chapter 2_investments-asset classes and financial instruments
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Chapter 2
Asset Classes and Financial Instruments
2.1 The Money Market
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Money Market Instruments
•
Subsector of the debt market
•
Short-term debt securities that are highly marketable
•
Trade in large denominations and are out of the reach of individua
l investors.
•
However, money market mutual funds are easily accessible to sma
ll investors.
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Treasury Bills (T-bills)
Treasury bills
- Issued by Federal Government
- Denomination $100, commonly $10,000
- Maturity 4, 13, 26, or 52 weeks
- Liquidity Highly liquid
- Default risk None
- Taxation Federal taxes owed, exempt from state and local taxes
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Certificates of Deposit (CD)
Certificates of Deposit
- Issued by Depository Institutions
- Denomination Any, $100,000 or more are marketable
- Maturity Varies, typically 14 day minimum
- Liquidity 3 months or less are liquid if marketable
- Default risk First $100,000 ($250,000) is insured
- Taxation Interest income is fully taxable
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Commercial Paper (CP)
Commercial Paper
- Issued by Large creditworthy corporations
and financial institutions
- Maturity Maximum 270 days, usually 1 to 2 months
- Denomination Minimum $100,000
- Liquidity 3 months or less are liquid if marketable
- Default risk Unsecured, Rated, Mostly high quality
- Taxation Interest income is fully taxable
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Federal Funds and LIBOR
Federal Funds
-
Depository institutions must maintain deposits of their
own at the Federal Reserve Bank.
-
Funds in the bank’s reserve account are called Federal
funds or Fed funds.
-
In the Federal funds market, banks with excess funds
lend to those with a shortage.
-
Usually overnight transactions at the Federal funds rate.
-
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.
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Brokers’ Calls
Call Money Rate
-
Investors who buy stock on margin borrow money
from their brokers to purchase stock. The borrowing
rate is the call money rate.
- Usually about 1 % + the rate on short-term T-bills.
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Yields on Money Market Instruments
Most money market securities are of low risk, not risk-free.
Money market securities promise yields greater than those on default-free T-bills.
For example, investors who want more liquidity will accept lower yields on securities
that can be more quickly and cheaply sold for cash.
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Figure 2.3 Spreads on CDs and Treasury Bills
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2.2 The Bond Market
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Capital Market - Fixed Income Instruments
•
Composed of longer-term borrowing or debt instruments t
han those that trade in the money market.
•
Treasury notes and bonds, corporate bonds, municipal bo
nds, mortgage securities, and federal agency debt.
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US Treasury Notes and Bonds
Issued by the U.S. government
Maturities
T-notes: Maturities ranging up to 10 years
T-bonds: Maturities ranging from 10 to 30 years
Denomination: Commonly trade in denominations of $1,000
Semiannual interest payments called coupon payments.
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Figure 2.3. Listing of Treasury Issues
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Source: Compiled from data from
The Wall Street Journal Online,
July 6, 2011.
Federal Agency Debt
Issued by government agencies to finance their activities.
These agencies are formed for public policy reasons to channel credit a particular sector of the econ
omy.
Most are home mortgage related
- Issuers: FNMA, FHLMC, GNMA, Federal Home Loan Banks
Risk of these securities?
-
Not explicitly insured by the federal government, but implied
backing by the government.
-
In September 2008, Federal government took over FNMA and
FHLMC.
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Municipal Bonds
Issued by state and local governments.
Similar to Treasury and corporate bonds, except their interest income is exempt from federal income
taxation and state/local taxation.
The higher the bracket, the more valuable the tax-exempt feature of municipals.
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Figure 2.4 Outstanding Tax Exempt Debt
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Corporate Bonds
Issued by private firms.
These bonds are structured much like Treasury issues.
The difference from Treasury bonds is in risk.
- Investment grade vs speculative grade
- Secured vs Unsecured
Secured bonds: specific collateral backing.
Unsecured bonds: Called debentures, No collateral
Subordinated debentures: a lower priority claim to the firm’s
asset in the event of bankruptcy.
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Mortgage-Backed Securities
A security backed by a pool of mortgages
Mortgage lenders originate loans and then sell packages of these loans
in the secondary market.
- Sell their claim to the cash inflows from the mortgages
In the year leading up to 2008, a large amount of subprime mortgages,
that is, riskier loans made to financially weaker borrowers, were bundl
ed and sold by private label issuers.
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
.
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Figure 2.6 Mortgage Backed Securities Outstanding
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2.3 Equity Securities
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Capital Market - Equity
Common stock
- Residual claim
In the event of bankruptcy or liquidation, what will stockholders receive?
: Stockholders are the last in line of all those who have a claim on the
assets and income of the corporation. (Debtholders – preferred – common)
- Limited liability
What is the maximum loss on a stock purchase?
: Can only lose your initial investment.
In the event of the firm’s bankruptcy, corporate stockholders at worst have worthless stock.
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Capital Market - Equity
Preferred stock
-
Features similar to both equity and debt
1) Debt feature: Pay to its holder a fixed stream of income each
year (i.e. perpetuity). Also, it does not give the holder voting power.
2)Equity feature: Retain discretion to make the dividend payments to
the preferred stockholders.
- Priority over common in the event of corporate bankruptcy
- Tax treatment
Preferred & common dividends are not tax deductible to the issuing firm
Corporate tax exclusion on 70% dividends earned
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Capital Market - Equity
Depository Receipts
- American Depository Receipts (ADRs) also called American Depository Shares (ADSs) are certificates traded in t
he U.S. that represent ownership in a foreign security.
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Capital Market - Equity
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