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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. This chapter introduces some of the major features of different asset classes and
some of the instruments within each asset class. The chapter first covers money market
securities. Money markets are the markets for securities with an original issue maturity of one
year or less. These securities are typically marketable, liquid, low-risk debt securities. These
LEARNING OBJECTIVES
Upon completion of this chapter the student should have an understanding of the various
financial instruments available to the potential investor. Readers should understand the
differences between discount yields and bond-equivalent yields and some money-market-rate-
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
classified by whether they represent money market instruments, which are primarily used for
savings, or capital market instruments. Savings may be defined as short-term investments that
1. Money Market Instruments
PPT 2-3 through PPT 2-11
The major money market instruments that are discussed in the text are presented in PPT 2-4
through PPT 2-11. 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, interest type and tax status are presented for these instruments. The majority of
undergraduate students will have very little knowledge of the workings of these investments and
this is very useful information for them. Generally less detail is provided for bankers’
Money Market Mutual Funds (MMMF) and the Credit Crisis of 2008:
PPT 2-12 shows that between 2005 and 2008 money market mutual funds (MMMFs) grew by
88%. Why? After years 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
Money Market Yields:
PPT 2-13 through PPT 2-19
Chapter 02 - Asset Classes and Financial Instruments
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.
2. The Bond Market
PPT 2-20 through PPT 2-29
Chapter 02 - Asset Classes and Financial Instruments
Debt instruments are issued by both government (sometimes called public) and by private
entities. The Treasury and Agency issues have the direct or implied guarantee of the federal
government. As state and local entities issue municipal bonds, performance on these bonds does
Agency issues have either explicit or implicit backing by the Federal Government and their
securities normally carry an interest rate only a few basis points over a comparable-maturity
Treasury instrument. Federal agencies have different charters but are generally charged with
assisting socially deserving sectors of the economy in obtaining credit. The major example is
housing, although farm lending and small business loans are other good examples. However, the
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 municipal yields you must calculate the taxable equivalent yield. The conversion formula
Chapter 02 - Asset Classes and Financial Instruments
Private Issues:
Private issues include corporate debt and equity issues and asset-backed securities, including
mortgage- backed securities. Bonds issued by private corporations are subject to greater default
risk than bonds issued by government entities. Corporate bonds often contain imbedded options
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 &
The mortgage market is now larger than the corporate bond market. 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-to-value
ratio; maximum debt-to-income ratio of around 30%; and a quality-credit score. Until about
2006, Fannie and Freddie only underwrote or guaranteed conforming mortgages. Under political
3. Equity Securities
PPT 2-30 through PPT 2-33
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.
Stockholders do have limited liability and a shareholder cannot lose more than their initial
investment. Common stockholders typically have the right to vote on the board of directors and
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
Capital gains and dividend yields
You buy a share of stock for $50, hold it for one year, collect a $1.00 dividend and sell the stock
for $54. What were your dividend yield, capital gain yield and total return? (Ignore taxes)
4. Stock and Bond Market Indexes
PPT 2-33 through PPT 2-40
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 or whether all firms must be included, c) how the index should be constructed.
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
changes in the value of the stock of a firm with smaller market capitalization. Value-weighted
5. Derivative Securities
PPT 2-41 through PPT 2-49
Listed call options are explained and illustrated on slides 41 through 49. Calls and puts are
defined and Text Figure 2.10 is used to illustrate option quotes and very basic option positions.
