Chapter 2 Asset Classes and Financial Instruments PDF

Because learning changes everything.® Chapter 2 Asset Classes and Financial Instruments INVESTMENTS BODIE, KANE, MARCUS © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.  Chapter...

Because learning changes everything.® Chapter 2 Asset Classes and Financial Instruments INVESTMENTS BODIE, KANE, MARCUS © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.  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. Capital markets: longer term and riskier securities. Divided into four segments—longer-term bonds, equity, options, and futures. © McGraw Hill 2  Money Market Securities 1 Treasury Bills (T-bills). Government issued debt sold to the public. Ask price: price you pay to buy a T-bill from a securities dealer. Bid price: lower price you receive if you sell a T-bill to a dealer. Bid–ask spread: difference in 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. Time deposit cannot be withdrawn on demand (without penalty). Insured up to $250,000 by FDIC. © McGraw Hill 3  Money Market Securities 2 Commercial paper. Short-tern 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. Bankers’ acceptance. An order to a bank by a customer to pay a sum of money at a future date. © McGraw Hill 4  Money Market Securities 3 Eurodollars. Dollar-denominated deposits at foreign banks or foreign branches of American banks. Repurchase agreements (Repos). Short-term, often overnight, sales of securities with an agreement to repurchase them at a slightly higher price. Term Repo: 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. © McGraw Hill 5  Money Market Securities 4 Federal funds. Funds in a bank’s reserve account at the Federal Reserve. Loans arranged at federal funds rate. Brokers’ calls. Investors may buy stocks on margin and brokers, in turn, may borrow the funds from a bank. © McGraw Hill 6  LIBOR and Its Replacement London Interbank Offer Rate (LIBOR). Was the premier European money market interest rate. Based on surveys of rates reported by participating banks not actual transactions. 2012 Scandal → Regulators phased out LIBOR by 2021. Secured Overnight Financing Rate (SOFR). Rate on overnight repurchase agreements collateralized by Treasury securities. Replaced LIBOR in the United States. Since well-collateralized → cleaner expression of time value of money. © McGraw Hill 7  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. Government funds hold short-term U.S. Treasury or agency securities. Prime funds also hold other money market instruments. © McGraw Hill 8  Figure 2.2 Spread Between Federal Funds and T-Bills Rates Access the text alternative for slide images. © McGraw Hill 9  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. © McGraw Hill 10  Debt Instruments 1 Treasury notes and Treasury bonds. U.S. 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. Inflation-protected treasury bonds. Government-issued bonds linked to a cost of living index. Provide citizens an effective hedge against inflation risk. In the United States, they are called TIPS. © McGraw Hill 11  Table 2.3 Listing of Treasury Securities, July 14, 2021 LISTING OF TREASURY ISSUES ASKED YIELD TO MATURITY COUPON BID ASKED CHANGE MATURITY 15-Nov-21 2.000 100.206 100.212 −0.008 0.013 31-Mar-22 1.750 101.060 101.064 −0.006 0.056 15-May-25 2.125 105.252 105.256 0.058 0.592 15-Feb-36 4.500 138.234 138.244 0.960 1.525 15-Feb-40 4.250 139.160 139.180 0.158 1.815 15-May-51 2.375 108.224 108.244 1.128 1.984 Note: the yield to maturity in the last column doubles the semiannual yield (APR) rather than compounding it. © McGraw Hill 12  Debt Instruments 2 Federal agency debt. Agencies formed to channel credit to a particular sector that Congress believes might not receive adequate credit through private sources. For example: FHLB, FNMA, GNMA, and FHLMC. International bonds. International capital market largely centered in London. Eurobond: denominated in a currency other than that of the issuing country (i.e., Eurodollar, Euroyen). Yankee bond: dollar-denominated bond sold in the United States by a non-U.S. issuer (see also: Samurai bond, Bulldog bond, etc. ). ete.ra © McGraw Hill 13  Debt Instruments 3 Municipal Bonds. Tax-exempt bonds issued by state and local governments. 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, and so on. etera Industrial development—revenue bond issued to finance commercial enterprises. Vary widely in maturity. © McGraw Hill 14  Figure 2.4 Tax-Exempt Debt Outstanding Access the text alternative for slide images. © McGraw Hill 15  Municipal Bond Yields Taxable Versus Tax- Exempt Bonds Compare after-tax returns on each bond. t = Investor's combined federal and local marginal tax rate rtaxable = Before-tax return on the taxable bond rtaxable × (1 − t ) =After-tax return on the taxable bond rmuni = Municipal bond rate rtaxable × (1 − t ) > rmuni Taxable bond gives a higher return; otherwise, the municipal bond is preferred. © McGraw Hill 16  Table 2.1 Tax-Exempt Yield Table Equivalent Taxable Yield. rtaxable × (1 − t ) =rmuni Tax-Exempt Yield Marginal Tax Rate 1% 2% 3% 4% 5% 20% 1.25% 2.20% 3.75% 5.00% 6.25% 30 1.43 2.86 4.29 5.71 7.14 40 1.67 3.33 5.00 6.67 8.33 50 2.00 4.00 6.00 8.00 10.00 © McGraw Hill 17  Figure 2.5 Yield Ratio on Muni Debt to Corporate Baa Debt Access the text alternative for slide images. © McGraw Hill 18  Debt Instruments 4 Corporate bonds. Private firms borrow money directly from the public. Secured bonds: specific collateral backed. Unsecured bonds: debenture. Subordinated debentures: lower priority debenture. 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. © McGraw Hill 19  Debt Instruments 5 Mortgage- and asset-backed securities. 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. © McGraw Hill 20  Figure 2.6 Mortgage-Backed Securities Outstanding Access the text alternative for slide images. © McGraw Hill 21  Figure 2.7 Asset-Backed Securities Outstanding Access the text alternative for slide images. © McGraw Hill 22  Equity Securities: Common Stock Represent ownership shares in a corporation. Each share entitles owner to one vote. Corporation controlled by board of directors elected by shareholders. Residual claim: last in line of all who have a claim on the assets and income of the corporation. Limited liability: shareholders can lose a maximum of their original investment in the event of corporate failure. © McGraw Hill 23  Equity Securities: 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/falls short of the purchase price. Price–earnings ratio. Ratio of a stock’s price to its earnings per share. © McGraw Hill 24  Table 2.8 Stock Listings Traded on the NY SE, June 2021 NAME SYMBOL CLOSE CHANG VOLUME 52 WK 52 WK DIV YIELD P/E E LOW LOW Herbalife Nutrition HLF 51.45 −0.05 434.355 59.00 43.01........ 13.77 Hershey HSY 177.57 1.64 658.253 178.36 134.46 3.22 1.81 26.42 Hess Corp HES 80.39 3.52 2,143.509 91.09 34.82 1.00 1.24.... Hewlett Packard HPE 14.01 0.25 9,448.992 16.74 8.28 0.48 3.43 28.42 Home Depot HD 319.22 2.17 33,775.308 345.69 246.59 6.60 2.07 23.27 Honda HMC 32.54 0.13 406.532 33.32 23.10 1.02 3.13 9.00 Honeywell HON 227.22 3.69 2,602,709 234.02 146.21 3.72 1.64 34.87 © McGraw Hill 25  Equity Securities: Preferred Stock Preferred stock has features similar to both equity and debt. Promises to pay a fixed amount of income each year in preference to the common stock (behaves as perpetuity). Does not convey voting power. No contractual obligation to pay, but dividends owed accumulate. Preferred stock payments are dividends rather than interest → not a tax-deductible expense for the firm. Other corporations that own domestic preferred stock may exclude 50% of dividends when computing taxable income. © McGraw Hill 26  Equity Securities: Depository Receipts American Depository Receipts (ADRs). 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. © McGraw Hill 27  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). More broad-based index of 500 largest domestic firms. Market-value-weighted. Index Fund and Exchange-Traded Funds (ETF). © McGraw Hill 28  Other Indexes U.S. market-value indexes. Russell Indexes: Market segment specific. NYSE, NASDAQ, Wilshire 5000, CRSP. Equally weighted indexes. Do not correspond to buy-and-hold strategies. Foreign and international stock market indexes. Nikkei, FTSE, DAZ, Hang Seng, TSX. © McGraw Hill 29  Figure 2.9 U.S. Fixed-Income Market ($ billions) Bond market indexes. Measure the performance of various categories of bonds. Access the text alternative for slide images. © McGraw Hill Securities Industry & Financial Markets Association, www.sifma.org October, 2018 30  Derivative Markets Derivative asset: A claim that’s value is directly dependent on the value of an underlying asset or assets. Also known as contingent claims. Options. Futures/Forwards. Swaps. © McGraw Hill 31  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 price on or before a specified expiration date. © McGraw Hill 32  Table 2.6 Stock Options, Microsoft, July, 2021 Expiration Strike Call Put 6-Aug-2021 280 7.74 5.18 6-Aug-2021 285 5.06 7.48 6-Aug-2021 290 3.31 10.35 17-Sep-2021 280 10.97 8.59 17-Sep-2021 285 8.45 10.79 17-Sep-2021 290 6.22 13.98 Note: Microsoft stock price on this day was $282.51. © McGraw Hill 33  Derivatives Markets: Futures Contract Futures contract. Calls for delivery of an asset (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. © McGraw Hill 34  Comparison Options Futures Contract Right, but not obligation, to Obliged to make or take buy or sell. delivery. Option is exercised only Long (short) position must when it is profitable. buy (sell) at the futures Options must be purchased price. at a premium. Futures contracts are entered into without cost. © McGraw Hill 35