BMGT343 Chapter 2 Asset Claims Financial Instruments The Money Market money markets include short term highly liquid and relatively low risk debt instruments treasury bills short term gov t securities issued at a discount from face value and returning the face amount at maturity o o o o simplest form of borrowing issued with initial maturities of 4 13 26 or 52 weeks highly liquid minimum denominations of 100 taxable at federal level but not state local asked price price you would have to pay to buy a t bill from a securities dealer bid price slightly lower price you would receive if you wanted to sell a bill to a dealer bid asked spread difference in these prices dealer s source of profit certificate of deposit bank time deposit bank pays interest and principal to depositor only at the end of the fixed term of the CD commercial paper short term unsecured debt issued by large corporations considered fairly safe asset o o CP trades in secondary markets and is quite liquid Bankers acceptances an order to a bank by a customer to pay a sum of money at a future date o Like a postdated check o Very safe assets o Acceptances sell at a discount from the face value Eurodollars dollar denominated deposits at foreign banks Repurchase agreements repos short term sales of government securities with an agreement to repurchase the securities at a higher price o Very safe in terms of credit risk backed by gov t securities o Term repo term of the loan can be 30 days o Reverse repo dealer finds an investor holding gov t securities and buys them with an agreement to resell them at a higher price on a future date Federal funds funds in the accounts of commercial banks at the Federal Reserve Bank o Fed funds rate is simply the rate of interest on very short term loans amongst financial institutions LIBOR lending rate among banks in the London market Although most market securities are of low risk they are not risk free These securities of the money market promise yields greater than those on default free t bills The Bond Market treasury notes bonds debt obligations of the federal gov t with original maturities of one year or more o o o o t notes issued with original maturities up to 10 years t bonds issued with maturities ranging from 10 30 years both are traded in denominations of 1 000 both make semiannual interest payments called coupon payments inflation protected treasury bonds TIPS principal on these bonds is adjusted in proportion to increases in the CPI consumer price index o an I following the bond s maturity date denotes that the bond is a TIPS some gov t agencies issue their own securities to finance their activities many firms borrow abroad and many investors buy bonds from foreign issuers municipal bonds munis tax exempt bonds issued by state local gov ts a Eurobond is a bond denominated in a currency other than the country in which it is issued o o o capital gains taxes must be paid on munis general obligation bonds backed by full faith and credit taxing power of the issuer revenue bonds issued to finance particular projects and are backed either by revenues form the project or by the municipal agency operating the project industrial development bond revenue bond that is issued to finance commercial enterprises t investor s combined federal plus local marginal tax rate r total before tax rate of return available on taxable bonds r t 1 after tax rate available on those securities if the value exceeds the rate of municipal bonds rm then the investor does better holding the taxable bonds we set after tax yields equal and solve for the equivalent taxable yield of the tax exempt bond r 1 t rm or r rm 1 t or t 1 rm r Thus the yield ratio rm r is the key determinant of the attractiveness of munis The higher the yield ratio the more preferable corporate bonds long term debt issued by private corporations typically paying semiannual coupons and returning the face value of the bond at maturity return the face value to the bond holder at maturity secured bonds have collateral backing them in the event of firm bankruptcy unsecured bonds debentures have no collateral callable bonds give the firm the option to repurchase the bond from the holder at a stipulated call price convertible bonds bondholder has the option to convert each bond into a stipulated number of shares of stock adjustable rate mortgages require the borrower to pay an interest rate that varies with some measure of the current market interest rate o mortgage backed security is either an ownership claim in a pool mortgages or an obligation that is secured by such a pool o conforming mortgages loans have to satisfy certain underwriting guidelines before they could be purchased by Fannie or Freddie subprime mortgages riskier loans made to financially weaker borrowers o o o o o o o mortgages Equity Securities common stock ownership shares in a publically held corporation shareholders have voting rights and may receive dividends o o residual claim stockholders are the last in line of all those who have a claim on the assets and income of a corporation limited liability initial investment is the most that shareholders can lose in the event of the failure of the corporation Price Earnings P E is the current stock price to last years earnings tells us how much stock purchasers must pay per dollar of earnings the firm generates for each share Preferred stock nonvoting shares in a corporation usually paying a fixed stream of dividends o Promises to pay to its holder a fixed stream of income each year o Does not give holding voting power regarding firm s management o No contractual obligation to pay those dividends o Preferred dividends are usually cumulative unpaid dividends cumulate and must be paid in full before any dividends may be pay to common holders o Not tax deductible expenses for the firm o Sells at lower yields than corporate bonds ADRs are certificates traded in US markets that represent ownership shares of a foreign company Stock and Bond Market Indexes Dow Jones is the average of the 30 stocks included in the index percentage change in the Dow measures the return on a portfolio that invests one share in each of the 30 stocks o o Price weighted average average computed by adding the prices of the stocks and dividing by a divisor o Averaging procedure is adjusted whenever a stock splits pays a dividend over 10 or when a company in the Dow is replaced by another Standard Poor s 500 S P 500 is based on 500 firms o Market value