Asset Classes and Financial

Instruments
Prof. Salvador Figueroa Nadal
 “The financial markets
Quote of the Day play an active role in
determining what’s
going to happen, how
the economy is going
to function.”
- George Soros

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The Money Market
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Asset Classes
Building an investment portfolio
• Asset allocation involves making decisions about how much money to
allocate to broad classes of assets
• Security selection occurs when the investor selects specific assets from
within each class

Financial markets
• Money markets are made up of short-term, marketable, liquid, low-risk
debt securities
• Money market funds are easily accessible to small investors

• Capital markets include longer term and riskier securities

• Divided into four segments – longer term bond markets, equity markets, and the
derivative markets for options and futures
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Money Market Securities
Money Market Instruments:
• Treasury Bills
• Certificates of Deposit
• Commercial Paper
• Bankers’ Acceptances
• Eurodollars
• Repos and Reverses
• Brokers’ Funds
• Federal Funds
• LIBOR (London Interbank
Offer Rate)

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Money Market Securities
• Treasury Bills (i.e., T-bills)
• Simplest form of borrowing wherein the government raises money by selling bills
to the public
• Ask price is the price you would have to pay to buy a T-bill from a securities
dealer
• Bid price is the slightly lower price you would receive if you wanted to sell a
bill to a dealer
• Bid-ask spread is the difference in these prices, which is the dealer’s source of
profit

• Certificates of Deposit (CD)

• Bank pays interest and principal to the depositor only at maturity
• Time deposit cannot be withdrawn on demand
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Money Market Securities
• Commercial paper
• Short-tern unsecured debt notes, often issued by large, well-known companies and
backed by a bank line of credit

• Bankers’ acceptance
• An order to a bank by a customer to pay a sum of money at a future date (<∼6m)

• Eurodollars
• Dollar-denominated deposits at foreign banks or foreign branches of American
banks

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Money Market Securities
• Repurchase agreements
• Short-term, often over-night, sales of securities with an agreement to repurchase
them at a slightly higher price

• Federal funds
• Funds in a bank’s reserve account at the Federal Reserve Bank
• Very short-term loan backed by government securities

• Brokers’ calls
• Investors may buy stocks on margin and brokers, in turn, may borrow the funds
from a bank
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The Money Market
LIBOR Yields on Money Market Instruments
• LIBOR is the premier short- term interest • Most money market securities are low
rate quoted in the European money risk, but not risk-free
market • Money market funds are mutual funds
• Based on surveys of rates reported by that invest in money market instruments
participating banks rather than actual • Government funds hold short-term
transactions U.S. Treasury or agency securities
• Regulators have proposed phasing out • Prime funds also hold other money
LIBOR by 2021 market instruments

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Spread between 3-month CD and Treasury
bill rates

Source: INVESTMENTS | BODIE, KANE, MARCUS

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The Bond Market
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The Bond Market
Bond market is composed of longer term borrowing or debt instruments
than those that trade in the money market
• Treasury notes and bonds
• Corporate bonds
• Municipal bonds
• Mortgage securities
• Federal agency debt

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Debt Instruments
• Treasury notes and treasury bonds
• U.S. government borrows funds in large part by selling T-notes and T-bonds
• Notes – maturities range up to 10 years
• Bonds – maturities range from 10 to 30 years
• Par value - $1,000
• Interest paid semiannually
• Interest payments called Coupon Payments
• Quotes – percentage of par

• Inflation-protected treasury bonds

• Many countries’ governments issue bonds linked to an index of the cost of living in
order to provide their citizens with an effective way to hedge inflation risk
• In the U.S., inflation-protected T-bonds are called TIPS 13
Debt Instruments
• Federal agency debt
• Agencies formed to channel credit to a particular sector that Congress believes
might not receive adequate credit through private sources
• E.g., FHLB, FNMA, GNMA, FHLMC

• International bonds
• International capital market centered in London
• Eurobond is a bond denominated in a currency other than that of the country
in which it is issued
• Yankee bond is a dollar-denominated bond sold in the U.S. by a non-U.S.
issuer
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Debt Instruments
• Municipal Bonds
• Tax-exempt bonds issued by state and local governments
• General obligation – backed by general taxing power of issuer
• Revenue – backed by proceeds from the project or agency they are issued to
finance
• Typically issued by airports, hospitals, etc.

• Industrial development – revenue bond issued to finance commercial enterprises

• Vary widely in maturity

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Tax-exempt outstanding

Source: INVESTMENTS | BODIE, KANE, MARCUS | Flow of Funds Accounts of the United States, Board of Governors of the Federal Reserve System, March, 2016.

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Municipal Bond Yields Taxable vs. Tax-Exempt
Bonds
• Compare after-tax returns on each bond
• Let t = investor’s combined tax bracket
• Let r taxable = before-tax return on the taxable bond
• Let r taxable(1-t) = after-tax rate
• Let rmuni = municipal bond rate

• r taxable (1-t) > rmuni

• Taxable bond gives a higher return; otherwise, the municipal bond is preferred

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Tax-Exempt Yield Table
Equivalent taxable yields corresponding to various tax-exempt yields.

Source: INVESTMENTS | BODIE, KANE, MARCUS

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Debt Instruments
• Corporate bonds
• Means by which private firms borrow money directly from the public
• Secured bonds
• Unsecured bonds (i.e., debentures)
• Subordinated debentures

• Similar to Treasury issued securities in that they usually pay semiannual

coupons and return face value to bondholder at maturity
• Larger default risk than Treasury issued securities
• May come with options attached
• Callable or convertible options

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Debt Instruments
• Mortgage- and asset-backed securities
• Ownership claim in a pool of mortgages or an obligation that is secured by such a
pool
• Conforming mortgages
• Loans must satisfy certain underwriting guidelines before they may be
purchased by Fannie Mae or Freddie Mac
• Subprime mortgages
• Riskier loans made to financially weaker borrowers

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Tax-exempt outstanding

Source: INVESTMENTS | BODIE, KANE, MARCUS | Flow of Funds Accounts of the United States, Board of Governors of the Federal Reserve System, March, 2016.

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Equity Securities
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Common Stock
• Common stocks, also known as Equity Securities or Equities.
• Represent ownership shares in a corporation
• Each share entitles owner to one vote
• Corporation controlled by board of directors elected by shareholders
• Residual claim
• Stockholders are last in line of all who have a claim on the assets and income of
the corporation

• Limited liability
• Most shareholders can lose in the event of failure of the corporation is their
original investment
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Stock Market Listings
• Dividend yield
• Annual dividend payment expressed as a percent of the stock price

• Capital gains
• Amount by which the sale price of a security exceeds the purchase price

• Price-earnings ratio
• Ratio of a stock’s price to its earnings per share

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Stock Market Listings
Listing of stocks traded on the New York Stock Exchange

Source: INVESTMENTS | BODIE, KANE, MARCUS | Compiled from data from The Wall Street Journal Online, May 10, 2016.

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Preferred Stock
• Preferred stock has features similar to both equity and debt
• Like a bond, promises to pay a fixed amount of income each year
• Does not convey voting power regarding the management of the firm
• Contractual obligation to pay interest, but not dividends
• Preferred stock payments are treated as dividends rather than interest, so they are
not a tax-deductible expense for the firm
• It may be callable by the issuing firm, in which case it is said to be redeemable

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Depository Receipts
• American Depository Receipts (ADRs)
• Certificates traded in U.S. markets that represent ownership in
shares of a foreign company
• Each ADR may correspond to ownership of a fraction of a foreign
share, one share, or several shares of the foreign corporation

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Stock and Bond Market Indexes
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Stock Market Indexes
• Dow Jones Industrial Average (DJIA)
• Includes 30 large blue-chip corporations
• Computed since 1896
• Price-weighted average

• Standard & Poor’s 500 (S&P 500)

• Improvement over DJIA in two ways
• More broadly based index of 500 firms
• Market-value-weighted Index

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Other Indexes
• U.S. market-value indexes
• NYSE, NASDAQ, Wilshire 5000, CRSP

• Equally weighted indexes

• Do not correspond to buy-and-hold strategies

• Foreign and international stock market indexes

• Nikkei, FTSE, DAZ, Hang Seng, TSX

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U.S. Fixed-Income Market ($b)

Source: INVESTMENTS | BODIE, KANE, MARCUS | Flow of Funds Accounts of the United States: Flows & Outstandings, Board of Governors of the Federal
Reserve System, March 2016.
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Derivative Markets
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Derivative Markets
• Derivative asset is a claim whose value is directly dependent on or is
contingent o the value of some underlying assets

• Also called Contingent Claims

• Options
• Futures

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Options
• Call option
• Gives holder the right to purchase an asset for a specified price,
called the exercise or strike price, on or before a specified
expiration date

• Put option
• Gives holder the right to sell an asset for a specified exercise price
on or before a specified expiration date

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Future Contract
• Futures contract
• Calls for delivery of an asset (or 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 held by the trader who commits to purchasing the

asset on the delivery date

• Short position held by trader who commits to delivering the asset

at contract maturity

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

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 THANK YOU!

Asset Classes and Financial Instruments

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