2
Asset Chapter Classes and Financial
Instruments
Money Market Instruments
Treasury Bills
Certificates of Deposit
Commercial Paper
Bankers Acceptances
Eurodollars
Repos and Reverses
Brokers Calls
Federal Funds
LIBOR (London Interbank Offer Rate)
2-2
Treasury Bills
Treasury bills
Issued by
Denomination
Maturity
Liquidity
Default risk
Interest type
Taxation
Federal Government
$10,000
4, 13, 26, or 52 weeks
Highly liquid
None
Discount
Federal taxes owed, exempt
from state and local taxes
2-3
Certificates of Deposit (CD)
Certificates of
Deposit
Issued by
Denomination
Maturity
Liquidity
Default risk
Interest type
Taxation
Depository Institutions
Any, $100,000 or more are marketable
Varies, typically 14 day minimum
3 months or less are liquid if marketable
First $100,000 ($250,000) is insured
Add on
Interest income is fully taxable
2-4
Commercial Paper
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
Interest type
Discount
Taxation
Interest income is fully taxable
New Innovation: Asset backed commercial paper is backed
by a loan or security. In summer 2007 asset backed CP
market collapsed when subprime collateral values fell.
2-5
Bankers Acceptances &
Eurodollars
Bankers Acceptances
Originates when a purchaser of goods authorizes its
bank to pay the seller for the goods at a date in the
future (time draft).
When the purchasers bank accepts the draft it
becomes a contingent liability of the bank and
becomes a marketable security.
Eurodollars
Dollar denominated (time) deposits held outside the
U.S.
Pay a higher interest rate than U.S. deposits.
2-6
Federal Funds and LIBOR
Federal Funds
Depository institutions must maintain deposits
with the Federal Reserve Bank.
Federal funds represents trading in reserves
held on deposit at the Federal Reserve.
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
Repurchase Agreements and
Reverses
Repurchase Agreements (RPs or
repos)
and Reverse RPs
Short term sales of securities arranged with an
agreement to repurchase the securities a set
higher price.
A RP is a collateralized loan, many are overnight,
although Term RPs may have a one month
maturity.
A Reverse Repo is lending money and obtaining
security title as collateral.
2-8
Money Market Instruments
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.
The loan may be called in by the broker.
2-9
2-10
Treasury Bills (T-bills)
2-11
MMMF and the Credit Crisis of
2008
Between 2005 and 2008 money market mutual
funds (MMMFs) grew by 88%. Why?
MMMFs had their own crisis in 2008 when Lehman
Brothers filed for bankruptcy on September 15.
Some funds had invested heavily in Lehmans
commercial paper.
On Sept. 16, Reserve Primary fund broke the
buck.
A run on money market funds ensued.
The U.S. Treasury temporarily offered to insure all
money funds to stop the run
- (up to $3.4 trillion in these funds.)
2-12
Money Market Instrument Yields
Yields on money market instruments
are 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
2-13
Bank Discount Rate (T-Bill
quotes)
$10,000 = Par
360
$10,000 - P 360
$10,000
r BD =
x
n
$10,000
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
$10,000 $9,875 360
r BD =
= 5%
x
$10,000
90
2-14
Bond Equivalent Yield
Cant compare T-bill directly to bond
360 vs 365 days
Return is figured on par vs. price paid
Adjust the bank discount rate to make it
comparable
2-15
Bond Equivalent Yield
rBD=5%
r BEY
10,000 - P
10,000
365
365
=
xn
P
P = price of the T-bill
n = number of days to maturity
Example Using Sample T-Bill
10,000 - 9,875
10,000 9,875
365
365
r BEY =
x
9,875
9
0
rBEY = .0127 x 4.0556 = .0513=5.13%
2-16
Effective Annual Yield
rEAY
365
n
$10,000 P
= 1 +
P
rBD=5%
1
rBEY=5.13%
rEAY=5.23%
P = price of the T-bill
n = number of days to maturity
Example Using Sample T-Bill
rEAY
365
$9,875 90
$10,000
= 1 +
$9,875
1
rEAY = 5.23%
2-17
Effective Annual Yield
r EAY
= (1+
(1+
10000 -
P
P
)365/n
P = price of the T-bill
rBD=5%
rBEY=5.13%
rEAY=5.23%
n = number of days to maturity
Example Using Sample T-Bill
r EAY
= (1+
(1+
10000 - 9875 365/90
9875
)
9875
rEAY 5.23%
2-18
Money = Market Instruments
Treasury bills
Discount
Certificates of deposit
BEY
Commercial Paper
Discount
Bankers Acceptances
Discount
Eurodollars
BEY
Federal Funds
BEY
Repurchase Agreements (RPs) Discount
and Reverse RPs
2-19
apital Market - Fixed Income Instruments
Government Issues
US Treasury Bonds and Notes
Bonds versus Notes
Denomination
Interest type
Risk?
Taxation?
Variation: Treasury Inflation Protected Securities (TIPS)
TIPS have principal adjusted for increases in the Consumer Price
Index
Marked with a trailing i in the quote sheet
2-20
Capital Market - Fixed Income
Instruments
2-21
Capital Market - Fixed Income
Instruments
Government Issues
Agency Issues (Fed Gov)
Most are home mortgage related
Issuers: FNMA, FHLMC, GNMA, Federal Home
Loan Banks
Risk of these securities?
Implied backing by the government
In September 2008, Federal government took
over FNMA and FHLMC.
2-22
Capital Market - Fixed Income
Instruments
Government Issues
Municipal Bonds
Issuer?
Differ from Treasuries and Agencies?
Risk?
G.O. vs Revenue
Industrial development
Taxation?
rTax Exempt = rTaxable (1 Tax Rate)
r = interest rate
2-23
Equivalent Taxable Yields
rTax Exempt = rTaxable (1 Tax Rate)
2-24
Capital Market - Fixed Income
Instruments
Private Issues
Corporate Bonds
Investment grade vs speculative grade
2-25
Capital Market - Fixed Income
Instruments
Mortgage-Backed Securities
Pass-through
A security backed by a pool of mortgages.
The pool backer passes through monthly
mortgage payments made by homeowners
and covers payments from any
homeowners that default.
Collateral:
Traditionally all mortgages were conforming
mortgages but since 2006, Alt-A and subprime
mortgages were included in pools
2-26
Capital Market - Fixed Income
Instruments
Mortgage-Backed Securities
Political encouragement to spur affordable
housing led to increase in subprime lending
Private banks began to purchase and sell
pools of subprime mortgages
Pool issuers assumed housing prices would
continue to rise, but they began to fall as far
back as 2006 with disastrous results for the
markets.
2-27
Capital Market - Equity
Common stock
Residual claim
Cash flows to common stock?
In the event of bankruptcy, what will
stockholders receive?
Limited liability
What is the maximum loss on a stock
purchase?
2-28
Capital Market - Equity
Preferred stock
Fixed dividends: limited gains, non-voting
Priority over common
Tax treatment
Preferred & common dividends are not tax
deductible to the issuing firm
Corporate tax exclusion on 70% dividends
earned
2-29
Capital Market - Equity
Depository Receipts
American Depository Receipts (ADRs) also called
American Depository Shares (ADSs) are
certificates traded in the U.S. that represent
ownership in a foreign security.
2-30
Capital Market - Equity
2-31
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 Pbuy)/ Pbuy
($54 - $50) / $50 = 8%
Total return: = Dividend yield + Capital gain yield
2% + 8%
= 10%
2-32
Stock and Bond 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?
2-33
Construction of Indexes
How are stocks weighted?
Price weighted (DJIA)
Market-value weighted (S&P500, NASDAQ)
A) What stocks to include
B) Weighting schemes
Price weighted: assumes buy 1 share of
each stock and invest cash and stock
dividends proportionately.
Value weighted: considers not only price but
also # shares outstanding:
$ invested in each stock are proportional
to
market value of each
stock
2-34
a) Price weighted series
(10+50+140)/3 = 200/3 = 66.67
Time 0 index value is
Time 1 index value = 190/3 = 63.33 Problem?
Refigure denominator (10+25+140) / Denom =
66.67
Denominator = 2.624869
Time 1 index value = (15+25+150) / 2.624869 =
72.38
Other problems
similar % change movements in higher price stocks
cause proportionately larger changes in the index
splits arbitrarily reduce weights of stocks that split
2-35
b) Value weighted series
indexV =
(15 40) + (25 160) + (150 50)
100 = 106.14
(10 40) + (50 80) + (140 50)
2-36
Examples of Indexes - Domestic
Dow Jones Industrial Average (30 Stocks)
Standard & Poors 500 Composite
NASDAQ Composite (> 3000 firms)
NYSE Composite
Wilshire 5000 (> 6000 stocks)
2-37
Companies in the Dow: Then &
Now
2-38
Examples of International Indices
2-39