Asset Classes and Financial Instruments

Asset Classes and Financial Instruments
Chapter 2-1 Asset Classes and Financial Instruments Describes the financial instruments traded in primary and secondary markets. Discusses Market indexes. Discusses options and futures. McGraw-Hill/Irwin Copyright © by The McGraw-Hill Companies, Inc. All rights reserved.

2.1 Money Market Instruments
Treasury Bills: Fed Certificates of Deposit: Banks Commercial Paper: Corp & banks Bankers’ Acceptances : Bank Eurodollars: bank & Corp Repos and Reverses Federal Funds: Deposit in Fed LIBOR (London Interbank Offer Rate):Banks

Treasury Bills Treasury bills Issued by Denomination Maturity
Liquidity Default risk Interest type Taxation Federal Government $100, commonly $10,000 4, 13, 26, or 52 weeks Highly liquid None, why? Discount-(later on this) Federal taxes owed, exempt from state and local taxes

Certificates of Deposit (CD)
Depository Institutions Any, $100,000 or more are marketable Varies, typically 14 day minimum 3 months or less are liquid ( marketable) First $100,000 ($250,000) is insured Add on ( you get the deposit + interset) Interest income is fully taxable Issued by Denomination Maturity Liquidity Default risk Interest type Taxation

Commercial Paper Commercial Paper Issued by
Maturity Denomination Liquidity Default risk Interest type Taxation Large creditworthy corporations and financial institutions Maximum 270 days, usually 1 to 2 months Minimum $100,000 3 months or less are liquid if marketable Unsecured, Rated, Mostly high quality Discount Interest income is fully taxable

Bankers Acceptances & Eurodollars
Originates when a purchaser of goods authorizes its bank to pay the seller for the goods at a date in the future (time draft). When the purchaser’s bank ‘accepts’ the draft it becomes a contingent liability of the bank and becomes a marketable security. Eurodollars Dollar denominated (time) deposits held outside the U.S. Pay a higher interest rate than U.S. deposits.

Federal Funds and LIBOR
Depository institutions must maintain deposits with the Federal Reserve Bank. Federal funds represents trading in reserves held on deposit at the Federal Reserve. Key interest rate for the economy LIBOR (London Interbank Offer Rate) Rate at which large banks in London (and elsewhere) lend to each other. Base rate for many loans and derivatives.

Repurchase Agreements and Reverses
Repurchase Agreements (RPs or repos) and Reverse RPs Short term sales of securities arranged with an agreement to repurchase the securities a set higher price. A RP is a collateralized loan, many are overnight, although “Term” RPs may have a one month maturity. A Reverse Repo is lending money and obtaining security title as collateral. “Haircuts” may be required depending on collateral quality

Haircut The buyer assumes the collateral as repayment should the seller default. If the collateral has a volatile price history the buyer is at risk. To reduce this risk, a haircut is imposed. The haircut is some percentage of the market value the buyer holds back from the cash payment to account for the price volatility as well as counterparty risk. Ex. If the haircut is 10% on 10mm market value bonds, the buyer receives 10mm in bonds and the seller receives 9mm in cash. At the end of the repo term, the seller pays the 9mm cash back plus interest and receives the same 10mm bonds back

Money Market Instruments
Call Money Rate (later ch 3) Investors who buy stock on margin borrow money from their brokers to purchase stock. The borrowing rate is the call money rate. The loan may be ‘called in’ by the broker.

Figure 2.2 Treasury Bills (T-bills)
Given the above, can you figure out the ask yield? can you calculate bid ask price of the bill?

Price = $10,000 x [ 1 – T-bill rate x (N/360)]
BID: $10,000 X [ X (161/360)] = $9,946.33 ASK: $10,000 X ( x(161/360) = $9,

BEY: Bond-Equivalent Yield
An investor who buys the bill for the asked price and holds it until maturity will see her investment grow over 161 days by a multiple of $10,000/$9, = , or .535%. But this is the return for 161 days only. Annualizing this return using a 365-day year results in a yield of .535% X 365/161 = 1.213%. In short:

Notice Bank discount BEY

bond-equivalent yield 9979 9979.525 0.594%
Exercise Do the same for Jan 29 March 26 BID ASK bond-equivalent yield 9979 0.594% BID ASK bond-equivalent yield 1.46%

Summarizing BEY-Ask Yield
If given the ask price, get the ASK yield on March 26

Exercise the price for T-Bill is $ 9979 and there is 126 days left. compute the Bank discount rate. = .006 r BD = $10,000 - $9,979 x 360 126 .6%

Example: Bank Discount Rate Given T-Bill price
rBD = bank discount rate P = market price of the T-bill n = number of days to maturity 90-day T-bill, P = $9,875 r BD = $10,000 - $9,875 x 360 90 5%

Bond Equivalent Yield P x x r = 10,000 - 365 n
rBD=5% r BEY = 10,000 - P x 365 n P = price of the T-bill n = number of days to maturity Example Using Sample T-Bill r BEY = 10,000 - 9,875 x 365 90 Both the smaller denominator of the real price P and the larger numerator due to 365 days increases the yield when one uses the BEY calculation. rBEY = x = = 5.13%

Example* An investor buys a T-bill at a bank discount quote of 4.80 with 150 days to maturity. What is the investor's actual annual rate of return on this investment was ?

Money Market Instrument Yields
Yields on money market instruments are not always directly comparable Factors influencing “quoted” yields Par value vs. investment value 360 vs. 365 days assumed in a year (366 leap year) Simple vs. Compound Interest Par Value is the face value of the instrument. Investment value is what you paid for it. Some rate methods use 360 days instead of 365 days BEY uses simple instead of compound interest. Three popular yield measurements used in quotations: Bank Discount Rate Bond Equivalent Yield Effective Annual Yield

Effective Annual Yield
rBD=5% rBEY=5.13% P = price of the T-bill n = number of days to maturity rEAY=5.23% Example Using Sample T-Bill The most realistic and correct value would come from the effective annual yield. It uses the compounding of interest. rEAY = 5.23% 23

Effective Annual Yield
r EAY = (1+ P )365/n rBD=5% rBEY=5.13% P = price of the T-bill n = number of days to maturity rEAY=5.23% Example Using Sample T-Bill r EAY = (1+ 9875 )365/90 The most realistic and correct value would come from the effective annual yield. It uses compound interest. rEAY = 5.23%

Money Market Instruments
Treasury bills Certificates of deposit Commercial Paper Bankers Acceptances Eurodollars Federal Funds Repurchase Agreements (RPs) and Reverse RPs Discount BEY* * NOTE: CD, Euro$ and FF all use add on which is not quite the same as BEY, since the add on uses a 360 day year. Add on is not covered in the text. To convert from add on to BEY: BEY = Add on * (365/360)

2.2 The Bond Market

Capital Market - Fixed Income Instruments
Government Issues US Treasury Bonds and Notes Bonds (10-30 years) versus Notes ( up to 10 years) Denomination ($100, mostly $1000) Interest type ( semi-annual) Risk? Taxation? Variation: Treasury Inflation Protected Securities (TIPS) Tips have principal adjusted for increases in the Consumer Price Index Fixed income have a defined stream of payments or coupons. Notes have a maturity up to and including 10 years, bonds beyond 10 years Minimum denomination is $100, but most have $1,000 denomination although many T-bonds are packaged and sold in multiples of $1,000. Pay interest semiannually with principal repaid at maturity (non-amortizing) Investors are federally taxed on capital gains and interest income, but interest income is exempt from state and local taxes. Municipal bonds are from local governments. Interest on municipal bonds is not taxed, so must use the taxable equivalent yield. Privately Issued instruments come from corporations, or are items like mortgage backed securities, where they pool a group of mortgages together and sell them to investors.

Fixed income have a defined stream of payments or coupons. Publicly Issued come from the government. Municipal bonds are from local governments. Interest on municipal bonds is not taxed, so must use the taxable equivalent yield. Privately Issued instruments come from corporations, or are items like mortgage backed securities, where they pool a group of mortgages together and sell them to investors. Buy the bond at = x 1000 = Coupon = .04 x 1000 = 40 CY = PMT/Price = 40/ = 3.784%

Government Issues Agency Issues (Fed Gov) Most are home mortgage related Issuers: FNMA, FHLMC, GNMA, Federal Home Loan Banks Risk of these securities? Implied backing by the government In September 2008, Federal government took over FNMA and FHLMC.(sup-prime) FNMA and FHLMC together financed or backed about $5 trillion in home mortgages, that is about 50% of the U.S. market.

Government Issues Municipal Bonds Issuer? municipalities Differ from Treasuries and Agencies? Risk? G.O. vs Revenue Industrial development Taxation? Fixed income have a defined stream of payments or coupons. Publicly Issued come from the government. Municipal bonds are from local governments. Interest on municipal bonds is not taxed, so must use the taxable equivalent yield. Privately Issued instruments come from corporations, or are items like mortgage backed securities, where they pool a group of mortgages together and sell them to investors. r = interest rate

Table 2.3 Equivalent Taxable Yields

Example A municipal bond carries a coupon rate of 6% and is trading at par. What would be the equivalent taxable yield of this bond to a taxpayer in a 35% tax bracket? Taxable equivalent yield = .06 / (1-.35) = .0923

Example An investor is in a 30% combined federal plus state tax bracket. If corporate bonds offer 9% yields, what must municipals offer for the investor to prefer them to corporate bonds? [0.09 x (1 – 0.30)] = = 6.30%. Therefore, the municipals must offer at least 6.30% yields.

Example Suppose that short-term municipal bonds (M) currently offer yields of 4%, while comparable taxable bonds (B) pay 5%. Which gives you the higher after-tax yield if your tax bracket is: a. Zero B b. 10% B c. 20% equal d. 30% M

Continue from previous
Find the equivalent taxable yield of the municipal bond in the pervious slide for tax brackets of zero, 10%, 20%, and 30%. 4.00% 4.44% 5.00% 5.71%

Example From Feb 2012: How much would you have to pay to purchase one of these bonds? 107:27 = % of par = $1, What is its coupon rate? $48.75 annually or, $ if semiannually. What is the current yield (i.e., coupon income as a fraction of bond price) of the bond? 48.75/ = 4.52%

Private Issues Corporate Bonds Investment grade vs speculative grade Risker than Gov bond Coupon : semi Callable Fixed income have a defined stream of payments or coupons. Publicly Issued come from the government. Municipal bonds are from local governments. Interest on municipal bonds is not taxed, so must use the taxable equivalent yield. Privately Issued instruments come from corporations, or are items like mortgage backed securities, where they pool a group of mortgages together and sell them to investors.

Mortgage-Backed Securities (read book 34-36) Pass-through A security backed by a pool of mortgages. The pool backer ‘passes through’ monthly mortgage payments made by homeowners and covers payments from any homeowners that default. Collateral: Traditionally all mortgages were conforming mortgages but since 2006, Alt-A and subprime mortgages were included in pools Conforming mortgages met traditional creditworthiness standards. Until about 2006, Fannie and Freddie only underwrote or guaranteed conforming mortgages. Under political pressure to make housing available to low income families, Fannie and Freddie began securitizing and backing subprime mortgages (mortgages to households with insufficient income to qualify for a standard mortgage) and so called “Alt-A” mortgages which lie between conforming and subprime.

Mortgage-Backed Securities Political encouragement to spur affordable housing led to increase in subprime lending Private banks began to purchase and sell pools of subprime mortgages Pool issuers assumed housing prices would continue to rise, but they began to fall as far back as 2006 with disastrous results for the markets. Conforming mortgages met traditional creditworthiness standards. Until about 2006, Fannie and Freddie only underwrote or guaranteed conforming mortgages. Under political pressure to make housing available to low income families, Fannie and Freddie began securitizing and backing subprime mortgages (mortgages to households with insufficient income to qualify for a standard mortgage) and so called “Alt-A” mortgages which lie between conforming and subprime.

The U.S. Bond Market

2.3 Equity Securities

Capital Market - Equity
Common stock (p 36-37) Residual claim Cash flows to common stock? In the event of bankruptcy, what will stockholders receive? Limited liability What is the maximum loss on a stock purchase? Residual Claim- Lowest priority in case of bankruptcy. First Debtholders, then preferred, then common. Limited Liability- Can only lose your initial investment Preferred- Have a fixed dividend stream that generally must be paid before common stock dividends Tax-Important to know that when one company owns stock in another, the dividends have a partial tax exemption.

Preferred stock Fixed dividends: limited gains, non-voting Priority over common Tax treatment Preferred & common dividends are not tax deductible to the issuing firm Corporate tax exclusion on 70% dividends earned Residual Claim- Lowest priority in case of bankruptcy. First Debtholders, then preferred, then common. Limited Liability- Can only lose your initial investment (Exclusion is for holdings of domestic preferred only) Preferred- Have a fixed dividend stream that generally must be paid before common stock dividends Tax-Important to know that when one company owns stock in another, the dividends have a partial tax exemption.

Depository Receipts American Depository Receipts (ADRs) also called American Depository Shares (ADSs) are certificates traded in the U.S. that represent ownership in a foreign security.

Capital Gains and Dividend Yields You buy a share of stock for $50, hold it for one year, collect a $1.00 dividend and sell the stock for $54. What were your dividend yield, capital gain yield and total return? (Ignore taxes) Dividend yield: = Dividend / Pbuy $1.00 / $50 = 2% Capital gain yield: = (Psell – Pbuy)/ Pbuy ($54 - $50) / $50 = 8% Total return: = Dividend yield + Capital gain yield 2% + 8% = 10%

2.4 Stock and Bond 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? Can anyone name some well know indexes. S&P, Dow,etc? Can use as a benchmark or as a passive portfolio. Often used as the base asset for derivatives. Is it based on the market value or price?

Construction of Indexes
How are stocks weighted? Price weighted (DJIA) Market-value weighted (S&P500, NASDAQ) Equally weighted (Value Line Index) How much money do you put in each stock in the index? Price Weighted- Add up the prices of the stock and divide by a given divisor. Higher priced shares get more weight. (Bad, High price doesn’t always mean it is big) Market-Value- Based on the market cap of the firm. Equally weighted-Each company’s returns are weighted equally.

Constructing market indices
Indexes can be distinguished in four ways: The market covered, The types of stocks included, How many stocks are included, and How the index is calculated (price-weighted, e.g. DJIA, versus value-weighted, e.g. S&P 500).

Constructing market indices
Price weighted average assumes buy 1 share each stock and invest cash and stock dividends proportionately. For a price-weighted index (i.e., the DJIA), higher priced stocks receive higher weights. Value weighted: considers not only price but also # shares : $ invested in each stock are proportional to market value of each stock For a value-weighted index (i.e., the S&P 500), companies with larger market values have higher weights. Equal weighted: considers not only price but also # shares: invest same amount of $ in each stock regardless of market value of stock VW and EW are often considered “True Indexes” because they measure value today with value at a prior point in time.

Example Price weighted
Three stocks have share prices of $12, $75, and $30 with total market values of $400 million, $350 million and $150 million respectively. If you were to construct a price-weighted index of the three stocks what would be the index value? Index = ( )/3 = 39

Price weighted Day 1 Stock Price (KD) NBK 1.2 Zain 2.1 Kipico 0.8
Index 1.37

Day 2 Stock Price (KD) NBK 1.3 Zain 2.2 Kipico 1 Index 1.50

Change in index / = 9.76%

Split- divisor?? Days 2 Going to Day 3 Stock Price (KD) NBK 1.3 Zain
2.2 1.1 Kipico 1 Index 1.50 1.13??

Going to day 3 ( divisor = 2.267)
Stock Price (KD) NBK 1.4 Zain 1.1 Kipico Sum 3.6

Summary Day 1 Day2 Day3 index 1.37 1.50 1.588 change 9.76% 5.88%

a) Price weighted series
Time 0 index value is Time 1 index value = 190/3 = Problem? split Refigure denominator ( ) / Denom = 66.67 Denominator ( divisor) = Time 1 index value = ( ) / = 72.38 Other problems similar % change movements in higher price stocks cause proportionately larger changes in the index ( )/3 = 200/3 = 66.67 Dow divisor in 2005 was 0.130 DJIA startedin 1896, that's why still used. Been around so long, part of tradition.

Example The Hydro Index is a price weighted stock index based on the 5 largest boat manufacturers in the nation. The stock prices for the five stocks are $10, $20, $80, $50 and $40. The price of the last stock was just split 2 for 1 and the stock price was halved from $40 to $20. What is the new divisor for a price weighted index?

2-3 handout Price-Weighted Portfolio Example I: $1,000,000 to Invest,
Company Boeing 67.50 0.5148 Nordstrom 41.93 0.3198 Lowe's 21.70 0.1655 1.000 Note: Shares = $1,000,000 / = 7,626

Example II: Changing the Divisor
What would have happened to the divisor if Home Depot shares were selling at $65.72 per share instead of $32.90?

To keep the value of the Index the same, i.e., 43.71: Boeing 67.50
What would have happened to the divisor if Home Depot shares were selling at $65.72 per share instead of $32.90? To keep the value of the Index the same, i.e., 43.71: Boeing 67.50 Nordstrom 41.93 Home Depot 65.72 Sum: 175.15 / Divisor = 43.71, if Divisor is:

Examples :Price weighted
An index consists of the following securities and has an index divisor of 3.0. What is the price- weighted index return? Price-weighted index = {[($19 + $11 + $33)/3] - [($17 + $14 + $26)/3]} / [($17+ $14 + $26)/3] = %

Examples :Price weighted
An index consists of the following securities and has an index divisor of 2.0. What is the price- weighted index return? Price-weighted index = {[($51 + $36)/2] - [($54 + $33)/2]}/[($54 + $33)/2] = 0 percent

Example A price-weighted index consists of stocks A, B, and C which are priced at $38, $21, and $26 a share, respectively. The current index divisor is 2.7. What will the new index divisor be if stock B undergoes a 3-for-1 stock split? ( )/2.7 = 31.48 [38 + (21/3) + 26]/x = 31.48 x =

Example A price-weighted index consists of stocks A, B, and C which are priced at $27, $11, and $18 a share, respectively. The current index divisor is If stock B undergoes a 1-for-3 reverse stock split, the new index divisor will be: = [( )/2.24] = 25 [27 + (11  3) + 18]/x = 25 x = 3.12

P-weight You have the following information: You want the beginning price-weighted index of these two stocks to be 100. Given this, what is the ending index value? Beginning price-weighted index = [( )/( )]  100 = 100 Ending price-weighted index = [( )/( )]  100 =

Value weighted Computed by calculating a weighted average of the returns of each security in the index, with weights proportional to outstanding market value.

V-Weight An index consists of the following securities. What is the value-weighted index return? Beginning value = (5,000  21) + (2,000  39) = 183,000 Ending value = (5,000  27) + (2,000  42) = 219,000 Return = (219, ,000)/183,000 = percent

Index=100 Value weighted series Equal weighted series: invest $300 in each Small cap increase will have more effect on EW than VW 50% change in price of A and about 7% change in price of C

# shares: $1,000,000 to Invest, Value-Weighted Portfolio
Note: Shares to Buy = $1,000,000*Weight / Price

Example IV: How Does the Value-Weighted Index Change?
Using the Portfolio from Example III:

The Day 3 Index Can be Calculated in Two Ways:

Case 1: 20% change in price of small cap firm.
Why do the two differ? Case 1: 20% change in price of small cap firm. invest $100 in each stock

Case 2: 20% change in price of large cap firm.
Case 1 VW = Case 1 EW = Why do the two differ? Case 2: 20% change in price of large cap firm. Assume that we invest $100 in each stock Which is better depends on what you are after. Better indicator of overall change in wealth in economy is probably better measured by VW. If you invest equal $ amounts in stock then EW is a better benchmark for you. Large cap increase will have more effect on vW than eW

2.5 Derivative Markets Read the book (P 45)
Listed Call Option: Holder the right to buy 100 shares of the underlying stock at a predetermined price on or before some specified expiration date. Listed Put Option: Holder the right to sell 100 shares of the underlying stock at a predetermined price on or before some specified expiration date.

Figure 2.10 Stock Options on Apple
What does the term ‘strike’ or exercise price refer to? What is an option premium?

Using the Stock Options on Apple
The right to buy 100 shares of stock at a stock price of $110 using the October contract would cost ________. (Ignoring commissions) Is this contract “in the money?” When should you buy this contract? Stock price was equal to $ & you will make money if the stock price increases above $ $7.45 = $ by contract expiration. When should you write it ( sell it) ? $745

The right to sell 100 shares of stock at a stock price of $110 using the October contract would cost ________. (Ignoring commissions) Is this contract “in the money?” Why do the two option prices differ? $810

Look at Figure 2.10 to answer the following questions: How does the exercise or strike price affect the value of a call option? A put option? Why? The higher Strike price for a Call (Put), the lower ( Higher) the option value for the call (PUT) How does a greater time to contract expiration affect the value of a call option? A put option? Why? The longer expiration date for the option, the higher option value. How is ‘volume’ different from ‘open interest?’ Volume is what is traded on a day. Open interest: The total number of buy options that are not closed on a particular day

Example Suppose you buy an April expiration call option with exercise price 105. a. If the stock price in April is $111, will you exercise your call? What are the profit and rate of return on your position? As long as the stock price at expiration exceeds the exercise price, it makes sense to exercise the call. Gross profit is: $111 - $ 105 = $6 Net profit = $6 – $ = $16.40 loss Rate of return = / = or 73.21% loss c. What if you had bought an April put with exercise price 105?

Continue c. What if you had bought an April put with exercise price 105? A put with exercise price $105 would expire worthless for any stock price equal to or greater than $105. An investor in such a put would have a rate of return over the holding period of –100%.

Continue b. What if you had bought the April call with exercise price 100? Yes, exercise. Gross profit is: $111 - $ 100 = $11 Net profit = $11 – $ = $14.10 loss Rate of return = / = or % loss

5. a. $40 4 -4 b. $50 c. $60 10 6 XYZ 6mo XYZ 6mo a. $40 10 6 4 b. $50
Value of call at expiration Initial Cost Profit a. $40 4 -4 b. $50 c. $60 10 6 XYZ 6mo Value of put at expiration Initial Cost Profit a. $40 10 6 4 b. $50 -6 c. $60 Max profit on the put is $50 - $6 = $44

Selected Problems 1. Find the after tax rate of return to a corporation that buys preferred stock at $40, holds it one year and sells it at $40 after collecting a $4 dividend. The firm’s tax rate is 30%. (Pretax rate or return = ____________ ) The total before-tax income is $4. After the 70% exclusion, taxable income is: 0.30  $4 = $1.20 taxable income Therefore Taxes owed are Tax rate  taxable income Taxes = 0.30  $1.20 = $0.36 After-tax income = $4 – $0.36 = $3.64 After-tax rate of return = $3.64 / $40 = 9.10% $4 / $40 = 10% These problems are similar to the problems in the text but the numbers used may be different. 85

b) How many shares could you buy for $5000?
2. a) Using the quote find GD’s closing price the day before the quote appeared The closing price is $94.80, which is $1.14 higher than yesterday’s price. Therefore, yesterday’s closing price was: $94.80 – $1.14 = $93.66 b) How many shares could you buy for $5000? You could buy: $5,000/$94.80 = shares c) Total annual dividend income from the __ shares? $1.44 * 52 = $74.88 d) What are EPS? (Approximate) P / (P/E) = EPS = $94.80 / 18 = $5.27 52 558,300 shares were traded Yld % and PE are rounded

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