Stock Mkt Investment

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Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

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Security Types


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Security Types

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.


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Classifying Securities

Basic Types Major Subtypes

Interest-bearing

Money market instruments

Fixed-income securities

EquitiesCommon stockPreferred stock

DerivativesOptions

Futures


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Interest-Bearing Assets

Money market instruments are short-term debt obligations oflarge corporations and governments.

These securities promise to make one future payment.

When they are issued, theirlives are less than one year.

Fixed-income securities are longer-term debt obligations ofcorporations or governments.

These securities promise to make fixed payments according to a

pre-set schedule.

When they are issued, theirlives exceed one year.


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Money Market Instruments

Examples: U.S. Treasury bills (T-bills), bank certificates ofdeposit (CDs), corporate and municipal money marketinstruments.

Potential gains/losses:A known future payment/except when

the borrower defaults (i.e., does not pay).

Price quotations: Usually, the instruments are sold on adiscount basis, and only the interest rates are quoted.

Therefore, investors must be able to do calculate prices from thequoted rates.


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Fixed-Income Securities

Examples: U.S. Treasury notes, corporate bonds, carloans, 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

Depending on the debt issue, illiquidity can be a problem.(Illiquidity means it is possible that you cannot sell thesesecurities quickly.)


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Quote Example: Fixed-Income Securities

Price quotations:

NEW YORK BONDSCorporation Bonds

CUR NETBONDS YLD. VOL CLOSE CHG.ATT 61/213 6.6 153 97.75 -0.13ATT 81/822 8.1 651 100.88 +0.25

ATT 81/824 8.0 316 101 -1.50

AT&T, the issuerofthe bond.The bond will mature in

the year 2022.

The annual coupon rate. You will receive 8 1/8% ofthe bondsface value each year in 2 semi-annual coupon payments.


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Quote Example: Fixed-Income Securities

Price quotations:

NEW YORK BO

NDSCorporation Bonds

CUR NETBONDS YLD. VOL CLOSE CHG.ATT 61/213 6.6 153 97.75 -0.13ATT 81/822 8.1 651 100.88 +0.25

ATT 81/824 8.0 316 101 -1.50

Current Yield =Annual Coupon / Current Price

The numberofbonds traded that day.

The closing price for the day is100.875% offace value.

The closing price is upby 0.25 ofone percentfrom the previous day.


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Equities

Common stock: Represents ownership in a corporation. A partowner receives a pro rated share of whatever is left over after all

obligations have been met in the event of a liquidation.

Preferred stock: The dividend is usually fixed and must bepaid before any dividends for the common shareholders. In the

event of a liquidation, preferred shares have a particular face

value.


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Common Stock

Examples: IBM shares, Microsoft shares, Intel shares, etc.

Potential gains/losses:

Many companies pay cash dividends to their shareholders.However, neither the timing nor the amount ofany dividend isguaranteed.

The stock value may rise orfall depending on the prospects forthe company and market-wide circumstances.


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Common Stock Price Quotes


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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 commondividends are distributed.

The stock value may rise orfall depending on the prospects forthe company and market-wide circumstances.


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Derivatives

Primary asset: Security originally sold by a business or government toraise money.

Derivative asset:A financial asset that is derived from an existingtraded 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 contract:An agreement made today regarding the terms of

a trade that will take place later.

Option contract:An agreement that gives the owner the right, but notthe 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 (i.e., S&P 500, T-bonds, foreigncurrencies, and others), commodity futures (i.e., wheat, crude oil,

cattle, and others).

Potential gains/losses: At maturity, you gain ifyour contracted price is better than themarket price ofthe underlying asset, and vice versa.

Ifyou sell your contract before its maturity, you may gain orlose depending on the market price for the contract.

Note that enormous gains and losses are possible.


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Futures Contracts: Price Quotes


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Option Contracts, I.

A call option gives the owner the right, but not the obligation, to

buyan asset, while aput option gives the owner the right, but

not the obligation, to sellan asset.

The price you pay today to buy an option is called the optionpremium.

The specified price at which the underlying asset can be bought

or sold is called the strike price, orexercise price.


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Option Contracts, II.

An American option can be exercised anytime up to and includingthe expiration date, while a European option can be exercised

only on the expiration date.

Options differ from futures in two main ways:

Holders ofcall options have noobligation to buy the underlyingasset.

Holders ofput options have noobligation to sell the underlyingasset.

Toavoid this obligation, buyers ofcalls and puts must pay a pricetoday. Holders offutures contracts do not pay for the contracttoday.


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Option Contracts, III.

Potential gains and losses:

Buyers ofoptions profit ifthe strike price is better than the

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

Sellers ofoptions gain the premium ifthe market price is betterthan strike price. Here, the gain is limited but the loss is not.


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Option Contracts: Price Quotes


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Investing in Stocks versus Options, I.

Stocks:

Suppose you have $10,000 for investments. Macron Technology isselling at $50 per share.

Numberofshares bought = $10,000 / $50 = 200

IfMacron is selling for $55 per share 3 months later, gain = ($55 v200) - $10,000 = $1,000

IfMacron is selling for $45 per share 3 months later, gain = ($45 v200) - $10,000 = -$1,000


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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 alsoavailable at a premium of$4.

A call contract costs $4 v 100 = $400, so numberofcontractsbought = $10,000 / $400 = 25 (for 25 v 100 = 2500 shares)

IfMacron is selling for $55 per share 3 months later, gain = {($55$50) v 2500} - $10,000 = $2,500

IfMacron is selling for $45 per share 3 months later, gain = ($0v

2500) $10,000 = -$10,000


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Useful Internet Sites

www.investinginbonds.com (reference for bond basics)

www.fool.com (reference to see whether you are a Foolishinvestor.)

www.stocktickercompany.com (reference for reproduction stocktickers.)

www.cnbc.com (reference for CNBC TV)

www.cbot.com (ChicagoBoard ofTrade)

www.cme.com (Chicago Mercantile Exchange)

www.nymex.com (New York Mercantile Exchange)

www.cboe.com (ChicagoBoard Options Exchange)


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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


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Stock Mkt Investment