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Chapter 2
Asset Classes and Financial
Instruments
INVESTMENTS
THIRTEENTH EDITION
BODIE, KANE, MARCUS

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 Chapter Overview
Building an investment portfolio.
• Asset allocation to broad classes of assets.
• Security selection within each class.

Financial markets.
Money markets: short-term, marketable, liquid, low-risk debt
securities.
Capital markets: longer term and riskier securities.
• Divided into four segments—longer-term bonds, equity,
options, and futures.

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 Money Market Securities 1

Treasury Bills (T-bills).

Government issued debt sold to the public.
• Ask price: price you pay to buy a T-bill from a securities dealer.
• Bid price: lower price you receive if you sell a T-bill to a dealer.
• Bid–ask spread: difference in ask price and bid price; dealer’s
source of profit.

Certificates of Deposit (CD).

• Bank pays interest and principal to the depositor only at
maturity.
• Time deposit cannot be withdrawn on demand (without penalty).
• Insured up to $250,000 by F DIC.

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 Money Market Securities 2

Commercial paper.
• Short-tern unsecured debt notes, often issued by large,
well-known companies and backed by a bank line of credit.
• Maturity: Up to 270 days, typically 1 month or less.

Bankers’ acceptance.
• An order to a bank by a customer to pay a sum of money
at a future date.

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 Money Market Securities 3

Eurodollars.
• Dollar-denominated deposits at foreign banks or foreign
branches of American banks.
Repurchase agreements (Repos).
Short-term, often overnight, sales of securities with an
agreement to repurchase them at a slightly higher price.
• Term Repo: term of the implicit loan can be 30 days or
more.
• Reverse Repo: dealer buys government securities from
investor, agreeing to sell them back on a future date.

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 Money Market Securities 4

Federal funds.
• Funds in a bank’s reserve account at the Federal Reserve.
• Loans arranged at federal funds rate.

Brokers’ calls.
• Investors may buy stocks on margin and brokers, in turn,
may borrow the funds from a bank.

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 LIBOR and Its Replacement
London Interbank Offer Rate (L IBOR).
• Was the premier European money market interest rate.
• Based on surveys of rates reported by participating banks not
actual transactions.
• 2012 Scandal → Regulators phased out L IBOR by 2021.

Secured Overnight Financing Rate (S OFR).

• Rate on overnight repurchase agreements collateralized by
Treasury securities.
• Replaced LIBOR in the United States.
• Since well-collateralized → cleaner expression of time value of
money.

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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, see Figure 2.2.
Money market funds are mutual funds that invest in money
market instruments.
• Government funds hold short-term U.S. Treasury or
agency securities.
• Prime funds also hold other money market instruments.

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 Figure 2.2 Spread Between Federal Funds
and T-Bills Rates

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 The Bond Market
Bond market is composed of longer-term borrowing or debt
instruments than those that trade in the money market.
• Treasury notes and bonds.
• Corporate bonds.
• Municipal bonds.
• Mortgage securities.
• Federal agency debt.

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 Debt Instruments 1

Treasury notes and Treasury bonds.

U.S. government borrows funds in large part by selling T-
notes and T-bonds.
• Notes—maturities range up to 10 years.
• Bonds—maturities range from 10 to 30 years.

Inflation-protected treasury bonds.

• Government-issued bonds linked to a cost of living index.
• Provide citizens an effective hedge against inflation risk.
• In the United States, they are called TIPS.

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 Table 2.3 Listing of Treasury Securities,
July 14, 2021
LISTING OF TREASURY ISSUES
ASKED YIELD TO
MATURITY COUPON BID ASKED CHANGE MATURITY
15-Nov-21 2.000 100.206 100.212 −0.008 0.013
31-Mar-22 1.750 101.060 101.064 −0.006 0.056
15-May-25 2.125 105.252 105.256 0.058 0.592
15-Feb-36 4.500 138.234 138.244 0.960 1.525
15-Feb-40 4.250 139.160 139.180 0.158 1.815
15-May-51 2.375 108.224 108.244 1.128 1.984

Note: the yield to maturity in the last column doubles the semiannual
yield (APR) rather than compounding it.

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 Debt Instruments 2

Federal agency debt.

Agencies formed to channel credit to a particular sector that
Congress believes might not receive adequate credit through
private sources.
• For example: FHLB, FNMA, GNMA, and FHLMC.
International bonds.
International capital market largely centered in London.
• Eurobond: denominated in a currency other than that of
the issuing country (i.e., Eurodollar, Euroyen).
• Yankee bond: dollar-denominated bond sold in the United
States by a non-U.S. issuer (see also: Samurai bond,
Bulldog bond, etc. ).
ete.ra

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 Debt Instruments 3

Municipal Bonds.
Tax-exempt bonds issued by state and local governments.
• General obligation—backed by general taxing power of
issuer.
• Revenue—backed by proceeds from the project or agency
they are issued to finance.
• Typically issued by airports, hospitals, and so on .
etera

• Industrial development—revenue bond issued to finance

commercial enterprises.
Vary widely in maturity.

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 Debt Instruments 4

Corporate bonds.
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.
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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 Debt Instruments 5

Mortgage- and asset-backed securities.

Ownership claim in a pool of mortgages or an obligation that
is secured by such a pool.
Conforming mortgages.
• Loans must satisfy certain underwriting guidelines before
they may be purchased by Fannie Mae or Freddie Mac.
Subprime mortgages.
• Riskier loans made to financially weaker borrowers.

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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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 Equity Securities: Common Stock
• Represent ownership shares in a corporation.
• Each share entitles owner to one vote.
• Corporation controlled by board of directors elected by
shareholders.
• 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.

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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.

Price–earnings ratio.
• Ratio of a stock’s price to its earnings per share.

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 Table 2.8 Stock Listings Traded on the NY
SE, June 2021
NAME SYMBOL CLOSE CHANG VOLUME 52 WK 52 WK DIV YIELD P/E
E LOW LOW
Herbalife Nutrition HLF 51.45 −0.05 434.355 59.00 43.01 .... .... 13.77

Hershey HSY 177.57 1.64 658.253 178.36 134.46 3.22 1.81 26.42

Hess Corp HE S 80.39 3.52 2,143.509 91.09 34.82 1.00 1.24 ....

Hewlett Packard HP E 14.01 0.25 9,448.992 16.74 8.28 0.48 3.43 28.42

Home Depot HD 319.22 2.17 33,775.308 345.69 246.59 6.60 2.07 23.27

Honda HMC 32.54 0.13 406.532 33.32 23.10 1.02 3.13 9.00

Honeywell HON 227.22 3.69 2,602,709 234.02 146.21 3.72 1.64 34.87

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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).
• Does not convey voting power.
• 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.
• Other corporations that own domestic preferred stock may
exclude 50% of dividends when computing taxable income.

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 Equity Securities: Depository Receipts

American Depository Receipts (ADRs).

• Certificates traded in U.S. markets that represent
ownership in shares of a foreign company.
• Each ADR may correspond to ownership of a fraction of a
foreign share, one share, or several shares of the foreign
corporation.

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 Stock Market Indexes
Dow Jones Industrial Average (DJIA).
• Includes 30 large blue-chip corporations.
• Computed since 1896.
• Price-weighted average.

Standard & Poor’s 500 (S&P 500).

• More broad-based index of 500 largest domestic firms.
• Market-value-weighted.
• Index Fund and Exchange-Traded Funds (ETF).

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 Other Indexes
U.S. market-value indexes.
• Russell Indexes: Market segment specific.
• NYSE, NASDAQ, Wilshire 5000, CRSP.

Equally weighted indexes.

• Do not correspond to buy-and-hold strategies.
Foreign and international stock market indexes.
• Nikkei, FTSE, DAZ, Hang Seng, TSX.

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 Figure 2.9 U.S. Fixed-Income Market ($
billions)
Bond market indexes.
• Measure the performance of various categories of bonds.

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 Derivative Markets
Derivative asset: A claim that’s value is directly dependent
on the value of an underlying asset or assets.
• Also known as contingent claims.
• Options.
• Futures/Forwards.
• Swaps.

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