INVESTMENT ALTERNATIVES

Assignment due on next lecture CHAPTER (1) : 1, 2, 5 and 13 CHAPTER (1) : 1, 2, 5 and 13 CHAPTER (2) : 1, 4, 12 and 26 (Questions) CHAPTER (2) : 1, 4, 12 and 26 (Questions)

Suggested topics for the paper Securitization Securitization Primary dealers Primary dealers IOSCO principles IOSCO principles Corporate governance Corporate governance Short selling and marginal trading Short selling and marginal trading Derivatives (Options and Futures) Derivatives (Options and Futures) Stock Exchange demutualization Stock Exchange demutualization Role of stock exchange in attracting FDI Role of stock exchange in attracting FDI Capital Markets Integration Capital Markets Integration

Organizing financial assets Investment Direct Non- Marketable Money Market Capital Market Fixed Income securities Equity securities Derivatives Market Options Futures Indirect

Indirect Investment The buying and selling of the shares of investment companies which in turn hold portfolio of securities. The buying and selling of the shares of investment companies which in turn hold portfolio of securities. Rather than investing directly in securities, investors can invest in a portfolio of securities by purchasing the shares of financial intermediary that invests in various types of securities on behalf of its shareowners. Rather than investing directly in securities, investors can invest in a portfolio of securities by purchasing the shares of financial intermediary that invests in various types of securities on behalf of its shareowners. Examples for investment companies: Examples for investment companies: Money market mutual fund Money market mutual fund Stock, bond and income funds Stock, bond and income funds

Direct Investment Investors buy and sell securities themselves, typically through brokerage accounts. Investors buy and sell securities themselves, typically through brokerage accounts. Investors can do both, investing directly through the use of a brokerage accounts and investing indirectly in one or more investment companies. Investors can do both, investing directly through the use of a brokerage accounts and investing indirectly in one or more investment companies.

Non-marketable financial assets 15% of total financial assets of US households is in the form of deposits. 15% of total financial assets of US households is in the form of deposits. These assets represent personal transactions between the owner and the issuer. In contrast, marketable securities trade in impersonal markets-the buyer does not know the seller. These assets represent personal transactions between the owner and the issuer. In contrast, marketable securities trade in impersonal markets-the buyer does not know the seller. These are safe investments and offer the ultimate in liquidity which is the ease with which an asset can be converted to cash. These are safe investments and offer the ultimate in liquidity which is the ease with which an asset can be converted to cash.

Money market securities This is the market for short-term, highly liquid, low-risk assets. They are short-term, highly marketable investments with an extremely low probability of default. This is the market for short-term, highly liquid, low-risk assets. They are short-term, highly marketable investments with an extremely low probability of default. The size of transactions in the money market is large ($100,000) and the maturities range from one day to one year. The size of transactions in the money market is large ($100,000) and the maturities range from one day to one year.

Capital markets Money market instruments are short-term, highly liquid, low risk securities while capital market instruments are long-term instruments of higher risk and varying degrees of liquidity. Money market instruments are short-term, highly liquid, low risk securities while capital market instruments are long-term instruments of higher risk and varying degrees of liquidity. Capital markets encompass fixed income and equity securities with maturities greater than one year. Capital markets encompass fixed income and equity securities with maturities greater than one year. Equity securities have no maturity date. Equity securities have no maturity date.

Fixed-income securities All of these securities have a specified payment schedule. All of these securities have a specified payment schedule. Bonds are long-term debt instruments representing the issuer’s contractual obligation. Bonds are long-term debt instruments representing the issuer’s contractual obligation. For fixed-income securities, the interest payments and the principle repayment are specified at the time of issuing and fixed for the life of the bonds. For fixed-income securities, the interest payments and the principle repayment are specified at the time of issuing and fixed for the life of the bonds.

Bonds Coupon Bond Coupon Bond The purchaser pays the par value (the redemption value of a bond) and this bond matures on a specified date where the issuer pays periodic coupon to the holder until maturity at which time the principle will be paid Zero-Coupon Bond A bond sold with no coupons at a discount and redeemed for par value at maturity.

It gives the issuer the right to call in a security and retire it by paying off the obligation. It gives the issuer the right to call in a security and retire it by paying off the obligation. It is attractive to issuer when interest rate drop sufficiently below coupon rate. It is attractive to issuer when interest rate drop sufficiently below coupon rate. Call provision

Bonds Federal government securities Government agency securities Federal Credit agencies Government Sponsored agencies Municipal securities General Obligation bonds Revenue bonds Corporate Senior Debenture Convertible

Federal government securities The US government in the course of financing its operations through the Treasury department, issues numerous bonds with maturities greater than one year. The US government in the course of financing its operations through the Treasury department, issues numerous bonds with maturities greater than one year. It is considered the safest credit risk. It is considered the safest credit risk. Treasury bonds generally have maturities of 10 to 30 years. Treasury bonds generally have maturities of 10 to 30 years.

Government agency securities Two types of federal credit agencies: Two types of federal credit agencies: Federal agencies Federal agencies These are part of the federal government and their securities are fully guaranteed by the treasury These are part of the federal government and their securities are fully guaranteed by the treasury Federally sponsored credit agencies Federally sponsored credit agencies These are privately owned institutions that sell their own securities in the marketplace to raise funds for their specific purpose. These securities are not guaranteed by the government. These are privately owned institutions that sell their own securities in the marketplace to raise funds for their specific purpose. These securities are not guaranteed by the government.

Municipal securities Bonds sold by states, counties, cities and other political entities. Bonds sold by states, counties, cities and other political entities. Two types of municipals are: Two types of municipals are: General obligation bonds which are backed by the full faith and credit of the issuer. General obligation bonds which are backed by the full faith and credit of the issuer. Revenue bonds which are repaid from the revenues generated by the project they were sold to finance (toll road) Revenue bonds which are repaid from the revenues generated by the project they were sold to finance (toll road) A term bond has a specified maturity date in the future for the entire issue while with a serial bond, a certain percentage of the issue matures each year. A term bond has a specified maturity date in the future for the entire issue while with a serial bond, a certain percentage of the issue matures each year.

Municipal securities Most municipals are exempted from federal tax. Most municipals are exempted from federal tax. The rate on these bonds will be lower than that on none-exempted bonds. The rate on these bonds will be lower than that on none-exempted bonds. The higher an investor’s tax bracket, the more attractive municipals become. The higher an investor’s tax bracket, the more attractive municipals become. To make the return on these bonds comparable to those of taxable bonds, the taxable equivalent yield (TEY) can be calculated. To make the return on these bonds comparable to those of taxable bonds, the taxable equivalent yield (TEY) can be calculated.

Municipal securities

Example on taxable equivalent yield An investor in the 28 percentage marginal tax bracket who invests in a 5 percent municipal bond would have to receive An investor in the 28 percentage marginal tax bracket who invests in a 5 percent municipal bond would have to receive 0.05 / ( ) = 6.94% From a comparable taxable bond to be as well off.

Corporate Most of large corporations issue corporate bonds to help finance their operations. Most of large corporations issue corporate bonds to help finance their operations. Corporate bonds are: Corporate bonds are: Senior securities: they are senior to any preferred and common stocks in terms of priority of payment. Senior securities: they are senior to any preferred and common stocks in terms of priority of payment. Debenture securities: a bond backed only by the issuer’s overall financial soundness. Debenture securities: a bond backed only by the issuer’s overall financial soundness. Convertible bonds: the bonds are turned in to the corporation in exchange for a specified number of common shares with no cash payment required. Convertible bonds: the bonds are turned in to the corporation in exchange for a specified number of common shares with no cash payment required.

Asset-backed securities Securitization is the transformation of illiquid, risky individual loan into more liquid, less risky securities referred to as asset- backed securities (ABS) Securitization is the transformation of illiquid, risky individual loan into more liquid, less risky securities referred to as asset- backed securities (ABS) ABS issued against some type of asset linked debt bundled together. ABS issued against some type of asset linked debt bundled together. Marketable securities have been backed by car loans, credit card receivables. Marketable securities have been backed by car loans, credit card receivables. ABS is attractive because it has relatively high yields and relatively short maturity. ABS is attractive because it has relatively high yields and relatively short maturity. Securitization works best when packaged loans are homogenous, so that income stream and risks are more predictable. Securitization works best when packaged loans are homogenous, so that income stream and risks are more predictable.

Rates on fixed-income securities Applying the risk-return tradeoff. Applying the risk-return tradeoff. Interest rates on corporate bond exceeds treasury rates because of the possible risk of default. Interest rates on corporate bond exceeds treasury rates because of the possible risk of default. Lowe - corporate yields more than do highe - bonds. Lowe - corporate yields more than do highe - bonds.

Example from Egyptian Stock Exchange for 1996 – May 2003 Number of issues for Government bonds 8 Value of Government bonds issued 13 Billions Number of issues for Corporate bonds 42 Value of Corporate bonds issued 7.4 Billions

Equity Securities Equity securities represent an ownership interest in a corporation and a claim on the income and assets. Equity securities represent an ownership interest in a corporation and a claim on the income and assets. Two forms of equities: Preferred stock and Common stocks. Two forms of equities: Preferred stock and Common stocks. Preferred stock. Preferred stock. It resembles both equity and fixed-income instruments. It resembles both equity and fixed-income instruments.

Equity Securities Preferred stock Preferred stock It has an infinite life and pays dividend like equity securities. It has an infinite life and pays dividend like equity securities. This dividend is fixed in amount and known in advance, providing stream of income similar to bonds. This dividend is fixed in amount and known in advance, providing stream of income similar to bonds. The stream of income continue forever unless the issue is called. The stream of income continue forever unless the issue is called. Preferred stockholders are paid after the bondholders but before the common stockholders in case of priority of payment of income or liquidation. Preferred stockholders are paid after the bondholders but before the common stockholders in case of priority of payment of income or liquidation.

Equity securities Common stock. Common stock. An equity security representing the ownership interest in a corporation. An equity security representing the ownership interest in a corporation. If a firm’s shares are held by only few individuals, the firm is said to be closely held. Most companies choose to go public. If a firm’s shares are held by only few individuals, the firm is said to be closely held. Most companies choose to go public. Dividends are the only cash payments regularly made by corporations to their stockholders. Dividends are the only cash payments regularly made by corporations to their stockholders. Dividend yield is the income component of a stock’s return. It is calculated as dividends divided by current stock price. Dividend yield is the income component of a stock’s return. It is calculated as dividends divided by current stock price.

Equity securities Common stock Common stock A stock split involves the issuance of a larger number of shares in proportion to the existing shares outstanding. A stock split involves the issuance of a larger number of shares in proportion to the existing shares outstanding.

Derivatives securities Options and futures contracts are two types of derivatives securities. Options and futures contracts are two types of derivatives securities. They are important to investors because they provide a way for investors to manage portfolio risk. They are important to investors because they provide a way for investors to manage portfolio risk. A futures contract is an obligation to buy or sell, but an options contract is only the right to do so. A futures contract is an obligation to buy or sell, but an options contract is only the right to do so.

Derivative securities Options refers to puts and calls. Options refers to puts and calls. Puts is an option to sell a specified number of shares of stock at a stated price within a specified period, while calls is an option to buy. Puts is an option to sell a specified number of shares of stock at a stated price within a specified period, while calls is an option to buy. A future contract is an agreement that provides for the future exchange of a particular asset between a buyer and a seller at a currently determined market price. A future contract is an agreement that provides for the future exchange of a particular asset between a buyer and a seller at a currently determined market price.

Example on options Assume on October 1, Compaq computer closed at $27 5/8 and that a December call option with a price of $25 is available. Assume on October 1, Compaq computer closed at $27 5/8 and that a December call option with a price of $25 is available. Intrinsic value of the call = 27 5/8 – 25=$2 5/8 Intrinsic value of the call = 27 5/8 – 25=$2 5/8 Time value of the call = Option price – Intrinsic value. Time value of the call = Option price – Intrinsic value. = 3 ½ - 2 5/8 = $ 7/8 = 3 ½ - 2 5/8 = $ 7/8 Option price = Intrinsic value + time value