Asset Classes and
Financial Instruments
Bodie, Kane, and Marcus
Essentials of Investments
2
McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
2.1 The Money Market
▪ Money Market
▪ A subsector of the fixed-income market (debt
market).
▪ It consists of very short-term debt securities
that are highly marketable (highly liquid) and
relatively low risk.
▪ Often have large denominations
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2.1 The Money Market
Money Market Instruments
• Treasury Bills • Repos and
• Certificates of Reverses
Deposit • LIBOR (London
• Commercial Paper Interbank Offer
• Bankers’ Rate)
Acceptances
• Eurodollars
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2.1 The Money Market
• Treasury Bills
▪ Treasury bills (T-bills, or just bills, for short) are
the most marketable of all money market
instruments.
▪ T-billsrepresent the simplest form of
borrowing.
▪ The government raises money by selling bills
to the public.
▪ Investors buy the bills at a discount from the
stated maturity value.
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2.1 The Money Market
• Treasury Bills
▪ At the bill’s maturity, the holder receives from
the government a payment equal to the face
value of the bill.
▪ The difference between the purchase price
and the ultimate maturity value represents the
investor’s earnings.
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2.1 The Money Market
• Treasury Bills
▪ The asked price is the price you would have to
pay to buy a T-bill from a securities dealer.
▪ The bid price is the slightly lower price you
would receive if you wanted to sell a bill to a
dealer.
▪ The bid–asked spread is the difference in
these prices, which is the dealer’s source of
profit.
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Figure 2.1 Treasury Bills (T-Bills)
Source: The Wall Street Journal Online, July 7, 2011.
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2.1 The Money Market
• Treasury Bills
• Issuer: Federal government
• Denomination: $100, commonly $10,000
• Maturity: 4, 13, 26, or 52 weeks
• Liquidity: High
• Default risk: None
• Interest type: Discount
• Taxation: Federal owed; exempt from state and
local
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2.1 The Money Market
• Certificates of Deposit (CDs)
▪ A time deposit with a bank. Time deposits may
not be withdrawn on demand.
▪ The bank pays interest and principal to the
depositor only at the end of the fixed term of
the CD.
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2.1 The Money Market
• Certificates of Deposit (CDs)
▪ CDs issued in denominations larger than
$100,000 are usually negotiable, however; that
is, they can be sold to another investor if the
owner needs to cash in the certificate before
its maturity date.
▪ Short-term CDs are highly marketable,
although the market significantly thins out for
maturities of three months or more.
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2.1 The Money Market
• Certificates of Deposit (CDs)
• Issuer: Depository institutions
• Denomination: Any, $100,000 or more
marketable
• Maturity: Varies, typically 14-day minimum
• Liquidity: CDs of 3 months or less are liquid if
marketable
• Default: First $100,000 ($250,000) insured
• Interest type: Add on
• Taxation: Interest income fully taxable
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2.1 The Money Market
• Commercial Paper (CP)
• Short-term unsecured debt issued by large
corporations.
• Large, well-known companies often issue their
own short-term unsecured debt notes directly to
the public, rather than borrowing from banks.
• Sometimes, CP is backed by a bank line of credit,
which gives the borrower access to cash that can
be used if needed to pay off the paper at maturity.
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2.1 The Money Market
• Commercial Paper (CP)
• CP maturities range up to 270 days; longer
maturities require registration with the Securities
and Exchange Commission (SEC) and so are
almost never issued.
• CP most commonly is issued with maturities of
less than one or two months in denominations of
multiples of $100,000.
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2.1 The Money Market
• Commercial Paper (CP)
• Issuer: Large creditworthy corporations, financial
institutions
• Denomination: Minimum $100,000
• Maturity: Maximum 270 days, usually 1-2 months
• Liquidity: CP of 3 months or less is liquid if marketable
• Default risk: Unsecured, rated, mostly high quality
• Interest type: Discount
• Taxation: Interest income fully taxable
• New Innovation: Asset-backed commercial paper
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2.1 The Money Market
• Bankers’ Acceptances
• Originate when a purchaser authorizes a bank to
pay a seller for goods at later date (time draft)
• When purchaser’s bank “accepts” draft, it
becomes contingent liability of the bank and a
marketable security
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2.1 The Money Market
• Eurodollars
• Dollar-denominated (time) deposits held outside
U.S.
• Most Eurodollar deposits are for large sums, and
most are time deposits of less than six months’
maturity.
• Pay higher interest rate than U.S. deposits
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2.1 The Money Market
• 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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2.1 The Money Market
• Repurchase Agreements (RPs) and Reverse RPs
• Short-term sales of securities with an agreement to
repurchase the securities at higher price
• RP is a collateralized loan; many RPs are overnight,
though “term” RPs may have a 1-month maturity
• Reverse RP is lending money and obtaining security
title as collateral
• “A reverse repo is the mirror image of a repo.
• The dealer finds an investor holding government
securities and buys them with an agreement to resell
them at a specified higher price on a future date.
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2.1 The Money Market
• Money Market Instrument Yields
• Yields on money market instruments 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
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2.1 The Money Market
• Bank Discount Rate (T-bill quotes)
r = $10,000 − P x 360 $10,000 = Par
BD $10,000 n
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
$10,000 - $9,875 360
r BD = × = 5%
$10,000 90
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2.1 The Money Market
• Bond Equivalent Yield
• Can’t compare T-bill directly to bond
• 360 vs. 365 days
• Return is figured in par vs. price paid
• Adjust bank discount rate to make it
comparable
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2.1 The Money Market
• Bond Equivalent Yield
P = price of the T-bill
rBD = 5%
n = number of days to maturity
10,000 − P 365
r = ×
BEY P n
• Example Using Sample T-Bill
r = 10,000 − 9,875 365
×
BEY 9,875 90
rBEY = .0127 × 4.0556 = .0513 = 5.13%
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2.1 The Money Market
• Effective Annual Yield
rBD = 5%
rBEY = 5.13%
rEAY = rEAY = 5.23%
P = price of the T-bill
n = number of days to maturity
• Example Using Sample T-Bill
rEAY =
rEAY = 5.23%
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2.1 The Money Market
• Money Market Instruments
• Treasury bills: Discount
• Certificates of deposit: BEY
• Commercial paper: Discount
• Bankers’ acceptances: Discount
• Eurodollars: BEY
• Federal funds: BEY
• Repurchase agreements and reverse RPs:
Discount
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2.2 The Capital Market
• Capital Market: a market that enables suppliers and
demanders of long-term funds to make transactions.
• Capital Market—Fixed-Income Instruments
• longer-term borrowing or debt instruments that
promise either a fixed stream of income or stream of
income that is determined according to a specified
formula.
• This market includes:
• Treasury notes and bonds,
• Corporate bonds,
• Mortgage securities.
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2.2 The Bond Market
• Government Issues—U.S. Treasury Bonds and Notes
• Debt obligations of governments with original maturities of
one year or more.
• T-notes are issued with original maturities ranging up to 10
years
• T-bonds are issued with maturities ranging from 10 to 30
years.
• Both bonds and notes may be issued in increments of $100
but far more commonly trade in denominations of $1,000.
• Both bonds and notes make semi-annual interest payments
called coupon payments.
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2.2 The Bond Market
• Capital Market—Fixed-Income Instruments
• Variation: Treasury Inflation Protected Securities
(TIPS)
• Issued bonds that are linked to an index of the cost
of living in order to provide their citizens with an
effective way to hedge inflation risk.
• Principal adjusted for increases in the Consumer Price
Index
• Marked with a trailing “i” in quote sheets
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Figure 2.3 Listing of Treasury Issues
Source: Compiled from data from The Wall Street Journal Online, July 6, 2011.
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2.2 The Bond Market
• Government Issues
• Municipal bonds
• Issuer?
• Differ from treasuries and agencies?
• Risk?
• G.O. vs. revenue
• Industrial development
• Taxation?
rtax exempt = rtaxable x (1 – Tax rate)
r = Interest rate
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Table 2.2 Equivalent Taxable Yields
Tax-Exempt Yield
Marginal Tax Rate 1% 2% 3% 4% 5%
20% 1.25% 2.50% 3.75% 5.00% 6.25%
30 1.43 2.86 4.29 5.71 7.14
40 1.67 3.33 5.00 6.67 8.33
50 2.00 4.00 6.00 8.00 10.00
rtax exempt = rtaxable x (1 – Tax
rate)
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2.2 The Bond Market
• Private Issues
• Corporate Bonds
• Long-term debt issued by private corporations
typically paying semi-annual coupons and returning
the face value of the bond at maturity.
• Default risk is a real consideration in the purchase of
corporate bonds.
• Corporate bonds sometimes come with options
attached.
• Callable bonds give the firm the option to repurchase
the bond from the holder at a stipulated call price.
• Convertible bonds give the bondholder the option to
convert each bond into a stipulated number of shares
of stock.
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2.2 The Bond Market
• Private Issues
• Mortgage-Backed Securities
• Backed by pool of mortgages with “pass-through”
of monthly payments; covers defaults
• Collateral
• Traditionally all mortgages conform, since 2006 Alt-A
and subprime mortgages are included in pools
• Private banks purchased and sold pools of
subprime mortgages
• Issuers assumed housing prices would continue
to rise
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2.3 Equity Securities
• Capital Market-Equity
• Represent ownership shares in a corporation.
• Each share of common stock entitles its owners
to one vote.
• The common stock of most large corporations
can be bought or sold freely on one or more of
the stock markets.
• A corporation whose stock is not publicly traded
is said to be private.
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2.3 Equity Securities
• Capital Market-Equity
• Common stock
• Residual claim
• Limited liability
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2.3 Equity Securities
• Capital Market-Equity
• Preferred stock
• Hybrid security (has features similar to both
equity and debt)
• Like a bond, it promises to pay to its holder a
fixed stream of income each year and it does
not give the holder voting power regarding the
firm’s management.
• Cumulative vs noncumulative.
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2.3 Equity Securities
• Capital Market-Equity
• Preferred stock
• Preferred stock can be callable by the issuing
firm.
• It also can be convertible into common stock at
some specified conversion ratio.
• A relatively recent innovation is adjustable-rate
preferred stock, which, like adjustable-rate bonds,
ties the dividend rate to current market interest
rates.
• Priority over common
• Fixed dividends: Limited gains
• Nonvoting
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2.3 Equity Securities
• Capital Market-Equity
• Capital gains and dividend yields
• Buy a share of stock for $50, hold for 1 year, collect
$1 dividend, and sell stock for $54
• What were dividend yield, capital gain yield, and total
return? (Ignore taxes)
• Dividend yield = Dividend / Pbuy = $1/$50 = 2%
• Capital gain yield = (Psell – Pbuy) / Pbuy = ($54 –
$50)/$50 = 8%
• Total return = Dividend yield + Capital gain yield = 2%
+ 8% = 10%
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2.4 Stock and Bond Market Indexes
• Uses
• Track average returns
• Compare performance of managers
• Base of derivatives
• Factors in constructing/using index
• Representative?
• Broad/narrow?
• How is it constructed?
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2.4 Stock and Bond Market Indexes
• Construction of Indexes
• How are stocks weighted?
• Price weighted (DJIA)
• Market value weighted (S&P 500, NASDAQ)
• Equally weighted (Value Line Index)
• How much money do you put in each stock in
the index?
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2.4 Stock and Bond Market Indexes
• Constructing Market Indexes
• Weighting schemes
• Price-weighted average: Computed by adding
prices of stocks and dividing by “divisor”
• Market value-weighted index: Return equals
weighted average of returns of each
component security, with weights proportional
to outstanding market value
• Equally weighted index: Computed from
simple average of returns
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2.4 Stock and Bond Market Indexes
Stock PriceB QuantityB P1 Q1
Price-Weighted A $10 40 $15 40
Series B 50 80 25 160
C 140 50 150 50
• Time 0 index value: (10 + 50 + 140)/3 = 200/3 = 66.7
• Time 1 index value: (10 + 25 + 140)/Denom = 66.67
• Denominator = 2.624869
• Time 1 index value: (15 + 25 + 150)/2.624869 = 72.38
• Other problems:
• Similar % change movements in higher-price stocks cause
proportionally larger changes in the index
• Splits arbitrarily reduce weights of stocks that split in index
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2.4 Stock and Bond Market Indexes
Stock PriceB QuantityB P1 Q1
A $10 40 $15 40
B 50 80 25 160
C 140 50 150 50
• Value-Weighted Series
IndexV =
• Equal-Weighted Series
• wlog invest $300 in each
IndexE =
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2.4 Stock and Bond Market Indexes
Case 1 Case 2
Stock PB QB P1 Q1 P1 Q1
A $10 40 $12 40 $10 40
B 100 80 100 80 100 80
C 50 200 50 200 60 200
• Why do the two differ?
• Case 1: 20% change in price of small-cap firm
IndexV =
• wlog invest $100 in each stock
IndexE =
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2.4 Stock and Bond Market Indexes
Case 1 Case 2
Stock PB QB P1 Q1 P1 Q1
Case 1 VW = 100.43
A $10 40 $12 40 $10 40
Case 1 EW = 106.67
B 100 80 100 80 100 80
C 50 200 50 200 60 200
• Why do the two differ?
• Case 2: 20% change in price of large-cap firm
IndexV =
• Assume $100 investment in each stock
IndexE =
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2.4 Stock and Bond Market Indexes
• Examples of Indexes—Domestic
1. EGX30
2. SHARIAH
3. EGX70 EWI
4. EGX100 EWI
5. Sectors
6. TAMAYUZ
7. S&P/EGX ESG
8. EGX30 Capped
9. EGX30 TR
10. EGX T BONDS
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2.5 Derivative Markets
• Derivative Asset/Contingent Claim
• Security with payoff that depends on the price
of other securities
• Listed Call Option
• Right to buy an asset at a specified price on or
before a specified expiration date
• Listed Put Option
• Right to sell an asset at a specified exercise
price on or before a specified expiration date
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Figure 2.9 Stock Options on Apple
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2.5 Derivative Markets
• Using the Stock Options on Apple
• The right to buy 100 shares of stock at a stock
price of $355 using the July contract would cost
$560 (ignoring commissions)
• Is this contract “in the money”?
• When should you buy this contract?
• Stock price was equal to $357.20; you will make
money if stock price increases above $357.20 +
$5.60 = $362.80 by contract expiration
• When should you write it?
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2.5 Derivative Markets
• Using the Stock Options on Apple
• The right to buy 100 shares of stock at a stock
price of $355 using the July contract would cost
$90 (ignoring commissions)
• Is this contract “in the money”?
• Why do the two option prices differ?
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2.5 Derivative Markets
• Using the Stock Options on Apple
• Look at Figure 2.9 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”?
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2.5 Derivative Markets
• 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.
• Purchaser (long position) buys specified
quantity at contract expiration for set price
• Contract seller (short) delivers underlying
commodity at contract expiration for agreed-
upon price
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2.5 Derivative Markets
• Futures Contracts
• Purchaser (long) buys specified quantity at
contract expiration for set price
• Contract seller (short) delivers underlying
commodity at contract expiration for agreed-
upon price
• Futures: Future commitment to buy/sell at
preset price
• Options: Holder has future right to buy/sell
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Figure 2.10 Futures Contracts
• Corn futures prices in the Chicago Board of
Trade, July 8, 2011
2-53
2.5 Derivative Markets
• Corn futures prices in the Chicago Board of
Trade, July 8, 2011
• Contract size: 5,000 bushels of corn
• Price quote for Dec. 12 contract: 614’0 translates to a
price of $6.14 + 0/8 cent per bushel, or $6.14
• If you bought the Dec. 12 contract, what are you
agreeing to do?
• Purchase 5,000 bushels of corn in December for
5,000 × $6.14 = $30,700
• What is your obligation if you sell the Dec. 12 contract?
• How does this contract differ from an option?
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2.5 Derivative Markets
Derivatives Securities
• Options • Futures
• Basic Positions • Basic Positions
• Call (Buy/Sell?) • Long (Buy/Sell?)
• Put (Buy/Sell?) • Short (Buy/Sell?)
• Terms • Terms
• Exercise price • Delivery date
• Expiration date • Deliverable item
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