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Chapter 02 - Asset Classes and Financial Instruments
CHAPTER TWO
ASSET CLASSES AND FINANCIAL INSTRUMENTS
CHAPTER OVERVIEW
One of the early investment decisions that must be made in building a portfolio is asset allocation.
principal risk. After covering money markets, the chapter discusses the major capital market
instruments. The capital market discussion is divided into three parts, long-term debt, equity and
derivatives. The construction and purpose of indexes is also covered in the capital markets
section.
LEARNING OBJECTIVES
have a basic understanding of options and futures contracts.
CHAPTER OUTLINE
PPT 2-2
The major classes of financial assets or securities are presented in PPT slide 2. This material can
be used to discuss the chapter outline and the purposes of these markets. Instruments may be
1. Money Market Instruments
PPT 2-3 through PPT 2-12
The major money market instruments that are discussed in the text are presented in PPT 2-3
through PPT 2-7. Treasury bills, certificates of deposit (CDs) and commercial paper are covered
in the most detail. The issuer, typical or maximum maturity, denomination, liquidity, default risk,
amounts of the different security types and spreads between CDs and T-bills. Notice the big run
up in spreads during the recent crisis. Make sure students understand the meaning of credit
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Chapter 02 - Asset Classes and Financial Instruments
of declining growth rates, MMMF inflows accelerated rapidly as investors fled risky assets during
the crisis and sought safety in money funds. However, MMMFs had their own crisis in 2008 after
Lehman Brothers filed for bankruptcy on September 15 because some money funds had invested
heavily in Lehman commercial paper. On Sept. 16 a MMMF, the Reserve Primary Fund, “broke
the buck.” What does this mean? MMMF shares normally have a value of $1.00 plus any accrued
Money Market Yields:
PPT 2-13 through PPT 2-18
Money market yield sample calculations are presented and illustrated in this set of slides. The
bank discount rate rBD is compared to the bond equivalent yield rBEY and the effective annual yield
rEAY.
n
360
rPar
PricePar
BD
n
365
rPrice
PricePar
BEY
; n = maturity in days
The rEAY = holding period return as a percent of price but is annualized with compounding using a
Chapter 02 - Asset Classes and Financial Instruments
Fixed-income securities have a defined stream of payments or coupons. Treasury notes have a
maturity up to and including 10 years; bonds mature beyond 10 years. The minimum
denomination is $100, but most have a $1,000 denomination, although many Treasuries are now
packaged and sold in multiples of $1,000. Treasury bonds pay interest semiannually with principal
repaid at maturity (non-amortizing). Most are callable after an initial call-protection period.
The major example is housing, although farm lending and small business loans are other good
examples. However, the major agencies are home-mortgage related, and include the Federal
National Mortgage Association (FNMA or Fannie Mae); the Federal Home Loan Mortgage
Corporation (FHLMC or Freddie Mac); the Government National Mortgage Association (GNMA
or Ginnie Mae); and the Federal Home Loan Banks. GNMA has always been a government
FNMA and FHLMC together finance or back about $5 trillion in home mortgages. This represents
about 50% of the U.S. market.
Municipal bonds are issued by state and local governments. Interest on municipal bonds is not
taxed at the federal level and is usually not subject to state and local taxes if the investor
purchases a bond issued by an entity in their state of residence. To compare corporate yields with
development bonds are municipal issues where the money is used for industrial development in the
local municipality. This may involve using the money to assist a specific business to encourage
that firm to locate a facility in the municipality.
Private Issues:
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such as a call feature which allows an existing corporation to repurchase the bond from issuers
when rates have fallen. Some bonds are convertible which allows the bond investor to convert the
bond to a set number of shares of common stock. Most bonds are rated by one or more of the
major ratings agencies approved by the federal government. The major agencies are Standard &
Poors, Moody’s and Fitch. The rating measures default risk. The higher the rating the lower the
Securities backed by mortgages have also grown to compose a major element of the overall bond
market. A pass-through security represents a proportional (pro-rata) share of a pool of mortgages.
The mortgage-backed market has grown rapidly in recent years as shown in Text Figure 2.6.
Originally only “conforming mortgages” were securitized and used to back mortgage securities.
Conforming mortgages met traditional creditworthiness standards such as a maximum 80% loan-
conforming and subprime in terms of credit risk. Most of the mortgages in the lower-quality
categories originated since 2006 have deteriorated in value. The term “underwater” means the
homeowners owe more than the market value of their home, creating an incentive to default.
Foreclosures depress local home prices, and add to the credit problems of banks and thrifts that
supply mortgage credit, hence the government’s efforts to limit the number of foreclosures.
3. Equity Securities
PPT 2-29 through PPT 2-32
Several key points are relevant in the discussion of equity instruments. First, common stock
owners have a residual claim on the earnings (dividends) of the firm. Debt holders and preferred
stockholders have priority over common stockholders in the event of distress or bankruptcy.
directors were reelected even though many shareholders were very vocal in their disapproval of
Citicorp’s performance (Citicorp had abysmal performance in 2008 and had to be bailed out by
the government; most shareholder value was destroyed). Michael Jacobs, a former Treasury
official, wrote in The Wall Street Journal that Citicorp had few directors with experience in the
financial markets and GE had only one director with experience in a financial institution even
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Preferred shareholders have a priority claim to income in the form of dividends. Ordinary
preferred stockholders are limited to the fixed dividend while common shareholders do not have
limits. The partial tax exemption on dividends of one corporation being received by another
corporation is important in discussing preferred stock. Preferred and common dividends are not
tax deductible to the issuing firm. Corporations are given a tax exemption on 70% of preferred
o Capital gain yield: = (Psell – Pbuy)/ Pbuy or ($54 - $50) / $50 = 8%
o Total return: = Dividend yield + Capital gain yield
2% + 8% = 10%
4. Stock and Bond Market Indexes
PPT 2-33 through PPT 2-44
Stock indexes are used to track average returns, compare investment managers’ performance to
an index and as a base for derivative instruments. Key factors to consider in constructing an index
include a) what the index is supposed to measure, b) whether a representative sample of firms can
be used to assess the performance of a manager that invests in Small-Cap firms, the DJIA would
not be as appropriate a benchmark as the NASDAQ Composite.
1 “How Business Schools Have Failed Business: Why Not More Education on the Responsibility of Boards?” by
Michael Jacobs, The Wall Street Journal Online, April 24, 2009.
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index (there is no theoretical reason for this) and stock splits arbitrarily reduce that weight. The
other choices are market-value weighted (most common) and equal-value weighted. Which of
these two is better depends on your objectives. In a value-weighted index the amount invested in
each stock in the index is proportional to the market value of the firm. The market value of the
firm is the weight for each stock. Changes in the value of larger firms affect the index more than
not as commonly used in many published indexes, the equal-weighted method is commonly used
in research. This method is important in describing results of empirical examinations on market
efficiency discussed in later chapters. Also if an investor actually does put equal dollar amounts
into various stocks then an equal-weighted index is probably the better benchmark. The PPT
slides contain sample calculations of price-weighted, value-weighted and equal-weighted indexes
Chapter 02 - Asset Classes and Financial Instruments
5. Derivative Securities
PPT 2-43 through PPT 2-51
Listed call options are explained and illustrated on slides 43 through 47. Calls and puts are
defined and Text Figure 2.9 is used to illustrate option quotes and very basic option positions. The
