Fundamentals of Investments

1. 3 FundamentalsofInvestments C h a p t e r Security Types Valuation & Management second edition CharlesJ.Corrado BradfordD.Jordan McGraw Hill / Irwin Slides by Yee-Tien (Ted) Fu

2. Goal Security Types Our goal in this chapter is to introduce the different types of securities that are routinely bought and sold in financial markets around the world. • For each security type, we will examine: • its distinguishing characteristics, • the potential gains and losses from owning it, and • how its prices are quoted in the financial press.

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

4. Fixed-income securities Longer-term debt obligations, often of corporations or governments, that promise to make fixed payments according to a preset schedule. Money market instruments Short-term debt obligations of large corporations and governments that mature in a year or less. Interest-Bearing Assets

5. Money Market Instruments • Examples: U.S. Treasury bills (T-bills), bank certificates of deposit (CDs), corporate and municipal money market instruments. • Potential gains/losses: Fixed future payment, except when the borrower defaults. • Price quotations: Usually, the instruments are sold on a discount basis, and only the interest rates are quoted. So, some calculation is necessary to convert the rates to prices.

6. 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. • Can be quite illiquid.

7. The bond will mature in the year 2022. AT&T, the issuer of the bond. CUR NET BONDS YLD. VOL CLOSE CHG. NEW YORK BONDS Corporation Bonds ATT 73/407 …… 7.8 56 100 + 1/4 ATT 81/822 …… 8.6 433 94 1/8 + 5/8 ATT 81/824 …… 8.7 453 93 3/4 – 81/8 22 ATT The bond’s annual coupon rate. You will receive 81/8% of the bond’s face value each year in 2 semiannual coupon payments. Fixed-Income Securities • Price quotations:

8. The closing price for the day is 94.125% of face value. Current yield =annual coupon current price CUR NET BONDS YLD. VOL CLOSE CHG. NEW YORK BONDS Corporation Bonds ATT 73/407 …… 7.8 56 100 + 1/4 ATT 81/822 …… 8.6 433 94 1/8 + 5/8 ATT 81/824 …… 8.7 453 93 3/4 – 8.6 941/8 + 5/8 433 The actual number of bonds traded that day. The closing price is up by 5/8 of 1% from the previous closing price. Fixed-Income Securities • Price quotations:

9. Work the Web • Check out bond basics at: • http://www.investinginbonds.com

10. 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. 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. Equities

11. Common Stock • Examples: IBM shares, Microsoft 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.

12. 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 common dividends are distributed. • The stock value may rise or fall depending on the prospects for the company and market-wide circumstances.

13. 3 - 13 Equities : Price quotations McGraw Hill / Irwin @2002 by the McGraw- Hill Companies Inc.All rights reserved.

14. Work the Web • Are you a Foolish investor? Go to “Fool School” at: • http://www.fool.com • You can also learn more about the “ticker tape” at: • http://www.stocktickercompany.com • and create your own ticker at: • http://www.cnbc.com

15. 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. Derivatives

16. 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. Derivatives

17. Futures Contracts • Examples: financial futures, commodity futures. • 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/losses are possible.

18. 3 - 18 Futures Contracts • Price quotations: McGraw Hill / Irwin @2002 by the McGraw- Hill Companies Inc.All rights reserved.

19. Work the Web • You can download lots of basic futures information from the Knowledge Center at: • http://www.cbot.com

20. Option Contracts • A call option gives the owner the right, but not the obligation, to buy an asset, while a put option gives the owner the right, but not the obligation, to sell an asset. • The price you pay 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.

21. Option Contracts • 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: • There is no obligation to buy/sell the underlying asset. • There is a premium associated with the contract.

22. Option Contracts • Potential gains/losses: • Buyers gain if the strike price is better than the market price, and if the difference is greater than the option premium. In the worst case, buyers lose the entire premium. • Sellers gain the premium if the market price is better than strike price. Here, the gain is limited but the loss is not.

23. 3 - 23 Option Contracts • Price quotations: McGraw Hill / Irwin @2002 by the McGraw- Hill Companies Inc.All rights reserved.

24. Investing in Stocks versus Options Example: • 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 Example: …continued • 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. Chapter Review • Classifying Securities • Interest-Bearing Assets • Money Market Instruments • Fixed-Income Securities • Equities • Common Stock • Preferred Stock • Common and Preferred Stock Price Quotes

27. Chapter Review • 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