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- Time deposit cannot be withdrawn on demand.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.