Chapter 3

Overview of Security Types

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 Overview
Overview of
Of Security Types
Security Types

“An investment operation is one which upon thorough

analysis promises safety of principal and an adequate return.
Operations not meeting these requirements are speculative.”

–Benjamin Graham

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 Learning Objectives
Price quotes for all types of investments are easy to find, but
what do they mean?

Learn the answers for:

1. Various types of interest-bearing assets.
Money market instruments + Fixed-income securities

2. Equity securities.

3. Futures contracts.

4. Option contracts.

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 Security Types

 Our goal in this chapter is to introduce the different types

of securities that investors routinely buy and sell in
financial markets around the world.

 For each security type, we will examine:

 Its distinguishing characteristics
 Its potential gains and losses
 How its prices are quoted in the financial press.

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 Classifying Securities

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 Interest-Bearing Assets

 Money market instruments are short-term debt

obligations of large corporations and governments.
 These securities promise to make one future payment.
 When they are issued, their lives are less than one year.

 Fixed-income securities are longer-term debt obligations

of corporations and governments.
 These securities promise to make fixed payments according to a pre-set
schedule.
 When they are issued, their lives exceed one year.

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 Money Market Instruments

 Examples: U.S. Treasury bills (T-bills), bank certificates of

deposit (CDs), corporate and municipal money market
instruments.

 Potential gains/losses: A known future payment, except when

the borrower defaults (i.e., does not pay).

 Price quotations: Usually, the instruments are sold on a

discount basis, and only the interest rates are quoted.

 Therefore, investors must be able to calculate prices from the

quoted rates.

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 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
 Depending on the debt issue, illiquidity can be a problem.

If you cannot sell securities quickly for their current market

value, the market is said to be illiquid.

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 Quote Example: Fixed-Income Securities

 Price Quotations from https://finra-markets.morningstar.com/BondCenter.

Looking for bonds from the 3M Company (some columns are self-explanatory):

The bond is callable.

The price (per $100 face) of the

You will receive 1.375% of the bond’s face bond when it last traded.
value each year in 2 semi-annual payments.

The Yield to Maturity (YTM) of the bond.

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 Equities

 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.

 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.

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 Common Stock

 Examples: IBM shares, Microsoft shares, Intel shares, Dell

shares, etc.

 Potential gains/losses:
 Many companies pay cash dividends to their shareholders. 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.

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 Common Stock Price Quotes

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 Common Stock Price Quotes Online:
http://finance.yahoo.com

First, enter symbol, JWN

Resulting Screen
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 Some Investors Want High Dividend Yields
www.wsj.com
Here is a list of stocks in the “Real Estate Sector.”

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 Derivatives, I.

 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.

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 Derivatives, II.

 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.

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 Futures Contracts

 Examples: financial futures (i.e., S&P 500, T-bonds, foreign

currencies, and others), commodity futures (i.e., wheat, crude
oil, cattle, and others).

 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 and losses are possible.

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Futures Contracts: Online Price Quotes

Source: Markets Data Center at www.wsj.com.

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 Futures Price Quotes Online
Source: www.cmegroup.com

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 Option Contracts, I.

 A call option gives the owner the right, but not the obligation,
to buy something, while a put option gives the owner the right,
but not the obligation, to sell something.

 The “something” can be an asset, a commodity, or an index.

 The price you pay today 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.

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 Option Contracts, II.

 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:

 Holders of call options have no obligation to buy the underlying asset.
 Holders of put options have no obligation to sell the underlying asset.
 To avoid this obligation, buyers of calls and puts must pay a price today.
Holders of futures contracts do not pay for the contract today.

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 Option Contracts, III.
 Potential gains and losses from call options:
 Buyers:
 Profit when the market price minus the strike price is greater than the option
premium.
 Best case, theoretically unlimited profits.
 Worst case, the call buyer loses the entire premium.

 Sellers:
 Profit when the market price minus the strike price is less than the option
premium.
 Best case, the call seller collects the entire premium.
 Worst case, theoretically unlimited losses.

 For buyers of call options: option losses are limited to the

purchase price; gains are theoretically unlimited.
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 Option Contracts, IV.
 Potential gains and losses from put options:
 Buyers:
 Profit when the strike price minus the market price is greater than the option
premium.
 Best case, market price (for the underlying) is zero.
 Worst case, the put buyer loses the entire premium.

 Sellers:
 Profit when the strike price minus the market price is less than the option
premium.
 Best case, the put seller collects the entire premium.
 Worst case, market price (for the underlying) is zero.

 For buyers and sellers of put options: Both gains and

losses are limited.
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 Option Contracts: Online Price Quotes
for Nike (NKE) Call and Put Options

Source: finance.yahoo.com.
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The New Method to Decode Option Symbols

In 2010, a new option symbol system was introduced.

Example: NKE151120C00100000

 The symbols expand from 5 letters up to 20 letters and numbers.

 The stated goal is to reduce confusion by explicitly stating:

 the underlying stock symbol, NKE

 option expiration date, 151120 (i.e., November 20, 2015)
 whether the option is a call or a put, C (uh, Call)
 the dollar part of the strike price, 00100 (i.e., 100—prices can be up to 5 digits)
 the decimal part of the strike price, 000

 We do not know whether quadrupling the size of the ticker will reduce
confusion.
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 Investing in Stocks versus Options, I.

Stocks (we assume no dividends):

 Suppose you have $15,000 for investments. Monster Beverage

Corporation is selling at $150 per share.

 Number of shares bought = $15,000 / $150 = 100

 If Monster is selling for $165 per share 3 months later, gain = ($165 
100) - $15,000 = $1,500 (10% gain)

 If Monster is selling for $135 per share 3 months later, loss = ($135 
100) - $15,000 = -$1,500 (10% loss)

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 Investing in Stocks versus Options, II.
 A call option with a $150 strike price and 3 months to maturity is also
available at a premium of $10.

 Traded option contracts are on a bundle of 100 shares.

 One call contract costs $10  100 = $1,000
 number of contracts bought = $15,000 / $1,000 = 15
(controlling 15  100 = 1,500 shares)

 If Monster is selling for $165 per share 3 months later,

gain = {($165 – $150)  1,500} - $15,000 = $7,500 (50% gain)

 If Monster is selling for $135 per share 3 months later,

loss = ($0  1,500) – $15,000 = -$15,000 (100% loss)

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 Useful Internet Sites
 www.investinginbonds.com (a reference for bond basics)
 www.finra.com (learn more about TRACE)
 www.fool.com (Are you a “Foolish investor”?)
 www.cmegroup.com (CME Group)
 www.cboe.com (Chicago Board Options Exchange)
 jmdinvestments.blogspot.com (reference for recent financial information)

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 Chapter Review, I.

 Classifying Securities

 Interest-Bearing Assets
 Money Market Instruments
 Fixed-Income Securities

 Equities
 Common Stock
 Preferred Stock
 Common and Preferred Stock Price Quotes

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 Chapter Review, II.
 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

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