The Investment Environment, Asset Classes, and Financial Instruments Flashcards
Fixed Income / Debt Securities
Promise either a fixed stream of income or a stream of income determined by a specified formula.
Derivative Securities
Provide payoffs that are determined by the prices of other assets such as bond or stock prices.
Two Types of Decisions When Constructing Portfolios
The ‘asset allocation’ decision is the choice among these broad asset classes, while the ‘security selection’ decision is the choice of which particular securities to hold within each asset class.
Bid-Ask Spread
The difference between the bid and the ask which is the dealer’s source of profit.
Bank-Discount Method
The bill’s discount from its maturity or face value is ‘annualized’ based on a 360-day year, and then reported as a percentage of face value. Flawed in two ways: assumes the year only has 360 days, and computes the yield as a fraction of par value rather than of the price the investor paid to acquire the bill.
Eurodollars
Eurodollars are dollar-denominated deposits at foreign banks or foreign branches of American banks. By locating outside the United States, these banks escape regulation by the Federal Reserve. Despite the tag “Euro,” these accounts need not be in European banks, although that is where the practice of accepting dollar-denominated deposits outside the United States began. Most Eurodollar deposits are for large sums, and most are time deposits of less than 6 months’ maturity. A variation on the Eurodollar time deposit is the Eurodollar certificate of deposit, which resembles a domestic bank CD except that it is the liability of a non-U.S. branch of a bank, typically a London branch. Firms also issue Eurodollar bonds, which are dollar-denominated bonds outside the U.S., although bonds are not considered part of the money market because of their long maturities
Repos and Reverses
Dealers in government securities use repurchase agreements, also called “repos” or “RPs,” as a form of short-term, usually overnight, borrowing. The dealer sells government securities to an investor on an overnight basis, with an agreement to buy back those securities the next day at a slightly higher price. The increase in the price is the overnight interest. The dealer thus takes out a 1-day loan from the investor, and the securities serve as collateral. A term repo is essentially an identical transaction, except that the term of the implicit loan can be 30 days or more. Repos are considered very safe in terms of credit risk because the loans are backed by the government securities. A reverse repo is the mirror image of a repo. Here, the dealer finds an investor holding government securities and buys them, agreeing to sell them back at a specified higher price on a future date.
Federal Funds
Just as most of us maintain deposits at banks, banks maintain deposits of their own at a Federal Reserve bank. Each member bank of the Federal Reserve System, or “the Fed,” is required to maintain a minimum balance in a reserve account with the Fed. The required balance depends on the total deposits of the bank’s customers. Funds in the bank’s reserve account are called federal funds, or fed funds. At any time, some banks have more funds than required at the Fed. Other banks, primarily big banks in New York and other financial centers, tend to have a shortage. Banks with excess funds lend to those with a shortage. These loans, which are usually overnight transactions, are arranged at a rate of interest called the federal funds rate. Although the fed funds market arose primarily as a way for banks to transfer balances to meet reserve requirements, today the market has evolved to the point that many large banks use federal funds in a straightforward way as one component of their total sources of funding. Therefore, the fed funds rate is simply the rate of interest on very-short-term loans among financial institutions. While most investors cannot participate in this market, the fed funds rate commands great interest as a key barometer of monetary policy.
Brokers’ Calls
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 requests it. The rate paid on such loans is usually about 1% higher than the rate on short-term T-bills.
LIBOR
The London Interbank Offer Rate (LIBOR) is the premier short-term interest rate quoted in the European money market and serves as a reference rate for a wide range of transactions. It was designed to reflect the rate at which banks lend among themselves. While such interbank lending has declined substantially in recent years, particularly at longer maturities, LIBOR remains a crucial benchmark for many financial contracts. For example, a corporation might borrow at a rate equal to LIBOR plus two percentage points. Hundreds of trillions of dollars of loans, mortgages, and derivative contracts are tied to it.
Most Important Characteristics of Common Stock
Residual claim and limited liability.
American Depositary Receipts (ADRs)
American Depositary Receipts, or ADRs, are certificates traded in U.S. markets that represent ownership in shares of a foreign company. Each ADR may correspond to ownership of a fraction of a foreign share, one share, or several shares of the foreign corporation. ADRs were created to make it easier for foreign firms to satisfy U.S. security registration requirements. They are the most common way for U.S. investors to directly invest in and trade the shares of foreign corporations.
How the DJIA is Calculated
Originally, the DJIA was calculated as the average price of the stocks included in the index. Thus, one would add up the prices of the 30 stocks in the index and divide by 30. The percentage change in the DJIA would then be the percentage change in the average price of the 30 shares.
The Standard & Poor’s 500 Index
The S&P 500 is computed by calculating the total market value of the 500 firms in the index and the total market value of those firms on the previous day of trading. The percentage increase in the total market value from one day to the next represents the increase in the index. The rate of return of the index equals the rate of return that would be earned by an investor holding a portfolio of all 500 firms in the index in proportion to their market values, except that the index does not reflect dividends paid by those firms.
Equally Weighted Indexes
Market performance is sometimes measured by an equally weighted average of the returns of each stock in an index. Such an averaging technique, by placing equal weight on each return, corresponds to an implicit portfolio strategy that invests equal dollar values in each stock. This is in contrast to both price weighting (which requires equal numbers of shares of each stock) and market-value weighting (which requires investments in proportion to outstanding value). Unlike price- or market-value-weighted indexes, equally weighted indexes do not correspond to buy-and-hold portfolio strategies. Suppose that you start with equal dollar investments in the two stocks of Table 2.2, ABC and XYZ. Because ABC increases in value by 20% over the year while XYZ decreases by 10%, your portfolio no longer is equally weighted. It is now more heavily invested in ABC. To reset the portfolio to equal weights, you would need to rebalance: Sell off some ABC stock and/or purchase more XYZ stock. Such rebalancing would be necessary to align the return on your portfolio with that on the equally weighted index.
