ChapterChapter 22Investment

Alternatives

Describe the major types of financial assets Describe the major types of financial assets and how they are organized.and how they are organized.

Explain what non-marketable financial assets Explain what non-marketable financial assets are.are.

Describe the important features of money Describe the important features of money market and capital market securities.market and capital market securities.

Distinguish among preferred stock, income Distinguish among preferred stock, income trusts, and common stock.trusts, and common stock.

Understand the basics of options and futures.Understand the basics of options and futures.

Learning ObjectivesLearning Objectives

Savings deposits Savings deposits Canada Savings Bonds (CSBs) Canada Savings Bonds (CSBs)

http://www.csb.gc.ca/eng/bonds.asphttp://www.csb.gc.ca/eng/bonds.asp Guaranteed Investment Guaranteed Investment

Certificates (GICs)Certificates (GICs) Commonly owned by individualsCommonly owned by individuals Represent direct exchange of Represent direct exchange of

claims between issuer and investorclaims between issuer and investor Usually “safe” investments which Usually “safe” investments which

are easy to convert to cash without are easy to convert to cash without loss of valueloss of value

Non-Marketable Non-Marketable Financial AssetsFinancial Assets

Examples: Examples: Treasury bills, commercial Treasury bills, commercial paper, Eurodollars, repurchase paper, Eurodollars, repurchase agreements, banker’s acceptances agreements, banker’s acceptances (B/As)(B/As)

Marketable: claims are negotiable or Marketable: claims are negotiable or saleable in the marketplacesaleable in the marketplace

Short-term, liquid, relatively low-risk Short-term, liquid, relatively low-risk debt instrumentsdebt instruments

Issued by governments and private firmsIssued by governments and private firms

Money Market SecuritiesMoney Market Securities

Treasury BillsTreasury Bills:: Short-term promissory notes issued by Short-term promissory notes issued by

governments governments T-bills accounted for about one-half of all T-bills accounted for about one-half of all

outstanding money market securities.outstanding money market securities. Sold at a discount from face value in Sold at a discount from face value in

denominations of $5,000, $25,000, 100,000, denominations of $5,000, $25,000, 100,000, and $1 million and $1 million

Typical maturities are 91, 182, and 364 days Typical maturities are 91, 182, and 364 days although shorter maturities are also offeredalthough shorter maturities are also offered

Treasury Bills (T-bills)Treasury Bills (T-bills)

Treasury Bills:Treasury Bills: Due to government backing, there is a Due to government backing, there is a

very low risk of default very low risk of default Widely distributed and actively traded – Widely distributed and actively traded –

high liquidityhigh liquidity In subsequent chapters we will use In subsequent chapters we will use

government T-bill rates as a measure of government T-bill rates as a measure of the “riskless rate” available to investors, the “riskless rate” available to investors, commonly referred to as the risk-free ratecommonly referred to as the risk-free rate

Treasury Bills (T-bills)Treasury Bills (T-bills)

Commercial PaperCommercial Paper:: Short-term unsecured promissory Short-term unsecured promissory

notes issued by large, well-known, notes issued by large, well-known, and financially strong corporations and financially strong corporations (including finance companies)(including finance companies)

Denominations start at $100,000 Denominations start at $100,000 with maturities of 30 to 365 days, with maturities of 30 to 365 days, and it is sold either directly by the and it is sold either directly by the issuer or indirectly through a dealer, issuer or indirectly through a dealer, with rates slightly above T-bill rates. with rates slightly above T-bill rates.

Commercial PaperCommercial Paper

Eurodollars:Eurodollars: Dollar-denominated deposits held in Dollar-denominated deposits held in

foreign banks or in offices of Canadian foreign banks or in offices of Canadian banks located abroadbanks located abroad

Although this market originally developed Although this market originally developed in Europe, dollar-denominated deposits in Europe, dollar-denominated deposits can now be made in many countries, such can now be made in many countries, such as those of Asiaas those of Asia

Consist of both time deposits and Consist of both time deposits and certificates of deposit (CDs), with the certificates of deposit (CDs), with the latter constituting the largest component latter constituting the largest component of the Eurodollar marketsof the Eurodollar markets

Maturities are mostly short-term, often Maturities are mostly short-term, often less than six monthsless than six months

EurodollarsEurodollars

Repurchase Agreements (RPs):Repurchase Agreements (RPs): agreements between a borrower and lender agreements between a borrower and lender

(typically institutions) to sell and repurchase (typically institutions) to sell and repurchase money market securitiesmoney market securities

borrower initiates an RP by contracting to borrower initiates an RP by contracting to sell securities to a lender and agreeing to sell securities to a lender and agreeing to repurchase these securities at a pre-specified repurchase these securities at a pre-specified (higher) price on a stated future date(higher) price on a stated future date

maturity is generally very short, from 3 to 14 maturity is generally very short, from 3 to 14 days, and sometimes overnightdays, and sometimes overnight

minimum denomination is typically $100,000minimum denomination is typically $100,000

Repurchase AgreementsRepurchase Agreements

Bankers Acceptances (B/As):Bankers Acceptances (B/As): Time drafts drawn on a bank by a Time drafts drawn on a bank by a

customer, whereby the bank agrees to customer, whereby the bank agrees to guarantee payment of a particular amount guarantee payment of a particular amount at a specified future dateat a specified future date

Differ from commercial paper because the Differ from commercial paper because the associated payments are guaranteed by a associated payments are guaranteed by a bank, and thus possess the credit risk bank, and thus possess the credit risk associated with that bankassociated with that bank

Issued in minimum denominations of Issued in minimum denominations of $100,000$100,000

Typical maturities range from 30 to 180 Typical maturities range from 30 to 180 days, with 90 days being the most common days, with 90 days being the most common

Bankers AcceptancesBankers Acceptances

Marketable debt with maturity greater Marketable debt with maturity greater than one yearthan one year

More risky than money market More risky than money market securitiessecurities

Fixed-income securities have a Fixed-income securities have a specified payment schedulespecified payment schedule Dates and amount of interest and principal Dates and amount of interest and principal

payments known in advance payments known in advance

Fixed-Income SecuritiesFixed-Income Securities

Bonds Bonds – long-term debt instruments– long-term debt instruments Major bond types:Major bond types:

Government of Canada bonds Government of Canada bonds U.S. Treasury bondsU.S. Treasury bonds Provincial bondsProvincial bonds Provincially-guaranteed bonds – Provincially-guaranteed bonds –

Ontario HydroOntario Hydro U.S. federal agency securities – GNMAs U.S. federal agency securities – GNMAs

(Ginnie Maes), FNMAs (Fannie Maes)(Ginnie Maes), FNMAs (Fannie Maes)

Fixed-Income SecuritiesFixed-Income Securities

Major bond types (cont’d):Major bond types (cont’d): Corporate bondsCorporate bonds

Usually pay semi-annual interest, are Usually pay semi-annual interest, are callable, carry a sinking fund provision, callable, carry a sinking fund provision, and have a par value of $1,000and have a par value of $1,000

Convertible bonds may be exchanged for Convertible bonds may be exchanged for another assetanother asset

Risk that issuer may default on paymentsRisk that issuer may default on payments

Fixed-Income SecuritiesFixed-Income Securities

Callable bondsCallable bonds give the issuer the option to give the issuer the option to ““callcall” or repurchase outstanding bonds at ” or repurchase outstanding bonds at predetermined “call” prices (generally at a predetermined “call” prices (generally at a premium over par) at specified times premium over par) at specified times

This feature is detrimental to the This feature is detrimental to the bondholders who are willing to pay less for bondholders who are willing to pay less for them (i.e., they demand a higher return) them (i.e., they demand a higher return) than for similar non-callable bonds. than for similar non-callable bonds.

Generally, the issuer agrees to give 30 or Generally, the issuer agrees to give 30 or more days notice that the issue will be more days notice that the issue will be redeemed redeemed

Bond CharacteristicsBond Characteristics

Extendible BondsExtendible Bonds:: gives the investor an gives the investor an option to extend the maturity dateoption to extend the maturity date

Retractable BondsRetractable Bonds:: gives the investor an gives the investor an option to redeem the bond at par prior to option to redeem the bond at par prior to maturitymaturity

Issuers are able to sell bonds with these Issuers are able to sell bonds with these features at higher prices than straight features at higher prices than straight issues issues

When bond prices rise (yields fall):When bond prices rise (yields fall): they are attractive long-term investmentsthey are attractive long-term investments

When bond prices fall (yields rise):When bond prices fall (yields rise): they can trade as short-term debtthey can trade as short-term debt

Bond CharacteristicsBond Characteristics

Convertible BondsConvertible Bonds may be converted into may be converted into common shares at predetermined prices.common shares at predetermined prices.

This feature makes the issue more saleable and This feature makes the issue more saleable and lowers the interest rate that must be offeredlowers the interest rate that must be offered

Permits the holding of a two-way security:Permits the holding of a two-way security: The safety of a bondThe safety of a bond The capital gains potential of a shareThe capital gains potential of a share

If the common shares of the company are split, If the common shares of the company are split, the convertible debt provides the convertible debt provides protection against protection against dilutiondilution by adjusting the conversion privilege by adjusting the conversion privilege

Convertibles are normally callableConvertibles are normally callable

Bond CharacteristicsBond Characteristics

The market price of convertible debt The market price of convertible debt depends on the value of the underlying depends on the value of the underlying common stockcommon stock When the stock is selling well below the When the stock is selling well below the

conversion price, the convertible debt is conversion price, the convertible debt is more like straight debtmore like straight debt

When the stock approaches conversion When the stock approaches conversion price, a premium appearsprice, a premium appears

When the stock rises above the conversion When the stock rises above the conversion price, the debt will rise accordingly, and price, the debt will rise accordingly, and will then be will then be selling off the stockselling off the stock

Bond CharacteristicsBond CharacteristicsConvertible Bonds Convertible Bonds

(cont’d)(cont’d)

Asset-backed securitiesAsset-backed securities are are “securitized” assets“securitized” assets

E.g. E.g. mortgage-backed securitiesmortgage-backed securities IInvestors assume little default risk as nvestors assume little default risk as

most mortgages are guaranteed by a most mortgages are guaranteed by a federal government agencyfederal government agency

Asset-Backed SecuritiesAsset-Backed Securities

Represent an ownership interestRepresent an ownership interest Preferred stockPreferred stock

Preferred shareholders are paid after Preferred shareholders are paid after bondholders but before common bondholders but before common shareholdersshareholders

Dividend known, fixed in advanceDividend known, fixed in advance May be cumulative if dividend May be cumulative if dividend

omittedomitted

Equity SecuritiesEquity Securities

Income trustsIncome trusts Pay out a portion of cash flows Pay out a portion of cash flows

generated from underlying assetsgenerated from underlying assets E.g. royalty trusts and real estate E.g. royalty trusts and real estate

investment trusts (REITs)investment trusts (REITs) Common stockCommon stock

Common shareholders are residual Common shareholders are residual claimants on income and assetsclaimants on income and assets

Common shareholders can elect board of Common shareholders can elect board of directors and vote on important issuesdirectors and vote on important issues

Equity SecuritiesEquity Securities

Securities whose value is derived Securities whose value is derived from some underlying securityfrom some underlying security

Futures and options contracts are Futures and options contracts are standardized and performance is standardized and performance is guaranteed by a third partyguaranteed by a third party Risk management toolsRisk management tools

Warrants Warrants are options issued by are options issued by firmsfirms

Derivative SecuritiesDerivative Securities

Exchange-traded Exchange-traded optionsoptions are created are created by investors, not corporationsby investors, not corporations

Call (Put) Call (Put) gives the buyer the right gives the buyer the right but not the obligation to purchase but not the obligation to purchase (sell) a fixed quantity of shares at a a (sell) a fixed quantity of shares at a a fixed price before a certain datefixed price before a certain date

Options can be sold in the market at a Options can be sold in the market at a priceprice

Increases return possibilitiesIncreases return possibilities

OptionsOptions

Futures contractFutures contract:: A standardized A standardized agreement between a buyer and agreement between a buyer and seller to make future delivery of a seller to make future delivery of a fixed asset at a fixed pricefixed asset at a fixed price A “good faith deposit” called margin, A “good faith deposit” called margin,

is required of both the buyer and is required of both the buyer and seller to reduce default riskseller to reduce default risk

Used to hedge the risk of price Used to hedge the risk of price changeschanges

FuturesFutures

Interest income from debt Interest income from debt securities is taxable at the full securities is taxable at the full marginal ratemarginal rate

Dividends and capital gains afford Dividends and capital gains afford investors a tax breakinvestors a tax break Dividends received from Canadian Dividends received from Canadian

corporations are taxable for all corporations are taxable for all provinces except Quebecprovinces except Quebec

Capital gain: only 50% is taxableCapital gain: only 50% is taxable

Appendix 2-AAppendix 2-ATaxation of Investment Taxation of Investment

Income in CanadaIncome in Canada