Fourth Edition1

Chapter 2

Financial Securities

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Outline• Major assets traded. (ttp://finance.yahoo.com/?u)

– Fixed income• Money market instruments• Bonds

– Equity securities– Derivatives

• Understanding Index– Different index– Construction of index

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Markets and Instruments

Money Market(<=1 year)

Capital Market(>1year)

Fixed-income T-bill CD, Federal Funds..

Bonds (T-notes, T-bonds, Muni, Corporate bonds)

Equity NA Common stock, Preferred stock

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Money Market Instruments• T(Treasury) bills:

– Short-term government debt security – Issued at discount from face value and returning the face

value at maturity

• Certificates of deposit– Time deposit with a bank– CD issued in denominations larger than

$100,000 are usually negotiable-sellable in the secondary market

• Commercial Paper– Short term unsecured debt issued by large corp

directly to the public.

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Money Market InstrumentsBankers Acceptances• An order to a bank by a customer to pay a sum of money at

a future date.• Like postdated check, with bank endorsement• Widely used in foreign trade• Sell at discount in secondary marketEurodollars• $ denominated deposits at foreign bank or foreign branches

of US bank• Can be traded in secondary market like CD before its maturityFederal Funds• Deposits of banks at Fed• Used for reserve requirements and transaction• Banks with surplus lend to those with shortage• Not directly sold to investors

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Money market instruments

Repurchases agreements and reverses• Def. Short-term sales of government

securities with an agreement of repurchase at a higher price Reverse repo: mirror image of a repo. Buys government securities with an agreement to resell them at a prespecified higher price

• Q: Who is who? A: Seller of security (borrower of funds) vs. Buyer (lender)

• Price increase is interest• Security is collateral

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Bonds

Publicly Issued Instruments• US Treasury Bonds and Notes• Agency Issues (Fed Gov)• Municipal BondsPrivately Issued Instruments• Corporate Bonds• Mortgage-Backed Securities

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Equity

• Common stock– Residual claim– Limited liability

• Preferred stock– Fixed dividends - limited– Priority over common

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Derivatives Securities

Options• Basic Positions

– Call (Buy)– Put (Sell)

• Terms– Exercise Price– Expiration Date– Assets

Futures • Basic Positions

– Long (Buy)– Short (Sell)

• Terms– Delivery Date– Assets

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Define option

• Option is the right to buy or sell an asset at a specified exercise price on or before a specified expiration date.

• Call Option:• Put Option:• Check:

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Market and Exercise Price Relationships

In the Money - exercise of the option would be profitable (without considering the cost/premium of the option)Call: market price>exercise pricePut: exercise price>market price

Out of the Money - exercise of the option would not be profitableCall: market price<exercise pricePut: exercise price<market price

At the Money - exercise price and asset price are equal

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Uses• Track average returns• Comparing performance of managers• Base of derivatives

Stock Indexes

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Examples of Indexes - Domestic

• Dow Jones Industrial Average (30 Stocks)

• Standard & Poor’s 500 Composite• NASDAQ Composite• NYSE Composite• Dow Jones Wilshire 5000

– Included all stocks(over 5,000) traded in US with available data

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Construction of Indexes

• How are stocks weighted?– Price weighted (DJIA)– Market-value weighted (S&P500,

NASDAQ)– Equally weighted (Value Line Index)

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Construction of Indexes• Price weighted

Initial P Final P Shares (M)

Yahoo $25 $30 20

MSN 100 80 1

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Construction of Indexes

• Price-weighted average– Adding the price and divided by a divisor (#

of stocks or adjusted divisor)– Index0=(25+100)/2=62.5– Index1=(30+80)/2=55

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Construction of Indexes• Price weighted-adjusting for splits

P0 #0 P1 #1 (M)

Yahoo $25 20 $30 20

MSFT 100 1 $50 2

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Construction of Indexes

• Price-weighted :adjusting for splits– Calculate new index value without split

effect( from time 0 to 1, stock prices can change without split effects)

• index1=(30+100)/2=65– With split, index1 should also equal 65

• (30+50)/d=65 d=1.23• (30+50)/1.23=65• d is divisor

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Construction of Indexes

• Market value-weighted – The weight is based on the market value of

each component stock– Set initial level to an arbitrarily chosen

starting value (e.t. 100)– New level: 100*(new market value 700/old

initial market value 600)=116.67

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Construction of Indexes• Equal weighted

– Each stock has the same weight– Set initial level to an arbitrarily chosen starting

value (e.t. 100)– The %change of the index=the simple average

of the %change of each component stock• % change of Yahoo=(30-25)/25=20%• % change of MSFT=(50-50)/50=0%• % change of index=(20%+0%)/2=10%

– New level: 100*(1+% change of the index)• =100*(1+10%)=110