Chapter 2: Asset Classes and Financial Instruments PDF

**CHAPTER 2-ASSET CLASSES AND FINANCIAL INSTRUMENTS** ===================================================== **CHAPTER OVERVIEW** **Building an investment portfolio** Asset allocation to broad classes of assets Security selection within each class **FINANCIAL MARKETS** **Money markets** - short...

**CHAPTER 2-ASSET CLASSES AND FINANCIAL INSTRUMENTS** ===================================================== **CHAPTER OVERVIEW** **Building an investment portfolio** Asset allocation to broad classes of assets Security selection within each class **FINANCIAL MARKETS** **Money markets** - short term, marketable, liquid, low-risk debt securities - Subsector of the fixed income market - Accessible to small investors **Capital markets** -- longer term and riskier securities - Divided into 4 segments: - Longer-term bonds - Equity - Options - futures **MONEY MARKET SECURITIES** **Treasury Bills (T-bills)** - Government issued debt sold to the public/raises money by selling bills to the public - Most marketable of all money market institutions - Sell in minimum denominations - Exempt from all state and local taxes - Highly liquid (easily converted to cash and sold at a low transaction cost, with not much price risk **Ask price** is the price you pay to buy a T-bill from a securities dealer **Bid price** is a lower price you receive if you sell a T-bill to a dealer **Bid-ask spread** is the difference in the ask price and bid price; dealer's source of profit **Certificates of deposit (CD)** - Bank pays interest and principal to the depositor only at maturity - Can be sold to another investor if the owner needs to cash in the certificate before its maturity date - Time deposit cannot be withdrawn on demand (without penalty) - Insured up to \$250,000 by FDIC - Short term CDs highly marketable **MONEY MARKET SECURITIES** **Commerical paper** - Short-term unsecured debt notes, often issued by large, well-known companies and backed by a bank line of credit - Maturity: up to 270 days, typically 1 month or less - Gives borrower access to cash that can be used (if needed) to pay off the paper maturity) - Fairly safe asset **Banker's acceptance** - An order to a bank by a customer to pay a sum of money at a future date - Safe assets because traders can substitute the bank's credit standing for their own - Sell at a discount from the face value of the payment order **MONEY MARKET SECURITIES** **Eurodollars** -- dollar denominated deposits at foreign banks or foreign branches of American banks - Banks escape regulation by Federal Reserve **Repurchase agreements (Repos)** - Increase in price is the overnight interest - Short term, often overnight, sales of securities with an agreement to repurchase the next day at a slightly higher price - **Term Repo** -- a term of the implicit loan can be 30 days or more - **Reverse Repo** -- dealer buys government securities from investor, agreeing to sell them back on a future date - Very safe in terms of credit risk because the loans are backed by the government securities **MONEY MARKET SECURITIES** **Federal funds** - Funds in a bank's reserve account at the Federal Reserve - Loans arranged at **federal funds rate** (rate of interest on very short-term loans among financial institutions - Each member bank is required to maintain a minimum balance in a reserve account with the fed **Brokers' calls** - Investors may buy stocks on **margin** and brokers, in turn, may borrow the funds from the bank - Rate paid on loans usually 1% higher than the rate on short-term T-bills **LIBOR AND ITS REPLACEMENT** **London Interbank offer rate (LIBOR)** - Rate at which large banks in London are willing to lend money among themselves - Was the premier European money market interest rate - Based on surveys of rates reported by participating banks not actual transactions - 2012 Scandal -- regulators phase out LIBOR by 2021 - Serves as a reference rate for a wide range of transactions **Secured overnight financing rate (SOFR)** - Rate on overnight repurchase agreements collateralized by treasury securities - Replaced LIBOR in US - Since well collateralized - cleaner expression of time value of money **YIELDS ON MONEY MARKET INSTRUMENTS** Most money market securities are low risk, but not risk-free, particularly during significant market events (see figure 2.2) **Money market funds** are mutual funds that invest in money market instruments and have become major sources of funding to that sector - Government funds hold short-term US Treasury or agency securities - Prime funds also hold other money market instruments **THE BOND MARKET** Bond market is composed of longer term borrowing or debt instruments than those that trade in the money market - Treasury notes and bonds - Corporate bonds - Municipal bonds - Mortgage securities - Federal agency debt **DEBT INSTRUMENTS** **Treasury notes and Treasury bonds** US government borrows funds in large part by selling T-notes and T-bonds - Notes -- maturities range up to 10 years - Bonds -- maturities range from 10 to 30 years (both make semi-annual interest payments called coupon payments) **Inflation protected treasury bonds** - Government issued bonds linked to a cost-of-living index - Provide citizens an effective hedge against inflation risk - Best place to start building an investment portfolio is at the least risky end of the spectrum - In the US, they are called **TIPS** (treasury inflation protected securities); provide a constant stream of income in real (inflation-adjusted) dollars **DEBT INSTRUMENTS** **Federal agency debt** Agencies formed to channel credit to a particular sector that Congress believes might not receive adequate credit through private sources - Ex: FHLB (federal home loan bank), FNMA (federal national mortgage association), GNMA (aka Fannie Mae, government national mortgage association), FHLMC (aka Freddie Mac, federal home loan mortgage corporation) **Internation bonds** Internation capital market largely centered in London - **Eurobond** denominated in a currency other than that of the issuing country (i.e. Eurodollar, Euroyen, internation bonds) - **Yankee** **bond** dollar denominated bond sold in the US by a non-US issuer (see also: Samurai bond, Bulldog bond, etc.) **DEBT INSTRUMENTS** **Municipal bonds** Interest income exempt from federal government Tax exempt bonds issued from state and local taxation - General obligation backed by general taxing power of issuer - Revenue backed by proceeds from the project or agency they are issued to finance - Typically issued by airports, hospitals, turnpike or port authorities - Industrial development revenue bond issued to finance commercial enterprises - Construction of a factory that can be operated by a private firm Vary widely in maturity - Key feature of municipal bonds is their tax-exempt status **DEBT INSTRUMENTS** **Corporate bonds** Private firms borrow money directly from the public - **Secured bonds** specified collateral backed in the event of bankruptcy - **Unsecured bonds** -- debenture, have no collateral - **Subordinated debentures** -- lower priority debenture, have a claim to the firm's assets in the event of bankruptcy Usually pay semiannual coupons Return face value to bondholder at maturity Larger default risk than Treasury-issued securities May come with options attached - **Callable** -- issuer has option to repurchase at call price - **Convertible** -- bondholder has option to convert bond to a prespecified number of shares of stock **DEBT INSTRUMENTS** Almost anyone can invest in a portfolio of mortgage loans **Mortgage and asset backed securities** - Major component of the fixed income market - Ownership claim in a pool of mortgages or an obligation that is secured by such a pool **Conforming mortgages** - Loans must satisfy certain underwriting guidelines before they may be purchased by Fannie Mae or Freddie Mac **Subprime mortgages** - Riskier loans made to financially weaker borrowers **EQUITY SECURITIES: COMMON STOCK** Represent ownership shares in a corporation Each share entitles owner to one vote on any matters of corporate governance Corporation controlled by board of directors elected by shareholders 2 most important characteristics of common stock as an investment: - **Residual claim** stockholders last in line of all who have a claim on the assets and income of the corporation - **Limited liability** shareholders can loose a maximum of their original investment in the event of corporate failure Proxy empowers another party to vote in their name **EQUITY SECURITIES: STOCK MARKET LISTINGS** **Dividend yield** Annual divident payment expressed as a percent of the stock price Ignores prospective capital gains (i.e. price increases) or losses **Capital gains** Amount by which the sale price of a security exceeds/falls short of the purchase price **Price-earnings ratio** Ratio of a stock's price to its earnings per share Tells us how much stock purchases must pay per dollar of earnings that the firm generates **EQUITY SECURITIES: DEPOSITORY RECEIPTS** American depository receipts (ADRs) - Certificates traded in US 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 - Created to make it easier for foreign firms to satisfy US security registration requirements **STOCK MARKET INDEXES** **Dow Jones Industrial Average (DJIA)** Best known measure of the performance of stock market Includes 30 large blue-chip corporations Computed since 1896 Price weighted average corresponds to a portfolio that holds one share of each component stock The investment in each company in that portfolio is proportional to the company's share price **Standard & Poor's 500 (S&P 500)** More broad-based index of 500 largest domestic firms Market value weighted Index fund and exchange-traded funds (ETF) - Index fund is a yield of return equal to that of the index and so provides a low-cost passive investment strategy for equity investors - Exchange-traded funds (ETF) is a portfolio of shares that can be bought or sold as a unit **OTHER INDEXES** **US market value indexes** Russell indexes: market segment specific NYSE, NASDAQ, Wilshire 5000, CRSP **Equally weighted indexes** Don't correspond to buy and hold strategies **Foreign and internation stock market indexes** Nikkei, FTSE, DAZ, Hang Seng, TSX **DERIVATIVE MARKETS** **Derivative asset** is a claim that's value is directly depended on the value of an underlying asset or assets - Aka: contingent claims because their payoffs are contingent on the value of other values - Options - Futures/forwards - Swaps **DERIVATIVES MARKETS: OPTIONS** **Call option** Gives holder the right to purchase an asset for a specified price, called the **exercise** or **strike price** on or before a specified expiration date **Put option** Gives holder the right to sell an asset for a specified exercise priced on or before a specified expiration date When the market price exceeds the exercise price, the option holder may "call away" the asset for the exercise price and reap a payoff equal to the difference between the stock price and the exercise price **DERIVATIVES MARKETS: FUTURE CONTRACT** **Future contract** Calls for delivery of an asst (or cash value) at a specified delivery or maturity date for an agreed-upon 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 trader who commits to delivering the asset at contract maturity