Chapter 2

Charles P. Jones, Investments: Analysis and Management,

12th Edition, John Wiley & Sons

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 Commonly owned by individuals
 Represent personal transactions between the
owner and the issuer
◦ Owner must open the account, maintain it, close it
◦ In contrast to marketable securities, which trade in
impersonal markets
 Usually very liquid or easy to convert to cash
without loss of value
 Examples: Savings accounts and bonds, CDs

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 Negotiable or salable in the marketplace
 Short-term, highly liquid, relatively-low risk
debt instruments—rates tend to move together
 Issued by governments and private firms
 Examples: T-Bills, Commercial paper
 T-bill is most prominent money market
security
◦ Safest asset available
◦ Serves as a benchmark asset

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 Marketable debt with maturity greater than
one year and equity securities, which have no
maturity date
 Riskier than money market securities
 Fixed-income securities have a specified
payment schedule
◦ Dates and amount of interest and principal
payments known in advance

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 Bonds are long-term debt instruments/IOUs
 Buyer of a newly issued coupon bond lends
money to issuer, issuer agrees to pay interest
and re-pay principal on maturity date
 Bonds are fixed-income securities
◦ Buyer knows future cash flows
◦ Known interest and principal payments

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 If sold before maturity, price depends on
current interest rates
 Considered safer than stocks or derivatives
 Prices quoted as a % of par value, which is
usually $1,000

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 Bond will be worth exactly face value at
maturity
◦ Until maturity, price changes depending on interest
rates
◦ Interest rates and bond prices move inversely
 Bond buyer in secondary market must pay the
price of the bond plus accrued interest
◦ Prices quoted without accrued interest
 Premium: amount above par value
 Discount: amount below par value

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Callable Bonds
 Provision gives the issuer the right to “call in,”
(i.e., buy back) the bonds from investors
 This option is attractive to issuers when
market interest rates drop sufficiently below
coupon rate
◦ Issuer can save money by replacing higher interest-
cost bonds with new, lower interest-cost bonds
◦ Wise investor note the bond issue’s provisions re:
call
 Most Treasury bonds cannot be called

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 U.S. government/Treasury securities
 Government agency securities
◦ Federal agencies, such as GNMA
◦ Government Sponsored Enterprises (GSEs)
◦ Mortgage-backed Securities (MBSs)
 Municipal securities
◦ Two basic types: General Obligation and Revenue
◦ Generally exempt from federal taxes
 Corporate bonds

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 Usually unsecured and callable
 Receive payment priority if bankruptcy or
liquidation
 Convertible bonds may be exchanged for
another asset at the owner’s discretion
 Risk that issuer may default on payments
 New Types: DANs, inflation-protected notes

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 Rate relative, not absolute, probability of
default
 Rating organizations
◦ Standard and Poor’s Corporation (S&P)
◦ Moody’s Investors Service Inc.
 Rating firms perform the credit analysis for
the investor, may disagree on ratings
 Bond ratings and coupon rates inversely
related

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 Investment grade securities
◦ Rated AAA, AA, A, BBB
◦ Typically, institutional investors only buy these
 Speculative securities
◦ Rated BB, B, CCC, CC
◦ Significant uncertainties
 Junk bonds
◦ Rated BB or lower
◦ High-risk, high-yield bonds

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 Transformation of illiquid, risky individual
loans into more liquid, less risky asset-
backed securities (ABSs)
◦ ABS is a securitized interest in a pool of non-
mortgage assets
◦ Marketable securities backed by auto loans, credit-
card receivables, small-business loans, leases
◦ ABSs can be structured in tranches with different
prices, credit ratings, average maturities

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 Denote an ownership interest in a corporation
 Denote control over management, at least in
principle
◦ Voting rights important
 Denote limited liability
◦ Investor cannot lose more than their investment
should the corporation fail

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 Hybrid security: features of both debt and
equity
 Preferred stockholders paid after bondholders
but before common stockholders
◦ Dividend known, fixed in advance
◦ May be cumulative if dividend omitted
 Often convertible into common stock
 May carry variable dividend rate

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 Common stockholders are residual claimants
on income and assets
 Par value is face value of a share
 Book value is accounting value of a share
◦ Book value per share can play a role in investment
decisions
 Market value is current market price of a
share
 Aggregate market value is market price per
share times number of shares outstanding

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 Dividends are cash payments to shareholders
◦ Common stockholder has no specific promises to
receive any cash from the corporation
◦ Lack of promise plus price volatility make common
stocks risky
◦ Dividend yield is income component of return =D/P
◦ Payout Ratio is ratio of dividends to earnings

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 Stock dividend is payment to owners in stock
 Stock split is the issuance of additional shares
in proportion to the shares outstanding
◦ The book and par values are changed
 Additional shares not additional value for
investor
 P/E ratio is the ratio of current market price
of equity to the firm’s most recent 12-month
earnings
◦ Shows how much the market is willing to pay for $1
of earnings
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 May provide higher returns, lower risk
 Changes in value of the US Dollar can
increase interest in owning foreign securities
 Investors can buy individual foreign securities
or use investment companies
 American Depository Receipts (ADRs)
represent indirect ownership of shares of a
foreign firm

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 Securities whose value is derived from
another security
 Futures and options contracts are
standardized and performance is guaranteed
by a third party
◦ Risk management tools
◦ Futures contract is an obligation to buy or sell
◦ Options contract is the right to do so, not an
obligation
 Warrants are long-term options on common
stock of issuing firm
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 Options are created by investors, not
corporations
 Call (Put): Buyer pays premium for the right
(not the obligation) to purchase (sell) 100
shares from (to) the seller at a fixed price
before a certain date
◦ Seller can re-sell option in secondary market
◦ Call (put) buyers betting the price of underlying
stock will rise (fall)
 Allow investors to speculate on short-term
movements of certain common stocks
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 Futures contract: 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
◦ Long (short) position: commitment to purchase
(deliver) the asset
◦ Used to hedge the risk of price changes
◦ Small margin size can result in large profits

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