Asset Classes and Financial Instruments

2.1 The Money Market

1) Money Market

Money Market: The market for short-term, highly liquid, and relatively low-risk debt instruments.

Money market instruments are often treated as cash equivalents.

Liquidity: The ability to convert an asset into cash quickly with little loss of value.

2) Money Market Instruments

Treasury Bill (T-bill): A short-term government security issued at a discount from its face value.

The investor receives the face value at maturity. The difference between the face value and purchase price is the investment return.

Certificate of Deposit (CD): A bank time deposit that pays interest and returns the principal at maturity.

Commercial Paper: An unsecured short-term debt instrument issued by a large corporation.

Bankers’ Acceptance: A bank-guaranteed order to pay a specified amount at a future date.

It is commonly used to finance international trade.

Eurodollar: A U.S. dollar deposit held in a bank outside the United States.

Repurchase Agreement (Repo): A short-term loan in which securities are sold with an agreement to repurchase them later at a higher price.

Federal Funds: Short-term loans of reserves between financial institutions.

3) Money Market Prices

Face Value: The amount paid to the security holder at maturity.

Discount Security: A security sold below its face value.

For a discount security,

$$\text{Return}=\text{Face Value}-\text{Purchase Price}.$$

The investor earns a return from the difference between the purchase price and face value.

Bid Price: The price a dealer is willing to pay for a security.

Asked Price: The price at which a dealer is willing to sell a security.

Bid-Asked Spread: The difference between the asked price and bid price.

$$\text{Bid-Asked Spread} = \text{Asked Price}-\text{Bid Price}.$$

The bid-asked spread represents compensation to the dealer.

Price-Yield Relationship: The price and yield of a fixed-income security move in opposite directions.

When the price rises, the yield falls. When the price falls, the yield rises.

2.2 The Bond Market

1) Bonds

Bond: A long-term debt instrument requiring the issuer to make promised payments to investors.

Par Value: The principal amount repaid when a bond matures.

Coupon Payment: A periodic interest payment made to a bondholder.

Coupon Rate: The annual coupon payment expressed as a proportion of par value.

$$\text{Coupon Rate} = \frac{\text{Annual Coupon Payment}}{\text{Par Value}}.$$

Annual Coupon Payment: The annual interest paid by a bond.

$$\text{Annual Coupon Payment} = \text{Coupon Rate}\times\text{Par Value}.$$

Maturity: The date on which the bond issuer must repay the principal.

Yield to Maturity: The annualized return earned when a bond is purchased at its current price and held until maturity.

It accounts for coupon payments and the difference between the purchase price and par value.

2) Government Bonds

Treasury Note: A government debt security with an original maturity of more than one year and up to 10 years.

Treasury Bond: A government debt security with an original maturity between 10 and 30 years.

Treasury Inflation-Protected Security (TIPS): A Treasury security whose principal changes with the Consumer Price Index.

TIPS protect investors from inflation by preserving the real value of principal and interest.

Federal Agency Debt: Debt issued by a government-related agency to finance a particular economic sector.

3) Municipal and Corporate Bonds

Municipal Bond: A bond issued by a state or local government.

Interest income from municipal bonds is generally exempt from federal income tax.

After-Tax Return: The portion of a taxable return remaining after income tax.

Let $r$ be the taxable return and $t$ be the investor’s tax rate.

$$r_{\mathrm{after-tax}}=r(1-t).$$

Equivalent Taxable Yield: The taxable return required to equal the return of a tax-exempt municipal bond.

Let $r_m$ be the municipal-bond yield and $t$ be the investor’s tax rate.

$$r_{\mathrm{equivalent}} = \frac{r_m}{1-t}.$$

Cutoff Tax Rate: The tax rate at which an investor is indifferent between a taxable bond and a tax-exempt municipal bond.

Let $r_m$ be the municipal-bond yield and $r_t$ be the taxable-bond yield.

$$t^{*} = 1-\frac{r_m}{r_t}.$$

Corporate Bond: A debt security issued by a corporation.

Corporate bonds generally provide higher yields than Treasury securities because they carry default risk.

Default Risk: The risk that an issuer will fail to make promised interest or principal payments.

4) Mortgage-Backed Securities

Mortgage-Backed Security (MBS): A security representing a claim on the cash flows from a pool of mortgage loans.

Mortgage Pass-Through Security: A mortgage-backed security that passes borrowers’ principal and interest payments to investors.

Private-Label Mortgage Security: A mortgage-backed security issued by a private institution without a government-agency guarantee.

2.3 Equity Securities

1) Common Stock

Common Stock: A security representing ownership in a corporation.

Common shareholders generally have voting rights and may receive dividends.

Dividend: A distribution of corporate earnings to shareholders.

Residual Claim: The right of common shareholders to receive the income and assets remaining after all other claims have been paid.

Limited Liability: The principle that shareholders cannot lose more than the amount they invested.

Proxy: Authorization allowing another party to vote on behalf of a shareholder.

2) Preferred Stock

Preferred Stock: An equity security that usually pays a fixed dividend and has priority over common stock.

Cumulative Dividend: An unpaid preferred dividend that accumulates and must be paid before common-stock dividends.

Perpetuity: A stream of payments that continues indefinitely.

Preferred Stock versus Bond: Bond interest is a contractual obligation, while preferred-stock dividends may be omitted without immediately causing bankruptcy.

3) Depositary Receipts

American Depositary Receipt (ADR): A certificate traded in the United States that represents ownership of shares in a foreign company.

2.4 Stock and Bond Market Indexes

1) Market Index

Market Index: A measure used to track the performance of a selected group of securities.

Indexes serve as market indicators and portfolio-performance benchmarks.

Benchmark: A standard against which the performance of an investment portfolio is evaluated.

2) Price-Weighted Index

Price-Weighted Index: An index in which each stock’s influence is proportional to its share price.

For an index containing $n$ stocks,

$$I = \frac{P_1+\cdots+P_n}{d},$$

where $P_k$ is the price of stock $k$ and $d$ is the index divisor.

A high-priced stock has more influence than a low-priced stock.

Dow Jones Industrial Average (DJIA): A price-weighted index composed of 30 major U.S. companies.

3) Market Value-Weighted Index

Market Capitalization: The total market value of a company’s outstanding shares.

Let $P$ be the share price and $N$ be the number of outstanding shares.

$$\text{Market Capitalization}=P\times N.$$

Market Value-Weighted Index: An index in which each company’s influence is proportional to its market capitalization.

For $n$ companies, the weight of company $i$ is

$$w_i = \frac{P_iN_i} {P_1N_1+\cdots+P_nN_n}.$$

Large companies have more influence on a market value-weighted index.

S&P 500: A market value-weighted index of 500 major U.S. companies.

4) Equally Weighted Index

Equally Weighted Index: An index that gives the same weight to the return of every included security.

If the index contains $n$ securities, the return is

$$r_{\mathrm{index}} = \frac{r_1+\cdots+r_n}{n}.$$

Each company has equal influence regardless of its share price or market capitalization.

5) Index Comparison

Price-Weighted Index: Weighted by each stock’s share price.

Market Value-Weighted Index: Weighted by each company’s market capitalization.

Equally Weighted Index: Gives the same weight to every security’s return.

2.5 Derivative Markets

1) Derivative Assets

Derivative Asset: A financial asset whose payoff depends on the value of an underlying asset.

Stocks, bonds, commodities, interest rates, and market indexes may serve as underlying assets.

Underlying Asset: The asset or variable from which a derivative obtains its value.

2) Options

Option: A contract giving its holder a right, but not an obligation, to trade an asset at a specified price.

Call Option: The right to buy an asset at a specified exercise price on or before the expiration date.

A call option becomes more valuable as the underlying asset price rises.

Put Option: The right to sell an asset at a specified exercise price on or before the expiration date.

A put option becomes more valuable as the underlying asset price falls.

Exercise Price: The price at which the option holder may buy or sell the underlying asset.

Expiration Date: The final date on which an option may be exercised.

Option Premium: The price paid to purchase an option.

3) Call Option Payoff and Profit

Let $S_T$ be the underlying asset price at expiration, $X$ be the exercise price, and $C_0$ be the call-option premium.

Call Option Payoff:

$$C_T = \max(S_T-X,0).$$

The call is exercised only when the underlying asset price exceeds the exercise price.

Call Option Profit:

$$\Pi_{\mathrm{call}} = \max(S_T-X,0)-C_0.$$

The option premium must be subtracted when calculating profit.

Call Option Break-Even Price:

$$S_T=X+C_0.$$

The call buyer earns a positive profit when the asset price exceeds the exercise price plus the premium.

4) Put Option Payoff and Profit

Let $S_T$ be the underlying asset price at expiration, $X$ be the exercise price, and $P_0$ be the put-option premium.

Put Option Payoff:

$$P_T = \max(X-S_T,0).$$

The put is exercised only when the exercise price exceeds the underlying asset price.

Put Option Profit:

$$\Pi_{\mathrm{put}} = \max(X-S_T,0)-P_0.$$

The option premium must be subtracted when calculating profit.

Put Option Break-Even Price:

$$S_T=X-P_0.$$

The put buyer earns a positive profit when the asset price falls below the exercise price minus the premium.

5) Futures Contracts

Futures Contract: A contract obligating two parties to trade an asset at an agreed price on a specified future date.

Futures Price: The price agreed upon when a futures contract is entered.

Long Position: The obligation to purchase the underlying asset at maturity.

The long position gains when the asset price rises.

Short Position: The obligation to sell or deliver the underlying asset at maturity.

The short position gains when the asset price falls.

6) Futures Profit

Let $S_T$ be the asset price at maturity, $F_0$ be the agreed futures price, and $Q$ be the contract quantity.

Long Position Profit:

$$\Pi_{\mathrm{long}} = Q(S_T-F_0).$$

Short Position Profit:

$$\Pi_{\mathrm{short}} = Q(F_0-S_T).$$

The long position’s gain is equal to the short position’s loss.

$$\Pi_{\mathrm{long}} = -\Pi_{\mathrm{short}}.$$

7) Options versus Futures

Option: Provides a right, does not require exercise, and requires payment of a premium.

Futures Contract: Creates an obligation to trade at maturity and generally has no initial purchase price.

Summary

• Money market instruments are short-term, liquid, and relatively low-risk debt securities.
• Treasury bills are issued below face value and pay face value at maturity.
• Bond prices and yields move in opposite directions.
• Bonds provide coupon payments and return principal at maturity.
• Treasury securities have low default risk, while corporate bonds generally offer higher yields in exchange for greater credit risk.
• Municipal-bond interest is generally tax-exempt, so taxable and tax-free returns must be compared on an after-tax basis.
• Mortgage-backed securities represent claims on payments from pools of mortgage loans.
• Common stock represents ownership, voting rights, limited liability, and a residual claim on corporate income.
• Preferred stock generally pays fixed dividends but does not create the same contractual payment obligation as debt.
• Price-weighted, market value-weighted, and equally weighted indexes assign different importance to their component securities.
• A call option benefits from an increase in the underlying asset price.
• A put option benefits from a decrease in the underlying asset price.
• Option profit equals the option payoff minus the premium.
• Options provide rights, whereas futures contracts impose obligations.
• A futures long position gains when the underlying asset price rises, while a short position gains when it falls.