Chapter

Asset Classes and

2 Financial Instruments

Bodie, Kane, and Marcus

Essentials of Investments
Tenth Edition
 2.1 Asset Classes

Common Stock

Asset
Classes

Fixed Income
Securities
Derivative Securities • Money Market
• Bond Market
• Preferred Stock

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 2.1 The Money Market: Instruments

• Treasury Bills • Repos and

• Certificates of Reverses
Deposit • Brokers’ Funds
• Commercial Paper • Federal Funds
• Bankers’ • LIBOR (London
Acceptances Interbank Offer
• Eurodollars Rate)

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 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
Interest Type: Discount
Taxation: Owed: Federal; Exempt: State, Local

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 2.1 The Money Market: Certificates of Deposit (CDs)

Certificates of Deposit
Issuer: Depository Institutions
Denomination: Any, $100,000 or more marketable
Maturity: Varies, Typically 14-day Minimum
Liquidity: High for CDs <3 months, if marketable
Default Risk: First $250,000 FDIC insured
Interest Type: Add on
Taxation: Owed: Federal, State, Local

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 Figure 2.2 Spreads on CDs and Treasury Bills
5.0
OPEC I

4.5

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

1980

1982

1984

1986

1990

1994

1996

2000

2006

2010

2014
1978

1988

1992

1998

2002

2004

2008

2012
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 2.1 The Money Market: Commercial Paper

Certificates of Deposit
Issuer: Large creditworthy corps.; financial institutions
Denomination: Minimum $100,000
Maturity: Maximum 270 days, usually 1-2 months
Liquidity: CP < 3 months liquid if marketable
Default Risk: Unsecured, rated, mostly high quality
Interest Type: Discount
Taxation: Owed: Federal, State, Local

• New Innovation: Asset-backed commercial paper

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 2.1 The Money Market
• Bankers’ Acceptances
• 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 ( and marketable)

• Eurodollars
• Dollar-denominated time deposits held outside U.S.
• Pay higher interest rate than U.S. deposits

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 2.1 The Money Market
• Federal Funds
• Trading in reserves held at the Federal Reserve *
• Key interest rate for economy

• LIBOR (London Interbank Offer Rate)

• Rate at which large banks in London (and
elsewhere) lend to each other
• Base rate for many loans and derivatives

* Depository institutions must maintain deposits with Federal Reserve Bank

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 2.1 The Money Market: Repurchase Agreements
• Repurchase Agreements (RPs)
• Short-term sales of securities with promise to
repurchase at higher price
• RP is a collateralized loan
• Many RPs are overnight; “Term” RPs may have a 1-
month maturity

• Reverse RPs
• Lending money; obtaining security title as collateral
• “Haircuts” may be required depending on collateral
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 2.1 The Money Market
• Brokers’ Calls
• Call money rate applies for investors buying
stock on margin
• Loan may be “called in” by broker

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 2.1 The Money Market: Credit Crisis
• MMMF and the Credit Crisis of 2008
• 2005-2008: Money market mutual funds
(MMMFs) grew 88%
• MMMFs had their own crisis in 2008: Lehman
Brothers
• Reserve Primary Fund “broke the buck”
• Run on money market funds ensued
• U.S. Treasury temporarily offered to insure all
money funds

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 2.1 The Money Market: Instrument Yields
• Yields on money market instruments not always
directly comparable

• Factors influencing “quoted” yields

• Par value vs. investment value
• 360 vs. 365 days assumed in a year (366 leap
year)
• Simple vs. compound interest

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 Figure 2.1 Treasury Bills (T-Bills)

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

Source: The Wall Street Journal Online, September 14, 2014.

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 2.1 The Money Market
• 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
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 2.1 The Money Market
• Bond Equivalent Yield
• Can’t compare T-bill directly to bond
• 360 vs. 365 days
• Return is figured in par vs. price paid
• Adjust bank discount rate to make it
comparable

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 2.1 The Money Market: Bond Equivalent Yield

• Bond Equivalent Yield

P = price of the T-bill rBD = 5%
n = number of days to maturity

10,000 − P 365
r = ×
BEY P n

• Example Using Sample T-Bill

r = 10,000 − 9,875 365

×
BEY 90
9,875

rBEY = .0127 × 4.0556 = .0513 = 5.13%

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 2.1 The Money Market: Effective Annual Yield

• Effective Annual Yield

365 Compare:
 $10,000  P  n
rBD = 5%
rEAY = 1   1
 P  rBEY = 5.13%
P = price of the T-bill rEAY = 5.23%
n = number of days to maturity

• Example Using Sample T-Bill

365
 $10,000  $9,875  90
rEAY = 1   1
 $9,875 
rEAY = 5.23%
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 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
Federal Funds Bond Equivalent Yield
Repurchase Agreements Discount
Reverse RPs Discount

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 2.2 The Bond Market
• Capital Market—Fixed-Income Instruments

•Government Issues—U.S. Treasury Bonds and Notes

• Bonds vs. notes
• Denomination
• Interest type
• Risk? Taxation?

• Treasury Inflation Protected Securities (TIPS)

• Principal adjusted for changes in the Consumer Price Index
• Marked with a trailing “i” in quote sheets

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 Figure 2.3 Listing of Treasury Issues

          ASKED YLD
MATURITY COUPON BID ASKED CHG TO MATURITY
15-Feb-2015 4.000 101.6250 101.6328 -0.0078 0.046
15-May-2017 4.500 109.3516 109.3750 0.0234 0.927
15-Feb-2020 3.625 108.8906 108.9375 0.0938 1.880
15-Feb-2025 7.625 146.1719 146.2500 0.2031 2.541
15-May-2030 6.250 141.3125 141.3906 0.2734 2.934
15-Feb-2036 4.500 121.3359 121.4141 0.2578 3.121
15-Aug-2044 3.125 95.9297 95.9922 0.1875 3.338

Source: Compiled from data from The Wall Street Journal Online, September 16, 2014.

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 2.2 The Bond Market: Agency Issues
• Agency issues (federal government)
• Most are home-mortgage-related: FNMA,
FHLMC, GNMA, Federal Home Loan Banks
• Risks of these securities?
• Implied backing by the government
• In September 2008, federal government took over
FNMA and FHLMC

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 2.2 The Bond Market: Municipal Bonds
• Municipal bonds
• Issuer?
• Differ from treasuries and agencies?
• Risk?
• G.O. vs. revenue
• Industrial development
• Taxation?
rtax exempt = rtaxable x (1 – Tax rate)
r = Interest rate

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 Table 2.2 Equivalent Taxable Yields

Tax-Exempt Yield
Marginal Tax Rate 1% 2% 3% 4% 5%
20% 1.25% 2.50% 3.75% 5.00% 6.25%
30 1.43 2.86 4.29 5.71 7.14
40 1.67 3.33 5.00 6.67 8.33
50 2.00 4.00 6.00 8.00 10.00

rtax exempt = rtaxable x (1 – Tax rate)

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 Figure 2.4 Outstanding Tax-Exempt Debt

3,000

2,500

2,000

1,500
$ billion

1,000

500

0
2005

2006

2007

2008

2009

2010

2011

2012

2013

2014
Industrial revenue bonds General obligation

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Figure 2.5 Yield Ratio: Tax-Exempt to Taxable Bonds
1.0

0.9

0.8
Ratio

0.7

0.6

0.5
1956

1959

1965

1968

1977

1980

1989

1992

2001

2004

2013

2016
1953

1962

1971

1974

1983

1986

1995

1998

2007

2010
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 2.2 The Bond Market: Private Issue
• Corporate Bonds
• Investment grade vs. speculative grade

• Mortgage-Backed Securities
• Backed by pool of mortgages with “pass-through” of monthly
payments; covers defaults
• Collateral
• Traditionally all mortgages conform, since 2006 Alt-A and subprime
mortgages are included in pools
• Private banks purchased and sold pools of subprime mortgages
• Issuers assumed housing prices would continue to rise

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Figure 2.6 Mortgage-Backed Securities Outstanding
9,000

8,000

7,000 Private issuers

Federal agencies
6,000

5,000
$ billion

4,000

3,000

2,000

1,000

0
1979

1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998

2000
2001

2003
2004

2006
2007

2009
2010

2013
1980

1999

2002

2005

2008

2011
2012

2014
2015
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 Figure 2.9 The U.S. Fixed-Income Market

Values in $ billion

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 2.3 Equity Securities
• Capital Market-Equity
• Common stock
• Residual claim
• Limited liability
• Preferred stock
• Fixed dividends: Limited gains, nonvoting
• Priority over common
• Tax treatment: Preferred/common dividends not
tax-deductible to issuing firm; corporate tax
exclusions on 70% of dividends earned
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 2.3 Equity Securities
• Capital Market-Equity
• Depository receipts
• American Depositary Receipts (ADRs), also
called American Depositary Shares (ADSs)
• Certificates traded in the U.S. representing
ownership in foreign security

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 2.3 Equity Securities
• Capital Market-Equity
• Capital gains and dividend yields
• Buy a share of stock for $50, hold for 1 year, collect
$1 dividend, and sell stock for $54
• What were dividend yield, capital gain yield, and total
return? (Ignore taxes)
• Dividend yield = Dividend / Pbuy = $1/$50 = 2%

• Capital gain yield = (Psell – Pbuy) / Pbuy = ($54 –

$50)/$50 = 8%
• Total return = Dividend yield + Capital gain yield = 2%
+ 8% = 10%
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 2.4 Stock and Bond Market Indexes
• Uses
• Track average returns
• Compare performance of managers
• Base of derivatives

• Factors in constructing/using index

• Representative?
• Broad/narrow?
• How is it constructed?

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 2.4 Stock and Bond Market Indexes
• Construction of Indexes
• How are stocks weighted?
• Price weighted (DJIA)
• Market value weighted (S&P 500, NASDAQ)
• Equally weighted (Value Line Index)
• How much money do you put in each stock in
the index?

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 2.4 Stock and Bond Market Indexes
• 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

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 2.4 Stock and Bond Market Indexes
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
• 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

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 2.4 Stock and Bond Market Indexes
Stock PriceB QuantityB P1 Q1
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)
• Equal-Weighted Series
• wlog invest $300 in each
(15  30)  (25 12)  (150  2.143)
IndexE = 100  119.05
(10  30)  (50  6)  (140  2.143)

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 2.4 Stock and Bond Market Indexes
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?

• 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)
• wlog invest $100 in each stock
(12 10)  (100 1)  (50  2)
IndexE = 100  106.67
(10  10)  (100 1)  (50  2)

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 2.4 Stock and Bond Market Indexes
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)

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 2.4 Stock and Bond Market Indexes
• Examples of Indexes—Domestic
• Dow Jones Industrial Average (30 stocks)
• Standard & Poor’s 500 Composite
• NASDAQ Composite (>3,000 firms)
• Wilshire 5000 (>6,000 stocks)

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 2.5 Derivative Markets
• Derivative Asset/Contingent Claim
• Security with payoff that depends on the price
of other securities
• Listed Call Option
• Right to buy an asset at a specified price on or
before a specified expiration date
• Listed Put Option
• Right to sell an asset at a specified exercise
price on or before a specified expiration date

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 Figure 2.10 Stock Options on Apple

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

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 2.5 Derivative Markets
• 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?

• Stock price was equal to $101.05; the resulting loss is

$0.30 ($101.35 - $95.00 - $6.35). The contract will make
money if the stock price increases above $101.35
( allowing the stock price to rise enough to cover the
cost of the option).
• When should you write it?
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 2.5 Derivative Markets
• 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?

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 2.5 Derivative Markets
• 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?

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 2.5 Derivative Markets
• Futures Contracts
• Purchaser (long) buys specified quantity at
contract expiration for set price
• Contract seller (short) delivers underlying
commodity at contract expiration for agreed-
upon price
• Futures: Future commitment to buy/sell at
preset price
• Options: Holder has future right to buy/sell

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 Figure 2.11 Futures Contracts
• Corn futures prices in The Wall Street
Journal Online, September 17, 2014

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 2.5 Derivative Markets
• Corn futures prices in the Chicago Board of
Trade, September 17, 2014
• Contract size: 5,000 bushels of corn
• Price quote for Dec. 15 contract: 388’2 translates to a
price of $3.88 + 2/8 cent per bushel, or $3.88
• If you bought the Dec. 15 contract, what are you
agreeing to do?
• Purchase 5,000 bushels of corn in December for
5,000 × $3.88 = $19,412.50
• What is your obligation if you sell the Dec. 15 contract?

• How does this contract differ from an option?

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 2.5 Derivative Markets
Derivatives Securities
• Options • Futures
• Basic Positions • Basic Positions
• Call (Buy/Sell?) • Long (Buy/Sell?)
• Put (Buy/Sell?) • Short (Buy/Sell?)
• Terms • Terms
• Exercise price • Delivery date
• Expiration date • Deliverable item

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