Financial Instruments

Chapter 2
McGraw-Hill/Irwin
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

Major Types of Securities

Debt
Money market instruments Bonds

Common stock Preferred stock Derivative securities

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Markets and Instruments

Money Market
Debt Instruments Derivatives

Capital Market
Bonds Equity Derivatives

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Money Market Instruments

Treasury bills Certificates of deposit Commercial Paper Bankers Acceptances Eurodollars

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Money Market Instruments (Cont.)

Repurchase Agreements (RPs) and Reverse RPs Federal Funds Brokers Calls LIBOR Market

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Bond Markets
US Treasury Bonds and Notes Agency Issues (Fed Gov) International Bonds Municipal Bonds Corporate Bonds Mortgage-Backed Securities

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Municipal Bond Yields

Interest income on most municipals is not subject to tax To compare the yields on municipals to other bonds use equivalent taxable yield (municipal return) / (1 tax rate) Or solve for the tax rate that equates the two yields Tax rate = 1 (municipal rate/taxable rate)

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Capital Market - Equity

Common stock
Residual claim Limited liability

Preferred stock
Fixed dividends - limited Priority over common Tax treatment

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Stock Market Indexes

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?

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Examples of Indexes - Domestic

Dow Jones Industrial Average (30 Stocks) Standard & Poors 500 Composite NASDAQ Composite NYSE Composite Wilshire 5000

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Examples of Indexes - International

Nikkei 225 & Nikkei 300 FTSE (Financial Times of London) Dax Region and Country Indexes
EAFE Far East United Kingdom

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Bond Indexes
Lehman Brothers Merrill Lynch Salomon Brothers Specialized Indexes
Merrill Lynch Mortgage

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Construction of Indexes
How are stocks weighted?
Price weighted (DJIA) Market-value weighted (S&P500, NASDAQ) Equally weighted (Value Line Index)

How returns are averaged?

Arithmetic (DJIA and S&P500) Geometric (Value Line Index)

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Averaging Methods
Component Return A=10% B= (-5%) C = 20% Arithmetic Average [.10 + (-.05) + .2] / 3 = 8.33% Geometric Average [(1.1) (.95) (1.2)]1/3 - 1 = 7.84%

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Derivatives Securities
Options Basic Positions
Call (Buy) Put (Sell)

Futures Basic Positions

Long (Buy) Short (Sell)

Terms
Exercise Price Expiration Date Assets

Terms
Delivery Date Assets

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