Chapter

Asset Classes and

2 Financial Instruments

Bodie, Kane, and Marcus

Essentials of Investments
Eleventh Edition
 2.1 Asset Classes

Fixed Income

Asset Classes Equity

Derivatives

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 2.1 Fixed Income: Money Markets

Money
Markets
Fixed Income
Capital
Markets
Asset Classes Equity

Derivatives

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 2.1 The Money Market

• Subsector of the fixed-income market

• Short-term
• Liquid
• Low risk
• Often have large denominations

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 2.1 The Money Market: Treasury Bills

Treasury Bills
Issuer: Federal Government
Denomination: Commonly $10,000; $1,000
Maturity: 4, 13, 26 or 52 Weeks
Liquidity: High
Default Risk: None
Interest Type: Discount
Taxation: Owed: Federal; Exempt: State, Local

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 2.1 The Money Market: Treasury Bills

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 2.1 The Money Market: Treasury Bills
• Bank Discount Rate (T-bill quotes)

r = $10,000 − P x 360 $10,000 = Par

BD $10,000 n

rBD = 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 - $9,875 360

r BD = × = 5%
$10,000 90
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 2.1 The Money Market: Certificates of Deposit (CDs)

Certificates of Deposit
Issuer: Depository Institutions
Denomination: Any, $100,000 or more marketable
Maturity: Varies, Typically 14-day Minimum
Liquidity: High for CDs <3 months, if marketable
Default Risk: First $250,000 FDIC insured
Interest Type: Add on
Taxation: Owed: Federal, State, Local

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 Figure 2.2 Spreads on CDs and Treasury Bills
5.0
OPEC I

4.5

4.0
Financial crisis

3.5
OPEC II
Percentage points

3.0
Penn Square

2.5

Market crash
2.0

1.5
LTCM

1.0

0.5

0.0
1970

1972

1974

1976

1980

1982

1984

1986

1990

1994

1996

2000

2006

2010

2014
1978

1988

1992

1998

2002

2004

2008

2012
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 2.1 The Money Market: Commercial Paper

Certificates of Deposit
Issuer: Large creditworthy corps.; financial institutions
Denomination: Minimum $100,000
Maturity: Maximum 270 days, usually 1-2 months
Liquidity: CP < 3 months liquid if marketable
Default Risk: Unsecured, rated, mostly high quality
Interest Type: Discount
Taxation: Owed: Federal, State, Local

• New Innovation: Asset-backed commercial paper

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 2.1 The Money Market: Instruments
• Bankers’ Acceptances
• Purchaser authorizes a bank to pay a seller for
goods at later date (time draft)
• When purchaser’s bank “accepts” draft, it becomes
contingent liability of the bank ( and marketable)

• Eurodollars
• Dollar-denominated time deposits held outside U.S.
• Pay higher interest rate than U.S. deposits

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 2.1 The Money Market: Instruments
• Federal Funds
• Trading in reserves held at the Federal Reserve *
• Key interest rate for economy

• LIBOR (London Interbank Offer Rate)

• Rate at which large banks in London (and
elsewhere) lend to each other
• Base rate for many loans and derivatives

* Depository institutions must maintain deposits with Federal Reserve Bank

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 2.1 The Money Market: Repurchase Agreements
• Repurchase Agreements (RPs)
• Short-term sale of securities + promise to repurchase at
higher price
• RP is a collateralized loan
• Many RPs are overnight
• “Term” RPs may have a 1-month maturity

• Reverse RPs
• Lending money; obtaining security title as collateral
• “Haircuts” may be required
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 2.1 The Money Market: Brokers’ Calls
• Brokers’ Calls
• Call money rate applies for investors buying
stock on margin
• Loan may be “called in” by broker

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 2.1 The Money Market: Credit Crisis
• MMMF and the Credit Crisis of 2008
• 2005-2008: Money market mutual funds
(MMMFs) grew 88%
• MMMFs had their own crisis in 2008: Lehman
Brothers
• Reserve Primary Fund “broke the buck”
• Run on money market funds ensued
• U.S. Treasury temporarily offered to insure all
money funds

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 2.1 The Money Market: Instrument Yields
• Yields on money market instruments not always
directly comparable

• Factors influencing “quoted” yields

• Par value vs. investment value
• 360 vs. 365 days assumed in a year (366 leap
year)
• Simple vs. compound interest

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 2.1 The Money Market: Bond Equivalent Yield

• Bond Equivalent Yield

• Can’t compare T-bill directly to bond
• 360 vs. 365 days
• Return is figured in par vs. price paid
• Adjust bank discount rate to make it
comparable

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 2.1 The Money Market: Bond Equivalent Yield

• Bond Equivalent Yield

P = price of the T-bill rBD = 5%
n = number of days to maturity

10,000 − P 365
r = ×
BEY P n

• Example Using Sample T-Bill

r = 10,000 − 9,875 365

×
BEY 90
9,875

rBEY = .0127 × 4.0556 = .0513 = 5.13%

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 2.1 The Money Market: Effective Annual Yield

• Effective Annual Yield

365 Compare:
 $10,000  P  n
rBD = 5%
rEAY = 1   1
 P  rBEY = 5.13%
P = price of the T-bill rEAY = 5.23%
n = number of days to maturity

• Example Using Sample T-Bill

365
 $10,000  $9,875  90
rEAY = 1   1
 $9,875 
rEAY = 5.23%
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 2.1 The Money Market: Instrument Yield

Money Market Instrument Instrument Yield

Treasury Bills Discount
Certificates of Deposit Bond Equivalent Yield
Commercial Paper Discount
Bankers’ Acceptances Discount
Eurodollars Bond Equivalent Yield
Federal Funds Bond Equivalent Yield
Repurchase Agreements Discount
Reverse RPs Discount

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 2.2 Fixed Income: Capital (Bond) Markets

Money
Markets
Fixed Income
Capital
Markets
Asset Classes Equity

Derivatives

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 2.2 The Bond Market
• Capital Market—Fixed-Income Instruments

•Government Issues—U.S. Treasury Bonds and Notes

• Bonds vs. notes
• Denomination
• Interest type
• Risk? Taxation?

• Treasury Inflation Protected Securities (TIPS)

• Principal adjusted for changes in the Consumer Price Index
• Marked with a trailing “i” in quote sheets

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 Figure 2.3 Listing of Treasury Issues

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 2.2 The Bond Market: Agency Issues
• Agency issues (federal government)
• Most are home-mortgage-related: FNMA,
FHLMC, GNMA, Federal Home Loan Banks
• Risks of these securities?
• Implied backing by the government
• In September 2008, federal government took over
FNMA and FHLMC

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 2.2 The Bond Market: Municipal Bonds
• Municipal bonds
• Issuer?
• Differ from treasuries and agencies?
• Risk?
• G.O. vs. revenue
• Industrial development
• Taxation?
rtax exempt = rtaxable x (1 – Tax rate)
r = Interest rate

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 Table 2.2 Equivalent Taxable Yields

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

rtax exempt = rtaxable x (1 – Tax rate)

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Figure 2.5 Yield Ratio: Tax-Exempt to Taxable Bonds

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 2.2 The Bond Market: Private Issue
• Corporate Bonds
• Investment grade vs. speculative grade

• Mortgage-Backed Securities
• Backed by pool of mortgages with “pass-through” of monthly
payments; covers defaults
• Collateral
• Traditionally all mortgages conform, since 2006 Alt-A and subprime
mortgages are included in pools
• Private banks purchased and sold pools of subprime mortgages
• Issuers assumed housing prices would continue to rise

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Figure 2.6 Mortgage-Backed Securities Outstanding

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Figure 2.7 Asset-Backed Securities Outstanding

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 Figure 2.9 The U.S. Fixed-Income Market

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 2.3 Equity

Money
Markets
Fixed Income
Capital
Markets
Asset Classes Equity

Derivatives

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 2.3 Equity Securities: Instruments
• Depository receipts
• American Depositary Receipts (ADRs), also
called American Depositary Shares (ADSs)
• Certificates traded in the U.S. representing
ownership in foreign security

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 2.3 Equity Securities: Instruments
• Equity Securities
• Common stock
• Residual claim
• Limited liability

• Preferred stock
• Priority over common
• Fixed dividends: Limited gains
• Nonvoting
• Tax treatment: Corporate tax exclusions on 70% of
dividends earned
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 2.3 Equity Securities: Instruments
• Equity Securities
• Common stock
• Residual claim
• Limited liability

• Preferred stock
• Priority over common
• Fixed dividends: Limited gains
• Nonvoting
• Tax treatment: Corporate tax exclusions on 70% of
dividends earned
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 2.3 Equity Securities: Returns
• Capital gains and dividend yields
• Buy a share of stock for $50, hold for 1 year, collect
$1 dividend, and sell stock for $54 What were
dividend yield, capital gain yield, and total return?

PSell  PBuy  Div $54  50  1

Total Return    10%
PBuy $50
Div $1
Dividend Yield    2%
PBuy $50
PSell  PBuy $54  50
Capital Gains Yield    8%
PBuy $50

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 Figure 2.8 Listing of stocks traded on NYSE

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 2.4 Stock and Bond Market Indexes
• Uses
• Track average returns
• Compare performance of managers
• Base of derivatives

• Factors in constructing/using index

• Representative?
• Broad/narrow?
• How is it constructed?

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 2.4 Stock and Bond Market Indexes
• Constructing Market Indexes
• Weighting schemes
• Price-weighted average:
• Add prices and divide by “divisor”

• Market value-weighted index:

• Return = weighted average of returns of each security
proportional to market value

• Equally weighted index:

• Computed from simple average of returns

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 2.4 Stock and Bond Market Indexes
• Construction of Indexes
• How are stocks weighted?
• Price weighted (DJIA)
• Market value weighted (S&P 500, NASDAQ)
• Equally weighted (Value Line Index)
• How much money do you put in each stock in
the index?

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 2.4 Stock and Bond Market Indexes
• Construction of Indexes
• How are stocks weighted?
• Price weighted (DJIA)
• Market value weighted (S&P 500, NASDAQ)
• Equally weighted (Value Line Index)
• How much money do you put in each stock in
the index?

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 2.5 Derivative Markets
• Derivative Asset/Contingent Claim
• Security with payoff that depends on the price
of other securities
• Call Option
• Right to buy an asset at a specified price on or
before a specified expiration date
• Put Option
• Right to sell an asset at a specified exercise
price on or before a specified expiration date

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 Figure 2.10 Stock Options on Apple

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 2.5 Derivative Markets: Call Option
• Call Options on Apple
• The right to buy 100 shares at a strike price of
$135 using the May contract costs:

Cost Call = 100  $7.63=$763

• Is this contract “in the money”?

• When should you buy this contract?
• When should you write it?

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 2.5 Derivative Markets: Put Option
• Put Options on Apple
• The right to buy 100 shares at a strike price of
$135 using the May contract costs:

Cost Put = 100  $1.17=$117

• Is this contract “in the money?”

• Why do the two option prices (Call and Put)
differ?

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 2.5 Derivative Markets
• Futures Contracts
• Purchaser (long) buys specified quantity at
contract expiration for set price

• Contract seller (short) delivers underlying

commodity at contract expiration for agreed-
upon price

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 Figure 2.11 Futures Contracts

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 2.5 Derivative Markets

• Options • Futures
• Basic Positions • Basic Positions
• Call (Buy/Sell?) • Long (Buy/Sell?)
• Put (Buy/Sell?) • Short (Buy/Sell?)
• Terms • Terms
• Exercise price • Delivery date
• Expiration date • Deliverable item

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