Investment Alternatives

Chapter 2
Charles P. Jones, Investments: Analysis and Management

2-1
INVESTMENT ALTERNATIVES

Basically, households have three choices with regard to savings options:

1. Hold the liabilities of traditional intermediaries, such as banks and insurance
companies. This means holding savings accounts and other financial assets well
known to many individual investors.
2. Hold securities directly, such as stocks and bonds, purchased directly through
brokers and other intermediaries.
3. Hold securities indirectly, through mutual funds and pension funds. In this case,
households leave the investing decisions to others by investing indirectly rather
than directly.

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Organizing Financial Assets
• It is necessary for all investors to understand the basic nature of
different investment alternatives
• Investors can invest directly in financial assets i.e. they themselves
buy and sell securities (Direct investing)
• Investors can buy and sell the shares of investment companies which
in turn hold securities (Indirect investing)
Direct investing
• Non-Marketable Financial assets
• Saving deposits
• Certificate of deposit
• Money market deposits accounts
• US saving bonds
Money Market securities
• T-bills
• Negotiable certificates of deposits
• Commercial papers
• Repurchase agreements
• Banker’s acceptance
Direct investing
• Capital market securities
A. Fixed income securities
• Treasury or government bonds
• Corporate bonds
B. Equity securities
• Preferred stock
• Common stocks
Derivative Securitas
• Options
• Futures
Indirect Investing
• Investment companies
• Unit trusts
• Open end mutual fund
• Close – end mutual fund
Nonmarketable Financial Assets

• Commonly owned by individuals

• Represent direct exchange of claims between issuer and investor
• Usually very liquid or easy to convert to cash without loss of value
• Examples: Savings accounts and bonds, certificates of deposit, money
market deposit accounts

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Money Market Securities
• Money market securities include short-term, highly liquid, relatively
low risk debt instruments
• This market is dominated by financial institutions like banks
• Maturity of money market securities range from one day to one year
• Investor may directly or indirectly invest in these instruments

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Types of Money marekt securites
• Treasury bills
• This is a short-term money market security sold at discount by
government and redeemed at face value
• Return or yield on T-bills is calculated as follows:

𝑌𝑖𝑒𝑙𝑑= [
(𝐹𝑎𝑐𝑒.𝑣𝑎𝑙𝑢𝑒− 𝑃𝑢𝑟 .Pr 𝑖𝑐𝑒)
𝑃𝑢𝑟 .𝑝𝑟𝑖𝑐𝑒 ][
𝑋
360
𝑀𝑎𝑡𝑢𝑟𝑖𝑦 in Days ]
• Commercial Papers
• Same as t-bills, the only difference is that it is issued by a firm
• Negotiable certificates of deposits
• Investors deposits money in a banks in return they get a deposits
certificates that can be negotiated
• Upon maturity, principal plus interest is paid to the depositor
• Repurchase agreements
• Short-term sales of government securities with an agreement to repurchase
the securities at a higher price
• Bankers' acceptance
• It is an order to a bank by a customer to pay a sum of money at a future date
• Once the bank accepts it, it is the banker’s responsibility to pay to the
holder
• It can be traded in the secondary market
• It allows traders to substitute the bank’s credit standing for their own
• Used in foreign trade
• Eurodollars
• Dollar denominated deposits at foreign bank
• Pakistani example can be MCB rupee dominated deposits in UAE
Capital Market Securities
• Capital market encompasses fixed-income and equity securities with
maturities greater than one year
• Risk is much higher than the money market securities
• Marketability is poorer in some cases
• It includes both debt and equity securities

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Debt (Fixed income securities)
• Bonds
• It is a long-term debt instrument
• It is a fixed income security because interest rate is fixed at the time
of issue
• Buyer can sell the bond before maturity, the price received will
depend on the level of interest rates at that time
Characteristics of bond
• Par value or face value of most bonds is $1000
• Typical bonds have a maturity time
• Most bonds are coupon bonds, where coupon refers to the periodic
interest that the issuer pays to the holder of the bond
• Interest on bonds is typically paid semi-annually
Characteristics of Bonds
• Zero coupon bond:
• An innovation in traditional format of bonds
• These bonds are sold at discount
• Issuers of zero bonds include local and federal government
• Bond prices are quoted as a percentage of par value
• If a bond is selling at 101-4/8, what price will it be selling if the par
value is Rs.1000
• The bond price reflect the par value and any accrued interest, and
increase or decrease in the market interest yield
• If bond is selling at discount, it means that the interest rate on the
bond is below the current interest rate on similar bonds in the market
and vice versa
• Callable bonds
• If a bond is callable, the issuer can call it back by paying off the
obligations
• Exercising the call provision become attractive to the issue when
market interest rate fall significantly below the coupon rate on the
bond
• Cost of calling back include call premium or administrative costs
• Senior securities:
• Corporate bonds are senior securities, which mans they are senior to
any proffered stock and to the common stock in terms of priority of
payment
• Within bonds categories, there exist differences of priority of claims
• Debentures: unsecured bond that is not backed by a specific asset
• Convertible Bonds:
• Bonds that are convertible at the holder’s option into common stocks
• Junk bonds: High risk, high yield bonds carrying low rating
Equity securities
• Equity securities represent ownership in a corporation
• These securities represetn resibual claim
• There are two types of equities:
• Preferred stock
• Common stock
Preferred stock
• Dividend is fixed in amount and known in advance on preferred stocks
(like debt)
• The stream of dividends continues forever(like on shares) unless it is
called
• Proffered shareholders cannot force the firm into liquidation if their
dividend is not paid (like in case of common stock)
• Preferred stock is also known as hybrid security because it resembles
both equity and fixed income securities
• Proffered stocks have the feature of cumulative dividends
• Preferred stock may carry variable rate of dividend that is tied to
current market interest rate
• Proffered stock may also have feature of convertibility into common
stock (may be mandatory or optional)
Common stock

• Common stock represents the ownerships interest of the corporation

• Ownerhisp is concentrated or closely held when the firm’s shares are
held by few individuals
• Ownership is scattered when shares are held by lots of people
Characteristic of common stock
• Common shares give the right to shareholders to vote
• It gives the right to receive dividends, however, dividend rate is not
fixed
• Common shares also give the right to right issues
• Common shares are riskier than preferred stock and bonds
Derivative Securities
• Securities that derive their values from an asset or security
• There are two types of derivative securities
• Future contracts
• Options
Future contract
• A future contract obliges traders to purchase or sell an asset at an
agreed-upn price at a specified future date
• The contract can be used for commodities or securities
• Cash is not required to be paid until delivery, only a margin is required
to reduce the chances of default of the other party
• The margin is small compared to the value of the purchase or sell
• Many investors in future markets are hedgers or speculator
• Hedgers seek to reduce price uncertainity over some future period of
time
• Speculators seek to profit from future uncertainty in prices
Types of future contracts
• There are two types of future contracts
– Long position
– Short-position
• Long-position:
• The long position is held by a trader who commits
to purchasing the asset on the maturity date
• Short position (short-selling)
The short position is held by a trader who commits to
delivering the asset on the maturity date
Advantages of future contract
• A. Helps in hedging
• B. investors can benefit from price fluctuations whether prices fall or
rise
• Helps producers to get orders at current prices and continue
production without worry
• Buyers do not have to pay the full price, still they can obtain the
commodities in future at current price
• Buyers don’t have to worry about storage problems
Option Contracts
• Option is a right to buy or sell a stated number of shares of stock
within a specified period at a specified price
• There are two types of option contracts:
• Put option
• Call option
• Put option
• An option to sell a stated number of shares at a stated period at a
specified price
• Call option
• A right to buy a stated number of shares at a stated period at a
specified price
• Parties in option contract:
• Option writer: who gives the right to the buyer of the option in
exchange for a price
• Option holder: who obtains the right to buy or sell shares