Chapter 2

Global Financial Instruments

 Major Classes of
Financial Assets/Securities
 Debt
– Money market instruments
– Bonds
 Common stock
 Preferred stock
 Derivative securities

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 Financial Markets
T-Bills
(Short-term) CD
Money CP
Market BA
Traditional Repos/Reverses
Financial Federal funds
Markets LIBOR market

(Long-term) T-Notes/Bonds
Financial Capital Bonds Municipal bonds
Markets Market Corporate Bonds
ABS/MBS
Stocks

Forward
Futures
Derivatives Option
Swap
Foreign Exchange
Market Whole sales market
Retail market

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 Money Market Instruments 1
 Short-term, marketable, low-risk securities
– Cash equivalents
 Treasury bill (T-Bill)
– Short-term (less than one year) gov’t securities sold at a
discount and paying off the face value at maturity
– Discount rate needs to be converted to a bond equivalent yield
(See example later)
– Tax-exempt from all state and local taxes, but not from fed taxes
– Issued in auction markets: Competitive vs. noncompetitive bids
 Certificates of deposit (CD)
– Time deposit with a bank, paying off interest and principal at
maturity, and negotiable before maturity
– Treated as a bank deposit by the FDIC (insured for up to
$100,000)
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 Money Market Instruments 2
 Eurodollars
– Dollar-denominated time deposits at foreign banks, with a
maturity less than 6 months
– Eurodollar CD is a variation that is negotiable before maturity
 Commercial Paper (CP)
– Short-term unsecured debt issued by a large corp. in
denomination of $100,000
– Fairly safe, but can default.
– Rated by a rating agency such as S&P, Moody’s, etc.
 Bankers’ Acceptances (BA)
– Widely used in foreign trade (import/export)
– A customer’s order accepted by a bank to make a payment at a
future date
– Sells at a discount in secondary markets
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 Money Market Instruments 3
 Repurchase Agreements (RPs) and Reverse RPs
– Short-term (overnight) sales of gov’t securities by dealers with an
agreement to repurchase them later at a higher price
– It is like a S/T low-risk loan with the securities held as collateral
– A reverse repo works in the opposite direction
 Federal Funds
– Banks’ deposits at the Federal Reserve Bank to maintain a
required minimum balance
– Banks with excess funds lend to those with a shortage at a rate
of the Federal fund rate (Fed fund rate)
 LIBOR Market
– LIBOR: lending rate among large banks in London
– Serve as a reference rate for a wide range of transactions
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 Discount Rate vs.
Bond Equivalent Yield
 Discount Rates on money market instruments
are not directly comparable to Bond Equivalent
Yield (BEY)
– They need to be converted into BEY to be
comparable with other bond yields
– 360 vs. 365 days assumed in a year

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 Bank Discount Rate (T-Bills)
10,000 - P 360
r BD = x
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 = x = 5%
10,000 90
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 Bond Equivalent Yield
 Convert the bank discount rate into BEY to
make it comparable with other bond yields
10,000 - P 365
r BEY = x n
P
P = market price of the T-bill
n = number of days to maturity
Example using the sample T-Bill:
10,000 - 9,875 365
r BEY = x
9,875 90
rBEY = .0127 x 4.0556 = .0513 = 5.13% 9
 Capital Market :
Fixed Income Instruments 1
 US Treasury Notes and Bonds
– Debt of the federal gov’t with maturities of 1 year or more, paying
off semiannual interests and principal at maturity
– Price quoted in units of 1/32 of a point
(Ex) 110:06 = 110 6/32 = 110.1875 (%) of par U$1 mil
– Yield-to-maturity (YTM) is an annualized rate of return, based on
an annual percentage rate (APR) or also called BEY
(Ex) YTM = semiannual yield ×2
 Mortgage-Backed Securities (Federal Agency)
– Ownership claim to cash inflows from a mortgage pool
– Interest and principal payments from borrowers are passed to
purchasers, and are called “pass-throughs”
– GNMA pass-throughs (since 1970), and others (FNMA, FHLMC)
– Market size is comparable to corporate and T-bond markets
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 Capital Market :
Fixed Income Instruments 2
 Municipal bond (“munis”)
– Issued by state and local gov’t, and interest income is exempt
from federal and sometimes state and local tax (but capital gains
are taxable)
– To compare yields on taxable securities, we compute a Taxable
Equivalent Yield as follows

rm = r×(1 – t) rm = muni bond yield

rm r = taxable equivalent yield
r =
1–t t = marginal tax rate

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 Capital Market :
Fixed Income Instruments 3
 Corporate bonds
– Long-term debt issued by private corporations, paying typically
semiannual interests and principal at maturity
– Secured (mortgage or collateral) vs. unsecured (Debenture)
– Guaranteed vs. straight bond
– Option-embedded bonds: Callable, puttable, convertible, etc.
– Current yield = Annual coupon / Current price
– Yield-to-maturity = current yield + capital gain yield
 International Bonds
– Eurobond: denominated in a currency other than the issuing
country, e.g., dollar-denominated bond issued in London
– Yankee bond, Samurai bond

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 Capital Market - Equity
 Common stock
– Ownership shares of a publicly held corporation
– Entitled to get voting right and dividend payments
– Residual claim
– Limited liability
– Dividend yield = Annual dividend / Current price
– PE ratio = Price / EPS
 Preferred stock
– Nonvoting shares, usually paying fixed dividends (usually
cumulative), like an infinite-maturity bond or a perpetuity
– Priority over common stock holders
– Sometimes, callable and convertible

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 International Equity
 Global markets continue developing, and more
opportunities of investing abroad are available
– ADRs (American Depository Receipts)
– Mutual funds like country funds or WEBS (World
Equity Benchmark Shares)
– Direct purchase of foreign securities
 Provides diversification benefits, but are
exposed to foreign exchange risk
– Global information and analysis skills are required

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Total nominal return in the U.S.

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Equity Risk Premium

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Performance by market sectors

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Risk vs. Return by market sectors

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International Stock Returns

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International Stock and Bond Returns

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 Stock Indexes
 Represent the performance of the stock market as a
whole, e.g., DJIA, S&P500, Wilshire 5000, etc.
– Useful to track average returns of the stock market
– Useful as a benchmark for the performance of fund managers
– Used as base of derivatives
 Many kinds of stock indexes exist
– Representative? Broad or narrow? How is it weighted?
– Price-weighted index
• Dow Jones Industrial Average (30 blue-chip stocks)

– Market value-weighted index

• Standard & Poor’s 500, NASDAQ Composite, Wilshire 5000

– Equally weighted index

• Value Line Index

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 Stock Indexes - Int’l
 Nikkei 225 (price-weighted, largest TSE stocks)
 Nikkei 300 (value-weighted, largest TSE stocks)
 FTSE (value-weighted, largest 100 LSE stocks)
 DAX (German stock index)
 Regional and Country Indexes by MSCI
– EAFE (Europe, Australia, Far East)
– Far East
– EM (Emerging markets)
– U.S., U.K., etc. (over 50 country indexes)

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Wilshire 5000 Index

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Top 20 companies in S&P500 Index

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 Derivatives Securities
Options Futures
 Basic Positions  Basic Positions
– Call (Right to Buy) – Long (Commitment to Buy)
– Put (Right to Sell) – Short (Commitment to Sell)
 Terms  Terms
– Exercise (Strike) Price – Futures price
– Expiration Date – Delivery (Maturity) Date
– Underlying Assets – Underlying Assets

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