Financial Markets and Institutions

Asset Classes: Money market, Bonds market,

Stocks, Indexing

Mehran Ebrahimian
Investment Management (BE452)
Spring 2025
Learning Goals

A bunch of every-day words in the finance industry :)

▶ Asset Allocation
▶ the investment process
▶ Asset Classes
▶ The Money Market
▶ The Capital Market
▶ bonds
▶ stocks
▶ indexing
▶ Return on Asset Classes
ASSET ALLOCATION
The Investment Process
Portfolio Choice

Portfolio choice: the collection of investment assets

Asset allocation:
▶ Choice among broad asset classes.
▶ For example: stocks, bonds, real estate, and so on
taste for risk
gov bonds ←−−−−−−−−−→ stocks
more return

Security selection:
▶ Choice of securities within each asset class
▶ For example: Ford, Alphabet, Microsoft, General Mills, etc

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The Investment Process
Security analysis

Security analysis: the valuation of particular securities that might

be included in the portfolio

“Top-down” approach:
▶ Asset allocation followed by determination of particular
securities to be held in each asset class

“Bottom-up” approach:
▶ Investment based on attractively priced securities without as
much concern for asset allocation.

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Money versus Capital Markets
A classification of asset classes by maturity!

▶ Money markets trade debt securities or instruments with

maturities of one year or less
▶ short-term, marketable, liquid, low-risk debt securities.
▶ most U.S. money markets are over-the-counter (OTC) markets

▶ Capital markets trade debt (bonds) and equity (stocks)

instruments with maturities of more than one year
▶ longer term and riskier securities—longer-term bonds, equity,
options, and futures
▶ wider price fluctuations than money market instruments

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MONEY MARKETS
Money Market Instruments
Outstanding, U.S.

EU figures

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Money Market Instruments

▶ Treasury Bills:
▶ Government issued debt sold to the public
▶ The most marketable of all money market instruments
▶ Short term (less than a year), no coupon paid, investor’s
return = Face value / Purchase price US Sweden
▶ Central banks buy and sell T-bills in their conduct of the
monetary policy riksbank.se/gov. bonds riksbank.se/T bills

▶ Certificates of Deposit (issued by banks), Commercial

Papers (debt notes, by large companies), Asset-backed CPs
(collateralized by a pool of underlying assets)

▶ Note: Most money market securities are low risk, but not
risk-free, particularly during significant market events Yields

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Money Market Funds

▶ A mutual fund that invests in short-term debt:

▶ Treasury bills (T-bills)
▶ Commercial Papers (CPs)
▶ Certificates of Deposits (CDs)
▶ Suitable for small investors...
▶ Differ in risk (government funds vs. prime funds)

Money market funds in the EU, facts and figures:

https://www.consilium.europa.eu/en/infographics/
money-market-funds/

more on funds: next lecture

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 CAPITAL MARKETS
(Classification of Assets based on Risk)
Capital Market Instruments
Outstanding, U.S.

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Capital Markets, Stocks
International Figures

”Triumph of the Optimists: 101 Years of Global Investment Returns”, by Elroy Dimson, Paul Marsh, Mike Staunton
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Capital Markets, Bonds
International Figures

”Triumph of the Optimists: 101 Years of Global Investment Returns”, by Elroy Dimson, Paul Marsh, Mike Staunton
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The Bond Market

▶ longer-term borrowing or debt instruments than those that

trade in the money market
▶ Treasury notes and bonds (government issued, up to 30
years maturity, coupon payments) example, US listed
▶ Corporate bonds (issued by firms, default risk: riskier than
Treasury-issued securities) features size, EU size, EU by sector
▶ Municipal bonds
▶ Mortgage-backed securities
▶ Asset-backed securities

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Equity Securities

Common Stocks:
▶ Represent ownership shares in a corporation
▶ Voting rights: Each share entitles owner to one vote, elect
board of directors to run the company
▶ 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.
▶ Dividend payments, Capital gains → investors’ return listing
▶ Market Cap: price ∗ shares largest companies, EU

▶ Preferred Stocks: have some debt-like features Preferred Stock

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Equity Securities: Example—VOLVO AB

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Derivative Security Markets
Derivatives: a financial security whose payoff is linked to another,
previously issued security, being traded in the market
▶ examples: future, option, swap, or mortgage-backed security
▶ generally involves agreement between two parties to exchange
a standard quantity of an asset or cash flow at a
predetermined price and at a specified future date
▶ The newest and the riskiest security in financial markets
▶ Derivative contracts by size, US:

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Indexing in Financial Market

▶ Abstracting from individual securities, the performance of the

market overall (big picture of financial markets)
→ wealth accumulation by investing in stocks, or bonds?
▶ A way to aggregate return movements of individual stocks...
Build an index by taking averages! alt. methods

▶ US, famous ones: Dow Jones Industrial Average (DJIA).

Standard & Poor’s 500 (S&P 500). Russell Indexes. NYSE,
NASDAQ Composite. Wilshire 5000. CRSP. major ones in the US

▶ International ones: Nikkei (Japan), FTSE (UK), DAX

(Germany), OMX Stockholm 30
▶ Bond market indicators (not straightforward, infrequent
trading). Merrill Lynch, Barclays, City Broad IG Bond Index
▶ Will see more later with Index Funds

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RETURN ON ASSET CLASSES

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Return on Stocks and Bonds, US, 1900-2000, nominal

”Triumph of the Optimists: 101 Years of Global Investment Returns”, by Elroy Dimson, Paul Marsh, Mike Staunton

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Return on Stocks and Bonds, US, 1900-2000

”Triumph of the Optimists: 101 Years of Global Investment Returns”, by Elroy Dimson, Paul Marsh, Mike Staunton

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Return on Stocks and Bonds, 16 counties, 1900-2000

”Triumph of the Optimists: 101 Years of Global Investment Returns”, by Elroy Dimson, Paul Marsh, Mike Staunton

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Return on Stocks and Bonds, 16 counties, 1900-2000

”Triumph of the Optimists: 101 Years of Global Investment Returns”, by Elroy Dimson, Paul Marsh, Mike Staunton
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Volatility of Stock and Bond Returns, US, 1900-2000

”Triumph of the Optimists: 101 Years of Global Investment Returns”, by Elroy Dimson, Paul Marsh, Mike Staunton

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Distribution of Stock Returns, US, 1900-2000

”Triumph of the Optimists: 101 Years of Global Investment Returns”, by Elroy Dimson, Paul Marsh, Mike Staunton

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Statistics of Asset Returns, 16 countries, 1900-2000

”Triumph of the Optimists: 101 Years of Global Investment Returns”, by Elroy Dimson, Paul Marsh, Mike Staunton

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Takeaway

Lessons from 100 years of data, many countries:

▶ return: Bills < Bonds < Equities
▶ riskiness: Bills < Bonds < Equities
▶ Risk-Return trade off, across asset classes

***There is no clear winner, when it comes to

the asset allocation decisions***

▶ Alternative portfolio models

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ASSET ALLOCATION,
Revisited

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Asset Allocation: Revisited

***“Top-down” approach:***
▶ Asset allocation followed by determination of particular
securities to be held in each asset class

“Bottom-up” approach:
▶ Investment based on attractively priced securities without as
much concern for asset allocation.

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Example: Four model portfolios

1. All Stock Portfolio – this portfolio is made of 100% US

stocks
2. 60/40 Portfolio – this portfolio splits allocation between the
total US equity market and bonds
3. Permanent Portfolio – portfolio designed to perform well in
all economic conditions. Includes growth stocks, precious
metals, government bonds, and Treasury bills.
4. Golden Butterfly Portfolio – this portfolio is meant to
perform well during all investing environments but higher
returns associated with the All Stock Portfolio

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Example: Four model portfolios

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Example: Four model portfolios
Performance: Risk-return Tradeoffs

Sharpe ratio: Golden Butterfly=0.63, Permanent Portfolio=0.52

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Where are we?
“Financial Markets and Institutions”

Today’s Lecture:
▶ Asset Classes
▶ money market
▶ bond market
▶ stocks
▶ Return on Assets
▶ Indexing
▶ Asset Allocation

Next Lecture:
▶ L3: Big players in the finance industry! Investment
Companies...
Key Terms
▶ Asset allocation
▶ Money markets
▶ Capital markets
▶ Certificates of deposits
▶ Commercial papers
▶ Treasury notes
▶ Yield to maturity
▶ Treasury bonds
▶ Corporate bonds
▶ Equities
▶ Residual claim
▶ Limited liability
▶ Capital gains
▶ Dividend yield
▶ Preferred stocks
▶ Price-weighted average
▶ Market-value-weighted average
Appendix

Supplementary Materials
Money Markets, EU
EUR (billions)

secured transactions –
repos and reverse repos
unsecured cash
transactions
short-term securities
foreign exchange (FX)
swap
overnight index swap
(OIS)

source link 1 , source link 2 go back

US T-Bills, return
▶ Face value: what you get at the bill maturity
▶ Yeild: the return on your investment (in annualized term)

▶ See the highlighted one:

▶ Assume a Face value $10,000
▶ The price gotta be $9,998.41.
▶ Why? Calculate the return: 10000/99841 - 1 = 0.0159%.
▶ multiply by 365/127 (days to maturity) to get in annual terms:
0.0159*365/127 = .0457% (what you see in ASKED YIELD)
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Treasury Bills, return

▶ Sweden Government Bonds - Yields:

source: world government bounds

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Yields on Money Market Instruments

Most money market securities are low risk, but not risk-free,
particularly during significant market events

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Treasury notes and bonds
▶ Governemnt issued debt, with maturity up to 30 years
▶ Coupon payment: (semi-annual) fixed payments, as
percentage of the par value

▶ Inflation protected Treasury bonds (TIPS): indexed with

inflation (the principal adjusts with the Consumer Price Index)
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Corporate Bonds, Features

▶ 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.
▶ cupon payments/price differ by the default risk
▶ 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.
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Corporate Bonds (EU, by country)

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Corporate Bonds (EU, by sector)

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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.

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Equity Securities: Largest ones in the Europe

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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). May
be adjustable according to the market rate
▶ 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
▶ Callable: the issuing company buys shares back at a pre-set
price.
▶ Convertible: can be converted to common stocks at some
ratio
▶ Example: next slide
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Preferred Stocks: Example

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How to build an index?
Averaging methods...

▶ Simple average of returns (of top 100 stocks)?

▶ equally-weighted. invest 1 dollar in each company...
▶ needs re-balancing every period...

▶ Weighted average of returns by their market size?

▶ value-weighted. buy stocks proportionate to mkt caps... (buy
x percent of each company)
▶ buy-and-hold strategy. As if you buy the entire market!
▶ example: S&P 500 (500 largest domestic firms). NASDAQ

▶ Weighted average of returns by their share price?

▶ price-weighted. buy 1 share of a company
▶ buy-and-hold strategy.
▶ example: Dow-Jones IA (30 large blue-chip corporations)
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Major US Equity Market Cap Indices

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