33C h a p t e r

Security TypesSecurity Types

second edition

Fundamentals

of InvestmentsValuation & Management

Charles J. Corrado Bradford D. Jordan

McGraw Hill / Irwin Slides by Yee-Tien (Ted) Fu

2002 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

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Security Types

Our goal in this chapter is to introduce the different types of securities that are routinely bought and sold in financial markets around the world.

Goal

For each security type, we will examine: its distinguishing characteristics, the potential gains and losses from owning it, and how its prices are quoted in the financial press.

2002 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

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Classifying Securities

Basic Types Major Subtypes

Interest-bearing Money market instruments

Fixed-income securities

Equities Common stock Preferred stock

Derivatives Options Futures

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Interest-Bearing Assets

Fixed-income securitiesLonger-term debt obligations, often of corporations or governments, that promise to make fixed payments according to a preset schedule.

Money market instrumentsShort-term debt obligations of large corporations and governments that mature in a year or less.

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Money Market Instruments

Examples: U.S. Treasury bills (T-bills), bank certificates of deposit (CDs), corporate and municipal money market instruments.

Potential gains/losses: Fixed future payment, except when the borrower defaults.

Price quotations: Usually, the instruments are sold on a discount basis, and only the interest rates are quoted. So, some calculation is necessary to convert the rates to prices.

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Fixed-Income Securities

Examples: U.S. Treasury notes, corporate bonds, car loans, student loans.

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. Can be quite illiquid.

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Fixed-Income Securities Price quotations:

CUR NETBONDS YLD. VOL CLOSE CHG.

NEW YORK BONDSCorporation Bonds

ATT 73/407 …… 7.8 56 100 + 1/4

ATT 81/822 …… 8.6 433 94 1/8 + 5/8

ATT 81/824 …… 8.7 453 93 3/4 –

AT&T, the issuer of the bond.

ATT

The bond’s annual coupon rate. You will receive 81/8% of the bond’s face value each year in 2 semiannual coupon payments.

81/8

The bond will mature in the year 2022.

22

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Fixed-Income Securities Price quotations:

CUR NETBONDS YLD. VOL CLOSE CHG.

NEW YORK BONDSCorporation Bonds

ATT 73/407 …… 7.8 56 100 + 1/4

ATT 81/822 …… 8.6 433 94 1/8 + 5/8

ATT 81/824 …… 8.7 453 93 3/4 –

8.6

Current yield = annual coupon current price

433

The actual number of bonds traded that day.

94 1/8

The closing price for the day is 94.125% of

face value.

The closing price is up by 5/8 of1% from the previous closing price.

+ 5/8

2002 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

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Work the Web

Check out bond basics at:http://www.investinginbonds.com

2002 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

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Equities

Preferred stockThe 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.

Common stockRepresents 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.

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Common Stock

Examples: IBM shares, Microsoft 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.

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Preferred Stock

Example: Citigroup preferred stock. 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.

Equities : Price quotations3 - 13

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Work the Web

Are you a Foolish investor? Go to “Fool School” at:http://www.fool.com

You can also learn more about the “ticker tape” at:http://www.stocktickercompany.com

and create your own ticker at:http://www.cnbc.com

2002 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

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Derivatives

Primary assetSecurity originally sold by a business or government to raise money.

Derivative assetA 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.

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Derivatives

Futures contractAn agreement made today regarding the terms of a trade that will take place later.

Option contractAn 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.

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Futures Contracts

Examples: financial futures, commodity futures.

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/losses are possible.

Futures Contracts Price quotations:

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Work the Web

You can download lots of basic futures information from the Knowledge Center at:http://www.cbot.com

2002 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

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Option Contracts

A call option gives the owner the right, but not the obligation, to buy an asset, while a put option gives the owner the right, but not the obligation, to sell an asset.

The price you pay 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.

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Option Contracts

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: There is no obligation to buy/sell the underlying

asset. There is a premium associated with the contract.

2002 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

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Option Contracts

Potential gains/losses: Buyers gain if the strike price is better than the

market price, and if the difference is greater than the option premium. In the worst case, buyers lose the entire premium.

Sellers gain the premium if the market price is better than strike price. Here, the gain is limited but the loss is not.

Option Contracts

Price quotations:

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Investing in Stocks versus Options

Example: 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

2002 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

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Investing in Stocks versus Options

Example: …continued 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

2002 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

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Chapter Review

Classifying Securities Interest-Bearing Assets

Money Market Instruments Fixed-Income Securities

Equities Common Stock Preferred Stock Common and Preferred Stock Price Quotes

2002 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

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Chapter Review

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