Chapter 2: Financial Instruments
Outline:
I. The Money Market
II. The Bond Market
III. Equity Securities
IV. Market Indexes
V. Derivative Markets
Financial markets = money markets (short-term) + capital markets (long-term)
I. The Money Market
Money Market Instruments:
1. Treasury Bills
- Short-term government securities.
- Sell at a discount, e.g., 2%, $9,800 from par $10,000.
- 28 days, 91 days, 182 days, and 52 weeks.
- Risk-free.
- Only subject to federal tax; no local taxes.
2. Certificate of Deposit (CD)
- A bank time deposit.
- Back by a bank; safe; liquid.
3. Commercial Paper
- Large, well-known corporations issue CPs.
- Maturities range up to 270 days.
- Quite liquid.
4. Bankers Acceptances
- An order to a bank by a customer to pay a sum of money at a future date.
- Back by banks; safe; liquid.
5. Eurodollars
- Dollar-dominated deposits at foreign banks or foreign branches of American banks.
- Mostly time deposits, but can be CDs.
6. Repurchase Agreements (RPs)
- Overnight borrowing.
- This is how it works: (1) government security dealer A borrows $ from government security dealer (or investor) B; (2) To borrow $, A sell government securities to B; (3) A agrees to buy those securities back the next day at higher prices.
7. Reverse RPs
- Dealers lend $, buy government securities, and resell them at higher prices.
8. Federal Funds
- Bankers’ funds in the banks’ reserve accounts.
- Banks with a shortage of federal funds borrow from other banks at “federal fund rate.”
- Important barometer and indicator of the money market.
9. LIBOR (the London Interbank Offer Rate)
- The international counterpart of the federal fund.
- Among large banks in London.
[Extra]
Money Market Instrument Yields:
Yield: current rate of return.
- Yields on money market instruments are not always directly comparable.
- Factors influencing yields: (1) par (face) value vs. investment value (price paid), (2) 360 vs. 365 days (366 days for leap years) assumed in a year, and (3) compounded or simply accumulated.
1. Bank Discount Rate (T-bills)
rBD = ´
where, P is the market price of the T-bill
n is the number of days to maturity
Example: Suppose that 90-day T-bill, P = $9,800.
rBD = ´ = 8.00%
2. Bond Equivalent Yield
rBEY = ´
Example (continued):
rBEY = ´ = 8.28%
3. Effective Annual Rate
- A more realistic method.
rEAR =
Example (continued):
rEAR = = 8.41%
General Rule: rEAR > rBEY > rBD
II. The Bond Market
1. US Treasury Bonds (10-30 years) and Notes (< 10 years)
- Semiannual coupon payments.
- Sold at or near par value.
2. (Federal Government) Agency Issues
- Some agencies issue their own securities.
- Example: Ginnie Mae and Fannie Mae.
3. Municipal Bonds (Munis)
- Issued by state and local governments.
- Interest income is exempted from federal (possibly from state) taxation.
4. Eurobond: a bond denominated in a currency other than that of the country in which it is issued.
5. Corporate Bonds
- Need to consider default risk.
- A big market.
6. Mortgage-Backed Securities.
III. Equity Securities
1. Common Stock
- Residual claim in the event of liquidation.
- Limited liability: the most shareholders can lose in the event of the failure of the corporation is their original investment.
- Shareholders might have voting rights.
- May receive dividends.
2. Preferred Stock
- Equity.
- Fixed dividends: issuing corporation “promises” to pay a fixed stream of income each year.
- Preferred dividend is not a liability.
- Priority over common stock.
- Dividend income fully taxable to individuals; partially taxable to corporations.
- Interest payments are treated as dividends, taxable to issuing firms; in contrast, bond interests are tax-deductible.
- No voting right.
CFAÒ Preferred stock:
a. Is actually a form of equity.
b. Pays dividends not fully taxable to U.S. corporations.
c. Is normally considered a fixed-income security.
d. All of the above.
Answer: d.
IV. Market Indexes
Why we use indexes?
1. Track average returns.
2. Comparing performance of fund managers.
3. Base of derivatives, e.g., S&P 100 options and S&P 500 futures.
Factors in constructing or using an index:
1. Representative?
2. Broad or narrow?
3. How is it constructed?
- Price-weighted, e.g., DJIA.
- Value-weighted, e.g., S&P 500, NASDAQ Composite.
- Equal-weighted, e.g., Value Line indexes.
Examples of domestic indexes: DJIA (30 stocks), S&P 500 Composite; NASDAQ Composite, and Wilshire 5000.
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S&P 500 is the most widely used domestic stock index.
Results for: S&P 500/ Index / / Index
Changes / / Index
Methodology / / News &
Analysis
Index Table(26-AUG-2005) / Enter Date:
(DD-MMM-YYYY)
Bottom of Form
Desc / / GICS®1 / / NC2 / / Adj MktCap3,4 / / Level5 / / Daily / / MTD / / QTD / / YTD
S&P 500 / 500 / 11,047,735 / 1,205.098 / (0.60%) / (2.36%) / 1.16% / (0.56%)
TR / 1,810.518 / (0.60%) / (2.21%) / 1.43% / 0.61%
Net TR / 1,754.898 / (0.60%) / (2.25%) / 1.35% / 0.25%
Energy / 10 / 29 / 1,025,146 / 363.66 / (1.23%) / 0.28% / 6.02% / 26.00%
Materials / 15 / 32 / 319,770 / 166.966 / (0.60%) / (5.09%) / (0.03%) / (8.85%)
Industrials / 20 / 53 / 1,221,414 / 273.546 / (0.48%) / (2.99%) / 0.23% / (5.54%)
Consumer Discretionary / 25 / 89 / 1,268,753 / 263.755 / (0.60%) / (3.66%) / 1.72% / (5.43%)
Consumer Staples / 30 / 38 / 1,120,261 / 236.355 / (0.26%) / (2.13%) / 0.76% / (0.27%)
Health Care / 35 / 55 / 1,454,993 / 359.056 / (0.45%) / (2.45%) / (0.24%) / 2.45%
Financials / 40 / 84 / 2,201,545 / 391.261 / (0.91%) / (2.57%) / (1.30%) / (4.82%)
Information Technology / 45 / 78 / 1,707,588 / 322.725 / (0.30%) / (1.60%) / 4.17% / (2.07%)
Telecommunications Services / 50 / 9 / 345,230 / 119.189 / (0.63%) / (4.56%) / (1.58%) / (7.68%)
Utilities / 55 / 33 / 383,035 / 162.132 / (0.38%) / (0.85%) / 1.19% / 14.50%
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Examples of international indexes: Nikkei 225, MSCI World Index.
Yahoo! Finance (finance.yahoo.com) provides quasi-real time information on a large number of domestic and international indexes.
V. Derivative Markets
Call (put) option: the right to buy (sell) an asset at a specified price, called the exercise price, on or before a specified expiration date.
Example: Suppose that today’s IBM price is $100. Some may want to issue a 3-month call option with an exercise price of $105.
Futures: the obligation to purchase or sell an asset at an agreed-upon price, called the futures price, at a specified date.
End-of-chapter problem sets: #2, #10