Chapter 2:

Asset Classes and Financial

Instruments

Financial Markets

Money Markets

Capital Markets

Long-term
Debt (Bond)
Markets

Equity Derivatives
Markets
Markets

Money Market: Subset of debt market. < 1 year shortterm debt instruments. Very liquid.
Capital Markets: Long-term debt, equity and derivative
securities. Riskier securities.
2

The Money Market

Treasury Bills (T-bills): Government securities with
maturities 12 months, issued at a discount from face
(maturity) value. Minimum denominations of $100.
$10,000 more common. Income exempt from state and
local taxes.

Treasury Bill Yields. July 17, 2012

3

The Money Market

T-Bills, continued
Yields quoted on bank discount basis / yield:
360
face value - price

bank discount yield

x
x 100%
face value days to maturity

At a 0.125% ask yield, what is the price of a $10,000

par T-bill that matures in 156 days?
Express the above price on a bond-equivalent yield.
365
face value - price

bond - equivalent yield

x

x 100%
price

days to maturity
4

The Money Market

Certificates of Deposit (CDs): time deposits at

banks. Large denominations negotiable.

Eurodollars: $ denominated deposits at foreign

banks or foreign branches of U.S. banks.

Bankers Acceptances: future payment by third

party backed/endorsed/accepted by its bank.

Commercial Paper: short-term (<270 days)

borrowing by large corporations. Backed by bank
lines of credit. Large denominations.

The Money Market

Repurchase Agreement (Repo): Dealer sells

securities to investor overnight and agrees to buy them
back the next day at higher price: a loan to the dealer.

Day 1

Dealer

Securities

Investor

$$
Day 2

Dealer

Securities

Investor

$$$

Reverse Repo: Opposite of Repo: Dealer buys

securities, resells to investor next day: a loan to the
investor.

The Money Market

Brokers Calls: interest rate paid by brokerage firm
on bank loan. Repayable upon demand.
Federal Funds Rate: bank to bank overnight lending
rate.

LIBOR: (London interbank offered rate): rate at

which large banks in London are willing to lend
money to one another. Can be in British Pounds,
U.S. dollars, euros, yen, etc

Major Components of The Money Market:

September 2012

*Small denominations are less then $100,000

The Bond (Fixed Income) Market

Treasury Notes and Treasury Bonds: Quoted as % of
par. i.e. 113.5391 = 113.5391% of par or $1,135.391
per $1,000 par value bond. Yield-to-maturity also
quoted. Notes, maturities of 1-10 years. Bonds, 10-30
years.

July 17, 2012

The Bond Market

Federal Agency Debt: debt issued by government
sponsored entities / government agencies. Predominant
issuers are the mortgage-related agencies FHLB,
FNMA (Fannie Mae), GNMA (Ginnie Mae), FHLMC
(Freddie Mac). Implied govt backing.

Mortgage backed securities (MBS): Proportional

ownership in a pool of mortgages. Periodic bond
payments to bondholders come from mortgages. Passthroughs. FNMA (Fannie Mae), FHLMC (Freddie Mac).
International Bonds (Eurobonds): what currency?
10

The Bond Market

Municipal Bonds: State and local issuers. General
obligation and revenue bonds. Exempt from federal taxes
and state and local taxes in issuing state. General
obligation bonds vs. revenue bonds. Difference?

1 =
r = before tax rate of return (yield) on a taxable bond
t = investors combined marginal tax rate
rm = equivalent rate of return on a municipal bond
If an investors tax rate is 28%, which offers a higher after-tax
yield, a 6% taxable bond or a 4% tax-free bond?
What is the equivalent taxable yield of the 4% tax free bond?
11

The Bond Market

Equivalent Taxable Yields Corresponding to
Various Tax-Exempt Yields

1 =
Marginal
Tax Rate
20%
30%
40%
50%

1%
1.25%
1.43%
1.67%
2.00%

Tax-Exempt Yield
2%
3%
4%
2.50% 3.75% 5.00%
2.86% 4.29% 5.71%
3.33% 5.00% 6.67%
4.00% 6.00% 8.00%

5%
6.25%
7.14%
8.33%
10.00%
12

The Bond Market

Corporate Bonds: Long-term borrowing by private
corporations. Secured vs. unsecured. Callable?
Convertible? Rated.
Some Current Corporate Bond
Market Data:
http://finramarkets.morningstar.com/BondCenter/TRACEMark
etAggregateStats.jsp

13

The U.S. Fixed Income Market:

June 2012

Values in $ billions
14

Equity Markets
Common stock: ownership, residual claim, dividend
and stock price, limited liability.
http://finance.yahoo.com/q?s=emc&ql=1
Preferred stock: fixed dividend (cumulative), no vote
(most of the time). Often callable or convertible into
common shares.
American Depository Receipts (ADRs): ownership in
shares of foreign company.
https://www.nyse.com/listings_directory/stock
15

Stock Market Indices

An Index: a basket or portfolio of securities designed to
track market changes.
Representation: 20 stocks or 2,000 stocks? What type
of stocks? What industry or sector?

http://www.wsj.com/mdc/public/page/mdc_us_stocks.ht
ml?mod=mdc_topnav_2_3012
Weighing: Price weighted, market value weighted or
equally weighted index?

16

Stock Market Indices: Price Weighted

Index
Stock

Price t=1

Shares
(millions)

Price t=2

Shares
(millions)

$25

20

$30

20

$100

$90

Index
Value

$25 + $100
= $125

$30 + $90
= $120

$125/2 =
62.5

$120/2 =
60

62.5 to 60 equals a -4% return. Same return as

owning a portfolio of one share of each stock.
17

Stock Market Indices: Price Weighted

Index, adjusting for splits
Stock

Price t=1

Shares
(millions)

Price t=2

Shares
(millions)

$25

20

$30

20

$45

Index
Value

$100

At t=1 Stock
B splits 2:1

$25 + $100
=$125

$30 + $45
= $75

$125/2 =
62.5

$75/1.2 =
62.5

($25 $50)
62.5
new divisor
Need to preserve index value despite the stock split. We do
this by changing the divisor. New divisor = 1.2. Other issues? 18

http://www.wsj.com/mdc/public/page/2_3022djiahourly.html

19

Stock Market Indices: Market Value

Weighted Index
Stock

Price Shares Market Value

t=1 (millions) ($millions)

Price
t=2

Shares
(millions)

Market
Value
($millions)

$25

20

$500

$30

20

$600

$100

$100

$90

$90

Market
Value

$600

Index
Value

100
(arbitrary
base)

$690
$690/$600
x 100

115

100 to 115 equals a 15% return. Same return as

owning a portfolio of A and B with amounts of A and B
held in proportion to their relative market value.

20

Stock Market Indices: Market Value

Weighted Index What about splits?
Stock

Price Shares
t=1 (millions)

Market
Value
($millions)

$25

20

$500

$100

$100

Market
Value

$600

Index
Value

100

At t=1
Stock
B splits
2:1

Price
t=2

Shares
(millions)

Market
Value
($millions)

$30

20

$600

$45

$90
$690

$690/$600
x 100

Again, 100 to 115 equals a 15% return. Can

we say this about the price weighted index?

115

21

Stock Market Indices: Equal Weighted Index

Price % Return
t=2
1 to 2

Stock

Price
t=1

$25

$30

$100

$90

Price
t=3

% Return
2 to 3

20%

$36

20%

-10%

$81

-10%

Average
% return
Index

100

5%

5%

105 (5%)

110.25 (5%)

t=1

t=2

t=3

$50,000

$60,000

$72,000

$50,000

$45,000

$40,500

???

Portfolio $100,000 $105,000 $112,500

% return

5%

7.14%

22

Bond Market Indices

Like stock indices, a variety of different types exist.
Stale price quotes are common and can make them
difficult to accurately calculate.
Common bond indices: Merrill Lynch, Barclays,
Citigroup, S&P Dow Jones
http://www.yieldbook.com/m/indices/browse.shtml
http://www.spindices.com/
https://research.stlouisfed.org/fred2/categories/32413
23

Derivative Markets
(Financial) Derivative: security with a payoff that
depends on the price of another security or asset
(the underlying asset).
Major classes traded options and futures
Call option: the right to buy an asset at a
predetermined price (the strike or exercise price) on
or before a specific expiration date.
Put option: the right to sell an asset at a
predetermined price (the strike or exercise price) on
or before a specific expiration date.
http://finance.yahoo.com/q/op?s=WFM&date=1447977600
24

Derivative Markets
Futures contract: a future transaction whose terms are
currently specified.
Or, a contract that calls for delivery of an asset at a
specified delivery or maturity date for an agreed upon
price (the futures price) to be paid at contract delivery.
Long position = buyer, commits to purchasing at maturity
Short position = seller, commits to delivering at maturity
http://www.cmegroup.com/trading/agricultural/grainand-oilseed/corn_quotes_globex.htm
Consider a long position in one December 2015 corn
futures contract (1 contract = 5,000 bushels). Profit to long
position if in December the spot price = $4.00 per bushel?25