Lou Rouselle – Chap 2 - Finance 1

Essentials of investments
Chapter 2 – Asset Classes and Financial Instruments
Building an investment portfolio:

Step 1 – deciding how much money to allocate to broad classes of assets = assets allocation

Step 2 – within each class, the investor selects specific assets from a detailed menu = security selection

Vocabulary:

Financial markets= are segmented into money markets and capital markets

➔ Money market instruments= short-term, marketable, liquid, low-risk debt securities = cash
equivalents = cash; trade in large dominations, so are out of reach of individual investors
except for money market mutual funds
➔ Capital market instruments= long-term, riskier securities and more diverse including three
segments: longer-term debt markets, equity markets and derivative markets in which options
and futures trade.

1. THE MONEY MARKET

U.S. Treasury bills (T-bills, bills)= the most marketable of all, representing the simplest form of
borrowing and highly liquid + sold at low transaction cost.

• They are short-term government securities issued at a discount from face value and returning
the face amount at maturity
• The government raises money by selling bills to the public.
• Investors buy the bills at a discount from the stated maturity value. At the maturity date, the
government pays the investors the face value of the bill.
• The difference between the purchase price and the ultimate maturity value = the investors’
earnings
• They are issued with initial maturities of 4 13 26 or 52 weeks.
• Where can they be purchased? from the treasury or on the secondary market.
• There are sold in minimum dominations= $100 or $100 000
• Tax advantage: the income earned on T-bills is taxable at the federal level, but exempt from
state and local taxes.

The bank-discount method:

➔ It means that the bill’s discount from its maturity, or face value is “annualized” based on a
360-day year and then reported as a % of face value (and not the price the investor paid to
acquire the bill). Example:
 Lou Rouselle – Chap 2 - Finance 2

Days to maturity = 177, yield= 0.895%

A dealer was willing to sell the bill at a discount from the face value of 0.895% x (177/360) = 0.440%

As a result, a bill with $10 000 face value could be purchased for $10000 x (1-0.0044) = $9956

Now for the bid yield, 0.905 -> a dealer would be willing to purchase the bill for $10 000 x (1 –
0.00905 x 177/360) = $9,955.504

How does the investment grow for an investor buying the bill for the asked price? 10 000/ 9 956 =
1.004419 for a gain of 0.4419%. annualizing this gain using a 365-day year = 0.4419% x 365/177 =
0.911% = “asked yield” = the Treasury bill’s bond-equivalent yield.

Certificates of Deposit

Definition: CD is a time deposit with a bank. It may not be withdrawn on demand. The bank pays
interest and principal to the depositor only at the end of the fixed term of the CD. (In sum, CD is a
product offered by banks that provides an interest rate premium in exchange for the customer
agreeing to leave a lump-sum deposit untouched for a predetermined period of time (Investopedia).

- They are issued in dominations larger than < $100 000 (negotiable) and are insured for up to
$250 000 in the event of a bank insolvency

- Can be sold to another investor if the owner needs to cash in the certificate before it matures

- Maturity of 3 months or more

Commercial Paper

Definition: unsecured, short-term debt instrument issued by corporations, typically used for the
financing of payroll, accounts payable, subprime mortgages and inventories, and meeting other short-
term liabilities (Investopedia).

• Well-known companies issued their own short-term unsecured debt notes to the public,
rather than borrowing from banks
• Sometimes they are backed up by a line of credit
• Maturity= up to 270 days (usual less than 1 or 2 months
• Dominations multiple of $100,000
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• Trade in secondary market, quite liquid and rated by at least one agency which will impact
the yield.
• They were originally issued by nonfinancial institutions but are now also called asset-backed
commercial papers meaning they are issued by financial firms (such as banks)

Bankers’ Acceptances

Definition: it is an order to a bank by a consumer to pay a sum of money at a future date, typically
within 6 months.

• They are used widely in foreign trade where the creditworthiness of one trader is unknown
to the trading partner

Eurodollars

Definition: they are dollar-dominated deposit at foreign banks or foreign branches of American
banks

• As a result, those banks escape regulation by the Federal Reserve Board

• They need not be in European banks
• Deposits are large sums with at least 6 months’ maturity

Repos and Reserves

Definitions: repurchase agreements, repos RPs, are used by dealers in government securities as a
form of short-term, usually overnight, borrowing.

• They sell securities to an investor with an agreement to buy back those the next day at a
slightly higher price.
• These securities serve as collateral for the loan.
• For the party originally selling the security (and agreeing to repurchase it in the future) it is a
repurchase agreement (RP). For the party originally buying the security (and agreeing to sell
in the future) it is a reverse repurchase agreement (RRP) or reverse repo.

Brokers’ call

Definitions: individuals buying stock on margin borrow part of the funds to pay for the stocks from
their broker (who in turn may borrow the funds from a bank and agree to repay on call).

• Rate paid: 1% higher than the short-term T-bills

Federal funds

Definition: funds in the accounts of commercial banks at the Federal Reserve Bank= Fed Funds

• In the Federal funds market, banks with excess funds lend to those with a shortage.

• The Fed funds rate is simply the rate of interest on very short-term loans among financial
institutions.

The LIBOR market

Definition: the London Interbank Offer Rate (LIBOR) is the lending rate among banks in the London
Market

• Similar rates: Euribor (European Interbank offer rate), TIBOR (Tokyo)

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Yields on Money Market Instruments

• More liquidity = lower yields = T-bills

• A yield premium increases with economic crisis and during these times, the TED spread (the
difference between the LIBOR and the Treasury bill rate) also peaked.

Money market funds are mutual funds that invest in money market instruments and have become
major sources of funding to that sector.

2. THE BOND MARKET

Another financial market is the bond market: longer-term borrowing or debt instruments, including
Treasury notes and bonds, corporate bonds, municipal bonds, mortgage securities, and federal
agency debt.

• sometimes said to comprise the fixed-income capital market

Treasury Notes and Bonds

Definition: Debt obligations of the federal government with original maturities of one year or more.

• trade in denominations of $1,000.

• Both make semi-annual interest payments called coupon payments

The coupon income or interest paid by the bond = 1.5% of par value = for a $1,000 face value
bond, $15 in annual interest payments will be made in two semi-annual instalments of $7.50
each.
The bid price = 100.3047 = should be interpreted as 100.3047% of par, or $1,003.047 for the
$1,000 par value bond.
The asked price= the bond could be purchased from a dealer is 100.3203% of par, or $1,003.203.
0.1719% = the asked price on this day increased by .1719% of par value from the previous day’s
close.
The yield to maturity based on the asked price is 1.394%.

Inflation-Protected Treasury Bonds

Definition: The principal amount on these bonds is adjusted in proportion to increases in the
Consumer Price Index.

• linked to an index of the cost of living

• 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
 Lou Rouselle – Chap 2 - Finance 5

Federal Agency Debt

Some government agencies issue their own securities to finance their activities.

• The major mortgage-related agencies are the Federal Home Loan Bank (FHLB), the Federal
National Mortgage Association (FNMA, or Fannie Mae), the Government National Mortgage
Association (GNMA, or Ginnie Mae), and the Federal Home Loan Mortgage Corporation
(FHLMC, or Freddie Mac).

International Bonds

Many firms borrow abroad and many investors buy bonds from foreign issuers.

• A Eurobond is a bond denominated in a currency other than that of the country in which it is
issued (+- international bond). E.g. Euroyen bonds, yen-denominated bonds sold outside
Japan.
• firms issue bonds in foreign countries but in the currency of the investor. E.g. a Yankee bond
is a dollar-denominated bond sold in the U.S. by a non-U.S. issuer

Municipal bonds

Definition: Tax-exempt bonds issued by state and local governments.

• Key feature: tax-exempt status (investors pay neither federal nor state taxes on the interest
proceeds, they are willing to accept lower yields on these securities.
• Two types of municipal bonds:

General obligation bonds Revenue bonds

are backed by the “full faith and credit” (i.e.,
the taxing power) of the issuer
are issued to finance particular projects and are
backed either by the revenues from that
project or by the municipal agency operating
the project. Typical issuers of revenue bonds
are airports, hospitals, and turnpike or port
authorities. Revenue bonds are riskier in terms
of default than general obligation bonds.

An industrial development bond is a revenue bond that is issued to finance commercial enterprises,
such as the construction of a factory that can be operated by a private firm.

Different maturities:

• short-term tax anticipation notes that raise funds to pay for expenses before actual
collection of taxes.
• long term and used to fund large capital investments. Maturities range up to 30 years.

Better a taxable bond or tax-exempt?

 Lou Rouselle – Chap 2 - Finance 6

- t = the investor’s combined federal + local marginal tax rate

- r taxable = the total before-tax rate of return available on taxable bonds
- r taxable(1 − t) = the after-tax rate available on those securities.
- r muni = the rate on municipal bonds

or

- the yield ratio rmuni/rtaxable is a key determinant of the attractiveness of municipal

bonds.
- The higher the yield ratio, the lower the cut off tax bracket, and the more individuals will
prefer to hold municipal debt

Concept check – tax

6% taxable return = after-return of 6% (1-30%) =

4.3%
➔ Better off in the taxable bond
The equivalent taxable yield of the tax-free bond =
4% / (1-30%) = 5.71%
➔ A taxable bond would have to pay 5.71%
yield to provide the same after-tax return
as the free tax of 4%.
Corporate bonds
Definition: Long-term debt issued by private corporations typically paying semi-annual coupons and
returning the face value of the bond at maturity.

Corporate bonds with options attached:

• Callable bonds give the firm the option to repurchase the bond from the holder at a
stipulated call price.
• Convertible bonds give the bondholder the option to convert each bond into a stipulated
number of shares of stock.

Mortgage and Asset-Backed Securities

A mortgage-backed security is either an ownership claim in a pool of mortgages or an obligation that
is secured by such a pool
• Before the crisis: Conforming mortgages, = the loans had to satisfy certain underwriting
guidelines (standards for the creditworthiness of the borrower) before they could be
purchased by Fannie Mae or Freddie Mac
• After it: subprime mortgages, that is, riskier loans made to financially weaker borrowers,
were bundled and sold by “private-label” issuers. -> that was a disaster

3. EQUITY SECURITIES
The 3rd financial instruments.

Common Stock as Ownership Shares

Definition: common stocks = Ownership shares in a publicly held corporation. Shareholders have
voting rights and may receive dividends.
• The common stock of most large corporations can be bought or sold freely on one or more
stock markets.
• A corporation whose stock is not publicly traded is said to be private
 Lou Rouselle – Chap 2 - Finance 7

Characteristics of Common Stock

Main characteristics: residual claim and its limited liability features.
1) Residual claim means stockholders are the last in line of all those who have a claim on the
assets and income of the corporation
2) Limited liability means that the most shareholders can lose in event of the failure of the
corporation is their original investment.

Concept check- shares

a. You are entitled to a prorated share of GE’s

dividend payments and to vote in any of its
stockholder meetings.

b. Your potential gain is unlimited because GE’s

stock price has no upper bound.

c. Your outlay was $30 × 100 = $3,000. Because of

limited liability, this is the most you can lose.

Stock Market Listings

The NYSE is one of several markets in which investors may buy or sell shares of stock.

How to read this table:

- the closing price of the stock = $29.20
- its change (−.03) from the previous trading day. Over 19 million SH of GE traded on this day.
- The table also provides the highest and lowest price at which GE has traded in the last 52
weeks.
- The .96 value = the last quarterly dividend payment was $0.24/share = annual dividend
payments of $0.24 × 4 = $0.96.
- A dividend yield (i.e., annual dividend / dollar paid for the stock) of .96/29.20 =.0329= 3.29%.
- GE’s stock price has decreased by 7.59% since the beginning of the year.
- The ratio of P/E is 27.21

The P/E ratio = price-to-earnings ratio = 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.
➔ If the dividend yield and P/E ratio are not reported in the table, the firms have 0 dividends,
or 0 or negative earnings.

Preferred Stock
Definition: Nonvoting shares in a corporation, usually paying a fixed stream of dividends.

• No contractual obligation to pay those dividends (but cumulative)

• Disadvantage: not tax-deductible expenses for the firm.
• sold at lower yields than corporate bonds.
 Lou Rouselle – Chap 2 - Finance 8

Depositary Receipts
American Depositary Receipts (ADRs) are certificates traded in U.S. markets that represent
ownership in shares of a foreign company.

4. STOCK AND BOND MARKET INDEXES

Stock Market Indexes
the Dow (the best-known measure of the performance of the stock market), Nikkei Average of Tokyo
or the Financial Times index of London are stock market.

The Dow Jones Industrial Average

The Dow Jones Industrial Average (DJIA) of 30 large, “blue-chip” corporations has been computed
since 1896.
• The Dow measures the return (excluding dividends) on a portfolio that holds one share of
each stock
• It is called a price-weighted average = An average computed by adding the prices of the
stocks and dividing by a “divisor.”

Example:

What happens to the stock price index if a company decides to split its shares?
“companies choose to split their shares so they can lower the trading price of their stock to a range deemed
comfortable by most investors and increase liquidity of the shares” (Investopedia).
➔ 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.
➔ The divisor used to compute the “average price” is adjusted so as to leave the index
unaffected by the event.

Example: The new value of the price-weighted average will be (30

+ 45)/1.20 = 62.5. The index is unchanged, so the rate of
return is zero, greater than the −4% return.

➔ The relative weight of XYZ, which is the poorer-

performing stock, is reduced by a split because
its price is lower, so the performance of the
average is higher.
➔ price-weighted average is somewhat arbitrary.
Concept check – stock price

The price-weighted index increases from 62.50

[=(100 + 25)/2] to 65 [=(110 + 20)/2], a gain of
4%. An investment of one share in each company
requires an outlay of $125 that would increase in
value to $130, for a return of 4% (=5/125), which
equals the return to the price-weighted index.
 Lou Rouselle – Chap 2 - Finance 9

S&P 500
The Standard & Poor’s Composite 500 (S&P 500) stock index = Index return = the weighted average
of the returns of each component security, with weights
proportional to outstanding market value.
➔ More broadly based index
Example:
Looking at table 2.3 again, the index value at year-end would be 100 × (690/600) = 115 = 100 x (final
value / initial value).
➔ The increase in the index would reflect the 15% return earned on a portfolio consisting of
those two stocks held in proportion to outstanding market values.
➔ Unlike the price-weighted index, the value-weighted index gives more weight to ABC.

a price-weighted index BOTH the value-weighted index

tracks the returns on a they reflect the returns to tracks capital gains on the
portfolio composed of equal straightforward portfolio underlying portfolio
shares of each firm. strategies

Concept check – Index

The portfolio of the two stocks starts with an initial value of $100
million + $500 million = $600 million and falls in value to $110 million +
$400 million = $510 million, a loss of 90/600 = .15, or 15%.

The index portfolio return = a weighted average of the returns on each

stock with weights of 1 ⁄ 6 on XYZ and 5 ⁄ 6 on ABC (weights
proportional to relative investments). Because the return on XYZ is
10%, while that on ABC is −20%

➔ the index portfolio return is (1 ⁄ 6) 10 + (5 ⁄ 6)(−20)

= −15%, = to the return on the market value
weighted index.
Vocabulary:
purchase an exchange-traded fund, or ETF, which is a portfolio of shares that can be bought or sold
as a unit, just as a single share would be traded.

Other U.S. Market Value Indexes

- The New York Stock Exchange publishes a market-value-weighted composite index of all
NYSE-listed stocks, in addition to sub-indexes for industrial, utility, transportation, and
financial stocks.
- NASDAQ computes a Composite index of > 3,000 firms traded on the NASDAQ market. A
subset of the larger firms in the Composite Index, but it accounts for a large fraction of its
total market capitalization.
- The Wilshire 5000 index -> all actively traded stocks in the U.S. 4,000 stocks traded in the

Equally Weighted Indexes

Definition: An index computed from a simple average of returns.
➔ do not correspond to buy-and-hold portfolio strategies

Equally weighted indexes Price weighting Market value weighting

placing equal weight on each
return, corresponds to a
portfolio strategy that places
equal dollar values in each
stock.
It requires equal numbers of It requires investments in
shares of each stock proportion to outstanding
value.
 Lou Rouselle – Chap 2 - Finance 10

Foreign and International Stock Market Indexes

Development in financial markets worldwide includes the construction of indexes for these markets.

Bond Market Indicators

Like stock market indexes, there are bond market indicators
measuring the performance of various categories of bonds.
Issue:
- true rates of return on many bonds are difficult to
compute because bonds trade infrequently, which
makes it hard to get reliable, up-to-date prices.
- In practice, some prices must be estimated from bond-
valuation models = “matrix prices”

5. DERIVATIVE MARKETS
Derivative asset = A security (features, or options) with a payoff that depends on the prices of other
securities.

Options
• Call option = The right to buy an asset at a specified exercise (strike) price on or before a
specified expiration date.
➔ Each option contract is for the purchase of 100 shares
➔ The holder of the call need not exercise the option; it will make sense to exercise only if the
market value of the asset > the exercise price.
• Put option = The right to sell an asset at a specified exercise price on or before a specified
expiration date.
➔ profits on put options increase when the asset value falls.

Concept check – options

The payoff to the call option is $150 − $140 =

$10. The call cost $4.80. The profit is $10 − $4.80
= $5.20 per share.

The put will pay off zero—it expires worthless

since the stock price exceeds the exercise price.
The loss is the cost of the put, $3.90.

Futures contract
Definition: Obliges traders to purchase or sell an asset at an agreed-upon price at a specified future
date.
• The long position is held by the trader who commits to purchasing the commodity on the
delivery date.
• The trader who takes the short position commits to delivering the commodity at contract
maturity.

➔ They are entered without cost (not like call that must be purchased; purchased price=
premium)
➔ the holder of a call has a better position than the holder of a long position on a futures
contract with a futures price equal to the option’s exercise price.
 Lou Rouselle – Chap 2 - Finance 11

Vocabulary:
Maturity of a bill= date when payment is due

Due date= It is a date on which the payment is expected/due.

The asked price= the price you would have to pay to buy a T-bill from a securities dealer

The bid price= the slightly lower price you would receive if you wanted to sell a bill to a dealer

The bid-asked spread= the dealer’s source of profit

The yield to maturity = a measure of the annualized rate of return to an investor who buys the bond for the
asked price and holds it until maturity

The dividend yield is only part of the return on a stock investment. It ignores prospective capital gains (i.e., price
increases) or losses. (page 7)

the bond equivalent yield (BEY) is a metric that lets investors calculate the annual percentage yield for fixed-
come securities= asked yield

A line of credit (LOC) is a preset borrowing limit that can be used at any time. The borrower can take money out
as needed until the limit is reached, and will only be charged interest on the actual amount borrowed.

Collateral = an asset that a lender accepts as security for a loan. Collateral may take the form of real estate or
other kinds of assets