Financial Instruments

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Chapter 2

• Financial Instruments

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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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T- Bill Pricing From dealer point of view Ask
Selling price Bid -- Purchase price
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Certificate of Deposit Fixed term
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Commercial paper Unsecured debt Backed by
line of credit
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Bankers acceptance Post dated check
Bank accepts responsibility for payment
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Eurodollars Dollar denominated deposits at
foreign banks No Fed regulations
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Repos Short term overnight borrowing Investor
buys securities and then sells back at higher
price price difference is interest
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Reverse Repo Dealer buys securities and then
sells back at a higher price
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Fed Funds Overnight loans of reserves between
banks
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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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Treasury Notes / Bonds Notes 10 yearsBonds
10 30 years
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Treasury Notes / Bonds 1,000
denominationsSemi-annual coupon payments
Coupon payment is interest Based value
coupon rate .5
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Federal Agency Debt Fannie Mae Federal
National Mortgage Association Ginnie Mae
Government national mortgage association
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Federal Agency Debt Freddie Mac Federal Home
Loan Mortgage Corporation Implicit government
guarantee Lower risk Lower interest
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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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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 (SP500, NASDAQ)
• Equally weighted (Value Line Index)
• How returns are averaged?
• Arithmetic (DJIA and SP500)
• Geometric (Value Line Index)

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Stock Indices
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Stock Indices
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Stock Indices
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Stock Indices
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Stock Indices
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Stock Indices
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Value Index
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Value Index
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Equally Weighted Index
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Averaging Methods

• Component Return
• A10 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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Construction of Indexes

• How returns are averaged?
• Arithmetic (DJIA and SP500)
• Geometric (Value Line Index)

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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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