Asset Classes and Financial Instruments
The Money Market
The money market consists of short-term debt instruments that are characterized by high liquidity, low risk, and correspondingly low returns. These instruments serve as close substitutes for cash and are essential for managing short-term funding needs.
| Treasury bills |
U.S. Government |
Risk-free benchmark, sold at discount |
| Certificates of deposit (CDs) |
Banks |
Negotiable, FDIC-insured up to limits |
| Commercial paper |
Corporations |
Unsecured, ≤270 days |
| Repurchase agreements (Repos) |
Dealers/banks |
Collateralized short-term borrowing |
| Fed funds |
Banks |
Overnight interbank lending |
Treasury bills deserve special attention because they serve as the benchmark “risk-free” rate in finance. They’re sold at a discount from face value and mature at par, with the difference representing the investor’s return. Commercial paper allows large corporations to borrow directly from investors, bypassing banks. Repurchase agreements (repos) are essentially collateralized loans: a dealer sells securities with an agreement to repurchase them the next day at a slightly higher price.
The Bond Market
The bond market encompasses longer-term fixed-income securities with a wider range of risk profiles. These instruments promise specified cash flows over time, typically in the form of periodic coupon payments plus return of principal at maturity.
| Treasury notes/bonds |
U.S. Government |
1–30 years, semi-annual coupons, benchmark rates |
| Treasury Inflation-Protected Securities (TIPS) |
U.S. Government |
Inflation-indexed principal |
| Municipal bonds |
State/local governments |
Tax-exempt interest (federal, often state) |
| Corporate bonds |
Corporations |
Credit risk varies, higher yields |
| Mortgage-backed securities |
Agencies/private issuers |
Pass-through of mortgage payments, prepayment risk |
Treasury notes and bonds form the backbone of the fixed-income market and establish benchmark interest rates across different maturities. Treasury Inflation-Protected Securities (TIPS) adjust their principal value for inflation, providing a real (inflation-adjusted) return. Municipal bonds offer tax advantages that make them particularly attractive to investors in high tax brackets—their tax-equivalent yield is often higher than it appears. Corporate bonds introduce credit risk, the possibility that the issuer may default, and compensate investors with higher yields. Mortgage-backed securities pass through payments from pools of mortgages, but their cash flows are complicated by prepayment risk: when interest rates fall, homeowners refinance, returning principal to investors at the worst possible time.
Equity Securities
Common stock represents an ownership claim on a corporation. Stockholders are residual claimants, meaning they receive what’s left after all other obligations are paid. This makes equity risky—in a bad year, there may be nothing left—but it also means stockholders capture all the upside when things go well. Common stockholders typically have voting rights on major corporate decisions and enjoy limited liability, meaning they can lose their entire investment but no more.
Preferred stock occupies a middle ground between debt and equity. Preferred shareholders receive fixed dividends that must be paid before any common dividends, but they typically don’t have voting rights. In liquidation, preferred claims are senior to common stock but junior to all debt.
American Depositary Receipts (ADRs) allow U.S. investors to trade foreign stocks on domestic exchanges, providing international diversification without the complications of trading in foreign markets.
Stock Market Indexes
Market indexes serve as benchmarks for evaluating portfolio performance and as the basis for index funds. Different indexes use different construction methods, which affects their behavior.
| Dow Jones Industrial Average |
Price-weighted |
30 large-cap stocks |
| S&P 500 |
Value-weighted (market cap) |
Broad large-cap U.S. |
| NASDAQ Composite |
Value-weighted |
Tech-heavy |
| Russell 2000 |
Value-weighted |
Small-cap |
The Dow Jones Industrial Average is price-weighted, meaning stocks with higher prices have more influence regardless of company size. This is an arbitrary and somewhat outdated methodology. The S&P 500 and most modern indexes are value-weighted (also called market-cap weighted), meaning larger companies have proportionally greater influence. This approach reflects the actual investment opportunity set—if you owned the entire market, your portfolio would naturally be value-weighted.
Derivative Securities
Derivatives are financial instruments whose value depends on (derives from) the value of some underlying asset. Options give the holder the right, but not the obligation, to buy (call option) or sell (put option) an asset at a specified price on or before a specified date. Futures contracts obligate both parties to complete a transaction at a predetermined future date and price.
Derivatives serve three main purposes:
- Hedgers use them to reduce risk—a farmer might sell futures on wheat to lock in a price before harvest.
- Speculators use them to make leveraged bets on price movements.
- Arbitrageurs use them to profit from price discrepancies across markets.
The leverage inherent in derivatives makes them powerful tools but also potentially dangerous; small price movements in the underlying asset can produce large gains or losses in derivative positions.
Securities Markets
Primary and Secondary Markets
Securities markets divide into primary and secondary markets, each serving a distinct function. The primary market is where new securities are born. When a company conducts an initial public offering (IPO) or issues new bonds, it’s raising fresh capital in the primary market. Investment banks typically underwrite these offerings, guaranteeing a price to the issuer and bearing the risk of selling the securities to investors. A prospectus must be filed with the SEC disclosing all material information about the issuer and the offering.
The secondary market is where existing securities trade among investors. When you buy shares of Apple on the stock exchange, Apple doesn’t receive any money—you’re buying from another investor who previously owned those shares. The secondary market serves the crucial function of providing liquidity: knowing you can sell a security easily makes you more willing to buy it in the first place. Secondary markets also provide continuous price discovery, generating the information that makes primary markets function.
Market Structures
Securities trade through several different market structures. Traditional exchanges like the NYSE provide a centralized, regulated venue where buyers and sellers meet. Over-the-counter (OTC) dealer markets, common for bonds, rely on dealers who stand ready to buy or sell from their own inventory, quoting bid prices (at which they’ll buy) and ask prices (at which they’ll sell). Electronic communication networks (ECNs) and modern electronic exchanges use automated systems to match orders, largely replacing the human intermediaries of earlier eras.
| Exchange |
Centralized, regulated |
NYSE |
| OTC (Dealer) |
Dealers quote bid/ask |
Bond markets |
| Electronic Communication Networks (ECNs) |
Automated order matching |
Many modern exchanges |
Order Types
Investors express their trading intentions through different order types (you’ll have to choose between these when you want to buy a stock for example):
- A market order instructs the broker to execute immediately at the best available price. You get certainty of execution but uncertainty about price.
- A limit order specifies a maximum buying price or minimum selling price. You get price certainty but risk the order not executing at all.
- A stop order remains dormant until a trigger price is reached, then becomes a market order. Stop orders are often used to limit losses or protect profits.
Buying on Margin
Margin trading allows investors to borrow from their brokers to purchase securities, amplifying both potential gains and potential losses. When you buy on margin, you put up a fraction of the purchase price (the initial margin, typically 50%) and borrow the rest from your broker.
Brokers protect themselves by requiring you to maintain a minimum equity percentage (the maintenance margin, typically 25-30%). If your equity falls below this level due to price declines, you’ll receive a margin call demanding that you deposit additional funds or sell securities to restore your margin.
Leverage is a double-edged sword. If you buy $10,000 of stock with $5,000 of your own money and the stock rises 20%, your return on equity is 40% (minus interest costs). But if the stock falls 20%, you’ve lost 40% of your equity. Margin amplifies outcomes in both directions.
Short Selling
Short selling allows investors to profit from falling prices by reversing the usual sequence of transactions. Instead of buying low and selling high, short sellers sell high first (borrowing shares to deliver to the buyer) and hope to buy low later (returning shares to the lender). The mechanics work as follows: you borrow shares from your broker’s inventory, sell them in the market, and later buy shares to return to the lender. If the price has fallen, you profit; if it has risen, you lose.
Short selling carries unique risks. Unlike a long position, where your maximum loss is your initial investment, short positions have theoretically unlimited loss potential—there’s no ceiling on how high a stock price can rise. Short sellers must also pay any dividends to the share lender and post margin against their positions. Despite these challenges, short selling plays an important role in markets by allowing negative information to be reflected in prices.
Market Regulation
Securities markets operate under extensive regulation designed to promote fairness, transparency, and investor protection. The Securities and Exchange Commission (SEC) is the primary federal regulator, overseeing securities laws and market participants. The Financial Industry Regulatory Authority (FINRA) is a self-regulatory organization that oversees broker-dealers.
Key regulatory principles include mandatory disclosure (companies must reveal material information), prohibition of insider trading (those with material nonpublic information cannot trade on it), and Regulation FD (fair disclosure), which requires companies to release material information to all investors simultaneously rather than selectively. These rules aim to create a level playing field where investors can trust that prices reflect publicly available information.
Mutual Funds and Other Investment Companies
The Value Proposition
Investment companies exist because they solve real problems for individual investors. Diversification is perhaps the most important: by pooling money from many investors, a mutual fund can hold hundreds of securities, reducing the risk that any single company’s troubles will devastate the portfolio. Individual investors would find it prohibitively expensive to achieve this diversification on their own. Professional management also provides expertise that most individuals lack. Record-keeping and administration handle the paperwork of tracking dividends, capital gains, and tax obligations. For open-end funds, immediate liquidity means investors can convert their holdings to cash on any business day.
Net Asset Value
Net asset value (NAV) is the per-share value of a fund’s holdings, calculated as:
\[\text{NAV} = \frac{\text{Market Value of Assets} - \text{Liabilities}}{\text{Shares Outstanding}}\]
For open-end funds (see below), NAV is calculated once daily after markets close, and all transactions that day occur at that price. This differs from stocks, where prices fluctuate continuously throughout trading hours.
Types of Investment Companies
Investment companies come in several varieties, each with distinct characteristics.
| Open-end (mutual funds) |
Redeemable |
NAV (end of day) |
Most common |
| Closed-end funds |
Fixed, trade on exchange |
Market price (premium/discount to NAV) |
Can trade intraday |
| ETFs |
Trade on exchange |
Near NAV via arbitrage |
Tax-efficient, low cost |
| Unit Investment Trusts |
Fixed portfolio |
Redeemable at NAV |
Unmanaged |
Open-end mutual funds are the most familiar type. They issue new shares when investors want to buy and redeem shares when investors want to sell, always at net asset value calculated at the end of each trading day. Closed-end funds issue a fixed number of shares that then trade on an exchange like stocks. Their market prices can diverge from NAV, sometimes trading at a premium and sometimes at a discount, creating puzzles that have fascinated researchers for decades.
Exchange-traded funds (ETFs) combine features of both. Like closed-end funds, they trade on exchanges throughout the day. But unlike closed-end funds, an arbitrage mechanism involving authorized participants keeps their prices close to NAV. ETFs have become enormously popular due to their tax efficiency, low costs, and trading flexibility.
The Critical Role of Fees
Fees deserve careful attention because they compound over time, creating a substantial drag on returns. Understanding the fee structure is essential for evaluating any fund.
| Front-end load |
At purchase |
Reduces initial investment |
| Back-end load |
At redemption |
Discourages early exit |
| 12b-1 fees |
Annual |
Marketing/distribution costs |
| Expense ratio |
Annual |
Management + operating costs |
Front-end loads take a percentage of your investment immediately—a 5% load means only $950 of your $1,000 actually gets invested. Back-end loads are charged when you sell, often declining over time to encourage longer holding periods. Annual expenses, including management fees, administrative costs, and 12b-1 distribution fees, are deducted from fund assets continuously.
The impact of annual expenses is often underestimated. A 1% annual expense ratio might sound modest, but over 20 years it reduces terminal wealth by approximately 18%. This is why low-cost index funds (funds built to track a specific index) have such an inherent advantage—they’re not fighting against the headwind of high expenses.
Fund Categories
Funds are categorized by their investment policies. Money market funds invest in short-term, high-quality debt and maintain a stable $1 NAV. Equity funds span the spectrum from conservative large-cap value funds to aggressive small-cap growth funds, with sector funds, international funds, and index funds offering further variety. Bond funds similarly range from safe government bond funds to risky high-yield (junk bond) funds. Balanced or hybrid funds hold both stocks and bonds, offering built-in diversification across asset classes.
Active versus Passive Management
The choice between active and passive management is one of the most consequential decisions an investor makes. Active managers attempt to beat their benchmark through superior security selection and market timing. They employ analysts, conduct research, and trade frequently, all of which costs money. Passive managers simply seek to match benchmark returns by holding an index portfolio, minimizing costs and turnover.
The empirical evidence strongly favors passive management for most investors. In any given year, roughly half of active managers underperform their benchmarks before fees and substantially more than half underperform after fees. Over longer horizons, the percentage of active managers who beat their benchmarks shrinks further. Past performance provides little help in identifying future winners. This doesn’t mean skilled managers don’t exist—some almost certainly do—but identifying them in advance is extraordinarily difficult.
The Rise of ETFs
Exchange-traded funds have grown explosively because they offer compelling advantages. Unlike mutual funds, which price only once daily, ETFs trade throughout the day, allowing investors to react quickly to market developments. ETFs are more tax-efficient than mutual funds because of their unique structure: when investors want to exit, they sell on the exchange rather than redeeming from the fund, so the fund doesn’t need to sell holdings and realize capital gains. Most ETFs are passively managed index funds with rock-bottom expense ratios, though actively managed ETFs are increasingly available.
Key Takeaways
Financial markets exist to channel capital from savers to borrowers, enabling productive investment while allowing risk to be shared efficiently. Different asset classes offer different combinations of risk, return, and liquidity, and understanding these tradeoffs is essential for portfolio construction. Market structure matters—the rules governing trading, margin, and short selling shape how information gets incorporated into prices. Costs are the one certain drag on investment returns, making the choice of investment vehicles critically important.
With these foundations in place, we can proceed to the central questions of the course: How should investors construct portfolios? How do we measure, price, and manage risk? Can skillful analysis identify mispriced securities?
Ask an LLM
Here are three questions you might ask an AI assistant to deepen your understanding of these concepts:
- Can you walk me through a concrete numerical example of how a 1% expense ratio compounds over 30 years compared to a 0.1% expense ratio, assuming the same underlying returns?
- Why do closed-end funds sometimes trade at persistent discounts to their NAV? If I can buy $100 worth of assets for $90, why doesn’t arbitrage eliminate this discount immediately?
- Explain the mechanics of how ETFs maintain prices close to NAV through authorized participants. What would happen if this arbitrage mechanism broke down?
- If short selling helps negative information get reflected in prices, what happens in markets where short selling is restricted or banned? Are there real-world examples?
- Walk me through a margin call scenario: if I buy $20,000 of stock with 50% initial margin and 30% maintenance margin, at what price do I get a margin call, and what are my options when it happens?