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This is an excellent general site that is dedicated to
finance education. It contains information on debt http://www.cme.com
securities, equities, and derivative instruments.
These sites contain information on equity securities.
The above sites contain information on derivative
This site has extensive information on bonds and securities
interest rates.

his chapter covers a range of financial securities and the markets in which they

T trade. Our goal is to introduce you to the features of various security types. This
foundation will be necessary to understand the more analytic material that fol-
lows in later chapters.
We first describe money market instruments. We then move on to debt and eq-
uity securities. We explain the structure of various stock market indexes in this chap-
ter because market benchmark portfolios play an important role in portfolio
construction and evaluation. Finally, we survey the derivative security markets for op-
tions and futures contracts. A summary of the markets, instruments, and indexes cov-
ered in this chapter appears in Table 2.1.

The money market The bond market
TA B L E 2.1 Treasury bills Treasury bonds and notes
Financial markets and Certificates of deposit Federal agency debt
Commercial paper Municipal bonds
Bankers™ acceptances Corporate bonds
Eurodollars Mortgage-backed securities
Repos and reverses Equity markets
Federal funds Common stocks
Brokers™ calls Preferred stocks
Indexes Derivative markets
Dow Jones averages Options
Standard & Poor™s indexes Futures and forwards
Bond market indicators
International indexes
Bodie’Kane’Marcus: I. Elements of Investments 2. Global Financial © The McGraw’Hill
Essentials of Investments, Instruments Companies, 2003
Fifth Edition

26 Part ONE Elements of Investments

Financial markets are traditionally segmented into money markets and capital markets.
money markets
Money market instruments include short-term, marketable, liquid, low-risk debt securities.
Include short-term,
Money market instruments sometimes are called cash equivalents, or just cash for short. Cap-
highly liquid, and
ital markets, in contrast, include longer-term and riskier securities. Securities in the capital
relatively low-risk
debt instruments. 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 debt markets, equity mar-
capital markets kets, and the derivative markets for options and futures.
The money market is a subsector of the debt market. It consists of very short-term debt se-
Include longer-term,
curities that are highly marketable. Many of these securities trade in large denominations and
relatively riskier
securities. so are out of the reach of individual investors. Money market mutual funds, however, are eas-
ily 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.
Figure 2.1 is a reprint of a money rates listing from The Wall Street Journal. It includes the
various instruments of the money market that we describe in detail below. Table 2.2 lists out-
standing volume in 2000 of the major instruments of the money market.

F I G U R E 2.1
Rates on money
market securities
Source: From The Wall Street
Journal, October 19, 2001.
Reprinted by permission of
Dow Jones & Company, Inc.
via Copyright Clearance
Center, Inc. © 2001 Dow
Jones & Company, Inc. All
Rights Reserved Worldwide.
Bodie’Kane’Marcus: I. Elements of Investments 2. Global Financial © The McGraw’Hill
Essentials of Investments, Instruments Companies, 2003
Fifth Edition

2 Global Financial Instruments

Treasury Bills
U.S. Treasury bills (T-bills, or just bills, for short) are the most marketable of all money mar- Treasury bills
ket instruments. T-bills represent the simplest form of borrowing. The government raises Short-term
money by selling bills to the public. Investors buy the bills at a discount from the stated ma- government securities
turity value. At the bill™s maturity, the holder receives from the government a payment equal issued at a discount
from face value and
to the face value of the bill. The difference between the purchase price and the ultimate matu-
returning the face
rity value represents the investor™s earnings.
amount at maturity.
T-bills with initial maturities of 28, 91, and 182 days are issued weekly. Sales are con-
ducted by an auction where investors can submit competitive or noncompetitive bids.
A competitive bid is an order for a given quantity of bills at a specific offered price. The or-
der is filled only if the bid is high enough relative to other bids to be accepted. If the bid is
high enough to be accepted, the bidder gets the order at the bid price. Thus, the bidder risks
paying one of the highest prices for the same bill (bidding at the top), against the hope of bid-
ding “at the tail,” that is, making the cutoff at the lowest price.
A noncompetitive bid is an unconditional offer to purchase bills at the average price of the
successful competitive bids. The Treasury ranks bids by offering price and accepts bids in or-
der of descending price until the entire issue is absorbed by the competitive plus noncompet-
itive bids. Competitive bidders face two dangers: They may bid too high and overpay for the
bills or bid too low and be shut out of the auction. Noncompetitive bidders, by contrast, pay
the average price for the issue, and all noncompetitive bids are accepted up to a maximum of
$1 million per bid.
Individuals can purchase T-bills directly at the auction or on the secondary market from a
government securities dealer. T-bills are highly liquid; that is, they are easily converted to cash
and sold at low transaction cost and with little price risk. Unlike most other money market in-
struments, which sell in minimum denominations of $100,000, T-bills sell in minimum de-
nominations of only $10,000. While the income earned on T-bills is taxable at the Federal
level, it is exempt from all state and local taxes, another characteristic distinguishing T-bills
from other money market instruments.

Certificates of Deposit certificate of
A certificate of deposit (CD) is a time deposit with a bank. Time deposits may not be with-
drawn on demand. The bank pays interest and principal to the depositor only at the end of the A bank time deposit.

$ Billion
TA B L E 2.2
Repurchase agreements 354.3
Components of the
Small-denomination time deposits* 1,037.8
money market
Large-denomination time deposits† 766.0
Bankers™ acceptances 7.8
Eurodollars 196.1
Treasury bills 682.1
Commercial paper 1,539.0
Savings deposits 1,852.6
Money market mutual funds 1,657.1

Small denominations are less than $100,000.

Large denominations are greater than or equal to $100,000.
Source: Economic Report of the President, U.S. Government Printing Office, 2001; and Flow of Funds
Accounts: Flows and Outstandings, Board of Governors of the Federal Reserve System, June 2000.
Bodie’Kane’Marcus: I. Elements of Investments 2. Global Financial © The McGraw’Hill
Essentials of Investments, Instruments Companies, 2003
Fifth Edition

28 Part ONE Elements of Investments

fixed term of the CD. CDs issued in denominations larger than $100,000 are usually nego-
tiable, however; that is, they can be sold to another investor if the owner needs to cash in the
certificate before its maturity date. Short-term CDs are highly marketable, although the mar-
ket significantly thins out for maturities of three months or more. CDs are treated as bank
deposits by the Federal Deposit Insurance Corporation, so they are insured for up to $100,000
in the event of a bank insolvency.

Commercial Paper
The typical corporation is a net borrower of both long-term funds (for capital investments) and
short-term funds (for working capital). Large, well-known companies often issue their own
short-term unsecured debt notes directly to the public, rather than borrowing from banks.
These notes are called commercial paper (CP). Sometimes, CP 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.
Short-term unsecured
CP maturities range up to 270 days; longer maturities require registration with the Securi-
debt issued by large
ties and Exchange Commission and so are almost never issued. CP most commonly is issued
with maturities of less than one or two months in denominations of multiples of $100,000.
Therefore, small investors can invest in commercial paper only indirectly, through money
market mutual funds.
CP is considered to be a fairly safe asset, given that a firm™s condition presumably can be
monitored and predicted over a term as short as one month. It is worth noting, though, that
many firms issue commercial paper intending to roll it over at maturity, that is, issue new pa-
per to obtain the funds necessary to retire the old paper. If lenders become complacent about
monitoring a firm™s prospects and grant rollovers willy-nilly, they can suffer big losses. When
Penn Central defaulted in 1970, it had $82 million of commercial paper outstanding”the only
major default on commercial paper in the past 40 years.
CP trades in secondary markets and so is quite liquid. Most issues are rated by at least one
agency such as Standard & Poor™s. The yield on CP depends on the time to maturity and the
credit rating.

Bankers™ Acceptances
A bankers™ 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 six months. At this stage, it is like a postdated check.
When the bank endorses the order for payment as “accepted,” it assumes responsibility for ul-
An order to a bank by
timate payment to the holder of the acceptance. At this point, the acceptance may be traded in
a customer to pay a
secondary markets much like any other claim on the bank. Bankers™ acceptances are consid-
sum of money at a
future date. ered very safe assets, as they allow traders to substitute the bank™s credit standing for their
own. They are used widely in foreign trade where the creditworthiness of one trader is un-
known to the trading partner. Acceptances sell at a discount from the face value of the pay-
ment order, just as T-bills sell at a discount from par value.

Eurodollars are dollar-denominated deposits at foreign banks or foreign branches of Ameri-
Dollar-denominated can banks. By locating outside the United States, these banks escape regulation by the Federal
deposits at foreign
Reserve Board. Despite the tag “Euro,” these accounts need not be in European banks, al-
banks or foreign
though that is where the practice of accepting dollar-denominated deposits outside the United
branches of American
States began.
Bodie’Kane’Marcus: I. Elements of Investments 2. Global Financial © The McGraw’Hill
Essentials of Investments, Instruments Companies, 2003
Fifth Edition

2 Global Financial Instruments

Most Eurodollar deposits are for large sums, and most are time deposits of less than six
months™ maturity. A variation on the Eurodollar time deposit is the Eurodollar certificate of de-
posit. A Eurodollar CD resembles a domestic bank CD except it is the liability of a non-U.S.
branch of a bank, typically a London branch. The advantage of Eurodollar CDs over Eurodollar
time deposits is that the holder can sell the asset to realize its cash value before maturity.
Eurodollar CDs are considered less liquid and riskier than domestic CDs, however, and so offer
higher yields. Firms also issue Eurodollar bonds, that is, dollar-denominated bonds outside the
U.S., although such bonds are not a money market investment by virtue of their long maturities.

Repos and Reverses
Dealers in government securities use repurchase agreements, also called repos, or RPs, as a repurchase
form of short-term, usually overnight, borrowing. The dealer sells securities to an investor on agreements
an overnight basis, with an agreement to buy back those securities the next day at a slightly (repos)
higher price. The increase in the price is the overnight interest. The dealer thus takes out a one- Short-term sales of
day loan from the investor. The securities serve as collateral for the loan. government securities
A term repo is essentially an identical transaction, except the term of the implicit loan can with an agreement to


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