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Overview of Security Types

3. Overview of Security Types. Classifying Securities. Basic Types. Major Subtypes. Interest-bearing. Money market instruments Fixed-income securities. Equities. Common stock Preferred stock. Derivatives. Futures Options. 3- 2. Interest-Bearing Assets.

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Overview of Security Types

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  1. 3 Overview of Security Types

  2. Classifying Securities BasicTypes Major Subtypes Interest-bearing Money market instruments Fixed-income securities Equities Common stock Preferred stock Derivatives Futures Options 3-2

  3. Interest-Bearing Assets All interest-bearing assets are basically loans Categorized by Maturity Money market instruments (< 1 year) Notes (1-10 years) Bonds (> 10 years) 3-3

  4. Interest-Bearing Assets Money market instruments Short-term debt obligations of large corporations and governments One future payment Issued with maturities less than one year Fixed-income securities Longer-term debt obligations of corporations or governments Fixed payments according to a pre-set schedule Issued with maturities exceeding one year 3-4

  5. Money Market Instruments Simplest form of interest-bearing assets Mature in less than one year Trade in large denominations Highly liquid market Sold on a discount basis Prices quoted as a % of face value Most familiar = U.S. Treasury Bill (“T-bill”) 3-5

  6. Treasury Bill Example A 26-week T-Bill is quoted at: Price = 99.15 Investment Rate = 1.718 You pay $10,000 x 99.15% = $9,915 In 26 weeks you receive $10,000 Dollar return = $10,000 - $9,915 = $85 6-month rate of return = $85 ÷$ 9,915 = 0.86% Annualized return = (1.0086)2 -1 = 1.72% 3-6

  7. Fixed-Income Securities Examples: U.S. Treasury notes and bonds Corporate bonds Car and student loans Potential gains/losses: Fixed coupon payments and final payment at maturity, unless borrower defaults Possibility of gain (loss) from fall (rise) in interest rates Liquidity 3-7

  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 of The Wall Street Journal (some columns are self-explanatory):

  9. Corporate Bond Quotes The first bond in the list matures in 2036 Is currently priced at 93.51% of par (discount) Pays an annual coupon rate of 5.875% versus a Yield-to-Maturity of 6.365% Has a current yield of 6.283% = 5.875/93.51 3-9

  10. Treasury Notes & Bonds “Fixed-income securities” Both pay periodic interest payments – coupon payments – over the life of the instrument Price quotes = percent of par… with a unique twist Percentage = 32nds Usually indicated by the colon between the whole percent and the number of 32nds. 3-10

  11. Treasury Note & Bond Quotation 5.000 May 18 95:05 95:07 22 5.51 Coupon rate = 5% Note matures in 2018 Bid price = 95 5/32 % of par Ask price = 95 7/32 % of par Price change = 22/32nds YTM based on Ask price = 5.51% 3-11

  12. Classifying Securities BasicTypes Major Subtypes Interest-bearing Money market instruments Fixed-income securities Equities Common stock Preferred stock Derivatives Futures Options 3-12

  13. Equities Common stock: Represents ownership in a corporation. In the event of liquidation, owner receives pro rated share of whatever is left after all obligations have been met. Preferred stock: Dividend usually fixed Dividend must be paid before any dividends paid to common shareholders. In the event of a liquidation, preferred shares have a particular face value. 3-13

  14. Common Stock Potential gains/losses: Cash dividends paid to shareholders Neither the timing nor the amount of any common stock dividend is guaranteed. Stock value may rise or fall 3-14

  15. Common Stock Price Quotes Fig 3.2

  16. First, enter symbol. Resulting Screen Common Stock Price Quotes Online at http://finance.yahoo.com

  17. Reading Stock Quotes Ticker symbol = HDI YTD price change = +15.6% Change since yesterday’s close = $1.13 Annual dividend = $.40 % YLD = dividend/closing price $.40/ $54.95 PE ratio = 21 Stock closing price = $54.95 3-17

  18. Preferred Stock “Hybrid” security Debt-like qualities Equity characteristics Potential gains/losses: Dividends are “promised” No legal requirement that dividends be paid as long as no common dividends are distributed. The stock value may rise or fall 3-18

  19. Classifying Securities BasicTypes Major Subtypes Interest-bearing Money market instruments Fixed-income securities Equities Common stock Preferred stock Derivatives Futures Options 3-19

  20. Primary vs. Derivative Assets Primary asset: Security providing a direct claim on the assets of the issuer “Primitive asset” Derivative asset: A financial asset whose value is derived from an existing traded asset Value derived from an “underlying asset” 3-20

  21. Futures Contracts A futures contract = an agreement made today regarding the terms of a trade that will take place in the future. Terms include: Price Asset to be delivered Date of delivery Two basic categories of futures contracts: Financial Futures Commodity Futures 3-21

  22. Futures Contracts 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. Enormous gains and losses are possible. 3-22

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

  24. Futures Price Quotes • For the July ’11 contract: • If you bought 2 contracts at the closing price: • The “Last” or closing price was 1293-4 • Prices are quoted in cents and 1/8ths per bushel • 1293-4 = $12.93 +4/8 or $12.935 • 2 contracts = 10,000 bushels x $12.9350/bushel • = $129,350 3-24

  25. U.S. T-Bond Futures • Treasury bond futures are traded on the CBOT with a contract size of $100,000 or multiples thereof. • Prices are quoted in points and one-half of 1/32 of a point. • The December 2010 contract closed at 113’225 which translates to 113 + 22.5/32nds percent or 113.7031% of face value 3-25

  26. Euro Futures • Euro currency futures are traded on the Chicago Mercantile Exchange (CME). • Contract size is 125,000 Euros and prices are quoted in U.S. dollars or USD per Euro. 3-26

  27. Suppose your company will need €1,000,000 in three months to pay for merchandise from Spain. The current exchange rate is $1.60 per Euro. To hedge your position, you could enter into a contract now and in 3 months you’ll pay $1,600,000 for one million Euros. This locks in a future price but it is essentially a bet on the direction of price movements. Hedging withFutures Contracts 3-27

  28. If, in three months, the Euro is selling at $1.65: The company saved by entering into the futures contract: ($1.65-$1.60) x 1,000,000 = $50,000 If the exchange rate in three months is $1.55 per Euro: Hedging has cost the company money: ($1.55 - $1.60) x 1,000,000 =($50,000) Gains & Losses on Futures Contracts 3-28

  29. An option contract is an agreement that gives the owner the right but not the obligation to buy (or sell) a specific asset at a specific price for a specific period of time. Two Types of Options: Call options Put options Two Positions: Buyer = “Holder” = Long position Seller = “Writer” = Short position Options Contracts 3-29

  30. Option Contracts American option: Can be exercised anytime up to and including the expiration date European option: Can be exercised only on the expirationdate 3-30

  31. Options vs. Futures Options holders: Have no obligation to perform Pay a premium Futures contract holders: Pay nothing at origination Are obligated to perform at maturity 3-31

  32. Option Contracts 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: call buyer loses the entire premium. Note: For buyers, losses are limited, gains are not. 3-32

  33. Option Contracts Potential gains and losses from call options: Sellers: Profit when the market price minus the strike price is less than the option premium. Best case: call seller collects the entire premium Worst case: theoretically unlimited losses 3-33

  34. Option Contracts: Online Price Quotesfor Hewlett-Packard (HPQ) options HPQ: $47.80 Call Options: As strike price , Premium  Put Options: As strike price , Premium  Source: www.finance.yahoo.com Fig 3.5

  35. Call Option Price Quotes • Stock option contracts are for 100 shares of stock • Premiums are quoted on a per share basis • With call options: • The lower the strike price, the more valuable the • option, and the higher the premium 3-35

  36. Suppose you believe the price of General Electric is going to rise over the next two to three months. General Electric (common stock) $32.00 3-month call option on GE with a strike price of $35 $ 2.50 You decide to buy 2 call option contracts (for 100 shares each) for an option premium of $2.50 x 200 = $500 This gives you the right over the next 3 months to buy 200 shares of General Electric for $35 per share. Buying a Call Option 3-36

  37. In 3 months, General Electric stock= $40 per share: You exercise your options Buy 200 shares for $35 each = $7,000 Sell them for $40 each = $8,000 Your profit = $8,000 - $7,000 - $500 = $500 In 3 months, General Electric stock = $30 per share: You do NOT exercise your options Your loss = $500 – what you paid for the option contracts Buying & Exercising a Call Option 3-37

  38. PutOption Price Quotes • With put options: • The higher the strike price, the more valuable the option. 3-38

  39. Suppose you believe the price of General Electric is going to fall over the next two to three months. General Electric (common stock) $32.00 3-month put option on GE with a strike price of $25 $ 1.00 You decide to buy 2 put option contracts (for 100 shares each) for an option premium of $1.00 x 200 = $200 This gives you the right over the next 3 months to sell 200 shares of General Electric for $25 per share. Buying a Put Option 3-39

  40. In 3 months, General Electric stock =$20 per share: You exercise your options Buy 200 shares for $20 = $4,000 Sell 200 shares for $25 each = $5,000 Your profit = $5,000 - $4,000 - $200 = $800 In 3 months, General Electric stock =$40 per share: You do NOT exercise your options Your loss = $200 – what you paid for the option contracts Buying & Exercising a Put Option 3-40

  41. Investing in Stocks vs. Options Stocks: Suppose you have $10,000 to invest. 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 3-41

  42. Investing in Stocks vs. Options 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, 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 3-42

  43. Investing in Stocks vs. Options Key Point: When buying an option contract: The most you can lose is the option premium. Your potential gain is unlimited. 3-43

  44. 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)

  45. 3 Chapter End

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