chapter 2_investments-asset classes and financial instruments

Chapter 2 Asset Classes and Financial Instruments 2.1 The Money Market 2-2 Money Market Instruments • Subsector of the debt market • Short-term debt securities that are highly marketable • Trade in large denominations and are out of the reach of individua l investors. • However, money market mutual funds are easily accessible to sma ll investors. 2-3 Treasury Bills (T-bills) Treasury bills - Issued by Federal Government - Denomination $100, commonly $10,000 - Maturity 4, 13, 26, or 52 weeks - Liquidity Highly liquid - Default risk None - Taxation Federal taxes owed, exempt from state and local taxes 2-4 Certificates of Deposit (CD) Certificates of Deposit - Issued by Depository Institutions - Denomination Any, $100,000 or more are marketable - Maturity Varies, typically 14 day minimum - Liquidity 3 months or less are liquid if marketable - Default risk First $100,000 ($250,000) is insured - Taxation Interest income is fully taxable 2-5 Commercial Paper (CP) Commercial Paper - Issued by Large creditworthy corporations and financial institutions - Maturity Maximum 270 days, usually 1 to 2 months - Denomination Minimum $100,000 - Liquidity 3 months or less are liquid if marketable - Default risk Unsecured, Rated, Mostly high quality - Taxation Interest income is fully taxable 2-6 Federal Funds and LIBOR Federal Funds - Depository institutions must maintain deposits of their own at the Federal Reserve Bank. - Funds in the bank’s reserve account are called Federal funds or Fed funds. - In the Federal funds market, banks with excess funds lend to those with a shortage. - Usually overnight transactions at the Federal funds rate. - Key interest rate for the 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. 2-7 Brokers’ Calls Call Money Rate - Investors who buy stock on margin borrow money from their brokers to purchase stock. The borrowing rate is the call money rate. - Usually about 1 % + the rate on short-term T-bills. 2-8 Yields on Money Market Instruments Most money market securities are of low risk, not risk-free. Money market securities promise yields greater than those on default-free T-bills. For example, investors who want more liquidity will accept lower yields on securities that can be more quickly and cheaply sold for cash. 2-9 Figure 2.3 Spreads on CDs and Treasury Bills 2-10 [...]...2-11 Capital Market - Fixed Income Instruments • Composed of longer-term borrowing or debt instruments t han those that trade in the money market • Treasury notes and bonds, corporate bonds, municipal bo nds, mortgage securities, and federal agency debt 2-12 US Treasury Notes and Bonds  Issued by the U.S government  Maturities T-notes: Maturities ranging... September 2008, Federal government took over FNMA and FHLMC 2-15 Municipal Bonds Issued by state and local governments Similar to Treasury and corporate bonds, except their interest income is exempt from federal income taxation and state/local taxation The higher the bracket, the more valuable the tax-exempt feature of municipals 2-16 Figure 2.4 Outstanding Tax Exempt Debt 2-17 Corporate Bonds Issued... security backed by a pool of mortgages Mortgage lenders originate loans and then sell packages of these loans in the secondary market - Sell their claim to the cash inflows from the mortgages In the year leading up to 2008, a large amount of subprime mortgages, that is, riskier loans made to financially weaker borrowers, were bundl ed and sold by private label issuers Pool issuers assumed housing prices... exclusion on 70% dividends earned 2-23 2-24 Capital Market - Equity 2-25 Capital Market - Equity Capital Gains and Dividend Yields You buy a share of stock for $50, hold it for one year, collect a $1.00 dividend and sell the stock for $54 What were your dividend yield, capital gain yield and total return? (Ignore taxes) - Dividend yield = Dividend / Pbuy = $1.00 / $50 = 2% - Capital gain yield = (Psell... with disastrous results for the markets 2-19 Figure 2.6 Mortgage Backed Securities Outstanding 2-20 2.3 Equity Securities 2-21 Common stock - Residual claim In the event of bankruptcy or liquidation, what will stockholders receive? : Stockholders are the last in line of all those who have a claim on the assets and income of the corporation (Debtholders – preferred – common) - Limited liability What... lose your initial investment In the event of the firm’s bankruptcy, corporate stockholders at worst have worthless stock 2-22 Capital Market - Equity Preferred stock - Features similar to both equity and debt 1) Debt feature: Pay to its holder a fixed stream of income each year (i.e perpetuity) Also, it does not give the holder voting power 2)Equity feature: Retain discretion to make the dividend payments... Dividend yield = Dividend / Pbuy = $1.00 / $50 = 2% - Capital gain yield = (Psell – Pbuy)/ Pbuy = ($54 - $50) / $50 = 8% - Total return: = Dividend yield + Capital gain yield = 2% + 8% = 10% 2-26 2.4 Stock and Bond Market Indexes Uses Track average returns Comparing performance of managers Base of derivatives Factors in constructing or using an index Representative? Broad or narrow? How is it constructed? . Chapter 2 Asset Classes and Financial Instruments 2. 1 The Money Market 2- 2 Money Market Instruments • Subsector of the debt market • Short-term. securities that can be more quickly and cheaply sold for cash. 2- 9 Figure 2. 3 Spreads on CDs and Treasury Bills 2- 10 2. 2 The Bond Market 2- 11 Capital Market - Fixed Income Instruments • Composed of longer-term. rise, but they began to fall as far back as 20 06 with disastrous results for the markets . 2- 19 Figure 2. 6 Mortgage Backed Securities Outstanding 2- 20