal Bonds
tax-exempt status: pay no taxes on i => willing accept low yield
• Types
– General obligation bonds: Backed by taxing
power of issuer
– Revenue bonds: backed by project’s revenues
or by the municipal agency operating the
project. airport,
riskier
hospital,...

- industrial development bond: issued to finance commercial enterprises, borrow at

tax-exempt rates => limit the amount of bonds
- tax anticipate notes: ST, raise funds to paid for expenses before actual collection of taxes

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Figure 2.4 Tax-exempt Debt

Outstanding

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Municipal Bond Yields

• To choose between taxable and tax-exempt
bonds, compare after-tax returns on each
bond.
• Let t equal the investor’s marginal tax
bracket
• Let r equal the before-tax return on the
taxable bond and r m denote the municipal
bond rate.
• If r (1 - t ) > r m then the taxable bond gives
a higher return; otherwise, the municipal
bond is preferred.
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Table 2.2 Tax-Exempt Yield Table

The equivalent taxable yield is simply the tax-free

rate, rm , divided by (1-t).
Suppose your tax bracket is 30%. Would you prefer to earn a 6% taxable return or
a 4% tax-free return? What is the equivalent taxable yield of the 4% tax-free yield?
rm= 6%x(1-30%)=4.2 > 4% => prefer 6% taxable return
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Corporate Bonds

• Issued by private firms

• Semi-annual interest payments
• Subject to larger default risk than
government securities -secured bonds
- unsecured ((subodinated debentures) bonds

• Options in corporate bonds

– Callable firm repurchase bonds at stipulated call price
– Convertible convert bond into stock

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Mortgage-Backed Securities

• Proportional ownership of a mortgage

pool or a specified obligation secured by
a pool
• Produced by securitizing mortgages
– Mortgage-backed securities are called
pass-throughs because the cash flows
produced by homeowners paying off their
mortgages are passed through to
investors.
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Mortgage-Backed Securities

• Most mortgage-backed securities were

issued by Fannie Mae and Freddie Mac.

• Traditionally, pass-throughs were

comprised of conforming mortgages,
which met standards of credit worthiness.

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Mortgage-Backed Securities
• Eventually, “Private-label” issuers
securitized large amounts of subprime
mortgages, made to financially weak
borrowers.
make housing more affordable to low-income household =>
• Finally, Fannie and Freddie were allowed
and even encouraged to buy subprime
mortgage pools.
• September, 2008: Fannie and Freddie got
taken over by the federal government.
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Figure 2.6 Mortgage-backed securities

outstanding

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Equity Securities
proxy: empowering another party to ote in their name
• Common stock: Ownership
– Residual claim
shareholders can lose in the event of failure of
– Limited liability corporation is their original investment, stock
become worthless
• Preferred stock: Perpetuity infinite-maturity bond
– Fixed dividends - cumulative: unpaid
dividends cumulate, pay full
-redeemable (callable)
- convertible
- adjusted-rate
– Priority over common in next period

– Tax treatment not tax-deductible expenses => exclude 70% of

dividends received from taxes income
=> lower yield than corporate bond (who can't use the tax exclusion)
• American Depository Receipts ADRs
represent the ownership in shares of a foreign company

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Stock Market Indexes

• Dow Jones Industrial Average
measure of the performance of the stock market
– Includes 30 large blue-chip
corporations
– Computed since 1896
– Price-weighted average higher-priced shares more weight in
determining performance

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Example 2.2 Price-Weighted Average

Portfolio: Initial value $25 + $100 = $125

110 +20 = 130
Final value $30 + $ 90 = $120
Percentage change in portfolio value
130-125/125= 4%
= 5/125 = -.04 = -4%
Index: Initial index value (25+100)/2 = 62.5
Final index value (30 + 90)/2 = 60
Percentage change in index -2.5/62.5
= -.04 = -4%
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Standard & Poor’s Indexes

• S&P 500
– Broadly based index of 500 firms
$100X200 shares + $90
– Market-value-weighted index index value = 600/690=15%

• Investors can base their portfolios

on an index:
– Buy an index mutual fund
– Buy exchange traded funds (ETFs)
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Other Indexes
U.S. Indexes Foreign Indexes
• NYSE Composite • Nikkei (Japan)
• NASDAQ Composite • FTSE (U.K.; pronounced
• Wilshire 5000 “footsie”)
• DAX (Germany),
• Hang Seng (Hong Kong)
• TSX (Canada)

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Derivatives Markets

• Options and futures provide payoffs that

depend on the values of other assets such
as commodity prices, bond and stock
prices, or market index values.

• A derivative is a security that gets its value

from the values of another asset.

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Options
on/before specified expiration date
• Call: Right to buy underlying asset at the
strike or exercise price.
– Value of calls decrease as strike price
increases
• Put: Right to sell underlying asset at the
strike or exercise price.
– Value of puts increase with strike price
• Value of both calls and puts increase with
time until expiration.
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Futures Contracts
• A futures contract calls for 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, to be paid at contract maturity.

• Long position: Take delivery at maturity

• Short position: Make delivery at maturity

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Comparison
Option Futures Contract
• Right, but not obligation, • Obliged to make or take
to buy or sell; option is delivery. Long position
exercised only when it is must buy at the futures
profitable price, short position must
• Options must be sell at futures price
purchased • Futures contracts are
• The premium is the price entered into without cost
of the option itself.

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