Chapter 2

1. Chapter 2 Investment Alternatives

2. 3 Options for Household Savings with regard to financial assets • Hold with the financial intermediaries such as bank, insurance companies, thrifts (??) • Direct Investing: Buying and Selling securities directly with the help of broker or investment banks such shares, bonds • Indirect Investing: Hold securities indirectly while leaving investment decisions to others such a mutual funds or pension fund [Exhibit 2.1 on page 22, P. Jones]

3. Indirect Investing • In Indirect Investment, investors handed-over their investment to third party; thus losing their direct control of the securities. • There are three types of investment companies. • Closed-End investment companies (Managed Firm) • Mutual Funds (Managed Firm) • Exchange-Traded Funds (ETFs) [Un-Managed Firm]

4. Direct Investing • Non-Marketable Investments • Marketable Investments • Money Market • Capital Market • Fixed-Income • Equity Securities • Derivatives Market

5. Non-Marketable Securities • Savings Accounts • Non-Negotiable Certificates of deposit • Money Market Deposit Accounts (MMDAs) • US government Savings Bonds

6. Savings Accounts – savings accounts in commercial banks and thrift (savings and loan institutions and credit unions) • Non-Negotiable Certificates of deposit (CDs) – commercial bank and other institutions offer a variety of savings certificates known as certificate of deposit (CDs) • Rate is directly proportional to maturity of CDs. • It is a buy-and-hold certificate

7. Money Market Securities (MMS) • The market for short-term, highly liquid, low-risk assets such as treasury bills and negotiable CDs. • The assets are sold by government, financial institutions and corporations. • The maturities of money market instruments range from 1 day to 1 year; usually 90 days

8. Forms of MMS • Treasury Bills • Negotiable Certificate of Deposit (CDs) • Commercial Papers • Repurchases Agreement (RPs) • Banker’s Acceptance

9. Forms of MMS....Treasury Bills • Short-term money market instrument sold at discount and redeem at face value issued by the Government • Sold at auction • Its a benchmark assets • Risk-Free financial asset (Rf) • Treasury Notes: 2-10 years maturity • Treasury Bonds: more than 10 years obligations

10. Forms of MMS...Treasury Bills • Return (Investment yield) on T-Bills

11. Forms of MMS • Commercial Paper – its like T-Bills; however, the issuer is a corporation not government • It is also an unsecured promissory note. • Negotiable Certificate of Deposit • The investor deposit money in a bank; in return, the bank issued a certificate which is negotiable. • The holder of the CD will receive the depoisted money alongwith interest.

12. Forms of MMS • Repurchase Agreement ( RPs or Repo) – • the short-term sell of government securities to corporations with an attention to repurchase the securities at higher price. • Interest rate is related with T-Bills mostly • Maturity runs from overnight to only a few day • How is different from T-Bills • T-bills are only issued at discount; however, it is not in the case of Repo.

13. Forms of MMS • Bankers’ Acceptance – • Short-term promissory note drawn on a bank by a firm to assist in foreign or domestic trade. • Once it is accepted by a bank, it becomes ‘BA’ • The drawer can negotiate the instrument in the secondary market at discount price. • The bank is supposed to pay the amount on maturity to the holder of the BA

14. Example of BA • Importer (Pakistani Firm) and Exporter (England Firm) a deal of Rs. 10,000 • Both companies agree to settle the deal in 90 days draft • Pakistani firm get a letter of credit from HBL; so HBL will honor the draft presented on behalf of Pakistani firm • England firm (drawer) order its bank (e.g., RBS) to draw a draft of Rs. 10,000 on HBL • Once HBL (drawee) accepts it; it becomes BA • Now the england firm can trade the BA in secondary market if it can not wait for 90 days. • On maturity, the holder (may be England firm or any other party) will receive the money from HBL.

15. Capital Market • The market for long-term securities. • Marketability is poor • Risk is higher due to long maturity time... • Include both debt and equity securities... • Fixed-Income Securities • Equity Securities

16. Fixed-Income Securities • The amount and date of each Payment is known in advance • Treasury bonds • Agency bonds • Municipal bonds • Corporate bonds • Asset-backed securities • Mortgage-related bonds • Money market securities

17. Bonds • Long-term debt instruments representing the issuer’s contractual obligation • Fixed-Income security • As interest (coupon rate) and principle payment is specified in advance • The buyer can sell the bonds before maturity; the price depends upon interest rates at that time.. • Default of the payment may lead to bankruptcy

18. Characteristics • Face value • Usually have maturity date... • Have coupon – the periodic interest payment by the issuer to the holder of the bonds • May be issued at discounts or premium • Credit Rating plays an important role in deciding interest rate.

19. Callable Bonds • The issuer of the bond has the right to call the bond and retire it by paying off the obligation... • The call option is attractive when the ‘market interest rate’ is lower then the coupon rate. • Costs are incurred on callable bonds such as ‘call premium’ and ‘administrative expenses’. • Call premium is usually equals to one’ year interest rate if the bond is called within a year; after the first year, it usually decline at constant rate. • Callable bonds can be re-issued at lower coupon rate but non-refundable bonds can be re-issued.

20. The Zero Coupon Bond • A bond issued at discount and redeem at its face value... • Having no interest (coupon) rate... • The difference between discount and redeemable value is rate of return

21. Types of Bonds • Treasury securities • Federal agency • Municipal • Corporate bonds

22. 1. Treasury Securities • Like T-Bills • Treasury-Notes: 2-10 years maturity • Treasury-Bonds: more than 10 years maturity • TIPS (Treasury Inflation-Indexed Securities) – protect the investors against the inflation losses....TIPS pay a fixed rate of interest but this rate is applied to the inflation-adjusted principal.

23. 2. Federal Agency Securities • US government established federal agencies to help certain sector either by providing direct loans or guarantee of private loan. • The securities issued by federal credit agencies (fully guaranteed) or by government sponsored agencies (not guaranteed). • Mortgage-Backed Securities: securities whose value depends on some set of mortgages.

24. 3. Municipal Securities • Securities issued by political entities other than the federal government and its agencies such as cities, states, counties. • General Obligation Bonds – backed by full faith and credit • Revenue Bonds – which are repaid from the revenues generated by the project in which the bonds are issued

25. 4. Corporate Bonds • Long-term debt securities of various types sold by corporations • Senior Securities: Debt securities have preference over shares in case of payments or in case of liquidation. • Debenture – unsecured bonds; backed by the issuer’s overall financial soundness

26. 5. Junk Bond • High risky and high yield bond • Usually issued by the firm as a last option

27. Equity Securities • Preferred Stock • Hybrid security as it resembles both equity and fixed-income securities • Like equity: having ownership position, infinite life and dividend receipt. • Like debt: fixed amount of dividend is received. • Having intermediate claim between bondholders and equity holders on a firm’s assets and earnings. • Having no voting power in annual general meeting usually • Having prior claim on the assets on liquidation • May be cumulative or non-comulative regarding dividend payment • My be convertible preferred stock to common stock

28. Equity Securities • Common Stock • Having voting power having control over management • Having second/last claim on the assets and earnings • Receive dividend (cash and stock)

29. Derivatives • The securities that derive their values by having claim on the some underlying securities.

30. Options – • Rights to buy or sell a stated number of shares of a security at a specified price; it may be: • Puts – an option to sell a specified number... • Calls – an option to buy a specified number... • Options only give a right to put and call; not an obligation to sell (purchase) shares.

31. Future Options • Agreement providing for the future exchange of a particular assets at a currently determined market price. • The assets may be commodities (corn, wheat) or financial assets (shares, bonds, T-Bills etc.) • The buyer pays the money upon delivery of assets by seller. • Used by both hedgers and speculators. • Hedgers purchase future contracts to reduce price uncertainty; while • Speculators purchase future contracts to exploit the uncertainty to earn profit.

32. In Conclusion, Direct Investment......

33. 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

34. 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