2-1 Investment Alternatives

2-2 Nonmarketable Financial Assets Commonly owned by individuals Commonly owned by individuals Represent direct exchange of claims between issuer and investor Represent direct exchange of claims between issuer and investor Usually very liquid or easy to convert to cash without loss of value Usually very liquid or easy to convert to cash without loss of value Examples: Savings accounts and bonds, certificates of deposit, money market deposit accounts Examples: Savings accounts and bonds, certificates of deposit, money market deposit accounts

2-3 Money Market Securities Marketable: claims are negotiable or salable in the marketplace Marketable: claims are negotiable or salable in the marketplace Short-term, liquid, relatively low risk debt instruments Short-term, liquid, relatively low risk debt instruments Issued by governments and private firms Issued by governments and private firms Examples: Money market mutual funds, Examples: Money market mutual funds, T-Bills, Commercial paper

2-4 Capital Market Securities Marketable debt with maturity greater than one year and ownership shares Marketable debt with maturity greater than one year and ownership shares More risky than money market securities More risky than money market securities Fixed-income securities have a specified payment schedule Fixed-income securities have a specified payment schedule –Dates and amount of interest and principal payments known in advance

2-5 Bond Characteristics Buyer of a newly issued coupon bond is lending money to the issuer who agrees to repay principal and interest 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 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 If sold before maturity price will depend on interest rates at that time

2-6 Prices quoted as a % of par value Prices quoted as a % of par value Bond buyer must pay the price of the bond plus accrued interest since last semiannual interest payment Bond buyer must pay the price of the bond plus accrued interest since last semiannual interest payment –Prices quoted without accrued interest Premium: amount above par value Premium: amount above par value Discount: amount below par value Discount: amount below par value Bond Characteristics

2-7 Innovation in Bond Features Zero-coupon bond Zero-coupon bond –Sold at a discount and redeemed for face value at maturity –Locks in a fixed rate of return, eliminating reinvestment rate risk –Responds sharply to interest rate changes –Not popular with taxable investors –May have call feature

2-8 Major Bond Types Federal government securities (eg., T- bonds) Federal government securities (eg., T- bonds) Federal agency securities (eg., GNMAs) Federal agency securities (eg., GNMAs) Federally sponsored credit agency securities (eg., FNMAs, SLMAs) Federally sponsored credit agency securities (eg., FNMAs, SLMAs) Municipal securities: General obligation bonds, Revenue bonds Municipal securities: General obligation bonds, Revenue bonds –Tax implications for investors

2-9 Corporate Bonds Usually unsecured debt maturing in years, paying semi-annual interest, callable, with par value of $1,000 Usually unsecured debt maturing in years, paying semi-annual interest, callable, with par value of $1,000 –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

2-10 Rate relative probability of default Rate relative probability of default Rating organizations Rating organizations –Standard and Poors Corporation (S&P) –Moody’s Investors Service Inc Rating firms perform the credit analysis for the investor Rating firms perform the credit analysis for the investor Emphasis on the issuer’s relative probability of default Emphasis on the issuer’s relative probability of default Bond Ratings

2-11 Bond Ratings Investment grade securities Investment grade securities –Rated AAA, AA, A, BBB –Typically, institutional investors are confined to bonds in these four categories Speculative securities Speculative securities –Rated BB, B, CCC, C –Significant uncertainties –C rated bonds are not paying interest

2-12 Securitization Transformation of illiquid, risky individual loans into asset-backed securities Transformation of illiquid, risky individual loans into asset-backed securities –GNMAs –Marketable securities backed by auto loans, credit-card receivables, small-business loans, leases High yields, short maturities, investment- grade ratings High yields, short maturities, investment- grade ratings

2-13 Equity Securities Denote an ownership interest in a corporation Denote an ownership interest in a corporation Denote control over management, at least in principle Denote control over management, at least in principle –Voting rights important Denote limited liability Denote limited liability –Investor cannot lose more than their investment should the corporation fail

2-14 Preferred Stocks Hybrid security because features of both debt and equity Hybrid security because features of both debt and equity Preferred stockholders paid after debt but before common stockholders 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 Often convertible into common stock May carry variable dividend rate May carry variable dividend rate

2-15 Common Stocks Common stockholders are residual claimants on income and assets Common stockholders are residual claimants on income and assets Par value is face value of a share Par value is face value of a share –Usually economically insignificant Book value is accounting value of a share Book value is accounting value of a share Market value is current market price of a share Market value is current market price of a share

2-16 Common Stocks Dividends are cash payments to shareholders Dividends are cash payments to shareholders –Dividend yield is income component of return =D/P –Payout Ratio is ratio of dividends to earnings

2-17 Common Stocks Stock dividend is payment to owners in stock Stock dividend is payment to owners in stock Stock split is the issuance of additional shares in proportion to the shares outstanding 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 P/E ratio is the ratio of current market price of equity to the firm’s earnings

2-18 Investing Internationally Direct investing 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 –Purchase ADR’s  Issued by depositories having physical possession of foreign securities  Investors isolated from currency fluctuations

2-19 Derivative Securities Securities whose value is derived from another security Securities whose value is derived from another security Futures and options contracts are standardized and performance is guaranteed by a third party Futures and options contracts are standardized and performance is guaranteed by a third party Future contract is an obligation to buy or sell Future contract is an obligation to buy or sell Option contract is only the right to do so, the buyer of an option have limited liability Option contract is only the right to do so, the buyer of an option have limited liability –Risk management tools

Derivative Securities Warrants Warrants –A corporation created option to purchase a stated number of common shares at a specified price within a specified time (typically several years) 2-20

2-21 Options Exchange-traded options are created by investors, not corporations Exchange-traded options are created by investors, not corporations Rights to buy or sell a stated number of shares of a security within a specified period at a specified price Rights to buy or sell a stated number of shares of a security within a specified period at a specified price

Options Puts Puts –An option to sell a specified number of shares of stock at a stated price within a specified price –Put buyers are betting that the price of the underlying common stock will decline, making the put option more valuable 2-22

Options Call : Buyer has the right but not the obligation to purchase a fixed quantity from the seller at a fixed price before a certain date Call : Buyer has the right but not the obligation to purchase a fixed quantity from the seller at a fixed price before a certain date –Right is sold in the market at a price –Buyers of calls are betting that the price of the underlying common stock will rise making the call option more valuable Increases return possibilities Increases return possibilities 2-23

Options Both put and call options are written (created) by other investors who are betting the opposite of the respective purchasers. Both put and call options are written (created) by other investors who are betting the opposite of the respective purchasers. The seller (writers) receive an option premium for selling each new contract while the buyer pays this option premium The seller (writers) receive an option premium for selling each new contract while the buyer pays this option premium Once option is created and the writer receives the premium from the buyer, it can be traded repeatedly in the secondary markets. Once option is created and the writer receives the premium from the buyer, it can be traded repeatedly in the secondary markets. 2-24

Options The premium is simply the market price of the contract as determined by investors. The premium is simply the market price of the contract as determined by investors. The price will fluctuate constantly, just as the price of the underlying common stock changes. The price will fluctuate constantly, just as the price of the underlying common stock changes. The option is affected directly by the price of the stock that gives it value. The option is affected directly by the price of the stock that gives it value. 2-25

Using puts and calls Puts and calls allow buyers and sellers to speculate on the short term investments. Puts and calls allow buyers and sellers to speculate on the short term investments. Premium is the maximum amount that the buyer can lose. Premium is the maximum amount that the buyer can lose. If the buyer is correct about the price movements on the common stocks, gains are magnified in relation to having bought common stock If the buyer is correct about the price movements on the common stocks, gains are magnified in relation to having bought common stock Writers(sellers) earned the premium as income, based on their beliefs about the stock Writers(sellers) earned the premium as income, based on their beliefs about the stock 2-26

2-27 Futures Futures contract: A standardized agreement between a buyer and seller to make future delivery of a fixed asset at a fixed price 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 Long position Long position –Commitment to purchase the asset –A person with long position will profit from an increase in the price of the asset Short position Short position –Commitment to sell the asset –A person with short position will profit from decrease in the price of the asset Every long position is offset by a short position Every long position is offset by a short position 2-28