Financial Instruments, Markets and Information

Latest Revision: October 26, 1995

I.1 Introduction

There are numerous financial instruments available to investors and financial managers. Each year new instruments arrive on the market and some leave. Many of the large investment houses have researchers developing new types of instruments. An example of a recent innovation is the Caput. This instrument is an option on an option. Some investment houses have been selling call options (an option to buy at a prespecified price) on put options (an option to sell at a prespecified price). We will examine methods to price these types of exotic instruments later in the course.

The following is a short list of some of the instruments available. I have split the instruments into a number of broad categories. The first is Money Market Instruments. These instruments are short-term cash substitutes. They usually have short maturities (one year or less), little or no default risk, and are highly liquid. The second category is Fixed-Income Capital Market Instruments. These instruments are characterized by longer term maturities (greater than a year), their default risk is sometimes higher and they are generally less liquid. The third category is Equity Securities. These securities represent a residual claim on the assets of a corporation, i.e., all the fixed income obligations must be paid first. The fourth category consists of all the other types of instruments such as Futures and Options.

(a) Money Market Instruments

1. Treasury Bills
2. Federal Agency Securities
3. Municipal Notes
4. Certificates of Deposit
5. Commercial Paper
6. Repurchase Agreements
7. Bankers' Acceptances
8. Eurodollars
9. Federal Funds

(b) Fixed-Income Capital Market

1. U.S. Savings Bonds
2. U.S. Treasury Notes
3. U.S. Treasury Bonds
4. U.S. Agency Issues
5. Municipal Issues
6. Corporate Issues
7. Eurobonds

(c) Equity Securities

1. Preferred Stock
2. Common Stock

(d) Other Instruments

1. Investment Company Shares
2. Options
3. Warrants
4. Forwards and Futures

I.2 Money Market Instruments

Treasury Bills have maturities of up to one year. They are purchased at a discount from face value. T-Bills are usually traded in $10,000 denominations.

Federal Agencies such as the Federal Home Loan Bank System (which lends to the nation's Savings and Loan Banks) often issue discount notes that resemble T-Bills.

Municipal Notes are debt securities issued by state and local governments. The notes are interest bearing with maturities that range from a month to more than a year. The interest from these notes is exempt from federal taxation and usually exempt from state income tax.

Certificates of Deposit are large deposits ($100,000 or more) placed in commercial banks at a stated rate of interest. There are also variable rate CDs. For example, if a month variable rate CD was purchased, at every roll date (30 days) the bank resets the coupon. A third type of CD is the Eurodollar CD. This is simply a certificate of deposit issued in U.S. dollars at a foreign bank (usually U.S. branches in London or the Caribbean).

Commercial Paper is issued by large corporations as an alternative to securing short-term bank loans. Commercial paper is an unsecured promissory note and is usually issued on a discount basis. Most of the paper issued is 30 days in maturity although paper can be issued up to 270 days.

Repurchase Agreements are contractual agreements between two parties to buy and sell U.S. government securities at particular points in time. Repos are usually used by dealers. If the dealer has a large inventory of T-Bills (which might exceed the firm's capital), this inventory has to be financed. The dealer could get a bank loan or he could enter into a repurchase agreement with some other party (e.g. a local government) that happens to be cash rich. The dealer will sell his inventory to the other party and will agree to repurchase at a fixed price on a certain date.

Bankers' Acceptances have traditionally arisen from international trade. The acceptance is a time draft which the accepting bank has agreed to pay at a specified future date. It is best illustrated by an example. Suppose I want to import digital audio tape players from Japan. I have my U.S. bank write a letter of credit to the exporter's bank in Japan guaranteeing the payment for the DAT players. After receiving the letter, the exporter ships the machines and prepares a draft on the U.S. bank. The Japanese bank pays the exporter. The draft is then sent to the U.S. bank where it is accepted. A bankers' acceptance has been created. It can be returned to the Japanese bank (if Japanese bank wants to hold it as an investment), it can be kept by the U.S. bank (if the Japanese bank wanted cash immediately) or it can be sold on the open market. The bankers' acceptance is essentially a promissory note which stipulates a payment date and the amount of payment. Often bankers' acceptances are used by borrowers who are too small or too risky to issue commercial paper.

Eurodollars are simply U.S. dollar deposits in foreign banks. The deposits are often made for fixed time interval at a stated rate of interest. The eurodollar market is quite liquid and it offers the advantage of not being regulated the U.S. government.

Federal Funds are only available to banks that are members of the Federal Reserve System. Banks that are members of the system are required to keep required reserves with the Federal Reserve. Since interest is not paid on these required reserves, it is in the member bank's interest to keep the reserves at the minimum level. Since it is impossible to predict the day-to-day withdrawals and deposits, some member banks will have deficiencies and some will have surpluses. The Fed funds market allows banks with excess reserves to lend to those with deficiencies. Most of the Fed funds market trading is done on an overnight basis.

I.3 Fixed-Income Capital Markets

U.S. Savings Bonds are generally sold to individuals are non-negotiable. Series EE bonds are essentially discount bonds (no periodic cash payments) while series HH bonds pay interest semiannually.

U.S. Treasury Notes are have maturities of 1 to 10 years and pay interest on a semiannual basis.

U.S. Treasury Bonds are similar to treasury notes with maturities ranging from 5 to 35 years. Some bonds have call provisions which allow the federal government to retire the issue at a stated price at most 5 years prior to maturity.

U.S. Agency Issues are sold by government agencies to support their financial activities. Although not all of the agencies' securities are backed by the U.S. government, they are considered low risk because of implied government backing. The major agencies selling marketable securities are:

1. Federal National Mortgage Association ( Fannie Maes)
2. Federal Home Loan Banks
3. Federal Land Banks
4. Federal Intermediate Credit Banks
5. Banks for Cooperatives
6. Government National Mortgage Association ( Ginnie Maes)
7. Student Loan Marketing Association ( Sallie Maes)

Municipal Issues are sold by states, counties, cities and other political corporations. The most important feature of the municipal bonds is their tax treatment.

Corporate Issues are usually term bonds with maturity of 5 years or more. The bond's indenture sets forth the repayment schedule, call provisions, restrictions on dividend payments and types of collateral. Unsecured bonds are known as debentures. In the event of liquidation, the debenture holders are paid after the other bond holders (ones with collateral) have been reimbursed.

Eurobonds are U.S. dollar bonds that offered outside of the United States. Since the Euromarket is unregulated and untaxed, there is considerable advantage in using these instruments.

I.4 Equity Securities

Preferred Stock is a security with a defined, fixed periodic claim on the income of a firm. Dividends on preferred stock must be paid before dividends on common stock.

Common Stock is the residual claim to the earnings of the corporation. Payment of dividends is discretionary.

I.5 Other Securities

Investment Company Shares take two forms: close-ended and open-ended. Investment companies sell shares to the public and use the proceeds to invest in debt and equity instruments. Open-ended investment companies are known as mutual funds. All transactions take place between the mutual fund and the investor. The price that the mutual fund will buy or sell shares is pegged at the net asset value of its portfolio of securities. A close-ended fund obtains all of its capital with some initial public offering. After the offering, the shares trade on the secondary market.

Options give the owner the right to buy or sell a particular security at a prespecified price on or before a prespecified expiration date. Note that the option has no direct claim on the assets of the firm. For this reason, options are sometimes referred to as secondary securities. They are written by investors -- not the firm. Call options give the owner the right to buy the underlying security at a prespecified price while Put options allow the owner to sell at a fixed price.

Warrants are call options issued by the firm. The warrant gives the holder the right to buy shares of stock in the corporation at a particular price. Note that the warrant is a primary security in that it represents a claim on the corporation's assets.

Forwards and Futures contracts obligate the holder of the contract to buy or sell a particular commodity at a set price on a fixed date.

I.6 Markets

There are two broad categories of markets: Primary and Secondary. The primary market is dominated by investment banking firms. New securities are usually sold in the primary market to these firms. The investment bank will then offer its part of the issue to the general investor. The secondary market is where securities are traded from investor to investor either on an organized exchange or over-the-counter.

Organized Exchanges are centralized auction-like markets. The two largest stock markets are the New York Stock Exchange (NYSE) and the American Stock Exchange (AMEX). Also, there are organized exchanges for options: the Chicago Board of Options Exchange (CBOE), the American Stock Exchange, the Philadelphia Stock Exchange and the Pacific Coast Stock Exchange. Futures contracts trade on the Chicago Mercantile Exchange, the Chicago Board of Trade and the New York Futures Exchange.

The Over-the-Counter market is a network of dealers in particular securities. Securities that are not traded on the organized exchanges are trade OTC. Prices are quoted through the National Association of Security Dealers Automated Quotation System (NASDAQ).

I.7 Information

Information is critical to the operation of capital markets. Prices respond to the arrival of new information. There are two broad classifications: Public and Private.

Examples of public information are regularly scheduled macro economic news announcements. A summary of the scheduled announcements for the week and the market forecasts appears on page 2 of the Wall Street Journal. Most of these announcements take place at 8:30am Eastern Time (before the U.S. stock markets open but ten minutes after the many of the futures contracts have begun trading). Most in finance track these important macroeconomic announcements. The surprises (actual minus forecast) move the market. For example, if inflation is higher than expected, the fixed income securities will almost always lose value (as investors demand a higher yield to compensate them for the higher inflation).

Private information is more difficult to pin down. It is usually revealed by trading activity. For example, an investor with negative information about a firm's prospects might sell a large block of stock. When the market observes the size of the block and the price drop, they will infer this negative news. However, the private information trader will act strategically. It is unlikely that she will dump all the stock in one block. Trades will probably be executed in smaller pieces (and might even be cloaked with some contradictory buy orders). [A comprehensive analysis of information and volatility is contained in the working paper ``Information Trading and Fixed Income Volatility'' by Campbell R. Harvey and Roger D. Huang.]

I.8 Information Technology

Timely information is critical to your success. The minimum condition is a daily read of the Wall Street Journal. One should concentrate on the third section, `Money & Investing'. You should also read the WSJ every day. The weekly Barron's also includes excellent financial coverage.

For an international perspective, I recommend the Financial Times. This is usually delivered one day late (however, same day delivery is possible in major cities). The Wall Street Journal Europe is also in the library.

Of course, for trading, these information sources are not enough. Most traders have access to the Reuters wire and most traders in the fixed income market use Telerate. Datastream is also an excellent service. The library has two ports.

I also recommend my homepage. It has a listing of useful Finance sites on the Internet.

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