Chapter 2: Asset Classes and Financial Instruments

Question 1

What is the “money market”?

Answer 1

Include short-term highly liquid and relatively low-risk debt instruments. Usually out of the reach of individuals, as in large denominations, but can be accessed via mutual funds. Ex.: Treasury bills, certificates of deposit, commercial paper, bankers’ acceptances, eurodollars, repos and reverses, federal funds, brokers’ calls.

Question 2

What is the “bank discount method”?

Answer 2

A way of reporting the value of a t-bill - discount from its maturity using an “annualized” value based on a 360-day year and reporting as a percentage of face value.

Question 3

What is a Treasury Bill?

Answer 3

The most marketable of money marketable instruments, it is a short-term government security issued at a discount from face value and returning the face amount at its maturity. These are highly stable instruments (in the US). It generally exempt from most kinds of taxation, except fed.

Question 4

What is a certificate of deposit?

Answer 4

A time deposit with a bank, where the bank pays interest and principal back to the depositor after an agreed upon period. They can be sold to another investor if a depositor needs to cash-in before agreed upon period.

Question 5

What is commercial paper?

Answer 5

A short-term unsecured debt issued by large corporations. Generally 1-2 months, but can go for up to 270 days. Typically considered safe and rated by at least one agency (e.g. S&P).

Question 6

What is a bankers’ acceptance?

Answer 6

An order to a bank by a customer to pay a sum of money at a future date. Kind of like a post-dated check, which the bank has ‘accepted’, and once that acceptance is decreed it can be bought and sold on the open market. Considered a very safe asset.

Question 7

What is a Eurodollar?

Answer 7

Dollar-denominated deposits at foreign banks or foreign branches of American banks. Good way of escaping federal regulation. Does not necessarily have to be in a European bank, that’s just where the practice originated.

Question 8

What are repurchase agreements (aka repos and reverses)?

Answer 8

Repurchases (repos) are short-term sales of securities with an agreement to repurchase the securities at a higher price. Generally overnight. A term repo is generally 30 days. And a reverse repo is an agreement to resell at a specified higher price on a future date.

Question 9

What is a brokers’ call?

Answer 9

Individuals who buy stocks on margin borrow part of the funds to pay for the stocks from their broker. The broker in turn may borrow the funds from a bank agreeing to repay the bank immediately (on call) if the bank request it. The rate paid is usually +1% higher than a T-bill.

Question 10

What are federal funds?

Answer 10

Funds in the accounts of commercial banks at the Federal Reserve Bank. Banks with excess funds lend to those with a shortage of funds, at the ‘federal funds rate’.

Question 11

What is the LIBOR Market?

Answer 11

The London Interbank Offer Rate (LIBOR) is a lending rate among banks in the London market. There are also competitor rates, Euribor and Tibor. Lending of this type is now sparse, and due for phasing out. A possible replacement is SONIA (Sterling Overnight Interbank Average Rate).

Question 12

What is the Bond Market?

Answer 12

Longer-term borrowing or debt instrument. Includes Treasury notes and bonds, corporate bonds, municipal bonds, mortgage securities and federal agency debt. Sometimes referred to as the ‘fixed-income capital market’ as most provide a steady stream of income according to a formula, but in practice, not generally fixed.

Question 13

What are Treasury notes or bonds?

Answer 13

Debt obligations of the federal government with original maturities of one year or more.

Question 14

What is an inflation-protected Treasury Bond?

Answer 14

In the US, these are called TIPS, adjusted in proportion to the Consumer Price Index, pretty much risk-free.

Question 15

What is Federal Agency Debt?

Answer 15

Usually issued from the government’s own agencies to finance activities in a specific realm (Ex.: FNMA or Fannie Mae, and FHLMC or Freddie Mac).

Question 16

What are International Bonds?

Answer 16

There is a thriving international capital market, largely centred in London. These are sometimes called ‘Eurobonds’, but it’s really best to think of them as international.

Question 17

What are Municipal Bonds?

Answer 17

Aka ‘munis’: tax exempt bonds issued by state and local governments. They fall into 2 categories: general obligations bonds, back by the ‘full faith and credit’ (‘taxing power) of the issuer OR revenue bonds, backed by revenue from the related project. Industrial development bonds use revenue from projects by private firms, but are backed by the tax-exempt status of the municipality. Investors pay neither federal nor state taxes on these instruments, so will accept low yields.

Question 18

How can investors choose between taxable and tax-exempt bonds?

Answer 18

The formula r(taxable)*(1-t) = r (muni) where t denotes the combined federal plus local marginal tax rate.

The formula can also be written as r(taxable) = r(muni)/(1-t)

Either of these formulas can be used to find the tax bracket at which investors are indifferent about which instrument they choose.

Question 19

How can you calculate the tax bracket at which investors are indifferent as to whether they choose a taxable or tax-exempt instrument?

Answer 19

The cut-off tax bracket can be found using the formula:

t= 1-[r(muni)/r(taxable)]

Thus the yield ratio r(muni)/r(taxable) is a key determinant of the attractiveness of municipal bonds.

Question 20

Suppose your combined tax bracket is 30%. Would you prefer to earn a 6% taxable return or a 4% tax-free yield? What is the equivalent yield of the 4% tax-free yield?

Answer 20

A 6% taxable return is equivalent to an after-tax return of 6%(1-.30) = 4.3%
The equivalent taxable yield of the tax-free bond is 4%(1-.30) = 5.7%
Therefore a taxable bond would have to pay a 5.7% yield to provide the same after-tax return as a tax-free bond offering a 4% yield.

Question 21

What are Corporate Bonds?

Answer 21

Long-term debt issued by private corporations typically paying semi-annual coupons and returning the face value of the bond at maturity.

Question 22

What are mortgage and asset-backed securities?

Answer 22

Either an ownership claim in a pool of mortgages or an obligations that is secured by such a pool.

Question 23

What are equity securities?

Answer 23

Equity securities include common stocks (ownership shares), preferred stock and depository receipts.

Question 24

What is common stock?

Answer 24

Ownership shares in a publicly held corporation. Shareholders have voting rights and may receive dividends.

Question 25

What are the characteristics of common stock?

Answer 25

Residual claim: stockholders are the last in line to have a claim on assets and income.
Limited liability: most shareholders will lose out on what they have invested, but they cannot be held personally responsible for the failure of the company with a claim on their personal assets.

Question 26

If you buy 100 shares of GE common stock, to what are you entitled?
What is the most money you can make over the course of the year?
If you pay $30 per share, what is the most you could lose over the year?

Answer 26

• The dividends (if paid) on each of the 100 shares and your voting rights.
• Depends on the value of the stock and the earnings/dividends paid at the company.
• $3,000 - your original investment

Question 27

What is preferred stock?

Answer 27

Nonvoting shares in a corporation, usually paying a fixed stream of dividends. More like an infinite-maturity bond. The firm nonetheless has discretion to pay dividends or not; must be paid out before common stock dividends, however.

Question 28

What are depository receipts?

Answer 28

Represent shares of ownership in a foreign company. They are the most common way for US investors to directly invest and trade the shares of foreign companies.

Question 29

What is a stock market index?

Answer 29

Measures of the performance of the stock market, e.g. the Dow Jones.

Question 30

What is The Dow Jones Industrial Average?

Answer 30

Measure the performance of 30 large, blue-chip corporations. It uses a price-weighted average, computed by adding the prices of the stocks and dividing by a divisor.

Question 31

How is the S&P 500 an improvement on The Dow Jones?

Answer 31

It improves it in 2 ways.

(1) More broadly based index of 500 firms, rather than 30.
(2) It is a market value-weighted index, where weights are proportional to outstanding market value.

Question 32

What is an equally weighted index?

Answer 32

An index computer from a simple average of returns.

Question 33

What are Derivative Markets?

Answer 33

Futures, options, and related derivative contracts provide payoffs that depend on the values of other variables, such as commodity prices, bond and stock prices, interest rates or market index values.

Question 34

What are call options?

Answer 34

The right to buy an asset at a specified exercise price on or before a specified expiration date.

Question 35

What is a put option?

Answer 35

The right to sell an asset at a specified exercise price on or before a specified expiration date.

Question 36

What would be the profit or loss per share of stock to an investor who bought the June expiration Apple call option with exercise price of $140 when the stock price at expiration is $150. What about an investor that purchased the put option?

Answer 36

For the call option, $10 is the gain. The call cost $4.80, so $10 - 4.80 = $5.20 per share.

The put option is worthless, as the stock price exceeds the exercise price, so the loss is the cost of the put, $3.90 per share.

Question 37

What is a futures contract?

Answer 37

Obliges traders to purchase or sell an asset at an agreed-upon price at a specified future date.