Financial MarketsFinancial Marketsand Instrumentsand Instruments

Chapter 2Chapter 2

Major Classes of Financial Assets Major Classes of Financial Assets or Securitiesor Securities

Debt- Money market instruments

- Bonds Common stock Preferred stock Derivative securities

Markets and InstrumentsMarkets and Instruments

Money Market- Debt Instruments

- Derivatives Capital Market

- Bonds

- Equity

- Derivatives

Money Market InstrumentsMoney Market Instruments

Treasury bills Certificates of deposit Commercial Paper Bankers Acceptances Eurodollars Repurchase Agreements (RPs) and Reverse RPs Federal Funds

Money Market Instrument YieldsMoney Market Instrument Yields

Yields on Money Market Instruments are not always directly comparable

Factors influencing yields Par value vs. investment value 360 vs. 365 days assumed in a year (366

leap year) Bond equivalent yield

rBD = bank discount rate

P = market price of the T-bill

n = number of days to maturity

rBD = 10,000 - P10,000

x 360n

90-day T-bill, P = $9,800

rBD = 10,000 - 9,800

10,000 x

360

90= 8%

Example

Bank Discount Rate (T-Bills)Bank Discount Rate (T-Bills)

Bond Equivalent YieldBond Equivalent Yield

Can’t compare T-bill directly to bond- 360 vs 365 days

- Return is figured on par vs. price paid Adjust the bank discounted rate to make it

comparable

P = price of the T-bill

n = number of days to maturity

rBEY = 10,000 - P

P x 365

n

rBEY = 10,000 - 9,800

9,800 x

365

90rBEY = .0204 x 4.0556 = .0828 = 8.28%

Example Using Sample T-Bill

Bond Equivalent YieldBond Equivalent Yield

Capital Market - Capital Market - Fixed Income InstrumentsFixed Income Instruments

Publicly Issued Instruments- US Treasury Bonds and Notes

- Agency Issues (Fed Gov)

- Municipal Bonds Privately Issued Instruments

- Corporate Bonds

- Mortgage-Backed Securities

Capital Market - EquityCapital Market - Equity

Common stock- Residual claim

- Limited liability Preferred stock

- Fixed dividends - limited

- Priority over common

- Tax treatment

Stock IndexesStock 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?

Examples of Indexes - DomesticExamples of Indexes - Domestic

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

Examples of Indexes - Int’lExamples of Indexes - Int’l

Nikkei 225 & Nikkei 300 FTSE (Financial Times of London) Dax Region and Country Indexes

- EAFE

- Far East

- United Kingdom

Bond IndexesBond Indexes

Lehman Brothers Merrill Lynch Salomon Brothers Specialized Indexes

- Merrill Lynch Mortgage

Construction of IndexesConstruction 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)

Averaging MethodsAveraging 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%

Derivatives SecuritiesDerivatives 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