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Chapter 2
Asset Classesand FinancialInstruments
Copyright 2010 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin
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Money Market Instruments
Treasury Bills
Certificates of Deposits
Commercial Paper
Bankers Acceptances
Eurodollars Repurchase Agreements (RPs) and Reverse RPs
Federal Funds
LIBOR Market
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Table 2.2 Major Components of theMoney Market
2-3
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Figure 2.2 Treasury Bills (T-bills)
2-4
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Figure 2.3 Spreads on CDs andTreasury Bills
2-5
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MMMFs in 2008 Between 2005 and 2008 money market mutual funds
(MMMFs) grew by 88%. Why?
MMMFs had their own crisis in 2008 when LehmanBrothers filed for bankruptcy on September 15.
Some funds had invested heavily in Lehmanscommercial paper.
On Sept. 16, Reserve Primary fund broke the buck.What does this mean?
A run on money market funds ensued.
The U.S. Treasury temporarily offered to insure allmoney funds to stop the run
- (up to $3.4 trillion in these funds.)
2-6
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Money Market Instrument Yields
Yields on money market instrumentsare 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
2-7
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Bank Discount Rate (T-Bill quotes)
rrBDBD = bank discount rate= bank discount rate
FF = Face Value= Face Value
PP = Market Price= Market Price
nn = number of days to maturity= number of days to maturity
rrBDBD == FF -- PP
FFxx360360
nn
90-day T-bill, P = $9,87590-day T-bill, P = $9,875ExampleExample
rrBDBD == $10,000$10,000--$9,875$9,875
$10,000$10,000xx
360360
9090== 5%5%
$10,000 = Face
2-8
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Bond Equivalent Yield
Cant compare T-bill directly to bond
360 vs 365 days
Return is figured on par vs. price paid
Adjust the bank discount rate to make itcomparable
2-9
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Bond Equivalent Yield
P = price of the T-billP = price of the T-bill
n = number of days to maturityn = number of days to maturity
rrBEYBEY == 10,00010,000 -- PP
PPxx
365365nn
rrBEYBEY == 10,00010,000 -- 9,8759,8759,8759,875
xx 3653659090
rrBEYBEY = .0127 x 4.0556 = .0513 = 5.13%= .0127 x 4.0556 = .0513 = 5.13%
Example Using Sample T-BillExample Using Sample T-Bill
2-10
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Effective Annual Yield
P = price of the T-billP = price of the T-bill
n = number of days to maturityn = number of days to maturity
rEAY = 5.23%
Example Using Sample T-BillExample Using Sample T-Bill
rBD=5%
rBEY
=5.13%
rEAY
=5.23%
1111,11$
1
111
+=n
EAYP
Pr
1111,1$
111,1$111,11$1 11
111
+=EAYr
2-11
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Money Market Instruments
Treasury bills Certificates of deposit
Commercial Paper
Bankers Acceptances
Eurodollars
Federal Funds Repurchase Agreements (RPs)and Reverse RPs
Discount
BEY*
Discount
Discount
BEY*
BEY*
Discount
2-12
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Bond Market
Corporate Bonds GE
Government Treasury Notes and Bonds
Federal Agency Debt GMNA
Municipal Bonds
Colorado E470 International Bonds
Mortgages and Mortgage-Backed Securities
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Treasury Notes and Bonds
Maturities Notes maturities up to 10 years
Bonds maturities in excess of 10 years
30-year bond 2001 Treasury suspended sales 2005 discussion to possibly resume sales
Sales have resumed
Par Value - $1,000
Quotes percentage of par Not Subject to State and Local Tax
One Arm of the Government cant tax the other
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Capital Market - Fixed IncomeInstruments
2-15
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Federal Agency Debt
Major issuers Government National Mortgage Association (GNMA)-
Ginnie Mae
Federal Home Loan Bank (FHLB)
Federal National Mortgage Association (FNMA)-Fannie Mae
Federal Home Loan Mortgage Corporation (FHLMC)-
Freddie MacAlso Student Loan Marketing Association (SLM)- SallieMae
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Municipal Bonds
Issued by state and local governments Types
General obligation bonds Ad Valorem- backed by unlimited taxing power
Revenue bonds Industrial revenue bonds- backed revenue from project
Maturities range up to 30 years
Not Subject to Federal Tax
Not subject to State and Local tax when investoris resident of State Colorado Residents investing in E470 Muni
Fi 2 5 O t t di T
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Figure 2.5 Outstanding TaxExempt Debt
2-18
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Municipal Bond Yields
To compare yields on taxable securities aTaxable Equivalent Yield is calculated
TEY= Tax Free Yield/(1- Tax Bracket) Colorado E470 Bond yielding 3.5%
GE Bond yielding 5.0%
Your Tax Bracket is 28% TEY of E470 Bond = 3.5/.72 = 4.86%
Equivalent Tax Free Yield Finding the tipping point between taxable and tax free
= Taxable Yield x (1- Tax Bracket)
= 5.0 x .72 = 3.6%
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Yields onTax-exempts to Taxables
All about Tax Brackets
Tax Brackets are 10%,15%, 25%, 28%, 35%
The market determines
the tipping point Recent history has
this ratio at .75
Meaning that thosein the 25% Bracketand above wouldinvest
T bl 2 3 E i l t T bl
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Table 2.3 Equivalent TaxableYields
Rate)Tax(1
rr TaxableExemptTax =2-21
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Corporate Bonds
Issued by private firms
Semi-annual interest payments
Accruing interest at buy and sell
Subject to larger default risk thangovernment securities
Options in corporate bonds
Callable
Convertible
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Figure 2.7 Investment Grade BondListings
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Capital Market - Fixed IncomeInstruments
Mortgage-Backed Securities Pass-through
A security backed by a pool of mortgages. Thepool backer passes through monthly mortgagepayments made by homeowners and coverspayments from any homeowners that default.
Collateral: Traditionally all mortgages were conforming
mortgages but since 2006, Alt-A and subprimemortgages were included in pools
2-24
C i l M k Fi d I
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Capital Market - Fixed IncomeInstruments
Mortgage-Backed Securities Political encouragement to spur affordable
housing led to increase in subprime lending
Private banks began to purchase and sell poolsof subprime mortgages
Pool issuers assumed housing prices wouldcontinue to rise, but they began to fall as farback as 2006 with disastrous results for themarkets.
2-25
Fi 2 7 M t B k d
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Figure 2.7 Mortgage BackedSecurities Outstanding
2-26
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The U.S. Bond Market
2-27
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Equity Markets
Common stock Residual claim
Limited liability
Preferred stock Fixed dividends - limited
Priority over common
Tax treatment
Depository receipts
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Capital Market - Equity
2-29
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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 gainyield 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%
2-30
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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?
2.4 Stock and Bond Indexes
2-31
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Examples of Indexes - Domestic
Dow Jones Industrial Average (30 Stocks)
Standard & Poors 500 Composite
NASDAQ Composite
Russell 2000
Wilshire 5000
Figure 2 9 Comparative
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Figure 2.9 ComparativePerformance of Several Stock
Market Indices, 2001-2008
Why has performance differed for the
indices? 2-33
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Construction of Indexes
How are stocks weighted? Price weighted (DJIA)
Market-value weighted (S&P 500, NASDAQ)
Equally weighted (Value Line Index)
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Table 2.4 Data to Construct StockPrice Indexes
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DJIAPrice-Weighted Average
Using data from Table 2.4; example 2.2Initial value = $25 + $100 = $125
Final value = $30 + $ 90 = $120Percentage change in portfolio value =Initial index value = (25 + 100)/2 = 62.5Final index value = (30 + 90)/2 = 60
Percentage change in index =-2.5/62.5 = -.04 = -4%
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S&Ps Composite 500Market Value-Weighted Index
Using data from Table 2.4:
ABC would have five times the weight given toXYZ
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Value LineEqually Weighted Index
Places equal weight on each return
Using data from Table 2.4
Start with equal dollars in each investmentABC increases in value by 20%
XYZ decreases by 10%
Need to rebalance to keep equal weights
Table 2 6 Companies in the
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Table 2.6 Companies in theDow Then & Now
2-39
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Examples of International Indices
2-40
D i ti S iti
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Derivatives Securities
Options Basic Positions
Call (Buy)
Put (Sell) Terms
Exercise Price
Expiration Date
Assets
Futures Basic Positions
Long (Buy)
Short (Sell) Terms
Delivery Date
Assets
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Figure 2.10 Stock Options on Apple
What does the term strike or exercise price refer to?