Chapter Two

Asset Classes and

Financial Instruments
[Fixed Income]
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 Chapter Overview

Fixed Income

Asset Classes Equity

Derivatives

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 Fixed Income

Money Markets
Fixed Income
Capital Markets
Asset Classes Equity

Derivatives

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 The Money Market
• Subsector of the fixed-income market
• Short-term
• Liquid
• Low risk
• Often have large denominations

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Major Components of
the Money Market

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 Money Market Securities
(1 of 2)

• Treasury bills:

• Bid and asked price

• Bank discount method
• Certificates of deposit:

• Commercial paper:

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 Money Market Securities
(2 of 2)

• Bankers’ Acceptances:

• Eurodollars:

• Repos and reverses:

• Federal funds:
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 Yields on
Money Market Instruments
• Money market securities are not free of
default risk

• The premium on bank CDs and the TED spread

have often become greater during periods of
financial crisis

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Spread between 3-month CD
and Treasury Bills

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The Capital Market
(1 of 2)

Treasur
y Notes

Corporate Treasur
Bonds y Bonds

Capital
Market Inflation-
Protecte
Municipa
l Bonds
s d
Securitie
s

Federal
Internationa
l Bonds Agency
Debt

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 The Capital Market
(2 of 2)

• Subsector of the fixed-income market

• Long-Term
• Liquid
• Low risk (but not as low as the Money Market)

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 Capital Market:
Treasury Notes and Bonds
• Treasury Notes and Bonds
• Maturities
• Notes –
• Bonds –
• Par Value — $1,000
• Interest paid semiannually
• Quotes — Percentage of par

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 Capital Market Securities
• Inflation-Protected Treasury Bonds
• TIPS:
• Federal Agency Debt
• Fannie Mae
• Freddie Mac
• Others
• International Bonds
• Eurobonds and Yankee bonds

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 Capital Market:
Municipal Bonds
• Municipal Bonds
• Issued by state and local governments
• Interest is exempt from federal income tax and
sometimes from state and local tax
• Types
• General obligation bonds:

• Revenue bonds:

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 Municipal Bond Yields
Taxable vs. Tax-Exempt Bonds
• Compare after-tax returns on each bond
• Let t = investor’s marginal tax bracket
• Let r = the before-tax return on the taxable bond
• Let rm = the municipal bond rate
• If
r  (1  t )  rm
then the taxable bond gives a higher return;
otherwise, the municipal bond is preferred

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Tax-Exempt Yield Table

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 Capital Market:
Corporate Bonds
• Corporate Bonds
• Issued by private firms
• Semi-annual interest payments
• Larger default risk than government securities
• Options in corporate bonds
• Callable
• Convertible

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 Bond Market Securities
• Mortgage-Backed Securities
• Traditionally conforming mortgages

• Later, “private-label” issuers securitized large

amounts of subprime mortgages

• Fannie and Freddie were allowed and even

encouraged to buy subprime mortgage securities

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 Bond Market Indexes

• Managed by major investment banks

• Reflect both the monthly capital gain and loss on bonds
plus any interest (coupon) income earned
• Changes in values of bond indexes can be used by bond
traders to evaluate changes in the investment
attractiveness of bonds of different types and maturities

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 Bond Market Participants

• The major issuers of debt market securities are federal, state and
local governments, and corporations
• The major purchasers of capital market securities are households,
businesses, government units, and foreign investors
– Businesses and financial firms (e.g., banks, insurance companies, and
mutual funds) are the major suppliers of funds for Munis and
corporate bonds
– Foreign investors and governments are the major suppliers of funds
for T-notes and T-bonds

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 International Bonds and Markets

• International bond markets involve unregistered bonds that are

internationally syndicated, offered simultaneously to investors in several
countries, and issued outside of the jurisdiction of any single country

• Eurobonds are long-term bonds issued outside the country of the

currency in which they are denominated

• Foreign Bonds are long-term bonds issued outside of the issuer’s home
country

• Sovereign Bonds are government issued debt

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Innovation in the Bond Markets

• Inverse Floaters
• Asset-Backed Bonds
• Catastrophe Bonds
• Indexed Bonds
– Treasury Inflation Protected
Securities (TIPS).

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