Investments Chapter 2: Asset Classes and Financial Instruments

Asset Classes and Financial Instruments

• Asset allocation involves making decisions about how much money to allocate to broad classes of assets.
• Security selection occurs when the investor selects specific assets from within each class.

Financial Markets

• Financial markets can be divided into two main segments: money markets and capital markets.
• Money markets are made up of short-term, marketable, liquid, low-risk debt securities.
• Capital markets include longer-term and riskier securities, divided into four segments:
  • Longer-term bond markets
  • Equity markets
  • Derivative markets for options and futures

Money Market Securities

• Treasury Bills (T-bills):
  • Simplest form of borrowing where the government raises money by selling bills to the public.
  • Ask price is the price you would have to pay to buy a T-bill from a securities dealer.
  • Bid price is the slightly lower price you would receive if you wanted to sell a bill to a dealer.
  • Bid-ask spread is the difference in these prices, which is the dealer's source of profit.
• Certificates of Deposit (CD):
  • Bank pays interest and principal to the depositor only at maturity.
  • Time deposit cannot be withdrawn on demand.
• Commercial paper:
  • Short-term unsecured debt notes, often issued by large, well-known companies and backed by a bank line of credit.
• Bankers' acceptance:
  • An order to a bank by a customer to pay a sum of money at a future date.
• Eurodollars:
  • Dollar-denominated deposits at foreign banks or foreign branches of American banks.
• Repurchase agreements:
  • Short-term, often overnight, sales of securities with an agreement to repurchase them at a slightly higher price.
• Federal funds:
  • Funds in a bank's reserve account at the Federal Reserve Bank.
• Brokers' calls:
  • Investors may buy stocks on margin, and brokers, in turn, may borrow the funds from a bank.

The Money Market

• Yields on money market instruments:
  • Most money market securities are low-risk, but not risk-free.
  • Money market funds are mutual funds that invest in money market instruments.
• LIBOR (London Interbank Offered Rate):
  • The premier short-term interest rate quoted in the European money market.
  • Based on surveys of rates reported by participating banks rather than actual transactions.
  • Regulators have proposed phasing out LIBOR by 2021.

The Bond Market

• The bond market is composed of longer-term borrowing or debt instruments than those that trade in the money market.
• Types of bonds:
  • Treasury notes and bonds
  • Corporate bonds
  • Municipal bonds
  • Mortgage securities
  • Federal agency debt

Debt Instruments

• Treasury notes and bonds:
  • U.S. government borrows funds in large part by selling T-notes and T-bonds.
  • Notes have maturities ranging up to 10 years.
  • Bonds have maturities ranging from 10 to 30 years.
  • Inflation-protected treasury bonds (TIPS) are issued by some countries to provide their citizens with an effective way to hedge inflation risk.
• Federal agency debt:
  • Agencies formed to channel credit to a particular sector that Congress believes might not receive adequate credit through private sources.
  • Examples include FHLB, FNMA, GNMA, and FHLMC.
• International bonds:
  • International capital market centered in London.
  • Eurobond is a bond denominated in a currency other than that of the country in which it is issued.
  • Yankee bond is a dollar-denominated bond sold in the U.S. by a non-U.S. issuer.
• Municipal bonds:
  • Tax-exempt bonds issued by state and local governments.
  • General obligation bonds are backed by the general taxing power of the issuer.
  • Revenue bonds are backed by the proceeds from the project or agency they are issued to finance.
  • Industrial development bonds are revenue bonds issued to finance commercial enterprises.
• Corporate bonds:
  • Means by which private firms borrow money directly from the public.
  • Secured bonds
  • Unsecured bonds (i.e., debentures)
  • Subordinated debentures
  • May come with options attached (e.g., callable or convertible options)
• Mortgage- and asset-backed securities:
  • Ownership claim in a pool of mortgages or an obligation that is secured by such a pool.
  • Conforming mortgages must satisfy certain underwriting guidelines before they may be purchased by Fannie Mae or Freddie Mac.
  • Subprime mortgages are riskier loans made to financially weaker borrowers.

Equity Securities

• Common stock:
  • Represents ownership shares in a corporation.
  • Each share entitles the owner to one vote.
  • Corporation is controlled by a board of directors elected by shareholders.
  • Residual claim: stockholders are last in line of all who have a claim on the assets and income of the corporation.
  • Limited liability: most shareholders can lose only their original investment in the event of corporation failure.
• Stock market listings:
  • Dividend yield: annual dividend payment expressed as a percent of the stock price.
  • Capital gains: amount by which the sale price of a security exceeds the purchase price.
  • Price-earnings ratio: ratio of a stock's price to its earnings per share.
• Preferred stock:
  • Has features similar to both equity and debt.
  • Like a bond, promises to pay a fixed amount of income each year.
  • Does not convey voting power regarding the management of the firm.
  • Contractual obligation to pay interest, but not dividends.
  • Preferred stock payments are treated as dividends rather than interest, so they are not a tax-deductible expense for the firm.
• Depository receipts:
  • American Depository Receipts (ADRs) are certificates traded in U.S. markets that represent ownership in shares of a foreign company.
  • Each ADR may correspond to ownership of a fraction of a foreign share, one share, or several shares of the foreign corporation.

Stock Market Indexes

• Dow Jones Industrial Average (DJIA):
  • Includes 30 large blue-chip corporations.
  • Computed since 1896.
  • Price-weighted average.
• Standard & Poor's 500 (S&P 500):
  • Improvement over DJIA in two ways:
    • More broadly based index of 500 firms.
    • Market-value-weighted index.
• Other indexes:
  • U.S. market-value indexes (e.g., NYSE, NASDAQ, Wilshire 5000, CRSP).
  • Equally weighted indexes.
  • Foreign and international stock market indexes (e.g., Nikkei, FTSE, DAX, Hang Seng, TSX).

Derivative Markets

• Derivative asset is a claim whose value is directly dependent on or is contingent on the value of some underlying assets.
• Types of derivatives:
  • Options
  • Futures
• Options:
  • Call option: gives the holder the right to purchase an asset for a specified price (strike price) on or before a specified expiration date.
  • Put option: gives the holder the right to sell an asset for a specified exercise price on or before a specified expiration date.
• Futures contract:
  • Calls for delivery of an asset (or cash value) at a specified delivery or maturity date for an agreed-upon price (futures price) to be paid at contract maturity.
  • Long position: held by the trader who commits to purchasing the asset on the delivery date.
  • Short position: held by the trader who commits to delivering the asset at contract maturity.
• Comparison of options and futures:
  • Options: right, but not obligation, to buy or sell.
  • Futures: obliged to make or take delivery.
  • Options: must be purchased, and the premium is the price of the option itself.
  • Futures: entered into without cost.