Slide2 - Chapter
2
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Unformatted text preview: Chapter
2
 Asset
Classes
and
Financial
 Instruments
 Key
Elements
 •  What
are
the
major
asset
classes?

 •  Have
an
overview
of
the
financial
instruments
 traded
in
primary
and
secondary
markets.
 •  Be
able
to
read
a
newspaper
graph/table
 regarding
market
informaBon
of
a
parBcular
 instrument
 •  Understand
how
major
market
indexes
are
 constructed
 •  Understand
how
opBons
and
futures
work
 2.1
The
Money
Market
 Money
Market
Instruments
 •  •  •  •  •  •  •  •  •  Treasury
Bills
 What
are
the
 Cer=ficates
of
Deposit
 common
features
 of
money
market
 Commercial
Paper
 instruments?
 Bankers’
Acceptances
 Eurodollars
 Repos
and
Reverses
 Broker’s
Calls
 Federal
Funds
 LIBOR
(London
Interbank
Offer
Rate)
 Treasury
Bills
 •  Treasury
bills
 –  Issued
by:
 –  Denomina=on:
 –  Maturity:
 –  Liquidity:
 –  Default
risk:
 –  Interest
type:
 –  Taxa=on:
 Federal
Government
 $100,
commonly
$10,000
 4,
13,
26,
or
52
weeks
 Highly
liquid
 None
 Discount
 Federal
taxes
owed,
 exempt
from
state
and
 local
taxes
 Cer=ficates
of
Deposit
(CD)
 •  Cer=ficates
of
Deposit
 –  Issued
by:

Depository
Ins=tu=ons
 –  Time
deposit
 –  Denomina=on:
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
 –  Interest
type:
Add
on
(a
varia=on
of
BEY)
 –  Taxa=on:
interest
income
is
fully
taxable
 Commercial
Paper
 •  Issued
by:
Large
creditworthy
corporaBons
and
financial
 insBtuBons
 •  Maturity:
Maximum
270
days,
usually
1
to
2
months
 •  DenominaBon:
Minimum
$100,000
 •  Liquidity:
3
months
or
less
are
liquid
if
marketable
 •  Default
risk:
Unsecured,
Rated,
Mostly
high
quality
 •  Interest
type:
Discount
 •  TaxaBon:
Interest
income
is
fully
taxable
 New
Innova=on:
Asset
backed
commercial
paper
is
backed
by
a
 loan
or
security.

In
summer
2007
asset
backed
CP
market
 collapsed
when
subprime
collateral
values
fell.
 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
 (=me
dra`,
or
similar
to
a
postdated
check).

 –  When
the
purchaser’s
bank
‘accepts’
the
dra`
it
becomes
 a
con=ngent
liability
of
the
bank
and
becomes
a
 marketable
security.
 –  Why
need
Bankers
Acceptances?
 •  Eurodollars
 –  Dollar
denominated
(=me)
deposits
held
outside
the
U.S.
 –  Pay
a
higher
interest
rate
than
U.S.
deposits.
Why?
 Federal
Funds
and
LIBOR
 •  Federal
Funds
 –  Depository
ins=tu=ons
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
deriva=ves.
 Repurchase
Agreements
and
Reverses
 •  Repurchase
Agreements
(RPs
or
repos)

 and
Reverse
RPs
 – Issued
by
dealers
in
government
securi=es
 –  Short
term
sales
of
securi=es
arranged
with
an
 agreement
to
repurchase
the
securi=es
at
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
=tle
as
collateral.
 Money
Market
Instruments
 •  Broker’s
call
 –  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.
 Figure
2
 Table
2.2
Major
Components
of
the
 Money
Market
 Figure
2.2
Treasury
Bills
(T‐bills),

 
on
Sept
25,
2008

 Figure
2.3
Spreads
on
CDs
and
 Treasury
Bills
 MMMF
and
the
Credit
Crisis
of
2008
 •  Between
2005
and
2008
money
market
mutual
funds
 (MMMFs)
grew
by
88%.


 •  MMMFs
had
their
own
crisis
in
2008
when
Lehman
Brothers
 filed
for
bankruptcy
on
September
15.
 •  Some
funds
had
invested
heavily
in
Lehman’s
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.)
 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
 Bank
Discount
Rate
(T‐Bill
quotes)
 rBD = 10, 000 − P 360 × 10, 000 n Now:
purchase
price
P
 n
days
later:
receive
$10,000
 € rBD = 10, 000 − 9, 875 360 × = 5% 10, 000 90 € Bond
Equivalent
Yield
 •  Can’t
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
 Bond
Equivalent
Yield
 rBEY = 10, 000 − P 365 × P n € rBEY = 10, 000 − 9, 875 365 × = 5.13% 9, 875 90 € Effec=ve
Annual
Yield
 rEAY $10, 000 − P = 1 + P $10, 000 − 9, 875 = 1 + 9, 875 365 90 365 n −1 rEAY − 1 = 5.23% € € Money
Market
Instruments
 •  •  •  •  •  •  •  Treasury
bills 
 
 

 CerBficates
of
deposit 

 Commercial
Paper 
 

 Bankers
Acceptances 

 Eurodollars 
 
 
 

 Federal
Funds 
 
 

 Repurchase
Agreements
 (RPs)

 and
Reverse
RPs 

 Discount
 BEY*
 Discount
 Discount
 BEY*
 BEY*
 Discount 
 

 Figure
2.2
Treasury
Bills
(T‐bills),

 
on
Sept
25,
2008

 Based
on
Figure
2.2,

par=$10,000
 •  What
is
the
ask
price
for
T‐bill
maturing
on
 March
5,
2009?
 •  What
does
ask
price
mean?
 •  What
is
the
bid
price?
 2.2
The
Bond
Market
 Capital
Market
‐
Fixed
Income
 Instruments
 Government
Issues
 •  US
Treasury
Bonds
and
Notes
 –  Bonds
versus
Notes:
T>10,
or
<=10
years
 –  Denomina=on:
minimum
$100,
mostly
$1000
 –  Interest
type
 –  Risk?



____________________
 –  Taxa=on:
Interest
income
exempt
from
state
&
local
taxes
 Varia=on:Treasury
Infla=on
Protected
Securi=es
(TIPS)
 •  Tips
have
principal
adjusted
for
increases
in
the
Consumer
Price
 Index
 •  Marked
with
a
trailing
‘i’
in
the
quote
sheet
(See
Figure
2.4)
 Treasury
Issues:

 Sept
25,
2008
(par=$1000)
 1.
At
what
price
can
you
buy
a

 2015
Feb
15
T‐bond?
 2.
How
much
interest
Payment

 you
can
receive
every
6
months?


 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
securi=es?
 •  Implied
backing
by
the
government
 •  In
September
2008,
Federal
government
took
over
 FNMA
and
FHLMC.
 Capital
Market
‐
Fixed
Income
 Instruments
 Government
Issues
 •  Municipal
Bonds
 –  Issuer?
Local
government
 –  Differ
from
Treasuries
and
Agencies?
 •  Risk?
 o  General
obliga=on
vs

Revenue
bond
 o  Industrial
development

 •  Taxa=on?
Interest
is
exempt
from
federal,
state,
local
 tax.
(r
=
interest
rate)
 Table
2.3
Equivalent
Taxable
Yields
 rTax Exempt = rTaxable × (1 − Tax Rate) € For
an
investor
in
the
50%
tax
bracket,
 which
bonds
offer
higher
ader‐tax
returns?
 a)  Municipal
bond
with
3%
rate
of
return;
 b)  Corporate
bond
with
5%
rate
of
return?

 Figure
2.5
Outstanding
Tax
Exempt
Debt
 rtax
exempt/rtaxable
 Figure
2.6
Ra=o
of
yields
on
tax
 exempt
to
taxable
bonds
 Capital
Market
‐
Fixed
Income
 Instruments
 Private
Issues
 •  Corporate
Bonds
 –  Investment
grade
vs
specula=ve
grade
 Capital
Market
‐
Fixed
Income
 Instruments
 •  Mortgage‐Backed
Securi=es
 –  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:

 –  Tradi=onally
all
mortgages
were
conforming
mortgages
but
 since
2006,
Alt‐A
and
subprime
mortgages
were
included
in
 pools
 Capital
Market
‐
Fixed
Income
 Instruments
 •  Mortgage‐Backed
Securi=es
 •  Poli=cal
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
con=nue
 to
rise,
but
they
began
to
fall
as
far
back
as
2006
with
 disastrous
results
for
the
markets.
 Figure
2.7
Mortgage
Backed
SecuriBes
 Outstanding
 The
U.S.
Bond
Market
 2.3
Equity
Securi=es
 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?
 Capital
Market
‐
Equity
 •  Preferred
stock
 –  Fixed
dividends:
limited
gains,
non‐vo=ng
 –  Priority
over
common
stock
 –  Tax
treatment
 •  Preferred
&
common
dividends
are
not
tax
deduc=ble
 to
the
issuing
firm
 •  Corporate
tax
exclusion
on
70%
dividends
earned
 Capital
Market
‐
Equity
 •  Depository
Receipts
 –  American
Depository
Receipts
(ADRs)
also
called
 American
DepositoryShares
(ADSs)
are
cer=ficates
 traded
in
the
U.S.
that
represent
ownership
in
a
foreign
 security
 Capital
Market
‐
Equity
 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%
 2.4
Stock
and
Bond
Indexes
 Uses
 •  Track
average
returns
 •  Comparing
performance
of
managers
 •  Base
of
deriva=ves
 Factors
in
construc=ng
or
using
an
index
 •  
Representa=ve?
 •  
Broad
or
narrow?
 •  
How
is
it
constructed?
 Construc=on
of
Indexes
 Construc=ng
market
indices
 a)  What
stocks
to
include









 b)  Weigh=ng
schemes









 •  Price
weighted
average
assumes
buy
1
share
each
stock
and
invest
 cash
and
stock
dividends
propor=onately.

 •  Value
weighted:
considers
not
only
price
but
also
#
shares
o/s:
 –  $
invested
in
each
stock
are
propor=onal
to



























 market
value
of
each
stock
 •  Equal
weighted:
considers
not
only
price
but
also
#

shares:
 –  invest
same
amount
of
$
in
each
stock
regardless
of
market
 value
of
stock

 
a)
price
weighted
series

 
Time
0
index
value
is

(10+50+140)/3=66.67
 
Time
1
index
value
=
190/3
=
63.33 

 Problem?
Stock
split
 
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
 propor=onately
larger
changes
in
the
index
 –  splits
arbitrarily
reduce
weights
of
stocks
that
split
in
index
 Suppose
the
ini=al
value
of
the
index
is
100:
 b)
Value
weighted
series

 c)
Equal
weighted
series:

wlog
invest
$300
in
 each
 d)
Why
do
the
two
differ?
 d)
Why
do
the
two
differ?
 
Case
1:
20%
change
in
price
of
small
cap
firm.
 wlog
invest
$100
in
each
stock


















 Case
1
VW
=
100.43
 Case
1
EW
=
106.67 
 d)
Why
do
the
two
differ?
 
Case
2:
20%
change
in
price
of
large
cap
firm.
 
 

 Assume
that
we
invest
$100
in
each
stock
 Examples
of
Indexes
‐
Domes=c
 •  Dow
Jones
Industrial
Average
(30
Stocks)
 •  Standard
&
Poor’s
500
Composite
 •  NASDAQ
Composite
(>
3000
firms)
 •  NYSE
Composite
 •  Wilshire
5000
(>
6000
stocks)
 Table
2.6
Dow
Companies
Then
&
Now
 Figure
2.9
Compara=ve
Performance
 of
Several
Stock
Market
Indices,
 2004‐2008
 Why
has
performance
differed
for
the
indices?
 Examples
of
Interna=onal
Indices
 2.5
Deriva=ve
Markets
 •  Listed
Call
Op=on:

 –  Holder
the
right
to
buy
100
shares
of
the
 underlying
stock
at
a
predetermined
price
on
or
 before
some
specified
expira=on
date. •  Listed
Put
Op=on:

 –  Holder
the
right
to
sell
100
shares
of
the
 underlying
stock
at
a
predetermined
price
on
or
 before
some
specified
expira=on
date.
 Figure
2.10
Stock
Op=ons
on
Apple
 What
does
the
term
‘strike’
or
exercise
price
refer
to?
 Using
the
Stock
Op=ons
on
Apple
 The
right
to
buy
100
shares
of
stock
at
a
stock
 price
of
$110
using
the
October
contract
would
 cost
$745.
 (Ignoring
commissions)
 Is
this
contract
“in
the
money?”
 When
should
you
buy
this
contract?

 • Stock
price
was
equal
to
$110.35
&
you
will
make
 money
if
the
stock
price
increases
above
$110.35
+
 $7.45
=
$117.80
by
contract
expira=on.

 Using
the
Stock
Op=ons
on
Apple
 The
right
to
buy
100
shares
of
stock
at
a
stock
 price
of
$110
using
the
October
contract
would
 cost
$810.
 (Ignoring
commissions)
 Is
this
contract
“in
the
money?”
 Why
do
the
two
op=on
prices
differ?
 Using
the
Stock
Op=ons
on
Apple
 Look
at
Figure
2.10
to
answer
the
following
 ques=ons:
 1. How
does
the
exercise
or
strike
price
affect
the
 value
of
a
call
op=on?

A
put
op=on?

Why?
 2. How
does
a
greater
=me
to
contract
expira=on
 affect
the
value
of
a
call
op=on?

A
put
op=on?

 Why?
 3. How
is
‘volume’
different
from
‘open
interest?’
 Futures
Contracts
 Who
might
long/short
 Futures
contract?
 In
a
futures
contract
the
purchaser
of
the
contract
(the
 long)
agrees
to
purchase
the
specified
quan=ty
of
the
 underlying
commodity
at
contract
expira=on
at
the
 price
(futures
price)
set
in
the
contract.


 The
contract
seller
(the
short)
agrees
to
deliver
the
 underlying
commodity
at
contract
expira=on
in
 exchange
for
receiving
the
agreed
upon
price.
 Futures
are
a
___________
to
buy
or
sell
in
the
future


 whereas
at
a
preset
price
whereas
op=ons
give
the
 holder
the
______
to
buy
or
sell
in
the
future.
 Figure
2.11
Futures
Contracts
 Figure
2.11
Futures
Contracts
 •  Contract
size:
5000
bushels
of
corn
 •  Price
quote
for
Dec
08
contract:
455’4
translates
to
a
price
of
 $4.55
+
4/8
cents
per
bushel
or
$4.555
per
bushel.
 •  If
you
bought
the
Dec
08
contract
what
would
you
be
 agreeing
to
do?

 –  Purchase
5000
bushels
of
corn
in
December
for
5,000
x
$4.555
=
 $22,775.
 •  What
would
be
your
obliga=on
if
you
sold
the
Dec
08
 contract?
 •  How
does
this
contract
differ
from
an
op=on?
 Deriva=ves
Securi=es
 Op=ons
 •  Basic
Posi=ons
 –  Call
(Buy/Sell?)
 –  Put
(Buy/Sell?)
 •  Terms
 –  Exercise
Price
 –  Expira=on
Date
 Futures

 Basic
Posi=ons
 Long
(Buy/Sell?)
 Short
(Buy/Sell?)
 Terms
 Deliverable
item
 Delivery
date

 Selected
Problems
 1.

Find
the
ader
tax
rate
of
return
to
a
corpora=on
that
buys
 preferred
stock
at
$40,
holds
it
one
year
and
sells
it
at
$42
ader
 collecBng
a
$4
dividend.

The
firm’s
tax
rate
is
20%.
What
is
the
 firm’s
ader‐tax
rate
of
return?
 (Pretax
rate
of
return
=
($42‐$40+$4)/$40=15%
)
 •  The
total
before‐tax
income
is
$6.

Ader
the
70%
exclusion,
taxable
income
 is:
 •  ($42‐$40)
+
0.30
×
$4
=
$3.20
taxable
income
 •  Therefore
Taxes
owed
are
Tax
rate
×
taxable
income
 •  Taxes
=
0.20
×
$3.20
=
$0.64
 •  Ader‐tax
income
=
$6
–
$0.64
=
$5.36
 •  Ader‐tax
rate
of
return
=
$5.36
/
$40
=
13.4%
 2.
 
a)
Using
the
quote
find
GD’s
closing
price
the
day
 before
the
quote
appeared
 
The
closing
price
is
$94.80,
which
is
$1.14
higher
than
 b) 
How
many
shares
could
you
buy
for
$5000?
 
You
could
buy:
$5,000/$94.80
=
52.74
shares

 c) 
Total
annual
dividend
income
from
the
shares
in
b)?
 
$1.44
*
52
=
$74.88
 d) 
What
are
EPS?

(Approximate)
 
P
/
(P/E)
=
EPS
=
$94.80
/
18
=
$5.27
 yesterday’s
price.

Therefore,
yesterday’s
closing
price
was:
 $94.80
–
$1.14
=
$93.66
 3. 
An
investor
has
a
30%
tax
rate
and
corporate
 bonds
are
paying
9%.

What
must
munis
pay
 to
offer
an
equivalent
ader
tax
yield?
 r Tax Exempt = 9% × (1 − 0.30) = 6.3% € 4. 

 a)
 
You
buy
one
July
2004
contract
at
the
seole
price.

 In
July
the
contract
closes
at
$42
per
barrel.

What
 was
your
$
profit?
 
The
July
maturity
futures
price
is
$41.14
per
barrel.

If
 the
contract
closes
at
$42
per
barrel
in
July,
your
profit
 on
each
contract
(for
delivery
of
1,000
barrels
of
crude
 oil)
will
be:

 ($42
‐
$41.14)
×
1000
=
$860
 
There
are
243,522
contracts
outstanding,
calling
for
 delivery
of
243,522,000
barrels
of
crude
oil.
 b) 
How
many
July
contracts
are
outstanding?
 5.

 Maturity
T=
6
months
 Strike
Price
K=50
 XYZ
6mo a.
$40 b.
$50 c.
$60 Value
of
call
 at
expiraBon 0 0 10 IniBal
Cost 4 4 4 Call
Profit ‐4 ‐4 6 XYZ
6mo a.
$40 b.
$50 c.
$60 Value
of
put
at
 expiraBon 10 0 0 IniBal
Cost 6 6 6 Put
Profit 4 ‐6 ‐6 6. 
What
would
you
expect
to
happen
to
the
 spread
between
yields
on
commercial
paper
 and
T‐bills
if
the
economy
were
to
enter
a
 steep
recession?
 
The
spread
will
widen.

Deteriora=on
of
the
 economy
increases
credit
risk,
that
is,
the
 likelihood
of
default.

Investors
will
demand
 a
greater
premium
on
debt
securi=es
 subject
to
default
risk.
 ...
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This note was uploaded on 05/12/2011 for the course FIN 300 taught by Professor Wang during the Spring '11 term at UChicago.

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