The Mathematics of Financial Modelingand Investment Management

1-Art to Engineering Page 3 Wednesday, February 4, 2004 12:38 PM

From Art to Engineering in Finance 3

begins with the asset allocation decision. That is, a decision must be

made as to how the funds to be invested should be distributed among

the major classes of assets.

Asset Classes

Throughout this book we refer to certain categories of investment prod-

ucts as an “asset class.” From the perspective of a U.S. investor, the con-

vention is to refer the following as traditional asset classes:

■ U.S. common stocks

■ Non-U.S. (or foreign) common stocks

■ U.S. bonds

■ Non-U.S. (or foreign) bonds

■ Cash equivalents

■ Real estate

Cash equivalents are defined as short-term debt obligations that have

little price volatility and are covered in Chapter 2.

Common stocks and bonds are further divided into asset classes.

For U.S. common stocks (also referred to as U.S. equities), the following

are classified as asset classes:

■ Large capitalization stocks

■ Mid-capitalization stocks

■ Small capitalization stocks

■ Growth stocks

■ Value stocks

By “capitalization,” it is meant the market capitalization of the com-

pany’s common stock. This is equal to the total market value of all of

the common stock outstanding for that company. For example, suppose

that a company has 100 million shares of common stock outstanding

and each share has a market value of $10. Then the capitalization of

this company is $1 billion (100 million shares times $10 per share). The

market capitalization of a company is commonly referred to as the

“market cap” or simply “cap.”

For U.S. bonds, also referred to as fixed-income securities, the fol-

lowing are classified as asset classes:

■ U.S. government bonds

■ Investment-grade corporate bonds

■ High-yield corporate bonds