2YOU LEARNED IN Chapter 1 that the pro- cess of building an investment portfolio usu- ally 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. Each broad asset class contains many spe- cific security types, and the many variations on a theme can be overwhelming. Our goal in this chapter is to introduce you to the important features of broad classes of securi- ties. Toward this end, we organize our tour of financial instruments according to asset class. Financial markets are traditionally seg- mented 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 contrast, 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, and the derivative markets for options and futures. We first describe money market instru- ments. We then move on to debt and equity securities. We explain the structure of various stock market indexes in this chapter because market benchmark portfolios play an impor- tant role in portfolio construction and evalua- tion. Finally, we survey the derivative security markets for options and futures contracts. CHAPTER TWO Asset Classes and Financial Instruments 2PART I bod61671_ch02_028-058.indd 28bod61671_ch02_028-058.indd 286/18/13 7:41 PM6/18/13 7:41 PMFinal PDF to printerCHAPTER 2 Asset Classes and Financial Instruments 29The money market is a subsector of the fixed-income market. It consists of very short- term debt securities that usually are highly marketable. Table 2.1 lists outstanding volume in 2012 for some of the major instruments in this market. Many of these securities trade in large denominations, and so are out of the reach of individual investors. 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. Treasury Bills 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. Unlike most other money market instruments, which sell in minimum denominations of $100,000, T-bills sell in minimum denominations of only $100, although $10,000 denominations are far more common. The income earned on T-bills is exempt from all state and local taxes, another characteristic distinguishing them from other money market instruments. Figure 2.1 is a partial listing of T-bill rates. Rather than providing prices of each bill, the financial press reports yields based on those prices. You will see yields corresponding to both bid and ask prices. 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 bidask spread is the difference in these prices, which is the dealer s source of profit. (Notice in Figure 2.1 that the bid yield is higher than the ask yield. This is because prices and yields are inversely related.) 2.1 The Money Market *Small denominations are less than $100,000. Sources: Economic Report of the President, U.S. Government Printing Office, 2012; Flow of Funds Accounts of the United States, Board of Governors of the Federal Reserve System, September 2012. $ BillionRepurchase agreements$1,141 Small-denomination time deposits and savings deposits*7,202Large-denomination time deposits*1,603 Treasury bills1,478 Commercial paper1,445 Money market mutual funds2,645Table 2.1 Major components of the money market bod61671_ch02_028-058.indd 29bod