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Chapter 4Chapter 4

Security TypesSecurity Types

• Classifying SecuritiesClassifying Securities• Interest-Bearing AssetsInterest-Bearing Assets• EquitiesEquities• DerivativesDerivatives• Option ContractsOption Contracts

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Security TypesSecurity Types Our goal in this chapter is to introduce the different Our goal in this chapter is to introduce the different types of securities that investors routinely buy and sell types of securities that investors routinely buy and sell in financial markets around the world.in financial markets around the world. For each security type, we will examine:For each security type, we will examine:

Its distinguishing characteristics,Its distinguishing characteristics, Its potential gains and losses, andIts potential gains and losses, and How its prices are quoted in the financial press.How its prices are quoted in the financial press.

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Classifying SecuritiesClassifying Securities

Basic Types Major Subtypes

Interest-bearing Money market instruments

Fixed-income securities

Equities Common stock Preferred stock

Derivatives Options Futures

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Interest-Bearing AssetsInterest-Bearing AssetsMoney market instrumentsMoney market instruments are short-term debt are short-term debt obligations of large corporations and governments.obligations of large corporations and governments.

These securities promise to make one future payment.These securities promise to make one future payment. When they are issued, their When they are issued, their lives arelives are less than one yearless than one year..

ExamplesExamples: Treasury bills (T-bills), bank certificates of deposit (CDs), corporate and municipal money market instruments.

Potential gains/lossesPotential gains/losses: A known future payment/except when the borrower defaults (i.e., does not pay).

Price quotationsPrice quotations: Usually, the instruments are sold on a discount discount basisbasis, and only the interest rates are quoted. Therefore, investors must be able to calculate prices from the quoted rates.

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Interest Bearing SecuritiesInterest Bearing Securities

Fixed-income securitiesFixed-income securities are longer-term debt obligations of are longer-term debt obligations of corporations or governments.corporations or governments. These securities promise to make fixed payments according to These securities promise to make fixed payments according to

a pre-set schedule.a pre-set schedule. When they are issued, their When they are issued, their lives exceed one yearlives exceed one year..

Examples: Examples: Treasury notes, corporate bonds, car loans, student Treasury notes, corporate bonds, car loans, student loans.loans.

Potential gains/lossesPotential gains/losses:: Fixed coupon payments and final payment at maturity, except Fixed coupon payments and final payment at maturity, except

when the borrower defaults. when the borrower defaults. Possibility of gain (loss) from fall (rise) in interest ratesPossibility of gain (loss) from fall (rise) in interest rates Depending on the debt issue, illiquidity can be a problem. Depending on the debt issue, illiquidity can be a problem.

(Illiquidity means it is possible that you cannot sell these (Illiquidity means it is possible that you cannot sell these securities quickly.)securities quickly.)

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Quote Example: Fixed-Income SecuritiesQuote Example: Fixed-Income Securities

Price quotations:Price quotations:

NEW YORK BONDS Corporation Bonds CUR NET

BONDS YLD. VOL CLOSE CHG.ATT 61/213 6.6 153 97.75 -0.13

ATT 81/822 8.1 651 100.88 +0.25

ATT 81/824 8.0 316 101 -1.50

AT&T, the issuer of the bond.The bond will mature in

the year 2022.

The annual coupon rate. You will receive 8 1/8% of the bond’s face value each year in 2 semi-annual coupon payments.

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Quote Example: Fixed-Income SecuritiesQuote Example: Fixed-Income Securities

Price quotations:Price quotations:

NEW YORK BONDS Corporation Bonds CUR NET

BONDS YLD. VOL CLOSE CHG.ATT 61/213 6.6 153 97.75 -0.13

ATT 81/822 8.1 651 100.88 +0.25

ATT 81/824 8.0 316 101 -1.50

Current Yield = Annual Coupon / Current Price

The number of bonds traded that day.

The closing price for the day is 100.875% of face value.

The closing price is up by 0.25 of one percent from the previous day.

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EquitiesEquities Common stockCommon stock:: Represents ownership in a Represents ownership in a corporation. A part owner receives a pro rated share of corporation. A part owner receives a pro rated share of whatever is left over after all obligations have been met in whatever is left over after all obligations have been met in the event of a liquidation.the event of a liquidation. ExamplesExamples: RIM shares, Royal Bank shares, Magna shares , etc. Potential gains/lossesPotential 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.

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Common Stock Price QuotesCommon Stock Price Quotes

Figure 4.2

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EquitiesEquities Preferred stockPreferred stock:: The dividend is usually fixed and The dividend is usually fixed and must be paid before any dividends for the common must be paid before any dividends for the common shareholders. In the event of a liquidation, preferred shares shareholders. In the event of a liquidation, preferred shares have a particular face value.have a particular face value.ExampleExample: Citigroup preferred stock. Potential gains/lossesPotential 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.

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DerivativesDerivatives Primary asset:Primary asset: Security originally sold by a business or Security originally sold by a business or government to raise money.government to raise money. Derivative assetDerivative asset:: A financial asset that is A financial asset that is derivedderived from from an existing traded asset, rather than issued by a business an existing traded asset, rather than issued by a business or government to raise capital. More generally, any or government to raise capital. More generally, any financial asset that is not a primary asset.financial asset that is not a primary asset. Futures contractFutures contract:: An agreement made today regarding An agreement made today regarding the terms of a trade that will take place later.the terms of a trade that will take place later. Option contractOption contract:: An agreement that gives the owner An agreement that gives the owner the right, but not the obligation, to buy or sell a specific the right, but not the obligation, to buy or sell a specific asset at a specified price for a set period of time.asset at a specified price for a set period of time.

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Futures ContractsFutures Contracts

ExamplesExamples:: financial futures (i.e., S&P/TSX 60, S&P 500, T- financial futures (i.e., S&P/TSX 60, S&P 500, T-bonds, foreign currencies, and others), commodity futures (i.e., bonds, foreign currencies, and others), commodity futures (i.e., wheat, crude oil, cattle, and others).wheat, crude oil, cattle, and others).

Potential gains/lossesPotential gains/losses:: At maturity, you gain if your contracted price is better than the At maturity, you gain if your contracted price is better than the

market price of the underlying asset, and vice versa.market price of the underlying asset, and vice versa. If you sell your contract before its maturity, you may gain or lose If you sell your contract before its maturity, you may gain or lose

depending on the market price for the contract.depending on the market price for the contract. Note that enormous gains and losses are possible.Note that enormous gains and losses are possible.

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Futures Contracts: Price QuotesFutures Contracts: Price QuotesFigure 4.3

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Option ContractsOption Contracts

A A call optioncall option gives the owner the right, but not the obligation, to gives the owner the right, but not the obligation, to buybuy an asset, while a an asset, while a put optionput option gives the owner the right, but gives the owner the right, but not the obligation, to not the obligation, to sell sell an asset.an asset.

The price you pay today to buy an option is called the The price you pay today to buy an option is called the option option premiumpremium..

The specified price at which the underlying asset can be bought The specified price at which the underlying asset can be bought or sold is called the or sold is called the strike pricestrike price, or , or exercise priceexercise price..

An An American optionAmerican option can be exercised can be exercised anytimeanytime up to and up to and including the expiration date, while a including the expiration date, while a European optionEuropean option can be can be exercised only on the exercised only on the expirationexpiration date.date.

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Option ContractsOption Contracts Options differ from futures in two main ways:Options differ from futures in two main ways:

Holders of call options have no obligation to buy the underlying asset.Holders of call options have no obligation to buy the underlying asset. Holders of put options have no obligation to sell the underlying asset.Holders of put options have no obligation to sell the underlying asset. To avoid this obligation, buyers of calls and puts must pay a price To avoid this obligation, buyers of calls and puts must pay a price

today. Holders of futures contracts do not pay for the contract today. today. Holders of futures contracts do not pay for the contract today.

Potential gains and losses:Potential gains and losses: Buyers of options profit if the strike price is better than the market price, Buyers of options profit if the strike price is better than the market price,

and if the difference is greater than the option premium. In the worst and if the difference is greater than the option premium. In the worst case, buyers lose the entire premium.case, buyers lose the entire premium.

Sellers of options gain the premium if the market price is better than Sellers of options gain the premium if the market price is better than strike price. Here, the gain is limited but the loss is not.strike price. Here, the gain is limited but the loss is not.

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Option Contracts: Price QuotesOption Contracts: Price QuotesFigure 4.4

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Investing in Stocks versus Options, I.Investing in Stocks versus Options, I.

StocksStocks::Suppose you have $10,000 for investments. Macron Suppose you have $10,000 for investments. Macron

Technology is selling at $50 per share. Technology is selling at $50 per share.

Number of shares bought = $10,000 / $50 = 200Number of shares bought = $10,000 / $50 = 200

• If Macron is selling for $55 per share 3 months later, If Macron is selling for $55 per share 3 months later, gain = ($55 gain = ($55 200) - $10,000 = 200) - $10,000 = $1,000$1,000

• If Macron is selling for $45 per share 3 months later, If Macron is selling for $45 per share 3 months later, gain = ($45 gain = ($45 200) - $10,000 = 200) - $10,000 = -$1,000-$1,000

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Investing in Stocks versus Options, II.Investing in Stocks versus Options, II.

Options:Options:A call option with a $50 strike price and 3 months to A call option with a $50 strike price and 3 months to

maturity is also available at a premium of $4.maturity is also available at a premium of $4.

• A call contract costs $4 A call contract costs $4 100 = $400, so number of 100 = $400, so number of contracts bought = $10,000 / $400 = 25 (for 25 contracts bought = $10,000 / $400 = 25 (for 25 100 = 100 = 2500 shares)2500 shares)

• If Macron is selling for $55 per share 3 months later, If Macron is selling for $55 per share 3 months later, gain = {($55 gain = {($55 –– $50) $50) 2500} - $10,000 = 2500} - $10,000 = $2,500$2,500

• If Macron is selling for $45 per share 3 months later, If Macron is selling for $45 per share 3 months later, gain = ($0 gain = ($0 2500) 2500) –– $10,000 = $10,000 = -$10,000-$10,000

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Useful Internet SitesUseful Internet Sites www.investinginbonds.com (reference for bond basics)www.investinginbonds.com (reference for bond basics) www.fool.com (reference to see whether you are a “Foolish www.fool.com (reference to see whether you are a “Foolish

investor.”)investor.”) www.stocktickercompany.com (reference for reproduction www.stocktickercompany.com (reference for reproduction

stock tickers.)stock tickers.) www.cnbc.com (reference for CNBC TV)www.cnbc.com (reference for CNBC TV) www.cbot.com (Chicago Board of Trade)www.cbot.com (Chicago Board of Trade) www.m-x.ca (Montreal Exchange)www.m-x.ca (Montreal Exchange) www.cme.com (Chicago Mercantile Exchange)www.cme.com (Chicago Mercantile Exchange) www.nymex.com (New York Mercantile Exchange)www.nymex.com (New York Mercantile Exchange) www.cboe.com (Chicago Board Options Exchange)www.cboe.com (Chicago Board Options Exchange)