Investments: Analysis and Management, Second Canadian Edition

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Investments: Analysis and Management, Second Canadian Edition Powered By Docstoc
					     Chapter 2
            Learning Objectives
   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.
Non-Marketable Financial Assets

   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
      Money Market Securities
   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
   Issued by governments and private firms
          Treasury Bills (T-bills)
   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:
     Due to government backing, there is a very low risk
      of default
     Widely distributed and actively traded – high
     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
           Commercial Paper
   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
   Eurodollars:
     Dollar-denominated deposits held in foreign
      banks or in offices of Canadian banks located
     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
        Repurchase Agreements
   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
         Bankers Acceptances
   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
         Fixed-Income Securities
   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 Securities
   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 Securities
   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
           Bond Characteristics
   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 Characteristics
   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
   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 Characteristics
   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 Characteristics
        Convertible Bonds (cont’d)
   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
           Asset-Backed Securities

   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
           Equity Securities

   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 Securities
   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
            Derivative Securities
   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

   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
   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
                 Appendix 2-A
    Taxation of Investment Income in
   Interest income from debt securities is taxable
    at the full marginal rate
   Dividends and capital gains afford investors a
    tax break
     Dividends received from Canadian corporations
      are taxable for all provinces except Quebec
     Capital gain: only 50% is taxable

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