Chapter 14 Investment Alternatives and Trading Fixed-Income Securities You are a LENDER to the...

Chapter 14Investment Alternatives and Trading

• Fixed-Income SecuritiesYou are a LENDER to the issuer of the security

Your return is a fixed amount of income over a fixed amount of time (interest payments on bonds)– Motivation for buying is INCOME

– All mature to a fixed amount

– Lenders have rights if borrower defaults


• All fixed-income securities eventually mature for fixed amount

– The maturity amount is called the par value or face value

– This amount is fixed regardless of what the security sold for prior to maturity


• Types of Fixed-Income SecuritiesMoney market instruments -- Mature within a

year

Bonds -- Mature anywhere from two to twenty years or even longer


• Money Market Instruments– A discount security sold for less than its face

value– When security matures, lender receives full

face value– Lender’s return based on the difference

between the price paid and the face value– Little or no default risk


• BondsA fixed-income security with maturity date

when issued greater than one year– Bonds are NOT discounted securities

– Most bonds pay regular, fixed amount of interest twice a year

– Interest is calculated as a percentage of the face value called the coupon rate (simple interest)


• Bonds--Callable FeatureMost bonds are “callable”

– This means issuer can buy back the bonds from investors

– Bonds are re-purchased prior to maturity date and at pre-specified prices

– Likely to be recalled when interest rates are low or falling


• Differences Between Bonds and Money Market InstrumentsLength of MaturityHow Returns Are EarnedCallable FeatureSafety (Ratings)


• Treasury Notes and Bonds– Issued by the U.S. Treasury– Both have fixed coupon rates– Both have face values of $1,000 to $5,000• T-Notes have much shorter maturities

than T-Bonds• T-Bonds are callable starting five years

from date of maturity; T-Notes aren’t


• Municipal BondsIssued by state and local governmental units:

Two types: General obligation• Backed by full faith and credit of issuing state

• General tax revenues can be used to pay bondholders


• Municipal Bonds Revenue• Issued to pay for a project like a new road

• Only revenues generated from the project are used to repay bondholder

Tax status– Exempt from federal income tax – NOT exempt from state income tax


• Bond RatingsRatings range from AAA (best) to D (in

default)

Bond with rating of B or above considered investment grade (fairly low risk of default)


• Corporate BondsIssued by U.S. and foreign corporations to • Finance expansions

• Finance acquisitionsInterest is subject to federal, state taxes


• Bond PricingDepending on the interest rate used to

discount future cash payments, a bond may sell for • Face value

• Less than face value

The interest rate used is called the bond’s “yield to maturity”


• Stock Investing– People invest in stock• In the hope that the price of the stock will

increase with company profit growth

• For the quarterly cash payments (dividends) which they may receive

– Return on stock based on both price appreciation and income (dividends)


• Types of Stocks– Blue Chip– Income– Growth– Speculative– Cyclical– Defensive


• Valuing Common StockTwo common questions which investors ask:How much am I willing to pay for this stock?At what price should I sell?


• Criteria in Valuing Common StockCurrent level of earningsCurrent level of dividendsExpected growth rate of earnings and

dividendsUncertainty about the growth rate in

earnings and dividendsLevel of interest rates


• Finding Information About StocksInvestor advisory services (like Standard & Poor’s)

given in-depth analysis of stock.

Their reports cover:

• Summary of company’s business

• Financial performance (for prior 5-10 yrs.)

• Prospects for the future (general business forecasts)

• Assessment of the stock


• Measures of Financial StrengthReturn on EquityEarnings per SharePrice/Earnings RatioBeta


• Real Estate– Home ownership may not be as good an

investment as it has been in the past– Returns from real estate have lagged behind

stocks and bonds on occasion (not this year)


• Exotic Investments: OptionsGives owner the right to buy or sell stock at

a fixed price over a fixed period of timeDepending on what happens to stock, an

option can go up or down in valueInvestor does NOT have to exercise the

option, but will still be charged a fee


• Options Example– If investor owns option to purchase a certain

stock at $40/share:

• Option is VALUABLE if the price rises to $55/share

• Option has LITTLE VALUE if price falls to $35/share


• Exotic Investments: Futures– A real contract between two parties that

calls for future delivery of some asset at a set price

– Contracts can be on: • Agricultural commodities• Precious metals • Petroleum products• Currencies


• Exotic Investments: Real assets and collectibles– Includes gold, silver, diamonds, great works

of art– All of returns come from price appreciation– Considerably more risky than investing in

stocks, bonds, or real estate


• Characteristics of Efficient MarketsSufficient information determining

underlying supply and demand• Is available to all participants

• Is available at about the same time

Trading takes place in full view of all market participants


• Characteristics of Efficient MarketsOne can buy or sell • At a price close to that of the most recent, similar

trade, assuming there is no new information

Transactions costs as a percentage of the security being bought or sold are low


• Characteristics of Efficient MarketsAll participants have equal access to market

• No investor can execute buy or sell orders faster than any other investor (No Arbitrage Opport.)

Prices adjust quickly to new public information.

• This information is available

– To all participants

– At about the same time


• Types of Financial Markets Primary market

• A market where investors buy newly issued securities

• The issuer ( perhaps a corporation) receives the proceeds from the security sale

– Example: Someone buys a T-bill from the U.S. Treasury or Shares of a Corporation in an IPO from the company.


• Types of Financial Markets Secondary financial market• A market where trading between investors

involves previously issued securities

• The original issuer is not directly affected by these transactions– Example: The New York Stock Exchange


• New York Stock ExchangeThe oldest stock market in the U.S.

More than 2,500 stocks traded

• Represent most of the largest, best-known corporations in America

Stocks traded have a total market value over $5 trillion

Companies must apply for listing to trade on NYSE


• The NASDAQ Stock MarketLargest, best-organized over-the-counter

market for stocks in the U.S.More than 5,000 stock issues trade on this

marketCompanies tend to be smaller and less well-

known than those in the NYSE


• The NASDAQ Stock Market– Trading takes place through the network;

Buyers and sellers never see each other– Buy and sell orders executed electronically– Maintains at least two market makers• Similar to specialists in NYSE• Buy and sell from their inventories to maintain

orderly market


• Selecting a Brokerage Firm– You must determine if you want a • Full-service firm

• Discount firm


• Full-Service FirmsOffer investment advice and

recommendations

Have access to reports written by analysts within the firm

Have lists of recommended securities

Assign specific brokers who are paid on commission to each client


• Discount FirmsProvide mainly execution order and record-

keeping servicesAlso provide investment information from

independent sources

Many brokers may deal with one client

Brokers work on salary instead of commission


• Types of Orders: MarketThe most common type of orderInstructs broker to obtain the best possible

price for youHighest if you are sellingLowest if you are buying

Most market orders are filled within one to two minutes


• Types of Orders: LimitEstablishes a limit to the price at which you

will buy or sell

A ceiling if you are buying A floor if you are selling

Can be valid for one day, one week, one month, or until it is canceled


• Reasons for Good Investment Record Keeping

– Tax Purposes

– Performance Tracking

Chapter 14 Investment Alternatives and Trading Fixed-Income Securities You are a LENDER to the...

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