Essentials of Investments

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Chapter 2

Financial Markets and Instruments

Essentials of Investments

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Major Classes of Financial Assets or Securities

• Debt– Money market instruments– Bonds

• Common stock

• Preferred stock

• Derivative securities

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Markets and Instruments

• Money Market– Debt Instruments– Derivatives

• Capital Market– Bonds– Equity– Derivatives

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Money Market Instruments

• Treasury bills

• Certificates of deposit

• Commercial Paper

• Bankers Acceptances

• Eurodollars

• Repurchase Agreements (RPs) and Reverse RPs

• Federal Funds

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Money Market Instrument Yields

• Yields on Money Market Instruments are not always directly comparable

Factors influencing yields

• Par value vs. investment value

• 360 vs. 365 days assumed in a year (366 leap year)

• Bond equivalent yield

Essentials of Investments

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Bank Discount Rate (T-Bills)

rrBDBD = bank discount rate= bank discount rate

PP = market price of the T-bill= market price of the T-bill

nn = number of days to maturity= number of days to maturity

rrBDBD == 10,00010,000 -- PP10,00010,000

xx 360360nn

90-day T-bill, P = $9,87590-day T-bill, P = $9,875

rrBDBD == 10,00010,000 -- 9,8759,875

10,00010,000 x x

360360

9090== 5%5%

ExampleExample

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Bond Equivalent Yield

• Can’t compare T-bill directly to bond– 360 vs 365 days – Return is figured on par vs. price paid

• Adjust the bank discounted rate to make it comparable

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Bond Equivalent Yield

P = price of the T-billP = price of the T-bill

n = number of days to maturityn = number of days to maturity

rr BEYBEY == 10,00010,000 -- PP

PP xx 365365

nn

rrBEYBEY == 10,00010,000 -- 9,8759,875

9,8759,875 x x 365365

9090rrBEYBEY = .0127 x 4.0556 = .0513 = 5.13% = .0127 x 4.0556 = .0513 = 5.13%

Example Using Sample T-BillExample Using Sample T-Bill

Essentials of Investments

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Capital Market - Fixed Income Instruments

Publicly Issued Instruments

• US Treasury Bonds and Notes

• Agency Issues (Fed Gov)

• Municipal Bonds

Privately Issued Instruments

• Corporate Bonds

• Mortgage-Backed Securities

Essentials of Investments

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Capital Market - Equity

• Common stock– Residual claim– Limited liability

• Preferred stock– Fixed dividends - limited– Priority over common– Tax treatment

Essentials of Investments

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Uses

• Track average returns

• Comparing performance of managers

• Base of derivatives

Factors in constructing or using an Index

• Representative?

• Broad or narrow?

• How is it constructed?

Stock Indexes

Essentials of Investments

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Examples of Indexes - Domestic

• Dow Jones Industrial Average (30 Stocks)

• Standard & Poor’s 500 Composite

• NASDAQ Composite

• NYSE Composite

• Wilshire 5000

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Examples of Indexes - Int’l

• Nikkei 225 & Nikkei 300

• FTSE (Financial Times of London)

• Dax

• Region and Country Indexes– EAFE– Far East– United Kingdom

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Construction of Indexes

• How are stocks weighted?– Price weighted (DJIA)– Market-value weighted (S&P500,

NASDAQ)– Equally weighted (Value Line Index)

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Derivatives Securities

Options• Basic Positions

– Call (Buy)– Put (Sell)

• Terms– Exercise Price– Expiration Date– Assets

Futures • Basic Positions

– Long (Buy)– Short (Sell)

• Terms– Delivery Date– Assets