Finance Chapter 2: Asset Classes and Instruments

Chapter 2: Asset Classes and Financial Instruments

• This chapter covers the basics of asset classes and financial instruments, focusing on investments.
• The authors are Bodie, Kane, and Marcus.

Chapter Overview

• Building an investment portfolio involves asset allocation to broad asset classes and security selection within each class.
• Financial markets include money markets and capital markets.

Money Markets

• Money markets consist of short-term, marketable, liquid, and low-risk debt securities.
• Treasury Bills (T-bills) are government-issued debt sold to the public.
  • Investors buy T-bills at the ask price and sell them at the bid price.
  • The difference between the ask and bid price is the dealer's profit.
• Certificates of Deposit (CDs) are time deposits offered by banks, paying interest and principal at maturity.
  • CDs cannot be withdrawn before maturity without penalty.
  • CDs are insured up to $250,000 by the FDIC.
• Commercial paper is short-term unsecured debt notes issued by large, well-known companies and backed by bank lines of credit.
  • Maturity typically ranges up to 270 days, usually 1 month or less.
• Banker's acceptances are orders to a bank by a customer to pay a sum of money at a future date.
• Eurodollars are dollar-denominated deposits at foreign banks or foreign branches of American banks.
• Repurchase agreements (Repos) involve short-term, often overnight, sales of securities with an agreement to repurchase them later at a higher price.
  • Term Repo: the implicit loan can be 30 days or more.
  • Reverse Repo: a dealer buys government securities from an investor, agreeing to resell them later.
• Federal funds are funds held in a bank's reserve account at the Federal Reserve.
  • Banks loan these funds to one another at the federal funds rate.
• Brokers' calls allow investors to buy stocks on margin, with brokers borrowing funds from banks to finance the purchase.

LIBOR and Its Replacement

• LIBOR (London Interbank Offered Rate) was the standard European money market interest rate.
  • It was calculated based on surveys of rates among participating banks, rather than actual transactions.
• The 2012 LIBOR scandal led regulators to phase out LIBOR by 2021.
• The Secured Overnight Financing Rate (SOFR) replaced LIBOR in the United States.
  • SOFR is the rate on overnight repurchase agreements collateralized by Treasury securities.
  • It's a better measure of the time value of money due to its collateralization.

Yields on Money Market Instruments

• Most money market securities are low risk, but not risk-free, especially during market downturns.
• Money market funds (MMFs) are mutual funds investing in money market instruments.
  • Government funds hold short-term U.S. Treasury or agency securities.
  • Prime money market funds often hold other money market instruments.

The Bond Market

• The bond market involves longer-term borrowing or debt instruments than the money market.
• Instruments include:
  • Treasury notes and bonds
  • Corporate bonds
  • Municipal bonds
  • Mortgage securities
  • Federal agency debt

Debt Instruments

• Treasury notes and Treasury bonds: U.S. government debt instruments with maturities ranging from 0 to 30 years.
  • Notes have maturities up to 10 years.
  • Bonds have maturities from 10 to 30 years.
• Inflation-protected treasury bonds (TIPS): linked to a cost of living index, providing an inflation hedge.
• Federal agency debt: government-sponsored agencies create credit for specific sectors that the private sector may not meet.
  • Examples include FHLB, FNMA, GNMA, and FHLMC.

Municipal Bonds

• These are tax-exempt bonds issued by state and local governments.
  • General obligation bonds are backed by the issuer's taxing power.
  • Revenue bonds are backed by the proceeds from the project or agency they finance

Corporate Bonds

• Corporate bonds are debt securities issued by private companies.
• They are often classified as either secured or unsecured, with secured bonds having collateral. Subordinated debentures are lower priority debentures.
• They typically pay semiannual coupons.
• Risk of default is typically higher than Treasury securities.

Mortgage- and Asset-Backed Securities

• These securities represent ownership in a pool of mortgages or an obligation backed by such a pool.
• Conforming mortgages satisfy specific underwriting guidelines for purchase by Fannie Mae or Freddie Mac.
• Subprime mortgages are riskier loans made to financially weaker borrowers.

Equity Securities: Common Stock

• Common stock represents ownership shares in a corporation.
• Each share entitles the owner to one vote.
• Corporations are controlled by a board of directors voted in by shareholders.
• Shareholders have a residual claim on the corporation’s assets and income.
• Shareholders have limited liability.

Equity Securities: Dividend, Capital and Price-Earnings Ratios

• Dividend yield: annual dividend expressed as a percentage of the stock price.
• Capital gains: amount by which the sale price of a security exceeds its purchase price.
• Price-earnings ratio: ratio of a stock's price to its earnings per share.

Equity Securities: Preferred Stock & Depository Receipts (ADRs)

• Preferred stock resembles both equity and debt, promising a fixed income payment (like a perpetuity) but without voting rights. Dividend payments accumulate until paid.
• American Depository Receipts (ADRs) are certificates traded in U.S. markets representing ownership in a foreign company's shares.

Stock Market Indices

• Dow Jones Industrial Average (DJIA) and Standard & Poor's 500 (S&P 500) are broad-based indexes of large U.S. companies.
  • DJIA is price-weighted.
  • S&P 500 is market-value weighted.
• Other market-value indexes and equally weighted indexes like Russell indexes, NYSE, NASDAQ, Wilshire 5000, and CRSP, also exist and measure performance.
  • Foreign and international stock market indexes include Nikkei, FTSE, DAZ, Hang Seng, and TSX.

Bond market indices

• These measure the performance of various categories of bonds.

Derivatives Markets

• Derivative assets are claims whose value depends on the value of underlying assets or a set of assets.
  • Also known as "contingent claims".
• Options (call, put): give the holder the right (not the obligation) to buy or sell an asset at a set price (exercise/strike price) on or before a certain date.
• Futures contract: obligates the holder to buy or sell an asset on a set date at a fixed price.
• Futures contracts often are entered into without cost.

Explore the fundamentals of asset classes and financial instruments through this quiz based on Chapter 2 of Bodie, Kane, and Marcus. Learn about the importance of asset allocation and the characteristics of money markets, including T-bills and CDs. Enhance your understanding of investment portfolios and financial markets.