Asset Classes and Financial Instruments

1
CHAPTER 2GLOBAL FINANCIAL INSTRUMENTS

• Asset Classes and Financial Instruments

2
2.1 THE MONEY MARKET
3
Major Classes of Financial Assets or Securities

• Money market
• Bond market
• Equity markets
• Indexes
• Derivative markets

4
Money Market Instruments

• Treasury bills issued by central bank to
  institutional buyers
• Certificates of deposits Fixed deposits can be
  enchased earlier than maturity
• Commercial Paper Short term unsecured debt
  issued by large corporations usually backed by
  credit lines to pay cash at maturity. CP maturity
  range up to 270 days, longer maturity requires
  SEC registration. Usual denomination of multiples
  of 100,000. Small investor only can invest
  through money market mutual funds.
• Bankers Acceptances An order to a bank by a
  customer to pay a sum of money at a future date,
  which can then be traded in secondary market.
  This is widely used in foreign trade where the
  credit worthiness of one trader is unknown to the
  trading partner

5
Money Market Instruments (Contd..)

• Eurodollars Dollar denominated deposits at bank
  of countries other than USA or foreign branches
  of US banks to escape regulations of Federal
  Reserve Board. Most Eurodollar deposits are for
  large sums, and most are time deposits of less
  than six months maturity.
• Repurchase Agreements (RPs) and Reverse RPs The
  dealer sells securities with an agreement to
  repurchase the securities at a higher price.
  Dealers in government securities use repurchase
  agreement, called repo as a form of short term
  borrowing.
• Federal Funds Statutory reserve maintained by
  commercial banks with the central bank. Banks
  with a surplus of such fund can sell it to a bank
  in deficit in money market.
• LIBOR (London Interbank Offer Rate) Market LIBOR
  is the rate at which large banks in London are
  willing to lend money among themselves. The rate
  has become the premier short-term interest rate
  quoted in the European money market and serves as
  a reference rate for a wide range of transactions.

6
2.2 THE BOND MARKET
7
Bond Market

• Treasury Notes and Bonds
• T-notes maturity up to 10 years
• T-bonds maturity in excess of 10 years
• Federal Agency Debt Some government agencies
  issue their own securities to finance their
  activities. These agencies usually are formed for
  public policy reasons to channel credit through
  normal private sources. Although these are not as
  risk-free as treasury bonds but are very safe as
  government will assist an agency nearing default.
  Some of these agencies are
• Federal National Mortgage Association
• Government National Mortgage Association
• Federal Home Loan Mortgage Corporation
• Federal National Mortgage Associations
• International Bonds
• Largely centered in London, a Eurobond is a bond
  denominated in any currency other than that of
  the country in which it is issued. For example, a
  Yankee bond is a dollar denominated bond sold in
  the U.S. by a non-US issuer.

8
Bond Market (Contd..)

• Municipal Bonds
• Issued by the state and local government.
  Maturity Up to 30 years. Unlike treasury bonds,
  interest income on these is exempt from federal
  income taxation.
• Corporate Bonds
• Issued by private corporations typically pay
  semiannual coupons
• Default risk secured bond (specific collateral
  backing them in the event of firm bankruptcy),
  unsecured bond or debenture, subordinated
  debenture (lower priority in the event of
  bankruptcy)
• Callable (by the firm) and convertible (by the
  holder) bond
• Mortgages and Mortgage-Backed Securities
• Investors can invest in a portfolio of mortgage
  loans, and these securities have become major
  component of fixed-income market. Fixed rate
  mortgages can create considerable difficulties
  for banks in years of increasing interest rates.
  Because banks commonly issue short term
  liabilities (the deposits of their customers) and
  hold long term assets, such as fixed-rate
  mortgages, they suffer losses when interest rate
  increases. So the conventional form of fixed
  interest rate mortgage was a threat for
  commercial banks. Now the rate is adjustable.

9
Mortgages and Mortgage-backed Securities

• Developed in the 1970s to help liquidity of
  financial institutions
• Proportional ownership of a pool or a specified
  obligation secured by a pool
• Market has experienced very high rates of growth

10
Figure 2.8 Mortgage-Backed Securities Outstanding
11
2.3 EQUITY SECURITIES
12
Equity Markets

• Common stock
• Residual claim
• Limited liability
• Owners of the firm (voting rights)
• Preferred stock
• Fixed dividends limited but cumulative
• Priority over common
• Redeemable (by the firm) convertible
• Tax treatment Different from bond

13
2.4 STOCK AND BOND MARKET INDEXES
14
Stock Market Indexes

• There are several indexes worldwide such as
• Dow Jones Industrial Average (DJIA) If there are
  30 stocks in the Index, one would add the value
  of the 30 stocks and divide by 30. Dividends
  excluded, so it is price weighted average.
• Nikkei Average
• Offer ways of comparing performance of managers
• Base of derivatives

15
Factors for Construction of Stock Indexes

• Representative versus blue chips?
• Broad or narrow?
• How is it weighted?
• Price weighted (DJIA)
• Market weighted (SP 500, NASDAQ)

16
Table 2.4 Data to Construct Stock Price Indexes
17
DJIA Price-Weighted Average

• Using data from Table 2.4 example 2.2
• Initial value 25 100 125
• Final value 30 90 120
• Percentage change in portfolio value
• Initial index value (25 100)/2 62.5
• Final index value (30 90)/2 60
• Percentage change in index
• (60-62.5)/62.5-2.5/62.5 -.04 -4

18
SPs Composite 500 Computation of value
weighted Index
Stocks Share price Number of shares Market value
Dec 31, 2005 A B C Total 10.00 15.00 20.00 1,000,000 6,000,000 5,000,000 10,000,000 90,000,000 100,000,000 200,000,000
Dec 31, 2006 A B C Total 12.00 10.00 20.00 1,000,000 12,000,000 (Split 2 for 1) 5,500,000 (10 stock div) 12,000,000 120,000,000 110,000,000 242,000,000
New Index Value(Current Market Value/Base Value) x Beginning Index Value (242,000,000/200,000,000)x100 121 New Index Value(Current Market Value/Base Value) x Beginning Index Value (242,000,000/200,000,000)x100 121 New Index Value(Current Market Value/Base Value) x Beginning Index Value (242,000,000/200,000,000)x100 121 New Index Value(Current Market Value/Base Value) x Beginning Index Value (242,000,000/200,000,000)x100 121
19
2.5 DERIVATIVE MARKETS
20
Derivative Securities

• Options
• Call (Buy)
• Put (Sell)
• Call (Buy) Option gives the holder the right to
  purchase an asset for a specified price, called
  exercise price, on or before expiration date. If
  the holder expect that price would increase in
  future then he would go for call option. He would
  buy at a lower price (strike price) and sell at a
  higher price, and thereby, make money.
• Put (sell) option gives the holder the right to
  sell an asset for a specified price, called
  exercise price, on or before expiration date. If
  the holder expect that price would decrease in
  future then he would go for put option option. He
  would buy at a lower price and sell at a higher
  price (strike price), and thereby make money.
• Terms
• Exercise Price
• Expiration Date
• Assets
• Premium

21
Call Option Payoffs Buyer
Buy a call
60
40
Option payoffs ()
20
80
120
20
40
60
100
50
Stock price ()
20
Exercise price 50
40
22
Call Option Payoffs Seller
60
40
Option payoffs ()
20
80
120
20
40
60
100
50
Stock price ()
20
Sell a call
Exercise price 50
40
23
Contingency graph Call Option
Buyer of a call
10
50
10
Exercise price 50 option premium 10
Seller of a call
24
Put Option Payoffs Buyer
60
50
40
Option payoffs ()
20
Buy a put
0
80
20
40
60
100
50
Stock price ()
20
Exercise price 50
40
25
Put Option Payoffs Seller
40
Option payoffs ()
20
Sell a put
0
80
0
20
40
60
100
50
Stock price ()
20
Exercise price 50
40
50
26
Put Option Profits
60
40
Option payoffs ()
20
Seller of a put
10
Stock price ()
80
20
40
60
100
50
10
Buyer of a put
20
40
Exercise price 50 option premium 10
27
Reading The Wall Street Journal
28
Reading The Wall Street Journal
This option has a strike price of 135
a recent price for the stock is 138.25
July is the expiration month
29
Reading The Wall Street Journal
This makes a call option with this exercise price
in-the-money by 3.25 138¼ 135.
Puts with this exercise price are
out-of-the-money.
30
Reading The Wall Street Journal
On this day, 2,365 call options with
thisexercise price were traded.
31
Reading The Wall Street Journal
The CALL option with a strike priceof 135 is
trading for 4.75.
Since the option is on 100 shares of stock,
buying this option would cost 475 plus
commissions.
32
Reading The Wall Street Journal
On this day, 2,431 put options with thisexercise
price were traded.
33
Reading The Wall Street Journal
The PUT option with a strike price of 135 is
trading for .8125.
Since the option is on 100 shares of stock,
buying this option would cost 81.25 plus
commissions.
34
Derivative Securities (Contd..)

• Futures
• A future contract calls for a delivery of an
  asset at a specified delivery or maturity date,
  for an agreed upon price, called future price, to
  be paid at the maturity of the contract.
• Basic Positions
• Long (Buy) The long position is held by trader
  who commits to purchasing the commodity on the
  delivery date.
• Short (Sell) The short position is held by trader
  who commits to delivering the commodity on the
  delivery date.
• Terms
• Delivery Date
• Assets