ch 2 - investment alternatives

7/27/2019 Ch 2 - Investment Alternatives

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Chapter 2

Investment Alternatives


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3 Options for Household Savings with

regard to financial assets

1. Hold with the financial intermediaries such asbank, insurance companies, thrifts (??)

2. Direct Investing: Buying and Selling securities

directly with the help of broker or investmentbanks such shares, bonds

3. Indirect Investing: Hold securities indirectly

while leaving investment decisions to otherssuch a mutual funds or pension fund

[Exhibit 2.1 on page 22, P. Jones]


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Indirect Investing

In Indirect Investment, investors handed-over their

investment to third party; thus losing their direct

control of the securities.

There are three types of investment companies.1. Closed-End investment companies (Managed

Firm)

2. Mutual Funds (Managed Firm)3. Exchange-Traded Funds (ETFs) [Un-Managed

Firm]


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Direct Investing

Non-Marketable Investments

Marketable Investments

Money Market

Capital Market

Fixed-Income

Equity Securities

Derivatives Market


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Non-Marketable Securities

1. Savings Accounts

2. Non-Negotiable Certificates of deposit

3. Money market deposits accounts4. US saving bonds


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Savings Accounts savings accounts incommercial banks and thrift (savings and loaninstitutions and credit unions)

Non-Negotiable Certificates of deposit (CDs) commercial bank and other institutions offer avariety of savings certificates known ascertificate of deposit (CDs)

Rate is directly proportional to maturity of CDs.

It is a buy-and-hold certificate


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Money Market Securities (MMS)

The market for short-term, highly liquid, low-

risk assets such as treasury bills and

negotiable CDs.

The assets are sold by government, financial

institutions and corporations.

The maturities of money market instruments

range from 1 day to 1 year; usually 90 days


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Forms of MMS

Treasury Bills

Negotiable Certificate of Deposit (CDs)

Commercial Papers Repurchases Agreement (RPs)

Bankers Acceptance


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Forms of MMS....Treasury Bills

Short-term money market instrument sold at

discount and redeem at face value issued by the

Government

Sold at auction

Its a benchmark assets

Risk-Free financial asset (Rf)

Treasury Notes: 2-10 years maturity

Treasury Bonds: more than 10 years obligations


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Forms of MMS...Treasury Bills

Return (Investment yield) on T-Bills

Daysin

365

.

)Pr.(

MaturiyX

pricePurchase

icePurchasevalueFaceYield


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Forms of MMS

Commercial Paper its like T-Bills; however,

the issuer is a corporation not government

It is also an unsecured promissory note.

Negotiable Certificate of Deposit

The investor deposit money in a bank; in return,

the bank issued a certificate which is negotiable.

The holder of the CD will receive the depoisted

money alongwith interest.


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Forms of MMS

Repurchase Agreement ( RPs or Repo)

the short-term sell of government securities to

corporations with an intention to repurchase the

securities at higher price.

Interest rate is related with T-Bills mostly

Maturity runs from overnight to only a few day

How is different from T-Bills T-bills are only issued at discount; however, it is not in

the case of Repo.


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Forms of MMS

Bankers Acceptance

Short-term promissory note drawn on a bank by a

firm to assist in foreign or domestic trade.

Once it is accepted by a bank, it becomes BA

The drawer can negotiate the instrument in the

secondary market at discount price.

The bank is supposed to pay the amount onmaturity to the holder of the BA


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Example of BA

Importer (Pakistani Firm) and Exporter (England Firm) a deal

of Rs. 10,000

Both companies agree to settle the deal in 90 days draft

Pakistani firm get a letter of credit from HBL; so HBL will

honor the draft presented on behalf of Pakistani firm

England firm (drawer) order its bank (e.g., RBS) to draw a draft

of Rs. 10,000 on HBL

Once HBL (drawee) accepts it; it becomes BA

Now the england firm can trade the BA in secondary market if

it can not wait for 90 days.

On maturity, the holder (may be England firm or any other

party) will receive the money from HBL.


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Capital Market

The market for long-term securities.

Marketability is poor

Risk is higher due to long maturity time... Include both debt and equity securities...

Fixed-Income Securities

Equity Securities


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Fixed-Income Securities

The amount and date of each Payment is known in advance

Treasury bonds

Agency bonds

Municipal bonds

Corporate bonds

Asset-backed securities

Mortgage-related bonds

Non-Zero Coupon Bonds

Zero Coupon Bonds Callable Bonds

Debenture


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Bonds

Long-term debt instruments representing the issuers

contractual obligation

Fixed-Income security

As interest (coupon rate) and principle payment isspecified in advance

The buyer can sell the bonds before maturity; the

price depends upon interest rates at that time.. Default of the payment may lead to bankruptcy


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Characteristics

Face value

Usually have maturity date...

Have coupon the periodic interest paymentby the issuer to the holder of the bonds

May be issued at discounts or premium

Credit Rating plays an important role indeciding interest rate.


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Corporate Bonds

Long-term debt securities of various types

sold by corporations

Senior Securities: Debt securities have

preference over shares in case of payments or

in case of liquidation.

Debenture unsecured bonds; backed by the

issuers overall financial soundness


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Non-Zero Coupon Bonds

having finite maturity

In such bonds, the investor receives interest (I)

in the form of annuity and terminal value

(principal amount)


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The Zero Coupon Bond

A bond issued at discount and redeem at its

face value...

Having no interest (coupon) rate...

The difference between discount and

redeemable value is rate of return


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Callable Bonds

The issuer of the bond has the right to call the bond

and retire it by paying off the obligation...

The call option is attractive when the market

interest rate is lower then the coupon rate. Costs are incurred on callable bonds such as call

premium and administrativeexpenses.

Call premium is usually equals to one year interestrate if the bond is called within a year; after the first

year, it usually decline at constant rate.

Callable bonds can be re-issued at lower coupon rate

but non-refundable bonds can be re-issued.


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Treasury Securities

Like T-Bills

Treasury-Notes: 2-10 years maturity

Treasury-Bonds: more than 10 years maturity TIPS (Treasury Inflation-Indexed Securities)

protect the investors against the inflation

losses....TIPS pay a fixed rate of interest but

this rate is applied to the inflation-adjusted

principal.


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Federal Agency Securities

US government established federal agencies

to help certain sector either by providing

direct loans or guarantee of private loan.

The securities issued by federal credit

agencies (fully guaranteed) or by government

sponsored agencies (not guaranteed).

Mortgage-Backed Securities: securities whose

value depends on some set of mortgages.


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Municipal Securities

Securities issued by political entities other

than the federal government and its agencies

such as cities, states, counties.

1. General Obligation Bonds backed by full faith

and credit

2. Revenue Bonds which are repaid from the

revenues generated by the project in which thebonds are issued


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Junk Bond

High risky and high yield bond

Usually issued by the firm as a last option


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Equity Securities

Preferred Stock Hybrid security as it resembles both equity and fixed-income

securities

Like equity: having ownership position, infinite life and dividend

receipt.

Like debt: fixed amount of dividend is received.

Having intermediate claim between bondholders and equity

holders on a firms assets and earnings.

Having no voting power in annual general meeting usually

Having prior claim on the assets on liquidation

May be cumulative or non-comulative regarding dividend

payment

My be convertible preferred stock to common stock


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Equity Securities

Common Stock

Having voting power having control over

management

Having second/last claim on the assets and

earnings

Receive dividend (cash and stock)


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Derivatives

The securities that derive their values by

having claim on the some underlying

securities.


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Options

Rights to buy or sell a stated number of shares

of a security at a specified price; it may be:

Puts an option to sell a specified number...

Calls an option to buy a specified number...

Options only give a right to put and call; not

an obligation to sell (purchase) shares.


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Future Contracts

Agreement providing for the future exchange of a particular

assets at a currently determined market price.

The assets may be commodities (corn, wheat) or financial

assets (shares, bonds, T-Bills etc.)

The buyer pays the money upon delivery of assets by seller.

Used by both hedgers and speculators.

Hedgers purchase future contracts to reduce price

uncertainty; while

Speculators purchase future contracts to exploit the

uncertainty to earn profit.


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In Conclusion, Direct

Investment......


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Direct investing Non-Marketable Financial assets

Saving deposits

Certificate of deposit

Money market deposits accounts

US saving bondsMoney Market securities

T-bills

Negotiable certificates of deposits

Commercial papers Repurchase agreements

Bankers acceptance


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Direct investing

Capital market securities

A. Fixed income securities

Treasury or government bonds

Corporate bondsB. Equity securities

Preferred stock

Common stocks

Derivative Securitas Options

Futures

ch 2 - investment alternatives

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