INVESTMENTS: Analysis and Management Second Canadian Edition INVESTMENTS: Analysis and Management Second Canadian Edition W. Sean Cleary Charles P. Jones

Chapter 2 Investment Alternatives

Describe the major types of financial assets and how they are organized. Explain what non-marketable financial assets are. Describe the important features of money market and capital market securities. Distinguish among preferred stock, income trusts, and common stock. Understand the basics of options and futures. Learning Objectives

Examples: Savings deposits, Canada Savings Bonds (CSBs), 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 to cash without loss of value Non-Marketable Financial Assets

Examples: Treasury bills, commercial paper, Eurodollars, repurchase agreements, banker’s acceptances (B/As) Marketable: claims are negotiable or saleable in the marketplace Short-term, liquid, relatively low-risk debt instruments Issued by governments and private firms Money Market Securities

Treasury Bills:  Short-term promissory notes issued by governments  T-bills accounted for about one-half of all outstanding money market securities.  Sold at a discount from face value in denominations of $5,000, $25,000, 100,000, and $1 million  Typical maturities are 91, 182, and 364 days although shorter maturities are also offered Treasury Bills (T-bills)

Treasury Bills:  Due to government backing, there is a very low risk of default  Widely distributed and actively traded – high liquidity  In subsequent chapters we will use government T- bill rates as a measure of the “riskless rate” available to investors, commonly referred to as the risk-free rate Treasury Bills (T-bills)

Commercial Paper:  Short-term unsecured promissory notes issued by large, well-known, and financially strong corporations (including finance companies)  Denominations start at $100,000 with maturities of 30 to 365 days, and it is sold either directly by the issuer or indirectly through a dealer, with rates slightly above T- bill rates. Commercial Paper

Eurodollars:  Dollar-denominated deposits held in foreign banks or in offices of Canadian banks located abroad  Although this market originally developed in Europe, dollar-denominated deposits can now be made in many countries, such as those of Asia  Consist of both time deposits and certificates of deposit (CDs), with the latter constituting the largest component of the Eurodollar markets  Maturities are mostly short-term, often less than six months Eurodollars

Repurchase Agreements (RPs):  agreements between a borrower and lender (typically institutions) to sell and repurchase money market securities  borrower initiates an RP by contracting to sell securities to a lender and agreeing to repurchase these securities at a pre-specified (higher) price on a stated future date  maturity is generally very short, from 3 to 14 days, and sometimes overnight  minimum denomination is typically $100,000 Repurchase Agreements

Bankers Acceptances (B/As):  Time drafts drawn on a bank by a customer, whereby the bank agrees to guarantee payment of a particular amount at a specified future date  Differ from commercial paper because the associated payments are guaranteed by a bank, and thus possess the credit risk associated with that bank  Issued in minimum denominations of $100,000  Typical maturities range from 30 to 180 days, with 90 days being the most common Bankers Acceptances

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

Bonds – long-term debt instruments Major bond types:  Government of Canada bonds  U.S. Treasury bonds  Provincial bonds  Provincially-guaranteed bonds – Ontario Hydro  U.S. federal agency securities – GNMAs (Ginnie Maes), FNMAs (Fannie Maes) Fixed-Income Securities

Major bond types (cont’d):  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 Fixed-Income Securities

Callable bonds give the issuer the option to “call” or repurchase outstanding bonds at predetermined “call” prices (generally at a premium over par) at specified times This feature is detrimental to the bondholders who are willing to pay less for them (i.e., they demand a higher return) than for similar non- callable bonds. Generally, the issuer agrees to give 30 or more days notice that the issue will be redeemed Bond Characteristics

Extendible Bonds: gives the investor an option to extend the maturity date Retractable Bonds: gives the investor an option to redeem the bond at par prior to maturity Issuers are able to sell bonds with these features at higher prices than straight issues When bond prices rise (yields fall):  they are attractive long-term investments When bond prices fall (yields rise):  they can trade as short-term debt Bond Characteristics

Convertible Bonds may be converted into common shares at predetermined prices. This feature makes the issue more saleable and lowers the interest rate that must be offered Permits the holding of a two-way security:  The safety of a bond  The capital gains potential of a share If the common shares of the company are split, the convertible debt provides protection against dilution by adjusting the conversion privilege Convertibles are normally callable Bond Characteristics

The market price of convertible debt depends on the value of the underlying common stock  When the stock is selling well below the conversion price, the convertible debt is more like straight debt  When the stock approaches conversion price, a premium appears  When the stock rises above the conversion price, the debt will rise accordingly, and will then be selling off the stock Bond Characteristics Convertible Bonds (cont’d)

Asset-backed securities are “securitized” assets E.g. mortgage-backed securities  I nvestors assume little default risk as most mortgages are guaranteed by a federal government agency Asset-Backed Securities

Represent an ownership interest Preferred stock  Preferred shareholders are paid after bondholders but before common shareholders  Dividend known, fixed in advance  May be cumulative if dividend omitted Equity Securities

Income trusts  Pay out a portion of cash flows generated from underlying assets  E.g. royalty trusts and real estate investment trusts (REITs) Common stock  Common shareholders are residual claimants on income and assets  Common shareholders can elect board of directors and vote on important issues Equity Securities

Securities whose value is derived from some underlying security Futures and options contracts are standardized and performance is guaranteed by a third party  Risk management tools Warrants are options issued by firms Derivative Securities

Exchange-traded options are created by investors, not corporations Call (Put) gives the buyer the right but not the obligation to purchase (sell) a fixed quantity of shares at a a fixed price before a certain date Options can be sold in the market at a price Increases return possibilities Options

Futures contract: A standardized agreement between a buyer and seller to make future delivery of a fixed asset at a fixed price  A “good faith deposit” called margin, is required of both the buyer and seller to reduce default risk  Used to hedge the risk of price changes Futures

Interest income from debt securities is taxable at the full marginal rate Dividends and capital gains afford investors a tax break  Dividends received from Canadian corporations are taxable for all provinces except Quebec  Capital gain: only 50% is taxable Appendix 2-A Taxation of Investment Income in Canada

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