Investment

FIN321E

Dr. Samia Kamel

 Chapter 2

Investment Alternatives
Topics
• Identify money market and capital market securities and understand the important features of these securities.
• Understand stock splits, bond ratings, and ADRs.
• Understand the basics of two derivative securities, options and futures, and how they fit into the investor’s
choice set.
INVESTING
• Direct Investing: Investors buy and sell securities for themselves,
typically through brokerage accounts.
• Indirect Investing: The buying and selling of the shares of investment
companies which, in turn, hold portfolios of securities.
A GLOBAL PERSPECTIVE
• Investors should adopt a global perspective in making their investment decisions.
Investors can choose to purchase foreign stocks. Investors today must understand
we live in a global environment that will profoundly change the way we live and
invest.
• Coca-Cola is famous for its brand name and its global marketing efforts. Its
success is heavily dependent on what happens in the foreign markets it penetrated.
If foreign economies slow down, Coke’s sales may be hurt. Furthermore, Coke
must be able to convert its foreign earnings into dollars at favorable rates.
Therefore, investing in Coke involves betting on a variety of foreign events.
Financial Assets
• Nonmarketable financial assets as deposits, including checkable
deposits and currency, and time and savings deposits. A distinguishing
characteristic of these assets is that they represent personal
transactions between the owner and the issuer. That is, you as the
owner of a savings account at a bank must open/close the account
personally.
• In contrast, marketable securities trade in impersonal markets—the
buyer (seller) does not know who the seller (buyer) is, and does not
care.
Money Market Securities
• Money markets include short-term, highly liquid (easily converted to cash), relatively low-risk
debt instruments sold by governments, financial institutions, and corporations to investors with
temporary excess funds to invest. The size of the transactions in the money market typically is
large. The maturities of money market instruments range from 1 day to 1 year and are often less
than 90 days.
• Some of these instruments are negotiable and actively traded, and some are not. Investors may
choose to invest directly in some of these securities, but more often they do so indirectly through
money market mutual funds (Chapter 3), which are investment companies organized to own and
manage a portfolio of securities and which in turn are owned by investors. Thus, many individual
investors own shares in money market funds that, in turn, own one or more of these money market
certificates.
Important Money Market Securities
1. Treasury bills. The premier money market instrument, a fully guaranteed, very liquid IOU from the U.S. Treasury. They are
sold on an auction basis every week at a discount from face value; therefore, the discount determines the yield. Typical
maturities are 13 and 26 weeks, although maturities range from a few days to 52 weeks. Outstanding (i.e., already issued) bills
can be purchased and sold in the secondary market.
2. Negotiable certificates of deposit (CDs). Issued in exchange for a deposit of funds by most American banks, the CD is a
marketable deposit liability of the issuer, who usually stands ready to sell new CDs on demand. The deposit is maintained in
the bank until maturity, at which time the holder receives the deposit plus interest. However, these CDs are negotiable,
meaning that they can be sold in the open market before maturity. Maturities typically range from 14 days (the minimum
maturity permitted) to one year.
3. Commercial paper. A short-term, unsecured promissory note issued by large, well-known, and financially strong
corporations (including finance companies). Maturity of 270 days or less (average maturity is about 30 days). Commercial
paper is usually sold at a discount either directly by the issuer or indirectly through a dealer, with rates comparable to CDs.
Although a secondary market exists for commercial paper, it is weak and most of it is held to maturity. Commercial paper is
rated by a rating service as to quality (relative probability of default by the issuer).
4. Repurchase agreement (RPs). An agreement between a borrower and a lender (typically institutions) to sell and repurchase
U.S. government securities. The borrower initiates an RP by contracting to sell securities to a lender and agreeing to
repurchase these securities at a pre-specified price on a stated date. The effective interest rate is given by the difference
between the two prices. The maturity of RPs is generally very short, from three to 14 days, and sometimes overnight.
5. Banker’s acceptance. A time draft drawn on a bank by a customer, whereby the bank agrees to pay a particular amount at a
specified future date. Banker’s acceptances are negotiable instruments because the holder can sell them for less than face value
(i.e., discount them) in the money market. They are normally used in international trade. Banker’s acceptances are traded on a
discount basis. Maturities typically range from 30 to 180 days, with 90 days being the most common.
Yeild
• Discount yield = (Face Value – Purchase Price)/Face Value] X (360/maturity of the bill in days)
• Example: (1000-990/1000) * 360/30 = 0.01* 12 = 0.12% = 12% p.a
• The discount yield understates the investor’s actual yield because it uses a 360-day year and divides by the
face value instead of the purchase price.
• The investment yield method (also called the bond equivalent yield and the coupon equivalent rate) can be
used to correct for these deficiencies, and for any given Treasury bill the investment yield will be greater
than the discount yield.
• Investment yield = (Face Value – Purchase Price)/Purchase Price ] X 365/maturity of the bill in days
• Example: (1000-990/990) * 365/30 = 0.01*12.16 = .1216= 12.16% p.a
MONEY MARKET RATES
• Money market rates tend to move together, and most rates are very close to each other for the same maturity.
• Treasury bill rates are less than the rates available on other money market securities because of their
presumed risk-free nature.
Checking Your Understanding
1. Why are money market securities referred to as impersonal assets, while the non-marketable financial assets
are not?
2. Holding maturity constant, would you expect the yields on money market securities to be within a few tenths
of a percent of each other?
3. Why does the Treasury bill serve as a benchmark security?
Capital Market Securities
• Capital Markets encompass fixed-income and equity securities with maturities greater than 1 year.
• Risk is generally much higher than in the money market because of the time to maturity and the very nature
of the securities sold in the capital markets.
• Marketability is poorer in some cases.
• The capital market includes both debt and equity securities, with equity securities having no maturity date.
Fixed-Income Securities
1. Bonds: Long-term debt instruments representing the issuer’s contractual obligation.
• Bonds are fixed-income securities because the interest payments (coupon) and the principal repayment for a
typical bond are specified at the time the bond is issued and fixed for the life of the bond.
• If the buyer decides to sell the bond before maturity, the price received will depend on the level of interest
rates at that time.
• From an investor’s viewpoint a bond is typically a “safe” asset, at least relative to stocks and derivative
securities.
• Principal and interest are specified and the issuer must meet these obligations or face default, and possibly
bankruptcy.
• All the characteristics of a bond are specified exactly when the bond is issued.
Bond Characteristics
 Par Value (Face Value) The redemption value of a bond paid at maturity, typically $1,000.
Example: A 10-year, 10% coupon bond has a dollar coupon of $100 (10% of $1,000); therefore, knowing the
percentage coupon rate is the same as knowing the coupon payment in dollars. This bond would pay interest
(the coupons) of $50 on a specified date every six months. The $1,000 principal would be repaid 10 years hence
on a date specified at the time the bond is issued. Similarly, a 5.5%coupon bond pays an annual interest amount
of $55, payable at $27.50 every six months.
 Bond Prices Corporations and Treasuries use 100 as par rather than $1,000, which is the actual par value of
most bonds. Therefore, a price of 90 represents $900 (90% of the $1,000 par value), and a price of 55
represents $550 using the normal assumption of a par value of $1,000. Each “point,” or a change of “1,”
represents 1% of $1,000, or $10. The easiest way to convert quoted bond prices to actual prices is to
remember that they are quoted in percentages, with the common assumption of a $1,000 par value.
• Bond prices are quoted as a percentage of par value, which is typically $1,000. Example: A closing price of
101.375 on a particular day for an IBM bond represents 101.375% of $1,000. Treasury bond prices are quoted
in 32nds and may be shown as fractions, as in 100 14/32.
Bond Characteristics
 Discounts and Premiums At any point in time some bonds are selling at premiums (prices above par value),
reflecting a decline in market rates after that particular bond was sold. Others are selling at discounts (prices
below par value of $1,000), because the stated coupons are less than the prevailing interest rate on a
comparable new issue.
 The price of the IBM bond is above 100 (i.e., $1,000) because market yields on bonds of this type declined
after this bond was issued. The coupon on the IBM bond became more than competitive with the going
market interest rate for comparable newly issued bonds, and the price increased to reflect this fact.
 Interest rates and bond prices move inversely.
Bond Characteristics
 Callable Bonds The call provision gives the issuer the right to “call in” the bonds, and retire it by paying off
the obligation thereby depriving investors of that particular fixed-income security.
 Exercising the call provision becomes attractive to the issuer when market interest rates drop sufficiently
below the coupon rate on the outstanding bonds for the issuer to save money. Issuers expect to sell new bonds
at a lower interest cost, thereby replacing existing higher interest-cost bonds with new, lower interest-cost
bonds.
• Some bonds are not callable. Most Treasury bonds cannot be called.
 The Zero Coupon Bond A bond issued with no coupons, or interest, to be paid during the life of the bond.
The purchaser pays less than par value for zero coupons and receives par value at maturity. The difference in
these two amounts generates an effective interest rate, or rate of return. As in the case of Treasury bills, which
are sold at discount, the lower the price paid for the coupon bond, the higher the effective return.
• Issuers of zero coupon bonds include corporations, municipalities, government agencies, and the U.S.
Treasury.
TYPES OF BONDS
TYPES OF BONDS
1. Treasury securities: The U.S. government, in the course of financing its operations through the Treasury
Department, issues numerous notes and bonds with maturities greater than 1 year. The U.S. government is
considered the safest credit risk because of the overall stability and economic power of the U.S. economy. For
practical purposes, investors do not consider the possibility of risk of default for U.S.
• Treasury Bonds: Long- term bonds sold by the U.S. government
• Treasury Notes: Treasury securities with maturities up to 10 years
• Treasury Inflation- Indexed Securities (TIPS): Treasury securities fully indexed for inflation
2. Government Agency Securities Securities: issued by federal credit agencies (fully guaranteed) or by
government-sponsored agencies (not guaranteed).
3. Municipal Securities
• Bonds sold by states, counties, cities, and other political entities (e.g., airport authorities, school districts)
other than the federal government and its agencies are called municipal bonds.
• Credit ratings range from very good to very suspect. Thus, risk varies widely, particularly given the recent
financial crisis, as does marketability. Overall, however, the default rate on municipal bonds historically has
been very favorable.
TYPES OF BONDS
4. Corporates Most of the larger corporations issue corporate bonds to help finance their operations. Many of
these firms have more than one issue outstanding.
• Although an investor can find a wide range of maturities, coupons, and special features available from
corporates, the typical corporate bond matures in 20 to 40 years, pays semi- annual interest, is callable,
carries a sinking fund, and is sold originally at a price close to par value, which is almost always $1,000.
Credit quality varies widely, and depends on the credit quality of the issuer.
• Corporate bonds are senior securities; senior to any preferred stock and to the common stock of a
corporation in terms of priority of payment and in case of bankruptcy and liquidation. However, within the
bond category itself there are various degrees of security.
• The most common type of unsecured bond is the debenture, a bond backed only by the issuer’s overall
financial soundness.
• Debentures can be subordinated, resulting in a claim on income that stands below (subordinate to) the claim
of the other debentures.
TYPES OF BONDS
• Convertible Bonds Some bonds have a built-in conversion feature. The holders of these bonds
have the option to convert the bonds into common stock whenever they choose. Typically, the
bonds are turned in to the corporation in exchange for a specified number of common shares, with
no cash payment required.
• Bond Ratings Rating agencies such as Standard & Poor’s (S&P) Corporation and Moody’s
Investors Service, Inc., provide investors with Bond Ratings—that is, current opinions on the
relative quality of most large corporate and municipal bonds, as well as commercial paper. By
carefully analyzing the issues in great detail, the rating firms, in effect, perform the credit analysis
for the investor.
• Standard & Poor’s bond ratings consist of letters ranging from AAA, AA, A, BBB, and so on, to
D. (Moody’s corresponding letters are Aaa, Aa, A, Baa, . . . , to D.) Plus or minus signs can be
used to provide more detailed standings within a given category.
Investment grade securities

Speculative securities

C currently not paying interest

D Currently in default
TYPES OF BONDS
• Junk Bonds The term Junk Bonds refers to high-risk, high-yield bonds that carry ratings of BB (S&P) or Ba
(Moody’s) or lower, with correspondingly higher yields.
• An alternative, and more reassuring, name used to describe this area of the bond market is the high-yield debt
market. Default rates on junk bonds vary each year. The default rate in 2001 was almost 9%, the highest level
since 1991. It was over 6% in 2000. In contrast, the global default rate in 2007 was approximately at its
lowest level in 25 years, reflecting several years of easy credit conditions. The financial crisis, starting in
2008, dramatically impact default rates.
Checking Your Understanding
4. Consider a corporate bond rated AAA versus another corporate bond rated only BBB. Could you say with
confidence that the first bond will not default while for the second bond there is some reasonable probability
of default?
5. Should risk-averse investors avoid junk bonds?
Equity Securities
• Equity securities represent an ownership interest in a corporation. These securities provide a residual claim—after
payment of all obligations to fixed-income claims—on the income and assets of a corporation.
1- PREFERRED STOCK
• Although technically an equity security, preferred stock is known as a hybrid security because it resembles both
equity and fixed-income instruments.
• As an equity security, preferred stock has an infinite life and pays dividends.
• Preferred stock resembles fixed-income securities in that the dividend is fixed in amount and known in advance,
providing a stream of income very similar to that of a bond. The difference is that the stream continues forever,
unless the issue is called or otherwise retired (most preferred is callable).
• Preferred stockholders are paid after the bondholders but before the common stockholders in terms of priority of
payment of income and in case the corporation is liquidated.
• Preferred stock dividends are not legally binding, but must be voted on each period by a corporation’s board of
directors. If the issuer fails to pay the dividend in any year, the unpaid dividend(s) will have to be paid in the future
before common stock dividends can be paid if the issue is cumulative. (If noncumulative, dividends in arrears do
not have to be paid).
Equity Securities
2- Common Stock
• Represents the ownership interest of corporations, or the equity of the stockholders. If a firm’s shares are held
by only a few individuals, the firm is said to be “closely held.”
• Most companies choose to “go public”; that is, they sell common stock to the general public. This action is
taken primarily to enable the company to raise additional capital more easily. If a corporation meets certain
requirements, it may, if it chooses to, be listed on an exchange.
• Stockholders are entitled to income remaining after the fixed-income claimants (including preferred
stockholders) have been paid; also, in case of liquidation of the corporation, they are entitled to the remaining
assets after all other claims (including preferred stock) are satisfied.
• As owners, the holders of common stock are entitled to elect the directors of the corporation and vote on
major issues. Most stockholders vote by proxy, meaning that the stockholder authorizes someone else
(typically management) to vote his or her shares.
• Stockholders also have limited liability, they cannot lose more than their investment in the corporation. In the
event of financial difficulties, creditors have recourse only to the assets of the corporation, leaving the
stockholders protected.
 Characteristics of Common Stock
• Par value (stated or face value) for a common stock, unlike a bond or preferred stock, is generally not significant.
Corporations can make the par value any number they choose—for example, the par value of Coca-Cola is $0.25 per share.
A typical par value is $1. Some corporations issue no-par stock.
• Book value of a corporation is the accounting value of the equity as shown on the books (balance sheet). It is the sum of
common stock outstanding, capital in excess of par value, and retained earnings. Dividing this sum, or total book value, by
the number of common shares outstanding produces the book value per share. In effect, book value is the accounting value
of the stockholders’ equity. Book value per share can play a role in making investment decisions.
• Market value (price) of stock is the variable of concern to investors. The aggregate market value for a corporation as
determined in the marketplace, is calculated by multiplying the market price per share of the stock by the number of shares
outstanding.
• Cash Dividends: Paid regularly to stockholders, they are decided on and declared by the BOD and can range from zero to
virtually any amount the corporation can afford to pay. The common stockholder has no specific promises to receive any
cash from the corporation, and dividends do not have to be paid.
• Common stocks involve substantial risk, because the dividend is at the company’s discretion and stock prices typically
fluctuate sharply, which means that the value of investors’ claims may rise and fall rapidly over relatively short periods of
time.
• Dividend yield is the income component of a stock’s return stated on a percentage basis. Calculated as the most recent 12-
month dividend divided by the current market price.
• Payout ratio is the ratio of dividends to earnings. It indicates the % of a firm’s earnings paid out in cash to its stockholders.
The complement of the payout ratio is the retention ratio; the % of a firm’s current earnings retained for reinvestment.
How Dividends Are Paid
• Dividends traditionally are declared and paid quarterly, although a few firms, such as Disney, have
moved to annual dividend payments.
• To receive a declared dividend, an investor must be a holder of record on the specified date that a
company closes its stock transfer books and compiles the list of stockholders to be paid. However,
to avoid problems the brokerage industry has established a procedure of declaring that the right to
the dividend remains with the stock until four days before the holder-of-record date. On this fourth
day, the right to the dividend leaves the stock; for that reason this date is called the ex-dividend
date.
• Assume that the board of directors of Coca-Cola meets on May 24 and declares a quarterly
dividend, payable on July 2. May 24 is called the declaration date. The board will declare a holder-
of-record date—say, June 7. The books close on this date, but Coke goes ex-dividend on June 5.
To receive this dividend, an investor must purchase the stock by June 4. The dividend will be
mailed to the stockholders of record on the payment date, July 2.
Dividends
• A stock dividend is a payment by the corporation in shares of stock instead of cash.
• Stock split involves the issuance of a larger number of shares in proportion to the existing shares
outstanding.
• P/E Ratio (Earnings Multiplier) is calculated as the ratio of the current market price to the firm’s
most recent 12-month earnings. Variations of this ratio are often used in the valuation of common
stocks. Because the price of a stock, which is determined in the marketplace, is divided by its
earnings, the P/E ratio shows how much the market as a whole is willing to pay per dollar of
earnings.
• The price of Coca-Cola in early February 2012 was $67.94. The most recent 12-month trailing
earnings per share for the company at the time was $5.44. The P/E ratio, therefore, was 12.9.
INVESTING INTERNATIONALLY IN
EQUITIES
• American Depository Receipts (ADRs) A popular way to buy foreign companies is to purchase
American Depository Receipts (ADRs).
• ADRs represent indirect ownership of a specified number of shares of a foreign company.
• These shares are held on deposit in a bank in the issuing company’s home country, and the
ADRs are issued by U.S. banks called depositories.
• ADRs are tradable.
• The bank (or its correspondent) holding the securities collects the dividends, pays any applicable
foreign withholding taxes, converts the remaining funds into dollars, and pays this amount to the
ADR holders.
Checking Your Understanding
6. Why might investors opt to hold preferred stocks rather than bonds in their portfolios?
7. Assume you wish to take advantage of an expected change in exchange rates. Would ADRs be an effective
way for you to do this?
Derivative Securities
• Securities that derive their value in whole or in part by having a claim on some underlying security.
1. Warrant A corporate created option to purchase a stated number of common shares at a specified price within a specified
time (typically several years).
2- Options Rights to buy (call option) or sell (put option) a stated number of shares of a security within a specified period at a
specified price
• LEAPs Puts and calls with longer maturity dates, up to two years
• Using Puts and Calls allow both buyers and sellers (writers) to speculate on the short-term movements of certain common
stocks. Buyers obtain an option on the common stock for a small, known premium, which is the maximum that the buyer can
lose. If the buyer is correct about the price movements on the common, gains are magnified in relation to having bought (or
sold short) the common because a smaller investment is required. However, the buyer has only a short time in which to be
correct. Writers (sellers) earn the premium as income, based on their beliefs about a stock. They win or lose, depending on
whether their beliefs are correct or incorrect.
3- Futures Contract: Agreement providing for the future exchange of a particular asset at a currently determined market price
• Most participants in futures are either hedgers or speculators. Hedgers seek to reduce price uncertainty over some future
period. For example, by purchasing a futures contract, a hedger can lock in a specific price for the asset and be protected
from adverse price movements. Similarly, sellers can protect themselves from downward price movements. Speculators, on
the other hand, seek to profit from the uncertainty that will occur in the future. If prices are expected to rise (fall), contracts
will be purchased (sold). Correct anticipations can result in very large profits because only a small margin is required.