Asset Classes and Financial Instruments

1. Asset Classes and Financial Instruments P.V. Viswanath For a First Course in INvestments

2. Learning Goals • What are the different asset classes? • Why is it important to separate them by asset class? • What distinguishes the various asset classes? • Why are indices important and how are they constructed?

3. Asset Classes • Financial Assets can be categorized in different ways: • Criteria for categorization • Maturity • Liability/equity • Tax Status • Option characteristics • Q: Why is it important to separate them by asset class?

4. Treasury Bills Certificates of Deposit Commercial Paper Bankers’ Acceptances Eurodollars Repos and Reverses Broker’s Calls Federal Funds LIBOR (London Interbank Offer Rate) Money Market Instruments

5. 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 Discount Federal taxes owed, exempt from state and local taxes

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

7. 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 New Innovation: Asset backed commercial paper is backed by a loan or security. In summer 2007 asset backed CP market collapsed when subprime collateral values fell.

8. Bankers Acceptances & Eurodollars Bankers Acceptances 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.

9. Federal Funds and LIBOR Federal Funds 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.

10. 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 A haircut is a percentage that is subtracted from the market value of an asset that is being used as collateral.The size of the haircut reflects the perceived risk associated with holding the asset. For example, a $1000 treasury bill will be accepted as collateral for a $990 loan, while a $1000 stock option might only allow a $700 loan.

11. Money Market Instruments 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. The loan may be ‘called in’ by the broker.

12. Figure 2.1 Money Rates

13. Table 2.2 Major Components of the Money Market

14. Figure 2.2 Treasury Bills

15. Figure 2.3 Spreads on CDs and Treasury Bills

16. MMMF and the Credit Crisis of 2008 Between 2005 and 2008 money market mutual funds (MMMFs) grew by 88%. Why? MMMFs had their own crisis in 2008 when Lehman Brothers filed for bankruptcy on September 15. Some funds had invested heavily in Lehman’s commercial paper. On Sept. 16, Reserve Primary fund “broke the buck.” What does this mean? A run on money market funds ensued. The U.S. Treasury temporarily offered to insure all money funds to stop the run - (up to $3.4 trillion in these funds.)

17. T-bill Quotations • T-bills represent promises of the government to the holder to pay a certain amount at a future date, usually within a year. • Investors buy the bills at a discount from the government from the stated maturity value. The return to the holder is the difference between the stated value received at maturity and the price paid in the beginning. • T-bills are usually quoted using the bank discount yield. • where FV is the face value of the bill, P is the price of the bill, and n is the number of days left to maturity on the bill. This is equal to the number of days left to maturity on the trade day less the one business day allowed for payment, following the skip-day settlement convention. • This can be contrasted to the bank-equivalent yield.

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

19. Bond Equivalent Yield 365 10,000 - P x r = BEY n P 365 10,000 - 9,875 x r = BEY 9,875 90 rBD=5% P = price of the T-bill n = number of days to maturity Example Using Sample T-Bill rBEY = .0127 x 4.0556 = .0513 = 5.13%

20. 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 rEAY = 5.23%

21. Bond Market • The Bond Market consists of • Government Bonds • Agency bonds • Municipal Bonds • Corporate Bonds.

22. Government Issues US Treasury Bonds and Notes Bonds versus Notes Denomination Interest type Risk? Taxation? • Variation: Treasury Inflation Protected Securities (TIPS) • Tips have principal adjusted for increases in the Consumer Price Index • Marked with a trailing ‘i’ in the quote sheet (See Figure 2.4)

23. Government Bonds

24. Agency Issues 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.

25. Municipal Bonds Issuer? Differ from Treasuries and Agencies? Risk? General Obligation Bonds versus Revenue Bonds Industrial development Taxation?

26. Table 2.3 Equivalent Taxable Yields

27. Figure 2.6 Ratio of yields on tax exempt to taxable bonds

28. Data for Index Construction

29. Dow Jones Index • The Dow, which represents 30 large "blue-chip" corporations, was originally computed as the simple average of the prices of the stocks in the index. • However, to ensure that the average did not change when there was a stock split, there were some adjustments to the weights, and hence to the divisor. • The percentage change in the Dow measures the return on a portfolio that holds one share in each stock. The amount of money invested in each stock is equal to the price of that stock.

30. Dow Jones Index • If Coca Cola splits as of the end of day 2, then we need to adjust the divisor (currently 2), so that the value of the index does not change. • This is necessary, if we presume that the stock split has not affected the "level" of the market. • Assuming that the split simply halved the price of Coca Cola’s stock, the new divisor, D, must satisfy the equation (32.25+132.375)/D = 98.4375; i.e. D = 1.67238. • Changes in the Dow Jones Index do not represent changes in the value of any portfolio.

31. S&P 500 Index • Represents a broad-based index of 500 stocks. • The Index is effectively the total market value of all the stocks in the index on each day. • Measures the return on a portfolio that invests an amount in each stock proportional to the market value of the outstanding shares.

32. Equally Weighted Indices • Measures the value of a portfolio that invests an equal amount in each stock at each point in time. • The percentage change in the index does not correspond to the return on any buy-and-hold portfolio. • For example, on day 1, to achieve the goal of investing an equal number of dollars in each stock, if we were to invest $50 in each stock, we would have to buy 50/63.75 = 0.7843 units of stock 1 and 50/135.25 = 0.3697 units of stock 2.

33. Equally Weighted Indices • From the first day to the second day, the return on Coca Cola would be (64.5/63.75) – 1 or 1.1765%; the return on Microsoft would be (132.375-125.25) – 1 or -2.126%. Hence the return on the portfolio would be a simple average of these two returns, or -0.475%. The value of the index, then, is 100(1-0.00475) or 99.525. This can also be computed by taking the number of shares in each stock and multiplying by the new share prices and adding.

34. Equally Weighted Indices • On day 2, the same number of shares in each stock would no longer be an equally-weighted portfolio, since the Microsoft shares would be worth 0.3697(132.375) or $48.94, while the Coca-Cola shares would be worth 0.7843(64.5) = $50.59. • Hence the next index value is computed by taking the simple average of the returns on the two stocks from day 2 to day 3 and grossing the index by that amount. For example, if Microsoft traded at 133 on day 3 and Coca-Cola at 65, their respective returns would be 0.47% (133/132.375) and 0.78% (65/64.5 - 1) • The simple average is 0.63%, and 99.526(1.0063) = 100.1491, which would be the next index value.

35. Derivative Markets 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.

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

37. 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? The stock price was equal to $110.35 & you will make money if the stock price increases above $110.35 + $7.45 = $117.80 by contract expiration. When should you write it? $745

38. 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?” Why do the two option prices differ? $810

39. Using the Stock Options on Apple 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? How does a greater time to contract expiration affect the value of a call option? A put option? Why? How is ‘volume’ different from ‘open interest?’

40. Futures Contracts In a futures contract the purchaser of the contract (the long) agrees to purchase the specified quantity of the underlying commodity at contract expiration at the price (futures price) set in the contract. The contract seller (the short) agrees to deliver the underlying commodity at contract expiration in exchange for receiving the agreed upon price. Futures are a ___________ to buy or sell in the future whereas at a preset price whereas options give the holder the ______ to buy or sell in the future. commitment right

41. Figure 2.11 Futures Contracts

42. Figure 2.11 Futures Contracts • Contract size: 5000 bushels of corn • Price quote for Dec 08 contract: 455’4 translates to a price of $4.55 + 4/8 cents per bushel or $4.555 per bushel. • If you bought the Dec 08 contract what would you be agreeing to do? • Purchase 5000 bushels of corn in December for 5,000 x $4.555 = $22,775. • What would be your obligation if you sold the Dec 08 contract? • How does this contract differ from an option?

43. Derivatives Securities Options Basic Positions Call (Buy/Sell?) Put (Buy/Sell?) Terms Exercise Price Expiration Date Futures Basic Positions Long (Buy/Sell?) Short (Buy/Sell?) Terms Delivery Date Deliverable item