CHAPTER TWO

Investment Alternatives
 Learning Objectives

● To describe the major types of financial

assets and how they are organized
● To explain what non-marketable financial
assets are
● To describe the important features of
money market and capital market
securities
 Learning Objectives
● To distinguish between preferred stock
and common stock
● To understand the basics of options and
futures
 Non-Marketable Financial
Assets
● Examples: Savings accounts, Savings Bonds
(SBs), Guaranteed Investment Certificates
(GICs)

● Commonly owned by individuals

● Represent direct exchange of claims between

issuer and investor

● Usually “safe” investments which are easy to

convert into cash without loss of value
Marketable Financial Assets

Money Market Securities

● Examples: Treasury bills, commercial paper,
repurchase agreement, banker’s acceptance
(B/A)
● Marketable: claims are negotiable or saleable
in the marketplace
● Short-term, liquid, relatively low risk debt
instruments
● Issued by governments and private firms
 Fixed-Income Securities

● Marketable debt with maturity greater

than one year
● More risky than money market
securities
● Fixed-income securities have a specified
payment schedule
– Dates and amount of interest and principal
payments known in advance
 Fixed-Income Securities

● Major bond types (continued):

– Corporate bonds
● Usually pay semi-annual interest, are
callable, carry a sinking fund provision,
and have a par value of $1,000
● Convertible bonds may be exchanged for
another asset
● Risk that issuer may default on payments
 Equity Securities
● Represent an ownership interest
● Preferred stockholders paid after
bondholders but before common
stockholders
– Dividend known, fixed in advance
– May be cumulative if dividend omitted
● Common stockholders are residual
claimants on income and assets
– Voting rights important
 Derivative Securities

● Securities whose value is derived from

some underlying security
 Derivative Securities
Business firms faces different types of risk:
● Risk of damage to the property and liability
might be covered through insurance
● But how to protect the firm from the adverse
movements of prices, interest rates, and
foreign currency exchange rates?

❖Hedging, Speculation, Arbitrage etc. are designed to

protect the firm against the adverse movements of
prices, interest rates, and foreign currency exchange
rates
Instruments: Derivatives
futures contracts, options, forward contracts, swaps
 The Nature of Derivatives

A derivative is an instrument whose

value depends on the values of other
more basic underlying variables
•Very often the variables underlying derivatives are the prices
of traded assets
•For Example: A stock option is a derivative whose value is
dependent on the price of a stock
 Ways Derivatives are Used

● To hedge risks (adverse movements of

prices, interest rates, and foreign currency
exchange rates)
● To lock in an arbitrage profit
● To speculate (take a view on the future
direction of the market)
Examples of Derivatives

1. Forward Contracts

2. Futures Contracts

3. Options
 1. Forward Contracts
It is an agreement to buy or sell an asset at
a certain time for certain price
–It’s not an option: both parties are expected to
hold up their end of the deal.
–If you have ever ordered a textbook that was not
in stock, you have entered into a forward
contract.
● Forward contracts are similar to futures except
that they trade in the over-the-counter market
● Forward contracts are particularly popular on
currencies and interest rates
 Example

● On June 3, 2019 the treasurer of a

corporation enters into a long forward
contract to buy £1 million in six months
at an exchange rate of 1.6100
● This obligates the corporation to pay
$1,610,000 for £1 million on December
3, 2019
● What are the possible outcomes?
● If spot exchange rate rose to 1.7000 at
the end of 6 mon.
Worth of forward contract= $90,000
● If spot exchange rate fell to 1.5000 at
the end of 6 mon.
Worth of forward contract= $110,000
 2. Futures Contracts

● Agreement to buy or sell an asset

for a certain price at a certain time
● Similar to forward contract
● Whereas a forward contract is
traded OTC, a futures contract is
traded on an exchange
 3. Options
An option gives one party the right to buy
(call) or sell (put) a specified amount at a fixed
price until a fixed maturity date

● A call option is an option to buy a certain asset by a

certain date for a certain price (the strike price)
● A put option is an option to sell a certain asset by a
certain date for a certain price (the strike price)
In contrast to a forward contract that requires performance (even if the
transaction is unfavorable), an option provides its holder with flexibility.
If the call option price is above the market price at the maturity date, the
option is allowed to lapse without exercise.
The option buyer pays a premium to the seller to induce it to accept the
price risk.
 Types of Traders
• Hedgers
• Speculators
• Arbitrageurs

Some of the largest trading losses in derivatives have

occurred because individuals who had a mandate to
be hedgers or arbitrageurs switched to being
speculators (See for example Barings Bank Case)
 Hedger Vs. Speculator
Example
● An investor with Tk. 1,100 to invest
● Plans to buy X Co.’s stock currently selling for
Tk. 100 each
● But afraid that price will fall after 3 months,
when he plans to sell
● Put option on X Co.'s stock selling at Tk. 10
premium, Strike Price Tk. 100
● What are the alternative strategies?