Investment Alternatives:

Generic Principles All investors

Must Know
Chapter 2
Investments: Principles and Concepts
Charles P. Jones,
11th ed.
 Learning Objectives
• Identifying and understanding the
characteristics of the money and capital
market securities.
• Understanding important terms such as stock
splits and bond ratings.
• Understanding the basics of two derivative
securities options and futures.
 Organizing Financial Assets
• Financial Assets: Pieces of paper evidencing a
claim on some issuer. (marketable securities)
• Household Saving Options
– Holding a saving account.
– Holding securities directly, such as stock and
bonds.
– Holding securities indirectly, investing through
intermediaries.
 Organizing Financial Assets
• Indirect Investing: The buying and selling of
the shares of investment companies which, in
turn, hold portfolios of securities.

• Direct Investing: Investors buy and sell

securities themselves, typically through
brokerage accounts.
 A Global Perspective
• We live in a global environment that will
profoundly change the way we live and invest.
• Emphasis on investing globally.
• Channeling through professional investment
organization.
Major Types of Financial Assets
 Nonmarketable Financial Assets
• Commonly owned by individuals.
• Represent direct exchange of claims between
issuer and investor.
• Usually very liquid or easy to convert to cash
without loss of value.
• Examples: Savings accounts, certificates of
deposit, money market deposit accounts.
 Money Market Securities
• Money Markets: The market for short-term,
highly liquid, low risk assets.
• Marketable: claims are negotiable or salable in the
marketplace.
• Short-term, liquid, relatively low risk debt
instruments.
• Issued by governments and private firms.
• Examples: T-Bills, Commercial paper and Repurchase
Agreements.
 Money Market Securities
• Treasury Bill: A short-term money market
instrument sold at discount by the U.S
Money market rates
– Money market rates tends to move together.
– Are very close to each other for same maturity
securities.
– T- bills rates are less than the other money market
securities because of their risk free nature.
 Capital Market Securities
• Capital Market: The market for long-term
securities such as bonds and stocks.
• Marketable debt with maturity greater than one year
and ownership shares.
• 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
• Fixed Income Securities: Securities with
specified payment dates and amounts,
primarily bonds.

• Bond: Long-term debt instruments

representing the issuer’s contractual
obligation.
 Bond Characteristics
• Buyer of a newly issued coupon bond is
lending money to the issuer who agrees to
repay principal and interest.
• Bonds are fixed-income securities,
– Buyer knows future cash flows.
– Known interest and principal payments.
• If sold before maturity price will depend on
interest rates at that time.
 Bond Characteristics
• Par Value (Face Value) The redemption value
of a bond paid at maturity, typically $1,000.
• Prices quoted as a % of par value.
• Bond buyer must pay the price of the bond
plus accrued interest since last semiannual
interest payment.
• Premium: amount above par value.
• Discount: amount below par value.
 Innovation in Bond Features
• Callable Bonds: Gives the issuer the right to
call in a security and retire it by paying off the
obligation.
• Call provision helps issuer to save money
when the market rate drops sufficiently below
the coupon rate on the bond.
• Costs are incurred to call a bond; Call
premium and administrative expense.
 Innovation in Bond Features
• Zero-coupon bond: A bond sold with no
coupons at a discount and redeemed for face
value at maturity.
– The purchaser pay less than par value and
receives par value at maturity.
– The difference in the amount paid and receives
generate an effective interest rate or rate of
return.
– May have call feature.
 Types of Bonds
• Treasury Securities
• Federal agency Securities
• Municipal Securities
• Corporate Securities
 Types of Bonds
• Treasury Securities: The U.S. government, in the course of
financing its operations issues numerous notes and bonds with
maturities greater than one year. The U.S. government is
considered the safest credit risk because of the overall stability
and economic power of the U.S. economy and because of the
government’s power to print money.
• Treasury Bonds: Long term bonds sold by the U.S
government.
– Has maturity of 10 to 30 years.
– Treasury Notes matures in 2, 5 or 10 years.
– Interest is paid semiannually.
 Types of Bonds
Treasury Bond Advantages and Disadvantages
•Maturity (10- 30 years)
•Safety
•Liquidity
•Risk free
•Low Yield
 Types of Bonds
• Government Agency Securities:
– Federal Agency:
• Are part of federal government.
• Securities are fully guaranteed by the treasury.
• Government National Mortgage Association (Ginnie Mae).
– Government Sponsored Enterprise (GSEs)
• Are publicly held, for profit corporations to help lower
and middle income people to buy house.
• Securities are not guaranteed by the government.
 Types of Bonds
• Municipal Securities: Securities issued by political
entities other than the federal government and
it’s agencies, such as states and cities.
– Revenue bonds: Principal and interest are secured by
revenues derived from tolls, charges or rents from the
facility built with the proceeds of the bond issue.
– General obligation bonds: Principal and interest are
secured by the full faith and credit of the issuer.
 Types of Bonds
• Corporate Securities: Usually unsecured debt maturing in 20-40
years, paying semi-annual interest, callable, with par value of
$1,000.
– Senior Securities, placed ahead of preferred and common stock in
terms of payments or in case of liquidation.
– Unsecured bond backed by the general worthiness of the firm.
– Callable bonds gives the issuer the right to repay the debt prior to
maturity.
– Convertible bonds may be exchanged for another asset at the
owner’s discretion.
– Risk that issuer may default on payments.
 Types of Bonds
• Bond Ratings
– Rate relative to probability of default.
– Rating organizations.
• Standard and Poors Corporation (S&P)
• Moody’s Investors Service Inc
– Rating firms perform the credit analysis for the
investor.
– Emphasis on the issuer’s relative probability of
default.
 Types of Bonds
• Bond Ratings
– Investment grade securities
• Rated AAA, AA, A, BBB.
• Typically, institutional investors are confined to bonds
in these four categories.
– Speculative securities
• Rated BB, B, CCC, C.
• Significant uncertainties.
• C rated bonds are not paying interest.
 Equity Securities
• Denote an ownership interest in a corporation.
• Denote control over management, at least in
principle.
– Voting rights important .
• Denote limited liability
– Investor cannot lose more than their investment
should the corporation fail.
 Equity Securities
• Preferred Stocks: Hybrid security because
features of both debt and equity.
• Preferred stockholders paid after debt but
before common stockholders.
– Dividend known, fixed in advance.
– May be cumulative if dividend omitted.
• Often convertible into common stock.
• May carry variable dividend rate.
 Equity Securities
• Common Stocks: Common stockholders are
residual claimants on income and assets.
• Par value is face value of a share.
– Usually economically insignificant.
• Book value is accounting value of a share.
• Market value is current market price of a
share.
 Equity Securities
• Common Stocks: Dividends are cash payments
to shareholders.
– Dividend yield is income component of return.
– Payout Ratio is ratio of dividends to earnings.
 Equity Securities
• Common Stocks: Stock dividend is payment to
owners in stock.
• Stock split is the issuance of additional shares
in proportion to the shares outstanding.
– The book and par values are changed.
• P/E ratio is the ratio of current market price of
equity to the firm’s earnings.
 Investing Internationally
• Direct investing
– US stockbrokers can buy and sell securities on
foreign stock exchanges.
– Foreign firms may list their securities on a US
exchange or on Nasdaq.
 Derivative Securities
• Futures and options represent two of the most
common form of "Derivatives". Derivatives are
financial instruments that derive their value from an
'underlying'.
• The underlying can be a stock issued by a company, a
currency, Gold etc., The derivative instrument can be
traded independently of the underlying asset.
• The value of the derivative instrument changes
according to the changes in the value of the
underlying.
 Derivative Securities
Warrants
A Corporate created long term option that gives
the holder the right to buy the stocks from the
company at a stated price with in a stated
period of time.
 Options
• Options contracts are instruments that give the
holder of the instrument the right to buy or sell the
underlying asset at a predetermined price. An option
can be a 'call' option or a 'put' option.
A call option gives the buyer, the right to buy the
asset at a given price.
• A put option gives the buyer a right to sell the asset
at the 'strike price' to the buyer.
 Futures
• Futures contract: A 'Future' is a contract to buy
or sell the underlying asset for a specific price at
a pre-determined time.
• If you buy a futures contract, it means that you
promise to pay the price of the asset at a
specified time.
• If you sell a future, you effectively make a
promise to transfer the asset to the buyer of the
future at a specified price at a particular time.
 Futures
Every futures contract has the following
features:
•Buyer
•Seller
•Price
•Expiry