Overview of Security Types 3 Overview of Security Types

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. 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, and How its prices are quoted in the financial press.

Classifying Securities Basic Types Major Subtypes Interest-bearing Money market instruments Fixed-income securities Equities Common stock Preferred stock Derivatives Futures Options

Interest-bearing securities

Interest-Bearing Assets Pay interest, as the name suggests. The value of these assets depends, at least for the most part, on interest rates. They all begin life as a loan of some sort, so they are all debt obligations of some issuers. Relatively low risk and often large denominations

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. Relatively more liquid than longer-term fixed-income securities. Fixed-income securities are longer-term debt obligations of corporations or governments. These securities promise to make fixed payments according to a pre-set schedule. When they are issued, their lives exceed one year. Less liquid.

Money Market Securities Examples: Treasury bills: Short-term debt of U.S. government Certificates of Deposits (CDs): Time deposit with a bank Commercial Paper: Short-term, unsecured debt of a company Eurodollars: Dollar-denominated time deposits in banks outside the U.S. Repos and Reverses: Short-term loan backed by government securities. Fed Funds: Very short-term loans between banks

Money Market Instruments Potential gains/losses: A known future payment/except when the borrower defaults (i.e., does not pay). Price quotations: Usually, T-Bills are sold on a discount basis, and only the interest rates are quoted. This means that T-bills are sold at a price that is less then their stated face value or maturity value. Therefore, investors must be able to do calculate prices from the quoted rates.

Example: T-Bill T-Bill is a short-term debt obligation backed by the U.S. government with a maturity of less than one year.  T-bills are sold in denominations of $1,000 up to a maximum purchase of $5 million and commonly have maturities of one month (four weeks), three months (13 weeks) or six months (26 weeks). Let's say you buy a 13-week T-bill priced at $9,800. Essentially, the U.S. government writes you an IOU for $10,000 that it agrees to pay back in three months.  You will not receive regular payments as you would with a coupon bond, for example.  Instead, the appreciation - and, therefore, the value to you - comes from the difference between the discounted value you originally paid and the amount you receive back ($10,000).  In this case, the T-bill pays a 2.04% interest rate ($200/$9,800 = 2.04%) over a three-month period.

U.S. National Debt

Fixed-Income Securities Examples: U.S. Treasury notes, corporate bonds (callable and/or convertible, car loans, student loans. Notes and bonds are generic terms for fixed-income securities. 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. (Yes, there is an inverse relationship between price and market interest rates.) Depending on the debt issue, illiquidity can be a problem. (Illiquidity means it is possible that you cannot sell these securities quickly.) Terminologies Current yield = Annual coupon dividend by the current bond price Coupon rate = Stated interest rate

Fixed-Income Price Quotes What Does Trade Reporting And Compliance Engine - TRACE Mean? A program developed by the National Association of Securities Dealers (NASD) which allows for the reporting of over-the-counter (OTC) transactions pertaining to eligible fixed-income securities. Brokers, who are NASD members and deal with specific fixed-income securities, are required to report their transactions by Securities and Exchange Commission (SEC) rules.

Quote Example: Fixed-Income Securities Price quotations from www.wsj.com—the online version of The Wall Street Journal (some columns are self-explanatory): You will receive 6.875% 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.

Interest rates : Market data from WSJ Friday, December 29, 2006 The key U.S. and foreign annual interest rates below are a guide to general levels but don't always represent actual transactions. Commercial Paper: Yields paid by corporations for short-term financing, typically for daily operation Prime Rate: 8.25% (effective 06/29/06). The base rate on corporate loans posted by at least 75% of the nation's 30 largest banks. Discount Rate (Primary): 6.25% (effective 06/29/06). Federal Funds: 5.375% high, 4.500% low, 5.125% near closing bid, 5.250% offered. Effective rate: 5.20%. Source: Tullett Prebon Information, Ltd. Federal-funds target rate: 5.250% (effective 06/29/06). Call Money: 7.00% (effective 06/29/06). Commercial Paper: Placed directly by General Electric Capital Corp.: 5.23% 30 to 60 days; 5.22% 61 to 90 days; 5.20% 91 to 122 days; 5.19% 123 to 151 days; 5.17% 152 to 180 days; 5.14% 181 to 210 days; 5.11% 211 to 241 days; 5.09% 242 to 270 days. Euro Commercial Paper: Placed directly by General Electric Capital Corp.: 3.58% 30 days; 3.62% two months; 3.68% three months; 3.72% four months; 3.76% five months; 3.81% six months. Dealer Commercial Paper: High-grade unsecured notes sold through dealers by major corporations: 5.27% 30 days; 5.28% 60 days; 5.30% 90 days. Certificates of Deposit: 5.30% one month; 5.33% three months; 5.33% six months.

Liquidity of Fixed-Income Securities Often quite illiquid, depending on the issuer and the specific type T-Bills are highly liquid Investment-grade corporate bonds are relatively liquid Speculative-grade corporate bond are relatively illiquid

equities

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. Also, shareholders retain voting rights. Common stock may or may not pay dividends at the discretion of a company's board of directors, which is elected by the shareholders. Tech stocks usually do not pay dividends, while utilities stocks pay a decent amount of dividends. Dividends can grow over time. There may be capital gains or losses.

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.

Common Stock Ticker Symbols Examples: IBM – IBM DELL – DELL AT&T – T Ford Motors – F Google – GOOG Exxon Mobil – XOM And CSCO, SBUX, BAC, FITB, C, MSFT, JNJ, K, KO, etc.

Common Stock Price Quotes

Common Stock Price Quotes Online at http://finance.yahoo.com First, enter symbol. Resulting Screen Round lots = multiple of 100 shares

Price Quotes Dividend yield = annualized dividend divided by the closing price Round lots = a multiple of 100 shares Dividends are usually paid on a quarterly basis. PE ratio = Price divided by EPS where EPS is earnings divided by the number of shares outstanding

Equities 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. Some preferred stocks are cumulative, meaning that any and all skipped dividends must be paid in full before common stockholders are paid. Most preferred stocks are issued by large companies, particularly banks and public utilities. Preferred stock resembles a fixed-income security. In this sense, it is a hybrid security. However, the main difference is that preferred stock is NOT a debt obligation. Also, for accounting and tax purposes, preferred stock is treated as equity.

Preferred Stock Information is a bit harder to find for preferred stock versus common stock. Example: Citigroup preferred stock, 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 dividends from common stock are distributed. The stock value may rise or fall depending on the prospects for the company and market-wide circumstances.

derivatives

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. Warning! Derivative assets are highly complicated securities and their pricings and trading process are quite technical.

Derivatives, II. Futures contract: An agreement made today regarding the terms of a trade that will take place later. For example, you are a jeweler and will need many ounces of gold in six months. You strike a deal today with a seller in which you promise to pay, say, $400 per ounce in six months for the 100 ounces of gold, no matter what actual price in six months will prevail. 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.

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.

Futures Contracts: Online Price Quotes Source: Markets Data Center at www.wsj.com.

Futures Contracts: Example The first column tells us the delivery date for the bonds specified by the contract. The settle is a price reflecting the trades at the end of the day. Suppose you buy one September contract at the settle price. What you have done is agree to buy T-bonds with a total par value of $100,000 in September at a price of 110-02 per $100 of par value, where the “02” represents 2/32. It represents a price of $110,062.50 per $100,000 face value. No money changes hands today between a buyer and seller. Upon maturity, your T-bonds will be delivered. Or, you can close out the contract before the maturity date by taking the opposite date, thereby canceling your current position. More details will be presented in more advanced classes.

Example continued

Futures Price Quotes Online 1066’2 = $10.66 2/8 *5000 bushels = 10.6625*5000=$53,312.5

Mexican Peso Futures, US$/Peso (CME) Maturity Open High Low Settle Change Open Interest Mar .10953 .10988 .10930 .10958 --- .11000 .09770 34,481 June .10790 .10795 .10778 .10773 .10800 .09730 3,405 Sept .10615 .10610 .10573 .09930 1,418 All contracts are for 500,000 new Mexican pesos. “Open,” “High” and “Low” all refer to the price on the day. “Settle” is the closing price on the day and “Change” indicates the change in the settle price from the previous day. “High” and “Low” to the right of Change indicates the highest and lowest prices for this specific contact during its trading history. “Open Interest” refers to the number of contracts outstanding for a particular delivery month—it’s a good proxy for demand for a contract. Notice that open interest is greatest in the nearby contract. In general, open interest typically decreases with term to maturity of most futures contracts. The holder of a March long position is committing himself to pay $.10958 per euro for peso 500,000—a $54,790 position. As there are 34,481 such contracts outstanding, this represents a notational principal of over $1.8 billion!

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.

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.

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. Note that, for buyers, losses are limited, but gains are not.

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. Note that, for buyers and sellers, gains and losses are limited.

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

Investing in Stocks versus Options, I. Suppose you have $10,000 for investments. Macron Technology is selling at $50 per share. Number of shares bought = $10,000 / $50 = 200 If Macron is selling for $55 per share 3 months later, gain = ($55  200) - $10,000 = $1,000 If Macron is selling for $45 per share 3 months later, gain = ($45  200) - $10,000 = -$1,000

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.

Investing in Stocks versus Options, II. A call option with a $50 strike price and 3 months to maturity is also available at a premium of $4. A call contract costs $4  100 = $400, so number of contracts bought = $10,000 / $400 = 25 (for 25  100 = 2500 shares) If Macron is selling for $55 per share 3 months later, gain = {($55 – $50)  2500} - $10,000 = $2,500 If Macron is selling for $45 per share 3 months later, gain = ($0  2500) – $10,000 = -$10,000

More Example: Put Option

More Example

Useful Internet Sites www.nasdbondinfo.com (current corporate bond prices) www.investinginbonds.com (bond basics) www.finra.com (learn more about TRACE) www.fool.com (Are you a “Foolish investor?”) www.stocktickercompany.com (reproduction stock tickers) www.cmegroup.com (CME Group) www.cboe.com (Chicago Board Options Exchange) finance.yahoo.com (prices for option chains) www.wsj.com (Online version of The Wall Street Journal)

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 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

Preferred stock is a derivative security. A) True B) False

The current yield is equal to the annual interest divided by the current bond price. A) True B) False

A futures contract is an agreement to trade at a later date with the quantity and the price set on the date that the trade actually occurs. A) True B) False

Which one of the following characteristics applies to money market instruments? A) issued by large corporations only B) issued only by the government C) long-term D) must be repaid in one year or less E) always guaranteed to be repaid

Who determines if, when, and how much will be paid as a common stock dividend? A) chief executive officer of the corporation B) chief financial officer of the corporation C) company shareholders D) company president E) board of directors

A round lot is: A) one bond. B) 100 bonds. C) 10 shares of stock. D) 100 shares of stock. E) 1,000 shares of stock.

You are a jeweler and will need to buy silver three months from now You are a jeweler and will need to buy silver three months from now. Today, you enter a futures contract to buy silver at $10.30 an ounce in three months. Assume that silver actually sells for $10.28 an ounce three months from now. Which one of the following is true? A) You benefited from the futures contract. B) The futures contract caused you to pay more than you needed to pay. C) You will be able to adjust the futures contract for the lower market price. D) You can just ignore the futures contract and buy silver at the lower market price. E) You can re-sell the futures contract and make a profit.

How much profit would you have earned if you had purchased three July soybeans futures contracts at their lowest lifetime price and sold those contracts at their highest lifetime price? Soybeans: 5,000 bushels, cents per bushel Net Prev Limit Exp Last Chg Open High Low Close Settle Hi 06Jul 602 ' 2 -2 ' 4 604 ' 4 604 ' 6 601 ' 4 602 ' 0 627 ' 6 581 ' 4 06Sep 613 ' 6 -6 ' 6 618 ' 0 619 ' 2 610 ' 2 613 ' 4 620 ' 4 641 ' 2 588 ' 6 A) $480.00 remember that prices are quoted in cents and eights of a cent B) $487.50 C) $2,312.50 D) $6,930.00 E) $6,937.50 $5.815*5,000 bushels *3 contracts, $6.2775*5,000*3

You bought a September European-style call option on 100 shares of stock at $14 a share. You have the: A) right to buy 100 shares at $14 a share at any time prior to the expiration date in September. B) obligation to buy 100 shares at $14 a share prior to the expiration date in September. C) right to sell 100 shares at $14 a share at any time prior to the expiration date in September. D) obligation to sell 100 shares at $14 a share on the expiration date. E) right to buy 100 shares at $14 a share but only on the expiration date.