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Chapter 2 Asset Classes and Financial Instruments Mc. Graw-Hill/Irwin Copyright © 2010 by The Chapter 2 Asset Classes and Financial Instruments Mc. Graw-Hill/Irwin Copyright © 2010 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

2. 1 The Money Market 2 -2 2. 1 The Money Market 2 -2

Money Market Instruments • • Treasury Bills Certificates of Deposit Commercial Paper Bankers’ Acceptances Money Market Instruments • • Treasury Bills Certificates of Deposit Commercial Paper Bankers’ Acceptances Eurodollars Repos and Reverses Federal Funds LIBOR (London Interbank Offer Rate) 2 -3

Figure 2. 1 Money Rates 2 -4 Figure 2. 1 Money Rates 2 -4

Table 2. 2 Major Components of the Money Market 2 -5 Table 2. 2 Major Components of the Money Market 2 -5

Treasury Bills • Treasury bills – – – – Issued by Denomination Maturity Liquidity Treasury Bills • Treasury bills – – – – Issued by Denomination Maturity Liquidity Default risk Interest type Taxation Federal Government $100, commonly $10, 000 4, 13, 26, or 52 weeks Highly liquid None Discount exempt from state and local taxes 2 -6

Bank Discount Rate (T-Bill quotes) $10, 000 = Par $10, 000 - P 360 Bank Discount Rate (T-Bill quotes) $10, 000 = Par $10, 000 - P 360 r BD = x n $10, 000 r. BD = bank discount rate P = market price of the T-bill n = number of days to maturity Example 90 -day T-bill, P = $9, 875 $10, 000 - $9, 875 r BD = x $10, 000 360 90 = 5% 2 -7

Bond Equivalent Yield • Can’t compare T-bill directly to bond – 360 vs 365 Bond Equivalent Yield • Can’t compare T-bill directly to bond – 360 vs 365 days – Return is figured on par vs. price paid • Adjust the bank discount rate to make it comparable 2 -8

Bond Equivalent Yield r BEY 10, 000 - P 365 = x n P Bond Equivalent Yield r BEY 10, 000 - P 365 = x n P r. BD=5% P = price of the T-bill n = number of days to maturity Example Using Sample T-Bill 10, 000 - 9, 875 365 r BEY = x 9, 875 90 r. BEY =. 0127 x 4. 0556 =. 0513 = 5. 13% 2 -9

Effective Annual Yield r. BD=5% r. BEY=5. 13% P = price of the T-bill Effective Annual Yield r. BD=5% r. BEY=5. 13% P = price of the T-bill r. EAY=5. 23% n = number of days to maturity Example Using Sample T-Bill r. EAY = 5. 23% 2 -10

Figure 2. 2 Treasury Bills (T-bills) 2 -11 Figure 2. 2 Treasury Bills (T-bills) 2 -11

Money Market Instrument Yields • Yields on money market instruments are not always directly Money Market Instrument Yields • Yields on money market instruments are not always directly comparable Factors influencing “quoted” yields • Par value vs. investment value • 360 vs. 365 days assumed in a year Simple vs. Compound Interest 2 -12

Certificates of Deposit (CD) • Certificates of Deposit – Issued by – – – Certificates of Deposit (CD) • Certificates of Deposit – Issued by – – – Denomination Maturity Default risk Interest type Taxation Depository Institutions Any, $100, 000 or more are marketable Varies, typically 14 day minimum $100, 000 ($250, 000) is insured by FDIC Add on Interest income is fully taxable 2 -13

Commercial Paper • Commercial Paper – Issued by – – – Maturity Denomination Default Commercial Paper • Commercial Paper – Issued by – – – Maturity Denomination Default risk Interest type Taxation Large creditworthy corporations and financial institutions Maximum 270 days, usually 1 to 2 months Minimum $100, 000 Unsecured, Rated, Mostly high quality Discount Interest income is fully taxable New Innovation: Asset backed commercial paper is backed by a loan or security. 2 -14

Bankers Acceptances & Eurodollars • Bankers Acceptances – Originates when a purchaser of goods Bankers Acceptances & Eurodollars • Bankers Acceptances – Originates when a purchaser of goods authorizes its bank to pay the seller for the goods at a date in the future (time draft). – When the purchaser’s bank ‘accepts’ the draft it : specifies the amount of money, date, to whom the payment is due and becomes a contingent liability of the bank – Can be traded in SM at Discounted rate. – Very safe assets, why? – International trade(importer, exporter) • Eurodollars – Dollar denominated deposits held outside the U. S. – Pay a higher interest rate than U. S. deposits, why(FRB)? – Less liquid than domestic 2 -15

Repurchase Agreements and Reverses • Repurchase Agreements (RPs or repos) and Reverse RPs – Repurchase Agreements and Reverses • Repurchase Agreements (RPs or repos) and Reverse RPs – Short term sales of GS with an agreement to repurchase the securities a set higher price. – A RP is a collateralized loan(backed by the government securities), many are overnight=one day loan , although it may have a one month maturity. – A Reverse Repo: the dealer buys GS and resell them at a specified higher price on a future date. 2 -16

Federal Funds and LIBOR • Federal Funds – Depository institutions must maintain deposits with Federal Funds and LIBOR • Federal Funds – Depository institutions must maintain deposits with the Federal Reserve Bank. – Federal funds represents trading in reserves held on deposit at the Federal Reserve. – Key interest rate for the economy(federal funds rate) • LIBOR (London Interbank Offer Rate) – Rate at which large banks in London are willing to lend money to each other. – Base rate for many loans(reference point) – EURIBOR 2 -17

Money Market Instruments • • Treasury bills Certificates of deposit Commercial Paper Bankers Acceptances Money Market Instruments • • Treasury bills Certificates of deposit Commercial Paper Bankers Acceptances Eurodollars Federal Funds Repurchase Agreements (RPs) and Reverse RPs Discount BEY* Discount 2 -18

Example • find the add-on interest rates, bond equivalent yields when: 40 days, discount Example • find the add-on interest rates, bond equivalent yields when: 40 days, discount rate of 6 percent? • Add-on rate = • Bond equivalent yield = r

2. 2 The Bond Market 2 -20 2. 2 The Bond Market 2 -20

Capital Market - Fixed Income Instruments Government Issues • US Treasury Bonds and Notes Capital Market - Fixed Income Instruments Government Issues • US Treasury Bonds and Notes – Bonds versus Notes – Denomination – Interest type – Consumer price index/index of living cost, why? • Treasury Inflation Protected Securities (TIPS) • real/adjusted-interest rate • Marked with a trailing ‘i’ in the quote sheet (See Figure 2. 4) 2 -21

Capital Market - Fixed Income Instruments 2 -22 Capital Market - Fixed Income Instruments 2 -22

Capital Market - Fixed Income Instruments Government Issues • Agency Issues (Fed Gov) – Capital Market - Fixed Income Instruments Government Issues • Agency Issues (Fed Gov) – Mostly are home mortgage related agencies like: • FNMA(Finnie Mae), FHLMC(Freddie Mae), GNMA(Ginnie) and FHLB • Implied backing by the government • Risk of these securities? • In September 2008, Federal government took over FNMA and FHLMC. 2 -23

International Bond • Eurobond: bond denominated in currency that differ from the currency of International Bond • Eurobond: bond denominated in currency that differ from the currency of the issuer(foreign currency) • Example: dollar denominated bond sold in UK called Eurobond • In contrast, there are firms issue bond in foreign countries with investor currency • Example: non US issuer will sell a dollar denominated bond in the US • • Since the currency Euro it can be a bit confusing we call it (international bond)

Capital Market - Fixed Income Instruments Government Issues • Municipal Bonds – Issuer? • Capital Market - Fixed Income Instruments Government Issues • Municipal Bonds – Issuer? • Risk? o G. O. vs Revenue • Taxation? 2 -25

Table 2. 3 Equivalent Taxable Yields 2 -26 Table 2. 3 Equivalent Taxable Yields 2 -26

Figure 2. 5 Outstanding Tax Exempt Debt 2 -27 Figure 2. 5 Outstanding Tax Exempt Debt 2 -27

Figure 2. 6 Ratio of yields on tax exempt to taxable bonds 2 -28 Figure 2. 6 Ratio of yields on tax exempt to taxable bonds 2 -28

Capital Market - Fixed Income Instruments Corporate Bonds(Private Issues) • Long term debt issued Capital Market - Fixed Income Instruments Corporate Bonds(Private Issues) • Long term debt issued by private corporations typically paying semi-annual coupons and returning the face value of the bond at maturity. • Kind of corporate bonds • Different options: Callable bonds , Convertible bonds 2 -29

Priority of Claims Priority of Claims

Capital Market - Fixed Income Instruments • Mortgage-Backed Securities – Conventional mortgage(fixed rate mortgage) Capital Market - Fixed Income Instruments • Mortgage-Backed Securities – Conventional mortgage(fixed rate mortgage) – As response, the bank start to apply the adjustable rate mortgage – Shift the risk from …. . To …. . – Adjustable vs fixed regarding the rate – Pass-through – investors can buy and sell mortgages like any other bond. 2 -31

Figure 2. 7 Mortgage Backed Securities Outstanding 2 -32 Figure 2. 7 Mortgage Backed Securities Outstanding 2 -32

The U. S. Bond Market 2 -33 The U. S. Bond Market 2 -33

2. 3 Equity Securities 2 -34 2. 3 Equity Securities 2 -34

Capital Market - Equity • • Common stock(equity securities) Controlled by a board of Capital Market - Equity • • Common stock(equity securities) Controlled by a board of elected directors by. . Oversee the management Agency problem Kinds of common stock Voting systems Characteristics of common stock – Residual claim • Cash flows to common stock? • In the event of bankruptcy, what will stockholders receive? – Limited liability • What is the maximum loss on a stock purchase? 2 -35

Capital Market - Equity • Capital Gains and Dividend Yields – You buy a Capital Market - Equity • Capital Gains and Dividend Yields – You buy a share of stock for $50, hold it for one year, collect a $1. 00 dividend and sell the stock for $54. What were your dividend yield, capital gain yield and total return? (Ignore taxes) – Dividend yield: = Dividend / Pbuy $1. 00 / $50 = 2% – Capital gain yield: = (Psell – Pbuy)/ Pbuy ($54 - $50) / $50 = 8% – Total return: = Dividend yield + Capital gain yield 2% + 8% = 10% 2 -36

Capital Market - Equity 2 -37 Capital Market - Equity 2 -37

Capital Market - Equity • Preferred stock differ from bond: • Contractual obligation, Tax Capital Market - Equity • Preferred stock differ from bond: • Contractual obligation, Tax treatment • Preferred & common dividends are not tax deductible to the issuing firm • Corporate exclude 70% dividends earned from domestic firm in computing the taxable income • Preferred stock similar to bond: – Fixed dividends, non-voting, redeemable, convertible and adjustable rate of return 2 -38

Capital Market - Equity • Depository Receipts – American Depository Receipts (ADRs) also called Capital Market - Equity • Depository Receipts – American Depository Receipts (ADRs) also called American Depository Shares (ADSs) are certificates traded in the U. S. that represent ownership in a foreign security. 2 -39

2. 5 Derivative Markets Derivative assets(contingent claims): debt instruments with value that derive from/ 2. 5 Derivative Markets Derivative assets(contingent claims): debt instruments with value that derive from/ contingent on the values of other assets • Listed Call Option: – Holder the right to buy 100 shares of the underlying stock at a predetermined price on or before some specified expiration date. • Listed Put Option: – Holder the right to sell 100 shares of the underlying stock at a predetermined price on or before some specified expiration date. • What does the term ‘strike’ or exercise price refer to? • What is an option premium? 2 -40

Exercising call option • For example, if stock is trading at $50 and you Exercising call option • For example, if stock is trading at $50 and you think it’s going to go up to$60, you might buy a $55”call” option for $2 • If the stock rose to $60, which would allow you to buy the stock at $55, netting you a $3 profit on each share because everyone else in the world has to pay the market price of $60. • On the other hand, the person that sold you the “call” would be obligated to sell you the stock at $55 at a loss of $3. • If the stock never rises above $55 by expiration date, the “call” expires worthless and the “call” buyer will lose only the $2 and the seller will keep the $2 per share

Exercising the put option • For example, if stock is trading at $50 and Exercising the put option • For example, if stock is trading at $50 and you think its going to go down to$40, you might buy a $45”put” option for $2 • If the stock dropped to $40, this would allow you to sell the stock at $45, netting you a £ 3 profit on each share. • On the other hand, the person that sold you the “put” would be obligated to buy from you the stock at $45 at a loss of $3. • If the stock never dropped below $45 by expiration date, the “put” expires worthless and the “put” buyer will lose only the $2 and the seller will keep the $2 per share • Is this contract “in the money? ” 2 -42

Using the Stock Options 1. How does the exercise or strike price affect the Using the Stock Options 1. How does the exercise or strike price affect the value of a call option? A put option? Why? -the right to purchase a share at a higher price is less valuable, while, the right to sell a share at a higher price is more valuable 2. How does a greater time to contract expiration affect the value of a call option? A put option? Why? -longer the time, more premium you would pay for the call 2 -43

Futures Contracts • Obliges traders to purchase or sell an asset at an agreed-upon Futures Contracts • Obliges traders to purchase or sell an asset at an agreed-upon price at a specified future date • In a futures contract the purchaser of the contract (the long) agrees to purchase the specified quantity of the underlying commodity at contract expiration at the price (futures price) set in the contract. • The contract seller (the short) agrees to deliver the underlying commodity at contract expiration in exchange for receiving the agreed upon price. • The distinction between the right to purchase and the obligation to purchase the asset is the difference between a call option and a long position in a futures contract 2 -44

Derivatives Securities Options • Basic Positions – Call (Buy/Sell? ) – Put (Buy/Sell? ) Derivatives Securities Options • Basic Positions – Call (Buy/Sell? ) – Put (Buy/Sell? ) • Terms – Exercise Price – Expiration Date Futures • Basic Positions – Long (Buy/Sell? ) – Short (Buy/Sell? ) • Terms – Delivery Date – Delivery price 2 -45