Overview of Major Classes in Financial Markets & Instruments - Prof. Alexei Boulatov, Papers of Finance

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Financial Markets and Instruments Class 2 Major Classes of Financial Assets or Securities • Debt – Money market instruments - short term, low risk • (Cash equivalent, or Cash) – Capital market - longer term, high/low risk • Equity (stocks) • Derivative securities Auction for Treasury Securities I Treasury bills (T-bills, bills) • Sales: Auction • Competitive bid: An order for the specific quantity at a specific price – the bid should be high enough to be accepted – “Winner’s curse” (overbidding); loosing (low bid) • Noncompetitive bid: Buy at average price of competitive bids (unconditional) Auction for Treasury Securities II ¢ T-Bills: Bid Submission Submit bids through one of about 50 “primary dealers” — these are the dealers the Federal Reserve trades with when implementing their open market operations — they attend the Treasury auctions and submit orders for their clients — before 1991, nonprimary dealers were not allowed to submit orders for their clients — after Salomon scandal (see below), some qualified bro- ker dealers are now allowed to submit orders — cannot bid for more than 35% of available offering Money Market Instruments III • Certificates of deposit: Time deposit with a bank (is not withdrawn before fixed term) – Large (larger than $100,000) • negotiable (can be sold to other investor) – Short-term (less than 3 months) - marketable (liquid) • Commercial Paper – short-term debt issued by large corporations • Bankers Acceptances (traded in secondary mkts) – An (accepted) order to a bank to pay at future date Treasury Notes and Bonds • Maturities: – T-notes: one to ten years – T-bonds: ten to thirty years • Both pay: – semiannual interest (coupon) – face value (normally, $1,000) at maturity • Low risk (essentially, interest rate) • Major distinction: – T-bonds may be callable (during last 5 years of life): Treasury may buy at par (face value) - are no longer issued Federal Agency Debt • Government agencies issue their own securities • Mortgage-related agencies: – Federal National Mortgage Association (FNMA, Fannie May) – Federal Home Loan Mortgage Corporation (FHLMC, Freddie Mac), etc. • Provide liquidity to mortgage market • Low risk (Government is expected to prevent the default) International Bonds • Eurobond: – Bond denominated in a currency other than the country it is issued • Example: Dollar-denominated Bond issued in France Eurodollar Bond Not to confuse with Euro (European currency) Q: Suppose, tax is 28% • What is better: 6% taxable return, or 4% tax-free? • What is Equivalent taxable yield to 4% tax-free? Answer: Equivalent r r = 4/(1-0.28) = 5.55% < 6% Therefore: taxable 6% is better than 4% txfree Corporate Bonds • Private firms borrow from investors – Similar structure of payments as T-Bonds (semiannual coupon + face value at maturity) – Major difference: Default risk may be large • May have options attached (Callable Bonds) • Current yield: (annual coupon income)/price Bonds: Cash Flow Structure I 1. Straight coupon bond (bullet bond) — fixed rate, semiannual coupon, principal paid only at terminal date (balloon payment) 2. Zero coupon or pure discount bond — no periodic payments, have a single payment at maturity 3. Deferred coupon bond — interest is deferred for a period, so that cash-constrained firms can fund other projects 4. Consol (perpetuity) bonds — bonds that pay only interest, last forever 5. Annuity bond — bonds that pay a mix of interest and principal for a finite amount of time Capital Market - Equity II • Preferred stock: has features of equity and debt – Fixed dividends, no voting power - like bond However: no contractural obligations to pay div. – Cumulative dividends: unpaid div. are paid before the common stock holders – Priority over common – Tax treatment: Payments are treated as dividends (rather than interest) - not tax-deductible However: corporation may exclude 70% of dividends • Track average returns • Comparing performance of managers • Base of derivatives • Bond market indexes - are also available Uses of Stock Indexes • Comprised: – 30 large companies • Measures: – Return (excluding dividends) on a portfolio that has one share of each stock • Price-weighted average – amount invested in each stock is proportional to stock price – higher-priced stocks have more weight Example: Dow Jones Industrial Average (DJIA) • Improves over DJIA – More broad (500 firms) – Value-weighted • In the above example: – ABC would have 5 times the weight of XYZ • Both PW and VW: – Reflect returns to well-defined portfolios Standard & Poor Composite (S&P 500) • Portfolio: – Equal dollar amount in each stock • Unlike PW or VW: – Do not correspond to buy-and-hold portfolio strategy (rebalancing is assumed) Equally Weighted (EW) Indexes Examples of Indexes - Domestic • NASDAQ Composite (4,000 OTC firms) NASDAQ: National Association of Securities Dealers Automatic Quotation • Wilshire 5000 (~7,000 stocks: NYSE, AMEX, NASDAQ)