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Chapter 3

Chapter 3. Overview of Security Types. Overview of 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. Learning Objectives.

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Chapter 3

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  1. Chapter 3 Overview of Security Types

  2. Overview of 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

  3. 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.

  4. Investing Overview • Fundamental Question: Why invest at all? • We invest today to have more tomorrow. • Investment is simply deferred consumption. • We choose to wait because we want more to spend later. • Investors have their own investment objectives and strategies • The Investment Policy Statement (IPS) • Designed to reflect your objectives and strategies • Two parts: 1) Objectives, 2) Constraints

  5. 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.

  6. Classifying Securities

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

  8. 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.

  9. 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 might not be able to sell securities quickly for their current market value, the market is said to be illiquid.

  10. The price (per $100 face) of the bond when it last traded. 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): You will receive 5.75% of the bond’s face value each year in 2 semi-annual payments.

  11. 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.

  12. 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.

  13. Common Stock Price Quotes

  14. Resulting Screen Common Stock Price Quotes Onlineat http://finance.yahoo.com First, enter symbol.

  15. Preferred Stock • Information is a bit harder to find for preferred stock versus common stock. • Example: Bank of America (BAC) preferred stock • Find all the BAC preferred stock issues via a Google search—one source is: quantumonline.com. • One issue has a ticker of: BAC-J (BAC-PJ is its symbol at Yahoo!) • 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 will rise or fall depending on the prospects for the company and market-wide circumstances.

  16. 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.

  17. 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.

  18. 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.

  19. Futures Contracts: Online Price Quotes Source: Markets Data Center atwww.wsj.com.

  20. Futures Price Quotes Online Source: www.cmegroup.com

  21. 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.

  22. Option Contracts, II. • An American optioncan 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. • 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.

  23. 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. • Forbuyers, option losses are limited, but gains are not.

  24. 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, gains and losses are limited.

  25. Option Contracts: Online Price Quotesfor Nike (NKE) options Source: www.finance.yahoo.com

  26. The New Method to Decode Option Symbols In 2010, a new option symbol system was introduced. • The symbols expand from 5 letters to 20 letters and numbers. • The stated goal is to reduce confusion by explicitly stating: • the underlying stock symbol • option expiration date • whether the option is a call or a put • the dollar part of the strike price • the decimal part of the strike price • We do not know whether quadrupling the size of the ticker will reduce confusion.

  27. Investing in Stocks versus Options, I. Stocks (we assume no dividends): • Suppose you have $10,000 for investments. Monster Beverage Corporation is selling at $50 per share. • Number of shares bought = $10,000 / $50 = 200 • If Monster is selling for $55 per share 3 months later, gain = ($55  200) - $10,000 = $1,000 (10% gain) • If Monster is selling for $45 per share 3 months later, gain = ($45  200) - $10,000 = -$1,000 (10% loss)

  28. Investing in Stocks versus Options, II. Call Options: • A call option with a $50 strike price and 3 months to maturity is also available at a premium of $4. • Traded option contracts are on a bundle of 100 shares. • One call contract costs $4  100 = $400 • number of contracts bought = $10,000 / $400 = 25 (controlling 25  100 = 2,500 shares) • If Monster is selling for $55 per share 3 months later, gain = {($55 – $50)  2,500} - $10,000 = $2,500 (25% gain) • If Monster is selling for $45 per share 3 months later, loss = ($0  2,500) – $10,000 = -$10,000 (100% loss)

  29. 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)

  30. 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

  31. 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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