1. 3 3 C h a p t e r Security Types second edition Fundamentals of Investments Valuation & Management Charles J. Corrado Bradford D. Jordan McGraw Hill / IrwinSlides by Yee-Tien (Ted) Fu

2.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 3 - 2 Security Types Our goal in this chapter is to introduce the different types of securities that are routinely bought and sold in financial markets around the world. Goal  For each security type, we will examine:  its distinguishing characteristics,  the potential gains and losses from owning it, and  how its prices are quoted in the financial press.

3.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 3 - 3 Classifying Securities  Financial assets can be grouped into three main categories, and each of these categories can be subdivided into a few major subtypes.  Some financial assets are hard to classify. The primary reason is that some instruments are Hybrids, meaning that they are combinations of the basic types  Financial assets such as bonds and stocks are often called “ Securities”

4.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 3 - 4 Classifying Securities Basic TypesMajor Subtypes Interest-bearing Money market instruments Fixed-income securities Equities Common stock Preferred stock Derivatives Options Futures

5.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 3 - 5 Interest-Bearing Assets  Interest bearing assets( as the name suggests) pay interest.  The value of these assets depends at least for the most part on Interest rates.  The reason that these assets pay interest is that they all begin life as a loan of some sort, so they are all debt obligations of some issuer.  There are many types of interest bearing assets, they range from simple to complex

6.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 3 - 6 Interest-Bearing Assets Fixed-income securities Longer-term debt obligations, often of corporations or governments, that promise to make fixed payments according to a preset schedule. Money market instruments Short-term debt obligations of large corporations and governments that mature in a year or less.

7.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 3 - 7 Money Market Instruments  Is the simplest form of interest bearing assets  Money market instruments have the following two properties: 1.They are I.O.U sold by large corporations or governments to borrow money. 2.They mature in less than one year from the time they are sold, meaning that the loan must be repaid within one year.

8.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 3 - 8 Money Market Instruments  Examples: U.S. Treasury bills (T-bills), bank certificates of deposit (CDs), corporate and municipal money market instruments.  T-bills are the most liquid type of Money market Instruments  Potential gains/losses: Fixed future payment, except when the borrower defaults.  Price quotations: Usually, the instruments are sold on a discount basis, this simply means that the T-bills are sold at a price which is less that their stated face value.

9.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 3 - 9 Fixed-Income Securities  Examples: U.S. Treasury notes, corporate bonds, car loans, student loans.  Potential gains/losses:  Fixed coupon payments and final payment at maturity, except when the borrower defaults.  Possibility of gain/loss from fall/rise in interest rates.  Can be quite illiquid.  Fixed income securities have lives that exceed 12 months at the time they are issued

10.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 3 - 10 Note  The words (Note) and ( Bonds) are generic terms for fixed income securities, but fixed income is more accurate.

11.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 3 - 11 Fixed-Income Securities  Price quotations: CUR NET BONDS YLD. VOL CLOSE CHG. NEW YORK BONDS Corporation Bonds ATT7 3 / 4 07……7.856100+ 1 / 4 ATT8 1 / 8 22……8.643394 1 / 8 + 5 / 8 ATT8 1 / 8 24……8.745393 3 / 4 – AT&T, the issuer of the bond. ATT The bond’s annual coupon rate. You will receive 8 1 / 8 % of the bond’s face value each year in 2 semiannual coupon payments. 81/881/8 The bond will mature in the year 2022. 22

12.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 3 - 12 Fixed-Income Securities  Price quotations: CUR NET BONDS YLD. VOL CLOSE CHG. NEW YORK BONDS Corporation Bonds ATT7 3 / 4 07……7.856100+ 1 / 4 ATT8 1 / 8 22……8.643394 1 / 8 + 5 / 8 ATT8 1 / 8 24……8.745393 3 / 4 – 8.6 Current yield = annual coupon current price 433 The actual number of bonds traded that day. 94 1 / 8 The closing price for the day is 94.125% of face value. The closing price is up by 5 / 8 of 1% from the previous closing price. +5/8+5/8

13.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 3 - 13 Equities Preferred stock The dividend is usually fixed and must be paid before any dividends for the common shareholders. In the event of a liquidation, preferred shares have a particular face value. Common stock Represents ownership in a corporation. A part owner receives a pro rated share of whatever is left over after all obligations have been met in the event of a liquidation.

14.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 3 - 14 Common Stock  Examples: IBM shares, Microsoft shares, etc.  Potential gains/losses:  Many companies pay cash dividends to their shareholders. However, neither the timing nor the amount of any dividend is guaranteed.  The stock value may rise or fall depending on the prospects for the company and market-wide circumstances.

15.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 3 - 15 Preferred Stock  Preferred stock differs from common stocks in several ways.  First, the dividend on preferred stock is fixed at some amount and never changed  The reason preferred stock is called like this, because the company must paid a fixed dividend to its preferred stock before any dividends can be paid to the common shareholders, in another way preferred stocks must be paid first.

16.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 3 - 16 Preferred Stock  Some preferred stock is cumulative, meaning that any and all skipped dividends must be paid in full, before common shareholders can receive a dividend.  Potential gains from owning preferred stocks consist of the promised dividend plus any gains from the prices increase.  The Potential losses the dividends maybe skipped and the value of your stocks maybe decline

17.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 3 - 17 Preferred Stock  Example: Citigroup preferred stock.  Potential gains/losses:  Dividends are “promised.” However, there is no legal requirement that the dividends be paid, as long as no common dividends are distributed.  The stock value may rise or fall depending on the prospects for the company and market-wide circumstances.

18. Equities : Price quotations 3 - 18 McGraw Hill / Irwin @2002 by the McGraw- Hill Companies Inc.All rights reserved.

19.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 3 - 19 The Summary  The first column: The percentage change in the stock price.  The second two numbers are the highest and lowest price per share  Then the next column is the name of the company followed by the ticker symbol  Following the ticker symbol is the dividend labeled “ Div”  Then the dividend yield is the annualized dividend divided by the closing price

20.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 3 - 20 The summary  Then the price earning ration which is the price per share divided by the earnings per share.  Then we have the trading volume for the day, measured in Hundreds.  The column labeled “Close” is the closing price meaning the last price at which the trade occurred.  Finally, the “Net CHG” is the change in closing price from the previous trading day.

21.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 3 - 21 Derivatives  There is a clear distinction between real assets which are tangible items and financial assets which are pieces of paper describing legal claims.  Financial assets can be divided into: 1.Primary assets 2.Derivative assets

22.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 3 - 22 Derivatives Primary asset Security originally sold by a business or government to raise money. Derivative asset A financial asset that is derived from an existing traded asset rather than issued by a business or government to raise capital. More generally, any financial asset that is not a primary asset.

23.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 3 - 23 Derivatives Futures contract An agreement made today regarding the terms of a trade that will take place later. Option contract An agreement that gives the owner the right, but not the obligation, to buy or sell a specific asset at a specified price for a set period of time.

24.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 3 - 24 Futures Contracts  Examples: financial futures, commodity futures.  Financial futures: the underlying asset is intangible usually stocks, bonds, currencies or money market instruments  Commodity futures: the underlying asset is a real one, either an agricultural product or a natural resource product such as gold or oil.

25.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 3 - 25 Future Contracts  Potential gains/losses:  At maturity, you gain if your contracted price is better than the market price of the underlying asset, and vice versa.  If you sell your contract before its maturity, you may gain or lose depending on the market price for the contract.  Note that enormous gains/losses are possible.

26. Futures Contracts  Price quotations: 3 - 26 McGraw Hill / Irwin @2002 by the McGraw- Hill Companies Inc.All rights reserved.

27.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 3 - 27 Futures Price quotes  An important feature of the traded future contract is that they are standardized, meaning that one contract calls for the purchase of a specific quantity of the underlying asset.  Further the contract specify in details what the underlying asset is and where it is to be delivered.  The letter CBT indicates where the contract is traded, it is the Chicago board of trade

28.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 3 - 28 Futures Price quotes  The first column tells us the delivery date for the bond specified by the contract.  Open price: the price at the start of the trading day  High and low : the highest and lowest prices during the trading day  Settle : is the price on the final trade of the day  CHG: change in the settle price from the previous trading day

29.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 3 - 29 Futures Price quotes  The column labeled “ LIFETIME HIGHT”, “LIFETIME Low” refer to the highest and lowest prices over the life of this contract  Finally, the Open INT : tells us how many contract are currently outstanding.  Actually, most futures contracts don’t result in delivery, most buyers and sellers close out their contracts before the delivery date. To close out the contract, you take the opposite side.

30.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 3 - 30 Option Contracts  A call option gives the owner the right, but not the obligation, to buy an asset, while a put option gives the owner the right, but not the obligation, to sell an asset.  The price you pay to buy an option is called the option premium.  The specified price at which the underlying asset can be bought or sold is called the strike price, or exercise price.

31.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 3 - 31 Option Contracts  An American option can be exercised anytime up to and including the expiration date, while a European option can be exercised only on the expiration date.  Options differ from futures in two main ways:  There is no obligation to buy/sell the underlying asset.  There is a premium associated with the contract.

32.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 3 - 32 Option Contracts  Potential gains/losses:  Buyers gain if the strike price is better than the market price, and if the difference is greater than the option premium. In the worst case, buyers lose the entire premium.  Sellers gain the premium if the market price is better than strike price. Here, the gain is limited but the loss is not.

33. Option Contracts  Price quotations: 3 - 33 McGraw Hill / Irwin @2002 by the McGraw- Hill Companies Inc.All rights reserved.

34.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 3 - 34 Investing in Stocks versus Options Example:  Suppose you have $10,000 for investments. Macron Technology is selling at $50 per share.  Number of shares bought = $10,000 / $50 = 200  If Macron is selling for $55 per share 3 months later, gain = ($55  200) – $10,000 = $1,000  If Macron is selling for $45 per share 3 months later, gain = ($45  200) – $10,000 = – $1,000

35.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 3 - 35 Investing in Stocks versus Options Example: …continued  A call option with a $50 strike price and 3 months to maturity is also available at a premium of $4.  A call contract costs $4  100 = $400, so number of contracts bought = $10,000 / $400 = 25 (for 25  100 = 2500 shares)  If Macron is selling for $55 per share 3 months later, gain = {($55 – $50)  2500} – $10,000 = $2,500  If Macron is selling for $45 per share 3 months later, gain = ($0  2500) – $10,000 = – $10,000

36.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 3 - 36 Chapter Review  Classifying Securities  Interest-Bearing Assets  Money Market Instruments  Fixed-Income Securities  Equities  Common Stock  Preferred Stock  Common and Preferred Stock Price Quotes

37.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 3 - 37 Chapter Review  Derivatives  Futures Contracts  Futures Price Quotes  Gains and Losses on Futures Contracts  Option Contracts  Option Terminology  Options versus Futures  Option Price Quotes  Gains and Losses on Option Contracts  Investing in Stocks versus Options

38.  2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 3 - 38  http://highered.mcgraw- hill.com/sites/0072443316/student_view0/chap ter1/work_the_web_exercises.html