Global Financial Instruments

1
Chapter 2

• Global Financial Instruments

2
Major Classes of Financial Assets/Securities

• Debt
• Money market instruments
• Bonds
• Common stock
• Preferred stock
• Derivative securities

3
Financial Markets
T-Bills CD CP BA Repos/Reverses Federal
funds LIBOR market
(Short-term) Money Market
Traditional Financial Markets
T-Notes/Bonds Municipal bonds Corporate
Bonds ABS/MBS
(Long-term) Capital Market
Bonds
Financial Markets
Stocks
Forward Futures Option Swap
Derivatives
Foreign Exchange Market
Whole sales market Retail market
4
Money Market Instruments 1

• Short-term, marketable, low-risk securities
• Cash equivalents
• Treasury bill (T-Bill)
• Short-term (less than one year) govt securities
  sold at a discount and paying off the face value
  at maturity
• Discount rate needs to be converted to a bond
  equivalent yield
• (See example later)
• Tax-exempt from all state and local taxes, but
  not from fed taxes
• Issued in auction markets Competitive vs.
  noncompetitive bids
• Certificates of deposit (CD)
• Time deposit with a bank, paying off interest and
  principal at maturity, and negotiable before
  maturity
• Treated as a bank deposit by the FDIC (insured
  for up to 100,000)

5
Money Market Instruments 2

• Eurodollars
• Dollar-denominated time deposits at foreign
  banks, with a maturity less than 6 months
• Eurodollar CD is a variation that is negotiable
  before maturity
• Commercial Paper (CP)
• Short-term unsecured debt issued by a large corp.
  in denomination of 100,000
• Fairly safe, but can default.
• Rated by a rating agency such as SP, Moodys,
  etc.
• Bankers Acceptances (BA)
• Widely used in foreign trade (import/export)
• A customers order accepted by a bank to make a
  payment at a future date
• Sells at a discount in secondary markets

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Money Market Instruments 3

• Repurchase Agreements (RPs) and Reverse RPs
• Short-term (overnight) sales of govt securities
  by dealers with an agreement to repurchase them
  later at a higher price
• It is like a S/T low-risk loan with the
  securities held as collateral
• A reverse repo works in the opposite direction
• Federal Funds
• Banks deposits at the Federal Reserve Bank to
  maintain a required minimum balance
• Banks with excess funds lend to those with a
  shortage at a rate of the Federal fund rate (Fed
  fund rate)
• LIBOR Market
• LIBOR lending rate among large banks in London
• Serve as a reference rate for a wide range of
  transactions

7
Discount Rate vs. Bond Equivalent Yield

• Discount Rates on money market instruments are
  not directly comparable to Bond Equivalent Yield
  (BEY)
• They need to be converted into BEY to be
  comparable with other bond yields
• 360 vs. 365 days assumed in a year

8
Bank Discount Rate (T-Bills)

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
9
Bond Equivalent Yield

• Convert the bank discount rate into BEY to make
  it comparable with other bond yields

P market price of the T-bill n number of days
to maturity
Example using the sample T-Bill
rBEY .0127 x 4.0556 .0513 5.13
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Capital Market Fixed Income Instruments 1

• US Treasury Notes and Bonds
• Debt of the federal govt with maturities of 1
  year or more, paying off semiannual interests and
  principal at maturity
• Price quoted in units of 1/32 of a point
• (Ex) 11006 110 6/32 110.1875 () of par U1
  mil
• Yield-to-maturity (YTM) is an annualized rate of
  return, based on an annual percentage rate (APR)
  or also called BEY
• (Ex) YTM semiannual yield 2
• Mortgage-Backed Securities (Federal Agency)
• Ownership claim to cash inflows from a mortgage
  pool
• Interest and principal payments from borrowers
  are passed to purchasers, and are called
  pass-throughs
• GNMA pass-throughs (since 1970), and others
  (FNMA, FHLMC)
• Market size is comparable to corporate and T-bond
  markets

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Capital Market Fixed Income Instruments 2

• Municipal bond (munis)
• Issued by state and local govt, and interest
  income is exempt from federal and sometimes state
  and local tax (but capital gains are taxable)
• To compare yields on taxable securities, we
  compute a Taxable Equivalent Yield as follows

rm muni bond yield r taxable equivalent
yield t marginal tax rate
rm r(1 t)
rm
r
1 t
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Capital Market Fixed Income Instruments 3

• Corporate bonds
• Long-term debt issued by private corporations,
  paying typically semiannual interests and
  principal at maturity
• Secured (mortgage or collateral) vs. unsecured
  (Debenture)
• Guaranteed vs. straight bond
• Option-embedded bonds Callable, puttable,
  convertible, etc.
• Current yield Annual coupon / Current price
• Yield-to-maturity current yield capital gain
  yield
• International Bonds
• Eurobond denominated in a currency other than
  the issuing country, e.g., dollar-denominated
  bond issued in London
• Yankee bond, Samurai bond

13
Capital Market - Equity

• Common stock
• Ownership shares of a publicly held corporation
• Entitled to get voting right and dividend
  payments
• Residual claim
• Limited liability
• Dividend yield Annual dividend / Current price
• PE ratio Price / EPS
• Preferred stock
• Nonvoting shares, usually paying fixed dividends
  (usually cumulative), like an infinite-maturity
  bond or a perpetuity
• Priority over common stock holders
• Sometimes, callable and convertible

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International Equity

• Global markets continue developing, and more
  opportunities of investing abroad are available
• ADRs (American Depository Receipts)
• Mutual funds like country funds or WEBS (World
  Equity Benchmark Shares)
• Direct purchase of foreign securities
• Provides diversification benefits, but are
  exposed to foreign exchange risk
• Global information and analysis skills are
  required

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Total nominal return in the U.S.
16
Equity Risk Premium
17
Performance by market sectors
18
Risk vs. Return by market sectors
19
International Stock Returns
20
International Stock and Bond Returns
21
Stock Indexes

• Represent the performance of the stock market as
  a whole, e.g., DJIA, SP500, Wilshire 5000, etc.
• Useful to track average returns of the stock
  market
• Useful as a benchmark for the performance of fund
  managers
• Used as base of derivatives
• Many kinds of stock indexes exist
• Representative? Broad or narrow? How is it
  weighted?
• Price-weighted index
• Dow Jones Industrial Average (30 blue-chip
  stocks)
• Market value-weighted index
• Standard Poors 500, NASDAQ Composite, Wilshire
  5000
• Equally weighted index
• Value Line Index

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Stock Indexes - Intl

• Nikkei 225 (price-weighted, largest TSE stocks)
• Nikkei 300 (value-weighted, largest TSE stocks)
• FTSE (value-weighted, largest 100 LSE stocks)
• DAX (German stock index)
• Regional and Country Indexes by MSCI
• EAFE (Europe, Australia, Far East)
• Far East
• EM (Emerging markets)
• U.S., U.K., etc. (over 50 country indexes)

23
Wilshire 5000 Index
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Top 20 companies in SP500 Index
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Derivatives Securities

• Options
• Basic Positions
• Call (Right to Buy)
• Put (Right to Sell)
• Terms
• Exercise (Strike) Price
• Expiration Date
• Underlying Assets

• Futures
• Basic Positions
• Long (Commitment to Buy)
• Short (Commitment to Sell)
• Terms
• Futures price
• Delivery (Maturity) Date
• Underlying Assets