Chapter 14Investment Alternatives and Trading
• Fixed-Income SecuritiesYou are a LENDER to the issuer of the security
Your return is a fixed amount of income over a fixed amount of time (interest payments on bonds)– Motivation for buying is INCOME
– All mature to a fixed amount
– Lenders have rights if borrower defaults
Chapter 14Investment Alternatives and Trading
• All fixed-income securities eventually mature for fixed amount
– The maturity amount is called the par value or face value
– This amount is fixed regardless of what the security sold for prior to maturity
Chapter 14Investment Alternatives and Trading
• Types of Fixed-Income SecuritiesMoney market instruments -- Mature within a
year
Bonds -- Mature anywhere from two to twenty years or even longer
Chapter 14Investment Alternatives and Trading
• Money Market Instruments– A discount security sold for less than its face
value– When security matures, lender receives full
face value– Lender’s return based on the difference
between the price paid and the face value– Little or no default risk
Chapter 14Investment Alternatives and Trading
• BondsA fixed-income security with maturity date
when issued greater than one year– Bonds are NOT discounted securities
– Most bonds pay regular, fixed amount of interest twice a year
– Interest is calculated as a percentage of the face value called the coupon rate (simple interest)
Chapter 14Investment Alternatives and Trading
• Bonds--Callable FeatureMost bonds are “callable”
– This means issuer can buy back the bonds from investors
– Bonds are re-purchased prior to maturity date and at pre-specified prices
– Likely to be recalled when interest rates are low or falling
Chapter 14Investment Alternatives and Trading
• Differences Between Bonds and Money Market InstrumentsLength of MaturityHow Returns Are EarnedCallable FeatureSafety (Ratings)
Chapter 14Investment Alternatives and Trading
• Treasury Notes and Bonds– Issued by the U.S. Treasury– Both have fixed coupon rates– Both have face values of $1,000 to $5,000• T-Notes have much shorter maturities
than T-Bonds• T-Bonds are callable starting five years
from date of maturity; T-Notes aren’t
Chapter 14Investment Alternatives and Trading
• Municipal BondsIssued by state and local governmental units:
Two types: General obligation• Backed by full faith and credit of issuing state
• General tax revenues can be used to pay bondholders
Chapter 14Investment Alternatives and Trading
• Municipal Bonds Revenue• Issued to pay for a project like a new road
• Only revenues generated from the project are used to repay bondholder
Tax status– Exempt from federal income tax – NOT exempt from state income tax
Chapter 14Investment Alternatives and Trading
• Bond RatingsRatings range from AAA (best) to D (in
default)
Bond with rating of B or above considered investment grade (fairly low risk of default)
Chapter 14Investment Alternatives and Trading
• Corporate BondsIssued by U.S. and foreign corporations to • Finance expansions
• Finance acquisitionsInterest is subject to federal, state taxes
Chapter 14Investment Alternatives and Trading
• Bond PricingDepending on the interest rate used to
discount future cash payments, a bond may sell for • Face value
• Less than face value
The interest rate used is called the bond’s “yield to maturity”
Chapter 14Investment Alternatives and Trading
• Stock Investing– People invest in stock• In the hope that the price of the stock will
increase with company profit growth
• For the quarterly cash payments (dividends) which they may receive
– Return on stock based on both price appreciation and income (dividends)
Chapter 14Investment Alternatives and Trading
• Types of Stocks– Blue Chip– Income– Growth– Speculative– Cyclical– Defensive
Chapter 14Investment Alternatives and Trading
• Valuing Common StockTwo common questions which investors ask:How much am I willing to pay for this stock?At what price should I sell?
Chapter 14Investment Alternatives and Trading
• Criteria in Valuing Common StockCurrent level of earningsCurrent level of dividendsExpected growth rate of earnings and
dividendsUncertainty about the growth rate in
earnings and dividendsLevel of interest rates
Chapter 14Investment Alternatives and Trading
• Finding Information About StocksInvestor advisory services (like Standard & Poor’s)
given in-depth analysis of stock.
Their reports cover:
• Summary of company’s business
• Financial performance (for prior 5-10 yrs.)
• Prospects for the future (general business forecasts)
• Assessment of the stock
Chapter 14Investment Alternatives and Trading
• Measures of Financial StrengthReturn on EquityEarnings per SharePrice/Earnings RatioBeta
Chapter 14Investment Alternatives and Trading
• Real Estate– Home ownership may not be as good an
investment as it has been in the past– Returns from real estate have lagged behind
stocks and bonds on occasion (not this year)
Chapter 14Investment Alternatives and Trading
• Exotic Investments: OptionsGives owner the right to buy or sell stock at
a fixed price over a fixed period of timeDepending on what happens to stock, an
option can go up or down in valueInvestor does NOT have to exercise the
option, but will still be charged a fee
Chapter 14Investment Alternatives and Trading
• Options Example– If investor owns option to purchase a certain
stock at $40/share:
• Option is VALUABLE if the price rises to $55/share
• Option has LITTLE VALUE if price falls to $35/share
Chapter 14Investment Alternatives and Trading
• Exotic Investments: Futures– A real contract between two parties that
calls for future delivery of some asset at a set price
– Contracts can be on: • Agricultural commodities• Precious metals • Petroleum products• Currencies
Chapter 14Investment Alternatives and Trading
• Exotic Investments: Real assets and collectibles– Includes gold, silver, diamonds, great works
of art– All of returns come from price appreciation– Considerably more risky than investing in
stocks, bonds, or real estate
Chapter 14Investment Alternatives and Trading
• Characteristics of Efficient MarketsSufficient information determining
underlying supply and demand• Is available to all participants
• Is available at about the same time
Trading takes place in full view of all market participants
Chapter 14Investment Alternatives and Trading
• Characteristics of Efficient MarketsOne can buy or sell • At a price close to that of the most recent, similar
trade, assuming there is no new information
Transactions costs as a percentage of the security being bought or sold are low
Chapter 14Investment Alternatives and Trading
• Characteristics of Efficient MarketsAll participants have equal access to market
• No investor can execute buy or sell orders faster than any other investor (No Arbitrage Opport.)
Prices adjust quickly to new public information.
• This information is available
– To all participants
– At about the same time
Chapter 14Investment Alternatives and Trading
• Types of Financial Markets Primary market
• A market where investors buy newly issued securities
• The issuer ( perhaps a corporation) receives the proceeds from the security sale
– Example: Someone buys a T-bill from the U.S. Treasury or Shares of a Corporation in an IPO from the company.
Chapter 14Investment Alternatives and Trading
• Types of Financial Markets Secondary financial market• A market where trading between investors
involves previously issued securities
• The original issuer is not directly affected by these transactions– Example: The New York Stock Exchange
Chapter 14Investment Alternatives and Trading
• New York Stock ExchangeThe oldest stock market in the U.S.
More than 2,500 stocks traded
• Represent most of the largest, best-known corporations in America
Stocks traded have a total market value over $5 trillion
Companies must apply for listing to trade on NYSE
Chapter 14Investment Alternatives and Trading
• The NASDAQ Stock MarketLargest, best-organized over-the-counter
market for stocks in the U.S.More than 5,000 stock issues trade on this
marketCompanies tend to be smaller and less well-
known than those in the NYSE
Chapter 14Investment Alternatives and Trading
• The NASDAQ Stock Market– Trading takes place through the network;
Buyers and sellers never see each other– Buy and sell orders executed electronically– Maintains at least two market makers• Similar to specialists in NYSE• Buy and sell from their inventories to maintain
orderly market
Chapter 14Investment Alternatives and Trading
• Selecting a Brokerage Firm– You must determine if you want a • Full-service firm
• Discount firm
Chapter 14Investment Alternatives and Trading
• Full-Service FirmsOffer investment advice and
recommendations
Have access to reports written by analysts within the firm
Have lists of recommended securities
Assign specific brokers who are paid on commission to each client
Chapter 14Investment Alternatives and Trading
• Discount FirmsProvide mainly execution order and record-
keeping servicesAlso provide investment information from
independent sources
Many brokers may deal with one client
Brokers work on salary instead of commission
Chapter 14Investment Alternatives and Trading
• Types of Orders: MarketThe most common type of orderInstructs broker to obtain the best possible
price for youHighest if you are sellingLowest if you are buying
Most market orders are filled within one to two minutes
Chapter 14Investment Alternatives and Trading
• Types of Orders: LimitEstablishes a limit to the price at which you
will buy or sell
A ceiling if you are buying A floor if you are selling
Can be valid for one day, one week, one month, or until it is canceled