MODULE 2(IM)MODULE 2(IM)• Capital Market Securities• Types,• Valuation Of Securities• Investment Risk- Systematic Risk

And Unsystematic Risk• Measurement Of Risk And Return • Derivatives- Options And Futures • Option Pricing.

Types of Capital Market Types of Capital Market Securities (CMS)Securities (CMS)

CMS

Bonds/Debentures Shares

Equity Shares/Common Stock

Preference Share

BondsBonds• A long-term debt instrument (a legal

contract) in which a borrower agrees to make payments of principal and interest, on specific dates, to the holders of the bond.

• A bond is a negotiable security by a corporation, government, or government agency.

• Bonds are loans from the bondholder (buyer) to the issuer (seller). A bond is a promise by the issuer to pay back the amount loaned to it (called principal) plus an agreed amount of interest on or before a stated date.

• The interest may be paid periodically during the life of the loan or all at once when the loan is paid back.

• Bonds are also called fixed income instruments, because the amount of income that the bond will generate is fixed by the stated interest rate of the bond.

• The date when the loan becomes due is called the maturity date of the bond.

• This market trades in the debt instruments issued by governments, government agencies, such as municipalities, and corporations. The bond market usually attracts more interest from professional and institutional investors than from the general public.

• Institutional investors include pension funds, insurance companies, bank trust departments and collective investment schemes.

TypesTypes• Convertible and Non Convertible bonds• Sinking Fund Bonds• Serial Bonds• Mortgage or Secured Bonds• Collateral Trust Bonds• Income Bonds• Adjustment Bonds• Assumed Bonds• Joint Bonds• Guaranteed Bonds• Redeemable and Irredeemable Bonds• Participating Bonds

Bearer and Registered Bearer and Registered BondsBonds

• Bonds are also identified by the way they are owned. Bearer bonds, for example,• belong to the person who holds them and ownership is not otherwise recorded.• Eurobonds are issued in this format. While this form of ownership carries the risk of• loosing the certificate, it offers the highest degree of anonymity and that is why in

some• countries, the United States for example, they are no longer allowed.• The other common type of format is a fully registered bond, either in certificate form

or in• book entry. The owner’s name is recorded with a transfer agent and interest

payments• are made either by check or electronic credit. The book entry method, where no• certificate is issued and ownership is merely recorded in a ledger, is growing in• popularity because it reduces transfer costs, simplifies handling, and decreases the• probability of loosing the certificate or having it stolen.

• The reason a bond is called a debt instrument is because there are no ownership rights

• in a bond. The promise to pay is what distinguishes bonds from stocks. The holder of a

• bond is a creditor, the holder or a stock is an owner. Although the holders of corporate

• bonds lack voting rights and have no participation in net profits, they may demand full

• payment of their bonds even if it means forcing the company into bankruptcy. Owners of

• stock have no such claim. In the case of liquidation or bankruptcy of the issuer, the

• bondholders are paid before shareholders. Bondholders are said to have a superior

• claim on the assets of the issuer. They are superior creditors in the eyes of the law.

General Obligation and General Obligation and Revenue BondsRevenue Bonds

• General obligation bonds usually refer to government bonds and are backed by the full

• faith and credit of the taxing power (country, municipality, etc.) that issues them.

• Revenue bonds are payable only from some specific source of taxes (highways tolls,

• water bills, etc.) and are not subject to the general taxing power of the issuer.

Treasury/Government BondsTreasury/Government Bonds

• A country’s long term financing needs are met by issuing bonds that mature from• anywhere after one year up to essentially as long as a country wants and to which

the• public is willing to commit its money. Average lengths run to 20 or 30 years and are• called long-term bonds. These long-term bonds are watched closely by the market as• an indication of where long-term interest rates will be heading.• Long -term bonds may be subject to being called before they mature. Callable

means• that the issuer has the right to pay off the bond sooner than the maturity date. If a

bond• is subject to being called before it matures, both dates are mentioned in its listing.

Thus• a bond that pays 5% and matures in June 2010, but is callable after June of 2005 is• referred to as the 5% of June 2005-2010. Treasury’s usually issue split-date callable• bonds during periods of high interest rates in order to have the opportunity to pay

them• off sooner if interest rates drop. The government would then issue new bonds at a

lower• rate.

Treasury/Government NotesTreasury/Government Notes

• Notes usually have a maturity of from 2 to 10 years and are known as intermediate term

• investment instruments. Notes are not callable before their maturity date. Notes usually

• pay interest semiannually.

Treasury/Government BillsTreasury/Government Bills

• T-bills, or bills, are the shortest term Treasury security and usually mature in 3, 6, 9 or 12

• months. T-bills carry no coupon rate of interest but are sold at a discount from par. Par

• is the face amount of the bond. This means that the price paid for a T-bill is less than its

• value at maturity. Thus a 12 month T-bill yielding 5% would be sold at a 5% discount

• from the face value of the bond.

Participating BondsParticipating Bonds

• These bonds not only bear a fixed rate of interest, but also have a profit-sharing feature.

• The bondholder is entitled to participate along with shareholders in earnings of the

• corporation to the extent described in the bond contract. These are used widely in

• Europe and are usually issued by weak companies as an added inducement to attract

• buyers.

Convertible BondsConvertible Bonds

• Usually all that the bondholder is promised is the principal and interest. There is an

• exception to this rule and it is called a convertible bond. This is a bond that at its

• maturity, or some other stated date, may be converted to a stated number of common

• shares in a corporation. A new corporation without much money or track record for

• paying off bonds or a corporation with a low credit rating might offer convertible bonds

• because the borrowing costs of straight bonds would be prohibitive. Convertible bonds

• rank below conventional bonds but ahead of any equity in their claim on the assets of a

• company.

Zero Coupon BondsZero Coupon Bonds• Zeros, as they are frequently referred to, are issued at a discount from their par

value.• Unlike a conventional bond, zeros pay no interest between issuance and redemption

but• only at maturity. Although the bondholder forfeits immediate income from the zero,

the• yield to maturity is computed on the assumption that the coupon interest is

reinvested at• the prevailing rate when received. Consequently, as interest rates fall the

reinvestment• is presumed to be at the lower rate, reducing the yield but increasing the price of the• bond. Likewise, if interest rates rise, the bond’s price will fall, but the coupons are• reinvested at the higher rate, raising the yield to maturity. With no cash flow from• coupon payments to act as a cushion, zero prices swing rapidly up and down in• response to even minor changes in the interest rate. In times of high interest rates,• zeros are very popular in order to lock in those high rates.

VALUATION OF SECURITIESVALUATION OF SECURITIES

VALUATION OF EQUITY SHARES

DIVIDEND CAPITALISATION METHODEARNING CAPITALISATION METHOD

SINGLEPERIOD

VALUATIONMETHOD

MULTI PERIOD

VALUATION METHOD

STABLEEARNING

SITUATION

EXPANSION SITUATION

DIVIDEND CAPITALISATION METHOD