CHAPTER TWO

FINANCIAL INSTRUMENTS

CHAPTER OVERVIEW
This chapter describes the financial instruments traded in the primary and secondary markets. It contains
an overview discussion of money market, capital market instruments and derivative securities. The various
market indexes that are used as indicators of "the market" are also described. The chapter concludes with a
discussion of options and futures.

LEARNING OBJECTIVES
Upon completion of this chapter the student should have a thorough understanding of the various financial
instruments available to the potential investor. The student should have an insight as to the interpretation,
composition, and calculation process involved in the various market indexes presented on the evening news.
Finally, the student should have some understanding of the basics of options and futures contracts.

PRESENTATION OF MATERIAL
1. Markets and Instruments
An overview of the various financial instruments is displayed in PPT 2-2. Discussion of the major classes
serves as a base for the discussion of the chapter material.

PPT 2-2 Major Types of Securities

The basic distinction between money and capital markets is then discussed. It is useful to discuss how the
various classes of financial assets fit into the classification of the money market and capital market.
Specifically, it is useful to describe examples of derivative securities that fit in both the capital and money
markets.

PPT 2-3 Markets and Instruments

2. Money Market Instruments

The major money market instruments that are discussed in the text are presented in PPT 2-4 and PPT 2-5.
In describing the individual instruments it is helpful for the students understanding of the market to
integrate discussion of institutional characteristics of the instruments. For example, commercial banks are
the major participants for many of the instruments. If students have adequate backgrounds from
prerequisite classes, discussion of characteristics of marketability, liquidity and default risk may be
appropriate. Discussion of the concepts should be delayed to later chapters if student’s backgrounds are
not adequate.

PPT 2-4 Money Market Instruments

PPT 2-5 Money Market Instruments (Cont.)

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3. Bond Market Instruments
Debt instruments are issued by both public and private entities. The Treasury and Agency issues have the
direct or implied guaranty of the federal government. Since state and local entities issue municipal bonds,
performance on these bonds does not have the same degree of safety. International bonds can be issued by
foreign governments or by corporations. Mortgage-backed securities can be issued by government
sponsored agencies or they can also be issued privately.

PPT 2-6 Bond Markets

Since the interest income on municipal bonds is not subject to federal taxes, the taxable equivalent yield is
used for comparison. Alternatively, the tax rate that makes you equivalent between a taxable and a
nontaxable instrument are used for comparison. Some difference in yields on municipals may be attributed
to lower liquidity of municipals and default risk differences.

PPT 2-7 Municipal Bond Yields

Two key points are relevant in the discussion of equity instruments. First, the issue of common stock
owners having a residual claim to the earnings of the firm should be emphasized. The priorities of debt
holders and preferred stockholders are contrasted with common shareholders. Second, the differences in
preferred stock and common stock dividends should be emphasized. Preferred shareholders have a priority
claim to income in the form of dividends. Ordinary preferred stockholders are limited to the fixed dividend
while common shareholders do not have limits. The partial tax exemption on dividends of one corporation
being received by another corporation is important in discussing preferred stock.

PPT 2-8 Capital Market - Equity

4. Stock Market Indexes

The uses of stock indexes provide a good starting point for the discussion of the structure and construction
of stock indexes. Motivational factors include tracking average returns, making comparisons of managers’
performance to average performance and, increasingly, indexes are used as a base for derivative
instruments. Discussion of the factors in constructing or using an index focused the students' attention to
key differences in the indexes.

PPT 2-9 Stock Market Indexes

The examples of domestic indexes shown in PPT 2-10 show significant contrast on breadth of the indexes.
The sample of domestic indexes also fit well with discussion of uses of the index. If the index were going
to be used to assess the performance of a manager that invests in Small-Cap firms, the DJIA would not be
as appropriate of benchmark as the NASDAQ Composite.

PPT 2-10 Examples of Indexes - Domestic

The international indexes in PPT 2-11 represent indexes that have popular appeal. They include only a
small example of what it available but they are representative of the major types of indexes and major
countries. The text has several examples of greater detail in several exhibits.

PPT 2-11 Examples of Indexes - International

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A sample of bond indexes is displayed in PPT 2-12. Bond indexes are more difficult to construct than
equity indexes due to the declining maturity of bonds. The structure of the indexes is presented in Table 2.6
of the text. In recent years specialized indexes such as the Merrill Lynch Mortgage Index have become
more widely used.

PPT 2-12 Bond Indexes

The issue of weighting structures for indexes is described in PPT 2-13. The major factor to contrast in the
discussion is whether the index is price weighted or market value weighted. The third possibility is equal
weighting. While this method is not too commonly observed in published indexes, it is commonly used in
research. This concept is important in describing results on empirical examinations on market efficiency in
later chapters. The issue of how the returns on the components of the indexes are averaged is also described
in PPT 2-13. An example of alternative averaging methods is presented in PPT 2-14.

PPT 2-13 Construction of Indexes

PPT 2-14 Averaging Methods

5. Derivative Securities
Basic positions and terms for options and futures are described in PPT 2-15. The basic positions and terms
are used to contrast the essential differences in the futures and options. The essential difference is related to
the right but not the requirement to exercise the option while the futures contract represents a firm
commitment to buy or sell for future delivery. The text provides discussion of options for individual stocks
and on agricultural futures contracts. The extension to discussion of other assets enhances understanding
of the uses and differences of options and futures.

PPT 2-15 Derivatives Securities