Chapter 2 - Asset Classes and Financial Instruments
Dow Jones Averages
(DJIA) of 30 large, "blue-chip" corporations has been computed since 1896. Its long history probably accounts for its preeminence in the public mind. (The average covered only 20 stocks until 1928.) Originally, the DJIA was calculated as the average price of the stocks included in the index. So, if there were 30 stocks in the index, one would add up the prices of the 30 stocks and divide by 30. The percentage change in the DJIA would then be the percentage change in the average price of the 30 shares.
International Bonds
A Eurobond is a bond denominated in a currency other than that of the country in which it is issued. For example, a dollar-denominated bond sold in Britain would be called a Euro- dollar bond. Similarly, investors might speak of Euroyen bonds, yen-denominated bonds sold outside Japan. Since the European currency is called the euro, the term Eurobond may be con- fusing. It is best to think of them simply as international bonds. In contrast to bonds that are issued in foreign currencies, many firms issue bonds in for- eign countries but in the currency of the investor. For example, a Yankee bond is a dollar- denominated bond sold in the U.S. by a non-U.S. issuer. Similarly, Samurai bonds are yen-denominated bonds sold in Japan by non-Japanese issuers. capital market
call option
A call option gives its holder the right to purchase an asset for a specified price, called the exercise or strike price, on or before some specified expiration date. An October call option on Apple stock with exercise price $355, for example, entitles its owner to purchase Apple stock for a price of $355 at any time up to and including the option's expiration date in October. Each option contract is for the purchase of 100 shares, with quotations made on a per share basis. The holder of the call need not exercise the option; it will make sense to exercise only if the market value of the asset that may be purchased exceeds the exercise price. When the market price exceeds the exercise price, the option holder may "call away" the asset for the exercise price and reap a benefit equal to the difference between the stock price and the exercise price. Otherwise, the option will be left unexercised. If not exercised before the expiration date, the option expires and no longer has value. Calls, therefore, provide greater profits when stock prices increase and so represent bullish investment vehicles.
closely held stock
A corporation whose stock is not publicly traded is said to be closely held. In most closely held corporations, the owners of the firm also take an active role in its man- agement. Takeovers generally are not an issue.
bank-discount method
A quoting convention used by financial institutions when quoting prices for fixed-income securities sold at a discount, particularly U.S. Government issues. The quote is presented as a percentage of face value, and is determined by discounting the bond by using a 360-day-count convention, which assumes there are twelve 30-day months in a year.
derivative asset
A security with a payoff that depends on the prices of other securities.
American Depository Receipts
ADRs, are certificates traded in U.S. markets that represent ownership in shares of a foreign company. Each ADR may correspond to ownership of a frac- tion of a foreign share, one share, or several shares of the foreign corporation. ADRs were created to make it easier for foreign firms to satisfy U.S. security registration requirements. They are the most common way for U.S. investors to invest in and trade the shares of foreign corporations.
Foreign and International Stock Market Indexes
Among these are the Nikkei (Japan), FTSE (U.K., pronounced "footsie"), DAX (Germany), Hang Seng (Hong Kong), and TSX (Toronto). A leader in the construction of international indexes has been MSCI (Morgan Stanley Capital International)
Bond Market Indicators
Just as stock market indexes provide guidance concerning the performance of the overall stock market, several bond market indicators measure the performance of various categories of bonds. The three most well-known groups of indexes are those of Merrill Lynch, Barclays (formerly Lehman Brothers), and Salomon Smith Barney (now part of Citigroup). Table 2.7 lists the components of the bond market in 2011. Problem with these indexes, is that the true rate of return on many bonds are difficult to compute
Convertible bonds
Convertible bonds give the bondholder the option to convert each bond into a stipulated number of shares of stock. These options are treated in more detail in Part Three.
Repos and Reverses
Dealers in government securities use repurchase agreements, also called repos, or RPs, as a form of short-term, usually overnight, borrowing. The dealer sells securities to an investor on an overnight basis, with an agreement to buy back those securities the next day at a slightly higher price. The increase in the price is the overnight interest. The dealer thus takes out a one-day loan from the investor. The securities serve as collateral for the loan. A term repo is essentially an identical transaction, except the term of the implicit loan can be 30 days or more. Repos are considered very safe in terms of credit risk because the loans are collateralized by the securities. A reverse repo is the mirror image of a repo. Here, the dealer finds an investor holding government securities and buys them with an agreement to resell them at a specified higher price on a future date.
put option
In contrast, a put option gives its holder the right to sell an asset for a specified exercise price on or before a specified expiration date. An October put on Apple with exercise price $355 entitles its owner to sell Apple stock to the put writer at a price of $355 at any time before expiration in October even if the market price of Apple is lower than $355. Whereas profits on call options increase when the asset increases in value, profits on put options increase when the asset value falls. The put is exercised only if its holder can deliver an asset worth less than the exercise price in return for the exercise price.
money market
Include short-term, highly liquid, and relatively low-risk debt instruments.
Brokers' Calls
Individuals who buy stocks on margin borrow part of the funds to pay for the stocks from their broker. The broker in turn may borrow the funds from a bank, agreeing to repay the bank immediately (on call) if the bank requests it. The rate paid on such loans is usually about one percentage point higher than the rate on short-term T-bills.
Federal Funds
Just as most of us maintain deposits at banks, banks maintain deposits of their own at the Federal Reserve Bank, or the Fed. Each member bank of the Federal Reserve System is required to maintain a minimum balance in a reserve account with the Fed. The required bal- ance depends on the total deposits of the bank's customers. Funds in the bank's reserve account are called Federal funds or Fed funds. At any time, some banks have more funds than required at the Fed. Other banks, primarily big New York and other financial center banks, tend to have a shortage of Federal funds. In the Federal funds market, banks with excess funds lend to those with a shortage. These loans, which are usually overnight transactions, are arranged at a rate of interest called the Federal funds rate. Although the Fed funds market arose primarily as a way for banks to transfer balances to meet reserve requirements, today the market has evolved to the point that many large banks use Federal funds in a straightforward way as one component of their total sources of funding. Therefore, the Fed funds rate is simply the rate of interest on very short-term loans among financial institutions. While most investors cannot participate in this market, the Fed funds rate commands great interest as a key barometer of monetary policy.
commercial paper
Large, well-known companies often issue their own short-term unsecured debt notes directly to the public, rather than borrowing from banks. These notes are called commercial paper (CP). CP maturities range up to 270 days; longer maturities require registration with the Securi- ties and Exchange Commission and so are almost never issued. CP most commonly is issued with maturities of less than one or two months in denominations of multiples of $100,000. Therefore, small investors can invest in commercial paper only indirectly, through money market mutual funds. CP is considered to be a fairly safe asset, given that a firm's condition presumably can be monitored and predicted over a term as short as one month. CP trades in secondary markets and so is quite liquid. Most issues are rated by at least one agency such as Standard & Poor's. The yield on CP depends on its time to maturity and credit rating. While most CP historically was issued by nonfinancial firms, in recent years there was a sharp increase in so-called asset-backed commercial paper issued by financial firms such as banks. This short-term CP typically was used to raise funds for the institution to invest in other assets, most notoriously, subprime mortgages. These assets in turn were used ascollateral for the CP—hence the label "asset-backed." This practice led to many difficulties starting in the summer of 2007 when those subprime mortgages began defaulting. The banks found themselves unable to issue new CP to refinance their positions as the old paper matured.
tax anticipation notes
Like Treasury bonds, municipal bonds vary widely in maturity. A good deal of the debt issued is in the form of short-term tax anticipation notes that raise funds to pay for expenses before actual collection of taxes. Other municipal debt may be long term and used to fund large capital investments. Maturities range up to 30 years.
Corporate bonds
Long-term debt issued by private corporations typically paying semiannual coupons and returning the face value of the bond at maturity. Default risk is a real consideration in the purchase of corporate bonds.
common stocks
Ownership shares in a publicly held corporation. Shareholders have voting rights and may receive dividends.
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 to a particular sector of the econ- omy that Congress believes is not receiving adequate credit through normal private sources. The major mortgage-related agencies are the Federal Home Loan Bank (FHLB), the Federal National Mortgage Association (FNMA, or Fannie Mae), the Government National CONCEPT check 2.1 What were the bid price, asked price, and yield to maturity of the 3.5% February 2018 Treasury bond displayed in Figure 2.3? What was its asked price the previous day? Find more at www.downloadslide.com Chapter 2 Asset Classes and Financial Instruments Mortgage Association (GNMA, or Ginnie Mae), and the Federal Home Loan Mortgage Corporation (FHLMC, or Freddie Mac).Although the debt of federal agencies was never explicitly insured by the federal govern- ment, it had long been assumed that the government would assist an agency nearing default.
Treasury notes and bonds
T-notes are issued with original maturities ranging up to 10 years, while T-bonds are issued with maturities ranging from 10 to 30 years. Both bonds and notes may be issued in incre- ments of $100 but far more commonly trade in denominations of $1,000. Both bonds and notes make semiannual interest payments called coupon payments, so named because in precomputer days, investors would literally clip a coupon attached to the bond and present it to receive the interest payment.
what type of average is the Dow Jones?
The Dow measures the return (excluding dividends) on a portfolio that holds one share of each stock. The amount of money invested in each company in that portfolio is there- fore proportional to the company's share price, so the Dow is called a price-weighted average. You might wonder why the DJIA is (in mid-2012) at a level of about 13,000 if it is sup- posed to be the average price of the 30 stocks in the index. The DJIA no longer equals the average price of the 30 stocks because the averaging procedure is adjusted whenever a stock splits or pays a stock dividend of more than 10% or when one company in the group of 30 industrial firms is replaced by another. When these events occur, the divisor used to compute the "average price" is adjusted so as to leave the index unaffected by the event.
London Interbank Offer Rate (LIBOR)
The London Interbank Offer Rate (LIBOR) is the rate at which large banks in London are willing to lend money among themselves. This 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. A corporation might borrow at a rate equal to LIBOR plus two percentage points, for example. Like the Fed funds rate, LIBOR is a statistic widely followed by investors. LIBOR interest rates may be tied to currencies other than the U.S. dollar. For example, LIBOR rates are widely quoted for transactions denominated in British pounds, yen, euros, and so on. There is also a similar rate called EURIBOR (European Interbank Offer Rate) at which banks in the euro zone are willing to lend euros among themselves.
Standard & Poor's Indexes
The Standard & Poor's Composite 500 (S&P 500) stock index represents an improvement over the Dow Jones averages in two ways. First, it is a more broadly based index of 500 firms. Second, it is a market value-weighted index. In the case of the firms XYZ andABC in Example 2.2, the S&P 500 would give ABC five times the weight given to XYZ because the market value of its outstanding equity is five times larger, $500 million versus $100 million. The S&P 500 is computed by calculating the total market value of the 500 firms in the index and the total market value of those firms on the previous day of trading.6 The percent- age increase in the total market value from one day to the next represents the increase in the index. The rate of return of the index equals the rate of return that would be earned by an investor holding a portfolio of all 500 firms in the index in proportion to their market value, except that the index does not reflect cash dividends paid by those firms.
Instruments of the money market
Treasury Bills: Short-term government securities issued at a discount from face value and returning the face amount at maturity. Certificates of deposit, Commercial paper, Bankers' acceptances, Eurodollars Repos and reverses, Federal funds, Brokers' calls
TIPS
Treasury inflated securities, effective way to hedge inflation risk. The principal amount on these bonds is adjusted in proportion to increases in the Consumer Price Index. Therefore, they provide a constant stream of income in real (inflation-adjusted) dollars, and the real interest rates you earn on these securities are risk-free if you hold them to maturity.
equally weighted index
an index computed from a simple average of returns. Do not corre- spond to buy-and-hold portfolio strategies. Suppose you start with equal dollar investments in he two stocks of Table 2.3, ABC and XYZ. Because ABC increases in value by 20% over the year, while XYZ decreases by 10%, your portfolio is no longer equally weighted but is now more heavily invested in ABC. To reset the portfolio to equal weights, you would need to rebalance: Sell some ABC stock and/or purchase more XYZ stock. Such rebalancing would be necessary to align the return on your portfolio with that on the equally weighted index.
Eurodollars
are dollar-denominated deposits at foreign banks or foreign branches of American banks. By locating outside the United States, these banks escape regulation by the Federal Reserve Board. Despite the tag "Euro," these accounts need not be in European banks, although that is where the practice of accepting dollar-denominated deposits outside the United States began. Most Eurodollar deposits are for large sums, and most are time deposits of less than six months' maturity. A variation on the Eurodollar time deposit is the Eurodollar certificate of deposit. A Eurodollar CD resembles a domestic bank CD except it is the liability of a non- U.S. branch of a bank, typically a London branch. The advantage of Eurodollar CDs over Eurodollar time deposits is that the holder can sell the asset to realize its cash value before maturity. Eurodollar CDs are considered less liquid and riskier than domestic CDs, however, and so offer higher yields. Firms also issue Eurodollar bonds, that is, dollar-denominated bonds outside the U.S., although such bonds are not a money market investment by virtue of their long maturities.
Municipal bonds
are issued by state and local governments. They are similar to Treasury and corporate bonds, except their interest income is exempt from federal income taxation. The interest income also is usually exempt from state and local taxation in the issu- ing state. Capital gains taxes, however, must be paid on munis if the bonds mature or are sold for more than the investor's purchase price.
debentures
bonds which have no collateral; and subordinated debentures, which have a lower priority claim to the firm's assets in the event of bankruptcy.
callable bonds
callable bonds give the firm the option to repurchase the bond from the holder at a stipulated call price.
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 con- tract maturity. The long position is held by the trader who commits to purchasing the com- modity on the delivery date. The trader who takes the short position commits to delivering the commodity at contract maturity.
Preferred stock
has features similar to both equity and debt. Like a bond, it promises to pay to its holder a fixed stream of income each year. In this sense, preferred stock is similar to an infinite-maturity bond, that is, a perpetuity. It also resembles a bond in that it does not give the holder voting power regarding the firm's management. Preferred stock is an equity investment, however. The firm retains discretion to make the dividend payments to the preferred stockholders: It has no contractual obligation to pay those dividends. Instead, preferred dividends are usually cumulative; that is, unpaid divi- dends cumulate and must be paid in full before any dividends may be paid to holders of common stock. In contrast, the firm does have a contractual obligation to make timely inter- est payments on the debt. Failure to make these payments sets off corporate bankruptcy proceedings. Preferred stock also differs from bonds in terms of its tax treatment for the firm. Because preferred stock payments are treated as dividends rather than as interest on debt, they are not tax-deductible expenses for the firm. This disadvantage is largely offset by the fact that corpo- rations may exclude 70% of dividends received from domestic corporations in the computa- tion of their taxable income. Preferred stocks, therefore, make desirable fixed-income investments for some corporations. Even though preferred stock ranks after bonds in terms of the priority of its claim to the assets of the firm in the event of corporate bankruptcy, preferred stock often sells at lower yields than corporate bonds. Presumably this reflects the value of the dividend exclusion, because the higher risk of preferred stock would tend to result in higher yields than those offered by bonds. Individual investors, who cannot use the 70% exclu- sion, generally will find preferred stock yields unattractive relative to those on other available assets. Corporations issue preferred stock in variations similar to those of corporate bonds. Preferred stock can be callable by the issuing firm, in which case it is said to be redeemable. It also can be convertible into common stock at some specified conversion ratio. A relatively recent innovation is adjustable-rate preferred stock, which, like adjustable-rate bonds, ties the dividend rate to current market interest rates.
how to invest in market indexes for portfolios?
index funds and exchange traded funds
bond prices and yields
inversely related
industrial development bond
is a revenue bond (muni) hat is issued to finance commercial enter- prises, such as the construction of a factory that can be operated by a private firm. In effect, this device gives the firm access to the municipality's ability to borrow at tax-exempt rates, and the federal government limits the amount of these bonds that may be issued.
certificate of deposit (CD)
is a time deposit with a bank. Time deposits may not be with- drawn on demand. The bank pays interest and principal to the depositor only at the end of the fixed term of the CD. CDs issued in denominations larger than $100,000 are usually nego- tiable, however; that is, they can be sold to another investor if the owner needs to cash in the certificate before its maturity date. Short-term CDs are highly marketable, although the mar- ket significantly thins out for maturities of three months or more. CDs are treated as bank deposits by the Federal Deposit Insurance Corporation, so they are insured for up to $250,000 in the event of a bank insolvency.
mortgage-backed security
is either an ownership claim in a pool of mortgages or an obligation that is secured by such a pool. Most pass-throughs traditionally comprised conforming mortgages, which meant that the loans had to satisfy certain underwrit- ing guidelines (standards for the creditworthiness of the borrower) before they could be pur- chased by Fannie Mae or Freddie Mac. In the years leading up to the financial crisis, however, a large amount of subprime mortgages, that is, riskier loans made to financially weaker borrow- ers, were bundled and sold by "private-label" issuers. Figure 2.6 illustrates the explosive growth of these securities, at least through 2007.
revenue bonds
issued to finance particular projects and are backed either by the revenues from that project or by the municipal
What type of index is S&P 500?
market value-weighted index: Index return equals the weighted average of the returns of each component security, with weights proportional to outstanding market value.
Residual claim
means stockholders are the last in line of all those who have a claim on the assets and income of the corporation. In a liquidation of the firm's assets, the shareholders have claim to what is left after paying all other claimants, such as the tax authorities, employ- ees, suppliers, bondholders, and other creditors. In a going concern, shareholders have claim to the part of operating income left after interest and income taxes have been paid. Management either can pay this residual as cash dividends to shareholders or reinvest it in the business to increase the value of the shares.
Limited liability (for shareholders)
means that the most shareholders can lose in event of the failure of the corporation is their original investment. Shareholders are not like owners of unincorporated businesses, whose creditors can lay claim to the personal assets of the owner—such as houses, cars, and furniture. In the event of the firm's bankruptcy, corporate stockholders at worst have worthless stock. They are not personally liable for the firm's obligations: Their liability is limited.
Treasury Bills
most marketable of all money market instruments T-bills are issued with initial maturities of 4, 13, 26, or 52 weeks. Individuals can purchase T-bills directly from the Treasury or on the secondary market from a government securities dealer. T-bills are highly liquid; that is, they are easily converted to cash and sold at low trans- action cost and with little price risk. Unlike most other money market instruments, which sell in minimum denominations of $100,000, T-bills sell in minimum denominations of only $100, although $10,000 denominations are far more common. While the income earned on T-bills is taxable at the federal level, it is exempt from all state and local taxes, another charac- teristic distinguishing T-bills from other money market instruments.
General obligation bonds
municipal bond are backed by the "full faith and credit" (i.e., the taxing power) of the issuer,
What is callable preferred stock referred as?
redeemable
P/E ratio
rice-to-earnings ratio, is the ratio of the current stock price to last year's earnings. The P/E ratio tells us how much stock purchasers must pay per dollar of earnings the firm generates for each share.
subprime mortgages
riskier loans made to financially weaker borrow- ers, were bundled and sold by "private-label" issuers.
Bid Price
slightly lower price you would receive if you wanted to to sell a bill to a dealer
bankers' acceptance
tarts as an order to a bank by a bank's customer to pay a sum of money at a future date, typically within six months. At this stage, it is like a postdated check. When the bank endorses the order for payment as "accepted," it assumes responsibility for ultimate payment to the holder of the acceptance. At this point, the acceptance may be traded in secondary markets much like any other claim on the bank. Bankers' acceptances are consid- ered very safe assets, as they allow traders to substitute the bank's credit standing for their own. They are used widely in foreign trade where the creditworthiness of one trader is unknown to the trading partner. Acceptances sell at a discount from the face value of the payment order, just as T-bills sell at a discount from par value.
bid-ask spread
the difference between bid/ask and shows the dealer's profit
Ask Price
the price you would have to pay to buy a T-Bill from a securities dealer
what is a key determinant to the attractiveness of municipal bonds?
the yield ratio, the higher the yield ratio the lower the cutoff tax bracket, and the more individuals will prefer to hold municipal debt
whats included in the bond market
treasury notes and bonds, corporate bonds, municipal bonds, mortgage securities and federal agency debt longer term money market instruments
equivalent taxable yield
way to compare bonds is to determine the interest rate on taxable bonds that would be necessary to provide an after-tax return equal to that of municipals
