2 Asset allocation → Asset classes Chapter OverviewAsset allocation → Asset classesMoney markets vs. capital marketsTypes of money market instrumentsCapital market securities:BondsEquityDerivatives
3 The Money MarketSubsector of the fixed-income market: Securities are short-term, liquid, low risk, and often have large denominationsMoney market mutual funds allow individuals to access the money market
5 Money Market Securities Treasury bills: Short-term debt of U.S. governmentBid and asked priceBank discount yield vs Effective annual yieldBank discount yield vs Bond equivalent yieldCompetitive vs Noncompetitive bidCertificates of deposit: Time deposit with a bankCommercial paper: Short-term, unsecured debt of a company
6 Money Market Securities Bankers’ Acceptances: An order to a bank by a bank’s customer to pay a sum of money on a future dateEurodollars: Dollar-denominated time deposits in banks outside the U.S.Repos and reverses: Short-term loan backed by government securities.Fed funds: Very short-term loans between banks
7 Yields on Money Market Instruments Except for Treasury bills, money market securities are not free of default riskBoth the premium on bank CDs and the TED spread have often become greater during periods of financial crisisDuring the credit crisis of 2008, the federal government offered insurance to money market mutual funds after some funds experienced losses
8 The Bond Market Treasury Notes and Bonds Inflation-Protected Treasury BondsFederal Agency DebtInternational BondsMunicipal BondsCorporate BondsMortgages and Mortgage-Backed Securities
9 Bond Market Securities Treasury Notes and BondsMaturitiesNotes – Maturities up to 10 yearsBonds – Maturities from 10 to 30 yearsPar Value - $1,000Interest paid semiannuallyQuotes – Percentage of par
10 Bond Market Securities Inflation-Protected Treasury BondsTIPS: Provide inflation protectionFederal Agency DebtDebt of mortgage-related agencies such as Fannie Mae and Freddie MacInternational BondsEurobonds and Yankee bonds
11 Bond Market Securities Municipal BondsIssued by state and local governmentsInterest is exempt from federal income tax and sometimes from state and local taxTypesGeneral obligation bonds: Backed by taxing power of issuerRevenue bonds: backed by project’s revenues or by the municipal agency operating the project.
13 Municipal Bond YieldsTo choose between taxable and tax-exempt bonds, compare after-tax returns on each bond.Let t equal the investor’s marginal tax bracketLet r equal the before-tax return on the taxable bond and rm denote the municipal bond rate.If r(1 - t ) > rm, then the taxable bond gives a higher return; otherwise, the municipal bond is preferred.
14 Table 2.2 Tax-Exempt Yield Table The equivalent taxable yield is simply the tax-free rate, rm, divided by (1 - t).
15 Bond Market Securities Corporate BondsIssued by private firmsSemi-annual interest paymentsSubject to larger default risk than government securitiesOptions in corporate bondsCallableConvertible
16 Bond Market Securities Mortgage-Backed SecuritiesProportional ownership of a mortgage pool or a specified obligation secured by a poolProduced by securitizing mortgagesMortgage-backed securities are called pass-throughs because the cash flows produced by homeowners paying off their mortgages are passed through to investors.Most were issued by Fannie Mae and Freddie Mac
17 Bond Market Securities Mortgage-Backed SecuritiesTraditionally, were comprised of conforming mortgages, which met standards of credit worthinessLater on, “Private-label” issuers securitized large amounts of subprime mortgages, made to financially weak borrowersFannie and Freddie were allowed and even encouraged to buy subprime mortgage securities
19 Equity Securities Common stock: Ownership Preferred stock: Perpetuity Residual claimLimited liabilityPreferred stock: PerpetuityFixed dividendsPriority over commonTax treatmentAmerican Depository ReceiptsCertificates traded in U.S. markets that represent ownership in shares of a foreign company
20 Stock Market Indexes Dow Jones Industrial Average Includes 30 large blue-chip corporationsComputed since 1896Price-weighted average
21 Example 2.2 Price-Weighted Average Portfolio: Initial value $25 + $100 = $125 Final value $30 + $90 = $120 Percentage change in portfolio value = 5/125 = -.04 = -4% Index: Initial index value (25+100)/2 = 62.5 Final index value ( )/2 = 60 Percentage change in index -2.5/62.5 = -.04 = -4%
22 Stock Market Indexes Standard & Poor’s 500 Broadly based index of 500 firmsMarket-value-weighted indexInvestors can base their portfolios on an indexBuy an index mutual fundBuy exchange traded funds (ETFs)
23 Other Indexes U.S. Indexes Foreign Indexes NYSE Composite NASDAQ CompositeWilshire 5000Nikkei (Japan)FTSE (U.K.; pronounced “footsie”)DAX (Germany),Hang Seng (Hong Kong)TSX (Canada)
24 Derivatives MarketsA derivative is a security that gets its value from the values of another asset, such as commodity prices, bond and stock prices, or market index values24
25 Derivatives Markets Options Call: Right to buy underlying asset at the strike or exercise priceValue of calls decreases as strike price increasesPut: Right to sell underlying asset at the strike or exercise priceValue of puts increase with strike priceValue of both calls and puts increases with time until expiration
26 Derivatives Markets Futures Contracts An agreement made today regarding the delivery of an asset (or in some cases, its cash value) at a specified delivery or maturity date for an agreed-upon price, called the futures price, to be paid at contract maturityLong position: Take delivery at maturityShort position: Make delivery at maturity
27 Comparison Option Futures Contract Right, but not obligation, to buy or sell; option is exercised only when it is profitableOptions must be purchasedThe premium is the price of the option itself.Obliged to make or take delivery; long position must buy at the futures price, short position must sell at futures priceFutures contracts are entered into without cost