Investment Alternatives
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Transcript of Investment Alternatives
INVESTMENTINVESTMENT ALTERNATIVES ALTERNATIVES
• Describe the major types of financial assets and how they are organized.
• Explain what non-marketable financial assets are.
• Describe the important features of money market and capital market securities.
• Distinguish among preferred stock, income trusts, and common stock.
• Understand the basics of options and futures.
Learning ObjectivesLearning Objectives
• Examples: Savings deposits, Canada Savings Bonds (CSBs), Guaranteed Investment Certificates (GICs)
• Commonly owned by individuals• Represent direct exchange of claims between
issuer and investor• Usually “safe” investments which are easy to
convert to cash without loss of value
Non-Marketable Financial AssetsNon-Marketable Financial Assets
• Examples: Treasury bills, commercial paper, Eurodollars, repurchase agreements, banker’s acceptances (B/As)
• Marketable: claims are negotiable or saleable in the marketplace
• Short-term, liquid, relatively low-risk debt instruments
• Issued by governments and private firms
Money Market SecuritiesMoney Market Securities
• Treasury Bills: Short-term promissory notes issued by
governments T-bills accounted for about one-half of all
outstanding money market securities. Sold at a discount from face value in
denominations of $5,000, $25,000, 100,000, and $1 million
Typical maturities are 91, 182, and 364 days although shorter maturities are also offered
Treasury Bills (T-bills)Treasury Bills (T-bills)
• Treasury Bills: Due to government backing, there is a very low
risk of default Widely distributed and actively traded – high
liquidity In subsequent chapters we will use government T-
bill rates as a measure of the “riskless rate” available to investors, commonly referred to as the risk-free rate
Treasury Bills (T-bills)Treasury Bills (T-bills)
• Commercial Paper: Short-term unsecured promissory notes
issued by large, well-known, and financially strong corporations (including finance companies)
Denominations start at $100,000 with maturities of 30 to 365 days, and it is sold either directly by the issuer or indirectly through a dealer, with rates slightly above T-bill rates.
Commercial PaperCommercial Paper
• Eurodollars: Dollar-denominated deposits held in foreign
banks or in offices of Canadian banks located abroad
Although this market originally developed in Europe, dollar-denominated deposits can now be made in many countries, such as those of Asia
Consist of both time deposits and certificates of deposit (CDs), with the latter constituting the largest component of the Eurodollar markets
Maturities are mostly short-term, often less than six months
EurodollarsEurodollars
• Repurchase Agreements (RPs): agreements between a borrower and lender
(typically institutions) to sell and repurchase money market securities
borrower initiates an RP by contracting to sell securities to a lender and agreeing to repurchase these securities at a pre-specified (higher) price on a stated future date
maturity is generally very short, from 3 to 14 days, and sometimes overnight
minimum denomination is typically $100,000
Repurchase AgreementsRepurchase Agreements
• Bankers Acceptances (B/As): Time drafts drawn on a bank by a customer,
whereby the bank agrees to guarantee payment of a particular amount at a specified future date
Differ from commercial paper because the associated payments are guaranteed by a bank, and thus possess the credit risk associated with that bank
Issued in minimum denominations of $100,000
Typical maturities range from 30 to 180 days, with 90 days being the most common
Bankers AcceptancesBankers Acceptances
• Marketable debt with maturity greater than one year
• More risky than money market securities• Fixed-income securities have a specified
payment schedule Dates and amount of interest and principal
payments known in advance
Fixed-Income SecuritiesFixed-Income Securities
• Bonds – long-term debt instruments• Major bond types:
Government of Canada bonds U.S. Treasury bonds Provincial bonds Provincially-guaranteed bonds – Ontario Hydro U.S. federal agency securities – GNMAs
(Ginnie Maes), FNMAs (Fannie Maes)
Fixed-Income SecuritiesFixed-Income Securities
• Major bond types (cont’d): Corporate bonds
• Usually pay semi-annual interest, are callable, carry a sinking fund provision, and have a par value of $1,000
• Convertible bonds may be exchanged for another asset
• Risk that issuer may default on payments
Fixed-Income SecuritiesFixed-Income Securities
• Callable bonds give the issuer the option to “call” or repurchase outstanding bonds at predetermined “call” prices (generally at a premium over par) at specified times
• This feature is detrimental to the bondholders who are willing to pay less for them (i.e., they demand a higher return) than for similar non-callable bonds.
• Generally, the issuer agrees to give 30 or more days notice that the issue will be redeemed
Bond CharacteristicsBond Characteristics
• Extendible Bonds: gives the investor an option to extend the maturity date
• Retractable Bonds: gives the investor an option to redeem the bond at par prior to maturity
• Issuers are able to sell bonds with these features at higher prices than straight issues
• When bond prices rise (yields fall): they are attractive long-term investments
• When bond prices fall (yields rise): they can trade as short-term debt
Bond CharacteristicsBond Characteristics
• Convertible Bonds may be converted into common shares at predetermined prices.
• This feature makes the issue more saleable and lowers the interest rate that must be offered
• Permits the holding of a two-way security: The safety of a bond The capital gains potential of a share
• If the common shares of the company are split, the convertible debt provides protection against dilution by adjusting the conversion privilege
• Convertibles are normally callable
Bond CharacteristicsBond Characteristics
• The market price of convertible debt depends on the value of the underlying common stock When the stock is selling well below the
conversion price, the convertible debt is more like straight debt
When the stock approaches conversion price, a premium appears
When the stock rises above the conversion price, the debt will rise accordingly, and will then be selling off the stock
Bond CharacteristicsBond CharacteristicsConvertible Bonds (cont’d)Convertible Bonds (cont’d)
• Asset-backed securities are “securitized” assets• E.g. mortgage-backed securities
Investors assume little default risk as most mortgages are guaranteed by a federal government agency
Asset-Backed SecuritiesAsset-Backed Securities
• Represent an ownership interest• Preferred stock
Preferred shareholders are paid after bondholders but before common shareholders
Dividend known, fixed in advance May be cumulative if dividend omitted
Equity SecuritiesEquity Securities
• Income trusts Pay out a portion of cash flows generated from
underlying assets E.g. royalty trusts and real estate investment
trusts (REITs)• Common stock
Common shareholders are residual claimants on income and assets
Common shareholders can elect board of directors and vote on important issues
Equity SecuritiesEquity Securities
• Securities whose value is derived from some underlying security
• Futures and options contracts are standardized and performance is guaranteed by a third party Risk management tools
• Warrants are options issued by firms
Derivative SecuritiesDerivative Securities
• Exchange-traded options are created by investors, not corporations
• Call (Put) gives the buyer the right but not the obligation to purchase (sell) a fixed quantity of shares at a a fixed price before a certain date
• Options can be sold in the market at a price• Increases return possibilities
OptionsOptions
• Futures contract: A standardized agreement between a buyer and seller to make future delivery of a fixed asset at a fixed price A “good faith deposit” called margin, is
required of both the buyer and seller to reduce default risk
Used to hedge the risk of price changes
FuturesFutures