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. 2
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
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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
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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
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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
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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. 10
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11
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U.S. National Debt 12
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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
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Fixed-Income Price Quotes What Does Trade Reporting And
Compliance Engine - TRACE Mean? A program developed by the National
Association of Securities Dealers (NASD) which allows for the
reporting of over-the-counter (OTC) transactions pertaining to
eligible fixed-income securities. Brokers, who are NASD members and
deal with specific fixed- income securities, are required to report
their transactions by Securities and Exchange Commission (SEC)
rules. 14
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Quote Example: Fixed-Income Securities Price quotations from
www.wsj.comthe online version of The Wall Street Journal (some
columns are self-explanatory):www.wsj.com You will receive 6.875%
of the bonds 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. 15
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Interest rates : Market data from WSJ 16
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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
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EQUITIES 18
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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. 19
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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. 20
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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. 21
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Common Stock Price Quotes 22
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Common Stock Price Quotes Online at
http://finance.yahoo.comhttp://finance.yahoo.com First, enter
symbol. Resulting Screen 23
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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 24
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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. 25
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Preferred Stock Information is a bit harder to find for
preferred stock versus common stock. Example: Citigroup preferred
stock, Bank of America (BAC) preferred stock Find all the BAC
preferred stock issues via a Google searchone source is:
quantumonline.com.quantumonline.com One issue has a ticker of:
BAC-J (BAC-PJ is its symbol at Yahoo!) Potential gains/losses:
Dividends are promised. However, there is no legal requirement that
the dividends be paid, as long as no dividends from common stock
are distributed. The stock value may rise or fall depending on the
prospects for the company and market-wide circumstances. 26
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DERIVATIVES 27
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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. 28
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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. 29
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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. 30
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Futures Contracts: Online Price Quotes Source: Markets Data
Center at www.wsj.com. www.wsj.com 31
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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 110-02 per $100 of par value, where the 02
represents 2/32. It represents a price of $110,062.50 per $100,000
face value. No money changes hands today between a buyer and
seller. Upon maturity, your T-bonds will be delivered. Or, you can
close out the contract before the maturity date by taking the
opposite date, thereby canceling your current position. More
details will be presented in more advanced classes. 32
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Example continued 33
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Futures Price Quotes Online 34
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Mexican Peso Futures, US$/Peso (CME)
MaturityOpenHighLowSettleChangeHighLow Open Interest
Mar.10953.10988.10930.10958---.11000.0977034,481
June.10790.10795.10778.10773---.10800.097303,405
Sept.10615.10610.10573---.10615.099301,418 All contracts are for
500,000 new Mexican pesos. Open, High and Low all refer to the
price on the day. Settle is the closing price on the day and Change
indicates the change in the settle price from the previous day.
High and Low to the right of Change indicates the highest and
lowest prices for this specific contact during its trading history.
Open Interest refers to the number of contracts outstanding for a
particular delivery monthits a good proxy for demand for a
contract. Notice that open interest is greatest in the nearby
contract. In general, open interest typically decreases with term
to maturity of most futures contracts. The holder of a March long
position is committing himself to pay $.10958 per euro for peso
500,000a $54,790 position. As there are 34,481 such contracts
outstanding, this represents a notational principal of over $1.8
billion! 35
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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. 36
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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.
37
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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. 38
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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. 39
Investing in Stocks versus Options, I. Stocks: 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 41
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The New Method to Decode Option Symbols In 2010, a new option
symbol system was introduced. The symbols expand from 5 letters to
20 letters and numbers. The stated goal is to reduce confusion by
explicitly stating: the underlying stock symbol option expiration
date whether the option is a call or a put the dollar part of the
strike price the decimal part of the strike price We do not know
whether quadrupling the size of the ticker will reduce confusion.
42
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Investing in Stocks versus Options, II. Options: 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
43
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More Example: Put Option 44
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More Example 45
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Useful Internet Sites www.nasdbondinfo.com (current corporate
bond prices)www.nasdbondinfo.com www.investinginbonds.com (bond
basics)www.investinginbonds.com www.finra.com (learn more about
TRACE)www.finra.com www.fool.com (Are you a Foolish
investor?)www.fool.com www.stocktickercompany.com (reproduction
stock tickers)www.stocktickercompany.com www.cmegroup.com (CME
Group)www.cmegroup.com www.cboe.com (Chicago Board Options
Exchange)www.cboe.com finance.yahoo.com (prices for option
chains)finance.yahoo.com www.wsj.com (Online version of The Wall
Street Journal)www.wsj.com 46
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Chapter Review, I. Classifying Securities Interest-Bearing
Assets Money Market Instruments Fixed-Income Securities Equities
Common Stock Preferred Stock Common and Preferred Stock Price
Quotes 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 47
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Preferred stock is a derivative security. A) True B) False
48
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The current yield is equal to the annual interest divided by
the current bond price. A) True B) False 49
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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 50
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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 51
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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 52
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A round lot is: A) one bond. B) 100 bonds. C) 10 shares of
stock. D) 100 shares of stock. E) 1,000 shares of stock. 53
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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. 54
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NetPrevLimit ExpLastChgOpenHighLowCloseSettle HiLow 06Jul602 '
2-2 ' 4604 ' 4604 ' 6601 ' 4602 ' 0602 ' 2604 ' 6627 ' 6581 ' 4
06Sep613 ' 6-6 ' 6618 ' 0619 ' 2610 ' 2613 ' 4613 ' 6620 ' 4641 '
2588 ' 6 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 A) $480.00 remember that
prices are quoted in cents and eights of a cent B) $487.50 C)
$2,312.50 D) $6,930.00 E) $6,937.50 $5.815*5,000 bushels *3
contracts, $6.2775*5,000*3 55
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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. 56
