CHAPTER 2 Asset Classes

and Financial
Instruments

Investments, 8th edition

Bodie, Kane and Marcus

Slides by Susan Hine

McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
 Major Classes of Financial Assets or
Securities
• Money market
• Bond market
• Equity Securities
• Derivative markets

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 The Money Market

• Treasury bills
• Certificates of Deposits
• Commercial Paper
• Bankers Acceptances
• Repos (RPs) and Reverses
• Federal Funds

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 The Money Market T-bills

 Government highly liquid Bills

 (Purchase – Face Value) = Proceed for holder
 28/91/182 days maturity
 Sold on $100 denominations
 Free from all state and local taxes

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 The Money Market T-bills

Bank Discount Method:

Asked Price Vs Bid Price
(Bid – Asked) = Proceed for the dealer
Calculations are based on a 360 day year

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For example, for the highlighted bill maturing on December 20, 2012,
days to maturity are 156 and the yield under the column labeled
“ASKED” is given as .125%.

This means that a dealer was willing to sell the bill at a discount from
face value of .125% x (156/360) = .0542%
.
So a bill with $10,000 face value could be purchased for $10,000 x (1
- .000542) = $9,994.58.

Similarly, on the basis of the bid yield of .130%, a dealer would be

willing to purchase the bill for $10,000 x (1 - .00130 x 156/360) =
$9,994.367.

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The Money Market – Certificate of Deposits

• It is a time deposit with bank

• Not highly liquid (except for short term deposits)

• Normally done in big denomination

• Denomination greater than $100,000 is negotiable and

may be sold to another investor

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The Money Market – Commercial Paper

• Issued by companies (mostly short term 1 or 2 months)

• unsecured debt
• Backed by a line of credit
• Both short and long term (upto 270 days)
• Denomination multiples of $100,000
• Not for small investors
• Mostly issued by non-financial firms
• Asset-backed commercial papers by Financial firms, to
raise funds to invest in other assets
• Negative impact: Subprime mortgage on 2007 in USA

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The Money Market – Bankers Acceptance

• Similar like a postdated check

• Order from Customer to a Bank to pay a sum or money,
within 6 months
• Its transferrable and bank pays to the last holder
• Typically traded in secondary market at a discounted
price
• Popular in foreign trade, where creditworthiness remains
a doubt

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The Money Market – Repos (RPs) and Reverses

• Government Security based repurchase agreements

• Short-term (Overnight) borrowing, for one day, mostly
• Dealer sells to Investor, purchase back within one day,
with higher price
• A term repo (same for 30 days)
• Very safe, since backed by Government Securities
• Reverse Repo (Dealer buys and then sell back to
investor)

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 The Money Market – Federal Funds

• All the Banks maintain a certain ratio of deposits in the

Federal (Central) bank
• It is simply a Deposit Swap between banks
• Overnight Loans from one bank to another in exchange
of an interest (fed-fund-rate)
• Interest rate is based on the rate of short-term loans
among financial institutions
• Medium is the Central (Federal) Bank

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 The Bond Market

• Treasury Notes and Bonds

• Inflation-Protected Treasury Bonds
• Federal Agency Debt
• International Bonds
• Municipal Bonds
• Corporate Bonds
• Mortgages and Mortgage-Backed Securities

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The Bond Market – Treasury Notes and Bonds

• Government Instruments, issued @ a denomination of

$1000 or more
• T-Note (10 years), T-Bond (10-30 years)
• Semi-annual interest payment (Coupon payment)

• $ 1000, 4% Coupon rate means: Bond will give $40 in a

year, dividing into two $20 semi-annual payment

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• The bid price should be interpreted as 113.5078% of par, or $1,135.078
for the $1,000 par value bond.

• Similarly, the ask price at which the bond could be sold to a dealer is
113.5391% of par, or $1,135.391.

• The -.0859 change means that the closing price on this day fell
by .0859% of par value, from the previous day’s close.

• Finally, the yield to maturity based on the ask price is .398%

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 Concept Check

• What were the bid price, ask price, and yield to maturity of
the 4.5% February 2036 Treasury bond displayed in Figure
2.3 ? What was its ask price the previous day?

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• The bid price of the bond is 138.0469% of par, or $1,380.469, and the ask price is 138.125% of par, or
$1,381.25.
•
• This ask price corresponds to a yield of 2.378%.

• The ask price fell .9375 from its level yesterday, so the ask price then must have been 139.0625, or $1,390.625.

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The Bond Market – Inflation Protected T-Bonds

• Adjusted with the inflation and linked to an index of cost

of living
• Citizens can hedge inflation-risk
• TIPS (Treasury Inflation Protected Securities)
• Provides a constant stream of income in a real term
• On listings an additional i is added
• TIPS yield is lower compared to ordinary Bonds

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 The Bond Market – Federal Agency Debt

• Government Agencies issue their own security

• Done on giant projects of government

• Channels social capital in the desired sector where the

government assumes dearth of resources

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 The Bond Market – International Bonds

• Typically called Euro-Bond

• Denominated in a currency other than that of the country
in which it is issued
• Euro-Dollar-Yen-Rupee Bond

• Yankee Bonds: In USA, in Dollar issued by Non-USA

citizens
• Samurai Bonds: In Japan, in Yen, issued by a non-
Japanese citizen

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 The Bond Market – Municipal Bonds

• Issued by Local governments, varies in maturities

– Short-term tax anticipation notes (months)
– Long-term large investment notes (up to 30 years)
• Almost similar to Treasury or Corporate Bonds (exception
is the exemption from federal/state/local tax)
• Revenue Bonds:
– Backed by the project Revenue
– Or by the project operating agency
• General Obligation Bonds:
– Backed by ‘full faith and credit’; i.e., the taxing power of the issuer

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 The Bond Market – Municipal Bonds
• Tax-exempt bonds; but before buying should be compared with the
taxable bonds

• If we let t denote the investor’s combined federal plus local marginal tax bracket and r denote the total before-tax rate of return available on taxable bonds, then r(1 - t) is the after-tax rate available on those securities.
• If this value exceeds the rate on municipal bonds, rm , the investor does better holding the taxable bonds. Otherwise, the tax-exempt municipals provide higher after-tax returns.
• Thus the equivalent taxable yield is simply the tax-free rate (rm) divided by (1 – t).

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Municipal Bonds – Comparison with Taxable Bonds

• Notice that the equivalent taxable interest rate increases with the investor’s tax bracket; the higher the bracket, the more valuable the
tax-exempt feature of municipals.

• Thus high-tax-bracket investors tend to hold municipals.

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 Municipal Bonds – Cut-off Tax Bracket

• Thus the yield ratio rm /r is a key determinant of the attractiveness of municipal bonds.

• The higher the yield ratio, the lower the cutoff tax bracket, and the more individuals will prefer to hold municipal debt.

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 Municipal Bonds – Concept Check

• 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?

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 Municipal Bonds – Concept Check

• A 6% taxable return is equivalent to an after-tax return of 6(1 - .30) = 4.2%. Therefore, you would be better off in the taxable bond.

• The equivalent taxable yield of the tax-free bond is 4/(1 - .30) = 5.71%. So a taxable bond would have to pay a 5.71% yield to provide the same after-tax return as a tax-
free bond offering a 4% yield.

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 The Bond Market - Corporate Bonds
• Private firm’s sourcing tool
• Similar in structure of Treasury Issues
• Riskier than Treasury Issues
• Secured Bonds: Backed by specific collateral in the event of bankruptcy
• Unsecured Bonds (Debentures): No collateral
• Subordinated Debentures: Lower priority claim in the event of bankruptcy
• Callable Bonds: Re-purchasable from the holder at a stipulated call price
• Convertible Bonds: Convertible into specific number of stock

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The Bond Market – Mortgages and Mortgage
Backed Securities
• Traditionally: Long-term (15-30 year), Fixed Interest rate, Fixed monthly payment
• Fixed Rate:
– Difficulties for the lenders in the inflationary period, since rate paid on deposit increased
• Adjustable Rate Mortgages:
– (T-bill rate + 2%)
– there remains a ‘cap’ for the highest rate of interest
– Shifts a bit of risk from the lenders to the borrowers
• Mortgage-backed Security (Pass-throughs):
– Lenders sell their loans (stream of cash-flows) to the secondary market and they take the responsibilities to pass the cash to the purchaser.

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 Equity Securities
• Common stock

• Preferred stock

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Equity Securities – Common Stock
• Ownership claim, one vote in annual meeting
• One share in the financial benefits
• Shareholders select BOD and BOD selects
Managers
• Absent owners can vote through proxy
• Managers can arrange proxy for them
• Publicly held Vs Closely held corporation
• Residual Claim: Liquidation & Operating Income
• Limited Liability Vs Unicorporated Business Liability

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Common Stock – Concept Check
a. If you buy 100 shares of IBM stock, to what are
you entitled?

b. What is the most money you can make on this

investment over the next year?

c. If you pay $180 per share, what is the most money

you could lose over the year?

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Common Stock – Concept Check
a. You are entitled to a prorated share of IBM’s
dividend payments and to vote in any of IBM’s
stockholder meetings.

b. Your potential gain is unlimited because IBM’s

stock price has no upper bound.

c. Your outlay was $180 3 100 5 $18,000. Because

of limited liability, this is the most you can lose.

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Figure 2.8 Listing of Stocks Traded on the NYSE

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 Preferred Stock

• Hybrid Security = Equity + Debt

• Fixed stream of income like bond and no voting power
• Dividend distribution is the discretion of the managers
• Preferred dividends are actually Cumulative
• Must pay interest; failure to pay such interest ignites
corporate bankruptcy proceedings
• Preferred stock payments are considered as dividend
and not tax deductible expense for the firm
• Redeemable / Convertible / Adjustable-rate Stocks

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 Derivatives Markets
Options Futures
• Basic Positions • Basic Positions
– Call (Buy) – Long (Buy)
– Put (Sell) – Short (Sell)
• Terms • Terms
– Exercise Price – Delivery Date
– Expiration Date – Assets
– Assets

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 Derivatives - Options
• Call Option: Right to purchase @ Strike Price / Exercise Price
• Put Option: Right to Sale
• Each option contract = 100 shares
• Quotations are made on per share basis
• Call Option holder waits for the market to go pass strike price
• Put Option holder waits for the reverse position
• Right to an option can be owned, in exchange of a premium
• Premiums are stated on a per share basis, but should be
converted into 100 share calculation

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Figure 2.10 Trading Data on GE Options

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 Options – Concept Check
• What would be the profit or loss per share of stock to an
investor who bought the October expiration GE call option
with exercise price $40, if the stock price at the expiration
date is $42?

• What about a purchaser of the put option with the same

exercise price and expiration?

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 Options – Concept Check
• Payoff for the call option is $2 per share at maturity. The
option cost (Premium) is $1.68 per share. So, the profit is
$.32

• The put option is not offering any value. Since, the share
price is already more than the bargained one. Put option is
worthless!

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 Derivatives - Futures
• Delivery of an asset (or equivalent cash), at a specified
date/maturity date.
• Long position: Trader who commits to buy the asset
• Short position: Trader who commits to sale the asset
• Long position holder profits from the price increase
• Short position holder profits from the price decrease

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Figure 2.11 Listing of Selected
Futures Contracts

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 Options Vs Futures
Options Futures
• Right to • Will
– Call (Buy) – Long (Buy)
– Put (Sell) – Short (Sell)
• No Obligation • Obligatory
• Premium Required • No Premium

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 Classification Summary of Instruments
• Classification by nature of claim.
– Debt market; Equity market
• Classification by maturity of claim.
– Money market; Capital market
• Classification by seasoning of claim.
– Primary market; Secondary market
• Classification by immediate delivery or future
delivery
– Cash or spot market; Derivative market

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 Typical Information for Bangladesh
• Islamic Investment Bond (
http://www.bdreports24.com/bangladesh-approves-islamic-fin
ancial-instruments/
)

• T-Bill Bangladesh Information (

https://www.bb.org.bd/monetaryactivity/treasury.php)

• Trading Instrument in Bangladesh (

http://dsebd.org/products_of_dse.php)

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