Overview of Security Types

1. 3 Overview of 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.

3. 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.

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

5. 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 areless than one year. • 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.

6. Money Market Instruments • Examples: U.S. Treasury bills (T-bills), bank certificates of deposit (CDs), corporate and municipal money market instruments. • 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 a discount basis, and only the interest rates are quoted. • Therefore, investors must be able to calculate prices from the quoted rates.

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

8. The price (per $100 face) of the bond when it last traded. You will receive 6.875% of the bond’s face value each year in 2 semi-annual payments. The Yield to Maturity (YTM) of the bond. Quote Example: Fixed-Income Securities • Price quotations from www.wsj.com—the online version ofThe Wall Street Journal (some columns are self-explanatory):

9. 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. • 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.

10. 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.

11. Common Stock Price Quotes

12. First, enter symbol. Resulting Screen Common Stock Price Quotes Onlineat http://finance.yahoo.com

13. 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.

14. 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.

15. Derivatives, II. • 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 not the obligation, to buy or sell a specific asset at a specified price for a set period of time.

16. 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.

17. Futures Contracts: Online Price Quotes Source: Markets Data Center atwww.wsj.com.

18. Futures Price Quotes Online

19. 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.

20. 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 expirationdate. • 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. • Buyers of calls and puts must pay a price today. Holders of futures contracts do not pay for the contract today.

21. 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.

22. 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.

23. Option Contracts: Online Price Quotesfor Hewlett-Packard (HPQ) options Source: www.finance.yahoo.com

24. 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

25. 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

26. Useful Internet Sites • www.nasdbondinfo.com(current corporate bond prices) • www.investinginbonds.com(bond basics) • www.finra.com (learn more about TRACE) • www.fool.com (Are you a “Foolish investor?”) • www.stocktickercompany.com (reproduction stock tickers) • www.cmegroup.com (CME Group) • www.cboe.com(Chicago Board Options Exchange) • finance.yahoo.com(prices for option chains) • www.wsj.com (Online version of The Wall Street Journal)

27. 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

28. Chapter Review, II. • 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