Financial Economics Bocconi Lecture2

Topic 2: Asset Classes and Financial Instruments

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 Asset Classes • Money market instruments • Capital market instruments  – Bonds  – Equity Securities  – Derivative Securities

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 Asset Classes • Money market instruments • Capital market instruments  – Bonds  – Equity Securities  – Derivative Securities

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The Money Market • Subsector of the fixed-income market:

Securities are short-term, liquid, low risk, and often have large denominations • Money market mutual funds allow individuals

to access the money market.

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Table 2.1 Major Components of  the Money Market

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Treasury bills (Part 1) • Short-term debt of U.S. government • Investors buy the bills at a discount from the • • • •

stated maturity value (the face value) Initial maturities: 4, 13, 26, 52 weeks Minimum denomination $100, but $10,000 much more common Primary market (auction), secondary market (government securities dealer) Exempt from all state and local taxes INVESTMENTS | BODIE, KANE, MARCUS

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Treasury bills (Part 2) • Financial press reports yields based on the T-bill prices • Bid and asked price, bid-asked spread • Bank discount method: quoting convention that

annualizes (based on 360-day year) the discount as a % of face value

r BD

F P 360 F

t

• where F is the face value, P is the purchase price and t

is the days to maturity • Why is the bank discount yield not a meaningful measure of the investor’s return ? INVESTMENTS | BODIE, KANE, MARCUS

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Treasury bills (Part 3) • Financial press reports yields based on the T-bill prices How to interpret the ASK yield of 0.043? The discount from par would be 0.043%* (36 days to maturity/360) = 0.0043%  A bill with a par value of $10,000 is therefore selling for  $10000*(1-0.000043) = $9,999.57

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Treasury bills (Part 3) • Holding period yield: • Effective annual yield:

HPY

EAY

F P P

(1 HPY) 365 /t

1

• Money-market yield/CD-equivalent yield: 360 F r mm HPY r BD t P • Bond-equivalent yield (asked yield)= HPY

365 t

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Money Market Securities • Certificates of Deposit: Time deposit with a bank  – Negotiable when in denominations > $100,000  – FDIC insured up to $250,000 as of the moment  – ST CDs highly marketable but market thins out at maturities

exceeding 3 months

• Commercial Paper: Short-term, unsecured debt of a

company  – Often backed up by a bank line of credit  – Maturities up to 270 days, typically < 2 months  –  Asset-backed CP: issued by banks (financial institutions) to raise

funds to invest in assets used as collateral

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Money Market Securities • Bankers’ Acceptances: An order to a bank by a bank’s customer to pay a sum of money on a future date • Eurodollars: dollar-denominated time deposits in banks outside the U.S. • Repos and Reverses: Short-term loan backed by government

securities.

 – Repos: dealer sells T-bills to an investor on an overnight basis, with

an agreement to buy them back the next day at a slightly higher  price (implicit interest)  – Term Repo: term of the implicit loan can be 30 days or more  – Reverse repo: dealer buys T-bills agreeing to sell them later at a specified higher price on a future date

• Fed Funds: Very short-term loans between banks  – Each member bank of the Federal Reserve System is required to maintain a minimum balamce in a reserve account INVESTMENTS | BODIE, KANE, MARCUS

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 Yields on Money Market Instruments • Except for Treasury bills, money market

securities are not free of default risk • Both the premium on bank CDs and the TED spread have often become greater during periods of financial crisis • During the credit crisis of 2008, the federal government offered insurance to money market mutual funds after some funds experienced losses  – Reserve Primary Fund “broke the buck” after the fall

of Lehman (value per share fell below $1) INVESTMENTS | BODIE, KANE, MARCUS

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The TED spread = LIBOR-T-bill rate

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CD-T-bill Spread and correlation with financial crises

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The Bond Market • Treasury Notes and Bonds • Inflation-Protected Treasury Bonds • Federal Agency Debt • International Bonds • Municipal Bonds • Corporate Bonds • Mortgages and Mortgage-Backed

Securities INVESTMENTS | BODIE, KANE, MARCUS

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Treasury Notes and Bonds • Maturities  – Notes – maturities up to 10 years  – Bonds – maturities from 10 to 30 yrs

• Par Value - $1,000 • Interest paid semiannually • Quotes – percentage of par  • Price of 102:29 = 102 +29/32=

102.906% of $1000 = $1029.06 INVESTMENTS | BODIE, KANE, MARCUS

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The Bond Market • Inflation-Protected Treasury Bonds  – TIPS: Provide inflation protection  – Principal amount is adjusted in proportion to increases in CPI

• Federal Agency Debt  – Debt of mortgage-related agencies such as Fannie Mae and

Freddie Mac  – Not explicitly insured by the federal government, widely assumed government would step in to assist an agency nearing default

• International Bonds  – Eurobonds: bonds denominated in a currency other than that of 

the country in which they are issued  – Yankee bonds: dollar-denominated bond sold in the US by a non-US issuer 

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Municipal Bonds • Issued by state and local governments • Interest is exempt from federal income tax

and sometimes from state and local tax • Types  – General obligation bonds: Backed by taxing power of issuer   – Revenue bonds: backed by project’s revenues or by the

municipal agency operating the project.  – Industrial development bond: revenue bond that is issued to finance commercial enterprises such as the construction of  a factory that can be operated by a private firm

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Tax-exempt Debt Outstanding

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Municipal Bond Yields • To choose between taxable and tax-exempt

bonds, compare after-tax returns on each bond. • Let t equal the investor’s marginal tax bracket • Let r equal the before-tax return on the taxable bond and r m denote the municipal bond rate. • If r (1 - t ) > r m then the taxable bond gives a higher return; otherwise, the municipal bond is preferred. INVESTMENTS | BODIE, KANE, MARCUS

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Table 2.2 Tax-Exempt Yield Table

The equivalent taxable yield is the rate that a taxable bond must offer to match the after-tax yield on the tax-free muni. The equivalent taxable yield is thus is simply the tax-free rate, r m , divided by (1-t ). We can also solve for cut-off tax bracket at which investors are indifferent between taxable and tax-exempt bonds. t =1- r m /r 

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Corporate Bonds • Issued by private firms • Semi-annual interest payments • Subject to larger default risk than government securities • Types:  – Secured (specific collateral backing them in the event of bankruptcy)  – Debentures (no collateral)  – Subordinated debentures (lower priority claim to the firm’s assets in the

event of bankruptcy)

• Options in corporate bonds  – Callable  – Convertible

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Mortgage-Backed Securities • Proportional ownership of a mortgage

pool or a specified obligation secured by a pool • Produced by securitizing mortgages  – Mortgage-backed securities are called passthroughs because the cash flows produced by

homeowners paying off their mortgages are passed through to investors.

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Figure 2.6 Mortgage-backed securities outstanding

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Equity Securities • Common stock: Ownership  – Each share entitles its owner to one vote on any matters of  corporate governance that are put to a vote at the corporation’s

annual meeting and to a share in the financial benefits of  ownership  – Residual claim: stockholders are the last in line of all those who have a claim on the assets and income of a corporation  – Limited liability: the most shareholders lose in the event of a failure of the corporation is their original investment

•  American Depository Receipts: certificates traded in US

markets that represent ownership in shares of a foreign company

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Equity Securities • Preferred stock: Perpetuity  – Fixed dividends  – No voting power regarding the management of the firm  – Firm retains the discretion to make the dividend payments to

preferred stockholders (no contractual obligation like bonds)  – Priority over common: preferred dividends are cumulative  – Tax treatment – not tax deductible for the issuing firm, but corporations can exclude up to 70% of dividends received from domestic corporations in the computation of taxable income. As a result, preferred stock often sells at lower yields than corporate bonds.

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Stock Market Indexes • Dow Jones Industrial Average  – Includes 30 large blue-chip corporations  – Computed since 1896  – Price-weighted average  – The return on the index is equivalent to holding a

portfolio that invests one share in each of the 30 stocks of the index

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Example 2.2 Price-Weighted Average Portfolio: Initial value $25 + $100 = $125 Final value $30 + $ 90 = $120 Percentage change in portfolio value = 5/125 = -.04 = -4% Index: Initial index value (25+100)/2 = 62.5 Final index value (30 + 90)/2 = 60 Percentage change in index -2.5/62.5 = -.04 = -4% INVESTMENTS | BODIE, KANE, MARCUS

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 Adjustments to the divisor of DJIA  The averaging procedure is adjusted whenever a stock splits or pays a stock dividend of more than 10%, or when a company is the group of  30 industrial companies is replaced by another. • The divisor used to compute the average price is adjusted so as to leave the price unchanged. • Suppose XYZ undergoes a 2:1 stock split in the beginning of the period. Price falls to $50, the number of shares outstanding doubles, leaving the market value of total shares unaffected. Index value before split (100+25)/2=62.5 To find the divisor, d, solve (50+25)/d=62.5 Result: d=1.2 Return on the index is affected by the split: Index value at the end of  the period = (30+45)/1.2 = 62.5, so return now is 0, instead of -4% •

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Standard & Poor’s Indexes • S&P 500  – Broadly based index of 500 firms  – Market-value-weighted index  – Rate of return on the index = rate of return on a

portfolio of the 500 underlying stocks where the portfolio weights are proportional to the total market value of each stock (or in a modified measure, the market value of free float)

• Market –value weighted index of XYZ and ABC:

the return would be (690-600)/600 = 15% INVESTMENTS | BODIE, KANE, MARCUS

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Indexes • Investors can base their portfolios on an index:  – Buy an index mutual fund • The index fund yields a return equal to that of the benchmark index

and thus provides a low-cost passive investment strategy for equity investors.

 – Buy exchange traded funds (ETFs) • Portfolio of shares that can be bought or sold as a unit

•

Equally-weighted indexes: equally-weighted average of the returns of each stock in the index  – Implicit portfolio strategy that places equal dollar values on each stock  – Unlike price-weighted and market-value-weighted indexes, this does not

correspond to a simple buy-and-hold strategy. Needs rebalancing to reset portfolio to equal weights.

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Other Indexes U.S. Indexes

Foreign Indexes

NYSE Composite • NASDAQ Composite • Wilshire 5000

• Nikkei (Japan)

•

• FTSE (U.K.; pronounced “footsie”)

Bond Indexes

• DAX (Germany),

• Difficult to compute true

• CAC (France)

rates of return since a lot of  bonds trade only infrequently • Matrix prices calculated from bond-valuation models instead of true market values

• Hang Seng (Hong Kong) • TSX (Canada)

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Derivatives Markets • Options and futures provide payoffs that depend

on the values of other assets such as commodity prices, bond and stock prices, or market index values. •  A derivative is a security that gets its value from

the values of another asset.

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Options • Call: Right to buy underlying asset at the strike

or exercise price.  – Value of calls decrease as strike price increases

• Put: Right to sell underlying asset at the strike or 

exercise price.  – Value of puts increase with strike price

• Value of both calls and puts increase with time

until expiration.

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Futures Contracts •  A futures contract calls for delivery of an asset

(or in some cases, its cash value) at a specified delivery or maturity date for an agreed-upon price, called the futures price, to be paid at contract maturity. • Long position: Take delivery at maturity • Short position: Make delivery at maturity

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