Financial Securities

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Financial Securities

• Riccardo Colacito

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Major classes of Financial Securities
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Money Market
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Money Market common characteristics

• Short term
• Highly liquid
• Low risk

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Treasury Bills

• Sell at discount price
• Maturities 1-3-6 month
• Bid-Ask spread
• Bank discount method
• Bond equivalent yield
• Data _at_ St. Louis Fed

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Historical 3-Month T-bill
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Certificates of Deposit

• Time deposit with a bank
• May not be withdrawn on demand

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Figure 2.3 Spreads on CDs and Treasury Bills

• Spread is higher during economic crises

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Fed Fund rate

• Rate at which commercial banks borrow from
  Federal Reserve

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Money Market other

• Commercial paper
• Short term
• Unsecured debt notes
• Issued to public (rather than banks)
• Eurodollars
• Dollar denominated deposits at foreign banks
• Repos
• Sell securities today buy them back tomorrow
• LIBOR
• Lending rate among banks in London

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Bond Market
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Treasury Notes and Bonds

• Maturities
• Notes maturities up to 10 years
• Bonds maturities in excess of 10 years
• 30-year bond
• 2001 Treasury suspended sales
• 2006 Treasury resumed sales
• Par Value - 1,000
• Quotes percentage of par

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Figure 2.4 Treasury Notes, Bonds and Bills
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Term spread

• 10-year T-bond yield higher return almost always
• Inverted yield curve usually predicts recession
• Interesting article in the Journal of Econometics
  

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Municipal Bonds

• Issued by state and local governments
• Types
• General obligation bonds
• Revenue bonds
• Industrial revenue bonds
• Maturities range up to 30 years

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Figure 2.6 Outstanding Tax-exempt Debt
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Municipal Bond Yields

• Interest income on municipal bonds is not subject
  to federal and sometimes state and local tax
• To compare yields on taxable securities a Taxable
  Equivalent Yield is constructed

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Equivalent Taxable Yields

• Need to equate r(1-t)rm
• The higher rm/r, the lower the cutoff tax bracket.

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Figure 2.7 Ratio of Yields on Tax-exempts to
Taxables
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Corporate Bonds

• Issued by private firms
• Semi-annual interest payments
• Subject to larger default risk than government
  securities
• Options in corporate bonds
• Callable
• Convertible

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Figure 2.8 Corporate Bond Prices
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Mortgages and Mortgage-backed Securities

• Developed in the 1970s to help liquidity of
  financial institutions
• Proportional ownership of a pool or a specified
  obligation secured by a pool
• Market has experienced very high rates of growth

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Figure 2.9 Mortgage-backed Securities Outstanding
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Bond Market other

• Federal agency debt
• Government agencies that issue their own
  securities
• Intl bonds
• Eurobond bond denominated in a currency other
  than that of the country in which it is issued

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Stocks
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Equity Markets

• Common stock
• Residual claim
• Limited liability
• Preferred stock
• No voting power
• Fixed dividends
• Priority over common
• Tax treatment

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Figure 2.10 Listing of Stocks Traded on the NYSE
Online quotes http//finance.yahoo.com/
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Example of quote of Yahoo Finance

• E.g. Microsoft (MSFT)
• Can you find Hi-Lo, dividend yield, PE ratio,?

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Stocks
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Stock Indexes

• Uses of Stock Indexes
• Track average returns
• Comparing performance of managers
• Base of derivatives
• Factors for Construction of Indexes
• Representative?
• Broad or narrow?
• How is it weighted?

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Construction of Indexes

• How are stocks weighted?
• Price weighted (DJIA)
• Market-value weighted (SP500, NASDAQ)
• Equally weighted (Value Line Index)

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Price weighted average

• Initial Value (25 100)/2 62.5
• Final Value (30 90)/2 60
• Percentage change -2.5/62.5 -4

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Price weighted average (contd)

• An average computed by adding the prices of the
  stocks and dividing by a divisor.
• What happens if there is a split?
• The averaging procedure is adjusted (i.e. the
  divisor changes to leave the index unaffected)

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Price weighted average (splits)
50
50
45
45
2

• Initial Value (25 50)/d 62.5
  d1.2
• Final Value (30 45)/d 60
• Percentage change -2.5/62.5 -4

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Dow Jones (example of price weighted)

• 3M Co. (NYSE MMM) (conglomerates,
  "manufacturing")
• ALCOA Inc. (NYSE AA) (aluminum)
• Altria Group Inc. (NYSE MO) (tobacco, foods)
• American Express Co. (NYSE AXP) (credit
  services)
• American International Group Inc. (NYSE AIG)
  (property casualty insurance)
• ATT Inc. (NYSE T) (telecoms)
• Boeing Co. (NYSE BA) (aerospace/defense)
• Caterpillar Inc. (NYSE CAT) (farm construction
  equipment)
• Citigroup Inc. (NYSE C) (money center banks)
• Coca-Cola Co. (NYSE KO) (beverages)
• E.I. du Pont de Nemours Co. (NYSE DD)
  (chemicals)
• Exxon Mobil Corp. (NYSE XOM) (major integrated
  oil gas)
• General Electric Co. (NYSE GE) (conglomerates,
  media)
• General Motors Corp. (NYSE GM) (auto
  manufacturers)
• Hewlett-Packard Co. (NYSE HPQ) (diversified
  computer systems)
• Home Depot Inc. (NYSE HD) (home improvement
  stores)
• Honeywell International Inc. (NYSE HON)
  (conglomerates)
• Intel Corp. (NASDAQ INTC) (semiconductors)
• International Business Machines Corp. (NYSE IBM)
  (diversified computer systems)

Look this up on Yahoo Finance (DJI)
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A better weighting scheme?

• Price weighted weighting scheme is a little
  arbitrary
• Wouldnt it be better to give weights
  proportional to outstanding market value?
• Value weighted indexes

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Value weighted average

• Initial Value 500 100 600
• Final Value 600 90 690
• Percentage change 90/600 15

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Comparison of weighting schemes

• Price weighted -4
• Value weighted 15

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SP500 vs Dow Jones
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Equivalent portfolio strategies

• Price weighted index
• Invest an equal amount in ABC and XYZ
• Hold the portfolio for one period
• Value weighted index
• Invest in ABC and XYZ an amount that is
  proportional to their market capitalization
• Hold the portfolio for one period

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Equally weighted return

• Return on ABC 5/25 20
• Return on XYZ -10/100 -10
• Average return (20-10)/2 5

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Examples of Indexes - Intl

• Nikkei 225 Nikkei 300
• FTSE (Financial Times of London)
• Dax
• Region and Country Indexes
• EAFE
• Far East
• United Kingdom

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Summary
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Options

• Call
• Right to buy an asset at a specified price on or
  before a specified expiration date
• Put
• Right to sell an asset at a specified price on or
  before a specified expiration date

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Example
Current Stock Price
Call Price
Exercise Price
88.64
3.82
85.00
88.82
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Summary
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Futures

• Deliver an asset at a specified delivery or
  maturity date for an agreed upon price (futures
  price) to be paid at contract maturity.
• Long position commits to purchasing
• Short position commits to delivering
• Option right to purchase/sell
• Futures obligation to purchase/sell

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Summary