1. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 2-1 Financial Markets and Instruments Financial Markets and Instruments Chapter 2

2. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 2-2 Major Classes of Financial Assets or Securities Debt - Money market instruments - Bonds Common stock Preferred stock Derivative securities

3. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 2-3 Markets and Instruments Money Market -Debt Instruments -Derivatives Capital Market -Bonds -Equity -Derivatives

4. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 2-4 Money Market Instruments Treasury bills Certificates of deposit Commercial Paper Bankers Acceptances Eurodollars Repurchase Agreements (RPs) and Reverse RPs Federal Funds

5. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 2-5 Money 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

6. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 2-6 Bank Discount Rate (T-Bills) R bd = bank discount rate P = market price of the bill n = number of days to maturity

7. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 2-7 Bond 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.

8. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 2-8 Bond Equivalent Yield: Sample T-Bill

9. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 2-9 Capital Market - Fixed Income Instruments Publicly Issued Instruments -US Treasury Bonds and Notes -Agency Issues (Fed Gov) -Municipal Bonds Privately Issued Instruments -Corporate Bonds -Mortgage-Backed Securities

10. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 2-10 Capital Market - Equity Common stock -Residual claim -Limited liability Preferred stock -Fixed dividends - limited -Priority over common -Tax treatment

11. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 2-11 Stock 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?

12. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 2-12 Examples of Indexes - Domestic Dow Jones Industrial Average (30 Stocks) Standard & Poor’s 500 Composite NASDAQ Composite NYSE Composite Wilshire 5000

13. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 2-13 Examples of Indexes - Int’l Nikkei 225 & Nikkei 300 FTSE (Financial Times of London) Dax Region and Country Indexes -EAFE -Far East -United Kingdom

14. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 2-14 Bond Indexes Lehman Brothers Merrill Lynch Salomon Brothers Specialized Indexes -Merrill Lynch Mortgage

15. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 2-15 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)

16. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 2-16 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%

17. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 2-17 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