Chapter 1.1 Notes - Asset Classes

Money Market

Debt Securities with maturities up to one year that are very liquid and have low default risks.

Examples of Money Market Assets

• T-Bills

• Certificate of Deposits (CDs)

• Commercial Paper

• Federal Funds

• Repurchase Agreements

Treasury Bills

• Short-Term Government Securities

• The government borrows money by selling to the public

• Typically sold at a discount from face value

• Face value can be as low as $100, although $10,000 is the most common.

• Can be purchased directly at Treasury Direct (treasury market) or through secondary market from financial institutions

Treasury Bills (cont.d)

• Difference between face value of the bill & price of the bill is interest earned until maturity.

• Bills are issued with initial maturities of 4,13,26,or 52 weeks.

Certificate of Deposit (CD)

• Time Deposit offered by banks

• These deposits may NOT be withdrawn on demand, which varies in contrast to demand deposits & checking accounts.

• Bank pays interest & principal only at maturity.

• CDs are insured by the FDIC (Federal Deposit Insurance Commission) for up to $250,000.

Commercial Paper (CP)

• Unsecured and short-term debt security issued by corporations to fund short-term financing needs (payroll, inventory, and other ST Liabilities)

• Maturities on most commercial paper range from a few weeks to 1-2 months.

• CP trades in secondary market, face value is around $100k

Fed Funds Rate

The Fed Funds Rate is the interest rate at which financial institutions trade federal funds (balances held at Fed Reserve Banks) with each other overnight

Repurchase Market

In a repurchase agreement, a dealer or hedge fund sells a security & simultaneously agrees to buy it back the next day for a slightly higher price.

• The dealer/hedge fund is effectively borrowing money secured overnight

• Government security is the collateral & price difference is the interest on the loan.

• The interest rate on the loan is known as the general collateral repo rate.

Secured Overnight Financing Rate (Risk-Free Rate)

SOFR is a broad measure of the cost of borrowing cash overnight collateralized by Treasury Securities.

• SOFR is calculated as a volume - weighted median transaction rate of overnight repo contracts collateralized by US Treasuries

• Each business day, the Fed publishes the SOFR rate @ 8 AM EST.

Summary of Important Interest Rates

• T-Bill Rate

• SOFR

• FOREX Market Rate

• Exchange Rates

T-Bill Rate

Interest Rate at which the US Government borrows from investors in the short-term.

• Investors can also lend money risk-free for the short term to the US Government.

SOFR (Secured Overnight Financing Rate)

Interest Rate at which financial institutions lend to/borrow from each other secured overnight.

• Very important benchmark rate because it indirectly effects almost every US Loan.

• Recently replaced the London Interbank Offer Rate (LIBOR)

FOREX Market

The Foreign Exchange Market - it’s the decentralized global market where all of the world’s currencies are traded.

FX Swaps

Two-part transactions where currencies are exchanged now & then reversed later at a specific date & rate.

Spot Transactions

An immediate exchange of one currency for another currency at the current market (spot) rate, typically settled in ± 2 days

Outright Forwards

An agreement to exchange currencies at a future date at a rate agreed today (no initial exchange occurs now)

Types of FOREX Rate

• FX Swaps Rate

• Spot Transactions Rate

• Outright Forwards Rate

Types of Exchange Rate Quotes

• Natural/Direct Quote

• Indirect Quote

Natural/Direct Quote

• Represents the amount of home currency that is equivalent to unit of the foreign currency.

• Tells you the price of the foreign currency (priced quotation)

Indirect Quote

• Represents the amount of foreign currency that is equivalent to one unit of the home currency.

• Tells you the quantity of foreign currency that is required to but one unit of the home currency (quantity quotation)

• FX Traders in the US often use the indirect quote.

Types of Bonds in Bond Market

• Treasury & Corporate Bonds

• TIPS (Treasury Inflation-Protected Securities)

• Corporate Bonds

• Treasury Floating-Rate Notes (FRNs)

• Municipal Bonds & Asset-Backed Securities

Treasury & Corporate Bonds

• US Government Debt

• Treasury Notes (T-notes) earn a fixed rate of interest every six months until maturity

• Notes are issues in terms of 2,3,5,7 and 10 years.

Treasury Inflation-Protected Securities (TIPS)

TIPS provide protection against inflation. The principal of a TIPS increases with inflation & decreases with deflation, as measured by the CPI.

Corporate Bonds

Debt issued by a company in order for it to raise capital.

Treasury Floating Rate Notes (FRNs)

Short-term investments issued by the US Treasury, also known as “floaters” due to interest payments over time.

How do FRNs work?

• The interest rate is based on the most recent 13-week T-Bill auction discount.

• It comprises of two parts:

  • Index Rate that changes weekly

  • Spread, which remains fixed for the life of the FRN.

• FRNs are issued in auctions, and the price is determined at the auctions.

• FRNs mature in two years & pay interest quarterly.

• US Treasury introduced FRNs in 2013.

Municipal Bonds

Debt securities issued by states & local governments to fund day-to-day obligations and to finance capital projects such as building schools, highways, etc.

• Interest is exempt from federal income tax

• Ex: General Obligations Bonds, Revenue Bonds

Asset-Backed Securities

Cash flows are tied to a specific pool of assets

• Mortgage-backed securities issued by FNMA, GNMA, and FHLMC

• Collateralized Debt obligations (CDOs) issued by banks

• Securities backed by student loans (Sallie Mae), car loans, corporate accounts, receivables, etc.

Equity Markets Components

• Common Stock

• Preferred Stock

Common Stock

• What we normally call stock

• Represents ownership in a firm

• Cash flow & voting rights

• Residual Claim

• Limited Liability

• Management runs day-to-day business

• Board of Directors (elected by shareholders) oversees management

Preferred Stock

• Some companies have this stock too

• Provides fixed dividend payments (similar to perpetual bond/consolidated bond)

• Cannot pay a dividend on common stock unless dividend is paid on the preferred stock.

• Senior to common stock in bankruptcy case

• No voting rights unless preferred dividends have been skipped for the same period now.

• Similar to debt, failure to pay dividends is not a default.

US Stock Market Valuation Graph

As interest rates fall, CAPE ratios rise, showing that lower rates = higher equity valuations

• CAPE is the cyclically adjusted Price-to-Earnings Ratio

Indexes

An index tracks the performance for a group of assets in a standardized manner.

Examples of Indexes

• Stock Market Indices: S&P 500, Dow Jones

• Bond Market Indices: US Aggregate Bond Index

• CBOE Volatility Index/VIX

• Case & Shiller Housing Price Index

• S&P Goldman Sachs Commodity Index

Index Investing

Mutual Funds/ETFs often track the performances of indicies.

DJIA (Dow Jones Industrial Average)

• Price-weighted average of 30 largest firms (publicly-traded) in the US

• Return-on-index is same as return on portfolio, consisting of one share of each company

• Dividends are NOT included.

S&P 500 Index

• Value-weighted index of 500 of the largest firms in the US

• Return-on-index is the same as return on a portfolio consisting of all traded shares of 500 companies

• Dividends are NOT included

  • 70% of entire US Stock Market

VIX/CBOE

• Known as the “fear gauge”, it measures expected volatility over the next 30 days based on S&P 500 options.

  • High VIX - More Fear

  • Low VIX - Less Fear

What is a financial derivative?

A financial security/contract whose payoff depends upon/derived from the value of the “underlying” asset, index, or good.

The “underlying” includes:

• Financial Assets (stocks, bonds, exchange rates, interest rates, etc.)

• Commodities (oil, gold, water)

• Events (corporate default, natural catastrophe)

• Indices (stock market index, bond market index, precipitation, snow, etc.)

Examples of Derivatives

• Forwards

• Futures

• Swaps

Where are derivatives traded?

• On exchanges such as the CME & CBOE

• In OTC Markets, where traders working for banks, fund managers, and corporate treasurers contact each other directly.

Who trades derivatives?

• Non-financial institutions: firms, governments

• Financial Institutions such as pension funds, insurance companies, banks, etc.

• Market Makers such as large dealer banks

• Individual Investors

Why are derivatives important?

Derivatives play a key role in transferring risks in the economy and are used to:

• a) Hedge: reduce/eliminate risks

• b) Speculate: With high leverage, allow investors to trade on future price expectations with minimal upfront investment

• c) Invest: Within underlying risks that cannot/are very costly to purchase directly (commodity ETFs)

• d) Predict: Future Events, use tools such as the CME Fed Watch Tool

Forwards Contract

A legal agreement between two parties to buy/sell the underlying asset at a predetermined price (the forward price) at a specific time in the future (maturity date)

• Example: A contract that requires an investor to buy $100k Euros @ $1.20 USD/Euros (forward price) in three months.

Futures Contract

A legal agreement to buy/sell a particular underlying at a predetermined price (futures price) at a specified TIME in the future.

• Futures contracts are standardized for quality & quantity to facilitate trading on a futures exchange.

• Examples include equity index futures contracts, commodity futures, Treasury Bond Futures, etc.

CME Group - Selected Products

Agriculture, Energy, Equity Indices, FX, Interest Rates, Metals, etc.

Call Options

Financial contracts that give the option buyer the right, but NOT the obligation, to buy the underlying at a specific price (strike/exercise price) in a specific TIME period.

• For example, an “at-the-money” call option on Apple traded on the CBOE gives the buy the right but NOT the obligation to sell the underlying at a specific price.

Put Options

Financial Contracts that give the option buyer the right but NOT the obligation to SELL the underlying at a specific price (strike/exercise price) within a specified time period.

• For Example, an SPX put option

CBOE - Selected Products

• US Equities

• European Equities

• US Options

• US Futures

• FX Market

• European Derivatives

• Indices

• Canadian Equities

• Australian Equities

• Japanese Equities