Real Assets
Used to produce goods and services: Property, plants and equipment, human capital, etc.
Financial Assets
Claims on real assets or
... [Show More] income generated by them. It is the _ALLOCATION_ of income or wealth among investors: Cash, stocks, bonds...etc... This course is on Financial Assets
•Performance of financial assets depends on underlying real assets
All Financial Assets (owner of the claim)
Are offset by a financial liability (issuer of claim): when you own a stock/bond issued by a firm, the stock/bond is a liability of the firm.
Net Wealth of economy =
Only the sum of Real Assets
1. Identify Real and Financial Asset that are created, destroyed, or traded hands.
Toyota takes out a bank loan to finance the construction of a new factory:
1. Toyota created a Real Asset: The Factory
2. The loan is a financial asset that is created in the transaction owned by the bank
2. Toyota pays off the loan
When the loan is paid, the financial asset is destroyed, but the real asset continues to exist.
Three Major Classes of Financial Assets
1. Fixed income Securities
2. Common Stock (equity)
3. Derivatives
Fixed income Securities
Various types of debt which promises to pay a fixed stream of income over a per-determined period.
•Money Market Instruments: very short term and low risk
•Bonds: longer term
Common Stock (equity)
An Ownership stake in a corporation, residual cash flow, riskier than debt securities
Derivatives
Contract, value derived from underlying market condition of other financial assets.
•Options
•Futures
•CDS (Credit Default Swap)
What are the roles and basic properties of financial markets?
•Allocate resources the places where it generates highest returns.
•Smooth consumption over time
•Risk Allocation: investors can choose different instruments with different risk levels to suit their needs
Role Of Financial Markets
Separation of management and ownership: good for business and investors, but also creates agency problems
Solution to Agency Problems: Corporate Governance
•Performance based pay
•Shareholders elect board of directors to represent themselves
•Threat of takeovers
Sarbanes-Oxley Act: 2002
-Requires more independent directors on company boards
-Requires CFO to personally verify the financial statements
-Created new oversight board for the accounting/audit industry
-Charged board with maintaining a culture of high ethical standards
1. Basic Properties of financial Markets
-There is always a risk-return tradeoff
•higher return = higher risk
•no such thing as free lunch
Example:
•S&P500 Index for stocks
•10-year & 3-month T-Bills are both issued by US government. Fixed income instruments with different maturities
•3-month T-Bill rate is normally considered as the risk free rate
2. Basic Properties of financial Markets
Passive Investment Philosophy:
Active Investment Philosophy:
Passive Investment Philosophy: "Indexing"
The market is very efficient, thus investors buy and hold a diversified portfolio "Indexing"
Active Investment Philosophy: "Stock Picking" or "Market Timing"
The market is not so efficient, thus investors try to identify mispriced securities and profit from it.
Primary Market
Where firms issue new securities (stocks or bonds) to raise capital from public or private investment firms
-They need help pricing and selling the securities: investment bankers provide those services called "underwriting"
Secondary Market
Where already existing securities are traded among investors.
Example: NYSE
Investment Banks
-Separated by law in US from 1933-1999
-Sep 2008: all major investment banks were absorbed by commercial banks, declared bankruptcy, or reorganized as commercial banks
"Top Down" Approach
Allocate capital among broad asset classes
"Bottom-Up" Approach
Choice of securities within each asset class.
After you choose which Asset class to buy, you need to pick which ones to buy. (Active or passive investments_
Fixed Income Market (Debt)
...
Characteristics of a debt instrument:
-Who is the borrower: federal Government (T-bills or bonds), or Corporations (corporate bond, bank loan)
-Maturity: short or long term
-Liquidity
-Risk: Default risk
-Coupon rate
-Denomination
-Yield: rate of return investing on debt
We can categorize all fixed income instruments into two groups based on:
-Length of Maturity
-Risk
-Liquidity
The Money Market: (Debt)
-Short Term, marketable, low risk, "cash equivalents"
-Lower return
-Not directly available to individual investors, but can access it through money market mutual funds
The Bond Market: (Debt)
-Longer term, not as liquid, higher risk
-Higher return
The Money Market Instruments:
• Treasury Bills
• Certificates of Deposit
• Commercial Paper
• Bankers' Acceptances
• Eurodollars
• Federal Funds
• LIBOR (London Interbank Offer Rate)
• Repos
Treasury Bills:
• Treasury" = issued by federal Government
• "Bills" means "short term", maturity is 4, 13, 26, or 52 weeks.
• Denomination: $100, commonly $10,000
• High liquidity
• No default risk
• No coupon payment, sold at discount.
• Taxation: interest income only taxable at the exempt from state and local levels
Certificates of Deposit (CD)
• Issuer: Commercial Banks
• Denomination: Any
• Maturity: varies, typically 14day minimum
• Liquidity: CDs of 3 months or less are liquid
• Default: First $250,000 insured by FDIC, just like bank deposits
• Taxation: Interest income fully taxable
Commercial Paper
• Issuer: Large creditworthy corporations, financial institutions
• Denomination: Minimum $100k
• Maturity: Maximum 270 days, usually 1-2 months
• Liquidity: CP of 3 months or less is liquid if marketable
• Default: Unsecured, rated, mostly high quality
• Interest Type: Discount
• Taxation: Interest income fully taxable
• New Innovation: Asset-backed commercial paper
Bankers' Acceptances
- Originate when a purchaser authorizes a bank to pay a seller for goods at a later date (time draft)
- When purchaser's bank "accepts" draft, it becomes contingent liability of the bank and a marketable security
-Basically a postdated check
Eurodollars
- Dollar-denominated (time) deposits at foreign banks or foreign branches of US banks
-Eurodollar CD: Pay higher interest rate than U.S. deposits, but less liquid and riskier
Federal Funds
-Commerical banks must maintain a minimum reserve deposits with Federal Reserve Bank. One can borrow from another bank if the balance is short. Typically overnight loans.
• Fed Fund Rate: the interest rate on such loans.
Why should average investors care?
-its an important benchmark rate, an important tool of federal monetary policy
LIBOR (London Interbank Offer Rate)
- Rate at which large banks in London (and elsewhere) lend to each other
-The premier short-term interest rate in European Money Market
- Base rate for many loans and derivatives. Important benchmark rate
Example: student loans even in the US are normally LIBOR plus 3%.
Repurchase Agreements (RPs)
- Short-term sales of securities with an agreement to repurchase the securities at higher price
- RP is a collateralized loan; many RPs are overnight, though "term" RPs may have a 1-month maturity
Reverse RPs
lending money and obtaining security title as collateral
The Money Market: Summary
• T-bills are the safest, the most liquid, as it's issued by US government, considered risk free.
• Other money market instruments are also pretty safe, but not risk free like can still go to bankruptcy.)
The Bond Market
•Treasury Bonds and notes
• Corporate Bonds
• Municipal Bonds
• Mortgage Securities
• Federal Agency Debt
Treasury Bonds and notes
debt obligations of the federal government with original maturities of one year or more
Corporate Bonds
Bonds issued by corporations to fund operating expenses
Mortgage Securities
secured by a mortgage on the real property of the borrower
Equity Securities
•Common stocks
•Preferred stocks
•Stock market indexes
Common stocks
• Represents a fraction of ownership in a corporation.
• The right to vote, and the right to receive quarterly dividends.
• Dividends are not mandatory for common stocks.
Preferred stocks
• Although a "stock", but more like debt
• Promises a fixed stream of dividends every year, infinitely. not an obligation, but has to be paid before common stock A lthough dividends.
Stock market indexes
• Basically a portfolio consisting of all stocks. • We use stock market index to measure the overall performance of the whole market.
• Performance is measured by rate of return.
Price weighted
• Invests equal number of shares in each proportional to the price of each firm. stock, or $ amount
• Price weighted index level = average price of all stocks
Market value weighted
• Invests $ amount proportional to the market value
(price * number of shares outstanding) of each firm.
• Market value weighted index level = average market value of all stocks.
Equally-weighted
• Invests equal $ amount in each stock.
• Return on an Equally-weighted index = average return of all stocks.
Stock Market Index
-Dow Jones: 30 large, blue chip corporations, **price-weighted
-S&P500: 500 firms, ***market value weighted
-NASDAQ: more than 3000 stocks traded, ***market value weighted
Derivative asset
-Security with payoff that depends on the price of other securities
Call options
the right to BUY a stock at a pre-specified price, the option expiration date on or before the expiration date
-you must pay to buy options [Show Less]