INVESTMENT INVESTMENT ALTERNATIVESALTERNATIVES

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CHAPTER (1) : 1 , 2 , 5 and 13CHAPTER (1) : 1 , 2 , 5 and 13 CHAPTER (2) : 1 , 4 , 12 and 26 CHAPTER (2) : 1 , 4 , 12 and 26

(Questions)(Questions)

Suggested topics for the Suggested topics for the paperpaper

SecuritizationSecuritization Primary dealersPrimary dealers IOSCO principlesIOSCO principles Corporate governanceCorporate governance Short selling and marginal tradingShort selling and marginal trading Derivatives (Options and Futures)Derivatives (Options and Futures) Stock Exchange demutualizationStock Exchange demutualization Role of stock exchange in attracting FDIRole of stock exchange in attracting FDI Capital Markets IntegrationCapital Markets Integration

Organizing financial Organizing financial assetsassets

Investment

Direct Indirect

Non-Marketable

Capital Market

Money Market

Derivatives Market

Fixed Income securities

Equity securities

Options

Futures

Indirect InvestmentIndirect Investment

The buying and selling of the shares of The buying and selling of the shares of investment companies which in turn hold investment companies which in turn hold portfolio of securities. portfolio of securities.

Rather than investing directly in securities, Rather than investing directly in securities, investors can invest in a portfolio of securities investors can invest in a portfolio of securities by purchasing the shares of financial by purchasing the shares of financial intermediary that invests in various types of intermediary that invests in various types of securities on behalf of its shareowners. securities on behalf of its shareowners.

Examples for investment companies: Examples for investment companies: Money market mutual fundMoney market mutual fund Stock, bond and income fundsStock, bond and income funds

Direct InvestmentDirect Investment

Investors buy and sell securities Investors buy and sell securities themselves, typically through themselves, typically through brokerage accounts.brokerage accounts.

Investors can do both, investing Investors can do both, investing directly through the use of a directly through the use of a brokerage accounts and investing brokerage accounts and investing indirectly in one or more investment indirectly in one or more investment companies. companies.

Non-marketable financial Non-marketable financial assetsassets

15% of total financial assets of US 15% of total financial assets of US households is in the form of deposits. households is in the form of deposits.

These assets represent personal These assets represent personal transactions between the owner and the transactions between the owner and the issuer. In contrast, marketable issuer. In contrast, marketable securities trade in impersonal markets-securities trade in impersonal markets-the buyer does not know the seller. the buyer does not know the seller.

These are safe investments and offer the These are safe investments and offer the ultimate in liquidity which is the ease ultimate in liquidity which is the ease with which an asset can be converted to with which an asset can be converted to cash.cash.

Money market securitiesMoney market securities

This is the market for short-term, This is the market for short-term, highly liquid, low-risk assets. They highly liquid, low-risk assets. They are short-term, highly marketable are short-term, highly marketable investments with an extremely low investments with an extremely low probability of default.probability of default.

The size of transactions in the The size of transactions in the money market is large ($100,000) money market is large ($100,000) and the maturities range from one and the maturities range from one day to one year.day to one year.

Capital marketsCapital markets

Money market instruments are short-Money market instruments are short-term, highly liquid, low risk securities term, highly liquid, low risk securities while capital market instruments are while capital market instruments are long-term instruments of higher risk long-term instruments of higher risk and varying degrees of liquidity.and varying degrees of liquidity.

Capital markets encompass fixed Capital markets encompass fixed income and equity securities with income and equity securities with maturities greater than one year.maturities greater than one year.

Equity securities have no maturity date.Equity securities have no maturity date.

Fixed-income securities Fixed-income securities

All of these securities have a specified All of these securities have a specified payment schedule.payment schedule.

Bonds are long-term debt instruments Bonds are long-term debt instruments representing the issuer’s contractual representing the issuer’s contractual obligation.obligation.

For fixed-income securities, the interest For fixed-income securities, the interest payments and the principle repayment payments and the principle repayment are specified at the time of issuing and are specified at the time of issuing and fixed for the life of the bonds.fixed for the life of the bonds.

BondsBonds Coupon Bond Coupon Bond The purchaser pays the The purchaser pays the

parparvalue (the redemption value (the redemption

value of a bond) and value of a bond) and this bond matures on this bond matures on a specified date a specified date where the issuer pays where the issuer pays periodic coupon to periodic coupon to the holder until the holder until maturity at which maturity at which time the principle will time the principle will be paidbe paid

Zero-Coupon BondZero-Coupon BondA bond sold with no A bond sold with no

coupons at a coupons at a discount and discount and redeemed for par redeemed for par value at maturity.value at maturity.

It gives the issuer the right to call in It gives the issuer the right to call in a security and retire it by paying off a security and retire it by paying off the obligation.the obligation.

It is attractive to issuer when It is attractive to issuer when interest rate drop sufficiently below interest rate drop sufficiently below coupon rate.coupon rate.

Call provisionCall provision

Bonds

Federal government securities

Government agency

securities

Municipal securities

Corporate

Federal Credit

agencies

GovernmentSponsoredagencies

GeneralObligation

bonds

Revenuebonds

Senior

Debenture

Convertible

Federal government Federal government securitiessecurities

The US government in the course of The US government in the course of financing its operations through the financing its operations through the Treasury department, issues Treasury department, issues numerous bonds with maturities numerous bonds with maturities greater than one year. greater than one year.

It is considered the safest credit It is considered the safest credit risk.risk.

Treasury bonds generally have Treasury bonds generally have maturities of 10 to 30 years. maturities of 10 to 30 years.

Government agency Government agency securitiessecurities

Two types of federal credit agencies:Two types of federal credit agencies: Federal agenciesFederal agencies

These are part of the federal government These are part of the federal government and their securities are fully guaranteed by and their securities are fully guaranteed by the treasurythe treasury

Federally sponsored credit agenciesFederally sponsored credit agencies These are privately owned institutions that These are privately owned institutions that

sell their own securities in the marketplace sell their own securities in the marketplace to raise funds for their specific purpose. to raise funds for their specific purpose. These securities are not guaranteed by the These securities are not guaranteed by the government.government.

Municipal securitiesMunicipal securities

Bonds sold by states, counties, cities and other Bonds sold by states, counties, cities and other political entities. political entities.

Two types of municipals are:Two types of municipals are: General obligation bonds which are backed by the General obligation bonds which are backed by the

full faith and credit of the issuer.full faith and credit of the issuer. Revenue bonds which are repaid from the revenues Revenue bonds which are repaid from the revenues

generated by the project they were sold to finance generated by the project they were sold to finance (toll road)(toll road)

A term bond has a specified maturity date in A term bond has a specified maturity date in the future for the entire issue while with a the future for the entire issue while with a serial bond, a certain percentage of the issue serial bond, a certain percentage of the issue matures each year.matures each year.

Municipal securitiesMunicipal securities

Most municipals are exempted from federal Most municipals are exempted from federal tax.tax.

The rate on these bonds will be lower than The rate on these bonds will be lower than that on none-exempted bonds. that on none-exempted bonds.

The higher an investor’s tax bracket, the The higher an investor’s tax bracket, the more attractive municipals become.more attractive municipals become.

To make the return on these bonds To make the return on these bonds comparable to those of taxable bonds, the comparable to those of taxable bonds, the taxable equivalent yieldtaxable equivalent yield (TEY) can be (TEY) can be calculated.calculated.

Municipal securitiesMunicipal securities

ratetaxinalm

yieldmunicipalexemptTaxTEY

arg1

Example on taxable Example on taxable equivalent yieldequivalent yield

An investor in the 28 percentage An investor in the 28 percentage marginal tax bracket who invests in marginal tax bracket who invests in a 5 percent municipal bond would a 5 percent municipal bond would have to receivehave to receive

0.05 / (1 - 0.28) = 6.94%0.05 / (1 - 0.28) = 6.94%

From a comparable taxable bond to be From a comparable taxable bond to be as well off.as well off.

CorporateCorporate Most of large corporations issue corporate Most of large corporations issue corporate

bonds to help finance their operations. bonds to help finance their operations. Corporate bonds are:Corporate bonds are:

Senior securities: they are senior to any Senior securities: they are senior to any preferred and common stocks in terms of preferred and common stocks in terms of priority of payment. priority of payment.

Debenture securities: a bond backed only by Debenture securities: a bond backed only by the issuer’s overall financial soundness.the issuer’s overall financial soundness.

Convertible bonds: the bonds are turned in to Convertible bonds: the bonds are turned in to the corporation in exchange for a specified the corporation in exchange for a specified number of common shares with no cash number of common shares with no cash payment required. payment required.

Asset-backed securitiesAsset-backed securities Securitization is the transformation of illiquid, Securitization is the transformation of illiquid,

risky individual loan into more liquid, less risky risky individual loan into more liquid, less risky securities referred to as asset-backed securities securities referred to as asset-backed securities (ABS)(ABS)

ABS issued against some type of asset linked ABS issued against some type of asset linked debt bundled together.debt bundled together.

Marketable securities have been backed by car Marketable securities have been backed by car loans, credit card receivables.loans, credit card receivables.

ABS is attractive because it has relatively high ABS is attractive because it has relatively high yields and relatively short maturity.yields and relatively short maturity.

Securitization works best when packaged loans Securitization works best when packaged loans are homogenous, so that income stream and are homogenous, so that income stream and risks are more predictable.risks are more predictable.

Rates on fixed-income Rates on fixed-income securitiessecurities

Applying the risk-return tradeoff.Applying the risk-return tradeoff. Interest rates on corporate bond Interest rates on corporate bond

exceeds treasury rates because of exceeds treasury rates because of the possible risk of default.the possible risk of default.

Lowe - corporate yields more Lowe - corporate yields more than do highe - bonds. than do highe - bonds.

Example from Egyptian Example from Egyptian Stock Exchange for 1996 – Stock Exchange for 1996 –

May 2003May 2003Number of issues for Number of issues for Government bondsGovernment bonds 88

Value of Government Value of Government bonds issuedbonds issued 13 Billions13 Billions

Number of issues for Number of issues for Corporate bondsCorporate bonds 4242

Value of Corporate Value of Corporate bonds issuedbonds issued 7.4 Billions7.4 Billions

Equity SecuritiesEquity Securities

Equity securities represent an Equity securities represent an ownership interest in a corporation ownership interest in a corporation and a claim on the income and and a claim on the income and assets.assets.

Two forms of equities: Preferred Two forms of equities: Preferred stock and Common stocks.stock and Common stocks.

Preferred stock.Preferred stock. It resembles both equity and fixed-It resembles both equity and fixed-

income instruments. income instruments.

Equity SecuritiesEquity Securities

Preferred stockPreferred stock It has an infinite life and pays dividend like It has an infinite life and pays dividend like

equity securities.equity securities. This dividend is fixed in amount and known in This dividend is fixed in amount and known in

advance, providing stream of income similar to advance, providing stream of income similar to bonds.bonds.

The stream of income continue forever unless The stream of income continue forever unless the issue is called.the issue is called.

Preferred stockholders are paid after the Preferred stockholders are paid after the bondholders but before the common bondholders but before the common stockholders in case of priority of payment of stockholders in case of priority of payment of income or liquidation.income or liquidation.

Equity securitiesEquity securities

Common stock.Common stock. An equity security representing the ownership An equity security representing the ownership

interest in a corporation.interest in a corporation. If a firm’s shares are held by only few If a firm’s shares are held by only few

individuals, the firm is said to be closely held. individuals, the firm is said to be closely held. Most companies choose to go public.Most companies choose to go public.

Dividends are the only cash payments regularly Dividends are the only cash payments regularly made by corporations to their stockholders.made by corporations to their stockholders.

Dividend yield is the income component of a Dividend yield is the income component of a stock’s return. It is calculated as dividends stock’s return. It is calculated as dividends divided by current stock price.divided by current stock price.

Equity securitiesEquity securities

Common stockCommon stock A stock split involves the issuance of a A stock split involves the issuance of a

larger number of shares in proportion larger number of shares in proportion to the existing shares outstanding. to the existing shares outstanding.

Derivatives securitiesDerivatives securities

Options and futures contracts are Options and futures contracts are two types of derivatives securities.two types of derivatives securities.

They are important to investors They are important to investors because they provide a way for because they provide a way for investors to manage portfolio risk.investors to manage portfolio risk.

A futures contract is an obligation to A futures contract is an obligation to buy or sell, but an options contract buy or sell, but an options contract is only the right to do so.is only the right to do so.

Derivative securitiesDerivative securities

Options refers to puts and calls.Options refers to puts and calls. Puts is an option to sell a specified Puts is an option to sell a specified

number of shares of stock at a stated number of shares of stock at a stated price within a specified period, while price within a specified period, while calls is an option to buy.calls is an option to buy.

A future contract is an agreement that A future contract is an agreement that provides for the future exchange of a provides for the future exchange of a particular asset between a buyer and a particular asset between a buyer and a seller at a currently determined market seller at a currently determined market price.price.

Example on optionsExample on options

Assume on October 1, Compaq computer Assume on October 1, Compaq computer closed at $27 5/8 and that a December closed at $27 5/8 and that a December call option with a price of $25 is available. call option with a price of $25 is available.

Intrinsic value of the call = 27 5/8 – Intrinsic value of the call = 27 5/8 – 25=$2 5/825=$2 5/8

Time value of the call = Option price – Time value of the call = Option price – Intrinsic value.Intrinsic value.

= 3 ½ - 2 5/8 = $ 7/8= 3 ½ - 2 5/8 = $ 7/8

Option price = Intrinsic value + time value Option price = Intrinsic value + time value