1. Asset Classes: Security Types

2. 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.

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

5. 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

6. 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.

7. 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

8. 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.

9. 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.

11. U.S. National Debt

12. 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

13. Quote Example: Fixed-Income Securities
Price quotations from 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.

14. Interest rates : Market data from WSJ

16. 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

17. 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.

18. 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.

19. 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.

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

21. 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

22. 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.

23. Preferred Stock
Example: Citigroup preferred stock (Do a Google search for it).
Potential gains/losses:
Dividends are “promised.” However, there is no legal requirement that the dividends be paid, as long as no common dividends are distributed.
The stock value may rise or fall depending on the prospects for the company and market-wide circumstances.

24. 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.

25. 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.

26. 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.

27. Futures Contracts: Online Price Quotes
Source: Markets Data Center at

28. 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 per $100 of par value, where the “02” represents 2/32.
It represents a price of $110, 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.

29. Example continued

30. Futures Price Quotes Online

31. 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.

32. 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.

33. 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.

34. 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.

35. Option Contracts: Online Price Quotes for Nike (NKE) options
Source:

36. 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

37. 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

38. More Example: Put Option

39. More Example

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

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

42. 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

43. 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

44. 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

45. 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.

46. 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) $ 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, $5.815*5,000 bushels *3 contracts, $6.2775*5,000*3

47. 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.