Chapter 2

Asset Classes and Financial Instr uments

McGraw-Hill/Irwin

Copyright 2010 by The McGraw-Hill Companies, Inc. All rights reserved.

Money Market Instruments

Treasury Bills Certificates of Deposits Commercial Paper
Bankers Acceptances Eurodollars Repurchase Agreements (RPs) and Reverse RPs Federal Funds LIBOR Market

Table 2.2 Major Components of the Money Market

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Figure 2.2 Treasury Bills (T-bills)

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Figure 2.3 Spreads on CDs and Treasury Bills

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MMMFs in 2008
Between 2005 and 2008 money market mutual funds (MMMFs) grew by 88%. Why? MMMFs had their own crisis in 2008 when Lehman Brothers filed for bankruptcy on September 15. Some funds had invested heavily in Lehmans commercial paper. On Sept. 16, Reserve Primary fund broke the buck. What does this mean? A run on money market funds ensued. The U.S. Treasury temporarily offered to insure all money funds to stop the run
- (up to $3.4 trillion in these funds.)
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Money Market Instrument Yields

Yields on money market instruments are not always directly comparable Factors influencing quoted yields Par value vs. investment value 360 vs. 365 days assumed in a year (366 leap year) Simple vs. Compound Interest
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Bank Discount Rate (T-Bill quotes)

r BD =
rBD F P

F - P F

x 360 n

= bank discount rate = Face Value = Market Price

n = number of days to maturity Example 90-day T-bill, P = $9,875 $10,000 = Face $10,000 - $9,875 360 r BD = = 5% x 90 $10,000
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Bond Equivalent Yield

Cant compare T-bill directly to bond
360 vs 365 days Return is figured on par vs. price paid

Adjust the bank discount rate to make it comparable

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Bond Equivalent Yield

r BEY 10,000 - P 365 = x n P

P = price of the T-bill n = number of days to maturity

Example Using Sample T-Bill 10,000 - 9,875 365 r BEY = x 9,875 90 rBEY = .0127 x 4.0556 = .0513 = 5.13%
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Effective Annual Yield

rEAY 11 $1 ,1 1 P = 1 + P
11 1 n

rBD=5% rBEY=5.13% rEAY=5.23%

P = price of the T-bill n = number of days to maturity

Example Using Sample 1 1 T-Bill 1

rEAY 1 1 ,1 1 $1 ,1 1 $1 1 = 1 + $1 1 ,1 1
1 1

rEAY = 5.23%
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Money Market Instruments

Treasury bills Discount Certificates of deposit BEY* Commercial Paper Discount Bankers Acceptances Discount Eurodollars BEY* Federal Funds BEY* Repurchase Agreements (RPs) and Reverse RPs Discount
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Bond Market
Corporate Bonds
GE

Government
Treasury Notes and Bonds

Federal Agency Debt

GMNA

Municipal Bonds
Colorado E470

International Bonds Mortgages and Mortgage-Backed Securities

Treasury Notes and Bonds

Maturities
Notes maturities up to 10 years Bonds maturities in excess of 10 years 30-year bond
2001 Treasury suspended sales 2005 discussion to possibly resume sales
Sales have resumed

Par Value - $1,000 Quotes percentage of par Not Subject to State and Local Tax
One Arm of the Government cant tax the other

Capital Market - Fixed Income Instruments

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Federal Agency Debt

Major issuers
Government National Mortgage Association (GNMA)Ginnie Mae Federal Home Loan Bank (FHLB) Federal National Mortgage Association (FNMA)Fannie Mae Federal Home Loan Mortgage Corporation (FHLMC)Freddie Mac Also Student Loan Marketing Association (SLM)- Sallie Mae

Municipal Bonds
Issued by state and local governments Types
General obligation bonds
Ad Valorem- backed by unlimited taxing power

Revenue bonds
Industrial revenue bonds- backed revenue from project

Maturities range up to 30 years Not Subject to Federal Tax Not subject to State and Local tax when investor is resident of State
Colorado Residents investing in E470 Muni

Figure 2.5 Outstanding Tax Exempt Debt

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Municipal Bond Yields

To compare yields on taxable securities a Taxable Equivalent Yield is calculated TEY= Tax Free Yield/(1- Tax Bracket)
Colorado E470 Bond yielding 3.5% GE Bond yielding 5.0% Your Tax Bracket is 28%
TEY of E470 Bond = 3.5/.72 = 4.86%

Equivalent Tax Free Yield

Finding the tipping point between taxable and tax free = Taxable Yield x (1- Tax Bracket) = 5.0 x .72 = 3.6%

Yields on Tax-exempts to Taxables

All about Tax Brackets Tax Brackets are 10%, 15%, 25%, 28%, 35% The market determines the tipping point Recent history has this ratio at .75
Meaning that those in the 25% Bracket and above would invest

Table 2.3 Equivalent Taxable Yields

rTax Exempt = rTaxable (1 Tax Rate)

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Corporate Bonds
Issued by private firms Semi-annual interest payments
Accruing interest at buy and sell

Subject to larger default risk than government securities Options in corporate bonds
Callable Convertible

Figure 2.7 Investment Grade Bond Listings

Capital Market - Fixed Income Instruments

Mortgage-Backed Securities
Pass-through
A security backed by a pool of mortgages. The pool backer passes through monthly mortgage payments made by homeowners and covers payments from any homeowners that default. Collateral:
Traditionally all mortgages were conforming mortgages but since 2006, Alt-A and subprime mortgages were included in pools

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Capital Market - Fixed Income Instruments

Mortgage-Backed Securities
Political encouragement to spur affordable housing led to increase in subprime lending Private banks began to purchase and sell pools of subprime mortgages Pool issuers assumed housing prices would continue to rise, but they began to fall as far back as 2006 with disastrous results for the markets.
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Figure 2.7 Mortgage Backed Securities Outstanding

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The U.S. Bond Market

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Equity Markets
Common stock
Residual claim Limited liability

Preferred stock
Fixed dividends - limited Priority over common Tax treatment

Depository receipts

Capital Market - Equity

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Capital Market - Equity

Capital Gains and Dividend Yields
You buy a share of stock for $50, hold it for one year, collect a $1.00 dividend and sell the stock for $54. What were your dividend yield, capital gain yield and total return? (Ignore taxes) Dividend yield: = Dividend / Pbuy $1.00 / $50 = 2% Capital gain yield: = (Psell Pbuy)/ Pbuy ($54 - $50) / $50 = 8% Total return: = Dividend yield + Capital gain yield 2% + 8% = 10%
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2.4 Stock and Bond Indexes

Uses Track average returns Comparing performance of managers Base of derivatives Factors in constructing or using an index Representative? Broad or narrow? How is it constructed?
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Examples of Indexes - Domestic

Dow Jones Industrial Average (30 Stocks) Standard & Poors 500 Composite NASDAQ Composite Russell 2000 Wilshire 5000

Figure 2.9 Comparative Performance of Several Stock Market Indices, 2001-2008

Why has performance differed for the indices?

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Construction of Indexes
How are stocks weighted?
Price weighted (DJIA) Market-value weighted (S&P 500, NASDAQ) Equally weighted (Value Line Index)

Table 2.4 Data to Construct Stock Price Indexes

DJIA Price-Weighted Average

Using data from Table 2.4; example 2.2 Initial value = $25 + $100 = $125 Final value = $30 + $ 90 = $120 Percentage change in portfolio value = 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%

S&Ps Composite 500 Market Value-Weighted Index

Using data from Table 2.4:
ABC would have five times the weight given to XYZ

Value Line Equally Weighted Index

Places equal weight on each return Using data from Table 2.4 Start with equal dollars in each investment ABC increases in value by 20% XYZ decreases by 10% Need to rebalance to keep equal weights

Table 2.6 Companies in the Dow Then & Now

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Examples of International Indices

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Derivatives Securities
Options Basic Positions
Call (Buy) Put (Sell)

Futures Basic Positions

Long (Buy) Short (Sell)

Terms
Exercise Price Expiration Date Assets

Terms
Delivery Date Assets

Figure 2.10 Stock Options on Apple

What does the term strike or exercise price refer to? What is an option premium?
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