financial system, asset classes, and instruments

financial system

• allow entities to borrow, save, issue equity, manage risk, exchange assets, + utilize info

• determines the returns that equate savings and borrowing

• allocate capital efficiently

assets

• financial + physical

financial assets

• securities, currencies, contracts

physical assets

• commodities + tangible assets

classification of markets

• timing of delivery

• who the seller is

• maturity of instruments

• types of securities

futures markets / forward markets / option markets

• traded contracts w delivery at a date in the future

spot markets

• traded contracts require immediate delivery

primary market

• funds flow from purchaser to the issuer

secondary market

• funds flow between traders

money markets

• debt instruments

• mature in one year or less

capital markets

• debt instruments

• mature in over one year

  • ex: bonds and equities

traditional markets

• debt and equity markets

alternative markets

• for hedge funds, commodities, real estate, collectibles, leases, and equipment

• harder to value, illiquid, + require due diligence

money market

• treasury bills

• certificates of deposit

• commercial paper

• bankers acceptances

• euro / dollars

• repos and reverses

• federal funds

• brokers calls

bond market

• treasury bonds and notes

• federal agency debt

• municipal bonds

• corporate bonds

• mortgage backed securities

equity markets

• common stocks

• preferred stocks

indexes

• dow jones averages

• standard & poors indexes

• bond market indicators

• international indexes

derivative markets

• options

• futures and forwards

• swaps

money market characteristics

• subsector of the fixed income market

• short term

• highly liquid

• low risk

• often have large denominations

treasury bills

• short term us govt debt

• issued at a discount from FV + returning face at maturity

bid

• highest money a buyer is willing to pay

ask

• lowest money a seller is willing to accept

bid ask spread

• margin

bank discount method

• assumes 360 days

• yield = fraction of face value

bank discount rate

• unique to t-bills

• based on a 360 day year

• understates investors actual return

• face = denominator

bond equivalent yield

• annualizes yield on a 365 day basis for comparison with coupon bonds

• yields are higher than BDR

• purchase price = denominator

CD

• a bank time deposit

commercial paper

• short term unsecured debt issues by large corporations

bankers acceptance

• purchaser authorizes bank to pay seller at later date (time draft)

• becomes liability after the purchasers bank accepts a draft

eurodollars

• dollar denominated time deposits held outside the US

• pay higher interest rate than US deposits

repurchase agreements (RPs)

• collateralized loan

  • short term sale of securities + promise to repurchase at higher price

• “terms” may have 1 month maturity

reverse RPs

• lending money

  • obtaining security title as collateral

brokers’ call

• call money rate applies to investors buying stock on margin

• loan may be “called in” by broker

federal funds

• trading in reserves held at federal reserve

• key interest rate for the economy

LIBOR (london interbank offer rate)

• rate where large banks + elsewhere lend to each other

• base rate for many loans + derivatives

• replaces by SOFR

SOFR (secured overnight financing rate)

• replaces LIBOR

• overnight repurchase agreements collateralized by treasury securities

us treasury notes

• debt obligations w original maturities from 2 - 10 yrs

us treasury bonds

• debt obligations w original maturities for 10+ yrs

• semiannual coupons + return face at maturity

TIPS (treasury inflation protected securities)

• principal adjusted for CPI

• marked with trailing i in quote sheets

agency issues

• debt securities issued by government-sponsored enterprises (GSEs) and federal agencies

• most are home mortgage related

  • NFMA

  • FHLMC

  • GNMA

  • Federal Home Loan Banks

• risk of these securities

  • implied backing by the government

  • sept 2008: took over FNMA + FHLMC

municipal bonds

• issued by state + local govts

• tax exempt status

  • on interest proceeds

• interest income is generally exempt from state/local taxes in the issuing state

• capital gains

  • apply if sold more than purchase price

• lower yields

  • due to tax exemption

• vary in maturity

muni bond types

• general obligation bonds

• revenue bonds

general obligation bonds

• backed by taxing power (full faith and credit)

revenue bonds

• backed by revenues from specific projects

• higher default risk than general obligation bonds

corporate bonds

• firms borrow money directly from the public

• structured like treasury bonds

  • semi annual coupons + return face at maturity

• higher default risk than muni

• categorized

  • investment grade vs. speculative grade

taxable vs tax exempt muni bonds

• if the after tax yield of taxed muni bonds is more than the muni bond, then choose taxed

corporate bond types

• secured bonds

• unsecured bonds

• subordinated debentures

secured bonds

• backed by collateral

unsecured bonds

• aka debentures

• no collateral

subordinated debentures

• lower priority claim in bankruptcy

options

• callable

  • firm can repurchase at stipulated call price

• convertible

  • bondholders can convert to shares

mortgage backed securities

• backed by a pool of mortgages with “pass through” of monthly payments

  • bank has mortgages + pools them

  • investors can buy the pool, mortgage payments then “passed through” to the investors

  • pool covers defaults

• became risky

  • after 2006: Risky mortgages (like “Alt-A” and “subprime” loans to people with weak credit) started being included too in the pool

equities

• represent ownership rights in companies

types of equity

• common stock

• preferred stock

common stock

• shareholders have right to dividends

• elect board

• share of proceeds if the company is liquidated

preferred stock

• no voting rights

• generally have a right to a regular dividend

• priority in liquidation process

warrants

• holder can buy a company’s securities at a certain price before a certain date

depository receipts

• ADRs (american depository receipts) aka ADS (american depository shares)

• certificates traded in the US, but represent ownership of foreign currency

derivative asset

• security payoff dependent on the price of an underlying asset, index, rate, or benchmark

• used to hedge risk

derivative call option

• right to purchase an asset for a specific price (strike price) before an expiration date

derivative put option

• right to sell an asset for a specific price before an expiration date

contract

• agreement among traders to do something in the future

  • usually derivatives

forward contract

• agreement to trade the UNDERLYING asset in the future at a price agreed upon today

futures contract

• standardized forward contract

• clearinghouse guarantees the performance of all traders

  • buyer: side that will take physical delivery / cash equivalent

  • seller: liable for delivery / cash equivalent

swap contract

• agreement to exchange payments or period cash flows

  • depends on future asset prices

origin of market indexes

• dow jones average was the worlds first security index

  • contained 9 railroads and 2 industrial companies

    • later became the dow jones transportation average

    • if the railroad is doing well, then the economy is doing good

  • transcontinental railroad

launch of dow jones

• 1896

• valued at 40.94 initially

• had 12 industrial stocks

security market indexes

• used to represent the performance of an asset class or segment of the market

• has numerical value + index return

uses of indexes

• gauging market sentiment

• return/risk proxies

  • plays a useful role in CAPM

• asset class proxies

• active management benchmarks

• model portfolios

types of equity indexes

• broad market

• multi market

• sector

• style

broad market

• measure the markets overall performance

  • S&P

  • Russell 3000

  • Wilshire 5000 Total market index

s&p 500 index

• 500 large cap US companies

• used as a benchmark for the US stock market

russell 3000 index

• 98% of US investable equity market

• large, mid, and small cap stocks

wilshire 5000 total market index

• includes virtually every publicly traded US stock

• “total stock market index”

multi market index

• comprise of securities from diff countries

• represents multiple security markets useful for global investing

• ex: global and international broad market indexes

  • msci world index

  • msci all country world index

  • ftse all world index

  • stoxx europe 600

msci world index

• large and mid cap stocks across 23 developed markets

msci all country world index

• large and mid cap stocks across both developed and emerging markets

ftse all world index

• large and mid cap socks

• developed + emerging markets globally

• includes virtually every publicly traded us stock

• “total stock market index”

stoxx europe 600

• broad measure of european companies across sectors

sector indexes

• measures returns for an industry sector

• used for cyclical analysis

• determines whether a manager’s performance is based on stock or sector selection

11 sectors of the s&p

• energy

• financials

• health care

• information tech

• consumer discretionary

• consumer staples

• industrials

• materials

• communication services

• utilities index

• real estate index

global industry classification standards (GICS)

• 4 tiers + hierarchical industry classification system

• bottom up

  • 11 sectors

  • 25 industry groups

  • 74 industries

  • 163 sub industries

style indexes

• represents groups of securities

• classified according to:

  • market capitalization

  • value, growth, and blend / core

market capitalization

• large, mid, and small

• financial metric that represents the total value of a publicly traded company's shares

  • russell 1000 growth index

  • russell 1000 value index

  • morningstar small core index

russell 1000 growth index

• large cap us stocks w higher growth potential

  • earnings/ sales growth

  • price momentum

russell 1000 value index

• large cap US stocks with value characteristics

  • low price to book

  • low P/E

morningstar small core index

• small cap blend/core companies

fixed income indexes

• can be categorized as

  • aggregate or broad market

  • market sector

  • style

  • economics sector

  • specialized

    • high yield, inflation linked and emerging markets

• examples

  • bloomberg us aggregate bond index

  • ftse us treasury strips index

  • ftse world government bond index

bloomberg us aggregate bond index

• “the agg”

• most widely used benchmark for the US investment grade bond market

ftse us treasury strips index

• zero coupon treasuries only

ftse world government bond index (WCBI)

• sovereign debt from emerging markets

investment grade bonds

• AAA

• AA

• A

• BBB

high yield bonds

• Aaa

• Aa

• A

• Baa

commodity indexes

• consist of futures contracts on one or more commodities

  • thomson reuters / core commodity CRB index

real estate investment trust indexes

• represent not only the market for real estate securities but also the market for real estate

  • ftse epra / nareit global family of reit indexes

hedge fund indexes

• reflect the returns on hedge funds

  • hfrx global hedge fund index

challenges in fixed income indexes

• larger universe

• illiquidity

• turnover

• variety

  • market, features, credit, sector

challenges in alternative assets indexes

• no obvious logical weighting choice for commodities

• futures prices vs. underlying asset

• real estate illiquid

  • reits traded

• hedge funds voluntary reporting + survivorship bias

index construction decisions

• what market does it represent?

• what weighing schemes will be used?

• when will the index be rebalances?

• when will the indexes securities be reconstituted / reexamined?

price weighted index

• sum of stocks / number of stocks

• high priced stocks have more weight

• portfolio must have equal number of shares in each stock

  • divisor must be adjusted for stock spilts

• example

  • dow jones industrial average

  • nikkei dow jones (japan)