Investments: Analysis and Management, Second Canadian Edition

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Chapter 2
Investment Alternatives
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Learning Objectives

• Describe the major types of financial assets and
  how they are organized.
• Explain what non-marketable financial assets are.
• Describe the important features of money market
  and capital market securities.
• Distinguish among preferred stock, income trusts,
  and common stock.
• Understand the basics of options and futures.

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Non-Marketable Financial Assets

• Examples Savings accounts, Canada Savings Bonds
  (CSBs), Guaranteed Investment Certificates (GICs)
• Commonly owned by individuals
• Represent personal transactions between the owner
  and the issuer. (e.g. owner of a savings account
  in a bank must open the account personally)
• Usually safe investments which are easy to
  convert to cash without loss of value (i.e. high
  liquidity)

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Examples Non-Marketable Securities

• A savings account (demand deposit) is a
  nonmarketable account at banks and other
  financial institutions (e.g. credit unions). The
  investors funds are available on demand, with no
  specific maturity date. It offers safety and
  liquidity.
• Guaranteed Investment Certificates (GICs) are
  non-transferable time deposits with banks and
  trust companies that offer investors higher
  returns than those available on savings accounts.
  They differ from savings accounts in that they
  are locked for a fixed period of time, and early
  withdrawals are not permitted, or else there are
  penalties.

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Marketable Securities

• Marketable securities are classified into one of
  three categories money market securities,
  capital market securities, and derivatives.
• 1- Money market securities are short-term, highly
  liquid, low risk securities. They include
  Treasury bills, commercial paper, Eurodollars,
  repurchase agreements, and bankers acceptances.
• 2- Capital market securities are long-term
  instruments of higher risk and varying degrees of
  liquidity. They are separated into fixed-income
  securities and equity securities.

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Marketable Securities (cont.)

• Fixed-income securities promise to pay stated
  amounts at stated times.
• Equity securities represent ownership rights,
  with a residual claim to assets and earnings.
• 3- Derivative securities derive their value in
  whole or in part by having a claim on some
  underlying security. They include warrants,
  options, and futures contracts.

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Money Market Securities

• Examples Treasury bills, commercial paper,
  Eurodollars, repurchase agreements, bankers
  acceptances (B/As)
• Marketable claims are negotiable or saleable in
  the marketplace.
• Marketable securities trade in impersonal
  markets, the buyer and seller do not know one
  another.
• Short-term, liquid, relatively low-risk debt
  instruments
• Issued by governments and private firms

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1- Treasury Bills (T-bills)

• Treasury Bills
• Short-term promissory notes issued by governments
  
• T-bills accounted for about one-half of all
  outstanding money market securities.
• Sold at a discount from face value in
  denominations of 5,000, 25,000, 100,000, and 1
  million
• Typical maturities are 91, 182, and 364 days
  although shorter maturities are also offered
• Treasury bills are auctioned every two weeks

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1- Treasury Bills (cont.)

• Treasury Bills
• Treasury bills are sold at less than face value
  (a discount), and redeemed at maturity for the
  face value, with this spread constituting an
  investor's return. The greater the discount (the
  smaller the price paid for the bills), the larger
  the return.
• Due to government backing, there is a very low
  risk of default
• Widely distributed and actively traded high
  liquidity
• In subsequent chapters we will use government
  T-bill rates as a measure of the riskless rate
  available to investors, commonly referred to as
  the risk-free rate

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2- Commercial Paper

• Commercial Paper
• Short-term unsecured promissory notes issued by
  large, well-known, and financially strong
  corporations (including finance companies)
• Denominations start at 100,000 with maturities
  of 30 to 365 days, and it is sold at a discount
  either directly by the issuer or indirectly
  through a dealer, with rates slightly above
  T-bill rates.

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3- Eurodollars

• Eurodollars
• Dollar-denominated deposits held in foreign banks
  or in offices of Canadian banks located abroad
• Although this market originally developed in
  Europe, dollar-denominated deposits can now be
  made in many countries, such as those of Asia
• Consist of both time deposits and certificates of
  deposit (CDs), with the latter constituting the
  largest component of the Eurodollar markets
• Maturities are mostly short-term, often less than
  six months

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4- Repurchase Agreements

• Repurchase Agreements (RPs)
• agreements between a borrower and lender
  (typically institutions) to sell and repurchase
  money market securities
• borrower initiates an RP by contracting to sell
  securities to a lender and agreeing to repurchase
  these securities at a pre-specified (higher)
  price on a stated future date
• maturity is generally very short, from 3 to 14
  days, and sometimes overnight
• minimum denomination is typically 100,000

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5- Bankers Acceptances

• Bankers Acceptances (B/As)
• Time drafts drawn on a bank by a customer,
  whereby the bank agrees to guarantee payment of a
  particular amount at a specified future date
• B/As are negotiable instruments that are sold at
  a discount in the money market
• Differ from commercial paper (unsecured) because
  the associated payments are guaranteed by a bank,
  and thus possess the credit risk associated with
  that bank
• Issued in minimum denominations of 100,000
• Typical maturities range from 30 to 180 days,
  with 90 days being the most common

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Capital Market Securities

• Fixed-Income Securities
• Marketable debt with maturity greater than one
  year
• More risky than money market securities
• Fixed-income securities have a specified payment
  schedule
• Dates and amount of interest and principal
  payments known in advance (e.g. bonds)

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Fixed-Income Securities (cont.)

• Bonds long-term debt instruments representing
  the issuers contractual obligation. The buyer of
  a bond is lending money to the issuer who agrees
  to pay principal on this loan and repay the
  principal at a stated maturity date
• Why are bonds considered fixed-income securities?
• Because the interest payments (if any) and the
  principal repayment for most bonds are specified
  at the time the bond is issued and fixed for its
  life.

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Fixed-Income Securities (cont.)

• Major bond types
• Government of Canada bonds (are marketable,
  transferable, fluctuate in price over time, and
  may sell above or below their stated par value).
• U.S. Treasury bonds
• Provincial bonds
• U.S. federal agency securities GNMAs (Ginnie
  Maes), FNMAs (Fannie Maes)

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Fixed-Income Securities (cont.)

• Major bond types (cont.)
• Corporate bonds
• Usually pay semi-annual interest, are callable,
  and have a par value of 1,000
• Convertible bonds may be exchanged for shares of
  common stock of the same corporation at
  predetermined prices
• Default risk is the risk that issuer may default
  on payments

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Bond Characteristics

• Callable bonds give the issuer the option to
  call or repurchase outstanding bonds at
  predetermined call prices (generally at a
  premium over par) at specified times
• Generally, the issuer agrees to give 30 or more
  days notice that the issue will be redeemed
• Most callable bonds have a time period (referred
  to as call protection) prior to the first call
  date during which the cannot be called
• The call price declines with time (why?)

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Bond Characteristics (cont.)

• Extendible Bonds gives the investor an option to
  extend the maturity date of the bond
• Retractable Bonds gives the investor an option
  to sell the bond back to the issuer at
  predetermined prices at specified time
• Issuers are able to sell bonds with these
  features at higher prices (and accept lower
  returns) than straight issues

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Bond Characteristics (cont.)

• Convertible Bonds may be converted into common
  shares at predetermined conversion prices.
• This feature makes the issue more saleable and
  lowers the interest rate that must be offered
• Permits the holding of a two-way security
• The safety of a bond
• The capital gains potential of a share
• Convertibles are normally callable

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Asset-Backed Securities

• Asset-backed securities (ABSs) are created when
  an underwriter, such as a bank, bundles some type
  of asset-linked debt and sells investors the
  right to receive payments made on that debt (e.g.
  car loans, credit-card debt, small business
  loans)
• E.g. mortgage-backed securities (MBSs)
• MBSs are created when a financial institution
  purchases a number of mortgage loans that are
  then repackaged and sold to investors as mortgage
  pools
• Investors in MBSs assume little default risk as
  most mortgages are guaranteed by a federal
  government agency (the Canadian Mortgage
  Housing Corporation)

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Equity Securities

• Represent an ownership interest in a corporation
• 1- Preferred stock
• A hybrid security that is part equity and part
  fixed-income (bond) because it increases in value
  but also pays a fixed dividend
• Preferred shareholders are paid after bondholders
  but before common shareholders
• Dividend amount is fixed and known in advance
• Dividends are cumulative, i.e., the firm has to
  pay all preferred dividends (both current and
  arrears) before paying any dividends to current
  shareholders

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Equity Securities (cont.)

• 2- Income trusts
• Investment instruments that pay out a portion of
  cash flows generated from underlying
  revenue-generating assets
• E.g. royalty trusts and real estate investment
  trusts (REITs)
• The trust owns the underlying assets and
  investors purchase units in the trust, which
  entitles them to a certain portion of the cash
  flows generated by the underlying assets

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Equity Securities (cont.)

• 2- Income trusts (cont.)
• Income trust structure generates tax savings at
  the business level, thus reducing the double
  taxation of income (dividends)
• This tax avoidance is possible because income
  trusts are permitted to treat part (or all) of
  the investment in the equity of the company as
  debt for tax purposes
• Thus, they can classify payments to trust unit
  holders as interest expense, which reduces
  taxable income

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Equity Securities (cont.)

• 3- Common stock
• Represents the ownership interest of corporations
  or the equity of shareholders
• Common shareholders are residual claimants on
  income and assets, i.e., entitled to income
  remaining after fixed-income claimant (e.g.
  preferred shareholders) have been paid
• Common shareholders can elect board of directors
  and vote on important issues
• Each shareholder is allowed to cast votes equal
  to the numbers of shares owned when such vote
  takes place
• Common stockholders have limited liability

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Derivative Securities

• Securities whose value is derived from some
  underlying security
• Examples of derivative securities options, and
  future contracts
• Risk management tools

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Options

• An option gives the owner of the option the
  right, but not the obligation, to buy or sell a
  certain asset at a fixed price (the strike price
  or exercise price) during a specified period of
  time.
• Options on stock and other assets are examples of
  derivative securities. The value of an option is
  derived from the price and other features of the
  underlying assets.
• The act of purchasing or selling the underlying
  asset, as specified in the option contract, is
  referred to as exercising the option.
• The maturity date of the option is called the
  expiration date the owner of the option cannot
  exercise the option after the expiration date.

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Options (Cont.)

• An American option can be exercised anytime up to
  the expiration date.
• A European option can be exercised only on the
  expiration date.
• Options on stocks and bonds are traded on several
  exchanges, the largest of which is the Chicago
  Board Options Exchange (CBOE).
• Option trading in Canada began in 1975 on the
  Montreal Exchange.

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Futures

• A future contract is a contract where two parties
  agree on the price of an asset today to be
  delivered and paid for at some future date
• The delivery date of the goods is called the
  settlement date
• With futures contracts, gains and losses to the
  buyer or seller are recognized on a daily basis.
  This daily settlement feature is referred to as
  marking-to-market
• This daily settlement greatly reduces the default
  risk associated with forward contracts
• Because of this, organized trading in futures
  contracts is much more common than in forwards
  contracts

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Futures Exchanges

• The largest futures exchange is the Chicago Board
  of Trade (CBOT)
• Other major exchanges include
• The Chicago Mercantile Exchange (COMEX)
• The London International Financial Futures
  Exchange (LIFFE)
• The New York Futures Exchange (NYFE)
• The Winnipeg Commodity Exchange (WPG)

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Hedging with Options
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Hedging with future contracts