Ch2ppt Updated

Chapter
Ch. 2
Brief accounts on asset

classes and financial
instruments
Notes:
• Complicated financial models* may not always
provide you with good return
• Long-term capital management (LTCM) was a massive
hedge fund led by Nobel Prize-winning economists and
renowned Wall Street traders
• Very often, simple models/calculations with sound
vision are more promising.
• You need to find your own strategies
• Class discussions (may be difficult) reinforce your
concepts and applications in practices
*some can be very useful
Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 2 2
Outcome
• Understand the risk and return*
characteristics of different financial
instruments before investing in those
assets
• *Note: who cares? As a small individual investor, you may not have
many choices. However, in the future, you may be a fund manager or
be investing for your firm, your choices do matter. Many investors
ignore the risk when they invest.
2.1 Asset Classes
Common Stock
Asset
Classes
Fixed Income
Securities
Derivative Securities
• Money Market (more
(options to be details)
covered) • Bond Market
• Preferred Stock
2.1 The Money Market: Instruments
• Treasury Bills • Repos and

• Certificates of Reverses
Deposit
• Commercial Paper
• Bankers’
Acceptances
• Eurodollars
Q: What are their risk and return characteristics?

2.1 The Money Market: Treasury Bills
Treasury Bills
Issuer: Federal Government
Denomination: Commonly $10,000; $1,000
Maturity: 4, 13, 26 or 52 Weeks
Liquidity: High
Default Risk: None, why?
Interest Type: Discount
Do you remember you have learned it from FINA 2010? Check:

https://www.bloomberg.com/markets/rates-bonds/government-bonds/germany,
yields are negative for 2-yr, 5-yr bund German bond in 2018 who would buy
bond with –ve return? Now –ve for 10-and 30-yr bond
Turkey- government bonds
• One year Turkey-government bond has a
yield of 24% (August 27, 2018), currently it
is about 16.25% (Sep. 3, 2019)
• Can the Turkish government print money
as much as she wants like the US
government?
• Source: https://www.investing.com/rates-
bonds/turkey-government-bonds
2.1 The Money Market: Certificates of Deposit (CDs)
Certificates of Deposit
Issuer: Depository Institutions
Denomination: Any, $100,000 or more
Maturity: Varies, Typically 14-day Minimum
Liquidity: High for CDs <3 months,
Default Risk: First $250,000 Federal Deposit
Insurance Corporation (FDIC) insured
It is a time deposit issued by banks

Maturity can be up to 5 years, you can buy it from brokerage firms.
T-bills vs CDs
• Should CDs or T-bills (with same maturity)

pay a higher rate of return (yield).?
• Why?
Figure 2.2 Spreads on CDs and Treasury Bills
5.0
OPEC I
4.5 What do you observe?
4.0
Financial crisis
3.5
OPEC II
Percentage points
3.0
Penn Square
2.5
Market crash
2.0
1.5
LTCM
1.0
0.5
0.0
1970
1972
1974
1976
1978
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
2006
2008
2010
2012
2014
2.1 The Money Market: Commercial Paper
CP
Issuer: Large creditworthy corps.; financial institutions
Denomination: Minimum $100,000
Maturity: Maximum 270 days, usually 1-2 months
Liquidity: CP < 3 months, liquid
Default Risk: Unsecured, rated, mostly high quality
Interest Type: Discount
e.g. A firm offers investors $1.008 million in face
value in exchange for $1 million in cash
GE relies on commercial paper to help fund its daily operations, and it used
to be one of the biggest issuers of the debt……
https://www.bloomberg.com/news/articles/2018-10-03/ge-downgrade-will-
lift-its-costs-in-a-debt-market-it-once-ruled
2.1 The Money Market
• Bankers’ Acceptances
• Maturity between 30 to 180 days
• 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
• banker’s acceptances function based on the
creditworthiness of the banking institution
• Bankers’ Acceptances
• e.g. US firm buys toys from a HK firm
• How to make sure the HK firm will get payment from
the US once toys are shipped to USA?
• Flipped classroom video (1 min. 32 sec):
https://www.investopedia.com/terms/b/bankersacce
ptance.asp
• Eurodollars
• Dollar-denominated time deposits held outside U.S.
• Pay higher interest rate than U.S. deposits
2.1 The Money Market: Repurchase Agreements
• Repurchase Agreements (RPs or repos)
• Short-term sales of securities with promise to
repurchase at higher price
• So a (short-term) borrowing
• RP is a collateralized loan
• Many RPs are overnight; some may have a 1-month
maturity
• Reverse RPs(the party on the other side of RPs)
• Lending money; obtaining security title as collateral
Video:
https://www.investopedia.com/terms/r/repurchaseagreement.asp
2.1 The Money Market: Instrument Yields
• Yields on money market instruments not always
directly comparable
• Factors influencing “quoted” yields

• 360 vs. 365 days assumed in a year (366 leap
year)
• Simple vs. compound interest
Figure 2.1 Treasury Bills (T-Bills)
0.01967%x365/177 =0.041%
Treasury Bills
DAYS TO ASKED
MATURITY MATURITY BID ASKED CHG YIELD
28-Nov-2014 73 0.010 0.005 -0.005 0.005

2-Jan-2015 108 0.015 0.010 0.000 0.010
12-Mar-2015 177 0.045 0.040 0.000 0.041
28-May-2015 254 0.045 0.040 -0.005 0.041
23-Jul-2015 310 0.080 0.075 0.000 0.076
So ask yield of 0.04% means dealer willing to sell the bills at a discount
from face value of 0.04% x (177/360) =0.01967%
i.e. $10,000 x (1-0.01967%) =$9,998.033
Source: The Wall Street Journal Online, September 14, 2014. Please try
figure 2.1 in the text using 2017 figures with asked yield 0.911
• 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
• Bond Equivalent Yield (BEY)
• Use BEY because
• We can’t compare T-bill directly to bond
• 360 vs. 365 days
• Return is figured in par vs. price paid
(previous slide)
• Adjust bank discount rate to make it
comparable
2.1 The Money Market: Bond Equivalent Yield
• Bond Equivalent Yield

P = price of the T-bill rBD = 5%
10,000 − P 365
r = ×
BEY P n
• Example Using Sample T-Bill
r = 10,000 − 9,875 365

×
BEY 90
9,875
rBEY = 0.0127 × 4.0556 = .0513 = 5.13%
2.1 The Money Market: Effective Annual Yield
• Effective Annual Yield (more accurate)
365 Compare:
 $10,000  P  n
rEAY = 1   1 rBD = 5%
 P  rBEY = 5.13%
P = price of the T-bill rEAY = 5.23%
• Example Using Sample T-Bill

365
 $10,000  $9,875  90
rEAY = 1   1
 $9,875 
rEAY = 5.23%
2.1 The Money Market: Instrument Yield
Money Market Instrument Instrument Yield

Treasury Bills Discount
Certificates of Deposit Bond Equivalent Yield
Commercial Paper Discount
Bankers’ Acceptances Discount
Eurodollars Bond Equivalent Yield
Repurchase Agreements Discount
Reverse RPs Discount
Note: the key point here is to understand the yield the instrument is referring to
instead of simply investing the one with highest yield,
For exam. purpose, all you need to know is included in this powerpoint
2.2 The Bond Market
• You should have the basics from FM course.
• We will come back in more details in later chapters
2.2 The Bond Market: Private Issue
• Before we leave the bond topic, you should know that bonds are
not always safe investments, e.g. corporate bond and the more
recent MBS
• Corporate Bonds
• Investment grade vs. speculative grade
• Mortgage-Backed Securities (MBS),

• see my in-class example or
https://www.investopedia.com/terms/m/mbs.asp
• Backed by pool of mortgages with “pass-through” of monthly payments;
covers defaults
• Private banks purchased and sold pools of subprime mortgages
• Issuers assumed housing prices would continue to rise
2.4 Stock and Bond Market Indexes
• Uses of indexes
• Track average returns
• Compare performance of managers
• Base of derivatives (e.g. Hang Seng Index
futures and options)
• Factors to be considered in
constructing/using index
• Representative?
• Broad/narrow?
• Construction of Indexes
• How are stocks weighted?
• Price weighted (DJIA)
• https://us.spindices.com/indices/equity/dow-jones-industrial-
average
• https://www.investopedia.com/articles/financial-
theory/10/introduction-to-the-dow.asp
• Market value weighted (S&P 500, NASDAQ)

• Equally weighted (Value Line Index)
• 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
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
• Need to adjust for split
• 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
Note: subscript B stands for base price
Price-Weighted A $10 40 $15 40
Series (no stock B 50 80 45 80
C 140 50 150 50
split at time 1)
• Time 0 index value: (10 + 50 + 140)/3 = 200/3 = 66.7
• Time 1 index value: (15 + 45 + 150)/3=
• 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
Note: subscript B stands for base price
A $10 40 $15 40
B 50 80 25 160
C 140 50 150 50
• Value-Weighted Series
(15  40)  (25 160)  (150  50)
IndexV = 100  106.14
(10  40)  (50  80)  (140  50)
A split you get 12
• Equal-Weighted Series shares (originally 6
shares)
• invest $300 in each
(15  30)  (25 12)  (150  2.143)
IndexE = 100  119.05
(10  30)  (50  6)  (140  2.143)
$300 you get 30 shares each of $10

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 (value weighted vs equal weighted)?
• Case 1: 20% change in price of small-cap firm

(12  40)  (100  80)  (50  200)
IndexV = 100  100.43
(10  40)  (100  80)  (50  200)
• invest $100 in each stock
(12 10)  (100 1)  (50  2)
IndexE = 100  106.67
(10 10)  (100 1)  (50  2)
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
(10  40)  (100  80)  (60  200)
IndexV = (10  40)  (100  80)  (50  200) 100  110.86
• Assume $100 investment in each stock
(10 10)  (100 1)  (60  2)
IndexE = 100  106.67
(10 10)  (100 1)  (50  2)
• Examples of Indexes
• Dow Jones Industrial Average (30 stocks)
• Standard & Poor’s 500 Composite
• NASDAQ Composite (>3,000 firms)
• Wilshire 5000 (>6,000 stocks)
• Hang Seng Index (www.hsi.com.hk)
• Hang Seng China Enterprises Index
2.5 Derivative Markets
• Derivative Asset
• Security with payoff that depends on the price
of other securities
• Call Option
• Right to buy an asset at a specified price on or
before a specified expiration date
• Put Option
• Right to sell an asset at a specified exercise
price on or before a specified expiration date
Figure 2.10 Stock Options on Apple
Let’s try a more volatile stock option: Tesla, put option using
August 22, 2017 data OR you want to try Apple first?
Source: www.cboe.com, September 17, 2014,

you may try the text example using 2017 figures of Apple
• Using the Stock Options on Apple (Call)
• The right to buy 100 shares of stock at a stock
price of $95 using the October contract would
cost $635 (ignoring commissions)
• Is this contract “in the money”?
• When should you buy this contract?
• When will you make money?
• When should you write it?
• Using the Stock Options on Apple (Put)
• The right to buy 100 shares of stock at a stock
price of $95 using the October contract would
cost $33 (ignoring commissions)
• Is this contract “in the money”?
• Why do the two option prices differ?
• 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?
Option:In case you miss our class
• https://www.investopedia.com/terms/s/stock
option.asp
• Futures Contracts
• Your self learning. You are welcome to come to
me for discussion.

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Chapter

Brief accounts on asset

• Treasury Bills • Repos and

Q: What are their risk and return characteristics?

Do you remember you have learned it from FINA 2010? Check:

It is a time deposit issued by banks

• Should CDs or T-bills (with same maturity)

4.5 What do you observe?

• Factors influencing “quoted” yields

28-Nov-2014 73 0.010 0.005 -0.005 0.005

r = $10,000 − P x 360 $10,000 = Par

rBD = bank discount rate

• Example: 90-day T-bill, P = $9,875

$10,000 - $9,875 360

• Bond Equivalent Yield

• Example Using Sample T-Bill

r = 10,000 − 9,875 365

rBEY = 0.0127 × 4.0556 = .0513 = 5.13%

• Example Using Sample T-Bill

Money Market Instrument Instrument Yield

• Mortgage-Backed Securities (MBS),

• Market value weighted (S&P 500, NASDAQ)

• Time 0 index value: (10 + 50 + 140)/3 = 200/3 = 66.7

$300 you get 30 shares each of $10

• Why do the two differ (value weighted vs equal weighted)?

• Case 1: 20% change in price of small-cap firm

• Why do the two differ?

Source: www.cboe.com, September 17, 2014,

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