1. Financial Assets Fixed-income securities

1. Financial Assets Real assets are assets used in the process of production in the economy, i.e., items such as factories, machinery, patents, human ...
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1. Financial Assets Real assets are assets used in the process of production in the economy, i.e., items such as factories, machinery, patents, human capital. Financial assets are claims to the output of the production process. Financial assets are also called capital assets, or securities. There are two main types of financial assets: - Securities that promise a specific amount, or rate of return, generally referred to as bonds, or fixed income securities. - Securities that do not make a firm promise of an amount, or a rate of return, but rather pay what is available to pay after other claims are paid, generally referred to as stocks, or equity, or equities, or shares. For the purchaser of a financial asset, such asset represents an alternative to consumption of current income. A consumer who has a certain current income level can either exchange it all for current consumption, past consumption, or future consumption. If a consumer consumed more than then current income level at some time in the past, this consumer had to borrow the funds, thus creating a security, and returning funds for someone else’s consumption in the future. Such a consumer gives up current consumption for past consumption. If a consumer consumes currently less than his/her level of income, the leftover income by default becomes a financial asset, and maybe traded for another financial asset. When that asset is traded for consumption in the future, the consumer ends up exchanging current consumption for future consumption. Thus, from the point of view of the consumer, the function of financial assets is to move consumption in time, backward or forward. Financial assets can be generally classified into the following groups: - Bonds and other fixed income securities, also termed debt securities. This includes preferred stocks, which are stocks that promise a fixed rate of dividend payment, thus behaving like fixed income securities. - Stocks. - Derivative securities, which are securities whose cash flows are derived from cash flows of other securities. Fixed-income securities Money market instruments are very short-term debt securities, of low risk, easily marketable, often called “cash” or “cash equivalents”. Individuals buy them via moneymarket funds. These securities come mostly in large denominations ($100,000 or more) and that’s why money-market funds exist, as most individuals do not have this much cash available and money market accounts have lower minimum investment. There exists a variety of money market instruments in the United States, and they include: - Treasury Bills: Short-term bonds issued by the Department of Treasury of the United States. They have maturities of 91 days to 182 days (those are issued weekly), 52 weeks (issued monthly). Treasury Bills (T-Bills) are sold in an auction, with competitive bids and noncompetitive bids, in denominations of $10000. They are quoted at Dollars Earned Bank Discount Yield = . Dollars Invested

annualized using Bank Discount Method, assuming 360 days in a year, and then often also quoted in terms of Bond Equivalent Yield, assuming 365 days in a year and simple interest annualization, resulting in the following inequalities: Bank Discount Yield < Bond Equivalent Yield < Effective Yield. More precisely: Face Value ! Price 360 Bank Discount Yield = " Face Value n n " % Price = Face Value ! $ 1Bank Discount Yield ' # 360 & Face Value ! Price 365 Bond Equivalent Yield = " Price n 365

Face Value ! Price % n " Effective Annual Yield = $ 1 + '& ! 1 # Price T-Bill interest income is exempt from state and local income taxes, due to the general idea in the U.S. income tax system that one government (federal, state, county, city) cannot tax another government. -

Certificates of Deposit (CD): time deposit with a bank, fixed term, cannot be withdrawn without penalty. Large CDs (more than $100,000) are negotiable, shortterm (less than 6 months), and highly marketable. Smaller (up to $100,000) bank CD’s are insured by Federal Deposit Insurance Corporation (FDIC) and not marketable.


Commercial Paper: short term unsecured notes issued by companies. Often backed by a bank line of credit. Have maturities up to 270 days (avoid SEC registration), usually up to 2 months. Rated by rating agencies (Standard and Poor’s, Moody’s), and companies issuing commercial paper usually must have very good credit.


Eurodollar deposits (Eurodollars): dollar denominated deposits in an offshore bank. Offshore bank is a bank outside of U.S. jurisdiction (hence, Canadian or Mexican banks are offshore banks). These are usually large deposits with maturities less than six months. Eurodollar CDs are negotiable, less liquid than domestic CDs, riskier, and carry higher yield. The average rate on CDs issued by a group of major London-based banks is called London Interbank Offered Rate (LIBOR) and is an important index of short-term interest rates in U.S. dollars. LIBOR is calculated for 3 months deposits and for 6 months deposits.


Banker’s acceptance: order to a bank by a bank customer to pay a sum of money at a future date (typically up to six months). Same as Lucy Ricardo’s postdated check. But if a bank accepts it, it assumes responsibility for that future payment, and future payment can be traded, of course trading at a discount from the face value. Very safe. Often used in foreign trade, as in the United States most foreign trade guarantees are given by bank’s letters of acceptance, unlike Germany, the other of the two largest

exporters in the world, where insurance, including government-sponsored insurance, is used. -

Repurchase agreement (Repo): An arrangement in which a dealer sells government securities to an investor agreeing to buy them back next day at a slightly higher price. Effectively, this is a one-day loan with securities serving as collateral. Term repo: a repo with a longer term (30 days or more). Reverse repo: dealer buys government securities from a customer and sells them back next day, or at a later time.


Federal funds (fed funds) rate: Banks have to have a reserve balance with the Federal Reserve (the Fed), and can borrow reserves from each other at this rate. This rate is not set by the Fed, but the Fed publishes a “target” fed funds rate, in addition to the discount rate, i.e., the rate at which banks can borrow required reserves from the Fed.


Broker’s call: Broker borrows at this rate from a bank to have funds for margin borrowing by customers.

Fixed Income: Capital Market (The Bond Market) - Treasury Notes (up to 10 years) and Treasury Bonds (10 to 30 years), are debt instruments issued by the Department of Treasury of the United States, in denominations of $1000 or more, and have semi-annual fixed coupon payments (semi-annual coupon payments are standard in the United States, unlike the rest of the world, where fixed coupons are rate, and interest on bonds is paid annually). Yield to maturity on these bonds is quoted as semiannual yield doubled, and is also called bond equivalent yield. Prices are quoted as percentage of par value. -

Federal Agency debt: These are bonds issued by agencies of the Federal Government of the United States to finance their activities. They should not be confused with derivative securities sponsored by these agencies, and created from mortgages issued in the private sector. These are agencies issuing debt: - Federal Home Loan Bank (FHLB) - Federal National Mortgage Association (FNMA, or Fannie Mae) - Government National Mortgage Association (GNMA, or Ginnie Mae) - Federal Home Loan Mortgage Corporation (FHLMC, or Freddie Mac) Agency debt is not explicitly insured by the Federal Government, but it is customarily assumed the Government would protect agency credit, so Agency debt’s yields not far in excess of Treasuries (i.e., otherwise equivalent bonds issued by the Department of Treasury of the United States).


International bonds: There exists a large international market for bonds issued outside of the United States or in currency other than the U.S. dollar. United States has an unusually high share of private sector bonds in its markets, while foreign government issues dominate other markets. London (England) is the largest center of trade for foreign bonds. Eurobond = bond denominated in currency other than that of the country of issue. There are also bonds issued by companies of one country, issued

in another country in the currency of the investor, e.g., Yankee bonds (U.S. dollar denominated bonds issued in countries other than the United States), Samurai bonds (Japanese yen denominated bonds issued in countries other than the United States). -

Municipal bonds: These are bonds issued by state and local governments in the United States. Income paid by these bonds is exempt from Federal Government income taxes. Note the natural question: Suppose your tax bracket is 28%, you can get 6% taxable, or 4% tax free, which one is better? This is answered by calculation of the equivalent taxable yield: Tax-Free Yield Equivalent Taxable Yield = . 1 ! Marginal Tax Rate Tax-cutoff bracket: tax-bracket at which investors become indifferent between taxable and tax-free yields (given the market level of those yields). It is calculated as: Tax-Free Yield Tax Cutoff Bracket = 1 ! . Taxable Yield Types of municipal bonds: - General obligation (backed by taxing power of the issuer). - Revenue bonds (issued to finance a specific project). - Industrial development bonds (revenue bonds issued to finance a commercial project).


Corporate bonds: issued by private issuers, usually callable, often convertible into common stock. Current yield = annual coupon/price, different than yield to maturity. Types of corporate bonds: - Secured (backed by collateral, i.e., property forfeited by the borrower to the lender in case of a default, i.e., non-payment of coupon or principal), often called mortgage bonds. - Debentures (not secured with collateral). - Subordinate debentures (debentures junior in payment priority to other debentures).


Mortgages and mortgage-backed securities Mortgages are loans secured by real estate (i.e., a building, or buildings) as a collateral. Mortgages are issued with the purpose of providing funds for the purchase (but not for the entire price, usually only for 70% to 80% of the purchase price) of a piece of real estate. If the real estate purchased is a house, which becomes the residence of the borrower, the mortgage so created is called a residential mortgage. If the real estate is purchased for the purpose of commercial activity, the mortgage is called a commercial mortgage. There are many types of mortgages: - Conventional fixed rate mortgages. Residential mortgages are usually issued for 30 years or 15 years, at a fixed interest rate, and they typically can be prepaid or paid-off at any time. - Adjustable rate mortgages, whose interest rate varies with some market index, initial rate is usually lower than current market, and usually there is an overall cap on the interest rate charged and a cap on the annual rate increase.


Pools of mortgages, transformed into mortgage-backed securities (MBS). Passthroughs are pro-rate shares in pools of mortgages, those issued through Agencies guarantee principal and interest, but not the timing. There are also, similar in nature, asset-backed securities (ABS) created out of pools of student loans, car loan receivables and credit card receivables.

Common Stocks Shares of common stock represent residual claim to income and/or assets of a corporation, after expenses, labor, and debt are paid. Shares issued in the United States are in limited liability, i.e., investor’s losses are limited to the amount invested. Return to an investor in stocks comes from dividends and capital gains. We have: - Dividend yield = Annual dividend / Current price, - Price/Earnings (P/E) ratio = Current price / Annual earnings. Preferred stock Preferred stock is effectively a perpetual bond, it typically pays a fixed dividend forever, but if a company is unable to pay the dividend, this is not a default leading to bankruptcy. There is no contractual obligation to pay dividends on preferred stock (the same is true with respect to the common stock, but payment of interest on bonds or loans of any type is a contractual obligation, and failure to pay is called a default). Dividends not a taxdeductible expense to a company paying them (while interest paid on bonds is such a deductible expense), but 70% of dividends received from another firm excluded from taxable income. Preferred stock is sometimes callable (redeemable). It is called “preferred”, because it has preference in payment of dividend over common stock. Sometimes companies issue adjustable rate preferred stock: such a stock has its dividend vary with some market index (usually interest rate index). Stock market indexes - Dow Jones Industrials Average (average price of 30 stocks, price averaged using a divisor, every time the composition of the index is changed, the divisor is changed to keep the index level unaffected by the change in its composition). There are also other averages: Transportation, Utilities, Composite. - Standard and Poor’s Composite 500 (market-value-weighted average price of 500 stocks), basis for most index funds. Other S& P Indexes: Transportation, Utilities, Financial. Index funds usually track S&P 500 index. - Value Line Index (about 1700 firms, uses geometric average of returns). - NYSE publishes a composite of all listed stocks and sub-indices for various industries. - NASD publishes an index of about 400 OTC stocks. - Wilshire 5000 Index includes NYSE, AMEX, and OTC stocks. - AMEX publishes an index of its stocks. Foreign and international stock market indexes - Tokyo: Nikkei 225 (price-weighted) and Nikkei 300 (value-weighted). - London: FTSE (value-weighted index of 100 largest corporations).


Frankfurt: DAX. Morgan Stanley publishes proprietary indexes of non-U.S. stock markets, Europe Australia Far East (EAFE).

Bond indices - Bond indices are more difficult to construct and maintain than stock indices, as prices of most bonds are not continuously available. Note also that a 1990 IBM bond is a different bond than a 2000 IBM bond, but stocks issued in 1990 and 2000 are identical. - Three main indices of U.S. bond markets: Merrill Lynch, Lehmann Brothers, Salomon Brothers. All include very large number of securities: 5,000 to 6,000. They generally include bonds of at least one year maturity, are market value-weighted, updated daily, exclude convertibles, junk, and in come cases flower bonds and floating coupon bonds. One big issue: it is difficult to obtain market values because of limited trading of all but new issued (on the run) Treasuries. Derivative markets A derivative security is a capital asset whose cash flows are derived from another security’s (underlying’s) cash flows. Main types of derivatives: - Options (calls, puts). Call option is a right to purchase the underlying at a predetermined price, at a predetermined time (or by pre-determined time). Put option is a right to sell the underlying. Options must be purchased for a premium (plus a commission), and the seller (writer) of option collects the premium. A person purchasing an option is said to be long that option, and a person writing an option is said to be short that option. - Futures and forwards. Long forward is a purchase transaction contracted now and performed in the future. Short forward is a sale transaction contracted now and performed in the future. Note that a long call plus short put equals a forward. - Futures contract is basically a forward, but guaranteed by margin deposit, daily marking to market, and standardized delivery. Futures are costless to enter into, but one must pay a commission, unless one owns a seat on the exchange.

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