Investment Alternatives Chapter 2 Investment Alternatives

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.

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)

Examples: Non-Marketable Securities A savings account (demand deposit) is a nonmarketable account at banks and other financial institutions (e.g. credit unions). The investor’s 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.

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 banker’s 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.

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.

Money Market Securities Examples: Treasury bills, commercial paper, Eurodollars, repurchase agreements, banker’s 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

1- Treasury Bills (T-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

1- Treasury Bills (cont.) 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

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.

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

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

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

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)

Fixed-Income Securities (cont.) Bonds – long-term debt instruments representing the issuer’s 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.

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)

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

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?)

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

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

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)

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

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

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

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

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

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.

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.

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

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)

Hedging with Options

Hedging with future contracts