Copyright © 2005 by South-Western, a division of Thomson Learning, Inc. All rights reserved. 1-1 Financing and Investing

Copyright © 2005 by South-Western, a division of Thomson Learning, Inc. All rights reserved. 1-2 Securities ●Stocks, bonds, or money market instruments that represent an obligation on the part of the issuer.

Copyright © 2005 by South-Western, a division of Thomson Learning, Inc. All rights reserved. 1-3 The Markets ●Primary Market—market where new security issues are first sold to investors; the issuer receives the proceeds from the sale. –Initial Public Offering (IPO) ●Secondary Market—financial markets where previously issued securities are traded among investors. –Examples: NY Stock Exchange and the NASDAQ

Copyright © 2005 by South-Western, a division of Thomson Learning, Inc. All rights reserved. 1-4 Securities ●Three major asset classes –Cash –Bonds (fixed income) –Stocks (equities) ●Asset allocation –The percent of your assets in each category –Very important concept in investing

Copyright © 2005 by South-Western, a division of Thomson Learning, Inc. All rights reserved. 1-5 Cash ●Money Market Instruments—short-term debt securities –Mature within one year –Examples:  U.S. Treasury Bills,  commercial paper,  repurchase agreements  Certificates of Deposit (CDs) ●Treasury Bills are special –The “risk-free asset”

Copyright © 2005 by South-Western, a division of Thomson Learning, Inc. All rights reserved. 1-6 Bonds ●Attributes –Par value – amount on the bond (principal)  Usually denominated in $1000 –Interest rate to be paid (usually 2x a year) –Maturity date – when principal is paid back ●Also known as fixed income –Interest payments do not change over the life of the bond

Copyright © 2005 by South-Western, a division of Thomson Learning, Inc. All rights reserved. 1-7 Corporate Bonds ●Secured Bond—bond backed by a pledge of a company’s specific assets. (Think collateral) ●Debenture—bond backed by the reputation of the issuer. (Think IOU)

Copyright © 2005 by South-Western, a division of Thomson Learning, Inc. All rights reserved. 1-8 Types of Bonds ●Government Bonds –issued by U.S. Treasury –Sovereign debt ●Municipal Bonds –Issued by state and local governments –Revenue bond is a bond whose proceeds are to be used to pay for a project that will produce revenue (e.g., a toll bridge) –General obligation bond is a bond whose proceeds are used to pay for a non-revenue producing project (e.g., a fire station)

Copyright © 2005 by South-Western, a division of Thomson Learning, Inc. All rights reserved. Bond Returns ●Interest –Paid bi-annually –Contractually obligated to pay ●Par value –Paid at maturity –Usually $1000 ●If sell before maturity –Price has probably changed from $1000 –Will have a capital gain or loss 1-9

Copyright © 2005 by South-Western, a division of Thomson Learning, Inc. All rights reserved. Bond Risk ●Default risk –Company or government is unable to pay ●Interest rate risk –Bond interest rate does not change from what is printed on the bond (fixed income) –If market interest rates change, it will affect how much people are willing to pay for the bond – the bond price –Rates go up -> price goes down and vice versa ●Inflation risk – same story as interest rates 1-10

Copyright © 2005 by South-Western, a division of Thomson Learning, Inc. All rights reserved Moody’s and Standard & Poor’s Bond Ratings

Copyright © 2005 by South-Western, a division of Thomson Learning, Inc. All rights reserved. Types of Stock ●Common stock ●Preferred stock –Half stock, half bond. –We’ll cover next time. 1-12

Copyright © 2005 by South-Western, a division of Thomson Learning, Inc. All rights reserved. Equity Returns ●Dividends –Optional –Usually quarterly –Sometimes one-time event –Not guaranteed for common stock ●Change in price –Based on investors’ view of a firm’s future –Will cause a capital gain or loss 1-13

Copyright © 2005 by South-Western, a division of Thomson Learning, Inc. All rights reserved Securities RiskReturn CashVery lowLow Bonds (fixed income) Moderate – HighModerate StocksHigh

Copyright © 2005 by South-Western, a division of Thomson Learning, Inc. All rights reserved Security Returns ●Note the risk – return trade-off ●U.S. Treasuries are considered risk free –how do you expect their return to compare to corporate bonds?

Copyright © 2005 by South-Western, a division of Thomson Learning, Inc. All rights reserved Interest Rates ●Do you expect a 5 year bond to have the same interest rate as a 10 year bond? –what factors affect the interest rate? ●How do you expect the rates for a 5 year bond and a 10 year bond to compare if: –current interest rates are historically low –current interest rates are historically high –you expect inflation to rise/fall ●Yield curve

Copyright © 2005 by South-Western, a division of Thomson Learning, Inc. All rights reserved Discussion ●The Fed announced a rate hike. –What do you expect to happen to bond yields? –What do you expect to happen to bond prices? –If long-term yields do not increase, what might that tell you?