CHAPTER 2

Asset Classes and Financial

Instruments

INVESTMENTS | BODIE, KANE, MARCUS

McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.
 2-2

Organizing Financial Assets

Financial assets are financial claims on the issuers of
securities. In this case, households, the net savings unit of
an economy have three alternative choices with regard to
savings options:
i. Hold the liabilities of traditional intermediaries, such
as banks thrifts, and insurance companies.
ii. Hold securities directly, such as stocks and bonds,
purchased directly through brokers and other
intermediaries.
iii. Hold securities indirectly, through mutual funds.

INVESTMENTS | BODIE, KANE, MARCUS

 2-3

Asset Classes

• Money market instruments

• Capital market instruments

– Bonds
– Equity Securities
– Derivative Securities

INVESTMENTS | BODIE, KANE, MARCUS

 2-4

The Money Market

• Subsector of the fixed-income market: Securities

are short-term, liquid, low risk, and often have
large denominations. Therefore, these securities
are out of reach for individual investors. Issued by
governments and private firms.
• T-bill is most prominent money market security
– Safest asset available
– Serves as a benchmark asset.
• Money market mutual funds allow individuals to
access the money market.
INVESTMENTS | BODIE, KANE, MARCUS
 2-5

Table 2.1 Major Components of

the Money Market

INVESTMENTS | BODIE, KANE, MARCUS

 2-6

Money Market Securities

• Treasury bills: Short-term debt of U.S.

government
– Bid and asked price
– Bank discount method
• Certificates of Deposit: Time deposit with a
bank
• Commercial Paper: Short-term, unsecured
debt of a company

INVESTMENTS | BODIE, KANE, MARCUS

 2-7

Money Market Securities

• Bankers’ Acceptances: An order to a bank
by a bank’s customer to pay a sum of
money on a future date
• Eurodollars: dollar-denominated time
deposits in banks outside the U.S.
• Repos and Reverses: Short-term loan
backed by government securities.
• Fed Funds: Very short-term loans between
banks
INVESTMENTS | BODIE, KANE, MARCUS
Estimating Discount and Yield on Money
Market Securities
 The annualized yield is:
SP  PP 365
YT  
PP n
 The discount represents the percent
discount of the purchase price from par
value for newly-issued securities:
Par  PP 360
T - bill discount  
Par n

INVESTMENTS | BODIE, KANE, MARCUS

 2-9

Computing the Yield and Discount of a

Treasury Bill
An investor purchases a 91-day T-bill for
$9,782. If the T-bill is held to maturity, what
is the yield the investor would earn? What is
the annualized discount rate that the issuer
has offered?

INVESTMENTS | BODIE, KANE, MARCUS

 2-10

Capital Market Securities

• Marketable debt with maturity greater than one

year and equity securities, which have no
maturity date
• Riskier than money market securities because
of less liquidity, greater risk and maturity.
• Fixed-income securities have a specified
payment schedule
– Dates and amount of interest and principal payments
known in advance

INVESTMENTS | BODIE, KANE, MARCUS

 2-11

The Bond Market

• Treasury Notes and Bonds

• Inflation-Protected Treasury
Bonds
• Federal Agency Debt
• International Bonds

INVESTMENTS | BODIE, KANE, MARCUS

 2-12

The Bond Market

• Municipal Bonds
• Corporate Bonds
• Mortgages and Mortgage-Backed
Securities

INVESTMENTS | BODIE, KANE, MARCUS

 2-13

Treasury Notes and Bonds

• Maturities
– Notes – maturities up to 10 years
– Bonds – maturities from 10 to 30
years
• Par Value - $1,000
• Interest paid semiannually
• Quotes – percentage of par

INVESTMENTS | BODIE, KANE, MARCUS

 2-14

Bond Characteristics
• Bonds are long-term debt instruments/IOUs
representing issuer’s contractual obligations
• Buyer of a newly issued coupon bond lends money to
issuer, issuer agrees to pay interest and re-pay
principal on maturity date
• Bonds are fixed-income securities
– Buyer knows future cash flows
– Known interest and principal payments
• If sold before maturity, price depends on current
interest rates
• Considered safer than stocks or derivatives
INVESTMENTS | BODIE, KANE, MARCUS
 2-15

The Bond Market

• Inflation-Protected Treasury Bonds
• TIPS: Since 1997, the Treasury has sold Treasury Inflation-
Indexed Securities (TIPS) which protect investors against losses
resulting from inflation. TIPS pay a fixed rate of interest twice a
year, but this rate is applied to the inflation-adjusted principal.
• Federal Agency Debt
– Debt of mortgage-related agencies such as
Fannie Mae and Freddie Mac
• International Bonds
– Eurobonds and Yankee bonds
INVESTMENTS | BODIE, KANE, MARCUS
 2-16

Computing the Interest Payment of an

Inflation-Indexed Bond
A 10-year bond has a par value of $1,000
and a coupon rate of 5 percent. During
the first six months after the bond was
issued, the inflation rate was 1.3 percent.
By how much does the principal of the
bond increase? What is the coupon
payment after six months?
Principal  $1,000  1.013  $1,013
Coupon Payment  5%  $1,013  $50.65
INVESTMENTS | BODIE, KANE, MARCUS
 2-17

Municipal Bonds

• Issued by state and local governments

• Interest is exempt from federal income
tax and sometimes from state and local
tax

INVESTMENTS | BODIE, KANE, MARCUS

 2-18

Municipal Bonds
• Types
– General obligation bonds: Backed by taxing
power of issuer
– Revenue bonds: backed by project’s revenues
or by the municipal agency operating the
project.

INVESTMENTS | BODIE, KANE, MARCUS

 2-19

Municipal Bond Yields

• To choose between taxable and tax-exempt
bonds, compare after-tax returns on each
bond.
• Let t equal the investor’s marginal tax
bracket
• Let r equal the before-tax return on the
taxable bond and r m denote the municipal
bond rate.
• If r (1 - t ) > r m then the taxable bond gives
a higher return; otherwise, the municipal
bond is preferred.
INVESTMENTS | BODIE, KANE, MARCUS
 2-20

Table 2.2 Tax-Exempt Yield Table

The equivalent taxable yield is simply the tax-free

rate, rm , divided by (1-t).

INVESTMENTS | BODIE, KANE, MARCUS

 2-21

Corporate Bonds

• Issued by private firms

• Semi-annual interest payments
• Subject to larger default risk than
government securities
• Options in corporate bonds
– Callable
– Convertible

INVESTMENTS | BODIE, KANE, MARCUS

 2-22

Mortgage-Backed Securities

• Proportional ownership of a mortgage

pool or a specified obligation secured by
a pool
• Produced by securitizing mortgages
– Mortgage-backed securities are called
pass-throughs because the cash flows
produced by homeowners paying off their
mortgages are passed through to
investors.
INVESTMENTS | BODIE, KANE, MARCUS
 2-23

Mortgage-Backed Securities

• Most mortgage-backed securities were

issued by Fannie Mae and Freddie Mac.

• Traditionally, pass-throughs were

comprised of conforming mortgages,
which met standards of credit worthiness.

INVESTMENTS | BODIE, KANE, MARCUS

 2-24

Equity Securities

• Common stock: Ownership

– Residual claim
– Limited liability
• Preferred stock: Perpetuity
– Fixed dividends
– Priority over common
– Tax treatment
• American Depository Receipts

INVESTMENTS | BODIE, KANE, MARCUS

 2-25

Stock Market Indexes

• Dow Jones Industrial Average
– Includes 30 large blue-chip
corporations
– Computed since 1896
– Price-weighted average

INVESTMENTS | BODIE, KANE, MARCUS

 2-26

Derivatives Markets

• Options and futures provide payoffs that

depend on the values of other assets such
as commodity prices, bond and stock
prices, or market index values.

• A derivative is a security that gets its value

from the values of another asset.

INVESTMENTS | BODIE, KANE, MARCUS

 2-27

Options
• Call: Right to buy underlying asset at the
strike or exercise price.
– Value of calls decrease as strike price
increases
• Put: Right to sell underlying asset at the
strike or exercise price.
– Value of puts increase with strike price
• Value of both calls and puts increase with
time until expiration.
INVESTMENTS | BODIE, KANE, MARCUS
 2-28

Futures Contracts
• A futures contract calls for delivery of an
asset (or in some cases, its cash value) at
a specified delivery or maturity date for an
agreed-upon price, called the futures
price, to be paid at contract maturity.

• Long position: Take delivery at maturity

• Short position: Make delivery at maturity

INVESTMENTS | BODIE, KANE, MARCUS

 2-29

Comparison
Option Futures Contract
• Right, but not obligation, • Obliged to make or take
to buy or sell; option is delivery. Long position
exercised only when it is must buy at the futures
profitable price, short position must
• Options must be sell at futures price
purchased • Futures contracts are
• The premium is the price entered into without cost
of the option itself.

INVESTMENTS | BODIE, KANE, MARCUS