Overview of Security Types Chapter 3 Overview of Security Types Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

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 Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Learning Objectives 1. Various types of interest-bearing assets. 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. Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

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. Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Classifying Securities Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

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 are less 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. Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

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. Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

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 cannot sell securities quickly for their current market value, the market is said to be illiquid. Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Quote Example: Fixed-Income Securities Price Quotations from https://finra-markets.morningstar.com/BondCenter. Looking for bonds from the 3M Company (some columns are self-explanatory): You will receive 1.375% of the bond’s face value each year in 2 semi-annual payments. The price (per $100 face) of the bond when it last traded. The Yield to Maturity (YTM) of the bond. The bond is callable. Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

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. Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Common Stock Examples: IBM shares, Microsoft shares, Intel shares, Dell shares, etc. Potential gains/losses: Many companies pay cash dividends to their shareholders. 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. Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Common Stock Price Quotes Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Common Stock Price Quotes Online: http://finance.yahoo.com First, enter symbol, JWN Resulting Screen Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Some Investors Want High Dividend Yields www.wsj.com Here is a list of stocks in the “Real Estate Sector.” Locate the entry for Five Oaks Investment (OAKS). The first two columns are the dividend amount and dividend yield, $1.20 and 17.32 percent, respectively. You should be thinking that the dividend yield seems quite high. Unlike most companies that pay a fairly consistent quarterly dividend, real estate companies, due to legal requirements, often pay out a set percentage of their profits. Thus, in good years the payouts are high, and in bad years they will be low. Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

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. Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

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. Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

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. Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Futures Contracts: Online Price Quotes Source: Markets Data Center at www.wsj.com. Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Futures Price Quotes Online Source: www.cmegroup.com Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

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. Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

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 expiration date. 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. Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

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. For buyers of call options: option losses are limited to the purchase price; gains are theoretically unlimited. Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

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 of put options: Both gains and losses are limited. Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Source: finance.yahoo.com. Option Contracts: Online Price Quotes for Nike (NKE) Call and Put Options Source: finance.yahoo.com. Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

The New Method to Decode Option Symbols In 2010, a new option symbol system was introduced. Example: NKE151120C00100000 The symbols expand from 5 letters up to 20 letters and numbers. The stated goal is to reduce confusion by explicitly stating: the underlying stock symbol, NKE option expiration date, 151120 (i.e., November 20, 2015) whether the option is a call or a put, C (uh, Call) the dollar part of the strike price, 00100 (i.e., 100—prices can be up to 5 digits) the decimal part of the strike price, 000 We do not know whether quadrupling the size of the ticker will reduce confusion. Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Investing in Stocks versus Options, I. Stocks (we assume no dividends): Suppose you have $15,000 for investments. Monster Beverage Corporation is selling at $150 per share. Number of shares bought = $15,000 / $150 = 100 If Monster is selling for $165 per share 3 months later, gain = ($165  100) - $15,000 = $1,500 (10% gain) If Monster is selling for $135 per share 3 months later, loss = ($135  100) - $15,000 = -$1,500 (10% loss) Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Investing in Stocks versus Options, II. A call option with a $150 strike price and 3 months to maturity is also available at a premium of $10. Traded option contracts are on a bundle of 100 shares. One call contract costs $10  100 = $1,000 number of contracts bought = $15,000 / $1,000 = 15 (controlling 15  100 = 1,500 shares) If Monster is selling for $165 per share 3 months later, gain = {($165 – $150)  1,500} - $15,000 = $7,500 (50% gain) If Monster is selling for $135 per share 3 months later, loss = ($0  1,500) – $15,000 = -$15,000 (100% loss) Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

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) Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

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 Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Chapter Review, II. Derivatives Option Contracts 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 Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.