Finance Chapter 2: Asset Classes and Instruments

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Questions and Answers

What is meant by limited liability in the context of common stock ownership?

Shareholders are entitled to frequent dividends.

Shareholders have voting rights in corporate decisions.

Shareholders can only lose their initial investment. (correct)

Shareholders can lose more than their original investment.

Which financial metric reflects the amount by which the sale price of a security exceeds its purchase price?

Capital gains (correct)

Dividend yield

Earnings per share

Price-earnings ratio

In equity securities, what does the price-earnings ratio indicate?

The historical performance of the stock over the past year.

The total earnings of the corporation divided by the number of shares.

The stock price relative to its earnings per share. (correct)

The dividend payments relative to the stock price.

What is the main characteristic of common stock in a corporation?

It represents ownership shares in the corporation. Signup and view all the answers

What does dividend yield represent for a stock?

The annual dividend payment expressed as a percentage of the stock price. Signup and view all the answers

What is the main reason for the phase-out of LIBOR by 2021?

It faced a scandal related to manipulation. Signup and view all the answers

Which of the following best describes SOFR?

A rate on overnight repurchase agreements secured by Treasury securities. Signup and view all the answers

What characterizes the risk level of money market securities during significant market events?

They are low risk but not risk-free. Signup and view all the answers

What instruments are included in the bond market?

Municipal and mortgage securities. Signup and view all the answers

What distinguishes Treasury bonds from Treasury notes?

Bonds have longer maturities than notes. Signup and view all the answers

What are Inflation-Protected Treasury Bonds commonly known as in the United States?

TIPS Signup and view all the answers

Money market funds primarily invest in which type of instruments?

Money market instruments. Signup and view all the answers

What types of securities do government funds in money market investments typically hold?

Short-term U.S. Treasury or agency securities. Signup and view all the answers

What is the formula to calculate the after-tax return on a taxable bond?

rtaxable × (1 - t) Signup and view all the answers

When would an investor prefer a municipal bond over a taxable bond?

When the after-tax return on a taxable bond is equal to the municipal bond rate Signup and view all the answers

What does the term 'secure bonds' refer to?

Bonds that have specific collateral backing them Signup and view all the answers

Which of the following describes a callable bond?

The issuer can repurchase it at a predetermined price Signup and view all the answers

What defines subordinated debentures?

They rank lower in priority compared to other debts Signup and view all the answers

Which type of mortgage is considered riskier and made to financially weaker borrowers?

Subprime mortgages Signup and view all the answers

How do municipal bonds differ from corporate bonds?

Municipal bonds are tax-exempt while corporate bonds are taxable Signup and view all the answers

In the tax-exempt yield table, what is the equivalent taxable yield if the marginal tax rate is 30% and the municipal bond rate is 5%?

7.14% Signup and view all the answers

What characterizes Treasury Bills (T-bills)?

They are government-issued debt sold to the public. Signup and view all the answers

What is a key feature of Certificates of Deposit (CD)?

They can only be redeemed at maturity, or with penalties if redeemed early. Signup and view all the answers

What defines commercial paper?

It is often issued by well-known companies and is unsecured. Signup and view all the answers

Which of the following describes repurchase agreements (Repos)?

They involve the sale of securities with a commitment to repurchase them at a later date. Signup and view all the answers

Which statement is true regarding Eurodollars?

They refer to dollar-denominated deposits at foreign banks or American banks abroad. Signup and view all the answers

What distinguishes federal funds in the banking system?

They are funds in a bank's reserve account at the Federal Reserve. Signup and view all the answers

What is the primary function of the bid-ask spread in the context of Treasury Bills?

It serves as a measure of a dealer’s profitability. Signup and view all the answers

What is the role of a Banker's Acceptance?

It is an order for a bank to pay a sum of money at a future date. Signup and view all the answers

What is the primary difference between a call option and a put option?

A call option gives the holder the right to purchase an asset, while a put option gives the holder the right to sell an asset. Signup and view all the answers

In a futures contract, who holds the long position?

The trader who commits to purchasing the asset on the delivery date. Signup and view all the answers

What is a characteristic of options compared to futures contracts?

Options provide the holder with the right but not the obligation, whereas futures require performance. Signup and view all the answers

What determines the value of derivative assets?

The value of the underlying asset or assets. Signup and view all the answers

Which statement accurately describes the premiums of call and put options for Microsoft in July 2021?

Put option premiums tend to be higher when the stock price is close to the exercise price. Signup and view all the answers

What is a significant advantage of trading options compared to futures contracts?

Options can limit losses to the premium paid, while futures can result in larger potential losses. Signup and view all the answers

What is meant by the term 'exercise price' in options trading?

The price at which the holder can buy or sell the asset in an option. Signup and view all the answers

What does the expiration date refer to in the context of options?

The last date the option can be traded or exercised. Signup and view all the answers

What is the primary distinction between preferred stock and common stock?

Preferred stock offers a guaranteed fixed income while common stock offers variable dividends. Signup and view all the answers

Which of the following is NOT a feature of American Depository Receipts (ADRs)?

Ensure a fixed return on investment, regardless of the performance of the foreign company. Signup and view all the answers

What is the difference between the DJIA and the S&P 500?

The DJIA is a broader index of 500 companies, whereas the S&P 500 focuses on 30 larger companies. Signup and view all the answers

Which type of index does NOT correspond to a buy-and-hold strategy?

Equally weighted indexes Signup and view all the answers

Which factor contributes to the high volume of transactions in the U.S. fixed-income market compared to the U.S. equity market?

Fluctuations in interest rates have a more significant impact on bond prices compared to stock prices, leading to higher trade volume. Signup and view all the answers

Which of the following would likely have the largest impact on the value of a company's preferred stock?

Changes in the prevailing interest rates in the market. Signup and view all the answers

Why are preferred stock dividends not considered a tax-deductible expense for companies?

Because preferred stock dividends are considered a distribution of profits, not a cost of doing business. Signup and view all the answers

Which of the following is a characteristic of a market-value-weighted index?

It gives more weight to companies with a higher market capitalization. Signup and view all the answers

Study Notes

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.

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Description

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.