1. Investment Alternatives
Chapter 2
Investment Alternatives

2. 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.

3. 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)

4. 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.

5. 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.

6. 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.

7. 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

8. 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

9. 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

10. 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.

11. 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

12. 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

13. 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

14. 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)

15. 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.

16. 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)

17. 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

18. 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?)

19. 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

20. 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

21. 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)

22. 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

23. 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

24. 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

25. 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

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

27. 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.

28. 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.

29. 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

30. 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)

31. Hedging with Options

32. Hedging with future contracts