1. Investment Alternatives
FIN 3600: Chapter 3 Timothy R. Mayes, Ph.D.

2. Categories of Investments
Previously, we have distinguished between two types of assets:
Financial Assets
Real Assets
We can further subdivide these into two categories:
Direct Investments – These are investments where you take actual direct ownership of the assets
Indirect Investments – These are investments where you have indirect ownership, such as mutual funds, ETFs, and REITs

3. Money Market Instruments
The “money market” is comprised of high quality, short-term, large denomination debt instruments:
High Quality – Generally the issuers have very high credit ratings (U.S. Government, money center banks, large finance companies, blue chip corporations).
Short-term – Most money market instruments mature within one year, and many within a few days.
Large Denomination – Most of these securities have a face value greater than $100,000.
Additionally, most of these investments are discount securities. They do not pay interest. Rather, they are sold at a discount to face value and later redeemed at full face value.

4. Types of Money Market Instruments
Treasury Bills (T-bills) and short-term agencies
Short-term Municipals
Commercial Paper
Banker’s Acceptances
Jumbo CDs (brokered CDs, large CDs)
Repurchase Agreements

5. T-Bills and Short-term Agencies
Treasury bills (and short-term agencies) are used to provide short-term liquidity for the U.S. government.
T-bills are backed by the “full faith and credit” of the U.S. government.
They are issued with original maturities of 4 weeks (new as of 31 July 2001), 13 weeks (3-month or 91 days), 26 weeks (6-month or 182 days). 52-week (1 year or 365 days) bills used to be regularly auctioned, but this practice was discontinued on 27 Feb 2001.
Occasionally, they also issue cash management bills (CMBs) with variable, but usually less than 3-months, maturities.
They do not pay interest, instead they are sold at a discount to face value and are redeemed at maturity for their full face value.
The face value of T-bills is $1,000 and multiples thereof.
The selling of T-bills is handled by the Federal Reserve Board in an auction. For T-bills, competitive bidders bid based on price. For T-notes and bonds (we’ll get to those later), the competitive bidders bid based on yield. Obviously, whatever it is auctioning, the Fed wants to get either the highest price or lowest yield. At this time, the auction schedule for T-Bills is as follows:
4-week bills are auctioned every Tuesday.
13-week and 26-week bills are auctioned every Monday.
CMBs are auctioned on an irregular schedule, as needed. However, in August 2003 the Treasury announced that it would be making more regular use of CMBs.
More information about auctions (including results of recent auctions) can be found at:

6. Calculating Yields on T-bills
Since T-bills are sold on a discount basis, their returns are not directly comparable to interest bearing bonds.
Returns on T-bills are quoted on a “bank discount basis”:

7. Calculating Yields on T-bills (cont.)
The Bank Discount Yield is a little misleading for two reasons:
It uses a 360-day year (12 months, 30 days each)
It is based on face value, not the actual price
For these reasons, and comparability with interest-bearing securities, we can calculate the Bond Equivalent Yield by adjusting the BDY or directly:

8. Calculating Yields on T-bills (cont.)
Here’s an example: Suppose you just bought a 26-week (182 days) T-bill at auction for a price of $975. What is the BDY and BEY?

9. Short-term Municipals
Cities, counties, and states all frequently have a need for short-term funds to provide for liquidity needs.
They can issue securities that are similar to T-bills called anticipation notes (in anticipation of some revenue, usually taxes).
The advantage of these securities is that the income they provide is free of federal taxation.
The disadvantage is that they are backed only by the taxing authority of the district that issues them.
For this reason, they are not as safe as T-bills.

10. Taxable Equivalent Yield
When comparing tax-exempt yields to taxable yields, we need to adjust for the tax rate.
We can either gross up the tax-free yield:
Or, we can discount the taxable yield:
Once we’ve made the adjustment, the yields are comparable

11. Commercial Paper
Commercial paper (CP) is very high-quality, unsecured, short-term corporate debt.
Generally, it matures in less than 9 months and is exempt from SEC registration (more than 270 days and it would have to be registered). In practice, most CP matures in 30 days or less.
There are about 1,500 companies (Bloomberg) that issue CP, but about 75% (NY Fed) of CP is issued by financial companies (the largest being GE Capital, GMAC, and Ford Motor Credit).
CP is not very liquid as it tends to be held to maturity by purchasers, though it can be traded in the secondary market if necessary.

12. Commercial Paper (cont.)
CP is issued by firms in one of two ways:
Direct – CP is sold directly to investors. This method is usually used by financial firms with frequent, large needs for short-term cash. Direct issuance lowers interest costs by 1/8 of a percentage point ($125,000 per $100 million issued, NY Fed estimate). This more than pays for having a full-time staff.
Indirect – CP is sold to a dealer at a discount (higher interest rate), and is then either held in the dealer’s own account, or resold to investors at a profit. Firms which do not regularly issue CP use dealers.
CP interest rates are usually lower than on bank loans, making it an attractive alternative for some firms.
CP defaults are rare, but they do occasionally occur.
As of January 2002, there was about $1.44 trillion in outstanding CP.
The current quantity of CP outstanding can be found at the NY Fed Web site:
Historical amounts outstanding (monthly since Jan 1991) is available at:

13. Bankers’ Acceptances
Bankers’ acceptances (BAs) are like a certified check from a bank, except that it is payable on some future date whereas a check is payable immediately.
Bankers’ acceptances are usually created in the process of international trade and are sold by banks.
A BA results when an importer buys from a foreign exporter and provides the exporter with a letter of credit from the importer’s bank guaranteeing payment (or vice versa).
The exporter may either take payment from the importer’s bank after delivery, or it may take payment immediately (at a discount) from its own bank.

14. Bankers’ Acceptances (cont.)
The exporter’s bank presents the letter to the importer’s bank which stamps it “Accepted.”
The exporter’s bank may then keep it (and collect later), return it to the importer’s bank (and collect the present value now), or sell it to an investor (also collecting now).
Once accepted, the BA becomes a liability of the importer’s bank, and they take the risk of non-payment by the importer (who is liable to the bank).
Banks charge a fee for this service, and borrowers must also pay the discount.
BAs typically mature in 30 to 180 days, but they may extend to 270 days. Usually the time to maturity covers the time to ship and sell the goods purchased.

15. Jumbo CDs
Jumbo (or large or brokered) Certificates of Deposit (CDs) are similar to small CDs, except:
They are larger (duh!). Minimum face value is $100,000
They are not federally insured (beyond $100,000)
In some cases, they may be sold in the secondary market
Terms range from 7 days to 5 years or longer, most are 1 to 6 months
Some banks now offer mini-jumbo CDs with minimum investments of $25,000 to $100,000. These are federally insured up to $100,000.

16. Repurchase Agreements
A repurchase agreement (Repo or RP) is not actually a security. Instead, it is a method of financing that involves money market securities.
Typically, a firm needing cash overnight or for a short time period (term RP) and having money market securities will pledge them as collateral for a short-term loan.
These deals are structured not as a loan, but a sale and repurchase. Usually, a dealer is involved and charges a fee.
The security pledged is sold and repurchased at the same price. Additionally, when the securities are repurchased, there is also an interest payment.

17. Non-Money Market Financial Instruments
There are many securities with longer terms that governments, banks, and corporations use to raise funds:
Long-term bonds
Preferred stock
Common stock
Derivatives

18. Long-term Bonds
Bonds are interest bearing debt securities with original maturities greater than one year.
Bonds are issued to raise capital by the following types of issuers:
Federal government
Federal agencies
State and local governments
Corporations
Various foreign issuers

19. Treasury Notes and Bonds
The U.S. Treasury is the largest issuer of long-term bonds in the world.
In addition to the T-bills we’ve already discussed, the U.S. Treasury issues:
Notes – These have original maturities of 2 to 10 years and are not callable.
Bonds – These have original maturities of more than 10 years and may be callable.
Both notes and bonds pay interest (originally determined at auction) semi-annually and may be purchased with face values of $1,000 or more.
They are backed by the full faith and credit of the U.S. government (and its ability to print money).
The 30-year T-Bond, which was discontinued in October 2001, has been revived and the first auction of the “long bond” will take place in Q The long bond will be auctioned twice per year in the future.

20. Agency Securities
Many U.S. Government agencies and Government Sponsored Enterprises (GSEs) also raise money in the debt markets.
These securities are not generally backed by the full faith and credit of the U.S. government, but most believe that the treasury would not allow a default.
They may be callable.

21. Agency Security Issuers
Federal Agencies
Tennessee Valley Authority (TVA)
U.S. Agency for International Development (US Aid)
International Bank for Reconstruction and Development (IBRD)
Government National Mortgage (Ginnie Mae)
Government Sponsored Enterprises:
Federal Farm Credit Bank (FFCB)
Federal Agricultural Mortgage Association (Farmer Mac)
Federal Home Loan Mortgage Corp (Freddie Mac)
Fannie Mae
Student Loan Marketing Association (Sallie Mae) used to be a GSE, but is no longer.

22. Municipal Bonds
Municipal bonds are issued by state and local governments. The interest paid by these bonds are exempt from federal income taxes.
There are two categories:
General Obligation (GOs) – These are backed by the taxing authority of the issuer. In 2004 about 35% of muni bonds were issued as GOs.
Revenue Bonds – These are backed by specific sources, such as Denver International Airport. In 2004 about 65% of muni bonds were issued as revenue bonds.
Municipal bonds are subject to credit risk, and there have been some high-profile defaults (Orange County, CA and Washington Power) and feared defaults that never occurred (State of California most recently).
Muni bonds may be insured against defaults by MBIA, Ambac, FSA and others.

23. Corporate Bonds
Corporations issue bonds that typically have original maturities of 5 to 30 years, and occasionally as long as 100 years (Coca-Cola and Disney).
There are several possible categorizations:
Debentures – Unsecured debt
Subordinated Debentures – Unsecured and have lower claim than regular debentures
Mortgage Bonds – Secured by specific assets
Income Bonds – Pay interest and principal based on income produced by specific assets

24. A Bond Certificate
This bond certificate from the Mansfield and Framingham Railroad Co. (incorporated in Massachusetts) is complete with a coupon in the lower-left corner.
Note that the face value of the bond is printed in pink, written, and also in the graphic in the upper-left of the picture.
This bond has been canceled as is evidenced by the cancellation holes over the signatures of the president and secretary (lower-right) and the “Cancelled” stamp in two locations.
In the upper-right, you can see that the bond is number 26.
Finally, note the ornate artwork which is to discourage counterfeiting.

25. Preferred Stock
Preferred stock is a hybrid of debt and equity, but it legally represents an ownership claim and is not debt.
Preferred stockholders have a lower claim on assets than bondholders (creditors), but higher than common stockholders.
Dividends are usually fixed, but failure to pay cannot trigger bankruptcy.
There is no specified maturity date, but most are eventually called or converted to common stock.
Preferred stock generally carries no voting rights.
Preferred stock is not a frequently used financing tool.

26. Common Stock
Common stock represents an actual ownership position in the firm, and stockholders are residual claim holders (they get paid last in a liquidation).
Many common stocks pay dividends, but they are not required and payout ratios have diminished greatly in recent years.
Common shareholders get to vote on major issues of importance.

27. A Stock Certificate
This certificate from The Grand Union Company is for 100 shares and was issued on June 20, In the lower-right corner you can see that the transfer agent was Chase Manhattan Bank. The dotted white text at the bottom (right of center) is the stamp of CMB on January 16, The registrar for the shares was Chemical Bank New York Trust Company. The owner of the shares was Ira Haupt & Co.

28. Foreign Stocks
Many foreign common stocks are listed on U.S. stock exchanges.
Some are directly listed (not many) and others trade in the form of an American Depositary Receipt (ADR).
ADRs are created by a U.S. Bank (Bank of New York is the largest) and usually contain more than one foreign share per ADR.

29. Indirect Investments
An indirect investment is a professionally managed portfolio in which investors can buy shares. Investors do not have a direct claim on the individual assets in the portfolio.
Examples include:
Mutual Funds (open-end)
Closed-end funds
Exchange-traded funds
Hedge funds
Real Estate Investment Trusts (REITs)

30. Mutual Funds
Mutual funds are professionally managed portfolios of securities that are owned by the shareholders and managed by a fund management firm. For example, Fidelity branded mutual funds are managed by Fidelity Management & Research, but the portfolios are owned by the shareholders.
Each mutual fund has an investment style that is described in its prospectus. Funds may invest in stocks, government bonds, municipal bonds, etc.

31. Closed-end Funds
Closed-end funds are like mutual funds, except that they have a fixed number of shares and are traded on a stock exchange.
They are traded all day during regular market hours and the price changes continuously throughout a trading session.
Closed-end funds may trade at a premium or discount to the net asset value of the underlying portfolio. There are likely many reasons for this, but there is currently no complete explanation for the phenomenon.
Funds that continually trade at a discount to NAV are occasionally liquidated and the money returned to shareholders. This gives shareholders an immediate gain equal to the amount of the discount.
Closed-end funds may trade at a discount or premium for many reasons, including:
Transparency – Outside of the managers, nobody knows for sure what is in the fund at any given moment.
2) Liquidity – The fund may not be actively traded.
3) Lack of arbitrage opportunities – Given the relative lack of transparency, it is impossible to arbitrage away the discount or premium. Note that ETFs don’t suffer from this problem because they have a built-in arbitrage mechanism.
4) Government restrictions on foreign ownership of shares – Shares of companies in some foreign markets may be difficult or impossible for individual investors to purchase. When such a market is in vogue, individual investors wanting exposure to that market may be willing to pay a premium for a closed-end fund. The opposite is true when a market is out of favor. This situation is exacerbated when there are no or few open ended mutual funds with significant exposure to that country.

32. Exchange Traded Funds
Its arguable whether ETFs are derivatives, but I’ll consider them one type.
An ETF is very similar to a mutual fund (especially a closed-end fund) except for several important features:
They are traded on a stock exchange and may be bought, sold, and sold short at any time. Mutual funds can only be bought or sold at the end of the day.
They may trade at a slight premium or discount to their NAV. This premium or discount is kept small by arbitrage mechanisms built into ETFs (unlike closed-end funds).
ETFs are typically passively managed portfolios which results in them being much more tax and capital gains efficient than actively managed mutual funds. There will be some actively managed ETFs in the near future.
Until June 2002 all ETFs were based on equity market indexes (S&P 500, Nasdaq 100, etc.). Now, there are a few debt market ETFs based on debt indexes such as the Lehman Brothers 1-3 year US Treasury Index.
Examples of ETFs would include SPDRs, HOLDRS, iShares, VIPERS, and more seemingly introduced every day. As of August 2005, there were more than 190 ETFs with assets of over $260 billion. New actively managed ETFs will be coming to the market soon.
The arbitrage feature of most ETFs allows large institutional (mutual funds, pension funds, insurance companies, hedge funds, etc) to exchange the ETFs for the underlying securities and vice versa. Suppose, for example, that the SPY is trading at an unusually large discount to the S&P 500 index. A hedge fund may decide to exchange for the actual underlying securities. This has the effect of lowering the price of the SPY and raising the value of the S&P 500 index. This will eventually erase that large discount.

33. Hedge Funds
Hedge funds are limited partnerships that use strategies that most mutual funds are not allowed to use. For example, many hedge funds short sell securities or have heavy exposure to derivatives.
Hedge funds are subject to little government regulation, as long as they adhere to certain restrictions:
No public advertising
Only “accredited investors” may own shares
Limited number of investors
Hedge fund managers generally charge between 1% and 2% of assets as a management fee plus an incentive fee of as much as 20% of profits.
Here is the SEC definition of an accredited investor as defined in Regulation D (
"Accredited investor" shall mean any person who comes within any of the following categories, or who the issuer reasonably believes comes within any of the following categories, at the time of the sale of the securities to that person:
(1) Any bank as defined in section 3(a)(2) of the Act, or any savings and loan association or other institution as defined in section 3(a)(5)(A) of the Act whether acting in its individual or fiduciary capacity; any broker or dealer registered pursuant to section 15 of the Securities Exchange Act of 1934; any insurance company as defined in section 2(13) of the Act; any investment company registered under the Investment Company Act of 1940 or a business development company as defined in section 2(a)(48) of that Act; any Small Business Investment Company licensed by the U.S. Small Business Administration under section 301(c) or (d) of the Small Business Investment Act of 1958; any plan established and maintained by a state, its political subdivisions, or any agency or instrumentality of a state or its political subdivisions, for the benefit of its employees, if such plan has total assets in excess of $5,000,000; any employee benefit plan within the meaning of the Employee Retirement Income Security Act of 1974 if the investment decision is made by a plan fiduciary, as defined in section 3(21) of such Act, which is either a bank, savings and loan association, insurance company, or registered adviser, or if the employee benefit plan has total assets in excess of $5,000,000 or, if a self-directed plan, with investment decisions made solely by persons that are accredited investors;
(2) Any private business development company as defined in section 202(a)(22) of the Investment Advisers Act of 1940;
(3) Any organization described in section 501(c)(3) of the Internal Revenue Code, corporation, Massachusetts or similar business trust, or partnership, not formed for the specific purpose of acquiring the securities offered, with total assets in excess of $5,000,000;
(4) Any director, executive officer, or general partner of the issuer of the securities being offered or sold, or any director, executive officer, or general partner of a general partner of that issuer;
(5) Any natural person whose individual net worth, or joint net worth with that person's spouse, at the time of his purchase exceeds $1,000,000;
(6) Any natural person who had an individual income in excess of $200,000 in each of the two most recent years or joint income with that person's spouse in excess of $300,000 in each of those years and has a reasonable expectation of reaching the same income level in the current year;
(7) Any trust, with total assets in excess of $5,000,000, not formed for the specific purpose of acquiring the securities offered, whose purchase is directed by a sophisticated person as described in § (b)(2)(ii); and
(8) Any entity in which all of the equity owners are accredited investors.

34. Real Estate Investment Trusts (REITs)

35. Derivative Securities
Derivative Securities derive their value from other securities.
Convertible bonds and convertible preferred stock
Warrants
Stock Options
Futures

36. Convertible Securities
Convertible bonds and preferred stock are similar to regular bonds and preferred but they also have an embedded call option on the company’s common stock.
The owner of a convertible security has the right, but not the obligation, to convert the security into a pre-specified number of common shares at a specific price on or before the maturity date.
Part of the value of these securities is therefore derived from the value of the stock. The higher the stock price (among other factors), the more attractive conversion becomes.

37. Warrants
Warrants are very similar to call options (see next slide), but they are issued by a company as a sweetener to entice investors to purchase a bond or preferred stock issue.
Warrants give the owner the right, but not the obligation, to purchase a certain number of common shares at a specified price.
Warrants usually have a life measured in years.
Warrants are frequently traded separately from the bond or preferred issue that they were issued with.

38. Options
Options are contracts that give the buyer the right, but not the obligation, to buy (call option) or sell (put option) the underlying security at a specified price on or before the expiration date (can be up to 9 months in the future).
Options are not created or sold by the company who’s common stock may be the underlying security.

39. Futures
A futures contract, unlike an option, carries with it the obligation to buy (for a long position) or sell (for a short position) the underlying commodity at expiration of the contract.
If you have not sold a long position, or covered a short, by expiration you must take or make delivery of the commodity at the specified price.
Futures contracts are different from forward contracts in that they are traded on an exchange, and are standardized as to quantity and quality of the commodity.

40. Real Assets Real Estate and REITs Precious Metals Gems Collectibles
Coins