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3 Overview of Security Types 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. 2. Equity securities. 3. Futures contracts. 4. Option contracts. Security Types

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3

Overview of Security Types


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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.

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, and

    • How its prices are quoted in the financial press.


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Basic Types

Major Subtypes

Interest-bearing

Money market instruments

Fixed-income securities

Equities

Common stock

Preferred stock

Derivatives

Futures

Options

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 areless than one year.

  • Fixed-income securities are longer-term debt obligations of corporations or 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. (Illiquidity means it is possible that you cannot sell these securities quickly.)


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The price (per $100 face) of the bond when it last traded.

You will receive 6.875% of the bond’s face

value each year in 2 semi-annual payments.

The Yield to Maturity (YTM) of the bond.

Quote Example: Fixed-Income Securities

  • Price quotations from www.wsj.com—the online version ofThe Wall Street Journal (some columns are self-explanatory):


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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. However, 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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First, enter symbol.

Resulting Screen

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


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Preferred Stock

  • Example: Citigroup preferred stock (Do a Google search for it).

  • Potential gains/losses:

    • Dividends are “promised.” However, there is no legal requirement that the dividends be paid, as long as no common dividends are distributed.

    • The stock value may rise or fall depending on the prospects for the company and market-wide circumstances.


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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 atwww.wsj.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 expirationdate.

  • 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.

    • 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.

    • Note that, for buyers, losses are limited, but gains are not.


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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.

    • Note that, for buyers and sellers, gains and losses are limited.


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Option Contracts: Online Price Quotesfor Hewlett-Packard (HPQ) options

Source: www.finance.yahoo.com


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Investing in Stocks versus Options, I.

Stocks:

  • Suppose you have $10,000 for investments. Macron Technology is selling at $50 per share.

  • Number of shares bought = $10,000 / $50 = 200

  • If Macron is selling for $55 per share 3 months later, gain = ($55  200) - $10,000 =$1,000

  • If Macron is selling for $45 per share 3 months later, gain = ($45  200) - $10,000 =-$1,000


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Investing in Stocks versus Options, II.

Options:

  • A call option with a $50 strike price and 3 months to maturity is also available at a premium of $4.

  • A call contract costs $4  100 = $400, so number of contracts bought = $10,000 / $400 = 25 (for 25  100 = 2500 shares)

  • If Macron is selling for $55 per share 3 months later, gain = {($55 – $50)  2500} - $10,000 =$2,500

  • If Macron is selling for $45 per share 3 months later, gain = ($0  2500) – $10,000 =-$10,000


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Useful Internet Sites

  • www.nasdbondinfo.com(current corporate bond prices)

  • www.investinginbonds.com(bond basics)

  • www.finra.com (learn more about TRACE)

  • www.fool.com (Are you a “Foolish investor?”)

  • www.stocktickercompany.com (reproduction stock tickers)

  • www.cmegroup.com (CME Group)

  • www.cboe.com(Chicago Board Options Exchange)

  • finance.yahoo.com(prices for option chains)

  • www.wsj.com (Online version of The Wall Street Journal)


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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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