Chapter 2: Asset Classes and Financial Instruments Flashcards
What is the “money market”?
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.
What is the “bank discount method”?
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.
What is a Treasury Bill?
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.
What is a certificate of deposit?
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.
What is commercial paper?
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).
What is a bankers’ acceptance?
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.
What is a Eurodollar?
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.
What are repurchase agreements (aka repos and reverses)?
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.
What is a brokers’ call?
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.
What are federal funds?
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’.
What is the LIBOR Market?
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).
What is the Bond Market?
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.
What are Treasury notes or bonds?
Debt obligations of the federal government with original maturities of one year or more.
What is an inflation-protected Treasury Bond?
In the US, these are called TIPS, adjusted in proportion to the Consumer Price Index, pretty much risk-free.
What is Federal Agency Debt?
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).
What are International Bonds?
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.
What are Municipal Bonds?
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.
How can investors choose between taxable and tax-exempt bonds?
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.
How can you calculate the tax bracket at which investors are indifferent as to whether they choose a taxable or tax-exempt instrument?
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.
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?
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.
What are Corporate Bonds?
Long-term debt issued by private corporations typically paying semi-annual coupons and returning the face value of the bond at maturity.
What are mortgage and asset-backed securities?
Either an ownership claim in a pool of mortgages or an obligations that is secured by such a pool.
What are equity securities?
Equity securities include common stocks (ownership shares), preferred stock and depository receipts.
What is common stock?
Ownership shares in a publicly held corporation. Shareholders have voting rights and may receive dividends.
