investment alternatives

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INVESTMENT INVESTMENT ALTERNATIVES ALTERNATIVES

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Page 1: Investment Alternatives

INVESTMENTINVESTMENT ALTERNATIVES ALTERNATIVES

Page 2: Investment 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

Page 3: Investment Alternatives

• 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

Page 4: Investment Alternatives

• 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

Page 5: Investment Alternatives

• 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)

Page 6: Investment Alternatives

• 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)

Page 7: Investment Alternatives

• 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

Page 8: Investment Alternatives

• 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

Page 9: Investment Alternatives

• 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

Page 10: Investment Alternatives

• 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

Page 11: Investment Alternatives

• 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

Page 12: Investment Alternatives

• 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

Page 13: Investment Alternatives

• 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

Page 14: Investment Alternatives

• 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

Page 15: Investment Alternatives

• 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

Page 16: Investment Alternatives

• 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

Page 17: Investment Alternatives

• 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)

Page 18: Investment Alternatives

• 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

Page 19: Investment Alternatives

• 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

Page 20: Investment Alternatives

• 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

Page 21: Investment Alternatives

• 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

Page 22: Investment Alternatives

• 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

Page 23: Investment Alternatives

• 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