McGraw-Hill/Irwin Copyright © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Asset Classes and Financial Instruments CHAPTER 2

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

THE MONEY MARKET Historical Graph

2-4 Money Market Instruments Treasury bills Certificates of deposits Commercial Paper Bankers Acceptances Repos and Reverse RPs Federal Funds

2-5 Treasury Bills Initial Maturities: 28, 91, and 182 days Issued: Weekly Issued on a discount basis Minimum Denomination: $1,000 Interest income: taxable at the federal level but exempt from state and local taxes

2-6 Figure 2.2 Treasury Bills

2-7 Computation of Treasury Bill Prices “Bank-Discount Method” a. You buy at the “asked” yield b. You sell at the “bid” yield c. 4.9% x (90/360) = 1.225% d. $10,000 x ( ) = $9,877.50: this is the price you buy at. e. Likewise, you sell T-Bill at $10,000 x ( x (90/360) = $9,877.25

2-8 Computation of Treasury Bill Yields “Bond-Equivalent Yield” in the last column: Ask Yield $10,000/$9, = or 1.24% 1.24% x (365/90) = 5.03%

2-9 Certificates of Deposits Time deposit (as opposed to Demand deposit): The bank pays interest and principal at the end of the fixed term of the CD CDs are protected by FDIC up to $100,000.

2-10 Commercial Paper Large, well-known companies issue CPs to borrow from the public rather than from banks. Denomination: Usually $100,000 Maturity: No longer than 270 days CPs are rated by rating agencies such as Standard and Poor’s and Moody’s. Yield = f(maturity; credit rating)

2-11 Bankers’ Acceptances An order to a bank by its customer to pay a sum of money at a future date (like a post-dated check) Maturity: < 6 months Once the bank endorses the order for payment as “accepted,” the acceptance may be traded in secondary markets Widely used in foreign trade

2-12 Federal Funds Banks are required to maintain a minimum balance in a reserve account with the Federal Reserve Bank or the Fed. The required balance depends on the total deposit of the bank’s customers. Federal Funds or Fed Funds = the funds in the bank’s reserve account In the Federal Funds market, banks with excess funds lend to those with a shortage….Usually overnight transactions

2-13 Federal Fund Rate Federal Fund Rate: 3.5% as of January 22, 2008

2-14 Table 2.2 Components of the Money Market

THE BOND MARKET

2-16 Bond Market Treasury Notes and Bonds Federal Agency Debt International Bonds Inflation-Protected Bonds Municipal Bonds Corporate Bonds Mortgages and Mortgage-Backed Securities

2-17 Treasury Notes and Bonds Maturities a.Notes: maturities up to 10 years b.Bonds: maturities 10 – 30 years Par Value: $1,000 Quotes : percentage of par

2-18 Figure 2.4 Treasury Notes and Bonds

2-19 Treasury Notes and Bonds Bid Price = == $96 9/32 = == $ is the price you sell at Ask Price = == $96 10/32 = == $ is the price you buy at

Inflation-Indexed Bonds (I) Designed to protect the bonds’ purchasing power by adjusting interest and principal payments to an index of price changes Inflation-Indexed Bonds a. The real return is certain but the nominal return is uncertain at the time of purchase b. Government assumes purchasing power risk Nominal bonds a. The nominal return is certain, but the real return is uncertain b. Investors assume purchasing power risk Asia-Pacific Financial Markets Research Center, University of Hawaii

Inflation-Indexed Bonds (II) Pros a.Complete Financial Markets by Providing Truly Risk- Free Securities b.Increase Credibility of Monetary Policy by Extending Maturity of Government-Issued Securities c.Fostering Development of Long-Term Government Bond Markets d.Cost Savings for Issuers e.Increase Savings Rate. f.Mitigate Wealth Transfer caused by Unanticipated Inflation between Creditors and Debtors Fisher/Keynes/Alchian-Kessel Hypothesis With “+” Unanticipated Inflation: Debtors Gain at the Expense of Creditors With “-” Unanticipated Inflation: Creditors Gain at the Expense of Debtors Asia-Pacific Financial Markets Research Center, University of Hawaii

Inflation-Indexed Bonds (III) Proponents: Marshall, Fisher, Keynes, Friedman, and Barro Inflation-Indexed Bonds First Issued by: Australia (1985), Canada (1991), New Zealand (1995), United Kingdom (1981), United States (1997), Japan (Planning) In US: Known as Treasury Inflation-Indexed Securities(TIIS) or Treasury Inflation-Protected Securities (TIPS) Asia-Pacific Financial Markets Research Center, University of Hawaii

Inflation-Indexed Bonds (IV) Q.1:Why are Inflation-Indexed Bond Issues Small and Issued infrequently? Q.2:Why Don’t Corporations Issue Such Bonds? Cons a. Cost Savings: Negligible or non-existent b. Perpetuate Inflation end Asia-Pacific Financial Markets Research Center, University of Hawaii

2-24 Treasury Inflation Protected Securities (TIPS) Principal Amount: Adjusted in proportion to changes in the Consumer Price Index to provide a constant stream of income in real (inflation-adjusted) dollars. Reported yield on TIPS is lower than that on conventional Treasury bonds due to inflation adjustment. Treasury offers a deflation-floor: TIPS holders will not receive back less than nominal principal value at maturity. However, semi-annual coupons are not protected against deflation. $300 billion of TIPS outstanding vs. $800 billion of inflation-linked bonds worldwide. First TIPS was issued in January 1997.

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2-27 Federal Agency Debt Government-Sponsored Enterprises –Federal Farm Credit System Banks –Federal Home Loan Banks –Federal National Mortgage Association (FNMA or Fannie Mae) –Government National Mortgage Association (GNMA or Ginnie Mae) –Student Loan Marketing Association (Sallie Mae) –Federal Home Loan Mortgage Corporation (FHLMC or Freddie Mac) –Tennessee Valley Authority

2-28 Municipal Bonds (Munis) Issued by state and local governments Interest income: exempt from federal income taxation and exempt from state and local taxation in the issuing state The “equivalent of taxable yield “ Types –General obligation bonds…”full faith and credit” of the issuer –Revenue bonds Industrial development bond: to finance commercial enterprises operated by a private firm; one of revenue bonds

2-29 Figure 2.5 Outstanding Tax-exempt Debt

2-30 Municipal Bond Yields Interest income on municipal bonds is not subject to federal and sometimes state and local tax To compare yields on taxable securities a “Taxable Equivalent Yield” is constructed r (1-t) = r m

2-31 Table 2.3 Equivalent Taxable Yields

2-32 Figure 2.6 Ratio of Yields on Tax-exempts to Taxables,

2-33 Corporate Bonds Issued by private firms Semi-annual interest payments Subject to larger default risk than government securities Options in corporate bonds –Callable –Convertible

2-34 Figure 2.7 Investment Grade Bond Listings

2-35 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

2-36 Figure 2.8 Mortgage-Backed Securities Outstanding

2-37 Summary of US Fixed Income Securities Markets Source: Securities Industry and Financial Markets Association

2-38 Equity Markets Common stock –Residual claim –Limited liability Preferred stock –Fixed dividends - limited –Priority over common –Usually cumulative –Preferred dividends are not tax deductible expenses for the paying firm –Corporations may exclude 70% of preferred dividend received in computing their taxable income Depositary receipts; ADR….watch out typo

2-39 Figure 2.9 Stock Market Listings