Investment Alternatives

FIN 3600: Chapter 3 Timothy R. Mayes, Ph.D.

Categories of Investments 

Previously, we have distinguished between two types of assets: 


Financial Assets Real Assets Direct Investments ± These are investments where you take actual direct ownership of the assets Indirect Investments ± These are investments where you have indirect ownership, such as mutual funds, ETFs, and REITs 

We can further subdivide these into two categories:  

Money Market Instruments 

The ³money market´ is comprised of high quality, shortterm, large denomination debt instruments:    

High Quality ± Generally the issuers have very high credit ratings (U.S. Government, money center banks, large finance companies, blue chip corporations). Short-term ± Most money market instruments mature within one year, and many within a few days. Large Denomination ± Most of these securities have a face value greater than $100,000. Additionally, most of these investments are discount securities. They do not pay interest. Rather, they are sold at a discount to face value and later redeemed at full face value.

Types of Money Market Instruments 
    

Treasury Bills (T-bills) and short-term agencies Short-term Municipals Commercial Paper Banker¶s Acceptances Jumbo CDs (brokered CDs, large CDs) Repurchase Agreements

Occasionally.T-Bills and Short-term Agencies       Treasury bills (and short-term agencies) are used to provide shortterm liquidity for the U. They are issued with original maturities of 4 weeks (new as of 31 July 2001).S. 13 weeks (3-month or 91 days). instead they are sold at a discount to face value and are redeemed at maturity for their full face value. .S. government. maturities. but this practice was discontinued on 27 Feb 2001. They do not pay interest. T-bills are backed by the ³full faith and credit´ of the U. 26 weeks (6-month or 182 days). they also issue cash management bills (CMBs) with variable. but usually less than 3-months. government. 52-week (1 year or 365 days) bills used to be regularly auctioned.000 and multiples thereof. The face value of T-bills is $1.

Calculating Yields on T-bills   Since T-bills are sold on a discount basis. their returns are not directly comparable to interest bearing bonds. Returns on T-bills are quoted on a ³bank discount basis´: .

FV  PP v 360 ! Discount % v 360 BDY ! FV M M .

we can calculate the Bond Equivalent Yield by adjusting the BDY or directly: FV 365 FV  PP 365 v ! v PP 360 PP M BEY ! BDY v .Calculating Yields on T-bills (cont.)  The Bank Discount Yield is a little misleading for two reasons:   It uses a 360-day year (12 months. and comparability with interestbearing securities. not the actual price  For these reasons. 30 days each) It is based on face value.

04945 v v ! 0.142 975 360 .)  Here¶s an example: Suppose you just bought a 26week (182 days) T-bill at auction for a price of $975.945 1000 182 1000 365 BEY ! .04945 ! 4.Calculating Yields on T-bills (cont.5142 ! 5. What is the BDY and BEY? BDY ! 1000  975 360 v ! .

The disadvantage is that they are backed only by the taxing authority of the district that issues them. counties.Short-term Municipals      Cities. The advantage of these securities is that the income they provide is free of federal taxation. . For this reason. They can issue securities that are similar to T-bills called anticipation notes (in anticipation of some revenue. they are not as safe as T-bills. usually taxes). and states all frequently have a need for short-term funds to provide for liquidity needs.

We can either gross up the tax-free yield: Tax Exempt Yield TEY ! .Taxable Equivalent Yield   When comparing tax-exempt yields to taxable yields. we need to adjust for the tax rate.

we can discount the taxable yield: After Tax Yield ! Taxable Yield v .1  t   Or.

the yields are comparable .  t 1 Once we¶ve made the adjustment.

unsecured. and Ford Motor Credit). GMAC. but about 75 (NY Fed) of CP is issued by financial companies (the largest being GE Capital. . CP is not very liquid as it tends to be held to maturity by purchasers. Generally.Commercial Paper     Commercial paper (CP) is very high-quality. though it can be traded in the secondary market if necessary. it matures in less than 9 months and is exempt from SEC registration (more than 270 days and it would have to be registered). There are about 1. short-term corporate debt. In practice. most CP matures in 30 days or less.500 companies (Bloomberg) that issue CP.

Direct issuance lowers interest costs by 1/8 of a percentage point ($125. there was about $1. CP defaults are rare. making it an attractive alternative for some firms. and is then either held in the dealer¶s own account.    CP interest rates are usually lower than on bank loans. This more than pays for having a full-time staff. large needs for short-term cash. but they do occasionally occur.Commercial Paper (cont. . As of January 2002.000 per $100 million issued.)  CP is issued by firms in one of two ways:   Direct ± CP is sold directly to investors.44 trillion in outstanding CP. or resold to investors at a profit. NY Fed estimate). This method is usually used by financial firms with frequent. Firms which do not regularly issue CP use dealers. Indirect ± CP is sold to a dealer at a discount (higher interest rate).

. or it may take payment immediately (at a discount) from its own bank.Bankers¶ Acceptances     Bankers¶ acceptances (BAs) are like a certified check from a bank. Bankers¶ acceptances are usually created in the process of international trade and are sold by banks. The exporter may either take payment from the importer¶s bank after delivery. except that it is payable on some future date whereas a check is payable immediately. A BA results when an importer buys from a foreign exporter and provides the exporter with a letter of credit from the importer¶s bank guaranteeing payment (or vice versa).

and borrowers must also pay the discount. the BA becomes a liability of the importer¶s bank. . Usually the time to maturity covers the time to ship and sell the goods purchased.Bankers¶ Acceptances (cont.)      The exporter¶s bank presents the letter to the importer¶s bank which stamps it ³Accepted.´ The exporter¶s bank may then keep it (and collect later). Once accepted. and they take the risk of non-payment by the importer (who is liable to the bank). BAs typically mature in 30 to 180 days. Banks charge a fee for this service. but they may extend to 270 days. or sell it to an investor (also collecting now). return it to the importer¶s bank (and collect the present value now).

they may be sold in the secondary market Terms range from 7 days to 5 years or longer. .Jumbo CDs  Jumbo (or large or brokered) Certificates of Deposit (CDs) are similar to small CDs.000 They are not federally insured (beyond $100. These are federally insured up to $100. except:     They are larger (duh!).000.000) In some cases. Minimum face value is $100.000.000 to $100. most are 1 to 6 months  Some banks now offer mini-jumbo CDs with minimum investments of $25.

Instead. a dealer is involved and charges a fee. . there is also an interest payment. when the securities are repurchased. The security pledged is sold and repurchased at the same price.Repurchase Agreements     A repurchase agreement (Repo or RP) is not actually a security. Typically. Additionally. Usually. These deals are structured not as a loan. it is a method of financing that involves money market securities. but a sale and repurchase. a firm needing cash overnight or for a short time period (term RP) and having money market securities will pledge them as collateral for a short-term loan.

Non-Money Market Financial Instruments  There are many securities with longer terms that governments. banks. and corporations use to raise funds:     Long-term bonds Preferred stock Common stock Derivatives .

Bonds are issued to raise capital by the following types of issuers:      Federal government Federal agencies State and local governments Corporations Various foreign issuers .Long-term Bonds   Bonds are interest bearing debt securities with original maturities greater than one year.

S.000 or more. . Bonds ± These have original maturities of more than 10 years and may be callable.   Both notes and bonds pay interest (originally determined at auction) semi-annually and may be purchased with face values of $1. Treasury issues:   Notes ± These have original maturities of 2 to 10 years and are not callable.S. Treasury is the largest issuer of long-term bonds in the world. government (and its ability to print money). They are backed by the full faith and credit of the U. the U. In addition to the T-bills we¶ve already discussed.Treasury Notes and Bonds   The U.S.

but most believe that the treasury would not allow a default. government. Government agencies and Government Sponsored Enterprises (GSEs) also raise money in the debt markets.Agency Securities    Many U. These securities are not generally backed by the full faith and credit of the U. .S. They may be callable.S.

S. Agency for International Development (US Aid) International Bank for Reconstruction and Development (IBRD) Government National Mortgage (Ginnie Mae) Government Sponsored Enterprises:     Federal Farm Credit Bank (FFCB) Federal Agricultural Mortgage Association (Farmer Mac) Federal Home Loan Mortgage Corp (Freddie Mac) Fannie Mae .Agency Security Issuers  Federal Agencies      Tennessee Valley Authority (TVA) U.

In 2004 about 35 of muni bonds were issued as GOs.Municipal Bonds   Municipal bonds are issued by state and local governments. . Revenue Bonds ± These are backed by specific sources. There are two categories:   General Obligation (GOs) ± These are backed by the taxing authority of the issuer. Ambac. such as Denver International Airport.   Municipal bonds are subject to credit risk. Muni bonds may be insured against defaults by MBIA. FSA and others. and there have been some high-profile defaults (Orange County. CA and Washington Power) and feared defaults that never occurred (State of California most recently). The interest paid by these bonds are exempt from federal income taxes. In 2004 about 65 of muni bonds were issued as revenue bonds.

and occasionally as long as 100 years (Coca-Cola and Disney).Corporate Bonds   Corporations issue bonds that typically have original maturities of 5 to 30 years. There are several possible categorizations:     Debentures ± Unsecured debt Subordinated Debentures ± Unsecured and have lower claim than regular debentures Mortgage Bonds ± Secured by specific assets Income Bonds ± Pay interest and principal based on income produced by specific assets .

A Bond Certificate .

but failure to pay cannot trigger bankruptcy. Dividends are usually fixed. but it legally represents an ownership claim and is not debt. . but most are eventually called or converted to common stock. Preferred stock is not a frequently used financing tool. but higher than common stockholders. There is no specified maturity date. Preferred stock generally carries no voting rights.Preferred Stock       Preferred stock is a hybrid of debt and equity. Preferred stockholders have a lower claim on assets than bondholders (creditors).

but they are not required and payout ratios have diminished greatly in recent years.Common Stock    Common stock represents an actual ownership position in the firm. . Common shareholders get to vote on major issues of importance. and stockholders are residual claim holders (they get paid last in a liquidation). Many common stocks pay dividends.

A Stock Certificate .

S. Some are directly listed (not many) and others trade in the form of an American Depositary Receipt (ADR). stock exchanges.Foreign Stocks    Many foreign common stocks are listed on U. . ADRs are created by a U. Bank (Bank of New York is the largest) and usually contain more than one foreign share per ADR.S.

Investors do not have a direct claim on the individual assets in the portfolio. Examples include:      Mutual Funds (open-end) Closed-end funds Exchange-traded funds Hedge funds Real Estate Investment Trusts (REITs) .Indirect Investments   An indirect investment is a professionally managed portfolio in which investors can buy shares.

but the portfolios are owned by the shareholders. municipal bonds. . Each mutual fund has an investment style that is described in its prospectus. Funds may invest in stocks. For example. Fidelity branded mutual funds are managed by Fidelity Management & Research. government bonds.Mutual Funds   Mutual funds are professionally managed portfolios of securities that are owned by the shareholders and managed by a fund management firm. etc.

There are likely many reasons for this. except that they have a fixed number of shares and are traded on a stock exchange. . They are traded all day during regular market hours and the price changes continuously throughout a trading session.Closed-end Funds     Closed-end funds are like mutual funds. but there is currently no complete explanation for the phenomenon. This gives shareholders an immediate gain equal to the amount of the discount. Closed-end funds may trade at a premium or discount to the net asset value of the underlying portfolio. Funds that continually trade at a discount to NAV are occasionally liquidated and the money returned to shareholders.

An ETF is very similar to a mutual fund (especially a closed-end fund) except for several important features:     They are traded on a stock exchange and may be bought. . sold. ETFs are typically passively managed portfolios which results in them being much more tax and capital gains efficient than actively managed mutual funds. VIPERS. and sold short at any time. New actively managed ETFs will be coming to the market soon.). There will be some actively managed ETFs in the near future. there are a few debt market ETFs based on debt indexes such as the Lehman Brothers 1-3 year US Treasury Index. HOLDRS. As of August 2005. Until June 2002 all ETFs were based on equity market indexes (S&P 500. This premium or discount is kept small by arbitrage mechanisms built into ETFs (unlike closedend funds).Exchange Traded Funds   Its arguable whether ETFs are derivatives. etc. there were more than 190 ETFs with assets of over $260 billion. but I¶ll consider them one type. and more seemingly introduced every day.  Examples of ETFs would include SPDRs. Nasdaq 100. iShares. They may trade at a slight premium or discount to their NAV. Mutual funds can only be bought or sold at the end of the day. Now.

Hedge funds are subject to little government regulation. For example.Hedge Funds   Hedge funds are limited partnerships that use strategies that most mutual funds are not allowed to use. as long as they adhere to certain restrictions:    No public advertising Only ³accredited investors´ may own shares Limited number of investors  Hedge fund managers generally charge between 1 and 2 of assets as a management fee plus an incentive fee of as much as 20 of profits. many hedge funds short sell securities or have heavy exposure to derivatives. .

Real Estate Investment Trusts (REITs) .

Derivative Securities  Derivative Securities derive their value from other securities.     Convertible bonds and convertible preferred stock Warrants Stock Options Futures .

. The owner of a convertible security has the right. but not the obligation. Part of the value of these securities is therefore derived from the value of the stock. to convert the security into a pre-specified number of common shares at a specific price on or before the maturity date. The higher the stock price (among other factors). the more attractive conversion becomes.Convertible Securities    Convertible bonds and preferred stock are similar to regular bonds and preferred but they also have an embedded call option on the company¶s common stock.

Warrants give the owner the right. but they are issued by a company as a sweetener to entice investors to purchase a bond or preferred stock issue. . Warrants usually have a life measured in years.Warrants     Warrants are very similar to call options (see next slide). Warrants are frequently traded separately from the bond or preferred issue that they were issued with. to purchase a certain number of common shares at a specified price. but not the obligation.

Options are not created or sold by the company who¶s common stock may be the underlying security. to buy (call option) or sell (put option) the underlying security at a specified price on or before the expiration date (can be up to 9 months in the future). .Options   Options are contracts that give the buyer the right. but not the obligation.

Futures    A futures contract. . Futures contracts are different from forward contracts in that they are traded on an exchange. or covered a short. by expiration you must take or make delivery of the commodity at the specified price. If you have not sold a long position. carries with it the obligation to buy (for a long position) or sell (for a short position) the underlying commodity at expiration of the contract. and are standardized as to quantity and quality of the commodity. unlike an option.

Real Assets      Real Estate and REITs Precious Metals Gems Collectibles Coins .

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