1. 2-1 Asset Classes and Financial Instruments CHAPTER 2 GLOBAL FINANCIAL INSTRUMENTS

2. 2-2 2.1 THE MONEY MARKET

3. 2-3 Major Classes of Financial Assets or Securities Money market Bond market Equity markets Indexes Derivative markets

4. 2-4 Money Market Instruments Treasury bills issued by central bank to institutional buyers Certificates of deposits: Fixed deposits can be enchased earlier than maturity Commercial Paper: Short term unsecured debt issued by large corporations usually backed by credit lines to pay cash at maturity. CP maturity range up to 270 days, longer maturity requires SEC registration. Usual denomination of multiples of $100,000. Small investor only can invest through money market mutual funds. Bankers Acceptances: An order to a bank by a customer to pay a sum of money at a future date, which can then be traded in secondary market. This is widely used in foreign trade where the credit worthiness of one trader is unknown to the trading partner

5. 2-5 Money Market Instruments (Contd..) Eurodollars: Dollar denominated deposits at bank of countries other than USA or foreign branches of US banks to escape regulations of Federal Reserve Board. Most Eurodollar deposits are for large sums, and most are time deposits of less than six months’ maturity. Repurchase Agreements (RPs) and Reverse RPs: The dealer sells securities with an agreement to repurchase the securities at a higher price. Dealers in government securities use repurchase agreement, called repo as a form of short term borrowing. Federal Funds: Statutory reserve maintained by commercial banks with the central bank. Banks with a surplus of such fund can sell it to a bank in deficit in money market. LIBOR (London Interbank Offer Rate) Market: LIBOR is the rate at which large banks in London are willing to lend money among themselves. The rate has become the premier short- term interest rate quoted in the European money market and serves as a reference rate for a wide range of transactions.

6. 2-6 2.2 THE BOND MARKET

7. 2-7 Bond Market Treasury Notes and Bonds –T-notes maturity: up to 10 years –T-bonds maturity: in excess of 10 years Federal Agency Debt: Some government agencies issue their own securities to finance their activities. These agencies usually are formed for public policy reasons to channel credit through normal private sources. Although these are not as risk-free as treasury bonds but are very safe as government will assist an agency nearing default. Some of these agencies are: –Federal National Mortgage Association –Government National Mortgage Association –Federal Home Loan Mortgage Corporation –Federal National Mortgage Associations International Bonds –Largely centered in London, a Eurobond is a bond denominated in any currency other than that of the country in which it is issued. For example, a Yankee bond is a dollar denominated bond sold in the U.S. by a non-US issuer.

8. 2-8 Bond Market (Contd..) Municipal Bonds –Issued by the state and local government. Maturity: Up to 30 years. Unlike treasury bonds, interest income on these is exempt from federal income taxation. Corporate Bonds –Issued by private corporations typically pay semiannual coupons –Default risk: secured bond (specific collateral backing them in the event of firm bankruptcy), unsecured bond or debenture, subordinated debenture (lower priority in the event of bankruptcy) –Callable (by the firm) and convertible (by the holder) bond Mortgages and Mortgage-Backed Securities: –Investors can invest in a portfolio of mortgage loans, and these securities have become major component of fixed-income market. Fixed rate mortgages can create considerable difficulties for banks in years of increasing interest rates. Because banks commonly issue short term liabilities (the deposits of their customers) and hold long term assets, such as fixed-rate mortgages, they suffer losses when interest rate increases. So the conventional form of fixed interest rate mortgage was a threat for commercial banks. Now the rate is adjustable.

9. 2-9 Developed in the 1970s to help liquidity of financial institutions Proportional ownership of a pool or a specified obligation secured by a pool Market has experienced very high rates of growth Mortgages and Mortgage-backed Securities

10. 2-10 Figure 2.8 Mortgage-Backed Securities Outstanding

11. 2-11 2.3 EQUITY SECURITIES

12. 2-12 Equity Markets Common stock –Residual claim –Limited liability –Owners of the firm (voting rights) Preferred stock –Fixed dividends – limited but cumulative –Priority over common –Redeemable (by the firm) & convertible –Tax treatment: Different from bond

13. 2-13 2.4 STOCK AND BOND MARKET INDEXES

14. 2-14 There are several indexes worldwide such as: –Dow Jones Industrial Average (DJIA): If there are 30 stocks in the Index, one would add the value of the 30 stocks and divide by 30. Dividends excluded, so it is price weighted average. –Nikkei Average Offer ways of comparing performance of managers Base of derivatives Stock Market Indexes

15. 2-15 Representative versus blue chips? Broad or narrow? How is it weighted? –Price weighted (DJIA) –Market weighted (S&P 500, NASDAQ) Factors for Construction of Stock Indexes

16. 2-16 Table 2.4 Data to Construct Stock Price Indexes

17. 2-17 DJIA Price-Weighted Average Using data from Table 2.4; example 2.2 Initial value=$25 + $100 = $125 Final value =$30 + $ 90 = $120 Percentage change in portfolio value = Initial index value = (25 + 100)/2 = 62.5 Final index value = (30 + 90)/2 = 60 Percentage change in index = (60-62.5)/62.5=-2.5/62.5 = -.04 = -4%

18. 2-18 S&P’s Composite 500 Computation of value weighted Index StocksShare priceNumber of sharesMarket value Dec 31, 2005 A B C Total $10.00 15.00 20.00 1,000,000 6,000,000 5,000,000 $10,000,000 90,000,000 100,000,000 $200,000,000 Dec 31, 2006 A B C Total $12.00 10.00 20.00 1,000,000 12,000,000 (Split 2 for 1) 5,500,000 (10% stock div) $12,000,000 120,000,000 110,000,000 $242,000,000 New Index Value=(Current Market Value/Base Value) x Beginning Index Value =(242,000,000/$200,000,000)x100 =121

19. 2-19 2.5 DERIVATIVE MARKETS

20. 2-20 Derivative Securities Options –Call (Buy) –Put (Sell) Call (Buy) Option gives the holder the right to purchase an asset for a specified price, called exercise price, on or before expiration date. If the holder expect that price would increase in future then he would go for call option. He would buy at a lower price (strike price) and sell at a higher price, and thereby, make money. Put (sell) option gives the holder the right to sell an asset for a specified price, called exercise price, on or before expiration date. If the holder expect that price would decrease in future then he would go for put option option. He would buy at a lower price and sell at a higher price (strike price), and thereby make money. Terms –Exercise Price –Expiration Date –Assets –Premium

21. 2-21 Call Option Payoffs: Buyer –20 120 204060 80 100 –40 20 40 60 Stock price ($) Option payoffs ($) Buy a call Exercise price = $50 50

22. 2-22 Call Option Payoffs: Seller –20 120 204060 80 100 –40 20 40 60 Stock price ($) Option payoffs ($) Sell a call Exercise price = $50 50

23. 2-23 Contingency graph: Call Option Exercise price = $50; option premium = $10 Seller of a call Buyer of a call –20 120 204060 80 100 –40 20 40 60 Stock price ($) Option payoffs ($) 50 –10 10

24. 2-24 Put Option Payoffs: Buyer –20 204060 80 100 –40 20 0 40 60 Stock price ($) Option payoffs ($) Buy a put Exercise price = $50 50

25. 2-25 Put Option Payoffs: Seller –20 0204060 80 100 –40 20 0 40 –50 Stock price ($) Option payoffs ($) Sell a put Exercise price = $50 50

26. 2-26 Put Option Profits –20 204060 80 100 –40 20 40 60 Stock price ($) Option payoffs ($) Buyer of a put Exercise price = $50; option premium = $10 –10 10 Seller of a put 50

27. 2-27 Reading The Wall Street Journal

28. 2-28 Reading The Wall Street Journal This option has a strike price of $135; a recent price for the stock is $138.25 July is the expiration month

29. 2-29 Reading The Wall Street Journal This makes a call option with this exercise price in-the-money by $3.25 = $138¼ – $135. Puts with this exercise price are out-of-the-money.

30. 2-30 Reading The Wall Street Journal On this day, 2,365 call options with this exercise price were traded.

31. 2-31 Reading The Wall Street Journal The CALL option with a strike price of $135 is trading for $4.75. Since the option is on 100 shares of stock, buying this option would cost $475 plus commissions.

32. 2-32 Reading The Wall Street Journal On this day, 2,431 put options with this exercise price were traded.

33. 2-33 Reading The Wall Street Journal The PUT option with a strike price of $135 is trading for $.8125. Since the option is on 100 shares of stock, buying this option would cost $81.25 plus commissions.

34. 2-34 Derivative Securities (Contd..) Futures A future contract calls for a delivery of an asset at a specified delivery or maturity date, for an agreed upon price, called future price, to be paid at the maturity of the contract. Basic Positions –Long (Buy) The long position is held by trader who commits to purchasing the commodity on the delivery date. –Short (Sell) The short position is held by trader who commits to delivering the commodity on the delivery date. Terms –Delivery Date –Assets