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In the first part of this article we have learned that the process of building an investment portfolio usually begins by deciding how much money to allocate to broad classes of assets, such as safe money market securities or bank accounts, longer term bonds, stocks or even asset classes like real estate or precious metals. This process is called asset allocation. Within each class the investor then selects specific assets from a more detailed menu. This is called security selection.
Financial markets are traditionally segmented into Money markets and Capital markets. Money market instruments include short-term, marketable, liquid, low-risk debt securities. Money market instruments some-times are called cash equivalents, or just cash for short.
Capital markets, in contract, include longer term and riskier securities. Securities in the capital market are much more diverse than those found within the money market. For this reason, we will subdivide the capital market into four segments:
- Longer term bond markets
- Equity Markets
- Derivative markets for options
The Money Market
The money market is a subsector of the fixed-income market. It consists of very short- term debt securities that usually are highly marketable. Money mar- ket funds, however, are easily accessible to small investors. These mutual funds pool the resources of many investors and purchase a wide variety of money market securities on their behalf.
U.S. Treasury bills (T-bills, or just bills, for short) are the most marketable of all money market instruments. T-bills represent the simplest form of borrowing: The government raises money by selling bills to the public. Investors buy the bills at a discount from the stated maturity value. At the bill’s maturity, the holder receives from the government a payment equal to the face value of the bill. The difference between the purchase price and ultimate maturity value constitutes the investor’s earnings.
T-bills are issued with initial maturities of 4, 13, 26, or 52 weeks. Individuals can pur- chase T-bills directly, at auction, or on the secondary market from a government securi- ties dealer. T-bills are highly liquid; that is, they are easily converted to cash and sold at low transaction cost and with not much price risk.
The income earned on T-bills is exempt from all state and local taxes, another characteristic distinguishing them from other money market instruments.
The ask price is the price you would have to pay to buy a T-bill from a securities dealer. The bid price is the slightly lower price you would receive if you wanted to sell a bill to a dealer. The bid–ask spread is the difference in these prices, which is the dealer’s source of profit .
Certificates of Deposit
A certificate of deposit, or CD, is a time deposit with a bank. Time deposits may not be withdrawn on demand. The bank pays interest and principal to the depositor only at the end of the fixed term of the CD.
CDs are treated as bank deposits by the Federal Deposit Insurance Corporation, so they are cur- rently insured for up to $250,000 in the event of a bank insolvency.
Large, well-known companies often issue their own short-term unsecured debt notes rather than borrow directly from banks. These notes are called commercial paper. Very often, commercial paper is backed by a bank line of credit, which gives the borrower access to cash that can be used (if needed) to pay off the paper at maturity.
Commercial paper is considered to be a fairly safe asset, because a firm’s condition presumably can be monitored and predicted over a term as short as 1 month.
While most commercial paper is issued by nonfinancial firms, in recent years there was a sharp increase in asset-backed commercial paper issued by financial firms such as banks. This was short-term commercial paper typically used to raise funds for the institution to invest in other assets, most notoriously, subprime mortgages. These assets were in turn used as collateral for the commercial paper—hence the label “asset backed.” This practice led to many difficulties starting in the summer of 2007 when the subprime mortgagors began defaulting. The banks found themselves unable to issue new commercial paper to refinance their positions as the old paper matured.
A banker’s acceptance starts as an order to a bank by a bank’s customer to pay a sum of money at a future date, typically within 6 months. At this stage, it is similar to a postdated check. When the bank endorses the order for payment as “accepted,” it assumes respon- sibility for ultimate payment to the holder of the acceptance. At this point, the acceptance may be traded in secondary markets like any other claim on the bank. Bankers’ acceptances are considered very safe assets because traders can substitute the bank’s credit standing for their own. They are used widely in foreign trade where the creditworthiness of one trader is unknown to the trading partner. Acceptances sell at a discount from the face value of the payment order, just as T-bills sell at a discount from par value.
Eurodollars are dollar-denominated deposits at foreign banks or foreign branches of American banks. By locating outside the United States, these banks escape regulation by the Federal Reserve. Despite the tag “Euro,” these accounts need not be in European banks, although that is where the practice of accepting dollar-denominated deposits outside the United States began.
Repos and Reverses
Dealers in government securities use repurchase agreements, also called “repos” or “RPs,” as a form of short-term, usually overnight, borrowing. The dealer sells govern- ment securities to an investor on an overnight basis, with an agreement to buy back those securities the next day at a slightly higher price. The increase in the price is the overnight interest. The dealer thus takes out a 1-day loan from the investor, and the securities serve as collateral.
A term repo is essentially an identical transaction, except that the term of the implicit loan can be 30 days or more. Repos are considered very safe in terms of credit risk because the loans are backed by the government securities. A reverse repo is the mirror image of a repo. Here, the dealer finds an investor holding government securities and buys them, agreeing to sell them back at a specified higher price on a future date.
Just as most of us maintain deposits at banks, banks maintain deposits of their own at a Federal Reserve bank. Each member bank of the Federal Reserve System, or “the Fed,” is required to maintain a minimum balance in a reserve account with the Fed. The required balance depends on the total deposits of the bank’s customers. Funds in the bank’s reserve account are called federal funds, or fed funds. At any time, some banks have more funds than required at the Fed. Other banks, primarily big banks in New York and other financial centers, tend to have a shortage of federal funds. In the federal funds market, banks with excess funds lend to those with a shortage. These loans, which are usually overnight transactions, are arranged at a rate of interest called the federal funds rate.
Although the fed funds market arose primarily as a way for banks to transfer balances to meet reserve requirements, today the market has evolved to the point that many large banks use federal funds in a straightforward way as one component of their total sources of funding. Therefore, the fed funds rate is simply the rate of interest on very short-term loans among financial institutions. While most investors cannot participate in this market, the fed funds rate commands great interest as a key barometer of monetary policy.
Individuals who buy stocks on margin borrow part of the funds to pay for the stocks from their broker. The broker in turn may borrow the funds from a bank, agreeing to repay the bank immediately (on call) if the bank requests it. The rate paid on such loans is usually about 1% higher than the rate on short-term T-bills.
The LIBOR Market
The London Interbank Offered Rate (LIBOR) is the rate at which large banks in London are willing to lend money among themselves. This rate, which is quoted on dollar- denominated loans, has become the premier short-term interest rate quoted in the European money market, and it serves as a reference rate for a wide range of transactions. For exam- ple, a corporation might borrow at a floating rate equal to LIBOR plus 2%.
Yields on Money Market Instruments
Although most money market securities are of low risk, they are not risk-free. The secu- rities of the money market promise yields greater than those on default-free T-bills, at least in part because of greater relative riskiness.
The Bond Market
The bond market is composed of longer term borrowing or debt instruments than those that trade in the money market. This market includes Treasury notes and bonds, corporate bonds, municipal bonds, mortgage securities, and federal agency debt.
These instruments are sometimes said to comprise the fixed-income capital market, because most of them promise either a fixed stream of income or a stream of income that is determined according to a specific formula. In practice, these formulas can result in a flow of income that is far from fixed. Therefore, the term fixed income is probably not fully appropriate. It is simpler and more straightforward to call these securities either debt instruments or bonds.
Treasury Notes and Bonds
The U.S. government borrows funds in large part by selling Treasury notes and Treasury bonds. T-notes are issued with maturities ranging up to 10 years, while bonds are issued with maturities ranging from 10 to 30 years. Both notes and bonds may be issued in increments of $100 but far more commonly trade in denominations of $1,000. Both notes and bonds make semiannual interest payments called coupon payments, a name derived from precomputer days, when investors would literally clip coupons attached to the bond and pres- ent a coupon to receive the interest payment.
The yield to maturity reported in the financial pages is calculated by determining the semiannual yield and then doubling it, rather than compounding it for two half-year periods. This use of a simple interest technique to annualize means that the yield is quoted on an annual percentage rate (APR) basis rather than as an effective annual yield. The APR method in this context is also called the bond equivalent yield.
Inflation-Protected Treasury Bonds
The best place to start building an investment portfolio is at the least risky end of the spectrum. Around the world, governments of many countries, including the United States, have issued bonds that are linked to an index of the cost of living in order to provide their citizens with an effective way to hedge inflation risk.
In the United States inflation-protected Treasury bonds are called TIPS (Treasury Inflation-Protected Securities). The principal amount on these bonds is adjusted in propor- tion to increases in the Consumer Price Index. Therefore, they provide a constant stream of income in real (inflation-adjusted) dollars. Yields on TIPS bonds should be interpreted as real or inflation-adjusted interest rates.
Federal Agency Debt
Some government agencies issue their own securities to finance their activities. These agencies usually are formed to channel credit to a particular sector of the economy that Congress believes might not receive adequate credit through normal private sources.
The major mortgage-related agencies are the Federal Home Loan Bank (FHLB), the Federal National Mortgage Association (FNMA, or Fannie Mae), the Government National Mortgage Association (GNMA, or Ginnie Mae), and the Federal Home Loan Mortgage Corporation (FHLMC, or Freddie Mac). The FHLB borrows money by issuing securities and lends this money to savings and loan institutions to be lent in turn to individuals bor- rowing for home mortgages.
Many firms borrow abroad and many investors buy bonds from foreign issuers. In addition to national capital markets, there is a thriving international capital market, largely centered in London.
A Eurobond is a bond denominated in a currency other than that of the country in which it is issued. For example, a dollar-denominated bond sold in Britain would be called a Eurodollar bond. Similarly, investors might speak of Euroyen bonds, yen-denominated bonds sold outside Japan. Because the European currency is called the euro, the term Eurobond may be confusing. It is best to think of them simply as international bonds.
Municipal bonds are issued by state and local governments. They are similar to Treasury and corporate bonds except that their interest income is exempt from federal income taxa- tion. The interest income also is usually exempt from state and local taxation in the issuing state. Capital gains taxes, however, must be paid on “munis” when the bonds mature or if they are sold for more than the investor’s purchase price.
Corporate bonds are the means by which private firms borrow money directly from the public. These bonds are similar in structure to Treasury issues—they typically pay semi- annual coupons over their lives and return the face value to the bondholder at maturity. They differ most importantly from Treasury bonds in degree of risk. Default risk is a real consideration in the purchase of corporate bonds.
Corporate bonds sometimes come with options attached. Callable bonds give the firm the option to repurchase the bond from the holder at a stipulated call price. Convertible bonds give the bondholder the option to convert each bond into a stipulated number of shares of stock.
Mortgages and Mortgage-Backed Securities
Because of the explosion in mortgage-backed securities, almost anyone can invest in a portfolio of mortgage loans, and these securities have become a major component of the fixed-income market.
Common Stock as Ownership Shares
Common stocks, also known as equity securities or equities, represent ownership shares in a corporation. Each share of common stock entitles its owner to one vote on any matters of corporate governance that are put to a vote at the corporation’s annual meeting and to a share in the financial benefits of ownership.
A corporation sometimes issues two classes of common stock, one bearing the right to vote, the other not. Because of its restricted rights, the nonvoting stock might sell for a lower price.
The corporation is controlled by a board of directors elected by the shareholders. The board, which meets only a few times each year, selects managers who actually run the corporation on a day-to-day basis. Managers have the authority to make most business decisions without the board’s specific approval. The board’s mandate is to oversee the management to ensure that it acts in the best interests of shareholders.
The common stock of most large corporations can be bought or sold freely on one or more stock exchanges. A corporation whose stock is not publicly traded is said to be closely held. In most closely held corporations, the owners of the firm also take an active role in its management. Therefore, takeovers are generally not an issue.
Characteristics of Common Stock
The two most important characteristics of common stock as an investment are its residual claim and limited liability features.
Residual claim means that stockholders are the last in line of all those who have a claim on the assets and income of the corporation. In a liquidation of the firm’s assets the shareholders have a claim to what is left after all other claimants such as the tax authorities, employees, suppliers, bondholders, and other creditors have been paid. For a firm not in liquidation, shareholders have claim to the part of operating income left over after inter-est and taxes have been paid. Management can either pay this residual as cash dividends to shareholders or reinvest it in the business to increase the value of the shares.
Stock Market Listings
The NYSE is one of several markets in which investors may buy or sell shares of stock. The P/E ratio tells us how much stock purchasers must pay per dollar of earnings that the firm generates.
Preferred stock has features similar to both equity and debt. Like a bond, it promises to pay to its holder a fixed amount of income each year. In this sense preferred stock is similar to an infinite-maturity bond, that is, a perpetuity. It also resembles a bond in that it does not convey voting power regarding the management of the firm. Preferred stock is an equity investment, however. The firm retains discretion to make the dividend payments to the preferred stockholders; it has no contractual obligation to pay those dividends. Instead, preferred dividends are usually cumulative; that is, unpaid dividends cumulate and must be paid in full before any dividends may be paid to holders of com- mon stock. In contrast, the firm does have a contractual obligation to make the interest payments on the debt. Failure to make these payments sets off corporate bankruptcy proceedings.
Preferred stock is issued in variations similar to those of corporate bonds. It may be callable by the issuing firm, in which case it is said to be redeemable. It also may be con- vertible into common stock at some specified conversion ratio. Adjustable-rate preferred stock is another variation that, like adjustable-rate bonds, ties the dividend to current mar- ket interest rates.
American Depository Receipts, or ADRs, are certificates traded in U.S. markets that repre- sent ownership in shares of a foreign company. Each ADR may correspond to ownership of a fraction of a foreign share, one share, or several shares of the foreign corporation. ADRs were created to make it easier for foreign firms to satisfy U.S. security registration require- ments. They are the most common way for U.S. investors to invest in and trade the shares of foreign corporations.
Stock and Bond Market Indexes
Stock market Indexes
The daily performance of the Dow Jones Industrial Average is a staple portion of the evening news report. Although the Dow is the best-known measure of the performance of the stock market, it is only one of several indicators. Other more broadly based indexes are computed and published daily. In addition, several indexes of bond market perfor- mance are widely available.
The ever-increasing role of international trade and investments has made indexes of foreign financial markets part of the general news as well. Thus foreign stock exchange indexes such as the Nikkei Average of Tokyo and the Financial Times index of London are fast becoming household names.
Dow Jones Averages
The Dow Jones Industrial Average (DJIA) of 30 large, “blue-chip” corporations has been computed since 1896. Its long history probably accounts for its preeminence in the public mind. (The average covered only 20 stocks until 1928.)
Originally, the DJIA was calculated as the average price of the stocks included in the index. Thus, one would add up the prices of the 30 stocks in the index and divide by 30. The percentage change in the DJIA would then be the percentage change in the average price of the 30 shares.
This procedure means that the percentage change in the DJIA measures the return (excluding dividends) on a portfolio that invests one share in each of the 30 stocks in the index. The value of such a portfolio (holding one share of each stock in the index) is the sum of the 30 prices. Because the percentage change in the average of the 30 prices is the same as the percentage change in the sum of the 30 prices, the index and the portfolio have the same percentage change each day.
Because the Dow corresponds to a portfolio that holds one share of each component stock, the investment in each company in that portfolio is proportional to the company’s share price. Therefore, the Dow is called a price-weighted average.
Standard & Poor’s Indexes
The Standard & Poor’s Composite 500 (S&P 500) stock index represents an improvement over the Dow Jones Averages in two ways. First, it is a more broadly based index of 500 firms. Second, it is a market-value-weighted index.
The S&P 500 is computed by calculating the total market value of the 500 firms in the index and the total market value of those firms on the previous day of trading. The percent- age increase in the total market value from one day to the next represents the increase in the index. The rate of return of the index equals the rate of return that would be earned by an investor holding a portfolio of all 500 firms in the index in proportion to their market values, except that the index does not reflect cash dividends paid by those firms.
Actually, most indexes today use a modified version of market-value weights. Rather than weighting by total market value, they weight by the market value of free float, that is, by the value of shares that are freely tradable among investors. For example, this procedure does not count shares held by founding families or governments. These shares are effec- tively not available for investors to purchase. The distinction is more important in Japan and Europe, where a higher fraction of shares are held in such nontraded portfolios.
Investors today can easily buy market indexes for their portfolios. One way is to pur- chase shares in mutual funds that hold shares in proportion to their representation in the S&P 500 or another index. These index funds yield a return equal to that of the index and so provide a low-cost passive investment strategy for equity investors. Another approach is to purchase an exchange-traded fund, or ETF, which is a portfolio of shares that can be bought or sold as a unit, just as one can buy or sell a single share of stock. Available ETFs range from portfolios that track extremely broad global market indexes all the way to nar- row industry indexes.
Standard & Poor’s also publishes a 400-stock Industrial Index, a 20-stock Transportation Index, a 40-stock Utility Index, and a 40-stock Financial Index.
Other U.S. Market-Value Indexes
The New York Stock Exchange publishes a market-value-weighted composite index of all NYSE-listed stocks, in addition to subindexes for industrial, utility, transportation, and financial stocks. These indexes are even more broadly based than the S&P 500. The National Association of Securities Dealers publishes an index of more than 3,000 firms traded on the NASDAQ market.
Equally Weighted Indexes
Market performance is sometimes measured by an equally weighted average of the returns of each stock in an index. Such an averaging technique, by placing equal weight on each return, corresponds to an implicit portfolio strategy that invests equal dollar values in each stock. This is in contrast to both price weighting (which requires equal numbers of shares of each stock) and market-value weighting (which requires investments in proportion to outstanding value).
Unlike price- or market-value-weighted indexes, equally weighted indexes do not corre- spond to buy-and-hold portfolio strategies.
Foreign and International Stock market Indexes
Development in financial markets worldwide includes the construction of indexes for these markets. Among these are the Nikkei (Japan), FTSE (U.K.; pronounced “footsie”), DAX (Germany), Hang Seng (Hong Kong), and TSX (Canada).
A leader in the construction of international indexes has been MSCI (Morgan Stanley Capital International), which computes over 50 country indexes and several regional indexes.
Bond Market Indicators
Just as stock market indexes provide guidance concerning the performance of the overall stock market, several bond market indicators measure the performance of various catego- ries of bonds. The three most well-known groups of indexes are those of Merrill Lynch, Barclays (formerly, the Lehman Brothers index), and Salomon Smith Barney (now part of Citigroup).
The major problem with bond market indexes is that true rates of return on many bonds are difficult to compute because the infrequency with which the bonds trade makes reliable up-to-date prices difficult to obtain. In practice, some prices must be estimated from bond-valuation models. These “matrix” prices may differ from true market values.
One of the most significant developments in financial markets in recent years has been the growth of futures, options, and related derivatives markets. These instruments provide payoffs that depend on the values of other assets such as commodity prices, bond and stock prices, or market index values. For this reason these instruments sometimes are called derivative assets. Their values derive from the values of other assets.
A call option gives its holder the right to purchase an asset for a specified price, called the exercise or strike price, on or before a specified expiration date. For example, a July call option on IBM stock with an exercise price of $180 entitles its owner to purchase IBM stock for a price of $180 at any time up to and including the expiration date in July. Each option contract is for the purchase of 100 shares. However, quotations are made on a per- share basis. The holder of the call need not exercise the option; it will be profitable to exer- cise only if the market value of the asset that may be purchased exceeds the exercise price.
If not exercised before the expiration date of the contract, the option simply expires and no longer has value. Calls therefore provide greater profits when stock prices increase and thus represent bullish investment vehicles.
In contrast, a put option gives its holder the right to sell an asset for a specified exercise price on or before a specified expiration date. A July put on IBM with an exercise price of $180 thus entitles its owner to sell IBM stock to the put writer at a price of $180 at any time before expiration in July, even if the market price of IBM is lower than $180.
A futures contract calls for delivery of an asset (or in some cases, its cash value) at a spec- ified delivery or maturity date for an agreed-upon price, called the futures price, to be paid at contract maturity. The long position is held by the trader who commits to purchasing the asset on the delivery date. The trader who takes the short position commits to delivering the asset at contract maturity.
The right to purchase the asset at an agreed-upon price, as opposed to the obligation, distinguishes call options from long positions in futures contracts. A futures contract obliges the long position to purchase the asset at the futures price; the call option, in con- trast, conveys the right to purchase the asset at the exercise price. The purchase will be made only if it yields a profit.
Clearly, a holder of a call has a better position than the holder of a long position on a futures contract with a futures price equal to the option’s exercise price. This advantage, of course, comes only at a price. Call options must be purchased; futures contracts are entered into without cost. The purchase price of an option is called the premium. It represents the com- pensation the purchaser of the call must pay for the ability to exercise the option only when it is profitable to do so. Similarly, the difference between a put option and a short futures posi- tion is the right, as opposed to the obligation, to sell an asset at an agreed-upon price.