chapter 2 investment alter

8/3/2019 Chapter 2 Investment Alter

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Investment AlternativesInvestment Alternatives

Institute of Management SciencesInstitute of Management Sciences

University ofUniversity of BalochistanBalochistanQuettaQuetta

KHURAM IMSKHURAM IMS


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Organizing Financial AssetsOrganizing Financial Assets

ThisThis chapterchapter focusesfocuses onon thethe financialfinancial assetsassets.. FinancialFinancialassets,assets, asas discusseddiscussed earlier,earlier, areare financialfinancial claimsclaims onon thetheissuersissuers ofof thethe securitiessecurities.. TheseThese areare thethe claimsclaims whichwhich areare

negotiable,negotiable, oror saleable,saleable, inin variousvarious marketplacemarketplace..

ThereThere areare variousvarious investmentinvestment alternativesalternatives throughthrough directdirectinvestinginvesting toto indirectindirect investinginvesting.. However,However, thisthis chapterchapterconcentratesconcentrates onon investmentinvestment alternativesalternatives availableavailablethroughthrough directdirect investing,investing, whichwhich involvesinvolves securitiessecurities thatthatinvestorsinvestors notnot onlyonly buybuy andand sellsell themselves,themselves, primarilyprimarilycapitalcapital marketmarket securitiessecurities andand derivativesderivatives securities,securities, butbutalsoalso havehave directdirect controlcontrol overover..



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Direct Investing vs. IndirectDirect Investing vs. Indirect

InvestingInvestingDirectDirect InvestingInvesting isis thethe oneone wherewhere investorsinvestors buybuy andand sellsell

securitiessecurities themselvesthemselves typicallytypically throughthrough brokeragebrokerageaccountsaccounts..

InvestorsInvestors whowho investinvest directlydirectly inin financialfinancial markets,markets, eithereitherusingusing aa brokerbroker oror byby otherother means,means, havehave aa widewide varietyvarietyofof assetsassets fromfrom whichwhich toto choosechoose.. NonNon--marketablemarketable investmentinvestment opportunities,opportunities, suchsuch asas savingssavings

accountsaccounts atat differentdifferent financialfinancial institutionsinstitutions.. MarketableMarketable securitiessecurities whichwhich maymay bebe classifiedclassified inin oneone ofof threethree

categoriescategories:: thethe moneymoney marketmarket thethe capitalcapital marketmarket andand thethe derivativesderivatives marketmarket..



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Direct InvestingDirect Investing

TheThe moneymoney marketmarket securitiessecurities includesincludestreasurytreasury bills,bills, commercialcommercial paperspapers etcetc

TheThe capitalcapital marketmarket securitiessecurities cancan bebeclassifiesclassifies eithereither fixedfixed--incomeincome oror equityequitysecuritiessecurities..

Finally,Finally, investorsinvestors maymay choosechoose toto useusederivativederivative securitiessecurities inin theirtheir portfoliosportfolios..



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Major Types of Financial AssetsMajor Types of Financial Assets

NonNon--MarketableMarketable Saving depositsSaving deposits Certificates of depositsCertificates of deposits

Money market deposit accountsMoney market deposit accounts U.S. saving bondsU.S. saving bonds

Money MarketMoney Market Treasury billsTreasury bills Negotiable certificates of depositsNegotiable certificates of deposits Commercial paperCommercial paper

EurodollarsEurodollars Repurchase agreementRepurchase agreement Bankers acceptanceBankers acceptance



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Capital MarketCapital Market Fixed incomeFixed income

TreasuriesTreasuries

AgenciesAgencies MunicipalsMunicipals

CorporatesCorporates

EquitiesEquities

Preferred StockPreferred Stock

Common StockCommon Stock

Derivatives MarketDerivatives Market OptionsOptions

Future ContractsFuture Contracts



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NonNon--Marketable FinancialMarketable Financial

AssetsAssets SavingSaving AccountsAccounts:: SavingSaving accountsaccounts areare heldheld atat

commercialcommercial institutionsinstitutions oror atat thriftthrift institutionsinstitutions suchsuch asassavingsaving andand loanloan associationsassociations andand creditcredit unionsunions..

NonNon--negotiablenegotiable certificatedcertificated ofof depositdeposit:: CommercialCommercialbanksbanks andand otherother institutionsinstitutions offeroffer aa varietyvariety ofof savingssavingscertificatescertificates knownknown asas certificatescertificates ofof depositdeposit (CDs)(CDs).. TheseThesecertificatescertificates areare availableavailable forfor variousvarious maturities,maturities, withwithhigherhigher ratesrates offeredoffered asas maturitymaturity increasesincreases (Large(Largedepositsdeposits maymay alsoalso commandcommand higherhigher rates,rates, holdingholdingmaturitiesmaturities constant)constant).. InstitutionsInstitutions areare freefree toto setset theirtheirownown ratesrates andand termsterms onon mostmost CDsCDs..



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MoneyMoney MarketMarket DepositDeposit AccountsAccounts (MMDAs)(MMDAs)::FinancialFinancial institutionsinstitutions offeroffer moneymoney marketmarket depositdeposit

accountsaccounts (MMDAs)(MMDAs) withwith nono interestinterest raterate ceilingsceilings..MoneyMoney marketmarket investment investment accounts,accounts, withwith aarequiredrequired minimumminimum depositdeposit toto open,open, paypaycompetitivecompetitive moneymoney marketmarket ratesrates andand areare insuredinsured

upup toto $$ 100100,,000000 byby thethe FederalFederal DepositDepositInsuranceInsurance CorporationCorporation (FDIC),(FDIC), ifif thethe bankbank isisinsuredinsured..


AssetsAssets



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UU..SS.. GovernmentGovernment SavingsSavings BondsBonds:: TheThenonnon--tradedtraded debtdebt ofof thethe UU..SS.. governmentgovernment

savingssavings bonds,bonds, areare nonnon--marketable,marketable, nonnon--transferable,transferable, andand nonnon--negotiable,negotiable, andandcannotcannot bebe usedused forfor collateralcollateral.. TheyThey

purchasedpurchased fromfrom thethe Treasury,Treasury, mostmost ofterofterthroughthrough banksbanks andand savingssavings institutionsinstitutions..


AssetsAssets



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Money Market SecuritiesMoney Market Securities

MoneyMoney MarketMarket:: TheThe moneymoney marketsmarkets includesincludes shortshort--term,term, highlyhighly liquid,liquid, relativelyrelatively lowlow--riskrisk debtdebt instrumentsinstruments(such(such asas TreasuryTreasury billsbills andand negotiablenegotiable CDs)CDs) soldsold byby

governments,governments, financialfinancial institutionsinstitutions andand corporationscorporations totoinvestorsinvestors withwith temporarytemporary excessexcess fundsfunds toto investinvest..

ThisThis marketmarket isis dominateddominated byby financialfinancial institutionsinstitutionsparticularlyparticularly banksbanks andand governmentsgovernments..

TheThe sizesize ofof transactiontransaction inin thethe moneymoney marketmarket typicallytypically isislargelarge (($$ 100100,,000000 oror more)more)..

TheThe maturitiesmaturities ofof moneymoney marketmarket instrumentinstrument rangesranges fromfromoneone dayday toto oneone yearyear andand areare oftenoften lessless thanthan 9090 daysdays..



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TreasuryTreasury BillsBills:: TheThe premierpremier moneymoney marketmarketinstrument,instrument, fullyfully guaranteed,guaranteed, highlyhighly liquidliquid IOUIOU(Issuers(Issuers ContractualContractual Obligation)Obligation) fromfrom thethe UU..SS..

treasurytreasury.. TheyThey areare soldsold onon anan auctionauction basisbasis everyevery weekweek atat

aa discountdiscount fromfrom faceface valuevalue inin denominationsdenominations ofof$$1010,,000000 toto $$ 11 millionmillion.. Therefore,Therefore, thethe discountdiscountdeterminesdetermines thethe yieldyield..

TheThe greatergreater thethe discountdiscount atat timetime ofof purchase,purchase,thethe higherhigher thethe returnreturn earnedearned byby investorsinvestors..

TypicalTypical maturitiesmaturities areare 1313 andand 2626 weeksweeks..



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NegotiableNegotiable certificatecertificate ofof depositdeposit (CDs)(CDs):: TheseThese areare issuedissued ininexchangeexchange forfor aa depositdeposit ofof fundsfunds byby mostmost AmericanAmerican banksbanks..

TheThe CDCD isis aa marketablemarketable depositdeposit liabilityliability ofof thethe issuer,issuer, whowho usuallyusuallystandsstands readyready toto sellsell newnew CDsCDs onon demanddemand..

TheThe depositdeposit isis maintainedmaintained inin thethe bankbank untiluntil maturity,maturity, atat whichwhich timetimethethe holderholder receivesreceives thethe depositdeposit plusplus interestinterest..

However,However, thesethese CDsCDs areare negotiable,negotiable, meaningmeaning thatthat theythey cancan bebe soldsoldinin thethe openopen marketmarket beforebefore maturitymaturity..

DealersDealers makesmakes aa marketmarket inin thesethese unmaturedunmatured CDsCDs..

MaturityMaturity typicallytypically rangerange fromfrom 1414 daysdays (the(the minimumminimum maturitymaturitypermitted)permitted) toto oneone yearyear.. TheThe minimumminimum depositdeposit isis $$100100,,000000..




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CommercialCommercial PaperPaper:: AA shortshort--term,term, unsecuredunsecuredpromissorypromissory notenote issuedissued byby large,large, wellwell knownknown andand

financiallyfinancially strongstrong corporationscorporations (including(including financefinancecompanies)companies)..

DenominationsDenominations startstart atat $$ 100100,,000000 withwith aamaturitymaturity ofof 270270 daysdays oror lessless..

CommercialCommercial paperpaper isis usuallyusually soldsold atat discountdiscounteithereither directlydirectly toto byby thethe issuerissuer oror indirectlyindirectlythroughthrough aa dealerdealer..




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EurodollarsEurodollars:: DollarDollar--denominateddenominated depositsdeposits heldheld ininforeignforeign banksbanks oror inin officeoffice ofof UU..SS.. banksbanks locatedlocatedabroadabroad..

Although Although thisthis marketmarket originallyoriginally developeddeveloped ininEurope,Europe, dollardollar--denominateddenominated depositsdeposits cancan nownow bebemademade inin maymay countries,countries, suchsuch asas thosethose ofof AsiaAsia..

EurodollarEurodollar depositsdeposits consistsconsists ofof bothboth timetime

depositsdeposits andand CD

s,CD

s, withwith thethe latterlatter constitutingconstituting thethelargestlargest componentcomponent ofof thethe EurodollarEurodollar marketmarket.. MaturitiesMaturities areare mostlymostly shortshort term,term, oftenoften lessless thanthan

sixsix monthsmonths..




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RepurchaseRepurchase agreementagreement (RPs)(RPs):: An An agreementagreementbetweenbetween aa borrowerborrower andand aa lenderlender (typically(typically institutions)institutions)toto sellsell andand repurchaserepurchase UU..SS.. governmentgovernment securitiessecurities..

TheThe borrowerborrower initiatesinitiates anan RPRP byby contractingcontracting toto sellsellsecuritiessecurities toto aa lenderlender andand agreeingagreeing toto repurchaserepurchase thesethesesecuritiessecurities atat aa prespecifiedprespecified priceprice onon aa statedstated datedate..

TheThe maturitymaturity ofof RPsRPs isis generallygenerally veryvery short,short, fromfrom threethreetoto 1414 daysdays andand sometimessometimes overnightovernight..

TheThe minimumminimum denominationdenomination isis typicallytypically $$ 100100,,000000..




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BankersBankers AcceptanceAcceptance:: AA timetime draftdraft drawndrawn onon aa bankbankbyby aa customer,customer, wherebywhereby thethe bankbank agreesagrees toto paypay aaparticularparticular amountamount atat aa specifiedspecified futurefuture datadata..

BankersBankers acceptanceacceptance areare negotiablenegotiable instrumentsinstruments becausebecausethethe holderholder cancan sellsell themthem forfor lessless thanthan faceface valuevalue (i(i..ee..discountdiscount them)them) inin thethe moneymoney marketmarket..

BankersBankers acceptanceacceptance areare tradedtraded onon discountdiscount basis,basis, withwithminimumminimum denomiationsdenomiations ofof $$ 100100,,000000.. MaturitiesMaturities typicallytypically rangerange fromfrom 3030 toto 180180 days,days, withwith 9090

daysdays beingbeing thethe mostmost commoncommon..




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FixedFixed--Income SecuritiesIncome Securities

CapitalCapital MarketMarket:: TheThe marketmarket forfor longlong--termterm securitiessecuritiessuchsuch asas bondsbonds andand stocksstocks..

CapitalCapital marketmarket encompassencompass fixedfixed--incomeincome andand equityequitysecuritiessecurities withwith maturitiesmaturities greatergreater thanthan oneone yearyear..

RiskRisk isis generallygenerally muchmuch higherhigher thanthan inin thethe moneymoney marketmarketbecausebecause ofof thethe timetime toto maturitymaturity andand thethe veryvery naturenature ofof

thethe securitiessecurities soldsold inin thethe capitalcapital marketsmarkets..

TheThe capitalcapital marketmarket includesincludes bothboth debtdebt andand equityequitysecurities,securities, withwith equityequity securitiessecurities havinghaving nono maturitymaturity datedate..



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FixedFixed--Income SecuritiesIncome Securities

FixedFixed--incomeincome securitiessecurities:: TheseThese areare thethesecuritiessecurities withwith specifiedspecified paymentpayment datedate andand

amountsamounts primarilyprimarily bondsbonds.. BondsBonds areare longlong--termterm debtdebt instrumentsinstruments

representingrepresenting thethe issuersissuers contractualcontractual

obligationobligation oror IOUIOU..



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Equity SecuritiesEquity Securities

PreferredPreferred StockStock:: AnAn equityequity securitysecurity withwithanan intermediateintermediate claimclaim (between(between thethe

bondholderbondholder andand thethe stockholder)stockholder) onon aafirmsfirms assetsassets andand earningsearnings..

CommonCommon StockStock:: An An equityequity securitysecurityrepresentingrepresenting thethe ownershipownership interestinterest inin aacorporationcorporation..



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Derivative SecuritiesDerivative Securities

DerivativeDerivative securitiessecurities:: areare thethe securitiessecuritiesthatthat derivederive theirtheir valuevalue inin wholewhole oror inin partpart

byby havinghaving aa claimclaim onon somesome underlyingunderlyingsecuritysecurity..

AA financialfinancial securitysecurity suchsuch asas anan optionoption oror

futurefuture whosewhose valuevalue isis derivedderived inin partpart fromfromthethe valuevalue andand characteristicscharacteristics ofof anotheranothersecurity,security, thethe underlyingunderlying assetasset..



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FutureFuture ContractContract:: FuturesFutures involveinvolve aafinancialfinancial contractcontract thatthat requiresrequires thethe buyerbuyer

toto purchasepurchase anan assetasset (or(or thethe sellerseller toto sellsellanan asset),asset), suchsuch asas aa physicalphysical commoditycommodityoror aa financialfinancial instrument,instrument, atat aa specificspecific

priceprice onon aa predeterminedpredetermined datedate inin thethefuturefuture..



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OptionOption: A contract in which the writer (seller): A contract in which the writer (seller)promises that the contract buyer has the right,promises that the contract buyer has the right,but not the obligation, to buy or sell a certainbut not the obligation, to buy or sell a certain

security at a certain price (the strike price) on orsecurity at a certain price (the strike price) on orbefore a certain expiration date, or exercisebefore a certain expiration date, or exercisedate. The asset in the contract is referred to asdate. The asset in the contract is referred to asthe underlying asset, or simply the underlying.the underlying asset, or simply the underlying.

An option giving the buyer the right to buy at aAn option giving the buyer the right to buy at a

certain price is called a call, while one that givescertain price is called a call, while one that giveshim/her the right to sell is called a put.him/her the right to sell is called a put.



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TheThe primaryprimary differencedifference betweenbetween optionsoptionsandand futuresfutures isis thatthat optionsoptions givegive thethe holderholder

thethe right,right, notnot thethe obligation,obligation, toto buybuy oror sellsellthethe underlyingunderlying assetasset untiluntil expiration,expiration,whereaswhereas thethe holderholder ofof aa futuresfutures contractcontract isis

obligatedobligated toto fulfillfulfill thethe termsterms ofof thethecontractcontract..




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Indirect InvestingIndirect Investing

IndirectIndirect InvestingInvesting refersrefers toto thethe buyingbuying andandsellingselling ofof thethe sharesshares ofof investmentinvestment companies,companies,

which,which, inin turn,turn, holdhold portfoliosportfolios ofof securitiessecurities.. IndirectIndirect investinginvesting isis aa veryvery importantimportant alternativealternative

forfor allall investorsinvestors toto consider,consider, andand hashas becomebecometremendouslytremendously popularpopular inin thethe lastlast fewfew yearsyears withwith

individualindividual investorsinvestors..



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Indirect InvestigIndirect Investig

Investment CompaniesInvestment Companies Unit InvestmentTrustUnit InvestmentTrust

Open EndOpen End

Money market mutual fundMoney market mutual fund

Stock, bond and income fundsStock, bond and income funds

Closed endClosed end



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