Lect 2 Ch 2 Fin Instruments

7/25/2019 Lect 2 Ch 2 Fin Instruments

1/68

McGraw-Hill/Irwin Copyright 2013 by The McGraw-Hill Companies Inc! "ll rights reser#e$!

Asset Classes

and FinancialInstruments

Bodie, Kane and MarcusEssentials of Investments9thGlobal Edition

2


2/68

MAJOR CLASSES OF FINANCIAL ASSETSOR SECURITIES

Money market

Bond market

Equity markets

Indexes

Derivative markets


3/68

2.1 THE MONEY MARKET

Default-Free Gov. Securities:

Treasury Bills

Risky Securities:

Certificates of Deposit (CD) Commercial aper (C)

Bankers! "cceptances (B")

Bearer Deposit #otes (BD#) $inance aper

Eurodollars

%epos and %everses Brokers! $unds

&'apped Deposits

$ederal $unds IB% (ondon

Inter*ank ffer

%ate)

Money Market Instruments


4/68


Default-Free Government Securities: Treasury Bills Issuer: $ederal +overnment

Denomination: ,-../ commonly ,-./...

Maturity: 0/ -1/ 23/ or 42 'eeks iquidity: 5i+6

Default risk: #one

Interest type: Discount

Taxation: Taxa*le at t6e federal level7 exempt from

state and local,


5/68


Risky Securities: Certificates of Deposit (CDs)

Issuer: Depository institutions Insured *y $DIC

Denomination: "ny/ ,-../... or more#e+otia*le (i8e8/ transfera*le) Maturity: 9aries/ typically -0day minimum (or more) iquidity: CDs of 1 mont6s or less are liquid if

marketa*le Default: $irst ,-../... (,24./...) insured Interest type: "dd on

Taxation: Interest income fully taxa*le


6/68


Commercial aper (C) Issuer: ar+e credit'ort6y corporations/ financial

institutions

Backed *y a line of credit

Denomination: Minimum ,-../... (or its multiples) Maturity: Maximum 2;. days/ usually -2 mont6s

(beyond which would require SEC approval)

iquidity: C of 1 mont6s or less is liquid if

marketa*le Default risk:


7/68


Bankers! "cceptances

&imilar to a postdatedc6eck issued *y a *ank (marked as

accepted) to a client

ri+inate '6en a purc6aser aut6ori=es a *ank to pay a

seller for +oods at later date (time draft)

>6en purc6aser!s *ank ?accepts@ draft/ it *ecomes

contin+ent lia*ility of t6e *ank and a marketa*le security

Can *e traded in secondary markets on a discounted value


8/68


Bearer Deposit #otes (BD#)

Issued *y Banks"t least ,-..A#oncas6a*le *efore maturityTransfera*le

$inance aperIssued *y sales finance companies

Eurodollars: T6ese are dollardenominated (time) deposits at

forei+n *anks (in Europe or outside Europe) orforei+n *ranc6es of "merican *anks8

ay 6i+6er interest rate t6an


9/68


%epurc6ase "+reements (%s) and %everse %s &6ortterm sales of securities 'it6 an a+reement to

repurc6ase t6e securities at 6i+6er price

% is a collaterali=ed loan7 many %s are

overni+6t/ t6ou+6 ?term@ %s may 6ave a -mont6maturity

%everse % is lendin+ money and o*tainin+

security title as collateral ?5aircuts@ may *e required/ dependin+ on

collateral quality


10/68

2.1 THE MONEY MARKETBrokers! $unds

Brokers allo'in+ investors to *uy on mar+in cover t6eir loans *y

*orro'in+ from *anks 'it6 an a+reement to pay on call8

Call money rate applies for investors *uyin+ stock on mar+in

Borro'in+ rate is normally - a*ove T*ills oan may *e ?called in@ *y *roker

&'apped Deposits

Investors deposit "merican dollars convert it to forei+n currency

'6ic6 'ill *e later converted *ack to "merican currency at a prespecified conversion price

- to 3 mont6 maturity

#ontransfera*le


11/68

2.1 THE MONEY MARKET $ederal $unds

$unds deposited in t6e accounts of mem*er commercial *anks

(depository institutions) at t6e $ederal %eserve Bank8

$ederal funds rate is t6e rate at '6ic6 one mem*er *ank lend

overni+6t to anot6er '6en its $ederal funds fall *elo' t6e

minimum requirement8

$ederal fundstradin+ in reserves 6eld on deposit at $ederal

%eserve

Aey interest rate for economy

IB% (ondon Inter*ank ffer %ate)

%ate at '6ic6 lar+e *anks in ondon (and else'6ere) lend to

eac6 ot6er

Base rate for many loans and derivatives


12/68

FIGURE 2.1A MONEY RATES


13/68

FIGURE 2.1TREASURY BILLS (T-BILLS)

Source:The Wall Street Journal Online,July 7, 2011.


14/68

FIGURE 2.1 TREASURY BILLS

NotesBid and asked are t6e Bank Discount

Field (BDF) *id and asked yields

annuali=ed *ased on 13. days reported as

percenta+e of par value

"sk Fld is t6e Bond Equivalent yield

(BEF) calculated *ased on 134 days

reported as percenta+e of price


15/68

.SPREADS ON CDS AND TREASURYBILLS


16/68


MMM$ and t6e Credit Crisis of 2..G

2..42..G: Money market mutual funds

(MMM$s) +re' GG

MMM$s 6ad t6eir o'n crisis in 2..G: e6man

Brot6ers %eserve rimary $und ?*roke t6e *uck@

%un on money market funds ensued


17/68


Bank Discount %ate (T*ill quotes) H "lso called Bank Discount Field (BDF)

Example: .day ,-./... T*ill/ P ,/G;4

rBD

= $10,000P$10,000

x360n

rBD = bank discount rateP = market price of the T-bill

n = number of days to maturity

$10,000 = Par

rBD=$10,000-$9,875

$10,000360

90=5%


18/68


Bond Equivalent FieldCan!t compare T*ill directly to *ond

13. vs8 134 days

%eturn is fi+ured in par vs8 price paid"dJust *ank discount rate to make it

compara*le

21THEMONEYMARKET


19/68

2.1 THE MONEY MARKET -EXAMPLES

Bond Equivalent Yield (also known as ASK YLD)

Example Using Sample T-Bill

rBEY

=10,000PP

365n

P= price of the T-bill

n= number of days to maturityrBD= 5%

rBEY

= 10,000 9,875

9,875 365

90

rBEY= .0127 4.0556 = .0513 = 5.13%


20/68

2.2 THE BOND MARKET

on+term Kovernment Issues:


21/68

2.2 THE BOND MARKET

on+term Kovernment Issues:


22/68

14.1 BOND CHARACTERISTICS


23/68

FIGURE 2.3 LISTING OF TREASURYISSUES

Source: Compiled from data fromThe Wall Street Journal Online,July 6,

2011.


24/68

8 8B#D&

Maturity Coupon Bid Asked Change

Asked

Yield

8/15/2012 1.750 101.570 101.594 -0.016 0.151

8/15/2014 4.250 116.547 116.594 -0.094 0.358

12/31/2015 2.125 105.789 105.820 -0.164 0.769

8/15/2017 4.750 120.219 120.266 -0.234 1.234

2/15/2020 8.500 152.063 152.094 -0.344 1.847

8/15/2023 6.250 137.406 137.438 -0.688 2.598

2/15/2027 6.625 145.547 145.594 -0.719 2.941

2/15/2031 5.375 130.266 130.297 -0.953 3.263

11/15/2039 4.375 116.766 116.813 -0.813 3.697

5/15/2041 4.375 116.719 116.750 -0.938 3.718

U.S. Treasury Quotes:Treasury note and bond data arerepresentative over-the-counter quotations as of 3pm Eastern time.


25/68


t6er


26/68

2.2 THE BOND MARKET

"+ency issues (federal +overnment)

Issued *y state and local +overnmentsKeneral o*li+ation *onds (*acked *y state

reputation)

Most are 6omemort+a+erelated

Issuers:$ederal #ational Mort+a+e "ssociation

($#M"/ or $annie Mae)/ $5MC/ $ederal5ome oan Banks ($5B)

Kovernment #ational Mort+a+e"ssociation (K#M"/ or Kinnie Mae)In &eptem*er 2..G/ federal +overnment

took over $#M" and $5MC


27/68

2.2 THE BOND MARKET

Other Government Issues

Revenue bonds (e.g., airports, turnpikes, hospitals, orport authorities) riskier than general obligationbonds

Municipal bondsIssuer local municipalities/citiesthese bonds are capped at a maximum (e.g., $150million or $50 per capita)

Maturities: up to 30 yearsDiffer from treasuries and agencies:

Risk?These are risky government securitiesGeneral Obligation (G.O.) vs. revenueIndustrial development


28/68

2.2 THE BOND MARKET

Government Issues

Municipal bonds - TaxationInterest income on municipal bonds is notsubject to federal and sometimes state andlocal tax (therefore, municipal bonds yield

lower yields)To compare yields on taxable securities aTaxable Equivalent Yield is constructed

rtax exempt rtaxa*lex (- H Tax rate)

r Interest rate


29/68

TABLE 2.2 EQUIVALENT TAXABLEYIELDS

rtax exempt=rtaxablex (1 Tax rate)

Tax-Exempt Yield

Marginal Tax Rate 1% 2% 3% 4% 5%

20% 1.25% 2.50% 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


30/68

8DEBT

FIGURE25YIELDRATIO TAXEXEMPTTO


31/68

FIGURE 2.5 YIELD RATIO: TAX-EXEMPT TOTAXABLE BONDS


32/68

2.2 THE BOND MARKET

ros of &tate and "+ency Bonds:

"ct as passt6rou+6 financin+ tool rovide liquidity to t6e mort+a+e market Implicitly protected *y t6e +overnment from

default &afe investment Field a *it a*ove T*ills


33/68

2.2 THE BOND MARKET

C%%"TE B#D& Issued *y private firms&emiannual interest payments (called coupons)&u*Ject to lar+er default risk t6an +overnment

securities (t6erefore/ corporate *ond interest ratereflects t6e risk level/ credit standin+ and level ofdefault/ so 6i+6er rates reflect riskier *onds)

$IK


34/68

$IK


35/68

TABLE 2.7 THE U.S. BOND MARKET

Sector Size ($ billion) % of Market

Treasury 9,434.6 29.5%Federal agency and gov'tsponsored enterprise 6,437.3 20.%

!orporate 4,653.9 4.6%

Ta"#e"e$pt 2,636.7 &.3%

ortgage#(ac)ed 6,90&.0 2.6%*t+er asset#(ac)ed 1,877.9 5.9% Total 3,94&.4 00.0%

ncludes private purpose ta"#e"e$pt de(t.

-ource Flow of Funds Accounts of the United States: Flows & Outstanding, /oardo 1overnors o t+e Federal eserve -yste$, une 20.


36/68

Mort+a+es and Mort+a+e*acked &ecurities

Developed in t6e -;.s to 6elp liquidity offinancial institutions

roportional o'ners6ip of a pool or a

specified o*li+ation secured *y a poolMarket 6as experienced very 6i+6 rates of

+ro't6

2.2 THE BOND MARKET


37/68

2.3 EQUITY SECURITIES Common stock

Issued *y t6e company and represents a s6are of o'ners6ipin t6e company

%esidual claimimited lia*ility%i+6ts of s6are6olders:

s6are in earnin+s (paya*le in t6e form of dividends)/capital +ains

votin+ ri+6ts (some 6ave no votin+ ri+6ts and are soldc6eaper)

preemptive ri+6tsproxy cumulative votin+ (not al'ays)vote on mer+ers/ takeover and ot6er maJor decisions


38/68

2.3 EQUITY SECURITIES

Common Stock, Contd8

&tock Dividend: Effect retained earnin+s accountdecreases and , common stock account increases8

&tock &plits: Effect no c6an+e in total , common stockaccount *ut num*er of s6ares increases8

#TE&:- %estricted common s6ares 6ave no or a limited votin+

(may or may not include votes on take over)

Classified common s6ares:

class " pays a cas6 dividend (not uniform)

class B pays a stock dividend (not uniform)

t6ese common s6ares are interconverti*le

different classes 6eld for tax purposes


39/68


Common Stock, Contd8

Disadvanta+es

6i+6 risk (expect 6i+6er return)

last to *e paid no fixed income (dividends)

a+ency pro*lems

O C A AC S CS


40/68


referred &tock

" 6y*rid security

Commonly pays fixed dividend (*ut no contractual

o*li+ation)

$loatin+ rate preferred s6ares 'ere introduced in -G28

ne +ets a minimum and a maximum dividend8 $loatin+

rate preferred stock *ecomin+ more popular

Mostly cumulative dividends

riority over common stock6olders

#o votin+ ri+6ts ('it6 fe' exceptions)


41/68


referred stock

%iskier t6an *onds *ut less risky t6an common stock t6er ri+6ts of preferred stock6older:

preemptive ri+6ts (sometimes do not exist) Converti*le

Disadvanta+es:

may not pay dividend (if noncumulative)

do not vote (unless provisional or missin+ directors for some

time or sinkin+ fund)

calla*le

unless existin+ s6are6olders 6ave preemptive ri+6ts coverin+

conversion cases/ t6ere 'ill *e equity dilution


42/68

2.3 EQUITY SECURITIESCapital MarketEquity

Depository %eceipts

"merican Depository %eceipts ("D%s)/ also called "merican

Depository &6ares ("D&s)

Made it easier for forei+n companies to meet


43/68


Capital MarketEquity

Capital +ains and dividend yieldsBuy a s6are of stock for ,4./ 6old for - year/

collect ,- dividend/ and sell stock for ,40

>6at 'ere dividend yield/ capital +ain yield/ andtotal return (I+nore taxes)

Dividend yield Dividend N P*uy ,-N,4. 2

Capital +ain yield (Psell H P*uy) N P*uy (,40 H

,4.)N,4. G

Total return Dividend yield P Capital +ain yield

2 P G -.


44/68

2.4 STOCK AND BOND MARKET INDEXES


45/68


$actors in constructin+Nusin+ index

%epresentative "re stocks included in t6e indexrepresentative of t6e state of t6e economy

Broad or narro' Blue c6ip stocks versus a more

*road sample of stocks

5o' is it 'ei+6ted

Different avera+es and indexes use different *ase

stocks in different industries so it can *e used for

specific comparison purposes

2.4STOCKANDBONDMARKET


46/68

2.4 STOCK AND BOND MARKETINDEXES

Construction of Indexes

5o' are stocks 'ei+6ted

rice 'ei+6ted (DQI")

Market value 'ei+6ted (&R 4../ #"&D"L)

Equally 'ei+6ted (9alue ine Index)5o' muc6 money do you put in eac6 stock in t6e

index


47/68


Constructin+ Market Indexes

>ei+6tin+ sc6emes

rice'ei+6ted avera+e: Computed *y addin+

prices of stocks and dividin+ *y ?divisor@

Market value'ei+6ted index: %eturn equals'ei+6ted avera+e of returns of eac6 component

security/ 'it6 'ei+6ts proportional to outstandin+

market value

Equally 'ei+6ted index: Computed from simple

avera+e of returns

2.4STOCKANDBONDMARKET


48/68

2.4 STOCK AND BOND MARKETINDEXES

Time . index value: (-. P 4. P -0.)N1 2..N1 3383;

Time - index value: (-. P #$P -0.)NDenom 3383; Denominator 28320G3

Time - index value: (-4 P 24 P -4.)N28320G3 ;281G

t6er pro*lems:

&imilar c6an+e movements in 6i+6erprice stocks cause proportionally lar+er

c6an+es in t6e index &plits ar*itrarily reduce 'ei+6ts of stocks t6at split in index T6e split of t!e

poor performin% stock reduces its relative 'ei+6t in t6e index/ t6us

overestimatin% t!e performance of t!e index8

T6e avera+e assi+ns 6i+6er 'ei+6t to pricy stocks/ and t6erefore it is

more affected *y c6an+es to t6ese stocks

Stock PriceB QuantityB P1 Q1

A $10 40 $15 40B 50 80 25 160

C 140 50 150 50

Price-WeightedSeries

.


49/68

.INDEXES

9alue>ei+6ted &eries

IndexV


A $10 40 $15 40

B 50 80 25 160

C 140 50 150 50

#otes: find t6e total market value of eac6 stock in t6e index (i8e8/ price S of s6ares

outstandin+) at a particular date divided *y t6e total measured at a previousdate/ and t6e ratio multiplied *y an ar*itrary startin+ valueNmultiplier8 T6epercenta+e c6an+e in t6e index 'ould *e t6e percenta+e c6an+e in t6e indexvalue from one period to anot6er8 9alue is proportional to outstandin+ value ofeac6 stock

split 6as no effect on t6e index %ood for measurin% returns of a portfolio

price-"ei%!ted avera%e can reflect returns of a portfolio "it! e&ual s!aresin eac! stock8

-.38-0-..4.)(-0.G.)(4.0.)(-.4.)(-4.-3.)(240.)(-4 =

++

++

.


50/68

INDEXES

Equal>ei+6ted &eries

invest ,1.. in eac6Index

E


A $10 40 $15 40

B 50 80 25 160

C 140 50 150 50

--I8.4-..)-0182(-0.3)(4.1.)(-.

)-0182(-4.)2-(241.)(-4=

++

++

2.4 STOCK AND BOND MARKET


51/68

INDEXES

Why do the two differ? Case 1: 20% change in price of small-cap firm

IndexV=

Assume $100 in each stock

IndexE=

Case 1 Case 2

Stock PB QB P1 Q1 P1 Q1

A $10 40 $12 40 $10 40

B 100 80 100 80 100 80

C 50 200 50 200 60 200

-..801-..2..)(4.G.)(-..0.)(-.

.)2.(4..)G(-..0.)(-2=

++

++

-.383;-..2)(4.)-(-..-.)(-.

2)(4.-)(-..-.)(-2=

++

++

2.4 STOCK AND BOND MARKET


52/68

INDEXES

Why do the two differ? Case 2: 20% change in price of large-cap firm

IndexV=

Assume $100 investment in each stock

IndexE=

Case 1 VW = 100.43

Case 1 EW = 106.67

Case 1 Case 2

Stock PB QB P1 Q1 P1 Q1

A $10 40 $12 40 $10 40

B 100 80 100 80 100 80

C 50 200 50 200 60 200

--.8G3-..2..)(4.G.)(-..0.)(-.

.)2.(3..)G(-..0.)(-.=

++

++

-.383;-..2)(4.)-(-..-.)(-.

2)(3.-)(-..-.)(-.=

++

++

24STOCKANDBONDMARKETINDEXES


53/68


E&uity 'ndexes (Domestic)Do' Qones Industrial "vera+e (1. &tocks) H since

-G3&tandard R oor!s 4.. Composite (0.. industrials/ 2.

transportation/ 2. utilities/ and 0. financials)

#"&D"L Composite (1/... firms)#F&E Composite>ils6ire 4... (3/... stocks)9alue ine "vera+eMoodyUs Composite "vera+eMoody!s Industrial "vera+e"MEO IndexC%& Index

24STOCKANDBONDMARKETINDEXES


54/68


E&uity 'ndexes ('nternational)

T6e $inancial Times &tock Exc6an+e -.. ($T&E) Toronto &tock Exc6an+e (T&E) Composite Index (-0 +roups/02 su*+roups)

Montreal Exc6an+eUs Canadian Market ortfolio Index aris C"C 0. Index

Oetra Dax Index (Blue C6ips Kerman Index) Commer=*ank (>est Kermany) Composite &6are Index &'iss Market Index Mi*tel Index (Italy)

Madrid Keneral Index


55/68

280 &TCA "#D B#D M"%AET I#DEOE&

E&uity 'ndexes ('nternational)

5an+ &en+ (5on+ Aon+) Bank IndexTokyo &tock Exc6an+e (#IAAEI) Index (#ikkei 224

R #ikkei 1..)Europe/ "ustralia/ and $ar East Index (E"$E)Mor+an &tanley Capital International >orld Composite

Index-/1.. stocks in - countries ('orld index)%e+ion and Country Indexes

E"$E$ar East


56/68


*onds 'ndexes

Do' Qones 0. Bond Index

&tandard R oorUs


57/68

280 &TCA "#D B#D M"%AET I#DEOE&

Commodities 'ndexesDo' Qones Indices of &pot Commodity rices

Do' Qones $utures Commodity Index


58/68

2.5 DERIVATIVE MARKETS

Derivative "ssetNContin+ent Claim

&ecurity 'it6 payoff t6at depends on t6e

price of ot6er securities

isted Call ption

%i+6t to *uy an asset at a specified price

on or *efore a specified expiration date

isted ut ption

%i+6t to sell an asset at a specified

exercise price on or *efore a specified

expiration date

FIGURE29STOCKOPTIONSON


59/68

FIGURE 2.9 STOCK OPTIONS ONAPPLE


60/68


Derivative "ssetNContin+ent Claim

&ecurity 'it6 payoff t6at depends on t6e

price of ot6er securities

isted Call ption

%i+6t to *uy an asset at a specified price

on or *efore a specified expiration date

isted ut ption

%i+6t to sell an asset at a specified

exercise price on or *efore a specified

expiration date

25DERIVATIVEMARKETS


61/68


" common misconception is t6at open interest is t6e same t6in+ as volume of options

and futures trades8 T6is is not correct/ as demonstrated in t6e follo'in+ example:

n Qanuary -/ " *uys an option/ '6ic6 leaves an open interest and also creates tradin+

volume of -8

n Qanuary 2/ C and D create tradin+ volume of 4 and t6ere are also five more options

left open8

n Qanuary 1/ " takes an offsettin+ position/ open interest is reduced *y - and tradin+

volume is -8 n Qanuary 0/ E simply replaces C and open interest does not c6an+e/ tradin+ volume

increases *y 48


62/68



63/68



64/68


6y5o' does a +reater time to contract expiration

affect t6e value of a call option " put option

>6y

5o' is ?volume@ different from ?open interest@


65/68


$utures Contracts

urc6aser (lon+) *uys specified quantity at

contract expiration for set price

Contract seller (s6ort) delivers underlyin+

commodity at contract expiration for a+reedupon price

$utures: $uture commitment to *uyNsell at

preset price

ptions: 5older 6as future ri%!tto *uyNsell


66/68

FIGURE 2.10 FUTURES CONTRACTSCorn futures prices in the Chicago Board of Trade,

July 8, 2011


67/68


Corn futures prices in t6e C6ica+o Board of Trade/ Quly

G/ 2.--

Contract si=e: 4/... *us6els of corn

rice quote for Dec8 -2 contract: 3-0!. translates to a

price of ,38-0 P .NG cent per *us6el/ or ,38-0

If you *ou+6t t6e Dec8 -2 contract/ '6at are you

a+reein+ to do

urc6ase 4/... *us6els of corn in Decem*er for

4/... V ,38-0 ,1./;..

>6at is your o*li+ation if you sell t6e Dec8 -2

contract

5o' does t6is contract differ from an option

25DERIVATIVEMARKETS


68/68


ptions

Basic ositions

Call

(BuyN&ell)

ut (BuyN&ell)

Terms

Exercise priceExpiration date

$utures

Basic ositions

on+ (BuyN&ell)

&6ort (BuyN&ell)

Terms

Delivery date

Delivera*le item

Derivatives Securities

Documents

Lect 2 Ch 2 Fin Instruments